The Confluence of Liquidity and Macro Policies

Despite their best efforts, central banks have not been able to make a distinction between liquidity policy and macro policy. While this is understandable for DM central banks with policy rates close to zero, EM central banks have also seen the distinction between the two blur. Take the example of recent EM easing. So far in 2012, the central banks of Chile, Israel, India and Hungary have all surprised markets by delivering more easing than had been expected (Hungary didn’t hike at all, against expectations of a hike). Of the four, India’s ‘easing’ was only a cash reserve ratio cut of 50bp with no change in the policy rate. However, despite a pointed remark in the RBI’s statement that the time was not yet appropriate for monetary policy to be eased, the CRR cut remains a clear signal of forthcoming traditional macro easing in March or April (see RBI Cuts CRR by 50bp; Urges Cut in Fiscal Deficit to Allow Interest Rate Cuts, January 24, 2012). A 50bp RRR cut by the PBoC in December also provided a similar signal to markets. EM policy-makers have never been shy about using liquidity measures, but the degree to which they are employed now is a magnitude higher than has been the case historically.

Pre-emptive easing delivered from a large chunk of the EM world: Since our concerns tilted to downside risks to growth (see Global Economics: Dangerously Close to Recession, August 17, 2011), we have been suggesting that central banks would do well to be pre-emptive if they don’t want to have to ease aggressively later. Indeed, nearly half of the EM central banks under our coverage have eased policy earlier than expected since then. The time for being pre-emptive, however, is now behind us. We believe that central banks are going to have to continue along the path of easing they have embarked upon.

Liquidity policy will be an intrinsic part of this easing, in our view. However, liquidity policy can only have an impact on the macro economy if it is used expansively. So far, this has not been the case. Going forward, we expect a combination of easing of liquidity and macro measures to be employed as EM inflation eases and policy-makers act to put a floor under growth.

Why have these usually distinct policy measures seen a confluence? And why is the blurring of consequence to investors? Historically, liquidity policy was the set of measures that made sure that the daily, weekly and monthly requirements of the financial system were met, and that any relatively small amounts of cash that were deemed surplus were soaked up. In contrast, macro policy used policy rates in order to lower the cost of borrowing and the yield on safe assets during an easing campaign to push consumers towards more consumption and investors towards riskier assets. For the last few years, this distinction has blurred. Liquidity policy, used aggressively in DM and EM economies, has produced macro effects and has even been used as a primary instrument of macroeconomic adjustment in both parts of the global economy.

This changed with QE: DM investors had a portfolio decision to make post-QE. In 2009 and 2010, such portfolio decisions pushed large sums of capital into risky assets and EM economies. When the risks turned in 2H11, some of this capital was pulled out of EM economies. These flows were quite large and came in (and out) rapidly. As we explain below, traditional monetary policy via policy rate hikes and cuts would not have been and still isn’t adequate or appropriate to deal with these flows primarily because of how EM exchange rates have behaved. Equally importantly, using traditional macro policy to deal with a global liquidity issue can potentially create a trade-off between internal and external balance. As always, when two distinct problems confront policy-makers, an optimal solution is to find two appropriate instruments to deal with them. Liquidity measures are just the thing.

Regardless of whether it is a DM or an EM economy, liquidity policy, when used expansively, spills over into macro policy. This spillover was exploited by DM policy-makers and was forced upon EM policy-makers, and will be with us for a while more, in our view.

DM central banks set the precedent: The efforts to keep liquidity and macro policy distinct were apparent, especially in the US as the Fed started its easing campaign in the wake of the freezing up of credit markets in 2007. For some time, the Fed was very careful in announcing liquidity measures and cuts in the fed funds rate on different days and it was successful in making markets aware of this distinction. When the collapse of Lehman Brothers shocked the financial system, the sudden stop that ensued in fixed income markets spilled over to the real economy…and QE was born.

QE – the love child of liquidity and macro policies: In late 2008, liquidity issues hurt the macro economy, and liquidity and macro policy blurred into one. The Fed, the ECB, the BoJ and the BoE all allowed their balance sheets to expand passively, allowing as much liquidity to pour out into the financial system as was required by financial institutions while delivering macro easing (see The Global Monetary Analyst: QE2, March 4, 2009). Once the traditional tools of monetary policy were exhausted, all that was left as a weapon was the love child of both policies, QE – a mix of liquidity and macro policies that pushed liquidity into the system in the hopes of pushing up asset prices and supporting the real economy.

QE2 – mixed blessings: The 2009 post-QE surge of capital into EM economies was not a problem in the first edition of QE from the Fed because EM policy-makers welcomed the extra boost it provided to their own economies. When QE2 arrived in mid-2010, DM markets and economies received another much-needed shot in the arm. However, EM economies had recovered sufficiently that this second massive infusion of liquidity in as many years and the resulting flow of capital into the EM world was more of a problem. Yet, EM policy-makers found it difficult to ward off these advances by DM policy and insulate their economies from the surge in capital inflows.

EMs handcuffed to DM policy: Why didn’t EM policy-makers repel these flows just as aggressively as DM central banks created them? The balance of global versus domestic risks is not the only reason why EM economies have found it difficult to shake off the shackles of DM policy. EM exchange rate policy and performance is equally to blame.

On the way up in 2010, EM policy-makers resisted currency appreciation as capital flowed in. The main reason? To stay competitive against China since: (i) EM economies are exporting a growing proportion of their exports to China; and (ii) they compete against China in DM export markets. The combination of a slow Rmb appreciation against the USD and the reluctance of EM policy-makers to allow appreciation against the Rmb implies a triangular arbitrage by which EM currencies are ‘soft pegged’ against the USD when currencies are appreciating. The soft-peg leads naturally to a loss of monetary independence (think of Hong Kong as an example). Raising policy rates with a soft peg in place then invites more capital inflows. Clearly, using instruments of liquidity policy is a better option under such a regime.

Liquidity policy became critical to macro policy: When capital inflows surged, using policy rates would have made matters worse. Cutting rates in order to discourage capital inflows would have meant pushing growth and inflation higher at a time when overheating was already becoming a concern. On the other hand, raising rates would have led to slower growth, which would have stemmed overheating concerns but invited even more capital inflows by exacerbating the interest rate differential between EM and DM economies. Left unhindered, capital flows were providing banks with adequate incentives to expand credit at a time when tempering credit growth was a greater priority for policy-makers. Clearly, using only macro measures to deal with this situation would have been a policy error. Using liquidity policy expansively provided policy-makers a second tool when external balance required a different degree of tightening than did internal balance.

While most EM economies used a wide range of quantitative tightening measures (see The Global Monetary Analyst: QT, March 30, 2011), central banks in China, India, Turkey and Brazil used them most aggressively. Along with the target for credit growth, RRR hikes in China became the main vehicle for reining in liquidity and bank lending. Policy rates did next to nothing, relatively speaking. India and Brazil used a variety of quantitative tools in addition to raising policy rates.

Finally, Turkey’s solution to dealing with internal and external balance was incredibly innovative. The CBT abandoned its single policy rate in favour of a corridor approach where the lending and borrowing rates offered by the CBT were pushed apart.

On the way down in 2H11, capital outflows and the associated EM currency weakness were primarily functions of the lack of response from DM central banks to growth risks in their own backyard. Starting from a significantly tighter policy stance, EM policy-makers have had to compensate for the lack of action from DM policy-makers by easing their policy stance earlier than most have expected. Much of the easing has come from liquidity measures and less from traditional policy rate cuts, which reflects the speed at which external and internal conditions have changed.

Internal versus external balance is important now too… The slowdown in EM growth is universal but the degree of the slowdown clearly varies across different economies. This is also true of the withdrawal of capital from EM economies. Within an economy, the speed with which portfolio outflows have occurred and currencies have depreciated has been very different from the speed at which growth has slowed down. Achieving internal and external balance using just the one policy instrument therefore looks as difficult now as it has for the last few years. Given these circumstances, we believe that it remains prudent for central banks to address the two-speed slowdown with two instruments.

…and is likely to be for the foreseeable future: The blurring of liquidity and macro policy will likely be with us at least until DM economies can get on a sustainable growth trajectory. At this point, DM central banks can slowly start unwinding the ultra expansionary policy stance and gain some flexibility around the extent to which liquidity policy is used. If DM policy-driven surges of capital into the EM world are done away with, EM policy-makers will have more breathing space too. Aggressive liquidity policy may then no longer be required and a return to traditional monetary policy is likely. However, with more easing to come from DM policy-makers, and an exit from easy policy very far away, EM policy-makers should not hold their breath. In turn, we believe that investors need to expand the bandwidth of their radars to catch the nuances of liquidity and macro policy measures in order to ascertain the true stance of monetary policy.

In fact, the ongoing round of global easing should ensure that liquidity policy in EM economies remains hyperactive. Our economics teams expect the Fed, the ECB, the BoE and possibly the BoJ to embark on further easing, mostly via QE. The script for EM economies has already been written. If QE3 arrives in late 1H12 in line with our US economics team’s expectation, capital will likely flow into EM economies and policy-makers will have to use liquidity measures to prevent an onslaught of liquidity, as was the case in 2010. As long as liquidity policy goes hand in hand with macro policies in DM economies, we believe that EM policy-makers will have little choice but to keep the two intertwined as well.

For 1H12, we expect most EM central banks to ease policy using a combination of macro and liquidity policy tools (see The Global Monetary Analyst: Who Can, Can’t and Can but Won’t, December 14, 2011). The central banks of Brazil and Indonesia, who have been both pre-emptive and aggressive, now have less work to do, as do some other LatAm central banks who never quite tightened policy as much as they wanted to. Others who have been reluctant to ease earlier may now find more room to ease thanks to EM disinflation.


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