Tightening in the West, now in China – PH will follow



Supported by the strong first quarter, China’s great shift to tightening has begun. Meanwhile, reflation in the West has not picked up as initially expected. What are the implications for Philippine rates, the peso and growth?

IN May, Moody’s Investor Service downgraded China’s credit rating. Yet, recently, index giant MSCI included China-traded A-shares in the MSCI Emerging Market Index. There is a reason to the seemingly mixed messages. Like advanced economies, China has a debt challenge. But it differs from that of the advanced economies.

In 2015, US total debt (private non-financial debt plus government debt) exceeded 251 percent of the economy. Except for Germany (166 percent), European figures are not that different, including UK (249 percent), France (278 percent), and Italy (253 percent). In Japan, total debt exceeds a whopping 415 percent of GDP, however.

The advanced economies’ debt is the result of high living standards that are no longer fueled by catch-up growth and are not adequately backed up by productivity, innovation and growth. So, living standards are sustained with leverage.

In China, total debt amounted to 221 percent in 2015, but it has grown very rapidly. If, in advanced economies, the debt is the result of half a century of deficits, in China it has accrued only in the past decade. Second, Chinese debt is not (central) government debt, but local debt. Third, China’s rising living standards, which the central government hopes to double by 2020, are fueled by catch-up growth and supported by productivity, innovation and growth.

Deleveraging has begun
The dramatic increase of Chinese debt can be attributed to two surges. The first is the result of the massive $585 billion stimulus package of 2009, which contributed to new infrastructure in China and to global growth. But it also unleashed a huge amount of liquidity, which is now reflected by excessive local government debt.

Another surge followed in 2016, which saw a huge credit expansion as banks extended a record $1.8 trillion of loans. As a result, credit has been growing twice as fast as the growth rate.

But the big story is that deleveraging has already begun, well before the 19th National Congress of the Chinese Communist Party in the fall.

In late 2016, People’s Bank of China adopted a tighter monetary stance and has increased tightening in the ongoing year. In May, according to Reuters, total social financing fell to $156 billion from $200 billion, much more than analysts expected. In turn, broad M2 money supply expanded by less than 10 percent on an annual basis, the weakest pace in two decades.

Beijing will no longer fund excessive leverage. For now, Chinese policymakers’ deleveraging is on track, as long as it does not downgrade the growth target.

Weaker global reflation
During the global crisis, while the US, Europe and Japan coped with the Great Recession, China accounted for much of global growth. Even today, China continues to drive a disproportionately large share of global growth. But in the near future, deleveraging could moderate Chinese contribution to global recovery.

Half a year ago, there were still great hopes about sustained global reflation.’ Last fall, the Trump triumph in the US election unleashed great expectations about coming fiscal expansion, tax reforms, and deregulation. In turn, European recovery has been faster than in years, thanks to the French election, expectations of a soft Brexit, and German Chancellor Angela Merkel’s anticipated election victory later in the fall.

Today, it seems that Trump’s fiscal expansion will move ahead slower than anticipated and the administration’s credibility, perhaps even its future, may be subdued by the impending Mueller investigation, even as the Federal Reserve is planning a third date hike in the fall. In Europe, growth rates remain predicated on ultra-low rates and huge quantitative easing. Collateral damage may prove unavoidable with the UK Brexit, French President Macron’s proposed labor reforms, and the struggling Italian banks.

In the next few years, China will continue to support global economic integration through its One Road, One Belt program and many other initiatives. But it can no longer fuel global growth and reflation on its own. The question is whether advanced economies can finally do their share for global growth prospects.

PH rates, peso and growth
What does Chinese deleveraging and slower reflation in the West mean from the standpoint of Philippine rates, the peso and growth?

First of all, the more country integrates globally, the more it will become immune to global headwinds. Despite strong growth momentum, the Bangko Sentral cannot afford complacency after the pick-up of core inflation in the first half of the year. The central bank may well raise rates once or twice between late summer and year-end.

Second, the peso depreciated significantly against the US dollar in the first half of the year; from P49.3 to the dollar in December to P50.6 today. Even as the Fed is tightening, the country is facing a twin (current account and budget) deficit.

As a result, the era of depreciation has only begun. If the interest rate will climb to 3.5 by the year-end, the peso-dollar rate could increase to P52.

Nevertheless, the Philippines may still prove the best performer in Southeast Asia. If the country avoids domestic pitfalls and internal divisions, deters external threats and can focus mainly on economic development, it may well thrive, even as much of emerging Asia will find it challenging to cope with tightening in both the West and the East.

Dr Steinbock is the founder of Difference Group and has served as research director at the India, China and America Institute (USA) and visiting fellow at the Shanghai Institutes for International Studies (China) and the EU Center (Singapore). For more, see www.differencegroup.net


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