We believe the PBOC is trying to shift the rhetoric away from the dollar‑yuan exchange rate.

Cyclical outlook

Policy Support Amid Sluggish Growth: Asia’s Economies in Transition

Policy will be critical over the coming year but options are constrained by excessive debt, domestic politics and potential asset bubbles.

The volatility in global financial markets that marked the start of 2016 emanated from China and underscores the key role that policy will play in assisting the Asia-Pacific region’s economic transition. In the following interview, Portfolio Managers Adam Bowe, Luke Spajic and Tadashi Kakuchi discuss this and other conclusions from PIMCO’s quarterly Cyclical Forum, in which the company’s investment professionals debated the outlook for global economies and markets. They share our views on economies and investment implications across the Asia-Pacific region over the next 12 months.

Q: What matters for Asia in 2016?

Bowe: Despite the Fed’s historic liftoff from zero in December, most central banks across Asia continue to contemplate additional policy stimulus to address weak domestic demand and sluggish regional trade. There are three important questions in 2016: What mix of tools will policymakers use? How successfully will they generate growth and inflation? And how will financial markets be affected?

As in 2015, investors need to answer all three questions correctly. (Last year provides an example of why: A simple but correct forecast of Chinese growth would probably have had little bearing on whether an investor made or lost money.) The answers to all these questions are critical because in many instances the policy tools are second-best options; transmission channels and outcomes are far from certain. Countries across the region face policy constraints due to excessive debt, excessive growth in debt, challenging and delicate political environments, potential asset bubbles and policy tools that are reaching their natural limits. In fact, many countries such as China, Japan and Australia are grappling with all of these constraints simultaneously in various sectors of their economies.

Q: Could you elaborate on PIMCO’s view for China over the cyclical horizon, including the outlook for monetary policy and the
exchange rate?

Spajic: In 2015, China experienced one of the largest equity bubbles in history, suddenly devalued its currency and embarked on aggressive monetary policy easing. The inauspicious start to the Year of the Monkey suggests that 2016 will have many echoes from last year. This means paying even more attention to Chinese policymaking in 2016. Last October, policymakers unveiled a lower GDP growth rate target of 6.5% as part of their five-year plan beginning in 2016, although we expect growth between 5.5% and 6.5% this year – a below-consensus estimate. The country is trying to transition from an infrastructure- and export-led model to one focused on domestic consumption and services. That said, China’s presence in global trade will still be keenly felt.

We expect the People’s Bank of China (PBOC) will cut rates a further 50 basis points (bps) and reduce its reserve requirement ratio by at least 150 bps. But, as early January’s weakening of the yuan showed, foreign exchange will remain the most pressing and eye-catching component of Chinese policy. Last August’s devaluation of the yuan caused global risk premia to rise markedly. And the IMF’s landmark decision in November to include the yuan in the basket of currencies used to calculate the value of the international reserve currency known as Special Drawing Rights (SDR) is a game changer. The yuan’s usage is rising quickly in international payments, trade finance, foreign exchange markets and in central bank foreign exchange reserve management. It remains to be seen how far and how fast China achieves full capital account liberalization. Longer term, though, we see SDR inclusion as the key that unlocks the door to China’s capital markets – which include the world’s second-largest for equities and the third-largest for government bonds.

For China, the yuan’s inclusion in the SDR is likely to be seen as a beacon for further reform, potentially driving more market-related structural reforms – especially in the financial sector. The long-term “reward” for China will be seen most clearly in flows into the currency from the world’s central banks and sovereign wealth funds – which should alleviate some concerns over potential capital outflows.

We believe the PBOC is trying to shift the rhetoric away from the dollar-yuan exchange rate to bypass any significant U.S. dollar appreciation arising from additional rate hikes by the Fed. Equally, the PBOC is keen to avoid appreciation of the yuan versus currencies of its other trading partners. These days, it’s hard to find a country that really wants a hard currency.

In our view, the PBOC is running a “dirty floating” regime, which represents a change in emphasis (away from the U.S. dollar) to ”justify” less currency intervention in the yuan. Indeed, since the yuan’s inclusion in the SDR on 30 November, we have seen greater tolerance for volatility and much faster yuan depreciation.

Q: How do the headwinds from slower growth in China, lower commodity prices and a potential peak in the housing market affect the outlook for Australia?

Bowe: Australia’s outlook for this year continues to reflect the forces that have been influencing the macro landscape for the past couple of years. From an external perspective, growth in China continues to moderate as policymakers attempt to rebalance their growth engines away from commodities-intensive infrastructure. And this is happening as the global supply of bulk commodities such as iron ore is booming, in part due to Australia’s past investments in the sector. Soft prices for Australia’s commodity exports look set to continue in 2016, and consequently terms of trade and national income growth will likely remain subdued. Additionally, declining mining investment will continue to weigh on domestic demand.

So the question once again is, what will fill the hole left by the mining sector? Last year, housing construction provided an important offset but it will likely become a less powerful force going forward. Household balance sheets remain stretched, house prices have already increased significantly, macroprudential controls are restricting banks’ appetite to lend and mortgage rates have risen from their lows. This is not to say we envision a significant housing correction but we certainly expect the housing market tailwind to subside. In short, we continue to see a very gradual and sluggish rebalance away from the mining sector, with the Reserve Bank of Australia more likely than not to provide additional policy support.

Q: Recently the policy focus in Japan appears to have shifted to wage growth. How does this affect the policy outlook and what are the macro implications?

Kakuchi: Wage growth has become a key policy focus as upward pressure on wages has remained weak despite tightening in labor market conditions. In our view, this stems chiefly from structural factors that will be difficult to reverse anytime soon. For example, growing numbers of retired workers have been returning to the labor market but are working part-time with lower wages. This suggests that NAIRU has fallen. (NAIRU is the non-accelerating inflation rate of unemployment, or the level of unemployment below which inflation rises.) So we expect inflation pressures will be moderate despite robust employment growth, with inflation of only 0.5%–1%, well below the Bank of Japan’s (BOJ) 2% target.

We forecast Japan’s growth to pick up modestly toward 1% in 2016. While the regional growth outlook remains a headwind, we expect fiscal policy will be supportive. The administration of Japanese Prime Minister Shinzō Abe recently announced new initiatives that are a clear contrast from the first stage of Abenomics, which focused on beating deflation. The new initiatives focus on distributing wealth via cash handouts to the elderly and poor and building more child- and elder-care facilities. With elections to the upper house of Japan’s bicameral legislature in July, policy is likely to be expansionary, favor more wealth distribution and lead to above-potential growth this year.

Still, with inflation likely to stay well below 2%, we expect the central bank will maintain its very aggressive quantitative easing (QE) with an increasing chance of further monetary easing over our cyclical horizon. There have been concerns about the technical limits of the current QE regime – some fear the BOJ could exhaust the supply of Japanese Government Bonds (JGBs). On 18 December, however, the BOJ acted pre-emptively to ensure smooth policy implementation; it extended the average maturity range of its JGB purchases and expanded eligible collateral. That reinforced our base case that the BOJ will be able to maintain very aggressive QE and potentially implement additional easing under the current QE framework.

Q: What are the key investment implications of PIMCO’s cyclical outlook for Asia?

Kakuchi: Our investment positioning in Asia continues to reflect our expectation for further policy support across the region. Anticipating the policy tools and their impact on financial markets will be key.

In duration, we seek to benefit from the BOJ’s aggressive QE program by positioning for a flatter yield curve in Japan. Potential further QE expansion should support the long end of the JGB yield curve. Even without additional QE, we expect the BOJ will need to extend the average maturity of its JGB purchases to sustain the current pace of base money expansion.

Spajic: In foreign exchange, we believe the bullish trend of the U.S. dollar will remain intact and that the changes made to the Chinese currency regime portend additional scope for the yuan to weaken over the next six to 12 months. In fact, the further out we look the more we expect policymakers to allow the yuan to move to balance capital flows. Thus, we are positioned for a stronger U.S. dollar against the yuan and a basket of other Asian emerging market currencies.

China’s slower growth trajectory is better understood and largely priced in to macro forecasts. We have already seen significant impacts through the commodity and trade channels. That said, it may be too early to tell whether the macro “spillover” is fully understood – especially given the more volatile currency moves we have seen so far this year.

Finally, we expect dislocations in the U.S. dollar/yen cross currency basis market to persist as Abenomics continues to encourage Japanese financial institutions to shift assets offshore. Due to strong Japanese demand to borrow U.S. dollars, lending dollars by investing in synthetic dollar short-term assets such as three-month Japan T-bills hedged back to the U.S. dollar should generate attractive spreads over U.S. Treasury bills.

The Author

Adam Bowe

Portfolio Manager, Fixed Income, Australia

Luke Spajic

Head of Asia EM Portfolio Management

Tadashi Kakuchi

Porfolio Manager, Japanese Bonds



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