Emerging Policy: Rate cuts proliferate
Emerging market central banks have clearly taken to heart the recent IMF warning that there is “an alarmingly high risk” of a deeper global growth slump.
Two central banks have cut interest rates in the past 24 hours: Brazil extended its year-long policy easing campaign with a quarter point cut to bring interest rates to a record low 7.25 percent and the Bank of Korea (BoK) also delivered a 25 basis point cut to 2.75 percent. All eyes now are on Singapore which is expected to ease monetary policy on Friday while Turkey could do so next week and a Polish rate cut is looking a foregone conclusion for November.
South Africa, Hungary, Colombia, China and Turkey have eased policy in recent months while India has cut bank reserve ratios to spur lending.
The BoK’s explanation for its move shows how alarmed policymakers are becoming by the gloom all around them. Its decision did not surprise markets but its (extremely dovish) post-meeting rhetoric did. The bank said both exports and domestic demand were “lacklustre”. (A change from July when it admitted exports were flagging but said domestic demand was resilient) But consumption has clearly failed to pick up after July’s surprise rate cut — retail sales disappointed even during September’s festival season. BoK clearly expects things to get worse: it noted that ” a cut now is better than later to help the economy”.
Analysts argue that more EM central banks could and should cut interest rates. After all, developed rates are rock bottom and falling (Australia cut rates last week and Japan is expected to ease policy again at the end of October). ING’s chief EEMEA economist Simon Quijano-Evans urges central banks in emerging Europe, especially Poland, to follow the example of Brazil and Korea. He notes:
The old argument of having high real interest rates as a risk premium simply doesn’t hold under current global conditions.
But how effective are these rate cuts? In Brazil’s case, not very so far. Despite 525 bps of rate cuts since July last year, growth this year will be 1.6 percent according to the central bank (versus the previous forecast of 2.5 percent) — that’s less that G7 nations such as the United States, Japan and Canada. In Korea, the hope is that lower rates will stimulate domestic spending and help the debt-burdened household sector. But the country’s high reliance on exports (53 percent of the economy, according the World Bank) makes it unlikely that growth can be significantly lifted. The BoK in fact acknowledged a worsening growth picture, cutting 2012 and 2013 GDP forecasts even more aggressively than the IMF did.
South Korea and Brazil have cut rates within the last 24 hours. More emerging central banks are expected to follow as growth gloom worsens Join DiscussionNo BRIC without China
Jim O’ Neill, creator of the BRIC investment concept, has been exasperated by repeated calls in the past to exclude one or another country from the quartet, based on either economic growth rates, equity performance or market structure. In the early years, Brazil’s eligibility for BRIC was often questioned due to its anaemic growth; then it was the turn of oil-dependent Russia. Over the past couple of years many turned their sights on India due to its reform stupor. They have suggested removing it and including Indonesia in its place.
All these detractors should focus on China.
China’s validity in BRIC has never been questioned. Aside from the fact that BRI does not really have a ring, that’s not surprising. China’s growth rates plus undoubted political and economic clout on the international stage put it head and shoulders above the other three. And after all, it is Chinese demand which drives a large part of the Russian and Brazilian economies.
But its equity markets have not performed for years.
This year, Russian and Indian stocks are up around 20 percent in dollar terms while China has gained 9 percent and Brazil 3 percent. In local currency terms however China is among the worst performing emerging markets, down 5 percent. Brazil has risen 9 percent.
Over the past five years, MSCI China. which makes up 40 percent of the BRIC index, has lost 18 percent, Thomson Reuters data shows. That has pushed the broader BRIC into a negative return of almost 10 percent in this period.
The BRIC equity losses and BRIC funds’ poor returns are now causing many to question the validity of the BRIC concept itself, a topic we explored in this recent article. But clearly the problem with BRIC equities lies with China and as the economy slows, more losses are likely in the short-term. The Shanghai market has taken little cheer from the Fed’s money printing-announcement, focusing instead on falling property prices locally and potential problems at Chinese banks.
BRIC equities have fared poorly as a bloc in recent years but the worst performing member of the quartet has been China which makes up 40 percent of the BRIC index. But there is no need to rule China out just yet. Join DiscussionNo policy easing this week in Turkey and Chile
More and more emerging central banks have been embarking on the policy easing path in recent weeks. But Chile and Turkey which hold rate-setting meetings this Thursday are not expected to emulate them. Both are expected to hold interest rates steady for now.
In Chile, the interest rate futures market is pricing in that the central bank will keep interest rates steady at 5 percent for the seventh month in a row. Most local analysts surveyed by Reuters share that view. Chile’s economy, like most of its emerging peers is slowing, hit by a potential slowdown in its copper exports to Asia but it is still expected at a solid 4.6 percent in the third quarter. Inflation is running at 2.5 percent, close to the lower end of the central bank’s percent target band.
Turkey is a bit more tricky. Here too, most analysts surveyed by Reuters expect no change to any of the central bank rates though some expect it to allow banks to hold more of their reserves in gold or hard currency. The Turkish policy rate has in fact become largely irrelevant as the central bank now tightens or loosens policy at will via daily liquidity auctions for banks. And for all its novelty, the policy appears to have worked — Turkey’s monstrous current account deficit has contracted sharply and data this week showed the June deficit was the smallest since last August. Inflation too is well off its double-digit highs.
But Turkey’s economy too faces headwinds, most of all from the euro zone where it sends most of its exports. Growth is slowing and there are signs the central bank as well as exporters are getting a bit restless about the currency (the lira is up 5 percent this year versus the dollar). UBS strategist Manik Narain says:
Turkey and Chile, the two emerging market central banks holding policy meetings this week, are expected to leave interest rates unchanged. Join DiscussionThe bias is for looser policy but there is no real need to cut the policy rate. They may reduce the ceiling of their overnight rates corridor to indicate they are starting to feel discomfort with the lira’s strength but for the time being their policy tools are doing their job for them.
Will Poland have an “ECB moment”?
When Poland stunned markets in May with a quarter-point rate rise, analysts at Capital Economics predicted that the central bank would have an “ECB moment” before the year was over, a reference to the European Central Bank’s decision to cut interest rates last year, just months after it hiked them. A slew of weak economic data, from industrial output to retail sales and employment, indicates the ECB moment could arrive sooner than expected. PMI readings today shows the manufacturing business climate deteriorated for the fourth straight month, remaining in contraction territory.
With central banks all around intent on cutting rates, markets, unsurprisingly, are betting on easing in Poland as well. A 25 bps cut is priced for September and 75 bps for the next 12 months, encouraged by dovish comments from a couple of board members (one of whom had backed May’s decision to raise rates). Bond yields have fallen by 60-80 basis points.
Marcin Mrowiec, chief economist at Bank Pekao says:
The market should continue to expect that the (central bank) will unwind the rate hike delivered in May.
There are two hurdles. One is inflation. Price growth is running at 4.3 percent, well above the 2.5 percent target set by the inflation-targeting central bank. That was what triggered the May rate rise.
Second, in Poland, as in Hungary, the central bank cannot afford to let the currency weaken much. A third of government and corporate debt is hard currency, while half of all mortgages are in Swiss francs. A fall in the zloty, caused by a rate cut, could raise defaults and problems for the banks. (See here for a story on Poland’s Swiss franc loan problem).
But with exports to the recession-hit euro economy providing a fifth of Poland’s GDP, Capital Economics reckon a rate cut is inevitable.
Poland's central bank may have an "ECB moment", forced to cut rates months after raising them. Markets are betting on 75 basis points in rate cuts over the next 12 months. Join DiscussionDoves to rule the roost in emerging markets
Interest rate meetings are coming up this week in Turkey, South Africa and Mexico. Most analysts expect no change to interest rates in any of the three countries. But chances are, the worsening global growth picture will force policymakers to soften their tone from previous months; indeed forwards markets are actually pricing an 18-20 basis-point interest rate cut in South Africa.
Doves in South Africa will have been encouraged by today’s lower-than-expected inflation print, coming soon after data showing a growth deceleration in the second quarter of the year. Investors have flooded the bond markets, betting on rate cuts in coming months. In Turkey and Mexico, no policy change is priced but a few reckon the former, reliant on a policy of day-to-day tinkering with liquidity, may narrow the interest rate corridor in a nod to slowing growth.
For now, all three banks could be constrained from cutting rates by fear of currency volatility and the potential knock-on effect on inflation. Of South Africa, analysts at TD Securities write:
In this environment, the odds of a rate cut to 5 percent in the near term are not negligible but… easing rates at this point would increase the risk of inflationary pressures intensifying via the exchange rate channel.
But the feeling overall is that if central banks don’t cut rates this month they will do so soon. In fact, policymakers are already behind the curve with monetary easing, says Benoit Anne, head of emerging markets strategy at Societe Generale. He reckons that with the U.S. Fed dragging its feel on QE3, worsening growth will soon overshadow any concerns for the currencies and inflation. (South Korea stunned investors last week with its first rate cut in three years). Anne says:
Few expect central banks in Turkey, South Africa and Mexico to cut interest rates this week. But they are likely to turn more dovish. Join DiscussionWe won’t get QE3 soon and a number of central banks in Asia have started shifting policy towards easing. To me that suggests we don’t need the green light from the Fed any more, there is enough justification at this point for emerging central banks to go ahead without the Fed. In some places like Mexico the economy has been resilient and the case for rate cuts is not well established. But they need to project a few months ahead as the slowdown could be considerable.
America Inc. share of GDP – 12 or 3 pct?
Wall Street has been doing pretty well in recent years. Just how well is illustrated by the steady rise in corporate profits as a share of the national economy. Look at the following graphic:
The profits share of GDP in the United States must rank as one of the most chilling charts in finance.
What this means is that around 12 percent of American gross domestic product is going to companies in the form of after-tax profits. A year ago that figure was just over 10 percent and in 2005 it was just 6 percent. In contrast, the share of wages and salaries in the U.S. GDP fell under 50 percent i n 2010 and continues to decline. Comparable figures for the UK or Europe are harder to come by but analysts reckon the profits’ share is within historical ranges.
Yet HSBC does not feel U.S. profit-GDP ratio levels are unsustainable. Analysts there argue that comparing profits to U.S. GDP alone gives an inaccurate reading because U.S. companies operate all all over the world and increasingly, their profits come from fast-growing emerging markets. There is truth in that. Just check out Coca-Cola’s results today showing Latin America sales volumes rising 3 times faster than in the home markets of North America. HSBC analysts write:
There is a widely held perception that profit levels are unsustainable. The argument goes that the profits share of GDP is high and ultimately it will mean revert. However, the profits share is not high when compared to World GDP, which we argue is the appropriate yardstick.
So compare U.S. profits with world GDP and the figure suddenly looks quite reasonable — under 3 percent. This points to a radically different picture and profits’ share here is not out of line with the historical range, HSBC adds.
Company profits' share of GDP has risen to an 85-year high of around 12 percent in the United States. But HSBC analysts argue that a more appropriate yardstick, given companies' multinational operations, should be world GDP. Join DiscussionFood prices may feed monetary angst
Be it too much sun in the American Midwest, or too much water in the Russian Caucasus, food supply lines are being threatened, and food prices are surging again just as the world economy slips into the doldrums.
This week, Chicago corn prices rose for a second straight day, bringing its rise over the month to 45%, and floods on Russia’s Black Sea coast disrupted their grain exports. Having trended lower for about nine-months to June, the surge in July means corn prices are now up about 14% year-on-year. And all of this after too little rain over the spring and winterkill meant Russia, Ukraine and Kazakhstan’s combined wheat crop would fall 22 percent to 78.9 million tonnes this year from 2011.
But as damaging as these disasters have been for local populations, their effects could be much more widely felt.
The problem is that not only do rising food prices raise the cost of living, squeezing incomes further during a downturn, but by raising inflation they severely restrict the government’s flexibility in setting monetary policy. Just as Mike argued previously on this blog that the falling oil price amounted to a green light for the cutting of interest rates, rising food prices will force many central banks to think again about the pace of monetary easing. And the problem is most acute in developing countries where the proportion of food in consumer price baskets is far higher than in the richer western economies. For example, according to the US Department of Agriculture, an additional $1 added to income sees 56 cents more spent on food, beverages and tobacco in Burundi, compared to 5 cents more in the United States.
The Russian central bank is a timely case in point when it comes to restrictions on monetary policy. On Friday they announced that they were keeping interest rates the same; as much as growth is struggling and could do with some monetary stimulus, high inflation, fuelled by food prices, is tying the bank’s hands.
Threats to the food supply are raising prices, with potentially dire consequences for emerging markets. Join DiscussionKorea shocks with rate cut but will it work?
Emerging market investors may have got used to policy surprises from Turkey’s central bank but they don’t expect them from South Korea. Such are the times, however, that the normally staid Bank of Korea shocked investors this morning with an interest rate cut, the first in three years. Most analysts had expected it to stay on hold. But with the global economic outlook showing no sign of lightening, the BoK probably felt the need to try and stimulate sluggish domestic demand. (To read coverage of today’s rate cut see here).
So how much impact is the cut going to have? I wrote yesterday about Brazil, where eight successive rate cuts have borne little fruit in terms of stimulating economic recovery. Korea’s outcome could be similar but the reasons are different. The rate cut should help Korea’s indebted household sector. But for an economy heavily reliant on exports, lower interest rates are no panacea, more a reassurance that, as other central banks from China to the ECB to Brazil ease policy, the BoK is not sitting on its hands.
Nomura economist Young-Sun Kwon says:
We do not think that rate cuts will be enough to reverse the downturn in the Korean economy which is largely dependent on exports.
Exports make up 53 percent of South Korea’s economy, World Bank data showed last year. That’s one of the highest rates in the world, far higher than China’s 29 percent or Brazil’s 12 percent. Nearly half these exports went to China. Europe and the United States – growth is looking shaky in all these destinations. Look at the figures to see how this is affecting Korea. Exports grew 19 percent last year. But in 2012 export growth is estimated at 3.5 percent, half government’s initial forecast. And correlation is high between exports and manufacturing — no wonder Korean factory activity shrank in June for the first time in five months.
Rather than reassure investors, the rate cut appears to have spooked, with stock markets falling more than 2 percent and many analysts criticising the BoK for surprising markets.
There could be a bright side. The won fell 1 percent after the shock announcement. It has been flat this year against the dollar while other Asian currencies, including China’s yuan, have lost ground. If the BoK stays dovish (which looks likely) and the won weakens more, that could help exporters compete better with Asian rivals. As Nomura’s Kwon says, ultimately the cut could limit downside growth risks via “confidence and foreign exchange channels”.
Worried about growth, South Korea's central bank shocked markets with an interest rate cut. But lower rates may offer little shelter to the country's export-reliant economy. Join DiscussionIndia rate cut clamour misses rupee’s fall-JPM
Indian markets are rallying this week as they price in an interest rate cut at the Reserve Bank’s June 18 meeting. With the country still in shock after last week’s 5.3 percent first quarter GDP growth print, it is easy to understand the clamour for rate cuts. After all, first quarter growth just a year ago was 9.2 percent.
Yet, there may be little the RBI can do to kickstart growth and investment. Many would argue the growth slowdown is not caused by tight monetary conditions but is down to supply constraints and macroeconomic risks –the government’s inability to lift a raft of crippling subsidies has swollen the fiscal deficit to almost 6 percent while inhibitions on foreign investment in food processing and retail keep food prices volatile.
The other side of the problem is of course the rupee which has plunged to record lows amid the global turmoil. Lower interest rates could leave the currency vulnerable to further losses.
It is the currency factor that should rule out rate cuts at this points, economists at JP Morgan write. They calculate that the rupee’s 12 percent plunge since March against the dollar translates into 100 basis points worth of monetary easing.
With India’s export-import sector now accounting for almost 60 percent of GDP now (up from less than 30 percent in 2000 ) that has already resulted in new export orders and an easing of non-oil imports, the bank notes.
Based on an analysis of the monetary conditions index (MCI) JPM economists conclude in fact that Indian monetary conditions have eased to well below their 2002-2007 average, possibly accounting for the pickup in headline inflation over the past two months. (The MCI is calculated by taking the weighted average of changes in short-term interest rates and the exchange rate over a period). The economists write:
Indian rupee's recent falls equate to 100 basis points of monetary easing, JP Morgan says. Join DiscussionMonetary conditions have eased dramatically over the last three months, are at their lowest level in 20 months, and the sharp depreciation of the currency is equivalent to a 100 bps reduction in market rates since March. This needs to be taken into account for those who believe more monetary easing is warranted.
Indian risks eclipsing other BRICs
India’s first-quarter GDP growth report was a shocker this morning at +5.3 percent. Much as Western countries would dream of a print that good, it’s akin to a hard landing for a country only recently aspiring to double-digit expansions and, with little hope of any strong reform impetus from the current government, things might get worse if investment flows dry up. The rupee is at a new record low having fallen 7 percent in May alone against the dollar — bad news for companies with hard currency debt maturing this year (See here). So investors are likely to find themselves paying more and more to hedge exposure to India.
Credit default swaps for the State Bank of India (used as a proxy for the Indian sovereign) are trading at almost 400 basis points. More precisely, investors must pay $388,000 to insure $10 million of exposure for a five-year period, data from Markit shows. That is well above levels for the other countries in the BRIC quartet — Brazil, China and Russia. Check out the following graphic from Markit showing the contrast between Brazil and Indian risk perceptions.
At the end of 2010, investors paid a roughly 50 bps premium over Brazil to insure Indian risk via SBI CDS. That premium is now more than 200 bps.
Moreover, at the end of 2010, SBI CDS traded on par with Russia. Now they are 130 bps higher. The premium over China is now about 250 bps, widening from less than 100 bps 18 months ago. (Markit quotes current 5-year Russian and Chinese CDS at 255 bps and 133 bps respectively)
Some of the premium is of course down to the fact that SBI is a quasi-sovereign with problems of its own. But that is insuffiicent to explain the widening gap. Clearly India’s underperformance even amid a general emerging markets rout shows this is payback time for poor policymaking.
Last year Goldman Sachs Asset Management head Jim O’Neill named India as the country that had disappointed him the most in the ten years since he coinced the BRIC investment concept.
Investors' cost of insuring exposure to India has risen far more than the other three BRICs in recent years. Join Discussion