The cheap liquidity is now drawing to an end in China. With China withdrawing liquidity and less generous liquidity provision from the US going forward the region is facing the consequences of having drunk too readily from an abundance of virtually free credit. The potential withdrawal of liquidity in China then highlights the countries vulnerable to an effective hangover. See Kyle Bass: China Could See ‘Full-Scale Recession’ Next Year
Via Tim Riddell, Head of Global Markets Research, Asia, ANZ from a new report titled What A Swell Party This Is Was, we focus on China below.
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Read more: China Liquidity Crunch
- The medium term outlook for Emerging Asia remains constructive with data over the past month confirming the likely durability of the US and Japanese recoveries. Still, the Asian production and export numbers have remained relatively muted to this improving outlook.
- Downside surprises in inflation had given policy makers scope for further precautionary monetary policy easing; however abrupt currency depreciation is now expected to mitigate any beneficial cyclical commodity price disinflation. In the real sector, pockets of food and energy price inflation remain problematic. In the financial sector, asset price deflation is now expected to be the overriding price dynamic.
- Regional trade dynamics remain mixed given the increased unevenness in the global growth backdrop, however we remain impressed by the continued strong gains in Japanese IP and manufacturing sentiment. Ultimately this will prove to be a ‘pull factor’ for ASEAN supply chains.
China Policy and Structural
- Financial stability demands policy stability. Rate cut windows are closed and regional central bankers prepared to insulate economies from capital flows via a macro-prudential tilt to policy will be rewarded with lower-volatility, higher quality funding.
Our China Core View: Who Has Partied Too Hard?
China Regional Overview
The first half of June was characterised by an environment where policy makers had the flexibility to respond to an uncertain global backdrop by further cutting policy rates. We expected that window for possible policy action to remain open through the third quarter when the disinflationary impact of commodity price falls would start to fade and output was likely to be supported by firmer growth in both the US and Japan. The ‘sudden stop’ episode of capital flows that occurred over the two weeks to 25 June has slammed that rate cut window closed. It would be a bold policy maker indeed, in fact we would consider it a deliberate invite to volatile currency depreciation, who cut rates in the near term.
Read More: China Money Market
In this current lull in capital outflows, typically after sudden-stops there is a more considered reappraisal before risk capital starts to make a tentative return, it is useful to clearly identify where future frailties are likely to lay. We did this in our recent feature note, Saffron Alert on India, where we identified a deterioration in the near term quality of current account deficit funding as the most likely outcome of India’s problems. It is also equally important to identify where future areas of resilience may lay, as we did in our recent update on the Philippines, Steady as She Goes!, which we see as being able to weather the capital outflow and financial volatility storm relatively well.
The sudden stop is that moment when funding, particularly of current account deficit economies dries up and investors heads for the exit. A sudden-stop event is typically considered to have occurred when the change in flows is two-standard deviations outside of normal. Based on our examination of weekly flows over the past 52 weeks, for the majority of economies we cover the outflows late June were three standard deviations larger than normal following a two standard-deviation outflow in mid-June. A large and abrupt sudden-stop indeed!
The sharp repricing of mature economy bond yields hardly seems a sufficient explanation. Earlier episodes of bond repricing have not necessarily led to a reversal in capital flows to emerging markets but something different is occurring now.
An additional explanatory factor is that growth drivers are rotating away from the emerging world and back towards the developed world. This in itself underpins a less supportive environment for capital flows, particularly as it entails a process of monetary policy normalisation in the US. And this leads to the final explanatory factor, which is perhaps the most powerful in the current situation, and that is liquidity, or more importantly, the expectation of ongoing liquidity. Where earlier than expected Fed tapering has been a game changer is that it has fundamentally changed the assumption of ongoing generous liquidity as a support to capital flows.
There needs to be a relative repricing of asset markets in this environment if emerging markets are going to continue to attract liquidity. The automatic stabiliser in currency outflow periods is that currency depreciation, via cheapening the relative price of domestic assets lends itself to this outcome helping economies and markets find a new equilibrium after sudden stop periods. As of the first week of July, it appears that we are in one of these lulls after a sudden stop period.
The risk is that during this lull, markets become unilaterally negative on the region. Certainly the conversation in the emerging market space focuses on who has been swimming
naked 1, whether the punchbowl has been left at the party for too long 2, and who will be left without a chair when the capital inflow music stops? Though markets are clearly fearful that a repeat of the debilitating capital outflows period of 1994, also a Fed tightening cycle and one when bond yields rose significantly, that ultimately led to the Asia Crisis of 1997-98 is playing out; there are some vitally important structural differences that suggest that this would be a tail risk event even given the dramatic size of capital flows seen to date. The generous liquidity party may have stopped, but our core scenario is that the region avoids a ghastly hangover for several key reasons:
- The region in general, with the exception of India and Indonesia, has moved to and remains in current account surplus compared to the period of the early 1990s.
- The region has accumulated a significant stock of FX reserves over this corresponding period.
- Regional initiatives such as the Chiang Mai initiative allow the pooling of these reserves and extension of swap lines if any country finds itself in the need of needing emergency funding.
- There is not the currency mismatch between assets and liabilities that was a feature of capital inflows in the early 1990s. A feature of the QE driven liquidity ‘push’ into the emerging markets is that it has been chasing higher yield and this has fostered growth in local currency denominated debt within Asia.
- The macro-prudential environment, particularly in the banking sector, is considerably stronger and some central banks are already taking precautionary steps to strengthen this further. Bank Indonesia is a key example here.
- The macro backdrop we see evolving in the latter half of 2013 and through 2014 will ultimately be constructive for Asia – that is, reflation in Japan and a more durable recovery in the US.
Still, we are not ignoring the risks. Capital inflows into the emerging world have been large and Asia has attracted a disproportionately high share of them. There are asymmetrical entry and exit points for quantitative easing which mean that capital has flown into these economies more easily and outflows may prove to be more problematic. As a final overlay, we note that capital outflows and the risk of disorderly currency depreciation (possible currency and current account crises) are occurring when some economies have elevated credit cycles that may expose domestic banking and financial sectors to additional risk. It is these risks or vulnerabilities which may expose who has been swimming naked when the generous liquidity tide was all the way in.
Not surprisingly, given the seemingly greater frequency with which systemic financial crises occur (1997 and 2007), multilateral institutions have been devoting considerable attention to what are some of the early warning signals that these could be occurring. We note that both the IMF and BIS focus on dislocations in the credit cycle as useful leading indicators and use this note to benchmark the Asian economies we cover on these two measures.
1. BIS Focuses On The Speed At Which Credit Is Dislocating.
The Bank for International Settlements (BIS) suggests that when private debt as a share of GDP accelerates to a level 6% higher than over the previous decade, such an outcome usually is a symptom of serious financial distress in an economy.
2. IMF Focuses On The Duration Of Credit Dislocation
In a similar vein, the International Monetary Fund (IMF) suggests that when private credit grows faster than the economy for 3-5 years, the rising ratio of private credit to GDP usually signals some degree of financial distress.
So How Does Asia Fare On These Metrics?
First, a note of caution! The IMF and BIS have generally used these metrics to apply to the developed world. A key feature of the emerging world is that credit and leverage generally rise as an economy develops. That is, emerging markets generally display a rising credit intensity of growth aligned with financial deepening and this is generally a benign dynamic, as long as it is not taken to excess.
Credit intensity is a term, normally in reference to the ratio of private domestic credit to GDP, used to describe the incremental change in credit required to generate one percentage point of growth. A clear feature of the emerging markets and of Asia in general is that the credit intensity of growth, which has been on a rising trend since the early 1980s, has stepped up markedly since the Asia crisis and the global financial crisis. That is, after each of these episodes, it has taken increasingly greater leverage to drive the same amount of economic growth.
A simpler way of expressing this is to simply look at the levels, that is to say that economies have become more leveraged because issuance of debt has increased faster than nominal GDP. This is perhaps too simplistic. We are interested in what is the economic impact of the marginal change in debt levels from period to period is on economic activity.
A rising credit intensity of growth is not necessarily a malignant signal. For the emerging markets in general, a rise credit intensity often goes hand-in-hand with financial deepening and is therefore a welcome signal, ultimately signalling the increased intermediation of high, often surplus, levels of savings by the domestic financial sector. Another explanation is that the relationship between credit and growth is non-linear. That is, as economies develop and their real sectors become more sophisticated, a greater quantum of credit is required to finance more elaborate economic activity and processes.
However, past a certain point, rising credit intensity may signal far less benign dynamics. The simplest explanation would be that credit transmission mechanisms start to weaken, that is, the same amount of money is simply not getting through to the real sector. The second explanation would be that there are growing externalities or leakages, that is, credit meant for the real sector is recycled back into the financial sector via investment in financial assets. Asset inflation, rather than growth, becomes the consequence of a rise in credit intensity. The final explanation is the most pernicious. After a certain point, new credit is being used to finance the obligations of the stock of credit that has built up in the past. At this point, the credit cycle will have extended well beyond anything that could be justified by economic fundamentals and actual credit dynamics will have dislocated significantly from the real sector.
This final explanation is at the heart of the early-warning metrics the BIS and IMF have attempted to establish. Past what point is a rising credit intensity of growth
symptomatic of fragilities in the financial sector that pose a significant risk of crisis if not urgently remedied?
Inherent in both warning metrics is a departure of credit from some type of norm. In the case of the BIS measure, if debt as a share of GDP accelerates to a level 6% higher than over the previous decade, the experience of other economies over time has shown that this dynamic is typical of an economy experiencing significant financial distress. For the IMF measure, if private credit has grown faster than nominal economic growth for an extended period, say 3-5 years, then this is also symptomatic of an economy where the function of credit is no longer aligned to that of the real sector of the economy, again a marker of likely imminent financial distress.
So where does Asia stand in relation to these metrics and are there more benign explanations for the sharp rise in credit intensity seen to date.
In terms of credit growth relative to its long run average we find that it is the two financial capitals of Asia that appear to be most susceptible to having had too strong a domestic credit cycle. Policy makers in both centres are already aware of that with a number of macro-prudential measures having been introduced in Singapore to lend cooling to the property sector. Hong Kong’s credit growth also appears to have been aligned to the property sector (see Hong Kong section on page 21) and measures to restrict purchases of property by non-residents appear to be cooling both property price and credit growth here.
We would tend to view the Philippines recent uptick of credit growth relative to its long run average as more symptomatic of financial deepening rather than reflecting an early warning signal of potential distress. On the second metric, when we compare the credit growth cycle to nominal GDP growth, the Philippines looks benign. Also on this metric, Singapore and Hong Kong have elevated readings compared to nominal GDP growth.
The two economies where these metrics suggest some further monitoring is required are Thailand and Indonesia. On the metric of credit growth relative to its long run average, Thailand credit growth has continued to remain strong over the past three years. Indeed, Bank of Thailand commentary in the past year has singled out the strength in credit growth as an ongoing constraint to the downward flexibility of the policy rate. The concern on Indonesia relates to the second metric, where we can see that credit growth has progressively been outperforming nominal GDP growth by a progressively larger margin over the past four years, bucking a regional trend for credit growth to generally re-couple back towards nominal GDP growth. Indeed, policy makers in Indonesia are aware of this with growing macro-prudential measures likely under the new BI Governor.
It will be particularly important for policy makers in Indonesia to demonstrate considerable resolve in taming the domestic credit cycle. As one of the two twin-deficit economies in Asia, highly-mobile international capital could be quick to pass harsh judgement on funding Indonesia’s current account. Fortunately for Indonesia, the pre-emptive policy decisions to raise rates and reduce subsidies (one makes domestic money stickier, the other should reduce the size of the fiscal deficit) appears to have placed Indonesia in a more beneficial position relative to the other twin-deficit economy, India. It may be a contributory factor. The other is that Indonesia clearly has a leverage to firmer demand in both the US and Japan (Japan is its largest export market) whereas India remains largely endogenously driven by a rural consumption dynamic. In this environment, India appears to be the weakest link in the chain of Asian economies vulnerable to capital outflow.
Read More: Indian Rupee Touches An All Time Low
China: With The Benefit Of Hindsight, The Punchbowl Could Have Been Taken Away A few Drinks Ago
Sure, Asia has vulnerabilities to capital outflows, but a disorderly unwind that morphs into a crisis is not the sequential outcome. The fact that Emerging Asia generally now enjoys current account surplus, sizeable FX reserves and a stronger macro-prudential position should firewall economies from a repeat of 1997-98. Still, credit cycles have been excessive and with the benefit of hindsight, the punchbowl could have been taken away sooner. We believe policy makers are now in the process of trying to take away it from a well imbibed crowd. There may be some belligerence from those who insist on one more for the road. Ultimately the move to more prudent policy settings now will prevent an Asian hangover as capital outflows continue to turn the regional liquidity party into a more sober affair.
China: Assessment Of Risks Around Our Core View
Given recent financial market and capital outflow dynamics over the past month we update the risk profile around our core view. The belly of the curve is still populated by a largely benign view on the regional outlook given the higher certainty we place on a more durable US and Japan backdrop falling into place. In the previous month we had a slightly fatter tail on the upside to our risk profile, which we have flattened out this month. We have slightly widened the tail on our downside risk scenario of disorderly capital outflows from the region.
As we noted last month, “A disorderly repatriation of capital in the event of a quick and significant rise in old-world yields is the downside risk tail event and will be smartly met by macro-prudential measures across the region”. We are pleased to see that this policy response appears to be falling into place which will mitigate the size of the downside risk.
China: Rates Forecast
While the recent liquidity squeeze has eased, we think it is
time for the PBoC to restore confidence in China’s financial system to avoid the risk of a further slowdown in the real economy. As rightly pointed out in the MPC statement, the PBoC will also need to fine-tune its monetary policy stance to reflect the rapidly changing internal and external economic conditions. We therefore maintain our call that a rate cut of at least 25bps should be a part of the fine-tuning process if the new government does not wish to see a hard landing scenario materialise. Li-Gang Liu
We maintain our view that Hong Kong will not abolish its currency board system under which the HKMA follows the US Federal Reserve in setting its policy rate. As the US is forecast to have an extraordinarily low policy rate until Q4 2014, we expect Hong Kong’s discount rate to remain unchanged over the same period. Raymond Yeung
We expect the Reserve Bank of India (RBI) to closely monitor currency and capital flow movements over the month before its policy review on 30 July. Only once volatility settles and the currency stabilises, do we expect the RBI to continue lowering the policy interest rate, cutting the repo rate twice more this year. Lacklustre growth and diminished inflation pressures from lower energy prices (and, looking forward, a normal monsoon), set the scene for the RBI. But if the currency continues to weaken, the RBI will likely leave the repo rate on hold. Roland Randall
As soon as Bank Indonesia (BI) was confident that an average 33% fuel price hike was about to finally be implemented by the Government, it moved quickly to raise by 25bps the BI policy rate to 6.00% and the deposit facility rate (FASBI) to 4.25%. We expect BI to hike the policy rate and FASBI rate by 25bps on or around its upcoming meeting on 11 July. Inflation is set to reach nearly 8% over the coming months and policy tightening will help tame expectations. Our baseline scenario is for a 25bps move, however the risk would be tilted towards a shaper move higher, on either the FABSI or policy rate. A hike of 50bps would not be overly surprising Roland Randall
We expect Bank Negara Malaysia (BNM) to keep rates on hold at the policy meeting on 11 July. The tone of its policy statement has turned more dovish of late, however volatility in financial markets puts the chance of a rate cut very low. Growth has eased and the economy runs the risk of a current account deficit in Q2 as production at a key oil refinery is shut after a fire. We expect BNM to remain on hold through the year.
We maintain our view that Bangko Sentral ng Pilipinas (BSP) will keep its overnight reverse repo rate for a prolonged hold at 3.50% to the end of 2014. We also reiterate our call for BSP’s SDA rate to stay on hold at 2.00%. With ANZ’s recent upward revision of 2013 GDP growth to 7.1% (up from 6.5%), along with our benign inflation forecast in 2013, we expect the central bank has enough room to keep rates steady. In our view, the Philippines is well-positioned to withstand recent market volatility. Eugenia Fabon Victorino
China GDP Growth Revised Down
Real activities remained weak while trade growth crashed in May. Given two consecutive months of weak data results, we thus revise down China’s GDP growth to 7.6% this year and 7.8% next year, from our previous forecasts of 7.8% and 8.0%, respectively.
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- The official Purchasing Manager’s Index (PMI) fell significantly to 50.1, from 50.8 in May. The magnitude of the PMI drop has shown that China’s overall economic activity has decelerated further.
- Real activities remained weak in May. Industrial production moderated to 9.2% y/y in May, from 9.3% in April. Electricity production grew 4.1% y/y, down from 6.2%. Fixed asset investment slowed to 20.4% y/y in January-May, compared with 20.6% over January-April. Retail sales picked up slightly by 0.1% to 12.9%.
- Export growth eased to 1.0% y/y in May, compared with market expectations of a 7.4% increase and April’s 14.7%. The slowdown largely reflects the authorities’ efforts to crack down on such activities that seek financial gain from the large offshore and onshore interest rate differential and RMB’s appreciation.
- CPI inflation declined further to 2.1% y/y in May, from April’s 2.4%. Food inflation eased further to 3.2% y/y from 4.0%. Sequentially, CPI fell 0.6% m/m, compared with a 0.2% gain the prior month.
- Interbank interest rates surged in June, reflecting severe liquidity tightness. The 7-day repo rate, the most important indicator to gauge market liquidity conditions, rose to a record high during the month. Although market interest rates have eased somewhat, the tightness will likely remain in the near-term, highlighting heightened financial and slowdown risks.
- Looking forward, the export sector looks weak as it will lose competitiveness on the strong yuan and rising trade protectionism. Domestic demand also appears to be sluggish. Therefore, we have revised down our GDP forecast to 7.6% this year and 7.8% next year, from our previous forecasts of 7.8% and 8.0%.
Read More: Staring Down China’s Inflation Dragon