2011: Yes to rebalancing, no to asset bubbles and inflation risks
This post is a guest contribution by Chetan Ahya of Morgan Stanley.
We believe that Asia ex-Japan (AXJ) will continue to lead the global growth trend in 2011. We expect regional GDP growth to be at a strong 7.9%, close to the trend-line (trailing five-year average) growth. This strong growth will be premised on sustained domestic demand, as the recovery in exports remains bumpy and below-par. In this context, the region could be effectively forced to move towards a more balanced growth model even as the push to domestic demand is supported by cyclical policy tools including loose fiscal and monetary policy. In many ways, this trend should appear to be similar to 2010. We think that the key difference between 2010 and 2011 will be that, as policy-makers push domestic demand with the support of monetary and fiscal policy, the side-effects of this approach in the form of inflation risks and asset bubble challenge will only exacerbate.
EM to Outpace DM, Led by AXJ
AXJ has seen a strong rebound in growth, led by China and India – a story that we been highlighting for a long time now. The rebound has been driven by domestic demand, supported by the underlying structural growth dynamics of the region and expansionary fiscal as well as monetary policies. In 2011, we expect AXJ GDP growth to be strong at 7.9% (closer to the trend-line of the trailing five-year average) compared with 9% expected in 2010. (Note: 2010 had the benefit of a low base effect in 2009 due to the credit crisis.) While growth in the AXJ region has already recovered back to the trend line, output in developed world countries such as the EU and the US is still below pre-crisis levels. In 2011, our global economics team expects a BBB recovery (bumpy, below-par, brittle) in the G3 economies.
Led by AXJ, the share of EM in world GDP on a purchasing power parity (PPP) basis has already risen from 37% in 2000 to an estimated 47% in 2010. According to the IMF, EM’s share is expected to reach closer to 50% by 2014. Leading this trend in the EM world would be AXJ, with its combined share in global GDP increasing to 30% in 2015 from 25% in 2010 and 16.8% in 2000. On the other hand, the US share is expected to decline to 18.4% in 2015 from 20.2% in 2010 and 23.6% in 2000. Similarly, the share of the euro area could decline to 12.8% in 2015, from 14.6% in 2010 and 18.4% in 2000.
On the Right Track Towards Balanced Growth Formula
The global recession and unprecedented sharp external demand shock have forced Asian countries to face up to the vulnerability in their export growth models. The above-trend global growth of 2004-07 was premised on the imbalanced formula of a debt super-cycle, consumer leveraging in the developed world and a giant export machine in C/A-surplus Asia. US households have now rediscovered the need to save and are unlikely to take on leverage with the same vigor. Asian exporters will therefore find it harder to extract growth beta in the current tepid G3 growth environment. The weakening of Asia’s export model has made it imperative for policy-makers to look for alternative growth sources.
Policy-makers have so far relied more on the easier path of reflating domestic demand via monetary policy easing and fiscal expansion. Monetary policy has been accommodative, with real rates remaining low and the fiscal deficit closer to all-time wides. Policy-makers have increased infrastructure spending and fiscal incentives to encourage consumer spending (see Asia Pacific Economics: Can Domestic Demand Lift the Burden of Rebalancing? July 27, 2009). Indeed, the current account surplus in the region has already almost halved to 3.8% of GDP during the four quarters ending June 2010, from 7.1% during 2007.
To be sure, the need for heavy lifting remains. Efforts to achieve more sustainable long-term domestic demand reflation are at far from desirable levels. The structural factors holding back the region’s domestic demand have been a lack of a social security net, poor public spending support for education and health, low levels of household credit penetration, and low household wealth, which have tended to necessitate higher household savings ratios. An added difficulty comes from the fact that a sizeable portion of savings are held by the corporate sector rather than by households. A closer look at the savings-investment gap for various economies also indicates that there is no single solution for Asia’s domestic demand reflation. In China, private consumption is the weaker link. In some parts of ASEAN, it is the low capex ratio that needs to be worked on. In Korea and India, we see a model already fairly balanced between exports and domestic demand, but there is still potential to lift investments higher.
The good news is that we believe policy-makers in the region are moving in the right direction, initiating structural changes to boost domestic demand on a sustainable basis. In China, policy-makers are steadily initiating measures, such as a rural pension scheme, provision of low-cost housing and increasing minimum wages. The governments of ASEAN, Korea and India are also moving in the right direction to support higher investments to GDP. Indeed, in 2011 we expect policy-makers in the region to continue to initiate more measures in the right direction.
China, India and Indonesia to Lead Domestic Demand Growth in the Region
We are optimistic that the region’s policy-makers will stand up to the challenge of boosting domestic demand on a sustainable basis, with China, India and Indonesia taking the lead. On a PPP basis, the three combined are estimated to account for 79.6% of the region’s GDP in 2010. This push in domestic demand should be reflected in the current account surplus declining further to 3.3% in 2011 from 3.9% in 2010 and 7.2% in 2007. Our China economist, Qing Wang, expects China’s growth to moderate a bit to 9%, with consumption growth at an even faster rate of 10%. We believe that India’s GDP growth will be 8.7% in 2011, compared with 8.5% in 2010, as investment growth accelerates further along with healthy growth in private consumption. In India, we expect private sector spending to accelerate even as government spending slows due to fiscal policy exit.
We also expect investment growth to accelerate in Indonesia, lifting its GDP growth to 6.5% in 2011, compared with 6% in 2010. We think that steady improvement in the macro balance sheet will continue to result in a structural decline in cost of capital, supporting a steady improvement in domestic demand. Similarly, with hopes of an improved political environment in Thailand, the fourth-largest developing economy in the region could also begin to lift its domestic demand, cutting external surplus.
Two Key Challenges for AXJ Policy-Makers
Currently, we believe that the region’s policy-makers are operating with an assumption that G3 domestic demand will continue to remain weak and so they are being careful in reversing the support from monetary and fiscal policy. We think it is imperative for policy-makers to ensure that domestic demand growth remains strong enough to offset the weak external demand. However, this approach brings the challenges of asset price bubbles and inflation. In our base case forecasts for 2011, we are already building in higher inflation pressures, pushing the region’s policy-makers to hike policy rates at a faster pace. Yet, we believe that rate hikes are unlikely to be disruptive. In the following paragraphs, we explain the framework to understand these risks of assets bubbles and inflation in detail.
How Serious Are Inflation Risks?
We believe that one of the key differences for the region in 2011 versus 2010 will be higher inflation pressures. We expect inflation to accelerate to 4.2% in 2011 from 3.1% in 2010 for the region ex India.
We expect policy-makers in the region to continue to support domestic demand in 2011 as we believe that domestic demand in the G3 will continue to see a muddle-through recovery, resulting in weak external demand for the region. With private corporate capex already recovering, we believe that capacity utilization is unlikely to be stretched in the region. However, with sustained strong growth for the second year, we believe that capacity slack is definitely likely to be lower in 2011 compared with 2010. Moreover, higher global commodity prices, even though they are driven by strong growth in EM, will likely begin to increase core inflation pressures.
We believe that policy-makers in the region will continue to manage with a combination of some exchange rate appreciation, some intervention in the FX market and simultaneous sterilization of excess liquidity and gradual tightening in monetary policy as domestic demand sustains high growth. In China, we expect policy rates to increase by 75bp to 6.31% by June 2011 compared with 25bp in 2010. For the region ex-China and India, we expect policy rates to rise by 70bp by June 2011 and an additional 40bp to 4.7% by end-2011, compared with a 40bp increase during 2010. In India, we expect policy rates to rise by 50bp by June 2011 and a further 50bp to 7.25% by end-2011, having already gone up by 150bp in 2010. Considering that domestic demand is the key source of growth, we believe that policy-makers will be careful not to initiate a disruptive rate hike policy unless developed world growth continues to surprise on the upside.
Upside-downside risk scenarios: Pace of external demand recovery will be the key. We expect a BBB (boring, bumpy and below-par) trend in external demand recovery in line with our global economics team’s outlook for domestic demand in the G3. After reaching a pre-crisis peak by July 2010, AXJ exports have been weak over the last 4-5 months, affirming that domestic demand growth in the G3 is unlikely to be strong during this cycle as it continues to suffer from the after-effects of the credit crisis. Indeed, our global economics team has a base case outlook of a BBB (boring, bumpy and below-par) recovery in the developed world. We believe that the region’s policy-makers are likely to aim for sustained growth in domestic demand growth due to this concern on the external demand (i.e., G3) outlook.
We believe that the key factor that will influence the region’s inflation outlook will be the pace of recovery in the developed world (particularly the G3). This will be exports as well global risk appetite and capital inflows to the region. Our base case outlook expects inflation in AXJ ex India to average 4.2% in 2011, from 3.1% in 2010 and 0.1% in 2009. (For 2011 our earlier estimate was 3.4%.) However, if domestic demand in the G3 surprises on the upside, resulting in a strong recovery in AXJ exports, then the risk of generalized inflation pressures will likely increase, forcing the region’s central banks to initiate disruptive rate hikes. Contrary to this, if the G3 were to experience a deeper slowdown, we would expect inflation to be at 3.1% in 2011 and policy rates to be lower than our base case expectation.
Upside Risks to Inflation: Three Key Factors to Watch
We believe that the risks to our inflation forecasts are skewed to the upside. In this context, there are three key risk factors to watch for, including a potential further rise in food inflation, a rise in global commodity prices and persistent rise in asset prices pushing inflation in non-tradables higher.
1) Food inflation is a bigger problem for developing Asia: Many parts of the region (India, Korea, Indonesia, Thailand and China) have had weather problems. The rise in global food prices at the same time is not helping AXJ. Food inflation tends to be a bigger problem for developing Asia – China, India, Indonesia and Thailand – as the weighting of food in CPI is high. If the upcoming crop season does not suffer from weather problems, food inflation may get a respite, but in the near term food inflation is a given, in our view. While persistent rises in food inflation can also weigh on core inflation through the inflation expectations channel, we think it’s hard to make a call that policy-makers will use monetary tightening in a disruptive manner.
2) Potential rise in oil and global commodity prices due to the strength in G3 economies: Our base case outlook assumes a gradual rise in commodity prices. However, if commodity prices, particularly oil prices, rise quickly to US$110-120/bbl, markets would become concerned about a potential disruptive rate hike from AXJ policy-makers. The recent QE2 announcement, along with a rise in PMIs in the US, Germany, China and India, has indeed begun to push commodity prices higher even as the US dollar was stable or rising. We believe that this is the most important risk factor to the AXJ inflation outlook.
3) Excess liquidity means risk of rise in inflation in non-tradable items: An open capital account along with hesitancy over allowing a quick appreciation in exchange rates have led to Asia’s monetary policy being constrained by low interest rates in the G3. Real rates are negative or very low across the region, even while GDP growth has been strong. Although a boost to domestic demand with low interest rates would be welcome, the key challenge for the region will be to prevent asset bubble risks.
Top cities in the region have seen a continued rise in property prices. However, the good news is that almost all central banks in the region are leaning heavily against asset prices, realizing that this is an important issue for achieving sustainable growth without increasing financial instability risks.
Inflation Risks – Bottom Line
• Upside risks to inflation forecasts are materializing: Headline inflation in the region ex India accelerated to 3.5%Y in September 2010 from 2.9% in June and 1.8% in January. Currently, a large part of the rise in headline inflation in the region is being driven by higher food prices. India is the only country where food inflation is moderating due to a high base effect and better crops this summer.
• Sustained growth trend and low interest rates should mean higher core inflation in 2011: We expect GDP growth in 2011 at 7.9% compared with 9% in 2010. While food inflation could moderate with better crops, we believe that core inflation pressures will rise in 2011 as capacity slack will be lower in 2011 versus 2009 and 2010. We expect headline inflation in the region (ex-India) to rise to 4.2% in 2011 from 3.1% in 2010.
• Base case policy response forecast – acceleration in pace of rate hikes in region ex-India: Considering that domestic demand is the key source of growth, we believe that policy-makers will be careful to not initiate disruptive rate hikes. We believe that in order to achieve greater control of monetary policy, policy-makers in the region will continue to implement capital controls to discourage debt-related capital inflows.
• Risks to our base case inflation forecasts are tilted to the upside: Three key risk factors to watch: (a) further spike up in food inflation; (b) sharp rise in global commodity prices in short span of time; and (c) persistent rise in asset prices in AXJ pushing inflation in non-tradable higher.
• Strong recovery in G3 domestic demand would increase the risk of disruptive rate hikes and/or aggressive capital controls: We believe that the policy environment in the region is premised on the assumption of the weak recovery in G3 domestic demand. Hence, any major upside in that could force the region’s policy-makers to initiate disruptive rate hikes to manage the attendant inflation risks.
Deflation risk in DM brings asset bubble risks in Asia: As the G3 continues to see risks of downside growth, policy-makers there are biased to continue with abundant liquidity. The Fed recently announced its decision to increase asset purchases by US$600 billion until 2Q11. On October 6, 2010, the BoJ returned to the zero interest rate policy (ZIRP), and will consider a special asset fund with Y5 trillion (1% of GDP) of extra funding. Interest rates in the G3 are expected to remain low for long periods whereas strong growth and the rise in inflation have meant that the AXJ central banks have started lifting policy rates in the region over the past 12 months. This has already resulted in a widening of spreads between AXJ and G3 policy rates to close to all-time highs. Indeed, if central banks in the region choose to follow our rate forecast path, the spread in rates would only rise, increasing the risk of a further rise in capital inflows into the region.
Open capital accounts along with hesitancy in allowing a rapid appreciation in exchange rates have led to Asia’s monetary policy being constrained by low interest rates in the G3. Real rates are negative or very low across the region, even as GDP growth has been strong. Although a boost to domestic demand with low interest rates would be welcome, we believe that the key challenge for the region will be to prevent asset bubble risks. Top cities in the region have already seen a sharp rise in property prices. As we have learnt from Japan, the unintentional side-effects of loose policy measures from the fuelling and bursting of asset bubbles could be a setback to the longer-term blueprint of domestic demand reflation.
The good news is that the policy-makers in the region are not shying away from leaning against the rise in asset prices and have already initiated measures which reduce the financial instability risks. Almost all central banks have announced measures to control credit allocation to the property sector. Policy-makers have tightened the prudential norms for mortgage lending to check speculative property demand.
Source: Chetan Ahya, Morgan Stanley, December 6, 2010.
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