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EM Monitor - where are interest rates heading?

August 2020

Are EM central banks running out of ammunition?

In recent months, most major emerging market central banks have sharply cut their policy-rates to alleviate the negative economic shock of the pandemic. But is this sustainable and what can we expect going forward?

Estimating equilibrium

According to our proprietary calculations, four major EM central banks have cut their policy rates too aggressively: South Africa, India, Indonesia and, by some margin, Turkey.
That sinking feeling...
Fig.1  - Policy rates in select emerging market versus our fair value estimates of equilibrium  using our proprietary Taylor Rule mode
Fig.1 - comparison of major EM policy rates and our fair value forecast based on Taylor Rule model

Source: Pictet Asset Management, Refinitiv, CEIC, August 2020

Using our proprietary Taylor Rule model, we calculate the fair value for Turkey's policy rate as 14 per cent, not 8.25 per cent. This is based on the recent upsurge in inflation and domestic currency depreciation. By contrast, the Bank of Russia and Bank of Korea appear to have made appropriate policy responses.

What about the next 12 months?

Fig.2 shows our expectations for policy-rate changes in the year ahead based on our fair value estimates. For most emerging markets the estimated policy-rate fair value is much higher in 2021. This shows that most central banks have no room to cut further and should gradually revert to higher rates as the economic shock of the pandemic subsides.

The road back...
Fig. 2 - Implied policy rate changes in 2021 based on our estimates of changes in fair value in 2021 and the actual policy rate in Q3 2020
Fig.2 - how much EM policy rates needs to change to match our fair value estimates in 2021

Source: Pictet Asset Management, Refinitiv, CEIC, August 2020

The most striking cases are in South Korea, South Africa and Russia. While we think these markets have appropriately cut their policy rates during the outbreak, we believe they will need to start raising rates more quickly in 2021 as their economies are expected to rebound at a stronger pace.

For other central banks however, it might be appropriate to keep their monetary policies broadly unchanged in 2021. This is particularly true in Mexico.

Turkey is once again an interesting case as our model calls for significant rate cuts in 2021, in sharp contrast with the policy recommendation for the current quarter.

This is explained by the significant disinflationary process and expected gradual recovery in economic growth which should take place in the coming year if the authorities take the appropriate policy measures to stabilise the lira, thus avoiding a full-blown balance of payments crisis. If this positive scenario materialises, it should be positive for Turkish risky assets in the coming year. Bottom line: it will get worse before it gets better.

Time to look beyond rates?

But if the scope to move EM policy-rates is increasingly limited, what about unconventional monetary tools to stimulate the economies?

The table below shows that only the central banks of South Africa, Indonesia and Poland have opted for an asset purchase program (QE) of government bonds in the secondary market (and in the case of Indonesia possibly covering corporate bonds). 

Most of the major EM central banks (China, India, Korea, Turkey, Russia, Brazil and Mexico) do not have a proper QE program yet. Still, those countries have introduced different refinancing facility schemes to provide ample liquidity to the interbank market thus supporting bank credit activity and the real economy.

The state of play
Fig. 3 - Our views on policy of select emerging market central banks
Fig.3 - our summary table of major EM central banks policy rates, QE programmes and our expectations

Source: Pictet Asset Management, Refinitiv, CEIC, August 2020. *Based on our Taylor Rule model.

Close to half of the major EM central banks are expected to ease monetary policy further in the coming months. This is the case in China, Indonesia, Russia, Brazil and Mexico, suggesting that market participants and possibly even the central banks themselves do not think they have actually run out of ammunition. But as suggested by our model, we believe further monetary policy easing will be very challenging in particular for South Africa and Russia, as well as for Turkey in the near term.