Notes from Beijing: v2.0 institutions dealing with v3.0 challenges

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1 Economics & Strategy Weekly Notes from Beijing: v2.0 institutions dealing with v3.0 challenges DBS Group Research 7 September 2018 Taimur Baig Chief Economist taimurbaig@dbs.com Duncan Tan Strategist duncantan@dbs.com Please direct distribution queries to Violet Lee violetleeyh@dbs.com There is unease, but no panic yet about prevailing currency weakness, corporate debt overhang, slowing growth momentum, or tightening US monetary policy Fiscal-monetary coordination to deal with forthcoming macro challenges is in better shape than they were just a few years ago Expectations are building for sizeable fiscal support From the PBOC, more accommodation for liquidity is likely Still, the authorities struggle, time to time, to provide clear policy communication, causing confusion and uncertainty among market participants China has thrived on ensuring economic and political stability in recent decades; continuing to do so in the period ahead will be quite difficult. Notes from Beijing These are contradictory times in China s capital. The city put up a strong display of international cooperation over the past few days as delegations from 53 African countries expressed their enthusiasm and support for China s infrastructure investment initiatives in the continent. In addition to adding vigour to the Belt and Road Initiative, China has also been busy reinforcing its ties with Europe and Asia on trade and investment, which can be seen as a constructive retort to US protectionism. But behind the surface lies growing uncertainty about both the near- and long-term economic outlook. For the near term, there is a need to balance deleveraging with the imperative to maintain growth as trade headwinds rise. For the longer term, China is grappling with a wide range of issues, including strengthening its institutions to foster durable reforms, ensuring prosperity while aging, maintaining productivity growth, not to mention its role in the world against the backdrop of protectionism. Some impressions from this trip follow: The macro situation There is unease, but no panic yet about prevailing currency weakness, corporate debt overhang, slowing growth momentum, or tightening US monetary policy. On the RMB, the authorities have allowed gradual but sizeable depreciation in recent months, although lately there has been active intervention to stem volatility, while some forbearance to slow down capital outflows is being exercised. Clearly the RMB crossing 7 against the USD would be seen as a psychologically critical threshold, but in the context of tariff increases and US rate hikes, such levels are not likely to be resisted with great force. On deleveraging, we don t think the monetary authorities have changed their minds about containing debt accumulation and keeping bank credit in check. At the same time, local governments have been encouraged to increase spending. It appears to the us that this is rather delicate exercise, Refer to important disclosures at the end of the report

2 giving dovish signals to provinces while not doing much to alter bank restraint. Perhaps the expectation is that local government financing will come from the bond market; or that reserve requirement cuts and downward shift of interest rates would provide the necessary nudge to banks to increase lending in any case. On the slowing of growth, we detected the least degree of discomfort. Despite months of trade war related news, trade figures are still strong, although the late data prints probably have an element frontloading in them (ahead of tariffs getting imposed). Beyond exports, high frequency data show to no sign of malaise in the economy, with consumption and investment growing in high single digit rates. Property prices have held up fairly well this year in many key markets. Currency depreciation is not causing any major concern about pass-through price fears. Rise in international fuel prices is not expected to create major change in pump prices as they remain under administrative control. The lack of discomfort about the present is sharply contrasted by heightened uncertainty about the near-term outlook. Could exports slow sharply in the coming months? Could capital outflows surge as RMB continues to weaken? Will sentiments take a dive and investments contract? Will the asset market sell-off exacerbate, further undermining confidence? Is monetary policy too tight? Is there fiscal wherewithal available to counter a likely impending slowdown? What will be the political cost of a major tussle with the US? We felt that dealing with the US administration has been very challenging for the Chinese government. Hopes for quick resolution to trade wars has been replaced by the grim realisation that accessing US markets will become costlier and in some cases impossible. A key challenge is to ensure that other countries don t join the US effort to contain China in economic, security, and diplomatic spheres. Another challenge, for the medium term, is to ensure that the China has the capability to acquire and develop technologies that will keep it at the frontier of development, something the US appears to be keen to prevent. Policy response Expectations are building for sizeable fiscal support; pipeline income tax reform measures should provide some relief (including, by raising the rate threshold for various income tax brackets). The centre has been encouraging provinces to pick up the pace of spending as well. It is however unlikely that measures to encourage property market transactions will be forthcoming. More likely will be relief for exporters hurt by US tariffs. From the PBOC, more accommodation for liquidity is likely, but the thrust of policy action will come from fiscal. There has been a marked improvement in coordination among the key agencies dealing with fiscal, monetary, and exchange rate policy over the past three years, so a more coherent policy package should be expected. Still, the authorities struggle, time to time, to provide clear policy communication, causing confusion and uncertainty among market participants. V2.0 institutions dealing with v3.0 challenges We left Beijing with the distinct impression that China s institutions are playing catch-up with the challenges being thrown at them. The economy has grown so spectacularly large and complex in recent decades that it has become very difficult to maintain a cohesive policy framework nationwide. While the population and markets continue to look at Beijing for directions on just about everything, the frequent instances of policy contradiction and error correction suggest there is still work to be done in terms of policy communication and coordination. The authorities need to collect, organize, and disseminate more data and analysis to allow for better diagnosis and prescription for the economy, region by region. Issues related to the proliferation of structured products and nonbank finance, wasteful investment by SOEs, state of the property market, copyright and intellectual property protection, liquidity management, expenditure control--all could do with better information and incentive compatible guidance. China s regulatory, supervisory, and policy executing institutions need better depth in this context. The ongoing trade war is putting China s economic and diplomatic institutions to test. We believe that recognition has set in that the adversarial moves seen so far could readily spill into areas beyond trade and vis-à- Page 2

3 vis countries beyond the US. China has to shore up domestic sentiments, succeed in an international charm offensive, keep its macro policies nimble, and it tradeplus-industrial policies flexible. We think some of the pushback and criticism around BRI, for instance, reflects weak administration and communication. The remedies are clear, but achieving them is hard, as that would entail lifting the capacity and capability of a very large bureaucracy and political management quickly. We left Beijing knowing that the authorities have clear understanding that China s export oriented growth model is under severe short and medium term challenge. China certainly has ample buffers to deal with pipeline headwinds, but it may not be able to respond to the myriad challenges ahead in a timely and cohesive manner given its institutional constraints. China has thrived on ensuring economic and political stability in recent decades; continuing to do so in the period ahead will be quite difficult. Postscript We spoke with a professor at one of Beijing s elite universities, who also has taught undergraduate and Ph.D. students at Boston s best universities. He said that the best of China s home grown young intellectuals were absolutely on par with their Western counterparts, not just in terms of aptitude and cutting edge expertise, but also in curiosity and creativity. The professor felt that the Chinese students had two more characteristics that bode well for the future. First, they received generous state support to pursue their research. Second, they were exceptionally driven, something that can only be seen in the first (or at most second) generation of population experiencing the first bouts of prosperity and upward social mobility. The professor felt that the hunger for betterment is what sets the best and brightest of Beijing apart from their equally smart but perhaps less driven peers in the US. Taimur Baig Page 3

4 Strategy FX: Global risks underpin USD The US dollar index (DXY) appreciated back to 95 in the first week of September. The US dollar is underpinned by the Fed s commitment to gradually hiking rates but its momentum has been dampened by its view that inflation would not accelerate with the strong US economy. The inability of the Indian rupee and the Australian dollar to rally on stronger-than-expected GDP growth in the past week have not gone unnoticed. The euro is vulnerable to the new Italian antiestablishment government looking to increase fiscal spending to support the slowing economy. If so, this would put Italy on a collision course with European Union over its commitment and respect for EU rules. Seeking a compromise with EU would disappoint voters who supported the populist parties and open the door for new elections. Italy is scheduled to finalize and present its budget and growth targets to its parliament by September 27, before submission to the European Commission by October 15. Brexit has become a binary risk for the British pound. According to a Reuters poll, a Brexit deal will lift the pound by 6% while a No Deal Brexit would hammer it down by 8%. The view is shared by the Bank of England Governor Mark Carney whose term has been extended to help smooth the Brexit transition after its March 2019 deadline. We remain cautious of overnight reports that Britain and Germany may have found middle ground for a watered-down Brexit deal. Any Brexit Deal would also require the support from all EU countries, and not Germany alone. British Prime Minister Theresa May s Chequers Brexit plan is not supported by Brussels and unlikely to be approved by UK lawmakers. Asia ex Japan currencies are weak on two fronts. The three Asian currencies with current account and fiscal deficits Indian rupee (-11.3% ytd), the Indonesian rupiah (-8.9%) and the Philippine peso (-7.2%) remain sensitive to rising US rates and emerging market stress, especially the Turkish lira (-42.3%) and the Argentinian peso (-50.2%). The Korean won (-4.7%), Taiwan dollar (- 3.2%) and the Singapore dollar (-2.8%) remain vigilant against an escalation in China-US trade tensions. Philip Wee Rates: Sentiment still fragile for Asia local rates but there is room for outperformance Sentiment on emerging market (EM) rates remains weak. The confluence of factors market contagion, trade war, and Fed hikes is too potent a mix to ignore. It probably does not help that the USD is also kept strong as the EUR languishes from Italy s budget woes. Total return for Asia bond indices (in USD terms) are largely down for the year. Within the economies we track, only the US and HK indices are still barely afloat. There appears to be a negative relationship between total returns and the volatility of total return over the past three quarters. There are two outliers Indonesia and Thailand. Indonesia may be more susceptible to global sentiment swings given the heavy foreign ownership of government bonds. Comparatively, India does not seem to suffer from this issue with its performance and volatility largely aligned. Once the global narrative improves, Indonesia govvies have significant room to outperform. Thailand has been somewhat surprising, exhibiting volatility that is on the high side (but outperforming the market on the FX side) despite stable monetary policy and strong external financing metrics. Optimism about domestic growth and a possible hawkish signal from the Bank of Thailand (BoT) have led to a sharp selloff in 5Y government bonds. This could have temporarily skewed volatility higher. On balance, longer-tenor THgov bonds are starting to look attractive after the sizable yield increases since early April. Eugene Leow Page 4

5 Equities: Trade war and currency turmoil priced in Trading at near average valuations (12-months forward PE), we think the ASEAN markets have priced in a lot of negative news on trade wars and currency turmoil. There were three instances in the past when these markets were under stress and traded below minus one standard deviation. They were during 1) euro weakness in 2011 eurozone crisis; 2) the QE tantrums in 2013; and 3) Asia currencies weakening in 2015 when CNY started to devalue. If the ASEAN markets were to test these past levels, our calculations show that they would suffer about 10-18% losses. However, we think these episodes are unlikely to repeat. Bearing in mind that the euro has already corrected 7% from this year s high at 1.16 vs in 2011, when the currency dropped 14% from 1.48 to This time round, the Italy crisis is unlikely to evolve into a eurozone crisis as long as Italy pledges to comply with the EU fiscal consolidation by end-september and a new election to be held next year. We also find comfort in that US bond yields are already at 3%, which is near the levels during 2013 taper tantrums. Last but not least, the CNY has already depreciated back to the 2015 level. interest rate volatility have probably trimmed risk appetite and kept inflows in check. The bulk of monthly inflows were for US equity ETFs which helped the S&P 500 leap above 2,900. International equities also saw improvement in flows after the past three months of selling and moderate flows. In the fixed income space, US fixed income ETFs registered net inflows as US bond yields held steady amid EM turmoil and flight to quality. International fixed income flows also followed suit with net inflows, albeit small, as a slight reprieve was seen with a halt in the USD rally. We do not think there is contagion selling which tends to disregard the weak and strong markets. However, commodity ETFs have continued to face redemptions for four consecutive months, during a period of high oil price volatility and where gold prices fell 12% from the high. We are more positive on oil prices as we move closer to the imposition of renewed US sanctions on Iran from November And until expectations on USD and rate hikes moderate, it would be hard for gold to gain attention in the asset market. US-listed ETFs: Monthly flows by major asset classes We think markets are feeling jittery on the implications of a potential 25% US import tariffs on the US$200bn worth of Chinese goods. If implemented, the impact would be quite severe. Further CNY depreciation cannot be ruled out, and a more pronounced slowdown in global growth will be felt. Nonetheless we think that it will be the last shot for Trump to surprise the market on the already highly-strung US-China trade tensions before the mid-term elections in November. We recommend investors to stay with safe havens such as Singapore and Malaysia where downside risks are lesser. Joanne Goh Equities ETF: US-listed ETF flows returned in August, but mainly for US equities Source: ETF.com, ETF Asia Analytics Highlights of the week: Joanne Goh August proved to be a solid month for US-listed ETFs with net inflows of US$25,285m. However, inflows are still below the average seen in the past two years. Ongoing US-China trade tensions amid earnings, currency and Indonesia s pain points India s FY19 growth to moderate after a strong start South Korea chart book Pre-emptively dovish Malaysia chart book Recalibrating growth Page 5

6 GDP growth, % YoY Key Forecasts CPI inflation, % YoY, ave f 2019f f 2019f China Hong Kong India* Indonesia Malaysia Philippines** Singapore South Korea Taiwan Thailand Vietnam Eurozone Japan United States*** * refers to year ending March ** new CPI series *** eop for CPI inflation Policy interest rates, eop 1Q18 2Q18 3Q18 4Q18 1Q19 2Q19 3Q19 4Q19 China* India Indonesia Malaysia Philippines Singapore** South Korea Taiwan Thailand Vietnam*** Eurozone Japan United States * 1-yr lending rate; ** 3M SOR ; *** prime rate Exchange rates, eop Q1 18 Q2 18 Q3 18 Q4 18 Q1 19 Q2 19 Q3 19 Q4 19 China Hong Kong India Indonesia Malaysia Philippines Singapore South Korea Thailand Vietnam Australia Eurozone Japan United Kingdom Australia, Eurozone and United Kingdom are direct quotes Page 6

7 Group Research Economics & Strategy Taimur Baig, Ph.D. Chief Economist - G3 & Asia taimurbaig@dbs.com Nathan Chow Strategist - China & Hong Kong nathanchow@dbs.com Joanne Goh Regional equity strategist joannegohsc@dbs.com Neel Gopalakrishnan Credit Strategist neelg@dbs.com Eugene Leow Rates Strategist - G3 & Asia eugeneleow@dbs.com Chris Leung Economist - China & Hong Kong chrisleung@dbs.com Radhika Rao Economist - Eurozone & India radhikarao@dbs.com Irvin Seah Economist - Singapore, Malaysia, & Vietnam irvinseah@dbs.com Samuel Tse Economist - China & Hong Kong samueltse@dbs.com Duncan Tan FX and Rates Strategist - Asean duncantan@dbs.com Philip Wee FX Strategist - G3 & Asia philipwee@dbs.com Ma Tieying Economist - Japan, South Korea, & Taiwan matieying@dbs.com Sources: Data for all charts and tables are from CEIC, Bloomberg and DBS Group Research (forecasts and transformations). Disclaimer: The information herein is published by DBS Bank Ltd (the Company ). It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation & the particular needs of any specific addressee. The information herein is published for the information of addressees only & is not to be taken in substitution for the exercise of judgement by addressees, who should obtain separate legal or financial advice. The Company, or any of its related companies or any individuals connected with the group accepts no liability for any direct, special, indirect, consequential, incidental damages or any other loss or damages of any kind arising from any use of the information herein (including any error, omission or misstatement herein, negligent or otherwise) or further communication thereof, even if the Company or any other person has been advised of the possibility thereof. The information herein is not to be construed as an offer or a solicitation of an offer to buy or sell any securities, futures, options or other financial instruments or to provide any investment advice or services. The Company & its associates, their directors, officers and/or employees may have positions or other interests in, & may effect transactions in securities mentioned herein & may also perform or seek to perform broking, investment banking & other banking or financial services for these companies. The information herein is not intended for distribution to, or use by, any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Sources for all charts & tables are CEIC & Bloomberg unless otherwise specified. DBS Bank Ltd., 12 Marina Blvd, Marina Bay Financial Center Tower 3, Singapore Tel: Company Registration No E. Page 7