Malaysia surprised markets last week when it did not raise interest rates. Instead Malaysia’s central bank instituted increased reserve requirements in an effort to restrain the flow of credit and cool inflation in a hot economy.
This is the new monetary calculus in emerging markets. In a globalized world, most emerging market central banks do not have the firepower to maintain prices with monetary policy alone. Capital from slow-growth mature markets, mainly the US and Europe, is attracted to emerging market bonds because of strong growth prospects, increased stability and widening interest rate spreads. As emerging market central banks raise rates to cool their economies, more foreign capital pours in and exacerbates the currency and inflationary imbalances that the central banks are looking to control.
Malaysia’s move will not go far enough to normalize its economic imbalances, but it is an important and creative start. Companies can expect similar moves by central banks in other emerging markets. If the new calculus can turn into consistent policy, currency appreciation will slow to mirror the pace of rising standards of living rather than the more rapid and unpredictable pace of foreign capital flows. This will impact hedging strategies as corporate treasuries can more accurately anticipate currency volatility across their growing emerging markets portfolio. Inflation may also cool as bank lending becomes more stringent, increasing consumer wallet-share for discretionary goods while also relieving some pressure from rising labor costs.
Brazil employed similarly creative strategies around taxing portfolio inflows to slow currency appreciation, while also using more traditional rate hikes in a combined effort to curb inflation and currency appreciation.
The new monetary calculus is a key step for financial stability and continued economic growth in emerging markets. Markets employing these strategies are likely to outperform in an unbalanced economic environment characterized by slow growth in mature markets and rapid growth in emerging markets.
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