The US Federal Reserve, in the latest Federal Open Market Committee (FOMC) meeting, signaled their first post-pandemic rate hike as soon as 2023, sending the dollar sharply higher. This comes as rising inflation has threatened the Fed’s patience for keeping borrowing costs at rock bottom. The Fed’s surprise of raising interest rates has exacerbated declines in assets from emerging Asian markets. As per analysts, the change in monetary policy outlook could cool the sizzling rally in Asia’s emerging markets (EM) and spur more capital outflows. This can change growth prospects for economies, that are yet to fully recover from the pandemic recession.
With the speculation of spillovers from higher US rates and stronger USD, investors have already started to flee exchange rates from emerging Asian countries this month. The EM currencies just pulled back from all-time highs, and, are still well up this quarter. The MSCI Emerging Markets Index of currencies dropped 0.5% in 2021, after climbing 3.3% last year.
Furthermore, stock markets in Thailand, Malaysia, the Philippines, and South Korea also suffered net outflows of capital in May 2021, amid inflation rise and chances of interest rate hikes in the US and Europe. The rush into emerging market assets faced its first backdrop in May. International investors sold $500 m more stocks and bonds than they bought in Asian emerging markets, data by Institute of International Finance suggested. The MSCI’s Emerging Markets, a broad index of equities in 27 countries, slipped about 5% from last week’s historic high.
The risk posed by rising global interest rates could also change the course of capital inflows in the region. As per the International Monetary Fund (IMF), capital inflows to Asia’s emerging markets are showing signs of drying up. This will be in contrast to last year’s figures. While Foreign Direct Investment (FDI) slumped around the world last year, it held up remarkably well across Asia in 2020, where interest rates are relatively low. FDI in China and India, grew the most, by 4% and 13%, respectively.
How likely are interest rate hikes in Emerging Asia?
As a path out of the Covid-19 pandemic and its economic fallout, central banks across Asia provided record-low lending rate cuts since last year, in the hope of spurring domestic borrowing. This helped for keeping liquidity up within financial institutions, allowing them to lend more freely to businesses.
Most of Asia’s emerging economies, including India and Indonesia, are keen to hold benchmark interest rates steady through 2021. Just after the Fed’s meet, Bank Indonesia kept rates on hold to assist domestic economic fallout, amid spiking coronavirus infections in Indonesia.
The central banks of China, Thailand, and the Philippines are to announce policy decisions this week. Both the Bank of Thailand and Bangko Sentral ng Pilipinas are expected to keep interest rates unchanged. The central bank of China is also expected to leave its benchmark rate unchanged, UOB Global Economics & Markets Research said in its latest report. The Bank of Japan also decided last Friday to leave interest rates unchanged in its monetary policy meeting.
“To support economic recoveries, Asian central banks are expected to maintain their accommodative stance and avoid hinting at future rate hikes,” Duncan Tan, rates strategist at DBS Banking Group told Bloomberg.
On the other hand, the central bank in South Korea has said its improving economy on the back of tight supply and sustained demand for tech products may eventually justify higher interest rates.
While some economists suggest actual rate hikes are clearly years away, some say that developing central banks may outpace the US in policy tightening. Mansoor Mohi-uddin, chief economist at Bank of Singapore Ltd told Bloomberg that emerging-market central banks are set to begin raising interest rates well before the Fed.
Central banks preparing their defenses
As a buffer against market volatility, Asia’s central banks accumulated their highest level of foreign exchange reserves since 2014. Central bank holdings of foreign currencies in Asia’s fast-growing emerging economies hit $5.82 trn as of May 2021($2.6 trn excluding China).
Amid a weaker US dollar and increased portfolio inflows, policymakers from emerging economies are deliberately preparing their defenses, Nicholas Mapa, an economist with ING Groep NV told Bloomberg. “They’re all the more aware of the eventual reversal in monetary policy stance of developed market central banks and the potential repercussions that may arise from a Fed taper or eventual rate hike,” she added.
While China’s foreign-currency holdings rose to their highest level in five years at $3.22 trn last month, India also built up record foreign-exchange reserves of more than $600 bn.