We have previously highlighted three macro themes that investors are likely to be focused on for 2010 (see ASEAN Economics: Preferring Domestic Demand Plays in a Slow and Steady World, September 24, 2009). They are 1) global conditions and the type of macro recovery; 2) inflationary pressures and potential inflation hedges; and 3) policy exit roadmap. We still think these themes are pertinent in assessing how ASEAN economies will fare and how they will perform relative to one another in 2010 and 2011. Based on this framework, our preference rankings for ASEAN (in terms of the growth outlook and the certainty of growth prospects) are Indonesia then Singapore and Malaysia followed by Thailand. We outline why below:
1. Not Quite a Bed of Roses but Global Macro Conditions Have Definitely Become Rosier
With the exception of Indonesia, ASEAN economies are fairly open to international trade, which is why global conditions is the single-most important factor affecting our preference rankings. The global economy is way past doom and gloom and now looks to be on a respectable rebound, which will have ripple effects, most notably for Singapore, then Malaysia followed by Thailand. This is why we rank Singapore and Malaysia ahead of Thailand in terms of our growth rankings.
The low base effects post Lehman in 2008 ensures a favourable export reading on a year-on-year percentage basis, but the strength of the momentum can be seen in the healthy sequential momentum across the region. Indeed, December exports in AXJ (excluding Malaysia) rose 11.1%M on a seasonally adjusted basis, a robust momentum by any account. To be sure, part of this surge may be due to restocking. The inventory-to-sales ratio in the US still stands at a low of 1.37 as at November 2009. Moreover, in the latest January US Manufacturing ISM, 40% of respondents indicated that their stockpiles were too low versus only 4% who reported that they were too high. Anecdotally, we heard that companies did not want to unduly stock up during the pre-Christmas season due to demand uncertainty. However, the ensuing momentum has caught them by surprise and, coupled with low inventory levels, led to the rush orders seen in recent datapoints. Indeed, we expect ASEAN economies to see very strong 1Q10 GDP numbers on the back of this and given the base effects. The sustainability of what may be a restocking bounce is key. However, to the extent to which the global macro team is not expecting a double-dip recession, we think the tail risk that the global economy will roll over after this data bounce is significantly reduced.
International trade aside, global macro conditions also matter from the perspective of asset market linkages and capital flows. This may be more relevant to Indonesia, given its comparatively thinner current account balance. Global risk appetite as seen in Morgan Stanley's GRDI indicator has been on the back foot recently, and our strategists also believe that markets may be range-bound for 2010. However, the improvement in Indonesia's macro fundamentals post the 1998 Asian Financial Crisis has strengthened its ability to withstand shocks from capital outflows with lesser impact on the currency, inflation and consequently monetary policy. To the extent to which the world is not returning to the severe risk-aversion mode we saw in late 2008 and early 2009, we think that global macro conditions are generally conducive for further unfolding of the structural decline in the cost of capital story in Indonesia. We see this structural secular domestic demand story as a more powerful one than the cyclical external demand stories in Singapore or Malaysia, hence our number one ranking for Indonesia.
2. Inflationary Pressures Are on the Rise, and Who Offers an Inflation Hedge?
With breakeven inflation (BEI) going higher (see ASEAN MacroScope: Inflation Risk or Scare? January 20, 2010), we think that a net commodity exporting base would be a nice inflation hedge to have in this environment. In this area, Malaysia (the largest net commodity exporting economy within Asia) and Indonesia have an edge over Singapore and Thailand. As we highlighted in our last ASEAN MacroScope, both the inflation camp and deflation camp may be right in the near-term assessment of the inflation outlook, depending on which inflation matrix one is looking at. We suspect that demand-pull inflationary pressures may take some time before coming back and core inflation would stay subdued. Indeed, while producers are facing higher input costs as seen in the PPI, pricing power does not seem to have returned as manufactured goods inflation still stays on a subdued trend. However, the aggressive policy stimulus and the sentiment support it provides have already led to significant asset reflation at a far earlier stage of this recovery cycle. In this regard, commodity reflation is likely to push headline inflation higher. As it is, tradeables and non-core inflation are already on an uptrend in ASEAN while non-tradables and core inflation lag behind.
3. Navigating the Policy Exit Roadmaps
2010 will be the year of policy exit for ASEAN and Asia for that matter. Indeed, on monetary policy, our base case has been for Indonesia to hike in 2Q10 and Malaysia and Thailand to hike in 3Q10. Yet, the recent initiation into monetary policy renormalization seen in China and India's reserve ratio hikes, the tonal shift seen in the monetary policy statements of the Bank of Thailand and Bank Negara Malaysia and our reassessment of GDP outlook lead us to think that monetary policy renormalization in some parts of ASEAN could proceed sooner than expected. We still expect Indonesia to start its first rate hike in 2Q10. For Malaysia and Thailand, we are now bringing forward the first policy rate hike to 2Q10 from 3Q10, though we are not changing our terminal policy rate forecast.
Fiscal policy response is where the differentiation is more stark, in our view. Most ASEAN economies are likely to see a fiscal winding down in 2010. In Malaysia, the 2010 budget deficit is expected to narrow to 5.6% of GDP from 7.4% in 2009. In Singapore, the government has extended but scaled down the stimulus measures announced in the 2009 budget, such as the Jobs Credit scheme and the Risk-sharing initiative. A second stimulus package is unlikely to be incorporated into the 2010 Budget to be announced on February 22. Meanwhile in Indonesia, the fiscal policy tool has not been used as aggressively as in other ASEAN economies despite the reduction in public debt ratios to be one of the lowest in the region. Thailand is where fiscal policy measures are most aggressive for 2010. While the budget expenditure is expected to come off in 2010, this understates the true expansionary nature of fiscal policy, given the Bht350 billion extra budgetary spending and investment in mega projects such as the mass transit lines being undertaken by the state-owned agencies. Overall, we think that Thailand still operates the most aggressive policy response.
Having said that, we note that at the trough of the cycle, having an aggressive policy response serves as a last line of defense against a too-severe macro slowdown. Yet, with the rebound now panning out and tail risks behind us, having an aggressive policy stimulus will help to bolster the recovery but is now a less critical factor in determining whether an economy will outperform, in our view. This is why we rank Singapore and Malaysia ahead of Thailand in terms of growth outlook.
Indonesia: On India's Trail?
Where Do We Differ?
We are bullish on Indonesia and our 2010 and 2011 GDP forecasts stand at 5.5%Y and 6.3%Y, respectively. This is more or less in line with consensus at 5.6% and 6.0%. Most analysts on the Street point to the improving political landscape, favourable demographic patterns and natural commodity resources as factors supporting higher growth. We agree but would point out that the most important factor in the growth equation is likely to be the structural decline in cost of capital, which we have been highlighting for some time now.
What's the Key Thesis?
From a structural perspective, we see Indonesia following India's trail (see Asia Pacific Economics: Indonesia on India's Trails? December 9, 2009). India's story has been one of a decline in the cost of capital and a consequent rise in corporate ROE spreads over cost of capital, which has in turn boosted investment and raised the growth trajectory. Indonesia is seeing a similar pattern. A structural decline in cost of capital has been underway and should continue to unfold as macro stability continues to improve.
As to why the structural decline in cost of capital is now underway, bad leverage structure in the form of high dependence on external leverage has been the key issue for Indonesia in the pre-1998 crisis. However, this has now been corrected as the government reduced the share of external debt in public debt from 100% in 1997 to 45.7% in 2008. Local borrowing now largely funds the government's fiscal deficit and fiscal consolidation has also been underway, with the fiscal deficit maintained in the tight range of 0.5-1.7% in the last five years. The current account has also been largely in surplus since 1999, given the strong resource base and elevated commodity prices. Banking sector and corporate sector restructuring has also been ongoing with the former maintaining conservative balance sheets and the latter deleveraging. The increased confidence among international investors and non-residents would also increase remittances and capital inflows, which should help reduce the cost of capital further. The upshot is that the private corporate sector is likely to get a boost. Investment would be increased, lifting GDP to a higher sustainable growth of 6.5-7%. Indeed, the recent upgrade of sovereign bonds by the rating agencies underscores the macro improvement which we are highlighting.
However, having said that, we would point out that while Indonesia holds similarities with India, it may be difficult to reach 8-9% GDP growth, unlike India. India has had a long history of sustaining a stable democracy. While Indonesia has made the transition to a stable democratic system, it is still relatively young. The tertiary education institutions in Indonesia are also not as strong as in India or China. Moreover, India also has an experienced bureaucracy and a strong regulatory system to manage the private sector in an environment where the economy is driven by the private sector. In this regard, Indonesia will need to strengthen its institutional capability to enable transparent and effective decision-making by the private sector.
From a cyclical perspective, the macro rebound is panning out nicely with both external demand and domestic demand lending support. In line with data seen elsewhere in the region, December data show exports surging 14.4%M sa, on the back of non-oil and gas exports (+21.4%M sa), which brought export levels to 6.8% above the pre-crisis peak levels of September 2008. Meanwhile on the domestic demand front, motorcycle sales (+22.3%Y, 3MMA in Dec-09 versus +1.8% in Nov-09), motor vehicle sales (+7.1%Y versus -10.8%Y) and commercial vehicle sales (-1%Y versus -24.9%Y) are also in the recovery mode, albeit to varying degrees.
For now, inflation readings remain subdued, with January headline and core CPI standing at 3.7%Y and 4.4%Y, respectively. However, we think the low reading is a result of the high base effect and inflation is likely to trend up as base effects get washed out. Moreover, we think that Indonesia is more susceptible to inflation risks within ASEAN. Elevated commodity prices translate into direct cost-push pressures in the CPI, given the high commodity weights in the CPI basket. They also bring about demand-pull pressures as they confer positive terms of trade. Moreover, infrastructure bottlenecks tend to accentuate such demand-pull pressures when they occur. We look for inflation at 6% in 2010 and 6.5% in 2011 and reiterate our call for the first rate hike in 2Q10.
Where Are The Risks?
Politics is a risk with the inquiry into the Bank Century bailout case. However, in our view, the risk may be somewhat lesser than what is generally perceived. We see President SBY as having enough support within the coalition government to withstand calls to remove officials who are known to be clean technocrats.
We see the oil price as being a double-edged sword for Indonesia. Low oil prices will not benefit Indonesia. Yet, high oil prices at above US$100/bbl may not be optimal either, given the potential for overheating concerns on top of the infrastructure bottlenecks which tend to exacerbate inflationary pressures when they happen and Bank Indonesia's typically dovish monetary stance.
Malaysia: Cyclical Support but Structural Gaps
Where Do We Differ?
We are raising our 2010 GDP forecast for Malaysia to 4.8%Y, from 4.3%Y, but keeping our 2011 forecast intact at 4.8%Y. This will bring our GDP forecast in line with consensus for 2010. However, our 2011 forecast is marginally below consensus' 5.0%Y.
What's the Key Thesis?
Our upgrade of 2010 GDP to +4.8% from +4.3% marks to market and takes into account the better-than-expected export data which have been coming out of the region and the corresponding spillover onto domestic demand. Malaysia's export data for December are not out yet, but export data for December have seen a relatively uniform bounce through Asia. We think Malaysia's non-commodity exporters still face structural pressures as seen in their declining global market share. Yet, with Malaysia being the second-most export-oriented within the ASEAN economies, the rising tide should help to lift this boat. Moreover, our conversations with manufacturers had reinforced that cyclical momentum is gaining strength. While 4Q08 had seen a slew of cost measures being taken such as reduction in compensation/overtime, layoffs, shorter workweeks and plant shutdowns, double-shifts are now back and full workweeks have resumed, given the new export orders and restocking trends. We believe these developments should gradually manifest in the incoming datapoints in addition to the positive terms of trade accorded by elevated commodity prices. Indeed, the commodity export base (includes inedible crude materials, mineral fuels and animal and vegetable oils and fats) makes up about 30% of total exports in Malaysia and the filter-through effect from positive terms of trade tends to be fairly strong, given the fragmented nature of the resource industry, such as in crude palm oil.
On the domestic demand front, private consumption should gradually follow suit as the job market improves and the rate of retrenchment abates. Expansion plans have not come back in a significant way, given the unstretched capacity utilization. However, the end-use classification of import data suggests that this is slowly catching up as well. Indeed, on a 3MMA basis, imports of consumption goods (+4.0%Y in Nov-09) and capital goods (+1.9%Y in Nov-09) have led the turnaround in the import momentum.
While we would point out that it should not be too difficult for Malaysia to achieve 4-5% growth in this global environment, our cyclical optimism is tempered by a cautious outlook on a longer-term structural basis. Looking at the longer-term GDP trends, it seems that Malaysia has seen a structural downshift in its GDP momentum post the 1998 crisis. Indeed, we highlighted before that Malaysia seems to be suffering from a ‘Dutch Disease' of sorts, where capital provided by commodity resources (K) and labour inputs from favourable demographic trends (L) have accorded a growth buffer while the competitiveness and productivity front have been neglected. The current PM has been undertaking well-intentioned reform efforts, which makes us less bearish on the structural aspect compared to before. However, the crux in these reform measures still boils down to the execution and consistency of policy action with policy rhetoric.
In light of this GDP upgrade, we also reassess our policy rate forecasts. In this cycle, Bank Negara (BNM) appears to have gotten on the front foot much earlier than expected, despite the nascent stage of the recovery. In its last monetary policy statement, BNM reiterated that "monetary policy would remain accommodative to ensure that the economic recovery is well-entrenched"; however, a new line was added saying that it "recognizes the need to ensure that the stance of monetary policy is appropriate to prevent the build-up of financial imbalances that could arise from interest rates being too low for a prolonged period of time". We think that calling for BNM to implement its first hike in the March 4 meeting would be too aggressive, particularly when growth economies such as China and India have yet to embark on hard tightening in the form of rate hikes. Moreover, BNM had been comparatively less aggressive in terms of implementing monetary policy easing. In terms of financial imbalances, the supply issues in certain segments of the real estate market have also kept a lid on the extent of real estate asset reflation, implying that BNM does not have to contend with the dilemma of a potential asset bubble in a nascent recovery environment. However, we do think that the upside growth surprises in the region, our forecast upgrade and the recent tonal shift in the monetary policy statement mean that BNM may move slightly earlier than our previous forecast of 3Q10. We now expect BNM to implement its first rate hike in the May 13 meeting, but we still maintain the terminal policy rate of 3% by end-2010.
Where Are the Risks?
The global environment and fluctuations in commodity prices would be key risks to watch out for in Malaysia, given how they impact the economy. Additionally, a potential downside risk to the consumer also stems from a planned adjustment in the fuel subsidy system in May. We have not factored this into our numbers, given the implementation track record on this front.
Singapore: Riding the Rising Tide
Where Do We Differ?
Our 2010 and 2011 GDP forecasts stand at 5.0%Y for both years. This is slightly below consensus for 2010 (+5.7%Y) but in line with consensus in 2011 (+5.1%Y). Looking into the details, our slightly below-consensus headline is due to our expectations on both the domestic demand and export front. Having said that, while we do not see the unbridled optimism reflected in some of our competitors' forecasts (as high as 7% for 2010), we think that 5%Y GDP growth is by all means a respectable rate for the economy. Indeed, if the 5% annual growth rate is achieved for 2010, it would be roughly in line with the average recovery momentum seen post a contraction year if one were to compare the four downcycles (1964, 1985, 1998 and 2001) since the 1960s.
What's the Key Thesis?
Trade and financial market linkages are two important transmitters that tie the Singapore economic outlook to global macro fortunes before domestic demand fluctuates in a similar fashion. Indeed, asset markets have rebounded strongly since the trough last year. On the trade front, while the initial phase of the second-order derivative improvement in non-oil domestic exports has been to a certain extent supported only by the volatile rise in pharmaceutical exports, the latest December data show that even cyclical components such as electronics NODX have finally also bounced back into positive territory (+26.1%Y in Dec-09 versus -6.2%Y in Oct-09).
As we highlighted in the earlier part of the note, part of this may reflect a restocking trend and rush orders as inventory levels were too low to begin with, in coping with the recovery that is underway. Restocking or not, Singapore will stand to benefit the most from the nice bounce in the sequential trade momentum which we saw across Asia, and we have factored this into our forecast. At the same time, however, we are cautious of the fact that the recent bounce is the mirror image of the destocking trend and the deep plunge in trade that we saw in late 2008. When exports fell off a cliff in late 2008, analysts (ourselves included) extrapolated the trend outwards and brought 2009 GDP growth forecasts to as low as -10%Y. We would be loath to repeat the same mistake of extrapolating the same trend on the way up. Moreover, even while global GDP momentum slowly edges back the trend momentum we saw in the 2004-07 cycle, we think the headline number likely represents a different growth mix altogether. 2004-07 saw a super credit cycle funding developed world consumers, which in turn supported the export machinery in Asia. Now, the growth rebound is driven by policy stimulus. The forecasts by our US economist, Dick Berner, show that the mix of US growth (of 3.1%Y in 2010) sees an increased contribution from public spending, inventory restocking and external balance rather than private spending and capex as was the trend in 2004-07. A rising tide will lift all boats, but to the extent to which global growth is not driven by the traditional growth driver of US consumer spending but more so by public spending or Chinese policy stimulus which tends to be more investment-related, Singapore exporters may not benefit from this as much as other capital goods exporters, in our view.
Another reason why we think growth will be at 5% rather than 7% is due to domestic demand. Indeed, the bigger gaps on our domestic demand component forecast versus consensus come from the fixed investment side. While we are still forecasting a capex recession in 2010, our peers forecast fixed investment to go back to positive territory of 7.5%Y in 2010. As a comparison, in all the down cycles since the 1980s where we saw a GDP contraction year, fixed capex has seen at least two years of year-on-year percentage decline before returning to positive territory. Moreover, this time round, the base effect is less favourable since we saw a big property boom in office space, private residential, hotels, retail space and tourism infrastructure before the downturn began, and this real estate supply is just beginning to come onstream. A transitional office site on the reserve list that has been triggered for sale recently may represent a bright spot. However, we think the still-elevated vacancy rate could put a cap on the strength of fixed capex in the future.
Another related component of domestic demand would be the job market. Here however, we note that job creation data have surprised us, with the unemployment rate for both overall headline and resident unemployment dropping to 2.1% and 3.1%, respectively, in the 4Q09 data (versus a low of 1.7% and 2.4% in 4Q07, and 3.4% and 5.0% in 3Q09, respectively). Arguably, a part of this drop is due to the opening timing of the integrated resorts. Indeed, we understand from our gaming analysts that the employment count at Resort World Sentosa has now exceeded 7,000. We see job market data as intertwined with the outlook on capex (expansion of capacity needs both K and L inputs). We have been arguing that job creation could stay lackluster, given the payback for previous strong numbers which have stayed higher than expected, given the lagged completion of previously commissioned capex and the need for manpower when they are eventually completed. However, if job market data continue to surprise on the upside, then the upside risk to our capex numbers will also concomitantly materialise.
Where Are the Risks?
Global macro conditions is the key upside and downside risk to the economy, given the high export orientation. Over the longer term, restructuring of the economy will be needed to rebalance growth in terms of the end-destinations and the type of end-demand (whether consumers, corporates or public sector).
Thailand: Of Exports and Public Spending
Where Do We Differ?
We are raising our 2010 GDP forecast to 4.6%Y, from 4.3%Y, but keeping our 2011 GDP forecast unchanged at 4.8%Y. At these numbers, our figures are slightly above consensus, which stands at 4.3%Y for 2010 and 4.5%Y for 2011.
What's the Key Thesis?
Similar to the upgrade on Malaysia, we are marking to market our 2010 GDP to take into account the high-frequency datapoints, both on the domestic demand front as well as on trade, which result in a higher entry point into 2010. Looking at the incoming datapoints versus the forecasts penciled into our model, the biggest upside comes from net external balance and then to a lesser extent from domestic demand. A case in point - 4Q09 export volume has moved back into positive territory of +4.6%Y while import volume is still declining at -4.6%Y, thereby opening up a positive expectation gap on the net external balance front. Meanwhile, domestic demand indicators such as composite consumption indicators also suggest that consumer spending has moved into positive momentum as early as 4Q09. Meanwhile, although the private investment index indicator is turning around, it still remains in negative territory, and it seems like investment momentum is likely to find more support from the public sector going forward.
We have been highlighting since last year that the differentiating factor in Thailand (versus other ASEAN economies) is the fact that policymakers will still run an aggressive fiscal policy in 2010. We hold onto this view, and this story is unfolding. The latest government expenditure data show it running at 19.9% of GDP on a 12M trailing sum basis in January 2010. Additionally, the signing of the second contract for the Purple Line also recently took place within schedule in mid-January and the third awarded contract for the Purple Line is similarly due for signing soon. Indeed, such capex investment will also serve to attract crowding-in impact from the private sector. Moreover, unlike what some have postulated, the 2010 expenditure budget (Bht1.7 billion versus Bht1.9 billion in the 2009 Budget) understates the true expansionary nature of the fiscal policy since another Bht350 billion under the stimulus plan is financed via extra-budgetary spending and investment in mega projects such as the mass transit lines, which is also under the second stimulus plan, is undertaken by state-owned agencies. Having said that, we think that the beta accorded by the global rebound, particularly given the high export orientation in other economies, means that this differentiating fiscal factor becomes comparatively less significant in terms of helping Thailand to outperform compared to when we were in a more subdued global environment.
In light of the growth upgrade, we also reviewed our assessment of the monetary policy exit. The January monetary policy statement marked important tonal shifts from the BoT. The reference that the economy "still requires sustained policy support" has been dropped and the statement that "MPC views the current interest rate level" as "appropriate and supportive of the economy recovery" has now been replaced with the statement that "MPC will continue to closely monitor inflation and economic developments". The next meeting will be on March 10, before which the 4Q09 GDP data, January trade data and February inflation data will be released. The 4Q09 GDP readings will be good (~+4%Y), which means that the January trade data would be the critical macro datapoint to watch out for. The change in tone prepares the market that the BoT is at the cusp of a transition phase. The tonal shift, coupled with our reassessment of the GDP outlook, makes us think that the likelihood of the BoT implementing its first rate hike in 2Q10 has become higher (versus our base case of 3Q10). Hence, we are bringing forward our expectation of the first policy rate hike to 2Q10 and for policy rates to reach 3.75% by 2Q11.
Where Are the Risks?
Politics continue to remain a risk due to the push for constitutional amendments and Thaksin's court case on February 26.
If oil prices go towards the US$100/bbl territory, this would be negative for Thailand, given the negative terms-of-trade impact and the inflationary impact.
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Towards a Higher Growth Path
February 05, 2010
By Chetan Ahya | Singapore & Tanvee Gupta | India
Domestic Demand Surprising on the Upside
As mentioned in India EcoView: Upside Risks to Growth Rising, January 21, 2010, strong incoming data have affirmed our view that upside risks to growth have increased significantly. Growth in domestic demand has lifted IP growth close to peak levels. IP growth accelerated to 11.7%Y in November 2009 from the trough of -0.2%Y in December 2008, driven by expansionary policy, low interest rates and a sharp rise in capital inflows. Indeed, seasonally adjusted IP increased by 10.9% between November and March 2009. The bulk of this rise occurred between November and June 2009. Private consumption has revived, with discretionary spending taking the lead. Passenger car and two-wheeler sales growth accelerated to an average of 44.3%Y and 46.8%Y (our estimates) during the three months ended January 2010 (versus 1.2%Y and -7.2%Y during the same period last year). Also, consumer durables sales growth accelerated to a 14-year high of 37.3%Y as of November 2009, after reaching a low of -4.2% as of December 2008. The segment breakdown of the IP trend indicates that the growth recovery is beginning to broaden. While in the initial months, growth was driven by consumption - discretionary as well as staples - over the last three months, there are incipient signs that capital goods demand is improving.
F2011 - Transitioning from Policy-Driven to Private Sector-Driven Growth
We expect GDP growth to rise to 8.5% in F2011 (12-months ended March 2011) compared to 7.1% in F2010. On a calendar year (CY) basis, we expect GDP growth to accelerate to 8.5% in 2010 from 6.4% in 2009. While the key driver of the growth acceleration recovery process in 2009 was greater traction to policy measures, in 2010 even as the policymakers will gradually withdraw the monetary and fiscal policy support, we expect the recovery trend to be sustained. The policy-driven domestic demand recovery is now replaced by visible signs of improvement in autonomous domestic demand. We expect consumer and business confidence to pick up significantly, helping to revert to private sector-driven growth in F2011. Simultaneously, we believe that the moderation in discretionary consumption growth due to withdrawal of policy support will be offset by a revival in the investment cycle.
In addition, one of the most important factors supporting this recovery is global growth. As we have argued, India's growth trend remains highly influenced by capital inflows. Improving global growth will mean more capital inflows into the country, as well as higher external demand. Over the past three months, our global economics team has lifted global GDP growth for 2010 to 4.4% from 4% (versus -1.1% in 2009).
Acceleration in Reforms to Enhance the Scope of Recovery
The verdict of the May 2009 general elections had raised hope of acceleration in the pace of reforms, considering that the share of the single-largest party in the Lower House of the Parliament had increased to the highest levels since the 1991 elections. However, every major policy decision in India goes through a one- to three-year cycle of POTA (Proposition, Opposition, Treaty-Consensus and Action). The good news is that many of the key reforms are now moving toward the action phase. The most prominent measures likely to see action in F2011 are: a) the Goods and Services Tax system; b) consolidation of the public sector deficit; c) meaningful steps towards divestment of the government's stake in state-owned enterprises; d) acceleration in infrastructure spending, particularly in roads; and e) direct tax reforms. We expect the government to be able to successfully push through a number of critical policy changes in 2010. We believe that some of these changes are key to lifting India on a sustainable higher growth path.
F2012 - Sustaining Higher Growth of Plus 8%
We forecast 2012 GDP growth of 8.4% in F2012 (and CY2011) compared with 8.5% in F2011 (and CY2010). Domestic demand will continue to be the primary growth driver. Acceleration in the pace of reforms in F2011 and a stable global growth trend (implying healthy capital inflows into India) should ensure that investments continue to improve in F2012. We believe that savings and investments (as a percentage of GDP) already reached a trough in F2009, at 32.5% and 34.9%, respectively. We expect the structural story of rising savings and investments to be reinforced after this major dip in F2009 due to the global credit turmoil.
Increasing Our Inflations Forecasts Too
In 2004 and 2005, the recovery in growth gradually allowed adequate time for the private corporate sector to initiate capex plans. In the current cycle, however, the recovery in growth has been sharp and the business investment cycle has been hit badly. The transition from low-capacity to full-capacity utilization is likely to occur in a much shorter period. For instance, in the current cycle, the seasonally adjusted IP index has risen 11% cumulatively in eight months from the trough, whereas in the previous cycle seasonally adjusted IP index took 19 months to rise 11% cumulatively from the trough. Moreover, the input price pressures appear to be emerging much earlier in the current cycle than in the previous one. For instance, crude prices reached US$77/bbl only by September 2007 - three years into the growth upcycle. For F2011, we expect the non-food inflation to average 5.5% compared to our earlier estimate of 4.5%, as domestic demand pressures build up.
Reversal in Monetary Policy Ahead
The January 29 monetary policy statement highlighted that the RBI's "main policy instruments are all currently at levels that are more consistent with a crisis situation than a fast-recovering economy". We agree and believe that the economy is in a fast recovery mode and that the RBI will need to start lifting policy rates toward normalized levels. Indeed, the reverse repo rate, at 3.25% currently, is a full 125bp below the previous cycle low of 4.5%, while growth has rebounded much more sharply than the previous cycle. Building in our higher growth and inflation forecasts, we expect the RBI to hike the reverse repo rate (the policy rate in operation right now) by 175bp in 2010 compared with 150bp estimated earlier. Similarly, in 2011 we expect the RBI to hike the repo rate (which will be the policy rate in operation then) by 100bp instead of 50bp estimated earlier.
Consolidation of Public Sector Deficit to Begin in F2011
We expect the government to take the first step towards reducing the deficit to more sustainable levels in the February 2010 budget. The recent report of the 13th Finance Commission will be a good guide for the government to move on this correction path. We expect the government to reduce expenditure to GDP, as there will be no major one-off expenditure items. A simultaneous increase in tax to GDP should help cut the consolidated national fiscal deficit to 8.8% of GDP in F2011 from 10.5% in F2010. In 2010, the government should be able to increase non-tax receipts through divestment of a stake in state-owned enterprises and 3G telecom license fees. We expect the government to continue to be on a consolidation path, reducing the fiscal deficit to 7.5% of GDP in F2012.
Bull-Bear Scenarios
We believe that there are two key factors that will influence India's growth outlook in F2011 and F2012. The most important among them will be the global growth trend. This will be reflected in global risk appetite and capital inflows into the country, as well as external demand. Second, we believe that the pace of structural reforms from the government can also swing the investment growth outlook. In our base case, we expect F2011 and F2012 GDP growth of 8.5% and 8.4%, respectively. The upside and downside risks to India's GDP growth estimates will likely depend on the influence of these two factors. Based on this framework, we see bull scenario growth for India at 10% in F2011 and 9.8% in F2012 and the bear case at 7% in F2011 and 6.8% in F2012.
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Economy Gets Better, Deflation Gets Worse: Upgrading 2010 Forecast
February 05, 2010
By Takehiro Sato & Takeshi Yamaguchi | Tokyo
Exports to Asia Are Pushing Manufacturing Beyond our Forecast
We must concede that the forecasts we made last December were too cautious. Though manufacturing is slowing just ahead by a touch, output is poised to continue rising in the Jan-Mar quarter, led by brisk exports to Asia. Last December, production levels were still about 20% below the peak of 2007, and it was touch-and-go as to whether the capacity utilization ratio would get back to 70%. Overall, levels of economy activity are far from satisfactory now, but momentum is proving far stronger than in past recoveries, and clearly ahead of our earlier forecast.
The encouraging manufacturing performance owes much to the strength of exports to Asia. Relative to pre-crisis average levels for 2007, volumes (after our seasonal adjustment) at end-December had rebounded to 67% for US-bound exports and 71% for European exports, but were already back to 100% for exports to Asia (and to 87% of the peak level from February 2008). Trade statistics for 2009, released alongside preliminary December data, also show that China (18.9% share) has now leapfrogged the US (16.1%) as Japan's biggest export market.
Japan's exports are increasingly reliant on Asia, and on China in particular. As the upward revision of our forecasts for Asia discussed below shows, Asian economies continue to boom, despite the authorities' attempts to check overheating, and the region is likely to remain the lynchpin of Japan's exports for some time.
Raising Our Growth Rate for Japan While Revising Up for Asia Overall
Our Asian economists, Chetan Ahya (covering India and ASEAN) and Qing Wang (China), have lifted their economic growth forecast for Asia ex-Japan in 2010 by 0.6pp to 8.8%. The salient changes are an increase of 1.0pp to 11.0% for China, and 0.5pp to 8.5% for India. In conjunction, we have raised our Japan forecast for 2010 by 1.4pp to 1.8%, primarily driven by exports.
The reason why our numbers move up more for Japan than for AXJ is the boost to the base effect for growth in the following year created by the strong export contribution in Oct-Dec 2009. We now estimate that real GDP in Oct-Dec grew at an annualized rate of 5.3%, which is substantially better than the 1.8% we were looking for last December, and pushes up the base effect for growth in 2010 by 0.7pp to 1.5pp. Also note that the manufacturing outlook for Jan-Mar 2010 is now more favorable, which reduces the likelihood that GDP growth in this quarter will be sharply negative. In connection with the base effect, this boosts the 2010 outlook significantly. The continuing decline in public investment will of course constrain growth, but the probability that this factor alone will trigger a double-dip in 1H10 is receding. Ultimately, we believe that despite a drop in growth rate in 1H10 relative to Oct-Dec last year, Japan's economy will avoid a true double-dip and maintain a path of moderate growth.
This brings up our global economic forecast for 2010 by 0.4pp to 4.4%. Note that in the previous growth period from January 2002 to October 2007, Japan's industrial output (smoothing out monthly variations) continued to rise in step with overall economic growth. Although the recent industrial production growth pace of 3-4%Q marks a slowdown from Apr-Jun and Jul-Sep (7-8%) last year, it approximates to the rate of global economic growth in 2010-11 (+4.3%). If Japan's manufacturing continues to recover at this clip, we would expect production to return to the 2005 level by 2012 or so, which lies within the current inventory cycle.
Nevertheless, Deflation Is Getting Worse
Meanwhile, deflation in Japan is intensifying. Wage declines are having an impact on a broad range of goods and services prices, especially clothing and personal effects, highlighting a negative spiral from wages to general prices.
Although we have moved up our real growth rate forecast substantially by 1.4pp for 2010 (and by 1.3pp for F3/11), the increase for nominal growth at 0.6pp (0.6pp for F3/11) is not all that large. This is due to a downward revision for the GDP deflator, where we now factor in a much slower rate of improvement, having incorporated a slower CPI improvement than in our outlook last December. So, although our economic forecast rises, deflation is actually getting worse.
We expect the Japan-style core consumer prices (excluding food and energy) to show narrowing margins of year-on-year decline as the effects of falling oil prices in 2009 drop out of the year-on-year comparison. Yet, keynote prices from the US-style core (a stripped-down version of the core CPI, also excluding food and energy) will show widening declines from April as the effects of the new administration's policies, such as ending high school tuition fees, filter through. On this measure, we expect deflation to run at around -1.5%Y.
It is necessary to distinguish between price declines due to such systemic factors and genuine deflation. But an upward revision to the growth rate is not going to rapidly close the output gap, which remains as wide as it has even been at about -7% (Cabinet Office estimate for Jul-Sep 2009). There is also an approximate four-quarter lag before the output gap affects actual prices, so it would be mid-2010 at the earliest before economic recovery from Apr-Jun last year shows up in key prices via a narrowing output gap.
As commodity prices, especially crude oil, have recently been rising in reflection of booming demand from emerging markets, declines in consumer prices could shrink by more than expected, depending on future energy and raw materials prices. However, as 2007 and 1H08 showed, price rises brought about by soaring commodity prices are ultimately deflationary, as they erode the purchasing power of domestic producers and consumers. In fact, trading gains, a measure of the real purchasing power of Japan's economy, deteriorated from an annualized JPY11.7 trillion loss in Jan-Mar 2009 to a JPY18.2 trillion loss in Jul-Sep.
The path from such cost-push inflation caused by rising import prices to demand-pull inflation is roundabout. So, it is necessary to front-load consumer and company investor behavior via changes in medium-term inflation expectations. There is an outside chance that this could set off a mechanism whereby a narrowing output gap feeds through to higher prices. However, overall demand is likely to be held back by a drop in purchasing power and lead to deflationary pressure in Japan before people's inflation forecasts change.
Further Loosening of Monetary Policy
Though the end of deflation remains a distant prospect, we expect the government to intensify calls for the BoJ to ease in the run-up to the July Upper House election. Essentially, we expect the BoJ to favor cooperation with the government. Along with our interest rate cut call for Apr-Jun 2010, we think that the following specific measures will be on the easing menu, in order of probability.
1) Increasing the current account balance held at the BoJ: The BoJ steps up the supply of funds liberally towards the end of the fiscal year with a view to increasing the current account balance by about JPY10 trillion, from some JPY15 trillion now to JPY25 trillion. This measure, however, would most likely not be accompanied by a clear announcement, such as a current account balance target.
2) Allowing a temporary fall in unsecured call rates from the target level: While stepping up quantitative easing, the bank holds off on fund absorption operations, thus allowing the weighted average overnight unsecured call rate to drop temporarily below 0.10%. The effect of this should be to guide market rates lower. However, we would not expect this to be accompanied by a clear announcement either.
3) Increasing JGB purchases: Under the regulations of the Public Finance Act, the probability of increased JGB purchase amounts is low in the current circumstances. However, if the medium-term framework for management of the public finances that the government plans to announce by May-June 2010 includes credible targets for balancing the public books, the BoJ could act from the standpoint of JGB market stability to demonstrate solidarity with the government and increase purchase amounts. For the ‘banknote rule', which prevents the BoJ from holding more JGBs than it has banknotes in circulation, we would expect such a decision to involve technical, systemic changes (for example, excluding mid/longer-term JGBs with less than one year to run from the definition of outstanding holdings). If so, we would expect the BoJ to gradually increase monthly purchases from the current JPY1.8 trillion to about JPY2.4 trillion.
4) Clarifying commitment to policy duration: The regular MPM on December 17-18, 2009 attempted to define the understanding of price stability more clearly, and a step on from that would be to re-clarify the commitment to policy duration. If so, a commitment relating not to a Japan-style core CPI but to a US-style core (core-core) would probably enhance the policy effect. However, the timing of such action could coincide with the adoption of an inflation target, as discussed below.
5) Unsterilization of forex intervention funds: Under the new finance minister, it seems clear that the MoF is veering towards a weaker yen strategy in its currency policy. In a destabilized forex market, the possibility of market intervention increases, and unsterilization of intervention funds is one means by which the BoJ can promote growth in the current account balance and step up quantitative easing. In terms of timing, we think the period around Feb-Mar, towards the end of the fiscal year when repatriating funds exert pressure for a higher yen, will be worth watching.
6) Adopting an inflation target: To demonstrate that the government and the BoJ are cooperating to rid Japan of deflation, they could share an inflation target, with the government entrusting the mandate to achieve this to the BoJ. Traditionally, the BoJ has been reluctant to adopt an inflation target in a deflationary setting. However, the scheme we would envisage is a UK-style one, wherein the government sets a common target with the BoJ, and the BoJ decides how it could be achieved. The government is already shifting to a weak-yen policy to achieve such a target; for the BoJ, intensified monetary easing, by means including those listed above, could be the way of achieving the target. With successive overseas central banks embarking on exit strategies from mid-2010, intensified easing by the BoJ would exert pressure for a weaker yen
Tweaking Our Interest Rate Outlook
We maintain our out-of-consensus call for a rate cut in Apr-Jun 2010. Although the domestic economy has recently been tracking ahead of our cautious forecast, the government has made beating deflation its economic priority, so we believe that tightening in Japan is unlikely to be a discussion item this year, even if overseas central banks embark on exit strategies. Meanwhile, we push back the expected timing of Japan's policy exit by six months from Jul-Sep 2011 to Jan-Mar 2012.
The BoJ did, however, bump up its forecast for core CPI in its interim assessment of the October Outlook Report, from -0.4%Y to -0.2% for F3/12. This does not speak to any core improvement in deflation, as the increase stemmed from a revised outlook for imported commodity prices such as oil. The BoJ has a track record here, though, as when ending quantitative easing in 2006, it justified tightening on the basis of inflation rooted in rising commodity prices. Implicit in the BoJ's forecast for average deflation of -0.2% in F3/12 is the perception that the core CPI could turn positive year on year in the second half of that year, and we can easily imagine the bank moving opportunistically towards an exit based on the timing of this price inflection.
Meanwhile, we expect long-term yields to stay stable at low levels, backed by the healthy private-sector investment/savings balance, even as fiscal anxiety mounts. With deflation now a policy priority, policy rates and long-term rates are not going to be keenly sensitive to economic data even if the domestic economy is surprising on the upside. More decisive for the bond market outlook is the trend for deflation, which we believe is here to stay.
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Upgrading 2010 Forecasts on Improved External Outlook
February 05, 2010
By Qing Wang | Hong Kong & Steven Zhang | Shanghai
Introduction
Both export growth and CPI inflation readings surprised on the upside by a considerable margin in December 2009, registering 17%Y (versus the consensus of 5%Y) and 1.9%Y (versus the consensus of 1.5%Y), respectively. These developments are symptomatic of stronger external demand than we had envisaged under our original baseline scenario (see China Economics: Rebalancing, Not Overheating, January 21, 2010).
Improved External Outlook
While the stronger-than-expected export growth in December 2009 to some extent reflects the low base effect, it is consistent with the trends of the OECD leading indicator - a stronger-than-expected 4Q09 GDP growth reading for the US and stronger-than-expected ISM for January 10, as well as the observations by our global economics team of more convincing signs of a sustainable recovery in major industrialized economies (see US Economics: Outlook 2010: Higher Rates, Fed Exit and Sustainable Growth, January 4, 2010; European Economics: Transition Towards a Tepid Recovery, January 4, 2010; and Japan Economics: Economy Gets Better, Deflation Gets Worse, January 29, 2010).
The latest strength of China's exports also reflects robust demand from emerging markets. The growth rate of exports to AXJ and Latam/Africa - which combined account for nearly 50% of China's total exports - was about 30%Y and 20%Y in December 2009, respectively.
The effective depreciation of the renminbi exchange rate may have also contributed to the remarkable recovery in exports. We estimate that the renminbi trade-weighted exchange rate has depreciated by nearly 6% since the end of March 2009, as the currencies of China's main trading partners have appreciated against the USD substantially, while the renminbi remains pegged to the USD at around the rate of 6.83.
Robust Domestic Demand Intact Despite Policy Shift
We continue to believe that the policy environment in 2010 will be characterized as one of normalization rather than outright tightening, despite the earlier-than-expected policy shift. We forecast Rmb7.5 trillion in new loans in 2010, which was recently confirmed by the bank regulator as the target amount for new loans in 2010, implying 19%Y loan growth. As long as the target amount for new loans remains unchanged at Rmb7.5 trillion in 2010, domestic credit conditions should be supportive of growth, in our view. In addition, we estimate that about Rmb1.0-1.5 trillion out of Rmb9.5 trillion in loans made in 2009 has not actually been utilized, but remains available for 2010. Therefore, the effective amount of new bank lending in 2010 could amount to Rmb8.5-9.0 trillion, versus Rmb8.0 trillion in 2009. The bottom line is that we expect monetary and credit conditions to remain supportive of the real economy this year. Moreover, private consumption is likely to show steady improvement through 2010 as consumer confidence and employment continue to improve.
Inflation: Higher Upside Risk
Export growth is an important gauge of inflationary pressure, because it is a useful proxy for output gap, especially in the industrial sectors, in China, in our view. Much weaker exports represent a powerful negative demand shock that is disinflationary. China has suffered three episodes of deflation in the last decade or so: one during the Asian Financial Crisis, the other in the aftermath of the TMT bubble burst, and the current one. The pattern has been that the deflation/disinflation either coincided with, or occurred in the immediate aftermath of, a collapse in export growth.
We have estimated that there is around a six-month lag between change in monetary conditions and headline inflation (see Worried About Inflation? Get Money Right First, October 19, 2009). Since money supply (M2) growth already peaked in November 2009, the key swing factor in determining the inflation outlook for the next six months is how fast the output gap will close, which, in our view, can be gauged approximately by the export growth rate. In this context, it is no surprise that stronger-than-expected export growth coincided with higher-than-expected headline CPI inflation in December last year.
Forecast Upgrade
In light of the developments since late November 2009, when we initially presented our 2010 outlook (see China Economics: A Goldilocks Scenario in '10, November 22, 2009), we have revised up our forecasts for China's GDP growth and inflation in 2010 to 11% (from 10%) and 3.2% (from 2.5%), respectively, primarily to reflect an external outlook that will likely turn out to be stronger than we originally envisaged.
Specifically, we have revised export growth for 2010 up to 15% from 9%, and accordingly import growth to 18% from 10%, partly to reflect the high imported content of China's exports. We envisage that the stronger exports will contribute to stronger economic growth mainly through their positive impact on private investment in the manufacturing sector, such that the contribution of net exports to growth - which is largely an accounting concept - remains zero.
In terms of trajectory, an early policy tightening should help lower the risk of overheating and prevent a boom-bust cycle. While the 2Q09 rebound represents a sharp bounce from the cyclical trough, we expect the sequential growth rate to return to a more sustainable 2.0-2.5% in the quarters ahead. Nevertheless, we project that the year-on-year growth rate is set to peak at 11.7%Y in 1Q10, before slowing down - in part on the base effect - towards a more sustainable high-single-digit level. The moderation in growth rate over the course of 2010 would reflect acceleration in private consumption and investment, as well as a recovery in exports, partly offset by a smaller dose of policy stimulus.
The upward revision of CPI inflation hinges on three key assumptions: 1) money supply (M2) growth will be around 19%; 2) export growth will be 15%; and 3) crude oil prices will rise steadily over the course of the year and reach US$95 per barrel by year-end (see Crude Oil: Fundamentals Improving: Raising Oil Price Forecasts, January 24, 2010). We forecast that headline CPI inflation could peak at 4.3%Y by June 2010 and then start to moderate over the course of 2H10.
Under the reviewed baseline scenario, we expect China's trade surplus to shrink further to 4.0% of GDP from 4.5% of GDP in 2009, but to remain broadly unchanged in absolute terms at about US$200 billion.
The risk to this revised baseline scenario is broadly balanced. The key swing factor will be external demand. If external demand were to be even stronger than envisaged under our revised baseline scenario, a full-blown overheating would become possible, as illustrated by the forecasts under the bull case. On the other hand, the strong export growth in December 2009 may well turn out to be transitory, and the subsequent export growth over the course of the year would be tepid. Under these circumstances, we would expect that neither investment nor consumption growth would accelerate from their levels in 2009.
Policy Implications: RRR Hikes in 1Q; Interest Rate Hike in 2Q; and Renminbi De-Peg in 3Q
Stronger-than-expected data, especially for exports, will likely bring forward the policy measures that we have envisaged to be part of policy normalization. First, we expect multiple RRR hikes, as warranted by the need to sterilize the liquidity impact, as persistent FX reserve accumulation returns (see China Economics: Rebalancing, Not Overheating, January 21, 2010). We choose not to forecast exactly how much the RRR might be raised, because this hinges on how much excess liquidity is created as a result of persistent FX inflows stemming from the twin balance of payments surpluses: the current and capital accounts. In general, we expect that the multiple RRR hikes will ensure that excess reserve ratio will not exceed 3%.
We now expect the first base interest rate hike to take place as early as April, to help manage inflation expectations by ensuring positive interest rates for savings deposits. We forecast that headline CPI inflation may exceed the one-year deposit interest rate at 2.25% by March-April. In view of its strong determination to manage inflationary expectations, the PBoC is unlikely to tolerate negative real interest rates on deposits for too long this time, in our view. We expect three hikes of base interest rates, distributed evenly over the three remaining quarters, with the primary purpose of the hikes being to maintain the rate hike cycle and expectations until real deposit rates climb out of negative territory.
While higher growth and inflation make a stronger case for renminbi appreciation, we maintain our call that an exit of the renminbi from the USD peg will take place in 2010, but not likely in 1H10. This is because it takes time to build consensus, given that any potential move would be tantamount to a regime shift instead of a fine-tuning of existing policy. At the same time, we would be surprised if the current de facto US peg regime remains intact beyond November 2010 (see China Economics: Five Potential Surprises in 2010, December 7, 2009).
According to our colleagues Dick Berner and David Greenlaw, the US Fed will likely make its first rate hike in 3Q10. If, as we expect, the PBoC were to hike interest rates in 2Q10, the mismatch in the timing of rate hikes would mean that China-US interest spreads would widen and likely trigger renewed expectations of renminbi appreciation, and thus hot money inflows, in our view. In response, the Chinese authorities may impose additional controls over inbound capital inflows and intensify scrutiny of trade-related transactions with a view to stemming hot money flows, in our view.
Moreover, aggressive front-loading of lending by the banks may force the authorities to respond in kind with administrative measures with the objective of achieving the new lending target of Rmb7.5 trillion for the year. In fact, the PBoC has already applied a higher bank-specific RRR to some banks that have engaged in aggressive lending so far this year (vis-à-vis the lending target), as a warning to other banks that might follow suit. This move appears to have been effective in forcing those banks to cut back their lending.
Market Implications
Policy uncertainty and non-transparency - instead of policy tightening per se - as a result of the cat-and-mouse game between commercial banks and the authorities will likely weigh on market sentiment in the near term. While the growth and inflation mix has become less benign for 2010 than we had envisaged under our original baseline, the fundamental strength of the economy remains intact, in our view.
On an interesting note, the cash flow/income implications of a rising interest rate environment on enterprises and households in aggregate are quite different. This is because the household sector as a whole is a net creditor, with bank savings deposits as its main form of financial assets, while the enterprise sector is a net debtor. We estimate that a 27bp hike in base deposit and lending rates could generate about Rmb56 billion in interest income for households, or 0.16% of annual household disposable income.
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Asian Amplification
February 05, 2010
By Joachim Fels | London
Pacing ahead: Asia was the first region to emerge from the Great Recession last year. It is also the first region where the incoming data justify a forecast upgrade this year. Consequently, our Asia team has just boosted its 2010 GDP growth forecasts for Japan (by 1.4pp), China (1pp), India (0.5pp), Malaysia (0.5pp) and Thailand (0.3pp). We now see Pan-Asia motoring along at a 7.4% pace (from 6.6% previously) and Asia excluding Japan (AxJ) at an 8.8% clip (previously 8.2%). The main trigger for this upward revision was a stronger-than-expected surge in external trade around the turn of this year, which should also lead to stronger capex and, especially in India, a better outlook for domestic demand. For details, see our Asia team's notes released earlier today.
Now looking for 4.4% global GDP growth in 2010 ... The Asian upgrade, along with some minor changes elsewhere, pushes our 2010 global GDP forecast up by almost half a point to a solid, above-consensus 4.4%, from 4.0% previously. Importantly, even though Asia's share in global GDP is only slightly above 30%, it will account for no less than 60% of global GDP growth this year, on our forecasts - Asian amplification.
... slowing to 4% in 2011: Our view on 2011 has barely changed - we have nudged up our global GDP forecast only marginally to 4%, from 3.9% previously. Thus, factoring in a stronger 2010 outlook, we now forecast a more accentuated fading of global growth momentum in 2011, reflecting less monetary and fiscal stimulus as well as the lagged effects of the sharp rise in long-term interest rates that we expect this year (which, admittedly, is still a forecast). The risks to our 2011 outlook are probably skewed to the downside, as several countries in the developed world might be forced into a sharper fiscal tightening than currently anticipated.
Amplifying our five global themes: Moving on from the naked numbers, our Asian forecast upgrade serves to underscore the five global economic themes we have been highlighting in recent months.
1. A tale of two worlds: This theme, which juxtaposes strong growth in emerging markets versus tepid growth in the advanced economies, shines even more brightly with our Asia growth revisions. We now see output in the EM economies growing by close to 7% this year, from 6.5% previously. Thus, the EM universe contributes fully 75% of the 4.4% global GDP growth we forecast for 2010, against a meagre growth contribution of 25% from the advanced economies.
2. BBB recovery in G10: We now forecast significantly higher GDP growth in Japan - 1.8% compared to 0.4% previously - and we have abandoned our call for a double-dip in Japan in the first half of this year. However, looking at the advanced economies as a whole, we still expect this recovery to be bumpy, below-par and boring overall, with GDP in the G10 rising at only just over 2.2% (against 2.0% previously).
3. G3 growth differentiation: With today's forecast revision, Japan has passed on the red lantern in terms of growth within the G3 to Europe, where we continue to see GDP growing by a sluggish 1.2% this year. However, our view that growth differentials within the G3 are likely to garner more attention this year remains unchanged, as we continue to see the US leading the pack with a 3%+ growth rate this year. We expect Europe to lag behind, mainly because the bulk of the labour market adjustment is still to come there and because credit availability is likely to be lower than in the US, where credit markets as opposed to banks play a larger role in financing the economy.
4. AAA liquidity cycle remains intact: While we now expect China to start hiking official interest rates already in 2Q, and thus one quarter earlier than previously thought, the big picture hasn't changed, in our view: central banks around the world are more likely to crawl rather than rush towards the exit. Any tightening is likely to be gradual and cautious, and short rates are likely to stay well below neutral levels in the foreseeable future. Hence, we expect liquidity in the hands of consumers, investors and companies to remain ample, abundant and augmenting.
5. Sovereign and inflation risks up: The sovereign risk theme has already started to play out with the Greek fiscal drama, and is now in the process of widening out to other European countries. While our Asian forecast upgrades do not affect the sovereign risk theme directly, they underscore the second part of the theme - rising global inflation risks. In fact, our 2010 CPI inflation forecast in the AxJ region has gone up from 3.7% to 4.1%, and our team believes that risks to this forecast are still skewed to the upside, given the pick-up in growth momentum and strong capital inflows into the region.
For further details, see Asian Amplification, February 4, 2010.
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Reining in the Front-Riders
February 05, 2010
By Manoj Pradhan | London
Today, Norges Bank (NB), which along with the Bank of Israel (BoI) and the Reserve Bank of Australia (RBA) had started the global rate hike cycle late last year, kept its policy rate steady. Likewise, on Tuesday the RBA refrained from hiking its policy rate for a fourth time, which came as a surprise to markets. These are not isolated incidents, in our view. All the central banks who either had embarked on removing policy accommodation in 2009, such as the BoI, the RBA and NB, or were expected to begin raising rates early in 1Q10, such as the Reserve Bank of India (RBI) and the Bank of Korea (BoK), have refrained from hiking policy rates in their meetings so far this year. Korea's strong recovery and extremely low policy rates, and India's economic bounce and the risk of inflation made the central banks of these two economies front-runners for hiking policy rates in early 2010. Yet none of these ‘front-riders' have made any fresh attempts to break away from the pack this year. Why? We believe that the decision to raise policy rates has to balance concerns about the domestic economy against policy constraints of a global nature. Headwinds from tightening ahead of the major central banks have made it difficult for the policy action to gain traction. Early-hiking central banks have had to deal with currency appreciation and asset markets that have stubbornly stayed buoyant in line with their counterparts in the major economies.
The monetary peloton rides on: In the past, we have likened the synchronisation of central bank policies in the Great Recession to the synergies exploited by cyclists in a peloton (see "The Peloton, the ‘Elastic Band Effect' and Monetary Policy", The Global Monetary Analyst, September 2, 2009). Being part of this peloton gives riders serious protection from wind-drag. Riders at the front of the peloton do attempt to break away from the bulk of the riders. However, breaking away makes sense only if you can fight the headwinds. Central bank strategy, it appears, is not very different.
Headwinds present central banks with a dilemma: In fact, the dual headwinds of currency appreciation and poor traction in stock and bond markets illustrate the dilemma that front-riding central banks are dealing with. In order to extract a meaningful reaction from domestic asset prices, policy rates would probably have to be raised substantially. However, such a strong move would most likely lead to a very strong appreciation of the currency, which the central bank is unlikely to find desirable.
The RBA is a case in point, having raised rates three times already in this hiking cycle. Markets followed the RBA's lead and priced in a series of rate hikes into front-end interest rates, but they also bid up the Aussie dollar. By contrast, stock markets and long-term interest rates in Australia have barely noticed all of this action. We illustrate that stock markets and bond yields have stayed closely linked to their counterparts in the US. Of the three early hikers, the RBA has been easily the most aggressive central bank, spurred by the resilience shown by the Australian economy. It is certainly in a position to argue that its actions have taken away a decent portion of the monetary accommodation and that these rate hikes will have an impact on household spending via variable-rate mortgages. However, the fact that asset markets have not responded to even the most aggressive central bank in this hiking cycle reflects the difficulty that early hikers face in finding policy traction.
Similar experiences for the BoI and the NB: The other front-riders, the BoI and NB, have both had similar experiences. In both economies, currency strength has constrained rapid tightening of monetary policy. The shekel has strengthened as the BoI's interventions in the FX markets have eased. Governor Fischer recently acknowledged that such interventions could not continue endlessly.
Our Israel economist Tevfik Aksoy continues to expect the trend of smaller interventions and shekel appreciation to persist. Similarly, part of the reason for NB's pause in its hiking cycle is the strength of the Norwegian krone. Further, stock and bond markets in Israel and Norway have mimicked their counterparts in the US and the euro area, respectively, mirroring Australia's experience.
AXJ central banks face these headwinds too: But perhaps the most persuasive argument in favour of this global trend is the reluctance of central banks in Asia to raise policy rates off their lows. Given its economic outperformance, the Asia ex Japan (AXJ) region has been the natural recipient of capital flows. In addition to monetary stimulus from the domestic central bank, countries with pegs to the US dollar also import the Fed's easy monetary policy through the fixed exchange rate. Keeping hyper-easy monetary stimulus in place when growth has already rebounded strongly is clearly not part of the central bank playbook. However, being part of the monetary peloton has prompted a change in strategies.
Living with the Trilemma: AXJ economies with fixed exchange rates face the prospect of even more capital flows if they tighten policy ahead of the peloton (see "Living with the Trilemma", The Global Monetary Analyst, January 20, 2010). Even India, with its relatively flexible exchange rate regime, has reason to worry. In its statement in October 2009, the RBI expressed concern about "perverse" capital inflows attracted to its rate hikes. Stronger capital inflows would likely have at least two effects: they would put pressure on the currency to appreciate and find their way into asset markets. In its policy meeting on January 29, the RBI kept the policy (reverse repo) rate on hold but raised the cash reserve ratio - a tool used for liquidity management - by 75bp. Part of the reason for such liquidity management is the capital that has been flowing into its economy. In a similar move aimed at managing excess reserves, the PBoC also raised reserve requirements on January 12. Upward pressure on AXJ currencies and capital flows into their markets are making independent monetary policy increasingly difficult to conduct. The parallels with the experience of the BoI, the NB and the RBA are striking but not surprising, since all of them are the result of excess liquidity provided courtesy of the peloton.
The international spillovers from the synchronised and massive policy response to the Great Recession helped to ward off a second Great Depression. However, the same forces of excess liquidity are now making it difficult for many central banks to start withdrawing monetary stimulus ahead of tightening by the major central banks. While these major central banks continue to encourage domestic growth through their AAA (ample, abundant and augmenting) liquidity regime, early hikers are going to have to work very hard if they want policy action to find any traction. Just like in cycling, breaking away makes sense only if you can fight the headwinds. After all, there is a reason that professional athletes find strength in numbers.
No easy resolution for the front-riders: Our global economics team expects the front-riders to continue to grapple with the risks of overheating and inflation in their domestic theatres. The BoK is expected to hike rates in 1Q10 while our India team thinks that the RBI could well raise its policy rates before its next policy meeting in April in an inter-meeting move some time in 1Q10 as well. Having stayed on hold today, our NB watcher Spyros Andreopoulos believes that a hike at the March 24 meeting is a close call but more hikes are very likely in 2H10. Finally, our Israel and Australia teams expect the BoI and the RBA to raise rates by 150bp and 50bp, respectively by 3Q10.
Switching gears for the hiking stage: We are not very far from the time when the peloton itself will change gears. Our US and euro area economics teams expect policy rates to be hiked in 3Q10 and withdrawal of excess reserves in the US and a gradual rise in EONIA in the euro area to begin before that. As markets price in those hikes, stock and bond markets in the US and euro area will likely respond. The close links between international financial markets that we have highlighted will be the conduit for transmitting these effects around the world. In such an environment, central banks who wish to tighten their policies will likely find the going easier. Rate hikes that are more in sync with the peloton are less likely to cause currency appreciation, giving central banks more legroom.
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