The Comeback of Uncertainty

The Federal Reserve raised interest rates by 0.25% in December, 2015.
The Federal Reserve raised interest rates by 0.25% in December, 2015.

The Federal Reserve raised interest rates by 0.25% in December, 2015.

After the US Federal Reserve Bank started to raise interest rates questions arise whether the region is well prepared to face resulting headwinds – BY CHRISTIAN VITS

It has been a historic move: In December, the US central bank lifted its benchmark interest rate for the first time in nearly a decade, ending an era of more and more abundant liquidity. Financial markets around the globe reacted calmly and welcomed the decision as it alleviated uncertainty about the central bank’s tightening pace and was seen as a confirmation that the US economy is on a relatively sound footing.

“The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run,” the Fed said. “However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”

But the latter is the main point which could prove to be tricky for Southeast Asian emerging markets. Two risk scenarios loom on the horizon: If the Fed increases its interest rates too fast it might trigger capital outflows, rattle financial markets and provoke a depreciation of local currencies. If the tightening path is more shallow than expected it may cause worries about the economic development in the world’s biggest economy, hampering investor sentiment and export growth in Asia.

Only two weeks after the rate hike China’s financial markets had a disastrous start into the New Year, triggering dovish comments by Fed policy makers.

“These declines have been accompanied by weak oil and commodity prices, furthering the concern that global growth has slowed significantly,” Boston Fed president Eric Rosengren said in mid-January. “While monetary policy should not overreact to short-term, temporary fluctuations in financial markets, policy makers should take seriously the potential downside risks to their economic forecasts and manage those risks as we think about the appropriate path for monetary policy.”

Welcome to the new uncertainty. “One cannot rule out that we will see surprises in the course of the year, because of a weaker US economy or because inflation rates do not develop as expected,” said Joerg Zeuner, chief economist of Germany’s development bank KfW. “Added together, we see an uncertain environment, in particular in ASEAN member states and in Asia overall as we face a lot of pending questions.”

One is certainly the risk of a capital flight from emerging markets to the US as a higher interest rate level attracts investor’s money. In January, emerging markets saw net non-resident portfolio outflows of $3.6 billion, marking an unprecedented seventh consecutive month of outflows, according to the Institute of International Finance (IIF) in Washington.

While Zeuner expects an improving economic development in the ASEAN region he also warned that “persistent capital outflows always pose risks.”

Back in May 2014, 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 only started to talk about cutting back monetary policy stimulus, the region’s markets were rocked. In the following five months, net capital flows to East Asia and the Pacific retracted by 20 percent, 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.

The situation seems to have improved since then but weak spots still remain. Indonesia is a case in point: “Indonesia’s ratio of external debt to gross domestic product (GDP) is not too high, but if you look at the ratio of external debt to foreign exchange reserves it’s about 2.3 times,” said Edward Lee, regional head of research Southeast Asia at Standard Chartered Bank in Singapore. “And importantly about 85 percent of their debt is in foreign currencies. So given this external vulnerability I would say Indonesia is one of the more affected countries.”

KfW’s Zeuner points to the high private sector indebtedness in Thailand, which rose 25 percent in relation to the country’s GDP over the past ten years. In Malaysia, he sees “a very high refinancing need on international capital markets this year.”

Last but not least, ASEAN companies have significantly increased their leverage. “With corporate debt now at a level equivalent to about 80 percent of ASEAN gross domestic product, the real question is whether these companies can withstand two major shocks: a fall in revenue due to a slowing China and a rise in interest burdens due to the Fed’s tightening,” said Alicia García-Herrero, chief economist Asia Pacific at Natixis in Hong Kong. “The latter is especially problematic, given the relatively high reliance on offshore borrowing in corporate financing strategies over the last few years.”

Veerathai Santiprabhob, a former economist at the International Monetary Fund (IMF) and now governor of the Bank of Thailand agrees: “Ultra-loose global monetary policies have made it much easier for firms in Emerging Markets to raise funds or borrow especially from abroad,” he said. “However, in the wake of tighter financial conditions, Emerging Market firms are facing greater difficulty to repay or roll over their debt.”

Still, the Fed may not ignore the global economic environment. Last September, many observers already expected a first interest rate increase in the US. But the central bank did not deliver, arguing that global economic and financial developments “may restrain economic activity somewhat” and are likely to put further downward pressure on inflation in the near term.

“I think the sense is now that the Fed is taking into account external market conditions and market volatility as part of its reaction function,” Lee said. He expects only one more interest rate move this year while the majority of observes calculates with two hikes after expecting three or more just a few weeks ago. “If the volatility of the Yuan in China continues, this will affect the Fed’s monetary policy decisions,” he added.

KfW’s Zeuner by contrast believes the Fed will predominantly monitor the development in the US as it did in the past. “I wouldn’t bank on a Fed pursuing a global monetary policy in the future,” he said. “There arises the question whether the central bank overloads its mandate.”

Whatever the outcome will be at the end of the year: It is obvious that the Fed’s policy entails a couple of risks for the ASEAN region. In particular, it seems that at least some parts of Southeast Asia are not ready yet to shoulder a new and prolonged tightening cycle.

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