By Divyang Shah
LONDON, March 20 (IFR) - Investors continue to search for clues as to how soft/hard a landing there will be for the Chinese economy/housing.
The concern, as always for a market that is long China risk, is that the expected soft landing will morph into a hard one, and it is this fear that has led markets to focus on the 'flattening' iron ore demand highlighted by the president of BHP Billiton's iron ore division.
Flattening demand will likely mean that Australia's terms of trade will eventually peak and level out, but that is only to be expected given the extraordinary rise over the last few years. It won't take the shine off the AUD, as the currency has failed to fully reflect the positive impact of the terms of trade gains since the market has persistently forecast a top on commodity prices. The AUD will remain an attractive destination for reserve managers and safe-haven seekers in an environment lacking in low-risk assets.
For risk markets, the reasons for flatter demand are important, and here BHP explains that the "economy is shifting, it's changing". The growth in demand previously related to the construction/housing sector looks now to be shifting toward household/consumption. The slowdown in China is much needed, and we would agree with RBA governor Stevens that China has the policy flexibility it needs (see "Policy flexibility = a preference for EM"; Feb 6).
"If the Chinese economy does slow 'too much', one could expect that the Chinese authorities will have both the will and the capacity to respond, the more so now that inflation has moderated," said Stevens yesterday (March 19) in Hong Kong.
An increase in noise and thus volatility is to be expected for risk assets in general as China looks to transition toward increased domestic demand, starts to consume more of what it produces leading to lower trade balances, and reduces the rate at which capital is exported.
This combination will mean that China/EM countries will start to exhibit more two-way volatility and increase the pressure to make sure capital is allocated properly, requiring a shift from a policy of targeting the exchange rate.