Emerging Risk from Emerging Economies

In recent years, China and India have emerged not only as leaders of the global manufacturing cycle, but also as the chief drivers of global growth. Some analysts fear, however, that their rapid pace may soon lead to exhaustion, and that the once rapidly growing economies will serve as incubators for the next financial shockwave.

In Asia, industrial production is running significantly above long-term trends and inflation is kicking in sooner than expected, cautions Societe Generale’s chief Asian economist Glenn Maguire.

“With China appearing to falter at the prospect of hard tightening, we believe the outlook for Asia in 2011 has now moved through the tipping point of ‘outperformance’ and into the ‘overheating’ space,” Maguire said.

With the redirection of the Asian supply chain to the “autonomous poles of growth” in China and India, there is now a “systemic linkage between overheating risks” in China and India, he adds.

The risk of overheating in China is “not something to be ignored,” reasons Michala Marcussen, another analyst at the European financial services company Societe Generale. “China will need to take steps to dampen the economy (but) it seems likely that China will remain ‘behind the curve,’ as the concern to maintain firm growth… takes precedent.”

China, Maguire notes, is currently producing “more vehicles per month than the United States, Germany and Japan combined” while Indian car sales are also surging in tandem.

“It is the sheer volume of demand emanating from China and India that has allowed Indian industrial production to recover so smartly — and India, South Korea, Singapore and Taiwan are running significantly above long-run trend production levels as of November 2010,” he said.

“The old asymmetry of Asian growth lagging U.S. economic growth is a thing of the past, and it is very clear that China and India are leading the global manufacturing cycle, and the job creation/destruction implicit to that cycle.”

In such a scenario, it isn’t surprising, he adds, that the “synchronized nature of the strong production upswing that has driven non-Japan Asian growth above potential is now making itself felt in the region’s inflation aggregates.”

Inflation in China was measured at 5.1 percent in November, well above the long-run trend, and even in India, despite some easing of pressures, inflation remains at an uncomfortable 5.5 percent.

While Maguire concedes that Asia’s quick stimulus measures have succeeded, he cautions that it is crucial that a “much more rapid unwinding of those stimulus measures, using fiscal, monetary and currency policy” is undertaken.

“China is likely to be the epicenter of an Asian bubble,” adds CLSA equity strategist Chris Wood. “The situation in the West is critical in terms of how the Asian cycle evolves. Asian governments have to be very aggressive if they really want to head off the risk of an asset bubble, which is theoretically possible in terms of much higher interest rates and allowing currencies to float freely. But most likely the outcome at present is that Asian tightening policies will continue primarily to address symptoms of the bubble risk, such as higher property prices, not the cause of it.”