Itaú BBA - The China effect

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The China effect

September 10, 2015

The renewed slowdown in China has a modest impact on developed economies, but the impact on emerging markets is bigger.

Please open the attached pdf to read the full report and forecasts.

Global Economy
China slowdown reduces global growth
The renewed slowdown in China has a modest impact on developed economies, but the impact on emerging markets is bigger. We lowered again our forecast for oil and metal commodity prices.

Supply shock made in China

China’s deceleration and lower commodity-price affect LatAm through further deterioration of their terms of trade, implying slower growth and weaker exchange rates.

Facing the storm

The scenario for Brazil has deteriorated, given the difficulties in the fiscal adjustment. The country had its sovereign rating downgraded and lost the investment grade by Standard & Poor’s.

Less impulse from the U.S.

We expect the growth momentum to improve from the second half of the year on. However, we reduced our growth forecast for next year, in line with the downward revisions in our forecasts for growth in the U.S.

Life with lower copper prices

The economy remained weak during 2Q15, and lower copper prices have dampened the expectations for a significant recovery. The peso has depreciated, and the current account deficit narrowed briskly.

Fighting exchange rate volatility

The central bank has imposed new restrictions on exchange rate derivatives from financial institutions, curbing the depreciation pressures on the sol. Even so, we now expect a weaker exchange rate to end the year.

Oil-led depreciation

Our new oil-price scenario has led us to reduce our 2015 growth forecast to 2.7%, from 2.8% previously. We also expect growth at 2.7% next year (down from 3.0%). The Colombian peso has been hard hit

The day after

Daniel Scioli leads the race to the presidency in October, but a runoff with Mauricio Macri in November is likely. The new administration will receive an economy in stagflation and will have to address several economic distortions.  

Lower price forecasts for oil and metals due to a weaker China

We reduced our price forecasts for Brent crude and base metals, as we incorporated an outlook for slower global growth. Our forecasts are below what the futures markets are pricing in, implying an unfavorable environment for commodity-exporting nations.


The China effect

China is weaker than expected. And the recent market volatility reflects this fundamental risk: a fast growing economy that need to rebalance without loosing too much steam. The Chinese deceleration has limited impact on developed economies, that would probably continue to recover slowly. In the US we expect the Fed to start hiking rates in December. But a weaker China significantly affects commodity prices and the emerging economies.

For Latin America, this scenario of slower China and lower commodity prices means worse terms of trade, more depreciated currencies (i.e, higher inflation) and an even slower growth rates (we revised down growth forecasts for next year, for all countries we cover). Weaker currencies push some central banks to intervene in the FX market and to talk tougher against rising inflation. Even amid weak activity, we now believe that central banks in Mexico, Chile, Colombia and Peru will likely start hiking interest rates in early 2016. In short, the slowdown in China represents a negative supply shock for Latin America: lower growth, higher inflation.

But not all is bad news, the economies in the region are adjusting: the current account deficit in most countries has been declining, especially in Chile.

In Brazil, domestic issues are playing a more important role. The scenario has deteriorated as a result of the disappointing fiscal adjustment and the perspective of rising debt ratios. This raises uncertainty and impacts asset prices in Brazil. The exchange rate depreciates further and pressures inflation, reducing the room for interest rate cuts next year. In this scenario, growth weakens further and unemployment increases.

In Argentina, the gradual adjustments advocated by presidential candidates have become more challenging. For example, the needed exchange rate correction after the elections may be more pronounced. The effective exchange rate is more overvalued. In this scenario, we also reduced our growth forecast for Argentina’s GDP next year.


Global Economy

China slowdown reduces global growth

• China’s economy is slowing faster than expected, reflecting the huge challenges to rebalance its leveraged economy. We maintain our below-consensus GDP forecast at 6.7% for 2015 and reduce it to 6.2% from 6.6% for 2016.

• The renewed slowdown in China has a modest impact on developed economies. This modest impact is consistent with the 0.2pp downward revision in our 2016 GDP forecasts for the U.S., the euro area and Japan. For 2015, we also trimmed our 0.2-pp forecast for Japan but increased it by 0.1pp in the U.S. and the euro area.

• The impact on emerging markets is bigger. The 0.40-pp reduction in China’s growth could translate into a further 0.25-pp aggregate weakening in other emerging economies. 

• We also lowered again our forecast for oil and metal commodity prices. 

• In the U.S., unemployment rate continues to fall and hence we expect the Fed to increase interest rates this year (in December).

China – Lower Growth Ahead

China’s economy is slowing faster than expected, reflecting the challenge it faces as it tries to rebalance its leveraged economy. Evidence of deterioration increased in the last few months with weak activity despite government stimuli (see graph), a crash in stock prices, increased capital outflows and a change in the FX policy that led to small depreciation of the renminbi. The challenges are indeed huge. China needs to reduce investments (and the savings rate) and strengthen domestic consumption; boost the service sector, reducing the role of the industrial sector; reduce government intervention; and liberalize transactions in the financial account of the balance of payments. What we see is a big slowdown in investment without a pickup in other areas. Excessive leverage (credit to the non-financial sector is at around 210% of GDP) might have led to less productive investment. High debt levels both in the private sector and at the level of local government also make it harder for the government to stimulate the economy through monetary and fiscal policies. See our report Macro Vision: What concerns are relevant? for a detailed analysis about the new scenario for China.

The slowdown is stronger in sectors that demand metal commodities. Demand for steel (and iron ore) is an example: the annual growth in apparent consumption receded from 10% in 2013 to 2% in 2014, and it now stands at -0.2% in the year-to-date figure. Iron ore imports have not slowed that much, but the steel produced is now exported, so that Chinese mills affect demand for iron ore in other nations.

We maintain our below-consensus GDP forecast at 6.7% for 2015, and we have reduced it to 6.2% from 6.6% for 2016. These forecasts assume growth of around 6.0% qoq/saar for the next few quarters. This pace is consistent with a modest boost from monetary and fiscal stimuli, including some recovery in the housing market, which is offset by a lower contribution from the financial sector (compared with the strong 1H15) and the structural slowdown.

Despite weaker growth, we believe the risks of a domestic financial crisis or sharp currency depreciation remain low. Banks rely more on deposits than on wholesale funding or external funding, and there is fiscal room to absorb losses. Besides, the external fundamentals are comfortable, as strong international reserves (USD 3,690 billion) and sizable current account surpluses are more than enough to cover any capital outflow pressure.

China slowdown has a modest impact on developed economies but a larger one on emerging economies

Our analysis suggests that the impact of the China slowdown on developed economies will likely be small. We estimate that a 1% decline in growth in China reduces growth between 0.1-0.5 pp in the U.S., the euro area and Japan (see table). This impact could be higher if China stirs up turbulence in financial markets. Indeed, if the sell-off in equity markets, the increase in volatility and the overall tightening of financial conditions in major markets persist, the slowdown could be stronger. But because we don’t expect a financial crisis in China or believe that it will force a shaper currency depreciation, we project that financial stress in developed countries will subside.

In emerging markets, the negative effect is bigger. We estimate that an aggregate of the emerging market GDP (excluding China) could slow down as much as 0.6% in response. Since we are revising our GDP for China to 6.2% from 6.6%, this could translate into a further 0.25pp aggregate weakening in other emerging economies. 

As a consequence, we now believe that the global economy will expand 3.4% instead of 3.6% in 2016. According to our estimates, a 1% slowdown in China would reduce global growth by 0.4%. The direct impact of the China deceleration is 0.20%, and the spillover to the rest of the world is 0.3% (see table).

US Fed – Liftoff likely at the end of this year, as China slowdown is unlikely to derail the recovery

We revised our 2015 U.S. GDP growth forecast upward to 2.5% (from 2.4%), but down to 2.2% (from 2.4%) for 2016. The better forecast for 2015 reflects the revision in 2Q15 (to 3.7% qoq/saar from 2.3%). Importantly, the new release also showed a good GDP composition, with better consumption (up to 3.1% from 2.9%) and non-residential investment (up to 3.2% from -0.6%). Nonetheless we reduced our forecast for 2016 because of indirect effects from China: slowdowns and currency depreciation in emerging markets will likely reduce net exports; lower commodity prices and higher volatility in financial markets will likely restrain some non-residential investment. 

Despite the slight downgrade in the economic outlook, job creation remains at 200k jobs per month, and the unemployment rate is falling. The unemployment rate declined to 5.1% in July, down from 5.7% at the start of the year (see graph). The current level is already close to the FOMC central tendency of the natural rate of unemployment (5.0%-5.2%).

Given continued progress in the labor market, the Fed is likely to start raising the Fed funds rate this year (we expect in December). At the Jackson Hole Symposium, the Fed’s vice-chairman, Stanley Fischer, reiterated that a forward-looking monetary policy maximizes the probability of the Fed achieving its dual mandate over time. Fischer added that there is a “good reason” to believe inflation will move up if inflation expectations remain anchored around 2% and the labor market slack continues to decline, as the transitory effects of the U.S. dollar appreciation and oil price declines dissipate. Liftoff in September is less compelling than in December, though, as the volatility in financial markets clouds the economic outlook, and there is scope to wait a bit longer, given the current low inflation.

Finally, because of the worse global outlook, we incorporate lower risk premiums in the yield curve over the forecast horizon. We have revised downward our forecasts for the 2-year Treasury rate, to 1.0% (from 1.2%), and for the 10-year yield, to 2.4% (from 2.7%).

ECB – Ready to act if the economic outlook deteriorates

Euro area growth has been in a broadly steady recovery pace since the beginning of the year and we made only minor revisions to our forecast. The average growth in 1H15 was revised to 0.4% from 0.3%. With the slowdown in China and some volatility in financial markets the pace is unlikely to increase from the 0.4% in 1H15, as we previously expected. Hence we revised our GDP forecast to 1.5% from 1.4% for 2015 but lowered it slightly, to 1.7% from 1.9%, for 2016.

The ECB is ready to respond to downside risks in the growth and inflation outlook. At its last meeting, the ECB said it is paying close attention to developments in emerging economies and volatility in financial markets to see how they impact the growth and inflation outlook in the euro area. We think the recent modest upward trend in core inflation and the moderate recovery will continue, and hence the ECB won’t need to act. But risks are tilted to the downside and the ECB is likely to react quickly if it sees any reversal in these trends. In that case, we believe the central bank will announce this year that it will continue to purchase assets (including government bonds) beyond September 2016, but we don’t expect it to increase the monthly pace of purchases.

Japan – China is a drag on exports but doesn’t change the modest growth outlook

China is impacting Japan’s exports, but the weaker yen provides some relief. Exports to China correspond to 18% of Japan’s total exports and 2.7% of Japan’s GDP and are already slowing down. Exports to other destinations are improving (see graph), helped by the depreciated yen.  Total exports will probably moderate slightly with China’s slowdown.

We lowered our GDP forecasts to 0.6% from 0.8% in 2015 and to 1.4% from 1.6% in 2016. This reflects not only a weaker China but also some disappointment with the domestic demand recovery. Indeed GDP contracted 1.2% in the 2Q on a negative contribution from net exports, investment and consumption. This should prove transitory as domestic demand returns to a moderate pace in 2H15, with wages increasing and investment resuming an upward trend supported by still optimistic firms.

Commodities – Lower oil and base metal forecasts on weaker global growth

The Itaú Commodity Index (ICI) has fallen further since the end of July (-3.7%), as weaker global growth weighs on the demand outlook. All components declined: agricultural (-5.3%), metals (-2.2%), and oil-related (-4.0%). Lower growth in China reduces the demand for metals.

The oil market faces additional volatility from changes in its supply structure. In the past, Brent price deviations from USD 110/bbl would trigger a coordinated response by some OPEC members. Recently, though, the market focus switched to the shale oil producers in the U.S., who have high costs and probably react rapidly to changes in price. However, the decline in prices since May has not elicited a response from shale oil producers, which increases uncertainty about the actual breakeven prices. The result is more volatility in oil prices, magnifying the impacts from China’s slowdown.

We lowered our oil forecasts (Brent to USD 55/bbl from USD 60/bbl for year-end 2016) and our base metals forecasts. The combined effect is a 5.1-pp downward adjustment to our ICI forecasts for the end of 2016, in addition to the 8.2-pp reduction in our previous scenario review.

Our new scenario is below the levels priced in the futures curve for most commodities, implying an unfavorable environment for most net commodity exporters.


Please open the attached pdf to read the full report and forecasts.


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