Stagflation-Lite in Some Emerging Markets

Here is an update on several emerging markets by my colleague Ilan Solot.  

Many of the major emerging market countries seem to be moving deeper into a sort of stagflation-light situation, with inflation sticky at high levels but with growth decelerating or stagnant. In this report, we look at some of the differences and similarities in policy responses to this situation, focusing specifically on two questions: (1) who is in the driver’s seat of the adjustment? (2) How this may be impacting asset prices?

We focus on Turkey, South Africa, India, Russia, and Brazil. The main take away seems to be that the institutional backdrop and credibility seems to matter just as much or even more than fundamentals, at least in this point of the cycle.

In Brazil, the Finance Ministry is clearly the one in the driver seat. After taking on much of the responsibility for FX policy over the last few years, it is now also in the business of fighting inflation. To this end, it has taken several short-term measures such as tax cuts and reducing administered prices. Still, Brazil faces rising inflation expectations along with stagnant growth and a sagging local industry. Despite the central bank’s tightening bias, this dilemma looks to be resolved by supporting growth at the expense of fanning inflation, just as most EM countries are doing. The difference, however, is that government decisions in Brazil had – and will probably continue to have – a very strong impact on asset prices, perhaps more than in any other country in the sample. This is made clear by the performance of the Bovespa and recent moves in Brazil’s CDS prices.

The out performance of the South African JSE index over the Bovespa this year may have left many scratching their heads. Adding insult to injury, the 5-year CDS for Brazil’s rose by more than that for South Africa, even though the latter suffered from destabilizing labour disputes and civil unrest. Both are facing this stagflation-light scenario, but Brazil’s fundamentals are still clearly the stronger ones. Just compare the unemployment rate between the two: 5.6% in Brazil vs. 25% in South Africa. In our view, the divergence in asset price performance can be partially attributed to current institutional differences. For example, unlike its Brazilian counterpart, South African Finance Minister Gordhan plans to cut spending for the next three years, limiting expenditure growth to an average 2.3% per year vs. 2.9% previously, despite the very delicate social situation. The burden of adjustment seems to be more evenly shared in South Africa, and policy more predictable. The central bank is easing at a cautious pace while the government is doing what it can to rein in spending. Markets seem to be rewarding them for this, in relative terms.

Similar to South Africa, the macroeconomic adjustment in India requires the budget to be reined in. But unlike South Africa, where the Finance Ministry seems to be taking on at least some responsibility, the Indian government has disappointed on this front. The governmental paralysis has forced the RBI to step up and try to shift the burden of the adjustment to the government. In our view, the extent of further rate cuts in India is conditional on fiscal tightening. The RBI strikes us as having held up well in the face of criticism for not conducting a far more aggressive easing cycle, and is not about to change this posture. The bank is also doing what it can to guard the rupee from weakening too much, mostly via regulatory measures. All this seems to be in line with a weak, but not terrible performance of Indian asset prices in India going forward.

In contrast to Brazil, the key driver of policy changes, surprises, and asset price behaviour in Turkey is the central bank. Turkey’s latest solution to its conundrum of economic slowdown with sticky inflation has been to do something else (this central bank is not known for its long attention span). Dissatisfied with the slow convergence of inflation, the bank has put the easing cycle on pause and is now back trying to limit the widening current account deficit. Resisting the temptation for immediate easing will help the bank solidify its recently acquired credibility. The bank is now focus on raising reserve requirements, which restrain credit to importers. It has also become more vocal about its discomfort with a stronger lira. The net result for Turkish asset prices may one of indifference – which can be very a very good in comparison. The Istanbul stock index has kept up well with the S&P 500, and USD/TRY has been incredibly stable since mid 2012. Hard to complain.

The Russian central bank came out dovish in its meeting yesterday, even though inflation is still high at 7.3%, more than a full percentage point above the 5-6% target. The bank kept all main policy rates unchanged, but set the tone by cutting its long-term repo rates (Lombard rate) by 25 bp. The economic backdrop is seen as weakening further but inflation is not cooperating. Still, easing is coming. From a macro standpoint, Russia is probably the strongest of this group, but it ranks the lowest in the institutional side. It is clear that the growth-inflation dilemma will be resolved by supporting growth; what’s not clear is the impact on asset prices. That’s because unlike the other countries, there is still only one variable that really matters to Russia: oil. So depending on oil prices, Russia may get a pass, but the other countries may not be so lucky.