Emerging markets – higher for longer
This post is a guest contribution by Manoj Pradhan of Morgan Stanley.
EM economies have had quite a ride over the last few years, but 2010 has been exceptional not just because growth has been strong, but also because it has been strong with no major hiccups along the way.
2011 is likely to be slightly different: With excess capacity now largely gone or going very quickly, unbridled growth is no longer an option. Accordingly, we set out five themes for emerging economies for 2011: i) EM versus DM growth rebalancing, led by cyclical EM underperformance; ii) Rebalancing within the EM world as economies move towards sustainable growth without overheating, which means lower growth for some, higher for others; This salutary rebalancing will allow EM growth to remain higher for longer; iii) EMflation scare means markets will likely worry about inflation even though core measures remain benign; iv) Second stage of monetary tightening as EM central banks move beyond just removal of extraordinary monetary stimulus to reduce monetary easing even further, but stop short of a tight policy stance; and v) Capital flows to continue, FX appreciation trend to persist and mild capital controls to be put into place.
Three main risks: The risks to these calls are that: i) EM inflation turns out to be more difficult to deal with; ii) DM growth surprises to the upside, causing EM policy-makers to tighten policy; and iii) Euro-zone periphery problems spread to the core and then to funding and/or export markets.
As the BBB (Bumpy, Below-par, Brittle) recovery in the G10 continues, the focus remains on the EM world as the engine of growth. Our year-ahead note today suggests that EM economies will remain the drivers of global growth, but the glaring outperformance will be toned down somewhat this year. Inflation worries, removing some of the monetary accommodation and currency appreciation in response to capital flows should keep growth in the EM world from overheating – a salutary development.
Theme #1: EM versus DM Growth Rebalancing: EM Underperformance in 2011
Absolute EM Outperformance Is Structural…
The absolute economic outperformance of emerging markets (EM) over developed markets (DM) should come as no surprise to anyone. Given the structure of emerging markets and the vast pockets of under-utilised resources, growth rates of 3% or thereabout which represent trend growth in most DM economies can feel like a recession to many EM economies. We expect the absolute outperformance of EM markets over DM markets to continue as a structural story.
…and Relative Underperformance in 2011 Is Salutary
On a relative basis, however, we expect the degree of this outperformance to narrow in 2011, thanks to EM underperformance. In other words, the ‘spread’ between DM and EM growth should narrow even though DM growth is likely to fall from 2.6% to 2.2%. EM growth, on the other hand, will likely fall 1pp from 7.4% to 6.4%. The narrowing spread between DM and EM is therefore more of an EM story than a DM one. The AXJ region, with a 30% weight in the global economy and a 60% weight in the EM world, naturally dominates EM growth dynamics. We believe that a slowdown in the blistering pace of growth in the AXJ region and an even bigger fall in the smaller LatAm region will pull EM growth down to more sustainable levels and prevent overheating. The DM world, on the other hand, may actually see a small step up in growth if the newly proposed tax cuts in the US are implemented.
Policy Support and the Balance of Risks Supports the Narrowing DM-EM Spread
With the notable exception of the euro area, where uncertainty is still quite high, the balance of risks for the rest of the G10 now appears to be tilted to the upside in 2011. We believe that monetary policy will continue to stay its course and provide AAA liquidity, and fiscal tightening seems more popular in market debates than it is with policy-makers.
In the EM world, however, the biggest risk is that of overheating. Central banks in the fastest-growing EM economies have stayed away from too much tightening as they balance strong domestic demand against weak G10 (and particularly US) growth. If the upside risks in DM materialise, that could also be the trigger for faster-than-expected EM tightening in order to prevent a ‘double whammy’ of domestic demand- and export-led overheating. The balance of risks and the policy reaction to them also support this rebalancing.
External Rebalancing Already Underway
In addition to the coming growth rebalancing, a rebalancing of global current account imbalances has already begun. Many of the current account imbalances in the world have started to resolve themselves to less extreme levels, and we expect this theme to be an important one over 2011. As we have pointed out, the presence of current account imbalances themselves is not a reason to worry. Rather, it is only when these imbalances are the result of excessive consumption or savings or excessively risky investment that the problem arises. And it is precisely here that much of the necessary rebalancing seems to be occurring, with savings in the US rising and the contribution of consumption to growth likely to rise in China.
Theme #2: Rebalancing Within EM: Convergence of Growth Rates
Global rebalancing isn’t the only rebalancing show in town. There is a trend towards rebalancing within the EM world as well. As always, it is a mistake to paint the entire EM world with the same brush. A little less vulgar generalisation is to split the EM world into two blocs – a first bloc of countries where the output gap is closed or positive, and a second where the output gap has yet to close.
At first glance, the number of EM countries where the output gap is closed or positive appear to be rather small, but their size accounts for three-fifths of the EM world. There are several countries where the output gap has yet to close and a few where the output gap is quite large still. Clearly, policy-makers would prefer to slow down growth to a sustainable level where the output gap is positive, as is the case for China and Korea. In Brazil, India, Poland, Peru and Taiwan, policy-makers would like to stay as close to a closed output gap as possible and are likely to resist strong growth going forward. Policy action here is likely to just tap on the brakes to ensure that growth does not surge again with the output gap already closed or even positive.
For the numerous countries whose output gaps are yet to close, growth has already been robust in many countries, but a temporary increase in growth until the output gap closes can be accommodated and is unlikely to worry policy-makers too much. Accordingly, we believe that the focus here will be on keeping policy from being excessively accommodative but accommodative enough to keep growth supported. The notable exceptions here are Hungary, Romania and Mexico, where the output gaps are still wide and negative and any and all growth would be welcome. Russia also has a wide output gap, and in spite of inflation concerns probably prefers to see higher growth for the near future. Another exception where the output gap isn’t wide but policy-makers are focused on keeping policy as accommodative as possible is South Africa, where policy rates have recently been cut by 100bp to keep the currency from appreciating and taking away the impetus to growth.
In summary, the difference in the strategies that policy-makers have adopted in the two blocs will likely push growth in both blocs to a sustainable level. Over 2011, this should lead to a convergence of growth rates towards sustainable levels in the EM world, allowing EM growth to stay higher for longer.
Theme #3: EMflation Scare
Looking from a different perspective, EM countries are fairly evenly divided among countries that have inflation concerns and those that do not. However, the percentage of the EM world that has inflation concerns is quite lopsided. With the heavyweights like China, India, Brazil, Russia, Korea and Poland all in the ‘inflation concerns’ camp, it is no surprise that four-fifths of the EM world falls into this category. Markets are particularly concerned that rampant growth here will create inflation problems. Yet, we are more sanguine about EM inflation for three reasons:
• First, inflation in only four economies under our coverage (Argentina, Brazil, Indonesia and Saudi Arabia) is both high and driven by the factor that policy-makers are most likely to move against – domestic demand. In all other countries where inflation is a concern, it is the food and/or energy-related components of inflation that have pushed headline numbers high, whereas core measures have stayed soft. Clearly, the inflation concern is present because of the risk of food and/or energy inflation slipping into core measures, and that is what policy-makers are moving to prevent.
• Second, early inflation problems like the one in India have been successfully kept under control – core inflation there is now manageable whereas food inflation is heading lower after a good agricultural season.
• And finally, since inflation is a slow-moving variable and subject to base effects in year-on-year calculations, it is not unusual for inflation to turn down only slowly. Markets are usually convinced that inflation is under control when inflation turns down – evidence of that comes from the high correlation of many surveyed measures of inflation expectations to current inflation levels.
In summary, we expect an EM inflation scare rather than a full-blown inflation crisis or even the prospect of inflation derailing growth by prompting policy-makers to aggressively lower growth in order to quell inflation. With ultra-accommodative policies in the DM world, the risks however remain skewed to the upside.
Theme #4: Second Stage of EM Monetary Tightening
The first stage of EM monetary tightening was about getting policy rates away from ultra-accommodative levels as part of the policy stance against the Great Recession. As global growth consolidates, EM tightening begins its second phase, to make monetary policy less accommodative but stop short of making it outright restrictive. The one thing that allows central banks to act less aggressively is that most of the inflation in the EM world is in food and energy prices rather than core measures, as discussed above.
EM central banks constrained by internal versus external balance, and the trilemma: But monetary policy in EM economies isn’t a simple unconstrained optimisation problem. Central banks there are working under at least two constraints. First, they are balancing off strong domestic growth against weak DM growth. The BBB recovery in DM markets, uncertainty in the euro area and the mid-year slowdown all led EM central banks to slow down the pace at which they might have wished to tighten policy. Second, the constraints of the trilemma (discussed further below) have also kept EM central banks from tightening policy too much for fear of attracting even more capital flows and pushing currency values higher.
Once again, how quickly and how much policy-makers remove monetary easing depends on which bloc the economy belongs to. And this can be seen more readily in the first bloc of countries where output gaps are closing rapidly or have already closed. In economies, particularly in the AXJ region, where policy-makers want to cap growth and inflation, the emphasis appears to be on keeping growth from rising further or bringing it just a touch lower but not materially lower. In the second bloc, where growth will not raise as many eyebrows in policy-making circles, monetary tightening is likely to be limited, in our view.
Our forecasts bear out the two-bloc view: If our forecasts are anything to go by, this story is borne out to a large extent. In the EM world we cover, six central banks are expected to raise rates by more than 2% over 2010-11: Turkey, Israel, India, Brazil, Chile and Peru. Of these, only Turkey and Israel have output gaps that have not yet closed. Our colleague Tevfik Aksoy, who covers both countries, expects Turkey to start hiking rates quite rapidly only towards the end of 2011 (by which time the output gap will have closed), while Israel has been raising policy rates very gradually from a historically low level as a process of ‘normalisation’ of policy rates.
But what of the others whose output gaps have already closed or are positive? In Poland, our economist Pasquale Diana expects rate hikes to happen sooner rather than later, while our Korea economist Sharon Lam has long been suggesting that the Bank of Korea would find it useful to raise policy rates at a faster pace in order to ward off inflation in the future. And finally China. The PBoC is particularly constrained by the trilemma, given its strictly controlled exchange rate, and hence does not depend on policy rates as much. Instead, it relies directly on setting credit quotas. As it moves to keep inflation under control, the credit quota for 2011 is expected to be lower at Rmb7 trillion.
Tools of Monetary Policy
As the China case points out quite clearly, it is important to keep in mind that EM policy-makers do not rely on interest rates to as large an extent as their DM counterparts. Partly, this is because they are less reluctant to use other tools like restrictions on credit. However, the use of a wider range of instruments also stems from the fact that EM economies tend to be more exposed to trade, which makes exchange rates an important variable to control, and also that money and financial markets are not as organised as their DM counterparts so the use of more monetary instruments is almost a necessity. In the AXJ and LatAm regions, for example, central banks are more willing to take a more proactive role with the banking sector and either guide or set credit controls. This gives central banks there very powerful tools to control economic activity that are not reflected in policy rate moves.
Theme #5: Continued Capital Flows, FX Appreciation, Mild Capital Controls
Capital flows to the EM world are a natural consequence of the economic outperformance, the two-track nature of the global recovery and the second stage of EM monetary tightening. In turn, this means that EM policy-makers have a hard battle on their hands with the trilemma – a constraint that allows policy-makers to choose only two out of the trio of mobile capital flows, a fixed exchange rate and an independent monetary policy. The trilemma has been on our radar since early 2010 and its constraints have been frustrating more and more as capital flows have surged to chase better-quality returns in the EM world.
Currency War? No. Trilemma? Yes
A now-famous example of the frustrations that the trilemma can create for policy-makers is the declaration by Brazil Finance Minister Mantega calling the trend of rising EM currency values a “currency war”. Rather than being the result of a retaliatory escalation of currency tensions, the “currency war” is essentially a result of the constraints of the trilemma. Faced with large capital inflows and a need to lift domestic interest rates to keep economies from overheating, EM policy-makers have had little choice but to let currencies appreciate. And they will continue to face similar pressures if their growth outpaces the DM world or their policy rates keep rising. One of the two seems imminent for the EM world, and so does the prospect of continued capital flows and more worries about currency appreciation.
Capital Controls: Limited Effectiveness
Chinese policy-makers, with their comprehensive system of constraints on capital flows and domestic credit, have successfully avoided being shackled by the trilemma, as did the global economy during the Bretton Woods era and its regime of ubiquitous capital controls. However, unless applied as comprehensively as in China or universally as was the case during Bretton Woods, capital controls have a limited shelf life and limited effectiveness. A recent IMF report (see Capital Inflows: The Role of Controls, February 19, 2010, for more details) suggests that capital controls tend to affect the composition of capital inflows rather than their overall size.
Balassa-Samuelson and Structural EM Real Appreciation
The cyclical pressure on EM currencies discussed above is in sync with longer-term pressure on currency appreciation from the Balassa-Samuelson effect. Given higher productivity in EM economies, policy-makers there are going to have to let their currencies appreciate and/or allow higher inflation over a longer period. EM currencies will therefore tend to appreciate in trade-weighted terms on a longer-term basis, unless they are willing to tolerate higher inflation, which is possible but less likely, in our view.
Three Main Risks
Downside risks to the EM world and our 2011 outlook come from three sources – one from within the EM world but two from DM economies: i) More serious inflation risks in the EM world; ii) Much stronger-than-expected DM growth; and iii) Contagion of the euro-zone’s problems from the periphery to the core, and then to the rest of the world.
Inflation spreads to core measures: As noted above, inflation concerns in EM countries right now are still dominated by domestic demand in a handful of countries. In most other countries, food and/or energy prices are the ones that have inflated while core measures have remained subdued. Any spreading of inflation pressures to core measures will most likely invite a much stronger response from central banks, which could then push EM growth much lower than we expect.
Upside risks to DM growth: Policy-makers have been balancing off strong domestic growth against weak DM growth by tightening policy very slowly. Should the upside risks to DM growth materialise, this balance will be upset and policy-makers will probably push policy tighter rather rapidly. Note that, even here, policy-makers could get their policy moves just right in order to keep EM growth from falling because exports will likely also rise along with DM growth. Should a stronger dollar accompany stronger-than-expected US growth, EM policy-makers should find it easier to raise rates in an environment where EM currencies are falling or at least steady against the US dollar.
Euro-zone periphery problems spread to core: Finally, one of the risks that our global outlook has highlighted is a spreading of euro-zone periphery issues to the core. Should this contagion occur, it could spark further weakness in funding markets that EM economies rely on, or could spread to other parts of the world through weaker trade.
Source: Manoj Pradhan , Morgan Stanley, December 17, 2010.
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