Time for Slash & Burn to Rejuven

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  Time for Slash & Burn
to Rejuvenate Markets
Policymakers in emerging markets have left policy settings at emergency levels
for too long, contributing to the current inflation problem

                                                          The Excess Liquidity Story
                                                          Both nominal and real rates in emerging markets are at close to record lows. Central bankers need to
                                                          at least normalise these rates to check the surge in commodity price-led inflation
                                                                    NOMINAL EMERGING MARKETS RATES
                                                                    REAL EMERGING MARKETS RATES

           RUCHIR SHARMA                                  10

                 lash-and-burn farming is still           8
                 popular in many parts of the
                 developing world, with farm-             6
           ers sometimes left with no choice
           but to burn the soil to eradicate              4
           poor nutrients before growing a
           fresh new crop. Bear markets often             2
           play a similar purgatory role in the
           investment landscape and it seems              0
           that emerging markets too may
                                                               2003 JAN
                                                                                      2004 JAN
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                                                                                                                                    2006 JAN
                                                                                                                                                           2007 JAN
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           have little option but to go through
           such a process in 2011.
             Inflation, driven largely by surg-
           ing commodity prices, is playing
           havoc in many developing coun-                 Nominal and real rates in emerging markets are GDP-weighted
           tries and central banks are at last
           coming round to the view that mon-                                                                                                                                                                                                                      SOURCE MORGAN STANLEY RESEARCH

           etary policy needs to play a more                                                                                                                                                                                                                                           JAYEETA
           active role in taming prices. A           all want to achieve a growth profile                                                 principal beneficiaries of the liq-                                                              prices accounting for a small part
           more restrictive monetary policy          similar to that period even though                                                   uidity deluge.                                                                                   of consumer prices in much of the
           stance is likely to cause collateral      the underlying dynamics have                                                           Reforms helped raise their under-                                                              developed world and where other
           damage to overall economic grow-          changed. Although the developed                                                                                     ,
                                                                                                                                          lying economic productivity set-                                                                 inflation measures are still sub-
           th and other asset classes such as        world has not seen a double-dip, the                                                 ting the stage for investment to rise                                                            dued, the onus of normalising in-
           equities. There is no other way out.      recovery has indeed been sub-par                                                     and emerging markets were able to                                                                terest rates and withdrawing some
             The role that the Fed’s quantita-       and, consequently external de-
                                                                           ,                                                              absorb large capital flows without                                                               liquidity falls mostly on policy-
           tive easing policies have played in       mand is not as strong a contributor                                                  any inflationary consequences.                                                                   makers in developing economies.
           inflating commodity prices is well        to growth in the developing coun-                                                      Fund flows into commodities                                                                      Food and energy prices there
           documented and flows into com-            tries as it was during 2003-07. Many                                                 were also small during 2003-07 as                                                                constitute more than a third of
           modity-linked financial products          emerging market policymakers th-                                                     real interest rates across the globe                                                             overall prices. High weights of
           continue to run at a record pace          ink they can just rely on loose mon-                                                 were relatively high and stable.                                                                 food and energy in the emerging-
           with free money providing market          etary and fiscal stance to boost do-                                                 These rates averaged 3% in emerg-                                                                market consumer’s basket render
           participants a licence to speculate.      mestic demand and compensate                                                         ing markets then compared to                                                                     the concept of core inflation that
           But Fed chairman Ben Bernanke             for weaker export growth for their                                                   barely 1% today  .                                                                               excludes food and energy prices
           was not just deflecting the blame         economies to expand as fast.                                                           The dramatic cut in interest rates                                                             irrelevant in the developing
           from his own very accommodative            The outcome of such policy set-                                                     led by the Fed in August 2007 in the                                                             world. Even in the developed econ-
           policies when he recently said that       tings is inflationary Long-term
                                                                              .                                                                            wake of the sub-                                                                omies, core inflation measures
           central bankers in the emerging           growth is a function of productivi-                                                                   prime crisis and                                                                grew in importance in the 1980s
           world should use their own mone-          ty-enhancing economic reforms                                                        The              followed by China                                                               and 1990s when commodity prices
           tary tools to tackle inflation.           and not artificially low interest                                                    withdrawal       and other emerg-                                                                were in a secular downtrend and
             Real, or inflation-adjusted, inter-     rates. In most parts of the world in                                                 of excess        ing markets in the                                                              all spikes turned out to be tempo-
           est rates are still far too low in most   the last couple of years, too much                                                   liquidity is     second half of 2008                                                             rary in nature.
           developing countries as policy-           emphasis has been placed on mon-                                                     likely to        as the financial                                                                  Higher interest rates and rising
           makers have been very slow in nor-        etary and fiscal activism to revive                                                  inflict          meltdown      went                                                              inflation always cause discomfort
           malising policy following the glob-       growth than on economic reform.                                                      collateral       global, spurred the                                                             in equity markets. Earnings grow-
           al financial crisis. Even though          The current cycle has surprisingly                                                   damage to        financialisation of                                                             th in the third year of an economic
           growth has returned to pre-crisis         not started to deviate from the pre-                                                 growth and       commodities.                                                                    recovery typically slows down and
           highs in several emerging mar-            vious expansion phase.                                                               bourses            Assets in comm-                                                               the burden falls on market multi-
           kets, and both core and headline in-       To be certain, the first two years of                                                                odity-linked funds                                                              ples — such as price-to-earnings
           flation are running at the same           the current recovery had a lot in                                                    have swelled to over $400 billion                                                                ratios — to increase to drive stocks
           pace that prevailed in the middle of      common with 2003 and 2004. How-                                                      compared to just $150 billion in                                                                 higher. That was why in 2005, em-
           the previous cycle, current short-        ever, in 2005, inflation was a non-is-                                               mid-2007, when the Fed began to                                                                  erging markets, including India,
           term interest rates are well below        sue in emerging markets. Food pri-                                                   sharply cut interest rates. The cor-                                                             rallied by nearly 30% despite slow-
           the levels of that period.                ces were relatively quiescent at the                                                 relation between commodities and                                                                 ing earnings growth. Multiples
             To justify their slowness in hik-       start of 2005 and while oil prices                                                   the US equity market since then                                                                  tend to expand only in a non-infla-
           ing interest rates, emerging mar-         were climbing, the rally was from a                                                  has been perfect. All commodities                                                                tionary environment and contract
           ket central bankers have been us-         rather low base and did not make                                                     currently move in-sync, almost im-                                                               when inflation is out of the comfort
           ing excuses such as potential hot         much of a difference to consumer                                                     pervious to their own specific sup-                                                              zone, as is the case now. Earnings
           money flows or the prospect of a          spending patterns. Meanwhile,                                                        ply and demand fundamentals.                                                                     growth too is at risk in such a sce-
           growth relapse in debt-stricken de-       other price components of the con-                                                   They all trade well above their mar-                                                             nario with margins pressured by
           veloped countries. Both those as-         sumer’s basket were moderating                                                       ginal cost of production, reflecting                                                             surging commodity prices.
           sessments have proved wrong. The          and, therefore, headline inflation                                                   largely a liquidity premium than                                                                   Unless commodity prices start to
           notion that capital flows between         in emerging markets trended low-                                                     genuine supply shortages.                                                                        magically retreat on their own,
           countries are based largely on in-        er, easing from 5% in January 2005                                                     But food and energy prices have                                                                central banks will have to with-
           terest rate differentials no longer       to 4.4% by the end of the year.                                                      now crossed the threshold of pain                                                                draw excess liquidity from the sys-
           holds true. Money has been pour-           At the same time, many emerging                                                                                      .
                                                                                                                                          and need to be reined in quickly To                                                              tem and interest rates will have to
           ing into emerging markets over the        markets were reaping the benefits                                                    attribute the record increase in                                                                 rise much further to cool down in-
           past few years due to their superior      of the major economic reforms                                                        food prices to routine weather dis-                                                              flation. This obviously has nega-
           growth prospects. The large capi-         carried out over the previous few                                                    turbances does not make logical                                                                  tive implications for economic
           tal outflows over the past month          years to integrate better with the                                                   sense. Following a 60% surge over                                                                growth and stocks markets in the
           from developing countries, even as        global economy following a lost                                                      the last six months, food prices are                                                             short to medium term.
           interest rates have risen, are evi-       decade in the 1990s. They also ad-                                                   now higher than at their 2008 peak,                                                                But cleansing the investment
           dence of the fact that a deteriora-       hered to strict monetary and fiscal                                                  implying the inflation prints are                                                                landscape of commodity-price in-
           tion in future growth and inflation       discipline, leading to improved                                                      likely to get much worse in the                                                                  flation with some slash and burn is
           prospects is a much more powerful         balance-sheets at a macroeconom-                                                     months ahead.                                                                                    the sacrifice that must be made for
           force behind capital flows.               ic level. So, when the global eco-                                                     If excess liquidity is the main                                                                a healthier crop to emerge in the
             An anchoring bias has also affect-      nomic cycle turned for the better in                                                 source of commodity price infla-                                                                 long term.
           ed decision-making: policymakers          2003 and investor risk appetite re-                                                  tion, sucking some of that out of                                                                (The author is head of emerging
           now use the 2003-07 boom years as         turned abetted by the low cost of                                                    the system is the only way to check                                                              markets at Morgan Stanley
           their main reference point. They          credit, emerging markets were the                                                    the price rise. With commodity                                                                   Investment Management)

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