Asia Versus The Fed


Asia’s divergence with the world’s biggest economy is set to widen with the U.S. Federal Reserve’s likely move on interest rates next week. However, the gap may not last for long should the world economy run into more trouble.

Market economists expect the U.S. Federal Reserve to make its first interest rate hike in nine years following its September 16-17 meeting, despite warnings from both the International Monetary Fund (IMF) and World Bank of possible market turmoil.

On Thursday, market pricing put the odds of such an increase at just 28 percent, compared with more than 50 percent a month earlier, reflecting recent equity and currency market volatility on the back of the “China shock.”

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World Bank chief economist Kaushik Basu told the Financial Times that China’s slowdown and a U.S. rate hike would have negative effects on the global economy, including the risk of “panic and turmoil” in emerging markets.

“I don’t think the Fed lift-off itself is going to create a major crisis, but it will cause some immediate turbulence,” Basu told the financial daily. “It is the compounding effect of the last two weeks of bad news with that [China devaluation] . . . In the middle of this it is going to cause some panic and turmoil.”

“The world economy is looking so troubled that if the U.S. goes in for a very quick move in the middle of this, I feel it is going to affect countries quite badly,” he said.

Basu said the Washington-based lender’s June forecast of 2.8 percent global growth faced headwinds from the slowdown in emerging economies such as China and Brazil, along with anemic growth in many industrialized nations.

The IMF has also urged the Fed to adopt a cautious approach before ending its easy money policy. Managing Director Christine Lagarde told the Group of Twenty (G20) meeting in Turkey that “it is better to make sure that data are absolutely confirmed, that there is no uncertainty, neither on the front of price stability nor on the employment and unemployment front, before it actually makes that move.”

However, with the U.S. economy expanding by 3.7 percent in the June quarter, unemployment falling to a seven-year low of 5.1 percent in August, and inflation staying consistently below the Fed’s target of 2 percent, other economists have urged the Fed to take a more aggressive approach.

“The Fed has been behind the curve” in tightening policy compared to previous periods, given the near halving of U.S. unemployment from its global financial crisis peak, BetaShares chief economist David Bassanese said.

U.S. housing starts have also rebounded but remain below their long-run average, indicating that more upside is ahead for this key cyclical driver, while U.S. stocks are in a solid “bull market,” the Australian economist said.

“I think the Fed will tighten – September is looking a good bet unless markets have a much deeper downturn than we’ve seen so far. While it will be negative for the [stock] market in the short term, over the next three to five years the U.S. will still be in a bull market, and prices should move up beyond the next few months,” he said.

Based on previous experiences of Fed tightening in 1994, 1999 and 2004, Bassanese said in two of three such instances the U.S. stock market had moved higher within six months of the interest rate increase.

Asia Loosens

Yet while the Fed weighs up tightening, Asia’s major economies are loosening policy settings further in a bid to offset weakening economic growth.

The People’s Bank of China has already moved to devalue the yuan and cut interest rates in the wake of August’s massive sell-off in Chinese stocks, which rocked global markets. With key manufacturing surveys flashing red warning lights for the authorities, analysts suggest further interest cuts are likely as Beijing seeks to prop up a faltering economy.

On September 8, China’s Ministry of Finance announced a more “proactive” fiscal policy to support the central bank’s accommodative monetary policy, including potentially more bond issuance by local governments, aimed at supporting the official 7 percent gross domestic product (GDP) growth target. A day later, China’s State Council flagged further reforms to state-owned enterprises, increasing the potential for privatizations.

ANZ Research said the central bank likely would cut its reserve requirement ratio by another 0.5 percentage point in the fourth quarter, with GDP only running at an estimated 6.4 percent currently. However, other analysts have suggested the Chinese economy may have slowed to half the official growth target, requiring more action from the authorities to boost the world’s second-largest economy.

Meanwhile, the Bank of Japan (BoJ) may be set to further expand its quantitative easing program amid faltering growth in the world’s third-biggest economy, which has been hit by the slowdown in its largest trading partner.

Eleven of 35 respondents to a Washington Post survey of Japanese economists expect the BoJ to step up its easy money policy at its October 30 meeting, marking a year since its last asset expansion. Two of those surveyed predicted a move as early as next week, according to the September 7-10 poll.

Falling oil prices and sluggish domestic demand have hindered the central bank’s move to revive inflation to its 2 percent target, with its main gauge of inflation dropping to zero in July.

The October 30 meeting could be a “good opportunity” to inject more stimulus of at least 10 trillion yen ($83 billion), ruling party lawmaker Kozo Yamamoto said.

“The China shock has changed the whole picture,” Mizuho Research Institute’s Hajime Takata said. “Even it doesn’t move next week, it will have to take action soon. As in the early 2000s and in 2007, it’s always been external shocks that have destroyed Japan’s recovery.”

U.S. economist Paul Krugman has warned that Japan needs to do more to escape its “deflationary trouble,” with the economy lacking sufficient momentum to change expectations.

In a bid to revive Abenomics, Japanese Prime Minister Shinzo Abe has flagged cutting the corporate tax rate by 3.3 percentage point over the next two years, while the ruling coalition is considering offering a partial rebate for consumption taxes imposed on food when the consumption tax rate rises to 10 percent in 2017.

However, Asia’s increasing divergence with the Fed may not last long. Citigroup’s chief economist Willem Buiter has estimated a 55 percent chance of a global recession in the next two years, forcing central banks in the United States, Japan, Europe and elsewhere to ramp up stimulus.

Unlike previous downturns, this time the slump could be led by emerging markets such as China, which have until recently been the engine of the global economy.

“We consider China to be at high and rapidly rising risk of a cyclical hard landing,” Buiter was quoted saying by the Australian Financial Review. He noted China’s excess capacity in key sectors as well as recent steep falls in Chinese stock and property prices.

“Should China enter a recession – and with Russia and Brazil already in recession – we believe that many other emerging markets, already weakened, will follow, driven in part by the effects of China’s downturn on the demand for their exports and, for the commodity exporters, on commodity prices.”

Buiter suggests the recent pick-up in industrialized nations such as the United States has been insufficient to offset the slowdown in the developing world, although a global recession could still be avoided if the major economies ease policies.

As the world holds its breath ahead of the Fed’s key policy meeting, Asia can only hope it has sufficient fiscal and monetary firepower to ride out the expected storm.

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