On the record...

Michael Spencer, Chief Economist Asia, on the macroeconomic outlook for emerging Asia
February 1, 2011 Economies in emerging Asia held up very well during the global recession and posted healthy growth in 2010. Whats the outlook for 2011? In fact, parts of Asia were very badly affected by the global recession: Singapore and Taiwan, for example, saw the worst ever declines in GDP in early 2009. But equally, they rebounded very strongly once global trade started to recover in the second half of that year. But indeed, the less export-dependent economies China, India and Indonesia were obviously much less affected by the recessions in Europe and the US and in fact stimulus measures offset most of the external shocks in these countries. Overall, growth in Asia slowed to 5.8% in 2009 from 6.7% in 2008, but excluding China and India, the smaller economies saw slow to 0.5% in 2009 from 3.3% in 2008. Growth rebounded to 9.4% last year in Asia 7.9% in the ex-China and India group. We expect the regions growth to slow down this year to 7.6% in 2011 and we forecast a similar growth rate in 2012. Inflation returned in 2010 after a period of very low inflation indeed, in most countries a period of deflation in 2009. Inflation will likely continue to rise in 2011 as commodity markets continue to struggle with the strength of the recovery in demand. We expect inflation to taper off temporarily in the second half of the year. Why do you expect growth rates to drop significantly in most economies in 2011 compared to 2010? In China and India, the withdrawal of 2009s stimulus measures has been compounded by the need to tighten monetary policy as inflation flared up over the last year. Arguably, Chinese policymakers over-reacted to the global recession: China is not an export-dependent economy the way its neighbours generally are, so the very aggressive fiscal and monetary policy response to the decline in exports in late 2008 not only meant that the economy experienced a relatively shallow downturn growth slowed to 8.7% in 2009 from 9.6% in 2008 but also that when exports did recover domestic demand was growing too quickly. The economy is overheating and monetary and fiscal policies are being tightened slowly. That means theres probably upside risk to our 8.7% growth forecast for this year but also to the inflation outlook. In India, there was less stimulus applied in 2009, but a food price shock that year quickly gave way to a more generalized inflation problem and the Reserve Bank is having to tighten policy forcefully. We expect growth to slow to 8.2% this year from 9.8% last year. For the regions small open economies the slowdown in 2011 is largely simply a statistical artefact: even with relatively high quarter-on-quarter growth in the first half of this year, for example, annual growth rates will fall very sharply because the comparable period in 2010 had seen much stronger growth. What is the biggest upside and downside risk to this outlook? Most economies in Asia are very sensitive to changes in demand growth in the major industrial economies and currently sentiment towards US growth in particular is quite positive. Risks in Europe are probably still weighted a little to the downside, although in some important respects data have surprised to the upside there as well. So for the first time in four years I think there is positive risk to the growth outlook in the small open economies in Asia. Conversely, the risks are probably weighted the other way in China and India. Policymakers are clearly worried by the rise in inflation which is still well above acceptable levels in India and still worryingly high in China. Were probably more likely to see policy tighten beyond our current forecasts than to see a letup in the inflation-fighting effort policymakers may be prepared to slow these economies down more than we currently forecast in order to take the pressure off prices. Inflation is especially hard to forecast in most countries, though, because it is still mostly contained to commodity prices measures of underlying inflation are generally quite moderate across the region. Food prices are rising quickly around the world some economies in Asia have not yet felt the impact of this and its hard to know how
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much longer this will continue. I expect that itll probably be well into the second quarter of the year before we start seeing any moderation of food price inflation at which point the rate of inflation in fuel prices will probably be rising. There has been much talk about a potential asset bubble in Chinas real estate market. Would you concur with the view that there is a bubble? Its hard to dispute that in some cities most visibly Beijing and Shanghai and especially in the luxury segments of the residential markets and in some parts of the commercial real estate sector there has been a bubble. When individuals buy multiple properties and hold them vacant its hard to dispute that they are buying solely in anticipation of a further rise in price. And prices were rising so rapidly in 2009 that that seemed a reasonable expectation. Do you think Chinese authorities are on the right track with the implemented measures to cool down the property market? What else to expect in 2011? The markets resilience to repeated rounds of measures aimed at reducing speculation raising downpayment requirements for mortgages, restricting credit to households who own multiple properties and announcing the introduction of new property taxes indicates how favourable the underlying economics of the property market are. Simply put, the cost of borrowing is so low well below expected price increases and pent-up demand for housing replacement/upgrades is so strong that without more aggressive actions we should expect property prices to continue to rise. At a minimum, if policymakers are serious about trying to discourage investment in real estate I think they need to raise the cost of borrowing many percentage points three or four 25bps interest rate increases will not, in my view, significantly change demand for property. I do not expect such aggressive tightening of monetary policy, though, so I think were most likely to see further rounds of measures a third set of measures was just announced this past week as policymakers struggle against the very strong underlying demand for real estate in China. Property is a symptom, though, of a broader policy dilemma in China. With real interest rates as low as they are monetary policy strongly rewards investors who are able to borrow (control over banks lending volumes is probably the most important policy tool available to the central bank) and invest in real assets. As the next Five Year Plan reportedly aims to reduce the importance of investment as the key driver of growth of the Chinese economy it would seem that a systematic increase in interest rates would fit into the policy agenda for the next few years. That would, however, also likely require a more rapid pace of appreciation in the RMB, something that until now the government has largely tried to avoid. More generally, many economies in the region saw substantial foreign capital inflows in 2010. Do you expect this trend to continue? The arguments in favour of capital reallocation away from the mature industrial economies towards emerging markets are even stronger today than they were before the crisis. The soaring government debt levels in the mature economies and generally much lower and often falling government debt levels in the emerging economies add to the relative growth rate story investors are familiar with. But its still likely to be the case that this shift in capital will be a gradual process. We saw late last year, for example, that a bout of uncertainty about Irelands debt sustainability saw capital flows reverse from emerging markets investors are not yet convinced that emerging markets are indeed safer places to invest. And with small, often very illiquid, capital markets its true that emerging markets cannot easily absorb large capital inflows. Moreover, price matters of course. Yields in emerging markets debt last year were pushed down to seemingly unsustainably low levels and equity market valuations are not especially compelling today. So while we expect capital to flow towards emerging economies over the medium term, we should expect that there will be periods where capital flows the other way. How do you expect authorities to cope with growing inflationary pressures on the one hand and very low interest rates in the US and Euroland on the other hand? At the risk of oversimplifying, I think the policy will broadly be one of hoping for the best. This policy dilemma the obvious need for higher interest rates but the apparent primacy of exchange rate stability as an objective of monetary policy is especially troubling at the moment. Central banks are to some extent justified in not reacting too aggressively to the current rise in inflation since it is largely contained in commodity prices. Higher interest rates will not grow more food and may only impact demand for food long after the supply response has already brought prices down. For example, if a return to more normal weather patterns globally can be expected by the
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middle of this year food prices may start falling in the second half of the year. But tighter monetary policy would typically only be expected to impact demand growth a year later. Note, however, that in a few economies property price inflation is at least as important a threat to inflation this year as food prices and obviously the argument that it is reasonable to wait for the supply response to bring prices down is less tenable. But significantly, central banks have effectively handed over to the tax and prudential regulatory authorities the responsibility of taming property price inflation. As we discussed above in the context of China so also elsewhere in Asia governments are using measures other than interest rate increases to try to reduce demand for property. We do not think such measures will succeed until they are combined with substantial interest rate increases. We expect central banks will continue to normalise monetary policy by raising interest rates and adjusting exchange rates gradually, essentially continuing with the policy framework of last year and the measures they had planned for 2011. At the rate at which policy is being normalised it will be another 18 months or more before monetary policy settings in most countries are even neutral, let alone tight. So there is clearly room for this process to be accelerated and indeed in South Korea and Thailand we saw central banks raise rates in January, a month or two before expected. Indonesia has been, in our view, too slow to begin raising rates and we still think they are inclined to wait until March or later before starting this process. The Philippines has the highest real interest rates in Asia and very low inflation so we continue to expect they will wait until the second quarter of the year or later before starting to raise rates as well. But with central banks continuing with a moderate pace of tightening, we expect investors will remain concerned that they are behind the curve well into the second half of the year. What are the implications of the ongoing Euroland debt crisis? Which countries will be affected most if things get worse (again)? As I mentioned earlier, the global crisis has added a new dimension to the argument in favour of investing in emerging markets. However, bouts of instability in Euroland capital markets do get transmitted to Asia through heightened risk aversion on the part of investors. So an improving relative fundamental position doesnt necessarily mean a smooth flow of capital. In addition, of course, Euroland is an important trade partner for Asia on par with the United States. So the decline in growth that we expect in Europe this year as every government embarks on a process of fiscal consolidation, is a significant drag on growth in Asia this year. The risk aversion impact on Asia can be expected to affect those economies where capital inflows have been the greatest or external debt is the highest Indonesia, Malaysia, South Korea. The potential for a negative growth shock can be expected to affect the most export-dependent economies the most: Singapore, Hong Kong, Taiwan and Malaysia. Will and should China play a more active role in helping to resolve Eurolands problems? What can they do and what are their motivations for instance in buying Spanish government bonds? China has a vested interest in stability in Europe which directly takes almost 20% of Chinas exports and of course Chinas USD 2.8tn of foreign exchange reserves include some sizeable investments already in Europe. It is for Europe to solve its problems, but China can play an important role in providing funding for economic restructuring programs. But I think China also expects its support will not simply lead to a stable export market and protect its investments. China is keenly interested in shifting its foreign exchange reserves away from bonds towards equities and physical assets and I would be surprised if its support for Eurolands sovereign debt stabilization is not also expected to unlock hitherto restricted investments in other asset classes.

Dr. Michael Spencer is Chief Economist Asia of Deutsche Bank and Regional Head Global Markets Research Asia-Pacific Michael Spencer (+852) 2203 8305

This interview was conducted by Steffen Dyck (+49 69 910-31753)

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