Research Asia: Overheating is the main concern

• Growth in Asia accelerated significantly in early-2010 and we have adjusted our GDP forecast up for all major Asian economies, including China and Japan. Our upward revision mainly reflects a very strong H1 10.

• We still expect GDP growth in Asia to peak in Q1 as the positive impact from inventory adjustments and policy stimulus gradually wanes and the impact from tightening kicks in, not least in China. So far we see a modest impact from the European debt crisis. With fiscal policy flexibility intact, Asia should continue to perform well even in a more negative scenario for Europe.

• Despite stronger than expected growth inflation has, with the exception of India, increased less than expected, mainly because commodity prices have stabilised globally. However, inflation is still expected to increase and reach close to 4% in China by the end of the year. In Japan, deflation is the main concern and consumer prices are not expected to start increasing until Q3 11.

• Muted inflation and increasing concern about the impact from European monetary tightening has postponed monetary tightening in most Asian countries. China’s revaluation has probably been postponed until Q3, but is not off the table. In Japan monetary tightening will lag the rest of Asia and the US but we ccan no longer rule out that Bank of Japan will tighten before the ECB.

Growth accelerates across Asia

Asia has so far performed better than expected in 2010. In emerging Asia GDP growth in Q1 10 accelerated to 12.2% q/q AR from 8.0% q/q in the previous quarter. Even Japan continued to perform strongly with GDP expanding by a solid 4.9% q/q AR following a respectable 4.0% q/q AR growth seen in the previous quarter.

The solid performance in Asia continues to be driven by a strong recovery in industrial production. As seen in the chart, industrial production again accelerated in Asia in Q1 10, following some moderation in growth in Q4 10 on the back of the exceptionally strong growth in the early recovery phase. Manufacturers across Asia continue to adjust production to demand and inventory cuts have eased substantially. Hence, growth in industrial production has continued to improve despite some slowdown in export growth. For Asia as a whole, export growth in Q1 eased slightly to 8.2% q/q from 11.2% q/q in the previous quarter. Growth in industrial production probably peaked in Q1 and consequently we expect Asian manufacturing PMIs to start decline slightly in coming months. OECD leading indicators suggest that growth in exports will continue to ease albeit remaining healthy. In addition the positive impact on industrial activity from the inventory cycle should be less in the coming quarters. However, this has not yet started increasing across Asia, suggesting that there will be still be a positive impact on growth from inventories in the coming quarters, but that it would be significantly less than in the previous quarters.

Recovery looks self-sustainable

Improvement in private domestic demand also contributed to the strong performance of the Asian economies in early-2010 and the recovery in Asia is looking increasingly self-sustainable. There are signs of further improvement in private consumption in both China and Japan and in the rest of Asia private consumption remains strong overall.

Subsidies for private consumption such as ‘cash-for-clunker’ programmes and subsidies for purchase of durable consumer goods have supported private consumption substantially in the early recovery phase. These consumer subsidies remain in place in both China and Japan until at least late this year. Nonetheless, the growth impact on private consumption from these programmes has started to wane and not least the demand for cars slowed substantially following the explosive growth seen last year. If and when these consumer subsidies programmes are terminated later this year it could have a negative impact on private consumption, particularly in 2011 albeit there could be a temporary boost as some purchases could be pushed forward on the announcement of the termination.

On the other hand, private consumption is increasingly being supported by stronger household real income growth. The unemployment rate is declining across Asia and private employment is increasing fast. Overall, when we look at private consumption, across Asia it looks like stronger income growth has offset the waning impact from policy measures.

Unwinding of stimulus will slow growth later in 2010

With the exception of Japan, investments in Asia have recovered relatively quickly even though investment demand is usually cyclically late. The main reasons for strong investments in the early-recovery phase are mainly higher public investments, as part of fiscal stimulus and some “normalisation” of investment demand from the extraordinarily depressed levels seen in early-2009. Some unwinding of the fiscal stimulus has started with public investments already declining in countries such as Japan and South Korea. In China, where the impact from public investments has been largest, the level of public infrastructure investments has been broadly flat and is not expected to decline until late-2010 or early-2011.

If we look at investment demand it appears that the negative impact from unwinding of fiscal stimulus is being more than offset by stronger private investment demand. Even in Japan private investment is likely to contribute significantly to growth in the coming quarters. Growth in machinery and equipment will remain strong on the back of the recovery in industrial activity. In addition real estate investments should continue to improve on the back of the recent rebound in house prices across Asia. So far there are no signs that slower credit growth in China has had any substantial impact on investment. On the contrary real estate investments appear to have accelerated in early-2010. That said the Chinese recent tightening measures targeting real estate are likely to slow real estate investments in China later this year. Hence, we are likely to see a substantial slowdown in investment demand in late-2010 and early-2011.

Asia still has fiscal flexibility

So far there are no signs that the European debt crisis will force any Asian countries to front load fiscal tightening. Overall, public finances in Asia are in much better shape than in Europe and the US. Among the Asian countries Japan and India looks most vulnerable (see chart). In Japan the European debt crisis has created some concern among policymakers and the DPJ government has promised to put forward a long-term plan for reducing the government’s deficit. However, the overall fiscal policy is likely to remain expansive this year, with lower taxes and higher consumer subsidies offsetting the negative impact from some reduction in public investments. As 95% of Japanese government bonds are held by domestic – to a large degree directly or indirectly controlled by the government – we believe there is little risk that the European sovereign debt crisis will spill over to Japan.

India has extensive capital controls and consequently, as in Japan’s case, foreign investors have very little exposure to the Indian bond market. By far the biggest investors in the Indian bond market are the big state owned banks that are required to invest a fixed share of their balance sheets in government bonds. In addition, with nominal GDP growth exceeding 10%, India is still in a relatively favourable position to improve its public finances.

Consequently, there is still considerable fiscal policy flexibility in Asia. Only in Japan it looks like fiscal tightening could weigh on the strength of the recovery, although the Japanese government so far has not been forced to frontload fiscal tightening. Fiscally Asia, as a whole, still has at least one more bullet in its gun and could ease fiscal policy further if the Asian economies started to deteriorate.

Inflation not yet out of control

Besides Japan – where deflation remains a concern – the main concern in the rest of Asia is overheating and possible bubbles developing in asset markets. Overall, monetary policy in Asia remains extremely accommodative and the output gap really never widened substantially in major Asian economies such as China, India and Indonesia in the wake of the global financial crisis. In the rest of Asia besides Japan the output gap has closed fast on the back of the strong “V-shaped” recovery.

However, it is too early to say that inflation will rise substantially. Based on the development in the output-gap we are still far from a situation similar to 2007/2008, where Asia clearly overheated. So far inflation has actually increased less than expected in 2009. While year-on-year increase in consumer prices has continued to increase, month-on-month increases in consumer prices have actually eased, particularly in Asia (excluding Japan and China) as seen in the chart on the next page. The increase in inflation in 2009 was, to a large degree, driven by higher crude oil and commodity prices. In addition, a bad harvest in India last year pushed inflation in India close to 10% y/y. However, stabilisation in crude oil and commodity prices (and even a decline recently) and a normal harvest and lower food prices in India is currently contributing to a temporary decline in inflationary pressure.

Danger that central banks are getting behind the curve

Nonetheless, there is increasing danger that Asian central banks are getting behind the curve. So far, only central banks in India, Malaysia and Vietnam have raised their leading interest rate. In China, the Peoples’ Bank of China (PBoC) has raised the reserve requirement for commercial banks and guided credit growth substantially lower. In addition, the Chinese government has made several regulatory changes, targeting the real estate sector. However, policymakers in Asia have again, in recent months, become very cautious in the wake of the European debt crisis and further tightening has been postponed, at least to Q3.

We still expect China to resume appreciation of the CNY soon but in light of the recent volatility in financial markets it has likely been postponed to Q3. We now believe that an increase in the leading interest rates in China is unlikely to happen until late-Q3. In general, we have started to raise leading interest rates for all Asian countries besides Japan during Q3. Although the recovery in Japan has been strong, Japan remains the weakest link in Asia and the Bank of Japan (BoJ) is unlikely to raise its leading interest rates until the year-on-year inflation rate turns positive and that it unlikely to happen until mid-2011. Consequently monetary tightening in Japan will lag the US, but not necessarily Euroland. In the short run further non-conventional easing from the BoJ cannot be ruled out, particularly if the yen strengthens. With Asia’s growth likely to continue to outperform and monetary policy likely to be tightened earlier and faster than in Europe and the US, we still expect Asian currencies, with the exception of the yen, to appreciate.