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Covid-19 Pandemic Response - What Emerging Market governments are spending and why central banks have moved into QE

The coronavirus is plunging the world economy into recession, forcing central banks and governments to race to the rescue. Stimulus plans totalling trillions of dollars across major and emerging economies have been crafted to prop up economies forced into lockdown. Whilst it is considered that fiscal policy has the most impact on directly supporting economies that have been hit by sudden stops, central banks have been leading the charge with liquidity support and asset purchases (QE) to stabilise turbulent financial markets and to provide support for bigger fiscal deficits (see IMF data below).

Whilst this was the playbook from the global financial crisis of 2008/09 for developed market central banks, this time central banks in Chile, Colombia, Costa Rica, Croatia, Hungary, Indonesia, Poland, Romania, South Africa, and Turkey have prepared or begun purchases of bonds of various kinds. Both Brazil and the Czech Rep have been given the power to do QE, but have yet to say they will use it.

Below we look at a selection of CEEMEA countries that have started QE or have the option, and compare their crisis responses:

  • S.Africa - The SARB has purchased government bonds across the entire yield curve and extended the main refinancing instrument maturities from 3 to 12 months. The government has announced a ZAR500bn (USD26bn) support package, which comes to 10% of GDP.
  • Turkey - The CBRT was already allowed to buy government bonds, which can reach 5% of its balance sheet, but announced at the end of March that it had ramped up bond buying. The government launched a 21 point stimulus package (Economic Stability Shield) worth USD15.4bn to tackle the coronavirus pandemic.
  • Poland - The NBP was the first to launch a QE programme on 19 March, with no time limit or amounts specified. Purchases will be in the 2-10yr part of the curve. Poland has the 3rd highest support package in the CEE totalling 11.3%/GDP, but of this it has the largest direct support component of 6.5%/GDP. This would not be possible without a large NBP program of asset purchases, which may reach 8.4-10.4%/GDP according to some estimates and will likely be the largest in the region.
  • Hungary - The NBH started QE on 5 May, and will purchase government bonds and mortgage backed bonds, from 3-15yr maturities. Again there is no time limit, but the programme will be reviewed once it hits HUF1tn. The government announced the biggest CEE anti-crisis response package of 13.6%/GDP.
  • Czech Rep - The CNB has so far not used its power to do QE and has said it is the last resort measure, which can be deployed in the case of a prolonged recession. The Czech government has pledged to deliver the second biggest CEE anti-crisis program worth 12.3%/GDP.
  • Romania - The NBR started its first-ever QE program on 1 April, but its scale is limited due to worries about RON fragility. The government has an anti-crisis program of 3.2%/GDP, the smallest in the region.

IGM FX and Rates 

 

The Impact of QE - a focus on CEEMEA countries.

To date, QE has only been used on a large scale in countries with strong currencies and deep pools of demand. There is a concern that in Emerging Markets, these conditions are not in place. For now the scale of EM QE is contained and the relatively limited bond buying programmes undertaken in the first weeks of the pandemic proved effective. Yields in all of the countries we are looking at (Poland, Hungary, Czech Rep, Romania, S.Africa and Turkey) have stabilised since mid March (see above for graph of 10yr yield performance)

However, whilst these measure may have at first taken the pressure of local currencies, in recent week there has already been a weakening in the currencies of those EMs doing QE (see graph of ccy pair percentage change above). Romania's CB has intervened to support the Leu in recent weeks and the CNB has said it could do the same. If CEE central banks do turn to large-scale QE, the impact on currencies would be even more negative and this may encourage them to tread more cautiously.

While quantitative easing worked in the developed world without pushing up prices, capital outflows and weaker currencies could quickly fuel inflation in EMs. The EPFR data in the dashboard shows that the CEEMEA region saw some sharp outflows from bonds and equities, but after the initial sell-off these have now stabilised.

For now, apart from Indonesia, EM central banks are not buying bonds directly, but looking to to mop up bonds from the secondary market to take the pressure off yields and make the market more attractive for foreigners. What is worrying is the prospect of QE creeping into direct deficit monetisation, especially in those countries with less fiscal space and weaker institutions.

Monetising fiscal deficits will risk a sharp currency sell-off, which can spark a deeper crisis given most EMs dependence on external and FX financing. The danger is that this will lead to capital flight, weaker currencies and a surge in inflation. In the end this could force central banks to tighten policy abruptly, delivering a further blow to their economies.

For now, growth and the immediate benefits to financial stability have taken priority over inflation and vulnerabilities to medium-term financial stability.

Which QE programmes will tread the line and be a success?

IGM FX and Rates

 

There are three key determinants for if a QE programme will work. The first is external imbalances, size of government debt and success at inflation targeting (see dashboard above for relative performance of CEEMEA countries based on these metrics). It is clear that for QE to not lead to a slump in currencies and a surge in inflation, central banks need to have credibility and independence (so that they are not perceived to be forced into financing deficits). From the above, it looks like bond-buying programs run by South Africa, Turkey and Hungary may face challenges over the medium-term as they run C/A deficits and/or have high government debt levels already. Turkey performs very well on these scores but is the one country that has consistently missed its inflation target and by some margin. There are also huge concerns over the central bank's independence and current policy mix (see our previous Viewpoint for more detail here).

The question is if central bank policy can trump fundamentals in Emerging Markets? There are also concerns about how fragile these markets are and what will happen once the fiscal and monetary support fall away. Will the stabilisation in capital outflows mentioned above be maintained?

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