27 June 2016
Domestic and external environment
Global financial markets tumbled after the UK voted to leave the European Union in the referendum. The ensuing political and economic uncertainties hanging over Europe, together with lingering concerns about global growth, would cast a shadow over the global economic and financial market outlook. In the US, despite the solid underlying strength of the economy and signs of inflationary pressures building up, markets continue to expect only a very slow pace of interest rate hikes by the US Federal Reserve. In the euro area, despite some improvements in growth, the recovery remains fragile. There are now uncertainties about the fallout from Brexit and continued concerns about the scope and effectiveness for further monetary easing. Similarly, in Japan, growth has rebounded but it remains highly uncertain whether the momentum can be sustained particularly given the strength of the currency. Like their counterparts in Europe, there are also concerns about the potency and side effects of negative interest rate policy. In East Asia, growth momentum generally stayed modest, with economic growth in Mainland China easing slightly on weak domestic and external demand in the first quarter of 2016. In Hong Kong, economic performance deteriorated visibly in the first quarter, dragged down by weaker domestic demand and sluggish export performance. Alongside the subpar economic conditions, the unemployment rate has edged up for the first time since July last year. The residential property market has shown some signs of stabilisation in recent months. Credit demand stayed sluggish amid the domestic economic slowdown and decline in cross-border funding activities.
Global financial markets tumbled after the UK voted to leave the European Union in the referendum. Europe is now set to face a period of heightened political and economic uncertainties. This, at a time of still-modest recovery in advanced economies and continued slowdown in emerging markets, would likely continue to cast a shadow over the global economic and financial market outlook. In the US, despite a sharp quarter-on-quarter (annualised) slowdown in real GDP growth to 0.8% in the first quarter of 2016, down from 1.4% in the previous quarter, as well as the recent release of weaker than expected job growth figures (averaged +81,000 per month in April and May), the underlying strength of the economy appears to remain solid with real consumption growth so far rebounding strongly in the second quarter. As a result of shrinking economic and labour market slack, annual growth in average hourly earnings remained close to a six-year high of 2.5% with core Consumer Price Index (CPI) inflation (excluding food and energy) trending higher to 2.2% in May. Similarly, in the UK, despite moderating growth momentum with real GDP growth slowing to 0.4% quarter on quarter in the first quarter, down from 0.6% in the previous quarter, the labour market continued to improve with the unemployment rate dropping further to a near 11-year low of 5.0% in the three months to April. Nevertheless, the huge political and economic uncertainties are now set to cloud the outlook of the UK economy. In the euro area, while growth picked up with real GDP advancing by a solid 0.6% quarter on quarter in the first quarter, up from 0.4% in the previous quarter, the recovery remains fragile amid subdued wage growth, continued debt overhang and fading support from the previous fall in commodity prices and depreciation of the euro. There are also uncertainties about the fallout from Brexit. The unemployment rate edged lower but remained high at 10.2% in April. As a result of the still-sizeable economic slack, core CPI inflation stayed subdued at 0.8% in May. Similarly, in Japan, real GDP growth rebounded to 0.5% quarter on quarter in the first quarter, up from the 0.4% contraction in the previous quarter, mainly driven by the strong rebound in private consumption. Nevertheless, with the outcome of pay adjustment in the annual spring wage negotiation expected to be modest, together with the recent strengthening of the yen, it remains highly uncertain if the latest improvement can be sustained. Inflation, as measured by the “new-core” inflation (excluding fresh food and energy), remained subdued at 0.9% in April, down from the recent peak of 1.3% in December 2015.
As prospects for growth and inflation are brighter in the US but remain more subdued in both the euro area and Japan, the divergence in monetary policy paths of major central banks is still expected to continue. In the US, the Federal Reserve (Fed) kept its monetary policy unchanged in the June FOMC meeting. Meanwhile, despite recent signs of inflationary pressure building up, driven by strengthening domestic demand and fading global and external headwinds, markets continue to expect only a very slow pace of US interest rate hikes. Indeed, the Federal funds futures now imply market expectations of the Federal funds rate to reach 0.4% by end-2016 and 0.5% by end-2017. These remain well below the Fed’s latest median projections, which were revised downward in June leaving markets prone to both inflation and interest rate surprises in the US. In the euro area, amid weak growth and subdued inflation, the European Central Bank (ECB) announced a larger and more comprehensive easing package than expected by markets at the March policy meeting. This includes new rounds of cheaper targeted long term refinancing operations (TLTROs), expansion of the asset purchase programme to €80 billion (including non-bank investment grade corporate bonds), and a further reduction of the deposit facility rate to -0.4%. Nevertheless, there are lingering concerns about the scope and effectiveness of further monetary easing given the ECB stressing that the room for further negative rate cut is limited. Similarly, in Japan, the Bank of Japan (BoJ) introduced negative interest rate policy at the January policy meeting. While the effects on stimulating growth and inflation are yet to be seen, markets have so far been critical of its potential side-effects, particularly on bank profitability and the pass-through to lower retail deposit rates and higher lending rates. The extent of these side effects would also likely pose a lower bound for the negative interest rate policy.
On the fiscal side, progress on fiscal consolidation appears to have stalled across major advanced economies. In the US, despite the continued recovery, fiscal deficit is projected by the Congressional Budget Office to rise to 2.9% of GDP in the current fiscal year (FY2016), up from 2.5% in the previous fiscal year. The projected increase is partly due to federal spending, particularly on social security, Medicare and interest payments on the federal debt outpacing growth in revenue. In Europe, while the headline government budget deficit for the euro area continued to decline to 2.1% of GDP in 2015 (from 2.6% in 2014), the appetite for fiscal austerity appears to be waning. According to the European Commission Spring Forecast, some member states, such as Portugal and Spain, are set to miss their budget deficit targets for 2016 and the structural budget deficit for the euro area is projected to deteriorate to 1.3% in 2016 and 1.4% in 2017 (after having remained unchanged at 1.0% in 2015). In Japan, the approved 778 billion yen of supplementary budget for funding reconstruction in the affected area hit by the Kumamoto Earthquake, as well as the postponement of consumption tax hike from April 2017 to October 2019, will add to the fiscal deficit of the Japanese government.
In East Asia 1 , growth momentum remained modest, weighed down by falling exports and softer domestic demand amid still-tight financial conditions in many regional economies. The prolonged weakness of commodity prices has also continued to pose a challenge to commodity exporters in the region. In Mainland China, real GDP growth continued to ease slightly to 6.7% year on year in the first quarter of 2016, with accelerated infrastructure spending partly offsetting the negative impact from weak external and domestic demand. For the region as a whole, real GDP expanded by 5.6% year on year in the first quarter of 2016, unchanged from the second half of 2015. On the price front, inflationary pressures remain benign across the region, with headline CPI inflation rates hovering at low or even slightly negative levels in several regional economies, reflecting the combination of soft global commodity prices and moderated domestic growth momentum. In Mainland China, consumer price inflation remained moderate in the first quarter despite picking up slightly from the previous quarter on higher food prices, with CPI inflation rising to 2.2% year on year in the first quarter of 2016 from 1.5% in the fourth quarter of 2015. The average CPI inflation rate in the region also stayed subdued, at 1.6% year on year in the first quarter compared to 1.3% in the second half of 2015. Facing downside risks to growth, a number of regional central banks have eased monetary policies. For example, the central banks of Taiwan and Korea cut their policy interest rates in March and June respectively, while Indonesia’s central bank has also lowered its policy rate four times in the first half of this year. Meanwhile, the Monetary Authority of Singapore set the rate of appreciation of the exchange rate policy band at zero percent in April, removing the gradual appreciation path of the band that was previously in place. In Mainland China, the central bank decided to extend its targeted liquidity support for three policy banks, which had played a major role in financing infrastructure projects, through Pledged Supplementary Lending every month starting from May. 2 Meanwhile, regional financial markets have experienced significant fluctuations in recent months. Having experienced capital outflow pressures in January, regional financial markets stabilised in March and April on market expectations of a more gradual pace of US monetary policy tightening and generally supportive economic data in the US and Mainland China. In particular, regional currencies have mostly recovered since mid-February from their troughs in January, while the MSCI Asia (ex-Japan) index has also recouped most of its earlier losses incurred in the January sell-offs. Nonetheless, regional financial markets experienced renewed volatilities in May and early June. Looking ahead, uncertainty about the timing and pace of normalisation of monetary policy in the US will likely remain a risk to financial stability in the region.
To view the full article, please go to page top to download the PDF version.