Thursday, December 22, 2011

Three Things to Watch in 2012

Three of the big themes for 2012 are already blatantly obvious: the ongoing sovereign debt saga in Europe, the path of economic growth in America and whether China manages a soft landing.


Europe and the various political attempts to resolve the sovereign debt crisis was the major theme of 2011. It will remain a key theme into 2012. We are not as negative as some commentators on recent developments, especially on the two most recent summits. Certainly politicians have failed the deliver the “bazooka” solution that many have wanted and expected, but incremental progress has been made.

Fiscal co-ordination has been the missing link in the set-up of the European monetary union. While it’s obviously too late to prevent the current crisis, its important in establishing a framework for the way forward. The ECB has also taken important steps to provide “unlimited liquidity” to the European banking sector.

The missing part has been the same provision of liquidity to the sovereigns. By our calculations there is around €900 billion (ESM when it is established in mid-2012, IMF, and currently uncommitted EFSF funds) available next year to assist governments (those that are either insolvent or illiquid) who need support. This will most likely not be enough. The question is how leverage can be used to boost the lending capacity of the €500b available to the ESM and/or at what point the ECB steps up its purchases of sovereign bonds.

In the meantime the European economy has slipped back into recession. At this point we think the recession will be relatively mild with contractions in activity in the fourth quarter of 2011 and the first two quarters of 2012. The reasons are well known: weak business confidence, fiscal austerity, higher funding costs and the availability of credit as banks strive to meet the new 9% capital adequacy ratio by mid-year. The weakness is centred in the periphery but even Germany is unlikely to avoid a contraction in activity – Germany’s export ratio is around 40% of GDP with most of that going to its European neighbours.

We expect a 2012 calendar year GDP outcome of around -0.5%. The risk is clearly skewed to the downside, but at this point, the weak exchange rate, bank deleveraging being done and dusted by mid-year and further interest rate easing from the ECB (another 50bps of easing to 0.5%) will help prevent a deeper and more protracted recession. The important qualifier to that view is that politicians and the ECB will do all they need to do to prevent an escalation in the situation. If the situation deteriorates from here it becomes more likely the ECB goes down the quantitative easing path but uses a monetary policy (price stability) rationale rather than lender of last resort.


Economic growth in America has this far been surprisingly resilient to developments in Europe, in fact GDP growth for the fourth quarter of 2011 will most likely be the strongest for the year: market expectations are for a seasonally adjusted annual rate of around 3% for the quarter.

But it’s important not to get too bullish about next year. Using the line of “fragile debt constrained growth” for America over the last 3 years has seen us accused, at various times, of being either too pessimist or too optimistic about the outlook for America. We think this line will continue to serve us well next year – we expect GDP growth of 2% in 2012.

Activity will be constrained by the same factors – soft consumption and jobs growth, weak housing (although there are positive signs emerging here as 2011 draws to a close) and tightening fiscal policy. We have assumed the payroll tax cuts are extended into 2012 although the politics are, once again, looking somewhat fraught. We will look for exports and business investment to be the strongest areas of growth. That assumes we are right about Europe.

The inflation story will be interesting. The Fed has done a great job of avoiding deflation. Annual core inflation is now over 2%. We think core inflation heads lower in 2012, but not dramatically so. In fact we think that inflation will remain too high a hurdle for the Fed to go down the path of QE3, at least for monetary policy reasons.

Another area of interest for us will be the labour market and the inflation implications of a structural unemployment rate that is now likely higher than it was pre-GFC. We don’t know where that is, but some recent research has suggested it may be as high as 7%. More on that topic next year!


Growth momentum is continuing to slow in China, reflecting weaker external demand and the continued transmission through the economy of tighter monetary conditions. Export and residential housing are soft while retail sales and investment are continuing to hold up well.

The good news is the now rapidly cooling inflation picture. After peaking at 6.5% in July this year headline inflation has now fallen to 4.2% in November. This reflects the dropping out of some of the supply-constraint induced food price increases at the end of 2010. We expect inflation to fall further and eventually settle around 3.5% during 2012.

The authorities have started the process of easing monetary conditions with a 50bp reduction in the reserve ratio requirement. We expect that will be followed by interest rate cuts in the next few months.

We continue to see GDP growth of around 9% this calendar year which we expect will be followed by growth of around 8.5% in 2012. The lower growth reflects the weaker external environment and weakness in domestic housing.

As with America, one of the key risks to China growth is a sharper-than-expected slowdown in Europe. If that eventuates we would also expect to see further fiscal as well as monetary stimulus, most likely in the form of subsidies to support consumption, particularly in rural areas. Indeed we are keen to see China policy move towards greater support for households. The recent increase in the poverty line will expose an estimated further 100m Chinese to initiatives to support poor households.

We will also be watching inflation development with interest in China. As demand for better wages continues to build, the wage/productivity/inflation dynamic will be fascinating to watch.

But that’s all next year. In the meantime have a great Christmas. No more posts till mid-January!!

Monday, December 12, 2011

A European “fiscal compact”

Important progress was made at the latest European Summit at the weekend. As was signalled pre-Summit by the French and German leaders, the important outcome was a “fiscal compact” amongst the members of the Euro Zone. The show of political unity at the Europe-wide level is a welcome development, although the UK has already opted out (this is likely to cause tension in the UK coalition government).

The agreement will require each member to introduce new rules on public finances into their constitutions which will have to be ratified by individual parliaments. There will be penalties for countries that then break these rules. However, political risks remain high as domestic politics in some countries may still get in the way of a fully-implemented outcome.

Other outcomes from the weekend include European central banks providing the IMF with €200 billion to use in Europe with the expectation (hope?) that other countries will contribute. The start date for the European Stability Mechanism (ESM), the permanent mechanism that will eventually replace the EFSF, has been brought forward to July next year. This will provide a further €500 billion of capital. Finally, demands that investors share in the costs of future bailouts have been dropped. This will go some way towards restoring investor confidence in European sovereign bonds.

The “fiscal compact” provides for a stronger fiscal framework in Europe. It should have been part of the original setup of the common currency, but that’s history. Alongside further measures from the ECB last week to provide liquidity to the European banking system, some progress has been made.

However the increase in the bailout funds will most likely be insufficient to relieve stress in sovereign debt markets. For that we are still looking for a stronger commitment from the ECB to step-up its purchases of bonds. Without that, the pathway to lower bond yields in Italy and Spain will be ever more austere budget initiatives. That will be counter-productive in terms of ensuring an appropriate balance between fiscal consolidation and supporting economic growth.

As we have warned after each of the previous “solutions” to the European debt crisis, there is still a lot of water to flow under the bridge. The critical factor in the period ahead is how the ECB see’s its role in alleviating pressures in sovereign debt markets. Watch this space.

Tuesday, December 6, 2011

Growth and monetary policy in the BIC economies

In 2009, in the aftermath of the sharp contraction in activity during the darkest days of the GFC, we argued the role of monetary policy in the respective recoveries of developed and emerging economies would be quite different. In the developed economies it was about supporting fragile economic growth and avoiding deflation. In the key emerging economies it was about controlling inflation in the face of structurally higher commodity prices and eventually, in some cases, overheating economies. Emerging markets are now in an important new phase. Growth is slowing in the China, Brazil and India. With inflation also past its peak (at least in China and Brazil), there are obvious implications for monetary policy.

But as emerging market central banks ease monetary conditions, there are important considerations for the global economy in terms of the rebalancing in global growth we think is important for a sustained recovery. This is particularly the case in China. There are equally important messages for India and Brazil. Easier monetary conditions are currently warranted in Brazil and at least an end to the tightening in India. But if they are serious about building higher sustainable growth – monetary policy must remain focussed firmly on price stability.

In China growth has slowed from a peak of 11.9% in the year to March 2010 to 9.1% in the year to September 2011. Activity indicators point to a further slowing, but are still consistent with a soft landing. We expect calendar year growth to come in at around 9%. Growth is slowing most sharply in the export sector. That reflects the weaker global growth environment, particularly out of Europe. Importantly inflation has also peaked, giving the authorities room to move on monetary policy.

China has an important role to play in the rebalancing of global growth as an important engine of demand. In that context, how China responds to the slowing of activity is critical. The Required Reserve Ratio has recently been eased by 0.5% for both large and small financial institutions. We expect interest rates will be lowered from early next year. We’re happy with that approach.

With exporters coming under most pressure, it would be tempting to shift from the stance of allowing a gradual appreciation in the Yuan. But such a move would be undesirable from a global growth perspective. While an appreciating exchange rate is challenging for exporters, especially in an environment in which trading partner growth is slowing, it gives a real income boost to households which is important in growing consumption. Furthermore, if China were to go down the path of further fiscal stimulus, this should also be directed at households through building a stronger social infrastructure which will allow households to save less and spend more.

Growth in India slowed sharply to 6.9% in the year to September 2011. That’s down from 7.7% in June and a peak of 9.4% in March 2010. Growth now looks like coming in at around 7% for the calendar year. The target growth rate for this year was 8.5% which is well in excess of what is sustainable (we think around 6.5%).

Recall our view that India was overheating before the GFC hit. Following aggressive monetary easing in the wake of the GFC, it went straight back into over-heated territory. Inflation at around 9% remains persistently high. Indeed it is in India where recent commodity price inflation has spilled over into more generalised inflation. The RBI has been behind the inflation problem for much of the last year or so and only just caught up with it after a series of 50bp moves on the benchmark rate.

It’s important for monetary policy in India to remain focussed on inflation. While we think there has been sufficient tightening, we’re not expecting an imminent cut in interest rates. If India has aspirations of higher sustainable growth it must look to a broader policy response that includes tighter fiscal policy, a change to foreign direct investment rules and investment in infrastructure.

In Brazil, growth has slowed from a peak of 9.7% in March 2010 to 3.1% in the year to June 2011. It appears likely to slow further in the period ahead. Calendar 2011 growth is likely to come in at around 3%. Much of this slowdown needed to happen. At over 9%, growth was running well into overheated territory. We think trend/sustainable GDP growth in Brazil is around 4%.

Interestingly in Brazil, the interest rate sensitive sectors such as consumptions have held up well recently. Also unemployment at 5.8% is low by historical standards. Inflation is coming off its highs but at 6.7% is still ahead of the target band of 4.5% +/- 2%. The benchmark Selic rate has so far been cut three times since August from a peak of 12.5% to 11% last week. While we expect further cuts, downside is limited (unless Europe deteriorates further). Look for a low in the Selic rate of around 10%.

In the future we see any lack of commitment to contain inflation as the biggest threat to the emerging market economies. We know they don’t have the same structural issues as the developed economies – they simply have different structural issues. Building higher sustainable growth requires a broad approach.