Constantly evolving macro dynamics have made it a tough year for investors getting the macro calls right. For instance, policy divergence (Fed tightening and ECB/BoJ easing), which was a pre-dominant theme 12 months ago, gave way to rates being ‘lower for longer’ around July/August, with the trigger being global growth worries led by a China-slowdown and its consequent deflationary impact. While global growth remains an issue, the Fed’s October policy statement alluded to policy divergence coming back into play sooner than market expectations. Similarly, recent policy steps taken by the Chinese authorities, both on the monetary and fiscal front, have helped assuage concerns on a hard landing. This is in sharp contrast to the chaotic measures that were imposed during June/July to stem the volatility in stocks and FX.
The resultant swings across financial markets highlight how dependent the global macro environment— both activity and investor sentiment—are on the US and Chinese economies. In this column, the predicaments facing the major central banks are examined and it is concluded that while ‘extended accommodation’ has—and could continue to—eased the pressure on emerging markets (EMs) in the near-term, it is temporary. The longer-term issues at play in the EM world include the implications of a lower growth trajectory and debt build-up.
First, let’s begin with a quick re-cap on what the major central bankers have been saying in the last few weeks. Starting with the Fed, while the September policy statement was clearly more dovish than market expectations, the Fed had then said “global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near-term.” The October statement dropped the sentence on “global restraint”, keeping the door open for a 2015 ‘lift-off’. While admittedly, the EM-led slowdown and strong dollar could be a drag on US growth, underlying economic activity in the US is healthy, thus suggesting that a continuation of ‘zero’ interest rates may no longer be needed.
Moving on to the European Central Bank (ECB), the ECB’s October statement reiterated its September concerns on downside risks for both growth and inflation. In addition, it stated the need for re-examining “the strength and persistence of the factors that are currently slowing the return of inflation”. This gave markets hints of potential further easing by the ECB later this year. Markets are now anticipating that the December meeting could result in negative interest rates and/or an additional round of quantitative easing.
As regards the Bank of Japan (BoJ), while the October meeting left its policy unchanged, the Japanese central bank cut and pushed out its inflation forecast of 2% to 2017. Nonetheless, all eyes will be on its upcoming meeting and whether one could see additional easing given that growth has been weaker than expected with the initial impact of its 80-trillion-yen QE programme is wearing off/offset largely by the contractionary fiscal policy (consumption tax increase).
Lastly, with regards to China, the People’s Bank of China continued with its expansionary policy cutting both the bench mark policy rate and one-year deposit rate by 25 bps to 4.35% and 1.5% and the RRR by 50 bps to17.5%. In addition, it completed the last step of interest rate liberalisation by removing the ceiling on deposit rates.
Continuation of monetary easing, coupled with the recovery of land sales boosting government revenues, have assuaged concerns on China’s ‘hard landing’ scenario.
So, what does this mean for the EM world? The ‘extended accommodation’ has and could continue to ease the pressure on EM in the near-term, however this may not sustain. Key issues at play include:
* Lower growth and disinflationary trends: The secular downtrend in EM growth has resulted in a sharp drop in commodity prices, excess capacity and consequently lack of pricing power. More-over, despite currency weakness, there has been little exchange-rate pass through on inflation. The slow growth in the face of excessive credit/investment has led to declining corporate profitability which turn weakens employment and slows wage gains, thereby hurting personal incomes and eventually demand.
* Debt build-up and servicing: As is well known, one of the unintended consequences of the G-3 accommodative policies have been a sharp rise in EM debt. Favourable macrodynamics in 2008 resulted in EMs receiving huge inflows. However, this is now reversing, and in an environment of lower growth, currency weakness could slowly result in balance sheet stress and debt-servicing concerns.
While India’s efforts on correcting its macro-imbalances are helping it be differentiated from other EMs, the recovery in growth remains anaemic as:
* the weak global backdrop is likely to keep external demand muted and
* the much-awaited private sector investment pick up could take longer given the stressed assets in the system, debt overhang in key sectors and global excess capacity.
Consumption alone cannot save the day, the government needs to walk the talk on public investments to sustain ~7% growth.
The author is former chief economist, Citigroup India, now based in the US. Views are personal