China kills two birds with one stone

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Jan Dehn, head of Research at Ashmore believes if inflation is slowing because a government is undertaking serious structural adjustment there are grounds for being optimistic.

This is China today. If inflation is slowing because a government is unable to undertake much needed structural adjustment you have a problem. Add in a major debt overhang and you are in big trouble. This is Europe and Japan today. This week Jan discusses China’s rate cut and interest rate liberalisation, subsidy cuts in Indonesia and the Russian economy.

China: “The declining pace of inflation in China last week enabled the central bank, PBOC, to cut interest rates. The PBOC lowered lending rates by 40bps to 5.6% and deposit rates by 25bps to 2.75%. At the same time, the PBOC announced a widening of the band within which banks must lend funds from 10% above the benchmark rate to 20%. PBOC guidance for 5-year savings rates was also removed. The timing of the move surprised the markets, but the central bank’s actions are consistent with the general direction of travel in China.

“China’s government is pro-actively re-engineering a transition of the economy towards consumption-led growth from export and investment led growth. This process is slowing the overall economy and putting downward pressure on inflation. The new growth model also requires brand new policy levers to manage the economy, particularly a greater reliance on interest rates. PBOC’s latest policy moves achieve two things: First, they help the economy though its economic transition. Second, they advance the objective of interest rate liberalisation.

“The latter is ultimately far more important than the former, in our view. The Chinese bond market is destined to be the main transmission mechanism for PBOC rate changes and interest rate management is in turn going to be China’s principal instrument of macroeconomic policy in the future (just as it is in most developed economies). That is why interest rate liberalisation and the development of the Chinese bond market, including opening of the market to foreign investors, is so key.

“In other Chinese news, the pace of slowdown in the Chinese property market slowed in October and there are signs that a recovery may soon take root. House prices are declining at progressively low rates. In October, house prices declined by 0.83% versus -1.03% in September, based on the NBS 70 city survey. Another survey, the Soufun 100-city survey, shows similar dynamics. Land prices are also picking up strongly, while housing starts and property investments are showing signs of stabilising.

“We think the broad macroeconomic environment – interest rate liberalisation, curtailment of excess credit creation, and a slowing economy – have weighed on the housing sector for some time. However, housing cycles are shorter in China than elsewhere due to the smaller role of mortgage financing and both central and local governments have extended various measures to support the housing market during this transition period, including easier criteria for applying for mortgages. The latest PBOC rate cut will also support the sector.

Indonesia: “The government formally announced fuel subsidy cuts of 30%. This will reduce the fiscal burden of subsidies from a peak of 3% of GDP to 1% of GDP next year. The freed-up resources will be allocated to infrastructure spending. In this way, the Jokowi administration will be able to effectively address the single largest constraint on growth in Indonesia despite Jokowi’s weak position in parliament. The price rises resulting from the subsidy cut will have a one-off effect on inflation. Bank Indonesia has already responded to this risk with an immediate 25bps rate hike; this measure is largely to manage expectations because the binding fasbi rate was left unchanged. Fuel subsidies remain protected by Indonesian law. A change in the law is required to move Indonesia structurally towards a more efficient system.

Russia: “The Russian economy continues to show considerably more robustness than the behaviour of Russian asset prices would seem to imply. Russian bonds, stocks and the currency have taken a beating this year on the back of lower oil prices, Western sanctions and continuing unrest in Eastern Ukraine. However, recent growth numbers beat expectations significantly and fresh data on retail sales released last week further underlined Russia’s economic resilience, at least relative to expectations in the market.

“Retail sales for September rose 1.7% versus 1.2% expected, while real wages rose at a rate of 0.3% yoy versus an expectation of a 0.9% yoy decline. Fixed asset investment declined 2.9% yoy versus -3.5% yoy expected. Industrial production rose 2.9% yoy versus -1.5% yoy expected. Unsurprisingly, given the decline in the RUB, weekly inflation picked up 0.1% to 0.3% on the week, which suggests that the Russian central bank could yet again raise rates. The resilience of the Russian economy compared to investor confidence and the insistence of the Russian central bank to do what it takes to keep inflation under control suggests that there may be considerable value in Russian assets.

“After all, investing is not about allocating resources to only good or popular countries. Rather, it is about allocating to countries, where asset prices and the true underlying risks have moved out of line with one another.

Ukraine: “A ruling coalition government has been formed following the recent election. The coalition, which controls 300 of the 450 seats will consist of President Petro Poroshenko’s supporters (132 seats), Prime Minister Yatsenyuk’s People’s Front with 82 seats, the Samopomich party with 33 seats plus former Prime Minister Tymoshenko’s Fatherland party with 19 seats and the Radical Party of populist Oleh Lyashko, which controls 22 seats. Despite the formation of a coalition, a new government team is yet to be formed (we expect this to happen shortly) without which talks with the IMF are unlikely to progress beyond the technical stages.”


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