fx and the world economy...poland 2016 (ytd)* source: reuters & hdfc bank note: *ytd = 1 january...
TRANSCRIPT
FX and the world economy – Focusing on fundamentals
We are releasing this report in the midst of yet another bout of turmoil in the global markets. This
particular episode appears to have been triggered by two things. First, there is a fear that the US Fed
will hike its policy rate in September itself and follow with another hike in December. Second, recent
statements by the European Central Bank president suggest that they might not be as accommodative
in their monetary policy stance as the markets anticipated. A reversal in oil prices driven by a dismal
forecast by the OPEC hasn’t helped things either. These are certainly risks going forward. However
our baseline scenario is of a Fed rate hike only in December. Second, while central banks are
increasingly facing constraints imposed by factors such as the size of their balance sheet, shrinking
pools of bonds that they can buy to inject liquidity and the dent on bank profitability made by super
low interest rates, we do not see any central bank standing on the sidelines if there is indeed a serious
disruption in the financial system. Thus, like other risk-off episodes, this too shall pass. In this report
we focus on the fundamentals of key global economies and forecast the exchange rates that correspond
to these fundamentals.
Over the last few months, emerging markets (EMs) seem to be climbing back on the
radar screen of investors after falling off completely for a couple of years.
Rotation of funds, diminishing China fears and improved commodity prices are
some of the factors responsible for the EM resurrection.
Markets will likely reward economies with relatively strong endogenous reforms,
growth and those better positioned in terms of macro risks such as high external
debt. India stands out as an outperformer.
Macro conditions—tight labour markets, rising inflation and the need to present a
credible face means a Fed rate hike in December in our opinion.
We see a shallow rate hike cycle going forward, reflecting a low
neutral interest rate.
However in our view, high valuation in terms of its trade-weighted index will cap
the USD’s upside even with a rate hike.
The UK might have escaped an immediate carnage in the wake of the Brexit vote but
there could be slow burn as the process of actual withdrawal gets under way. UK’s
hefty current account deficit is a risk hanging over the GBP.
The Euro-area remains sluggish but a current account surplus gives it significant
support.
FX update Treasury Economics Research
14 September, 2016
We believe that China will not see a meltdown despite the recent spate of weak
numbers. High corporate leverage is its biggest risk but also means that large one-
off depreciation is unlikely.
We see the JPY-USD pair settling at a lower level than before as poor domestic
macros hamper risk appetite for investments and limit JPY depreciation.
Our FX forecasts
Dec-16 Mar-17 Jun-17 Sep-17 Dec-17
USD/INR 67.00 - 68.00 68.00 - 69.00 67.50 - 68.50 66.50 - 67.50 66.50 - 67.50
EUR/USD 1.0600 - 1.0800 1.0800 - 1.1000 1.1000 - 1.1200 1.1400 - 1.1500 1.1400 - 1.1500
GBP/USD 1.25 - 1.26 1.23 - 1.25 1.24 - 1.25 1.24- 1.25 1.24- 1.25
USD/JPY 102.00 - 104.00 104.00 - 106.00 108 - 110.00 110.00 - 112.00 112-113
USD/CNY 6.70 - 6.80 6.80 - 6.90 6.90 - 7.00 7.05 - 7.10 7.05 - 7.10
FX forecasts
In Focus
Emerging Markets – cautiously optimistic…remains a differentiated story
Over the last few months, emerging markets (EMs) seem to be climbing back on the radar screen of
investors after falling off completely for a couple of years. EM’s fall from grace had been driven by a
number of things. China’s structural changes (from investment to consumption) that entailed a sharp
drop in the growth rate (that now seems to be its new normal) coupled with its stock-market selloff
and the fear of a financial crisis in its wake was certainly a key factor. Other drivers – some in part a
result of China’s decline - like plummeting commodity prices – as also excess capacities, domestic
and dollar debt overhang also played a role in the disaffection with EMs. Domestic politics in these
economies did not help much either –the graft scandal in Brazil involving president Roussef, a failed
state in Venezuela; Mexico threatened by the antitrade rhetoric of Donald Trump and so on and so
forth.
Chart 1: Fall and rise of the Emerging Markets
Exchange rate against the USD, % change
-60.0 -40.0 -20.0 0.0
Russia
Brazil
Turkey
Thailand
Philippines
India
Malaysia
Indonesia
Poland
2015
-5.0 0.0 5.0 10.0 15.0 20.0 25.0
Russia
Brazil
Turkey
Thailand
Philippines
India
Malaysia
Indonesia
Poland
2016 (YTD)*
Source: Reuters & HDFC Bank
Note: *YTD = 1 January 2016 to 7th September 2016
Why the rediscovery of EM’s charms?
1. Rotation and Brexit – Some of the revival in interest in EMs could be deemed as purely
‘technical’. As valuations in most EM related asset classes became compelling and baked in
most of the negative outlook, a natural process of ‘rotation’ set into the asset allocation
process. It is difficult to identify when this commenced but there was certainly a noticeable
inflexion by end of February this year. As per the IIF portfolio flows data, emerging market
attracted USD 107 billion of inflows during March-August 2016, offsetting outflows
witnessed over the previous couple of months. ‘Brexit’ gave this a fillip as it fostered
expectations of central banks turning more accommodative to contain a likely contagion.
The Bank of England obliged with a sizeable quantitative easing programme, the Bank of
Japan disappointed but did infuse additional funds through ETF buybacks and the Fed used
Brexit as an excuse to hold off a rate hike. A majority (around 70%) of the inflow into EMs
happens to be ETF flows (a classic marker of rotation) away from DMs (predominantly
Europe post “Brexit) towards emerging markets.
Chart 2: Bouncing back – EMs back on investors’ radar screen
-15.0
-10.0
-5.0
0.0
5.0
10.0
15.0
20.0
25.0
30.0
3/1/
2015
5/1/
2015
7/1/
2015
9/1/
2015
11/1
/201
5
1/1/
2016
3/1/
2016
5/1/
2016
7/1/
2016
Net portfolio flows to EMs (3MMA)
$ billions
Source: Bloomberg, IIF & HDFC Bank
2. China–temporary respite? Fears of an imminent collapse in China seemed to have
diminished somewhat after informal pledges by the Chinese authorities not to let the
economy slide were backed up by stimulus policies, including a big deficit funded fiscal push
and a ramp-up in credit growth. Tighter capital controls stemmed the outflows from China.
This is not to suggest that China’s woes are over. Indeed data flow has turned a tad worse
over the last couple of months. However, given the fiscal space that China has and an
aggressive pro-growth central bank, there is perhaps grudging acceptance of the fact that
Chinese authorities have the firepower to prevent a meltdown.
3. Diversification of the demand base for commodities – a large chunk of EMs are commodity
plays and along with the marginal improvement in the sentiment towards China, there is
increasing evidence of the diversification of the demand base for commodities. Incremental
demand is now increasingly coming from other emerging markets. South East Asia,
surprisingly, is becoming a heavy lifter. For instance, more than USD 50 billion of
infrastructure projects are coming through in Thailand, along with Vietnam’s USD 10 billion
rail modernization and plans for new projects in Indonesia and the Philippines. 1 This has
reflected in rising commodity prices that has lifted the growth rates and sentiment. There is
another facet to this. The fact that non-china Asian EMs are in a position to invest also
suggest a degree of ‘decoupling’ from China. Thus in a scenario where China wobbles again,
satellite EMs in Asia could be spared the extreme knock-on effects.
Table 1: Steel outlook shows demand diversification away from China
Regions 2015 2016 2017
World -3.0 -0.8 0.4
Developed Economies -4.0 1.7 1.1
Emerging and Developing Economies -2.7 -1.7 0.1
China -5.4 -4.0 -3.0
EM and Dev Economies excl China 2.0 1.8 4.8
Steel Demand Forecasts (finished steel products), y/y growth rates %
Source: World Steel Association & HDFC Bank
1 Bloomberg article “A Commodities rebound is accelerating at China’s doorstep” dated 19 August 2016
4. Of course, strengthening oil prices along with the expectation that they will remain range-
bound have been a critical prop for the EM pack. Apart from direct beneficiaries like Russia,
stronger oil prices have signaled that global growth though muted is not falling off a cliff.
EMs have traditionally been high beta plays on global growth and their traction has reflected
the uptick in oil prices.
Chart 3: A bounce back in commodity prices helped resources driven countries such as Russia
40.0
60.0
80.0
100.0
120.0
140.0
160.0
Jan
-15
Mar
-15
May
-15
Jul-
15
Sep
-15
No
v-1
5
Jan
-16
Mar
-16
May
-16
Jul-
16
Commodity prices bounced back
All Commodity IndexMetals IndexCrude oil Index
Source: IMF & HDFC Bank
5. Lower for longer and other central banking tales: The delay and uncertainty in the Fed’s
decision to hike rates is not merely about responding to an event risk like Brexit. It is
becoming increasingly clear now that while the US central bank is likely to hike rates once
towards the end of the year, hikes going forward are likely to be shallow and terminate at a
much lower rate than in past business cycle upswings. (We discuss this in detail in the
section on the US). Communications from other major central banks like the ECB and the
Bank of Japan suggest that they are ready to counter any disruption with further
accommodation. This has revived yield seeking in EM assets through carry-trades.
6. Fundamentals have played ball – Some of the turn in sentiment is backed by fundamentals
in terms of likely short to medium term performance. Some examples are:
The latest growth forecasts from the International Monetary Fund offer some
optimism. It expects the pace of GDP growth in emerging markets to
increase every year for the next five years while developed markets stagnate.
In particular, two troubled economies—Brazil and Russia—are expected to
stop shrinking next year. More frequent data shows that many Asian
countries have even reported above-forecast second-quarter growth.
Chart 4: Macro health parameters for most of EM countries have improved
0.0
2.0
4.0
6.0
8.0
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021
Growth prospects for the EMs pick upy/y GDP growth rates (%)
Advanced economies
Emerging market and developing economies
-10
-8
-6
-4
-2
0
201
3-Q
1
201
3-Q
2
201
3-Q
3
201
3-Q
4
201
4-Q
1
201
4-Q
2
201
4-Q
3
201
4-Q
4
201
5-Q
1
201
5-Q
2
201
5-Q
3
201
5-Q
4
201
6-Q
1
Improving current account balances
% of GDP (3QMA)
Turkey BrazilIndonesia India
0 5 10 15 20
Brazil
India
Indonesia
Mexico
Russian Federation
Turkey
Short term debt (% of GDP)
2015 2013
0 20 40 60 80 100 120
Brazil
India
Indonesia
Mexico
Russian Federation
Turkey
Short term debt (% of reserves)
2015 2013
Source: IMF, OECD & HDFC Bank
After a long period of deficit, some of EM countries are also nearing towards
a trade surplus mark.
Other parts of the emerging world showing genuine signs of economic
strength, including Poland and the Czech Republic in Eastern Europe and
Mexico in Latin America.
Finally, overall macro health parameters have shown mild to palpable improvement in most EMs
improving their vulnerability scores.
Vive La Difference
The case against viewing EMs as a homogeneous block and instead looking for difference in their
economic and political fundamentals has grown strong over the last few years. For one thing, this
difference would manifest in the degree of sustainability in their growth. More importantly for an
asset class that are by nature leveraged on global growth and consequently vulnerable to sudden
stops during ‘risk-off’ episodes, these differences would determine their ability to withstand ‘risk-off’
in the global markets. And indeed there one could think of many triggers that could lead to sudden
stops. An unforeseen crisis in China, sharper than anticipated rate hikes by the Fed (say two hikes by
the US Fed) or an unanticipated outcome in the US elections could all lead to some flight to safety
away from EMs. Elections are also due in France and Germany in 2017 and a victory or even a large
vote share for the populist parties could bring back fears of protectionism and diminished trade, a
major negative for EMs.
These differences across EMs can be seen clearly in Asia. India and Philippines are arguably in the
initial stages of an upswing phase of the economic cycle driven by endogenous structural change and
reforms. Indonesia and Thailand also show progress. However, commodity exporters and “reform
laggards” including Malaysia are merely seen to bottoming out. 2Thailand and South Korea are
sitting on large mounds of external debt compared to the others and this clearly weakens their case.
Consider the bigger picture and take Brazil and Russia. Consumer and business confidence appears
to have bottomed out in Brazil, and the GDP contraction in the first quarter was milder than
anticipated. Declining inflation and modest reforms might justify taking a fresh look at the economy.
Despite that, political and policy uncertainties remain and cloud the outlook. Higher oil prices are
providing some relief to the Russian economy, where the decline in GDP this year is now projected to
be milder, but prospects of a strong recovery are subdued given longstanding structural bottlenecks
and the impact of sanctions on productivity and investment3.
India – remains our outperformer
In the current environment, what does one look for? Economies with endogenous structural change,
low dependence on commodity exports, relatively low external debt and a large domestic base are
clinchers. Sticking to the Asians, India, Indonesia and the Philippines fit this profile. Among these,
India remains a likely outperformer, with expected GDP growth (we set the matter of the accuracy of
these numbers aside) of 7.6-7.8% in FY17, making it one of the fastest growing economy. High
structural growth, strong infrastructure investment growth, market-friendly reforms (GST), progress
on fiscal consolidation and the narrowing of the current account deficit all bode well for India’s
macroeconomic stability and investment. An interesting change in the composition of fund flows
captures the changing sentiment towards India. While there has been significant selling in ETFs, it
has been more than compensated by infusion by dedicated active strategy funds (where investment is
long-term and involves stock-picking instead of index benchmarking).
Barring some mild movements on either side, we broadly expect the INR to move in sync with its
peer EM currencies in terms of direction but depreciate less in times of an adverse movement. On the
upside, however, appreciation is likely to be limited with the RBI keen to purchase dollars both to
buffer reserves and infuse liquidity into the system. While the INR could stabilize or even appreciate
a tad once the current turmoil subsides we expect it coming back under pressure towards end-2016
and 1Q-2017 with our expectations of one rate hike by the US Federal Reserve in December. We
maintain our end-2016 target range of 68.00-69.00
2 The Diplomat article “Asia’s Emerging Markets: From Busts to Boom?” dated 22 August 2016 3 IMF “World Economic Outlook” - July 2016
US – recovery yes but structural problems weigh heavy
Of the G-7 economies, only the US seems to be on the path of sustained recovery. However this time
it is different.
While the labour market has tightened considerably pulling the unemployment rate down to
a 5 per cent ball-park, wage growth has been tepid (although there is some sign of an uptick
of late). This has mapped into soft real income growth, patchy increases in retail spending.
However, micro indicators of the American job market (for instance JOLTs survey showed an
all-time high of 5.87 million openings in July 2016 and an increase in total hires to 5.23 million
from 5.17 million in June) have long been suggesting tightness and some rise in average
wages.
Inflation has remained subdued though in terms of direction there is noticeable northward
movement. Core inflation (stripped of food and fuel) has fared better breaching the 2%
bound that is considered to be the Fed’s ‘target’. Clearly risks of deflation are a thing of the
past.
Investment in home-building, home sales both of new and existing stock have improved
along with house prices. Business investment on the other hand remains weak suggesting
both excess capacity in number of sectors and a downbeat prognosis for future sales.
GDP growth remains below trend although we expect some bounce in 2H numbers.
The long and short of the barrage of data that has come of out of the US is that while there are some
signs of a cyclical recovery, there are other macro markers that have not followed the textbook
patterns seen in previous upswings. (We have analyzed these data points in detail in our daily
briefings). The Fed’s decision to stay on hold despite statements from senior officials (that suggest a
rate hike is desirable) stems largely from the inability to gauge whether a comprehensive cyclical
recovery is under way or whether there is a risk, by hiking rates, of taking away the punchbowl
before the party’s begun.
Chart 5: Economic data trends show recovery isn’t broad based yet
1.5
2.0
2.5
3.0
0.0
2.0
4.0
6.0
8.0
10.0
Jan
-13
Ap
r-1
3
Jul-
13
Oct
-13
Jan
-14
Ap
r-1
4
Jul-
14
Oct
-14
Jan
-15
Ap
r-1
5
Jul-
15
Oct
-15
Jan
-16
Ap
r-1
6
Jul-
16
While unemployment has steadily come
down, wages have been sticky
Unemployment rate, %
Average Hourly Earnings (RHS, y/y %)
-5.0
0.0
5.0
10.0
Jan
-13
Ap
r-1
3
Jul-
13
Oct-
13
Jan
-14
Ap
r-1
4
Jul-
14
Oct-
14
Jan
-15
Ap
r-1
5
Jul-
15
Oct-
15
Jan
-16
Ap
r-1
6
Jul-
16
as a result real income and retail sales have been
relatively soft
Real disposable income (y/y %)
Retail sales (y/y %, 3MMA)
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0Ja
n-1
3
Ap
r-1
3
Jul-
13
Oct-
13
Jan
-14
Ap
r-1
4
Jul-
14
Oct-
14
Jan
-15
Ap
r-1
5
Jul-
15
Oct-
15
Jan
-16
Ap
r-1
6
Consumption driven growth gets offset by weak
business investments
(y/y, %)
-0.5
0.0
0.5
1.0
1.5
1.0
1.2
1.4
1.6
1.8
2.0
2.2
2.4
2.6
Jan
-15
Mar-1
5
May
-15
Jul-
15
Sep
-15
No
v-1
5
Jan
-16
Mar-1
6
May
-16
Jul-
16
Inflation remains subdued
Core CPI Inflation (YoY %)
CPI Inflation (YoY %, RHS)
Source: FRED Economic Research & HDFC Bank
When cyclical patterns confound, structural changes almost invariably lend some clarity. For one
thing, there is a multi-decade slowdown in wage or unit labour cost increases suggesting
fundamental changes in the structure of the labour market. While there are many hypothesis
explaining this (diminishing bargaining power of workers for instance), the nub of the problem is a
change in the structure of the economy where low to mid-end manufacturing has seen demise, low
skill service jobs are aplenty and a small but highly remunerative pool jobs in super-skilled areas like
IT or financial management have emerged associated with wages that are competent out of sync with
the rest of the economy. The enduring concern about rising inequality in the US is consistent with this
secular patter in wages, If this trend were to continue, even if there is some rise in wages, it will not
match the traction seen in the past.
Weak and patchy productivity growth post the Great Financial Crisis (GFC) is another factor and
could explain a punch of things. For one thing, it means that growth iss not as labour-shedding as
was in the past and in segments where productivity has declined, more workers are needed to
produce the same the level of output growth. This means that sub-trend GDP growth could be
compatible with rising employment. Indeed if productivity trends continue like this, a lower GDP
growth could well emerge as the new ‘normal’.
Chart 6: Declining labour productivity justifies sub-trend GDP growth
Source: U.S. Bureau of Labour Statistics & HDFC Bank
From a rates and currencies perspective, a few things need to be borne in mind. First,
The neutral or steady interest rate associated with a situation of full employment (where
acceleration in price pressures is at least theoretically zero is much lower (2%) than in the
past (around 4%). Thus the rates hikes going forward will be shallow.
Potential output growth has declined. While this is indeed cause of concern this needs a
structural policy fix. From a purely cyclical perspective, it means that the US Fed can justify
hiking rates at lower rates of output growth than in the past.
This might appear counterintuitive but the implication of this if one follows the
macroeconomic logic is that the US has a lower threshold (neutral) inflation rate at which the
Fed should be hiking its policy rate.
The Fed’s narrative on monetary policy tends to be dominated by short term data flow although we
suspect that the underlying structural factors underpin their decisions. Indeed FOMC members have
over the last couple of years revised their forecasts of the neutral rate down.
The US central bank does seem prepped to hike rates once this year. Fed Chair Janet Yellen’s speech
at the recent symposium at Jackson Hole (25-27 August 2016) claimed that the case for a rate hike
had strengthened but did not provide a hard signal on the timing. However vice-chair Fischer’s
interview to a television channel where he claimed that Yellen’s statements were (if subsequent data
was supportive) perfectly compatible with even two rate hikes seemed to suggest that at least one
hike is a done deal this year. We continue to stand by our case for a rate hike of 25 bps in the Fed
Funds rate in December.
The compelling case for a rate hike, in our opinion, would stem from the Fed’s need to regain
credibility and ensure that its communication does move markets. The Fed has been accused of
‘crying wolf’ a little too often, seemingly building up to a rate hike and then disappointing. The
markets are now shrugging off a lot of the Fed-talk and one rate hike seems imperative to ensure that
the Fed retains control of the markets. Thus we see one rate hike in December followed by perhaps
three hikes in 2017 and more in 2018 to bring the policy rate to around 2.5%.
What about the dollar then? An actual move by the Fed would through the rate difference route
fetch some gains for the dollar. But its current valuation (the Trade weighted index is at a fairly high
level of 95.64 as of 13 September 2016) seems to bake in not just the current differential but also
possible moves by the Fed going forward. Thus while some softness in both the EM and DM
currencies is likely in 4Q-2016, a runaway rally in the USD is unlikely. Our forecasts reflect this.
Besides, excessive dollar appreciation would threaten US exports and slow the American economy
down. This itself will set off a correction that will keep the USD index below an upper bound.
Chart 7: USD valuation still remains fairly high
90
92
94
96
98
100
102
4-Ja
n-1
6
25-J
an-1
6
15-F
eb-1
6
7-M
ar-1
6
28-M
ar-1
6
18-A
pr-
16
9-M
ay-1
6
30-M
ay-1
6
20-J
un
-16
11-J
ul-
16
1-A
ug
-16
22-A
ug
-16
Trade Weighted US Dollar Index
Source: Reuters & HDFC Bank
The UK – the slow burn of Brexit
Recent economic data shows resilience to ‘Brexit’
A batch of recent data suggests that the UK economy is coping with the result of the Brexit vote much
better than expected. The latest health check of the economy shows that some of market and real
economy losses after the Brexit vote was perhaps a knee jerk reaction. This was partly made up in
August helped by a sharp rebound in manufacturing PMI (53.3 in August from July's figure of 48.3),
improved consumer confidence (-7 in August from -12 in July) and rising house prices 4(5.6 % YoY in
August after a 5.2 % YoY increase during the previous month).
But some words of caution….
Despite these numbers, we have our concerns about the sustainability of this nascent improvement.
For one, we believe that Brexit will be a slow burn, with the impact only felt over time once
negotiations between UK and EU policymakers commence. The vote has not only heightened
significant political risks in the UK, but has generated significant uncertainty about the nature of its
future economic relations with and outside the EU, which in turn is likely to weigh on consumption
and especially investment. Mirroring the sentiment, the IMF has slashed its 2017 growth forecasts for
the UK by 0.9 percentage points (ppt) to 1.3%.
A deeper malaise – Current Account deficit
A critical and enduring problem would be UK’s long running current account deficit. The UK had a
deficit in 2015 that was equivalent to 5.4% of annual national income, the widest among comparable
advanced economies (for instance, the US ran a current-account deficit last year of 2.6% of income). In
our opinion, the economy has become all the more vulnerable post “Brexit” to its persistent current-
account deficit problem with increased dependency on the "kindness of strangers", in the form of
4 As per Nationwide House Price Index
persistent foreign support. For one, persuading foreign capital to continue investing in more
domestically focused assets will be far more difficult given the ramifications of Brexit.
Chart 8: UK runs a critical problem of unfavorable current account position
-8
-6
-4
-2
0
2
200
0
200
1
200
2
200
3
200
4
200
5
200
6
200
7
200
8
200
9
201
0
201
1
201
2
201
3
201
4
201
5
1Q
201
6
UK current account: breakdown
% of GDP
Trade balance Net investment income
Source: UK National Statistics & HDFC Bank
An accommodative central bank
Since the referendum, the Bank of England has taken a number of accommodative steps to boost the
UK economy. It has cut interest rates from 0.5% to 0.25% - it's the first reduction since 2009, restarted
quantitative easing, initiated a corporate bond buying programme and provided financing support to
the banking system. Of this, the BOE’s asset purchase programme will take six months to complete
and the corporate bond purchase programme is intended to be completed over an 18-month period.
This suggests monetary policy will remain highly accommodative for much of the cyclical horizon.
“Brexit” implications + CAD + accommodative stance by the BOE = weakness in GBP over
2016-17
Overall we believe that although GBP may rebound in short term reacting to some of the fast moving
economic indicators aided by short-covering, the deferred but not averted consequences of “Brexit”
will add downside risk to the UK economy, which will be negative for GBP. The move will further be
cushioned by the BOE easy policy moves and the inherent economic imbalances in the economy. We
are not predicting a collapse in GBP but its recent momentum could abate and a reversal is perhaps
on the cards.
The Euro - the unbearable heaviness of the union
Economy remains below its potential
The Eurozone’s recovery remains subdued as the flow of data shows. While the overall GDP growth
in H1-2016 stayed at 0.4% (the growth rate registered in H2-2015 as well), supported by loose
monetary policy and an improving labor market, 2Q showed a loss in traction as GDP growth
slowed to 0.3% QoQ sa, from first quarter’s 0.5% increase. Divergent growth patterns within the bloc
are also a cause of worry. While France’s economy grounded to a halt and Italy’s economy stagnated
in Q2, Spain and Belgium recorded strong gains. A stark contraction in fixed investment dragged on
Germany’s Q2 growth which came in at 0.4% quarter-on-quarter, down from Q1’s 0.7% increase.
Some of the other high frequency-indicators reveal a mixed picture of the economy. For instance,
retail sales (grew by a healthy 1.1% MoM in July) pointing to a better Q3 growth number but
simultaneously indicators like inflation remaining depressed at 0.2% YoY in August and
unemployment rate remained high at 10.1% in July. This diversity in data highlight the challenges
facing the economy going forward. From a currency perspective however the fact that the region
continues to run a healthy current account position provides a much needed cushion and limits the
downside to an already ‘undervalued’ Euro. Analysts who have predicted a deep dive for the single
currency with parity or even sub-parity to the USD have perhaps underestimated the power of the
inward flows that a sizeable current account surplus entails.
Chart 9: A current account surplus provides a cushion to the Euro Area
-10
-5
0
5
10
2000 2005 2010 2015 2016F 2017F
Current account position
% of GDP
France Germany Spain Euro-zone
Source: IMF & HDFC Bank
That said, we are not suggesting that EUR will remain rock-solid. Vulnerabilities remain and could drive both
volatility and some downside from current levels.
1. Most importantly, Brexit has increased downside risks for the Eurozone economy. In
particular, market, liquidity, and event risks may rise going forward as businesses try to
adjust to new political developments. Focus on the news flow, tracking negotiation
developments, may contribute to uncertainty and greater asset price volatility, which might
then impact the macroeconomic environment adversely. The actual brunt of the impact is not
expected to be felt much this year but will be felt in the longer term and will depend on what
kind of trade arrangement with the UK is put in place and political developments in
countries like Italy and France where there is growing support for an exit from the union.
2. In fact political developments continue to pose some of the biggest risks to the Eurozone’s
outlook and could increase uncertainty in the region. For instance, the Eurozone’s two largest
economies, France and Germany, face key elections next year. Political stability is also at risk
in Italy, as the upcoming referendum on Senate reform has turned into a de facto vote on
Prime Minister Matteo Renzi’s leadership and Spain which remains in political limbo after
two rounds of inconclusive elections.
3. Additionally, prevalent high levels of debt in many economies (for instance Greece and Italy)
remains a point of concern. Italy’s banks are under severe pressure partly because of high
exposure to sovereign debt and their funding problems could intensify going forward. Also,
developments in the United States’ political space could have ripple effects on the Eurozone
economy through trade and foreign direct investment flows.
Outlook
On the whole we believe that Euro-zone growth remains well below its potential level that
underscores the need for the ECB to maintain an accommodative stance. This coupled with the
funding problem in Italian banks (if it were to unravel) and the likely enduring problems associated
with Brexit may therefore limit any upside in EUR. However, with a high level of Eurozone’s current
account surplus, we see limited case for a sustained decline in EUR/USD pair. (Again the high levels
of sovereign debt are in most part a legacy issue and there has been a noticeable improvement in
incremental budgetary positions since 2012-13). Internal imbalances within the union have been
partly addressed by things like falling unit labour costs. A Fed rate hike could lead to some softness
but a breach of the 1.06 barrier on the downside seems unlikely.
While we continue to expect that the ECB would alter and enhance its monetary easing program
before March-2017, absence of cues about future monetary easing by the ECB (as was the case in 8th
September 2016 policy) could prove to be a risk to our base case scenario and consequently Euro
could settle higher.
China: debt-pile a risk but perhaps no meltdown
The near-term outlook on China appears to have improved with the government’s mix of fiscal and
monetary policy support. 2Q growth too has printed at a somewhat comfortable 6.7% YoY,
unchanged from the previous three-month period. The fine print confirms steady progress towards
rebalancing (away from investment and to consumption) with investment contributing only 2.5 ppt
to GDP growth in the first half, down from 2.9 ppt last year, while the consumption contribution rose
from 4.2 ppt to 4.9 ppt. This is not to gloss over China’s problems -- some of the other unofficial
estimates on metrics such as unemployment still show vulnerabilities in the economy particularly in
industries with excess capacity, where unemployment rate has reached as high as 10%.
That said, the biggest threat to China's economy, in our opinion, remains continuing expansion of
corporate credit. As per S&P Global Ratings, China’s total outstanding corporate debt in 2015 was
USD 17.8 trillion, or 171% of GDP, making it by far the world’s largest in both absolute and relative
terms. The concern about China’s vulnerability is also reflected in fund flows data - while fund
managers have poured capital into emerging markets as a whole since early July, they have
withdrawn it from specialist China funds since mid-June. The only comfort is that the China’s
economy is relatively a closed system in which state-owned banks lend to domestic companies while
bonds are also bought mostly by state-owned financial institutions. However, even if it is a relatively
low fraction of total debt, external debt is very hefty in absolute terms. As of 2015, China’s external
debt amounted to USD 1.4 trillion and contributed to around 12% of all global emerging market
external debt.
Chart 10: China’s corporate debt remains at precarious levels
Source: S&P Global ratings & HDFC Bank
Outlook
While we remain cautious on the Chinese debt situation and the low growth rate, we believe fears of
a hard landing and spillovers to the global economy have subsided to a great extent. Unlike in
August and December 2015, the market’s reaction to the last few months’ RMB weakness has largely
been calm driven by a more transparent and communicative FX policy-making and more gradual and
controlled depreciation move than in the past. The orderly weakness in the CNY against USD, in our
opinion, will likely persist going forward. While the creeping depreciation has added up to quite a
substantial change (around 8% since January 2015), an episode of a sharp devaluation is unlikely
given the stock of external loans.
We see limited impact of Brexit given China’s low trade and financial exposure to the United
Kingdom. However, if growth in the European Union were to be affected significantly going
forward, the adverse effect on China could be material.
Japan – Mrs. Watanabe is not buying dollars
At the beginning of the year 2016, the BoJ began applying negative interest rate policy on certain
deposits held by commercial banks. It was expected that along with its bond buying program,
monetary policy stimulus would encourage investments in the economy. Besides, there were some
hopes of a rise in consumer spending. Markets also believed that the JPY would depreciate and that
the economy would soon shed its sustained deflation risk. The dynamics of the Yen are somewhat
peculiar – improvement in the domestic economy leads to increased risk taking (often driven by
retail investors represented by the fictional Mrs Watanabe) in overseas assets leading to Yen
depreciation. While this might appear to be simplistic, the bottom-line is that improving local
fundamentals are associated with Yen depreciation
For a push towards economic revival, monetary policy was eased slightly more in July. While the
central bank kept its expansion of monetary base unchanged at JPY 80 trillion annually, it decided to
buy larger quantities of exchange traded funds. In addition, measures were announced to guarantee
smooth foreign currency funding for Japanese firms and the BoJ doubled its size of US dollar lending
program to USD 24 billion.
However, capital investment and consumer spending failed to take off (household spending fell 0.5
% YoY in July). On a quarterly basis, GDP growth came in at 0.2% during the second quarter, missing
already subdued forecasts. On an annualized basis, GDP expanded 0.7%, slowing dramatically from
the 2.1% spike in the first three months of the year. Core consumer prices, including energy, fell for
the fifth straight month in July, and markets continued to criticize the negative interest rate policy
amidst repercussions on the banking sector profitability. Consequently, against the intentional
impact, JPY appreciated around 8% since February.
As we move ahead, there is growing caution with regards to further reduction in the policy rate.
Recently, BoJ Governor acknowledged the downsides of his negative-interest-rate policy saying “that
such developments can affect people’s confidence by causing concerns over the sustainability of the
financial function in a broad sense, thereby negatively affecting economic activity.”
In our view, even as the BoJ has some room to expand its monetary policy program and could try
“other new ideas” (as per Mr. Kuroda’s recent speech), we believe there is growing skepticism
about a) success of BoJ’s monetary policy, b) new policy ammunition that the BoJ could use going
ahead and c) with regards to structural long-term reforms in the country.
Outlook
Therefore, while at a fundamental level, policy divergence between Fed and BOJ coupled with a
deflationary outlook is likely to weigh on JPY, the downside movement could be limited in our view.
Disappointment from the BOJ in its upcoming policy review on 21 September 2016 on turning
further accommodative and risk aversion going forward (as and when Brexit negotiations start)
could impart marginal strength to JPY on its medium term path of depreciation. Compared to our
earlier expectation of around 8% depreciation between October-16 and March-17, we now forecast
around 5-6% in JPY.
Treasury Economic Research team
Abheek Barua,
Chief Economist,
Phone number: +91(0) 124-4664305
Email ID: [email protected]
Shivom Chakravarti,
Senior Economist
Phone number: +91 (0) 124-4664354
Email ID: [email protected]
Tushar Arora,
Senior Economist
Phone number: +91 (0) 124-4664338
Email ID: [email protected]
Tanvi Garg,
Economist
Phone number: +91 (0) 124-4664372
Email ID: [email protected]
Disclaimer: This document has been prepared for your information only and does not constitute any offer/commitment to
transact. Such an offer would be subject to contractual confirmations, satisfactory documentation and prevailing market
conditions. Reasonable care has been taken to prepare this document. HDFC Bank and its employees do not accept any
responsibility for action taken on the basis of this document