The high cost of currency (rouble) stability

This is from Reuters today:

“The Russian currency has opened higher Thursday, continuing its recovery from the biggest intraday drop since 1998 default on so-called ‘Black Tuesday’. The dollar was down 65 kopeks at the opening on the Moscow Exchange, while on the stock market, the dollar-denominated RTS index was up 6.5 percent. That’s was hours before President Vladimir Putin commenced his much-anticipated Q&A marathon, in which he’s expected to face tough economic questions about the ruble and turmoil in the financial markets. ….On Wednesday, the ruble jumped 6 percent against the US dollar to finish trading at 60.51 against the Greenback. On ‘Black Tuesday’ the ruble dipped to as low as 80 rubles against the US dollar and hit a threshold of 100 against the euro.”

So after a terrible start to the week the Russian rouble has stabilised over the past two days. However, the (temporary?) stabilisation of the rouble has not been for free. Far from it in fact. Just take a look at this story from ft.com also from today:

Russian banks are getting cautious about lending each other money, with the interest rate on three-month interbank loans hitting its highest since at least 2005. The three-month “mosprime” interbank lending rate has soared to 28.3 per cent, which is its highest since it hit its financial crisis peak of 27.6 in January 2009. The rate is also sharply higher than it reached on Wednesday – the day after the Central Bank of Russia hiked interest rates to 17 per cent to stem a plunge in the rouble – when it closed at 22.33. Stresses have been building in Russian economy because of Western sanctions and a sharp fall in the oil price But another reason for the mosprime spike is that Russian banks are unsure about the state of each other’s businesses. Russian bank customers have been rushing to withdraw their roubles out of their bank accounts and convert them to dollars or euros.

Hence, the rouble might have stabilised, but monetary conditions have been tightened dramatically. So the question is whether the benefits of a (more) stable rouble outweigh the costs of tighter monetary conditions?

We might get the answer by looking that the graph below. The consequence of higher interest rates in 2008-9 was a 10% contraction in real GDP. This week’s spike in money market rates is even bigger (and steeper) than the spike in rates in 2008-9. Is there any good reason why we should not expect a similar contraction in real GDP this time? I think not… MosPrime 3m RGDP

PS obviously I would be the first to acknowledge that money market rates is not the entire story about monetary contraction and money market rates are only used for illustrative purposes here. There are also some differences between 2008-9 and now, but it should nonetheless be noted that the recent drop in oil prices is similar to what we saw in 2008-9.

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Turning the Russian petro-monetary transmission mechanism upside-down

Big news out of Moscow today – not about the renewed escalation of military fighting in Eastern Ukraine, but rather about Russian monetary policy. Hence, today the Russian central bank (CBR) under the leadership of  Elvira Nabiullina effectively let the ruble float freely.

The CBR has increasing allowed the ruble to float more and more freely since 2008-9 within a bigger and bigger trading range. The Ukrainian crisis, negative Emerging Markets sentiments and falling oil prices have put the ruble under significant weakening pressures most of the year and even though the CBR generally has allowed for a significant weakening of the Russian currency it has also tried to slow the ruble’s slide by hiking interest rates and by intervening in the FX market. However, it has increasingly become clear that cost of the “defense” of the ruble was not worth the fight. So today the CBR finally announced that it would effectively float the ruble.

It should be no surprise to anybody who is reading my blog that I generally think that freely floating exchange rates is preferable to fixed exchange rate regimes and I therefore certainly also welcome CBR’s decision to finally float the ruble and I think CBR governor Elvira Nabiullina deserves a lot of praise for having push this decision through (whether or not her hand was forced by market pressures or not). Anybody familiar with Russian economic-policy decision making will know that this decision has not been a straightforward decision to make.

Elvira has turned the petro-monetary transmission mechanism upside-down

The purpose of this blog post is not necessarily to specifically discuss the change in the monetary policy set-up, but rather to use these changes to discuss how such changes impact the monetary transmission mechanism and how it changes the causality between money, markets and the economy in general.

Lets first start out with how the transmission mechanism looks like in a commodity exporting economy like Russia with a fixed (or quasi fixed) exchange rate like in Russia prior to 2008-9.

When the Russian ruble was fixed against the US dollar changes in the oil price was completely central to the monetary transmission – and that is why I have earlier called it the petro-monetary transmission mechanism. I have earlier explained how this works:

If we are in a pegged exchange rate regime and the price of oil increases by lets say 10% then the ruble will tend to strengthen as currency inflows increase. However, with a fully pegged exchange rate the CBR will intervene to keep the ruble pegged. In other words the central bank will sell ruble and buy foreign currency and thereby increase the currency reserve and the money supply (to be totally correct the money base). Remembering that MV=PY so an increase in the money supply (M) will increase nominal GDP (PY) and this likely will also increase real GDP at least in the short run as prices and wages are sticky.

So in a pegged exchange rate set-up causality runs from higher oil prices to higher money supply growth and then on to nominal GDP and real GDP and then likely also higher inflation. Furthermore, if the economic agents are forward-looking they will realize this and as they know higher oil prices will mean higher inflation they will reduce money demand pushing up money velocity (V) which in itself will push up NGDP and RGDP (and prices).

This effectively means that in such a set-up the CBR will have given up monetary sovereignty and instead will “import” monetary policy via the oil price and the exchange rate. In reality this also means that the global monetary superpower (the Fed and PBoC) – which to a large extent determines the global demand for oil indirectly will determine Russian monetary conditions.

Lets take the case of the People’s Bank of China (PBoC). If the PBoC ease monetary policy – increase monetary supply growth – then it will increase Chinese demand for oil and push up oil prices. Higher oil prices will push up currency inflows into Russia and will cause appreciation pressure on the ruble. If the ruble is pegged then the CBR will have to intervene to keep the ruble from strengthening. Currency intervention of course is the same as sell ruble and buying foreign currency, which equals an increase in the Russian money base/supply. This will push up Russian nominal GDP growth.

Hence, causality runs from the monetary policy of the monetary superpowers – Fed and the PBoC – to Russian monetary policy as long as the CBR pegs or even quasi-peg the ruble. However, the story changes completely when the ruble is floated.

I have also discussed this before:

If we assume that the CBR introduce an inflation target and let the ruble float completely freely and convinces the markets that it don’t care about the level of the ruble then the causality in or model of the Russian economy changes completely.

Now imagine that oil prices rise by 10%. The ruble will tend to strengthen and as the CBR is not intervening in the FX market the ruble will in fact be allow to strengthen. What will that mean for nominal GDP? Nothing – the CBR is targeting inflation so if high oil prices is pushing up aggregate demand in the economy the central bank will counteract that by reducing the money supply so to keep aggregate demand “on track” and thereby ensuring that the central bank hits its inflation target. This is really a version of the Sumner Critique. While the Sumner Critique says that increased government spending will not increase aggregate demand under inflation targeting we are here dealing with a situation, where increased Russian net exports will not increase aggregate demand as the central bank will counteract it by tightening monetary policy. The export multiplier is zero under a floating exchange rate regime with inflation targeting.

Of course if the market participants realize this then the ruble should strengthen even more. Therefore, with a truly freely floating ruble the correlation between the exchange rate and the oil price will be very high. However, the correlation between the oil price and nominal GDP will be very low and nominal GDP will be fully determined by the central bank’s target. This is pretty much similar to Australian monetary policy. In Australia – another commodity exporter – the central bank allows the Aussie dollar to strengthen when commodity prices increases. In fact in Australia there is basically a one-to-one relationship between commodity prices and the Aussie dollar. A 1% increase in commodity prices more or less leads to a 1% strengthening of Aussie dollar – as if the currency was in fact pegged to the commodity price (what Jeff Frankel calls PEP).

Therefore with a truly floating exchange rate there would be little correlation between oil prices and nominal GDP and inflation, but a very strong correlation between oil prices and the currency. This of course is completely the opposite of the pegged exchange rate case, where there is a strong correlation between oil prices and therefore the money supply and nominal GDP.

If today’s announced change in monetary policy set-up in Russia is taken to be credible (it is not necessary) then it would mean the completion of the transformation of the monetary transmission which essentially was started in 2008 – moving from a pegged exchange/manage float regime to a floating exchange rate.

This will also means that the CBR governor Elvira Nabiullina will have ensured full monetary sovereignty – so it will be her rather than the Federal Reserve and the People’s Bank of China, who determines monetary conditions in Russia.

Whether this will be good or bad of course fully dependent on whether Yellen or Nabiullina will conduct the best monetary policy for Russia.

One can of course be highly skeptical about the Russian central bank’s ability to conduct monetary policy in a way to ensure nominal stability – there is certainly not good track record, but given the volatility in oil prices it is in my view also hard believe that a fully pegged exchange rate would bring more nominal stability to the Russian economy than a floating exchange rate combined with a proper nominal target – either an inflation target or better a NGDP level target.

Today Elvira Nabiullina has (hopefully) finalized the gradual transformation from a pegged exchange to a floating exchange rate. It is good news for the Russian economy. It will not save the Russia from a lot of other economic headaches (and there are many!), but it will at least reduce the risk of monetary policy failure.

PS I still believe that the Russian economy is already in recession and will likely fall even deeper into recession in the coming quarters.

 

 

Monetary sovereignty is incompatible with inflation targeting

When I started working in the financial sector nearly 15 years ago – after 5 years working for government – one thing that really puzzled me was how my new colleagues (both analysts and traders) where thinking about exchange rates.

As a fairly classically thinking economist I had learned to think of exchange rates in terms of the Purchasing Power Parity. After all why should we expect there to be a difference between the price of a Big Mac in Stockholm and Brussels? Obviously I understood that there could be a divergence from PPP in the short-run, but in the long-run PPP should surely expected to hold.

Following the logic of PPP I would – in the old days – have expected that when an inflation number was published for a country and the number was higher than expected the currency of the country would weaken. However, this is not how it really was – and still is – in most countries. Hence, I was surprised to see that upside surprises on the inflation numbers led to a strengthening of the country’s currency. What I initially failed to understand was that the important thing is not present inflation, but rather the expected future changes to monetary policy.

What of course happens is that if a central bank has a credible inflation target then a higher than expected inflation number will lead market participants to expect the central bank to tighten monetary policy.

Understanding exchange rate dynamic is mostly about understanding monetary policy rules

But what if the central bank is not following an inflation-targeting rule? What if the central bank doesn’t care about inflation at all? Would we then expect the market to price in monetary tightening if inflation numbers come in higher than expected? Of course not.

A way to illustrate this is to think about two identical countries – N and C. Both countries are importers of oil. The only difference is that country N is targeting the level of nominal GDP, while country C targets headline inflation.

Lets now imagine that the price of oil suddenly is halved. This is basically a positive supply to both country N and C. That causes inflation to drop by an equal amount in both countries. Realizing this market participants will know that the central bank of country C will move to ease monetary policy and they will therefore move reduce their holdings of C’s currency.

On the other hand market participants also will realize that country N’s central bank will do absolutely nothing in response to the positive supply shock and the drop in inflation. This will leave the exchange of country N unchanged.

Hence, we will see C’s currency depreciate relatively to N’s currency and it is all about the differences in monetary policy rules.

Exchange rates are never truly floating under inflation targeting

I also believe that this example actually illustrates that we cannot really talk about freely floating exchange rates in countries with inflation targeting regimes. The reason is that external shifts in the demand for a given country’s currency will in itself cause a change to monetary policy.

A sell-off in the currency causes the inflation to increase through higher import prices. This will cause the central bank to tighten monetary policy and the markets will anticipate this. This means that external shocks will not fully be reflected in the exchange rate. Even if the central bank does to itself hike interest rates (or reduce the money base) the market participants will basically automatically “implement” monetary tightening by increasing demand for the country’s currency.

This also means that an inflation targeting nearly by definition will respond to negative supply shocks by tightening monetary policy. Hence, negative external shocks will only lead to a weaker currency, but also to a contraction in nominal spending and likely also to a contraction in real GDP growth (if prices and wages are sticky).

Monetary policy sovereignty and importing monetary policy shocks

This also means that inflation targeting actually is reducing monetary policy sovereignty. The response of some Emerging Markets central banks over the past year illustrates well.

Lets take the example of the Turkish central bank. Over the past the year the Federal Reserve has initiated “tapering” and the People’s Bank of China has allowed Chinese monetary conditions to tighten. That has likely been the main factors behind the sell-off in Emerging Markets currencies – including the Turkish lira – over the past year.

The sell-off in Emerging Markets currencies has pushed up inflation in many Emerging Markets. This has causes inflation targeting central banks like the Turkish central bank (TCMB) to tighten monetary policy. In that sense one can say that the fed and PBoC have caused TCMB to tighten monetary policy. The TCMB hence doesn’t have full monetary sovereignty. Or rather the TCMB has chosen to not have full monetary policy sovereignty.

This also means that the TCMB will tend to import monetary policy shocks from the fed and the PBoC. In fact the TCMB will even import monetary policy mistakes from these global monetary superpowers.

The global business cycle and monetary policy rules

It is well-known that the business cycle is highly correlated across countries. However, in my view that doesn’t have to be so and it is strictly a result of the kind of monetary policy rules central banks follow.

In the old days of the gold standard or the Bretton Woods system the global business cycle was highly synchronized. However, one should have expected that to have broken down as countries across the world moved towards officially having floating exchange rates. However, that has not fully happened. In fact the 2008-9 crisis lead to a very synchronized downturn across the globe.

I believe the reason for this is that central banks do in fact not fully have floating exchange rate. Hence, inflation targeting de facto introduces a fear-of-floating among central banks and that lead central banks to import external shocks.

That would not have been the case if central banks in general targeted the level of NGDP (and ignored supply shocks) instead of targeting inflation.

So if central bankers truly want floating exchanges – and project themselves from the policy mistakes of the fed and the PBoC – they need to stop targeting inflation and should instead target NGDP.

PS It really all boils down to the fact that inflation targeting is a form of managed floating. This post was in fact inspired by Nick Rowe’s recent blog post What is a “managed exchange rate”?

Listen to my new hero Jose Dario Uribe

The turmoil in the Emerging Markets currencies markets continues. Most EM central bankers seem to be very scared by the continued sell-off in Emerging Markets and central banks around the world have moved to hike interest rates and have intervened to curb the weakening of the Emerging Markets sell-off. This means that most EM central banks effectively are tightening monetary policy in response to a negative external demand shock. This is hardly wise in my view.

However, it is not all EM central bankers who suffer from a fear-of-floating. Hence, today the Colombian peso came under pressure after Colombian central bank governor Jose Dario Uribe said the weakening of the peso is “something we view as positive.”  Uribe added that the central bank had “enormous” margin to allow the peso to weaken as inflation continue to be well-below the central bank’s 3% inflation.

Furthermore, it should be noted that given the down-trend in commodity prices Colombian export prices are coming under pressure. Hence, from an Export Price Norm perspective a weakening of the peso is justified from a policy perspective to ensure a stable development in nominal spending.

In recent years the Colombian economy has been a major success story due to significant economy reforms, privatizations and fiscal consolidation. Luckily monetary policy also seems to support the continued positive development in the Colombian economy.

It will be interesting to follow the development in the Colombian economy – where the central bankers seem to understand the value of a floating exchange rate regime – relative to other countries – such as Turkey – where central bankers fear floating exchange rates. Is Colombia the new Australia? And is Turkey the new New Zealand. (See here on Australia and New Zealand in 1997).

Please don’t fight it – the risk of EM policy mistakes

Emerging Markets are once again back in the headlines in the global financial media – from Turkey to Argentina market volatility has spiked from the beginning of the year.

The renewed Emerging Markets volatility has caused some commentators to claim that the crisis back. It migtht be, but also I think it is very important to differentiate between currency movements on its own and the underlying reasons for these movements and in this post I will argue that currency movements in itself is not necessarily a problem. In fact floating exchange rate regimes mean that the currency will move in response to shocks, which ideally should reduce macroeconomic volatility.

Imagine this would have been 1997

I think it is illustrative to think about what is going on in Emerging Markets right now by imagining that the dominant monetary and exchange rate regime had been pegged exchange rates as it was back in 1997 when the Asian crisis hit.

Lets take the case of Turkey and lets assume Turkey is operating a pegged exchange rate regime – for example against the US dollar. And lets at the same time note that Turkey presently has a current account deficit of around 7% of GDP. This current account deficit is nearly fully funded by portfolio inflows from abroad – for example foreign investors buying Turkish bonds and equities.

As long as investors are willing to buy these assets there is no problem. But then one day investors decide to close down their positions in Turkey – for example because of they expect the dollar to appreciate because of the Federal Reserve tightening monetary conditions or because investors simply become more risk averse for example because of concerns about Chinese growth. Lets assume this leads to a “sudden stop”. From day-to-day the funding of Turkey’s 7% current account deficit disappears.

Now Turkey has a serious funding problem. Turkey either needs to attract investors to fund the current account deficit or it needs to close the current account deficit immediately. The first option is unlikely to work in the short-term. So the current account deficit needs to be closed. That can happen either by a collapse in imports and/or through spike in exports.

To “force” this process the central bank will have to tighten monetary conditions dramatically. This happens “automatically” in a fixed exchange rate regime. As money leaves the country the lira comes under pressures. The central bank will then intervene in the market to curb to the currency from weakening thereby reducing the foreign currency reserve and in parallel the money base drops. The drying up of liquidity will also send money market rate spiking. This is a sharp tightening of monetary conditions. The result is a collapse in private consumption, investments, asset prices and increased deflationary pressures (inflation and wage growth drop). An internal devaluation will be underway. The result is normally a sharp increase in public and private debt ratios as nominal GDP collapses.

This process will effectively continue until the current account deficit is gone. This would cause a massive collapse in economic activity and as asset prices and growth expectations drop financial distress also increases dramatically, which could set-off a financial crisis.

This is the kind of scenario that played out during the Asian crisis in 1997, but it is also what happened in Turkey in 2001 and forced the Turkish government to eventually give up a failed pegged (crawling) peg regime.

Luckily we have floating exchange rates in most Emerging Markets

Compare that to what has been going on the Emerging Markets over the past 6-7 months. We have seen widespread sell-off in Emerging Markets and yes we have seen growth expectations being adjusted down (mostly because some EM central banks have been fighting the sell-off by tightening monetary policy). BUT we have not seen financial crisis and we have not seen a collapse in Emerging Markets property markets. We have not seen major negative spill-over to developed markets. Hence, the sell-off in Emerging Markets currencies cannot be called a macroeconomic or a financial crisis.

In fact the sell-off in EM currencies means that we have avoided exactly the 1997 scenario. That is not to say that everything is fine. It is not. Anybody who have been following the still ongoing corruption scandal in Turkey or the demonstrations in Ukraine and Thailand know these countries are struggling with some real fundamental political and economic troubles. In fact I fear that a number of Emerging Markets countries at the moment are seeing an erosion of their long-term growth potential due to regime uncertainty and general macroeconomic mismanagement. But we are not seeing an unnecessary economic, financial and political collapse induced by a foolish exchange rate regime. Luckily most Emerging Markets today have floating exchange rate regimes.

But some foolishness remain   

So yes, I believe we – and the populations in most Emerging Markets – are lucky that fixed exchange rate regimes mostly are a thing of the past in Emerging Markets today, but unfortunately it is not all Emerging Markets central bankers who have learned the lesson. Hence, many central bankers still suffer from a fear-of-floating.

Just take the Turkish central bank (TCMB). On Tuesday it will hold an emergency monetary policy meeting to discuss measures to curb the sell-off in the lira. Officially it about ensuring “price stability”, but the decision to have an emerging meeting only a week after a regular monetary policy meeting smells of desperation on part of the TCMB.

It is widely expected that the TCMB will hike its key policy rate – the market is already pricing a rate hike in the order of 200bp. If the TCMB delivers this then it will only have marginal impact on the lira – if the TCMB delivers more then it could prop up the lira at least for the short-run. But a larger than expected rate hike would also be constitute monetary policy tightening and given the present sentiment in the global Emerging Markets the TCMB likely will have to do something very aggressive to have a major impact on the lira. And what would the outcome be? Well, it is pretty easy – we would get a major contraction in Turkish growth to well-below potential growth in the Turkish economy.

Given the fact that inflation expectations (24 month ahead) is around 7% and hence the TCMB official 5% inflation target there might certainly be a need for a moderate tightening of monetary policy in Turkey, but should that happen as an abrupt tightening, which would send the Turkish economy into recession? I think that would be foolish. The TCMB should instead try to get over its fear-of-floating and focus on ensuring nominal stability. It is failing to do that right now by pursuing what mostly look like 1970s style stop-go policies.

Luckily the stop-go policies of TCMB is no longer the norm for Emerging Markets central banks who generally seem to understand that the level of the exchange rate is best left to the market to determine.

PS see also my preview on Tuesday’s Turkish monetary policy meeting here.

PPS This post is about value of floating exchange rates and even though I think floating exchange rate regimes now substantially reduce the risk of major Emerging Markets financial and economic crisis I am certainly not unworried about the state of Emerging Markets. I already noted my structural concerns in a number of Emerging Markets, but I am even more worried about the monetary induced slowdown in Chinese growth and I am somewhat worried that the PBoC might “mis-step” and cause a major financial and economic crisis in China with global ramifications particularly is it fails to keep the eye on the ball and instead gets preoccupied with fighting bubbles.

Update: My friend in Malaysia Hishamh tells the same story, but focusing on Malaysia.

Helmut Reisen on the “China as monetary superpower” hypothesis

I have in a number of blog posts argued that China is a global or at least an Asian monetary superpower, which is exporting monetary tightening across Asia.

In a new very good blog post the former head of research at the OECD’s Development Centre Helmut Reisen discusses this hypothesis:

Usually, the current travails in emerging markets are blamed on expectations of slowing open market purchases by the US Federal Reserve System. Lars Christensen, head of emerging market research at Danske Bank, however, blames China´s monetary tightening as at least as important as the expected US Fed ´tapering´.  I have myself, with former colleagues, pointed to the growing impact that China´s growth has exerted since the last decade on GDP growth in middle- and low-income countries[1], pointing to the growing raw material, trade and production links of increasingly China centric emerging countries. So I shall have a lot of sympathy for Lars Christensen’s earlier proposition that China has also grown into a monetary superpower in a Sino monetary transmission mechanism with the rest of Asia. China´s monetary tightening, however, can hardly explain the current slump in Asian markets, on closer inspection.

So I nearly got Helmut convinced, but not quite. Here is Helmut again:

First, let us consider  the expected monetary stance in the US and in China. Graph 1 clearly shows that the market has formed expectations since May that the Fed would not continue open market purchases at the pace witnessed over the last years, partly fueled by Bernanke´s taper talk that month to US Congress. China´s monetary tightening, by contrast, occurred during late 2010 to early 2012 from when the Bank of China[2]. Since then, minimum reserve requirements were repeatedly reduced. Further, the PBC reduced its benchmark deposit and loan rates in June 2012. In addition, the PBC has also used a mix of monetary policy instruments to appropriately increase market liquidity. Even considering huge time lags, the current turmoil of Asia stock and bond markets cannot be blamed on China´s monetary tightening.

Hence, Helmut’s argument is that this is mostly caused by the Fed rather than by the People’s Bank of China. I do not disagree that the discussion of Fed tapering is having a negative impact on market sentiment in Asia. My view is just that that is not the whole story. China remains very important.

Furthermore, this is a good illustration of the Market Monetarist view of how to “measure” the monetary policy stance. While Helmut stresses that the PBoC has cut reserve requirements and interest rates recently Market Monetarists would instead focus on what markets are telling us about the monetary policy stance.

This discussion of course is similar to what happened in the euro zone and the US in 2008. Did the Fed ease or tighten monetary policy? Well, despite cutting nominal interest rates inflation expectations plummeted as did expectations for NGDP growth. That was indeed monetary tightening. And if we had good indicators for NGDP growth or inflation in China I would expect them to indicate a continued tightening of the Chinese monetary policy stance did the cut in official interest rates and reserve requirements.  The best market indicators for Chinese NGDP growth are probably copper and the Aussie dollar – and the Chinese stock market.

Hence, judging from for example the Chinese stock market monetary conditions have not become easier. Rather the opposite. And if the PBoC really had eased monetary conditions the Renminbi would have weakened significantly – it has not.

Furthermore, I would argue that communication about future changes in the money base is at least – in fact more – important than present changes to for example reserve requirements or interest rates. Hence, the communication from the Chinese authorities over the last couple of months has been decisively hawkish and if one wants to forecast the future path of the money base or the money supply in China one surely would have to conclude that the PBoC now plans a much slower rate of growth in the money supply than market participants had expected only a few months ago.

Furthermore, the PBoC’s rather clumsy handling of money market distress back in May-June left the impression that the Chinese authorities were quite happy about the impact it had on parts of the Chinese banking sector. In fact the turmoil gave reason to question that the PBoC really would act as lender-of-last-resort. That in my view was a very clear signal that the PBoC was quite happy with monetary conditions becoming tighter.

So yes, the PBoC has eased reserve requirements and cut official interest rates, but given the PBoC’s continued hawkish rhetoric market participants are not seeing the PBoC’s monetary policy stance becoming more accommodative – rather the opposite and judging from market pricing monetary contraction continues in China. That is having a clearly negative impact on the financial market sentiment across Asia.

That of course does not mean that Fed tapering is not important for what is going on in Asia at the moment. I think it is very important and it is for example clear that the sell-off in the Asian markets accelerated further this morning after the release yesterday of minutes from the latest FOMC meeting.

My point is just that the Fed is not the only monetary superpower in the world. The PBoC is also tremendously important. And on that I think Helmut and I are in total agreement.

China as a monetary superpower – the Sino-monetary transmission mechanism

This morning we got yet another disappointing number for the Chinese economy as the Purchasing Manager Index (PMI) dropped to 47.7 – the lowest level in 11 month. I have little doubt that the continued contraction in the Chinese manufacturing sector is due to the People’s Bank of China’s continued tightening of monetary conditions.

Most economists agree that the slowdown in the Chinese economy is having negative ramifications for the rest of the world, but for most economist the contraction in the Chinese economy is seen as affecting the rest of world through a keynesian export channel. I, however, believe that it is much more useful to understand China’s impact on the rest of the world through the perspective of monetary analysis. In this post I will try to explain what we could call the Sino-monetary transmission mechanism.

China is a global monetary superpower

David Beckworth has argued (see for example here) that the Federal Reserve is a monetary superpower as “it manages the world’s main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy gets exported to much of the emerging world. “

I believe that the People’s Bank of China to a large extent has the same role – maybe even a bigger role for some Emerging Markets particularly in Asia and among commodity exporters. Hence, the PBoC can under certain circumstances “dictate” monetary policy in other countries – if these countries decide to import monetary conditions from China.

Overall I see three channels through which PBoC influence monetary conditions in the rest of the world:

1) The export channel: For many countries in the world China is now the biggest or second biggest export market. So a monetary induced slowdown in the Chinese economy will have significant impact on many countries’ export performance. This is the channel most keynesian trained economists focus on.

2) Commodity price channel: As China is a major commodity consumer Chinese monetary policy has a direct impact on the demand for and the price of commodities. So tighter Chinese monetary policy is causing global commodity prices to drop. This obviously is having a direct impact on commodity exporters. See for example my discussion of Chinese monetary policy and the Brazilian economy here.

3) The financial flow channel: China has the largest currency reserves in the world . This means that China obviously is extremely important for demand for global financial assets. A contraction in Chinese monetary policy will reduce Chinese FX reserve accumulation and as a result impact demand for for example Emerging Markets bonds and equities.

For the keynesian-trained economist the story would end here. However, we cannot properly understand the impact of Chinese monetary policy on the rest of the world if we do not understand the importance of “local” monetary policy. Hence, in my view other countries of the world can decide to import monetary tightening from China, but they can certainly also decide not to import is monetary tightening. The PBoC might be a monetary superpower, but only because other central banks of the world allow it to be.

Pegged exchange rates, fear-of-floating and inflation targeting give PBoC its superpowers

I believe it is crucial to look at the currency impact of Chinese monetary tightening and how central banks around the world react to this to understand the global transmission of Chinese monetary policy.

Take the example of Malaysia. China is Malaysia’s second biggest export market. Hence, if PBoC tightens monetary policy it will likely hit Malaysian exports to China. Furthermore, tighter monetary policy in China would likely also put downward on global rubber and natural gas prices. Malaysia of course is a large exporter of both of these commodities. It is therefore natural to expect that Chinese monetary tightening will lead to depreciation pressures on the Malaysian ringgit.

Officially the ringgit is a freely floating currency. However, in reality the Malaysian central bank – like most central banks in Asia – suffers from a fear-of-floating and would clearly intervene directly or indirectly in the currency markets if the move in the ringgit became “excessive”. The financial markets obviously know this so even if the Malaysian central bank did not directly intervene in the FX market the currency moves would tend to be smaller than had the Malaysian central bank had a credible hands-off approach to the currency.

The result of this fear-of-floating is that when the currency tends to weaken the Malaysian central bank will step in directly or indirectly and signal a more hawkish stance on monetary policy. This obviously means that the central bank in this way decides to import Chinese monetary tightening. In this regard it is import to realize that the central bank can do this without really realizing it as the fear-of-floating is priced-in by the markets.

Hence, a fear-of-floating automatically will automatically lead central banks to import monetary tightening (or easing) from the monetary superpower – for example the PBoC. This of course is a “mild” case of “monetary import” compared to a fixed exchange rate regime. Under a fixed exchange rate regime there will of course be “full” import of the monetary policy and no monetary policy independence. In that sense Danish or Lithuanian monetary policy is fully determined by the ECB as the krone and the litas are pegged to the euro.

In regard to fixed exchange rate regimes and PBoC the case of Hong Kong is very interesting. The HK dollar is of course pegged to the US dollar and we would therefore normally say that the Federal Reserve determines monetary conditions in Hong Kong. However, that is not whole story. Imagine that the Federal Reserve don’t do anything (to the extent that is possible), but the PBoC tighens monetary conditions. As Hong Kong increasingly has become an integrated part of the Chinese economy a monetary tightening in China will hit Hong Kong exports and financial flows hard. That will put pressure the Hong Kong dollar and as the HK dollar is pegged to the US dollar the HK Monetary Authority will have to tighten monetary policy to maintain the peg. In fact his happens automatically as a consequence of Hong Kong’s currency board regime. So in that sense Chinese monetary policy also has a direct impact on Hong Kong monetary conditions.

Finally even a central bank that has an inflation inflation and allow the currency to float freely could to some extent import Chinese monetary policy. The case of Brazil is a good example of this. As I have argued earlier Chinese monetary tighening has put pressure on the Brazilian real though lower Brazilian exports to China and lower commodity prices. This has pushed up consumer prices in Brazil as import prices have spiked. This was the main “excuse” when the Brazilian central bank recently hiked interest rates. Hence, Brazil’s inflation targeting regime has caused the central bank to import monetary tightening from China, while monetary easing probably is warranted. This is primarly a result of a focus on consumer price inflation rather than on other measures of inflation such as the GDP deflator, which are much less sensitive to import price inflation.

The Kryptonite to take away PBoC’s superpowers

My discussion above illustrates that China can act as a monetary superpower and determine monetary conditions in the rest of the world, but also that this is only because central banks in the rest of world – particularly in Asia – allow this to happen. Malaysia or Hong Kong do not have to import Chinese monetary conditions. Hence, the central bank can choose to offset any shock from Chinese monetary policy. This is basically a variation of the Sumner Critique. The central bank of Malaysia obviously is in full control of nominal GDP/aggregate demand in Malaysia. If the monetary contraction in China leads to a weakening of the ringgit monetary conditions in Malaysia will only tighten if the central bank of Malaysia tries to to fight it by tightening monetary conditions.

Here the case of the Reserve Bank of Australia is telling. RBA operates a floating exchange rates regime and has a flexible inflation target. Under “normal” circumstances the aussie dollar will move more or less in sync with global commodity prices reflecting Australia is a major commodity exporter. In that sense the RBA is showing no real signs of suffering from a fear-of-floating. Furhtermore, As the graph below shows recently the aussie dollar has been allowed to weaken somewhat more than the drop in commodity prices (the CRB index) would normally have been dictating. However, during the recent Chinese monetary policy shock the aussie dollar has been allowed to significantly more than what the CRB index would have dictated. That indicates an “automatic” monetary easing in Australia in response to the Chinese shock. This in my view is very good example of a market-based monetary policy.

CRB AUD

If the central bank defines the nominal target clearly and allows the currency to float completely freely then that could works “krytonite” against the PBoC’s monetary superpowers. This is basically what is happening in the case of Australia.

As the market realizes that the RBA will move to ease monetary policy in response to a “China shock” the dollar the market will so to speak “pre-empt” the expected monetary easing by weakening the aussie dollar.

Kryptonite

Related posts:

Angola should adopt an ‘Export-Price-Norm’ to escape the ‘China shock’

The PBoC’s monetary supremacy over Brazil (but don’t blame the Chinese)

The antics of FX intervention – the case of Turkey

Should PBoC be blamed for the collapse in gold prices?

Malaysia should peg the renggit to the price of rubber and natural gas

Too easy AND too tight – the RBI’s counterproductive stop-go policies

Only a couple of days ago I was complaining that the Turkish (and the Polish) central bank(s) have been intervening in the currency markets. My complains of the Turkish central bank’s fear-of-floating and what seemed to be politically motivated monetary operations were then followed by the Brazilian central bank that hiked interest rates – officially to curb inflationary pressures, but what to me very much looked like an effort to prop up the Brazilian real.

It indeed seems like there is a pattern emerging in particularly in Emerging Markets. The latest central bank to jump on the FX intervention bandwagon is the Reserve Bank of India (RBI). This is from Reuters:

“The Reserve Bank of India (RBI) announced measures late on Monday to curb the rupee’s decline by tightening liquidity and making it costlier for banks to access funds from the central bank.

The RBI raised the Marginal Standing Facility (MSF) rate and Bank Rate each by 200 basis points to 10.25 percent, capped the amount up to which banks can borrow or lend under its daily liquidity window and announced a sale of government securities through an open market operation.

The RBI said total funds available under its repo window will be capped at 1 percent of banks’ deposits – roughly 750 billion rupees – from Wednesday. It announced a 120 billion rupee sale of government bonds for Thursday.

The central bank does not set a target for the rupee, which hit a record low of 61.21 to the dollar last week, but it does take measures to manage volatility”

It is very hard to be impressed by the RBI’s de facto currency targeting as there is hardly any economic arguments for  the RBI’s actions, but we can safely conclude whatever motivated the RBI have just implemented significant monetary tightening.

Too easy AND too tight – it’s called stop-go monetary policy

I have earlier argued that there might be arguments for tightening monetary policy in India. Hence, since 2009 nominal GDP has risen much sharper than the earlier NGDP-trend of around 12% NGDP growth.  The graph below illustrates this.

NGDP India July 2013Furthermore, there is there is nothing “optimal” about a 12% NGDP growth path. In fact I believe that the RBI if anything rather should target an NGDP growth path around 7-8% (as I have argued earlier).

The problem with the RBI’s recent actions is not necessarily the decision to tighten monetary policy per se, but rather the in fashion it is done.

The RBI’s decision has clearly not been based on a transparent and rule based monetary framework.

Hence, after years of high NGDP growth and high inflation the RBI suddenly slams the brakes. And mind you not to hit an NGDP level target or an inflation target for that matter, but to “stabilize” the currency.

The result of this currency “stabilization” might be that the RBI will be able to curb the sell-off in the rupee (I doubt it), but we can be pretty sure that the cost of this “operation” will likely be a fairly sharp slowdown in Indian real (and nominal) GDP growth. You have to choose – either you have a “stable” currency or stable macroeconomic conditions. I fear that the RBI has just sacrificed macroeconomic stability in a ill-fated attempt to stabilize the currency – at least if the RBI insist to continue the policy of FX intervention.

In a sense the RBI has been pursuing both too easy monetary policies – too high NGDP growth and inflation – and at the same time too tight monetary policy in the sense of an abrupt monetary contraction to prop up the rupee. This is the core of the problem – the RBI’s counterproductive stop-go policies.

The way forward – a completely freely floating rupee and 8% NGDP target 

In my view the RBI urgently needs give up its policy of fiddling with the currency and instead let the rupee float completely freely and instead announce an target on the nominal GDP level.

In my view the historical trend of 12% NGDP growth is too high and a lower NGDP growth target of 8% seems to be more appropriate. The RBI should hence announce that it gradually will slow NGDP growth to 8% over a five period. It is important that this should be a level target. Hence, if growth is faster than 11% in 2014 then it is important that NGDP growth will have to be even slower in the next four years. That is exactly the idea with a level target – you should not allow bygones-to-be-bygones. After 2018 the RBI will keep NGDP on 8% growth path.

Such a policy will ensure a lot more nominal stability than historically has been the case and therefore also very likely significantly increase macroeconomic stability.

Furthermore, a side effect will that the rupee likely will be more stable and predictable than under the present stop-go regime as FX volatility to a very large extent tend to be a result of monetary disorder.

A serious need for kick-starting economic reforms

There is no doubt that India seriously needs nominal stability, but there also is also a massive need for structural reforms in India. I think this story (quoted from Bloomberg) tells you everything you need to know about the extent of harmful and unnecessary government intervention in the Indian economy:

“For more than 100 years across the 19th and 20th centuries, its gnomic messages, worked into Morse code and out into language again, then delivered by postmen, connected human beings in faraway places. It announced births, marriages and deaths; called soldiers home from war or announced their demises to their families (or changed the course of the war itself); confirmed job offers or remittances to anxious and impatient souls. The voice of history whenever it was in haste, it was stoic by nature — concealing waves of emotion under its impassive, attenuated syntax — and easily available to rich and poor, in city and village.

In India, it was installed by the British as a way of administratively and militarily linking up the vast reaches of the subcontinent. But it became one of the engines of the freedom movement, a way for the Indian migrant to keep up a tenuous link to the world he had left far behind. The Indian word for it was “taar,” or wire, invoking an image more concrete than the English “telegraph.” (The “wire,” in English, was claimed by news media services.) Long after the rest of the world had moved on to more advanced technologies, the humble telegraph continued to enjoy great currency in India, before the onset of the digital revolution began to chip away at its hegemony. But the end has been in sight for some years now.

With the explosion of the mobile-phone revolution in the last decade (described recently in “The Great Indian Phone Book“), the telegraph service began for the first time to appear anachronistic. Text messages sent from mobile phones began to make the taar service seem quaint, even to rural users. This weekend, Bharat Sanchar Nigam Ltd, the state-run company that runs the system, is finally set to wind down its telegraph service for good, just as Western Union decided in 2006 that it was over for its telegrams in the U.S. Almost 16 decades after a member of the Indian public sent a telegram for the first time in 1855, the telegram will finally give up the ghost in one of its last surviving redoubts.

The Indian telegraph service still processes about 5,000 telegrams each day (most of them government notifications).

It is truly bizarre that a developing country like India until this day has continued to have a government run telegraph company, but I think it tells you a lot about how extreme the level of government intervention in the Indian economy still is.

In the 1990s growth was kick-started by a number of supply side reforms. However, over the past decade speed of reforms have been much more slower and in some area reforms have even been scaled back.

In this regard it should be noted that inflation has been stubbornly high – around 7-8% (GDP deflator) – since 2009. But at the same nominal GDP growth has slowed. This to me is an indication that while monetary policy has indeed become tighter India has also at the same time seen a deterioration of supply side conditions. The result has been a fairly sharp slowdown in real GDP growth in the same period.

I think it is quite unclear what is potential real GDP growth in India, but I think it likely is closer to 5-6% than to 8-10%. This would seems to be a quite low trend-growth given the low level of GDP/capita in India and India’s trend-growth seems to be somewhat lower than that of China.

Concluding, while a monetary regime change certainly is needed in India serious structural reforms are certainly also needed. The best place to start would be to get rid of India’s insanely high trade tariffs and generally opening up the economy significantly.

Update: s shorter edition of this blog post has also been published at financeasia.com. See here.

The PBoC’s monetary supremacy over Brazil (but don’t blame the Chinese)

Brazilian Finance Minister Guido Mantega likes to blame the Federal Reserve (and the US in general) for most evils in the Brazilian economy and he has claimed that the fed has waged a ‘currency war’ on Emerging Market nations.

As my loyal readers know I think that it makes very little sense to talk about a currency war and  I strongly believe that any nation with free floating exchange rates is in full control of monetary conditions in the country and hence of both the price level and nominal GDP. However, here the key is a freely floating exchange rate. Hence, a country with a fixed exchange rate – like Hong Kong or Denmark – will “import” the monetary policy from the country its currency is pegged to – the case of Hong Kong to the US and in the case of Denmark to the euro zone.

In reality few countries in the world have fully freely floating exchange rates. Hence, as I argued in my previous post on Turkey many – if not most – central banks suffers from fear-of-floating. This means that these central banks effectively will at least to some extent let other central banks determine their monetary policy.

So to some extent Mantega is right – the fed does in fact have a great impact on the monetary conditions in most countries in the world, but this is because that the national central banks refuse to let their currencies float completely freely. There is a trade off between control of the currency and monetary sovereignty. You cannot have both – at least not with free capital movement.

From Chinese M1 to Brazilian NGDP  

Guido Mantega’s focus on the Federal Reserve might, however, be wrong. He should instead focus on another central bank – the People Bank of China (PBoC). By a bit of a coincidence I discovered the following relationship – shown in the graph below.

China M3 Brazil NGDP

What is the graph telling us? Well, it looks like the growth of the Chinese money supply (M1) has caused the growth of Brazilian nominal GDP – at least since 2000.

This might of course be a completely spurious correlation, but bare with me for a while. I think I am on to something here.

Obviously we should more or less expect this relationship if the Brazilian central bank had been pegging the Brazilian real to the Chinese renminbi, but we of course all know that that has not been the case.

The Chinese-Brazilian monetary transmission mechanism

So what is the connection between Chinese and Brazilian monetary conditions?

First of all since 2008-9 China has been Brazil’s biggest trading partner. Brazil is primarily exporting commodities to China. This means that easier Chinese monetary policy likely will spur Brazilian exports.

Second, easier Chinese monetary policy will also push up global commodity prices as China is the biggest global consumer of a number of different commodities. With commodity prices going up Brazil’s export to other countries than China will also increase.

Therefore, as Chinese monetary easing will be a main determinant of Brazilian exports we should expect the Brazilian real to strengthen. However, if the Brazilian central bank (and government) has a fear-of-floating the real will not be allowed to strengthen nearly as much as would have been the case under a completely freely floating exchange rate regime.Therefore, effectively the Brazilian central bank will at least partly import changes in monetary conditions from China.

As a result the Brazilian authorities has – knowingly or unknowingly – left its monetary sovereignty to the People’s Bank of China. The guy in control of Brazil’s monetary conditions is not Ben Bernanke, but PBoC governor Zhou Xiaochuan, but don’t blame him. It is not his fault. It is the result of the Brazilian authorities’ fear-of-floating.

The latest example – a 50bp rate hike

Recently the tightening of Chinese monetary conditions has been in the headlines in the global media. Therefore, if my hypothesis about the Chinese-Brazlian monetary transmission is right then tighter Chinese monetary conditions should trigger Brazilian monetary tightening. This of course is exactly what we are now seeing. The latest example we got on Wednesday when the Brazilian central bank hiked its key policy rates – the SELIC rate – by 50bp to 8.50%.

Hence, the Brazilian central bank is doing exactly the opposite than one should have expected. Shouldn’t a central bank ease rather than tighten monetary policy when the country’s main trading partner is seeing growth slowing significantly? Why import monetary tightening in a situation where export prices are declining and market growth is slowing? Because of the fear-of-floating.

Yes, Brazilian inflation has increased significantly if you look at consumer prices, but this is primarily a result of higher import prices (and other supply side factors) due to a weaker currency rather than stronger aggregate demand. In fact it is pretty clear that aggregate demand (and NGDP) growth is slowing significantly. The central bank is hence reacting to a negative supply shock (higher import prices) and ignoring the negative demand shock.

Obviously, it is deeply problematic that the Brazilian authorities effectively have given up monetary sovereignty to the PBoC – and it is very clear that macroeconomic volatility is much higher as a result. The solution is obviously for the Brazilian authorities to get over the fear-of-floating and allowing the Brazilian real to float much more freely in the same way has for example the Reserve Bank of Australia is doing.

The antics of FX intervention – the case of Turkey

I have often been puzzled by central banks’ dislike of currency flexibility. This is also the case for many central banks, which officially operating floating exchange rate regimes.

The latest example of this kind of antics is the Turkish central bank’s recent intervention to prop as the Turkish lira after it has depreciated significantly in connection with the recent political unrest. This is from cnbc.com:

“On Monday, the Turkish central bank attempted to stop the currency’s slide by selling a record amount of foreign-exchange reserves in seven back-to-back auctions. The bank sold $2.25 billion dollars, or around 5 percent of its net reserves, to shore up its currency – the most it has ever spent to do so”

A negative demand shock in response to a supply shock

I have earlier described the political unrest in Turkey as a negative supply shock and it follows naturally from currency theory that a negative supply shock is negative for the currency and in that sense it shouldn’t be a surprise that the political unrest has caused the lira to weaken. One can always discuss the scale of the weakening, but it is hard to dispute that increased ‘regime uncertainty’ should cause the lira to weaken.

It follows from ‘monetary theory 101′ that central banks should not react to supply shocks – positive or negative. However, central banks are doing that again and again nonetheless and the motivation often is that central banks see market moves as “excessive” or “irrational” and therefore something they need to “correct”. This is probably also the motivation for the Turkish central bank. But does that make any sense economically? Not in my view.

We can illustrate the actions of the Turkish central bank in a simple AS/AD framework.

AS AD SRAS shock Turkey

The political unrest has increased ‘regime uncertainty’, which has shifted the short-run aggregate supply curve (SRAS) to the left. This push up inflation to P’ and output/real GDP drops to Y’.

In the case of a nominal GDP targeting central bank that would be it. However, in the case of Turkey the central bank (TCMB) has reacted by effectively tightening monetary conditions. After all FX intervention to prop up the currency is “reverse quantitative easing” – the TCMB has effectively cut the money base by its actions. This a negative demand shock.

In the graph this mean that the AD curve shifts  to the left from AD to AD’. This will push down inflation to P” and output to Y”.

In the example the combined impact of a supply shock and the demand shock is an increase in inflation. However, that is not necessarily given and dependent the shape of the SRAS curve and the size of the demand shock.

However, more importantly there is no doubt about the impact on real GDP growth – it will contract and the FX intervention will exacerbate the negative effects of the initial supply shock.

So why would the central bank intervene? Well, if we want to give the TCMB the benefit of the doubt the simple reason is that the TCMB has an inflation target. And since the negative supply shock increases inflation one could hence argue that the TCMB is “forced” by its target to tighten monetary policy. However, if that was the case why intervene in the FX market? Why not just use the normal policy instrument – the key policy interest rates?

My view is that this is a simple case of ‘fear-of-floating’ and the TCMB is certainly not the only central bank to suffer from this irrational fear. Recently the Polish central bank has also intervened to prop up the Polish zloty despite the Polish economy is heading for deflation in the coming months and growth is extremely subdued.

The cases of Turkey and Poland in my view illustrate that central banks are often not guided by economic logic, but rather by political considerations. Mostly central banks will refuse to acknowledge currency weakness is a result of for example bad economic policies and would rather blame “evil speculators” and “irrational” behaviour by investors and FX intervention is hence a way to signal to voters and others that the currency sell-off should not be blamed on bad policies, but on the “speculators”.

In that sense the central banks are the messengers for politicians. This is what Turkish Prime Minister Erdogan recently had to say about what he called the “interest rate lobby”:

“The lobby has exploited the sweat of my people for years. You will not from now on…

…Those who attempt to sink the bourse, you will collapse. Tayyip Erdogan is not the one with money on the bourse … If we catch your speculation, we will choke you. No matter who you are, we will choke you

…I am saying the same thing to one bank, three banks, all banks that make up this lobby. You have started this fight against us, you will pay the high price for it.

..You should put the high-interest-rate lobby in their place. We should teach them a lesson. The state has banks as well, you can use state banks.”

So it is the “speculators” and the banks, which are to blame. Effectively the actions of the TCMB shows that the central banks at least party agrees with this assessment.

Finally, when a central bank intervenes in the currency market in reaction to supply shocks it is telling investors that it effectively dislikes fully floating exchange rates and therefore it will effectively reduce the scope of currency adjustments to supply shocks. This effective increases in the negative growth impact of the supply shock. In that sense FX intervention is the same as saying “we prefer volatility in economic activity to FX volatility”. You can ask yourself whether this is good policy or not. I think my readers know what my view on this is.

Update: I was just reminded of a quote from H. L. Mencken“For every problem, there’s a simple solution. And it’s wrong.”

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