The job of an emerging market central banker is never easy, but it’s been a long time since it was this difficult.
The challenges they face right now are growing in number, complexity and severity: escalating global trade tensions, rising U.S. interest rates and bond yields, a strong dollar, slowing economic growth and increasing capital outflows.
The natural response to some of these pressures, such as slowing growth, would be to cut interest rates, while the natural response to others, like a weakening currency and capital flight, would be to raise them.
Both carry serious health warnings, which is why the divergence between emerging central bank policy responses this year is deepening.
An analysis of 10 of the largest EM central banks’ policy decisions this year that have involved changes to benchmark interest rates shows that there have been eight cuts and 13 hikes.
The speed and extent to which circumstances can change, thereby intensifying the spotlight on the challenges facing an emerging central bank, is illustrated best in Argentina.
The Banco Central de la Republica Argentina has cut rates twice this year and raised them three times. On April 24 it kept its main policy rate unchanged at 27.25 per cent, only to jack it up by a whopping 300 basis points three days later.
Latin America’s second largest country is going through a full-blown currency crisis, has tapped the IMF for a $50 billion credit line, raised interest rates to 40 per cent and is staring down the barrel of recession.
Argentina is an extreme case but it’s a reminder of how volatile, unpredictable and risky emerging markets are. The BCRA was forced to act quickly and aggressively when the crisis started to unfold in late April, and the nation will almost certainly pay a price of recession and higher unemployment.
Turkey, another EM country boasting twin current account and budget deficits, also stands out. The central bank has more than doubled interest rates to 17.75 per cent since April, and like Argentina, its currency has sunk to a record low.
For investors and policy-makers alike, there’s no easy path.
Raising interest rates will help relieve the intense selling pressure on their currencies, ease inflationary pressures and attract foreign capital into their domestic asset markets. But this course of action is likely to hit investment, choke growth, raise unemployment and tip the economy towards recession.
Lowering borrowing costs, meanwhile, helps support faltering growth through the exchange rate, credit and investment channels, but risks fuelling inflation and exacerbating capital outflows.
Again, for both investors and policy-makers, the exchange rate is critical. Gentle depreciation is manageable and often desirable, but that can quickly snowball into a capital flight-induced rout, which is highly undesirable.
Getting that balance right is made even more difficult by rising U.S. interest rates, which are lifting U.S. bond yields and the dollar, and tightening global financial conditions. Emerging market governments and companies have borrowed heavily in dollars, and their debt repayment burdens are rising.
So far this year, Argentina’s peso is down 30 per cent against the dollar, Turkey’s lira is down 20 per cent and Brazil’s real is down 10 pct. The Russian ruble, Indonesian rupiah, South African rand, Indian rupee and Chinese yuan are all down between 5-8 per cent, while Mexico’s peso is up 5 pct.
According to State Street, emerging currencies are broadly undervalued by around 7 per cent, which might sound like a buying opportunity for many investors.
But If previous episodes of EM volatility, like the 2008 global financial crisis or the Fed’s “taper tantrum” in 2013, are any guide, they can fall a lot further if the current turmoil deepens.
Below is a list of 10 of the biggest emerging markets and the action on interest rates their central banks have taken this year. The only one not to change rates is the People’s Bank of China, but it has eased policy in other ways, including lowering the reserve ratio requirements for banks and allowing its currency to depreciate.
- Argentina: 2 cuts, 3 hikes (net change +1,275 bps)
- Mexico: 3 hikes (+75 bps)
- Russia: 3 cuts (-100 bps)
- Turkey: 2 hikes (+975 bps)
- Indonesia: 2 hikes (+100 bps)
- India: 1 hike (+25 bps)
- Mexico: 2 hikes (+50 bps)
- China: no change
- Brazil: 2 cuts (-50 bps)
- South Africa: 1 cut (-25 bps)