The less effective QE2 is, the bigger Asia’s bubble: Daiwa

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Summary
􀂃 QE2, US elections and fiscal policy, and their impact on Asia. US real-GDP growth
accelerated slightly to 2% QoQ (seasonally-adjusted annualised rate [saar]) for 3Q10, with
business investment in equipment/software up 12% QoQ, and private consumption
expenditure (PCE) up 2.6% QoQ, but residential construction declining a precipitous 29.1%
QoQ and net exports subtracting 2% from GDP. The core PCE deflator, however, increased
by a meagre 0.8% QoQ, adding to the plethora of data supporting the likely resumption of
quantitative easing (QE2) at the US Fed’s policy meeting this week. The mid-term US
elections are likely to deal a crushing blow to President Obama’s Democratic Party (very much
in the tradition of losses suffered by Reagan, Clinton, etc., at the same stage of their
presidencies). The Democrats’ majority in the House of Representatives appears likely to be
overturned, and their Senate majority visibly trimmed. The resulting political gridlock will rule
out US fiscal expansion over the next two years, in our view. With few remaining sources of
growth, QE2 is likely to remain ineffective in the initial months – and is thus likely to have to
persist, and be expanded, over the next 12-15 months. Given Asia’s large overall balance of
payments (BoP) surplus (exceeding 5% of GDP for the past seven years), we continue to
expect Asia to experience the ‘mother of all asset bubbles’ over the next 15-18 months.


􀂃 The longer QE2 takes to be effective, the greater the likely boost to Asia asset prices …
Output gaps have closed across Asia (and in most other emerging economies [EMs]), so
inflation (of both goods and asset prices) will increase more in Asia (and other EMs) the longer
QE2 persists in the US, in our view. Since the latter (likely matched by a renewed programme
of Yen sales by the BoJ) is likely to be ineffective in boosting G3 economies initially, much of
the excess liquidity is likely to flow to Asia, boosting asset prices. Asia (and EM) currency
appreciation will contribute both to dampening inflationary pressures and helping to redress
global imbalances. Those economies that resist currency appreciation will likely see the
biggest boost to asset prices in the near term, while storing up potential problems for the future.

􀂃 … but the (eventual) success of QE2 will hold the greatest danger for Asia, hence the
need for near-term defences: The greatest danger for Asia will come, however, when QE2
succeeds. As in 1994, the resulting rise in US interest rates will begin to reverse Asia asset
inflation. In the interim, we expect most of Asia to gradually impose costs (taxes, reserve
requirements) on capital inflows. These will likely slow but not stop the inflation of asset bubbles.