Developed Market Privilege

With Boris Johnson proroguing parliament the chat has turned again to whether UK is becoming an Emerging Market (EM). Sure – suspending democracy to avoid losing power is a bold move for any British government/ monarch. But what does it actually mean to go full-EM?

The IMF definition of an Emerging Market studiously avoids words like dictatorship and democracy, focusing instead on income per capita and export diversification, but leaving plenty of wiggle room to change minds if an upstart somehow qualified as Developed. The World Bank scrapped the definition completely in 2016. MSCI and JP Morgan have their own convoluted definitions that control the entry into their widely followed equity and bond indices, respectively. Under any of these definitions the UK is miles away from going EM. But it’s a conversation with a very smart tweep about a year ago that really sticks in my mind.

If you live in a Developed Market it means that you are pretty likely to be well-off individually (when measured on a global scale). But it also means that you benefit from Developed Market Privilege: your government can run counter-cyclical monetary and fiscal policy.

Reducing (rather than raising) interest rates, and loosening (rather than tightening) government purse strings when an economic downturn comes might sound like common sense. And for Developed Market economies it is. But if you are an Emerging Market (EM) economy, things aren’t quite as simple. For EM economies, rate cuts and easier fiscal policy (that might help cushion the blow of a slowing or shrinking economy) might well be met by currency weakness, rising inflation, and a higher risk premium applied to the country’s debt and financial instruments by foreign (and domestic) investors, all of which might be somewhat counterproductive to the happiness of EM citizens. Bottom line, in the words of my interlocutor “at the risk of provoking the fixed-income goblins, the shibboleth is ‘in risk-off, am I buying or selling your debt?’”.

So being EM sounds not exactly brilliant, but also actually something that has a concrete definition relating to how credibility issues lead directly to currency weakness and financing issues. Given that pretty much everyone knows that a central bank can control the level of bond yields (if it is willing to pay a high enough price) this sounds like a story of Exchange Rate Pass Through (EPRT). A high EPRT should indicate EM-hood. A low ERPT might deliver DM-privilege. It’s actually a bit tricksy to calculate ERPT. Professor Kirsten Forbes is pretty awesome on this whole EPRT issue, and has the benefit (from my perspective) of having served on the MPC and looked at where the UK sits in all of this.

Taking both Forbes’ EPRT data, and looking also at what happens in risk-off situation, we get chart 1. The dark blue blobs are considered Developed Markets in bond indices, the blue diamonds are considered Emerging Markets. Higher ERPT are higher in the chart, and lower ERPT are lower in the chart. The average EPRT for his small sample of Developed Markets is lower than the average EPRT for this small sample of Emerging Markets, but there is not really much in it.

Chart 1: Exchange-Rate Pass-Through coefficient, vs Local bond-equity correlation coefficient 2004-15

erpt

One reason why ERPT differences might be so slight is precisely the different reaction functions of the central banks in EM and DM respectively. And this could be the thing that is informing the real distinction shown on the horizontal axis of the chart and observed by my clever friend: in risk-off I buy your sovereign debt if you’re DM and sell your debt if you’re EM. (Eg, perhaps Turkey’s ERPT was contained in 2004-15 precisely because every time there was a downturn that caused its local equity market to weaken, fiscal and monetary policy-makers may have collectively tightened sufficiently to push bond yields higher but protect the currency from moves that delivered higher inflation pass-through.)

So I think that the chart tells a story, and it’s one of control. Being rich, diversified, and having strong institutions has put a bunch of countries’ sovereign debt into that bracket labelled ‘safe assets’. These assets are bought by investors when things get hairy, bestowing upon respective governments the ability to deliver counter-cyclical policy (cutting rates and boosting government borrowing and spending when things get tough). This Developed Market Privilege is something that countries around the world have sought. Developed Market Privilege delivers enhanced control over your destiny – a form of economic sovereignty that is far from universal.

So is the UK going full-EM? It doesn’t seem that investors have yet given up on Gilts, although long Gilts look as though they have underperformed Bunds and Treasuries as the risk of a disorderly Brexit have increased. UK inflation isn’t soaring despite extended currency weakness. These things tend not to be linear, but I think it’s too early to declare the UK a banana republic quite yet. That said, the institutions on which the UK’s Developed Market Privilege depend appear to me to being eroded by the day.