SG predicts challenging 2010 for policymakers and China

The key risk facing China, the US and Europe, is that they may discontinue their financial stimulus strategies too early, Societe Generale economists said at an economic outlook briefing last week. "If it is too soon, it may create another downturn. But if is too late, it may create long-term inflation and financial bubbles," said Stephen Gallagher, SG's chief economist for the US market.

"Gradualism is the key for monetary policy [tightening] in China," emphasised Glenn Maguire, SG's chief economist for Asia. He foresees that over the course of 2010, the normalisation in policy in China is likely to occur in three stages -- informal guidance (targeting the quality of loans with no absolute restrictions on the amount of lending), quantitative restrictions (restricting the volume of lending by lifting the Reserve Requirement Ratio (RRR)) and rate hikes (adjusting the cost of money). But these policies are not expected to occur before the second quarter.

Comparing the current economic situation to that in the 1970s, SG's chief economists said that global economies, after moving in tandem for a decade following the oil crisis shock in 1970s and then desynchronising due to the US and Japan bubbles in the 1990s, showed signs of synchronising again in the latter half of 2009 under the common monetary policy responses to the credit crisis.

Divergence should emerge in 2010 for various reasons, including differences in consumption potential and exit strategies, SG's economists predicted.

"We should be careful how we interpret the bottoming of the dollar," said Maguire, as this does not necessarily imply the topping out of Asian currencies. Indeed, he expects most Asian currencies will continue to strengthen. The exceptions, due to government policies, are the Japanese yen and the Chinese renminbi.

Maguire also expects the Chinese economy to face a trade deficit in 2010 because of its pursuit of heavy infrastructure investment. As part of the ambitious programme to generate consumer-driven growth in the long run, China is importing huge amounts of commodities to meet the demand of its infrastructure projects. Meanwhile, Chinese exports posted their first full-year decline in 30 years in 2009 and are forecast to achieve only single-digit growth next year. The export slowdown, coupled with rising commodity prices, suggests trade deficits in China are inevitable.

However, SG's global economic group argues that the expected rise in commodity prices due to the surge in demand may encourage the Chinese government to let the renminbi appreciate. This would then help to complete the structural shift in global consumption towards a more balanced situation.

Maguire described the Asian recovery at this stage as "a more domestic one". As industrial production in Asia has recovered more than exports at a time when "the pick-up in inventories is absent", the only way to make it sustainable is "to allow industrial production to meet the domestic demand," he said.

"China's auto sales are absorbing the capacity of not just Asian buyers, but the global supply chain as well," Maguire added. Recent trends show that there is a surge in demand for cars, particularly in China and India, with an emerging dynamic that low-income households can afford mass-produced, cheap vehicles.

In response to the National Congress of China's underscoring of its stimulatory policy for domestic consumption last week, Maguire said it is not really a surprise that the Chinese government would maintain a rather loose monetary policy in 2010.

As of October 2009, the Chinese government had Rmb25 trillion ($3.7 trillion) of funding in projects to be completed over the next few years, many of which are related to infrastructure developments like railways. The Chinese government thus has to be careful about how to taper off bank lending in order not to repeat its mistake of the mid-1990s when many projects became non-viable after the government cut off bank lending too quickly.

"Railroads simply cannot operate if they are only half built, and they will turn into non-performing loans which is not good," said Maguire. "Therefore, we expect that China won't do anything significant on policy until after the National People's Congress in March 2010, which means we can get at least two more very strong quarters on lending," he added.

He expects that the People's Bank of China (PBOC) will adjust interest rates at or around the same time as the Fed does, which is not surprising given that China is broadly keeping its currency pegged to the US dollar.