Interest Rates Going Down in the EMs? Who is Hot and Who is Not?

Once again, I am flattering an entry with a picture taking here in Switzerland where I am currently entertaining courses at HEC Lausance. As you can see, it is a beautiful place and also, as it were, very interesting with respect to tail fume patterns from the enormous amount of airplanes moving back and forth over le Lac Léman (middle of Europe remember!). Posting is slim I know, but so unfortunately is time; I can assure that it is not out of lack of enthusiasm to write and opinion on current events.

Moving on to the topic du jour it is interesting to observe wow fast things sometimes change. We need not go back more than 5-6 months to observe how hawkish central banks across the economic edifice were busy scrambling to raise rates in order to quell inflationary pressures. Most notably, the price-hamping effect from a rising currency emerged as a key policy tool. Especially across the Eastern European edifice, at the ECB, and in some key Latin American economies this view was prevalent (arguably in New Zealand and Australia too, but the reversal has been very quick here).

However, as they say, this was then and this is now. In some cases and given the obvious severity of the incoming slowdown this policy was a mistake. In some cases, it may have made an otherwise dire situation worse, and in other cases it may, unfortunately, turn out be an extremely dear error. At this point it is still too early to say anything conclusive. Yet, as I point out in my recent installment the deflation ghost is moving closer and policy makers are positioning themselves accordingly. Just witness today's pre-December Christmas party at the European commission; I wonder how they are going to pay for it though.

Along the lines of the taxonomy described above I would, in particular, flag the economies in Eastern who are now confronted with some tough choices all at the same time as their real economies are heading straight to h'll. Add to this that the IMF and most notably the EU will be trying hard to pull the strings in the background and you end up with a great mess, both in economic and political terms. A small refresher might however be in order and although many examples would be illustrative here, Hungary and Ukraine are particularly telling. Let us thus go briefly back to May this year where Hungary's central bank decided to scrap the trading band against the Euro in an effort to quell rampant inflation by letting money come in to boost the currency.

A similar set of events was played out in Ukraine a couple of months later. Faced with a drastically changing market environment in which policy makers and market participants turned all eyes on inflation  the Ukrainian monetary policy almost turned into a comic farce. Basically, Ukrainian monetary policy makers got caught, and understandably so, between market expectations on one side and economic fundamentals on the other side. As Edward so neatly put it at the time; 

Does anyone happen to know offhand the "official" dollar rate of the Ukrainian currency, the Hryvnia? I am asking this question since clearly over at the central bank they are having difficulty deciding at the moment, since - like the legendary character Hydra - they seem to be speaking with two "heads" at the same time, and the only question I can ask is: would the real representative of the Ukraine central bank please stand up!

A lot of water has gone under the bridge since then and today we are, if only a very small bit, more knowledgeable of the dynamics at hand. In the case of both Hungary and Ukraine I was skeptical of the faith put in these aggressive inflation fighting policies through currency appreciation[1]. Hindsight is of course always a cherished luxury and I am not suggesting that the decisions to depeg from the anchor currency (either the Euro or USD) were wrong; in fact this is an inbuilt necessity if these economies are to have a fair chance of "emerging" once again. However, I am suggesting that whatever faith we ascribe to the dictum of so-called rational expectations and the agents supposed to be imbued with these, we should always be careful taking knee jerk market discourses at face. The massive push to revalue Eastern European currencies in the context of the policy attempt to lower headline inflation was obviously such a reaction. As is clear now, it did not last long before the tide turned.

Forwarding our perspective to the present it is thus pretty clear that the shit has hit the proverbial fan. Once a clear and bright example of this is the events unfolding in Russia which is, if you remember, still a part of Goldman Sach's venerable BRIC group. That narrative is of course long gone now. We have all observed how Russia has been hit hardest from capital outflows amongst the emerging economies. Edward has a very useful summary of the situation here, but we need not go much beyond the immediate news this week to learn that Russia inevitably is moving towards a devaluation of the currency (and then I imagine a series of interest rate cuts to get exports going in the non-energy sector).  The numbers are really quite extraordinary. Since August the total outflow from Russia's capital market has, so far, amounted to a staggering $190 billion according to Bloomberg. It does not take much advanced arithmetic here to realize that even if Russia is in possession of a healthy portion of foreign exchange reserves such a buffer can melt away within a matter of month if investors collectively decide to pull out. Or to put it in a Macro Man package; defending the Rouble at this point in time amounts to a h'll of alot more than mere pisstaking to mess up hedgies' punts on the Rouble. 

As a consequence, the devaluation of the Rouble appears to be anything but certain since it simply makes no sense to keep on defending the Rouble's peg to its current basket. In this context, it is true that Russia's central bank announced today that rates would go up a full 100 basis points, to 13%, from December in an attempt to shore up inflows. Yet, this may also be an initial step to lock in a high level of interest from which to lower once a devaluation (scrapping of trading etc) is announced. Hungary's example a few weeks ago in relation with the plan to secure Swiss denominated consumer and mortgage loans might be a yardstick here.

Spot the Pattern?

While Russia definitely will mount an example to follow for other emerging economies (not least in Eastern Europe), it seems that as the money flows out and as economic momentum is winding off significantly many emerging economies are beginning to look south with respect to interest rates.

Emerging market central banks may follow Hungary, Turkey and Malaysia in lowering interest rates to support faltering economies even as investors shun assets in developing nations, TD Securities said. In the past week, the Turkish, Hungarian and Malaysian central banks have carried out unexpected cuts to their key rates. Poland’s central bank today reduced its key rate a quarter point, to 5.75 percent, while 15 of 20 economists in a Bloomberg survey predicted rates would be left unchanged.

As the lira, forint and the ringgit have held up, policy makers in Mexico, South Africa and Brazil, the next in line to meet in coming weeks may be more tempted to ease rates, Beat Siegenthaler, the London-based chief strategist for emerging markets at TD Securities, wrote in a note to clients.

Now, as Mr. Siegenthaler also points out and as I would strongly reiterate the danger is of course that the currency plummets completely as the central bank begin to ease the nominal rate. This is important not least in the context of Hungary and Ukraine where the central bank has to balance a knife's edge and ultimately is left to the whims of foreign punters. Such is the situation, in fact, across the entire Eastern European edifice and in this respect I would strongly agree with Nouriel Roubini's comment as quoted by Bloomberg;

“The currency is overvalued in nominal and real terms,” Nouriel Roubini, the New York University professor who predicted the current financial crisis two years ago, said in a Bloomberg Television interview in Moscow. “How to move to a more flexible exchange-rate regime is going to be one of the most important policy challenges to avoid a hard landing.”

I would apply this reasoning on a broad range across Eastern Europe, or as Stiegthaler puts it in a more polemic tone;

The recent examples “may signal to other central banks that they can get away with rate cuts,” Siegenthaler said.

So what exactly will Eastern European (and indeed their fellow colleagues in other EM economies) be able to get away with here? Not a whole lot I imagine which is also why I really hope that the IMF manages to play its hand wisely since the way in which we move from A to B will likely be up to the way the fund is able to knit together a working solution at the same time as the central banks maintain their credibility. It is important here to take the real economic forecast into account here. The latest tableau d'horreur in the context of Eastern Europe came from Ukraine where the government now forecasts a 5% contraction next year. This is depression territory which is also why a currency crisis would be devastating.

In Hungary, things do not look much rosier either and together with Ukraine the economy is competing fiercely for the ill-wanted position as the most exposed economy in Eastern Europe. Meanwhile in other erstwhile sturdy CEE economies interest rates also seem set to come down. Consequently, Poland's central bank lowered its benchmark recently and in particular we should pay attention to the following point;

“Concerns about economic growth outweighed concerns about high inflation and strong wage pressure,” said Maja Goettig, the chief economist at Bank BPH in Warsaw. “The decision opened up a cycle of loosening monetary policy in Poland.”

This is exactly the main issue. The discourse has changed since Spring/Summer and we are now seeing the obvious policy consequences. However, for Eastern European economies it was never going to be an easy process in either direction since, some way or the other, the economies are saddled with economic (as well as structural) imbalances which need to unwind. In this way, the current process crucially need to be a managed one less we really want to see what a crisis looks like.

One example where this is blatantly clear is in the Baltics where we are moving towards the end of the line for the pegs. Edward asked the obvious question a couple of days back of whether a Baltic devaluation is now in the works. I think this is pretty much given at this point. Whatever kind of road the Baltics need to take to get out of the current mess a look at the Euro peg simply needs to be included. What kind of arrangement we will see is debatable. A recent commenter suggested to me that Scandinavia is using the Baltics as a spearhead to help prevent Russian influence. This was undoubtedly true back in the heaty days where the Baltics first claimed independence and the Scandinavian countries were among the first to recognise their independence. Whether today's situation is reminiscent, I really do not know. One thing which will be interesting in that respect will be what e.g the Riksbank does in the context of Swedbank (Hansabank) if and when the pegs are loosening. Remember in this respect that the Baltics themselves really do not have their own banking system which means that if the foreign subsidiaries draw back, a new system needs to be built up from the ground. In this light, whatever scenario will unfold it will be messy and filled with compromises, but one thing is certain. The peg will loosen, it has to. The only thing that would prevent this would be a Euro pushed to substantially lower levels against a weighted global basket. 

This may of course still happen and we should also take note of the reverse effect as some economies (e.g. my own home country) seem to be scrambling for a quick entry into the Eurozone. Yet I cannot put it strongly enough how detrimental this would be. The Eurozone has enough on its plate as it is and if suddenly half of Eastern Europe, Denmark (and Iceland?) are considered for a potential rushed membership the edifice will crack, I have no doubt. I am a strong fan of Europe as a common idea, but the Eurozone has some deep structural issues to deal with and admitting 5+ new members in the face of financial crisis is not one of the solutions.

How to go From A to B then?

This notes has been primarily concerned with emerging economies in Eastern Europe, but the argument can be applied more widely I think. To the extent that emerging economies on a large will now embark on a collective easing of monetary policy it raises some important questions. Firstly and as I noted above, some economies will have an easier time lowering interest without suffering a real rout on the currency and capital market. In this sense I would expect some emerging economies to use the devaluation tool as an alternative to a gradual nominal depreciation, the point being that in some cases this downward nominal adjustment will be anything but gradual if markets have their way.

However, there is a flip side to this. What about the emerging economies who will start growing again in mid 2009 and onwards (and trust me, some of them will). In particular, I am speaking about those economies such as India, Brazil, Chile, etc whose trend growth alone (based on domestic momentum) should help the ward off the most significant impact even though the current climate is dangerous for everybody. Clearly, these economies (no matter who this will turn out to be) are face with an equally big dilemma. As such, how do they maintain an interest rate to reflect domestic capacity and momentum conditions in a world where the Fed, the ECB, and the BOJ all are headed for some kind of quasi zirp/QE scheme. It does not take much of an economic literate to see that the potential carry gains flows here are enormous and even though any kind of revival of carry would mean a significant change in risk sentiment, it would happen in a world where more economies (than before!) have very low interest rates relative to those brave souls who dare (or are able to) keep interest at "normal" levels. Thus the screw turns yet again for the global economy and the asymmetry of capital flows. In fact, before we get to a reasonable understanding of why this is, and why some economies are inadvertently driven towards a specific growth path directed by crisis, fundamentals or both, we are still, as it were, sailing without a compass.

[1] - See in particular my article entitled Currency Dilemmas in Eastern Europe" for a detailed argument.