Covid-19 Crisis: Normalisation And Its Discontents For Emerging Markets
Global market pressures are an upshot of capital forcing a synchronicity of monetary normalisation across economies despite a sharp asynchronicity in their recoveries from Covid-19, against a backdrop of U.S. exceptionalism.
A Resurgence of U.S. Exceptionalism
First, the good news, but primarily from a U.S. perspective. With every passing tranche of stimulus, the cumulative fiscal response in the United States has grown from an axe to a sledge hammer to an 800-pound gorilla. Likely chastened from the experience of the global financial crisis, where both the quantum of the fiscal response and the speed of the rollback was retrospectively believed to be too conservative – leaving a disproportionate burden on the Federal Reserve, policy makers in the U.S. have doubled down on their fiscal bets this time around.
The total quantum of direct fiscal support — including the latest package — is a staggering 25% of GDP. The consequence is that the United States will be one of only two economies — the other being China — to make a complete recovery from Covid-19 this year, i.e. to converge back to its pre-pandemic path.
Ordinarily, stronger U.S. growth should be good news for the world, spilling over into other economies and driving a more synchronised global pick-up. That, in turn, typically induces a ‘risk-on’ in global markets, and drives capital inflows into emerging markets, a weaker dollar and easier financial conditions all around.
But this Goldilocks script is not playing out this time around. Instead, there is a growing likelihood of “U.S. exceptionalism”, with the U.S. recovery significantly outpacing the rest of the world, both because of the quantum of stimulus but also the faster pace of vaccinations compared to most developed and emerging markets. (At the time of writing this, the U.S. had administered about 27 vaccines per 100 people compared to less than 10 per 100 people in most other developed economies, barring Great Britain, and the gap is expected to widen.)
Furthermore, stronger U.S. growth in 2021 is unlikely to have the typical global spill-over effects because, given the unique nature of the Covid-shock, the U.S. consumer has more than normalised goods (tradable) consumption, but is lagging services (non-tradable) consumption, given the contact-intensity of the latter. Therefore, as the U.S. economy opens up, a disproportionate quantum of spending and stimulus checks are expected to be directed towards the domestic non-tradable sector.
In a role reversal, therefore, U.S. growth which is typically lower than EM growth, is instead forecasted to surge to the 8-9% levels (sequentially) in the middle of the year, almost twice the forecasted EM level.
Asynchronous Recoveries; Synchronous Tightening
All else equal, growth differentials skewed in the America’s favour to this extent, should drive a stronger dollar and induce capital outflows from emerging markets – a process that has already begun.
But this is not the only pressure point for EMs. The hefty U.S. fiscal response, and brightened growth prospects, have triggered an understandable re-pricing in long-end bond yields, even as the Fed remains patient at the short end. U.S. 10-year yields have increased 50 basis points over the five weeks, reflecting a rise in real rates, rather than inflation expectations, in response to the emerging fiscal-growth dynamics.
Furthermore, from the perspective of emerging markets, there seems to be a worryingly-reinforcing synergy between a stronger dollar and higher U.S. yields beyond a threshold, as seen in the next chart.
This then, is the uncomfortable reality that confronts emerging markets:
- First, almost all emerging markets will be much below their pre-pandemic GDP path at the end of 2021 as they fight to shake off the hysteresis from Covid-19.
- Second, any spill-over from the U.S. rebound in 2021 is likely to be limited.
- Despite that, EMs are being confronted with higher global yields and capital outflows which are pushing up domestic yields, tightening domestic monetary conditions, and creating yet more growth headwinds.
In sum, the seamless flow of global capital is forcing a synchronicity of monetary conditions across economies despite a sharp asynchronicity of their recoveries from the pandemic.
Even as EMs lag the U.S. recovery, they are being forced to import the latter’s, de facto, monetary normalisation. In a sense, the world is looking eerily like 2018 again.
The New EM Equilibrium
In the wake of rising U.S. yields and a stronger dollar, the new emerging market equilibrium will need to entail some combination of weaker exchange rates and higher domestic interest rates. Countries will have to choose where on this spectrum they’d like to be. The expectation is that most emerging markets will use exchange rates, to the extent possible, as their first line of defense.
The benefit of a floating exchange rate (or a managed float) is precisely for situations like this: when faced with a heterogeneous shock, countries can use the exchange rate to retain some monetary policy independence. Letting the exchange rate depreciate to absorb the shock will therefore not only mitigate the extent to which domestic rates need to rise but will, in itself, be stimulative and help offset some of the domestic tightening on account of higher yields. Conversely, if countries are constrained from letting their currencies weaken (either because their liabilities are dollarised or inflation is elevated and the pass-through into domestic prices is strong) monetary conditions will need to be tighter, often disproportionately so.
Use of policy buffers will be crucial in ensuring this new equilibrium is reached non-disruptively. EMs with sufficient foreign currency reserves will be able to intervene in forex markets to reduce volatility, ensure the depreciation is not untoward, and any overshooting is minimized. This forex intervention — which soaks out domestic currency liquidity — will, in turn, allow central banks to sterilise through OMO purchases that can simultanously prevent overshooting in the bond market. So adequate forex reserve buffers will be crucial in tempering the shock in both markets.
But all this can only soften the blow, not eliminate it. The fact is monetary conditions will tighten in emerging markets — albeit to different degrees — creating more headwinds for these economies to emerge from the shadow of Covid.
Countries that suffer from policy credibility or large funding requirements will confront a more acute trade-off between economic recovery and macroeconomic stability, and be forced to tighten disproportionately. Brazil, Turkey and Russia are all expected to witness policy rates hikes in the coming months, and the list could grow.
More broadly, as EMs have repeatedly discovered, global capital can often become a poisoned chalice. Spillovers from G3 central banks create uncomfortable trade-offs in both directions – often arriving in a glut creating a problem of plenty, and then leaving at the most inopportune of moments from the perspective of domestic business cycles. The lesson for EMs remains familiar: self-insure through sound macro fundamentals, policy and foreign currency buffers.
The value of fixing one’s roof is felt, and felt acutely, only on a stormy day.
India: Revisiting The Trilemma
How is India positioned to handle the global turmoil? India’s external fundamentals — current account, balance of payments, foreign exchange reserves — are far improved from 2013, creating important buffers vis-à-vis the Taper Tantrum. That said, India shares some of the same pressures experienced by other EMs: an externally-induced tightening of financial conditions amidst an incomplete recovery from Covid-19.
To be sure, some yield normalisation commenced even before global yields rose, in response to some normalisation (reduction) of domestic savings as the temporary savings surge from Covid abates, along with higher-than-expected government borrowing for 2021-22. But this is now being accentuated by a tightening of global financial conditions. The challenge for the RBI is to ensure that bond yields don’t harden too disruptively – in the wake of India’s incipient recovery – even while simultaneously trying to avoid adding more interbank liquidity (with the core surplus already at Rs 8.5 lakh crore) which, in turn, could create financial stability or inflation risks down the line, especially against an increasingly reflationary global backdrop.
What’s different about India – and at the heart of the RBI’s trilemma – is that unlike most emerging markets, the pressure on the Rupee for the most part has been to modestly appreciate, not depreciate, because the BoP is still tracking a surplus, albeit a smaller one. Letting the Rupee appreciate is undesirable, particularly when other EMs are depreciating, because it hurts external competitiveness and so further tightens monetary conditions, already impacted by hardening bond yields. Now if the RBI were to intervene to prevent Rupee appreciation and buy dollars, it simply adds to inter-bank liquidity, and further reduces space to intervene in bond markets.
At a more simplistic level, therefore, the RBI is often forced to choose whether to accommodate tighter monetary conditions through a stronger rupee or higher bond yields. In contrast, if domestic currencies in other EMs are under depreciation pressure, their central banks can sell dollars to calibrate the depreciation, and use the resulting liquidity space to intervene in bond markets and temper the yield increases – creating an automatic stabiliser of sorts.
The RBI will therefore have to continually look for new instruments and spread the pressure across instruments and time: finds ways to soak out the existing stock of liquidity so as to create space for fresh forex or bond intervention, and opportunistically use Operation Twist and forward intervention in bond and currency markets respectively – as we have previously discussed on these pages (see, “RBI’s Quadrilemma”).
If the BoP were to turn and the Rupee were to eventually face depreciation pressures, the central bank should gently accommodate this, and not resist it, for all the aforementioned reasons.
Finally, one growing risk for India is the recent inexorable rise of crude prices. If this sustains, macroeconomic challenges will only grow. To be sure, rising crude prices will widen the current account, reduce the BoP surplus, and therefore make the trilemma less binding for the RBI. Fundamentally, however, rising crude prices constitute a negative terms of trade shock for the economy, equivalent to an adverse supply shock, which risks simultaneously hurting growth (thereby making tighter monetary conditions less palatable) while creating fresh fiscal and inflation risks (thereby making tighter monetary conditions more inevitable).
As the lockdown of 2020 gives way to the normalisation of 2021, the challenges confronting emerging market policymakers have not abated. They have only changed.
Alas, there is no rest for the weary.
Sajjid Z Chinoy is Chief India Economist at JPMorgan. All views are personal.
The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.