China drives growth. The U.S. Federal Reserve determines interest rates. That sets us up for tensions that few investors fully appreciate. No surprise: Both are spurring regional economies at the moment. China's economy has soared over the past year, driving trade and lifting growth across much of Asia. The Fed has gingerly raised rates at the same time, but hardly enough to discourage funding for Asian businesses and households. It may not always be so. At its Sept. 20 policy meeting, the Fed held rates but hinted at increases ahead. And that poses risks to the region.
Think back to the decades before the global financial crisis. The U.S. economy was Asia's primary growth engine. Soaring imports would lift growth across the region as American consumers bought more shoes, electronics, bicycles, and much besides. Interest rates also followed the U.S. cycle, rising when growth was brisk and falling when demand slumped. A neat process that finds an equilibrium over time, as Asia's economy was tethered to that of the U.S.
No longer. China is now what matters for growth. Its economy contributes around 30% of global gross domestic product. More and more, mainland consumers are the ones who matter for regional exporters. As flashy as the new iPhone may be, vastly more smartphones are sold in China each year than in the U.S. These require components from South Korea, Taiwan, and others.
Commodities from Indonesia and Malaysia are now sold mostly to Chinese, not American, manufacturers. And mainland tourists in Thailand and Hong Kong are filling hotels and malls. Then there is investment: China is building plants and infrastructure throughout much of the 10 member countries of the Association of Southeast Asian Nations and further to the west. An integrated and increasingly inward-looking Asian economy is in the making.
And yet, interest rates are still set, by and large, based on benchmarks a world away. The Fed rules. Its easy money over the last nine years has stoked credit and fired up local investment and consumption. True, it may have gently nudged short-term rates higher over the past year, but the Fed's now vast balance sheet has kept longer-term funding costs nailed to the floor.
Capital, as a result, has poured into the region. The weak dollar has further eased financial conditions in Asia. Demand from China has lifted growth, and cheap funding, courtesy of the Fed, has amplified it, setting Asia up for the best of all worlds.
Cracks beginning to show
That, however, may not last. Now partly tethered to the Fed, and partly to Chinese growth, much of emerging Asia is in a precarious situation. Tensions are building that may expose a fault line now unappreciated. Monetary conditions may in future no longer suit the region's growth prospects.
China's torrid pace of development, after all, is likely to cool. A new "regulatory storm" is sweeping the mainland. Hardly a week goes by without new stipulations for the country's financial institutions to curb risky lending. These may not yet have made a dent, but regulators are pressing ahead, hinting they will push for full implementation later this year or in early 2018. Without other reforms, such as that of state-owned enterprises, slowing credit is bound to curb demand. When China sneezes, emerging Asia may need more than a scarf.
At the same time, the Fed is tightening the screws. Not rapidly, but unrelentingly. Over the coming months, the U.S. central bank is likely to build on the hints it gave on Sept. 20 and move to gradually reduce its balance sheet. How this will affect capital flows, and hence funding costs, in emerging Asia, no one knows precisely. Investors, for now, seem relaxed. The U.S. economy appears robust enough to take the monetary squeeze in its stride. Less certain is whether Asia can.
In recent years, debt has climbed inexorably in many economies, such as South Korea, Hong Kong, Singapore, Malaysia, and Thailand. Yet funding costs have dropped, thanks in large part to a generous Fed and a weaker dollar. The latter has kept local inflation bottled up and encouraged foreign investors to park their funds in Asia. If things turn, as they almost certainly must, local borrowers will quickly find that their debt has become far less affordable. At the very least, servicing it will take a bigger bite out of their revenues and income, and knock down investment and consumption.
Asia, then, is stuck between two giants. China drives growth, but the U.S. still largely determines interest rates. This arrangement has spurred the region along blissfully for a number of years. But, if China fizzles and the U.S. sizzles, the region might be exposed. This, optimists argue, may never happen: China will continue to barrel along, and the Fed can keep rates affordable for a long time yet.
Perhaps. But the potential tension is apparent. Growth determined in China, and monetary policy elsewhere, is not a recipe for sustained expansion. At some point, the divergence will start to bite.
What to do about this? Investors had better beware. The region's policymakers, on the other hand, face a more daunting task. Small, open economies have few options at their disposal. The giants are too big to ignore and too powerful to rein in. That leaves little choice: strengthen competitiveness, curb lending by regulatory means, and preserve fiscal ammunition for trouble one day. When giants collide, one had better be prepared.
Frederic Neumann is co-head of Asia Economics Research at HSBC.