To hike or not to hike, EM CBs fret

Woe is the EM central banker; as RBI’s Dr. Subir Gokarn pointed out in Wednesday’s FT, for instance, the delicate balance between “keep[ing] inflation in check by containing the potential spillovers from food and energy prices, while minimising deviations from a sustainable growth trend” has rarely been so harrowing.  For the Central Bank of Turkey (CBT), the foundations underpinning 8.4% annualized real growth last year have paradoxically also pressured a rapidly ballooning current account deficit (roughly -48.6bn USD in 2010 versus -14.0bn in 2009) as Q4 private sector credit extension surged (41% y/y) and has remained above 40% in the first two months of 2011–well above the government’s 20-25% y/y guidance and despite reserve requirement increases.  This ‘monetary normalization lite’ underscores the degree to which lira depreciation remains the Bank’s primary tool (rather than rate hikes which invite capital flows, not to mention political scorn in an election year) to reverse the CA deficit bulge, since the alternative would be to raise real rates and encourage portfolio financing (which saw record flows in 2010) of the very deficit officials purportedly seek to address.  The Bank’s policy has also been helped hitherto by falling inflation which slowed to only 4.2% y/y in February, a record low.  Yet against the backdrop of the CA breakout and secular lira fall this magic act cannot last forever.  Barclays notes, for instance, that low inflation last year “was driven largely by base effects (tax increases early in the year)” while projecting that headline as well as core prices would respond sharply going forward–to 8% by July and then “to about 7.5% by end-year, much of it depending on local harvest dependent developments in unprocessed food prices.”  Said occurrence, however, coupled with a CB new governor this month and a further entrenched AKP by summer, may finally create the perfect recipe for bona fide monetary hawks to spread their wings, which in turn would theoretically signal an end to the lira’s nearly four year fall from grace.  Payer swaptions, which pay a fixed rate while receiving floating, seem a sensible way to play this envisioned outcome, especially since the market’s current 125bp hike expectations seem low.