China Daily

Chinese and US economies to diverge in 2011

China and the US are oft en seen in the headlines disputing various issues ranging from political to economic matters.  However, their policies and goals have at times been aligned in an effort to stimulate global growth.

This year, though, we see a divergence in the policies of both countries due to the unique domestic situations they face.  Interest rates, GDP growth and inflationary worries are just a few to mention as central bankers and policy makers work to stabilize and spur growth in their respective nations.

The past two years in the US have been marked by monetary loosening through the process of quantitative easing (QE).  Beginning in November 2008, the US Federal Reserve began purchasing $600 billion of mortgage-backed securities (MBS). They continued this in March 2009 by spending $1,000 billion on agency MBS, bonds and some government debt in its first QE.

US equities gained 29.5 percent and the US dollar dropped 12.6 percent 12 months after the November 2008 announcement.  The impact of the first QE is obvious due to its success in driving up equities and growth during a time of stagnant activity.

Concerns over a double dip recession amidst a weakening domestic economy motivated US Federal Reserve Chairman Ben Bernanke to put growth back on the agenda with QE2.  On November 3, 2010, the US Fed announced that it would take further action through a second round of quantitative easing.

However, the real rally in US equities actually began in August last year when Bernanke first started making hints about QE2 in Jackson Hole, Wyoming.  Since the end of August 2010, the S&P500 rallied from 1,064 to a year-to-date high of 1,276 on January 5, 2011 representing just under a 20 percent increase during that time period.  The markets acted just as they should, with equities rising and treasury yields pushed down as a result of the Fed purchases.

New York Fed governors and other central bank members argued that monetary loosening through QE inflates balance sheets, boosts consumption, increases spending and in the end helps to grow US GDP.  It's clear that the $600 billion QE2 has helped rally stock markets in the US. The question is though: What happens afterwards?  At the end of June this year, QE2 will come to an end with the last $90 billion purchase of treasuries.  For this reason, the economic situation in the US should outpace emerging markets – including China – with good growth seen in the first half of 2011.

In China, inflation is the main concern.  Rising CPI and food prices have headlined news stories recently.  The Central Government's priority will be to rein in inflation and achieve price stability to maintain social harmony.  According to Bloomberg data, food prices in China's CPI (November 2010) rose 11.6 percent (compared with 10.1 percent in October, and in percentage terms increased 15.84 percent).  This upward trend exists today and inflation expectations are still high.

In Algeria, riots occurred in January as rampant inflation and political uncertainty persisted.  Food prices increased sharply, making basic necessities unaffordable for many Algerian citizens and culminating in a 9 percent plunge in the country’s stock market on January 10, 2011. These are the type of situations China will work hard to avoid.

A main focus for Chinese policy makers should be to maintain high growth in the economy in order to cover increased inflation.  Higher income and wages plus some price controls can help cool down inflation and support economic growth.

In the end, China will succeed in lowering inflation and stabilizing prices.  After the Lunar New Year in February, prices should come down and indications of controlled inflation should appear.  Unlike last year, China should see good growth in the second half of this year as important events such as the National Day (October 1, 2011) will mark dates for the Chinese to have its most problematic issues under control.

Price instability could mean social unrest and this is what China and its central bankers will be fighting strongly against. Sentiment should smooth out as an increase in labor prices should also help partially off set living costs.  For China, strong growth, slightly higher inflation, and steady growth in wages will be the main drivers of its economy.


Monetary policies divide world into two camps

The US Federal Reserve acted last week on its much-anticipated second round of quantitative easing (QE2) by buying an additional $600 billion of Treasuries through June 2011. This expands on its record stimulus package and is an effort to reduce unemployment and avert deflation. Originally it was reported that purchases might be higher but after a series of encouraging economic data and earnings reports, the case for a one off large scale QE no longer seemed appropriate. Since December 2008, interest rates have remained low at 0 percent to 0.25 percent with core inflation at almost zero.

The impact of QE2 provides a welcome level of support for the US economy.  Effectively, the US Fed has repaired its own balance sheet through purchases of treasuries in exchange for its mortgage-backed securities (MBS) and agency debt.  By exporting its own inflationary pressures overseas through excess liquidity, corporate balance sheets may also improve on the back of higher asset prices.  With the ability to change and act accordingly through securities purchases, the Fed has given itself the option to wait and see how the US economy will recover and to what extent assistance will be needed.

QE2 will increase inflationary pressures for some emerging countries and their asset prices will remain at high levels. The US Fed is using QE2 to increase the money supply in order to reduce the debt burden.  US policymakers have accepted some levels of inflation in hopes of boosting domestic domes-tic consumption and reducing the country’s level of unemployment.

We believe the world falls in two camps: the first being the "QE Camp" including the US, UK, and Japan; the second being the "non QE camp" consisting of emerging market economies which is led by China The former has and will continue to loosen its monetary policy in efforts to revive economies, devalue currencies and inflate asset prices. The “non QE camp” is focused on containing inflationary pressures through tighter monetary policies.

In the "non QE camp", China has recently raised interest rates by 0.25 percentage point for both lending & deposit rates on the back of renewed inflationary concerns.  In its third quarter macroeconomic report, the People’s Bank of China raised warnings of rising food prices, wages and commodity prices.  China's consumer price index (CPI) climbed to 3.6 percent year-on-year in September and is expected to rise to 4 percent year on- year in October.  This exceeded the Central Government’s goal of keeping inflation below 3.5 percent – it was at 3 percent at the beginning of the year.  The rising CPI is eroding the purchasing power of the people and the higher price of food, energy, rent, and wages, could weaken China’s competitiveness.

Additionally, gasoline prices are at high levels and adverse weather conditions have created a shortage in soft commodities leading to further price increases in that segment. In 2010, China suffered from a series of droughts and dust storms.  Moreover, floods in China began in early May 2010.  Consequently, most soft commodities including agricultural goods such as corns, experienced record high prices.

China will be carefully watching the inflation level as it deals with other important issues such as the inflow of hot money, and yuan reval revaluation.  The so-called "hot money" inflow has been a prolonged issue for China as this will directly inflate asset prices.  As previously discussed, the yuan is also another major concern and China will have to gradually appreciate its currency according to the relationship between exports and domestic demand.

As we are approaching the year's end, central bankers around the world will watch carefully the impacts of QE from the "QE Camp" and monetary tightening from the "non QE camp".  A measured pace of intervention by central banks and other regulators is what we have seen this year and expect to continue until year-end.


Beijing rewrites G20 agenda with yuan de-pegging

please download here: ChinaDaily_2010.6.23.pdf


The People’s Bank of China (PBoC) surprised the market with its announcement over the weekend to end its currency peg with the dollar as it reintroduced the scheme that pegs the renminbi (RMB) against a basket of currencies – a move that has been widely welcomed internationally. During the past six months, the RMB has been a scapegoat, taking heat from the protectionists of the West for its “inflexibility” leading to the slowdown of global economy recovery. By taking the initiative, China shook off this charge from Western politicians and more importantly, rewrote the agenda for the G20 meeting, to focus on the source of the problems: the debts of the developed economies.

Even though China did not bow to Western pressure to carry out a large scale, one-off appreciation of the Yuan or to expand the trading bands of the RMB, as many has expected, the market overreacted with the PBoC’s currency peg announcement, as the RMB rose almost 0.5 percent Monday, which prompted traders to sell US Treasuries and increase equities and commodities positions.

The sell-off of US dollar assets makes a strong case, as a large-scale appreciation of the RMB would prove devastating to the greenback and disturb global financial stability. With an accumulated 17 percent appreciation against the euro this year that’s already priced in and the

diminishing current account surplus of China, the path of the revaluation of RMB should continue in an orderly manner.

The Chinese economic data for May has shown the domestic economy has been growing at a healthy pace, with inflation slightly over target. A moderate appreciation of the RMB should be able to boost domestic consumption and help control inflation. Commodities that are crucial to the future development of China would also be imported at controlled and reasonable prices. All of these benefits would, however, be at the cost of the exporters.

For years, exports have been the pillar of the country’s economic development, which feeds hundreds of millions. Although surging labor costs and currency appreciation are eroding exporters’ competitiveness, the increased purchasing power of the RMB over time will eventually begin to ease the inflationary pressures on labor costs. The European debt crisis has affected the demand for Chinese goods and poses uncertainty for the sector. Yet, under a controlled pace of appreciation and given the ability to provide subsidies or tax relief, the Central Government should be able to relieve the pain of the sector.

The calculated move of Beijing was wise and came at the right time – one that will benefit the economy more than hurt it. The re-peg against a currency basket offers Beijing the flexibility and stability to insulate the RMB from extreme volatility in the forex market. The new policy signals that the Chinese economy is slowly walking out of the shadow of the 2008 financial crisis while it marks a turn from an export-oriented toward a more diversified economy.

While the action has been interpreted by some observers as a pre-G20 meeting gift to the West, especially the US, the future movement of the Yuan depends on the speed of GDP growth and structure of the economy. The Yuan is still undergoing structural development toward becoming an international currency; however, the priority remains ensuring the stability of the domestic economy and the harmony of Chinese society.


Beijing charting a safe course

please download here: ChinaDaily_2010.6.18.pdf


The data released by National Bureau of Statistics (NBS) last week for May displayed mixed economic indications. The 48.5 percent robust increase in exports, far exceeding the 32 percent growth widely expected by the market, quickly seized the market spotlight. However, the strong growth is likely to falter in the months to come, with demand from Europe expected to decrease gradually as a result of the weakened euro. Concurrently, the Consumer Price Index surged 3.1 percent. It is interesting to see how some of the Western media linked the export data with the rising CPI to expatiate on the possibility of an overheating mainland economy and increasing pressure on Beijing to allow appreciation of the Yuan against the US dollar.

According to the NBS, housing and food prices surged 5 percent and 6.1 percent, respectively, for the month of May. On the other hand, although new home sale prices for the 70 major cities grew 0.20 percent last month, overall residential properties sold slid 16 percent, while the total transaction amount fell 25 percent compared with April. The Central Government’s macro policies adopted to contain the overheating sector are paying off, so the housing prices should not post any imminent threat of in the near future.

The surging food prices are perceived as temporary as natural disasters, such as droughts causing a decrease in supply in the first five months of the year. Middle and lower-income family groups in the countryside are most vulnerable to rising food costs, so prices and pricing controls should be considered by the Central Government to protect their livelihoods through subsidies. Further agriculture planning and environmental controls should provide a medium to long-term solution to the challenge of maintaining a stable food supply while tackling the rising food prices problem.

The wage problems recently making headlines are leading to rising concerns about their effect on inflation and other aspects of economic performance. However since average monthly wages for factory workers are relatively low compared with elite professionals working in major cities, the impact of raises on the overall economy should be limited. More importantly, with the GDP of China continuing to climb, and to ensure a better balance in the distribution of wealth as part of the goal of building a harmonious society, wages of workers have to catch up at a healthy pace. The Central Government, for its part, could have policies providing subsidies or tax relief to ease the burden of the manufacturers and exporters.

With the cooling of the housing market, the government should be able to contain inflation within the approximately 3 percent levels this year.

Given that the European crises will most certainly impact the mainland’s exports, it is unlikely that the People’s Bank of China will raise interest rates in the near future.

The Central Government has delicately and successfully maneuvered the economy, steering away from perilous shoals, viz., inflationary pressure and currency instability, without posing any threat in the near term. Indeed, inflationary pressure has significantly eased compared with the first quarter.


The smart euro-debt strategy for China

please download here: ChinaDaily_2010.6.1.pdf


Shortly after the euro’s chaotic decline against the USD on May 24, the Financial Times reported that the State Administration of Foreign Exchange (SAFE) of China was reviewing its $630 billion holdings of euro debts. The SAFE denied the report, saying, on the following day, that the report was “groundless” and affirmed it will continue to follow the principle of diversification in its foreign exchange reserve investments. The president of China Investment Group (CIC), which manages $300 billion in sovereign wealth, also affirmed the next day that CIC will continue to maintain its investments in the euro-zone.

The comments of CIC and SAFE should not be taken as posturing, but as an affirmation that both organizations will act accordingly. Since 2007, the euro zone has replaced the US as the largest importer of Chinese goods. In the first quarter alone, it already bought $65.3 billion of goods from China. It is also the second largest exporter to China, selling $127.7 billion worth of goods in 2009. More importantly, China’s net inflow of Euros resulted in a constant growth in foreign reserves. Inevitably, the euro is becoming more important to China’s foreign exchange system, so it is not in our interest to sell euro denominated debts to worsen the panic selling in the short run.

Dollar-denominated assets, mostly Treasury securities, are estimated to compose around 70 percent of the $2,447 billion foreign reserve managed by SAFE, which has grown 58 percent since the end of 1999. With the significant increase in volume, the shortcomings of a concentrated basket become obvious, especially in the aftermath of the financial tsunami. Amid the short-term strength relative to other currencies with capital fleeing for safe havens, doubts remain regarding the greenback’s capacity to assure its function as a store of value in the long run, given the huge US fiscal deficit. Flooding the market with more greenbacks makes it easier to finance the deficits than imposing higher taxes and cutting government spending.

With the series of downgrades of the sovereign bonds of the PIIGS countries by the credit rating agencies, concerns over sovereign bonds credit worthiness have escalated to panic selling. Investors choose to punish the poor financially disciplined PIIGS countries by abandoning their euro-denominated assets, including bonds that are backed by strong balance sheets. Take the German Bunds auctions in May for example: the targeted 7 billion auctions fell short by 1.55 billion.

On the other hand, appetite for US Treasuries increased in the past 5 months as the euro slid – an approximate 20 percent fall from its peak of 1.5122 against the dollar in December to the low of 1.2181 on May 19. Capital was also driven to other USD-denominated assets and pushed down US mortgage rates. The 30 year fixed-rate mortgage rate fell to 4.92 percent last week, its lowest since September 1985. In the midst of the euro crisis, the US federal government and US consumers are the benefit ting parties.

Nevertheless, it is neither in the Chinese nor the American’s best interest to witness further deterioration of the euro. First of all, the US private sector is holding billions of euro assets. Within the sovereign debts issued by PIIGS countries, the US banks together have been holding in total $97.7 billion in Spanish sovereign debt. A continuing free-fall of the euro might induce wave in the recovering global financial system. Moreover, the euro zone collectively is the largest trading partner of the US – in 2009 alone importing $220 billions of goods and services. President Obama has promised to double exports in 5 years, create 2 million new jobs and to limit the strengthening of the dollar in order to sustain the competitiveness of American goods.

The stability of China’s economy depends largely on global financial stability. That was the reason the central government continued to buy US Treasuries in the middle of the 2008 financial crises. It is in the long-term interest of China to diversify her foreign reserve holdings against the possible devaluation or depreciation of the greenback in the future.

China should seize the golden opportunity to strengthen the greenback to reduce the USD denominated asset exposure as well as to capitalize on the appreciation and to further diversify her reserves.