The US economy is slowly but surely healing: Louis Kuijs & Sanjay Mathur

Interview with chief China economist, RBS MD & head of economics research for Asia Pacific (ex-Japan), RBS

Market participants have been fine-tuning their investment strategy amid speculation the US Federal Reserve's quantitative easing programme might well be entering the final lap. Data from China and Japan and the movement of key currencies have also impacted sentiment. Sanjay Mathur, managing director and head of economics research for the Asia-Pacific (ex-Japan), The Royal Bank of Scotland (RBS), and Louis Kuijs, chief China economist, RBS, tell Puneet Wadhwa that with the US housing and labour markets on the mend, the healing looks more durable. Edited excerpts:

What is your assessment of how things have shaped up for the global economy over the past six months and what is the road ahead?  

Louis: To start with, two important items of positive news from the developed world which at the end of the day still matters a lot for the global growth picture, uncertainty and risk emanating from the Euro zone crisis has come down and the US economy is starting to recover, with reasonably positive signals from the housing and labour markets. There are still quite a few caveats. There is no growth in the Euro zone and, with fiscal austerity, high unemployment and weak sentiment, even next year is going to look subdued, growth wise.

Our colleagues forecast 1.1 per cent growth next year, after a 0.4 per cent contraction this year. In the US, the recovery is still not that strong with several risks hanging over the outlook. Nonetheless, economically, the global growth outlook should get better in the developed world later this year and next year. That will be helpful in supporting growth in emerging markets and developing countries, where economic is needed to meet expectations and mitigate financial risks from higher debt and less easy monetary policy in the developed world.

Are the markets over-reacting to the developments, especially the readings on the US Federal Reserve’s (Fed) quantitative easing (QE) plans?
Louis: I find it hard to say whether the markets are over-reacting or not, because it seems that the recent rise in prices of financial assets globally was in no small part based on monetary easing. I would say, though, that, from an economic perspective, an eventual fading out of QE in the US is on balance good news, since it means that the FED has concluded that growth in the US, and the labour market performance, are strong enough to warrant a gradual return to normal monetary conditions. This should be good for the global economy and, eventually also for equity markets.

A lot of nervousness in the global markets, including India, has been due to what’s happening to the key currencies. Given this, what is the sense you are getting from foreign investors as regards their allocation strategy in the Asian and emerging markets (EMs)?
Sanjay: It is difficult to club all emerging markets in one basket as the set of issues and challenges confronting each of them are different. For India, investors are very concerned with external imbalances. Even if there is a moderation in the current account deficit from the peak rate of 6.7 per cent of GDP, investors will remain worried. Rising US yields have only added to the problem. In terms of foreign investor positioning in EM, I would think that investors have yet to materially exit EMs. What we have seen is probably only a trailer.

Bond yields in the US have firmed up after the S&P boosted the outlook for the government debt. Do you see this trend continuing as investors lap up US bonds and exit from the EMs / Asian markets?
Sanjay: The rise in US bond yields is symptomatic of waning interest in US bonds. Emerging markets have been impacted to an even greater extent. As long as US bond yields are rising, there will be nervousness around EM debt. However, once US yields stabilise, we may see better interest in EM debt.

How do you see Japan’s economy shaping up going ahead?

Louis: Our colleagues working on Japan are reasonably constructive on its economic and financial outlook in the coming 6-12 months, as Abenomics seems to have revived confidence among businesses and consumers alike. The impact of the sizeable increase in liquidity in Japan on global financial markets may become significant, looking at the numbers, thus offsetting in part the possible impact of a tapering off of QE3 in the US.

Whether Japan is able to raise its economic growth rate on a sustained basis will depend on the third arrow of Abenomics, the structural reform component. In any case, given Japan's demographic prospects, I would expect its impact on global growth to diminish in the coming decade.

What about China?
Louis: We remain fairly constructive on China's economic outlook. With exports weak and domestic demand also having slowed, growth is not going to be stellar this year, but I think it will not fall below the bottom of the comfort range of the government of around 7 per cent; we currently project 7.5 per cent for this year.

As the labour market is also holding up reasonably well, the government is for now resisting calls for a more expansionary macro stance, instead trying to focus on getting in place a concrete reform agenda. With capital controls still containing financial flows, the impact of China's economic and financial developments on the rest of the world will continue to be concentrated in the real economy sphere, in the coming 6-12 months. On the basis of our reasonably constructive growth prospects, we think China will remain the most important source of demand on most commodity markets.

There has been a lot of debate regarding the housing bubble in China. Can this bubble burst and, if so, what are the implications for the global economy and the real estate market?
Louis: Given the modest exposure of banks to real estate and rather conservative habits and prudential regulation, which are reflected for instance in high average down payments for mortgages, it is not likely, in my view, that a potential substantial housing price decline by itself would trigger a financial crisis.

However, there is a real risk that a downturn in real estate would be a major drag on growth and, via this channel, have additional financial implications. With overall growth still relatively unconvincing in both China and the world at large, such an outcome would have a major impact on growth and financial stability in China, and also have global impact.

Has India become less attractive now given the macros and the political landscape? Do you think that the policymakers have failed to deliver? Which other markets, according to you, appear more attractive?
Sanjay: Investors are concerned with the India's balance-sheet. However, to be fair, they have become more relaxed on the fiscal situation. On other matters such as creating an enabling policy framework for investment in infrastructure or accelerating FDI flows in general, disappointment is widespread.

I also want to make an additional point – what investors want is real economy reforms – opening up the capital market to foreign investors does not augment the long-term productivity/growth of the economy and therefore, does not amount to real reform.

Is the worst behind us as regards the rupee? How do you see the fortunes for India Inc shaping up over the next few months given the macro-economic conditions?
Sanjay: I do think that while prospects for the Rupee are far from great, there is a case to expect some stability. India's macro problems are well known and discounted in financial market. Going forward, the current account should improve albeit still not to a safe level.  Still, an improvement is better than at all. This should lend stability to the Rupee. One caveat though. In times like this attaining stability requires the central bank to stand up and lean against the wind i.e. the RBI needs to send a strong signal. We have not seen that until now.

What has been your asset allocation strategy over the past one year and do you see this changing over the next 12 – 18 months?
Sanjay: Over the last year or so, we had been bullish Asian bonds and currencies. Asian growth was stronger, interest rate differentials were high and volatility was low. The environment is radically different now and developed markets and the US in particular looks more attractive.

The US economy is slowly but surely healing. Of course, over the last three years, there have been many false starts for the US economy but with the housing and labour markets on the mend, the healing looks more durable. US stocks is really the way to go for now.

What is your interpretation of the key economic data in the Indian context and the expectations from the Reserve Bank of India over the next few months?
Sanjay: The growth related data is unambiguously weak. Going forward, the growth momentum may improve assuming that some reforms do take place and the monsoon is normal, but even so, growth will remain below trend. The good news is that the MAY CPI print notwithstanding, inflation is decisively turning lower. After a long time, inflation and growth are aligned with each other. This should allow the RBI to cut rates by another 50-75 basis points (bps) during the course of FY14.

Fitch has recently upgraded its India ratings. Do you feel others will follow?
Sanjay: No, I think Fitch upgrade is an isolated one. A major acceleration in reforms and a material reduction in the current account deficits are needed before upgrades become the norm. We do not see a downgrade for now.