In focus - Managers' views
Emerging Markets: Cushioning the blow
Emerging markets (EM) have some advantages over their slower growing, low interest rate cousins in the developed world. Should a global slowdown arrive, they still have an arsenal of familiar weaponry to deploy.
Central banks: fully loaded
Happily for emerging markets, monetary policy is one area where convergence with their developed market (DM) counterparts is still some way off. DM central banks face serious challenges in responding to any future downturn, as discussed elsewhere in this Viewpoint, with rates in some cases already in negative territory. Quantitative easing (QE) and other non-orthodox tools are increasingly viewed as weapons of first resort, rather than last.
In EM, however, there is no need to deviate from the tried and tested playbook. Nominal rates are universally in positive territory and in most cases so are real rates (Chart 1). Policymakers are not yet facing the constraint of the zero lower bound, which pushed DM central banks into the realms of QE. Furthermore, existing monetary conditions are not obviously already inflationary. Should the economy require support, there is nothing here to prevent central banks from acting.
Chart 1: Real rates are mostly positive in EM after a cautious 2018
Central banks across the emerging world are in this position in many cases because they took a very cautious stance in 2018. Against the backdrop of a hawkish Federal Reserve (Fed), which seemed set to continue hiking through 2019, many EM central banks oversaw a tightening of monetary conditions. Even in cases where easing occurred, it was typically modest and did not leave real rates in negative territory. Given the dovish turn from the Fed, this caution now looks excessive, providing greater comfort to central bankers who may want to ease in the face of softer global demand.
We also take confidence in this view when looking at the broader historical backdrop of EM inflation. One of the less remarked upon successes in EM is the structural decline in inflation. Notwithstanding the recent surge in inflation in Turkey (which distorts the CEEMEA picture), the story of regional inflation in EM over the last couple of decades has been one of moderation and stability. Part of this reflects the lower inflation global environment, but it is also associated with an improvement in policymaking and policy credibility in EM. This ultimately strengthens the hands of EM central banks, who can now ease for orthodox reasons (to support weak demand, or because inflation is low) without worrying that they will be accused of acting purely for political gain. They are also in a better position because with a long history of well managed inflation, expectations of future inflation also become more moderate among consumers and businesses. A rate cut therefore generates less fear of uncontrolled future price increases than it once did. Turkey unfortunately is an exception, and has considerable ground to make up in this regard.
One potential constraint for EM central banks is the currency consideration. Aggressive easing could serve to undermine the domestic currency, with a depreciation feeding inflation and so forcing an easing cycle short. A key consideration here is the interest rate differential versus the US, which is what prompted many central banks to hike, or cut short easing, in 2018. However, with the Fed also likely to be easing in any global slowdown scenario, weaker growth generally exerting deflationary pressures, and EM currencies having already depreciated substantially in 2018 and so reducing the needed adjustment, easing should very much be on the table in EM in a slowdown.
While there is a clear case for monetary space in EM, fiscal space seems a lot tighter. Year end projections for fiscal balances across EM by the IMF show that most EM economies are running primary deficits (i.e. before interest payments are taken into account) already. This does not immediately rule out the use of fiscal stimulus in a downturn – it may be possible to run a larger deficit – but it is not an encouraging starting point.
A more complete analysis of the fiscal policy space available would also consider the availability of finance and the sustainability of debt. That is, could a government borrow additional funds for stimulus if required, and would doing so lead to a spiralling debt problem. The IMF has recently conducted such an analysis, and concluded that for most EM economies there is some space (as opposed to substantial space) for fiscal stimulus.
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