Is emerging market growth at risk?
EM risky assets and currencies saw a sharp sell-off over the last two weeks. At the same time, the Bank of Israel joined the central banks of Turkey, Brazil and Russia in easing monetary policy, while China has already eased fiscally. Are forward-looking markets predicting a turn for the worse in the last bastion of the global recovery – EM growth? And is the monetary response likely to become more widespread? In our view, EM growth will still handsomely outperform DM growth over the business cycle, but it will not be immune to the downside in DM growth that appears to become more entrenched with each day that passes without a convincing policy response.
With DM policy gridlocked and growth moving dangerously close to recession as our base case, the only way to square the circle from a global perspective is either to expect EM growth to weaken meaningfully, or for EM policy to ease either aggressively or then at least pre-emptively (see Emerging Issues: Structural Alpha, Cyclical Beta, August 15, 2011). We have argued that more EM central banks are likely to respond to global growth risks by easing policy before 2011 ends. Some may worry right now about easing policy and exacerbating currency weakness, but delaying easing could put EM growth at risk and would require much more aggressive easing down the road.
Currency weakness: Symptom, not cause: Currency weakness is not something that needs to be addressed by policy-makers as an objective in itself. Rather, the recent weakness simply reflects a rise in the EM risk premium as investors take EM risk off the table due to: (i) a rising risk of economic and financial contagion from the DM world to EM economies; (ii) the reluctance or inability of DM policy-makers to respond convincingly to debt and growth concerns; and (iii) the reluctance of EM policy-makers to respond aggressively or pre-emptively to the risks to EM growth. While EM policy-makers can do very little about the first two concerns, they appear to have become more willing to address the third.
In doing so, they also address the risk premium that caused the sharp currency sell-off. Further currency weakness in line with monetary easing would then likely be orderly, not an indication of panic or de-risking. A reversal in currency weakness could come from aggressive monetary easing by DM economies (implying DM currency weakness and hence EM appreciation) or from an improvement in the prospects for EM growth and valuations. At the moment, there is very little appetite to use policy options aggressively to insulate growth, in which case it becomes exigent that easing be provided pre-emptively. A small but important set of EM economies are doing just that.
Easing is easier for some: Monetary easing in EM is not an open-and-shut case because global risks have to be balanced off against domestic issues. The global slowdown has complicated matters for many EM economies for at least three reasons. First, having just finished monetary tightening as part of a nine-month battle with inflation, the textbook prescription would be to keep monetary policy at its new, tighter stance and crush inflation expectations, sacrificing growth if need be. Inflation continues to be the primary concern for many EM economies including China, India, Brazil and Poland (among others), and an early reversal of policy tightening could push inflation higher. Second, the currency sell-off will likely worry many about their ability to cut policy rates (since this could exacerbate currency weakness), but is particularly a problem for the likes of Hungary (given its foreign currency loans – see FX Mortgage Plan Raises Deleveraging Risks, September 26, 2011) and Poland (given the impact of a weaker currency on debt, which is not far from the 55% ceiling that government is keen to avoid breaching – see “Poland: Election Preview – Poles to the Polls”, CEEMEA Macro Monitor, September 23, 2011). Finally, some LatAm central banks continue to face robust growth and would likely have kept raising rates had it not been for the emergence of global growth risks.
Traditional channels of contagion now kicking in: EM economies are vulnerable to DM woes via three ‘channels’ of contagion: (i) funding markets; (ii) traditional export and financial market links; and (iii) policy errors from DM and EM policy-makers. Our strategists have long highlighted the importance of funding markets to the EM world, whose funding needs exceed US$1 trillion over the next 12 months (see EM Profile: Channels of Financial Market Contagion – Funding Risks, August 11, 2011). Funding stress remains elevated, but not close to the levels we saw in 2008, in part because central banks have been ubiquitously aggressive in ensuring that markets stay liquid. The recent sell-off, precipitated by investors de-risking and slowing export momentum, suggests that the traditional channel is now beginning to kick in. To balance the equation, policy-makers on both sides of the economic divide need to ‘get it right’, we think.
Domestic and external momentum slowing: After many fits and starts, EM monetary tightening proceeded in earnest only from the end of 2010 when export growth surged after stagnating in mid-2010. To complicate matters, oil prices soared due to political unrest in the Middle East, and inflation rose in response to this supply shock. The combination of strong domestic and external demand gave EM policy-makers the confidence to tighten policy without putting the economic recovery in jeopardy. Mostly as a result of this tightening campaign, PMIs in the EM world have consistently fallen over the last six months. Growth expectations for many economies have moderated even though current growth prints remain robust. Finally, export momentum has slowed down considerably over the last five months. Though not yet at the stagnant levels of mid-2010, the gradient of export momentum is not encouraging at all. Domestic and external conditions thus appear to be more supportive of easing.
Is EM easing a bet on global disinflation? Given that inflation has not yet turned and growth remains strong, policy rate cuts could be seen as a risky bet that global growth weakness will be disinflationary enough to push EM inflation lower. Given that monetary policy works with lags, such ‘bets’ are almost an integral part of the process of running forward-looking monetary policy. Looking at EM-DM economic and policy conditions, this bet looks a lot less risky than when viewed in isolation.
We have pointed out the negative feedback loop between markets and the economy as an important recent characteristic of DM markets. Past policy mistakes and the ongoing inability or unwillingness of DM policy-makers to find a convincing policy circuit-breaker has been an important propagator of this negative feedback loop (see Global Economics: Dangerously Close to Recession, August 17, 2011). To the extent that DM policy-makers delay or disappoint in terms of their policy response, the probability of a DM recession (and hence a spillover to EM) rises. Less action on the DM policy side would then imply that EM policy-makers would have more to do. In other words, there exists a ‘strategic substitutability’ between the actions of DM and EM policy-makers. It is this strategic substitutability that is likely to convince many EM central banks to look through currency weakness as a symptom rather than a constraint on policy and address the cause of the weakness, the risk of EM contagion.
‘Easy Club’ – membership now open: Central banks that wish to ease will likely find it increasingly easier to do so as the ‘Easy Club’ expands its membership. While the policy rate cuts by the central banks of Turkey and then Brazil raised quite a few eyebrows, easing by Russia and then Israel has become significantly less surprising. As our Israel economist, Tevfik Aksoy, has pointed out, policy decisions by the Bank of Israel have set the trend. It was the first to ease policy in 2008 and the first to tighten monetary policy in 3Q09. This time as well, it is among the first to ease policy, a decision that is unlikely to go unnoticed in policy circles.
Plenty of options: Unlike DM policy-makers, most EM policy-makers have a plethora of options – monetary and fiscal. On the monetary side, they can ease via policy rates and reserve requirements or use FX reserves to prevent disruptive changes in the exchange rate. Indeed, a large number of EM central banks globally have been active in the FX market recently. Along with better sentiment globally, this has pushed USD/EM exchange rates higher (see EM Macro Strategy Comment: And Now They’re Selling, September 27, 2011. Reserve holdings withstood the shock to the currency in 2008 remarkably well and are well poised for an even better performance. Reserve requirements were used as a policy tool to address abundant liquidity in money markets by many prominent central banks including China, India, Russia, Brazil and Turkey (see Emerging Issues: QT, March 30, 2011) and these could be relaxed if liquidity conditions tighten. Finally, the broadest easing tool of rate cuts could and has been employed. Since the Bank of Israel first hiked rates in September 2009, most EM central banks have followed suit. CEEMEA economies were late in the cycle and carried on easing and then tightened policy only more recently. Given falling domestic and external demand momentum, easing will likely come via policy rates.
Fiscal options are abundant as well: While economies like India have used up a fair amount of fiscal leverage so that further fiscal easing is unlikely and probably counterproductive, most EM economies (particularly China and the rest of the AXJ region) have sufficient legroom to ease fiscal policy should they decide to keep monetary policy relatively tight to see off inflation.
In summary, EM easing appears to have gotten underway with a small but important set of policy-makers opting to provide small and pre-emptive stimulus. Given the lags of monetary policy and the risks of contagion coming from poor DM growth and policy gridlock, a bet that global risks will be disinflationary does not appear to be as risky from a global perspective. The recent sell-off in EM risky assets and currency values highlights the risk premium that investors still attach to the EM world, and rightly so. While EM growth will likely outperform DM growth by a wide margin, it should not be immune to poor DM performance. As global risks take centre stage, EM policy-makers will likely view currency weakness as a symptom and address the cause of the sell-off: risks to EM growth. The central banks of Brazil, Mexico and Israel are likely to cut policy rates this year, and more central banks could join the ‘Easy Club’ before 2011 is over.
Source: Manoj Pradhan, Morgan Stanley, September 30, 2011.