Early last month, Bloomberg observed that plunging currencies were “handcuffing bankers from Chile to Colombia.” The problem was described as follows:
Central bankers in commodity-dependent Andes economies aren’t even considering interest-rate cuts to revive growth, even as prices for oil, copper and other raw materials collapse.
That’s because the deepening price slump is also dragging down currencies in Colombia and Chile -- a swoon that’s fanning inflation and tying policy makers’ hands.
That was six days before China’s decision to devalue the yuan.
Needless to say, Beijing’s entry into the global currency wars did nothing to help the situation and indeed, since the yuan devaluation, things have gotten materially worse. The real, for instance, has plunged 10.5%, the Colombian peso is down 6.6%, the Mexican peso is off 4.4%, and the Chilean peso is down a harrowing 8% (thanks copper). And again, that’s just since China’s devaluation.
Meanwhile, plunging commodity prices, falling Chinese demand, and depressed global trade aren’t helping LatAm economies. Just ask Brazil, where the sellside GDP forecast cuts are coming in fast (Morgan Stanley being the latest example) now that virtually every data point one cares to observe shows an economy that’s sliding into depression.
Of course a plunging currency, FX pass through inflation, and a soft outlook for growth is a pretty terrible place to be in if you’re a central bank, but that’s exactly where things stand for the “LA-5” (believe it or not, that’s not a reference to the Lakers, it’s short for Brazil, Chile, Colombia, Mexico, and Peru), who very shortly will be forced to decide whether the risks associated with further FX weakness outweigh those of hiking rates into a poor economic environment.
For Goldman, the outlook is clear: LatAm central banks will, in “stark” contrast to counter-cyclical measures adopted during the crisis, hike in a desperate attempt to shore up their currencies and control inflation.
First, we have the test:
The LA-5 economies are, once again, being tested. They currently face an acute external shock involving a combination of: low (likely for long) commodity prices, incoming monetary policy normalization in the US, and weaker CNY and growth in China with the latent risk of a sharper economic slowdown.
The last time these countries were tested, they had sufficient room to maneuver counter-cyclically:
The Global Financial Crisis of 2008-09 (GFC) provided almost the perfect applied experiment to test the shock-absorbing capacity of the new institutional framework. And the results were remarkably positive. The spike in risk aversion in the initial stages of the crisis was followed by sizeable capital outflows from EMs. Yet, officials across the LA-5 did not attempt to stop the hemorrhage of capital and the ensuing pressures on local currencies by hiking interest rates or by tightening fiscal belts (which would have been the classic pro-cyclical response of the past). To the contrary, the authorities managed to loose fiscal stances and cut interest rates aggressively to support domestic demand, letting exchange rates depreciate significantly along the way.
This time around, however, policy flexibility is severely constrained:
Financial conditions are very accommodative and most currencies are now slightly in undervaluation territory. Initial conditions differ considerably from those prevalent at the beginning of the GFC. Broad financial conditions are, on average, more accommodative today than before (lower real rates and currencies that underwent large adjustments since mid-2013 and are now, on average, slightly undervalued versus domestic fundamentals). Furthermore, with the notable exception of Mexico, inflation has been accelerating across the region (Exhibit 3) and is now tracking above the respective targets, the fiscal stances are on average weaker, and external imbalances are generally wider.
And the crisis - at least as it relates to LatAm, is actually more acute:
Arguably, these combined shocks may pose greater risks to the region compared to the challenges faced during the GFC as the later was largely a DM centered event. In fact, current external headwinds have compounded the effects of domestic developments in places (e.g., Brazil and to some extent Chile), imparting a sizeable adverse shock to sentiment and a negative impulse to growth across the LA-5 economies.
With less policy flexibility and a more acute crisis, comes a divergent response:
Against this backdrop, the continuation of a bearish FX market may be soon followed by higher policy rates, despite admittedly sluggish real business cycles all across the region. That is, a pro-cyclical monetary reaction may be imminent in a number of places – Chile, Colombia, Mexico, and Peru. Policy pro-cyclicality is knocking on the door.
What's particularly interesting here is that round after round of the type of counter-cyclical policy measures Goldman suggests saved the LA-5 in the wake of the 2008 meltdown have not only failed to resuscitate the global economy, but have in fact contributed to the current worldwide deflationary supply glut that is at least partially to blame for the economic malaise plaguing EMs and the attendant pressure on commodity currencies.
That pressure has now put LatAm's financially integrated countries in the position of having to hike rates even as the outlook for their economies - the same economies which were presumably saved by counter-cyclical post-crisis measures - deteriorates. Meanwhile, if the Fed hikes, it will only put further pressure on EM FX, which could serve to drive inflation still higher, prompting a still more hawkish EM CB response which would in turn put still more pressure on their underlying economies.
In the end, Goldman concludes that should LatAm resort to pro-cyclical measures to shore up their currencies at the expense of their economies, it will represent a return to the policies adopted by EMs during the Asian Financial Crisis. This would appear to provide the final piece of evidence we need to conclusively determine that all pundit/analyst protestations aside, we have indeed turned back the clock two decades and sit on the verge of another outright emerging market meltdown. And on that note, we'll give the final word to Goldman:
The LA-5 economies have already spent part of their policy ammunition fighting the initial stages of the current turmoil. In the meantime, a number of economies are still grappling with visible domestic (inflation/fiscal deficits) and external (current account deficits) imbalances. Therefore, the room to ease policy further, i.e., to adopt counter-cyclical policies, is now much more limited than in the past. To the contrary, in some cases monetary tightening may be needed (despite weaker real business cycles) in order to continue to attract foreign capital, anchor domestic currencies and preserve the integrity of the respective inflation targeting frameworks. Hence, we may soon enter a period of weaker FX and higher policy and market rates: i.e., market dynamics that would resemble more the 1997 Asian Financial Crisis (where the authorities hiked rates to stabilize the respective domestic currencies despite the recessionary real sector dynamics) rather than the 2008-09 Global Financial Crisis (where weakening currencies coincided with sharply declining short-term interest rates).