Letter from China

By explicitly introducing a reference to easing in their prepared statement, the ECB has cemented the market’s – and ours – expectation of a rate cut in June. What we found particularly interesting in the press conference was a sense that the central bank would be ready to tolerate some pressure on energy prices – accepting “fluctuations” around their disinflation baseline – which is welcome given the recent escalation in the Middle East.

The disinflation narrative is clear in the Euro area, it is not in the US, and we had another disappointing print for the US CPI last week. Although producer prices brought some reassurance, we feel time is getting tight to get enough confidence for the Fed to cut by June and we have brought our expectation for the first easing to July.

The real estate slump continues in China, which is consistent with the past experience of other countries: these issues don’t disappear fast. We draw on these episodes to look into China’s overall macroeconomic strategy. The US reaction to the subprime crisis was to engage in policy “carpet bombing”, with massive fiscal and monetary support. In contrast, some of the Euro area peripherals such as Spain which had to deal with a collapse in residential investment did not have the same policy space and had to resort to “internal devaluation” : they owe the success of their adjustment to strong improvement on the export side. China’s current fiscal position makes it difficult to expect there the same quantum of government support the US enjoyed after 2008. It is going to be very tempting to rely on exports to make up for the output lost to the real estate crisis. The sheer size of China in world trade makes it however difficult to expect an export-led strategy could be accepted without significant tension with trade partners. When looking for a solution to China’s current predicament, we think that a key issue is how the proceeds of stronger productivity growth could be channelled towards higher real wages, rather than lowering further the price of Chinese exports, with looser monetary policy “greasing the wheels” of the adjustment.