beyondbrics

While Indonesia this week made headlines by becoming the latest emerging market to cut interest rates, Nigeria added its name to a growing list of frontier markets that have this month raised their rates – and followed Uganda, Kenya, and Vietnam.

These moves reflect an uncomfortable reality. The big EMs can afford to cut rates because they’re confident their reserves are large enough to weather hard currency outflows.  The frontier economies are in too fragile a condition to take the risk.

But if the global crisis gets much worse, could some EMs also be forced to hike? The numbers suggest this is a serious danger.

Uganda, Kenya, Vietnam and Nigeria are all responding to inflation and currency depreciation. Unlike leading EMs, they have failed to manage the global inflationary pressures that increased late last year through big hikes in world food and energy prices.

Vietnam is struggling with Asia’s highest inflation rate – 22.4 per cent in September, compared with a government 2011 target of 15-17 per cent.  Inflation in Uganda surged to 28.3 percent in September and reached 17.3 percent in Kenya. The pressures are a little easier in Nigeria, where the rate was a mere 9.3 per cent in August.

The difficulties have been compounded by strong domestic credit growth, combined, in some cases, with spiralling public spending.  Currencies have this year fallen against the dollar, some by far more than their EM counterparts. The Kenyan shilling is down by 29 per cent, the worst performing currency as measured by Bloomberg. The Ugandan shilling has fallen by only a little less – 25 per cent.

Heavy intervention by the central bank has limited the drop in the Nigerian naira: it was down 9.3 per cent on Monday, just before the central bank raised rates, and now trades 2.3 per cent lower against the US dollar.  The Vietnamese dong’s exchange rate is controlled by the authorities – it has lost 6 per cent this year due to a devaluation in the spring.

This month’s interest rate hikes have been dramatic -  Kenya and Uganda have announced increases of 400 basis points to 11 per cent and 20 per cent respectively. Nigeria raised rates on Monday by 275 bps to 12 per cent. Vietnam lifted its refinancing rate – one of a range of policy rates – by ‘only’ 100 bps to 15 per cent – but that was after cutting the rate by 100 bps as recently as July.

All this is reminiscent of crises past when large developing world economies were generally forced to respond to global turmoil with rate hikes.  Charles Robertson, global chief economist at Renaissance Capital, says Turkey, for example, raised rates by 325 bps in 2006 to defend its currency – and it worked.

But in 2008-9 big EMs have learnt that they were now strong enough to reduce rates in a global recession – Turkey slashed rates by 1,025 bps over 2008-2009.  But frontier markets, with smaller reserves and a lower credibility among investors (both foreign and domestic), can be less sure of their currencies.  So they cannot afford to take the risk.

Among the largest emerging markets, India is an exception, having raised rates as recently as last month (to 8.25 per cent), for the 12th time since early 2010. But India’s inflation  – 9.78 per cent in August – is much higher than in other big EMs and the poor – who are more vulnerable to inflation than the rest of society – form a bigger proportion of the population than elsewhere.

But other states may be vulnerable to the latest developments in the global turmoil, driven as it is by the eurozone crisis. RenCap’s Robertson reckons Ukraine and Kazakhstan may have to hike rates. So might Hungary.

And as the RenCap chart below shows, even advanced EMs in Europe have been forced to sell big chunks of their foreign exchange reserves to defend their currencies:

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By combining the currency decline and the drop in foreign exchange reserves, Robertson portrays the “costs” to each country in a dramatic way. It may, for purists, be mixing apples and oranges, but it does highlight who is vulnerable:

The determining factor is not domestic economic trouble. It is proximity to the eurozone crisis, combined with liquidity. Invesotrs sold Poland because they could – it has large enough markets.  Robertson says: “The lesson is don’t be in eastern Europe when Europe is in trouble.”

You can change your foreign exchange policy, but you can’t change your geography.

Related reading:
Global concerns prompt Indonesia rate cut, FT
Asian interest rates, FT
IMF: EMs still vulnerable to domestic pressures and external shocks, beyondbrics