China and India: Prospects for Recovery

The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of
the danger - but recognize the opportunity.

-John F. Kennedy

The BRIC nations (Brazil, Russia, India and China) are some of the largest emerging market economies and many are hoping that this group will lead the global economy out of the worst growth slowdown in seventy years. Russia has had a tumultuous few months. The economy and the currency have tumbled as falling oil prices, outflows of foreign investment, dramatic economic contraction in Central and Eastern Europe and growing concerns about Russian aggression have taken their toll. Brazil's situation is not quite as dramatic, but both the currency and the economy have been impacted by the global slowdown and falling commodity prices, and the economy looks set to contract in 2009. The central bank cut rates by a record amount last week in an effort to boost the economy.

There is more optimism about the economic prospects for India and China, partly from a belief that Asia is the region best positioned for a recovery and that a rising tide will lift the economic prospects of the entire region. In addition, both countries have significant consumer sectors and are consequently not completely at the mercy of their export sectors, as is the case with Taiwan and other regional economies. While I agree those reasons are valid for both countries, they are unlikely to recover at the same time or pace. That should result in varying equity and currency performance.

China: Mixed signals, but better days ahead?
After a downbeat fourth quarter, China's economy is showing some signs of life. Manufacturing has rebounded, PMI surveys have bounced, credit is expanding and auto and home sales show signs of life. However, exports continue to plummet and lower export revenues will result in a slowing of reserve accumulation. Inflation has fallen sharply, permitting rate cuts and a significant fiscal stimulus by the government. Analysts expect GDP to grow at around 5 percent in 2009. Given recent data, growth could even be higher, whereas the earlier perception was that if anything, growth would undershoot expectations. The jury is still out as to whether a true recovery can be sustained without a healthy rebound in exports. The risk is that recent signs of life are temporary, fueled by a boost in confidence caused by upbeat official statements. If that proves to be the case, the economy could slow again in Q2 or Q3, followed by a more sustainable recovery in 2010.

Despite the uncertainty, China is in an enviable position compared to most major economies. Growth remains robust even now, consumer savings are high and consumer and government debt are low. Even though the growth in reserves has slowed, China has plenty of ammunition to combat an additional slowdown. If anything, the risk is that China will divert resources towards the domestic economy by drawing down (or not adding to) external investments. China remains well positioned to participate in a global recovery and GDP is expected to grow at 9 percent in 2010.

India: Challenging times ahead
India's growth unexpectedly slowed to 5.3 percent year-on-year in the last quarter, as agriculture, exports, manufacturing and capital expenditure all fell. GDP growth would have fallen even more sharply if not for soaring government spending, which has driven the federal deficit to over 10 percent of GDP and caused S&P to downgrade India's sovereign outlook to "negative."

India has actually been helped by falling commodity prices in recent months. Should commodity prices begin to rise again (as I expect later this year), the balance of payments situation will deteriorate further, unless there is a renewed surge in foreign direct investment. That appears unlikely under current conditions, as large fiscal and external deficits are an impediment to growth and the expectation is that after growing at around 6 percent in this fiscal year, India's growth will match or undershoot that next year, in sharp contrast to China. The central bank is expected to cut rates further in 2009 in response to falling inflation and slowing growth, but that will only cushion the slowdown, not reverse it.

What are markets pricing in?
From the beginning of the year until last Friday, China's stock market is up over 16 percent in both local currency and dollar terms, as the CNY is virtually unchanged against the dollar. The consensus forecast is for the CNY to remain almost unchanged in 2009 and appreciate by just over 4 percent between now and the end of 2010 (Source: Bloomberg Page FXFC). India's stock market is down by just under 10 percent in 2009 in local currency terms and with the currency having lost over 5 percent vs. the dollar, the adjusted equity return is down over 14 percent. The consensus forecast for the INR is 48 by the end of 2009 and 45 by the end of 2010 (Source: Bloomberg Page FXFC), which equates to an appreciation of 6.8 percent and 12.6 percent respectively from current levels.

In other words, the equity market is anticipating a recovery in China, not in India, while the foreign exchange market expects the INR to outperform the CNY in gains vs. the dollar. I do expect the CNY to stay close to current levels for most of this year and believe it will appreciate by 5 to 6 percent in 2010 - slightly ahead of consensus. I am a lot less constructive on the INR; I expect it to end 2009 at 52, slightly weaker than it is now, and end 2010 at 50, an appreciation of less than 3 percent, compared to the consensus of 12.6 percent. India's current situation and prospects are far less favorable and market forces will work to weaken the INR, with the implicit blessing of the central bank.