Emerging markets are not poor countries, nor are they countries which are making economic progress. They are defined by a very specific set of macroeconomic properties, which financial markets are conscious of, but are rarely clearly articulated.
The overriding characteristic of an emerging market is that a currency devaluation is a tightening of policy. In the developed world, a devaluation is typically an economic stimulus, indeed it often coincides with an easing of monetary policy through lower interest rates or an increase in QE. The post-Brexit policy response of the Bank of England is a case in point – sterling fell sharply and the Bank cut interest rates and initiated more QE.
In emerging markets the opposite occurs. These economies usually have public and private sector liabilities denominated in a currency which they do not issue. So when the Turkish Lira falls against the dollar the burden of finance on many Turkish corporates increases. Due to their US dollar liabilities, the interest payments and capital repayments in Turkish Lira rise. That is the first way in which a devaluation is a tightening of monetary conditions.
The second mechanism is more instructive and carries important lessons for monetary reform in the developed world, and in particular how we should think about the challenges posed by the zero-bound.
Emerging markets suffer from widespread price indexation and significant inflation expectations. In other words, when the currency falls, inflation rises, and when inflation rises the economic system attempts to respond by raising wages, and then raising prices. The 1970s concept of a wage-price spiral has meaning.
Because emerging markets have widespread wage and price indexation and alert inflation expectations central banks cannot exploit ‘temporary’ increases in the inflation rate by reducing real interest rates and stimulating demand, as they do in the developed world. Central banks, as we have seen in Brazil, Turkey and South Africa, have to respond to devaluations by tightening policy in order to prevent an increase in the underlying inflation rate.
What is going on, and what can we learn?
The most accurate way to think about this is that the emerging markets are 1970s-style economies. They are often characterised micro-economically by unionised labour markets, and perhaps more importantly, by oligopolistic and uncompetitive product markets. They typically have formalised and widespread indexation of wages and prices, in the private or public sectors – so second-round effects of an increase in prices are automatic, and they have a recent legacy of relatively high underlying rates of inflation. Rational expectations models broadly make sense in these economies.
In the developed world we now have price stability, as defined by Alan Greenspan. The Greenspan definition of price stability is inflation so low (and perhaps low for so long) that no one pays much attention to it. Put another way, relative price moves carry all the information – firms interpret changes in their prices as reflecting changing conditions of supply and demand in their industry or product area, and workers interpret changes in wage rates as indicative of supply and demand for their skill set. No one, other than central bankers and investors who care about central banks, pays much attention to inflation in the developed world any more. This is one reason why central bankers talking obsessively about inflation expectations is a bit silly. Most people have no idea what the rate of inflation is (statisticians included!), let alone have any expectations about it.
This is in fact why stabilisation policy in the developed world can be so powerful. Because there is price stability in the developed world, under the Greenspan definition, central banks and governments can literally throw money at the private sector in a recession and there will be a very strong recovery in demand without any change in underlying inflation – variance in measurement may well be more significant.
Emerging markets, however, suffer from indexation, uncompetitive micro-structure, and relevant inflation expectations. They are rational expectations-relevant economies, where policy is unable to exploit deep-rooted price stability.
The first lesson, therefore, is that emerging markets should devise policies to obtain price stability and the developed world should do nothing to threaten it. Price stability, of the Greenspan variety, is in fact the premise of macro-stabilisation. Immediately it is clear that ideas such as raising inflation targets in the developed world are, in fact, quite dangerous.
A final point is worth making on the consequences for asset price correlation, investing, MMT, and fiscal policy. If interest rates have to rise in response to exchange rate-induced spikes in inflation, government bonds start to behave like equities. Emerging market bonds are an asset class of their own. Why? Because when the currency falls – which tightens policy through higher interest expense and capital requirements on foreign currency debt – the central bank raises interest rates to offset the effect on inflation. Recessionary risks is compounded by higher interest rates, in contrast to the developed world when interest rates would be cut in response to recession risk. The pricing of government bonds, issued in local currency, is best understood as an interest rate expectation. So if interest rates rise, government bond prices fall.
So in emerging markets, equities fall as recession risk rises and bonds fall because interest rates are rising. There is positive covariance and no diversification. This is profoundly important, because it not only results in pro-cyclical monetary policy, but it also neuters fiscal policy. In the developed world one consequence of price stability that has become crystal clear is the negative cyclical covariance between government bonds and the private sector’s equity cost of capital. This makes a nonsense of austerity. In simple terms, because of price stability, whenever there is a recession in the developed world the cost of debt to the government collapses and the volatility aversion of the private sector creates a huge shift in demand for the assets issued by the state – money and government bonds – which creates a spectacular fiscal free lunch.
In summary, if macro-economic stabilisation is one precondition of social stability and progress, the definition of an emerging market is surprisingly important.
The literature talks about “well-anchored” inflation expectations in the developed world particularly in inflation-targeting countries, observing that developing countries have less well-anchored expectations. This framing is unsatisfactory. It almost assumes a dominant role for inflation-targeting central banks in the process, and underplays changes in microeconomic structure and the duration of prevailing low inflation regimes in the formation of beliefs and changes in behaviour. Using evidence from financial markets, which most of the literature does, to identify structural shifts in inflation expectations after central bank independence and inflation-targeting is suspect. Clearly investors in CPI-linked government bond markets are focused on the inflation-targeting objectives of central banks. Announcing an inflation target with reasonable credibility will anchor beliefs in the index-linked bond market quite predictably, but this in no way implies that the rest of the economy, where the effects of inflation may be trivial relative to the variance in relative price, is paying much attention.
The first draft of this post received some thought-provoking feedback, notably from Sri Thiruvadanthai director of research at the Jerome Levy Forecasting Centre. Sri points out that emerging markets typically have less liquid bond markets, and that depth and liquidity could affect the cyclical behaviour of government bond markets. There should be some truth in this – liquidity premia may be cyclical – but it doesn’t strike me as the dominant cause of price behaviour. Also, I see very little correlation between liquidity and covariance in other asset markets – all German and US bonds rally during extreme risk events – including illiquid ones. The simple reality is that the Turkish authorities have to tighten fiscal and monetary policy to prevent an inflationary spiral. The UK doesn’t, and isn’t. Hence their respective bond markets have different risk properties. Government bonds, denominated in local currency, are an interest rate expectation plus or minus a term premium and an inflation risk premium.