EM Policy-Makers Are Finally Starting To ‘Get It’

By Win Thin

Developments in EM over the past couple of weeks suggest to us that EM policy-makers are finally starting to “get it” with regards to inflation and a strong currency. Brazil and Korea were the first to signal that greater appreciation would be a tool for fighting inflation during the last week of March, when they moved their lines in the sand lower. MAS followed suit on April 14 with a move to move the S$NEER band stronger (within the context of tighter monetary policy). This week, we saw Poland signal a desire to rely more on zloty strength to limit prices pressures by pledging to sell EU funds directly into the FX market. Thailand too made a strong statement by hiking rates 25 bp and then signaling that it is willing to let the baht appreciate to help limit inflation. BOT Deputy Governor Atchana noted the benefits to inflation of a strong baht and added that it only plans to intervene if the baht “overshoots or undershoots or doesn’t move in line with fundamentals.” As we wrote earlier this week, China appears ready to shift its currency policy soon, with our base case (65% chance) being a faster rate of appreciation in the double digits vs. 4-5% currently.

This is a welcome, if somewhat tardy shift. In recent months, EM policy-makers were simply trying to do too many things with not enough policy tools, and so we are heartened by what appears to be baby steps towards an orthodox response to rising inflation; namely, hiking rates and accepting a stronger currency. Many have tried to rely more on so-called macroprudential policies in order to avoid the rate hike/strong currency path, but these are generally been recognized to be failing. We have always said that macroprudential measures should be seen as a complement to orthodox tightening, not a substitute. Countries that have a good policy mix that includes all three factors (macroprudential, rate hikes, currency strength) are likely to have the best chance of addressing rising inflation. Of course, we are weighted more towards the latter two orthodox and would ideally like to see something like a 20/40/40 mix. Most EM economies in EM have closed their respective output gaps, and right now is not the time to be timid in tightening.

Overall, we remain positive on EM given what has been a relentless march upwards for “risk assets” over the past several months. There are certainly some worrisome trouble spots in EM, but for now, they are being overlooked. We also warn that the perceived shift towards accepting stronger currencies is not wholehearted, and that policy-makers will still try to manage the pace. EM FX at this juncture can best be viewed as very dirty floats bordering on crawling pegs. Asia has lagged the EM rally this year due in large part to official obstruction of currency gains, but recent signals from that region suggest that there may be some catch-up in the coming weeks. THB in particular has potential for catch-up, as it is the worst performer in Asia YTD. CNY too has potential for larger gains ahead. In Latin America, we think MXN still offers the best potential gains given lack of official concern regarding the stronger peso. CLP also appears to be a candidate for further gains despite nearing the 465 level that brought on FX intervention in January. For EMEA, PLN is likely to outperform given this week’s signal from Polish authorities. TRY has lagged the region, but we are not yet ready to move to a positive stance on the lira given Turkey’s continued outsized reliance on macroprudential measures. RUB probably offers the next best value in the region, as high oil prices and official acceptance of a strong ruble should result in continued gains for the currency.