IN principle, interest rates in Asian countries with open capital accounts - such as Hong Kong, Thailand, Indonesia, Malaysia, Singapore and the Philippines - should closely track US interest rates. The degree of tracking, in terms of both the extent and the speed of adjustment to a US rate change, will depend on the exchange-rate regime in each country; the more rigid the exchange rate, the less independence a country has in determining its interest rates. An open capital account means that there should be no long-term, risk-adjusted interest rate arbitrage possibilities. If Asian interest rates are out of kilter with US rates, capital will flow to close this gap. Therefore, any difference between US rates and Asian rates reflects the risk premium that investors demand for holding assets denominated in Asian currencies. This risk premium can be broken into two components: a devaluation premium and a country risk premium. Thus, interest rates in Thailand are essentially the sum of US rates, the devaluation premium on the baht and the country-risk premium for Thailand. If US rates rise, the interest rate gap between the US and the country in question will rise. This will result in a (relative) capital outflow. This, in turn, will affect financial assets, as their prices will be driven down and their returns will rise. In other words, interest rates will rise. If the country has a fixed exchange rate regime, this is all that will happen: the stock of money will decline and interest rates will rise. However, if the exchange rate is flexible, the situation gets trickier. Now, the burden of adjustment will be shared by the currency and interest rates. Remember that money is leaving, and thus its price must rise. Given the Hong Kong dollar's peg with the US dollar, the results are as expected. Hong Kong rates adjust fully and almost immediately to changes in US rates. Similarly, if US rates rise, then, barring a further decline in the country-risk premium, which has, incidentally, almost halved since the middle of last year, rates in Hong Kong will follow suit. After Hong Kong, Thailand's currency has the most rigid peg with the dollar. Thus, as expected, Thai rates are strongly connected with US rates: adjustment is complete and takes one quarter. Our estimates show that the risk premium on Thai assets should now be about 600 basis. However, Thai three-month rates exceed their US counterparts by about 750 basis points. This is not surprising, given that the baht has been subject to speculative pressure. Nonetheless, the result is interesting: if all else remained equal, then, on a fundamental basis, Thai rates should decline. The market just needs to be convinced (as we are) that the baht is no danger of depreciating in the near term. On a fundamental basis, the future magnitude of the risk premium will depend on a mixed bag. For one, there is risk in the banking sector. Second, gross domestic product growth is likely to be 5 per cent or less for the next couple of years. On the other hand, the government has acted quite decisively to try to reduce the current-account deficit. Unless US rates display a secular uptrend, the upside on Thai interest rates will be limited. There could be an occasional upward spike, but such events should be of limited duration. As the Indonesian rupiah fluctuates in a wider band than that of the baht, it takes on more of the responsibility of adjusting to changes in US interest rates. This mutes the downward movement in Indonesian interest rates. The estimated risk premium on Indonesia is now about 360 basis points. The interest-rate difference between Indonesian rates and their US counterparts is about 640 basis points. Thus, if one expects about a 3 per cent depreciation of the rupiah, Indonesian rates are at equilibrium. If a greater (smaller) depreciation is expected, Indonesian rates should rise (fall), even if US rates remain steady. In short, there is little scope for maneuverability. Singapore and Malaysia both float their currency and are not afraid to let the exchange rate move in response to foreign capital flows. This means the currency takes on enough of the burden of adjustment so that the relationship between US and local rates breaks down. Thus, if US interest rates rise, we would expect little change in either Singapore or Malaysian rates. That means that their currencies would tend to remain on the weak side. In the Philippines, the 91-day Treasury bill rate is about 500 basis points above its US counterpart, while the estimated risk premium for the Philippines is about 560 basis points. Thus, a rise in US rates is likely to push Philippine rates higher; that is, unless the currency takes on some of the adjustment burden. We believe it will. The currency has now held steady for some time, for the government was targeting inflation. With inflation down and the trade deficit widening, some weakness in the exchange rate is called for. Thus, if US rates rise, we believe that the Philippine peso will weaken in the near term. If US rates display a secular uptrend, then Philippine rates are likely to follow. If not, look for rates to stay where they are; little upside, little downside. Arup Raha is a senior economist and Mike Leong is a senior quantitative analyst at Lehman Brothers Asia.
