While it is difficult to establish statistical evidence of causality, we believe that the USD and oil will likely remain negatively correlated, for various reasons. Oil prices, therefore, will remain an important – though not the only – consideration for the dollar. Specifically, lower and stable oil prices should be positive for the USD, while rising oil prices should be negative for the USD. The Oil-Dollar Link The circle of rising oil prices and a falling dollar was vicious. In contrast, the recent reversal of these trends is virtuous and, all else equal, positive for the world. Not only will lower oil prices help to support global demand, they should also permit greater monetary flexibility to deal with lower economic growth. (There are two aspects of the nexus between oil and the dollar: their correlation and the direction of causality. We have conducted Granger Causality tests, and found that, in practice, and for the most recent period (1992-2008), the dollar tends to lead oil, rather than the other way around.) Until around 2003, higher oil prices were correlated with a stronger dollar. This was primarily because petrodollars were not only recycled back in to the US through trade but also because of financial flows: the US was dominant in every way back then, in terms of the attractiveness of its exports and assets. However, since 2004, this correlation has evaporated, and since 2006, the correlation has turned intensely negative. There are several possible explanations for this negative correlation between oil prices and the dollar, especially the EUR/USD bilateral cross. We have, in previous work, touched on some of these reasons (see The USD and Oil Prices: Some Conceptual Issues, August 9, 2007). We list them here, paying particular attention to the direction of causality. There are primarily three channels through which oil prices could affect the dollar: • Link 1. Petrodollar recycling less dollar-friendly. The economic reliance of oil exporters on the US has declined over the years. Specifically, petrodollar owners now have a higher marginal propensity to consume European-made products than before. (Back in the 1970s, around 18% of OPEC’s imports were from the US. Now, this ratio has fallen to 9%, and OPEC sources 26% of its imports from the EU.) Also, they are likely to have a lower marginal propensity to invest in USD assets, simply because the array of assets in the world available to the petrodollar investors is now much wider than before. This is also related to the issue of reserve diversification by oil exporters. The establishment of the EMU has enhanced the liquidity of EUR-denominated assets, and intra-Eurozone divergence has preserved the diversification benefits of investing in EUR assets. Petrodollar owners have responded to these changing global financial markets. Thus, the higher the oil price, the more diversification takes place, and the weaker the dollar is. • Link 2. Different central bank responses to oil shocks. Investors have different opinions about how the Fed and the ECB may react to rising oil prices, one opinion being that the latter might act more aggressively than the former, because of their different mandates. Thus, higher oil prices tend to lead to general expectations of a more hawkish reaction from the ECB – an inflation targeter – than from the Fed, which has a ‘dual mandate’ on growth and inflation. In other words, rate hikes in response to oil price rises appear more ‘automatic’ for the ECB than for the Fed. This may help to explain why EUR/USD and oil are correlated on a real-time basis – a trend that cannot be satisfactorily explained by the diversification argument mentioned above. Thus, in general, a higher USD price of oil may have conveyed to the world the impression that there was more global inflation than there really was. Monetary tightening in response to this positive inflation shock had further depressed the dollar, thereby perpetuating the circle. • Link 3. High oil prices hurt the US C/A deficit. The US C/A deficit has shrunk rapidly since 4Q05, especially the non-oil portion of the C/A. (The US C/A deficit reached a peak of 6.8% of GDP in 4Q05, and has just breached the 5.0% GDP mark in 4Q07. It is likely to decline to around 4.5% by end-2008.) Indeed, trends in non-oil and oil trade balances have diverged substantially since 2005. While the former improved from U$40 billion to around U$30 billion a month, the oil trade balance – reflecting the sharp move in the US terms of trade – deteriorated from around U$20 billion to U$30 billion a month. In short, high oil prices have offset the tremendous improvement in the US external imbalance that has and continues to take place, and have prevented the dollar from being rewarded for this improving trend. And there are three links through which the dollar drives oil quotes, in addition to the numeraire effect: • Link 4. Feedback through the de facto dollar zone. The de facto dollar zone could also help to explain the link between the dollar and oil, and the causality running from the former to the latter. While the de facto dollar zone is looser now than two years ago, many Asian and other EM currencies are still quite ‘sticky’ vis-à-vis the dollar. Dollar depreciation effectively makes Asian exporters even more competitive, and economic buoyancy in these dollar zone countries (i.e., Asia) has led to high consumption of energy products. Therefore, a weak dollar may, on balance, increase the world’s demand for energy products. • Link 5. Financial investment in commodities. There are anecdotal signs that institutional funds may be starting to treat commodities as a separate asset class. To the extent that real commodities are treated as ‘anti-dollars’, there could be a negative relationship between these two variables. Similarly, if commodities are seen as a hedge against inflation, expectations of higher US inflation will drive the dollar down and oil prices up. • Link 6. Weak dollar and the lack of oil demand destruction. Many countries have tried to let their currencies appreciate in the past quarters so as to offset the impact of oil price increases in USD. But what may make sense from an individual country’s perspective has in fact been inflationary from the world’s collective perspective. Essentially, strong currencies provided an implicit subsidy on oil, and rising oil prices have not caused the level of demand destruction they should have done. As a result, oil prices continue to march higher, the longer this strong currency policy is maintained. These are some explanations for why oil and the dollar have been so negatively linked since 2006. However, a further theory we have is that oil and the dollar could appear correlated only because they are driven by the same factor. We see this thesis as particularly relevant for the recent episode of oil price correction and the rise in the dollar. The dollar could have risen in the past month due to the ‘Dollar Smile’ effect. At the same time, a broad-based deceleration in global growth, on top of the oil demand-destruction that had already begun in many developed countries, should driver oil prices lower. As a result, the dollar rose at the same time as oil prices fell, not because one ‘caused’ the other, but because they were both driven by the same factor: a deteriorating global economic outlook. Our Outlook for the Dollar, Conditional on Oil Price We have two thoughts: 1. A strong dollar helps the world to rationalise on oil consumption. The vicious circle between a weak dollar and high oil prices was bad for the global economy. The contraction in Germany’s GDP was due to weak domestic demand, rather than exports. This raises the whole concept of ‘de-coupling’ and ‘re-coupling’, that Germany has not weakened because of a weak US or a weak world. Rather, it has weakened due, possibly, to the sharp energy shock and the credit crunch. As we argued under ‘Link 6’, a stronger dollar would force the rest of the world to rationalise energy consumption. A currency-based policy reaction to the oil price rise – such as the strong EUR policy adopted by the ECB – never made sense from a global perspective, in our view. This was a ‘negative-sum’ solution, due to the lack of oil demand-destruction. We believe that a virtuous circle of a stronger dollar and lower oil prices is what the world needs now. 2. Inflation-targeting central banks to become more dovish. Calmer commodity prices make sense if the global economy is decelerating. This should help anchor inflation expectations and permit inflation-targeting central banks to ensure that two-year forward inflation does not fall below their targets. The speed with which the RBA may make a U-turn (it last tightened in March, and may ease on September 2) on its policy and the market’s positive reaction to the RBA’s flexibility are a good example of what other inflation-targeting central banks (ECB, BoE, Sweden’s Riksbank, RBI, BoK, SARB and RBNZ) could do – though such a policy reversal may not come as soon as the case of the RBA, further supporting the dollar. Bottom Line The USD and oil are likely to remain negatively correlated for some time; the performance of the USD will in part be determined by the evolution of oil prices. For the global economy, a strong dollar/low oil price combination is much better than a cheap dollar/high oil price combination. Calmer commodity prices should also temper the hawkish bias that some inflation-targeting central banks have had.
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Recession: Short and Shallow, or Long and Deep?
August 25, 2008
By Takehiro Sato | Tokyo
Is the Ongoing Recession Really Short-Lived? The possibility needs to be faced that Japan will see a sharp, protracted recession, rather than the short and shallow version that the consensus is expecting. Already output cuts are on pace with the average in past recessions, defying hopes that adjustment in manufacturing would be mild. Cabinet Office timelines for the economic cycle put the average length of post-war recessions at 16 months, or 21 months since the first oil shock, with 36 months following the second oil crisis the record length. Our main scenario for Japan assumes an average recession pattern, and calls for the economy, having turned down from a peak last November, to bottom out in the first three months of 2009 and revive from the April-June quarter. However, the risk is now that the recession may be longer; it is not likely to be shorter, at any rate. Triggers for a protracted recession would be sharper global credit tightening as credit costs spike for financial institutions round the world, a hard landing for emerging economies such as China, and an increase in real income outflows as energy and resource prices remain high. Whatever the real state of China’s economy, the stock market there has already gone from boom to bust, but other emerging markets may be only at the beginning of the bust phase, in which case there is a real possibility that Japan – a beneficiary of global economic growth since 2003 – will slide into an unexpectedly severe recession (according to our simple elasticity model using exports and industrial production, if China slows from 10% in 2008 to 8% in 2009 (note that our official scenario is 9%), Japan’s real growth could be negative at -0.4%, assuming 0.2% growth for 2009 as a base case). Why the Recession Is Expected to be Short and Shallow We see three reasons why the orthodox view, shared by the government and the Bank of Japan, is that this recession will be short and shallow: (1) balance sheet repairs for both financial/non-financial corporations and households in the first half of the decade are seen to have resolved Japan’s problem of excessive debt. (2) Manufacturing industry does not face a global inventory glut, so the coming trough for production adjustment should not be all that steep. (3) Many companies in Japan had trimmed most of the fat from their workforces and capital stock by 2003, and further cuts are no longer the key business priority. The argument is that after whittling down these surpluses, Japan’s economy is now robust again. Our official scenario buys into these assumptions to some extent too. Is this view correct, however? Part of what enabled Japan’s economy to sustain expansion, led by external demand, was the ballooning of credit overseas, rooted in overheated real estate markets. By contrast, the received view is that any overheating of real estate in Japan was on a much smaller scale, and that the bursting of a localized bubble has left a corresponding smaller mess behind. But the foundering overseas of a credit expansion mechanism based on rising real estate prices does not leave Japan unaffected. It has begun to have an impact on real estate company and property prices in Japan’s own backyard, by reducing the inflows of risk money. Under such circumstances, there is a risk that the fragility of Japan’s economy, which has lacked powerful support from domestic demand, will become increasingly exposed. Risk of a Sharp, Protracted Recession (1): Domestic Factors We view the current upswing in corporate bankruptcies as the chief domestic warning signal. Surveys by private credit research institutions also point to a spate of failures among small real estate companies, other than the recent well-documented cases that originate in defaults on straight corporate bonds. The typical pattern in these bankruptcies is that the assets which companies own cannot be made liquid fast enough to forestall a funding crisis, signifies that liquidity in the real estate is drying up. The problem is what lies ahead. For example, condo sales in metro Tokyo showed a contract rate in July of 53.5%, well below the 70% boom/bust watershed, and condo inventory stocks have been above the key 10,000 units mark for eight straight months. Condo developers with excess inventories appear to be reacting to funding difficulties by offloading properties quickly at steep discounts to access cash, but that means realizing inventory losses, and there may be cases in which companies fold as they are unable to survive these realized losses. Some highly leveraged newly-established real estate firms that are primarily involved in securitization business are relying on funding from foreign banks whose balance sheets have been battered by the subprime problem, and some are also taking out syndicated loans from multiple banks. The old main bank system does not work effectively in these cases, and as the banks’ commitment to corporate borrowers as going concerns fades, companies are left more exposed to the risk of failure due to funding problems. This process could play out on a wider scale from autumn, triggered for example by banks’ unwillingness to help borrowers refinance, leading to a vicious circle whereby higher credit costs make financial institutions even more conservative about lending. An increase in corporate bankruptcies could hurt consumption by damaging job security. Current corporate bankruptcy levels are a long way short of the peak around 2001 at the end of the IT bubble, but there is now a steady uptrend in the number of bankruptcy cases, and some concern that these may move close to the peak from 2001-02. Risk of a Sharp, Protracted Recession (2): Factors Abroad With regard to the overseas economy, we take note of the frequency of credit events ahead. According to the past pattern, we are nearing the point where there could be a rising default of corporate bonds. My personal view here is that moving past the summer, the US economy could move into a downward spiral as credit contracts further. The writing is already on the wall. For example, the ratio of distressed companies in the US corporate bond market (those with credit spreads that exceed 1,000bp) has risen rapidly since 2H07 and now stands around 20%. A spike in this ratio has historically spelled an increase in defaults 6-12 months down the line, implying the risk of more credit events in the coming months. Conditions for fundraising via direct financing such as commercial paper are already tight, and companies are reliant on commitment lines from banks to access liquidity. US commercial banks would start reducing these lines if there is a rash of defaults, likely affecting credit in the non-financial sector, which so far has remained in relatively good shape. The household sector has also seen home equity lines of credit (HELOC) reined in since the start of the year, as housing prices slump and households are reacting by taking out more credit as a defensive measure. This increased use of credit, along with the recent tax breaks, has apparently allowed personal consumption in the US to hold up better than expected in 1H08, but as commitment lines shrink, the household sector just like the corporate sector faces the risk of credit being choked off. That would trigger entrenchment in the US economy, as both corporations and households wait for the storm to pass, and in an extreme case could spark the onset of a Japan-style debt deflation as falling asset prices depress the real economy. Our US economics team’s official forecast also calls for two straight quarters of negative growth in October-December and January-March next year, meaning a technical recession. In Asia, manufacturing production has already been slowing sharply against a backdrop of energy price hikes, mainly in India. Also China is expected to reduce energy subsidies after the Olympic games. These Asian countries have been weathering higher energy prices through governments’ subsidizing policies. However, given the severe fiscal conditions everywhere except in China, such policy may no longer be sustainable, and thus the Asian economy is likely to be more sensitive to energy price fluctuations. Risk of a Sharp, Protracted Recession (3): Manufacturing Production and Exports Exports from Japan now seem to be slowing, especially to Europe, and although in Asia imported fuel tax cuts have led to a surge in light oil exports to China, without this special circumstance exports (excluding light oil) even to China turned negative year on year in June. This special China factor plus the strong export growth in January-March make it look as if the trajectory of the economy from its apparent peak around October last year has been less steep than in past recessions. This gives encouragement to the optimists, but exports even to Asia may struggle ahead, in our view. There is widespread belief that the production correction brought about by export shrinkage may not be as severe this time as in 2001, thanks to the cautious inventory management of companies discussed above. However, the low current levels of inventories and inventory/shipment ratios do not eradicate the risk of an upcoming correction. In past recessions, the inventory/shipment ratio has often moved up simultaneously and in parallel with production adjustment, rather than in advance of a downturn in production. The usual pattern in times of recession is for output to undershoot corporate plans, and the plans themselves to be lowered repeatedly. This is because unintended build-ups of inventory cannot be avoided in this process. The pace at which manufacturing production has corrected since the peak last year in October-December, in fact, matches the average pattern during past recessions. It is true that the previous production increase was slower than the past average, but that does not mean the upcoming correction will be similarly measured. Policy and Market Implications As the outlook for recession becomes gloomier, the government and ruling parties are looking at ways to stimulate the economy with an eye on the general election. There is little scope to boost fiscal spending to begin with, however, and even if the goal of a positive primary balance is pushed further out, any expenditure that relied on issuing government bonds would risk dampening household and corporate expectations for the future, offsetting the intended stimulus effect. Fiscal stimulus might give equities a fillip and depress bonds in the short term, but surely not for long. A current theme in the bond markets is the fear that a fiscal stimulus package funded by a supplementary budget could trigger a major correction. Yet, the tone of the bond markets is ultimately set not by fiscal deficit levels (supply of JGBs) but by the trend of the economy (nominal growth rate, demand for JGBs). This trend, as we outlined earlier, appears to be tilting if anything in a more negative direction than the consensus view. Also in countries such as Japan that run current account surpluses, the impact of fiscal deficits and government debt on long-term interest rates is rather limited, and even frequently shows an inverse correlation. The keywords in unlocking this conundrum are 1) the thesis of Ricardian equivalence; 2) expansion of the I-S balance (net private sector savings); and as a result, 3) the absence of textbook crowding out. For example, if fiscal policy is widely accepted, Keynesian stimulus can be effective if expectations are maintained that economic improvement resulting from fiscal expansion will then lead to an improved fiscal balance. If fiscal policy has low credibility, on the other hand, fiscal expenditure funded by larger government debt convinces companies and households that tax increases are on the way, and results in no stimulus effect since rational economic behavior is to rein back consumption now in anticipation of the future tax burden. In other words, issuing public debt to provide fiscal stimulus to the economy has virtually no impact (the equivalence proposed by Ricardo). Ricardian equivalence holds that measures to kick start the economy by issuing public debt will lead to a commensurately higher savings rate at households and companies due to the fear of future tax hikes. Thus increases in government debt can be autonomously and ex-post financed by higher household savings. This is because households turn to savings mainly as deposits, and once these funds reach the banking sector, the limited availability of investment opportunities means they are used to purchase JGBs rather than invested (as new loans) in the real economy. Our rough empirical analysis also suggests that fiscal deficits and government debt balances function only very tenuously as an explanatory variable for long-term interest rates. The factor that supposedly links the fiscal deficit with long-term yields is the risk premium for the former. But the built-in stabilizer function means that generally the fiscal balance improves in good economic times and deteriorates in bad times. Since the big-picture trend for long-term rates is a function of the nominal economic growth rate, long-term rates will rise when the fiscal balance is improving and fall when it is worsening. Thus, there is frequently an apparent inverse correlation between the fiscal balance and long-term rates. This line of thought suggests that the bouts of stimulus in the eight years since 2000 may initially have buoyed equities and dampened bonds, depending on the scale of effective demand (‘real water’) and the amount of additional issuance of deficit-covering bonds, but that in fact these would eventually have been good opportunities to sell equities and buy bonds on the dip. There is considerable uncertainty on the fiscal side about the scale of economic measures being assembled for the end of August, but an apparent inconsistency between the perceptions of the scale of the package and of the ‘real water’. Defined roughly, the ‘real water’ is the amount that directly and incrementally boosts GDP. This is different from the scale of the package, as sometimes measures that have already been budgeted for will be included, for example, which provide no incremental boost to GDP. Historically, ‘real water’ has accounted for only about one quarter of the package in major rounds of economic stimulus since the late 1980s. In the upcoming case, the problem is that with economic deterioration expected to create a shortfall in tax revenues (an actual JPY1.4 trillion in F3/08), it is not easy to find alternative sources of funding, which makes it questionable whether there can be enough ‘real water’ to have any impact on the stock and bond markets. Upside Risks Upside risks to the scenario we have outlined – the risk that instead the recession will be shallow and short – rest on these conditions: (1) energy prices fall sharply by another notch; (2) the risk-mediating function of overseas financial institutions recovers swiftly; and (3) emerging economies (and especially China) avoid a hard landing through mobilization of macro policies. For (1), energy prices have been coming down sharply since mid-July, but are not yet at levels that imply a significantly brighter economic outlook. They would need to drop further for this to be the case. For (2), provision of public funds would be a quick way to recapitalize financial institutions, but as in the case of Japan in the past, the barriers to this approach are high. If the authorities were to reach the conclusion that this step needs to be taken, it would probably only be after the economy and the markets have gone through a lot more pain first. For (3), there are major imbalances in emerging markets in each region, but if there were to be a hard landing, China – the country where the impact on the global economy would presumably be large – fortunately has a wide menu of macro options for both fiscal and monetary policy. Our China economist Qing Wang, while highlighting the risk of an imported slowdown in 2009, is also maintaining a constructive stance on a soft landing for China because of the scope for fiscal measures and monetary easing.
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Post-Olympics China and the AXJ Currencies
August 25, 2008
By Stephen Jen & Spyros Andreopoulos | London
Back in February, we argued that China should not suffer from the ‘Olympic Curse’. While we still believe this is the right call, we now feel that there is a risk of a growth scare in China following the Olympics. However modest this economic slowdown turns out to be, it is likely that investor discomfort might become rather acute, with meaningful implications for the region. This will add to our bearish attitude towards the AXJ (Asia ex-Japan) currencies. Our Note from February 20, 2008 Back then, we wrote When the Torch Burns Out, Beijing Will Still Go for Gold. The key points made were as follows: 1. The ‘Olympic Curse’. Since WWII, the economic growth of almost all of the host countries of the Summer Olympics has suffered in the year following the Games. (Of the 11 cases we examined since 1956, only the US (Atlanta) in 1996 did not show a slowdown following the Olympics. The slowdown was particularly stark in Australia (1956), Japan (1964), the US (1984) and Korea (1988). Spain actually fell into a recession in 1993. In the two most recent Olympics (Athens and Sydney), both Greece and Australia decelerated by 1.5-2.0% between the year before and that after the Olympics.) Specifically, on average, the growth rates of GDP, capex and overall investment have experienced a 4%, 6% and 10% deceleration, respectively, from the year before the Games to the year following the Games. 2. Intuitive reasons behind this curse. This growth profile should not be too surprising. In the lead-up to the Olympics, it is reasonable to expect large investment, particularly in non-dwelling and hotel construction. Tourism receipts should also surge in the Olympic year. In the case of Beijing, the issue of ‘prestige’ could also be important, as China tries to showcase its economy and country: doing so costs money and such efforts show up in the GDP. The front-loading of infrastructural and other physical investment naturally implies a slowdown following the Olympics. Just as importantly, a positive sentiment effect may accompany the Olympics, buoying consumption and business investment in areas not directly related to the Games or the host city. Such a build-up could be followed by an anti-climactic sentiment effect, as the hype cools down and the world’s attention focuses elsewhere. 3. Currency depreciation post-Olympics. Another regularity is that the currencies of the host countries tended to weaken in the year following the Olympics. 4. The case of China. Beijing’s growth cycle is unlikely to dominate the business cycle of such a big country. Further, China is very diverse, in terms of levels of economic development between the East, Central and West. This should provide ample scope for asynchronous demand growth to stabilise overall growth. In addition, the US business cycle will likely be exactly the opposite of the ‘Olympic growth cycle’ for China. In sum, China will likely exhibit the typical growth pattern around an Olympics, but the magnitude of the swing in growth will likely be modest. A Growth Scare, Not a ‘Meltdown’ As already pointed out by my colleague Qing Wang, we are likely to witness a growth slowdown, not a severe meltdown. (Please see the latest China Chartbook by Qing Wang, Denise Yam, Steven Zhang, and Katherine Tai: Slowdown, Not Meltdown; Easing, Not Stimulating.) Correspondingly, policy-makers in China have switched their financial stance from tightening to easing, to help cushion the likely growth deceleration in the months ahead. Nevertheless, we are concerned that China’s growth deceleration may become a focus for investors, and such an investor attitude may echo throughout Asia. We have these thoughts: • Thought 1. Synchronised global slowdown will feed on the China growth scare. What makes us more concerned about a sharp deterioration in investor attitude towards China and Asia is that the developed world seems to be decelerating at the same time as the Olympics. China’s macro data for the period before and during the Olympics may be distorted by the factory shutdown (negative for growth) and buoyant retail sales (positive for growth). These data are, in our view, more noise than signals. However, post-Olympics, the anti-climactic mood in China will likely coincide with a slowing developed world, with the US, Euroland, Japan and the rest of the G10 likely to decelerate meaningfully below trend growth. The inability of investors to distinguish the ‘Olympic Curse’ from the impact of global slowdown will likely heighten the growth scare. • Thought 2. Financial conditions have deteriorated significantly in China. We have argued in the past that the energy shock will prove severe for China and the rest of Asia (see The Energy Shock to Asia (July 3, 2008) and The Path of Energy Conservation (July 10, 2008)). Despite the recent correction in oil and other commodity prices, due to large subsidies on oil products and electricity, China will likely continue to unwind the subsidies, meaning that the energy shock will be ‘amortised’ and gradually released into the economy. Further, equity wealth helps form the overall financial conditions in China. Year-to-date, A-Shares have fallen by half. (52.8% to be exact. B-Shares have fallen by 55.6% YTD.) At the same time, China’s property markets have begun to weaken. The CNY’s appreciation has also meaningfully affected China’s manufacturing sector. While aggregate figures are unavailable, bankruptcies and closures of companies and factories in coastal China have surged sharply, according to anecdotal evidence. These tightening financial conditions have led Beijing to adopt an easier monetary stance. A fiscal stimulus package is likely if growth slows to below 9%. But even with monetary, fiscal and exchange rate easing, it is unclear that Beijing will be able to dispel investors’ concerns, particularly if the developed world slows dramatically. In short, factors unrelated to the Summer Olympics will likely pose headwinds for China, partially validating the ‘Olympic Curse’. • Thought 3. There will likely be a growth scare for the rest of Asia, as a result. We have been warning against the risk of a slowdown in Asia since May. (Also see Stewart Newnham’s AXJ: The AXJ Cyclicals Are Trending Down, August 20, 2008.) China had been seen as a potential counterweight to a faltering West. But if China also begins to decelerate, even if it is just a soft landing, we believe that investor sentiment on the AXJ economies will also start to deteriorate, hurting AXJ assets, including their currencies. We have also written about high shipping costs undermining the Asian trade model (see High Transport Costs to Un-Flatten the World, June 26, 2008). High shipping costs will be, in our opinion, a persistent headwind for Asia. Capital Withdrawal from Asia While some countries in Asia have received more foreign investment (FDI and portfolio) than others in recent years, overall Asia has been a solid recipient of foreign portfolio capital. (Portfolio capital flows into the BRICs (Brazil, Russia, India and China) have been much larger than those going into other smaller EM economies. There has thus been some diversion of capital away from small EM economies.) At a country-specific level, we could get a rough gauge of how various countries may be sensitive to outflows by assessing the liquidity of the capital markets. We show the market capitalisations and the turnovers of the AXJ equity markets. Our thesis is that, the more liquid the equity market in question, the easier it will be for investors to withdraw capital, and such capital withdrawals should be larger, all else equal. We remain bearish on INR and KRW, in particular. Not only have these two economies received large capital inflows in recent years, but their capital markets are also more liquid than many others in Asia. Further, India does have several familiar macro imbalances (‘twin deficits’) that may become additional excuses for foreign investors to retreat from that market. Investor Sentiment Still Broadly Positive on Asia Our impression is that there is still a meaningful gap between the current investor sentiment – which is broadly positive on Asia, as it has been for the past two years or so – and what would be consistent with the weaker data we will likely witness in the near future. In our conversations with clients, we still get more pushback on the bearish Asia call, which suggests to us that AXJ currencies and other assets are indeed vulnerable to downside correction. Bottom Line Since May, we have been bearish on AXJ currencies, and believe that the dollar will rally further against most AXJ currencies in the coming months. A post-Olympics growth scare in China is now more probable than we had thought six months ago, given the tighter domestic financial conditions and unfavourable external conditions. Such a regional growth scare should provide further support for our call on USD/AXJ.
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