Base Effects Kicking in Soon
Most AXJ economies, Brazil and Mexico in the LatAm region, and Russia, Poland, Hungary, Romania and Israel in the CEEMEA region will all likely see base effects pushing year-on-year inflation lower around 2Q11 or 3Q11. The notable exceptions to this pattern are consumer price inflation in India, Turkey and South Africa, where such base effects do not push inflation lower. Policy-makers know this too. Rather than a decline in inflation on a statistical basis, policy-makers would prefer to see the sequential momentum in inflation (i.e., the month-on-month inflation) slow down. To the extent that the sequential momentum does not slow down, the peak in year-on-year inflation will likely be higher than expected and the decline even when the base effects kick in should not be very strong. In that case, we think that EM central banks would be ill-advised to take inflation off their radar.
Cyclical and Structural Risks to EM Inflation
Cyclically, risks to EM inflation are still skewed to the upside. Continued upside risk to oil prices and higher producer price inflation and import price inflation could all potentially pass through to other prices in the economy. As tensions in the Middle East persist, the upside to oil prices remains a high-risk scenario. In a recent exercise, our economics team estimated the impact of oil prices at US$140 and a 5% reduction in global trade would be an increase in global inflation by nearly 1% in 2011 and a decrease in global GDP by 1% (see Global Forecast Snapshots: Global Resilience, April 6, 2011). While the downside risk to world trade from the natural disaster in Japan has abated somewhat, the stagflationary impact of high oil prices still remains in place. In simple terms, a ‘supply shock' like a rapid increase in oil prices not driven by stronger growth should push inflation higher and growth lower. A ‘demand shock' such as a sudden increase in spending either by the government or by private households and firms tends to push both growth and inflation higher.
Producer Price Inflation and Import Price Inflation Trends Remain Strong
Even though energy inflation has turned down in many EM economies, producer price inflation and imported inflation have continued to rise. For a country-wise breakdown of headline, energy, food, core and producer price inflation, see the accompanying Emerging Issues).
In part, these are likely to be manifestations of the global shock from higher oil prices feeding through to rising input costs and higher import prices. Producer price inflation could also be rising thanks to the dwindling or already absent slack in EM economies. Finally, import price inflation has likely been aided by the general reluctance of EM policy-makers to allow a large nominal appreciation of their currencies.
A Strong Policy Response Is Unlikely
If the rise in producer prices and import prices is due in part to higher oil prices, then allowing or encouraging currency appreciation could provide some relief from both. If producer prices are rising in part due to strong domestic growth, then slowing down domestic spending by pushing real policy rates higher might do the trick. At the moment, EM policy-makers are more likely to use the currency as a tool, but even that would not be an aggressive move, given the persistent risks to the sustainability of the global recovery. Risks to inflation therefore could easily remain skewed to the upside for some time.
Structural Pressures Point to Higher EM Inflation...
In past notes, we have highlighted that structural and cyclical forces are reinforcing upward pressures on EM inflation (see Emerging Issues: A Macro Trinity Grips as the Impossible Trinity Ebbs, March 16, 2011, and Emerging Issues: The Great Rebalancing, February 16, 2011). The process of global rebalancing has meant that EM currencies have been appreciating in real terms for the better part of a decade now. While this real appreciation can happen through any combination of nominal appreciation of currency values and EM inflation running higher than DM inflation, the last few years have seen real appreciation almost exclusively through the inflation channel. Competing against China in the global marketplace, EM policy-makers have been reluctant to allow appreciation against the renminbi. As the renminbi appreciates only slowly against the US dollar, this implies that the entire EM world is ‘soft pegged' to the US dollar. With such a ‘peg' in place, EM inflation has had to remain above DM inflation to keep real appreciation going. With risks to DM inflation to the upside, the risks to EM inflation are therefore rising as well.
...Unless EM Currencies Show Significantly Greater Nominal Appreciation
The way out of this structural issue would be for EM economies to allow significantly greater nominal appreciation for their currencies. The renminbi could act as a catalyst here if Chinese authorities allow greater appreciation in response to higher inflation prints (see Watching Inflation, Watching the CNY, April 15, 2011). It is noteworthy that the policy response to give EM inflation some relief using nominal currency appreciation works not just from a cyclical but also a structural perspective.
Will EM Inflation Hurt Growth?
While the question appears straightforward, the answer depends on the source of the inflation problem.
Oil Prices and Stagflation
If inflation is currently being driven by the rise in oil prices due to risks in the Middle East region, then we are looking at a supply shock to EM economies, which, as we explained above, should push inflation higher and growth lower. Because the size of this shock isn't too large (we consider the excess over the mid-January price of US$100 per barrel to constitute the supply shock in oil prices), effects on EM growth are likely to be moderate but in proportion to the intensity of oil consumption.
Can Higher EM Inflation by Itself Push Growth Lower? Unlikely at These Levels
The simple answer here is: not at the levels of inflation that most EM economies are likely to experience. In Russia, Ukraine, Argentina and Indonesia, the quarterly profile from our economics teams suggests peaks in quarterly inflation on a year-on-year basis in the neighbourhood of 8-10%. Inflation in the rest of the EM world under our coverage, however, is likely to peak at significantly lower levels. Past academic studies suggest that the negative impact of inflation on growth works in a non-linear fashion. At the moderate levels of inflation that we expect in most EM economies, the impact of inflation on growth is statistically insignificant. Most of the EM economies that we cover are thus ‘safe' from this effect. It is only when inflation rises to and persists at high levels is there an economically meaningful impact on growth. If the quartet of countries listed above were to run inflation higher than 8-10% for a meaningful period of time, then we would worry about the adverse impact of inflation on growth there.
The Main Risk to Growth Comes from the Policy Reaction to Inflation
While our base case remains that EM policy-makers appear to be reluctant to take monetary policy into restrictive territory (see Emerging Issues: A Macro Trinity Grips as the Impossible Trinity Ebbs, March 16, 2011), the risk is that this stance could change in one of three ways. First, faced with imported inflation and the risks to oil prices, faster currency appreciation could be allowed or even encouraged. We believe that this is the path of least resistance and is likely to be the preferred mode of tightening for EM policy-makers, not just because of the cyclical and structural reasons we have highlighted, but also because it allows for policy tightening ‘by stealth', without the fanfare of a hike in policy rates. The impact on growth from this strategy would be moderate. This scenario constitutes the best option available to EM policy-makers, in our opinion.
Second, the coming reacceleration in US growth that our team expects in 2H11 might give EM policy-makers enough confidence in the global recovery to reaccelerate their own monetary tightening process. Note that an increase in risk appetite under this scenario coupled with faster tightening in the EM world would mean currency appreciation pressures as well.
Finally, the risk of sooner-than-expected tightening by the Fed has abated but hawkish talk in 2H11 before policy rates are most likely raised in 1Q12 would remove some of the monetary accommodation that EM economies have been inheriting through their ‘soft peg' to the US dollar. This means that the monetary stance of EM economies could well be tighter without EM policy-makers lifting a finger, and even more so if they tighten policy themselves too.
But Why Would EM Central Banks Tighten if Inflation Is Not a Threat?
Even as we state that EM inflation at the levels we expect over the next couple of years is not enough to impact growth, we argue that growth pushed lower thanks to monetary tightening as a reaction to inflation. If inflation is not a threat, then why put growth at risk to fight inflation? The answer is two-fold. First, inflation is likely to remain at moderate, benign levels because of monetary policy action. Second, if monetary policy-makers were to disregard inflation, it would eventually climb to levels where the impact on growth would be economically significant (as per our discussion of the non-linearity of the inflation-growth relationship above). EM policy-makers would then have to tighten policy a lot in order to curb inflation. Paul Volcker had to tighten policy by a magnitude that triggered a recession in the US in the early 1980s in order to bring inflation under control. Rather than hurt growth so severely later, monetary policy-makers prefer to ‘bruise' growth from time to time to prevent inflation from ever getting out of hand.
In summary, even though base effects should push year-on-year inflation in most of the EM world lower in 2H11, monetary policy-makers will (and investors and markets should) pay attention to the sequential momentum in inflation. The risks to oil prices and rising producer price inflation and import price inflation mean that core prices could yet become contaminated. Structurally as well, there are upside risks to EM inflation. Nominal currency appreciation is well placed to bring down these risks to inflation, but the catalyst for a significant EM-wide currency appreciation remains the renminbi. The front-loaded CNY appreciation that our strategists expect would provide welcome relief. Disappointment on that front, however, would skew EM inflation risks even more pointedly to the upside than they are now.
Overview
Range of outcomes: In terms of the impact of the 2008-09 global financial crisis on the domestic banking system, the CEEMEA emerging markets display a full spectrum of outcomes. In the CIS and the Baltics, the global financial crisis was amplified by a domestic banking crisis which continues to provide a headwind to growth, while in the other large CEEMEA economies, there were no major bank failures, and relatively short and shallow credit contractions.
Still low levels of credit: The importance of the banking system to the economy can be simply measured by the loan to GDP ratio. The leading CEEMEA markets significantly lag DM markets, with an average loan to GDP ratio of 56% compared to 107% in the EU-15. Consequently, since CEEMEA is set to grow faster than the EU-15, and the stock of domestic bank loans is half as large relative to the economy, the impact of a domestic banking crisis in CEEMEA should be less severe than in the EU-15.
Causes of the crisis: In CEE/CIS, the global financial crisis typically put the domestic banking system under severe stress. The origins of the crisis were similar across the region. The first ingredient was access to cheap money in international markets, whether directly through DM banks entering domestic markets, as in most of CEE, or through domestic banks tapping international markets, as was more common in the CIS. The second ingredient was a competitive scramble to gain greater market share in an under-banked region which was seen to be either converging on EU levels of prosperity (CEE) or advantageously exposed to the commodity price boom (CIS). The result was sharp pre-crisis gains in credit aggregates, fuelling consumption and asset price growth.
External and fiscal imbalance: On a macro level, unless, as in Russia, offset by the positive impact of the simultaneous commodity price boom, this credit expansion drove external imbalances to unprecedented levels, with current account deficits reaching as high as 20% of GDP in some places. Similarly, the fiscal position looked solid, but the crisis revealed that much of the revenues were cyclical, and had masked a growing pre-crisis structural deficit.
Plotting the banking misery: We measure the depth and current impact of the credit crunch on the domestic banking system by plotting a banking misery space. On the vertical axis we plot the decline in the rate of credit expansion from peak to trough as a measure of ‘depth', while on the horizontal axis we plot the current rate of credit growth minus nominal GDP growth as a measure of the extent to which the banking system is currently providing credit to the economy. Typically, we would expect EM credit growth to exceed growth in nominal GDP, and so a point to the left indicates an underperforming banking system.
NPL hangover: Another measure of the potential duration of a banking system crisis is the post-crisis level of NPLs as a percentage of GDP - the hangover. This suggests that Latvia, Kazakhstan and potentially Ukraine, particularly if the level of bad loans in Ukraine is significantly understated, as Moody's and various analysts claim, have a much worse hangover than the major CEEMEA economies.
Adequate capital: Measured by reported capital adequacy ratios, the banking systems across CEEMEA appear to be adequately capitalised, well above the minimum 8%.
More secure funding: We also found that the banks in Central and Eastern Europe have made substantial progress towards a more stable funding base, with an increase in deposits and a decline in their loan book leading to an improved loan-to-deposit ratio, partially offset by an increase in the value of outstanding FX loans following depreciation, as in Hungary.
Conclusions
FSU misery continues: The CIS and Baltic economies have suffered a deeper and longer-lasting credit contraction. Even though NPLs appear to have peaked, and funding has improved, the legacy impact of the global financial crisis on the banking system in these economies continues to provide a headwind to growth.
Elsewhere, out of the woods: Turkey, the big CEE economies and South Africa have all emerged from the correlated contraction of credit during the global financial crisis, and now display a range of outcomes from a credit boom in Turkey to subdued credit growth in Hungary and South Africa, reflecting different domestic conditions.
FX loans a source of instability: Countries where FX loans were not a significant part of the credit pool, such as the Czech Republic and South Africa, have done better than countries which allowed them, and then faced additional problems as devaluation exacerbated the debt problem (Hungary), or the stock of FX loans constrained policy options (Latvia).
Country Breakdown
Russia - Returning to Normal
Russia has a comparatively low loan to GDP ratio of 41%. Pre-crisis, credit growth in 2006-08 was very high at 40-50% per annum, but credit growth came to a sudden stop in autumn 2008. Since spring 2010, lending started to turn positive in nominal terms, and in the last few months it has accelerated to an annual rate of 15% for personal loans and 14% for corporate loans, which is slightly above our expectations for growth in nominal GDP.
During the crisis, over 30 Russian banks defaulted on their obligations, while the Russian authorities provided liquidity support through a wide range of measures to the banks, including through large capital injections into the main state-owned banks VTB and Sberbank. The number of credit institutions has fallen to 955 in 2011 compared to 1,092 at the start of 2008, but Russia continues to have a long tail of small banks. The government plan to double minimum capital requirements from the current RUB 90 million (US$3 million) to RUB 180 million in 2012, and then further to RUB 300 million in 2015 (US$9 million), which should drive further consolidation in the sector.
Following the crisis, Russian banks sought to access more reliable funding by increasing their deposit base, and initially offered very high deposit rates, which were successful in attracting a large inflow of deposits, mainly from households, and dramatically improving the loan to deposit ratio from 1.59 in November 2008 to 1.15 at the start of 2011. Led by Sberbank, Russian banks have now reduced their deposit rates.
According to CBR data, overdue loans for both households and corporates peaked in 2010, and are now in decline, and the banking sector capital asset ratio is now estimated by the CBR at 10.6% (January 2011). The still significant level of NPLs (8.3%) and the comparatively low level of capital may explain the comparatively mild rates of credit expansion, despite the high oil price and the consequent improving credit of households and corporates across the economy. The CBR's regulatory initiatives, including disclosure of the beneficial ownership of banks, and efforts to disclose and reduce borrower concentration, which was identified as a key risk factor at defaulting banks, have the potential to improve asset quality.
In the Strategy for the Development of the Banking Sector approved earlier this year, the government set the objective of exiting from equity ownership in banking, which implies a dramatic structural change in the sector, given that the top four banks with 48% of banking assets are all majority state-owned. Meantime, even while the government continues to privatise stakes in them, state-owned VTB and Sberbank are emerging as the two dominant banks, with 40% of banking assets between them.
Kazakhstan: Restructured, Still Working Out
Four sizeable defaults: Kazakhstan had a dramatic banking crisis, with the default of four major financial institutions (BTA Bank, Alliance Bank, Temirbank and Astana Finance). In 2010, Kazakhstan reached agreement with creditors on debt restructuring at Alliance Bank, BTA Bank and Temirbank, and recapitalised the banks from the sovereign wealth fund. In April 2011, Kazakhstan announced the establishment of a ‘bad bank' to manage the stock of bad loans from the three banks.
Origins of the crisis: Pre-crisis there was a rapid expansion in credit at annual rates as high as 80-100%, mainly funded abroad, and mainly to make loans to the non-tradeable real estate and construction sectors. This unsustainable credit expansion was abruptly halted by a sudden stop to foreign funding of Kazakh banks after the Lehman bankruptcy in September 2008. Since 43% of loans were in FX at the end of 2007, the crisis was exacerbated by a devaluation in the tenge in early 2009, as a result of the drop in commodity prices and the devaluation of the Russian ruble, which made it harder for domestic borrowers to service their obligations.
Credit since the crisis: Since then, credit in Kazakhstan has been shrinking as the loan to GDP ratio has fallen from its peak of 59% in August 2007 to the current level of 37%. At end-2010, lending to corporates started to expand for the first time, but credit to households continues to shrink, although at a falling rate, while NPLs peaked at 36.3% in February 2010 and have recently fallen to under 33%.
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