Why central banks' arsenal gives EM advantage

Earlier this week we looked at “what’s left in the central bank toolkit for central in developed markets”, but how does this compare with emerging markets (EM)?

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.

Fully loaded

There has been much talk in the last decade or so of “convergence” between the economies of emerging and developed markets (DM), as the emerging world began catching up with the developed via huge improvements in living standards.

Happily for EM, monetary policy is one area where convergence with their DM counterparts is still some way off.

DM central banks face serious challenges in responding to any future downturn, as my colleague Piya Sachdeva discussed elsewhere this week.

With interest rates in some cases already in negative territory (this is when it effectively costs you money to save) there is no room for manoeuvre on that front. As a result, quantitative easing (QE) and other non-orthodox tools are viewed in DM as central bank weapons of first resort, rather than last.

In EM, however, there is no need to deviate from the tried and tested playbook. “Nominal” interest rates (which are unadjusted for inflation) across the countries that make up EM are universally in positive territory. In most cases so are “real” interest rates (nominal interest rate minus inflation).

Policymakers in EM are not yet close to hitting rock bottom for rates, the factor which pushed DM central banks into the realms of QE.

Also, current central bank policy is not obviously likely to spark high inflation. Should the economy require support, there is nothing here to prevent central banks from acting.

Central banks across the emerging world are in this position in many cases because they took relatively aggressive stances in 2018, at the same time that the US Federal Reserve (Fed) was raising rates and still sounding hawkish. It appeared that the Fed would continue on that path into 2019 too. Many EM central banks tightened monetary conditions (raised rates) during this period. Even in instances where rate cuts occurred in EM, they were typically modest and did not leave real rates in negative territory.

Now that the Fed has turned more dovish by indicating that there may be interest rate cuts ahead, the caution shown by EM central banks looks excessive. This will comfort EM central bankers who may want to ease rates if global demand slackens.

Central banks gaining upper hand over inflation

This is also backed up by looking at the broader history of EM inflation. One of the less remarked upon successes in EM is the significant long-term decline in inflation (see chart below). Aside from the recent surge in inflation in Turkey (which distorts the 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 environment globally, but it is also associated with an improvement in the credibility of EM central banks and their policymaking.  

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.

Winning the inflation war (but losing the occasional battle) in EM

Source: Thomson Reuters Datastream, Schroders Economics Group. 25 June 2019.

Fiscal firepower

While it is clear EM central banks have plenty of monetary policy wriggle-room, their fiscal (ie tax and spending) space seems a lot tighter.

According to projections by the International Monetary Fund (IMF), most EM economies are already running what is know as primary deficits. This is when a government’s total expenditure exceeds its total tax revenue.

This does not immediately rule out the use of fiscal stimulus (ie lowering taxes and/or increasing spending) in a downturn – as it may be possible to run a larger deficit – but it is not an encouraging starting point.

Further IMF analysis which looked at the extent to which governments can borrow additional funds for stimulus if required, showed that for most EM economies there is some space, but not substantial. However, it sees manoeuvrability as particularly limited in South Africa, Argentina and Brazil.

It may seem surprising that China is not flagged by the IMF. It has a considerable deficit already, after all. Two saving graces for China are that it is not burdened with huge interest repayments on its debt, and the ease with which it can finance government debt from domestic investors.

China’s government will also have far fewer qualms than, for example, the eurozone, in deploying whatever firepower is needed. We would agree that China would not hesitate to ramp up spending should the situation require it.