Each quarter, PIMCO investment professionals from around the world gather in Newport Beach to discuss the firm’s outlook for the global economy and financial markets. In the following interview, members of the Asia-Pacific Portfolio Committee – Robert Mead, Tomoya Masanao and Ramin Toloui – discuss PIMCO’s outlook for the region over the next six to 12 months.
Q. Before we focus on the Asia-Pacific region, could you summarize PIMCO’s global cyclical outlook following the March economic forum?
Mead: Since we last met in December, there have clearly been some improvements in short-term market sentiment. The most significant factor was the easing liquidity conditions following the Long-Term Refinancing Operations (LTRO) carried out by the European Central Bank (ECB) in early December 2011 and early March 2012, which provided European financial institutions with nearly a trillion euros in term financing. This slowed the pace of balance sheet deleveraging that was threatening the global economic outlook in the final quarters of 2011. While this was an important step in the right direction, we continue to expect the eurozone economy to experience a recession in 2012 on the back of continuing pro-cyclical fiscal austerity measures.
In terms of the U.S., we expect 2012 to be the year in which the residential construction sector begins to gradually contribute to U.S. economic growth after a long and painful five-year hiatus. We don’t expect this sector to be a material contributor to overall growth. However, when combined with the nascent revival of the availability of consumer credit, we expect both housing and the automobile sectors to benefit, leading to the creation of jobs in sectors that had endured a long depression. In the non-Asian emerging market sectors, many economies are addressing domestic over-investment, rising income inequalities and inflation risks. As a result, we expect a less significant contribution to global growth compared to the outsized role they have played in recent years.
Q. Following the crisis in 2008, Asia played a lead role in the global economy. Given the current backdrop, is Asia likely to provide a similar contribution?Mead: My colleagues will explain in much more detail later, but lower policy rates and larger fiscal deficits give policymakers far less room for countercyclical policies versus 2008. This will be exacerbated by political timetables and the ongoing consequences of previous credit-oriented policies employed in response to the previous crisis. As a result, we expect Asia to follow the lead of developed markets this time around.
Q. In January, you indicated that you expected to see changes in China’s policy responses. Has this happened? What are your current views on Chinese policy?
Toloui: Well, when the global financial crisis hit in 2008, China responded with extraordinarily expansionary fiscal and monetary policies. This not only cushioned the impact of the crisis on China’s economy, but also actually spilled over to support growth in other countries in this region and indeed the globe.
The situation is different today. Chinese policymakers are acutely aware that the rapid credit expansion from 2009 onward was accompanied by some degree of overinvestment and potential problems with bad loans in the banking sector. Because of this, China’s objective over the last year or so has been to achieve what we would call a dual soft landing, meaning a smooth downward trajectory for domestic demand, alongside a gradual unwinding of excesses in the financial sector. It is difficult to strike the right balance in fiscal, monetary and credit policies to achieve this smooth landing – too easy a policy perpetuates the financial imbalances, while too tight a policy could cause too rapid a contraction and undermine financial stability.
For this reason, we think that China’s authorities are likely to keep turning the dials of their policy instruments in response to the economic and financial indicators. They will be very data dependent, as we would say in a central bank context. We saw this at the end of last year when China’s central bank reversed course on its policy tightening and began easing in response to strained financial conditions. In other words, the policy course is unlikely to be firmly in one direction or the other.
So, aside from some cuts in the reserve requirement ratio, we do not expect to see aggressively expansionary policy to combat the incremental economic slowdown that is unfolding right now in China. Investment is dragging due to the constrained financial conditions, pessimism about the property market and questions about global demand. Altogether we expect that 2012 growth will come in around the 7.5% to 8.0% area, which is substantially below many market forecasts.
Q. You mentioned potential bank losses as an impediment to policy response. Are you also concerned about systemic risk in China?
Toloui: We have examined this question in great detail, because of its importance not only to Asia but to the global economy. Our baseline anticipates that non-performing loans (NPLs) will rise in the financial system, reflecting the impact of the property market adjustments. That is one reason why easing policies, such as reducing the required reserve ratios, are less potent than before – since banks are more inclined to reduce rather than expand their balance sheets. Under the baseline scenario, banks will likely experience losses, but those losses can be absorbed out of the annual profits of the banks.
In our stress tests, we have also examined scenarios of more severe property price declines, higher NPLs and larger losses for the banks. Under these more extreme assumptions, there are scenarios in which assistance from the government would be needed to inject additional capital into the financial system. Even in these instances, however, the amounts are well within the financial capacity of China’s overall fiscal and net asset position, suggesting that the risk of a systemic crisis is low.
Q. Currency has been an actively imposed policy tool across the Asia-Pacific region. How will currency influence policy in the region?
Masanao: We believe that most countries in emerging Asia will continue to put their currency appreciation on hold as inflation peaked in summer 2011 and is expected to remain subdued over the cyclical horizon. Allowing its currency to appreciate, albeit at a gradual pace, was emerging Asia’s policy response to increased inflationary pressures that resulted in part from extraordinary monetary accommodation in the U.S. and elsewhere in the developed economy. With inflation moderating, this will no longer be the case. Declining current account surpluses in China and elsewhere in emerging Asia are another factor prompting a reevaluation of the currency policy in these economies. In China, for instance, the current account surplus declined to 2.7% of its GDP in 2011, down substantially from 10.2% in 2007. So then, will emerging Asia actively allow its currency to depreciate from here? We don’t think so, because inflation remains elevated after peaking in the summer last year.
Elsewhere in the region, Japan is not an exception of currency appreciation prompting policy responses. The Bank of Japan (BOJ)’s decisions in February to clearly state a policy goal of 1% inflation and to buy more Japanese government bonds were probably due to domestic political pressures. Yet, an underlying fundamental driver behind those political forces was an increased deflationary pressure (via currency appreciation) that resulted from the extraordinarily easy monetary policy in the U.S. Will the BOJ shift gears and aggressively try to depreciate its currency to achieve its 1% inflation target soon? Probably not. We believe that the BOJ remains firmly in the camp that believes costs and risks associated with a super-accommodative policy in the Japanese economy outweigh the potential benefits.
Q. Japan’s near-term growth prospects look positive on the back of the fiscal response to the post-quake reconstruction, but how sustainable is this growth profile?
Masanao: PIMCO forecasts 0.5% to 1.5% real GDP growth for Japan over the next 12 months, which is below the market consensus of 1.7% but a bit higher than our estimate of Japan’s potential growth rate. Government reconstruction spending will indeed be a main contributor to Japan’s growth, adding an estimated 0.4 to 0.5 percentage points to the GDP growth in the next 12 months. But even so, the consensus forecast looks too optimistic. While the private sector demand is likely to pick up in northeast Japan, the overall private sector demand on a national level will likely remain subdued given lingering uncertainty in the external environment. PIMCO has revised up its cyclical growth forecast in the U.S. and believes the eurozone has bought some time again, but we are still more conservative in the global economic outlook than the market consensus. The earthquake and nuclear crisis have also raised risks and costs for manufacturing operations in Japan, which should have profound implications for capital expenditure plans in the manufacturing sector.
We are also concerned about the sustainability of Japan’s economic growth beyond 2012. The government’s reconstruction spending will fade dramatically in 2013, which will likely cause a drag, though small, on Japan’s GDP growth. Some may argue there will be a boost in the private sector demand in 2013 if the government decides to raise the consumption tax in 2014 as planned, but that would only be borrowing from future demand.
Q. How vulnerable is Asia to commodity prices, especially oil?
Masanao: Global stagflation, or a combination of low growth and higher commodity prices (oil in particular), is indeed a key risk for Asia as a whole with the exception of Australia.
Emerging Asia forms the largest block of oil consumption at around 25% of the world’s total and China and India account for 66% of the region’s total. Emerging Asia is also the fastest growing oil consumer. In 2010, oil consumption in the region grew by around 7% compared to the world’s average growth of 3%. But it is not just high levels and fast growth rates in oil consumption that relate to Asia. Oil intensity, defined as primary oil consumption per unit of GDP, is high across emerging Asia.
Therefore, sustained high oil prices will have “demand destruction” implications and a broad contractionary impulse in emerging Asian economies. At the same time, the resulting elevated inflation will constrain central banks’ ability to cushion the blow to domestic demand.
Japan is also vulnerable to commodity prices and especially vulnerable since the nuclear accident. Its liquid natural gas (LNG) imports have surged as nuclear power generation, which contributed to 29% of Japan’s total power generation in 2010, had to be replaced by thermal generation. Increased input costs dampen corporate competitiveness and shrink trade balance on a macro level.
Q. Is there a beneficiary of higher commodity prices somewhere in the world? How does Australia fare?
Mead: Relatively speaking, Australia is indeed a beneficiary of higher commodity prices as a result of the strong demand for coal, iron ore, and more recently, LNG. Australia is also a net exporter of energy and therefore less vulnerable to oil price pressures. However, given the outlook for China described above, we see weakening demand for iron ore, which will result in a softer terms of trade for Australia. We also believe that the Reserve Bank of Australia (RBA) will be in a reactive mode when setting its monetary policy, in spite of the significant fiscal drag expected from the May annual budgetary outcomes.
Q. Bringing all these points together, where does this leave us in terms of our Asia-Pacific cyclical outlook?
Toloui: We would emphasize three key points. First, unlike in 2009 when Asia played a catalytic role in leading the global economy out of the crisis, we expect that Asia’s outlook in 2012 is more likely to take its cue from events in Europe and the U.S. Second, Asian policymakers are likely to be more reactive and data dependent, as opposed to embracing aggressive expansionary policies, in the face of global weakness. This is because of less fiscal and monetary maneuvering room as compared to the previous cycle, as well as persisting concerns about inflation in the region. Third, continued increases in commodity prices would threaten to further confound the conduct of policy – mainly because this inflationary impulse would coincide with a particularly strong contractionary impulse from the region’s heavy dependence on oil imports.