As the Fed winds down its bond purchase
program, countries like India and Indonesia could suffer
The US
Federal Reserve has been winding down its bond purchase program, widely known
as “quantitative easing,” since December 2013. With the US economy appearing on
the mend, the Fed suggested at its policy meeting in March that the program,
started in 2008 to attempt to stimulate the US , may end this coming fall and
it may start raising interest rates about six months from then.
The
fear of US rate hikes triggered yet another sell-off right after the meeting,
bringing down equity prices and widening credit spreads across Asia. The MSCI
equity market index for Asia excluding Japan lost 6.3 basis points, or 1.24
percent, in the week of 17 March alone. Bond markets also slumped, while credit
spreads widened. The JP Morgan Emerging Bond Market Index recorded spreads
ranging from 287 to 295.7 basis points for sovereign, and 176 to187 basis
points for corporates. The prospect of a possible slowdown in the People’s
Republic of China is further weighing on investors’ confidence in Asia.
The
higher cost of capital reflecting heightened financial volatility and risk
premiums has important implications for economic growth in many Asian
economies, especially those that rely on foreign capital to fund their vital
investments. Previous experience suggests the loss of real income in emerging
Asia could amount to nearly half a percentage point reduction in real GDP
growth for each 1 percentage point increase in the US interest rate.
Impact of US monetary policy on Asia
Historically,
a tightening cycle in US monetary policy has often adversely affected Asian
economies by reducing aggregate demand through various channels. First, higher
yields on US assets attract capital, thus reversing international capital
flows. Heightened uncertainty combined with declining international liquidity
and weakening currency conditions add to volatility in emerging markets,
further hiking risk premiums, and therefore increasing the cost of capital.
Second,
the transmission of higher US interest rates through international capital
markets yields higher domestic rates, exerting downward pressure on domestic
investment and consumption. Previous studies show that global transmission of
interest rates is significant for developing countries. Empirical evidence
indicates that local interest rates in Asian developing economies tend to
follow movements in short-term US rates regardless of existing exchange rate
regimes.
Third,
expectations of higher interest rates may dampen global consumption spending,
hence reducing external demand for Asian exports. Higher interest rates also
raise the borrowing cost of and debt-service burdens on the government and
public sector.
Emerging
Asian economies are not a homogenous group and the impact of higher US interest
rates is unlikely to be uniform. Countries with external imbalances or a
reliance on external funding would be the most vulnerable to the effects of
higher rates. This is why Asian countries with substantial budget and current
account deficits—Indonesia and India for example—are the ones that have been
hit the most since QE started late last year.
Prudential
fiscal management has proven to be key in safeguarding financial stability in
the global tightening cycle. Governments in vulnerable economies should
exercise rigorous fiscal discipline and start consolidating budget deficits.
Hopeful signs
The
regional economic picture is not all bleak though. While risks of higher interest
rates remain real, to what extent they will materialize is highly uncertain.
There are also some positive factors. First, US policy rates are unlikely to
rise significantly higher in the near term given the fragility of the US
recovery and its job market, and considering a substantial overhang of US
fiscal and current account deficits and debt-laden households.
Second,
Asian economies have generally reduced their reliance on short-term external
debt while building up their foreign exchange reserves since the financial
crisis, which makes them more resilient to a sudden reversal in capital flows.
Third, there has been a significant strengthening in the domestic demand base
in many Asian economies, which may help them cope with potential demand shocks,
even as a modest recovery in advanced economies continues. Governments should
be ready to provide support in reaction to any serious fallout in demand.
In a
rising rates environment, it is crucial that the authorities foster a positive
investment climate through deeper structural reforms. As investors carefully
scrutinize risks and returns in individual emerging markets, sustained progress
in economic reforms to improve productivity and competitiveness ultimately
determines a country’s attractiveness as an investment destination.
Cyn-Young
Park
Cyn-Young
Park is assistant chief economist and director of the Economic Analysis and
Operations Support Division in the Economics Research Department of the Asian
Development Bank. This article was first published by the ADB
Development Blog
Business & Investment Opportunities
Saigon Business Corporation Pte Ltd (SBC) is incorporated
in Singapore since 1994.
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