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Credit tightening 'dominoes' threaten Asia with hidden risks

Higher interest rates could roil stock markets and upset currency flows

Giant cranes are seen at the Hanjin Shipping container terminal at Incheon New Port in Incheon, South Korea, on Sept. 7, 2016.   © Reuters

HONG KONG/SINGAPORE -- With Asia's economies humming along, consumer prices rising and the U.S. edging toward higher interest rates, markets have been unloading Asian government bonds and sending long-term interest rates soaring. Expectations are growing that Asian central banks will start raising rates soon, in what could amount to "credit tightening dominoes."

This could significantly affect flows of investment funds, creating risks for international financial markets, which might be in for a ride. So far, the currencies and stock markets of emerging Asia have been mostly stable, but there is no basis for unreserved optimism.

The central banks of South Korea, Malaysia and the Philippines are all expected to raise rates in the coming months, while in India, expectations for easing have subsided.

Central banks ready to tighten

When the Bank of Korea released the minutes of its Oct. 19 policy board meeting on Nov. 7, it reaffirmed the broad view that it was getting ready to tighten policy.

The BOK kept its policy rate unchanged at a record low 1.25%, but one of seven board members voted for the first increase in over six years. Two other members mentioned the need to raise the rate at some point, local reports said.

Calls for tighter policy have been rising as South Korea's economy improves. In October, the government announced that real gross domestic product grew 1.4% in the July-September period from the preceding quarter, the fastest in about seven years. The BOK has raised its projection for real GDP growth in 2017 to 3.0%.

The central bank is now expected to raise its key rate at its Nov. 30 meeting for the first time since June 2011. Nomura International (Hong Kong) says the BOK will likely to push its policy rate above 2% by the first half of 2019.

Since the October meeting, the yield on 10-year South Korean government bonds, the long-term benchmark, has risen sharply, hovering around 2.6% since Nov. 20, the highest since early 2015.

The exchange rate of South Korea's currency, the won, is currently at a 14-month high against the U.S. dollar, and there have been no capital outflows from the country, which investors see as strong enough to withstand higher rates. But markets could be less sanguine if the BOK tightens credit repeatedly, sparking concerns that the economy could suffer. 

Malaysia is expected to raise its policy rate by 0.25 percentage point in January, according to Mohamed Faiz Nagutha, economist at Bank of America Merrill Lynch. Malaysia last raised its policy rate in July 2014.

The central bank is considering the rate rise as inflationary pressure builds in a strong domestic economy. In July-September, real GDP grew 6.2% from a year earlier, the fastest pace in about three years. The consumer price index rose 4.3% in September from a year earlier, the most since April. Prices are expected to climb further on higher crude oil prices.

The major Singapore financial house, DBS Group, forecast that Malaysia's long-term rates could rise to around 4.5% in the first quarter of 2018, the highest since the onset of the global financial crisis in 2008. On Nov. 13, Malaysian long-term interest rates rose to 4.12%, the highest since April.

Inflation in the Philippines

The Philippine central bank last raised rates in September 2014, but is widely expected to tighten its policy rate by around 0.5 percentage point in 2018, reflecting economic growth of nearly 7% on strong services exports and government spending. Concerns about inflation have also been growing.

The CPI gained 3.5% in October from a year earlier, the fastest in three years, due to higher prices of daily commodities and energy, as well as falls in the value of the currency, the peso, sending overall prices higher.

Manufacturers experienced rising global commodity prices in October.   © Reuters

Long-term interest rates rose to the 5% level, nearing this year's high of 5.55% set in April.

In many Asian countries, the current rates of economic growth and inflation are being fueled by developments in the U.S., where, the technology sector has been booming, as seen in the earnings of companies such as Apple and Google.

Many Asian companies supply parts and services to the U.S. tech behemoths, which have been sucking up exports from Asian economies that have been incorporated into the supply chains.

Another big factor in expectations for a wave of Asian monetary tightening is the U.S. Federal Reserve. The Fed started raising rates at the end of 2015 and is poised to close the money tap further. It is curtailing asset purchases and widely expected to bump up rates in December for the third time this year.

As seen in the Philippines, a stronger dollar against local currencies due to higher U.S. rates generally pushes up import prices.

Fed tightening is often followed by similar moves in emerging countries. Time lags between U.S. rate rises and those in emerging countries tend to affect capital flows and roil markets. 

Tighter Fed policy can create gaps in investment returns between the U.S. and other countries, raising concerns about massive capital outflows from emerging countries to the U.S.

Immediately after the Fed raised interest rates at the end of 2015, for the first time in nine and a half years, Chinese stocks tanked and markets around the world tumbled. Similarly, a move by the Fed to raise rates in 1994 triggered a financial crisis in Mexico.

Lessons from China and India

Emerging countries tighten monetary policy not just to curb an overheated economy, but also to prevent serious capital flight and currency crises. 

A case in point is China.

The People's Bank of China has not changed its base interest rate for more than two years. But it has been nudging short-term rates higher since early 2017, a clear sign of a tightening bias.

According to KGI Securities in Hong Kong, the PBOC's policy reflects the government's ongoing efforts to reduce financial leverage and control risks.

A number of analysts, however -- including one at U.S. research firm Pantheon Macroeconomics -- are coming to the view that the PBOC is trying to stabilize the yuan by guiding government bond yields higher.

Long-term interest rates in China rose above the 4% mark for the first time in 37 months On Nov. 14.

In India, where the economy is vulnerable to high inflation and interest rates because of the relatively lower standard of living, there are some worrisome signs in financial markets. Radical economic reforms have also been hurting short-term economic performance.

For months, there were expectations that the central bank would cut rates to shore up the economy. But the latest data released on Nov. 13 and 14 pointed to faster-than-expected inflation, dousing expectations for rate cuts.

On Nov. 14, the yield on the benchmark 10-year government bond climbed above 7% for the first time in 14 months. In the week though Nov. 15 the benchmark Sensex stock index fell by nearly 3%.

Andrew Tilton, chief Asia-Pacific economist at Goldman Sachs, predicts interest rates will go up in many Asian countries in the coming year due to factors such as rate increases in the U.S. and reduction of excess production capacity in Asia.

Higher rates as a policy response to inflation and capital outflows would be a negative for stock markets, he says. But for the moment, tightening in Asia is a response to stronger economic growth and should not be a big drag on stock markets.

Yet there are many reasons for investors to carefully consider potential risks lurking below the surface.

Two decades ago, in 1997, the emerging economies of Asia were engulfed in an unprecedented currency crisis. In November that year, South Korea asked the International Monetary Fund for help, its financial system brought to its knees by the swift, unanticipated exodus of hot money.

Even the IMF had not foreseen South Korea's collapse into full-fledged crisis. 

While the economic fundamentals of many Asian countries are much stronger now, the power of big international investment funds to upset markets has also grown.

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