Virus strengthens case for EM cuts; little effect on DMs - Capital Economics
Global Economics

Virus strengthens case for EM cuts; little effect on DMs

Global Central Bank Watch
Written by Jennifer McKeown

With the coronavirus spreading faster and set to have bigger economic effects than initially assumed, many people are asking how and when central banks will respond. The People’s Bank of China (PBOC) and the central banks of Sri Lanka, Malaysia, the Philippines and Thailand have already cut interest rates, citing the effects of the virus. And even in advanced economies, financial markets have shifted from an assumption of no policy change to pricing in at least some chance of rate cuts since fears about the virus escalated in mid-January.

  • Central bank action so far focused on crisis management in virus-hit countries.
  • Likely fallout reinforces our existing dovish views on several EMs.
  • But the temporary shock does not yet warrant a response from advanced economies.

With the coronavirus spreading faster and set to have bigger economic effects than initially assumed, many people are asking how and when central banks will respond. The People’s Bank of China (PBOC) and the central banks of Sri Lanka, Malaysia, the Philippines and Thailand have already cut interest rates, citing the effects of the virus. And even in advanced economies, financial markets have shifted from an assumption of no policy change to pricing in at least some chance of rate cuts since fears about the virus escalated in mid-January. (See Chart 1.)

Chart 1: Market Implied Overnight Rates in 2 Years’ Time (%)

Source: Refinitiv

So how should we think about this crisis from a monetary policy standpoint? There are two key questions for central banks. First, can and should emergency liquidity measures be undertaken to limit the near-term disturbance? And second, will there be a sustained impact on the economic and/or inflation outlook which would warrant fundamental policy loosening?

Recent policy action has focused on the former. As well as cutting its reverse repo rate on 3rd February, the PBOC has made several liquidity injections. It also announced a RMB300bn special lending fund to support firms helping to combat the virus and has instructed lenders to roll over loans to companies that struggle to repay their debts as a result of the outbreak and related containment measures.

Other central banks have similar facilities which they could use in the event of liquidity shortages. The Fed has been supplying extra funds to the short-term lending market since last September and could increase its provision. Meanwhile, the ECB’s TLTRO lending programme is ongoing and banks are free to take up more liquidity if they need it. We think that the bar would be relatively low for advanced economy central banks to step up, or increase the generosity of, their liquidity provision if it were needed. But for now, there is little evidence of troubles in credit markets resulting from the virus.

Any sustained conventional policy loosening should reflect a belief that there will be some permanent damage to demand or inflation. Monetary policy takes time to affect the economy (most assume a lag of around a year to 18 months), so interest rates are not an effective tool to counter temporary disruption. By the time any cuts were taking effect, the economy would be back on its normal growth path and, all else unchanged, the stimulus wouldn’t be needed.

For the most affected economies, central banks might assume some permanent damage. Our own view is still that most of the lost output is likely to be made up in the coming months as the virus is brought under control. (See, for example, this China Economics Update.) But it could prove difficult for Chinese firms to make up the output from workplace closures. And lost tourism to other countries in Emerging Asia is unlikely to be recouped now that the Chinese Lunar New Year holiday is over. It is worth being cautious in a disaster scenario, if only to stave off declines in business confidence and to reassure financial markets. What’s more, we suspect that policy loosening would have been needed in most of the Asian economies in question in time. Note that we were already more dovish than the consensus about the outlook for monetary policy in China and the Philippines. Recent moves have done little more than bring the loosening forward. (See this Emerging Markets Economics Update for much more detail about the outlook for policy in EMs.)

For the advanced economies and more distant EMs, monetary policy loosening is harder to justify. So far, there has been little obvious impact on activity, with measures of business sentiment continuing to rise in January in the US, euro-zone and Japan. (Next week’s first survey releases for February will tell us more.) And while advanced economy financial markets suffered as the severity of the outbreak became clear late last month, equity markets have since recovered their lost ground. This is in contrast to the situation in China, where equity prices have remained relatively depressed. (See Chart 2.)

Chart 2: Equity Price Indices (1st Jan 2020 = 100)

Source: Refinitiv

Accordingly, the Fed Chair and the Governors of the ECB and BoJ have all struck a cautious yet sanguine tone so far. Assuming that the virus comes under control in the coming weeks and Chinese production resumes in full, we think that markets are wrong to price in rate cuts in the US and Japan. And our view that the ECB will cut rates later this year does not relate to the coronavirus.

However, there are significant risks. Supply chain disruptions might be more severe than we have assumed. As we pointed out in a recent Global Economics Update, difficulties sourcing just one small component could shut down entire production lines. A lack of inputs from China has already caused Hyundai to shut down its car factories in South Korea, Nissan to close a factory in Japan and Fiat Chrysler to warn that one of its European plants might need to close in a matter of weeks.

But perhaps the most worrying possibility for the global economy, and the one that is most likely to prompt a widespread monetary policy response, is that the virus could trigger a “black swan” event in China or elsewhere. Such events are, by definition, difficult to predict, but we can think of a few possibilities. We have long warned about risks to the Chinese property sector, related particularly to high levels of debt. Sales have already ground to a halt and, if they fail to pick up soon, the resulting pressure on property firms could trigger a wave of defaults. A collapse in the Chinese property market would have direct ramifications for commodity exporters including Australia and Brazil. But it might also spark a more general increase in risk aversion and associated financial market disturbance.

Another concern is that prolonged shutdowns in China might cause sustained declines in commodity prices and expose vulnerabilities in the energy sector. We will have more to say about this in a forthcoming Global Economics Focus, but the key point is that energy firms’ earnings cover of debt service costs is particularly low and it might not take much to tip some over the edge.

A third is that trade finance might be disrupted. Prolonged bank closures in China or major shipping delays resulting from quarantine requirements might lead to failures in the trade finance chain. Any knock-on effects on international trade finance could threaten to derail the fragile recovery in world trade.

For now, central banks, financial markets and other economic actors seem braced for severe but temporary disruption. Broadly speaking, we agree with this judgement and have not made significant changes to our monetary policy or economic forecasts, aside from factoring in a temporary fall in activity in Q1 and bringing forward policy loosening in some of the most affected economies. However, there are big risks to this view, and we will continue to monitor the situation closely for signs of more fundamental economic disturbance. You can see the data that we are following and related analysis on the dedicated coronavirus page of our website.

Review of recent policy changes

Of the 20 central banks covered in this publication, only the Swedish Riksbank has raised rates since our last Global Central Bank Watch in November. Meanwhile, central banks in emerging markets have cut rates ten times. (See Chart 3.) These include 10bps in China, a 50bp and a 25bp cut in Brazil, 25bps in South Africa, two 25bp cuts in Mexico, two 25bp cuts in Russia, and two cuts in Turkey which total 275bps.

Chart 3: Changes in Benchmark Rates

Sources: Bloomberg, Capital Economics

Among the advanced economies, the January policy meetings of both the Fed and the ECB passed with no change to monetary policy settings and with only very minor tweaks to the accompanying statements. In other developments, the White House formally nominated Judy Shelton and Christopher Waller to fill the two vacant seats on the Fed Board. While Waller is a more ‘mainstream’ candidate, Shelton – an overtly political choice – has already faced intense scrutiny and opposition in the Senate. Meanwhile, the Bank of England also left rates unchanged, though the policy statement had a slightly more dovish tilt and left the door open to a rate cut in the coming months. Finally, the Riskbank continued to go it alone in December and hiked rates for the third time in 2019, making it the only G10 country to raise rates in the second half of 2019.

What’s next?

We expect that there will be a fairly even spread between those central banks tightening monetary policy and those leaving settings unchanged by the end of 2020. (See Table 1.) On balance, though, monetary policy around the world will remain accommodative. Of the economies covered in this publication, we think that only India and Turkey will raise interest rates.

Table 1: Summary of CE Forecasts for Policy Rate
Net Changes by the End of 2020

Policy

Direction

Economies

Easing

Australia, China, Mexico, South Korea, Euro-zone, Brazil, Switzerland, Denmark, Russia, Turkey

No Change

UK, US, Canada, Poland, New Zealand, Norway, South Africa, Sweden, Japan

Tightening

India

Source: Capital Economics

Since incoming data suggest that the US economy is picking up, the Fed is unlikely to cut interest rates in response to the coronavirus. But at the same time, the continued stability of core CPI inflation has supported our view that rates will not be hiked for the foreseeable future.

In the euro-zone, in contrast to the consensus, we expect a 20bp rate cut by year-end as growth and inflation disappoint. But it might hold off until the ECB has completed its strategy review. As usual, we expect that Denmark will mirror any interest rate changes by the ECB. And, since growth in Switzerland is set to remain sluggish, we think the SNB will also loosen policy in line with the ECB to avoid the franc strengthening much against the euro.

Elsewhere in Europe, we still think that subdued growth and low inflation will ultimately convince Sweden’s Riksbank to reverse some of their recent tightening by the end of the year. And in Norway, we expect the Norges Bank to hold off changing its policy rate until 2022.

We think that the Bank of England will keep rates on hold for the rest of this year, though the UK’s exit from the EU and the upcoming change of guard at the helm of the Bank of England mean that the policy outlook is far from certain. Meanwhile, we think that further policy stimulus will be needed in Australia as underlying price pressures and GDP growth remain weak. But we think rates will be left unchanged this year in Canada and New Zealand, where encouraging signs in the data point to a pick-up in GDP growth.

Chart 4: Change to Policy Rates by End-20 Implied by OIS Markets & CE Forecasts (%)

Sources: Bloomberg, Capital Economics

Moving on to EMs, the outlook in China is clouded by the outbreak of the coronavirus. That aside, in light of its slowing growth, we had already pencilled in policy stimulus from the People’s Bank in the form of rate cuts to both the medium-term lending facility and reverse repo rates. As the headwinds to activity in China continue to mount, and with the size of the economic fallout from the coronavirus unclear, it seems increasingly likely that policymakers will remain in easing mode.

In India, continued weakness in the economy led the RBI to keep rates on hold in February, despite a jump in the headline rate of inflation. We think that previous rate cuts will start to feed through to stronger domestic activity and underlying price pressures in the coming months. Accordingly, we hold the non-consensus view that the RBI will begin tightening policy later this year.

The central bank in Russia cut the policy rate by 25bp in February and, with inflation likely to remain well below target, we think that there are another 50bp of cuts yet to come in this easing cycle. In Turkey, the pick-up in inflation in January is unlikely to deter the central bank from cutting the policy rate later this month. However, we anticipate that policymakers will be forced to eventually reverse course as the headline rate picks up to around 15% y/y by end-2020.

Finally, Brazil’s central bank cut the Selic rate by a further 25bp in February and gave a clear signal that the easing cycle there has ended. We think that domestic demand in Brazil will remain subdued, which will prompt monetary policymakers to leave rates low for longer than most expect. Meanwhile, we think that Mexico will disappoint expectations for a marked recovery in 2020. But the end of the loosening cycle in the US will limit the space for rate cuts by Banxico this year – we predict just 50bp of cuts by the end of this year compared to the market-implied 100bp.

Table 2: Central Bank Policy Rates

Country

Policy rate

Latest

Last Change

Next Change

(CE Forecast)

End-2020

End-2021

Major Advanced Economies

US

Fed funds target

1.50-1.75

Down 25bp (Oct. 2019)

None on horizon

1.50-1.75

1.50-1.75

Euro-zone

Deposit rate

-0.50

Down 10bp (Sep. 2019)

Down 10bp (Q4 2020)

-0.70

-0.70

Japan

Interest on excess reserves

-0.10

Down 10bp (Jan. 2016)

None on horizon

-0.10

-0.10

UK

Bank Rate

0.75

Up 25bp (Aug. 2018)

Up 25bp (H1 2021)

0.75

1.00

Other Advanced Economies

Canada

Overnight target rate

1.75

Up 25bp (Oct. 2018)

Up 25bp (H2 2021)

1.25

2.00

Australia

Cash rate

0.75

Down 25bp (Oct. 2019)

Down 25bp (Q2 2020)

0.25

0.25

Switzerland

Sight deposit rate

-0.75

Down 50bp (Jan. 2015)

Down 25bp (Q1 2020)

-1.00

-1.00

Sweden

Repo rate

0.00

Up 25bp (Dec. 2019)

Down 25bp (H2 2020)

-0.25

-0.25

Denmark

Deposit rate

-0.75

Down 10bp (Sep. 2019)

Down 10bp (Q4 2020)

-0.85

-0.85

Norway

Sight deposit rate

1.50

Up 25bp (Sep. 2019)

None on horizon

1.50

1.50

New Zealand

Cash rate

1.00

Down 50bp (Aug. 2019)

None on horizon

1.00

1.00

Major Emerging Economies

China

7-day reverse repo rate

2.40

Down 10bp (Feb. 2020)

Down 20bp (Q1 2020)

2.00

2.25

India

Repo rate

5.15

Down 25bp (Oct. 2019)

Up 35bp (H2 2020)

5.50

6.25

Brazil

Selic rate

4.25

Down 25bp (Feb. 2020)

None on horizon

4.25

4.25

Russia

1-week repo rate

6.50

Down 25bp (Feb. 2020)

Down 25bp (Mar. 2020)

5.50

5.50

Mexico

Overnight target rate

7.00

Down 25bp (Feb. 2020)

Down 25bp (May 2020)

6.75

6.75

South Korea

Base rate

1.25

Down 25bp (Oct. 2019)

Down 25bp (Feb. 2020)

1.00

1.50

Turkey

1-week repo rate

11.25

Down 75bps (Jan. 2019)

Down 75bp (Feb. 2020)

12.50

16.00

Poland

Reference rate

1.50

Down 50bp (Mar. 2015)

None on horizon

1.50

1.50

South Africa

Repo rate

6.25

Down 25bp (Jan. 2020)

Down 25bp (Q2 2020)

6.00

6.00

Sources: Bloomberg, Capital Economics.

Table 3: Quantitative Easing & Other Unconventional Policies

Sources: Central banks, Capital Economics. *Latest

Table 4: Calendar of Policy Decisions

Date

Economy

Policy Instrument

Prior

Survey

CE Forecast

19th February

Turkey

1-week repo rate

11.25

10.75

10.50

27th February

South Korea

Base rate

1.25

1.00

3rd March

Australia

Cash rate

0.75

0.75

4th March

Poland

Reference rate

1.50

1.50

4th March

Canada

Overnight target rate

1.75

1.75

1.75

12th March

Euro-zone

Deposit rate

-0.50

-0.50

18th March

United States

Fed Funds target range

1.50-1.75

1.50-1.75

1.50-1.75

18th March

Brazil

Selic rate

4.25

4.25

19th March

Switzerland

Overnight target rate

-0.75

-1.00

19th March

South Africa

Repo rate

6.25

6.25

19th March

Japan

Interest on excess reserves

-0.10

-0.10

19th March

Turkey

1-week repo rate

19th March

Norway

Sight deposit rate

1.50

1.50

20th March

Russia

1-week repo rate

6.00

5.75

25th March

New Zealand

Cash rate

1.00

1.00

26th March

Mexico

Overnight target rate

6.75

6.75

26th March

United Kingdom

Bank rate

0.75

0.75

3rd April

India

Repo rate

5.15

5.15

7th April

Australia

Cash rate

0.75

8th April

Poland

Reference rate

1.50

9th April

South Korea

Base rate

1.00

15th April

Canada

Overnight target rate

1.75

22nd April

Turkey

1-week repo rate

24th April

Russia

1-week repo rate

28th April

Sweden

Repo rate

0.00

0.00

28th April

Japan

Interest on excess reserves

-0.10

29th April

United States

Fed Funds target range

1.50-1.75

30th April

Euro-zone

Deposit rate

-0.50

5th May

Australia

Cash rate

0.50

6th May

Brazil

Selic rate

4.25

7th May

United Kingdom

Bank rate

0.75

7th May

Norway

Sight deposit rate

1.50

13th May

New Zealand

Cash rate

1.00

14th May

Mexico

Overnight target rate

6.50

Sources: Bloomberg, Capital Economics


Jennifer McKeown, Head of Global Economics Service, +44 20 7811 3910, jennifer.mckeown@capitaleconomics.com
Bethany Beckett, Assistant Economist, +44 20 7808 4052, bethany.beckett@capitaleconomics.com