China will do what it takes

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We draw five conclusions from this week’s big macro events. First, China will do what it takes to support the economy, with the yuan devaluation the latest in a line of measures to support growth. Second, the eurozone economy lost some of its upward momentum in Q2, but there are plenty of positives signalling better growth going forward. Meanwhile, the Dutch and Spanish economies are back in the top league in terms of eurozone economic performance. Fourth, the US economy is back on track helped by consumers. Finally, Greece is set for an ESM programme, but likely also new elections.

...China will do what it takes to support the economy, with the yuan devaluation the latest in a line of measures to support growth. Nick Kounis Nick Kounis Head of Macro Research

China's FX regime shift

The big event of the week was China’s shift in currency regime, which we see as a sign that the authorities will do what it takes to support growth. The PBoC allowed the currency – which is pegged to the dollar - to better reflect market forces. It fell by around 3%, to take it to the lowest level since 2011. On Friday, the central bank ended a 3-day slide, by setting the reference rate slightly higher. The move partly reflects a desire to show commitment to currency liberalisation ahead of the IMF’s decision on whether to include the Chinese currency in the SDR basket. This is seen as an important milestone in China’s long-road to achieving major reserve currency status.

Supporting economic growth

However, that is certainly not the end of the story. We think the yuan devaluation should be seen as the latest in a line of measures to support economic growth. Data over the last few days showed a slowdown in industrial production  and investment in July after signs of a stabilisation in June, while exports have been persistently weak over recent months. Although the official GDP numbers are bang on the government’s 7% target, the Bloomberg GDP indicator – for instance – was running at 6.6% in July. We see further moderate yuan devaluation ahead and additional monetary stimulus in coming months, which added to other measures, should help the economy to regain some traction. 

Currency war talk looks overblown

We do not think that the devaluation of the yuan will now trigger a currency war given that it is not too aggressive, while other countries also recognise that China’s economy faces challenges. It is good for the overall global economy if countries that are losing momentum also have weakening currencies. The yuan real effective exchange rate has risen by almost 10% since the start of last year and by around 4% this year, so the move in the fixing is still quite modest from that perspective and would need to go further to be a significant stimulus for the tradable goods sector.

Reactions from other countries do not suggest any strong resistance at this stage. An EU spokesperson described the move as a ‘positive development’ to the extent that it better reflects market forces. South Korea’s Deputy PM for Finance said that greater Chinese export competitiveness will also benefit Korea. Even the normally hawkish US Treasury adopted a restrained tone, saying it was too early to judge the full implications of the move.

20150818-China's yuan strengthened before this week

No Fed delay

Speculation that the Fed will now delay raising interest rates, which has weighed on the dollar, also look off the mark at this stage. The yuan devaluation will not have a big impact on the US economic outlook. Recent good economic data (see also below) and FOMC member commentary point to a September increase in the Fed’s target range for the fed funds rate.

Eurozone has lost momentum

Meanwhile, GDP data confirmed that the eurozone economic recovery has lost some pace. Eurozone GDP rose by 0.3% qoq in Q2, which was below the consensus forecast of 0.4% and also down slightly from 0.4% in Q1. Business surveys have suggested that the eurozone economy lost momentum over recent months, which could reflect some fall-out from the Greek crisis and potentially weakness in the Chinese economy. 

Reasons to expect better growth ahead

Nevertheless, there are plenty of positives coming through and we think the eurozone economy will regain momentum in the coming quarters. Domestic fundamentals are improving. We have seen a drop in interest rates, while banks are easing their lending standards. The windfall gains from lower oil prices should support consumer demand. In addition, there are signs that companies will step up investment in the coming months. Banks are reporting increased demand for loans from companies, while orders for German machinery and equipment from other eurozone countries has started to grow strongly. Increased hiring should follow.

The outlook for exports should also brighten. We think global growth will pick-up. The US economy has firmed after a bad start to the year, while the impact of the various stimulus measures should allow the Chinese economy to regain some traction. Meanwhile, most of the effects of the euro depreciation are still to feed through to eurozone exports.

20150818-Eurozone GDP in the year to Q2

Netherlands and Spain are back in the premier league

The country breakdown showed that the Dutch and Spanish economies are once again structurally outperforming. The Dutch economy slowed to 0.1% in Q2 from 0.6% in Q1. However, GDP was heavily weighted down by the temporary effects of lower gas output. Stripping this effect out the Dutch economy maintained the strong pace seen at the start of the year. Meanwhile, already released data showed the Spanish growth surging by 1% in Q2 following 0.9% in Q1. Unfortunately, data for Ireland are not yet available for Q2, but it has also been booming in the last few quarters.

A heart-warming tale of successful adjustment

These are three very different economies but all have at various stages over the last few years dropped down to the low growth league, underperforming the eurozone average. All three had to various extents had to deal with sharp housing market corrections and fiscal consolidations. In the case of Ireland and Spain, we also saw sharp labour cost declines as well as structural reforms. They have come through a period of pain and are now out the other side and are doing well. In a world often dominated by doom and gloom, it is nice to take a short intermezzo for a good news story.

The US is back on track

US economic reports were generally encouraging, and add to evidence that the recovery is back on track after a terrible start to the year. Consumers look to be leading the way. Retail sales were up by 0.6% in July after a revised flat reading in June (from -0.3%). This left sales up by 7.9% annualised in the 3-months to July. This compared to 6.9% in June and -4% in March. GDP in Q2 could be revised up to an annualised 3% or above.

Households are benefiting from ongoing strong job growth as well as healthy balance sheets. A separate report published this week also showed mortgage foreclosures falling to the lowest level in the survey’s 16-year history.

Greece set for programme and new elections

Meanwhile, Greece continued to make strong progress towards a new ESM programme. It has agreed the terms with the quartet of institutions while the programme has also received the backing of parliament. At time of writing the Eurogroup needed to rubber stamp the deal on Friday. The German government seemed to have some concerns, but European officials seemed quietly confident there would be approval. The final step is the approval of national parliaments in the coming week. We have set out some potential pitfalls that could knock the agreement off track in coming months (see our Global Daily Insight, 11 August).

The vote in the Greek parliament on the programme once again underlined that Prime Minister Tsipras’ government no longer has a majority in parliament. New elections therefore seem likely before year end. With further economic hardship on the cards, Mr Tsipras may want to get elections out the way as soon as possible. The far left of his party will probably splinter, but we think that Syriza could still win a majority in new elections.

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