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Fed rate hikes impact on Asia

Gabriel Domínguez, Srinivas MazumdaruDecember 17, 2015

While the Fed's rate raise was welcomed in Asia as a sign of strength, experts warn the impact may be much more severe by the end of next year, with US policymakers projecting four quarter-point rate hikes. DW examines.

USA Symbolbild Zinswende
Image: picture-alliance/dpa/A. Burgi

After carefully preparing financial markets for an imminent jump in its benchmark interest rates, the US Federal Reserve finally moved on December 16 to nudge up its target band for the rates by a quarter of a percentage point, to 0.25-0.5 percent.

This marks the first rate increase by the US central bank in over nine years, since the 2007-08 global financial crisis forced the bank to embark on a policy of rock-bottom rates. The move suggests the Fed is confident about the underlying strength of the US economy and its growth prospects.

In the run up to the Fed's decision, analysts believed higher US rates could pose a challenge to a number of emerging market economies - particularly across Asia, a top exporter to the US - by pushing up bond yields, augmenting capital outflows and depreciating currencies.

Nevertheless, the initial reactions across Asia have been largely positive, with markets across the region registering gains on the back of the Fed move. But while a Fed rate raise of 0.25 percentage points is a small step, financial markets are more concerned about what is coming down the road from the Fed, as Rajiv Biswas, Asia-Pacific Chief Economist at the analytics firm IHS, told DW.

Another four rate hikes are expected from the Fed in 2016, with more increases expected to follow in 2017.

A surge in money outflows?

"This will significantly increase the attractiveness of USD short-term yields compared to most other currencies, and is expected to push the USD higher against most emerging market currencies. Rising US interest rates will also tighten liquidity conditions in Asian markets, which have been fueled by cheap money from the world's major central banks since 2009, particularly due to ultra-loose US monetary policy," said Biswas.

USA U.S. Federal Reserve Erhöhung Leitzins Janet Yellen
Chairwoman Janet Yellen announced the Fed's first interest rate hike in more than nine yearsImage: Reuters/J. Ernst

Carlos Casanova, an economist and Asia expert at BBVA Research in Hong Kong, agrees. "Higher interest rates and a stronger USD may be bad for Asia, as they could trigger capital to move out of emerging markets in Asia and into higher yielding dollar-denominated assets."

The pace of the outflows will depend on the pace of US interest rate hikes as well as the differential between both regions. While capital inflows boosted lending and consumption in many emerging markets across the globe, a reversal of these flows could affect countries which have depended on them to fuel growth, Casanova added.

Gary Hufbauer, an economist and international trade expert at the Washington-based Peterson Institute for International Economics, has a similar view. He argues the recent quarter-percentage-point hike by itself means very little.

"This was universally expected, so it was priced in the market. What counts is the trajectory going forward. The median view of Fed governors is that the rate will reach 1.4 percent at the end of 2016. If that proves accurate, the impact will be severe for some countries."

The hardest hit

Hufbauer explains that while 1.4 percent may sound like a low rate, what it implies is regular quarterly increases in the Fed's policy rates. "That will make financial markets nervous that the 'drumbeat' will continue until the policy rate is three percent or higher. If, at the same time, the world economy is only growing at two percent or so, lots of people will see the next recession around the corner," the trade expert told DW.

Most vulnerable are countries like the Philippines, Thailand, Laos, Cambodia and Bangladesh, with banks expected to be even more reluctant to lend to borrowers. Further rate increases by the Fed could also limit the scope for some major Asian economies which are still struggling with low inflation and growth headwinds, such as China and South Korea.

And for commodity exporters such as Indonesia and Malaysia, whose currencies have already fallen significantly against the USD, this is likely to create a rising burden of debt service costs, which could potentially affect growth.

"Commodities will be hit the hardest, as they face triple headwinds, including a slowing Chinese economy, low commodity prices and the beginning of a tightening cycle in the United States," Casanova explained.

Impact on currencies

The impact of such measures may also extend to Asia's largest economy, China. Experts point out that further Fed rate hikes will increase the attractiveness of the USD against most other currencies, including the Chinese yuan. "This could create a policy dilemma for the People's Bank of China (PBoC) in 2016," said Biswas.

The IHS expert argues the PBoC can either choose to keep the Chinese yuan (CNY) stable against the USD, possibly requiring further significant depletion of its foreign exchange reserves, or allow the CNY to fall against the USD which could trigger further capital flight.

"Faced with a choice between the devil and the deep blue sea, the PBoC may choose to set the yuan exchange rate against a trade-weighted basket of currencies," Biswas added.

The decision by the PBoC in December to launch a new index tracking the CNY against a basket of currencies indicates that Chinese authorities may indeed be considering setting the yuan exchange rate against a trade-weighted basket of currencies, rather than just the USD.

That could result in the yuan falling further against the USD during 2016, which would create competitive pressures for other East Asian economies, especially for exports into the US market, said the economist.

Meanwhile, Southeast Asian currencies such as the Malaysian ringgit and Indonesian rupiah have been amongst the weakest during 2014-15, having already depreciated significantly against the USD. "Both are expected to be vulnerable to further depreciation against the USD if the Fed continues to hike policy rates through 2016," noted Biswas.

But the picture is not entirely grim, particularly when it comes to countries such as India - whose current account deficit has been falling steadily in recent months and which has ample foreign exchange reserves to cope with sudden capital outflows in the short run.

IMF Scheine chinesisches Yuan
China's central bank launched a new index in December tracking the Chinese yuan against a trade-weighted basket of currenciesImage: picture alliance/dpa

Industry and property sector

But the impact may not be limited to currencies, with many expecting the Fed rate hikes to increase the cost of debt for Asian borrowers. The industry sectors in Asia most likely to be affected by tighter US monetary policy will be those that have been utilizing cheap USD credit to fund investments.

"Everyone will suffer, but the export industries will suffer most," said Hufbauer. "They will see a small increase in their borrowing rates, but more importantly they will find it hard to get new loans or to enlarge their lines of credit," potentially triggering debt defaults.

This problem may be acutely felt in China, where non-bank borrowers held an estimated $1.2 trillion of USD debt in mid-2015, according to IHS.

"The combination of moderating Chinese growth, excess capacity in key industries, rising USD yields and potential further USD appreciation against the yuan all create risks of further stress for some corporate borrowers, which could trigger an increasing number of corporate debt defaults in 2016," said Biswas.

The real estate sector - especially in places like Hong Kong, Malaysia and Singapore - has also seen significant investment inflows driven by low interest rates and excess liquidity. It is therefore seen as vulnerable to corrections as monetary conditions tighten.

Chinesische Zentralbank Hauptsitz Peking 2014
'The US rate hikes could create a policy dilemma for the People's Bank of China in 2016,' said BiswasImage: Reuters/Petar Kujundzic

What can Asia do?

Trade expert Hufbauer fears that a regular 0.25 percent quarterly rate hike in 2016 would further depress growth in Asian economies. Given these concerns, a question often raised is what Asian economies can do to mitigate the impact of future Fed raises. Hufbauer argues that they should let their currencies decline against the dollar, if that's what the markets want.

Economist Biswas says these countries can implement macroprudential measures to buffer themselves against any potential fallout from the Fed's decisions.

"Macroprudential measures similar to those imposed by some Southeast Asian countries during the real estate boom - such as imposing higher collateral requirements for mortgages - can also be deployed selectively to stem volatile capital outflows from local equity and bond markets, or by reducing collateral requirements if real estate markets weaken," said Biswas.

But as BBVA analyst Casanova points out, the impact of future Fed rate hikes on Asian economies will ultimately depend on the pace and depth of interest rate normalization in the US. "Currently, markets are factoring in roughly two interest rate hikes in 2016, but the situation could worsen if the Fed hardens its hawkish stance."