Emerging Markets: Bracing for inflation

Emerging Markets World Bank editions, October 2013

As concerns grow that tapering may lead to inflation flaring up in emerging markets as their currencies weaken, economists are diagnosing very different outcomes for some of the world’s biggest economies.

Brazil, in particular, is attracting cautious glances. This week Morgan Stanley put out a report entitled: “Brazil – not worth the carry”, with the broker bearish on the currency and on Brazilian rates, and instead recommending a short position against the real. “The low growth and high inflation dynamic has only marginally improved and remains a drag, while the fiscal balance has deteriorated and external accounts have shown no significant improvement,” said Felipe Hernandez. He also commented: “potential negative surprises on inflation in the short term, that could force tighter-than-expected monetary policy and reduce room to allow for the real to depreciation, are a concern,” though he said they were not Morgan Stanley’s base case scenario.

“Brazil’s structural inflation problem – strong domestic demand and a strong REER [real effective exchange rate] that has driven a wedge between consumption and local output – has not been appropriately tackled, in our view, and is unlikely to be this year, given the presidential election in 2014,” the bank wrote.

Turkey, too, is causing concern. Headline inflation there declined from 8.2% in August to 7.9% in September, but Deutsche Bank chief economist Robert Burgess said underlying inflation pressures were continuing to build. “Given the continued build-up in underlying inflation pressure and further upside risks from lira weakness, the Central Bank of Turkey’s year-end inflation forecast of 6.2% looks almost certain to be breached,” said Burgess – indeed, the CBT itself has acknowledged this. Deutsche’s own year-end forecast for Turkish inflation, at 7.3%, “is subject to upside risk,” Burgess said.

Morgan Stanley economist Simon Waever added: “High inflation and reduced monetary flexibility add further to the difficulties that Turkey faces.” Turkey has other problems besides – external funding needs of $220 billion over the next 12 months, a current account deficit among the highest in emerging markets – but they are likely to worsen if a weak currency pushes inflation pressure higher.

Indonesia and India, too, face inflationary pressures.

On the other side, economists are positioning investors towards some markets precisely because they appear more resilient to inflation. Morgan Stanley, for example, recommends buying two-year Russian rouble bonds, “given the decline in inflation, the likelihood of the central bank easing in the moving months, and front-end underperformance in recent weeks.” Inflation in Russia has been on a downward trend since May, when it stood at 7.4%. That said, the 6.1% figure in September is still above the CBR’s 5-6% target range.

Deutsche, in turn, recommends South Africa over Turkey, “where monetary policy is more credible and inflation and currency risks are now lower.” Deutsche also favours Hungary for its low inflation outlook, and highlights the Philippines for having achieved high growth accompanied by subdued inflation.