Tuesday, June 26, 2012

What do we expect from the Summit?

The upcoming EU summit (June 28 and 29) presents the latest last chance for Europe to get its act together.  We expect nothing more than further incremental progress on some issues, but others will remain in the “too hard” basket. 

The most interesting aspect of the summit will be the impact of the shifting sands of political alliances.  Let’s remember the euro is a political construct and it is politics that will determine its fate.  The Merkel/Sarkozy alliance is broken and Mr Hollande seems to be striking up a strong rapport with Mr Monti.  Fascinating.

There have been a couple of positive (or at least non-negative) developments in the lead up to the Summit.  The second Greek election was pro-bailout so we can park the issue of Greece exiting the euro, at least in the near term.  Some renegotiation of the bailout terms will still be sought.  That may well be delayed until the health of Prime Minister Samaras improves and a new finance minister is appointed, following the resignation of the current finance minister for health reasons.

The audit of the Spanish banking system has revealed the recapitalisation will require €62b, less than the €100b that was made available.  The detail of the recapitalisation is still yet to be determined.  Most important of those details is whether the funds will be channelled through the Government or made directly available to the banks, breaking the negative feedback loop between bank recapitalisation and sovereign debt.  That issue will be part of a broader Summit discussion around the role of the European Stability Mechanism (ESM).

Fiscal union is the ultimate end-game, but we are not expecting any significant progress on that front.  Fiscal union ultimately requires some form of debt mutualisation.  Germany has refused to countenance the concept of eurobonds, however some alternatives have been flagged recently such as the issuance of euro treasury bills and the establishment of a redemption fund.  

We still think eurobonds are inevitable, but it’s too early for individual Governments to endorse such a concept.  The loss of economic sovereignty at a time of heightened financial stress is too big a bridge to cross.  Debt mutualisation can only occur from a starting point of some degree of fiscal co-ordination, and we are a long way from that now.  Such a concept may be part of the longer-term roadmap for the survival of the euro currently being prepared by officials.

With fiscal union off the immediate agenda, we may see some progress on the only slightly less challenging issue of the formation of a eurozone banking or financial union.  That would still require a central agency to act as banking supervisor (the existing European Banking Authority or possibly the European Central Bank itself). 

We like the concept of the ESM being available for common bank recapitalisation funds, reducing the negative feedback loop between bank recapitalisation and sovereign debt as we have recently seen in Spain.  Some form of deposit guarantee to prevent runs on banks could be part of such a plan.  Both the International Monetary Fund and Bank for International Settlements have come out in support of a banking union in recent days.

The other issue we would like to see some progress on is an improved balance between fiscal austerity and economic growth.  Ideas to boost growth have been floated such as boosting the capital of the European Investment Bank, but the fundamental problem is front-loaded fiscal austerity.  A relaxation of agreed deficit reduction targets is the best action that can be taken now to support growth and reduce the risk of a popular backlash.  Greece, Portugal and Spain would all benefit from such a move and in so doing, cement in attainable medium-term targets from both an economic and social perspective.  The key challenge would be the credibility of those medium-term targets. 

A more immediate issue is the recent increase in Spanish and Italian bond yields.  In that last few days there has been some suggestion that the European Financial Stability Facility (EFSF) could be used to purchase Spanish and Italian bonds.  We are in favour of action being taken to bring those yields down to more sustainable levels, whether that be through purchases by the EFSF or by a resurrection of the ECB’s Securities Markets Program.  As we said last week, we believe bond purchases by the ECB can be justified on monetary policy grounds given that traditional monetary policy transmission channels have broken down in Europe.

In short, we are expecting not too much more than further incremental progress in Europe.  That approach limits risk of disappointment, but provides some glimmer of hope of being pleasantly surprised.

Friday, June 22, 2012

NZ GDP a ripper, but don’t get too excited

The big surprise of the week this week was home-grown.  March 2012 GDP beat all forecasts with a ripper 1.1% for the quarter, taking the annual rate of growth to 2.4% up from 1.9% in the year to December 2011.  The annual rates were given a bit of assistance from small upward revisions to recent quarters. 

This result also comes after just having revised down our near-term growth expectations.  That was based on lower than originally expected final demand over the course of 2012.  That story still remains intact.  Indeed the upward surprise in the March data was the contribution from stock-building with final demand still soft. 

That has us continuing to expect subdued growth for the rest of this year.  We have not changed our forecast quarterly GDP track on the back of this latest result with the next three quarters growth expected to average around 0.5% per quarter.  However, the much better starting point now has us forecasting annual growth of around 2.5% this year.
Of course when we lowered our GDP forecasts we also shifted out our expected start to the next tightening cycle to mid-next year from the end of this year.  I’m still happy with that story at this point.  Sure the output gap just closed up a bit more quickly than expected, but soft growth over the next few quarters means we think the Reserve Bank can still wait till next year to start taking the foot of the monetary policy accelerator.  That of course continues to assume a "muddle through" scenario in Europe. 

Tuesday, June 19, 2012

Around the world by central bank

The focus for central bank-watchers of late has been what action monetary authorities would take in the event of a rapid deterioration (think Greek elections) in the financial and economic situation in Europe.  While Europe is still the major global risk, this post looks at the expected action of each of the central banks should Europe continue to “muddle through”.

US Federal Reserve
Another bout of soft labour market data in the US has raised the odds of the Fed doing more stimulus work, most likely in the form of an extension of “Operation Twist” which, absent an extension, is scheduled to end this month.  For us the data remains consistent with our expectation of around 2% GDP growth this year which will be sufficient to see further modest employment gains and a gradual reduction in the unemployment rate.  The important development for us over the past few months has seen increased signs of stability in the housing market, which adds some stability and sustainability to the (albeit modest) growth outlook.  Last week’s inflation data added fuel to the debate with a petrol-price related drop in the annual rate of headline inflation to 1.7%.  The annual rate of core inflation (more important for the Fed) was unchanged at 2.3%.  I’m somewhat ambivalent towards more “twist”; I don’t think it adds much to the outlook for the real economy, but it doesn’t do any harm either.  It’s simply a signalling tool for the Fed.  As for more QE you know what I think: the Fed has done its job and the rest is structural (see India below on that point!).  But if I were a dovish Fed, I might want to keep my powder dry and wait to know how big the fiscal cliff is in 2013 before I act.

European Central Bank
The ECB left interest rates unchanged at their last meeting, but left the door open to further cuts should economic and financial conditions deteriorate.  There are clearly bigger issues in Europe than conventional monetary policy actions cannot cope with.  We think interest rates will be cut again.  A strong argument can be made for more targeted action from the ECB.  As we argued last year, bond purchases through the Securities Market Program (SMP) can be justified on monetary policy grounds in countries such as Spain where a cut to the benchmark interest rate will do little to assist.  The Spanish bank bailout has simply served to shift concern about the banks to the sovereign with the funds to be channelled through the government, adding to Spain’s sovereign debt ratio.  In terms of the real economy, we expect Europe GDP to come in at around -0.5% for the year.  That masks extreme divergence across the continent with significant recessions in countries implementing harsh austerity measures with stronger outcomes in Germany and France.  Risk to growth is to the downside.

Bank of England
The Bank of England took no action in June, leaving both the benchmark interest rate (0.5%) and the asset purchase program (£325b) unchanged.  An extension to the asset purchase program had been expected.  More recently, however, the Government has announced £100b of cheap funding to the UK banking sector (through the Extended Collateral Term Repo Facility), reminiscent of the ECB’s LTRO program.  The expectation of the Government and the BoE is that the banks will then lend these funds on to households and the SME sector.  That remains to be seen.  More QE is also likely as the risks have shifted to the downside for expected UK GDP growth of 1% this year.

Bank of Japan
No change in policy at the June BoJ meeting.  The Bank was reasonably upbeat about the outlook for the domestic economy but that was largely based around earthquake reconstruction activity.  However, we expect they may add to their ¥70t asset purchase program later this year, based largely on the expectation that they are likely to miss their new 1% inflation target without further stimulus.  Indeed the IMF last week encouraged the BoJ to undertake a “powerful” easing to assist then in meeting their inflation target.

People’s Bank of China
The PBoC has made several cuts to reserve ratio requirement (RRR) in recent months and cut interest rates by 25bps earlier this month.  Fiscal policy is also being eased via infrastructure spending and some subsidies for consumption.  The slowdown in the economy has been accompanied by a cooling of inflation pressures with the CPI falling to 3.0% in May, creating room for further easing on all fronts (the official target is 4%).  However we don’t expect aggressive policy action like we saw during the GFC.  We expect further cuts to the RRR and another two 25bp cuts to deposit and lending rates.  We also expect further fiscal easing, but authorities will also remain committed to better quality growth and rebalancing in the economy, ruling out aggressive action on this front too.  That is based on our expectation of GDP growth bottoming out in the current quarter at around 7.5% with a modest recovery into the second half of the year.

Reserve Bank of India
The limited room to move on monetary policy in India was highlighted this week with the decision by the Reserve Bank of India to leave interest rates unchanged at 8% (the repo rate) and the cash reserve ratio unchanged at 4.75%.  We have previously discussed the challenges for India are mainly structural and that fiscal policy (subsidies) is too loose.  The RBI seems to agree.  The RBI said : “Our assessment of the current growth-inflation dynamic is that there are several factors responsible for the slowdown in activity, particularly in investment, with the role of interest rates being relatively small”.  They went on to say that a “Further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures”.  Inflation rose to 7.55% (the WPI or Wholesale Price Index) last month shortly after it was announced that GDP growth had slowed to 5.3%. They clearly believe the Government has a significant role to play in improving the growth/inflation balance saying that the decision to front load an Interest rate cut in April was based on the premise the Government would be undertaking a program of fiscal consolidation and other supply side initiatives.  The stage is set for an interesting policy debate.  

Central Bank of Brazil
Brazil has continued to ease monetary conditions in the face of a sharply weaker economy.  The benchmark Selic rate is at an historic low of 8.5%.  The slowdown in the economy has been contained to the industrial sector and business investment reflecting the high exchange rate and the slowdown in external demand (Europe).   Consumption growth remains solid and the unemployment rate is at record lows.   That means (you guessed it!) a structural response is required here too, particularly in the labour market.  A recovery in growth at (over?) full employment suggests further upward pressure on labour costs and a quick return to high inflation.  We wouldn’t rule out further interest rate cuts, but the more they cut from here, the more we start to worry about inflation next year.   

Australia and New Zealand
We have seen two recent rate cuts by the Reserve Bank of Australia: 50 basis points in May followed by 25 in June.  The June rate cut was swiftly followed by stronger than expected GDP and employment data.  That caused our team in Sydney to call a pause to further near-term rate cuts, but they believe the door is open for more cuts later this year.  In New Zealand we believe the RBNZ’s bias to hike rates is right, but we won’t see a start to the tightening cycle from the current OCR of 2.5% until mid-2013.  Our projected OCR peak remains at 4.5%, significantly lower than historical highs.

Monday, June 18, 2012

Election in Greece (2)

New Democracy has emerged as the front-runner to form a new government in Greece.  Anti-austerity Syriza has come in a close second with Pasok in third place.  This is the preferred outcome, at least from a financial market’s perspective.  It was the inconclusive first election along with the dominant position of Syrzia that led to heightened fears of an imminent Greek euro exit.

This second election saw a consolidation of support for the major parties, helped by their being around a dozen less parties to choose from on the ballot this time.  No party received over 20% of the vote in the first election.   This result is more in line with other polls suggesting a majority of Greek’s prefer to stay in the euro and a (smaller) majority want Greece to honour the commitments it made under the terms of the bailouts.

A Government still needs to be formed.   A New Democracy-Pasok coalition seems most likely.  Those two parties along with the 50 bonus seats awarded to New Democracy as the highest-polling party would command around 160 seats in the 300 seat parliament. 

There will still be calls for a renegotiation of the terms of the bailout.  In the run up to this second election, all three of the major parties adopted a “renegotiation” position.  The good news is the troika (EU, ECB and IMF) appear open to some tweaks.  After the first election we suggested some degree of pragmatism would inevitably have to prevail.  Indeed hints emerged last week that Greece would be offered lower interest rates on loans, longer repayment periods and EU financial support for public works programs in return for continued commitment to the terms of the bailout.

Coalition talks will most likely take some days.  In the meantime there is a G20 meeting scheduled this week and an EU Summit at the end of next week.  We need to remember the Greek election was just another hurdle in a very long steeplechase!

We expect the G20 to increase the rhetoric on encouraging Europe to get their house in order and to continue to work towards a more fulsome solution to Europe's sovereign debt and banking sector issues.  There may also be further financial commitment to the IMF’s bailout resources.

The EU summit scheduled for the end of this month will continue to address some of the weighty systemic issues such as the possible role for the ECB in Europe-wide bank supervision, deposit guarantees, euro bonds and the possible role of the European Stability Mechanism in being able to directly recapitalise banks.  Recall this was the problem with the Spain bank bailout.  The fact that the funds have to be channelled through the sovereign means that Spain’s debt to GDP ratio will rise.  That led to markets simply swapping their angst over the banks to the sovereign.

Germany is becoming isolated on some of these issues, with a block forming on the other side of the debate including France, Italy and the Netherlands.   Hollande (with a strong mandate following the socialists win in this weekend’s parliamentary elections) seems to be striking a positive rapport with Italian Prime Minister Mario Monti. 

It could be viewed that Europe is becoming increasingly fragmented on some of these issues.  I disagree; they were always fragmented on these issues - it's just they are now being openly talked about.  The good news is they are talking. 

Thursday, June 14, 2012

No surprises from the RBNZ

As expected the Reserve Bank of New Zealand (RBNZ) left the Official Cash Rate (OCR) unchanged at 2.5% this morning.  The outlook, however, very much hinges on how Europe plays out from here.  The Bank is clearly ready to act aggressively if things go from bad to worse in Europe, but based on the central scenario of a continued muddling through the New Zealand economy will continue to grind slowly upwards.  That has the RBNZ continuing to project less stimulatory monetary condition from mid-next year.

The Bank lowered their growth forecasts to be more in line now with market consensus.  They are forecasting GDP growth of 1.9% in the year to March 2013, followed by 3.0% and 1.6% in the subsequent two years.  Our forecasts are 2.0%, 2.8% and 2.0% respectively. 

The RBNZ has also lowered its estimate of potential GDP.    The change in potential growth explains how the bank is able to construct an outlook that has both lower growth and higher inflation.  All else being equal, one would assume lower growth would lead to lower inflation.   The higher inflation track is also due to future planned tobacco excise increases.

The Bank believes potential GDP is 1.2% in the current year and that it will rise only gradually to 1.4% and 1.8% over the following two years.  That compares with estimates of 1.5%, 2.1% and 2.3% in the March Monetary Policy Statement.  We have consistently argued that New Zealand potential growth is now significantly lower than it was pre-GFC and that estimates of current spare capacity would likely prove to be over-inflated.  The upshot is that inflationary pressure is likely to emerge earlier in the cycle than it has historically.

That means, absent any more or less knowledge than we have on the outlook for Europe, the Bank is right to continue to flag a bias to tighten.  Their initial tightening has been shifted out to June 2013.  That’s in line with our expectation on the back of our revised GDP forecasts discussed in the post below: Lower NZ near-term growth, OCR hikes pushed out.
While retaining a bias to tighten, the RBNZ has lowered the trajectory of the projected increases over successive Statements.  We continue to believe the tightening cycle will be more aggressive than the Bank is projecting, although not as aggressive as previous New Zealand interest rate cycles, partly because fiscal policy will also be contractionary.  We continue to expect an OCR peak of around 4.5% in the second half of 2014, again assuming Europe muddles through.

Tuesday, June 12, 2012

China activity soft, but lower inflation gives room to move

China activity data was mostly softer than expected in May, although there were signs in the fixed asset investment, money supply and loans data that efforts to stimulate growth are starting to have some impact.  Importantly, lower-than-expected inflation gives scope for further stimulus.

Some bounce back (or blip back??) in industrial production growth had been expected following the holiday-impacted April slowdown, but the bounce wasn’t as large as expected: year-on-year (yoy) growth was 9.6% in May, up from 9.3% in April but lower than the expected 9.8%.  Retail sales growth slowed further to a yoy 13.8%, down from 14.1% in April. 
On the positive side exports were stronger than expected with growth coming in at 15.3% for the year to May, up on the 4.9% recorded in April.  As with IP the bounce back was holiday related, but it’s still a good outcome considering what’s going on in the world. 

Fixed asset investment (FAI) growth fell slightly in year-to-date (ytd) terms to 20.1% in the January to May period, down from 20.2% in January to April.  The small slowdown in ytd terms suggests to us a modest increase in growth in yoy terms to May (China only releases FAI data in ytd terms), reflecting recent reductions in bank reserve requirements.  That’s supported by a modest tick-up in both growth in the money supply (yoy 13.2% in May, up from 12.8% in April) and loans (yoy 15.7% in May, up from 15.4% in April).
The best news of all was the drop in the annual inflation rate to 3.0% in May, down from 3.4% in April.  The market consensus was for a drop to 3.2%.  It was obviously in the knowledge of this data that the PBoC acted to cut benchmark lending and deposit rates by 0.25 percentage points last week.  Annual rates of increase in both food and non-food (core) inflation slowed significantly.

The drop in inflation means there is room to move on both monetary and fiscal policy.  Remember the recent drop in the official PMI index was partly due to a significant drop in the prices paid index.  That’s a good omen for near-term inflation.  In the months ahead we expect further reductions in the reserve ratio requirement, further cuts to interest rates and more fiscal announcements on infrastructure spending and consumption subsidies.  That would support our view that the June quarter of this year will most likely mark the bottom of the current cycle with a modest recovery in growth over the second half of the year.

Monday, June 11, 2012

Spain bank recapitalisation

European leaders are getting better at acting decisively.  The weekend’s announcement that Europe would provide up to 100 billion to recapitalise Spain’s banks was only held up by the reluctance of Spain to ask for assistance.  In the end the agreement came before the results of an independent audit of the bank’s needs: the government will confirm the amount required once that process is complete in about a few days time. 

The 100 billion allocated will likely be sufficient.  It’s well in excess of the 40 billion estimated by the IMF, although that estimate was based on historical data.  More recent private sector estimates put the capital requirement at around 80 billion.

It is yet to be determined whether the funds will come from the temporary European Financial Stability Facility (EFSF) or the permanent European Stability Mechanism (ESM).  Our preference is for the funds to come from the EFSF, as that would leave the full 500 billion available through the ESM intact.

The only downside to the plan is the (German) insistence that the recapitalisation funds are channelled through the Spanish Government via the Fund for Orderly Bank Restructuring (FOBR or FROB in Spanish).  As a result Spain’s sovereign debt-to-GDP ratio will likely rise by over 10 percentage points depending on the final amount required.  That raises the possibility that the market shifts its angst from the banks to the sovereign, especially given the current recessionary environment.

That brings us back to the perennial growth vs. austerity debate.  Spain’s more recent woes are largely related to the weak housing market and the impact on bank balance sheets.  The preferred government fiscal response is an orderly but timely return to fiscal sustainability and structural economic reform to support long-term growth.  There is a strong case to be made for shifting Spain’s fiscal targets out in return for agreed structural reform in labour and product markets.  That should be on the agenda at the next EU Summit at the end of June. 

More immediately, it was important this element of uncertainty was dealt to before potentially disruptive elections in Greece this weekend.  We also take it as a further sign of Europe’s capacity and willingness to (eventually) do whatever it takes to save the euro.

Friday, June 8, 2012

Lower NZ near-term growth, OCR hikes pushed out

We’ve knocked a little bit off our NZ GDP growth forecasts for this year.  Some of the recent partial activity data (e.g. construction) has been on the soft side, knocking our March quarter GDP growth forecast back to 0.5%.  Other small adjustments (lower expected growth in consumption and export volumes) over the course of 2012 take our forecast for the calendar year down to 2.0% (from 2.4% previously). 

Our underlying view of the world remains broadly unchanged.  We expect modest 2% growth in America this year, continued mild recession in Europe (modest growth in Germany offset by continued contractions in activity in the periphery) and a further slowdown in China into the current June quarter followed by recovery into the second half of the year.  Today’s interest rate cut by the PBoC helps that story.

We also retain a constructive view on both the capacity and willingness of Europe to work through the latest bout of fiscal and banking sector angst (see “Growth, austerity and Greece” below).

Our calendar 2013 forecast is unchanged at 2.8% (reflecting stronger global growth, monetary policy easier for longer), with growth then coming off again to 2.0% in 2014 as fiscal policy reaches its contractionary zenith.  Canterbury rebuilding activity supports growth through-out the forecast period.
Despite lower near term growth, we continue to disagree with the market pricing in interest rate cuts (although that has backed off a bit over the last couple of days following stronger than expected GDP and jobs data out of Australia).   The market has recently delivered an easing in monetary conditions via the reduction in wholesale interest rates and the lower New Zealand dollar (remember the MCI?).   

The monetary policy implication of lower near-term growth is that we now join the throng and shift the expected start of the tightening cycle out from the end of this year to mid-2013.  From our perspective, the case for the next move in the OCR being up remains compelling.  It’s still our view that potential GDP growth is lower than it was before (pre-GFC) and the structural unemployment rate is higher than it was before.  That means capacity constraints and inflationary pressure kicks in earlier in the cycle than previously.  (That’s true for most of the developed world – it’s just that growth hasn’t been strong enough yet to test, or challenge, the theory!!)

However, we also remain of the view that this interest rate cycle remains modest compared to the past.  As with other new-normal’s, the neutral cash rate is probably now lower than before.  And of course monetary and fiscal policy will be working in the same direction in the period ahead: contractionary fiscal policy means less work for monetary policy to do.  We’ve still got an OCR peak of 4.5% pencilled in, but with the later start to the cycle, the OCR won’t get to that level until the back half of 2014.

Monday, June 4, 2012

The “non-linear” US recovery

May US payrolls data was unambiguously disappointing.  Payrolls expanded by 69k in the month, well below expectations of around 165k.  Previous months were revised down.  The unemployment rate edged up to 8.2% from 8.1% in April.  The only bright spot in the data was the rise in the participation rate (the main reason for the rise in the unemployment rate), suggesting that people have renewed confidence to get out and seek work.

This result continues the trend of slowing job growth since strong January and February data which was influenced by better weather conditions which “borrowed” activity and jobs growth (particularly construction) from the second quarter.  Supporting that story was the 28k drop in construction sector employment in the May result.

This data supports our view that Q2 GDP data will come in moderately weaker than the March quarter’s revised 1.9% annualised gain.  We expect Q2 GDP to print in the range 1.0-1.5%.  Indeed growth in trend hours worked has halved since the mid-point of the previous quarter.

However, the release of the May ISM manufacturing index after the employment data helped remove some of the disappointment. 

While the overall index dropped modestly to 53.5 in May from 54.8 in April, the make-up of the sub-indices was pretty pleasing.  In particular new orders (i.e. future production) rose from 58.2 to 60.1.  That was no doubt assisted by the drop in inventories from 48.5 to 46.0. 

The employment indexed dropped slightly but remains in expansion territory.  The biggest drop was in the prices index which fell from 61.0 to 47.5, paving the way for yet another debate on the merits (or otherwise) of more action from the Fed: a continuation of Operation Twist perhaps?

We have become all too accustomed to these periods of weakness in the post GFC economic recovery (remember the “non-linear” recovery?).  This year isn’t as bad as last year when the first two quarters of 2011 saw annualised GDP outcomes of 0.4% and 1.3%, but the continued waxing and waning of the recovery remains challenging for markets (and tiresome for economists!!).   At this point we are still comfortable with our forecast of 2% US GDP growth for the calendar year.

Friday, June 1, 2012

India’s structural challenge and China’s balancing act

This week we saw critical GDP data out of India and PMI data out of China.  Both highlight challenges for the respective economies.  In India, both monetary and fiscal policies have constraints, meaning structural change will be important in the recovery.  In China, the authorities have more room to move, but need to balance the desire for a soft landing with not giving up the hard won gains on inflation.
India's GDP growth rate slumped to a disappointing 5.3% in the year to March 2012.  The market consensus was expecting growth to remain unchanged at December 2011's 6.1%.
The problem in India is that authorities are somewhat constrained.  Failure to contain expenditure (particularly subsidies) saw the March 2012 year fiscal deficit come in at 5.9% of GDP, missing the official target of 4.6%. 

Monetary policy is constrained by an inflation rate that is proving to be “sticky” at around 7%.  That is in some part due to the 20% depreciation in the Indian rupee over the last 12-months.  While that will no doubt prove of some assistance to the tradeable sector, it limits scope for further interest rate reductions.  That’s a problem given the extent to which private sector investment has come off the boil in recent months.  The Reserve Bank of India cut interest rates by 50bps in April.

The high budget deficit is coinciding with the worst current account balance (-3.6% of GDP) in over 2 decades.  In that respect, India is facing similar challenges to some developed economies where fiscal consolidation is an important part of the pathway to higher sustainable growth. 

The best thing India could do right now is articulate a credible strategy to reduce government spending which would provide further scope for interest rates to fall and support a recovery in private sector investment.  Stronger investment will also require policy (particularly regulatory) reform.  The current government does not have a strong reform track-record after back-tracking on planned retail sector reforms last year.  In short we are anticipating neither a strong nor swift recovery in growth.  

In China the official PMI fell from 53.3 in April to 50.4 in May.  The continued strength in this index has been at odds with the unofficial HSBC index which has been languishing under the critical 50 level for several months.  Part of that difference is explained by the coverage of the two indices with the official index focussing on the larger SOE’s while the HSBC index captures the SME market.
As discussed in our last China post, we think China has further to slow with the June quarter of this year now likely to be the low point in the current cycle.  We think GDP will fall from an annual 8.1% in March 2012 to under 8% in the June year.  This dip down in the May PMI, along with weaker than expected April month partial activity data, supports that view.

The Chinese authorities are faced with a challenging balancing act:  generating a soft-landing for activity without giving up the hard won gains on inflation.  Inflation looks well behaved at the moment and we expect headline inflation to cool further over the next few months.  Indeed the prices index in today’s PMI data fell 10 points to 44.8.

We continue to expect easing of both monetary and fiscal policy to support a tick-up in growth in the second half of the year.  The authorities have already cut bank required reserve ratios several times and we expect it will be cut further.  We also expect interest rates to be reduced, but probably not until the authorities see inflation move lower.

In the last couple of weeks authorities have also taken steps to boost infrastructure spending, although that requires another balancing act.  Fiscal policy was used aggressively in the GFC recession: we don’t expect a repeat of that approach this time, nor do we think it will be needed.  The Chinese leadership committed to “better quality growth” in its 12th 5-year plan and aggressive easing in fiscal policy does not fit well with that commitment. 

However fiscal measures to assist the rebalancing in China growth towards consumption, such as the recent announcement of RMB 36 billion in subsidies for household purchases of energy saving appliances and automobiles, will provide a useful boost to domestic demand.  We also like moves towards allowing the private sector to invest in some state dominated industries such as railways.

We continue to expect China GDP growth of around 8.5% for the calendar year.