External Shocks, Stagflation and Policy Response

Transcription

1 JUL External Shocks, Stagflation and Policy Response Chen Zhao» The collapse in commodity prices since 2011 has spurred serious economic difficulties for most commodity-producing countries. Indeed, either stagflation or slowflation slowing growth with rising inflation has plagued a large number of commodity-driven economies in Latin America, Africa, and the Middle East over the past 2-3 years. Stagflation or Slowflation Take Latin America as an example. As shown in Chart 1 below, Gross domestic product (GDP) growth as a whole peaked at 6.6% in 2010 and has been falling steadily since, alongside weakening commodity prices. In 1Q 2015, the region as a whole saw growth slow to a standstill of about 1.2%. The picture of growth stagnation may persist with yield curves either inverted (e.g. Brazil or Argentina) or fairly flat, and credit continuing to contract the latter of which is shown in Chart 2.

2 The aggregate picture is somewhat deceptive because the economic weakness for the entire region is exaggerated by a few trouble spots such as Brazil, Argentina, and Venezuela though growth has softened substantially from the pace seen in in stronger economies such as Mexico, Chile, and Peru. For Mexico, GDP growth averaged 4% between and has been below 2% for the past two years. While growth has slowed, inflation has been rising in a number of commodity-producing countries. For Latin America, consumer price index (CPI) inflation rose to well over 8% currently, from just about 4% in Admittedly, this large jump has been skewed by a few troubled economies, and the dispersion of inflation among countries is fairly uneven. Venezuela has the highest inflation rate at 70%, while Mexico has the lowest at 2.9%. Nonetheless, Brazil, Chile, and Colombia have all seen CPI inflation move higher over the past two years, while it has been steady in Peru at 3.5%. Mexico and more recently, Chile are the only countries in Latin America where CPI inflation has actually fallen in recent months. Inflation versus Currency It is somewhat counterintuitive that commodity-producing economies have been going through bouts of rising inflation, as falling commodity prices are unambiguously deflationary for commodity producers. The culprit is foreign-exchange rate depreciation. Had the world still operated in the gold standard, most commodity-producing nations would have seen their current-account deficits increase and monetary aggregates contract, leading to a fall in real income. In a fiat money system, however, the decline in real income is typically realized through a fall in the foreign-exchange rates, which usually leads to rising inflation, and ultimately a reduction in real income. Chart 3 shows how Latin American currencies have adjusted to the large fall in the Commodity Research Bureau (CRB) Index since 2011:

3 There is a steady and well-defined correlation between the magnitude of foreign-exchange rate depreciation and the levels of domestic inflation. Indeed, the levels of domestic inflation seem to be largely dictated by the severity of currency depreciation. The Russian ruble, the Brazilian real, and the Turkish lira are the currencies that have fallen the most since 2011; not surprisingly, inflation in Russia, Brazil, and Turkey are significantly higher. The Mexican peso and the Peruvian new sol have been the best-performing Latin American currencies, only falling by 17% and 19% versus the dollar, respectively since Correspondingly, inflation rates in Mexico and Peru are significantly lower than other countries in the region. In fact, most emerging market countries seem to have fallen into a narrow corridor around the regression line, as evidenced in Chart 4 below. In other words, different inflation rates among nations are largely explained by the degree of currency weakness.

4 Two Types of Policy Response When faced with similar external shocks, a very relevant question to ask is, Why have some countries fared significantly better than others? For example, both Chile and Brazil have endured similar terms-of-trade shocks, and Chile ran an even bigger current-account deficit than Brazil in 2013, when the Federal Reserve-induced taper tantrum struck the emerging market world (see Chart 5 below). Yet Chile has seen much smaller currency depreciation, lower inflation, and significantly stronger economic growth than Brazil.

5 Current Account Comparison: Brazil versus Chile There are obviously many complicated reasons why some countries have done better than others in terms of economic performance, though how policymakers have responded to the external shock may have played an important role in explaining the differences in economic performance. During and since the 2013 taper tantrum, there have been two very different policy responses in the emerging market world: one focuses on protecting economic growth, and the other emphasizes defending a falling currency. Brazil, Russia, Colombia, and Indonesia fall into the category of currency defenders as they have all increased interest rates in an effort to stabilize their local currencies since Chile, Mexico, Peru, and South Africa seem to be growth defenders because these countries have taken the opposite course of action by easing monetary policy even though their currencies also fell. Outside the commodities space, Turkey raised rates sharply to defend the lira since Some may also include India in countries that have raised rates, but we should look at India in a broader context. The Reserve Bank of India (RBI) began cutting rates in 2012, only to be interrupted by the taper tantrum in the summer of 2013 at which time the RBI brought rates back up to their 2012 levels. Since the end of 2014, the RBI has resumed monetary easing (see Chart 6).

6 Interestingly, the countries that hiked interest rates ended up with much weaker currencies, higher inflation, and dramatic economic slowdowns or even recessions versus those countries with central banks that opted to cut rates to protect growth. In other words, the efforts by these countries to stabilize their currencies and inflation have often been counterproductive. Indeed, the growth defenders that opted to cut rates on a negative trade shock have fared much better in terms of growth, inflation, and financial market performance, as shown in Chart 7 below.

7 It is not too difficult to understand why currency defenders have often failed to achieve their policy objectives. Raising rates has never been a successful strategy for defending a currency, and tightening monetary policy on the back of a major negative trade shock is an even worse policy choice. Such action can only aggravate economic pain and financial instability by making a bad situation worse. Brazil, Russia, and Turkey are typical examples of countries with central banks that have made policy mistakes. In 2013, the ruble, real, and lira were already plagued by falling commodity prices or current account deficits, but rising interest rates in these countries forced currency markets to make additional downward adjustments to discount looming economic recession. As a result, inflation has soared on much larger currency declines. By design, a free-floating exchange-rate system allows the foreign-exchange rate to fall on a negative terms-of-trade shock. Such a decline in the currency alleviates economic and financial stress on impacted sectors, thus protecting growth. Of course, the side effect of a falling currency is an increase in inflation, but inflation induced by the foreign-exchange rate is always transitory. The inflation rate tends to fall once the foreign-exchange rate reaches a new equilibrium. Better still, if monetary authorities can lower rates, they can greatly mitigate the impact of a negative trade shock on the economy, making the adjustment process and recovery much easier. Of course, this is easier said than done. It takes both courage and good judgement on the part of monetary authorities to ease policy on the back of a weakening currency, or sometimes rising inflationary expectations. In hindsight, the central banks in Mexico, South Africa, Chile, and Peru have bravely eased monetary policy even though they have all encountered currency weakness. The policy action has successfully protected domestic growth, while keeping inflation at the tolerable range in all of these countries. In reality, the interactions between policy, inflation, foreign-exchange rates, and the underlying economy are fairly complicated. Labor productivity, leverage, foreign debt, and the general health of financial institutions all play crucial roles in how an economy can cope with a negative terms-of-trade shock. For instance, the scandal surrounding Petrobras has further undermined investor confidence in Brazilian financial markets. Western economic sanctions have only added to Moscow s economic difficulties. Nevertheless, policy orientation seems to be an important factor behind nations diverging economic performances.

8 So What? What does it all mean? We need to distinguish between two kinds of currency weakness in emerging market countries: one that is reflective of falling commodity prices, and the other driven by policy mistakes. The worst currency and sovereign bond performers are usually those that have a combination of both negative forces. By the same token, investment opportunities in both bonds and currencies in the currency defending countries usually arise when central banks abandon their tight monetary policy and begin to cut rates. Indonesia is close to this point, whereas Brazil is still a distance away from this spot. For growth defenders with accommodative central bank policies and falling rates, their currencies and bonds will likely stabilize and rally earlier on signs of a bottom in commodities prices. The Mexican and Chilean pesos hold the promise of an early and broad rebound, once oil and copper prices settle down to new equilibria. Finally, the stock markets of growth defenders tend to perform much better than those of currency defenders. This is largely because growth defenders usually have much more stimulative monetary conditions than the latter. For instance, domestic equity indices in Mexico and South Africa are either at or very close to their respective record highs in local currency terms, while in U.S. dollar terms both have stayed virtually flat for the last few years. Performance in Mexican and South African equity indices are significantly better than stock equity performance in some currency-defending countries such as Brazil, Turkey, and Russia. Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach Brandywine Global Investment Management, LLC. All Rights Reserved. Social Media Guidelines Brandywine Global Investment Management, LLC ("Brandywine Global") is an investment adviser registered with the U.S. Securities and Exchange Commission ("SEC"). Brandywine Global may use Social Media sites to convey relevant information regarding portfolio manager insights, corporate information and other content. Any content published or views expressed by Brandywine Global on any Social Media platform are for informational purposes only and subject to change based on market and economic conditions as well as other factors. They are not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy. This information should not be considered a solicitation or an offer to provide any Brandywine Global service in any jurisdiction where it would be unlawful to do so under the laws of that jurisdiction. Additionally, any views expressed by Brandywine Global or its employees should not be construed as investment advice or a recommendation for any specific security or sector. Brandywine Global will monitor its Social Media pages and any third-party content or comments posted on its Social Media pages. Brandywine Global reserves the right to delete any comment or post that it, in its sole discretion, deems inappropriate or prevent from posting any person who posts inappropriate or offensive content. Any opinions expressed by persons submitting comments don't necessarily represent the views of Brandywine Global. Brandywine Global is not affiliated with any of the Social Media sites it uses and is, therefore, not responsible for the content, terms of use or privacy or security policies of such sites. You are advised to review such terms and policies.