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Differing business cycles pose challenges to monetary policies

Differing business cycles pose challenges to monetary policies
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First Published: Wed, Jul 27 2011. 08 57 PM IST

Updated: Wed, Jul 27 2011. 08 57 PM IST
A few days ago, the HSBC Flash China Manufacturing Purchasing Managers’ Index for July, which is based on 85-90% of survey responses, came in at 48.9, lower than June’s 50.1. The number is important because a reading below 50 for the PMI indicates a contraction. The flash PMI, therefore, indicates that manufacturing contracted in China in July. New orders, new export orders, output, stocks, all showed a contraction. According to the PMI, Chinese manufacturing production declined at the fastest rate since March 2009.
That isn’t all. The Markit Flash Eurozone PMI, which comprises both services and manufacturing PMI, fell to a 23-month low in July and was only marginally in positive territory, at 50.8. Manufacturing was hit harder, with the manufacturing output index at 49.5, which again indicates a contraction. The ratio of manufacturing new orders to inventories, which acts as a leading indicator of output growth, fell to its lowest since April 2009.
Elsewhere too, growth is slowing, including the US, although PMIs continue to be in expansionary territory. This slowing growth has led to the hope that commodity prices will be subdued. The Reuters/Jefferies CRB Commodity index has indeed come off from a high of around 370 at the end of April to around 345 now.
This in turn has sparked the hope that we may finally be seeing a peak in inflation in emerging markets, which has also been supported by the fact that central banks in those markets have raised interest rates in an attempt to cool their economies. The recent flash PMI numbers from China and Europe should strengthen that belief.
Around October last year, fund flows started to move out of emerging markets and into the developed world. That was partly because fears of a double dip in the US subsided, while rising inflation in emerging markets led investors to conclude that central bank tightening would slow growth.
But that outlook has changed. With lower commodity prices, inflation in emerging markets is close to its peak or has already peaked. That should mean the end of the interest rate tightening cycle is also round the corner. The PMI data too show that output price inflation is easing in India and China, although inflation in input prices has moved up a bit again.
A recent Citibank note on global emerging markets strategy sums up the issues. Says the note, “In our view, EM inflation falls over the rest of 2011 due to weaker global activity, flatter commodity prices, the monetary tightening now in place and base effects.” The Citibank analysts say that the main reason for the underperformance of Brazil, India and China this year has been rising inflation. They predict that emerging markets will do better in the second half of the year, as the inflation fears recede.
It’s a plausible story and fund flows to emerging market equities have picked up in recent weeks. But unfortunately, the Reserve Bank of India’s monetary policy puts a spanner in the works. It says that global growth might indeed slow, but commodity prices are likely to stay elevated because of liquidity continuing to be abundant as there are “no immediate prospects of monetary tightening in the advanced economies”. This is debatable, as investors in commodity funds too would see that a rise based purely on liquidity is not sustainable. In fact, International Monetary Fund’s latest World Economic Update says that commodity prices should fall a bit in 2012. Nevertheless, it doesn’t pay to fight the central bank. The markets have been spooked and the end-of-the-rate-cycle story is likely to take a back seat for some time.
What is very interesting is the Citibank note referred to above also draws attention to the loose monetary policy in the advanced economies, but in a different way. It says that emerging markets are likely to go up in the second half of 2011, as inflation will decline by the end of the year. But here’s the sting in the tail: “There is a risk of another nasty bout of inflation in the emerging markets over the long term, perhaps 12-24 months. This is based on the Fed’s accommodating policy pushing liquidity towards emerging markets, the global economy picking up steam again, commodity prices rebounding and an overheating condition returning to several emerging markets. In short, the Fed staying on hold will continue to support EM equities in the second half of 2011, but may present fresh inflation challenges for emerging markets towards the end of 2012.”
The problem is that different countries are at very different stages of their business cycles. While the developed world is deep in a slump, emerging nations are trying to prevent their economies from overheating. This divergence is what has made policymaking so difficult for central banks in emerging markets.
Illustration by Shyamal Banerjee/Mint
Manas Chakravarty looks at trends and issues in the financial markets. Comment at capitalaccount@livemint.com
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First Published: Wed, Jul 27 2011. 08 57 PM IST