Tuesday, December 6, 2011

Growth and monetary policy in the BIC economies

In 2009, in the aftermath of the sharp contraction in activity during the darkest days of the GFC, we argued the role of monetary policy in the respective recoveries of developed and emerging economies would be quite different. In the developed economies it was about supporting fragile economic growth and avoiding deflation. In the key emerging economies it was about controlling inflation in the face of structurally higher commodity prices and eventually, in some cases, overheating economies. Emerging markets are now in an important new phase. Growth is slowing in the China, Brazil and India. With inflation also past its peak (at least in China and Brazil), there are obvious implications for monetary policy.

But as emerging market central banks ease monetary conditions, there are important considerations for the global economy in terms of the rebalancing in global growth we think is important for a sustained recovery. This is particularly the case in China. There are equally important messages for India and Brazil. Easier monetary conditions are currently warranted in Brazil and at least an end to the tightening in India. But if they are serious about building higher sustainable growth – monetary policy must remain focussed firmly on price stability.

In China growth has slowed from a peak of 11.9% in the year to March 2010 to 9.1% in the year to September 2011. Activity indicators point to a further slowing, but are still consistent with a soft landing. We expect calendar year growth to come in at around 9%. Growth is slowing most sharply in the export sector. That reflects the weaker global growth environment, particularly out of Europe. Importantly inflation has also peaked, giving the authorities room to move on monetary policy.

China has an important role to play in the rebalancing of global growth as an important engine of demand. In that context, how China responds to the slowing of activity is critical. The Required Reserve Ratio has recently been eased by 0.5% for both large and small financial institutions. We expect interest rates will be lowered from early next year. We’re happy with that approach.

With exporters coming under most pressure, it would be tempting to shift from the stance of allowing a gradual appreciation in the Yuan. But such a move would be undesirable from a global growth perspective. While an appreciating exchange rate is challenging for exporters, especially in an environment in which trading partner growth is slowing, it gives a real income boost to households which is important in growing consumption. Furthermore, if China were to go down the path of further fiscal stimulus, this should also be directed at households through building a stronger social infrastructure which will allow households to save less and spend more.

Growth in India slowed sharply to 6.9% in the year to September 2011. That’s down from 7.7% in June and a peak of 9.4% in March 2010. Growth now looks like coming in at around 7% for the calendar year. The target growth rate for this year was 8.5% which is well in excess of what is sustainable (we think around 6.5%).

Recall our view that India was overheating before the GFC hit. Following aggressive monetary easing in the wake of the GFC, it went straight back into over-heated territory. Inflation at around 9% remains persistently high. Indeed it is in India where recent commodity price inflation has spilled over into more generalised inflation. The RBI has been behind the inflation problem for much of the last year or so and only just caught up with it after a series of 50bp moves on the benchmark rate.

It’s important for monetary policy in India to remain focussed on inflation. While we think there has been sufficient tightening, we’re not expecting an imminent cut in interest rates. If India has aspirations of higher sustainable growth it must look to a broader policy response that includes tighter fiscal policy, a change to foreign direct investment rules and investment in infrastructure.

In Brazil, growth has slowed from a peak of 9.7% in March 2010 to 3.1% in the year to June 2011. It appears likely to slow further in the period ahead. Calendar 2011 growth is likely to come in at around 3%. Much of this slowdown needed to happen. At over 9%, growth was running well into overheated territory. We think trend/sustainable GDP growth in Brazil is around 4%.

Interestingly in Brazil, the interest rate sensitive sectors such as consumptions have held up well recently. Also unemployment at 5.8% is low by historical standards. Inflation is coming off its highs but at 6.7% is still ahead of the target band of 4.5% +/- 2%. The benchmark Selic rate has so far been cut three times since August from a peak of 12.5% to 11% last week. While we expect further cuts, downside is limited (unless Europe deteriorates further). Look for a low in the Selic rate of around 10%.

In the future we see any lack of commitment to contain inflation as the biggest threat to the emerging market economies. We know they don’t have the same structural issues as the developed economies – they simply have different structural issues. Building higher sustainable growth requires a broad approach.