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Asia-PacificMarch 1 2018

Asia's insulation: why were Fed rate hikes a non-event?

The US Federal Reserve raised interest rates three times in 2017, but the panic that some in the industry predicted would overtake Asia-Pacific’s emerging markets as a result did not materialise. Has the region finished insulating itself from market shocks? Stefania Palma reports.
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Insulated Asia

In the wake of the global financial crisis of 2007-08, a hike in US Federal Reserve rates sparked unease in emerging markets, where investors had been chasing yield ever since the world’s three key central banks – the US Federal Reserve, the European Central Bank (ECB) and the Bank of Japan (BOJ) – implemented extra-low interest rates and aggressive quantitative easing (QE) programmes. 

When in 2013 the Fed announced it would start cutting back on its bond purchases, investors were scared away and US Treasury yields shot up. This was the beginning of the so-called ‘taper tantrum’, with investors taking money out of emerging markets to chase higher yielding Treasury bonds, resulting in capital outflows and currency devaluations. In Asia, Indonesia and Malaysia were hit particularly hard.

So when the Fed hiked rates three times in 2017 by a total of 75 basis points, fears of a similar situation overtook emerging markets. But how susceptible is Asia today to a shift in global monetary policy? Has the region built enough buffers to shield its capital, currencies and inflation levels from market turmoil?

No risks yet

Economists argue that the 2017 US Fed rate hikes have yet to hurt Asian markets. “There is still a wall of money coming into emerging markets looking for yield,” says Frederic Neumann, co-head of Asian economics research at HSBC. “In some sense, it is still a hypothetical risk that Fed rate rises will affect Asia. So far it has gone the other way.” 

The Institute of International Finance (IIF) predicts that $1300bn will flow into emerging markets in 2018 thanks to favourable financial conditions, especially in portfolio equity and cross-border banking flows. This is $100bn above the estimated volume for 2017. Flows to China should account for more than one-third of the total, while India, Indonesia, Malaysia, the Philippines, South Korea and Thailand should make up roughly 20% of the total, says Sonja Gibbs, senior director for global capital markets at the IIF.

Some market participants argue that Fed rate moves could start affecting Asia once the long end of the US yield curve – distorted due to the Fed’s remarkable asset purchasing programme – starts trending upward. As of now, long-term rates have not shifted. Combined with a weak US dollar, this could “blunt any effect of Fed rate hikes on Asia”, says Mr Neumann. “We may need to see further unwinding of the Fed balance sheet before the long end of the curve breaks free.” 

Although markets remain very sensitive to US Fed rate moves, Standard Chartered global chief economist David Mann believes the ECB and the BOJ are the “really big story” for 2018.

Mr Mann expects the ECB to finish winding down its QE programme by September 2018. Meanwhile, though still targeting 0% yield on 10-year Japanese government bonds, the BOJ no longer sets an asset purchasing target to meet that policy objective. In other words, by the second half of 2018, the three major central banks’ rate of balance sheet expansion will be down to about one-quarter of the present rate, says Mr Mann. “If we see markets pricing in bad news without the support of liquidity by the central banks, it could be a tougher time for emerging markets by the second half of this year and it won’t necessarily be about the Fed hikes,” he adds.

Independent Asia

So how are Asian central banks reacting to this turn towards tightening global monetary policy? In 2018, economists expect central banks in the Philippines (Bangko Sentral ng Pilipinas, or BSP) and South Korea (Bank of Korea) to hike rates once, maybe twice in the former’s case. Counter to the global trend, Indonesia’s central bank (Bank of Indonesia) might cut rates on the back of economic expansion, low credit growth and the fact it has kept high rates relative to domestic macroeconomic fundamentals in the past to control capital flows.

While Asian central banks will handle rates differently, none of them will be acting merely in response to the US Fed, according to market participants. “In some sense the Fed has become impotent in tightening US financial conditions, so Asian central banks don’t have to follow it,” says Mr Neumann. “I would argue that what everyone’s doing [is just] trying to normalise [rates and] giving themselves more room for cuts in the next downturn.” 

Asked if US rate moves in 2017 pressured the Philippines to tighten monetary policy, BSP governor Nestor Espenilla says: “Our domestic monetary policy settings need not move in step with monetary policy adjustments in the US.”

Managing risk

The Fed rate moves, however, did trigger net capital outflows from the Philippines in 2017 totalling $205m. This in turn hit the Philippine peso, which on February 14 closed at 52.12 pesos to the US dollar, the lowest level in almost 12 years. The country’s balance of payments also registered a deficit of $863m in 2017.

Mr Espenilla, however, says the BSP remains “well-equipped against policy risks and external imbalances, [having] ample policy space to respond”. The country also has strong macroeconomic fundamentals. The Philippines' gross domestic product (GDP) continues to expand – after 76 consecutive quarters of growth – and foreign debt accounted for only 23.4% of GDP in 2017, 45.2 percentage points below 2003 levels. The country has $81.2bn in foreign exchange reserves, which can cover about eight months of imports, payments and primary income.

If anything, Mr Espenilla believes the US Fed rate moves could be constructive for emerging markets such as the Philippines. “The recovery in the US could boost the country’s external sector through increased export receipts, investments and remittance flows,” he says.

Capital flows to Taiwan

While the Philippines registered capital outflows, Taiwan has seen capital flow into its economy despite US Fed rate hikes. Before a sharp correction on February 2, the capitalisation-weighted index of all listed common shares traded on the Taiwan Stock Exchange grew 4.5% to 11,126 from the end of 2017.

What is more, the Taiwanese dollar is among those Asian currencies that have appreciated against an uncommonly weak dollar, by 10.41% between the end of 2016 and February 2, 2018. This is atypical. When the US economy grows and the Fed increases rates, the dollar usually strengthens. But the US currency did the opposite in 2017, losing 12% of its value against the euro and about 6% against the renminbi. This is why some central bank governors, including Norman Chan, chief executive of the Hong Kong Monetary Authority (HKMA), say Asian markets should pay more attention to the US dollar in 2018.

According to Fai-nan Perng, governor of the Central Bank of the Republic of China (Taiwan) (CBC), further Fed rate hikes pose a risk in that they “could potentially lead to foreign capital outflows from the region, including Taiwan”. If the Taiwanese dollar exchange rate starts fluctuating, “the CBC will, in line with its mandate, step in to maintain an orderly market and provide ample market liquidity to support economic activity”, he adds.

Some economists also point to Taiwan’s household debt-to-GDP ratio, which at 83.9% was among the highest in Asia in 2016, as a potential risk. If rates rise and households struggle to service their debt, the property market could be hit and banks would suffer.

But Mr Perng argues that higher wages and lower unemployment have bolstered Taiwan’s household sector’s ability to repay debt. Taiwanese households also benefit from a savings rate of 21.8% (in 2016) and of net financial assets accounting for about 860% of GDP. Indeed, the non-performing loan ratio for household lending sits at a meagre 0.29%, according to Taiwan’s financial institutions.

Cautious Hong Kong

Taiwan is not the only country where household debt has accelerated on the back of low interest rates following the global financial crisis. Hong Kong’s debt-to-GDP ratio increased by about 20 percentage points to almost 70% between 2007 and 2016.

During the Hong Kong Legislative Council’s (LegCo) panel on financial affairs held on February 5, HKMA’s Mr Chan said the domestic property market is one of the central bank’s concerns. Though prices and transaction volumes in Hong Kong’s property market increased in 2017, “high valuations in asset markets have been based on rather optimistic expectations, including persistently low interest rates and limited risk from trade protectionism and geopolitical tensions”, said Mr Chan. “Should the actual outcomes not tally with [these] optimistic expectations, then significant corrections could take place.”

Citing the 1% to 2% drop in equity markets at the end of January following lower-than-expected wage growth in the US, Mr Chan asked Hong Kong’s public to be “cautious in taking out loans and [to] avoid excessive leverage”.

As for the foreign exchange rate, HKMA policy involves buying or selling foreign exchange to keep the Hong Kong dollar’s value between HK$7.75 and HK$7.85 to the US dollar. In 2017, the Hong Kong dollar was stable, trading close to HK$7.8 to the US dollar. But when the interest rate spread between Hong Kong and the US starts increasing, “the Hong Kong dollar may reach HK$6.85 against the dollar”, says Mr Chan. At that point, the HKMA’s exchange fund will start selling US currency and buying Hong Kong dollars to stabilise the domestic currency. “This will also lead to increases [in] interest rates,” adds Mr Chan.

China’s special case

Across Hong Kong’s northern border, mainland China is relatively shielded from US Fed rate hikes in that its capital controls do not allow for free movement of money in and out of the country. “But even here, should the Fed accelerate tightening, it will make the job tougher for the People’s Bank of China [PBoC] to maintain strong credit growth and keep funding costs low,” says HSBC’s Mr Neumann.

The PBoC might consider hiking rates, but that will not necessarily be in response to the US Fed. Higher rates would help China in its national deleveraging policy aimed at puncturing a debt bubble that has grown to more than 250% of GDP. “It also doesn't want to have too wide a spread versus US interest rates,” says Standard Chartered’s Mr Mann.

Singapore is another special case in Asia. As a very small, open economy, inflation is often determined by external factors, such as oil prices. The Monetary Authority of Singapore (MAS), the central bank, does not have an inflation target. Fiscal, rather than monetary, policy tends to determine inflation in Singapore.

This is why it is more likely for the US Fed rate hikes to hit Singapore only if Singapore’s neighbours or trade partners suffer as a result of US policy. “If rates go up faster than what most people expect and if some countries in the region took this a bit worse than we currently anticipate, then there will be knock-on effects on Singapore because we are so open and exposed,” says MAS managing director Ravi Menon.

FX debt

Excessive foreign currency-denominated debt could also damage Asian countries as the US Fed continues to hike rates and if the US dollar strengthens. In that scenario, local currencies would depreciate versus the US currency and servicing this debt would become problematic, which is what happened during the Asian financial crisis of 1997.

Although Asian markets have not necessarily cut their US dollar borrowings, the volume of local currency debt has grown thanks in part to the creation of local currency-denominated bonds bought by offshore investors. “It has been proven through the taper tantrum years to be a much better type of vulnerability than having short-term dollar lending by foreign banks. We’ve already seen a lot of these markets tested and they’ve come out the other end pretty strongly,” says Mr Mann.

Indonesia is the latest Asian market to have launched such a product, the 'komodo bond'. State-run toll road operator Jasa Marga printed the debut note in December 2017, a Rp4000bn ($295.7m) deal listed on the London Stock Exchange.

Mr Neumann argues that, today, “real US dollar funding risks are more prevalent in other parts of the world, such as Latin America, where you have less liquid local markets with higher local interest rates, which incentivises corporations to borrow in hard currency”.

New US tax reforms could pose a further risk for Asian markets. The new policy could widen the US fiscal deficit by about $150bn in 10 years, driving up US Treasury yields and potentially triggering capital outflows from emerging markets. What is more, the reforms also encourage US corporates to repatriate overseas earnings. “If this happens it will tighten offshore US dollar liquidity, which may negatively impact emerging markets,” said HKMA’s Mr Chan at the LegCo panel.

Thus far, the 2017 US Fed rate hikes have not hurt Asian markets. Strong macroeconomic fundamentals and growing local currency debt are keeping Asia safe. But the tightening monetary policy cycle has just begun, with the ECB and the BOJ set to give this trend more momentum in 2018. And if the Fed’s tightening is more aggressive than expected, those Asian countries with large foreign exchange-denominated and household debt stocks might suffer.

Asian CBs charts 0318

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