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The pace of GDP growth in China slowed to the softest rate for ten quarters overnight, although at 8.9%, the economy has hardly ground to a halt.  

Furthermore, the growth was a touch firmer than expected (market was looking for 8.7%), but as Chinese statistics go, this difference is insignificant.   Nevertheless, what China needs to see is a slowing in the pace of growth and a softening of the credit cycle, but not so much that it threatens the stability of the economy.  Video:

Furthermore, the focus of the authorities is to cushion the blow, without threatening the required reduction in inflation currently underway. As such, the data fit with our view that further policy easing is likely, but perhaps not at the speed that markets are expecting and especially so if the yuan continues to take some of the strain by reversing a degree of the appreciation seen during December.
Commentary

The EFSF downgrades arrives.   It was only a matter of time before the EFSF followed the multiple downgrades awarded by S&P at the end of last week. Its long-term credit rating is downgraded from AAA to AA+, with Germany now the only AAA guarantor.   The EFSF remains 65% over-collateralised, but the focus is on getting its replacement, (the European Stability Mechanism) up and running by the middle of this year. As such, there is a heavier burden being placed on the ECB at this point in time, as it is now effectively the only backstop left for the first half of this year. Politicians were playing down the move even before it happened, with German Chancellor Merkel stating last week that she was “of the opinion that the EFSF doesn’t necessarily need a triple-A rating”.   That remains true, but having one it certainly helps.

No berating the ratings agencies. Two interesting points from last week’s S&P statement.   The first is the acknowledgement by S&P that “the agreement is predicated on only a partial recognition of the source of the crisis”. This is based on the notion that it goes beyond just “fiscal profligacy”, but was just as much owing to the growing external imbalances and widening competitiveness gaps. We would probably disagree with the assertion that the EU has not acknowledged the issue of growing imbalances having taken several measures to tighten surveillance. However, having built up such a competitiveness gap, the solutions are out of the EU’s hands i.e. devaluation, deflation or default, or at least ones that can be officially sanctioned. The second point that S&P pushes is that “the effectiveness”¦ of European policymaking and political institutions have not been as strong as we believe are called for”. There is cause for much stronger agreement with S&P on this one, as we outlined last year (“Simple reason EU summits disappoint”). The fundamental framework of the EU is designed for a period of stability, with the EU institutions applying a light touch to the tiller in terms of leadership as countries sail along their way. They are not built for the storm in which the EU now finds itself and cannot offer the leadership and decision-making at a eurozone-wide level that’s required.   No doubt the tensions will intensify this year, but the worst thing politicians could do would be to start directing their ire at the agencies. On the macro issues above – for the eurozone – S&P is merely highlighting the shortcomings that have been true for years but that are now only seeing the bright light of day.

Palpable ECB anger at fiscal compact draft.   The European Central Bank has waded into the debate over the fiscal compact with some blunt and scathing criticism of a second draft submitted to it by European lawmakers. Leading the rebuke from the ECB has been board-member Joerg Asmussen, who claimed that it implied “a substantial watering-down of the earlier draft proposal” and that it counters the spirit of “the initial general agreement on an ambitious fiscal compact”. Representatives from Europe are working furiously to put together a ‘rulebook’ on budget discipline which they have pledged to complete by the end of this month.   Asmussen’s critique went further, with a series of suggestions that lawmakers should implement, including “ambitious and binding calendars of convergence” for sovereigns with respect to debt and fiscal deficits, automatic corrective measures should fiscal targets not be met, a tightening of the fiscal escape clause and the ability of any country to seek redress with the European Court of Justice should there be any breaches of the fiscal rules. Also, Asmussen wants all parties to the treaty to ensure that balanced-budget legislation becomes a part of each national constitution.   Of interest in terms of the stridency of Asmussen’s remarks is that there were some signs that the European Commission has already been taking a much more active policing role in the fiscal affairs of eurozone sovereigns. Witness the recent threat to impose fines on Belgium if its new government did not impose larger spending cuts after the Commission declared the growth assumptions in their draft budget too optimistic.   For investors, the hope is that European lawmakers incorporate Asmussen’s suggestions into the next draft because if they do not, then unfortunately the perception will develop that the fiscal compact is actually just another SGP without teeth.

Yuan trades at two month low.    Early Monday, the Chinese yuan fell in Asian trading to its lowest level against the dollar for more than two months. Given the latest surge in the dollar, after Friday’s S&P downgrade of many eurozone sovereigns took the wind out of the euro’s sails, this latest decline in the Chinese currency is no surprise. As we have been observing over recent months, foreign investors have been putting some pressure on the currency by reducing their exposure to both equities and bonds. Chinese stocks dropped sharply again overnight, with the Shanghai Composite down another 1.7%. The economy is losing momentum, property prices are declining and export growth has slowed markedly (not surprising given the weakening in global growth). Also, foreign exchange reserves fell by USD 20bln in the final quarter of 2011, the first quarterly decrease for almost twenty years. The yuan, which so many have argued for so long is massively undervalued, no longer looks a one-way bet. Should the dollar continue to rise, then it is entirely plausible that Chinese policy-makers will permit a further mild depreciation.

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