In the dollar bear market of the past decade, the BRIC countries [Brazil, Russia, India and China] have been the darlings of international speculative capital, like Southeast Asia fifteen years ago.
The BRIC countries exhibit all the symptoms of binging on cheap credit: high levels of indebtedness, inflation and strong currencies. In the past decade broad money has risen by 17.2% per annum in India and 18.2% in China, while their real gross domestic product rose by 7.5% and 10% respectively.
The faster money growth has turned into inflation. The broadest gauge for inflation is the difference between nominal and real GDP growth rates or GDP deflator. It averaged 7.5% per annum in India and 7.3% in China.
High inflation and a strong currency have propelled demand for foreign capital. It is essentially to arbitrage the difference in the cost of capital on and offshore. High inflation makes the real cost of capital onshore low or negative.In recent months, the BRIC countries no longer receive strong inflows anymore. Their currencies have been under downward pressure. The BRIC economies now are similar to Southeast Asian economies in 1996. Wrong policy moves could aggravate the situation and trigger a full-blown financial crisis.
The strong currency gives foreign capital providers high returns offshore. This arbitrage is self-fulfilling in the short term. Foreign capital inflow supports their currencies, increasing their money supplies and inflation.In recent months, the BRIC countries no longer receive strong inflows anymore. Their currencies have been under downward pressure. The BRIC economies now are similar to Southeast Asian economies in 1996. Wrong policy moves could aggravate the situation and trigger a full-blown financial crisis.
India just cut interest rates. Its latest inflation rate is 7.2%. Though it is at a three-year low, the level is still high. The moderating inflation gives the central bank the excuse to cut interest rates. Its goal is to stimulate growth. However, declining interest rates could speed up capital outflow. The resulting currency depreciation could worsen inflation again.
The real angle to the rate cut is the confidence game. Foreign capital, especially the footloose kind, plays the bubble game. It needs growth to embolden its risk appetite. The rate cut may increase capital inflow in the short term. The wrong policy in a conventional sense could work in a bubble environment.
The confidence game works when speculators want to play. It requires the global environment to be supportive. The most important supporting factor is the weak dollar.
The chances are that the market consensus on the dollar will change within three months. The dollar index has fluctuated between 76 and 82 for two years. It is now at 80. Within three months, it would break through 82. The market consensus will follow then.
The confidence game doesn’t work when the dollar is strong. The BRIC economies need to shift their priority from growth at any cost to financial stability. The biggest mistake that Southeast Asian economies made 15 years ago was their reluctance to sacrifice growth despite the inflation challenge.
The right policy for the BRIC countries would be tightening now, ahead of the curve. Unfortunately, all policy makers are oriented to the short term nowadays. Some emerging market turbulence is quite likely within the next 24 months.
Source: Marketwatch (Andy Xie)