Official interest rate cuts by Indonesia and India have signified Asia’s growing divergence from the West on monetary policy, as China’s policy moves assume increasing significance. Yet while emerging markets have continued to rally, the risks have intensified for those most exposed to capital outflows.
On August 22, Indonesia’s central bank cut its policy rate by 0.25 percentage points to 4.75 percent, in what ANZ Research described as a “surprise” move to address subdued economic and credit growth.
According to Bank Indonesia, the rate cut is expected to strengthen the financial system as well as stronger economic growth, given a lower than expected rise in gross domestic product (GDP) of 5.01 percent in the second quarter of 2017, compared to the 5.18 percent of the same period last year. The bank blamed the sluggish expansion on reduced household and government consumption spending, while exports also slowed due a “tepid” global economic recovery.
Another rate cut may come in the fourth quarter according to ANZ Research, which said “the combination of weak macro data, within-target inflation and diminished external vulnerabilities do make a case for further easing.”
In what was described as a “neutral” easing, India’s central bank also cut official rates on August 2, dropping 0.25 percentage points to 6 percent.
Explaining its decision, the Reserve Bank of India said “some of the upside risks to inflation have either reduced or not materialized,” allowing for an easing of policy to support growth in Asia’s third-largest economy. Nevertheless, it still pointed to a rising trajectory of inflation from its current lows, with the central bank aiming to keep headline inflation “close to 4 percent” on a durable basis.
“Coming against the backdrop of unusually low inflation and sluggish growth, the cut was widely anticipated,” ANZ Research said, with the Australian bank also pointing to another rate cut in the fourth quarter of 2017.
Elsewhere in Asia, central banks have generally been more accommodative than restrictive. Japan, South Korea, and Thailand are among those expected to keep policy steady through 2017, while Vietnam has already cut rates to spur growth. The only exception to this trend might be the Philippines, which could start tightening policy from December, according to ANZ Research.
China’s money market rates have also hit nearly five month highs recently, amid efforts by the central bank to curb speculative lending, although it officially aims to maintain a “prudent and neutral” policy.
In contrast, the U.S. Federal Reserve is widely expected to hike rates again later this year after previous increases in March and June, with the next tightening potentially as early as September 20. Interest rate futures are pointing to a roughly “one-in-three” chance of a move by December, despite soft inflation data, according to Bloomberg News.
In July, the Bank of Canada announced its first interest rate increase in seven years, while the European Central Bank (ECB) has tapered its quantitative easing (QE) program amid expectations of tightening policy this year or next.
According to ANZ Research, “the divergence between Asia’s and U.S. monetary policy is understandable, given the decoupling between their respective business cycles since the [global financial crisis].”
Following the GFC, “Asia’s sensitivity to U.S. growth has greatly diminished while it has become a lot more reliant on Chinese growth. In that regard, the U.S. monetary policy outlook currently offers limited guidance on Asia’s, with domestic considerations and particularly developments in China having much greater bearing,” the bank said.
Slowing growth in India and Indonesia since early 2016 has pointed to rate cuts ahead, while middle-income Southeast Asian economies such as Malaysia and the Philippines have seen improved growth momentum from domestic demand. Inflation in Asia also remains low and generally within central banks’ target range, with little sign of increased inflationary pressures, ANZ Research noted.
“We see policy rates in Asia staying low for longer, with the Philippines the only exception, where we expect [its central bank] to start hiking rates in December this year,” it said.
Capital Economics also sees interest rate settings staying on hold in Asia for the remainder of 2017, except for Indonesia and Vietnam, which could cut rates “once more in 2017.”
According to the London-based consultancy, the year-on-year rate of inflation is now below 5 percent in all of emerging Asia’s major economies, with emerging Asia’s GDP growth rate steady at 4.2 percent in the first and second quarters of 2017.
While worries over the scaling back of the Fed’s QE program have previously rattled financial markets, Capital Economics said it should not cause “significant” problems this year or next.
“We think that the yields of ‘safe’ assets are likely to pick up a little in the next few years, especially in the U.S. where we expect interest rates to rise slightly faster than is currently discounted in markets. However, assuming that policymakers continue to tread carefully when it comes to unwinding asset purchases, we expect yields to rise only gradually, and ultimately to remain low by past standards,” it said in an August 24 report.
U.S. Treasury yields have fallen this year due to the Fed’s slow pace of tightening, while the ECB’s tapering is also likely to be gradual. For emerging markets (EMs), “our forecasts are for most EM central banks to leave their policy rates at already-low levels, or to reduce them further this year and next. This should help EM local currency bonds in particular to cope with the scaling back of QE,” it said.
Not all analysts are relaxed on the growing split between Western and Asian central banks, however. ANZ economist Weiwen Ng has pointed to China, India, Malaysia and South Korea as particularly exposed to the Fed’s tightening, due to deteriorating reserve adequacy.
A faster pace of tightening by the Fed could also put Asian currencies, stocks and dollar-denominated debt under pressure, particularly major debtors such as Hong Kong, Australia, China and South Korea.
In its latest Asia bond monitor report, the Asian Development Bank pointed to risks for East Asian bond markets including “tightening global liquidity conditions and the vulnerability of financial markets to cyberattacks.”
Analysts have also warned of growing divergence between the Fed and the ECB as sparking a currency war, which could hit Asian markets. US President Donald Trump’s focus on the large U.S. trade deficits with China and Japan has also prompted speculation of action on currencies, although Trump declined the opportunity to label Beijing a “currency manipulator.”
In a July 2017 report, Nikko Asset Management’s Robert Samson said “pockets” of EM would become “increasingly risky” as the U.S. and Eurozone central banks tighten policy further into 2018.
However, rather than the so-called “Fragile 5” of Brazil, India, Indonesia, South Africa, and Turkey being the most threatened, he suggested a “Fragile 2” or three, with recent reform efforts in India and Indonesia leaving the others as most exposed.
“We expect the EM rally will continue on the back of strong growth, but in 2018, performance is likely to diverge, with imbalanced economies that depend on foreign capital inflows likely feeling the strain of tighter policy by the Fed and the ECB,” he said.
“Both [central banks] intend to shift policy very slowly, and since global growth is broad and policy in China mostly accommodative, the sell-off (mostly confined to EM currencies) caused by [central banks] suddenly sounding hawkish in late June is unlikely to escalate into a taper tantrum as experienced in 2013. However, the steady removal of balance sheet support will start to become meaningful in 2018, reducing flows to EM with potentially pockets of outflows.”
However, should such strains broaden into a sufficiently negative pullback, he suggested that central banks “seem more likely to pull back rather than forge ahead as they will be eager to preserve their policy gains.”
In the meantime, attention may turn toward Beijing and its deleveraging efforts, even while the interest rate gap between East and West grows ever wider.