Ranking Tightening
It's a tough ask, particularly in EM world. Simple comparisons of how much policy rates are likely to rise deliver only part of the message, primarily because EM central banks are quite comfortable with using a variety of different instruments to nuance their policy objectives. A fair attempt at ranking central banks according to policy tightening requires a more complete view of how and how much central banks will tighten, and some idea about the risks of aggressive action over a reasonable horizon (which we choose to be the next 6-12 months).
Think locally, rank globally: Our economics teams across the world have put their local expertise to work to provide us with an overall assessment of the policy stance today as well as the one expected a year hence. The assessment of the policy stance was split into seven scores ranging from -3 for ‘very accommodative' to a score of 0 for ‘neutral' and +3 for ‘very restrictive'. Our ranking of expected tightening combines these policy stance metrics with the information embedded in how much policy rates are expected to rise. In doing so, we pay particular attention to weighing the information in policy rates by the importance our teams have assigned to interest rates in the conduct of monetary policy.
A Taylor Risk Rule? To come up with a ranking for the risk of aggressive tightening by the central bank, we adapted the logic of Taylor Rules to our team's assessment of the risk of an upside surprise to inflation and growth, and the risk of the central bank turning hawkish over the next 6-12 months. How? The ‘Taylor Risk Rule' used the risk of an upside surprise to inflation and growth in place of the usual deviation of inflation and output from the desired level. The risk of a hawkish central bank was then used to assign more (or less if dovish) to inflation relative to growth.
Clustering into quintiles: Regardless of how much attention we pay to comparability and discipline, a perfect comparison across all EM economies or a perfect way to rank economies will always remain unattainable. We therefore cluster central banks into ‘tightening quintiles' - one set for expected tightening and another for the risk of aggressive central bank action - as a way to reflect the uncertainty that will always be present in such an exercise. Technical readers should view our quintiles as the equivalent of standard error bands that are used to qualify the confidence in the estimates from statistical analysis.
Interested readers can read more about the rankings and the information they embody in a forthcoming note.
AXJ in No Hurry to Tighten
The blistering recovery in the AXJ region hardly needs any elaboration. In a recent note, we highlighted that the combination of strong growth and accommodative monetary policy was a recipe for rising risks to goods and asset price inflation (see "Hot Economies Need Policy Cooling", The Global Monetary Analyst, April 21, 2010). Central banks in the region are balancing off the persistent downside risks to a sustainable recovery in many G10 economies against strong domestic growth. For now, the downside risks in the advanced economies seem to have won out in the debate regarding tightening that is undoubtedly going on within policy circles. Of the AXJ heavyweights, the PBoC, through its constraints on new loans for 2010 and absorption of excess liquidity in the banking system (see China Economics: RRR Hike Again, May 3, 2010), and the RBI, through policy rate hikes and liquidity withdrawal, have already made a start to tightening their policies. The Bank of Korea, however, is only expected by our Korea economist, Sharon Lam, to start raising rates in 3Q10 after a series of dovish statements and on-hold decisions.
The RBI is the exception: Our ranking shows that, within the region, the RBI is pursuing a relatively tough monetary policy. However, its policy so far has been softer than we expected. On our rankings, the RBI did get squeezed into the second quintile for expected tightening, but the risk of aggressive action from the RBI is high and in the top quintile of our risk rankings. The risk of aggressive action from the Bank of Korea and the PBoC, however, is significantly lower.
The Hawks
The very top of our tightening rankings are dominated by central banks from the CEEMEA and LatAm regions. In fact, central banks from these regions hold seven of the top ten spots in the ranking for expected tightening, and seven of the top eight spots for the risk ranking.
Copom likely to outpace most... The central bank of Brazil has already showed its appetite for aggression with a 75bp hike on April 28. Even before it hiked, our Brazil economist, Marcelo Carvalho, expected a total of 400bp of rate hikes by 1Q11. Post the rates decision, the total hikes forecast remains intact so that we expect another 325bp of hikes by 1Q11. And looking over at the risk index, Brazil falls within the second quintile of central banks ranked by the risk of aggressive action, suggesting that Copom decisions will likely outpace most others.
...but probably not the CBT: Most others that is, except perhaps the Central Bank of Turkey. In its description of the exit policy, the CBT did not sound like it was in a hurry to hike rates, sounding almost dovish. On its own inflation forecasts, the first hikes could be expected in 4Q10. However, our Turkey economist, Tevfik Aksoy, believes that the CBT might have to act earlier, especially if the deterioration in inflation expectations persists. Accordingly, the CBT is at the top of both rankings - those for expected tightening and those for the risk of aggressive policy action. In line with its recently released exit strategy, the CBT has recently been withdrawing liquidity from the market. This has gone relatively unnoticed with all the attention on the exit policy. The exit policy itself shows that some of the central bank's actions, such as the widening of the spread between the weekly repo rate (its new policy instrument) and the borrowing rate, could deliver policy tightening by stealth (see Turkey Economics: A Stealth Tightening? April 14, 2010).
The other contender - Chile: The other contender in the top quintile for tightening is the central bank of Chile. With rate hikes to start in 2Q10, our Chile economist, Luis Arcentales, expects a total rise of 450bp in the policy rate to be delivered by 2Q11. As in Brazil, the risk of aggressive central bank action is quite high for Chile.
Peru and Israel, though marked out for expected tightening, make less compelling cases because of how low they feature on the risk ranking.
Indian, Russian and Colombian policy merits watching: Monetary policy developments in India, Russia and Colombia also merit a mention in the tightening rankings, given that they all occupy a slot in the second and top quintiles of our expected tightening and risk rankings, respectively. This is particularly tricky in the case of Russia because interest rates play a much smaller role in monetary policy than they do in many other economies, which makes the policy stance of the CBR particularly difficult to ascertain, track and compare.
To illustrate this, consider that the CBR just cut policy rates by 25bp on April 29 and our Russia economist, Oliver Weeks, expects it to take them lower by a further 50bp by the end of the quarter before raising rates in 1Q11. By then, we expect policy to move from its current accommodative level to a ‘just restrictive' stance. How? Monetary policy in Russia works predominantly through money supply and exchange rates, and it is these instruments that will deliver policy tightening faster than the policy rates suggest. In the rates space itself, the spread between policy and lending rates is quite large and lending rates are driven not just by policy rates but by other factors as well. Lending rates therefore may not fall as much as policy rates do. Interbank borrowing rates on the other hand, are already below the repo rate and with abundant liquidity, a further fall in these rates will not ease conditions much more.
The central bank of Colombia cut rates by 50bp in a surprise move last Friday, citing benign inflation and a large output gap. Our team believes that the rate cut and the decision to stop sterilising reserve accumulation are potentially inflationary measures. As a consequence, the first hike from the central bank will now likely happen only in 4Q10, but policy rates will have to be hiked more aggressively than we first anticipated and will likely reach 6.5% by end-2011 (see This Week in Latin America, May 3, 2010). We have already discussed the case of the RBI earlier as the stand-out central bank in the AXJ region when it comes to tightening.
The Doves
The AXJ pair: The most interesting economies at the dovish end of the spectrum are Malaysia and Indonesia. Both are part of the AXJ story and will likely show solid growth of 6.5% and 6%, respectively this year. Indonesia needs to be wary of inflation, but it has a great structural story that our AXJ team has highlighted (see ASEAN MacroScope: Cyclical Tide and Structural Disparity: Reviewing Outlook, April 27, 2010). Malaysia faces a slowdown in growth next year but has the luxury of low inflation for the next couple of years. Clearly these central banks do not appear to be in a hurry to fight off either inflation or an overheating economy, and the policy rates should be slow in their journey back to neutral.
The CEEMEA pair... Poland and Hungary feature for the CEEMEA region in the bottom two quintiles, but they are very different from the AXJ pair in that the risk of aggressive action for Poland and Hungary ranks quite high (falling in the first and second quintile, respectively). Poland faces the risk of upside surprises to inflation and growth, while the risk of inflation rising is very high in Hungary.
...and the less flexible regimes: Monetary policy regimes in Argentina (M2 targeting), Singapore (exchange rate targeting) and the UAE (fixed exchange rate) are subject to significant constraints. The Central Bank of Argentina, for example, needs to vary its interest rates in order to meet its monetary targets. MAS and the Central Bank of the UAE are subject to their exchange rate constraints and therefore follow the monetary policy of the currency they're connected to.
And the In-Betweens
The most interesting inhabitant of this grey zone is China. Even when growth slows down by 2% on our estimates in 2011, China will still have the highest growth rate among the countries we cover. What affords the PBoC the luxury of taking monetary policy slowly to neutral in spite of this growth dynamic is the benign inflation outlook. Monetary policy in China works through a mix of lending constraints, liquidity management and policy rates. Thus, while the policy rate is forecast by our China economist, Qing Wang, to rise 54bp over the next 12 months, the combination of the Rmb 7.5 billion target for new loans and liquidity management via more RRR hikes and modest renminbi revaluation will still see China through to a neutral stance. The key ingredient that sets China firmly in the middle of our rankings is the risk of aggression, for which it also lies in the middle of the risk rankings.
And the middle-of-the-pack rankings story holds for the central banks of the Czech Republic, Mexico and South Africa as well. All three are in the middle of our expected tightening and risk rankings, suggesting very few surprises on the horizon beyond what is already priced in or expected from these policy-making institutions.
Macroeconomic Implications
The absence of monetary tightening from AXJ central banks in a manner commensurate with their growth dynamic suggests that the risks to goods and asset price inflation in the AXJ region are to the upside. Most central banks there (with the exception of the RBI and to a lesser extent Bank Indonesia) have the luxury of a benign inflation outlook. With an eye on risks to sustainable growth in the G10, many AXJ central banks have been less aggressive in tightening policy. Some central banks there started using nuanced tools to quell property prices and they may have to do much more of the same. This is particularly likely to be the case if overall monetary policy continues to move very slowly towards neutral.
CEEMEA and LatAm central banks are the ones that dominate the top of our rankings. The LatAm central banks that are expected to hike are the ones that face very strong growth, which merits their desire to move relatively quickly towards neutral. Strong domestic demand and links to the robust growth in the US economy will likely stand them in good stead during the tightening process. The CEEMEA region, on the other hand, seems to have a slightly more fragile domestic demand story than Latin America. Further, it is more exposed to the persistent downside risks in Europe through trade and credit linkages. In addition, inflation concerns stemming from overheating seem broadly absent in the CEEMEA region, which makes the case for tightening a little less persuasive. Aggressive tightening in CEEMEA therefore seems to pose more of a threat to growth in the region.
Greece received a three-year EMU/IMF loan amounting to €110 billion. EMU countries will provide €80 billion in total and €30 billion in the first year (first disbursement ahead of redemption on May 19) - with an interest rate of around 5%. This fiscal package is likely to resolve the short-term liquidity issue, as Greece can avoid issuing bonds for about two years, but Greece will have to work very hard to solve its fiscal problems, which remain substantial, to reduce its long-term solvency risk appreciably.
Very strict conditionality: possible boomerang as investors have shown doubts on effective achievement. The loan is conditional upon further belt-tightening in Greece, which will have to put in place yet another fiscal austerity package amounting to about €30 billion over three years (about 12.5% of 2009 GDP) on top of the tightening already implemented. The tightening will amount to 9.5% of GDP this year alone (including previously announced measures and the portion of the newly announced measures for the first year). There will be strict monitoring of Greece's progress on the fiscal front, with Greece reporting to the European Commission and the IMF at least every quarter. The loan is conditional upon Greece staying on track in terms of deficit-reduction targets. The market reaction to the package (positive on the news, but further sell-off on the following days) has highlighted that investors have low conviction on the possibility of achieving those criteria.
Medium-term solvency challenge is set to remain in Greece. Assuming that Greece will honour the package conditions and forecasting GDP contractions of 5% and 3.5% in 2010 and 2011, respectively, we expect the debt/GDP ratio to increase from 125% to 140-150% in two years. Investors may not be willing to remain committed for so long, before having a notable inversion of the debt/GDP trajectory.
The ring-fencing of Greece may prove to be a challenging task. What is the possible backdrop for Southern Europe? The Southern European countries have experienced increasing volatility, and credit risk concerns are likely to linger, in our view. The scale of the macroeconomic challenges is greatest in Spain, while Italy looks to be in a more favourable position from a fundamental standpoint. Portugal seems mainly a contagion story at this stage, we think, as its economic and fiscal backdrop look more robust than Greece's. Moving from a static to a more dynamic analysis, we conclude that Spain is likely to be more challenged from unfavourable funding conditions, as its interest expenditure versus total revenue seems to be more sensitive to the growing stock of debt.
We noticed a complete shift of perception in the credit premia in Southern Europe: Caution is warranted. We have computed the 2- and 5-year bond yield differentials between the Southern European countries and German Bunds, analysed the 2s5s slopes of risk premia and compared them to the 5-year yield differential (5-year risk premia). We assume that yield differentials are mainly driven by risk premia. Interestingly, we noticed an important shift in trading mode between the November 2008-March 2009 period and more recently: sovereign risk premia 2s5s slopes have moved from bear-steepening to bear-flattening. In other words, investors have skewed the probability of liquidity tension to the left, as they now see debt sustainability to be more challenging in those countries.
CEE countries present better fundamentals than Southern European ones. We widen the macro comparison to beyond Greece, and look at Greece, Italy, Portugal and Spain (GIPS), comparing standard vulnerability indicators with their equivalent numbers in CEE (Czech Republic, Hungary, Poland, Romania and Bulgaria). Subsequently, we offer our view as to what would trigger contagion concern spreading to CEE, even if macro fundamentals may not warrant it.
The macro comparison suggests that on most measures of vulnerability, CEE overall fares better than the Southern European area.
i) The fiscal position is well known by now: even Hungary, with its debt/GDP ratio approaching 80%, has a debt stock which is far smaller than Greece or Italy's among the GIPS. Moreover, its primary balance corrected sharply over the last few years, and is now roughly zero. By comparison, Greece's primary balance (i.e., before interest payments) was over -7% of GDP last year (Spain's was -9%, Portugal's was -5%).
ii) The current account gaps, which were singled out as a key indicator of CEE vulnerability ahead of the crisis, have corrected dramatically in Emerging Europe as imports and dividend outflows dried up during the crisis. The correction has been so sharp that in Hungary the C/A deficit has actually turned into a small surplus. Of course, with a normalisation in credit and consumption likely to materialise in the months ahead, these gaps will likely expand again. But given how unlikely we think it is that credit will resume at its pre-crisis pace, the double-digit C/A gaps seen in CEE pre-crisis will probably not be seen again. By contrast, the external gaps in Greece and Portugal in particular among the GIPS still look high. That means they remain reliant on foreign capital to keep funding these gaps to a larger extent than CEE.
iii) Looking at external debt (i.e., the liabilities to non-residents) gives another measure (a stock, rather than a flow) of external dependency. In particular, the short-term portion of external debt (up to one year) offers an indication of how exposed these countries are to capital flight, in case non-residents decide not to roll over the debt. Hungary and Bulgaria look quite vulnerable on external debt, at 140% and 111% of GDP, respectively. But three of the GIPS (Greece, Portugal and Spain) look even more vulnerable on that score.
iv) Private sector leverage is much higher in the GIPS than in CEE. In a sense, this is not at all surprising, given that credit penetration should be higher in economies that are more developed, and that CEE remains under-banked (this is indeed the rationale for the aggressive expansion of Western European banks into Emerging Europe). At the same time, the fast rise in private sector credit in Spain and Portugal over recent years has left their private sectors saddled with debt, which will hamper the recovery. In CEE, the Bulgarian private sector also looks over-levered, given the income level. This is the result of heady credit growth in the pre-crisis period.
CEE countries have entered Stage 2 of the contagion process: Caution is warranted. Since the Greek debt-sustainability concerns took centre stage in December 2009, we have been projecting a full decoupling of CEE countries from Greece, as fundamentals looked much better and valuation more attractive in the former area. What next? The CEE region has entered Stage 2 of the contagion path (outperformance on the downside as opposed to divergence), in our view, as debt concerns have spread to Southern Europe and both positioning and valuation are much less compelling in CEE now. We expect CEE credit spreads to outperform the GIPS, if market dynamics remain unfavourable (our base case scenario), while GIPS spreads could tighten quicker, if market conditions were to improve. We believe that the risk/reward profile of long CEE credit risk has deteriorated further and do not see any attractive relative value trade between GIPS and CEE countries (i.e., buying protection in CEE versus selling protection in GIPS), as this strategy looks very much directional to us. Stage 2 of contagion warrants caution and we reiterate our cautious stance in both credit and rates. FX markets are likely to experience high volatility as well. We offer some hedges that we find attractive on the next page.
Conditions are not mature to foresee a re-coupling in CEE. Although we acknowledge that a combination of less compelling valuations and more challenging technicals will expose CEE to higher volatility (in fact we anticipated an EM correction for May), we do not foresee a re-coupling with GIPS yet. Fundamentals are stronger and CEE countries are set to outperform GIPS in a volatile environment as long as capital markets are functioning, in our view. We are monitoring the 1-year CCS basis swap in CEE countries to gauge the level of tension and do not currently see any worrisome conditions.
We believe that debt-sustainability concerns spreading to Core Europe (CE = Austria, Belgium, France and Germany) is necessary to kick off the re-coupling of CEE to GIPS (Stage 3). Given the strong correlation between Core European 5-year CDS spreads and the 1-year basis swap, we would expect a much more critical situation for CEE, if the Core European average CDS spreads were to increase towards and above 100bp (current value 65bp).
For the accompanying charts, and some strategies that we believe offer good hedging potential (in a negative environment) and limited potential loss (if concerns were to recede), see CEE - Stages of Contagion, May 6, 2010.
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