India, China ‘at risk of overheating’ in 2011

China and India are now leading the global manufacturing cycle, but they are at serious risk of ‘overheating’ in 2011 — and transmitting that risk to the rest of Asia, worry economists.

Industrial production is running significantly above long-run trend in major Asian economies, and unsurprisingly inflation is kicking in earlier than expected, notes Societe Generale’s chief Asia 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.”

And the rapid retooling and redirection of the Asian supply chain to the “autonomous poles of growth” in China and India now presents a “systemic linkage between overheating risks” in China and India with the rest of Asia, he adds.

The risk of overheating in China is “not something to be ignored,” reasons Societe Generale analyst Michala Marcussen. “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, points out Maguire, is currently producing “more vehicles per month than the US, Germany and Japan combined” — and Indian car sales are also surging.

“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.”

Purchasing managers index (PMI) readings in China and India — a measure of the health of the manufacturing economy — are in multi-month upswings, notes Maguire.

“The old asymmetry of Asian growth lagging US 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 “synchronised 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 at 5.1% in November, well above the long-run trend, and even in India, despite some easing of pressures, inflation remains “uncomfortably high” and above long-run trend.

In Maguire’s estimation, while it is doubtless true that Asia’s stimulus measures have “paid off”, the crucial requirement is for a “much more rapid unwinding of those stimulus measures, using fiscal, monetary and currency policy.”

CLSA equity strategist Chris Wood too reckons that Asian governments and central banks are going to have to be “very aggressive if they really want to head off the risk of an asset bubble in an environment where Western monetary policy stays easy.”

Such an aggressive approach, he believes, is “theoretically possible — in terms of much higher interest rates and allowing currencies to float freely.” But the most likely 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, he adds.

“The extremely easy monetary policy in the West remains a perfect ingredient for an asset bubble in Asia, which is an argument for now to remain overweight on the region,” adds Wood. However, from a longer-term perspective, the other side of an asset bubble in Asia, with China at its epicentre, is a “deflationary bust… This is why it is correct to say that an extended period of near-zero rates in the US has the potential to destabilise Asia in the sense that the long-term healthy domestic demand story is fast-forwarded into a boom-bust cycle.” In his estimation, however, the Chinese leadership as well as other Asian governments, understands the risks and will be seeking to counter it.

In 2011 Asia will become more ‘Chinese’ in one aspect, adds CLSA’s head of economic research Eric Fishwick. The second round of Quantitative Easing in the US has the potential to make the “most economic difference in economies like Indonesia and India, which historically have had high cost of capital and constrained bank balance sheets.”

In 2011, he expects to see “more and more aggressive interference in property markets and attempts to control banks’ ability to lend.” There could, he adds, also be an increase in the use of capital controls to restrict inflows into monetary systems at source, as happens in China. In that sense, he expects the rest of the Asian region “to become more ‘Chinese’ in how it administers banking systems.”