Ripple effect

The tightening of the US Federal Reserve’s monetary policy will confront Asean member states with tougher financing conditions and lower capital inflows, putting growth prospects at risk
By Christan Vits
The good old days might be over. Those times when central banks flooded financial markets with ultra-cheap money in the aftermath of the financial crisis – with large tranches of these funds pouring into emerging markets such as Southeast Asia. Now, as the tightening of monetary policy has begun in the US and is on the radar elsewhere, Asean member states must quickly adapt if they are to maintain high economic growth rates and address their external financing needs.

“Market jitters in recent days have reminded us that emerging economies have yet to complete their adjustment to more volatile external conditions and higher risk premiums,” said José Viñals, director of the monetary and capital markets department at the International Monetary Fund (IMF), when presenting the Fund’s Financial Stability Outlook at the end of January. “Emerging-market economies remain vulnerable to future increases in US interest rates, although investors are increasingly differentiating among countries based on their financial vulnerabilities and macroeconomic imbalances. The best thing [they] can do is to prepare for a rainy day by having their umbrellas ready.”
Back in May last year, Southeast Asia got a taste of what is to come if markets react nervously to changes in international financial conditions. After former Fed chief Ben Bernanke started to talk about cutting back monetary policy stimulus, the region’s markets were rocked. Speculation about the tightening’s timing resulted in global portfolio shifts towards US assets whose yields nearly doubled, plummeting stock market indices and depreciating currencies.
Net capital flows to East Asia and the Pacific retracted by 20% between May and September last year, according to the World Bank. Hardest hit were those economies where prolonged expansionary policies had increased domestic vulnerabilities such as current account deficits and high debt. For instance, domestic credit in Cambodia, Laos, Malaysia, Thailand and Vietnam surged by more than 20% between 2007 and 2012. During the market tensions in the middle of last year, Indonesia’s currency declined by about 9%, reflecting the country’s deteriorating current account and rising inflation. Thailand’s baht dropped by about 7%.
While economists do not expect a recurrence of the Asian financial crisis, concerns remain. “The vulnerability to external shocks is linked to the amount of trade as a share of gross domestic product (GDP) and the linkage of the financial system to the world financial system,” said Rajiv Biswas, chief economist for Asia at IHS Global Insight in Singapore. “So the more export-driven an economy is, like Singapore, Malaysia, Thailand, to some extent also Indonesia, the more vulnerable it is.” Usually, Indonesia wouldn’t be included in this list, Biswas added. But Indonesia has a “very high share” of foreign investment. “So they would be vulnerable to capital outflows, portfolio capital outflows. If global investors are fleeing into safer areas, then Indonesia, like other emerging markets, would be hit.”

In the period following the financial crisis, financial inflows had averaged about 6% of GDP in developing countries, supported by historically low interest rates in high-income countries and stronger growth prospects across emerging and developing regions. In its baseline scenario, the World Bank expects global interest rates to reach 3.6% by mid-2016, implying “limited disruption” to developing countries. This slowdown in capital inflows could amount to 0.6% of developing-country GDP between 2013 and 2016, driven in particular by weaker portfolio investments.
“However, the risk of more abrupt adjustments remains significant, especially if increased market volatility accompanies the actual unwinding of unprecedented central bank interventions,” the bank said. “Abrupt changes in market expectations, resulting in global bond yields increasing by 100 to 200 basis points within a couple of quarters, could lead to a sharp reduction in capital inflows to developing countries by between 50% and 80% for several months.” Countries that have seen a substantial expansion of domestic credit over the past five years, deteriorating current account balances, high levels of foreign and short-term debt and over-valued exchange rates could be more at risk, the World Bank added.
An adverse scenario resulting in market overreactions may be triggered if new Fed chief Janet Yellen turns out to be less eager than expected to follow in the footsteps of her predecessor in maintaining a lax monetary policy.
“In Asean, this could result in selling assets, including domestic Asean currencies,” the Centre for Economics and Business Research (CEBR) recently warned. “The resulting currency depreciation would almost certainly weaken investor confidence, affecting external financing and investments, and rapidly transforming the credit environment in the region. Such an outcome would have a significant impact on countries – particularly Indonesia and Thailand – that have experienced high capital inflows since the financial crisis.”
Some concerns may be overblown as “the Fed will dilute the punch rather than remove the punch bowl, at least for the foreseeable future,” said Leif Eskesen, chief economist for Asean and India at HSBC in Singapore. “However, this shouldn’t spell complacency for […] policymakers. Indonesia’s imbalances are still large and need to be attended to; Thailand’s uncertain policy environment and weakening fiscal position present risks; and Vietnam still has a way to go before it has shaken the financial stability risks. Moreover, Indonesia’s and Vietnam’s foreign exchange reserve coverage is on the low end, especially in Vietnam’s case,” he added.
If capital shifts do not peak concerns, a look to China might be advisable, IHS’s Biswas suggests. “A hard landing in China is my biggest concern. I am not so concerned about the impact of Fed tapering on emerging markets, because there is an offset from stronger growth coming into the exports sector which we have already seen. But what I am worried about is… the probability of a hard landing in China over the next three years, which we put at about 20%,” Biswas said.
“There is a risk because there are imbalances, which have increased in the Chinese economy due to the shadow-banking sector – because of the expansion of credit, bad debt in the local government sector and also the rapid growth in house prices. There are some imbalances in the Chinese economy which, if not managed properly, could result in a hard landing,” Biswas added.
So there is a lot to do if Asean member states want to stay competitive. “There has to be a switch away from relying on loose monetary and fiscal policies, as well as abundant capital inflows, which have built up leverage a bit too fast in some countries,” HSBC’s Eskesen said. “Policymakers in all countries have to re-invent the wheel when it comes to what should drive growth. The days of easy growth are behind us.”
 
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