To get a better handle on measuring and tracking the de facto policy stance in the BRICs implied by the interest rate and exchange rate developments, we have estimated monetary conditions indices (MCIs) that combine the effects of interest rate and exchange rate changes on the economy. If our estimated MCIs are anything to go by, the BRIC economies showed fairly different dynamics in monetary conditions in both during the Great Recession as well as the recovery.
In a nutshell, our MCIs are weighted sums of market interest rate and exchange rate changes designed to provide a measure of the de facto monetary stance in an economy. An increase (decrease) in the value of the index suggests that monetary conditions have tightened (eased). While the absolute level of MCI provides no information as to whether the monetary stance is expansionary or contractionary, changes in the MCI between any two points in time reflect a tightening or easing of monetary conditions over that period. On request, we are happy to provide our clients with a user-friendly spreadsheet to test the impact of interest rate and exchange rate scenarios on monetary conditions in the BRIC economies.
The onset of the Great Recession: During the early part of the Great Recession, EM central banks seemed reluctant to imitate the aggressive monetary easing embraced by their G10 counterparts as the problems were (rightly) seen as emanating from within DM and as the EM decoupling thesis was quite popular. However, when rising risk-aversion led to capital flight from EM and the EM economic data started deteriorating, EM central banks were just as aggressive in slashing policy rates, often to historical lows for most EM central banks. However, as the evolution of our estimated MCIs and their two components - interest rates and exchange rates - illustrate, the responses by the BRICs were quite varied:
• China: The PBoC responded to growth concerns with rapid rate cuts and an easing of credit controls in October 2008. While market interest rates plummeted in sync with the policy rate cuts, the effective exchange rate kept overall monetary conditions from easing rapidly until as late as 1Q09. The easing in monetary conditions was relatively mild. However, this understates the true extent of monetary easing because the easing of credit controls and the large increase in the quantity of loans, a significant instrument in delivering monetary stimulus, are not reflected adequately in prices that drive the MCI.
• Russia: The plunge in global growth and oil prices led to a large depreciation in the exchange rate. Using intervention in foreign exchange markets and higher policy rates, the central bank was successful in stabilising the value of the currency. Once stability was achieved, the CBR proceeded to cut policy rates, effectively offsetting the slow appreciation of the effective exchange rate. On a net basis, monetary conditions have stayed at easy levels, helping to consolidate growth in Russia.
• India: Even though policy rate cuts from the RBI arrived only in October 2008 (around the same time as in many other EM economies), monetary conditions in India began to get supportive much earlier as the effective exchange rate depreciated from early 2008. The rate cuts in October 2008 only added to the easing bias already in place and formed an important part of the resilient front that India was able to show against the global slowdown.
• Brazil: The sharp depreciation of the effective exchange rate starting August 2008 and the subsequent rate cuts starting January 2009 provided a rapid easing of monetary conditions in the Brazilian economy. Even though the exchange rate rebounded quite quickly, sustained cuts in policy rates from 13.75% in December 2008 to 8.75% by July 2009 kept monetary conditions from rising as quickly.
The great EM rebound: Once it became clear during 2009 that aggressive policy action in the G10 had averted a Great Depression and that the global economy was on the mend, EM central banks started to prepare for an exit from easy policies. Yet, as on the way down, they again moved at different times and speeds, as illustrated by our MCIs:
• Brazil: Of the BRICs, the Brazilian economy has seen the most tightening, with 200bp of hikes in the policy rate (with a further 25bp of hikes expected when the Copom meets later tonight) to add to the appreciation of the exchange rate that started much earlier. The tightening of monetary conditions has almost reversed the easing of the previous years. The process hasn't been easy, however, and the central bank has expressed concern about "excessive" currency appreciation in response to its tightening campaign.
• India: Fighting an obvious inflation problem, the RBI has raised policy rates by 100bp. It too faces a situation similar to the central bank of Brazil in that capital flows attracted to its rate hikes and strong economic performance have led to currency appreciation, making it more difficult for the central bank to hike rates aggressively.
• China: The de-pegging of the renminbi over the summer hasn't yet translated into the steady and modest appreciation that most participants were expecting. Our China economics team expects the appreciation to occur slowly against an evolving backdrop of a softening of the policy tone in 3Q10 followed by an easing of lending constraints in 4Q10. With a relatively slow-moving exchange rate and no hikes in policy rates through 2H10, monetary conditions in China in the narrow sense of our MCI are unlikely to rise quickly. The recent volatility in interbank rates and appreciation of the effective exchange rate have tightened conditions somewhat recently.
• Russia: The CBR was the last of the BRIC central banks to start and finish cutting rates, and the need to provide support to economic recovery means that monetary tightening in Russia has not yet started. Despite a slowly appreciating currency, downward pressure on interest rates has meant that monetary conditions are still at easy levels.
Back to pre-crisis levels? Monetary conditions are still not back to their pre-crisis levels in any of the BRIC economies. The central bank of Brazil has come the closest to establishing conditions that prevailed before the Great Recession. These would represent tighter conditions than Brazil has had over most of the last decade, however, and will likely support the slower tightening of policy that our Brazil team expects. In India, conditions are still shy of pre-crisis levels but this should mean reverting back to a stance that is more or less in line with the one that has persisted over the last decade. Monetary conditions in Russia remain solidly below pre-crisis levels.
Looking ahead: The central bank of Brazil seems to be first in line to take a breather from monetary tightening. Risks to growth there have increased not just because of its aggressive campaign to normalise policy rates, but also due to the expiry of fiscal stimulus measures and the possibility of a drag on growth from US economic growth in 2H10 (see US Economics: Changing Our H2 US Growth Outlook, August 27, 2010). Our economists expect policy rates and currency values to rise a little further still, with a 25bp hike expected at its meeting tonight, and an additional 150bp of hikes expected next year. Monetary conditions are therefore expected to stabilise sooner in Brazil. In India, with inflation still a threat and no sign of a 2Q slowdown (unlike most AXJ economies where growth has slowed for the better - see "Good Slowdown, Bad Slowdown", The Global Monetary Analyst, August 25, 2010), our economists expect the RBI to raise rates a further 50bp this year and 125bp next year. Monetary conditions in India too are expected to stabilise some time in 2011, albeit after Brazil.
At the other extremes, again, are China and Russia. Our China team expects policy easing through 2H10 via a softer policy tone and looser credit constraints. However, with the team expecting the CNY-USD exchange rate to go to 6.20 by end-2011 and no rate hikes through 2H10, monetary conditions should tighten at a modest but consistent pace going forward. Russia, having only just completed its policy rate-cutting cycle and achieved stability in its currency value, has it all to do when it decides to tighten policy. Our economics and strategy teams expect 75bp of rate hikes by end-2011, starting in 1Q11, while the currency is also expected to appreciate. The dual tightening will likely produce a relatively sharp tightening of monetary conditions if interest rates and exchange rates evolve according to our forecasts.
Emphasis on consolidating growth: On a global EM basis, we expect the policy emphasis to remain squarely on consolidating growth rather than fighting inflation. India and Indonesia are the stand-out exceptions to the broad trend. Policy rates tightening in most EM economies will likely be part of a normalisation process, but we doubt that central banks will tighten policy rates aggressively enough to put their economic recovery in jeopardy.
In summary, the benefit of using a uniform approach to constructing MCI indices is that it allows for better comparison of the dynamics of the policy stance over the Great Recession. The relatively stable behaviour of monetary conditions in China stands in stark contrast to more dramatic moves in India, Brazil and Russia, thanks mostly to the PBoC's ability to control credit growth more directly. As these economies have recovered rapidly, the need for policy tightening has become just that much more pressing. Central bankers face the challenging task of balancing off the risks of overheating if they do too little versus downside risks to growth from being too aggressive. Our MCI indicators suggest that Brazil and India have already embarked on this path, reversing some of the easing provided during the Great Recession. Information from the MCI measure out of China needs to be considered more carefully than elsewhere, however, given that the PBoC has much better control of credit and lending and is likely to ease constraints there later in the year. Tracking developments in EM economies is never easy, and monetary conditions are no exception. The most interesting part of central bank exit policies and the trade-offs they face is still ahead of us, and we will look to our MCI measures in part to provide a gauge for checking the progress that monetary policymakers have made.
For full details, see "An Eye on MCI", The Global Monetary Analyst, September 1, 2010.
The Food Inflation Snare?
June to September are typically the dry months in Indonesia. Yet this year, thanks to La Niña's effect, rainfall in what is supposedly the dry season so far has been higher than average. In fact, the Indonesian Agency for Meteorology, Climatology and Geophysics (BKMG) forecast is that increased rainfall is also likely for September. This means the dry season, which was initially forecast to be delayed, looks unlikely to happen at all. Due to unusually wet weather conditions, food inflation has picked significantly in Indonesia, rising at 13.2%Y in August (versus 6.7%Y in May), driven primarily by rice. On the back of this, we are raising our general inflation forecast to 5.3% (from 5.0%) for 2010 and 6.0% (from 5.7%) for 2011.
Given the seasonal demand due to Muslim festivities and cyclical inflation pressures from the strong growth trajectory, the weather-induced food inflation is rather untimely. Food is a huge component of the CPI basket at 36% (including processed food). Hence, food inflation also tends to affect core inflation via expectations in Indonesia. Prior to this, Bank Indonesia has been the only central bank in Asia ex-Japan not to have embarked on policy rate normalization - rightfully so, in our view, as policymakers reaped the benefits of a structural downtrend in inflation amid improved macro fundamentals and reduced currency stability. However, food inflation and its spillover now increase the risk of higher cyclical inflation pressures and the need to normalise policy rate in a timely fashion.
The Bigger Picture on Food
To be sure, food inflation is not exactly new in Indonesia. Although Indonesia produces a substantial part of its needs for main crops such as rice, cassava and maize, food inflation in Indonesia has surprisingly tended to be higher than it is even in some of its non-food producing neighbours such as Singapore.
We think one potential factor contributing to food inflation at the margin is that Indonesia's own food price stabilization mechanism has been weakening. BULOG, the National Logistics Agency, has a mandate for food price stabilization. Up until 1998, BULOG had an international trade monopoly for major crops like rice, sugar, wheat and soya, allowing it to bring in imports when domestic prices rose above the price ceiling and to export when prices fell below the price floor. BULOG's import monopoly later gave way to greater private sector participation after September 1998 as part of IMF conditions following the 1998 crisis.
Yet since early 2004, the freedom in food trade was curtailed by a rice import ban, removing what was a natural vent for rice price pressures. Administrative import measures were implemented only on an ad hoc basis. Indeed, the last time the ban was suspended was in 2007. Also, where BULOG and private-sector players had freedom and ease to import in the past, parliamentary approval is now required for rice imports, further adding to the process time and potentially food inflation. Indeed, the absence of food trade barriers served the dual purpose of containing food inflation for consumers via imports when prices rise and containing food disinflation for producers via exports when prices fall.
The Non-Monetary Policy Way of Tackling Food Inflation
At its last monetary policy meeting, Bank Indonesia signaled its intention "to tighten liquidity management" as part of the "action to safeguard against increased expectations of future inflation". Nothing concrete has been announced yet and, in the interim, non-monetary measures formed the key modus operandi to control food inflation.
Policymakers have a few such tools at their disposal - and they are mostly targeted towards rice. For example, under the RASKIN (Rice for Poor) programme, started in 1998, rice is subsidized for a targeted 17.5 million poor households (30% of total households in Indonesia), with a target allocation of 15kg/month at a subsidized price of Rp1,600/kg. This represents a 73% subsidy using the wholesale rice price of Rp5,900/kg. A significant portion, 2.4 million tons of rice, out of an expected stockpile of about 3.8 million tons (including the 2.4 million ton targeted procurement for 2010 and 1.4 million ton outstanding stock from last year), is targeted for RASKIN distribution this year.
More generally for the broader masses, BULOG intervenes via market operations from its stockpile to stabilize rice prices by buying rice at a designated government purchase price during peak harvest season to mitigate price falls and selling rice from its reserve stockpile during shortage periods to contain price rises. Food and agriculture-related subsidies accounted for 0.6% of GDP in 2009. Policymakers now too appear to be considering the possibility of allowing imports, as the rice stockpile may fall below the usual 1.5-2.0 million tons by end-2010. However, nothing has been firmed up at this stage.
Given how rice prices have remained elevated, these measures may not have been completely effective in dampening food inflation. Indeed, according to World Bank reports, the RASKIN programme is subject to significant leakages and inefficiencies, limiting the extent to which it really cushions price rises for poor households. Meanwhile, on market operations, the quantity distributed is very small. For Jan-Aug 2010, only 5,686 tons of rice (versus total demand of 32.6 million tons expected by the government) have been distributed in market operations. Also, the price at which BULOG was selling rice in its market operations was not significantly lower than the market price, prompting calls by policymakers to push for lower prices.
The Monetary Policy Angle to Food Inflation
Policy rate normalisation will not eradicate what is now a supply-side food inflation issue. Yet, amid global food price pressures and the risk that food inflation could be less temporary than expected if unusual weather patterns affect the planting of rice crops later in Indonesia this year, policy normalisation will likely be key in preventing food inflation from spilling over to core inflation, given the strong domestic demand growth momentum, shrinking trade balance and rising credit growth. Indeed, core inflation has picked up further in August to 4.5%Y (versus +4.2%Y in July and 3.6% at the trough in Mar-10).
Between the two tools of ‘price' and ‘quantity', the signals from BI in the last MPC statement are that liquidity management is likely to be the first step in this Friday's MPC meeting. Our sense is that this is likely to come in two components which have opposite effects.
• The first is a return to the LDR-linked reserve requirement ratio that was in place before the global crisis. In order to encourage more effective intermediation and to get banks with lower LDR to lend more, banks with lower LDR ratios would be required to park more reserves with the central bank. This would be expansionary.
• The second is a potential hike in the primary reserve requirement (which is currently at 5%), which is contractionary and would siphon off excess liquidity.
How different is the effectiveness of the ‘quantity' tool versus the ‘liquidity' tool? We think concerns that rate hikes may invite more capital inflows and excess liquidity and the need to deal with the ‘impossible trilemma' is the reason policymakers may opt for liquidity tightening over policy rate hikes as the first step. Rate hikes could attract capital inflows, putting added pressure on the currency at a time when the rupiah is already at the stronger end of the 9,000-9,500 range and there is a need to keep a watch on manufactured export competitiveness.
On this front, we have some concerns. First, the liquidity management measures that policymakers seem likely to take (i.e., LDR-linked RR and a hike in the primary reserve requirement) have opposite effects and may not be clear in sending the right signals to the market in terms of BI's stance. Second, despite the massive improvement, Indonesia is still one of the AXJ economies more exposed to short-term external funding. This is what prompted BI to take measures in June to lengthen the tenure of the SBI bills to 9 and 12 months, impose a minimum one-month holding period for SBI bills and introduce a new 1M term-deposit facility that, unlike SBI bills, is not accessible to foreign investors, but would help to withdraw excess liquidity from the system.
In this context, a comfortable current account surplus is needed as insurance against potential capital flight. Yet as it is, the latest July trade balance has dipped into negative territory to US$129 million for the first time since July 2008. Even if policy makers react now, policy response filters in to the real economy only with a time lag. Moreover, between liquidity management and policy rate hikes, the latter still remains the key and more effective tool in terms of containing inflation expectations. SRR tightening measures can only be a complementary step to mop up the excess liquidity which rate hikes may spur, with lesser sterilisation costs.
We continue to be of the view that policy rate normalisation is necessary. Our official forecast is for the first rate hike in Friday's MPC meeting. We do not think markets should take a rate hike negatively. In fact, we believe that a timely rate hike would not derail the economy and would be a signal of BI's commitment towards inflation management - helping to prevent what is now a benign growth cycle from turning into an overheated one. However, we concede that the debate has become one of ‘what we think BI should do' versus ‘what BI will do'. Our sense from BI's signals is that liquidity management may be the first step, with the risk that rate hikes could start later than our forecasts.
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