INTERNATIONAL. In a recent report, Standard Chartered says the recent correction in risk appetite is long overdue. Meanwhile, the mix of rising inflation pressures and deteriorating outlook for global growth is causing much added stress on emerging market (EM) economies.

The second quarter of the year, turned out to be a quarter of two halves. Global equity benchmarks showed glimpses of optimism that the worst may be over in April, ran into a wall in May, and were dazed and confused in June. The Dow Jones Industrial Average (DJI) is down almost 10% on the month. The S&P500 is not far behind down over 8% in June. This is not a purely US phenomenon. Emerging market indices are suffering just as much, if not more. The MSCI ex-Japan index has fallen almost 12% in June. So much for theories on financial de-coupling.

Needless to say, risk appetite has deteriorated sharply and is likely to remain fragile for some time. The Standard Chartered Risk Appetite Index (RAI) is firmly in risk aversion territory. Standard Chartered, in its latest Global Focus report, advises investors to be underweight risk or at least very cautious with the level of risk exposure. Pockets of improvement in risk appetite cannot be ruled out. But just as we saw in April-May, the underlying frailties in confidence have not been resolved. Markets remain too optimistic about the prospects for US performance in first half 2008.

Only in May, a Thomson Reuters survey of analysts' expectations for quarterly S&P500 earnings showed a projected profit rebound of 13% year-on-year in third quarter and 62% year-on-year in fourth uarter These numbers seem wholly inconsistent with the fragility still evident in the global economic backdrop. The latest US corporate profitability data also makes for worrying reading. Year over year profit growth in domestic and non-financial sectors for first quarter 2008 were down 4.8% and 2.6% respectively and has been contracting since early 2007.

Financials, unsurprisingly, have been hammered by a 8.5% decrease in first quarter 2008, though slightly better than fourth quarter 2007's 16.4% fall in profits. The bottom-line is it would take a serious recovery in the US and global growth picture to justify such optimism, a justification we have yet to see.

Emerging markets under stress

The mix of rising inflation pressures and deteriorating outlook for global growth is causing much added stress on emerging market (EM) economies. Indeed, for Asia, this is arguably the greatest challenge to macro policy making since the Asian financial crisis, says Standard Chartered. The score card so far is fairly mixed with some doing better than others. Given a more risk averse climate in the second half, foreign exchange markets will likely become more discerning, rewarding and penalising currencies on policymakers' ability to manage macro pressures. We are already beginning to see a divergence in
performance within the EM space.

The immediate challenge is inflation. Increasing price pressures is a global phenomenon though the domestic impact has varied across emerging markets. Many countries experience varying degrees of inflation overshoot in relation to respective central bank policy targets/bands. Almost all are experiencing some degree of overshoot. The worst offenders are India, Chile, the Philippines and Indonesia. It is no coincidence that three of the aforementioned were also among the worst four performing currencies in second quarter 2008.

Asia's monetary stance is way too loose

Many central banks have been slow to respond to price pressures. As a result, the monetary stance in Asia is significantly looser than in other EM economies and way too accommodative from a real interest rate perspective. The concern is that this will remain the case as policymakers try to limit the political and social fallout by sacrificing some degree of policy credibility. Malaysia, Indonesia and India have all taken the difficult decision to reduce energy subsidies. Removing such distortions makes fiscal and market sense in the longer run but will also inevitably add to near term price pressures.

Policy credibility is now under far greater scrutiny given intensifying macro risks. Capital outflows from EM economies have accelerated as the macro outlook becomes less certain for some more than others. In this environment, central banks will be pushed harder and harder to do more to underpin stability and avoid the potentially vicious cycle of prolonged currency weakness exacerbating the severity of imported inflation. It is true that most Asian central banks have replenished FX reserves to far more comfortable levels, allowing the option to support the currency should pressures persist. But this is not a solution should commodity prices remain elevated.

South Korea's sizeable current account surpluses in 2004-2005 have eroded away quickly and the Bank of Korea (BoK) has revised down its 2008 current account forecast to a deficit of US$ 9 billion from US$ 3 billion at the beginning of the year. Standard Chartered forcasts that we cannot expect to see a resumption of a  surplus until fourth quarter 2008. What is more, measuring FX reserves in per capita terms reveals that this buffer may not be as strong as once thought. Compared with China's USD$1,248 and Malaysia's US$ 4,580 FX reserves per capita, the likes of the Philippines (US$ 378), India (US$ 257) and Indonesia (US$ 242) could become much more vulnerable should conditions deteriorate rapidly.

China and India

One of the big ironies about the rise of Chindia (China and India) is that the two countries really are very, very different. It has become commonplace to mention them in the same breath. Both represent emerging economic giants, countries that are set to be even more important to the global economy in the future. A key part of both economies’ success has been their rapid growth, which is necessary considering that both have huge populations. Until now, their economic stories have had little in common. Start with the fact that China’s economy is three times as big, and getting bigger quicker. Its per capita income is double that of India on a purchasing power basis. US$4,088 compared to US$2,222 in 2005, the latest data we
have. In part this is a reflection of India’s largely agricultural economy, in contrast to China’s established manufacturing economy.

Even so, India’s pace of growth has picked up in recent years. Investment has dominated the recent fast growth in China, while India still faces a yawning infrastructure deficit. Nonetheless, India is clearly the leader when it comes to global services, and it scores more companies in the Fortune 500 than China. New Delhi tries every year to extricate itself a little bit from a large budget deficit, while Beijing has to work hard to spend all the money that pours into its Ministry of Finance.

Despite these huge differences, in recent months the two have faced a common set of big problems, which they share with the Middle East: a global slowdown, rising inflation, big FX inflows, excess liquidity, and pressure on their currencies to appreciate. And the way New Delhi and Beijing have managed these pressures are remarkably similar in many ways. Look past the short term and we cannot but notice that the kinds of policies that New Delhi is now pursuing are, slowly but surely, making India a little more like China every day. Higher savings, more investment and a better fiscal position (well, kind of), are some of the examples. Both though are finding the balancing act between growth and inflation tricky to manage; risks in both economies have risen considerably in the last six months and look set to remain elevated. For both the golden years of fast, untroubled growth, are over, at least for the moment.

Fast, but slowing growth

Both India and China are slowing, predominantly because of US weakness, cost pressures and domestic tightening measures (both raised interest rates in 2007, India two times, China five). So far in 2008, India has already raised rates twice by a total of 75bps (the repo rate is now at 8.5%). Needless to say, more aggressive rate hikes could still be in the offing in India and we still expect more hikes in China too, although the bank credit quota is doing the heavy lifting there at present. Even in this weak patch though, we see both countries still moving ahead: India should grow 7.4% year-on-year in fiscal 2008-2009, China at 9.5% in 2008.

There is a difference though. India should still be able to bounce back a bit in 2009-2010 to 8.5%, but China will continue to decelerate. The impending government staff wage hikes in India could provide a boost to consumption. The Indian central bank (RBI) could quickly reverse its tightening bias gradually once inflation starts reverting towards 5% year-on-year in second half 2009. Corporates could still continue to build capacity in anticipation of future demand. In China's case, though, given the capacity issues that the global downturn will likely reveal, and the slow movement of the bureaucracy towards fiscal stimulus, it is hard to see a recovery in 2009. Indeed, the era of double-digit official growth in China may well be over. Pressure on Beijing, though, to loosen the credit quota will clearly rise as the second half progresses and the export sector continues to slow. Standard Chartered counsel clients though to prepare for its lasting till year end.

Dangerously high inflation

Both India and China are tightening because of inflation. Inflation in India hit a 13-year high of 11.63% in June, more than 600bps above the RBI's comfort zone. China's CPI moved up 7.7% year-on-year in May. In China, most of the current push in CPI is coming from food (although we should be more concerned about non-food factory gate prices now rising at over 8%).

In India, while food prices are rising too the big driver of the wholesale price index is fuel and raw materials, which are filtering down to the household level more quickly than in China. Fuel prices were hiked in India in February (by a nominal 3% to 5% for gasoline and HSD) and more recently in June (by 9% to17%), while Beijing recently hiked retail gas prices by almost 17% in June, after a 20% move in November 2007. Both governments have tried to delay these hikes but with global oil likely to remain above US$120 for the next few months, more hikes will have to come. If India passes on the full impact of global oil prices to the local consumer, inflation could easily approach 25%. What is even more worrying in India's case is
that since aggregate demand is still strong, wages are rising.

In China, manufacturing wages are rising too although with wages going up at the same pace as GDP growth and this should not be seen this as a signal for a wider inflation break-out, at least for the moment. We are concerned though with upstream inflation falling on households. Post Olympics, retail energy prices in China still have at least 20% to 30% to rise.

Greater caution on the exchange rate

Just as Beijing seems to have become more cautious about the exchange rate in recent months, so has New Delhi. After moving by 4% against the US Dollar in first quarter the CNY dawdled in May. However, Beijing then pushed forward with its appreciation policy. In second quarter it did 2.2% against the USD. Most importantly, though, the CNY's nominal effective exchange rate moved 1.0% and 3.7% in first quarter and second quarter respectively. The USD-CNY rate is now seen reaching 6.55 by year end, but that said, the risks are clearly on the slow side, as the export growth engine splutters.

The INR has had a more volatile time of it. It strengthened by almost 7.5% in 2007-2008. And this is in spite of the RBI's aggressive intervention (it bought US$ 78 billion or 25% of outstanding FX reserves in 2007-2008) to stem appreciation. Since then the INR has shed all its gains and is back to its end-March 2007 level. The portfolio inflows which drove the currency up have evaporated, indeed they have reversed for this year. The INR seems to be bearing the brunt of the current account adjustment. Imports remain buoyant not only because of the bigger oil import bill (India imports roughly 70% of its oil, China 50%) but because other imports are growing too.

Another factor is India's interest rates; they have been too low in recent years. Now the economy is paying the price. But even as inflation drives policy rates higher, the INR may not benefit till aggregate demand pressures abet and inflation falls. It could weaken more before this happens.

Fast credit growth, now slowing, but not enough

India's credit growth was fast in 2007, 30% year-on-year, while China's was slow in comparison, 16%, though this is the fifth year of strong credit growth in an already liquid economy. Both are now focused on bringing that down in order to control inflation, but neither has done enough. Indian loan growth is still rising at 26% year-on-year, and money supply (M3) is growing at 21%, well outside the RBI's comfort zone of 16.5% to 17.0%. As a result we can expect more hikes in the banks' cash reserve requirement (CRR), which has already been hiked by 125bps (to 8.75%) since January 2008. 

In China, the CNY reserve requirement is now 17.5%, and while it will also inevitably be hiked again soon, the key tool in play now is the relatively crude, but also more effective, credit quota. But even that is only half-effective, given the widespread use of entrustment loans, underground financing, and so on. In India one could never even attempt to introduce such a quota, the banks are too commercial. That said, moral suasion and increased risk weights and capital requirements can be used. So far, when all is said and done, China does seem to be doing a better job in tightening policy.

India exporting more manufactured goods

One of the most encouraging stories of the past few months has been the rise of Indian exports of processed goods. They have boomed, a significant change from the previous dominance of agricultural exports. This has been useful in preventing a massive ballooning of the trade deficit on the back of high oil prices and other imports. Trade has grown as a proportion of GDP, with imports now equivalent to 20% of GDP, exports 14%. (Of course, India is only a few steps along the road that China took in the 1980s, to a place where total trade is now equivalent to 64% of GDP in China.) But like China, India's exposure to a slowing US economy is more limited. Last year, only 14% of exports were to the US, compared with 23% for China.

There is another important contrast to draw here. Too much of India's export growth in 2007-2008 has been driven by commodity prices. If these were to decline, then the overall trade deficit would likely sharpen, although this would also depend on the price of oil products, of which India is a major importer. China, in contrast, would see its surplus rise again if commodity prices fell, but this would be because of a falling import bill.

For good and for bad, both economies receive lots of FX inflows

India received large FX inflows in 2007. In 2007-2008, almost US$ 30 billion of portfolio inflows, plus more FDI and corporate borrowing (which together made up 54% of the total capital flows). In 2008, portfolio inflows and corporate borrowing are slowing sharply. Global investors have turned sour on Indian markets on policy credibility issues. The current account too does not add comfort in the near-term and the deficit could easily touch 3.0% of GDP. Yet, in spite of weaker portfolio inflows and deteriorating current account, foreign direct investors have kept their interest in India alive with their eye on India's long term structural strengths. China's tighter capital controls have not prevented the economy becoming similarly flush with outside funds. Most is coming from trade, as well as FDI, while only a limited amount is coming from corporate borrowing since this is restricted. 

Standard Chartered now forecasts a current account surplus of US$ 398 billion for 2008, 9.1% of GDP. FX flows continue to grow fast, some US$ 330 billion in total in the first four months alone. Beijing is scared of all the 'hot' money leaving, with some analysts arguing there is anywhere between US$ 500 billion to US$1,500 bilion ready to leave. The methodology behind such calculations is questionable, and the low-bound is estimated to be the ball-park figure. That said, all the worry about hot money is now overblown: the central bank has a huge amount of liquidity tied up on its own balance sheet, which it can release if money starts to leave.

Moreover, in a crisis, as 1997 in Asia taught us, it is households you have to worry about, not financial institutions. If households lose confidence in their currency (a very low probability event for China), then you have a real problem. No one in China seems to be considering that factor yet.

Both countries are using the full panoply of sterilisation instruments to insulate themselves from the effects of these inflows, reserve hikes, sterilisation bonds (issued by the central bank but count as the MOF's liability in India) and reverse repo operations by the central bank. Ultimately though, the success of such policies is measured by the rate of credit expansion, and in both, especially India, this is still running too high, as we argued above.

Higher savings in India, financing higher investment

Short-term exigencies aside, India seems to be also solving one key challenge: its savings rates are rising. Not to China levels, perhaps, but this is still really significant as savings can finance investment. In 2007-2008 India's savings rate was 34.8% of GDP, thanks to higher corporate and government saving, as well as stable household savings. Investment has risen as a result, from around 20% of GDP five years ago to 34% today. India still needs to be a bit more of a dragon here, as 30% of agricultural output is still wasted before reaching market because of the lack of infrastructure, and the country also has a power deficit of some 15% at times of peak demand.

Investment in China is officially 42% of GDP. Its overall savings rate is still high too, 50% of GDP in 2007, which means overall investment can remain elevated for quite some time yet. As we pointed out recently though, in real terms fixed asset investment is slowing.

More alike, but still stuck between growth and inflation

Higher saving, more investments, plus more manufactured exports. In these respects, India is looking a bit more like China these days, and that will support more growth over the next decade. However, challenges remain, particularly on the fiscal side for India. That said, the era of plain sailing for China has also come to an end. Neither New Delhi nor Beijing has quite worked out how to handle the inflation that their growth is now unleashing. India has used more market tools, including both the exchange rate and interest rates, but still seems behind the curve.

Equities and the currency could take more hits as a result. China has taken a more planned approach to the problem, resisting any significant appreciation and controlling bank lending. And yet, its inflation situation is still dangerously poised and small and medium-sized firms are suffering. The stock market is still 50% off, and real estate prices looks vulnerable in a number of cities. Beijing also has to deal with a lot more FX inflows, and potential outflows over the next few years. Much of the fears associated with these are exaggerated, but they are still clearly playing on Beijing's nerves. As far as hot money is concerned, at least, India is in much better shape.

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