Emerging markets battle inflation

After briefly losing some investment inflows to developed markets, especially the U.S., emerging markets have pulled back the pendulum of inventor mood with measures to rein in inflation.

The first quarter of 2011 saw about $18.6 billion leave emerging market equity funds, about the same as gained by the U.S.-dedicated equity funds during the period, said Pablo Goldberg, head of emerging market research, HSBC Securities (USA) Inc., in a recent conference call.

Goldberg attributes this transformation to a change of perception of the output inflation tradeoffs between the emerging markets and the developed markets.

“In the case of the emerging market space, we saw a lot of people concentrated on the issue of inflation, so the output inflation trade-off was deteriorating,” said Goldberg. “But in the case of the developed markets we saw an important increase in growth expectations, particularly for the U.S., after the expansion of the tax cuts, so a lot of money moved away.”

However, as oil prices soared, people started to lower their growth expectations for the U.S., he added.

Central banks in emerging economies, on the other hand, are tightening their monetary policy to buoy investors’ moods. “In the emerging world, where we were worried about inflation, we’re starting to become a little more confident that central banks are now actually focusing on the problem and are taking action,” said Goldberg. “So the output inflation trade-off improved again in favour of EM.”

He stresses, however, that despite focusing on inflation, central banks in emerging economies are, in fact, still behind the curve and there persists a sense that more needs to be done in terms of tightening.

On a more reassuring note, Goldberg says, contrary to popular belief, governments are moving to curb inflation and restore investor confidence in Chile, Brazil, Turkey and China.

“Over the course of the last six weeks or so, we have seen more action in terms of interest rate hikes and countries that were behind the curve actually regaining some of the room lost,” he said, citing Chile, which surprisingly raised interest rates by 50 basis points against the market expectation of 25 basis points.

The market was even less convinced that the central bank in Brazil will take similar measures. Goldberg agrees. “Brazil is probably a country where we believe quite a bit [needs] to be done in terms of tightening, because authorities have indicated [they’re] more on the quantitative tightening side rather than interest rate hikes.”

Goldberg is of the opinion that “probably more reassurance needs to be provided in terms of more action against inflation.”

There is something to say in favour of Brazil, though. “Brazil, like Chile, is one of only two countries in emerging market space that have also used fiscal policy to counterbalance inflationary pressures,” said Goldberg.

Not long ago, Brazil announced a budget cut of 50 billion reals (about $30.4 billion) to cool its economy. “Although we believe that it’s going to be very difficult that they can implement the whole 50 billion, at least they’re showing that they’re adding more instruments to the policy mix to attack inflation,” he said.

It remains to be seen, though, how quickly Brazil’s tightening and unconventional policies act on inflation.

Goldberg also addressed fears that China has come to the end of its tightening cycle. “We don’t think that China has come to the end of its tightening cycle, we actually expect China to continue to raise interest rates.”

He shared the view that inflation will be contained without a hard landing in China.

There is a view that Chinese equities remain very attractive, partly on the belief the tightening cycle is coming to an end. Goldberg says China’s definitely not there yet.

“Actually they’ll continue to hike both the reserve ratios and interest rates. For China, we’re actually expecting interest rates to end up at 6.56% at the end of the second quarter [and] then we expect China to be done in terms of raising rates,” he said. “Our view is that the policy makers will be able to engineer a soft landing, and that is why we’ve actually become [bullish] on China equity.”