COMMENT: EM central bank credibility comes into sharp focus

By bne IntelliNews October 20, 2014

Dr Nicholas Spiro of Spiro Sovereign Strategy -


Volatility in global financial markets is surging as investors fret about the state of the global economy. 

The CBOE’s Volatility Index, commonly known as “Wall Street’s fear gauge,” is now at its highest level since May 2012 when markets feared the Eurozone was about to break up.  The benchmark 10-year US Treasury yield has been driven down to 2.1% as investors rush into perceived safe havens while the S&P 500 Index has fallen 7% over the past month.

If there was ever a time when emerging market (EM) central banks ought to be reassuring investors about the conduct of monetary policy, it is now. Yet even central banks in some of the most creditworthy and stable EMs are in danger of losing credibility as a result of erratic policymaking and confusing signals.

Caught off guard

Poland’s central bank, which has long prided itself on its conservative approach to policymaking, has once again caught investors off guard – never a good thing for institutions that, ideally, are supposed to be predictable and transparent.   

On October 8, the National Bank of Poland (NBP) surprised investors by cutting its benchmark reference rate by a sharper-than-expected 50 basis points to 2% and, more importantly, slashing its Lombard rate – which sets the maximum rate banks can charge for loans – by 100 basis points to 3%. 

Investors had been pricing in rate cuts in Poland, but they didn’t expect the NBP to act so aggressively – not least given that the central bank had been resisting rate cuts during the summer months when Poland was already experiencing deflation and the recovery began to lose steam.

The credibility of the NBP is being further undermined by sharp differences of opinion on the conduct of monetary policy even within the dovish camp of the central bank’s rate-setting Monetary Policy Council (MPC). 

Still, at least markets and the NBP are on the same page: investors expect and are pricing in further rate cuts because of the deflationary conditions in the economy, with forward markets betting on another 50 basis points of rate cuts in the next three months.

Even in Hungary, whose central bank has thrown caution to the wind by cutting interest rates aggressively over the past two years, the return of deflation in September after two months of meagre rises in consumer prices justifies keeping rates at exceptionally low levels – although not as low as Poland’s given Hungary’s significantly weaker underlying fundamentals.

Of far greater concern is the conduct of monetary policy in Turkey and Russia.

Dove in hawk’s clothing

In Turkey, the central bank has been a dove in hawk’s clothing ever since it raised rates in an extremely aggressive manner in January to shore up the wilting lira.

Despite a surge in inflation to 9.4% in April (up from 7.4% at the end of last year and nearly double the central bank’s target), the central bank began cutting interest rates, squandering the inflation-fighting credibility it had gained earlier this year. While Turkey’s central bank has at least stopped cutting rates, it took a sharp deterioration in sentiment towards EMs in September to force its hand. 

The damage is already done. Even before October’s turmoil in global markets, Turkish assets were under renewed pressure partly because of the lack of confidence in monetary policy.  The yield on 10-year Turkish local debt shot up 100 basis points in September to 9.8% (but has since fallen back to 9%), while Turkish stocks have dropped a whopping 15% over the past three months (compared with declines of 3-4% in Poland and Hungary).

In Russia, meanwhile, the central bank has seemingly lost control of the ruble as the sharp decline in oil prices, the fallout from the toughening of the West’s sanctions regime against Russia and the general deterioration in sentiment towards EMs render the central bank’s frequent interventions to prop the currency – already some $13bn since September – wholly ineffective.

While Russia’s huge stockpile of foreign reserves and its strong public sector balance sheet provide a degree of reassurance, the steep decline in oil prices is severely testing the credibility of the central bank at a time when it is preparing to let the ruble float freely. The whiff of further rate hikes – the last thing Russia’s depressed economy needs right now – has been in the air for some time already.

Much now hinges on the extent to which the current growth scare that is gripping markets turns into something a lot more frightening. 

The fact that investors are now pushing back their expectations of the first US interest rate hike – the key catalyst for last year’s EM sell-off – is not helping sentiment towards developing economies one bit.  EM equities are down 3.5% in October alone, with Emerging Europe stocks performing the worst.

The region’s central banks are about to face their sternest test yet.

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