Emerging market central banks face acute dilemma
The biggest challenge facing EM central banks is convincing national governments to do more of the heavy lifting
Spare a thought for central banks in vulnerable emerging markets (EMs). On Friday, Russia’s central bank will hold its monthly interest rate-setting meeting at which many analysts expect it to resume the rate-cutting cycle it put on hold last July.
Over the past year or so, Russia’s benchmark rate has been kept at a punitive 11 per cent despite a severe recession, with the oil-dependent economy contracting at an annualised rate of nearly 4 per cent last year and 1.2 per cent in the first quarter of this year.
The case for a rate cut is compelling. Russia’s inflation rate has tumbled from nearly 16 per cent last summer to just over 7 per cent last month. The rouble, meanwhile, Russia’s currency, has strengthened more than 17 per cent against the dollar since mid-February as oil prices have shot up 85 per cent to just over US$52 a barrel.
Most importantly, Russia’s economy, further weakened by a harsh sanctions regime imposed by the West in response to Russia’s intervention in Ukraine, is crying out for looser monetary policy, with retail sales and construction output contracting in April.
Yet a rate cut on Friday is far from assured. Inflation is still nearly double the central bank’s 4 per cent target, partly fuelled by strong wage growth. Sentiment towards EMs has also proved extremely volatile of late, with many investors remaining sceptical about the recent rally in commodities. Russia’s central bank, one of the most hawkish EM central banks, may decide to leave rates unchanged with a view to loosening policy later this year provided inflation continues to decline.
The acute dilemma confronting Russia’s monetary guardian – whether to provide much-needed stimulus to a recession-stricken economy or safeguard its inflation-fighting credibility – is one which many other EM central banks are grappling with to varying degrees.
Brazil’s central bank, which was expected to leave its main rate unchanged at its policy review on Wednesday, faces the most unenviable predicament.
Despite having raised rates aggressively since April 2013 – Brazil’s benchmark rate has been increased by seven percentage points to a painfully high 14.25 per cent – the central bank has patently failed to suppress inflation which currently stands at more than 9 per cent, roughly double its target.
As if that wasn’t bad enough, Brazil’s economy has collapsed, contracting at an annualised rate of 5.4 per cent in the first quarter of this year after shrinking nearly 4 per cent last year, the sharpest contraction in two-and-a-half decades. According to Goldman Sachs, Brazil has been in recession for two years and is now on the brink of a depression.
This ensures that Ilan Goldfajn, who on Tuesday was confirmed as Brazil’s new central bank governor, will face a baptism of fire. Goldfajn, who claims Brazil is “going through the worst recession in [its] history”, has pledged to bring inflation down to “low and stable levels.”
Yet he rejects the “fallacious dilemma” between growth and low inflation, fuelling speculation that he is preparing the ground for rate cuts, possibly as early as next month.
However Brazil’s central bank can only lower rates if the country’s new government under acting president Michel Temer begins to restore fiscal discipline. Brazil’s budget deficit has surged to a whopping 11 per cent of GDP amid a collapse in revenues and a conspicuous failure to curb expenditures.
Turkey’s central bank also faces a severe challenge. Under intense political pressure not to tighten monetary policy, the central bank has been cutting rates cautiously over the past several months despite a core inflation rate (which excludes volatile food and energy prices) that has remained stubbornly above 9 per cent since October, nearly double the central bank’s target.
Yet the biggest challenge facing EM central banks is the one which their counterparts in developed economies are also confronting: convincing national governments to do more of the heavy lifting in reducing macroeconomic vulnerabilities and reforming economies.
The limits of monetary policy are becoming more apparent by the day. While the effectiveness of central banks’ policies in vulnerable EMs like Brazil and Russia is extremely limited given the damage wrought by the plunge in commodity prices and the reluctance of governments to undertake fiscal and structural reforms, ultra-loose monetary policies in advanced economies are having perverse consequences.
In a hard-hitting note published on Wednesday, Deutche Bank claimed the ultra-accommodative monetary policies of the European Central Bank (ECB) have “allowed [Europe’s] politicians to sit on their hands with regard to reforms.”
It’s not just EM central banks that are in a pickle.
Nicholas Spiro is a partner with Lauressa Advisory