From PIMCO:
Q: Could you elaborate on PIMCO’s view on China over the cyclical horizon? What are the implications of the plunge in equity markets and the yuan’s devaluation?
Meng: The Chinese economy is going through a multi-year New Normal adjustment. Growth will inevitably moderate as policymakers rebalance the economy away from investment and toward consumption, over-leveraged borrowers repair their balance sheets and frothy asset prices adjust.Indeed, the adjustments got very bumpy in the third quarter. The credit-fueled equity bubble crashed and China’s A-share market has fallen by about 40% from its peak on 12 June. This sent severe shocks via the wealth, expectations and balance sheet channels. PIMCO estimates that the equity market crash will drag down GDP growth by up to 100 basis points (bps) over the next 12 months.
On 11 August, the People’s Bank of China (PBOC) relaxed the yuan’s quasi-peg to the dollar, a move that was followed by devaluation of around 4% in one week. Although this helped to correct the yuan’s moderate overvaluation and was marginally positive for exports, the surprising policy change raised the specter of policy exhaustion and the risk of competitive devaluation. This amplified negative shocks and spilled over to other emerging markets (EM), commodities and the global economic outlook. Capital outflows intensified, and the PBOC was forced to intervene heavily to stabilize the currency.
Clearly, there are daunting challenges in managing a gradual slowdown and structural adjustment in a highly leveraged economy with frothy asset prices. The PBOC, for instance, will face challenges in transmitting its monetary policy under a rigid foreign-exchange regime, while the need for fiscal consolidation in local governments (where debts are some 40% of GDP) also will limit fiscal stimulus. The risks of further real economic and market shocks are high.
Under these circumstances, our baseline outlook anticipates GDP growth in China between 5.5% and 6.5% over the next four quarters. This is 25 bps weaker than our March forecast and remains well below consensus. We expect private capital expenditures and property prices to weaken further, risking a negative spillover to employment and consumer spending; these will be only partly offset by a marginal improvement in net exports and stimulus from constrained public investment. We see headline inflation between 1.5% and 2.5%. Given this, we expect to see a significant monetary policy response from the PBOC, including 75 bps in deposit rate cuts, a 200 bps cut in the required reserve ratio and devaluation of the yuan to 6.80 to the dollar.
Q: How do recent developments in China affect the outlook for Australia?
Bowe: Developments in China and broader emerging market Asia affect Australia through three key channels. First, via potentially weaker commodity prices that negatively affect Australia’s terms of trade and national income growth. Second, via export volumes, where Australia is the most exposed developed market economy to emerging Asia (including China). And third, via financial conditions that to date have been both positive (from a weaker Australian dollar) and negative (from weaker equity markets). The net impact via these three channels has undoubtedly been negative for Australia, and this is factored into our below-consensus outlook for growth and inflation.Importantly, however, Australia continues to face its own domestic challenges as growth rebalances away from the resource sector. This rebalance is clearly happening, albeit slowly, and is the key reason we are not more pessimistic on the outlook. One can see the rebalance occurring geographically, with the mining states contracting while the larger non-mining states are growing at the quickest pace in several years. One can see the labor market rebalancing, with mining job losses being offset by gains in other sectors such as tourism. Indeed, aggregate employment growth through August this year had increased to 2%, its fastest pace for this period since 2011. Finally, one can see the rebalance occurring in the composition of private investment and in the growth of external demand, where the value of services exports is now larger than the value of iron ore exports for the first time since 2011.
Thus, our outlook for Australia calls for a continuation of the sluggish rebalance away from mining-led growth, in an environment where a reluctant Reserve Bank of Australia (RBA) will more likely than not be required to provide additional policy support over the cyclical horizon. Our below-consensus outlook for China, which incorporates the recent equity market correction and currency-regime shift, continues to skew the balance of macroeconomic risks firmly to the downside.
Tick, tick and tick. And then the shock.
