China
Further Growth Forecast Downgrade amid Deeper Global Recession
November 12, 2008

By Qing Wang, Denise Yam & Steven Zhang | Hong Kong

A More Challenging External Environment

The rapid evolution of a global financial crisis featuring massive deleveraging has led to a substantial deterioration in the fundamentals of the global economy. Our global economics team has further downgraded its GDP growth forecasts for the G3 economies in 2009: -1.3% for the US, -0.6% for Europe and -1.1% for Japan (see Beyond a Deeper Recession: Tepid Recovery, November 10, 2008).

The external environment for the Chinese economy has undoubtedly become more challenging than we organically envisaged. Since the G3 economies constitute the destination of about 45% of China’s exports, when their demand weakens, China’s export growth tends to slow accordingly.

Lackluster exports in China will likely translate into poor performance of corporate earnings and weak confidence, dampening investment appetite in exports-oriented industries. Investment in the manufacturing sector accounts for about 30% of total fixed-asset investment.

Downside Risk to Property Sector Investment Intensifies

As property sales have continued to deteriorate in recent months, both central and local governments have recently launched a range of policy measures with a view to boosting demand. These policy changes are in line with our expectations, and additional measures will likely be introduced over the coming months (see China Economics: Can the Property Sector Be Counted on as the Engine of Growth? September 2, 2008).

While we continue to believe that housing affordability is not the primary reason behind the slow sales and property price correction, the sentiment of potential homebuyers appears to have been so damaged that it is unclear whether these policy changes can turn round sentiment anytime soon. Until then, property sales will likely remain sluggish and property prices under significant downward pressure. Slow sales will translate into slow investment in this sector down the road or likely through 1H09, in our view.

Growth Forecast Downgrade

We downgrade China’s GDP growth forecasts for 2009 to 7.5% from 8.2% (versus the October consensus forecast of 8.8%). The general rationale for this downgrade remains broadly the same as when our last growth forecast downgrade was made (see China Economics: Unscathed from Crisis; Not Immune to Downturn, October 6, 2008). Compared to the previous revision, the lower growth forecasts this time are mainly explained by the smaller contribution of net exports and weaker investment in the real estate sector.

Specifically, we revise our growth forecasts for exports and investment in real estate to +3% (from the previous +8%) and -6% (from the previous +5%), respectively. We envisage that the much weaker investment in real estate will be largely offset by stronger investment in infrastructure projects. We forecast that the growth of infrastructure investment will rise sharply to 38% in 2009 from the 6-7% range in previous years, contributing 2.5 percentage points to overall GDP growth in 2009. We revise down consumption growth, but only moderately, reflecting the impact of rising unemployment and slower income growth.

The economy will likely continue to decelerate over the next three quarters before bottoming out by mid-2009, and stage a modest recovery in 2H09, as external demand starts to improve and the effect of the pro-growth policy kicks in. We expect a recovery in growth to 8.5% in 2010. Our CPI inflation forecasts are 1.5% in 2009 and 3.0% in 2010.

Policy Outlook

The State Council announced an aggressive economic stimulus package on Sunday, November 9. The authorities stated that the policy mix going forward will be “proactive fiscal and moderately loose monetary policies”. The authorities provide a long list of areas where investment/spending will be made. Conversion of VAT from production- to consumption-based will also be rolled out, which, according to authorities’ estimate, could result in an Rmb120 billion reduction of the tax burden for Chinese enterprises. The authorities also called to “reasonably expand” bank lending and urged that the implementation of this stimulus package should be “fast and front-loaded”. The authorities estimated that the spending amount planned is Rmb400 billion in 4Q08 (i.e., about 1.6% of GDP) and a total Rmb4 trillion (i.e., about 16% of GDP) through 2010.

The policy mix of “proactive fiscal and moderately loose monetary policies” is stronger than the one adopted in the aftermath of Asian financial crisis, featuring “proactive fiscal and prudent monetary policies”. While this is in line with our expectation, the size of the stimulus package is larger than we originally envisaged. Moreover, the authorities’ call on the banks to “reasonably expand lending” suggests that banks are actually being urged to extend loans to accommodate the spending need under the expansionary fiscal policy.

Specifically, we expect the following policy components: a) at least five more 27bp cuts in base interest rates through 2009 and multiple RRR cuts; b) a bond issuance program of Rmb400-750 billion (or 1.5-3.0% of GDP) to finance part of the infrastructure projects (e.g., railway system); c) an increase in the minimum threshold of personal income tax and conversion of production- to consumption-based VAT; d) additional measures to boost the property sector; e) energy price normalization (e.g., for refined products, coal and electricity); and f) further financial support to farmers (see China Economics: How Much Can Be Expected From Fiscal Stimulus? November 4, 2008).

The appreciation of the renminbi exchange rate against the US dollar will likely remain very slow through 2009. The persistence of a large trade surplus – as envisaged in our forecasts – and the absence of large capital outflows due to capital account controls would suggest that any meaningful depreciation is unlikely to be sustained, in our view.

Risks

The authorities’ latest announcement of an Rmb4 trillion stimulus package – if consistently implemented – should help to translate the balance sheet strength of the economy into economic growth resilience, limiting the extreme downside risk to the economy (see China Economics: An Aggressive Stimulus Package Announced, November 9, 2008).

In making the announcement, the authorities used unusually strong statements, suggesting that they are very eager to boost private sector confidence through making a very strong commitment to maintaining strong growth. This surprisingly strong style of policy-making is welcome and appropriate, and should help to reduce a key downside risk that we recently highlighted: “A fiscal policy response without the necessary transparency and communication with the market ex-ante could run the risk of greatly compromising its growth-boosting impact by failing to boost private sector confidence, even if a large amount of spending were involved ex-post” (see China Economics: How Much Can Be Expected from Fiscal Stimulus?).

The primary downside risks stem from a potential downturn in China’s property markets across the country that could lead to a collapse in real estate investment. The attendant consequences for the macro economy could become serious enough that even a strong policy response would unlikely be able to prevent a hard landing of the economy (i.e., lower than 7% GDP growth).

The upside surprise to our baseline forecasts would probably come from a better-than-expected export performance, in our view. China’s strong external competitiveness – especially in the low-end segments of a wide range of markets – may help to underpin China’s export growth, as the ‘trading-down’ effect plays out amid a synchronized global slowdown.

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United States
The Obama Policy Mix
November 12, 2008

By Richard Berner & David Greenlaw | New York

The election outcome marks a sea change in American politics, and likely in US economic policies as well.  Partisan politics and gridlock seem no longer to be a major hurdle to an ambitious agenda of economic policy change: The Democrats now control the White House and Congress for the first time since Bill Clinton’s first term in 1992.  But even with at least 57 seats in the Senate and 256 in the House, their Congressional control isn’t absolute, and the election mandate is to fix problems, not to swing dramatically to the left.  Thus, to govern and meet America’s daunting list of near-term and longer-term economic challenges, the Obama Administration and even the Congress likely must move rapidly to the center. 

There are three major hurdles to getting the job done.  First, the recession has become global in scope and is deepening fast.  Second, the fiscal resources already employed to fight the financial crisis and recession represent constraints on policymakers’ ability to fix longer-term problems.  And finally, the scale of those longer-term challenges is intimidating, and four or more years of neglect has only intensified them.  Common sense dictates setting priorities and scaling back ambition.  The conventional wisdom we encounter has handicapped the chances of real accomplishment − especially achievements that come within shouting distance of the high level of post-election expectations − at low levels. 

The doubters may be surprised.  In our view, the Obama Administration is unlikely to shrink from addressing America’s economic challenges, despite huge fiscal deficits.  Their plans will probably unfold in two steps: First will come additional stimulus to combat a deepening recession.  Addressing longer-term problems likely must wait, but only a couple of years.  Our sense is that the incoming Administration is pragmatic and understands the urgency of building a coalition to achieve some early wins on both the economy and on easily-passed down payments on big-ticket domestic priorities.  That will begin to help restore confidence that government can work.  And while the Administration will raise revenue to help pay for this agenda, we expect the combination will add up to deficits not seen in the past 50 years. 

Cutting our GDP estimates again.   The economic backdrop, of course, is the immediate focus.  Notwithstanding massive policy stimulus and more on the way, the intensifying global credit crunch has once again prompted us to mark down our estimates for global and US economic activity in 2009 − to 1.7% from 2.5% and -1.3% from -0.2%, respectively.  In our view, risks through 2009 are still tilted to the downside, as a synchronized downturn in industrial and developing economies ricochets from one economy to another.  If we’re close to the mark, this global downturn will be the deepest in two decades, and we can’t rule out an even weaker outcome − possibly as weak as in 1982, when global GDP growth fell below 1%. 

Indeed, we now believe that this US recession will be the deepest since 1981-82, with GDP declining by 2% from the mid-2008 peak to the trough we expect in mid-2009.  Incoming data strongly suggest that the US economy, already weakening through the summer as the impact of tax rebates waned, fell off a cliff in October.  The credit crunch claimed victims in both vehicle sales and retailing results, with the former plunging to 10.5 million units, a 26-year low, and the latter, especially at high-end retailers, the worst in memory.  Both manufacturing and non-manufacturing ISM surveys plummeted in October, as did both leading indicators of consumer sentiment.  And nonfarm payrolls tumbled by 240,000 in October, following substantially bigger revised declines in the prior two months, while the unemployment rate surged to 6.5% − a 14-year high.  The 217,000 monthly average decline in payrolls over the past three months has begun to rival those of past recessions.  As a result, we expect that the economy will contract at a 3.5% annual rate in the current quarter and by 3.25% in the first quarter of 2009.

Other developments − the woes of Detroit’s Big 3 automakers, likely cutbacks in capital spending, job and spending cuts at state and local governments, and weakness in overseas data − suggest that the downturn is far from over.  We’re especially concerned that economic and financial shocks will weaken growth in emerging market (EM) economies significantly, and that such weakness will circle back to US growth.  The culprits: spillovers through trade from the industrial economies and a sharp slowdown in capital flows.  We now see growth in EM economies at just 4.3% next year, down 210bp from 2008.  In China, we’ve reduced the prognosis for 2009 growth from 8.2% to 7.5%, and the outlook would be weaker still without the benefits of a 4 trillion renminbi ($586 billion) spending and stimulus program announced this weekend.

Modest recovery in H2 2009.  Despite this deterioration, we think that the global economy will trough in the course of next year, with a modest recovery beginning in the second half and in 2010.  The key reason: Massive recent and forthcoming policy action by central banks and governments will get traction next year (see Beyond a Deeper Recession: Tepid Recovery, November 10, 2008).  Our first estimate for 2010 global GDP growth comes out at 3.6%, well below the trend of the past decade of 4.0%.  In the US, we expect that GDP in 2010 will rise by scarcely more than 2% (2.9% fourth quarter over fourth quarter).  One aid to recovery will be plummeting commodity prices, which are a boon to consumers; the plunge in US retail gasoline prices alone from a peak of $4 gallon in July to below $2.45 will be the functional equivalent of a $200 billion tax cut for consumers − and more if prices fall to $2, as seems possible.  Indeed, this shift in the ‘terms of trade’ benefits consumers and most businesses, even in commodity-producing countries.

Sharp declines in inflation, but no deflation.  Reflecting such commodity price declines, we expect dramatically lower global and US inflation: Measured by the CPI, it likely will decline from 6.2% to 3.9% globally and from 3.9% to -0.2% in the US.  Key factors: plunging commodity prices and emerging slack in both product and labor markets in the developed and EM economies.  Indeed, US headline inflation now seems likely to fall by 2% or so in October and November and to go negative by mid-2009, with prices then falling by 1.5% from mid-2008. 

Against this backdrop, it’s becoming fashionable to argue that deflation will supplant inflation as a key threat to markets and the economy.  We disagree.  A deflation scare is likely, but deflation − a general, ongoing decline in prices − is unlikely for four reasons.  First, the current inflation decline largely represents a reversal of the inflation spike of early 2008, rather than ushering in a new era.  Second, we think companies will quickly cut excess capacity to balance supply with demand.  Third, some of the emerging global declines in goods prices are clearly declines in relative prices, not prices generally.  Most important, the Fed and other central banks are easing aggressively and in some cases now quantitatively to influence inflation expectations (see The Coming Deflation Scare, October 27, 2008).  We think they will succeed; our tentative forecast for 2010 looks for a pickup in inflation in the advanced economies from around 1% in 2009 to 2.2% in 2010 as we assume a gradual rise in oil and other commodity prices once the economy recovers.

More easing from the Fed.  Sharp downward revisions to growth and inflation imply equally significant revisions to our outlook for monetary policy.  We expect the Fed will reduce the official target funds rate to an historic low level of 50bp at the December FOMC meeting, and retain that stance through 2009.  The Fed has clearly moved to quantitative easing over the past eight weeks, allowing the funds rate to trade some 50bp or more below the current official target of 1%.  Evidence of quantitative easing − made easier by the Fed’s ability to pay interest on reserves since early October − is found in the volume of excess reserves in the banking system, which soared to $364 billion in the latest measurement period, compared with a bi-weekly average of roughly $2 billion in the past. 

A two-step stimulus plan.  Reviving economic growth will be the new Administration’s first priority, and because monetary policy alone can’t tame the credit crunch quickly, sizable fiscal stimulus seems likely.  The stimulus is expected to come in two installments.  First, Congress returns next week for a lame-duck session, and the Democratic leadership will immediately propose a short-term stimulus plan designed to support those most harmed by the recession until a broader package can be crafted in January.  On the menu for this appetizer, which could reach $100 billion: extended unemployment insurance benefits, increased food stamp aid, stepped-up energy assistance for low-income families (LIHEAP), increases in the federal share of Medicaid that would alleviate the strains on state governments (FMAP), and municipal bond relief.

Congress and the Obama Administration likely will begin work on the main course immediately following inauguration on January 20.  The centerpiece of that plan, which could total as much as $200 billion, would be Mr. Obama’s middle-class tax cut.  This might take the form of the proposed ‘Make Work Pay’ tax credit, worth up to $500 for individuals and $1,000 for married couples, expansion of the Earned Income Tax Credit, and/or cuts in withholding rates.  Top tax rates likely will go back up to 39.6% and top capital gains and dividends rates to 20% to pay for Alternative Minimum Tax relief, to extend the 2009 level of the estate tax ($3.5 million indexed per-spouse exemption and a 45% top rate).  But 90% of the Bush tax cuts, represented by the 10% bottom bracket, the $1,000 child credit, and the marriage penalty relief, will be preserved, we believe.  Significant new infrastructure investment and direct grants to the states for foreclosure mitigation and other purposes likely would also be included, although spendout rates for infrastructure probably will extend over two or more years.  In all, we expect the ‘cash-flow’ deficit to be $1.5 trillion in F2009, or 10.2% of GDP.  This assumes a ‘core’ deficit of $600 billion, $150 billion of forthcoming fiscal stimulus, $600 billion of spending under the TARP, $50 billion in FDIC outlays for resolution of failed banks, and $100 billion of MBS purchases under the GSE support plan (see Budget and Financing Update: Time to Tally the Red Ink, November 3, 2008).

Longer-term priorities include healthcare reform, financial regulatory reform, education, energy, and trade policy.  We think the Administration will seek early wins on and be pragmatic about healthcare reform, a new financial regulatory framework, and education.  For example, we expect they will seek quickly to pass the expansion of the State Children’s Health Insurance Program (SCHIP) that President Bush vetoed last year.  Key elements from the Obama-Biden platform − for example, coverage of preexisting conditions, a Small Business Health Tax Credit, a National Health Insurance Exchange, and using tobacco tax hikes to pay for them − probably will be part of a new proposal.  But to increase access, reduce costs, and improve quality the Administration likely will choose a centrist course.  Likewise, to achieve meaningful progress on financial regulatory restructuring, the new Administration will likely promote compromises among Congress, regulators, consumer groups and the industry.  Unless oil prices rise significantly, major changes to energy policy aren’t likely soon. 

Market implications.  The tug of war between the credit crunch and immense stimulus has created three sets of crosscurrents in financial markets: First is a growing fear of deflation near term and equal concern about inflation down the road.  Second, investors worry that too much public debt will undermine investor confidence in sovereign obligations.  We think those concerns are overblown, because the use of the debt matters.  Issuing debt to facilitate the use of the government’s balance sheet to help recapitalize the financial system does not reflect ‘spending’. Instead, it finances a loan temporarily to replace lenders’ capital eroded by defaults.  But we recognize that those concerns may continue to push real longer-term rates − now about 2.8% − even higher. 

Finally, the stagflationary consequences of a potential backlash against capitalism and globalization that results in protectionist policies are also worries.  The weaker that global growth proves to be, the higher the risks that such policies will take hold.  These factors all seem likely to promote an extended period of low short-term rates, upside risks to long-term yields, and steeper yield curves.  Indeed, our interest rate strategy team expects the US Treasury curve from 2-year to 10-year notes to steepen to 300bp over the next few months.

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Turkey
Downgrading Growth Forecasts Once Again
November 12, 2008

By Tevfik Aksoy | Istanbul

Lowering Both 2008 and 2009 GDP Growth Forecasts

On the back of a combination of recent data releases as well as revisions to our global growth forecasts, we have downgraded our real GDP growth forecasts for Turkey. Compared to the most recent revision in October (see Strong Headwinds from the West: Slow Growth Ahead, October 9, 2008), we revised down our 2008 forecast to 2.3% from 2.7%. We made a similar but more sizeable revision to our 2009 GDP growth forecast by slashing it to 1.9% from 2.5%. Our 2010 real GDP growth forecast stands at 4.6%, which foresees a modest recovery in private consumption and investment spending, as well as a pick-up in exports. However, the pace and timing of the recovery is likely to be dominated by the improvement in global markets, rather than Turkey’s internal dynamics, in our view.

Industrial Production Continues to Disappoint

In September, the IP growth rate eased to -5.5%Y, bringing the average growth rate to -2% in 3Q. The slowdown in production had been visible in almost all sectors, especially in certain groups such as textiles (major employer). However, over the past few months, the industrial heavyweights – such as machinery and equipment, motor vehicles and other transportation equipment, as well as electrical machinery – received their share of the slowdown. The recent IP growth data deviated significantly from our forecast of -2%Y, and based on the outlook for exports, as well as domestic consumption prospects, we have revised down our 2008 growth forecast. In fact, we expect to witness a negative headline growth rate in 3Q08, which might improve marginally in 4Q08 if government spending and a possible improvement in the contribution of net exports outweigh the slowdown in private consumption.

Meanwhile, capacity utilization data continued to display a weak picture in 3Q, as the long religious holiday was extended by some car manufacturers when the plants were shut down for production temporarily as a result of weak sales and inventory build-up. At this juncture, we do not expect the capacity usage rate to show any signs of revival until year-end, and the upcoming religious holiday in early December is unlikely to help the picture.

On the sales front, the gloomy news on the global economy, rising unemployment and the deteriorating outlook for job security was illustrated by a noticeable decline in consumer confidence and expectations. Nevertheless, more concretely, we have witnessed a continued and sharper decline in passenger car/light commercial vehicle sales, possibly signaling the upcoming weakness in growth. Since most of the car sales depend heavily on consumer loans, we do not expect a pick-up in the sector in the near term, with interest rates at their highest levels in years.

Monetary Easing Unlikely to Be a Panacea for Some Time

Unlike various central banks, the CBT is not going to ease monetary policy, in our view. Looking forward, we expect the double-digit inflation rate to linger until 2Q09 in the absence of an appreciation in the currency and/or a marked decline in local natural gas/gasoline and/or electricity tariffs. This, coupled with the pressure on the currency, is likely to force the CBT to preserve its cautious stance. Hence, we maintain our view that no rate cuts will materialize in 2008, and we have recently revised the timing of our first rate cut call to 2Q09 from 1Q09, while maintaining the 150bp total. However, as indicated by the CBT governor during the presentation of the Inflation Report, we would expect the de facto policy rate to become the CBT’s lending rate rather than the borrowing rate, which is 300bp higher than the 16.75% policy rate (current borrowing rate). While the base rate or the borrowing rate might remain unchanged in the next 3-6-month period, the de facto policy rate could fall, which would still mean that the monetary policy rate remains tight. In any case, even the envisaged rate cut in 2009 might not prove effective in inducing spending, since both real and nominal interest rates will still be considered high.

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Asean Economics
Credit Crunch Broadening: More Collateral Damage in 2009
November 12, 2008

By Chetan Ahya & Deyi Tan | Singapore & Shweta Singh | India

Factoring in a Broadening of Credit Crunch in 2009

Financial markets have deteriorated rapidly since early October. We no longer feel comfortable with our ASEAN GDP growth forecast of 3.5%Y for 2009 and are now lowering it by 1.5pp to 2.0% to reflect a higher degree of collateral damage from the credit crunch. The credit problem is turning out to be more severe, and not only in terms of the depth of the impact in the epicenters of the developed world. Liquidity problems are also reaching the shores of emerging markets, and tight credit conditions are no longer a problem faced only by the private sector. Below, we outline the extension of the credit crunch in terms of depth, geography and sectors:

•           From financial markets to real economy: The transmission from credit market deterioration to the real economy is leading our US and Europe economists to further downgrade their GDP forecasts for 2009 from -0.2%Y and 0.2%Y, respectively, to -1.3%Y and -0.6%Y. As a result, we now expect the industrial world to contract 0.9%Y in 2009 from 0.1%Y previously, with ramifications for trade demand for ASEAN. The industrial world accounts for 52% of the global economy, and the US, EU and Japan still constitute around 28% of ASEAN’s export market demand.

•           From developed world to emerging markets: The credit crunch is not just being felt in developed economies. The impact is also percolating in the emerging markets as the supply of risk capital reverses. Risk-aversion will deprive emerging markets of capital, and the real economy implications would be all the more severe if growth had been credit-dependent over the past few years. Export demand from emerging markets had been one of the last dominos to fall in the de-coupling story. Global demand destruction and the spillover into commodity prices were already negatively affecting the terms of trade for commodity-producing EMs. The further shutting of the liquidity tap will deliver a double-whammy, in our view.

Anecdotally, EM commodity producers are seeing an increase in defaults by end-market wholesale traders. Traders are now finding it hard to break even, as spot prices have fallen significantly from the contracted prices. This will likely create a vicious cycle, leading banks to pull back further on letters of credit (LCs) at a time when they are already in short supply. This not only has the indirect impact of slowing export demand from EM. ASEAN economies such as Indonesia are also directly affected as their CPO contracts are defaulted on.

•           From private sector to sovereigns: The credit crunch is no longer localized in the private sector; it is now also infecting sovereign debt. In this regard, the nationalization of the pension fund in Argentina aggravated sentiment, particularly for emerging market sovereigns. ASEAN sovereign CDS spreads have since retraced their steps, but they remain 150-450bp above the levels seen in January 2008. Specifically, ASEAN economies with a relatively higher share of external public debt and perceived currency vulnerability (Indonesia) have seen a disproportionately bigger widening in their sovereign CDS spreads. On the other hand, Malaysia and Thailand have seen a relatively smaller increase in their CDS spreads, from 43bp and 57bp, respectively, in early 2008 to 210bp in November 2008. Unless the government has a pristine balance sheet, the spillover of the credit crunch from the private to the public domain – and consequently higher costs of fiscal financing – is likely to undermine how aggressively ASEAN governments can engage in fiscal pump-priming.

Assessing ASEAN in a Three-Factor Framework

As developed economies likely contract in 2009, ASEAN economies will face their most difficult test since 2001. To set the context, while the 1997-98 financial crisis had its epicenter in the East, this credit crunch was not made in Asia. The debt supercycle in the US saw American financial institutions, GSEs, corporates and households leveraging up. However, ASEAN economies (government, corporates and households) have deleveraged coming out of the 1998 crisis. Bank credit (as a percentage of GDP) fell from 60-166% of GDP at the peak to 25-100% in 2007. Government debt similarly fell from peak levels of 61-93% of GDP to 35-42% in 2007. Macro imbalances such as the current account deficits that most ASEAN economies were running prior to the 1998 crisis had also given way to either a surplus or a milder deficit. 

To the extent that macro problems are not domestic in ASEAN, better fundamentals will enable ASEAN to quickly regain its footing once the global macro recovery is in sight. Yet, ASEAN remains vulnerable to the spillover impact from the credit market fallout. In our view, the relative ranking of ASEAN macro vulnerability hinges on what we see as a two-fold transmission mechanism and the propensity/ability for monetary and fiscal policy response, which we outline below:

•           Who is most addicted to risk-capital liquidity? Overall balance sheets are less overstretched compared to 1997-98. However, economies that have, at the margin, been most dependent on leverage as a fuel of economic growth would be most affected, as liquidity becomes scarcer and more costly in this deleveraging cycle. The source of credit funding is also critical. In an environment of risk-aversion, economies that had been running a credit cycle alongside current account deficits are likely to see the most disruptive tightening of liquidity conditions. By these measures, we believe that Indonesia is most vulnerable, followed by Singapore, Thailand and then Malaysia, as credit growth in the latter two remained relatively subdued. 

Indeed, we believe that the disruptive tightening in liquidity conditions for Indonesia could be further exacerbated. The rupiah remains vulnerable to depreciation pressures and liberal capital account convertibility. If the central bank chooses to intervene to preserve FX stability, it will withdraw liquidity (buying rupiah and selling dollars) from the system at a time when liquidity conditions are tight. In addition, the fall in commodity prices could further depress the commodity trade balance at a time when the non-commodity trade balance has already fallen into negative territory. On the other hand, Singapore also had a strong credit cycle with loan growth at 24.8%Y in September 2008. Its liquidity conditions are less dismal, given the huge current account surplus and the central bank’s excess liquidity pool. Nonetheless, Singapore banks have not been immune to widening financial CDS spreads. Lending spreads have risen, and bank lending standards have tightened.

•           Who is most exposed to global trade and asset markets? Economies with a smaller domestic demand base and higher trade and asset market linkages will be more susceptible to a bigger growth deceleration in this coming global slowdown. In this regard, we believe that Singapore remains most vulnerable, followed by Malaysia, Thailand and then Indonesia.

Indeed, Singapore’s dependence on external demand is further undermined by the relative underperformance of its exporters. Its electronics export industry lags in terms of technology and does not have a fully integrated tech food chain or strong local brand names, as is the case with Taiwan or Korea. Moreover, its biomedical exports are notoriously volatile, as production remains dominated by a few key players. Malaysia faces a similar problem with its non-commodity exports. Its exporters of integrated circuits and telecommunications equipment saw their global market shares decline from 8% and 4.5%, respectively, in the early 2000s to 6.5% and 2.6% in 2006.

•           Who has the ability and wherewithal to undertake policy responses? The ability to cushion the downcycle would depend on the authorities’ propensity for and the extent of policy responses. However, widening spreads, a change in the pricing of risk and tighter lending standards have rendered the monetary policy easing less effective than usual. Indeed, despite the rate pause, we believe that monetary policy rate changes have already ceased being an effective signaling tool in Indonesia, as automatic tightening by the market will likely continue. Nonetheless, economies where the central banks are sitting on reasonable liquidity (i.e., Malaysia) and that have not seen a strong credit cycle (i.e., Malaysia and Thailand) – hence have a lesser possibility of bad lending – will likely experience a higher degree of success in terms of monetary easing.

As discussed earlier, fiscal expansion is likely to be constrained by a higher cost of fiscal financing, particularly for Indonesia. Despite the 2009 elections, the Indonesian government expects the fiscal deficit to narrow to 1% of GDP from 1.3% in 2008. Malaysia and Thailand’s fiscal pump-priming would similarly be constrained by rising financing costs. The Singapore government has the most gunpowder, given its history of fiscal surpluses, and the government is also looking to revise regulations to unlock more of its SWFs’ expected stream of capital gains for government expenditure. However, in spite of the anti-cyclical stance, we note that Singapore’s fiscal expansion tends to be less aggressive than its ASEAN neighbors. Recall that the fiscal deficit stood at around -0.9% of GDP in F2001 and -1% of GDP in F2003. Our ranking in terms of policy responses is Singapore (more effective), Malaysia, Thailand and then Indonesia (less effective).

Based on the above three criteria, the pecking order for ASEAN macro vulnerability in a downcycle would be Indonesia (most pain), followed by Singapore, Malaysia and then Thailand (lesser pain). 

A Tepid Growth Recovery in 2010

We are simultaneously rolling out our forecasts for 2010. As highlighted by our global economists, Joachim Fels and Richard Berner (see Beyond a Deeper Recession: Tepid Recovery, November 10, 2008), our macro team expects the 2010 recovery to be anemic rather than dynamic, mainly because still-lower asset values and slower growth constrain consumer spending while negative operating leverage makes it less compelling for capital investment. Moreover, credit costs are also likely to be structurally higher from regulatory reforms.

As a result, we expect ASEAN 2010 growth to come in at 4.4%, significantly lower than the five-year average of 5.8% seen between 2003 and 2007. We continue to see the risks to our forecasts as skewed to the downside, with 1% global growth as a real possibility.

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Taiwan
Mild Recession but Negative Growth Not Likely
November 12, 2008

By Sharon Lam | Hong Kong

Summary and Conclusions

We are cutting our GDP forecasts yet again. The reasons behind the latest round of revisions are largely the same as in prior occasions, only the move down is more severe. We expect that Taiwan could head into a mild recession in 4Q08 and 1Q09, i.e., two consecutive quarters of sequential negative growth. Although the global economy is facing a deep recession this time, we do not see Taiwan heading for a 2001-like recession.

We cut our GDP forecast to 3.8% (from 4.2%) for 2008 and to 1.5% (from 3.4%) for 2009, meaning that next year’s growth will be the lowest since 2001 when GDP posted a 2.2% contraction.  We are also revising down 2009 CPI growth to 1.5% but keeping 2008 unchanged at 3.5%. In terms of policy response, we expect further interest rate reductions of 100bp before mid-2009 (see Running Ahead in This Rate Cut Race, November 10, 2008) along with tax rate cuts and infrastructure spending that we estimate would add up to 1-1.5% of GDP of fiscal stimulus in 2009.

The recent debate on Taiwan’s GDP outlook centers on whether it will dip into negative territory next year on a year-on-year basis. We think that negative growth is highly unlikely. Focusing solely on any one single economy in the region, the outlook appears very weak, as no one country may be immune from this global recession. Therefore, it is more important to observe an economy on a comparative basis to determine which ones can climb out from the global recession sooner than others. We still view Taiwan as having a safer domestic economy due to the lack of excesses in consumption and investment in this cycle. Taiwan’s problems – namely export slowdown and decline in asset prices – are not Taiwan-specific. On the other hand, there are many macro concerns facing other economies in the region that Taiwan does not face.

Negative Growth Next Year Seems Unlikely

Some pundits argue that export growth next year could be extremely weak, and thus Taiwan’s real GDP growth could turn negative for the first time since 2001. This argument is not entirely accurate, in my view. No matter how bad export growth could be next year, the contribution from net exports is likely to remain positive. On a trend average, exports account for 65% of GDP, while imports takes up 60%, and this 5% gap is always a stable contribution to GDP growth. When exports slow, imports of goods for export purposes typically slow proportionately; thus, the only way to erase the positive net export gap is for strong domestic demand to push up imports. In the last 10 years, net exports turned negative only in 1997, 1998 and 2004 – when domestic demand was exceptionally strong; apparently, this will not be the case this time. It simply does not make sense to have a negative net export contribution and weak domestic demand at the same time. Even during the 2001 recession when exports plunged, the contribution from net exports to GDP was still 2.5pp; we forecast a 2.1pp contribution for 2009. Using falling export growth to argue for negative GDP growth is therefore incorrect.

So, we have explained why the net export contribution to GDP growth will remain positive, and the next question is can domestic demand plunge so much to drag overall GDP growth to negative? We believe that our forecasts on domestic demand are already conservative enough. We forecast private consumption growth next year to be at a historical low (since data became available from 1950) at +0.5%Y and contribute 0.3pp to GDP growth. We are reluctant to revise this figure down further to negative since Taiwanese consumers have already been spending below their income growth for years, while population growth is still positive. As for capex, we expect a 6% decline, which would cut GDP growth by 1.1pp. Some may call into question our capex forecast, as the drop this time will be much milder than in 2001. We argue that our view reflects no serious overcapacity in this cycle. There was a significant build-up in capex in the years preceding 2001, which created a major correction and wiped out the overcapacity.  However, this time is different since there was almost no growth in capex every year since 2005; we think it is highly unlikely that capex will drop as much as 2001 this time. 

The Macro Risks That Taiwan Doesn’t Face

Many Asian economies are facing problems that Taiwan has, namely daunting exports and falling asset prices, but there are also a number of challenges for other economies that Taiwan doesn’t have. First, Taiwan does not have liquidity issues as reflected in the strong reserves of the domestic banks and falling interbank rates. Second, Taiwan does not have dollar shortage problems since it is running a decent current account surplus of nearly 7% of GDP, and it also has a very strong foreign reserves position that would allow it to cover its total short-term external debt three times. Third, it does not have over-consumption problems created by the wealth effect in the last few years. Therefore, the downward adjustment in consumption is also likely to be milder than in other economies where consumption has been on the back of paper wealth gains. Finally, Taiwanese households have already started to deleverage since 2006, while other economies are only at the beginning of this painful deleveraging process. 

Although Taiwan will have to endure 2-3 quarters of severe export slowdown, we believe that its domestic economy should stand out versus others in the region, given the lack of the aforementioned macro risks. A domestic-led recession typically drags on for longer, while an export-led cyclical adjustment is completed faster; Taiwan is going through the latter. We believe that Taiwan will outperform most of the region, probably after China, starting in 2Q09; other economies will still be struggling to rebuild their domestic economy, while Taiwan will be climbing out from the trough of the export growth with a solid domestic economy.

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