Global rebalancing: Opportunities and risks :: JPMorgan

· Cyclical and structural forces driving reduction in global
imbalances likely to persist, though domestic distortions (for
example, the imbalance between consumption and investment in
EM Asia) need to be addressed
· Capital flows related to G3 QE can overwhelm EMs. Policy should
strengthen lines of defense, including creating a crisis management
framework. EM capital markets should be deepened, not closed off
or protected, to better absorb the inflows
· After sluggish growth for more than two decades, Japan is only at
the beginning of a sharp policy shift to revive its economy. Three
pillars of Abenomics are likely to boost growth and asset prices, but
unlikely to reach the 2% inflation target
· Slower growth and inflation in China is an ongoing theme. Despite
room for further policy easing, significant changes in monetary or
fiscal policies look unlikely in the near term. Weak demand
conditions expected to persist in the next one to two quarters
· India’s near-term macro success shifts focus back to medium-term
challenges. Focus is currently on alleviating supply side bottlenecks
to boost investment and growth
· Despite near-term economic softness, outlook for Korean GDP
growth in the medium-term remains generally positive, with limited
impact seen from JPY depreciation
· Indonesia’s economic performance has been impressive, but
recently has cooled. This puts reforms, including fuel price
adjustments, into focus.

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Global rebalancing proceeding, but
further policy adjustments needed
Global imbalances narrowed significantly in 2009 and
since then have stabilized. EM Asia remains a major
surplus area, but its external surplus has halved since the
global financial crisis. The progress in global rebalancing
has been driven by both cyclical and structural factors.
Cyclical factors include: (1) domestic demand has fallen
in deficit countries, although it stays close to pre-crisis
trend in surplus countries; (2) relative output gaps also
contributed to the decline in global imbalances.
Structural factors include: (1) in the US, private fixed
investment and personal saving rate increased, and oil
deficit declined; (2) REERs have generally risen in
surplus regions and fallen in deficit regions since the
crisis; (3) terms of trade effect; (4) diminished pace of
China’s market share gains and FDI.
As most of these constructive forces are likely to
persist, global imbalances are expected to improve
further. However, domestic distortions (e.g.
inappropriate balance between consumption and
investment in surplus countries) will likely remain.
Specifically, oil exporter’s surplus may fall if commodity
prices retreat, but China’s surplus will rise again when
external demand recovers. On the other hand, the US
deficit may remain stable as domestic demand recovers
but this is partly offset by the positive impact of lower
prices and fiscal consolidation. There is only a small
chance of extreme outcomes, i.e. either global
rebalancing (both external and internal balances) will be
fully achieved or global imbalances return and intensify.
In order to remove distortions, further policy adjustments
are needed, such as: (1) appropriately paced fiscal
consolidations in deficit countries; (2) greater reliance on
internal relative to external demand in surplus countries;
and (3) appropriate structural and financial reforms in
both deficit and surplus countries.
EM forced to respond to QE-driven
inflows, though restraint cautioned
G3 central banks have entered unchartered waters,
leading to trends that can overwhelm EM countries.
The next force to watch is whether, down the line, Bank
of Japan QE will lead to large capital flows to EM, but
what is clear is that there is a structural shift of flows
from the West to the East and South.
It is hard to tell ex- ante what the ramifications of
these inflows will be, but EM countries must
undertake strategies to best manage them. These can
be broken down into three areas. First, EM governments
must recognize that they cannot prevent the next crisis,
but they can put absorbers in place to strengthen their
lines of defense. This includes policies that "lean against
the wind" and the creation of a crisis management
framework. Second, Asia's capital markets remain small,
so greater financial liberation and larger debt markets
would help to absorb inflows. Third, countries need to
harmonize cross border rules and regulations. Countries
must also refrain from protectionism and closing off of
markets, guard against currency wars, and avoid beggarthy-
neighbor policies.
Japan policy shift just getting started
After sluggish growth for more than two decades,
Japan is only at the beginning of a sharp policy shift
to revive its economy. The extreme easing of Japan’s
monetary policy adopts lessons from the US Federal
Reserve, where Fed QE weakened USD value against
JPY and many of Asian currencies. Notably, USD/JPY is
currently only back to its level at the start of the Fed’s
QE. Going forward, Japan’s policymakers do not want to
see further sharp yen depreciation and would become
uncomfortable if USD/JPY enters the 105-110 range. In
terms of the reaction of the JGB market to the shift in
Bank of Japan policy, the recent volatility has likely been
an unpleasant surprise to policymakers. The likely
reaction from the BoJ would be to lean on
communication policy, emphasizing to the markets their
commitment to their aggressive asset purchase program.
Overall, the three pillars of Abenomics are likely to
boost growth and asset prices, but not the 2%
inflation target. Given fiscal stimulus pillar and
corporate restructuring that has occurred, it is possible
for Japan to sustain 2% real GDP growth. However, for a
country that is in deflation to set and then achieve a
positive 2% inflation target is difficult. This is because
Japan’s deflation is structural, largely due to its deep
integration with low-cost countries like China. Note that
even during cyclical recoveries, prices continued to fall
in Japan.
Longer term, even beyond the Abenomics period,
Japan should look more to its “re-Emerging Asia”
than to the West. Until the early 19th century, China
and India comprised more than 40% of global GDP and
with the two are poised to being key drivers of the global
economy in the decades to come. Notably, in the next
decade China’s growth is expected to slow, constrained
by demographic factors, but India’s growth is more likely
to accelerate and to sustain for longer. Meanwhile, Asia
has become very integrated, though this integration has
been only in terms of markets, with intraregional trade
comprising 60% of Asia’s trade, similar to the EU.
However, there have been few institutional structures to
support this economic integration, which is not surprising
given the unfavorable history. Current trends, including
the escalation of territorial, risk a worsening of the
political dynamics between Japan, China, and Korea.
Another dangerous dynamic is Abe’s position on TPP,
which clearly leans toward the US instead of putting the
priority on deepening trade relations within Asia.
China patient as growth softens
China’s recent data show a combination of slow
growth and low inflation. The 1Q GDP report showing
only 6.4% q/q, saar growth was the lowest in four years,
but the fact that slower growth is accompanied by low
inflation, means China’s macroeconomic situation is not
that worrying as this dynamic allows some room for
potential policy easing. One factor behind the lower
growth rate has been the trend in money supply. While
M2 and total social financing (TSF) have grown rapidly,
the M1/M2 ratio had declined notably in recent years,
reflecting slowing home sales. This means, from a
portfolio allocation perspective, households had to hold
more bank deposits (instead of buying properties), hence
driving up M2 growth, but that does not necessarily mean
stronger domestic demand (which is more reflected in
M1 growth).
With the current inflation rate, there is room for
modest policy easing. Under the current dynamic, 2013
CPI inflation rate looks like it could be as low as
2.2%yoy, well below the official target of 3.5%, while
nominal deposit rates remain above 3%. Policy easing
could be done by lowering the rate on bill financing
which is the marginal loan rate in the banking system and
which currently stands about 6%. A mild relaxation of
monetary conditions can also be achieved by relaxing
certain administrative constraints on loans and not
necessarily by lowering administered rates.
Despite having room for policy easing, it is unlikely
that there will be significant changes in monetary or
fiscal policies in the near term, so weak demand
conditions will likely persist in the next one to two
quarters. China’s new leaders seem to accept that
potential GDP growth has declined and that it is likely to
trend down further in the coming years. That said, the
new leaders do not seem to have formulated a clear
strategy to manage the cyclical ups and downs in the
economy. As for economic reform under the new
leadership, interest rate reform will likely progress at a
gradual pace, with the next step likely to raise the upper
band on deposit rates to 20% above the benchmark rates.
On the exchange rate, even assuming no further increase
in fx reserves, there is the room for about 10% CNY
appreciation against the USD.
On longer term issues, the consensus view that China
has invested too much, and the public sector and
SOEs have over-borrowed may not be correct.
Against the consensus view, an argument can be made
that China’s investment-to-GDP ratio could be
maintained at its current level or could even move higher.
It is not realistic to expect economic policy to help lower
investment and raise consumption at the same time.
Indeed, historically, the real growth rate of household
consumption has been negatively correlated with
household consumption’s share of GDP. Meanwhile,
there is the need for reforms that are critical for
investment, including allowing local governments to
have a larger share of national tax revenue and allow
local governments to borrow directly from the market.
Another problem with the consensus “rebalancing”
view is that, as the population ages, there is the
natural tendency for the household sector to maintain
high savings rate. The simplistic view that savings
would decline if the government were to provide more
support of a retirement safety net is flawed as this would
require the government to tax more now, given that in
thirty years the working-age population will fall. Given
the change in population structure, either the household
sector or the public sector needs to save, which will mean
high national savings either way. From another
perspective, looking at the return on investment, ROA of
industrial enterprises was about 13% in 2012, with ROE
at 20% (16% after tax). The average rate of return on
national capital stock (including infrastructure and
housing) is about 7% in real terms. With real bank
deposits at about zero, this again argues that investment
should be high.
Risks in China’s financial sector
China’s financial sector is akin to the Imperial
Palace: large, operating in silos, with varying degrees
of independence and regulatory oversight. Many
operate as fiefdoms with high degrees of freedom,
especially within the regions where local governments
have a high degree of independence from the central
authorities. It is this structure that has historically
enabled the banks to expand rapidly with little regulatory
oversight and governance - This is where the risks to the
banking sector likely reside. Moreover, the linkage
between the banks and the political economy makes the banks themselves the single biggest obstacle to financial
reform.
The historical context of the banking sector as a tool
of centralized financial planning explains much of the
current challenges. Indeed, over a decade ago, the
authorities consolidated control over banks via
management centralization. Meanwhile, in spite of
attempts to reform the banking industry, the banks were
still used as policy vehicles when necessary – credit
increased by 30% of GDP in past several years amid the
government's stimulus in response to the global financial
crisis, though NPLs were very low (see below). The
interplay of low yielding investment returns against the
assets deployed means is that the net worth of the state
could be running down to zero, with oscillations in net
value reflecting the ups and downs in the equity price of
State Owned equities of SOEs. Indeed, the main thrust of
policy comes from banks and banks are too big to fail
due to the centrality of their role in policy in maintaining
full employment as much as possible.
Much of the low level of NPLs owes to the switching
of bank loans into bonds, leading to an overall
increase in total system credit, with much of the NPLs
embedded and distributed into the bond market. This
transformation of loans into bonds suggests a potential
pile up of bad debt in the future. More importantly, the
main funding source of the state sector comes from
household deposits mobilized via the banking sector and
this will have a knock-on impact on medium-term
household consumption if the deposits are effectively
locked up in the banking sector as funding for the state.
The net impact is that the past household savings are
effectively trapped and if NPLs rise, the ability of
households to consume by drawing down savings could
be questionable.
India’s near-term macro success turns
focus back to medium-term challenges
Since the new economic team came in the middle of
last year, its key tasks were to stabilize
macroeconomic conditions and display a commitment
to reform. When the team took office, India was under
the cloud of a ratings downgrade. The fiscal deficit had
ballooned, inflation was still high and the current account
deficit remained high. Authorities’ first priority was to
contain the fiscal deficit and, against market
expectations, the government was able to bring the
deficit down to below its revised target of 5.3% of GDP
by containing expenditures. One large component of this
was raising diesel prices – first through a sharp 5 Rupee
increase in September and then through more calibrated
increases in recent months. This, in conjunction with
falling crude prices, has meant that the under-recovery on
diesel is currently one-quarter of what it was back in
September. The government remains committed to fiscal
consolidation and, with the Budget already decided for
the year, the space for election-related populism does not
exist. The Food Security Act – when passed – will take
some time to roll-out. Sustainable fiscal consolidation
will, however, also require bolstering tax revenues, and
authorities are getting close to a goods and services tax
(GST). Furthermore, the move to direct cash transfers is
expected to plug leakages, remove dual-price distortions,
and improve household choice. On the external side, the
government has engaged in some FDI reforms (retail,
aviation) and rationalized capital inflows into rupeedenominated
assets (collapsing limits, reducing the
withholding tax) to bolster financing for the current
account deficit. More opportunities exit to increase FDI
limits (e.g. in defense) to improve the mix of capital
flows used to finance the CAD. Finally, inflation
pressures have are moderating sharply and this is
contributing to the restoration of macroeconomic
stability.
The focus is currently on alleviating supply side
bottlenecks to boost investment and growth. Large
projects have undoubtedly suffered on account of
execution bottlenecks (land acquisition, coal linkages,
environmental clearances). A Cabinet Committee on
Investment was set up to resolve these issues and has
begun clearing big-ticket projects. The hope is that
individual line ministries will hasten decision-making in
anticipation of coming up before the CCI. Some
resolution to the coal issue is expected in a matter of
weeks. Furthermore, lowering of interest rates is, at least,
expected to help bolster smaller-scale investment not
dependent on land, coal or environmental permissions.
However, fine-tuning the timing of investment is tricky.
As such, policymakers need to be careful not too reflate
the economy too quickly – before investment and supply
comes online -- for fear of reigniting pricing power and
core inflation again.
Investments in physical infrastructure, human capital
and institutions can take India’s medium-term
growth potential back to the 8-10% level. There is no
reason why India cannot grow at 8-10% of GDP over the
medium term. The economy is poised at a similar level to
where China was a decade ago, with a large fraction of
the population in the agricultural sector. But this will
require sustained investments in physical infrastructure.
The governments expect one trillion dollars of
infrastructure investment over the next five years, only
half of which can come from the public sector. The rest
would need to be privately financed, with foreign
financing also playing a role. In addition, building skills
is a key requirement of the economy, for which
vocational training institutes are crucial. Finally, “soft
infrastructure” – institutions, regulatory architecture,
governance – are also critical to facilitating a higher
growth trajectory.
Korea policy coordination on track
Despite near-term economic softness, the outlook for
Korean GDP growth in the medium-term remains
generally positive. In particular the degree of export
sensitivity (gross exports to GDP) has increased to 55%,
and 2013 growth should be driven primarily by the
external sector as exports are expected to increase 1-3%
following last year's contraction, with growth expected to
gradually reaccelerate to the country's potential growth
rate over the next two years. Inflation should soon
rebound from the current 1.2% level back up into the
target band of 2.5~3.5% due to the expected
reacceleration in GDP growth from 2H, and the fall in
global commodity prices would not be a significant risk
to this.
Policies to support growth in the near-term were led
by the passing of the supplementary budget and other
measures meant to support the real estate market. In
that context, the Bank of Korea’s recent policy rate cut
should be interpreted as participation and coordination
with other economic support measures. Meanwhile, it is
somewhat doubtful that the supplementary budget's real
additional spending of 7-8 tril KRW would have much
impact at all on overall economic growth; instead there is
greater potential for real estate supports to act on growth
in the near term. On the whole, Korea's macroeconomic
fundamentals are naturally supported and further policy
support is not particularly crucial for returning to the
potential growth and inflation trends.
Current levels of JPY depreciation do not have a
major impact on Korea's economy, nor on downside
risks to current growth forecasts. While the JPY
weakening trend is being discussed in policy circles, it
was not a primary reason for the recent easing. In fact,
the impact from yen weakness is multi-faceted – for
example, Korea has a trade deficit with Japan as
companies like Samsung Electronics are importers of
Japanese capital goods, and the recent currency moves
would make such imports much cheaper. Furthermore,
the competitiveness of several pillar industries in Korea
namely electronics, cars, steel, shipping, and chemicals
has increased versus Japan over the past decade, and so
the ability of the economy to cope with currency
appreciation has also risen in this time.
Indonesia tested by fuel price hike
Indonesia's economic performance of the past few
years has defied gravity, but more recently growth
has finally begun to slow on both the external and
domestic fronts. The outlook will depend on if fuel price
hikes are finally delivered. Core inflation remains well
behaved, though again the outlook is dependent on the
outcome of the subsidy reform process. Regardless,
consumer confidence has remained resilient in the face of
fuel price hike talk, and while the inflation impact could
be up to 1%-pt in headline, the core inflation impact will
be manageable, especially if policy rates are hiked in
conjunction. The current account deficit
underperformance has been exacerbated by an
unfortunate particular drop in the price of commodities
that Indonesia specifically exports, although strong
investment driven import growth is also responsible.
However, most recent IMF studies suggest that
Indonesia’s current account has only slightly overshot
that position which was deemed desirable. A slightly
narrower current account deficit around 1.5-2% of GDP
should be able to be sustainably funded by FDI inflows.
Meanwhile, a revised budget is being prepared, which
reflect revised assumptions reflecting more recent
data and trends. Assumptions for growth has been
lowered, currency weaker, oil price higher, and energy
production lower. Importantly, the new budget is
reflecting a rise in the fuel subsidy regime where
premium fuel (Ron88) prices will rise 44% and diesel
prices by 22%. This will raise the inflation assumption
to 7.2%. Meanwhile cash transfers will be used to offset
the first-round impact of inflation. In sum, the new
deficit assumption will be 2.48% of GDP. This will result
in the need to increase issuance by as much as IDR60trn,
but overall debt-to-GDP ratios will be minimally affect,
and remain below 24%.
Thailand domestic demand dynamics
reduce need for policy support
Growth will continue to be supported by Thailand’s
robust private domestic demand. Meanwhile further
stimulus from fiscal policy will take the form of the
seven-year THB2tn investment projects, though these
projects will take time to implement, and may be
delayed. In terms of liquidity the large public spending
programs should not be a problem. In all, they mean only
an extra THB300bn of supply per year, and this should
not impact the long term yield curve dramatically.

A feature of strong domestic demand in Thailand has
been fast credit growth and therefore financial
stability may come under question in the future.
Thailand should avoid credit bubbles like in Europe or
US few years ago. In this context, there are potential and
initial signs of bubbles forming in some pockets of the
economy; these may necessitate measures to cool real
estate loan growth, for example. Monetary policy is still
accommodative, with the real policy rate already near
zero in Thailand and lower than other Asian markets.
The relationship between the policy rate and FX
strength is ambiguous, and previous studies have
shown that cutting rates is not very useful in
adjusting the FX rate. Historically, the authorities have
tried to reduce FX volatility, not change the direction of
THB. In this context, any future easing in the policy rate
would be to provide a boost to the economy, not to
directly influence flows. A strong currency may weaken
the economy (through the hit to exports); an easing in the
policy rate could thus provide a boost to the economy.
Capital flow measures are one option that could slow
inflows and reduce pressure on the currency. However,
any potential introduction of measures would likely be
implemented step by step from the lightest to the
strongest measure.
Mongolia focused on medium-term
challenges
Mongolia’s economy has registered robust growth
over the past four years, while GDP per capita has
doubled over the same period. Two decades ago, the
economy was fairly evenly split between the mineral,
non-mineral and agricultural sectors, but Mongolia’s
economy has undergone significant structural changes
and the mining sector now dominates. However, the
mining industry accounts for only 4% of employment.
Mongolia’s external position has deteriorated, with the
current account deficit worsening, and the trade balance
likely to remain in significant deficit this year. Inflation
remains sticky, and is a key concern for policymakers.
The government’s target of single-digit inflation has
generally not been achieved, owing to persistently high
fuel and food prices. Meat accounts for around 30% of
the CPI basket, and while Mongolia has a large number
of livestock, poor infrastructure hampers the ability to
transport livestock, pushing up meat prices.
Significant challenges cloud Mongolia’s medium-term
outlook. Sustained economic growth will depend on the
successful implementation of SOE projects, as well as
the rolling out of major mining plans into 2015-16. New
legislation that was passed recently has deterred foreign
direct investment in certain sectors of the economy, and
underscores the need for a stable legal environment in
securing stable foreign investment inflows. Fiscal
discipline remains a key concern, with the government
balance deteriorating significantly into end-2012 on the
back of cash handouts and large-scale public investment
projects. These pushed the fiscal deficit up to 8.5% of
GDP, the highest in 13 years. The government is
targeting a smaller budget deficit of just 2% of GDP, but
it is uncertain whether this can be achieved. If the
government misses this target, an amended budget will
be needed in order to cut government expenditure
significantly. Failing this, the government could be
forced to resign. In all, growth in the low to mid teens
looks likely in the medium term, while inflation is
expected to remain sticky, and the unemployment rate
likely to remain at around 5%.
Sri Lanka’s post-IMF success turns
focus on foreign investor access
Since the completion of the IMF lending facility in
July 2012, Sri Lanka can count a number of
macroeconomic successes. These include the rise in the
country’s reserves to 6.9 bil USD and the nearly 6%
appreciation in LKR over the past 12 months. Reductions
in the country’s fiscal deficit are moving in the right
direction having registered 6.4% in 2012 with a target of
5.8% in 2013. One of the key reform initiatives for this
year is the reduction of energy subsidies to restore breakeven
loss rates for oil and power SOEs. The 50 bp policy
rate reduction by the Central bank earlier in May, in
conjunction with the easing begun in December 2012
should boost growth from the current slow patch, with
room to support growth now that the headline inflation
rate at 6.4% has been below the 10% level for a record
51 months.
Despite these improved macroeconomic dynamics, it
is not clear if foreigner access to Sri Lanka will
improve in the near-term. Foreign investor appetite for
a further increase market allocations is strong, notably
for local currency bonds. However, currently the
authorities believe that the current allocation size is
sufficient for the government’s current borrowing needs.
In fact, officials would rather see foreign liquidity go to
develop the corporate bond market. However even the
corporate bond market would not likely offer significant
size in the near term, as Sri Lankan bank foreign fund
raising needs do not exceed 1 bil USD in 2013, similar to
last year.

Asian politics: accommodating rise of
big powers and growing challenges in
SE Asia
The biggest issue confronting Asia over the next
decade is how to accommodate rise of India and
particularly China. This could lead to a Cold War
among regional neighbors but the outbreak of a "hot" war
is not likely, though the risk of mistakes occurring that
could lead to military clashes will be high. Reasons for
cold war dynamics include domestic politics in China
(mainly that Chinese leaders are insecure as they have
lost the trust of the population), China's view that it is a
rising power and the US is a declining power, the US
view that it has legitimate interests in the region, Japan's
fear of being relegated to second tier status, and China's
strategy to push the US away from China and the Asia
Pacific and to force its neighbors to accept its rise. These
issues and a Cold War mentality will dictate how events
within the region develop.
North Korea is the region’s most volatile and
worrying near-term geopolitical risk. The recent deescalation
will not persist as North Korean leaders cannot
be seen as weak. At the same time, North Korea used its
usual arsenal of risks to get attention and aid but the
South and US did not accommodate it. This will lead to
aggressive posturing by the North, which means that
China who has already been losing patience with North
Korea, may have to tighten its noose around the North.
In South-East Asia, recent electoral events highlight
significant ongoing erosion of political support of
incumbent one-party governments. With the loss of
support among the youth vote, this represents a
generational change. While these incumbent single-party
governments do realize that substantive change is needed
to address this voter discontent, their responses have
been conservative ones. This reflects a continuation of a
paternalistic approach towards interacting with the
populace, rather than real engagement with the people as
citizens. Without change in the fundamental underlying
approach of their relationships with the populace, a
widening gap is opening up between increasingly
conservative governments and a growing progressive
civil society that is no longer apathetic, and which is
increasingly being represented by alternative and social
media. One particular risk is that the incumbent
governments are losing their nationalist narrative, with
increasing examples of respective opposition groups
making credible appeals to nationalism. The implication
is that while these political systems will stay relatively
stable in the near-future, the existing effectiveness of
leadership is weakening and policymaking more shallow,
making desirable transformative policies less likely.
Meanwhile populist initiatives will grow and the ability
for incumbent governments to maintain legitimacy and
co-opt opposition will wane.