Emerging Markets
EMerging Challenges for Central Banks
July 24, 2009

By Manoj Pradhan & the EM economics team | London/New York/Asia

The strong worldwide rally in risky assets since March reflects not just the relief that the worst is likely behind us, but also anticipation of a return to growth for most economies. Much is expected from Emerging Markets, particularly from Asia ex-Japan, which is expected to outperform the rest of the world. Markets and investors realize, however, that not all EM economies are alike, and some will show output growth that is lower than the 1.3% growth our global team expects from the G10 economies in 2010. In this piece, our EM team discusses whether recent ‘green shoots' have changed the outlook for monetary policy, and whether the inflation outlook is likely to act as a constraint on the ability of central banks to provide monetary stimulus to their economies. Broadly speaking, central banks seem set to continue to provide monetary stimulus for the foreseeable future. Where growth is already evident, rising asset prices could give reason for central banks to be cautious. In regions that faced significant currency turmoil, the economic bottoming has given central banks some room to cut rates. Inflation is likely to be benign over the next 6-12 months, but inflation risks are not uniformly low across all countries and regions.

Challenges in line with performance: The challenges facing central banks in different EM regions vary in line with their expected economic performance. With the AXJ region expected to outperform the rest of the world by a wide margin, central banks in that region are now more worried about upside risks, given the large monetary stimulus and even sizeable fiscal stimulus, notably in China and to a lesser extent in India. The CEEMEA and Latin America regions, however, are very much focused on ensuring that the economic bottom is sustained and a recovery is entrenched.

In the AXJ region, policy rates reached their trough earlier this year, and central banks are now beginning to get concerned about risks from rapidly rising asset prices, particularly property prices. Our AXJ team expects monetary policy to stay stimulatory because central banks are unlikely to use broad tools like policy rate hikes to fight property price increases.

In Latin America, Brazil and Peru are nearly at the end of their easing cycles while Mexico, Chile and Colombia have already reached their policy rate troughs. Many central banks in the CEEMEA region, on the other hand, were forced to keep interest rates high even at the height of the global recession in order to defend their currencies. With the end of the downturn in sight, Russia, Hungary and Romania are expected to deliver significant cuts in policy rates. Both regions will likely see central banks in a wait-and-see mode once rate cuts are in place before the monetary stimulus affects the economy with its usual lag.

Inflation - dead and buried? The global recession has pushed inflation lower in most EM economies. While most teams cite large output gaps as a reason for inflation to remain under control going forward, the picture is not uniform across regions. AXJ again seems to have the most benign inflation regime. While inflation rates are likely to fall next year in the CEEMEA and Latin America regions, the levels are not always low enough for central banks to concentrate almost exclusively on growth. Uncertainty regarding the size of the output gap as well as global factors such as commodity price inflation remain risks for inflation in some countries.

Latin America: End of Easing Nears

Marcelo Carvalho, Luis Arcentales and Daniel Volberg

Across Latin America, central banks have signaled that the aggressive monetary policy easing cycle is drawing to a close as incoming data suggest that the worst of the economic downturn is behind us. Across the region, the pace of the downturn has moderated and in some cases a rebound is underway. Currencies - historically a potentially destabilizing factor - have retraced the financial turmoil-induced weakness and have stabilized at levels that are largely consistent with long-term equilibrium in a modest growth environment.  Looking ahead, a key question is the duration that central banks will maintain low policy interest rates for. Here are more detailed thoughts on the key regional economies:

Brazil: The monetary easing cycle seems close to an end, as the economy finds firmer footing. So far this year, the central bank has cut policy rates by 450bp to 9.25%, reaching nominal single-digits for the first time in decades. This came in the context of a growth slump in late 2008, which then moderated in 1Q09, with several signs of growth recovery in 2Q. For its part, CPI inflation has fallen towards the 4.5% official target center, while inflation expectations have stabilized, also consistent with the target. The central bank now looks likely to slow down the pace of easing at its COPOM meeting on July 22, after a 100bp rate cut in June. There are at least three main reasons to look for a more cautious approach on monetary policy. First, the central bank has underscored that any additional rate cuts from here will be "residual". Second, the central bank has underscored the cumulative impact of the easing already in place - so far this year, policy rates have already fallen 450bp. Third, the central bank has emphasized that there are time lags between monetary policy and its impact on the economy - the bank may thus soon turn to a wait-and-see mode, as it gauges the economy's response to monetary stimulus already put in place. Looking ahead, we expect that interest rates will remain lower for longer than the local yield curve currently implies, as we expect subdued economic activity and significant spare capacity to limit inflationary pressure in the months ahead.

Mexico: The central bank decided on July 17, after slashing overnight rates by 375bp since mid-January to 4.5%, that it was ‘taking a pause' in its easing cycle. The decision came against a backdrop of still very depressed economic activity, though the pace of the slump is easing; while signs of stabilization are far from uniform, the central bank expects an improvement in growth during 2H09. After remaining stubbornly high earlier in the year, annual inflation is trending lower, thanks mainly to persistent disinflation in services costs - a consequence of the deep economic slump - which has been partly offset by pressure in selected goods linked to the peso's depreciation. However, with the currency relatively stable in recent months, the central bank believes that the bulk of the pass-through from the currency into inflation has already taken place. Thus, looking ahead, we expect policy rates to remain low for the rest of this year and all of 2010 on the back of limited inflationary pressure due to significant spare capacity and a wide output gap.

Chile: The central bank - which has been the most aggressive in the region - slashed its target rate to 0.50% and signaled that it represented a "minimum level" that it planned to maintain for a "prolonged period of time". Moreover, it announced a series of additional measures - including a term liquidity facility for banks and suspending issuance of some short-term debt - aimed at aligning the short end of the yield curve closer to the 0.5% level. With the economy slowly approaching the point of stability, which we expect to take place in 3Q, the central bank's decision seemed driven mainly by plummeting inflation; in fact, Chile is set to experience a temporary period of deflation in 4Q09. 

Andean region: Both Colombia and Peru's central banks have signaled a pause in their policy easing cycles. In the case of Colombia, the central bank signaled a pause in its June meeting after bringing interest rates down to 4.5% in a total easing cycle of 550bp since December. In Peru, the central bank signaled the end of aggressive easing in July when it cut the policy rate to 2.0% in an easing cycle of 450bp since February. In both cases, incoming data suggest that the economic slump appears to be moderating but inflation pressures should remain subdued for an extended period on the back of significant spare capacity and prospects for a below-trend growth recovery amid a challenging global growth environment. This gives us comfort in our call that policy rates should remain lower for longer than markets now expect.

CEEMEA: Easing Relief

Oliver Weeks, Pasquale Diana, Michael Kafe, Andrea Masia and Tevfik Aksoy

Russia: We think Russia is in the process of an interesting monetary policy shift. It also remains quite out of synch with much of the rest of the world. Pre-crisis policy was dominated by FX intervention, leaving real interest rates sharply negative as capital flooded in, the CBR unable to sterilize intervention, inflation increasingly out of control, and the domestic bank deposit base weak. Just as a result of the 1998 crisis was conservative fiscal policy, we think that the government has started to accept the need for a more active monetary policy and positive real interest rates. Policy transparency is also improving, with the CBR issuing a statement for the first time with its latest rate cut and promising a more meaningful inflation report. We expect inflation to fall almost 400bp over the next nine months, allowing 200bp of further policy interest rate cuts. With the balance of payments close to equilibrium and the CBR now an active lender, rate moves are more significant than in the past. However, we also think that the government's willingness to tolerate a full free-float of the RUB remains limited and the transmission mechanism remains weak. Sharp capital flows or oil price moves should continue to prompt FX intervention that may overwhelm policy rate moves. A resumption of bank lending still looks distant to us. That the CBR has to put administrative pressure on banks to cut deposit rates in line with policy rate moves underlines that a fully conventional monetary policy is still some years away, we think. 

Central Europe: The monetary policy picture is far from uniform. Broadly speaking, there are central banks which are very close to the end of their easing cycle (Czech Republic, Poland) and others which have a significant way to go, we believe (Hungary, Romania). It is no coincidence that the Czech and Polish monetary authorities were able to proceed more boldly than the rest, given that they occupy a safer part of the spectrum of CEE sovereigns than Hungary and Romania, which display greater vulnerabilities and had to resort to IMF assistance. Recently, the improvement in market conditions has increased the likelihood that even the regional central banks which have had to be more cautious, like the NBH, will embark on an easing cycle soon (already in July, we believe). We now see 150bp of rate cuts in Hungary (see Hungary: The Virtues of Prudence, July 20, 2009) this year, and a further 150bp next year. In Romania, the central bank should continue to take rates down at a gradual pace (by a further 150bp this year), in line with slowing CPI. Overall, there are some tentative signs of improvement in the data (particularly in the surveys), but by and large central banks remain agnostic. They sound relaxed about medium-term inflation prospects, placing a great deal of faith in the power of the output gap to tame all inflationary pressures. We think that this approach could be dangerous, as there is no reliable relationship between slack and core inflation, and the size of the output gap is very uncertain. Therefore, we think that the odds are tilted towards upside surprises in CPI prints. Monetary tightening remains a distant prospect in most countries, with the Czech Republic most likely leading the pack on the way up (first hike in 1Q10), as it did on the way down.

South Africa: Tentative signs of green shoots have emerged in South Africa, with the SARB's composite leading indicator now rising for the second consecutive month (after spending 23 months in negative territory). Similarly, manufacturing production has just posted its first positive reading in a year. It is therefore not surprising that, contrary to market expectations of a growth-supportive policy rate cut, the SARB opted to keep the policy rate unchanged at its June MPC meeting. Looking ahead, it is clear that the 1Q09 currency blowout has largely been reversed over the past quarter, providing a much-needed cap to upside inflation risks. And, although we think that the currency is some 12% overvalued (see South Africa: USDZAR Fair Value: A Fresh Look, July 9, 2009), we nevertheless believe that the SARB may be willing to tolerate such strength, given the beneficial impact that this is likely to have on future inflation. However, key upside risks to inflation do exist from a normalization in the currency towards our fair value estimates of USDZAR of 9.2 in 3Q09 and 9.0 by 4Q09. Rising oil prices, high wage settlements (in excess of the inflation target) and a recent decision to raise electricity tariffs by more than 30% are worrisome too.

Turkey: There have been minor signs of recovery, but these are insufficiently strong to suggest any upcoming pressures on prices. Hence, the CBT has been rather dovish and has suggested that the easing bias will continue for some time. The currency has not only been stable amid record-low nominal and real interest rates, but has also strengthened in line with rising risk appetite. The main risk to inflation is now associated with fiscal policy measures, which have so far been confined to raising indirect taxes (which might have one-off implications). However, we think the large output gap and high unemployment rate are likely to keep a lid on inflation.

Israel: Exports seemed to have dipped and a recovery seems to be on its way, but too soon for the BoI to take pre-emptive action, in our view. But since the BoI had been one of the first central banks to ease and as rates had been in synch with that of the Fed, the future actions are likely to be close in terms of timing. We expect inflation to get in and out of the 1-3% target band in the coming months, but think it is likely to end up outside the band at above 3% at year-end. We view this as a blip for the moment, as the rise in inflation will be mostly due to one-off factors associated with various tax increases and energy prices that should receive minimal policy response.

AXJ: End of Easing, but Rate Hikes Are Some Time Away

Qing Wang, Chetan Ahya and Sharon Lam

Summary: Aggressive policy action is beginning to gain traction, with AXJ industrial production having improved to 2.8% in May 2009 from the trough of -7.5% in January. With export and IP growth trends still way below potential, central banks have little concern on inflation. Indeed, unusually low interest rates and rising excess liquidity have raised the risk of asset price concerns. However, we believe that potential concern on asset price rises in the next six months will be addressed by sector-specific measures, such as tightening lending standards for the property sector and/or other non-monetary policy measures. However, we do not expect any rise in policy rates in the region over the next six months.

China: A policy-driven economic decoupling between China and the rest of world is materializing, in our view. We upgrade our GDP growth forecasts to 9% for 2009 and 10% for 2010. Although the rapid expansion of bank credit has caused concern about the risk of inflation, we argue that these concerns are unwarranted, at least in the next 12 months, as the dominant contributing factor to headline CPI inflation is export growth instead of money growth. We forecast CPI inflation at -0.6% in 2009 and 2.5% in 2010. As recovery gains traction, concerns about potential policy change that could derail the recovery are also on the rise. However, we do not expect any meaningful policy change through 2009. Since the strong recovery has been largely policy stimulus-driven, it makes little sense to us for the authorities to make a major policy shift towards outright tightening in the absence of robust autonomous organic growth, especially when inflation does not pose a risk. Any meaningful policy tightening will be endogenous, i.e., contingent on sufficient evidence of sustainable, autonomous demand, in our view. The next 6-12 months will likely feature a mix of growth acceleration and low inflation against the backdrop of a relatively stable policy stance - a macroeconomic environment that is conducive to asset price reflation. The key risk to our base scenario lies in external demand. While strong policy responses could help to achieve a meaningful decoupling between China and the rest of the world for several years, there is no absolute decoupling as long as China remains deeply integrated into the global economy.

India: Given the current weak export and industrial production trend, we do not expect policy rate hikes over the next six months. We believe that, by 1Q10, IP growth would have accelerated to 6% plus and WPI inflation would have risen to the 5% range, prompting the RBI to start normalizing the policy rate from February-March 2010. In the near term, if asset prices rise significantly, we believe that the RBI may initiate measures to tighten lending to the property sector and also to start sterilizing excess liquidity from the banking system.

ASEAN-4: The growth trajectory has gradually begun to turn around across the region. However, except Indonesia, all the other three countries in the region suffer from very low capacity utilization levels for the central banks to be concerned about any potential inflation risks. While the growth trend remains relatively strong in Indonesia, improving balance of payments and reduced currency volatility should help to keep inflation within the central bank's comfort zone over the next six months, in our view. Apart from Singapore, we do not see any major asset (property) price challenge in the other three ASEAN economies. We do not expect any central bank in the region to hike policy rates until 3Q10.

Korea: The economy has proven to be much more resilient than expected. The adjustments in production and inventory have been aggressive but short-lived, while labor market and consumption slowdowns are very mild. Corporate earnings continue to surprise on the upside, despite weak global demand, as Korean products gain market share. As a result, the central bank does not see any more urge to cut the interest rate further after February. As the economy is stabilizing, the central bank, along with the government and regulators, has also started to speed up corporate restructuring, with the BoK warning against excessive lending.  The BoK has also made comments about asset price reflation, pointing out property price increases in certain speculative areas. That said, it does not mean that tightening is in sight because the central bank thinks that the economic sluggishness will be protracted. We expect a very moderate increase in inflation in 2010 because KRW appreciation will be more than enough to offset the rise in commodity prices.

Taiwan: Although its stock market has outperformed most countries in the region this year, the Taiwanese economy is as weak as we had expected. 1Q09 GDP was at a record low of -10.2%Y, and the latest export growth is still hovering at a disastrous -30%. As a result, although the central bank has stopped cutting interest rates since February, it is not showing any cautious stance. In fact, in its latest 2Q monetary policy statement, the CBC encouraged more corporate lending.  Inflation is not a threat, with negative CPI growth year to date, while weak demand is capping pricing power. However, liquidity conditions have always been abundant in Taiwan, and they have now become excessive due to record-low interest rates and capital inflows. We believe that the CBC will have the exit strategy ready and will raise interest rates as soon as 1Q10.

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