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US, Chinese And Emerging Economies Outlook

Emerging markets, which now account for more than 50% of global GDP in purchasing power parity terms, are in particular likely to witness another year of heightened uncertainty and their outlook seems mixed

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In an environment of elevated uncertainty and rising interest rates in the US, the global economy is likely to struggle to gain sufficient traction in 2017. Weak demand, poor productivity growth and subdued business investment are likely to ensure that the global economy will grow slightly higher than 3% in 2017 (around 3.3% - according to some estimates) i.e. far below 4% (the rate of growth that can be termed as healthy), even though stronger US demand and a strengthening US dollar will possibly provide some support to global growth - unless the Trump administration resorts to unhealthy trade protectionism. Further, the expected aggressive fiscal expansion under Trump administration will probably have only a modest positive impact on US economic growth in 2017 (and 2018), the Chinese economy is likely to witness a relatively steady slowdown and for other emerging market economies (EMs), the economic outlook is mixed. However, considering the plethora of downward and upward pressures on growth (stated later in this article), overall, I expect EMs to grow at a slightly more rapid pace in 2017 - when compared to 2016.

Key Uncertainties Confronting the Global Economy
Elevated levels of uncertainty about global growth prospects in 2017 are primarily due to Donald Trump's triumph in US elections in November, Federal Reserve hiking Fed target rate by 25 basis points to 0.5-0.75% in December along with signals of three rate hikes in 2017, rising US long term bond (for example, 10-year government bond) yields towards the end of 2016 on expectations of aggressive fiscal expansion by Trump administration and higher inflation (yields on the same may rise to at least 3% by the end of 2017, from around 2.42% currently) and strengthening of the US dollar resulting in tightening of financial conditions, uncertainty about whether Trump will resort to undesirable trade protectionism and its impact on export-oriented economies, a slowing Chinese economy (according to the IMF, a 1% negative shock to China's final demand growth could have a cumulative impact on global GDP of about 0.25% after one year), concerns about further depreciation of the yuan against the US dollar in 2017, possibility of greater capital outflows from EMs, Brexit related negotiation process, and prospects of political uncertainty and Italian banking crisis tempering Eurozone growth prospects in 2017.

US Economic Outlook - expected fiscal expansion to have only a modest impact on growth
The US economy (which accounts for around 20% of global GDP), according to latest data from the Commerce Department, grew strongly by annualized 3.2% in the third quarter of 2016. However, on an annual basis, it is expected to grow by only around 2% (the US economy grew very sluggishly in the first half of 2016). According to my econometric based economic forecast, the US economy is projected to grow by 2.3% in 2017. I expect solid consumer spending (duly supported by moderately higher wage growth and healthier household balance sheets), revival of business investment (with some pick up in energy related investment), higher housing market activity - despite rising mortgage rates and higher house prices - (as a result of expanding economy, rising wages (according to the Labour Department, annual hourly earnings rose 2.9% year-on-year in December 2016 - the fastest year-on-year rise since mid-2009), income and wealth and lower unemployment rate) and expected fiscal expansion to be the principal factors boosting US economic growth in 2017.

Next, the expected aggressive fiscal stimulus (which includes the promise to reduce corporate tax rate from 35% to 15%, changes in personal income taxes, infrastructure and defense spending) that will possibly be introduced by Trump's administration is likely to give only a modest (not significant) boost to US growth in the short run (for reasons stated later in this article), starting in the second half of 2017 - with the impact on the real economy being really felt in or mostly pushed into 2018 (i.e. the boost to aggregate demand and consequently US GDP growth is likely to become more apparent (though only moderately higher) in 2018, when compared to 2017).

My assumption is that corporate and personal income tax cuts will come into effect in the middle of 2017, which in turn should positively impact GDP growth in the following quarters primarily by providing some support for business investment (proposed business deregulation should also result in revival of business investment and stimulate activity), encouraging labour supply, lowering leverage in the economy and supporting consumer spending as a result of strong income growth supported by income tax reductions. Further, increased infrastructure spending, which hopefully would start in late 2017, should start to boost growth mainly in 2018.

Having stated the above, it must noted that the expected aggressive fiscal expansion in the US will lead to a marked rise in the level of government budget deficit and government debt (that is already excessively high - the US debt-to GDP ratio was 104.17% in 2015, according to the US Bureau of Public Debt), which over time could lead to a weaker US dollar and significantly higher long term bond yields - possibly post 2018 (which in turn could hurt the interest sensitive sectors of the US economy (for example, housing, automobile and consumer durables sectors), crowd out business investment and lower business confidence - resulting in lower growth trajectory or even reversal of initial upward push to growth in 2017 & 2018 from the fiscal expansion).

Another worrying factor is that China has recently been rapidly selling large amounts of its US government bond holdings to support its currency (yuan) and stem capital outflows, and at some stage (in the near future) if it decides to dump these holdings, then US bond yields could rise significantly higher. This in turn could have serious downside implications for the US economy because these bond yields (i.e. long term nominal interest rates) are used to price mortgage, consumer, corporate and auto loans. Significantly higher cost of funds would naturally adversely impact consumer spending on durables and business investment and consequently put brakes on growth. Further, given China's slowing economy and its worrying economic outlook post 2017 (i.e. medium-term outlook) along with continuing substantial capital outflows (from China), cheap financing of US current account and budget deficits may be coming to an end.

Several factors (stated below) are likely to constrain the expansionary effect of Donald Trump's expected aggressive fiscal policies and it is possibly a delusion that it will result in US GDP growing by 4% or lead to rapid GDP growth, surging corporate profits and robust consumer spending and wage growth. Achieving a growth rate of even 3% on a sustained basis over a decade would be incredible. Further, a real worry that I have is that a real downside risk confronting the US economy is that post 2018, the negative effect of any protectionism - either through imposing new tariffs or renegotiating or dumping any trade deals - could possibly increasingly outweigh the positive impact of expansionary fiscal policy on the real economy and result in lower business investment and growth trajectory or even a plunge in growth.

Why expected aggressive fiscal expansion is likely to have a modest impact on growth
First, consumer spending (which accounts for around 70% of US GDP) seems already relatively healthy, unemployment rate is already at 4.7% - with possibly little slack remaining in the US economy, employment growth remains solid, wages (as a result of a tighter labour market) and inflation are slowly returning to normal values and the economy is close to its potential (the current economic expansion started in June 2009) - and an aggressive expansionary fiscal policy at such a time is very likely to spur inflation, which along with firming up of oil prices, could result in inflation rising more than 2% in 2017. The implication of all this is further increases in the federal funds rate, further strengthening of the US dollar, small fiscal policy multiplier (fiscal multipliers tend to be very small, when the economy is close to potential) and higher rates for both firms and consumers - all restraining or crimping growth. I expect the Fed to raise interest rates twice in 2017 - with the first hike probably in March - and, possibly four more rate hikes in 2018 - taking Fed funds rate to 2-2.25% by end of 2018.

Second, with the US dollar expected to strengthen further in 2017, sluggish global demand and possibility of moderate rise in imports, net trade should be a drag in 2017 (and 2018) for the US economy. third, if trade protectionism and marked limits on immigration are implemented, it would not only dampen global growth but also US economic growth and business confidence, as the US would face retaliation which could result in higher import prices and inflation and lower exports; fourth, if fiscal measures consist mostly of tax reductions to the wealthier households with a low propensity to consume, it would be much less effective (i.e. fiscal policy multiplier will be much lower) than any fiscal stimulus targeted at the bottom half of households; fifth, while rising US long term bond yields and a stronger dollar are likely to weigh on US economic growth in 2017, yet the positive impact of fiscal stimulus will mostly be pushed into 2018 and make its real impact then; sixth, there has been a stupendous rise in levels of outstanding corporate debt in the US in the past decade and an aggressive fiscal expansion would result in pushing up cost of borrowing at time when firms would need funds for expansion (i.e. business investment) and lead to further build up of debt - I'm not too sure whether rising cost of borrowing will be offset by higher corporate earnings in 2017 as a result of the expected aggressive fiscal stimulus; and, seventh, I expect further wage growth in 2017 due to economic expansion and a tighter labour market, which in turn should have a lagged impact on inflation (i.e. lead to higher wage induced inflation in 2018 and beyond). This in turn should result in even higher long term nominal interest rates - as these rates are strongly influenced by expectations of the future path of the federal funds rate (rising inflationary pressures would lead to a further hike in the federal funds rate) and inflation expectations. As a result, financial conditions could become tighter and put more downward pressure on growth.

Having stated the above, I would say that given the existing state of US infrastructure, lackluster business investment and other factors that have been restraining US growth, I am all for a suitably designed smaller fiscal stimulus that enhances potential output, spurs productivity and sustainably enhances business investment, rather than an aggressive one that would probably result in all out or unsustainable fiscal deficits and debt in the long run, significant rise in cost of interest on national debt, much higher interest rates on treasury bonds and the usual resultant crowding out of private investment. As it is, US fiscal deficit is set to rise over the next few years, as the US population is aging and this will put more pressure on Medicare and Social Security.

Chinese Economic Outlook - Expect Relatively Steady Slowdown in 2017
The Chinese economy grew by 6.7% in the first three quarters and is expected to grow annually at the officially targeted rate of 6.5-7% in 2016 - buoyed by higher fiscal spending on infrastructure, property market rebound and unsustainably high credit growth. Further, economic growth momentum has steadied and the Chinese economy is entering 2017 with fairly steady domestic demand (as reflected in solid import growth - imports grew at their fastest rate in more than two years in November), slight pick up in external demand (as reflected in unexpected rise in exports (November), rising producer prices (which rose for the third consecutive month in November), strong rebound in industrial profits witnessed in 2016 and overheated property markets that continue to cool (first and second-tier cities are witnessing moderation in price growth).

For 2017, I expect Chinese policy makers to set an official growth target of 6.5%. However, according to my own economic forecast, the Chinese economy is projected to grow by 6.3% in 2017. Maintaining economic stability and curbing asset price bubbles will be the overriding concern of policy makers in 2017 and, in my estimation, this will take precedence over supply side reforms that are needed to address some of the most serious imbalances/macroeconomic risks (stated later in this article) that confront the Chinese economy. Consequently, higher deficit spending would have to be undertaken - with infrastructure investment playing a key role and tax cuts too.

In essence, in order to maintain economic stability, policy makers in China would possibly have to go in for a moderately higher fiscal deficit as percentage of GDP in 2017 (probably above 3.2%) relative to 2016 (China had planned for a fiscal deficit of 3% of GDP in 2016, up from 2.3% n 2015), as monetary policy loosening is not an option. This is because looser monetary policy could result in more capital outflows and mount depreciation pressure on the yuan. Further, higher fiscal spending is needed as China has to ensure that GDP growth is relatively stable amid serious imbalances that exist within the Chinese economy and continuing cooling of the real estate market (policy makers have been undertaking measures to cool property sales and prices in many tier 1 cities) that is likely to lead to lower real estate investment growth in 2017 - which in turn should exert downward pressure on growth, particularly in the first half of 2017.

Serious Imbalances/Macroeconomics Risks/Challenges - A Threat to Growth
The aforesaid GDP figures, both expected and projected, and favorable developments in China towards the end of 2016 mask serious imbalances/macroeconomic risks (stated below) that exist within the Chinese economy and are making 2017 economic outlook more uncertain (particularly so post 2017 i.e. in the medium term - I expect China's growth rate to fall below 6% post 2017 (which could have significant adverse implications for emerging market (EMs) growth prospects via trade, commodities, asset prices and confidence channels)), though I don't envisage any hard landing of the Chinese economy and neither a systemic financial crisis in the near future or in the medium term. Stated below are some of the key imbalances/ macroeconomic risks/challenges:

First, China is currently witnessing unprecedented turmoil in its bond market which recently resulted in a sharp rise in 10-year government bond yields (yields rose to 3.4% - a 16 year high - the day after the Federal Reserve announced hike in the federal funds rate) and consequently marked rise in borrowing costs for companies. If bond yields continue to rise, which they could over the coming months, it could substantially enhance default risk; second, corporate debt as a percentage of GDP (145% of GDP, according to the IMF) is unsustainably high and continues to rise; third, growth continues to be fueled by credit (pace of credit growth continues to expand twice as fast as nominal GDP), higher fiscal spending on infrastructure and overheated real estate market and China still wants to maintain a relatively high level of investment; fourth, China witnessed substantial capital outflows in 2016 and the formidable challenge to stem them continues; fifth, there has been significant depreciation of the yuan in 2016 and this could continue in 2017; sixth, uncertainty about Donald Trump's protectionist measures with reference to China (for example, possibility of branding China as a currency manipulator or imposing stringent tariffs on Chinese imports) and a tentative global demand recovery; seventh, high non-performing assets in the banking sector; eighth, curbing asset price bubbles, particularly the overheated property market; ninth, very high levels of leverage in some sectors; tenth, reform measures such as reducing excess capacity in heavy industries such as coal, steel, cement, aliminium and SOE reform remains too slow; and, eleventh, excess housing inventories.

Fortunately for China, two factors might help stabilize/and or support growth in 2017

Having stated the above, two factors might help stabilize and/or support Chinese growth in 2017: first, China's services sector (which now accounts for slightly more than 50% of China's GDP) and consumption growth which are increasingly important engines of growth. Relatively strong wage growth and high government spending have made Chinese households more affluent and which has translated into strong consumption spending. These factors should continue to support consumption spending in 2017, although I expect growth in such spending to moderate slightly on expectations of lower wage growth. The services sector should continue its robust expansion. second, possibility of some improvement in the export outlook, due to substantial weakening of the yuan in 2016 and prospects of it further weakening (albeit moderately) in 2017, boost to US economic growth from expected fiscal stimulus by Trump administration, expectations of cyclical improvement in other EM economies and possible further pick up in global demand.

Yuan depreciation - I expect modest depreciation in 2017 and not a precipitous decline
With reference to the yuan (which fell to a 8-1/2 year low against the US dollar in 2016 and depreciated almost 7% against the US dollar since January 2016 is currently trading at 6.7883 per USD - as of January 5th, 2017), I expect it to witness modest depreciation in 2017 ( i.e. yuan will possibly depreciate to 7.20 over the next 12 months), despite strong possibility of further hike in US interest rates and further strengthening of the US dollar - both of which raise the risk of higher capital outflows from China in 2017.

I predicate my expectations of a modest depreciation of the yuan in 2017 on various factors: steps already taken by PBOC to stem capital flows (for example, restrictions on capital movements) and more steps likely to be undertaken; policy makers are focused on containing macroeconomic risks; China's economy is stabilizing and likely to witness relatively steady slowdown in growth in 2017 (with consumption and services sector likely to support growth); large foreign exchange reserves to combat depreciation of the yuan; the surge in the US dollar witnessed in November is unlikely to reoccur: and, policy makers in China know that they cannot afford more than a modest depreciation of the yuan, as it could derail the economy, increase the cost of servicing dollar denominated debts for firms and might result in a hike in short-term interest rates (leading to higher borrowing costs) which could pose a serious risk to economic and financial stability, as economic growth in China is very substantially supported by borrowing.

It might be noted that China's foreign exchange reserves fell by US$69.1 billion to US$3.052 trillion in November and thereafter to just over US$3 trillion in December 2016 ( the sixth consecutive month of fall in foreign exchange reserves and to near six-year lows)- according to central bank (PBOC) data. For a perspective, foreign exchange reserves in November witnessed the largest drop since January 2016. The marked drop in foreign exchange reserves observed over recent months has been mainly due to the central bank's efforts to prevent the yuan from depreciating more rapidly on the back of accelerating capital outflows.

Monetary policy - no rate hike or cut envisaged in 2017. Inflation to remain benign

Unfortunately for the Chinese economy, PBOC would find it very difficult to hike interest rates in 2017 to prevent more capital outflows from China into higher yielding US long term bonds, as Chinese economic growth is very heavily reliant on borrowing (though China's money market rates have risen, as PBOC seeks to reduce depreciation pressure on the yuan and lower leverage). On the other hand, I don't expect PBOC to lower policy rate in 2017 to boost the economy, due to strong possibility of two further rate hikes in the US in 2017 and also because it would want to avoid any bond and real estate market bubbles. Further, reduction in interest rates could weaken the yuan against the US dollar significantly. However, given that policy makers have undertaken various measures to cool property sales and prices, in order to curb bubbles in the housing market, the real estate sector is likely to witness lower investment in 2017. Therefore, PBOC may loosen credit supply to make the real estate sector slowdown less painful.

Finally, turning to inflation on the CPI measure, the same is expected to remain well below the Chinese central bank (PBOC's) target of 3% - i.e. at around 2.5% in 2017 (from an inflation rate of 2.3% year-on-year in November according to National Bureau of Statistics). Further, producer price inflation is likely to fall in the second half of 2017.

Emerging Markets (EMs) - expected to grow slightly faster in 2017, despite challenges
Emerging markets (EMs), which now account for more than 50% of global GDP in purchasing-power-parity terms - according to the IMF, are in particular likely to witness another year of heightened uncertainty and their outlook seems mixed. These economies have already witnessed substantial capital outflows and depreciated currencies, as a result of expectations of aggressive fiscal expansion under Trump administration in 2017 (which has led to a rise in long term interest rates in the US and further strengthening of the US dollar) and Federal Reserve's rate hike (the U.S. dollar index rose to a near 14-year high after the rate hike in December 2016).

Factors that could put downward pressure on EMs growth (2017)
Emerging markets face the prospects of further tightening of US monetary policy, higher capital outflows, rise in interest rates to stem currency depreciation & capital outflows, increase in dollar denominated debt servicing costs (for example, China, South Africa, Turkey, Russia and Brazil have substantial dollar denominated debts) - according to the Bank of International Settlements (BIS), dollar-denominated debt outstanding has increased in emerging markets to USD 3.3 trillion - further depreciation of the yuan against the US dollar (which if more than modest or if China is labelled as a currency manipulator by the US, could rattle EM currencies), higher inflation, a slowing Chinese economy (which could be serious, particularly for EMs, as according to Bank of England's Quarterly Bulletin 2016 Q1, China accounts for more than 17% of global GDP and Chinese imports account for around 10% of global trade), uncertainty regarding Trump's trade policies - which if protective - could have adverse implications for China and export-oriented economies (such as Mexico (for example, there is a strong possibility of renegotiation of NAFTA), Colombia, Chile, Peru, Malaysia, Thailand and South Korea - the US accounts for a sizable part of their exports), slower net FDI and pressure on fiscal and current account balances. All these factors are likely to exert downward pressure on growth in these economies.

Factors that could put upward (positive) pressure on EMs growth (2017)
However, factors that could exert upward pressure on growth prospects of emerging markets will possibly be expected expansionary fiscal policy stimulating the US economy moderately in 2017 and weaker EM currencies (as a result of a stronger USD), which in turn might have a net positive effect for emerging markets that export to developed economies and on corporate investment in these (EM) economies (though this positive impact is likely to be small (according to IMF calculations, an unexpected 1% rise in US growth increases emerging markets' growth by 0.3%), given the lingering weakness in global trade and consequently, export growth is no longer a reliable source of demand), oil prices, which are currently hovering at around US$54-56 per barrel are expected to rise further in 2017 (I expect oil prices to gradually rise to around US$60 per barrel by end of 2017), and rising prices of other commodities will positively impact the economic situation in EMs such as Russia, Nigeria, Brazil, Argentina, South Africa, MENA economies, Colombia and other commodity exporting EMs (though EMs such as South Korea, Indonesia, China and India could be adversely affected (I expect INR volatility to rise in 2017 as a result of rising oil prices and it could depreciate to 71 against the USD within the next 12 months) because they are major net importers of commodities, particularly oil), cyclical improvement in growth performance of EMs based on more sound policy fundamentals and positive near term outlook for commodities.

Overall, given the aforesaid factors (both downside and upside), I expect EMs as a whole to grow at a slightly more rapid pace in 2017 - than in 2016.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.


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Sher Mehta

The author is Director of Macroeconomic Research and Econometrics, Virtuoso Economics

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