Growth has slowed across Asia as exports to Europe and the US suffer and China’s growth has failed to recover. This is now forcing a more aggressive policy response with both fiscal and monetary policy being eased across Asia.
In China growth remains subdued and we cut our GDP forecast for 2012 to 8.0%. The property market has rebounded on the back of monetary easing and the risk of a major meltdown in the property market is declining.
China’s growth to remain subdued in Q3 on the back of weaker exports but growth should improve more markedly in Q4 on the back of fiscal and monetary easing.
Japan faces a substantial slowdown in H2 12 as the positive growth impact from reconstruction after the earthquake starts to wane.
Growth in Asia was weaker than expected in H1 12. In China growth is stuck below trend as domestic demand remains subdued and exports again face intensifying weakness on the back of particularly weaker growth in Europe. Nonetheless, GDP growth in China broadly stayed in the 7%-8% q/q AR range suggesting that China remains in soft landing territory. In India growth has also disappointed and there is increasing concern that the slowdown might not just be cyclical but could be structural and permanent as economic reforms in India have stalled in recent years. Despite the headwinds from exports the usually export-dependent Japanese economy performed better than expected in H1 12 on the back of resilient domestic demand supported by continued reconstruction. That said, there are signs that the economy is starting to lose steam.
With the exception of Japan and to some degree India policy flexibility remains Asia’s strength. Unlike in Europe and the US there is still ample room to cut interest rates and healthier public finances leave room to ease fiscal policy. Across Asia monetary and fiscal policy are now being eased more aggressively and the coming months will be a tug of war between the weaker exports and the impact from policy easing across Asia.
After a solid H1 Japan faces a marked slowdown in growth in H2. Even though Japan’s public deficit and substantial public debt have not yet forced the Japanese government to frontload fiscal tightening, the impact from fiscal policy will be negative in H2 12 as the positive impact from reconstruction starts to wane. Hence growth is poised to slow markedly to just around 1% AR in H2. With the leading interest virtually zero, Bank of Japan will be forced to continue its asset purchase programme with particular focus on stemming the appreciation of JPY.
China: Risk of property meltdown is declining
In our view four factors are decisive for how China’s growth will perform over the next year: 1) The degree to which the recent weakness in domestic demand has been cyclical, 2) To what extent China can ease monetary and fiscal policy, 3) China’s willingness to use this policy flexibility to boost growth and 4) How much headwind China’s export will experience from slower global growth
Our view remains that the weakness in domestic demand has been mainly cyclical in the sense that it has been driven by tighter monetary policy, regulatory tightening targeting the property market and a gradual normalization of fiscal policy after the big boost from infrastructure investments in the wake of the global financial crisis in late 2008. In a sense it has been a ‘managed’ slowdown with the goal of bringing inflation down from more than 6% during the summer last year, cooling the overheated property market.
Another prevalent view is that this time it is different because China is not just facing an ordinary cyclical slowdown but is in the middle of a severe burst of a property bubble after years of excessive investments. If this is true, the implications could be that the slowdown will turn out not to be ‘manageable’ as many traditional policy tools will prove to be increasingly ineffective. We will not go through all the arguments here; suffice to say we believe that China is going through a development that appears to be very similar to what other East Asian countries like Japan, South Korea and Taiwan experienced when they were at a similar stage of development as China is today. In that sense it is hard to find evidence that China’s development is much more imbalanced than other countries’. That said, the developments in the other East Asian countries do suggest that China in the coming years will enter a phase where construction’s contribution to growth will start to decline.
The property market has been stabilizing in recent months and at this stage it does not look like the big meltdown. Sales of new homes have been recovering since May as People’s Bank of China’s interest rate cuts in early June and July appear to have lured home buyers back to the market. In addition, the supply of new homes has been declining markedly in recent months as a lagged response to the drop in housing prices late last year. Hence, the demand supply balance in the property market has finally started to improve and this has also been evident in property prices. New home prices started to increase again on a m/m basis in June and July. Housing starts have stabilized but have so far only improved moderately (see top chart).
The business surveys also show tentative signs of stabilization in the property sector. Business sentiment in real estate has stabilized and even improved marginally in Q2 12. Business sentiment in construction resumed its decline in Q2 after a temporary improvement in Q1. However, both real estate and construction remain above the bottom reached in connection with the previous monetary tightening cycle in 2007/2008 and hence do not suggest that the recent downturn has been particularly severe.
This development suggests that the negative contribution to growth from the property market will be less in the coming quarters and the question is rather how much the Chinese government will allow the property market to rebound in the coming months.
Stepping up easing but still cautious
Inflation has declined substantially in recent months to just 1.8% y/y in July and is hence markedly below the 4% comfort zone the Chinese government announced for 2012. As seen in the chart, the main explanation for the drop in inflation is lower food inflation, albeit core inflation excluding food and energy has also eased.
We expect inflation to pick up slightly in the coming months around 2% y/y mainly on the back of a slight pick-up in food inflation. At this stage we do not regard the recent increase in global agricultural commodity prices as a major constraint on China’s ability to ease monetary policy. While wheat prices have surged globally on the back of the US draught, the increase in rice prices globally has so far been limited. In addition, the summer harvest in China this year has been a bumper one, which should also limit the negative impact. Liberalization of electricity, natural gas and water prices could add as much as 0.5%-point to inflation over the next year and for that reason inflation will probably be back above 2.5% by year-end. Nonetheless, this remains comfortably below the 4% inflation target and hence should not be a severe constraint on monetary policy.
If needed China has ample room to ease monetary and fiscal policy. Unlike in Europe and the US there remains ample room to cut interest rates and in a worst case scenario some of the recent regulatory tightening targeting the property market could be abolished. For the government the weakness of monetary easing is that it will boost the property market. The health of central government finances also leaves considerable room to ease fiscal policy. The weakness of fiscal easing is that it has to rely on increased infrastructure spending and will be dependent on spending by local governments with weaker finances than the central government. Hence, it is important that fiscal easing is supported by increased access to financing for local governments. While the possibility of excess investment in infrastructure should not be ignored, this fear is most likely premature. When we compare China’s stock of physical infrastructure with the US’s, China’s infrastructure stock will probably still have to more than double to catch up with the US.
The Chinese government now believes that the stimulus measures in 2008/2009 were overdone as the economy overheated. Hence, the Chinese government will be more cautious this time and there is a risk that it could be too cautious. Until May the pace of monetary easing has been slower than we expected and People’s Bank of China (PBoC) and the Chinese government were generally regarded as being behind the curve. Arguably this has contributed to China’s growth slowing more than expected. However, in May the Chinese government signalled that the pace of both monetary and fiscal easing would be stepped up on the back of disappointing growth data for April, a marked decline in inflation and not least perceived increasing downside risk from the European debt crisis. Remarkably, starting early June, China’s leading interest rates were cut twice in less than a month. However, the rebound in the property market in the wake of the interest rate cuts appears to have given the government second thoughts and it increasingly looks like it prefers fiscal easing to across-the-board monetary easing. We still expect PBoC to cut its leading interest rates by at least another 25bp and the reserve requirement by 150bp but there is a risk that they will be cut less or it will happen more slowly.
While fiscal easing is being stepped up, there is still little transparency in the size of the fiscal easing. While some local governments have published infrastructure investment plans, these should be regarded as wish lists rather than actual estimates for what will actually be implemented. We assume that fiscal easing will be about 1% of GDP over the next year. Based on the experience from 2008/2009 there will be an implementation lag of around 4 months suggesting we should start to see a substantial impact from September if this pattern is repeated.
In the short term the biggest risks are now external
OECD’s leading indicators and export orders in China’s manufacturing PMIs indicate that export growth is poised to slow in the coming months. However, they also suggest the slowdown in exports at this stage will be far from as severe as the one China experienced in the wake of the collapse of Lehmann brothers in late 2008. Should the European debt crisis for some reason intensify, there is of course the risk that 2012/2013 could turn into a repeat of 2008/2009 with China caught in a double whammy between weak domestic demand from previous monetary tightening and a collapse in exports.
In the short run China’s economy will be a tug of war between the gradual impact from monetary and fiscal easing and the negative impact from weaker exports. We now only expect a moderate recovery in GDP growth in Q3 12 to 8.0% q/q AR and weak industrial production in July suggests that there could even be downside risk to this forecast. However, in Q4 12 the impact from fiscal and monetary easing should be more substantial and GDP growth is expected to exceed 9% q/q AR as long as exports do not continue to deteriorate. China’s policy response will to some degree be the buffer for any further deterioration in the global outlook.
Real money supply growth is one of the best leading indicators. Over the past 15 years an acceleration in real money supply growth has always been followed by an acceleration in growth in China, albeit the size of its lead can differ significantly. As seen in the chart, real money supply growth at the moment gives a pretty strong signal that growth should soon start to pick up.