Jan 27: A call to monetary arms
Markets are betting that EM central banks will cut rates in earnest, but their capacity to act remains constrained by ongoing concerns over currency, capital flows and inflation
Its back to the future for emerging market central banks.
In the grip of uncertainty over the eurozone crisis and global growth prospects, market consensus hardened this week that emerging market central banks are set to turn on the monetary tap in the coming months.
Rate cuts are now in vogue, with Israel and Thailand easing this week, hot on the heels of similar action in the Philippines, Brazil, Indonesia and Chile. Meanwhile, the Reserve Bank of India was forced to maintain rates due to continued fiscal expansion a challenge Brazil, in particular, faces but made clear its easing bias.
This monetary easing cycle in EM is a volte-face from 2010 and early 2011, when emerging economies in Asia and Latin America in particular grappled with the challenge of arresting inflation in the face of strong capital inflows and relatively robust investment and consumption prospects.
But the policy calculus has shifted in the face of a darkening global backdrop. This week, for example, the IMF lowered its growth forecasts for emerging and developing economies to 5.4% in 2012, 0.7 percentage points lower than its previous projection in its September 2011 WEO, reflecting both the eurozone crisis, as well as a slowdown in domestic demand in key emerging economies.
Still, markets largely shrugged off global growth concerns this week, banking that emerging market central bankers would continue to combat the storm with monetary tools, if needed, a commitment central bankers across EM have made clear in their respective MPC statements in recent weeks.
Meanwhile, the ECBs liquidity injection for eurozone banks, announced in December, continues to give the bulls a spring in their step. To wit, EM bond funds and EM equity funds, in the week to Wednesday, saw $907 million and $3.5 billion of inflows, respectively, according to EPFR data, the biggest fixed-income inflow since the beginning of August last year. The US Federal Reservescommitment this week to keep interest rates frozen till 2014 should boost capital inflows to emerging markets and potentially widen the interest rate differential between the US and developing markets.
But at a cost. Low US rates, and potentially a further round of quantitative easing, could trigger a speculative capital inflow into emerging markets, exacerbating inflationary pressure and highlighting the limits to monetary expansion. Nevertheless, the consensus remains that capital flows will be weaker this year than last, with the IIF forecasting flows are set to fall to $746 billion in 2012, from $910 billion last year, led by a reduction in Western bank lending.
While markets are banking on interest rate cuts across the board in EM, there is significantly less scope for fiscal expansion, in China, in particular, with rising deficits and asset quality concerns forcing monetary policy to do most of the heavy lifting.
Still, on the upside, in Asia specifically, a recent report from RBC fed cautious optimism that growing intra-Asia market demand has made the region better-placed to withstand exogenous growth shocks from the West barring another global crisis.
Conversely, smaller domestic markets with acute trade and financial links with Europe, such as in central and eastern Europe, are more exposed and have fewer policy-tools.
But all EM central banks need to look beyond the positive short-term boost to economic growth, as a result of rate cuts, and ensure the longer-term effects of their policies, principally price stability, are taken into account.
There are 10 global emerging market central bank policy meetings scheduled for February. Its do or die.