reposted from Natixis Flash Economics
We find the following cause-and-effect mechanisms in a "dangerous spiral":
- Capital outflows, leading to weak investment;
- Accordingly, exchange-rate depreciation;
- Hence inflation, loss of purchasing power and weakening of consumption;
- Hence problems for the central bank, which is faced with both sluggish growth and inflation;
- The sluggish growth amplifies the capital outflows.
Several major emerging countries are caught in this dangerous spiral; we will look at Russia, Brazil, Turkey, Argentina, India and South Africa.
This "dangerous spiral" is very clear in Russia, Brazil, Argentina and South Africa. Some of its components are appearing in Turkey and India.
First stage: Capital outflows and weakening investment
If a country is faced with large capital outflows because this capital is not being invested in the country, investment is weakened.
This can be seen for all types of capital in Russia and Argentina and since 2013 in South Africa (Charts 1A and B); for non-residents’ purchases of equities and bonds in 2011 and 2013, and since the summer of 2014 in Russia, Brazil, Turkey, South Africa and India (Charts 2A and B).
This has weakened investment in all six countries we are looking at (Charts 3A and B).
Second stage: Exchange-rate depreciation
The capital outflows lead to an exchange-rate depreciation. This has been very clear since 2011 in all six countries (Russia, Brazil, Turkey, Argentina, India and South Africa, Charts 4A and B).
Third stage: Imported inflation, loss of purchasing power, weakening of consumption
The exchange-rate depreciation leads to imported inflation and hence a deterioration in the terms of trade, a decline in real income and a weakening of consumption.
Inflation is rising in Brazil, Russia, Turkey, Argentina and South Africa, but no longer in India since the start of 2014 (Charts 5A and B). Inflation is reducing the real wage and consumption in Russia, Brazil, Turkey, Argentina and South Africa (Charts 6A and B, 7A and B).
Fourth stage: Problems for the central bank
These countries’ central bank is therefore faced with both sluggish growth (Charts 8A and B) and inflation (Charts 5A and B above).
It is then faced with a difficult dilemma:
- Either it reacts primarily to the sluggish growth; it will then choose a low interest rate which will amplify the capital outflows;
- Or it reacts primarily to the high inflation; it then hikes its interest rates, which will depress domestic demand even more.
Charts 9A and B show that among the countries studied:
- Brazil has chosen a restrictive monetary policy;
- The other countries have chosen to keep real interest rates low, close to zero or negative (Argentina).
Fifth stage: Amplification of the capital outflows
If there is sluggish growth and, even more so, if the central bank does not react to inflation and gives rise to negative real interest rates, the capital outflows are amplified and the "dangerous spiral" becomes self-sustaining. This seems to be the case currently in Russia, Brazil, South Africa and Argentina.
Conclusion: It is very difficult to get out of the "dangerous spiral"
We use the term "dangerous spiral" for the following cause-and-effect mechanisms:
How can the countries get out of it? The loss of growth caused by the capital outflows and by the deterioration in the terms of trade amplifies the capital outflows. If the central bank reacts to imported inflation by hiking interest rates, it amplifies the weakness of activity. If it reacts to the sluggish growth by keeping interest rates low, it amplifies the capital outflows.