What Fed's new tightening cycle holds for Asia
Higher interest rates could disrupt region's economic growth
The U.S. Federal Reserve raised interest rates for only the third time this decade at its Wednesday meeting. The policy rate now stands at 0.75-1%. The hike itself was heavily discounted, but markets were tuned in to the Federal Open Market Committee's hints as to what might happen next. The Fed now expects interest rates to increase twice more this year, with the median projection rising to 1.4% at the end of this year, and then to just over 2% at the end of 2018.
If the Fed is right, then we now have a proper tightening cycle for the first time since 2004, rather than the one-off mini-shocks triggered by the "taper tantrum" of 2013, when the Fed announced an end to its policy of quantitative easing, and raised rates twice, at the end of 2015 and 2016.
The reasons for tightening have become more convincing but not yet totally persuasive. After an unusually long inventory rundown that slowed U.S. economic growth to a crawl between mid-2015 and mid-2016, the economy has been performing better. The increase in nonfarm employment averaged just over 200,000 jobs a month in the three months to February, a faster rate than the Fed thinks is compatible with a stable labor market. There have been other encouraging signs, including a drop in the unemployment rate to 4.7%, a pickup in wage formation and a slight rise in the labor force participation rate. Aggregate hours worked -- the product of new jobs and hours worked -- plus underlying productivity growth point to the resumption of an annual economic growth rate of around 2-2.5%. Against that, the Federal Reserve banks of Atlanta and New York, which publish real-time gross domestic product forecasts, think that growth early this year was much lower.
Nevertheless, the economy looks reasonably good, all things considered, and should benefit a bit from the economic and tax programs that will be offered by the administration of President Donald Trump once details are negotiated with the U.S. Congress. We should learn more about this in the next two months. Even if expectations in financial markets prove to be somewhat exaggerated, it is highly likely that there will be corporate and individual tax cuts, some reform of the corporate tax structure, higher defense spending and efforts to boost infrastructure spending. If we conservatively estimate, for example, that the net fiscal stimulus turns out to be less than 0.5% of U.S. GDP in 2017 and more like 1% in 2018, it would create modest inflationary pressure in the absence of protectionist trade measures.
If that happens, we should expect the Fed to raise interest rates as it anticipates, or even a little faster if the economy picks up additional momentum. These monetary policy expectations alone, leaving aside any effects from U.S. tax reform changes, would be enough to push U.S. bond yields up toward 3% in 2017 and add momentum to a stronger U.S. dollar.
What might this all mean for emerging Asia?
The combination of a gradually tightening monetary policy, an administration intent on narrowing the U.S. trade deficit and encouraging U.S. companies to repatriate cash held overseas, and regulatory changes that limit cross-border repurchase financing and funding will likely result in U.S. dollar funding pressure in Asia, higher U.S. and local currency interest rates and a depreciation of local currencies. We already had an indication of this in late 2016. It is highly likely that capital outflows will periodically create difficult market conditions and even lower economic growth resulting from higher interest rates.
Asia's ability to withstand these pressures is not insubstantial. China holds $3 trillion of currency reserves, South Korea, Taiwan and Singapore a further $1 trillion among them. India, Thailand and the Philippines also hold adequate reserves based on metrics such as imports and external debt, although Malaysia comes up short in this regard. If you add together current account positions and net foreign direct investment, the so-called basic balance looks strong in Singapore, Thailand, South Korea, Malaysia and China but less so in India, Indonesia and the Philippines. But this is not the only criterion for judgment.
Corporate debt problems
Debt is always an important benchmark for assessing vulnerability to external financial disturbances, but unlike the 1997-98 Asian financial crisis, the main problem in Asia today is neither bloated external debt nor public debt. Malaysia does have relatively high levels of both and India has high public debt. China's public debt is officially low at about 25-30% of GDP, but that is before the addition of debt held by local and provincial governments, state enterprises and quasi-fiscal institutions, such as policy development banks, which results in substantially higher public debt levels. In fact the debt focus is not here but in the private sector.
The eruption in recent years of private debt has been startling. It now stands at over 200% of GDP in China, nearly 190% in South Korea, 170% in Malaysia and 130% in Thailand. Debt levels are lower in India, Indonesia and the Philippines, but debt growth rates in recent years have also been significant. China's situation is by far the most worrying.
Even though much of the surge in nonfinancial corporate debt in emerging Asia has been funded by domestic capital markets in local currencies, it is highly unlikely that these markets will be immune to rising U.S. interest rates and a stronger U.S. dollar, especially if capital that previously flowed to nonfinancial companies and local bond markets flows out again. Many countries, including China, will find the financing, refinancing and repaying of U.S. dollar-denominated loans increasingly uncomfortable.
All things considered, Asia is still reasonably able financially to deal with a modest tightening cycle in the U.S., but there are many things that remain uncertain.
Markets may not be prepared for a more assertive tightening cycle, since few existing participants have experienced one. The Trump administration's protectionist fiscal and trade policies might worsen the economic and financial environment in Asia. Chinese capital outflows, curbed for now by the recent tightening of capital controls, are liable to resume before long, which would cause the weakening of the yuan. European markets would be rocked if the populist tide sweeps nationalists to power in France's presidential elections in May.
Asian investors and markets may be sitting comfortably for now, but they should be prepared for stormy financial weather ahead, with the Fed's tightening cycle serving as a catalyst.
George Magnus is an associate at Oxford University's China Center and former chief economist at UBS.