Emerging Markets | Monetary Policy & Inflation
Global asset purchases under Quantitative Easing (QE) could top $6 trillion in 2020, Fitch Ratings estimates – three times the previous peak in 2013. Yet, the Emerging Market (EM) countries’ purchase plans look quite small so far.
Major EM countries like China, Korea, Taiwan, India, Russia, Brazil and Mexico have announced no QE programs so far despite facing the deepest recession in recent memory. The hesitation is perhaps explicable. Once QE is initiated, it’s far from clear if there is an ideal exit strategy. More importantly for an EM country, the extent of the impact on its currency is highly uncertain.
In the developed markets (DM) world, pursuing unconventional policies may not be as risky for currencies. The U.S. has had the luxury of possessing the world’s reserve currency. Europe and Japan also, being developed, stable regions, have currencies that essentially mean revert around USD, albeit with big swings. EM economies, on the other hand, can be plagued by structurally higher inflation, bouts of exchange rate depreciation and occasional capital flight. If QE adds to that volatility and/or chronic weakness, it would make foreign debt servicing that much harder for many of them. Incidentally, there has been a surge in EM foreign debts since the GFC: the outstanding international debt securities have doubled in the past decade to $4.2 trillion (public plus private), as per BIS data. Excluding China, the figure is $3.1 trillion.
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Global asset purchases under Quantitative Easing (QE) could top $6 trillion in 2020, Fitch Ratings estimates – three times the previous peak in 2013. Yet, the Emerging Market (EM) countries’ purchase plans look quite small so far.
Major EM countries like China, Korea, Taiwan, India, Russia, Brazil and Mexico have announced no QE programs so far despite facing the deepest recession in recent memory. The hesitation is perhaps explicable. Once QE is initiated, it’s far from clear if there is an ideal exit strategy. More importantly for an EM country, the extent of the impact on its currency is highly uncertain.
In the developed markets (DM) world, pursuing unconventional policies may not be as risky for currencies. The U.S. has had the luxury of possessing the world’s reserve currency. Europe and Japan also, being developed, stable regions, have currencies that essentially mean revert around USD, albeit with big swings. EM economies, on the other hand, can be plagued by structurally higher inflation, bouts of exchange rate depreciation and occasional capital flight. If QE adds to that volatility and/or chronic weakness, it would make foreign debt servicing that much harder for many of them. Incidentally, there has been a surge in EM foreign debts since the GFC: the outstanding international debt securities have doubled in the past decade to $4.2 trillion (public plus private), as per BIS data. Excluding China, the figure is $3.1 trillion.
Putting aside the risks on currency, another reason for lower QE seems to be comparatively muted fiscal stimulus plans within EM. While the developed countries among the top 20 economies in the world are planning to spend 11% of their 2019 GDP in stimulus packages (including guarantees and quasi-fiscal measures), developing countries are aiming for barely 2% so far.
Furthermore, EM central banks still have some conventional weapons left in their arsenals. In most large EM economies, policy rates are nowhere near zero. In countries like India, Indonesia, Russia, Turkey, Mexico they are still at 4% or higher; China and South Africa are at 3% or higher.
Most Are Still Reluctant
China appears to believe that there is enough market demand for its government bonds to need PBOC to come to its rescue. Some countries, like Korea, have announced a so-called QE-lite plan, which sounds more like repo operations. Under this program, financial institutions are supposed to buy the bonds back after a few months.
Within EM, Poland has had the largest QE purchases so far: 4% of GDP, comprising both government bonds (2.3% of GDP) and bonds issued by the national development bank and Polish development fund. Markedly, the country also announced the largest fiscal package among EM, at 6.5% of its GDP (excluding loans and guarantees), and the country’s fiscal deficit could top 10% this year. It is understandable, therefore, why Poland resorted to QE at a relatively larger scale.
Chile is the rare EM country that began its QE after nearly exhausting conventional methods (policy rate at 0.5%). The central bank is mostly providing direct funding to local banks and incentivizing them for onward lending. It has injected 2.5% of GDP so far.
Among the rest, Brazil is a likely candidate for QE in near future. The central bank has obtained the legislative approval, but it has not announced any program yet. Given the large expected fiscal deficit and already high public debt, it could be forced to do QE eventually – especially if financial market conditions deteriorate again.
Note that QE can come in different avatars. Beyond buying government bonds, the central banks could also provide unlimited liquidity to financial institutions, with or without collaterals. It could also purchase corporate bonds, ETFs or other asset-backed securities directly from firms or mutual funds. Even under this broad definition, only a handful of EM countries (Indonesia, Philippines, Turkey, South Africa, Chile, Colombia, Poland and Hungary) have begun to tiptoe around QE. More significantly, many of them claim that the purpose is to stabilise the financial markets – akin to their foreign exchange intervention – rather than financing the government stimulus bills. Indeed, the purchases have been small: only Poland and Chile’s QE programs have exceeded 1% of their GDPs so far. This is in stark contrast to the massive QE programs undertaken in DMs.
Favour EM Bonds, Not Stocks
Going forward, the muted fiscal and monetary response will likely exacerbate the deflationary shock in most EM economies. Remarkably, even though the current recession is expected to be much deeper than the one followed by the GFC, real interest rates in many EM countries are still not lower than they were in 2009. Put differently, monetary policy actions have not yet caught up with the expected slowdown.
The situation worsens as new Covid-19 cases keep rising in much of EM (except in north Asia). This will entail both weaker consumption and lower capex in the months ahead; as a result, growth in EM will likely underperform that of DM. So will their stock prices.
EM local currency bonds, however, could do well. This is partly because of their relatively better starting point. Even before the pandemic hit, most EM economies were plagued by high real lending rates, which contributed to decelerating credit since early 2019. Now, facing an unprecedented recession, the monetary authorities will be forced to cut rates much more drastically to revive bank credit than would otherwise be the case.
The EM central banks have indeed been cutting rates – despite a marked sell-off in their currencies. This is a remarkable change in their behaviour from the past global downturns when they often hiked rates to defend the currency. That said, slashing rates is the correct policy action given the magnitude of the looming shock. And this backdrop is bond bullish. Foreign investors should consider buying / overweighting EM local currency bonds (currency hedged), which offer value relative to 5-year US treasuries.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)