Emerging markets: looking on the bright side
We have mixed revisions to our emerging market forecasts this quarter following a surprisingly strong first quarter in Russia. A small upside surprise in China also prompts an upgrade but we remain of the view that growth will continue to decelerate this year and next. India is still the best growth story in the group and indeed of any large emerging market, though reform progress is still modest at best. On the inflation side, rising oil prices are a challenge for India, but a boon to Russia through the currency channel.
China: slowing, but still no crisis call
GDP growth slowed marginally in the first quarter of the year. However, much of the real data were actually better in Q1 than in Q4 2015. The big drag on growth came from the services sector, specifically from the financial sector, which contributed an outsized share to growth in 2015. The unwinding of these base effects will continue to weigh on growth in Q2 and to an extent in Q3.
At first, it seemed the government was once again ramping up stimulus to rev up the stalling economic engine; Q1 credit growth was notably strong. The reacceleration in the rate of growth is helping to support investment. But with nominal GDP growth of just 7.1%, the debt/GDP ratio will be accelerating too, and it seems concerns around this have prompted a pulling back of stimulus efforts. Also, we are already seeing some signs of growing corporate stress; announcements of spare capacity cutbacks have seen corporate defaults for 2016 exceed the combined level for the last two years, as it becomes more difficult to evergreen their borrowing. A further headwind to growth from this area seems likely.
Our base case is that, for now, the authorities can contain this credit stress and prevent systemic risk. However, there is a tail risk probability in which significant credit events spark investor concerns and undermine faith in the financial system generally, leading by twists and turns to a seizing up of lending and potentially triggering a hard landing.
Aside from stimulus hopes, another area of Chinese policy that continues to draw attention is the exchange rate. Towards the end of 2015, the People’s Bank of China announced that it now viewed a trade-weighted basket as the most appropriate reference for the currency, rather than just the US dollar. An appreciation of the basket versus the dollar (i.e. a weaker USD) saw only a very moderate strengthening of the currency, and there appears to be a preference for currency weakness. We continue to expect depreciation this year and next, to 6.7 and 7 respectively.
Recent state elections increased the national footprint of the ruling party, and weakened the opposition Congress Party. If the government gains a majority in India’s upper house, that will ensure it presses on with reform, with the state level victories interpreted as popular support for the government’s policy aims. We have continued to see marginal gains in this respect, which support our view of a modest upward trend in growth over the next two years.
Another bill passed this year has formalised the Monetary Policy Committee, a positive step for India’s battle with inflation. Central bank Governor Rajan has been doing well, though admittedly he has received a helping hand from lower global commodity prices. Rajan’s first three years are due to end this September. The market consequences of his removal would be strongly negative, both because of the implications for inflation and because of what it would reflect about government policy more generally.
One other risk for India lies in the monsoon rains. The past two years have seen below-normal monsoons, hurting harvests and resulting in lower growth and higher inflation. This year, with the El Niño weather phenomenon switching to La Niña, monsoon conditions are much more favourable, and so we should see a better harvest. On the growth side, this can compensate for weaker manufacturing output. On inflation, given that food is around 46% of the consumer price index (CPI) inflation basket, the benefits are obvious.
Russia: rumbling no more
2016 began well for Russia, as first quarter GDP surprised positively, contracting 1.2% year-on-year rather than the 2% expected, and much better than the 3.8% contraction in the final quarter of 2015. The economy looks to be weathering the oil price slump better than anticipated.
The early GDP release reflects the advantages of allowing the currency to perform a large share of the adjustment to the oil slump and economic slowdown. The rouble fell in line with oil and has remained at weakened levels as oil remains relatively range bound. As a result, the current account surplus has grown; we expect net exports to have supported growth.
The weaker currency looks to have prompted a shift in the economy towards the tradeables sector as Russian industrial competitiveness has been boosted. We still expect a small negative for growth this year, but risks look to the upside, and a return to positive growth in the near future seems likely.
Meanwhile, assisted by a modest rouble recovery, inflation has been trending lower in Russia. Base effects will likely switch from a tailwind to a headwind, but the disinflationary trend should resume in the third quarter and will allow the central bank to begin easing. We anticipate 200 basis points of cuts this year. This does assume a certain outlook for oil and that weak growth continues to weigh on wage growth. Oil shocks or a much stronger growth profile would lead us to review our inflation and monetary policy outlook.
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