As the Fed starts to reduce the size of its balance sheet, Asian policymakers and businesses must prepare themselves for the fallout, says Manu Bhaskaran
This article was first published in the November/December 2017 China edition of Accounting and Business magazine.
The economic news in recent weeks has been good for Asia. Exports are rising strongly and this appears to be complemented by a gradual recovery in the domestic engines of growth as well. However, with the US Federal Reserve Bank (‘the Fed’) preparing to step up the normalisation of its monetary policy, could financial turbulence get in the way of Asia’s economic rebound?
Many Asian economies still manage their exchange rates against the US dollar and rely heavily on inflows of portfolio capital, both of which are sensitive to the Fed’s policy moves. Its ultra-easy policy stance has caused interest rates to fall virtually everywhere, and the massive liquidity that it unleashed has flowed into Asian assets, such as equities, bonds and real estate, while also providing support for commodity prices.
There is reason for concern. The Fed started to reduce the size of its balance sheet in October. It has also indicated that it will raise its policy rate again this year and through 2018 and 2019. The Conference Board lead indicator rose 0.4% in August, after rising 0.3% in July. Moreover, there is little risk of an upsurge in inflation, which might cause the Fed to aggressively raise rates to the point where the economy might be tipped into a recession.
The bright US prospects will benefit Asian exporters greatly. More robust capital spending would provide the US economy with another growth engine, thus making its recovery more durable and in a position to support Asian trade for longer. But there are downsides.
First, global investors will probably shift their asset allocation strategy as monetary normalisation proceeds. Capital is likely to flow out from Asian markets as higher rates in the US and the expectation of a stronger US dollar make US assets more attractive. However, we do not expect a repeat of the so-called ‘taper tantrum’ of 2013 when hints of policy tightening in the US caused convulsions in financial markets.
Second, asset valuations rose because of the easy availability of liquidity. As liquidity becomes scarcer, it is likely that this support will fade – necessarily depressing valuations of Asian assets.
A third impact will be greater financial pressures on those who took on more debt in the past eight or nine years. Higher rates must mean more severe servicing burdens, hurting the governments and corporations that took on high levels of debt.
Finally, Asian policymakers will have less space to keep domestic interest rates low. As other central banks gradually follow the Fed, it will be harder for Asian policy rates to remain as low as they have been. As we get into 2018, we are likely to see several Asian countries, such as China and Singapore, tighten policies.
The bottom line is we are entering uncharted territory. It will be harder for policymakers to calibrate policy correctly since few understand how this reversal of unprecedented levels of easy money will pan out. That raises the risk of policy errors as well.
In other words, economic prospects for Asia may well continue to brighten but financial risks will rise.
Manu Bhaskaran is CEO at Centennial Asia Advisors, Singapore
"As we get into 2018, we are likely to see several Asian countries tighten policies"