Rising inflation and a general shift towards higher real bond yields, led by the US, has brought loose monetary policy in emerging markets (EM) under the microscope.
There were hawkish surprises at central bank meetings in Brazil, Russia and Turkey last week. And with eight more EM central banks set to review policy this week, the EM bond market may have to digest a further shift in rhetoric.
The greatest risks of unexpected rate hikes this week appear to be in relatively small markets such as the Philippines and Nigeria. But at the very least, others such as Mexico and South Africa, are likely to be forced into more hawkish communiques.
In Turkey, the decision to raise rates proved terminal for central bank governor Agbal. Local financial markets came under heavy pressure on Monday after his sacking over the weekend. Incoming governor Kavcioglu will face a tough task to steady the ship. However, fears of contagion are likely to prove exaggerated, given that Turkey is a fairly specific story and as most other EM have more solid external positions.
EM central banks: go big or go home
There were a string of hawkish surprises at central bank meetings in major EM last week. In Brazil, the policy Selic interest rate was raised by 75bps to 2.75%, beating expectations for a 50bps increase. The Central Bank of Russia confounded expectations for it to leave its policy settings unchanged by raising its key rate by 25bps to 4.5%. And the Turkish central bank raised its benchmark one-week repo rate by 200bps to 19%, against expectations for a smaller 100bps increase.
As the chart below shows, a common thread among all three economies is that inflation is above target and rising. And headline rates are likely to climb even further in the coming months as higher food and energy costs, coupled with powerful base effects, drive-up inflation. The increase in food and energy inflation is a global phenomenon and should prove temporary. But EM central banks are less able to look through these transitory bouts of inflation, given the greater weight of food and energy in consumer price index baskets and generally poorer credibility with investors for dealing with inflation.
Inflation is rising in many emerging markets
Source: Refinitiv Datastream, as at 22 March 2021
Rising inflation has brought the spotlight onto the historically low level of interest rates in many EM. As the chart below shows, these are deeply negative in real terms, adjusted for the effects of inflation, in several economies.
This, combined with a backdrop of rising real Treasury yields, meant that EM policymakers felt compelled to act.
Low or negative real policy rates do not offer much cushion to rising inflation in many EM
Source: Refinitiv Datastream, as at 22 March 2021
In the case of Brazil, the decision to hike by 75bps was not that much of a surprise given that the market already anticipated a half-point increase. But by signalling another 75bps hike at the May meeting, policymakers are clearly minded to front-load tightening.
The decision by the Russian central bank was more of a surprise, perhaps aggravated by a probable announcement of sanctions by the Biden administration this week. But policymakers appear to have prioritised maintaining hard-won credibility with markets in recent years, and it seems likely that more rate hikes will now follow.
Could other EM central banks surprise markets?
Looking ahead, the People’s Bank of China left its loan prime rates unchanged on Monday. But with no fewer than eight more EM central banks due to make policy announcements this week, and none expected to hike rates, there is a chance of more hawkish surprises.
Perhaps the greatest risks of a surprise are in the Philippines and Nigeria given that these economies tick all three boxes of having above target and rising inflation, coupled with negative real policy rates.
Hungary and the Czech Republic also flash red in this regard and are likely to see food inflation rise significantly in the coming months. However, both central banks have historically been able to look through bouts of higher inflation and often follow the direction of monetary policy in the neighbouring euro area; which was given a dovish tilt earlier this month as Covid-19 rears its head again on the continent.
While positive, real policy rates in Colombia, Mexico and South Africa are only wafer thin and give little cushion against a probable increase in inflation in the coming months. We doubt that any will actually lift rates this week unless pressure in financial markets intensifies, indeed some analysts still expect Mexico to deliver a second successive 25bp cut on Thursday. However, there is a good chance that guidance will take a more hawkish stance than before. The least risk of a surprise is probably in Thailand given that inflation is very low.
Why a change in central bank governor in Turkey has rattled markets
After last week’s 200bps interest rate hike, Turkey’s central bank governor, Naci Agbal, was removed by President Erdogan and replaced by a relatively unknown government ally, Sahap Kavcioglu. The move sent Turkish markets into a tailspin on Monday, with the lira down by as much as 15% in early trading before strengthening back to about 7.80/$ at the time of writing. Equities also suffered heavy losses.
The fact that Mr Agbal has been replaced with a government ally is not a complete surprise. After all, President Erdogan has often spoken publicly in the past about his dislike of high interest rates and unconventional view that they cause higher inflation rather than cure it.
But the timing is a surprise. Mr Agbal only took office in November, tasked with steadying the ship after foreign exchange reserves had been depleted after the lira came under heavy pressure. He had made good progress in recent months, but what little credibility Mr Agbal had been able to build has now been shattered and the incoming Mr Kavcioglu will have to fight hard to stabilise the lira.
Outright capital controls have historically been off the table under President Erdogan, but for a period last year there were question marks over its convertibility, while several overseas banks were temporarily banned from the market. There could be a repeat if the currency remains under pressure and it is worth noting that Turkey comes into this period of turbulence with low foreign exchange reserves. Somewhat perversely, interest rates could ultimately be forced much higher than otherwise would have been the case if the lira goes into freefall.
The debt view: James Barrineau, Global Head of EMD Strategy
“The decision to remove Agbal comes after he had solidly begun to establish credibility in markets. Our positioning data showed investors had added to lira exposure aggressively as Agbal was given free reign. That suggests that the currency could fall for some time. Local rates have also jumped and the evisceration of the hard won credibility will surely lead to higher rates, a weaker currency, and higher inflation. Although unlikely, we would not rule out capital controls as a way to mitigate foreign exchange reserve outflows.”
The equities view: Nicholas Field, Global Emerging Market Equity Strategist, EM Equities
“During the 2018 currency crisis in Turkey we opined that, “In order to arrest the crisis, Turkey needs to regain the confidence of potential foreign funding sources. To do this would most likely require a combination of aggressive interest rate hikes, action to shore up the banking system and fiscal discipline….”
“As it happened, in the autumn of last year, Turkey seemed to take some of these actions with the appointment of Naci Agbal as central bank governor and the reintroduction of monetary orthodoxy, culminating in last week’s 200bps rate rise. Agbal’s replacement, Sahap Kavcioglu, appears to have unorthodox views on policy which leaves the future direction of policy deeply unclear. It is hard to see how he will be able to create the confidence necessary to be able to manage Turkey’s large funding needs over the coming months, and hence it is hard to see how pressure on the currency is alleviated.
Contagion to other EM is unlikely
Events in Turkey sent a ripple through other EM on Monday, with high beta currencies such as the Brazilian real, Mexican peso and South African rand coming under pressure. However, any talk of contagion is likely to prove exaggerated.
For a start, the sacking of Mr Agbal is a risk specific to Turkey that is unlikely to be repeated across EM. Meanwhile, fundamental external positions are generally much better elsewhere in the emerging world. As we noted earlier this year, Turkey and Colombia were two economies that stood out as having poor external positions. But on the whole, other EM are on a far more stable footing and do not face foreign currency liquidity issues in the way that Turkey does. For example, as the chart below shows total short-term external debt is less than half of foreign exchange reserves in the vast majority of EM offering insulation from any contagion.
Most EM have solid external positions
Source: World Bank, Refinitiv Datastream, as at 22 March 2021
Nonetheless, all of this underscores the need for active management to differentiate across the emerging markets.