The Chinese economy posted stronger-than-expected real GDP growth of 6.1%Y in 1Q09, mainly reflecting the sharp sequential rebound in economic activity in March following the sharp plunge in January-February (especially in trade), which vindicated fears of economic conditions getting worse before getting better (see China Economics: Data Preview – Longing for Inflection, April 7, 2009). Indeed, as we had expected, the economy had weakened further (‘getting worse’) in 1Q09, from the 6.8%Y growth rate in 4Q08, but the dip was milder than expected. On a seasonally adjusted basis, we estimate that the economy staged a 5%Q rebound in 1Q09, after the first quarter-on-quarter contraction (-0.5%) in almost eight years in 4Q08. We attribute the better-than-expected economic performance to the very aggressive policy response to the hard landing in 4Q08 that has served to lessen the depth of the cyclical trough. In particular, policy-driven monetary expansion drove money and loan growth to record highs in March, up 25.5% and 29.8%Y, respectively, with new loans made in 1Q09 totaling Rmb4.6 trillion, almost 3.5 times the amount in the year-ago period, or 93% of 2008’s total. Although we do not think that such rapid credit expansion is sustainable throughout the year (see China Economics: Recent Rapid Bank Credit Expansion Not Sustainable, February 2, 2009), the heavily front-loaded policy response of ‘crisis-management’ style to supporting growth has helped to effectively shore up the confidence of private investors and households and reflate the asset markets, in our view. This in turn contributed to the resilience in consumption and the rebound in real estate development investment (+7.3%Y in March versus +1% in January-February), offsetting the negative impact from job losses and slower income growth from the weak external environment. The latest report card remains broadly consistent with our ‘getting worse (in 1H09) before getting better (in 2H09)’ call. We continue to believe that the bulk of real stimulative effect from the multi-trillion-renminbi fiscal package and expansionary monetary and credit policy is only expected to materialize in 2H09, when we should see a more genuine recovery in the economy. External Weakness versus Domestic Demand Resilience Although the year-on-year plunge in exports narrowed in March (-17.1%Y versus -21.1% in January-February) (see China Data Releases: Strong Rally of Exports in March on Sequential Basis, April 10, 2009), suggesting that we might have seen the worst in external demand, China did experience an unprecedented drop in trade flows in 1Q09 (exports -19.7%, imports -30.8%). The deceleration in overall GDP growth was undoubtedly milder than that suggested by the contraction in trade, as the strong fiscal policy response helped to support domestic demand. Even though retail sales growth has been slowing in nominal terms due to rapid disinflation, consumer spending remained strong in real terms. March sales totaled Rmb932 billion, up 14.7%Y (versus our forecast of +14.5%). Although this represented further deceleration from the 15.2% gain in January-February, growth actually strengthened in real terms (deflated by retail price inflation) in March to 16.4%Y, from 15.7% in the first two months. Meanwhile, urban fixed asset investment picked up further in March, gaining 30.3%Y (+26.5% in January-February, +23.4% in 4Q08). In particular, in reaction to the pick-up in property transactions upon stabilizing sentiment, real estate development investment rebounded, growing 7.3%Y in March, after dipping to just 1% in January-February, though still much weaker than the 20.9% expansion last year. Meanwhile, we believe that government initiatives remained a strong driver behind the pick-up in capex, with investment in the western (+46.1%Y in 1Q09) and middle (+34.3%) regions far outpacing that in the eastern region (+19.8%). Nevertheless, we again note that FAI statistics capture the value of asset acquisition transactions (e.g., land transactions before property construction), which are not genuine capital formation activities. But we do believe that the fiscal stimulus plan should bring about a meaningful boost to capex in the coming months. No apparent further deterioration in sentiment, resilience in domestic demand and narrowing declines in trade helped to stage a noticeable bounce back in value-added industrial output, to 8.3%Y in March from 3.8% in the first two months. This beat our forecast (+3%) by a large margin. On the contrary, however, power output fell 0.7%Y in March (-2.6% in 1Q09), seemingly contradicting the trend in overall output. We believe that this could suggest a more severe slowdown in the power-intensive sectors, such as steel and other metals, as high raw material prices last year encouraged speculative production and overstocking. Price Adjustment Continues, but Milder than Expected Broadly in line with our expectation, consumer prices remained in deflation in March, falling 1.2%Y (we forecast -1.4%). Consumer deflation averaged 0.6%Y in 1Q09. In the upstream, nevertheless, price drops seem to be alleviating in line with the pick-up in sentiment and activity. Although producer prices (PPI, -6%Y (Morgan Stanley estimate) in March versus -4.5% in February) and raw materials purchasing prices (RMPPI, -8.9% versus -7.1%) both posted steeper year-on-year declines in March than February, the figures were less negative than our forecasts (-7% and -9.5%, respectively). Policy Outlook Despite the latest data for March indicating that the economy may have bottomed and even shown signs of recovery and the surge in bank lending growth, we do not expect any meaningful shift in monetary policy stance in the near term. We expect monetary policy to be kept sufficiently loose until an economic recovery is firmly underway, which we expect to materialize by mid-year (see China Economics: US Fed’s QE Points to More Monetary Easing in China, March 25, 2009). In view of the persistence of deflation, we expect one 27bp interest rate cut in 2Q09 and further RRR cuts if warranted by liquidity need. We expect rapid new loan creation to moderate in the coming months, as the authorities’ monetary policymaking shifts from the ‘crisis management’ mode to a ‘conventional monetary easing’ one over the course of the year. The total new loan creation could reach Rmb6-7 trillion for the year, in our view. We expect loan growth to moderate to the 18-20%Y range toward the latter part of the year. Despite the likely moderation in loan growth, the share of medium- and long-term loans in total new loan creation should increase as the investment projects under the stimulus plan are being carried out. Meanwhile, upon realizing the better-than-expected performance in 1Q09, we believe that there is no need for additional fiscal policy stimulus in the near term. The maintenance of the status quo of fiscal and monetary policy stances should lead the economy further up its recovery path, in our view. Upside Risk to Growth Forecasts In view of this better-than-expected performance in 1Q09, we think there is now considerable upside risk to our current forecast for 5.5% real GDP growth in 2009. In particular, we believe that the very aggressive policy response – as in part reflected in the surge in bank lending – has helped to contain the deterioration in sentiment and confidence and reflate asset prices, preventing a too rapid slowdown in private consumption and investment. While we still believe that a meaningful recovery in real economic activity will not take place until mid-year, as the bulk of the effect of policy stimulus kicks in and a tepid recovery in G3 demand starts to set in towards year-end, it appears that a rosy ‘goldilocks recovery scenario’, which we had previously thought of as a low probability event, is playing out (see China Strategy and Economics: 2009 GDP Recovery Unlikely to Boost Profits or Equities, February 23, 2009). Regular readers of our reports may recall that under this ideal recovery scenario, we envisage the Chinese authorities taking a rather unorthodox approach in managing the economic downturn: boosting the real economy through reflating the stock market first. The goldilocks recovery scenario would therefore feature a series of positive catalysts, such: 1) a technical rebound in growth as destocking runs its course and trade finance normalizes somewhat in 1Q09; 2) on the back of a policy-induced, liquidity-driven stock market rally (despite weakening fundamentals), the confidence of consumers and private investors is boosted despite job loss and slower sales/income growth, thus preventing too rapid a slowdown in consumption and private investment in late 1Q and 2Q09; 3) the effect of fiscal stimulus starts to show in a major pick-up in public investment growth in late 2Q or early 3Q09; and 4) the G3 economies bottom and stage a tepid recovery in 4Q09, improving external demand and further boosting confidence. Although we had attached a low probability to this ‘everything-goes-exactly-right’ scenario at the time, it is looking increasingly probable that this scenario is playing out. In particular, it has become evident that the Chinese authorities, who still have a powerful and pervasive influence over the business community (including in particular the banking sector), are determined to leverage the ‘strong balance sheet’ of the economy for a ‘decent-looking income statement’ of the economy in the next couple of years. If this scenario were to materialize, we believe that the ‘getting-worse’ leg under our baseline recovery scenario would not be as deep as we envisage, and thus the average GDP growth rate in 2009 could be higher than 5.5%. We will likely revisit our forecasts after we take comprehensive stock of the developments based on a full set of data that will be made available in the coming days. Implications: China to Be Among First to Recover In our view, the aggressive policy stimulus should bring about further recovery in GDP growth in 2H09, making China among the first countries to emerge from the global downturn. Nevertheless, while the policy stimulus can help to bring about a rebound in the headline GDP growth rate and may even prevent a sharp rise in the unemployment rate, we believe that it is unlikely to be able to deliver corporate earnings growth nearly as strong as when the same level of headline GDP growth is fueled by buoyant private sector spending. This would be a relatively ‘job-rich’ but ‘profit-deficient’ macroeconomic environment, especially in 1H09, with sectors/companies exposed to government-supported capex programs most likely being able to benefit most, in our view. For more details, please see China Economics: ‘Worse’ in 1Q09, but Not as Bad as Expected, April 16, 2009.
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Ready to Cope with the New Global Environment?
April 17, 2009
By Chetan Ahya | Singapore & Tanvee Gupta | India
Summary The recent period of strong global growth, which was premised on widening global imbalances, is over. Contraction in global growth has resulted in a major reversal in capital inflows into India and other major emerging markets. This, coupled with a sharp contraction in exports, has caused an unprecedented growth shock. The worst may now be behind us, and we do expect a gradual recovery from 2H09. However, investors’ focus will shift to the pace and strength of recovery. We believe that the weak global growth environment will affect the pace of recovery. Our economics team expects global GDP growth to recover to a tepid 2.7% in 2010, well below the average of 4.9% between 2004 and 2007 (a period of strong global growth). Moreover, India needs to pay back from its own credit cycle excesses and has limited flexibility to further increase its fiscal deficit. In this environment, we believe that a quick recovery to 7.5-8% GDP growth requires a stronger pace of structural reforms. Easy Growth Trend Over Over the last few years prior to the recent emergence of the credit turmoil, India’s growth trend was extremely strong. While factors such as demographics and significant restructuring of the corporate sector have been key in lifting the structural growth rates, it is important to disentangle the contribution of the strong global growth trend and unusually high level of global financial risk appetite. We believe that these global factors had more to contribute to India’s growth acceleration in the four years ended 2007 than structural factors. Indeed, we believe that the pace of structural reforms has been much slower than warranted during this period. Strong growth driven by cyclical global factors meant some amount of complacency towards structural reforms. Therefore, it should come as no surprise that a sharp reversal in the global growth and financial risk appetite has now thrown India’s growth trend out of gear. In many ways, India had witnessed a classic emerging market growth boom. Increased global financial risk appetite meant large capital inflows into India (a large part of this being unstable non-FDI inflows), in line with other emerging markets. The central bank left an average of about 70% of the capital inflows unsterilized over the last four years ending March 2008, resulting in a significant decline in real interest rates even as real GDP growth kept accelerating. The unprecedented credit boom that followed this trend ensured strong growth in domestic demand. However, this trend was always fraught with risk due to its extreme dependence on global capital inflows, which over the years have proved to be volatile. The period of strong global growth premised on widening global imbalances is over. Compared with total capital inflows of US$108 billion during the 12 months ending March 2008 (F2008), India witnessed capital outflows of US$3.7 billion during the quarter ended December 2008. A reversal in capital inflows is causing India’s growth engine to slow dramatically. A sharp decline in exports is also adding to the pain. Industrial production growth has already decelerated to -0.5%Y during the three months ended February 2009 from a peak of 13.6%Y in the quarter ended January 2007. Just as during 2005-07 when strong positive global factors supported India’s growth above its then-sustainable growth trend, negative global factors are now pulling its growth below potential. Apart from adverse global factors, India faces the payback from the excesses of its own credit cycle and unusually high level of fiscal deficit. Payback from India’s Own Credit Cycle Excesses Over the four years prior to the Lehman event, the banking system has witnessed average credit growth of 28.6%Y – the highest credit growth among the top 10 economies in the AXJ region. To the extent to which banks were aggressive in disbursing credit at unusually low rates to marginal borrowers at cycle-peak GDP growth, they are now facing a rise in non-performing loans (NPLs). We believe that, from 2H05, the banking and non-banking financial sector was extremely liberal in pricing credit. However, the first round of growth shock is now causing an increase in NPLs in the non-banking as well as banking system. NPLs are already rising in the real estate sector, unsecured personal loans and SME loans. With industrial production reaching close to a 16-year low of -1.2%Y as of February 2009 and the cost of capital still high, NPLs will likely rise further. We expect banks to remain risk-averse, resulting in credit growth slowing to 10%Y by 4Q09. High Level of Fiscal Deficit Is an Added Challenge Over the last few years, while GDP growth accelerated, the government continued to pursue a pro-cyclical fiscal policy, taking the deficit and public debt to higher levels. From the recent trough of 6.8% in F2008, the consolidated fiscal deficit including off-budget items increased to 12.6% in F2009. Moreover, public debt to GDP is at an extremely high level of 83.8% of GDP (including off-budget items), as per our estimates. Typically, the cost of a high fiscal deficit would have been higher real interest rates. However, India witnessed an unusually low real interest rate environment right at the time when its fiscal policy had been loose, as reflected in rising public debt to GDP. The key to lower-than-warranted real interest rates was the large capital inflows. Almost 85.6% of the total US$207 billion capital flows that India received over the four years ending March 2008 were in the form of non-FDI flows. However, in the era of global deleveraging and significantly lower capital inflows, the high level of deficit issue should remain in the form of higher real interest rates for the private sector. One could argue that, considering the long-term fundamentals of the private sector, global capital inflows should continue unabated and a further rise in real interest rates would be prevented for longer. However, the past trend indicates that swings in these capital inflows have little to do with the long-term fundamentals of the recipient country. Moreover, the current high level of unproductive government expenditure and public debt is weighing on the long-term growth potential. The government’s spending on productive areas such as infrastructure, education, health and welfare has been constrained by high levels of non-development expenditure and the high starting point of the debt level. The government’s development expenditure has averaged 14.5% of GDP over the last five years, declining from 17% at the commencement of the liberalization process in F1991. Election Outcome Is Key Considering the current state of the economy and the global growth environment, we believe that the general election results will be important in influencing the medium-term growth outlook. There are three possible outcomes from the general elections: a) Status quo – a moderately wide coalition government led by the Congress party or the Bhartiya Janata Party (BJP); b) Narrow coalition government led by the BJP or the Congress party – in this outcome, either the BJP or the Congress party would get close to 170-180 parliamentary seats; or c) Extremely wide coalition government led by the ‘Third Front’ (a group of political parties other than the Congress and the BJP). The probability of this outcome will increase significantly if the two leading parties – the BJP and Congress – together manage to get less than 250 seats. Decisive policy actions will be critical to lift the pace of GDP growth closer to potential. We believe that the most important policy measure will be to achieve a significant rise in infrastructure spending without increasing the fiscal deficit and public debt burden. While outcome (c) should mean that chances of acceleration in the pace of reforms will be low, we think that outcome (b) will increase the likelihood of implementing politically difficult economic reforms. Bottom Line The global growth environment will likely remain poor over the next two years compared with the boom years of 2004-07. Assuming a status quo in the current pace of reforms, we believe that India’s GDP growth is likely be tepid at 6.1% in 2010. The upside and downside risks to our estimates emerge from the pace and strength of global growth recovery and the outcome of the general elections in May 2009.
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Green Shoots to Bear Fruit?
April 17, 2009
By Manoj Pradhan | London
Our latest global economic forecasts and our bull/base/bear scenarios for output, inflation and policy rates have left our main thesis intact, but show quite clearly where the risks to the main macroeconomic indicators lie going forward. In a nutshell, we continue to expect global growth to resume in 2H09 but warn our readers that any recovery will likely be anaemic. We see some ‘green shoots’ in the survey measures, with improvements in the Ifo and the ISM for the last three months along with a significant improvement in the second derivative of GDP. Further, we expect that the drop in global inflation and deflation in most of the G10 and much of Asia will likely be temporary and mild inflation will make a return to both these regions in 2010. Massive global policy action has moved us further away from a Great Depression-type outcome, and the risks of contracting output and structural deflation have waned. The most pertinent concerns right now are the prospects of a weak recovery along with the risk of rising inflation further down the road. The risk of higher inflation comes from conventional monetary stimulus and unconventional Quantitative Easing measures that are going to be tricky to reverse. Central banks are going to have to decide when growth has become entrenched enough to start tackling inflation. At best, this is perhaps the most difficult decision central banks will have had to make in the last three decades. For detailed global, regional and country forecasts, readers should refer to Global Forecast Snapshots, April 14, 2009. Is the worst behind us? On our forecasts, yes! However, the Great Recession still has a way to go. Global output will probably start growing in 3Q09, with G10 output growth turning positive in 4Q. However, growth for 2009 as a whole will stay firmly in negative territory for all regions except AXJ (where China and India will continue to keep growth in positive territory). We expect AXJ’s outperformance to be sustained next year with a 6.4% increase in output, compared to 2.1% for CEEMEA, 1.1% for the G10 and 0.3% for Latam. The bull/base/bear exercise highlights the risks to growth. Our global team has also produced bull/base/bear scenarios for output, inflation and policy rates. The bull and bear scenarios are not tail-risk events. Rather, they have been constructed so that there is a reasonable 20% probability that either could materialise, which leaves the base case to account for the central 60% of outcomes. In our base case, around 80% of the economies we cover will contract in 2009. Even if our bull case was realised, only Korea would show significant positive output growth (though Poland and Colombia are expected to record 0.2% growth)! In 2010, our base case has growth exceeding 2% only in the AXJ countries, Turkey and South Africa. But risks to growth remain in 2010. If the bear case were to materialise, only nine countries under our coverage would show positive output growth even in 2010, with six of the nine in the AXJ region. Clearly, even with a return to growth in our sights, the risks to growth remain significant. G10 outlook: Weak recovery, tame inflation prints but inflation risks further down the road. G10 growth is clearly critical for the global economy. Our EM economists have long stressed that even massive policy responses will not lead to sustainable growth if the G10 region does not show some progress on the growth front. Encouragingly, our G10 economics forecasts show that the second derivative of growth has likely already turned positive in 1Q09, implying that further contractions in output will be smaller and that output growth will return to positive territory in 4Q10. The massive policy response seems to be gaining some traction and the risks of a repeat of the Great Depression seem to have receded. However, any hopes of a strong bounce off the bottom should be put to rest. Growth in 2009 will likely be a very poor -3.5% while growth in 2010 in the G10 will likely clock in at just 1.1%. Deflation is expected to be a temporary phenomenon, with a return to inflation in 2010. However, while inflation itself will likely remain tamely below the inflation targets of G10 central banks in 2010, the same cannot be said of the risk of higher inflation beyond 2010. Monetary policy will most likely continue to stay in expansionary territory. Policy conditions are likely to continue to provide ongoing stimulus through 2010. Our teams expect interest rates to come off their historical lows only next year (with the notable exception of the UK, where our team expects a hike in the base rate in 3Q09). A nominal G10 aggregate policy rate of 1.7% by end-2010 is still below neutral, implying that the major central banks will likely keep policy expansionary in order to ensure that economic growth is entrenched. What is less clear is how quickly central banks that have conducted outright purchases of securities as part of a QE strategy – namely the Fed, the BoE, the BoJ and the SNB – will be able to lighten their balance sheets. These purchases have been enabled by ‘printing’ (electronic) money. The risks to inflation are likely to persist until central banks can withdraw this liquidity, something they would like to achieve without derailing the fragile recovery (see “QE2: Size Matters”, The Global Monetary Analyst, March 25, 2009). Outside chance of aggressive policy tightening in our bull case. There is a possibility that central banks could aggressively raise interest rates in 2010, pushing the G10 policy rate to 3.5%. Such aggressive action corresponds to our ‘bull’ scenario in which strong G10 growth of 2.8% in 2010 and an inflation rate of 2.6% prompt central banks to worry less about growth and more about inflation. Under our base or bear scenarios, policy is likely to remain expansionary. EM outlook: Similar story in EM with much greater differentiation. The essence of the thesis remains similar for emerging economies, but there is much greater differentiation in the different regions for growth and for our bull/base/bear scenarios. Recovery in 2010 with AXJ outperformance on virtually all counts. Our base case is for most EM economies to record positive growth in 2010. In the EM universe, only Venezuela is likely to turn in significant negative growth in 2010, while four others should see growth hover around zero (Hungary -0.2%, Mexico 0.2%, Colombia 0.2%, Argentina -0.1%). Again, our bull/bear scenarios highlight exactly where the growth risks are concentrated – in the CEEMEA and Latam regions. If the bear case were to be realised, only Turkey would record significant positive growth (2%) in CEEMEA and Latam compared to growth of 0.5% or more for six countries in the AXJ region in 2010. On the inflation front as well, the AXJ region scores better than the CEEMEA and Latam regions in both 2009 and 2010. In 2010 in particular, AXJ inflation is likely to print at 2.5%. CEEMEA at 8.3% and Latam at 6.2% are likely to show higher inflation. However, the CEEMEA region scores poorly on an additional dimension – in our bear case, inflation in CEEMEA would print at a whopping 12.6% (driven by higher inflation in Russia and Ukraine due to weaker currencies), compared to 6.6% in Latam. Inflation has shackled the CEEMEA and Latam regions but has allowed AXJ central banks to ease rapidly. The higher inflation and the risks from currency weakness in CEEMEA and Latam have meant less policy flexibility as well. Central banks in these regions have had to grapple with both issues and have generally been less willing to slash rates to very low levels. Hong Kong, Korea, Taiwan, Malaysia and Thailand are all likely to have troughs in policy rates at 1% or less while India and China have cut rates rapidly and implemented sizeable fiscal policy packages. Compared to this, only the central banks of the Czech Republic and Chile are likely to take rates to 1.5% and 1%, respectively.
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