On Wednesday the Federal Reserve is highly likely to raise US interest rates, resuming the cycle of tightening that was put on pause early in 2016 amid heightened financial market volatility. It is a nervous time for Asia. Not only are US interest rates rising, but the US currency is strong – the US dollar has risen 24 per cent against a basket of major currencies in the last two and a half years.
The precedents are hardly encouraging. The last time the US entered a tightening cycle, the result was the credit crunch of 2007 and the financial crisis that followed the year after. And the last time we had US interest rates and the US dollar going up at the same time, we got hammered by the Asian crisis of 1997. So how worried should Asia be this time around?
The answer depends on where in the region you are standing. A strong US dollar means US consumers have greater purchasing power. And if US interest rates are going up to mitigate the inflationary effects of strong US demand, that demand will tend to favour Asia’s exporters. On the other hand, a stronger US currency and higher US interest rates make it punishingly expensive for Asian companies that have borrowed in US dollars to service their debts.
The good news is that neither a 2008-style US financial meltdown, nor a 1997-style Asian currency crisis is on the cards. American consumers are much less indebted today than a decade ago, and the US financial system is more resilient. And Asian economies have largely abandoned the fixed exchange rate systems that shackled their currencies to a rising US dollar and made them such easy targets for speculative attack.
Nevertheless, with the yield on 10-year US Treasury bonds up from an all-time low of 1.3 per cent in June to a little over 2.3 per cent currently, it looks very much as if the long 35-year bull market in bonds is finally over. Such major turning points in financial markets do not occur without casualties. And if US dollar bond markets now enter a protracted bear phase, propelled by the inflationary effects of US president-elect Donald Trump’s proposed economic stimulus policies, the collateral damage could be severe.
So which markets in Asia are most likely to catch a stray bullet? Among the most vulnerable are those which rely heavily on volatile flows of foreign capital to fund their domestic investment programmes. In 2013, when the Fed announced it would wind down its policy of quantitative easing, foreign financial institutions took fright and pulled their capital out of exposed Asian economies. The result was the infamous “taper tantrum” that saw both the Indian rupee and the Indonesian rupiah fall by around 20 per cent against the US dollar.
Asia is experiencing similar capital outflows today. According to data from the Washington-based Institute of International Finance, foreign investors yanked US$16 billion of portfolio capital out of Asian emerging markets in November, compared to US$20 billion in June 2013 at the height of the taper tantrum. As a result, Asian currencies have come under pressure, although the pattern of the sell-off is different from 2013. Both India and Indonesia have narrowed their current account deficits – the gaps between their savings and their investment needs – and as a result, have seen only a modest weakening in their currencies. However, for Indonesia, any further declines will begin to make foreign currency financing uncomfortably expensive, which will weigh on growth next year.
More severely affected has been Malaysia. Although Malaysia runs a current account surplus, it is highly exposed to international capital flows, with foreign investors owning more than half the domestic bond market. As foreigners have bailed out in recent weeks, the ringgit has slumped by 5.4 per cent.
By and large, economies in North Asia are less vulnerable. Japan, in particular, stands to benefit from the change in the financial and economic environment. A strong US dollar and solid US demand lift Japanese exports and boost earnings from the US operations of Japanese companies.
As a result, as the yen has softened against the US dollar since the US election, the Tokyo stock market has climbed 16 per cent.
The exception here is Hong Kong. Because of its exchange rate peg to the US dollar, the city directly imports US interest rates. With local housing prices within 2 per cent of their all time high, and with payments on a new mortgage typically eating up 60 per cent of household income, US interest rate increases are a worrying prospect.
As the International Monetary Fund warned last month, “there is the risk of an accelerated price adjustment should interest rates rise faster than expected”, which could cause “an adverse spiral of negative wealth effects, lower collateral values, slower credit growth, and weaker household and corporate spending”. It might not be as painful as the 1997 property market crash, but it certainly won’t be pleasant. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years