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US rate hike fears make Asia vulnerable to capital outflows

TOKYO -- With an interest rate hike by the U.S. looming, Asian nations are getting jittery, worried about the effects of such a rate hike on their economies and the flows of "hot money," or large amounts of speculative funds that can slosh dangerously in and out of a country's markets, possibly destabilizing its economy.

     Following the 2008 collapse of Lehman Brothers, central banks around the globe accelerated their monetary easing actions to prevent the world economy from sinking into a double-dip recession. Central banks cut interest rates over 500 times. The combined value of assets held at central banks in the U.S., Europe and Japan reached nearly $10 trillion, more than twice the amount before the Lehman shock.

     The series of monetary easing has resulted in a torrent of hot money flowing out of the U.S. with near-zero interest rates and into emerging markets. But if the U.S. raises its benchmark interest rate for the first time in nine years, this could spark capital outflows from emerging markets.

     Indonesia's current-account deficit -- the amount by which a country's expenditures abroad exceed its revenue from abroad -- is equal to almost 3% of its gross domestic product. To make up for the shortage of foreign exchange, the country has invited investment from overseas. Accordingly, sudden capital outflows may cause the country to experience a severe shortage of foreign exchange liquidity.

     Matthew Sutherland, senior investment director for Asian equities at Fidelity Worldwide Investment, named Indonesia as the most susceptible to the impact of the expected U.S. interest rate increase. "The consensus view is that Indonesia is quite vulnerable," he said, "because they have the biggest current-account deficit in the region."

     The Indonesian monetary authorities are trying hard to relieve growing investor concerns. Juda Agung, executive director of economic and monetary policy at Bank Indonesia, the country's central bank, underscored that the country is running a "high-quality current-account deficit," reflecting its infrastructure expansion.

Crisis triggers

In an effort to persuade international investors to keep their money longer in Indonesia, the central bank is saying that its economy will grow in the long run, driven by infrastructure projects, which will lead its current-account deficit lower, although the deficit will not shrink anytime soon due to the need to import large volumes of materials for building infrastructure and other goods.

     In the past, U.S. interest rate hikes triggered major financial crises in emerging markets. The rate increase in 1994 set off the Mexican peso crisis, also known as the Tequila crisis. The 1997 rate hike wreaked havoc in Asian economies such as Thailand, Indonesia and South Korea. When then-Federal Reserve Chairman Ben Bernanke merely hinted at a possible end to quantitative easing in May 2013, his comments caused turmoil in financial markets.

     Therefore, as the U.S. is widely expected to hike rates this year, attention is focused on what will happen in emerging markets. According to projections released in June by the World Bank, "capital inflows to emerging markets could decline by 0.8-1.8 percentage points of GDP." The numbers attracted much attention from investors worldwide.

     If emerging markets like Indonesia experience a flood of capital flight, their economies may be caught in a vicious cycle. One of the scenarios envisioned by Projit Chatterjee, equity strategist within the Global Emerging Markets and Asia Pacific Equities team at UBS Global Asset Management, is that: "The currencies could remain under downward pressure and provide little leeway to the central banks to cut interest rates amidst a slowing economy. This could prolong the economic downturn."

     Needless to say, the Asian countries hardest hit by the financial crisis in the late 1990s have implemented measures to prevent a recurrence of a similar crisis, taking a lesson from the experience. Among them, South Korea would be the most successful country that turned the crisis into an opportunity to revive the economy.

     After the crisis, the South Korean government initiated what is known as the "Big Deal," and urged its chaebol business groups to focus on core businesses and sell off noncore businesses -- an initiative that has helped enhance the international competitiveness of domestic industries. The country's adoption of a floating exchange rate system accelerated the Korean won's depreciation against the dollar, which resulted in an increase in exports, allowing South Korea to continue to run a healthy current-account surplus.

Higher resistance

Other Asian countries now have higher resistance to capital outflows. For instance, total foreign currency reserves held by six major Southeast Asian countries stood at about $800 billion at the end of 2013, a more than fourfold increase from the late 1990s.

     Even so, as indicated by the famous quote on investing -- "This time is different" -- it is dangerous to think the current situation is noticeably different from the past. Asia currently faces the unexpected economic situation in which China's economic growth is slowing much faster than expected. This factor, combined with the expected U.S. rate increase, constitutes the major threats to the Asian economy.

     U.S. credit ratings agency Standard & Poor's predicts that the pace of economic contraction in Asia if China's growth rate will fall by 0.7 percentage point in two years. S&P expects the Hong Kong economy to shrink 2.3 points, Taiwan's 2.1 points, South Korea's 1.3 points and Singapore's 1 point. Thus, the pace of contraction in these economies will be faster than that in China.

     Also worrisome is the Shanghai stock market's wild swings -- it has surged more than 100% in the past year.

     Orix Bank President Haruyuki Urata expressed his concern over the negative impact the highly volatile Chinese market will have on the country's individual consumption. "Steep stock falls will cause serious financial damage not only to Chinese households with stakes in the market, but will also dampen consumption by Chinese tourists visiting Japan, a driving force of Japan's economy," he said. The major cause of the stock price drop might be a risk-off phenomenon triggered by an increase in U.S. rates -- in which speculative investors attempt to reduce risk by selling existing risky positions and moving to cash positions or low/no-risk positions.

     To convince investors about their growth potential, emerging countries have no choice but to maintain enough economic power to endure a headwind.

     In New Delhi on June 18, John Chambers, CEO of Cisco Systems, a U.S. multinational technology company, visited Indian Prime Minister Narendra Modi and conveyed to him his company's additional investment plan, worth $60 million. The move was in response to Modi's "Make in India" campaign aimed at inviting highly competitive industries to the country.

     Around that time, Indian Finance Minister Arun Jaitley was in New York to explain to Wall Street investors that the economic reforms pursued by the Modi government can push India's economic growth higher. Back in 2013, when global stock markets faced intense turbulence, India continued to run a current-account deficit, and the currency and stocks there came under heavy selling pressure. This time, India is in dire need of capital, so it must do everything it can to boost investor confidence in the country.

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