BackCredibility, consistent policymaking will differentiate India from EMs: Sameer Goel
Deutsche Bank head of Asia rates and currency research on the challenges ahead for emerging markets and what lies in store for the Indian rupee in 2014
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Singapore: The recent rate hike by India’s central bank has enabled governor Raghuram Rajan to convey the message that he is taking steps towards a new inflation-targeting framework the Reserve Bank of India (RBI) will adopt, Sameer Goel, head of Asia rates and currency research, Deutsche Bank, said in an interview. The rupee had managed to outperform most of its emerging market peers over the past three months, he said, after having spent three years as one of the world’s worst-performing currencies. The rupee will fare better in 2014 as India was seeing a big improvement in its external balances, and its dependence on portfolio flow was also falling. Goel said that emerging markets would have a challenging time in 2014, and if India were to take the right steps, it could differentiate itself from other emerging markets on two key factors—credibility and consistency of policymaking. Edited excerpts:
For much of 2013, India and Indonesia were outliers in Asia, raising interest rates and tightening policy. Do you agree with the view that the rest of the region is expected to join them in 2014?
I think there will be other economies in the region which will start to raise interest rates, and tighten monetary and macro-prudential policies in 2014. However, I see a key difference between the steps taken by India and Indonesia last year, and the ones we are likely to see in 2014. The former were more about managing crises, and to defend their respective currencies from weakening against the backdrop of re-pricing in global rate expectations. I think central banks will shift this year from fighting fires to managing cycles, and will raise interest rates as a traditional counter-cyclical measure in face of changes to the growth-inflation matrix. This could include countries like China, Malaysia, Thailand and the Philippines.
Do you see emerging markets getting caught in a repeat of last year’s storm?
Emerging markets (EM) will likely have a challenging time this year as well, though we are less likely to see the same scale of abruptness in market re-pricing as happened last year in the face of a regime shift on US rate expectations. The hurdle for emerging markets to attract sustained flows has gone up significantly, as the outlook for relative returns improves in the developed markets. But equally, valuations have started to adjust, policymakers in EM have responded to the challenges though in varying degrees, and external imbalances in several parts of EM are responding to both of these factors. So, while emerging markets will remain under pressure, we see a broader interplay of themes as determining the direction of markets this year, rather than just a high correlation to US rates. Growth will matter more, as will factors like energy prices and politics.
Do you see the panic spreading from some emerging markets to all emerging economies? What are the triggers that may cause its spread and what must one watch out for?
The stress in emerging markets is more likely to be concentrated in the weakest economies, the ones which have not adjusted their policy mix, and have not allowed flexibility in pricing of assets. That said, there is indeed risk that the weakness spills over into the remainder of the emerging markets world as well because of cross holdings of risk in global investor portfolios and, particularly, if global growth remains unconvincing. Lack of growth could indeed be an important trigger for more widespread fears of weakness in emerging markets. Again, institutional money has been sticky thus far in its EM investments. One needs to watch whether that begins to change as a sign of contagion.
Of late, there has been a lot of debate if Southeast Asia’s boom is a bubble-driven illusion. The central banks of many Southeast Asian countries, including that of Singapore, Malaysia and the Philippines, have joined the debate denying their countries are caught up in an economic bubble. Is the boom driven by a credit bubble? Are property bubbles ballooning across this region?
It is true that years of low rates and ample liquidity under quantitative easing by developed economy central banks have driven a credit and housing boom in several parts of Southeast Asia. And indeed, as the credit cycle matures, the leveraged parts of these economies will likely come under pressure from re-pricing higher of interest rates. But equally, we cannot ignore the structural improvement in balance sheets—sovereign, corporate and household—since the crisis, and the macro-prudential measures taken by several policymakers in the region to contain financial leverage. These measures should now provide a much-needed buffer to manage the impact of de-leveraging as the interest rate cycle turns.
Do you think RBI’s recent rate hike will help protect the rupee? Do you think Rajan has been smart in acting before the markets forced his hand?
I see the recent hike by RBI as furthering the attempt by Rajan to cement the credibility of policymaking in India, and in particular with reference to the transition to a new inflation targeting framework which RBI is due to adopt. To the extent that he succeeds in putting across this message, it should indeed help protect the rupee, at least on a relative basis, against the performance of other emerging market currencies. Indeed, the Indian rupee has managed to outperform most of its EM peers over the past three months. I think Rajan appreciates the advantage of being ahead of the curve in managing market perceptions of credibility.
Don’t you agree Rajan’s response to stabilize the rupee and rein in consumer prices may not be enough to heal India’s economy without an adequate fiscal policy response in the longer term?
That is correct. The central bank, I think, both appreciates and is vocal about this factor, including in the latest RBI panel report on revising and strengthening the monetary policy framework. A fiscal response is essential both to address the supply side shortages in the Indian economy, and more broadly to help contain the inflationary impulse driven by fiscal dominance of the policy mix.
How do you see the rupee faring, both in the short term and over 2014?
After spending three years as one of the world’s worst performing currencies, the Indian rupee should fare better in 2014 for three main reasons. First, India has seen a large improvement in her external balances. The trade deficit, which is the main driver of the current account gap, has almost halved from its peak. While gold import compression has driven most of the trade improvement and could face slippage in the coming months, exports and services have also been bright spots. Second, even as India’s portfolio flow dependence is falling, both debt and equity flows could see positive swings. Offshore holdings of local debt have fallen to core levels after the outflows seen last year. Indeed, foreigners have returned as buyers in recent weeks. With large unallocated limits, a more positive duration view as the rate cycle peaks, and the possibility of index inclusion and wider access to the markets for offshore portfolio investors, India could attract more money into her debt markets. The key swing factor for equities will be the elections in May. To be sure, this is a binary event. But hopes of a pro-growth, stable coalition could boost portfolio inflows in the run-up to elections. Third, RBI’s swap activities have been a success in adding to currency reserves, and breaking the negative feedback loop on sentiment. Concerns about demand for dollars by oil companies appear exaggerated. Their return to the market in November did not raise volatility in any appreciable manner. A majority of their obligations to buy dollars ahead of imminent swap repayments in the early part of this year have been met.
The International Monetary Fund (IMF) has asked emerging market economies such as India to prepare for a rainy day. The IMF is of the view EMs remain vulnerable to future increases in US interest rates. What steps should countries such as India take?
Ultimately, the prescription is the same for a majority of emerging markets, to correct fundamental imbalances in their economies, both internal and external, and calibrate policy accordingly. As the global economy comes out of what is probably the biggest financial experiment in history, there are very likely to be hiccups and disruption. And to the extent that emerging markets have benefited the most from the flow of portfolio capital on the back of expansion of central bank balance sheets in the developed world, equally they must contend with a reversal of at least a part of the same. What could however differentiate India from other emerging economies in that context would be the credibility and consistency of policy-making.
Does the risk of a hard landing in China pose a serious threat to emerging Asia? Can it affect commodity exporters globally? Can China also impact developed markets?
Our house view is constructive on China. We think growth in China will be held up in 2014 by an improving global demand backdrop, deregulation in sectors which face severe undercapacity, and a pro-cyclical fiscal policy. The financial sector liberalization process underway should also help improve efficiency of resource allocation in the economy. Equally though, the risk of policy error during this process of re-balancing and deregulation presents a relevant threat to China’s own growth story, and to our broader positive view of the world economy. The introduction of interest rate and credit risk in particular, and the sequencing of reforms, will be key to manage, and will present a challenge for Chinese policymakers as they try to keep the monetary conditions adequately calibrated while opening up access to their domestic markets for global investors. Commodity exporters, and countries which have supplied into the investment-led growth in China over the past couple of decades will stand to lose the most in the event of a hard landing in China. The rest of Asia, too, will stand to lose by way of association, and poorer risk sentiment; though it is important to note that most of other Asia interacts with China more by way of a regional production chain which ultimately supplies to the consumption demands of the advanced economies. To that extent, economic fortunes of the US and Europe are probably more relevant to rest of Asia than necessarily growth in China.
Do you think investors should take advantage of the low valuations in emerging markets? Or, do you think investors’ response only will be based on the actions policymakers are taking?
Valuations have certainly improved in a lot of the emerging markets since we first saw the impact of tapering on investor fears about capital flows into EM, both in terms of real interest rate differentials versus the US, as well as real effective exchange rates. This might hold some promise for long-term investors. However, valuations are not cheap enough just yet to warrant a broad re-entry into emerging market assets, particularly if you scale the risk premium and carry in these markets by the level of volatility. Indeed, events of the past few days have shown yet again that even if the sell-off is driven by concerns over lack of adjustment in a few economies, the risk of contagion to the broader asset class is very real. In such an instance, and beyond the EM beta, policy actions in the various emerging markets will be a key differentiating, and likely the determining, factor for the decision on when to buy back into the asset class.
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