Weak activity and low inflation will keep EM central banks dovish

In addition to sluggish G3 growth, emerging market (EM) economic activity has been hampered by tight liquidity conditions. These became especially tight after the volatility spike that followed the 11 August CNY move and the Fed's decision to delay liftoff on 17 September. By contrast, trackers show that, although liquidity tightened somewhat in recent months, conditions remain generally loose in G3. Furthermore, liquidity conditions may become even looser there. The ECB's pre-announcement of extended and expanded quantitative easing will enhance liquidity in Europe.

"We see a little more than 50% chance in Japan that the Bank of Japan will stay on hold on 30 October, but the odds of additional easing in 1H16 are higher than 50%. The US remains an exception, as we still expect liftoff in December. However, we see a very gradual hiking path, with inflation picking up very slowly", says BofA Merrill Lynch.

Such divergence between EM and G3 liquidity conditions is not new, but was exacerbated by the oil price bust of mid-2014. Economists have argued before that such divergence will support further easing by EM central banks. The likely easing of EM liquidity also supports the view of a gradual recovery of EM economic activity, consolidating in 2H16. Indeed, EM liquidity is correlated with GEM-10 growth.

In addition, statistical tests indicate that, conditional on EM growth, improved EM liquidity leads to higher EM growth. The favorable impact is particularly strong during the first year. According to this exercise, if liquidity conditions returned to the post-2010 average, GEM-10 GDP growth would pick-up by 0.5ppt after four quarters.