Goldman on monetary policy in the BRICs

Excellent recap of what’s happening through the eyes of Wall St. in the BRICS.

To be noted:

The BRICS all seem to be fighting inflation, which means the problem is that bad.

Unfortunately, hiking rates via direct rate hikes, reserve requirement hikes, and the like, which they all are doing, add to aggregate demand through the interest income channels, making their inflations that much worse. (That’s the price of being out of paradigm, as reinforced by analysts who are also out of paradigm)

Some are using credit controls, which do slow demand, as does fiscal tightening which generally happens through automatic stabilizers that work through higher nominal growth, including reduced transfer payments and higher tax receipts.

In general, this type of thing tends to end with a very hard landing, which their equity markets may be starting to discount.

BRICs Monthly : 11/04 – Monetary Policy in the BRICs

Published April 28, 2011

The BRICs’ central banks rely on a variety of tools to adjust monetary policy. As output gaps have closed and inflation pressures have accelerated, policy stances in the BRICs have shifted meaningfully towards tightening. We expect policy to continue to tighten in the coming months via a combination of policy rate hikes, reserve ratio requirement hikes and other measures.

There is a large degree of variation in the stated goals of monetary policy and the tools used to achieve those goals, both among the BRICs and relative to the advanced economies. The BRICs (like many other emerging markets) rely more heavily on a broader set of tools than is typical in the developed world. These include several policy rates, reserve ratio requirements, open market operations and FX intervention. As a result, looking at the policy rate alone does not provide an accurate picture of the overall monetary policy stance.

Over the past year, BRICs’ policymakers have shifted from an accommodative policy stance (in response to the financial crisis) to tightening (in response to closing output gaps and rising inflation pressures). However, the unusual shape of the global recovery—in which most of the BRICs and other EMs have rebounded quickly, while the developed world has lagged behind—has brought about a shift in the way in which the BRICs have tightened monetary policy. This time around, most have relied less on policy rate hikes and more on alternative tools.

While the BRICs have tightened monetary policy meaningfully, we believe that more is on the way. We expect Brazil, India and Russia to hike their policy rate by another 125bp and China to hike by 25bp by end-2011. In addition, we expect further tightening through the exchange rate, the reserve requirement ratio and other measures.

Monetary Policy in the BRICs

There is a large degree of variation in the stated goals of monetary policy and the tools used to achieve those goals, both among the BRICs and relative to advanced countries. The BRICs (like many other EMs) rely more heavily on a broader set of tools than is typical in the developed world. Hence, looking at the policy rate alone does not provide an accurate picture of their monetary policy stance.

Brazil’s monetary policy framework has shifted dramatically over the past two decades. As it struggled against hyper- and high inflation in the early 1990s, the government first introduced a period of extremely high interest rates (over 50%) in 1994, and then transitioned in 1995 to a soft exchange rate peg accompanied by high and volatile interest rates. In 1999, Brazil shifted to its current inflation-targeting regime. The current inflation target is set at 4.5%, with a relatively wide band of +/- 2% and no repercussions if the target is missed (as it has been for the past three years). To this end, COPOM targets the SELIC interest rate (the overnight interbank rate).

China uses a more eclectic form of monetary policy that involves a range of players, objectives and instruments. The People’s Bank of China (PBoC) is the official implementer, but the central government often weighs heavily on the PBoC’s decisions. The Bank does not hold regular policy meetings and policy changes are typically released after the close of the local market without advance notice. The Monetary Policy Committee of the PBoC is an advisory body, which does not determine policy direction. Chinese monetary policy has an official quad mandate of growth, employment, inflation and a balanced external account. To achieve these goals, the PBoC uses a range of quantity- and price-based mechanisms, such that there is no single policy instrument that can be used as a main indicator of its monetary policy stance at any given time. Quantity-based tools include reserve requirement (RRR) changes and credit controls. Price-based tools include changes in the benchmark deposit and lending interest rates.

India’s monetary policy is conducted by the Reserve Bank of India (RBI), which has the dual mandate of price stability and the provision of credit to productive sectors to support growth. To this end, the RBI targets the interest rate corridor for overnight money market rates, with the reverse-repo rate as the floor and the repo rate as the ceiling. The RBI also utilises open market operations and two types of reserve ratio requirements (the cash reserve ratio and the statutory liquidity ratio).

In Russia, monetary policy is set by the Central Bank of Russia (CBR). Until recently, the CBR concentrated on exchange rate stability and allowed inflation to vary. Its main policy rates are the overnight deposit rate and the 1-week minimum repo rate, although these historically have played a subordinate role to FX intervention. The CBR also monitors liquidity through reserve requirements, FX interventions and open market operations.

Shift in BRICs’ Approach to Monetary Tightening

The unusual shape of the global recovery—in which most of the BRICs and other EMs have rebounded quickly, while the developed world has lagged—has brought about a shift in the way in which the BRICs have tightened monetary policy.

Policymakers in Brazil have been hesitant to raise rates as aggressively as they normally would in response to the current high-growth/high-inflation domestic cyclical picture, given their concern that this would attract greater capital inflows. Instead, they have increasingly relied on two alternative mechanisms to tighten the overall policy stance: (1) a gradual FX appreciation and (2) several ‘macro-prudential’ measures that slow the pace of new credit concessions, raise the cost and lengthen the maturity of new loans, and raise the tax on foreign fixed income inflows.

Over the recent cycle, Chinese policymakers have relied most heavily on explicit and implicit credit controls, including window guidance meetings and the Dynamic Differentiated RRR System (under which the PBoC imposes a differentiated RRR for some banks but removes it for others, if they have been following government lending controls). Frequent RRR hikes have generally not produced any net tightening, as they were counterbalanced by increased FX inflows and expiring central bank bills. Likewise, recent interest rate hikes have been an effective signalling device but have been too small in magnitude to have a large impact.

In India, the RBI has kept liquidity tight in order to pass policy rate hikes through to bank deposit and lending rates. However, excessively tight and volatile liquidity has caused overnight borrowing rates to fluctuate widely in recent months, such that market participants have focused more on liquidity than policy rate actions in determining the direction and magnitude of interest rates at the short end. In an effort to address this issue and increase transparency, the RBI has proposed shifting to a single policy rate target (the repo rate) while simultaneously improving its control over system-wide liquidity.

Russia has seen the largest change in its monetary policy framework since the onset of the financial crisis. The CBR has shifted towards more FX flexibility with a greater focus on inflation, with the goal of an eventual move towards an inflation targeting regime (although, as the CBR has highlighted, such a move would ultimately be a government decision, which is unlikely to be realised in the absence of a strong political will to make the change). To this end, the CBR has moved towards interest rates as its primary monetary policy tool, and has scaled down its presence in the FX markets. It now sterilizes most FX interventions so as not to impact money supply growth. It has also relied more heavily on reserve requirement changes in recent months, in an effort to signal tightening liquidity.

More Tightening to Come

While the BRICs have meaningfully tightened monetary policy via a variety of tools, we believe more is needed. Demand-driven inflationary pressures are picking up as output gaps close, contributing to an acceleration in core inflation. Moreover, the BRICs also face large food and energy price spikes, which are likely to continue to push up headline inflation at least through the summer. In addition, fiscal policy is not turning sufficiently contractionary, leaving the burden of tightening on monetary policymakers.

In Brazil, we expect five more SELIC hikes by 25bp per meeting and further macro-prudential measures. For China, we forecast at least one more rate hike (25bp in 2011Q2), further currency appreciation (6% annualised), liquidity absorption measures through RRR hikes and open market operations, and tight control over credit issuance. We have a much more hawkish view of India than consensus, where we now expect the RBI to hike policy rates by another 125bp in 2011. Russia’s CBR should hike deposit and repo rates by 150bp and 125bp respectively by end-2011.

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