beyondbrics

By Philip Poole of HSBC

Given the scale of the financial and real economic crisis that subsequently enveloped the globe, it is hard to believe that for much of 2007-08 it was inflation that was the big policy concern, particularly in emerging markets. But while the sovereign debt overhang in peripheral Europe is currently monopolising the attention of global markets, inflation is again clawing its way back in EM. China provided more evidence of this trend Tuesday with the release of CPI data for April which showed inflation continuing to move higher.

Pre-crisis inflationary pressures did not show up exclusively in goods and services prices. In some cases they were administratively repressed; in others, excess demand or monetary expansion drove up asset prices, particularly real estate, and fuelled excessive credit extension. Now there’s a strong whiff of déjà vu.

Renewed pressures are the result of a rebound in food and energy prices, tightening capacity constraints and continuing failure to sterilise FX intervention. Real estate prices in economies including China have also rocketed again. Asia and markets like Brazil in Latin America are on the front line, with pressures much less evident in emerging Europe. These pressures will not go away without concerted tightening.

Having had deflation until late last year, headline inflation in China has now moved back up to 2.8% yoy (from 2.4% yoy in March) with food price inflation a key element – up 5.9% yoy vs. 5.2% in March. There is also evidence of growing pass through from PPI to CPI – as a result of rapid growth in industrial production and very strong export growth – which is tightening capacity constraints. And credit extension remains very strong (774bn yuan for the month compared to market expectations of 570bn yuan.)

But will EM central banks take a firm stand while the Fed keeps rates on hold? For the most part we think they will, and believe monetary policy in most of EM is now biased to tightening. There won’t necessarily be a direct relationship between inflation and rate hikes, as central banks and governments will fight back with a mixture of hikes, quantitative restrictions, higher tolerance for currency appreciation, regulation and controls. In the case of China, on the back of rising inflation concerns HSBC expects policy tightening to continue with 100-150bp of hikes in reserve requirements, a small rise in rates (27bps) and active open market operations through bill purchase to soak up liquidity. In addition, we expect a move back to a pre-crisis style appreciation track for the yuan before mid-year.

Inflation fears – and the expectation that central banks in EM will tighten to counter them – are again shifting the balance of value from debt to FX, commodities and real assets in large parts of the emerging world. We believe greater EM currency flexibility will additionally be supported by China moving back to a pre-crisis-style track of currency appreciation.

Our constructive view on EM currencies reflects a belief that global liquidity will remain flush with G3 monetary policy on hold. Consequently, a tightening bias via rates in response to inflation pressures in many emerging markets should be interpreted as carry and currency supportive – or more directly in the sense that currency appreciation itself ends up being the mechanism of tightening. This said, if EM central banks refuse to tackle this rising threat, currencies will eventually have to pay the price.