Weakening of central bank independence could prove to be a lasting side effects from the pandemic-related expansionary policies in Emerging Markets (EM). As we discussed in the last quarterly, one of the unusual features of this crisis was that policy reactions in EMs were similar to those of developed markets (DM). They cut rates, enacted substantial fiscal expansions, provided credit backstops, bypassed the banking system with new lending facilities and, in many cases, central banks intervened in local fixed income markets.
We are in the camp that the interventions by EM central banks in fixed income markets are not quite the same as QE as practiced by the BOJ, ECB, or FED. To start with, EM central banks are not at the lower bound in rates. But more importantly for the purposes of this discussion, the primary intention of most of these programs is not to stimulate the economy or finance government spending. Yes, buying bonds or changing the shape of the yield curve does help finance the budget by keeping a lid on yields, but this was not the focus. Instead, most EM central banks have been (so far) just trying to stabilize local markets and providing liquidity during market stress.
But even so, this doesn’t mean the outcomes or exit paths from the extraordinary measures will be the same for EM as for DM. Governments in EMs can’t fund as cheaply and at such long maturities as those in DM (chart). And in many cases, the relationship between the government and central banks can be blurred (thought this is happening the DMs as well). Below we pick one example from each region (South Africa, Indonesia, and Brazil) to show the increasing risks to central bank credibility and temptation of debt monetization in the years to come.
Perhaps Indonesia will become the reference point in the forthcoming discussion about EM central bank independence. In short, the Parliament is considering legislation that would give the government more authority over Bank Indonesia (BI) by proposing a five-member monetary board led by the finance minister. Also, like the debate in South Africa, supporters are arguing for adding growth and employment to the BI’s mandate. Recall that a few months ago, the BI agreed to finance the government deficit through direct purchases and primary auctions, with a predetermined amount of the equivalent of $40 bln. The price action speaks for itself with Indonesia assets have been underperforming since then.
The Reserve Bank of South Africa (SARB) provided a good example of an EM bond purchase program focused primarily on market functioning. According to SARB’s Governor Kganyago, the program is designed to help “restart price discovery and has encouraged the re-entry of private sector participants.” Indeed, the bank has been tapering its purchase over the last few months as the situation in local markets normalized. The latest figures show purchase of around ZAR400 mln in August compared to over ZAR 11 bln in April.
But what will happen when budget constraints become even more severe? The South African economy contracted by a whopping 51% q/q in Q2 amid rolling energy blackouts. Despite attempts to restrain spending, a relatively small pandemic response, and the IMF’s $4.3 bln program, the 2020 budget deficit will be close to 15% of GDP, putting debt to GDP at a steady path towards 100%. Just the Eskom bailout alone will cost over 2% of GDP over the next three years. We wouldn’t be surprised to see a revival of last year’s debate over SARB’s independence, and of changing its target to growth and job creation. The temptation is strong and will only grow stronger.
Brazil is an interesting case for both the actions taken during the pandemic and the institutional setup. The government approved the use of QE by BCB, but it didn’t use it yet. Instead, the bank focused on providing credit lines and smoothing out FX volatility. But going forward, it’s important to remember that while the BCB has de facto independence, it’s not de juri. In fact, there is a legislative proposal currently in discussion that would give the bank full autonomy. The measure – supported by FM Guedes, the central bank, and some important members of the legislature – was gaining momentum before the crisis but has since stalled. We don’t have a clear view on whether the proposal will be passed before President Bolsonaro’s current mandate is over, but it would be a crucial piece of institutional insurance as Brazil’s fiscal position continues to deteriorate. The next elections are in 2022, and there is no shortage of politicians in Brazil who believe the central bank should be subservient to the central government.
We think it’s just a question of time EMs government will start looking towards unconventional ways to relieve the post-pandemic debt burdens. There are plenty of options to pick from, ranging from letting inflation erode the debt to MMT-type policies. Ongoing discussions of such policies in the DM world provide a convenient intellectual cover to pursue them in EM. While the risk of a policy mistake can be high in for both cases, the risk to institutional credibility is far higher in EM, in our view. Central bank independence in general (and inflation targeting in particular) is an institutional check on governments’ impulse to let the economy run hot; without it, EMs could jeopardize decades of hard earning credibility building.
For our investment outlook, this means a greater focus on differentiation and the re-weighting a variable (institutional credibility) that we have largely ignored for some time. As seen in the case of Indonesia, and Turkey much before the pandemic, investors can be very quick in repricing assets on this basis, especially with risk premiums starting from a relatively compressed point. (See Where has All the Carry Gone?). The sheer magnitude of borrowing from both DM and EM suggest a far more competitive issuance environment in the years to come. But the true test will probably come with inflation starts rearing its head.