QT: The five major EM central banks we consider have all used QT tools along with conventional policy rate moves in different ways. The combination has helped make policy more restrictive than looking at policy rates alone would have suggested. Sterilised intervention in FX markets, evidenced by a build-up in FX reserves and (in the case of Brazil) capital controls, has been used to keep exchange rates from surging, while required reserve ratio hikes and open market operations have helped to tighten liquidity in money markets and within the banking system. At the same time, policy rates have been raised as well (with the notable exception of Turkey, where policy rates have been cut).
• China: RRR hikes have replaced rate hikes as the preferred tool to deal with a large pool of liquidity. The 300bp of RRR hikes has withdrawn over CNY 2 trillion from money markets. Continued intervention in the FX markets has led to further accumulation of FX reserves. Restrictions on lending are already apparent in softer loan growth in the first two months of 2011. All these measures prompt our China team to believe that monetary policy is close to now easing somewhat, having achieved most of the objectives of the tightening cycle already (see China Economics: Front-Loaded Monetary Tightening At Work, March 14, 2011). Further hikes in the policy rate are expected in 2011, but these will not be enough to change the overall stance of monetary policy, which is just restrictive at the moment.
• India: The RBI has preferred to let liquidity remain tight in the last few months, which has prompted commercial banks to hike deposit rates (see India Economics: Policy Rates Hiked - No Surprises, Inflation Concerns Remain, March 17, 2011). The move in deposit rates far outstrips the move in policy rates, taking monetary policy into restrictive territory while real policy rates remain near zero. A principal concern of the RBI is to bring credit growth (23% in March) closer to deposit growth (17% in March), something that higher deposit rates should help with. In India too, further policy rate hikes from the RBI are expected but they will not be enough to take the overall stance into outright restrictive territory, in our view.
• Brazil: Hikes in the IOF tax as policy rates have been hiked are designed to reduce the attractiveness of the carry trade (see "Brazil: Taxing Flows", This Week in Latin America, March 28, 2011). In addition, reserve requirements have been hiked in order to reduce liquidity in money markets. Collectively, the Brazilian authorities are trying to directly soften capital inflows by making high interest rates in Brazil less attractive, reduce liquidity in the money markets and slow the economy down to prevent overheating. The monetary policy stance is likely to move into a slightly restrictive one over the course of 2011.
• Russia: Despite strong resident capital outflows driven by election uncertainty, we expect net accumulation of reserves, driven by Russia's strong current account surplus and inflows from international investors. Russian monetary policy tends to rely less on policy rates (partly because excessive liquidity has pushed short-term interest rates lower) and is likely to use exchange rates in line with its ‘tighten and widen package' (see The Mighty Ruble Marches On, March 10, 2011). Reserve requirements have been raised before policy rates were taken higher. The CBR is likely to continue with both but will likely stay mindful not to disturb the stability of the banking system by overdoing the withdrawal of liquidity. Despite the expectation of more hikes (particularly after the presidential elections) and further currency appreciation, we believe that the overall stance of monetary policy will only move from an outright expansionary stance currently to a moderately expansionary one towards the end of 2011.
• Turkey: Turkey offers the most interesting (but also most complicated) policy setting in the EM world, in our opinion. Reserve requirements have been raised sharply in a highly nuanced manner. They have climbed 800bp for deposits maturing up to three months, and less so further out. These changes affect institutions with a local presence in Turkey. In order to sharply reduce the incentives for foreign players sending portfolio flows into Turkey, the policy rate was cut by 75bp in conjunction with reserve requirement hikes in order to weaken the currency. The signaling aspect of such a cut has clearly played a strong role in driving market perception because investors tend to see Turkey's monetary policy as expansionary. However, the net result of QT and policy rate cuts has likely been to make Turkish monetary policy tighter, not looser. The removal of over TRY 40 billion (US$26 billion) from the money markets means that policy is already slightly restrictive, a far cry from the picture painted by cuts in the policy rate (see "Turkey: A Q&A on Monetary Policy", CEEMEA Macro Monitor, March 28, 2011).
The common thread running through the monetary policy strategies employed by each of these central banks clearly is the use of QT tools to deal with a liquidity issue. The roots of this issue lie in the ultra-expansionary monetary policy used to fight the Great Recession that has still not been withdrawn adequately in the EM world, and not withdrawn at all in the major DM economies.
ZIRP and QE accelerated the flow of capital into EM... Near-zero policy rates and QE in major DM economies generated plenty of liquid capital looking for a better yield than was domestically available. Much of this capital found its way into the EM world to leverage better growth and higher interest rates there. For most of 2010 and to a lesser extent this year, EM policy-makers have been shackled by the ‘trilemma' (which allows policy-makers to choose only two out of a trinity of free capital flows, stable exchange rates and policy tightening). In part because of the trilemma and partly because they don't want to hurt growth, EM monetary policy has refrained from venturing into outright restrictive territory.
...complicating EM monetary policy: As if dealing with the difficult balance between inflation and growth from a strong cyclical rebound, expansionary monetary policy and structural pressures on inflation wasn't enough (see Emerging Issues: A Macro Trinity Grips as the Impossible Trinity Ebbs, March 16, 2011), capital inflows have added to the complications facing EM monetary policy-makers. Rising liquidity in the banking system pushed interbank rates lower, making it difficult for monetary policy rates to have as strong an impact as usual. Access to this pool of liquidity during a time of rising growth made it a relatively easy choice for banks to push some of these funds into credit to the private sector. In turn, rapid credit growth by itself (as is the case in Turkey and to a lesser extent in Russia) or rapid credit growth when the risk of overheating is still present (in China, India and Brazil) clearly makes monetary policy an extremely complicated exercise.
Fighting QE with QT: Using QT as a complement to traditional monetary policy tightening thus gives EM central banks a measure of flexibility that the blunt tools of monetary policy themselves cannot provide. In essence, the use of these QT tools is a direct response to the inflow of liquidity thanks to ZIRP and QE policies in the DM world.
But underlying macro backdrops are very different: Even though fighting QE with QT is what these central banks have in common, it is interesting to note that the macro backdrops against which they have employed these tools are very different:
• Lack of economic slack (i.e., a closed output gap) is a primary concern for China, India and Brazil, whereas Turkey (with some slack in the economy) and Russia (with substantial slack in the economy) have less to worry about. Concerns about rapid credit growth due to excessive liquidity would be highest in economies where economic overheating is already a concern. Luckily for China, India and Brazil, credit growth seems to have at least stopped rising. In Russia and Turkey, the economic slack gives the central banks there some time to deal with credit growth.
• Inflation concerns: India and Russia, and to a slightly lesser extent China and Brazil, have inflation concerns. Turkey, on the other hand, is in a sweet spot as far as inflation is concerned at the moment. Even though inflation will likely rise from this point on, the move is unlikely to be large enough to raise concerns. Excessive liquidity means upside risks to money and credit growth, which would clearly not be constructive for the inflation outlook.
• Risk from further increases in oil prices: An escalation of Middle East tensions would clearly act as a supply shock to the economies of China, India, Brazil and particularly Turkey, leading to a stagflationary outcome. Russia, however, would see an increase in oil prices as a demand shock. QT could rapidly be unwound in if a stagflationary outcome was at hand.
• Money and credit growth: Our band of five central banks is split into two camps on these metrics. Money and credit growth has already moderated in China, India and Brazil, while credit growth is picking up in Russia and rampant in Turkey. Some of the credit in moderating money and credit growth in China, India and Brazil must be attributed to QT, which raises the probability that QT will also be effective in aiding Russia and Turkey in gaining better control of credit growth. In turn, softer credit growth can reduce the risks of overheating.
• Current account positions: While China and Russia are running current account surpluses, India, Brazil and Turkey are all running chronic current account deficits which are not fully financed by FDI inflows. Thus, they continue to rely on portfolio flows to fund the gap and are sensitive to an excessive strengthening of the currency, which can afford some relief from imported commodity prices but also hurt export competitiveness.
QT is a complement, not a substitute: The use of a common set of QT tools by central banks faced with such large differences in their macro backdrops should clearly spell out the particular usefulness of these tools. They are adept at managing liquidity and are extremely flexible to use (as Turkey's nuanced strategy clearly shows) and quite easy to reverse. To the extent that liquidity-fuelled credit creation creates an additional concern for overheating, the use of QT can provide some relief to policy-makers by reducing credit growth and lowering inflation risks. However, a fully fledged attack using primarily QT tools is beyond the scope of the QT strategy.
Traditional tools remain critical: Policy rates and exchange rates will continue to be the tools that do the heavy lifting for monetary policy, dealing with the macro issues of overheating and inflation. These tools have a stronger signaling aspect and play an important role in shaping expectations about the policy stance. QT tools, on the other hand, work primarily through the banking system, i.e., through one part of the credit channel of monetary transmission. Where fiscal issues are also part of the picture (India and Brazil), monetary policy may be limited in its ability to ‘win' the battle with inflation. In an earlier note (see again Emerging Issues: A Macro Trinity Grips as the Impossible Trinity Ebbs), we suggested that EM policy-makers prefer not to use the expenditure-reducing tool of policy rate hikes so that they can safeguard growth. They can still resist importing inflationary monetary policy from DM central banks and gain insulation against imported inflation by allowing currency appreciation, i.e., using an expenditure-switching tool to tackle inflation. To the extent that EM central banks rely on QT as a way of doing less using traditional tools, they risk allowing inflation to become entrenched in inflation expectations.
Inflation in Asia Remains a Concern
Headline inflation in Asia has been rising rapidly since 2H10, reaching 4.6% in January 2011 and nearing the previous peak of 6.1% seen in June 2008. Headline inflation in the region has been persistently above its long-term average of 3.0% for the past 14 months and is resulting in a rise in inflation expectations in some of the key countries in the region.
Within the region, inflation problems are more acute in Asia ex-Japan. Headline inflation in Asia ex-Japan ex-India accelerated to 4.7% in February 2011, from 2.9% in June 2010. While food inflation has been driving headline inflation higher, core inflation is now at 2.3%, tracking close to its previous peak of 3.0% in July 2008.
The Asia ex-Japan Inflation Story
In our base-case scenario, we expected headline inflation in Asia ex-Japan ex-India to rise to 4.9% on average in the quarter ending June 2011, from 4.7% in February 2011. However, we think that there is increased probability of the upside risk scenario materialising, if external demand continues to surprise on the upside and commodity prices continue their current pace. In our view, the region's inflation story can be explained by the following four key factors, which we will examine in turn:
1) Relatively strong domestic demand at the start.
2) Sharp rebound in exports for the region. Asia ex-Japan has seen a 24% (seasonally adjusted, not annualised) rise in exports over the last four months.
3) Supply shocks, first in the form of higher food prices and now in the form of higher global commodity prices, including oil.
4) Relatively slow policy exit. Real rates are still negative throughout the region.
Pressing the Pedal Hard on Domestic Demand
As the global recession unfolded, policy-makers in the region implemented aggressive fiscal and monetary policies to offset the collapse in external demand. Indexed total Asia ex-Japan exports declined from the pre-crisis peak of 100 in July 2008 to the trough of 70.4 in February 2009. Weighted average policy rates in the region ex-India were cut from a peak of 6.6% in August 2008 to 4.4% in August 2009, while India's rates were cut from 9.0% in August 2008 to 4.75% in April 2009. Correspondingly, fiscal deficits for the region (on a weighted average basis) expanded from the trough of -0.3% of GDP in 2007 to -2.1% in 2008 and -4.4% in 2009. This played a key role in pushing domestic demand across the region, with China, India and Indonesia recovering the fastest because of their strong structural growth dynamics.
However, just as domestic demand was rising sharply, external demand recovery also emerged faster than expected. While exports in the region did see a much deeper trough in the current cycle, the recovery to pre-crisis peak took almost the same number of months as it took during the Asian financial crisis and 2001 technology crisis. In this cycle, exports had already recovered to pre-crisis levels by May 2010. However, policy-makers were slow to take away the support of loose fiscal and monetary policy, as they remained concerned about the outlook for growth in the developed world.
European Union Sovereign Debt Concerns Only Delayed Policy Exit
Concerns about deleveraging in the developed world in the current cycle meant that policy-makers in Asia ex-Japan were less confident of the sustained support from exports and aimed to support strong domestic demand growth with loose fiscal and monetary policy. The European Union sovereign debt concerns that broke out in the middle of 2010 resulted in a downtick in exports for the region and reaffirmed the slow policy exit approach adopted by policy-makers in the region.
Sharp Rebound in Exports in the Past Four Months
The weakness in external demand was short-lived. After a brief downtick, exports recovered sharply and grew by a strong 24% (seasonally adjusted, not annualised) from October 2010 to January 2011. We believe that this strong rebound in exports has only added to the inflation pressure in the region, given that domestic demand has been strong.
Supply Shocks Have Exacerbated Short-Term Price Pressures
Just when the inflation pressures were beginning to build due to stronger domestic and external demand, back-to-back crop failures across many of the large food-exporting and food-consuming countries pushed food inflation up sharply. Against this backdrop, the Commodity Research Bureau (CRB) food index has risen by 40% since June 2010 and is now 16% above its previous peak in July 2008.
Commodity prices have also seen huge increases in the past few months. Oil prices (Brent) had already risen to the US$100/bbl tolerance mark amid stronger global growth - but recent events in the Middle East have caused oil prices to increase further to US$115/bbl on concerns of supply disruptions. In addition, the CRB metals index has risen by 48% since June 2010 and has already surpassed its 2008 peak by 13%. High commodity prices will exert pressures on input costs for manufactured products, which will translate into higher consumer prices later on.
We believe that the developments in the Middle East and Japan are another form of supply shock that could increase the upside risks to inflation in the region. In this context, we remain concerned about inflation risks arising from commodity price shocks for the region.
Policy-Makers Are Not Removing Policy Supports Aggressively Enough
Policy-makers in the region have partially reversed their aggressive fiscal and monetary policy. Weighted average policy rates in the region ex-India have risen from the trough of 4.4% in August 2009 to 5.2% in March 2011, while India's rates have risen to 6.75% in March 2011 from 4.75% in April 2009. However, policy rates are still way below the levels seen in mid-2008, when the region was facing similar inflation pressures.
Similarly, fiscal deficits for the region (on a weighted average basis) have also been reduced from -4.4% in 2009 to -3.4% in 2010 and should narrow slightly to -3.1% this year on our estimates. In comparison, in 2007 (the year before the peak in inflation), the region's fiscal balance was close to zero. We believe that policy-makers remain concerned about a potential slowdown in US and developed world growth and are reversing the fiscal and monetary policy supports in a calibrated manner.
Do Developments in Japan Change Our Base Case Outlook for the Region?
Following the tragic events in Japan, our Japan economics team's rough and preliminary estimates show that Japan's GDP could contract by between 1% and 3% in 2011, which would constitute a shortfall of 3-5% as compared with our pre-quake forecast of more than 2%. Both output and demand are expected to contract very sharply in 2Q11 and by somewhat less in 3Q, followed by an economic rebound later this year and in 1H12. The rebound will be helped by several shots of fiscal stimulus, which we expect to see implemented incrementally in 2011 and 2012. The stimulus would total several tens of trillion yen and would be likely financed by debt issuance and spending cuts.
In our base case outlook for the region ex-Japan, we are expecting growth to be 7.7%, supported by healthy domestic demand this year. Consumption and capex growth are expected to maintain a healthy pace in 2011, while stronger-than-expected external demand has added to demand pressures in an environment where domestic demand was already strong.
Core inflation pressures are expected to intensify, given the starting point of low capacity slack. With policy-makers in the region removing policy support in a calibrated manner and the supply shocks to food and commodities, inflation risk has been the most important macro issue for the region, as we mentioned above.
The developments in Japan do not change our core thesis on the growth and inflation outlook for the region. We believe that the impact on the region's net exports will be low, as our Japan economist, Takehiro Sato, expects import growth to decelerate less than export growth. The damage to transportation systems and production capacity creates near-term supply chain disruptions, and we believe this to be more of a concern for the region than demand destruction per se. This disruption would likely be concentrated in the next two quarters. The supply chain impact on Asia ex-Japan production and the consequent impact on Asia ex-Japan growth could bring downside risks of 20-40bp to Asia ex-Japan growth in 2011. Hence, we do not expect any meaningful change in our base case outlook. In the medium term, Takehiro expects some part of the damaged production capacity in Japan to be relocated to Asia, which would likely benefit manufacturers in the region.
China, India and Indonesia Face a Bigger Inflation Challenge
While inflation is a concern for the entire region, we believe that the inflation risks are not identical in all countries. We classify the region into four groups based on their inflation risks.
1) Strong Domestic Demand Stories: China, India and Indonesia
Within the region, we believe China, India and Indonesia are the most vulnerable to the current inflation challenge. These countries have structurally strong domestic demand and benefited from it during the crisis. Inflation expectations have already risen in these countries. China and India were also aggressive in pushing domestic demand immediately after the crisis with the support of loose fiscal and monetary policy. Hence, this group has little room to breathe, as external demand and commodity prices continue to rise. It is not a surprise that India, China and Indonesia have the highest inflation rate in the region.
2) Structurally Weak Domestic Demand: Korea, Taiwan, Malaysia and Thailand
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