There is an eerie air of calm in Asian markets. After years of easy money, much of which found its way into Asia, the U.S. Federal Reserve is finally applying the brakes. Investors seem to be cheering the prospects of higher dollar interest rates. Financial markets barely responded when America's central bank tightened policy again on March 15, the second time in four months, and promised more to come this year. Perhaps that is because Asian export data has been more reassuring of late. Or perhaps it is because China has bounced back from its earlier growth stumble. Whatever the reason, few seem to appreciate the risk Fed tightening poses to Asia.
Here is the issue: Debt. Since 2008, the region has splurged on it. And for good reason: Balance sheets, at least initially, were lean, and export markets in the West had faltered. What better way to sustain growth than leverage up and invest locally. The recipe worked, possibly better than many had imagined at the time. Growth continued to soar in Asia's emerging markets even as much of the world struggled to recover from recession. And it was all financed at record-low interest rates.
That, however, is now changing. The Fed itself has penciled in two more increases this year and three more for 2018. That will mark a chunky rise considering that interest rates had been virtually flat all these years. For Asia, this means that existing debt will be more costly to service. Furthermore, additional credit will become dearer still, even while it is vital to keep growth humming.
All this would not be much of a problem if Asia's growth engine could somehow be retooled: easing off investment and consumption and returning to exports as the main fuel. In that case, the rise in interest rates, even if unappetizing to stretched borrowers, could be digested without too much harm. Overall gross domestic product growth would continue without much interruption. But this seems an unlikely prospect, despite the surprising bounce in shipments across the region in the last few months.
Let us call the latest export surge what it is: a cyclical bump, masking deeper, structural issues ailing Asia's external sector. A temporary inventory correction in electronics is playing a role here, plus some broader restocking after a harsh production decline in the prior two years. But a sustained lift to exports, one big enough to compensate the region from the drag of higher dollar rates, seems improbable. Expenditure in the West is shifting away from the goods that emerging Asia typically exports (more healthcare, less furniture), while some companies in the U.S. and EU are even re-onshoring production as labor costs in the East have become less competitive. And that is not to speak of the growing risk of protectionism.
Asia, in short, is not helped as much by strengthening U.S. growth as in the past: a transmission failure of sorts as the conveyor belt across the Pacific has decoupled from American demand. As the Fed continues to raise rates, therefore, emerging Asia will see its debt costs climb -- but without the compensation of stronger shipments. As America's central bank tightens monetary policy, this will act as an even more powerful brake on activity in Asia's developing markets than in the past.
And that is not all: To keep domestic markets on an even keel, local central banks may be forced to tighten at the margin as well, or at least forgo further easing, even as inflation risks are not acute and growth might still slow in the coming months.
Take China for example. A mere few hours after the Fed raised interest rates last week, the People's Bank of China increased borrowing costs as well, only by 10 basis points, compared with the Fed's boost of 25 basis points, but a tightening move nonetheless. In part, the rate increase was necessary to pre-empt capital outflows and exchange rate volatility by limiting the lure of higher U.S. dollar interest rates.
Japan is facing a similar challenge. Happily, inflation has turned positive again in recent months. But it remains far from the Bank of Japan's target of 2% by the middle of 2018. Part of the problem is that inflation expectations remain nailed to the floor. The current round of wage negotiations looks set to deliver even smaller gains than last year. That calls for ongoing monetary accommodation.
However, because of rising U.S. interest rates, the BOJ is forced to purchase bonds at a near unprecedented pace in order to keep 10-year bond yields, as promised, close to 0%. If the Fed pushes rates up further, Japan's central bank may run out of assets to buy and thus be forced to lift its cap on bond yields, tightening policy without having achieved its inflation objective.
Other countries face similar challenges. From South Korea to the Association of Southeast Asian Nations and India, Fed rate increases will exert a powerful drag on debt-fuelled growth. Yet the ability of local central banks to pursue more accommodative policy is limited, if only because of the risk of heightened exchange rate volatility.
The question is: What to do about it? In part, more fiscal easing will be needed. China and Japan are already leading the way on this front, increasingly relying on extra government spending and tax cuts to sustain demand.
Elsewhere, however, the scope for government pump priming is more limited given self-imposed fiscal rules or already elevated public debt. That leaves only one solution: spurring productivity gains through structural reforms. Pruning the privileges of state-owned enterprises, opening up local markets to foreign direct investment and competition, negotiating meaningful bilateral and regional free trade agreements, improving governance standards and strengthening transparency and the rule of law. The list is long, but it forms the basis of sustained growth.
As the Fed tightens the screws and easy money is no longer readily available, it will be back to the fundamentals for Asia.
Frederic Neumann is co-head of Asia economics research at HSBC.