The China case for a slimmer surplus
Albeit not a 'hard landing', Pimco's analysts say China is set for a structural downshift that will leave Australia with considerable scope for additional rate cuts – and a more expansionary fiscal policy.
Each quarter, PIMCO investment professionals from around the world gather in Newport Beach to discuss the firm’s outlook for the global economy and financial markets. In the following interview, members of the Asia-Pacific Portfolio Committee – Tomoya Masanao, Robert Mead and Ramin Toloui – discuss PIMCO’s outlook for the region over the next six to 12 months.
Q: What are the key conclusions relevant to Asia from PIMCO’s third quarter cyclical outlook?
Toloui: PIMCO’s global GDP forecasts anticipate continued weakness into 2013, alongside aggressive monetary policy in the developed core to promote reflation. Within this global context, several conclusions are particularly important for Asia.
First, Asia’s slowdown reflects a structural downshift in growth rates due to the exhaustion of previous engines of growth, particularly in China. This is critical because conventional analyses of inventory cycles used to forecast near-term growth dynamics will misfire unless they incorporate these structural changes.
Second, we expect Asian policymakers will use fiscal and monetary tools to cushion the slowdown, but will not use aggressive expansionary policies to restore previous rates of growth. The cost-benefit calculation has shifted for many emerging market policymakers: In a world of slower global growth, aggressive fiscal expansion is seen as less likely to bridge to sustained higher growth, while the costs – in terms of perpetuating credit/investment imbalances or elevating debt levels – are perceived to have increased.
Finally, global portfolio rebalancing – the diversification by global investors away from lopsided concentrations in traditional developed markets and into under-represented emerging markets – will likely provide a financial cushion amid global bank deleveraging and support to Asian bond markets. A common thread running through all these conclusions is that longer-term secular forces are increasingly shaping cyclical economic outcomes in Asia.
Q: PIMCO’s cyclical growth forecast of 6.5 per cent to 7 per cent for China is substantially lower than market consensus. Is China heading for a hard landing?
Toloui: Our view for the last year has been that many analysts were underestimating the extent of the impending slowdown in China. The reason is that China’s economy and policymakers are grappling with a major change in the economic growth model, rather than simply a cyclical slowdown. The engines of the previous Chinese model – net exports and investment – have reached their limits, owing to high levels of debt among developed market consumers and a period of over-investment in China following the 2008-09 global financial crisis.
The good news is that the Chinese household sector has extraordinary potential to fill the void, given large pent-up demand for consumer durables, services, low-cost housing and transportation. But unleashing that demand requires a variety of changes in government policy and household behaviour that will not happen overnight. In the past, China’s leadership has risen to the challenge of accelerating reform during structural growth slowdown, but this time there is the added challenge of a weak global economy and a political transition at home.
While our growth forecast is substantially below consensus, we do not consider this to be a "hard landing” scenario. China’s government retains numerous policy tools to avert a hard landing, including more aggressive cuts to reserve requirements and interest rates, relaxation of housing market controls, and if needed, a larger fiscal response. Rather than a hard landing, we regard growth around 7 per cent for 2013 and subsequent years as a structural downshift that could be called a "New Normal with Chinese characteristics”, underscoring the extent to which structural rather than cyclical phenomena are shaping the near-term growth trajectory.
Q: How will slower growth in China impact the region?
Mead: China’s slowdown will continue to act as a drag on growth for the rest of the region, via at least two channels. The first is commodity prices. As China’s fiscal focus shifts from public investment to tax cuts and consumption subsidies, demand for steel will fall. Given that iron ore is Australia’s largest export, recent price weakness will have a significant impact on Australia’s terms of trade and nominal income, making the government’s goal of delivering a budget surplus in 2012/13 much more challenging. The second channel is export demand. Highly integrated production chains in Asia produce a great deal of trade interdependence across the region. For open economies with smaller domestic markets, overall GDP growth is highly correlated with trade, so the knock-on effects of China’s slowdown are very significant for overall economic activity in countries like Korea.
The ability of different Asian countries to respond to regional weakness varies significantly. At one end of the spectrum is Australia, which has considerable scope for additional rate cuts and more expansionary fiscal policy. At the other end of the spectrum is India, which has constrained policy options due to high levels of government debt and sticky inflation that inhibits the ability to reduce policy rates, raising stagflationary risks.
Q: How does Japan fit into the regional equation? How will the Bank of Japan’s policy be affected by external factors?
Masanao: Weak economic growth in China will surely have knock-on effects to the Japanese economy, which will add more pressure for the Bank of Japan to respond. PIMCO has been cautious on Japan’s economic outlook, "looking through” strong GDP growth over the last few quarters, which was inflated by the quake reconstruction stimulus demand. Our cautious growth outlook has been rooted in the structural weaknesses of both the domestic and international economies. Japan’s private sector demand remains largely depressed due to a secular adjustment to lower potential growth domestically. China’s exhaustion of its previous growth model adds to structural headwinds in Japan, at least until China successfully transitions to a new growth model that benefits Japan.
As our cautious outlook on China becomes a reality, there will be increased pressure on the BOJ. The bank’s scenario of a smooth handoff from policy-induced stimulus demand assumes a sustainable recovery in external demand, which seems unlikely. The BOJ’s policy will also continue to be driven by exchange rates, which are primarily driven by what the Federal Reserve does. However, the BOJ’s incrementalism seems unlikely to change given the bank’s view that the costs of further easing would outweigh the benefits.
Q: With global central banks pumping money into the system, is inflation in Asia a risk?
Masanao: Over the cyclical horizon, the inflation outlook is benign in Asia and elsewhere globally due to the subdued outlook for economic activity. In China, we expect the bulge in food prices earlier this year to cause headline inflation to edge up in the near term, before fading due to weak economic activity exerting downward price pressures over the next 12 months. Hard commodity prices should also be pressured by weak Chinese growth and contribute to moderating inflation globally, with the caveat that geopolitical risks remain a known-unknown risk to oil prices.
However, over the longer-term horizon, inflation will likely be a concern. Central banks that have exhausted traditional monetary policies and are engaged in quantitative easing will continue to add a massive amount of liquidity into the system. While it remains debatable whether QE will reflate structurally impaired economies, the intention of central banks is clear: reflation.
Q: What are the key investment implications for global and Asian bond investors?
Mead: With global growth continuing to be weak, we expect that developed country central banks, such as the Fed, the ECB and Bank of Japan will continue to implement unconventional monetary policies that keep core government bond yields low and dampen interest rate volatility. Yield curve strategies in this environment should emphasise intermediate maturities, which take advantage of the steep portion of yield curves in core markets while avoiding long-end bonds that are most vulnerable to longer-term inflation resulting from sustained money printing. Likewise, investors should consider including real assets such as inflation-indexed bonds in their portfolios to hedge against longer-term inflationary risks, as well as selected high-quality credit instruments that should be supported by central bank policies.
The combination of low yields in core developed markets and subdued Asian growth is likely to produce continued inflows into the region’s bond markets, as we have seen in Australia and Korea over the past year. "Clean dirty shirt” sovereign investments will likely remain sought-after diversifiers for global reserve managers, and we see attractive opportunities in Asia as well as other non-traditional markets with attractive nominal interest rates (Brazil, Mexico, South Africa). We expect emerging market currencies to generate positive returns via both higher carry plus moderate price appreciation.
Tomoya Masanao is Pimco's Tokyo office managing director and head of portfolio management Japan. Robert Mead is Pimco's Sydney office managing director. Ramin Toloui is an executive vice president in Pimco's Singapore office and global co-head of emerging markets portfolio management.
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