A Goldilocks scenario in 2010 has been our call since November 2009. We stick to this view. Developments in 1Q10 suggest that this base case scenario is well on track, in our view. Specifically, the Chinese economy strode forward to +11.9%Y GDP growth in real terms in 1Q10 from +10.7%Y in 4Q09, in line with our forecast of +12%Y but beating market consensus of +11.7%Y. This strongest reading since 4Q07 can be partly explained by the low base in 1Q09, when the Chinese economy tumbled to +6.2%Y. On a seasonally adjusted basis, quarter-on-quarter sequential growth accelerated to +2.7% (+11.2% annualized) from +2.4% (+10.2% annualized) in 4Q09. CPI inflation was +2.4%Y in March and +2.2%Y in 1Q10, as inflationary pressures from food prices, the traditional driver of headline CPI inflation, have been well contained, while reflation of non-food prices has thus far been orderly.
In this note, we first take stock of the economic and policy developments and their impact on the equity market within the four-season framework we have been using to analyze potential scenarios and risks regarding the outlook in 2010. We also lay out some latest thoughts on inflation - especially the ‘disconnect' between PPI and CPI inflation - the outlook on which our base case Goldilocks scenario hinges. We then turn to discussing our policy calls and near-term risks to the economic outlook. We devote the latter part of the note to a comprehensive review of the key macroeconomic indicators.
Another Revisit to Our Four-Season Framework
Regular readers of our research may recall that in discussing the outlook for 2010, we envisage two types of uncertainties facing the Chinese economy in 2010: a) G3 economic outlook: is it a tepid recovery, which is our base case, or could it be a vigorous recovery? And b) Domestic policy stance: is there going to be normalization, as we are expecting? Might the Chinese authorities tighten aggressively? Along the two dimensions of uncertainty, we envisage four potential scenarios in 2010 in a four-season framework (see A Goldilocks Scenario in '10, November 23, 2009).
The Goldilocks scenario, or autumn, is our base case scenario. The underlying idea is quite straightforward. Tight supply of raw materials and energy inputs has been a significant headwind to rapid expansion of the Chinese economy in recent years. When economies in the rest of the world are also in an expansionary phase of the cycle, any incremental demand from China tends to drive up the global prices of commodities, generating inflationary pressures and making it a challenge to deliver a Goldilocks scenario - a mix of high growth and low inflation. If, however, the recovery of the rest of the global economy were to remain tepid in 2010, it would help China to benefit from relatively low commodity prices for a reasonably long period of time until the economies of its competitors for the same limited supply of commodities recover. This potentially creates a ‘window of opportunity' for China to deliver a Goldilocks scenario.
However, equity investors do not appear to have much conviction in this Goldilocks scenario since the start of this year, with market sentiment swinging between ‘overheating' and ‘double-dip' scenarios, especially in January-February.
At the beginning of this year, China's CPI inflation for December registered a jump, and bank lending resurged in the first weeks of the year, while key macroeconomic indicators from the US pointed to increasingly convincing evidence of economic recovery. In this context, investors were worried that the Chinese economy was going to experience overheating in general and high inflation in particular, or the summer scenario. This sentiment seems to have dominated the market in January.
In response, the Chinese authorities started to rein in the rapid expansion of bank lending through two surprise hikes of the ratio for required reserves (RRR) and some rather non-transparent measures, such as administrative controls over bank lending. Meanwhile, the debt crisis in some European countries also intensified, casting clouds over global economic recovery. Against this backdrop, investors were concerned that the Chinese economy was going to have a double-dip in growth, or the winter scenario. This sentiment seems to have dominated the market in February.
In March, the debt crisis in Greece started to stabilize, while the policy intentions of the Chinese authorities were also being better understood by the market (see China Economics: Déjà Vu: Dissecting Heightened Uncertainty, February 8, 2010). In this context, there appears to be rising confidence in the Goldilocks scenario, or autumn, of late.
Inflation Outlook: The PPI-CPI Disconnect
Whether the Goldilocks scenario will play out throughout the year hinges critically on the inflation outlook, in our view. While being keenly aware of the upside risk in the near term, we have taken a rather benign view of inflation for the year as a whole (see China Economics: Fear of Inflation to Intensify; Launching Inflation Tracker, January 4, 2010). Specifically, we forecast that headline CPI inflation will creep up in 1H10 and peak at 4.3%Y by June 2010 and then start to moderate over the course of 2H10, such that the average inflation will be 3.2% for the year.
Many market observers are concerned about the risk of high inflation in China, mainly because money and credit expansion in 2009 has been extraordinarily strong. They think the lag effect of rapid monetary expansion will create strong inflationary pressures. While this monetarist view of inflation is theoretically sound, the implications for inflation in practice may not be as straightforward in a China-specific context, in our view.
The primary source of monetary creation in China's effort to cope with the crisis was through bank lending to finance investment projects. The direct impact of this bank credit-driven ‘demand shock' tended to be manifested in increased demand for key inputs to carry out fixed-asset investment (FAI) projects, such as metal and non-metal materials, as well as relevant machinery and equipment, instead of typical consumer goods. Therefore, the attendant inflationary pressures tended to be in the form of a pick-up in PPI inflation for upstream goods.
We offer an example to explain why high PPI inflation may not necessarily translate into high CPI inflation. For instance, Company A receives a large bank loan to finance building a bridge. To start the work, Company A needs to purchase steel, cement and other construction materials, as well as specialized machinery and equipment. This increased demand for steel and cement may drive up their prices. However, unless steel and cement are used as direct inputs for making consumer goods, the price increases for steel and cement are unlikely to cause the prices of consumer goods to rise, at least in the near term. Moreover, the finished product of the investment activity will be a new bridge, the service of which will likely help lower, rather than increase, the costs of consumption and production activities.
Another channel through which the investment activity by Company A could cause broad-based inflationary pressures is the labor market. Company A needs to hire more workers to build the bridge. To the extent that this increase in demand for labor causes wages to rise, it could result in broad-based wage increases and thus inflationary pressures. However, there are at least two reasons why there may not be strong significant pressures on wages: a) the labor market is not tight in the first place, given the massive layoffs in the immediate aftermath of the crisis; and b) building a bridge is, after all, not a labor-intensive production activity.
This example illustrates how bank-credit-driven infrastructure investment activity may result in PPI inflation but may not necessarily cause CPI inflation, and thus there could be a significant ‘disconnect' between PPI and CPI inflation, as in China currently.
In this context, we think that as long as domestic food price inflation pressures are well contained, headline CPI inflation - which is the most important inflation indicator to watch as far as monetary policy is concerned - is unlikely to spike up this year. Speaking of food prices, the latest development is that the price of pork - which was the culprit of high inflation during 2007-08 - has been under downward pressure since March, such that the Chinese government recently increased its purchases of pork to help stabilize pork prices.
The serious drought raging in the five provinces of southwestern China has led the market to speculate as to its potential impact on inflation. We, however, believe that the current high inventory level, together with proper supply adjustment guided by the government, should be sufficient to smooth any grain price volatility caused by the drought (see China Economics: China Inflation Tracker, March 24, 2010).
Reining in Rapid Property Price Increase a Policy Priority
Property prices have been rising rapidly since mid-2009, especially in some tier-1 cities. Despite Chinese Premier Wen's high-profile public promise at the National People's Congress meeting in March to stabilize property prices, property prices have since continued to rise rapidly in these cities. We expect Chinese authorities to soon roll out a series of measures with a view to arresting the current trend. These measures will be property sector-specific and aimed at discouraging speculation, including 1) higher down-payment requirement for second mortgages (i.e., currently 40% and could be raised to 60%); 2) higher interest rates on second mortgage (i.e., charge a 10% or higher premium over the rates applied to first mortgage); 3) impose a special tax on high-end houses that are not occupied as a primary residence with a view to increasing the carry cost for speculators; and 4) substantially increase the supply of government-sponsored, low-cost houses.
Implications for Economic and Policy Outlook
The developments in 1Q10 are broadly consistent with our original forecasts. Goldilocks in 2010, a call we initially put forward in November 2009, remains our base case, featuring average 11% GDP growth and 3.2% CPI inflation for the year. The normalization in monetary expansion also suggests that the system is on track to reach the new loan target at Rmb7.5 trillion for this year, which implies about 19%Y in outstanding amount of credit. This pace of credit expansion should provide a relatively accommodative monetary environment to help solidify the achievements of the economic recovery so far, in our view.
However, we have tweaked our policy calls slightly, while keeping the broad parameters unchanged, featuring a first RRR hike in 1Q, first interest rate hike in 2Q, and renminbi revaluation in 3Q (see China Economics: Upgrade 2010 Forecasts on Improved External Outlook, February 3, 2010). Specifically, we now expect one rate hike in 2Q, most likely in May, renminbi revaluation in the summer, most likely in July, and potentially a second hike in 3Q, hinging on the timing of the first rate hike of US Fed, as well as the inflation outlook.
Risks
While the types of risks to the base case Goldilocks scenario remain the same, the degree of uncertainty concerning growth and inflation should diminish going forward, in our view. At the same time, a Goldilocks macroeconomic scenario is typically conducive to asset price inflation. In particular, the pace of increase in property prices in some tier-1 cities has been too rapid of late and has become a primary concern of the policymakers. Policymakers will need to strike a delicate balance between arresting the current trend in property prices and implementing heavy-handed measures that could damage the underlying economic fundamentals.
A key risk facing the Chinese economy at the current juncture is that if property prices continue to rise at a stubbornly rapid pace, the Chinese authorities may be forced to take strong measures to cool off the market, which could cause a major slowdown in real estate construction activity, posing downside risks to our growth forecasts. A case in point is 2008, when the Chinese authorities imposed tight controls over bank lending to property developers. These measures caused widespread concerns about the viability of property developers and strong expectations of an outright decline in property prices, resulting in a buyers' strike, despite improved affordability, and a massive slowdown in property sales and construction activity.
On the positive side, the Chinese authorities appear to have learned lessons from the 2008 experience, and the measures they have taken, and will likely take in the near term, have been aimed at discouraging speculation from the demand side, rather than penalizing the developers from the supply side.
GDP
Developments in 1Q10 suggest that our base case Goldilocks scenario is well on track: Despite a bumpy economic recovery in the rest of the world, the Chinese economy strode forward to +11.9%Y in real terms in 1Q10 from +10.7%Y in 4Q09, in line with our forecast of +12%Y but beating market consensus of +11.7%Y. This strongest reading since 4Q07 can be partly explained by the low base in 1Q09, when the Chinese economy tumbled to +6.2%Y at the nadir of the financial crisis. On a seasonally adjusted basis, quarter-on-quarter sequential growth accelerated to +2.7% (+11.2% annualized) from +2.4% (+10.2% annualized) in 4Q10.
Regarding the industry breakdown, a broad-based acceleration was witnessed, led by the secondary industry (mining, manufacturing and construction), reflecting aggressive policy stimulus that boosted fixed asset investment growth. Secondary and tertiary (service) industry outperformed headline growth, growing by +14.5% and +10.2%, respectively (versus +9.5% and +8.9%Y for 2009, and +3.5% and +5.4% in 1Q09). Primary industry recorded 0.3pp of improvement from +3.5% in 1Q09, but weaker than the +4.2%Y seen in 2009.
Inflation
CPI inflation came in lower than expected: CPI inflation slid to +2.4%Y in March from +2.7%Y in February, weaker than our forecast of +2.5%Y and market consensus of +2.6%Y. Consumer prices dropped 0.7% on a month-on-month sequential basis but rose 0.13% after being seasonally adjusted. For 1Q, CPI increased +2.2%Y (versus +0.7%Y in 4Q09), which falls into the mild-increase zone of 2-2.5% forecast by the NDRC. Despite fears of the potential impact from the heavy drought in southwestern China, food inflation softened to +5.1%Y (versus +6.2%Y in February), captured in our inflation-tracker-based high-frequency MoFcom data. Non-food inflation remained tame, suggesting the unsmooth channel of cost transmission between upstream and downstream sectors. Given the recent rally of the property market, residence inflation remained high at +3.3% (versus +3% in February). NBS said that it planned to raise the weight of residence to rationalize the CPI compilation this year.
Upstream inflation remained pronounced: PPI inflation gained momentum by accelerating to +5.9%Y in March from +5.4% in February, short of market consensus of +6.2% but milder than our forecast of +6.8%. On a seasonally adjusted month-on-month basis, sequential gains of PPI inflation were sustained at +0.1% in March (+0.4%M sa in February). Raw materials remained the key driver of upstream inflation, and RMPPI intensified to +11.5%Y in March (versus +10.3% in February), spearheaded by ferrous metals (+32.8%Y) and fuels & power (+25.6%Y).
Given deflation (-0.7% CPI and -5.4% PPI) last year, the carryover effects have contributed noticeably to this year's inflation, especially in 1H10. We estimate that 1.1pp of CPI and 4.3pp of PPI should be attributable to the carryover effects in March.
Trade
A temporary trade deficit in March: Export growth decelerated to +24.3%Y from +31.3% in January-February (stripping out the CNY seasonality), beating our forecast of +22%Y but lower than market consensus of +26.9%Y. Growth momentum of imports sustained by accelerating to +66% (versus +44.7% in February). On a seasonally adjusted month-on-month basis, March exports were flattish with February, while imports grew +4.6%. China recorded a US$7.24 billion trade deficit in March, which terminated the six-year-long trade surplus since May 2004.
After the strong rally in February, shipments to the US (+17.5%Y in February versus +39.2% in January), EU (+24.6% versus +60.1%) and Japan (+18.9% versus +34.5%) all decelerated noticeably. Sales to the ASEAN countries also weakened to +36.8%Y from +53.1% in February. As the biggest contributors to headline import growth, imports of machinery (27.9pp) and hi-tech products (16.8pp) rebounded to +56% and +51%Y, respectively (versus +27.6% and +30.2% in February). Among raw materials, imports of crude oil grew by +131%Y, contributing 9.7pp to the rise. Iron ore and copper increased by +42.6% and +128%Y, adding 2.5pp and 2.6pp to headline growth, respectively.
A small deficit is not surprising in the aftermath of the global financial crisis, given the strong domestic demand spurred by aggressive policy stimulus and the bumpy recovery in the rest of the world. However, we believe that March's trade deficit will prove temporary and will not be sustained for the rest of year. We forecast that China's export and import growth will be 15%Y and 18%Y, respectively in 2010, which would result in a trade surplus of US$198 billion.
Fixed Asset Investment
Normalization of fixed asset investment: Urban FAI softened marginally to +26.5%Y in 1Q (versus +26.6% in January-February), stronger than our forecast of +25% and market consensus of +26%Y. It also translates into a slowdown to +26.4% in March alone from +26.6% in January-February. Public investment (SOE FAI: +21.1% in 1Q versus +27.4% in January-February), which assumed the responsibility to cushion the hard landing of the Chinese economy during the crisis, has gradually passed the baton to private investment, spearheaded by real estate development investment (+35.1% in 1Q versus +31.1% in January-February). Infrastructure-related FAI, such as rail transportation, has fallen from the high base of last year.
Providing the solid recovery on track, the ultra-easing monetary stance adopted in 2009 to cope with the financial crisis has been transformed into a properly accommodative one in 2010. In this context, the growth of bank loans used to finance FAI has been contained, inching up to +41.2% in 1Q from +41.1%Y in January-February. Meanwhile, the support from the fiscal front rallied (+25.3% in 1Q versus +14.1% in January-February) as a result of the 2010 fiscal budget approved by the Congress. Reflecting the ongoing financial deleveraging in the aftermath of the financial crisis, foreign-funded FAI remained negative, albeit improving to -10.8%Y in 1Q from -11.8%Y in January-February.
Industrial Production
Supported by export recovery: In line with our (+18%) and market (+18.2%) forecasts, growth in industrial value-added softened to +18.1%Y (+4.2%M sa) in March from +20.7%Y in January-February. This is also consistent with the retreat of electricity generation to +17.6% (versus +22.1%). Since the extraordinary strength in January-February was partly explained by the extremely low base in the same period last year (+3.8%Y), the decline in March should not be interpreted as a setback for industrial activity. In the context of weakening FAI and placid retail sales growth, the robust industrial activity was mainly underpinned by the strong export recovery, endorsed by the rise of growth of output value for export delivery to +25.7% from +22.5% in January-February.
Heavy industry remained the engine of the ongoing recovery: Heavy industry (+20%Y in March versus +23.7% in January- February) continued to outperform light industry (+13.4%Y versus +14.5%) as a result of the aggressive policy stimulus centering on infrastructure construction. However, we expect the engine of the ongoing recovery to move from upstream sectors to downstream sectors in the coming months with the gradual policy exit. In this context, light industry should catch up and close the gap with heavy industry.
Retail Sales
Hardly moving, but still robust: Retail sales growth edged up to +18%Y (versus +17.9%Y in January-February), in line with our and market forecast of +18%Y. On a seasonally adjusted month-on-month basis, retail sales decreased to -1.9%, compared with +9.3% in February. Contrary to strengthening nominal growth, real growth of retail sales weakened to +15.2%Y (versus +15.5%Y in January-February) by factoring in the pick-up of headline CPI inflation (+2.4% versus +2.1%Y). The weakening sales of home appliance (+24.8% in March versus +31.7% in January-February) and construction & decoration materials (+21% versus +30.5%) suggested that the hot property markets might be in part explained by speculation investment instead of genuine demand. Auto sales remained high in March, registering record-high single month sales of 1.74 million units. Its softening growth (+36.2%Y in March versus +41.7% in January-February) is attributed mainly to the high base.
With the gradual rebalancing of the Chinese economy in the aftermath of the financial crisis, high hopes have been placed on consumption to take the baton from investment and exports to fuel sustainable growth in the long run. Besides the temporary pro-consumption measures to address the shortfall during the crisis, the government is mulling far-reaching reforms to overcome the barriers of consumption growth, such as income disparity and a weak social security system, in the context of pushing ahead with urbanization (see China Economics: One Country, Three Economies: Urbanization as a Primary Driver of Growth, March 2, 2010).
Monetary
Monetary normalization continued in March: Both M1 and M2 growth decelerated significantly, with growth falling to +29.9% and +22.5% (versus +35% and +25.5% in February), respectively. New Rmb loan creation totaled Rmb510 billion (versus Rmb700 billion in February), short of our forecast of Rmb660 billion and market consensus of Rmb750 billion. Medium-to-long-term loans remained the main driver of ongoing credit expansion, increasing by Rmb669 billion (Rmb150 billion of household loans and Rmb519 billion of non-financial-institution loans). Owing to the scale-back of new Rmb loan creation and the high base due to the record-high new loan growth of Rmb1.89 trillion in March 2009, year-on-year loan growth slid from +27.3% in February to +21.8% in March. New loans totaling Rmb2.8 trillion were extended in 1Q10, or about 37% of the targeted amount of new bank lending of Rmb7.5 trillion. This is broadly in line with the usual quarterly distribution of new bank lending (i.e., about 35-40% of total new loan in one year is made in 1Q).
FX reserve accumulation continued to be robust in 1Q10: China's foreign exchange reserves reached US$2.45 trillion in March, or US$47.9 billion new accumulation from the end-2009 level. In particular, despite a trade deficit of US$7.2 billion in March, China still managed to increase its FX reserves by US$22.5 billion in the month, suggesting that other FX inflows through the capital accounts may have been quite strong.
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Euro Wreckage Reloaded
April 16, 2010
By Joachim Fels l London|
A pyrrhic victory... The joint euro area/IMF financial backstop package and the ECB's recent climb-down on its collateral rules have clearly reduced the short-term liquidity risks for Greece. However, as our European economists have emphasised, long-term solvency risks remain firmly in place. More broadly, and more worryingly, recent developments significantly raise the (long-term) risk of a euro break-up, in our view.
... which gives rise to moral hazard: The bail-out and the ECB's softer collateral stance set a bad precedent for other euro area member states and make it more likely that the euro area degenerates into a zone of fiscal profligacy, currency weakness and higher inflationary pressures over time. If so, countries with a high preference for price stability, such as Germany, might conclude that they would be better off with a harder but smaller currency union. And because the Maastricht Treaty does not provide for the possibility of expelling euro area members, the only way how Germany could achieve this would be by leaving the euro to introduce a stronger currency.
Seceding to revalue is easier: It has been our long-standing view that such a break-up scenario - where a country or a group of countries want to leave to introduce a stronger currency - is more likely than a scenario where a country wants to leave to devalue. The reason is that the costs of leaving to devalue are extremely high.
• First, borrowing costs for the seceding country would likely rise significantly as investors will demand a currency and inflation risk premium.
• Second, while contracts between parties in the seceding country could by law simply be redenominated in the new currency, redenomination would not easily apply to cross-border contracts. Foreign creditors would still demand to be repaid in euros (‘continuity of contract'). Thus, a country that secedes and devalues would still have to honour its foreign-held debt in euros and would thus face a rising debt burden. If it decided to default instead, it would, at least for some time, be totally shut off from foreign financing.
• Third, a country that decided to leave the euro to devalue would immediately face a bank run by domestic depositors who would want to shift their funds into banks in other euro area member countries. This would provoke a financial meltdown which could only be prevented by a freezing of bank deposits and the imposition of strict capital controls.
By contrast, none of these costs would apply for a country that wanted to secede in order to revalue. Its borrowing costs would likely fall rather than rise as it would attract an inflow of funds.
How it all started... None of these deliberations are new. In fact, we first started to worry about a potential euro break-up along these lines in 2003-04 in a series of notes (see, for example, Euro Wreckage? January 22, 2004, and Debating ‘Euro Wreckage', February 9, 2004, with a reply by Noble laureate Robert Mundell). Back then, it had become increasingly clear that the move towards political union in Europe had stalled, partly because the EU has simply become too large and diverse a club due to successive enlargements. Moreover, the old Stability and Growth Pact (SGP), which was meant to ensure fiscal discipline within the euro, was effectively buried in late 2003 when both Germany and France kept violating the 3% budget deficit limit. It was later ‘reformed' into a toothless tiger that allowed for much more fiscal flexibility. Thus, we worried about an increasing divergence of fiscal policies with widening bond yield spreads and increasing political pressures for an easier monetary policy stance, which could make the monetary union unpalatable for countries like Germany.
...and why it has become more likely now: Obviously, we have not reached the end-game yet. However, with the recent developments, such a break-up scenario has clearly become more likely, for two reasons. First, the lesson for other euro area members from the Greek bail-out package is that no matter how badly you violate the SGP guidelines, financial help will be forthcoming, if push comes to shove. This introduces a serious moral hazard problem into the European equation. Fiscal slippage in other countries has now become more rather than less likely.
Second, the ECB's climb-down on its collateral rules regarding lower-rated bonds, which ensures that Greek government bonds will still be eligible as collateral in ECB tenders beyond 2010, adds to this moral hazard problem and confirms that the ECB is not immune to political considerations and pressures.
Don't get us wrong: It is quite obvious that if Greece had not received a financial backstop package and if the ECB had stuck to its previous pronouncements on the collateral rules, the consequences not only for Greece but the whole euro area financial system and the economy could have been dire. However, the unintended consequence of such action is that it sows the seeds for potentially even bigger problems further down the road.
What are the signposts that would indicate our break-up scenario is in fact unfolding?
• First, watch fiscal developments in other euro area countries closely: Our suspicion is that the aid package for Greece lessens other governments' resolve to tighten fiscal policy, especially in an environment of ongoing economic stagnation or recession.
• Second, watch ECB policy closely: If the ECB turns out to be slow in raising interest rates once inflation pressures return, this would be a sign of a politicisation of monetary policy.
• Third, watch the political debate in Germany: Support for Greece has been extremely unpopular and fears that the euro will turn into a soft currency abound. If the aid package for Greece, which so far is a backstop credit line, becomes activated, eurosceptic forces would receive a significant further boost. And, needless to say, if other countries also needed financial support, this would further strengthen euro opposition.
Bottom line: To be clear, we neither advocate a euro break-up, nor is this our main scenario. However, the risk that it happens is far from negligible and the consequences for financial markets would be very severe. Hence, investors ignore the euro break-up risk at their own peril.
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