Contrary to general perception, central banks in emerging markets will not be forced to tighten rates materially as the Fed hikes, notes Bank of America.
Ethan S. Harris and team at Bank of America Merrill Lynch in their March 27, 2015 research report titled: “Get real on EM”, however, points out some countries have severe political issues entirely unrelated to the Fed.
Central Banks: Appropriate policy rate at EM
The Bank of America analysts point out that the priced-in policy rate difference vs the U.S. is in line with the median of the 2003-06 cycle in most markets, and materially higher in China, India and Russia, while it is lower in Hungary and Poland, where inflation is structurally much lower now. The following graph captures the 2-year swap rate differential in various EM vs the U.S.
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The analysts believe the risks from exchange rates to inflation and corporate balance sheets are limited in most EM, allowing central banks to trim rates despite the strong dollar. As set forth in the following chart, among the major markets, only Brazil and Turkey are in a particularly tight spot as 2016 inflation is likely to overshoot the target, and at the same time external debt is high relative to export earnings.
The analysts wonder if most EM central banks can run policy independently of the Fed, and what the appropriate policy rates are at this stage of the cycle. The analysts have employed four models to answer this query.
For instance, they have run the Hodrick-Prescott filter on the policy rate net of inflation expectations, to detect the underlying medium-term trend in the data by removing the cycle. As depicted in the following graphs, the filter puts the appropriate real rate for Poland at about 1% and for South Africa at about zero.
As far as China is concerned, the Bank of America analysts note the data don’t lend themselves well to their models and the analysts anticipate further easing. The analysts anticipate that the PBOC will trim the policy rate by 50 bp this year and additionally cut the RRR by 75 bp. Focusing on India and Korea, they point out that their models put the appropriate real policy rate around zero, strengthening their calls for further rate cuts in these countries. The BOA analysts forecast another 50 bp policy rate cut in 2015 in India, while in Korea, they forecast another 25 bp policy rate cut this year.
Mixed outlook for exports in US
Harris et al. note a closer look at U.S. trade points to a robust domestic recovery, but a more mixed outlook for exports. The analysts point out that a near-term rebound in exports may be in the cards, but the longer-term outlook for the sector is fraught with challenges. They point out that the dollar’s ascent of 20% over the past year boosts the cost of US exports abroad, eroding competitiveness. They note the non-petroleum trade balance has been acutely deteriorating in recent years, with 16 out of 21 categories of manufacturing trade in deficit:
The Bank of America analysts remain confident that the U.S. economy will continue to grow briskly this year at a pace of around 3%, propelled by domestic demand. They note the increase in import demand will provide a helping hand to the rest of the world.
Turning their focus towards Europe, they point out that Greece has two weeks to demonstrate a strong commitment to reforms. The analysts believe Greece will stay in the euro, though they argue that the country has not been on the right track.
As far as the EMEA is concerned, Harris and colleagues highlight that considering a weak economic growth outlook and a projection of only a temporary breach of inflation above target in 1Q 2016, they anticipate SARB to remain cautious. They reiterate their call for next 25 bp hike in November 2015.