The Federal Reserve has increased its’ policy rates for the second time… However, the markets moved more by the signal that it might hike three times in 2017, instead of two. Of course, it would be quite abundant to write about this, after almost a month since the decision. Instead, we want to analyze which emerging market central banks could follow these rate hikes, in order to defend their currencies and prevent capital outflows.
FED’s rate hikes, in its’ essence, would cause long term U.S. rates to increase and pull funds out of emerging markets to flow towards the so-called safe havens. This implies that the emerging markets would need to take some steps, if they want to keep the capital in their countries. Otherwise, they face the risk of entering into a vicious cycle, characterised by currency depreciation, higher inflation and lower growth. Therefore, maybe the pre-requisite for our question at the title should be: “Who will have to follow the FED.?”
In order to answer this question, we can look at the emerging markets’ external funding needs. The first indicators that come to mind are current account balance and net international investment position. In this context, we plot these indicators for 16 emerging markets.
The green area in the graph above shows the countries, which enjoy surplusses in both CAB and NIIP. They are net creditors to the world, which supposedly means less dependence on short-term capital inflows, and so, more comfort in not matching FED hikes. On the other hand, the red area at the southwest covers the emerging markets, which depend on external funding, to keep their economies running smoothly. These can be said to be our main candidates that would have to follow the monetary tightening in the U.S. The graph suggests that Turkey and Colombia, being farthest from the center, would likely feel the most pressure to match FED hikes.
Of course, emerging market central bankers can also tap in their forex reserves to defend their currency against capital flows. Or, can they..?! The markets seem to know the answer with correlation coefficient, between short term external debt/fx reserves ratio and currency movements for the past two months, being 0,65 (excluding Mexico, due to being specifically targetted by Mr. Trump).
Next, we try to find which countries have the policy space to follow the FED. Here, we define the policy space as growth being above potential and inflation being above target. Therefore, it seems appropriate to compare economic growth to its’ potential and inflation rate to target, for year 2017. For the first part we take our sample countries’ annual growth rates from the IMF WEO Database, with forecasts until year 2021, and calculate potential growth rates with the help of HP filter. The workload for finding 2017 inflation targets was minimal, just googled it. Then we have used Bloomberg survey forecasts (*) to calculate growth and inflation gaps. Here are the results…
Similar to our previous graph, we have defined green and red areas. The countries in the red area would have minimum policy space for monetary tightening, since both their growth and inflation rates are under their potential and target levels respectively. We observe that only Chile and S. Korea fall in this area. However both countries are close to the axes that define optimal growth or inflation, thus we choose not to directly label them as having ‘limited space’.
Conversely the green areas cover the countries, with expected growth rates above potential and inflation rates exceeding announced target. This combination apparently gives those countries enough space (in fact some necessity, independent from the FED) for monetary tightening. Here we exclude Brazil and Russia, which are suffering recessions, thus would be very cautious about hiking rates(**).
Maybe, the upper left quarter of the above graph, which includes Turkey, S. Africa, Colombia, Malaysia(***) and Mexico should also be painted red. These countries are expected suffer below-potential growth, coupled with above-target inflation, which means risk of stagflation. Therefore, the central banks in those emerging market economies are facing a policy dilemma about monetary tightening. Fortunately, here Robin can come to help Batman, in most of those countries.
In the countries, where inflation fighting central bankers fear hurting economic growth and find it difficult to raise policy rates, might get some help from the fiscal policy. In this case, governments can adapt expansionary policies and support growth, depending on their fiscal space. So, the final part of this post is dedicated to assess the fiscal spaces in our sample. The safe level of public debt/GDP ratio, which is deemed as strong fiscal position in emerging markets, has been accepted as being less than 60%, for the past decades. In fact, recent literature still confirms around this level. So, we assess the fiscal spaces in our sample, using a heat map approach. The table is easy to understand. The greener, the better.
We don’t go through each country to decide whether they should/could follow FED hikes, since the angles we had put in this post might differ from person to person or from country to country. Plus, we did not want to put more words in an already quite long post. Anyways, we will probably revisit the subject in the months to come and see which emerging markets have indeed followed the FED.
(*) Despite using IMF data for calculating potential growth rates, we decided not to use the Fund’s 2017 growth and inflation forecasts, since they were published in October 2016, and thus, did not include significant events after that, Trump’s presidency being the most noteworthy.
(**) In fact these recessions are so deep that they distort both countries’ data, carrying potential growth rates down to around 0.5%. Thus, even IMF’s 2017 growth forecasts, which are quite low (Brazil: 0,5%, Russia: 1,1%), become enough to calculate positive output gaps. More up-to-date Bloomberg surveys correct this bias a little, but it still fails to move Brazil or Russia to another region in the graph.
(***): Malaysia is not an inflation targetting country. Therefore, we have employed the expected increase in inflation, from year 2016 to year 2017.