TOKYO -- Escalating trade tensions between the U.S. and China are raising economic uncertainty in Asia and sending ripples through financial markets in Indonesia and India, Paul Gruenwald, global chief economist for S&P Global Ratings said in an interview.
Investors have been shifting from emerging markets because of better interest rates in the U.S., and the ongoing economic uncertainty will further fuel this shift, he said.
"Relative to the rest of Asia, I think India and Indonesia are probably the most at risk," he said.
Gruenwald added, though, that these economies are not as vulnerable as in 2013, when they were hit by capital outflows following the first signs of monetary policy normalization in the U.S., in what became known as "a taper tantrum."
The latest bout of capital outflows, which started in earnest in April, was also triggered by Fed tightening and expectations that the U.S. central bank will be more aggressive in fighting inflation than previously anticipated.
The unease has been compounded by an escalation in the trade spat between the U.S. and China. OnFriday, the U.S. imposed tariffs on $34 billion in Chinese goods, and China retaliated on the same scale. This is just the first part of a plan to impose tariffs on $50 billion of each other's imports, and that could be followed by another round of tariffs on $100 billion of imports.
Economists agree that the direct economic impact of these tariffs would be limited. The real concern is that a prolonged standoff could cause delays in investment and big-ticket spending, and derail the global economic recovery that has been underway since last year.
Concerns about the trade war will likely reduce investor appetite for risky assets, and could fuel further capital outflows from emerging markets.
On the front line of the brewing financial turbulence are Indonesia and India.
Indonesia's central bank, Bank Indonesia, raised its policy rate by a total of 100 basis points to 5.25% in May and June to counter the falling rupiah and stock prices. The Reserve Bank of India last month raised its main lending rate to 6.25% in the first rate increase in more than four years amid a sharp slowdown in capital inflows into the country.
Both countries run sizable current account deficits, relying on foreign debt to finance them. Capital outflows in 2013 sent both the Indian rupee and the Indonesian rupiah skidding down more than 20%.
The two countries are a new frontier for investors looking for opportunities outside more established emerging economies such as Taiwan and Malaysia.
Indonesia and India have been seen as complements to the other emerging economies because they are more domestic-demand orientated, with large populations and rising middle classes, while offering investment-grade products, Gruenwald said.
But their newfound popularity means they are the first to shudder in times of market upheaval.
China, the focal point of the trade dispute, won't be free from financial turmoil, Gruenwald warned.
Since April, the Chinese yuan has fallen more than 5% against the U.S. dollar, reflecting flagging confidence in the Chinese economy, even if the situation is not so serious yet, he said.
The Shanghai stock market has fallen more than 20% since its January peak, and has entered bear-market territory, another sign of diminished confidence.
At the heart of this market instability is China's high debt levels.
According to the Bank for International Settlements, the debt of non-financial corporations in China reached 160% of gross domestic product at the end of 2017, compared with 103% for Japan and 74% for the U.S.
Such debt is used to finance overseas acquisitions and for domestic capital investment in cement, steelmaking, shipbuilding, renewable energy and so on.
The Chinese authorities want to purge the economy of excessive debt without causing too much of a slowdown and a loss in confidence in the system. That could spark an exodus of money from the banking system and out of the country, triggering instability in the financial system, Gruenwald warned.
He said China's growth has been sustained by a loop of steady wage growth creating confidence in the economic system, encouraging people to put their money in the banking system, which then lends the money out to companies.
"As long as that circle keeps going and there is nothing leaking outside, then the model can continue," Gruenwald said. If there is a loss of confidence, "then you are going to see stress, pressure on the exchange rate and pressure on the reserves."