Reining In the Front-Riders

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.

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.

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.

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.