Mark Lister: World's central banks in conflict with Fed

How do Asian markets view recent central bank intervention around the world and what perceptions do they have of long-term regional economic trends? A meeting in Auckland with Michael Spencer, Deutsche Bank Asia's chief economist, gave some useful insights.

Hong Kong-based Spencer, who has been with the bank for 13 years, oversees economics, foreign exchange, fixed-income, commodities and credit market research in emerging Asia (including China and India), Japan and Australia.

Spencer worked at the International Monetary Fund (IMF) in Asia during the region's late 1990s financial crisis, so he has a good understanding of how central banks operate.

In his view, the key policy issue in the short term is the management of capital inflows into small, open, emerging-market financial systems. Central banks want policy independence in an environment of prolonged zero-rate policy in the United States and they are looking increasingly at capital controls to achieve this.

One area of concern is that high capital inflows from the US into emerging markets could lead to emerging-market asset bubbles.

Excess global liquidity, a weak US dollar and an ineffective monetary-policy tightening response from central banks in emerging markets would all contribute to such an outcome. A key indicator to watch is inflation pressure in emerging Asian economies.

Although acknowledging the risk, I would point out that the large inflows of capital come off a relatively low base and many global fund managers are only moderately weighted to the emerging world. Inflation, therefore, is simply a risk to be aware of, rather than an expectation.

Currently, there is a conflict between most central banks, which are tightening (raising interest rates), and the Fed, which is loosening (keeping interest rates at accommodative levels - virtually zero).

Some are questioning whether the US actually needs such stimulus, given the economy is achieving gross domestic product growth of about 2 per cent, which isn't far off trend growth. Others would argue that off such a low base, trend growth is not good enough.

Many central banks are criticising the Fed for essentially trying to devalue the US currency and they are also conscious that periods of crisis in emerging markets have tended to follow periods of loose US monetary policy.

This loose Fed policy has the potential to lead to increasing inflation, credit growth and the aforementioned asset bubbles.

If problems do arise, it will likely be when the US starts to tighten and raise interest rates. While this may not begin until late next year, or even early 2012, the risk is that the Fed continues to ease for another six months and inflation rises faster than expected, which forces the Fed to raise rates and withdraw its stimulus quickly. This could have negative implications for markets and growth.

However, if inflation does rise quickly, it is of some comfort that the Fed can tell banks to increase reserve requirements from 10 to 15 per cent, as Asian central banks have done in the past, to curb excess credit growth.

This is a strategy that China has used aggressively of late. China increased its banks' reserve requirements twice last month (taking it to five increases so far this year), raising it to 18.5 per cent as it tries to rein in inflation.

China's inflation rate increased to 4.4 per cent in October from a year earlier, the fastest pace in two years, driven largely by food costs, and well above this year's target for average inflation of about 3 per cent.

Spencer doesn't believe the Fed is trying to inflate its way out of trouble with its stimulus and quantitative easing (QE) and points to the average maturity of government bonds being relatively short. The only way a government or central bank can inflate their debts away is with "unexpected" inflation.

Markets are acutely aware of the risk of inflation and if they felt the Fed was trying to inflate the US Government's debt away, interest rates would rise significantly and quickly. The Government would then be forced to pay these higher interest rates when it rolled over its debt or sought to issue new government bonds.

The Fed clearly wants the Chinese currency to appreciate so it can shift some growth away from China and back to the US. China has a different view. It sees itself as the less wealthy country and would prefer to keep all of that growth for itself.

Spencer is expecting only a slow creep at best with regard to the Chinese currency, with gradual 3-4 per cent appreciation over the next 10 years versus the US dollar.

On the global front, he notes that while growth has slowed in the third quarter, it is far from a double dip and he is not expecting one. His team is forecasting 2011 growth in China of 8.7 per cent, India 8.1 per cent and the rest of emerging Asia 4.6 per cent.

This compares with 3.6 per cent in New Zealand and 3.2 per cent in the US. Spencer believes China and India are important for Australia and New Zealand. He retains a positive view on the commodity theme both countries are exposed to and sees it lasting another 10 to 20 years.

He believes the long-term growth potential in China continues to be underestimated and that investors should remain conscious of the demographic underpinnings of Asian growth.

During the past 10 years, China has focused on achieving GDP growth of 8 per cent a year and it has got closer to 10 per cent. Over the next 10 years, China is looking for a higher quality, a more sustainable level of growth, about 7 per cent a year and, again, there is the potential for actual growth rates to exceed expectations.

In China, about 40 per cent of the workforce are underemployed and the agricultural sector provides one of the biggest opportunities for a shift in employment demographics.

It is estimated that of the nation's 325 million agricultural workers, about 180 million are aged 40 or younger. Add to this youthful workforce the 52 million unemployed members of the rural population and you have a total of 232 million.

The Chinese Government estimates that with proper agricultural technology, they would need only 90 million agricultural workers. This means that the potential supply of young migrant workers available to take on other jobs is an astounding 140 million. This compares with 131 million migrants that China has seen over the previous 20 years.

In India, the potential underemployment is even more pronounced, with estimates ranging as high as 500 million surplus farmers. While China is often the focus when talk of "new world" growth ensues, India has equally strong prospects, with the potential to achieve trend growth of about 10 per cent a year in time.

Although short-term growth is likely to be strongest in China, over the medium term, and certainly on a 20-year view, India could well surpass China.

* Mark Lister is head of private wealth research at Craigs Investment Partners. His disclosure statement is available free of charge under his profile on www.craigsip.com. This column is general in nature and should not be regarded as specific investment advice.