Markets have been buffeted by recent economic headwinds. Faster-than-expected-wage growth in the U.S. was the spark that sent markets around the world into a tailspin, igniting worries about growing inflation pressures, and fanning expectations that the U.S. Federal Reserve may need to douse an overheating economy with a rapid succession of rate increases.
The accompanying spike in U.S. long-term interest rates is of particular concern for Asia: After years of credit-fueled growth, the region has become vastly more sensitive to changes in funding costs. Even a small uptick in interest rates could slow demand as companies and households need to put more money aside to service their debt, leaving less for other purchases.
After initial wobbles, however, the region's financial markets quickly regained their poise. True, equities do not look quite as stellar as before. But, overall, investors have taken the latest U.S. interest rate "scare" in their stride. Compare this with the "taper tantrum": After then-Fed Chairman Ben Bernanke hinted in 2013 at marginal tightening in the form of slower central bank purchases of U.S. bonds, it sparked many months of unease in the region. Why have investors so quickly shrugged off the latest signs of possibly more aggressive tightening by the Fed?
In part, because China, as the region's growth anchor, looks more resilient this time around. During the earlier episode, its economy was in the process of shifting down sharply: Commodities tumbled and investors asked hard questions about the mainland's sharp rise in debt over the preceding years. This time, with a slower pace of growth, China does not appear to be heading for another demand tumble. Meanwhile, Asia's current resilience also reflects stronger fundamentals, with Indonesia and India in particular having much smaller current-account deficits, and sturdy surpluses continuing in most other economies.
But that is hardly the whole story. Something deeper is going on, something that currently insulates emerging Asia from the spike in U.S. interest rates: a weak dollar. Unlike in most previous episodes when data pushed the Fed into a more aggressive tightening path, the greenback has not benefited as much as one might have expected. On a global basis, it now trades near a three-year low.
That provides a powerful buffer for Asia. A weaker dollar helps insulate the region against a rise in U.S. interest rates. That is because stronger local currencies keep inflation at bay, reducing the need for central banks to nudge interest rates higher still. Equally important, it dissuades capital outflows that could push up funding costs for Asian companies and households alike: Investors are happy to keep their money locally invested, as potentially higher U.S. dollar returns are eroded by a sliding greenback.
That, however, also points to a risk for the region: that the dollar might reverse course at some point, and rally convincingly and durably. In that case, the Fed's tightening impact on Asia would not be blunted but actually would be accentuated: Capital flows to the U.S. would accelerate, lured by both higher interest rates and currency appreciation, depriving Asian borrowers of cheap funding.
Local central banks, too, might then be forced to compound the effect, raising policy rates in response to higher imported inflation.
For now, however, the dollar shows few signs of regaining its mojo. Sure, the Fed is tightening, but by how much and how quickly is not entirely clear. For all the upbeat U.S. data, inflation has in recent years failed to take off. Plus, growing budget deficits by the American government are raising broader questions: While these may fan growth in the short-term, thus keeping the Fed on guard, they can also dampen demand over time as officials need to address a rising debt burden.
As long as the dollar remains weak, therefore, growth in Asia will stay broadly shielded from climbing U.S. interest rates. The region, most likely, is looking at another year of solid growth, with the International Monetary Fund forecasting economic growth for the Asia-Pacific nations at an annual 5.5% in combined gross domestic product.
Still, this should not blind investors and policymakers to a hidden risk. While a sliding, or at least stable, greenback provides a welcome buffer for the time being, one can hardly trust that this will remain the case indefinitely. Currency markets can appear tranquil and torpid for a while, and then erupt in a frenzy of activity, reversing course just when everyone has become accustomed to stability. The greenback, still by a wide margin the world's foremost reserve currency, is bound to rally eventually.
And that would expose cracks in Asia. Exports, of course, might benefit, but local investment and consumption, so reliant on cheap credit, would slow. This need not entail financial stress as on occasion in years past, but it would squeeze borrowers enough to hold back growth. The prudent path would be to throttle back on debt now, even as funding remains cheap.
Fortunately, there are signs that Asian officials have begun the hard work, above all in China where deleveraging of certain sectors has become a policy priority. It is only a start, however. Much more work lies ahead. The dollar, after all, may not provide a buffer indefinitely.
Frederic Neumann is co-head of Asian economics research at HSBC.
