China
Goldilocks on Track Despite Faster Moderation in Growth
July 16, 2010

By Qing Wang | Hong Kong & Steven Zhang | Shanghai

Faster-Than-Expected Growth Moderation

Developments in 2Q10 indicate that our base case ‘Goldilocks' scenario - featuring strong growth and benign inflation outlook - remains on track, despite a faster-than-originally-envisaged moderation in growth. Specifically:

The headline GDP growth in 2Q10 continued to be robust at 10.3%Y, albeit a significant deceleration from 11.9%Y in 1Q10. The average growth for 1H10 was 11.1%Y. On a seasonally adjusted basis, the sequential growth slowed to 2.0%Q (or about 8.4% annualized) in 2Q10 from 2.2%Q (or about 9.2% annualized) in 1Q10. Of note, the deceleration in GDP growth of secondary sector (or from 14.5%Y in 1Q10 to 13.2%Y YTD in 2Q10) is more pronounced than that of primary (or from 3.8%Y in 1Q10 to 3.6%Y YTD in 2Q10) and tertiary (or from 10.2%Y in 1Q10 to 9.6%Y YTD in 2Q10) sectors.

The headline CPI inflation in 2Q10 was moderate at 2.9%Y, in part due to a surprise decline in CPI inflation to 2.9%Y in June from 3.1%Y in May. This earlier-than-expected decline in headline CPI inflation has been primarily attributed to the lagged reflection in retail prices of a sharp decline in wholesale vegetable prices of late (above 30% since early May). While we do not think that the decline in vegetable prices will be sustainable, this development is consistent with our assessment that the underlying inflationary pressures have started to ease. And we reaffirm our call for the headline year-on-year CPI inflation to peak in July and start to edge down over the rest of the year.

Disconnect between Supply- and Demand-Side Indicators

An important observation based on this data package is a seeming disconnect: the marked deceleration in industrial value-added growth on the one hand, and continued robustness in such demand-side indicators as FAI, retail sales and exports on the other. Specifically, while the growth rates of industrial value-added declined to 13.7%Y in June from 16.5%Y in May, those of FAI (24.7%Y in June versus 25.4%Y in May), retail sales (18.3%Y in June versus 18.7%Y in May), and exports (43.9%Y versus 48.4%Y in May) also declined but by considerably less magnitude.

First, the across-the-board decline in the year-over-year growth rates of these indictors has in part reflected the base effects: economic activity started to rebound strongly in the same period of last year.

Second, the relatively large decline in the growth rate of industrial value-added is as a result of Chinese authorities' campaign to close down energy-inefficient industrial enterprises in order to achieve its ambitious energy conservation target by year-end. The historical background is that the Chinese government sets the target to cut energy consumption per unit of GDP by 20% between 2006 and 2010. This is one of only two quantitative targets specified in the current 11^th five-year plan and also a commitment by the Chinese government to the international community.

However, China only managed to reduce energy consumption per unit of GDP by 14.4% by end-2009, making it a challenge to reach this target by China's self-imposed deadline. In this context, Chinese authorities have recently launched a campaign to close down inefficient enterprises through administrative order by following an ambitious production capacity retrenchment plan. We estimate that in order to reduce energy consumption per unit of GDP by another 5.6% within this year, this policy initiative could shave off 1.5pp in industrial production growth.

Third, these supply-side adjustments will likely have a direct impact in terms of weak readings of key headline indicators (e.g., IP, power usage), which, however, do not indicate a sharp deterioration in the economic fundamentals, in our view. This is because closing down inefficient, polluting enterprises have fundamentally different implications to a sharp slowdown in investment, consumption, or exports caused by demand shocks (e.g., policy tightening, external shocks), although they have similar negative impact on the headline data.

Goldilocks on Track: Revisiting the Four-Season Framework

Regular readers of our research may recall that in discussing the outlook for 2010, we envisage two types of uncertainties facing the Chinese economy in 2010: a) G3 economic outlook: will it be a tepid recovery, which is our base case, or could it be a vigorous recovery? And b) domestic policy stance: is there going to be normalization, as we are expecting? Might the Chinese authorities tighten aggressively? Along the two dimensions of uncertainty, we envisage four potential scenarios in 2010 in a four-season framework (see A Goldilocks Scenario in '10, November 23, 2009). The Goldilocks scenario, or autumn, is our base case scenario.

In view of the weak tone of data from US and the fiscal stress in Europe, we should be able to rule out a vigorous G3 recovery and thus the Summer and Spring scenarios by now. The current debate is about Goldilocks versus double-dip. In this regard, many investors do not have much conviction in this Goldilocks scenario and China's equity market appears to have priced in a high probability of a hard landing of the economy.

We, however, stick to our long-standing call for the Goldilocks scenario. The key uncertainty facing the Chinese economy at the current juncture is the potentially serious negative impact of austere measures against property speculation on investment growth in particular and the real economy in general. We argue that these measures will not cause a hard landing of fixed asset investment growth, as long as the overall macro policy stance remains unchanged (i.e., new bank lending target of Rmb7.5 trillion). This is because market-based residential property construction in large cities only accounts for a small portion of total construction activity and an ambitious social housing program has been launched and can offset potential weakness in market-based residential construction activity (see China Economics: Can Recent Policy Campaign Against Property Speculation Cause a Hard Landing? May 23; China Economics: Can Social Housing Program Help Secure a Soft Landing? June 17, 2010).

Economic and Policy Outlook in 2H10 and Beyond

We expect the headline year-on-year GDP growth and CPI inflation to moderate further in 2H10. Given these latest developments, the downside risks to both growth and inflation outlook under our base case scenario for 2010 - which we have flagged in our research notes earlier - are materializing (see China Economics: Renminbi Exits from USD Peg and Returns to Pre-Crisis Arrangement, June 20, 2010). While we would need to mark-to-market and revisit our forecasts, we still feel quite comfortable with our long-standing call for a Goldilocks scenario in 2010.

In light of receding inflationary pressures, the policy stance in 2H10 will likely show an easing bias, in our view. In particular, we assign more than 50% probability that the target for bank lending set for the year at Rmb7.5 trillion could be revised up by early 4Q10. In addition, we maintain our call for no interest rate hike through 2010. We reaffirm our call for sustained renminbi appreciation against the USD, with the year-end target for USD/Rmb at 6.60 for 2010 and 6.20 for 2011. Despite that exports are expected to slow down in the rest of the year, we expect China to continue to run a large current account surplus, which constitutes the foundation for our renminbi appreciation call.

For details, see China Economics: Goldilocks on Track Despite Faster Moderation in Growth, July 15, 2010.

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UK
Inflation: Higher for Longer
July 16, 2010

By Melanie Baker, CFA & Cath Sleeman | London

Updated Short-Term Inflation Outlook (18 Months)

Our key assumptions and changes are listed below, as usual.  Since we now have six months' worth of inflation data for 2010, in the following section we take a more detailed-than-usual look at the outlook.  We think that the balance of risk to our inflation forecasts is still to the upside over the next 18 months.

Key Factors and Assumptions Affecting Our Central Inflation Forecasts

•           Growth: We forecast that GDP growth will be low but positive over 2010 and 2011 and that a significant amount of spare capacity will dampen inflationary pressures.  We assume broadly flat unit wage cost growth in 2010 (partly on increased productivity) and 1.6% in 2011 (after around 4.4% in 2009).

•           Interest rates: We expect the BoE to keep interest rates on hold until mid-1Q11, ending 2011 at 2.00%. This helps to keep RPI inflation above CPI inflation over the rest of our forecast horizon.

•           Oil: We have assumed that Brent oil prices rise gradually over the next two years, broadly in line with futures prices.  In sterling terms, oil prices rise over 2H10, then gradually decline over 2011 (when sterling is forecast to appreciate).  For details of the currency forecast, see the FX Pulse.

•           Food price inflation: We expect annual food (and non-alcoholic beverage) price inflation to average around 2.8%Y over the rest of 2010 and 1.6%Y over 2011.  But we see upside risks beyond the next few months after recent dry weather.

Main changes over the past month

•           We assume that the upward surprise to our June forecasts is only partly reversed.  This leaves our 12-month ahead forecast around one-tenth higher for CPI and 2-3 tenths higher for RPI inflation. 

•           Our currency strategists recently raised their forecasts for GBP.  This lowers our inflation forecast by an average one-tenth in 2011.

•           We estimate that the Budget will add about 0.5pp to inflation over 2011 as a result of the VAT rise.

•           We have revisited some of our assumptions about the RPI-CPI differential.  We now assume a much slower return of the ‘formula effect' to its average, similarly the residual (that largely captures the effect of inflation trends in components that we do not model separately but that have a very different weight in CPI and RPI inflation). This methodology change has up to a two-tenths upward effect on our RPI inflation forecast in some months.

Key Risks

•           We remain alert to upside inflation risks from the clothing and footwear component, despite weak prices in June, and have already absorbed some of these risks into our central forecast.  Our retail team thinks that global apparel sourcing costs will increase over 2010 on higher commodity price inflation, container freight rates and increased manufacturer confidence in the Far East (see Apparel Sourcing Outlook: Product Cost Pressures to Return in 2H, Charlie Muir-Sands et al, January 21, 2010). 

•           There are some signs of an upward drift in medium-term household inflation expectations.  This significantly raises the chances that current high inflation outcomes have more serious implications for future inflation. 

The Budget and Inflation

We leave our below-consensus 2011 GDP growth forecast unchanged at 1.2%. However, the VAT rise adds 0.6pp and 0.5pp to our CPI and RPI inflation forecasts, respectively, in 2011. There are some upside risks since pass-through could be higher than we expect, given rising inflation expectations.

Some upside risks to our 2011 GDP forecast: In terms of government spending cuts, the new government's spending plans mark a less front-loaded fiscal tightening than we had expected. All else equal, this would actually imply some upside risk to our already below-consensus GDP growth forecast for 2011 (1.2% compared to consensus at around 2.0%). 

However, there are offsets: The VAT change, all else equal, lowers our forecast for consumer spending in 2011: the planned VAT rise would lower our forecast for the contribution to GDP growth from household consumption by about 0.4pp.  So, we leave our 2011 GDP growth forecast unchanged at 1.2% at this stage. 

VAT rise keeps inflation above 2% over our forecast horizon: From January 4, 2011, the VAT rate will rise from 17.5% to 20%. We estimate that this would raise inflation by around 0.5pp from January 2011. On our forecasts, this will also keep inflation from dipping below 2% in 2011.  The ONS assessed the effect of the VAT rise in January 2010 from 15% to 17.5% at 0.4pp for the January 2010 CPI inflation number.

Risks to our forecast are on the upside: Our forecast, however, assumes less than full pass-through.  On an assumption of immediate and full pass-through, the ONS estimates that the VAT rise would add 1.47pp to CPI inflation and 1.24pp to RPI inflation in January 2011.  In terms of the balance of risk to our forecast of the effects of VAT, the bigger risk is for a larger-than-expected effect, given rising household inflation expectations.

Further government steps that might directly impact inflation: A January 2011 rise in Insurance Premium Tax may add almost 0.05pp to RPI inflation, further fuel duty increases are scheduled, as is a further rise in air passenger duty (November 2010).  There is a review into the taxation and pricing of alcohol, which may yet see some additional effects on inflation there for example.

Inflation Expectations and Inflation

Increasing upside risks from signs of rising household inflation expectations.

All else equal, our downbeat GDP growth forecast should lead us to expect weak inflationary pressure: We continue to think that the outlook for the UK is for a decidedly weak recovery and that there is significant spare capacity in the economy.  All else equal, that should weigh down on inflation. 

However, all else is not equal: Household survey measures of inflation expectations have clearly held up very well despite the deep recession, helping to explain some of the upside surprises in inflation seen over the past 12 months or so.  However, medium-term inflation household expectations appear to be rising and the VAT rise in January against a backdrop of already high inflation may add to this pressure.  This increases upside risks to our forecasts. 

Sterling and Inflation

Not all of the short-term risks to our forecasts are to the upside. We lower 2011 inflation by 0.1pp on the back of changes to our currency team's sterling forecast.  Over the next 12 months, import price movements should dampen inflation, given lags.

A less weak sterling forecast: Our currency strategy team's forecast for trade-weighted sterling is now 4% higher in 2010 than it previously forecast and 9.4% higher in 2011.  This feeds through quickly into our profile for petrol prices, but with a lag into other components.  This lowers our inflation forecast, all else equal, by an average one-tenth in 2011 (where a two-tenth downward effect would then be likely in 2012).

12-month pass-through recently: There is a strong relationship between sterling movements and import prices.  But the strength of pass-through and lags are variable.  Lags appear relatively short for food price inflation, but the lag between movements in manufactured consumer goods import prices and ‘core' consumer goods inflation appears to be longer.  Lags may also lengthen in recessions and shorten in times of stable growth.  For much of the last decade, a lag of only six months would have fitted better than the 12-month lag that works well more recently.  Exchange rate pass-through can fail to occur altogether.

Models suggest weak but positive pass-through: Our models shed some light on the average relationship between inflation and the exchange rate.  In our ‘Phillips Curve' model, a 10% depreciation in GBP (versus the USD) raises inflation by about two-tenths after about 12 months.

One Further Concern: Some ‘Longer-Term' Inflation Pressures Manifesting Early?

In our in-depth report on inflation in March we identified four pressures on inflation that might ultimately make the inflation target untenable in the longer term.  Arguably, in persistent upward surprises to inflation, we may be seeing the early manifestation of some of those pressures (for more details see The Only Way Is Up?... March 31, 2010).  That particularly applies to the risk 1) that inflation expectations might become unhinged because of the MPC missing the inflation target and forecasting errors. 2) Global upward pressures on goods prices where UK inflation is particularly sensitive to movements in global inflation and where services inflation is persistently high.

The Gap between CPI and RPI Inflation

There is likely to be increased focus on the difference between CPI and RPI inflation following the government's announcements on changes in pension payment/indexation from RPI to CPI.  Over the next 18 months, we expect the difference between year-on-year CPI and RPI inflation to remain above 1pp.  However, in the longer term the difference between CPI and RPI seems likely to depend considerably on whether or not a measure of owner-occupied housing costs is incorporated into CPI.

Recap: The main differences between RPI and CPI:

•           A formula effect: The different calculation methodologies had been lowering CPI relative to RPI by about 0.5pp, although currently this is making about a larger difference of 0.8pp.

•           The exclusion of mortgage interest payments from CPI: The main driver of changes in this component is changes in mortgage interest rates.  During periods of big interest rate changes, this can have a very large effect on the RPI-CPI differential.

•           The exclusion of a measure of owner-occupied housing costs from CPI: This ‘housing depreciation' component in RPI reflects movements in UK house prices.  Since house prices have tended to rise at a faster pace than overall inflation, on average this dampens CPI relative to RPI.

‘Housing components' add 0.3pp to the RPI-CPI differential: We estimate that the ‘housing depreciation' and ‘mortgage interest payments' components of RPI add about 0.3pp in the longer run to the RPI measure of inflation compared to CPI.  In a ‘steady state', both of these components should grow at the pace of house price inflation.  The current weight of those two components in RPI is 8.9%.  Say that a steady-state rate of growth for house prices is about 3.8% (a guess at sustainable earnings growth if CPI inflation is 2.0% and productivity growth is at the long-term average of 1.8%).  Then these components would imply about three-tenths of the difference between RPI and CPI inflation.

In June, the main sources of difference between CPI and RPI were housing components other than mortgage interest payments and the formula effect.

But the make up of CPI will change: At some point the inclusion in CPI of owner-occupied housing costs is likely (although not in the immediate future).  The UK's CPI is currently produced on a harmonised basis - i.e., the methodology is largely decided at a Europe-wide level.

The government had seemed most likely to wait until Eurostat has finished its deliberations about including owner-occupied housing costs in HICP before changing the definition of CPI.  However, e.g., in his letter of May 18 to BoE Governor King, Chancellor Osborne wrote that "over the longer term I would welcome your views on how we might accelerate the process of including housing costs in the CPI inflation target."

Eurostat is likely to adopt the net acquisitions approach to measuring housing cost into the HICP, in our view.  This measures the cost of net acquisitions by the household sector only (i.e., largely new homes and ex-land).  The next stage would then be publication of stand-alone House Price Indices for EU economies.  That will happen before a decision on integrating these into HICP.  So, a decision on integration may not happen any time before 2012/13.

There is always the possibility that the UK government decides to go ahead sooner than this.  However, such a ‘CPI' inflation measure would then no longer be harmonised (i.e., HICP), but rather another alternative national inflation measure.  Its importance would then derive from what would link to it.  It would also depend on whether the government switched the MPC's inflation target to this new measure (which would seem likely) and what that new target was.  Such a change in inflation target need not be neutral for ‘underlying inflation'. 

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Global
Appetite for Restriction
July 16, 2010

By Manoj Pradhan | London

While markets debated the possibility of a double-dip recession, central bankers in the major economies showed very little sympathy. Some Fed officials suggested that the threshold for further stimulus was very high, while ECB policymakers hinted at an end to its bond purchases programme. On the other hand, EM economies took even less kindly to these concerns, with the central banks of India, Korea, Malaysia, and Peru all hiking policy rates within the last 10 days while the central bank of Thailand hiked today. Less than a month ago, the PBoC de-pegged the renminbi from the US dollar, while the central bank of Brazil is expected by our economists to follow up its first two hikes of 75bp each with another 150bp of hikes this year. If taken at face value, policymakers, and clearly those in emerging markets, appear to be much more convinced about the sustainability of the global recovery than markets are.

Appetite for restriction: With China, India, Korea, Malaysia and Thailand showing some appetite for restriction in the AXJ region, and Brazil and Peru echoing that sentiment in Latin America, the world economy's two fastest-growing regions are now beginning to take away some of policy accommodation that they had delivered during the Great Recession. However, the major developed economies as well as the CEEMEA region are far from being in a position where rate hikes are justifiable or expected. The global monetary exit sequence that emerges is thus consistent with the growth profile that our global economics team expects from these different regions.

The balancing act in the AXJ region: Despite being the clear front-runner in terms of growth, central banks in the AXJ region appeared to be in no hurry to start hiking rates in early 2010, with the notable exception of the Reserve Bank of India, which was clearly heading for a showdown with inflation. Prior to the summer, most monetary policymakers in the region were balancing off strength in their domestic economy against the risks to global growth. Early in 2010, the RBI and the BoK spurned the opportunity to raise rates even though these could easily have been justified by strong domestic fundamentals and (in the case of India) the prospect of rising inflation. Chinese monetary policymakers opted to use a combination of liquidity management and credit constraints to engineer some restraint on growth. The PBoC shied away from outright hikes in the policy rate, and the de-pegging of the currency arrived only towards the end of June. Instead, it was the Malaysian central bank that surprised markets by being the first in the region to start normalising its policy stance with a rate hike in March.

The PBoC's de-pegging of its currency on June 20 and the RBI's two inter-meeting hikes in March and July kick-started the process of monetary policy normalisation in the AXJ region. In April, the Monetary Authority of Singapore adopted an appreciating trend for its policy instrument - its currency. With the central bank of Malaysia hiking again and the central banks of Korea and Thailand instituting their first rate hikes in the last seven days, Indonesia remains the only large AXJ economy whose rapid growth has not been matched by an effort to normalise the policy stance.

Policy normalisation likely to continue: With markets debating a double-dip recession, and 3% yields seemingly pricing in an extremely weak growth path (see "How I Stopped Worrying and Learned to Love the Double-Dip Scare", The Global Monetary Analyst, July 7, 2010), central banks in the AXJ region had enough of a reason to grow increasingly concerned about downside risks to global growth. Instead, policymakers there, like their counterparts in the US and euro area, have shrugged off these concerns. Policy normalisation has started in earnest, and we believe that it is likely to continue.

LatAm central banks are close behind: Our LatAm team has been emphasising the strength of the recovery in the region for a while now. That thesis is being borne out by not just by the broad-based nature of the recovery there, but also the rapid rate hikes that have come from the central banks of Brazil and Peru. The COPOM is likely to follow up its two rate hikes of 75bp each in April and June with another one of 75bp when it meets next on July 21. By year-end, we expect policy rates there to rise from their current level of 10.75% to 11.75%. The central bank of Peru also surprised markets with its first rate hike in May, followed by hikes in June and another one very recently on July 9. With growth generally surprising to the upside in the region, market expectations for central banks to act on the basis of a rapidly closing output gap can't be far behind.

G10 and CEEMEA lagging at the back of the pack: The recent double-dip scare has accomplished at least two things. First, it has focused attention on the bumpy nature of the recovery as well as a down-shifting of growth in 2H10. Second, and rather counter-intuitively, it has allowed markets to ease monetary conditions at a time when central banks are either unwilling or unable to do exactly that. How? By moderating excessive asset price inflation and bringing inflation expectations lower, markets have removed two causes of concerns that could have prompted policymakers to tighten policy early. This allows central banks to stay on hold for longer (see again How I Stopped Worrying and Learned to Love the Double-Dip Scare). Our US team expects the Fed to first raise policy rates only in 1Q11, while our European team expects the ECB to raise much later, in 3Q11. According to our forecasts, slower growth in 2H10 and even in 2011 mean that the recovery will remain below-par.

The CEEMEA region, with many countries there exposed to eurozone demand, doesn't face very rosy prospects. Indeed, some central banks in the region are not done cutting rates, thanks to the currency collapses they faced in mid-2009. Raising rates on the back of domestic demand, export demand from Europe and a reduction in overall economic risks is a very distant prospect. With the exception of the Bank of Israel, our CEEMEA team doesn't expect any central bank to hike policy rates for the remainder of 2010.

AAA liquidity from major central banks allows AXJ and LatAm banks to hike rates with a safety cushion: Absent an abundance of liquidity provision by the major central banks, AXJ and LatAm central banks would likely have found it difficult to start pushing their domestic policy rates towards more normal levels. The AAA liquidity regime in the G10 region allows EM central banks some breathing room and some margin for error in their tightening campaign. Despite this, we expect EM central banks to stay vigilant to domestic and global risks. Unlike fiscal policy, monetary policy direction can be reversed relatively easily, as is evidenced by the ECB's summer hike in 2008 and its subsequent switch to rapid cuts in the policy rate. And evidence of policy vigilance comes from the PBoC's reaction to a recent decline in liquidity. When Shibor shot up to 4%, the PBoC promptly injected over Rmb900 billion into the system in order to bring the overnight rate back down to around 2.5%.

Global monetary exit sequence makes sense to us: Compared to the early part of 2010 when the roaring recoveries in the AXJ region were accompanied by monetary silence, the normalisation of the monetary policy stance that is well underway now is much more consistent with a sensible exit sequence for monetary policy globally. The beginning of tightening in Latin America initiated by the central bank of Brazil and echoed by the central bank of Peru highlights the game of catch-up that LatAm economies and central banks seem to be playing with their AXJ counterparts. And finally, the G10 economies which house the epicentre of sovereign risks and the CEEMEA economies with their close links to the euro area are at the back of the tightening pack. The AAA liquidity regime in the major economies is thus set to stay in place for longer, with growing risks that an eventual reversal of that regime may need to be stronger.

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