2020 was a rough year for capital markets in Southeast Asia. As elsewhere in the world, the region saw huge outflows in March and April as investors panicked and dumped assets. This in turn sent local currencies into freefall, while the U.S. dollar skyrocketed. As the year went on and capital markets adjusted to the realities of the pandemic, the situation began to equilibrate. By the end of 2020, net capital inflows had returned to many of the largest economies in Southeast Asia. The Institute of International Finance expects a strong recovery in non-resident capital flows to major regional economies in 2021.
There are several factors at play here. One is that virtually every country in Southeast Asia has elected to run short-term fiscal deficits in order to pump stimulus into their pandemic-battered economies. This means governments have been issuing a considerable amount of debt and, at least so far, investors have been buying it. One big reason is because interest rates in the United States are extremely low. In response to the pandemic, the U.S. Federal Reserve dropped its benchmark interest rate to practically zero, sending yields on U.S. Treasury bills way down. When yields are so low in the U.S., it often pushes capital into assets with more attractive returns.
This is one likely explanation for why the U.S. stock market has been on a huge upswing since March, seemingly detached from economic reality. It also helps explain why capital has once again started flowing into big emerging markets like Indonesia and Thailand. Investors are apparently expecting them to snap back pretty quickly as vaccination programs kick into high gear in 2021, and they offer returns that are far in excess of what a U.S. Treasury bill would yield. The benchmark rate in Indonesia, for instance, is currently 3.75 percent.
Things are playing out very much as they did in the wake of the Global Financial Crisis, when low-rate environments in the U.S. and Europe pushed investors toward markets like Indonesia and Brazil that were offering much higher rates of return. But there is a catch: if assets in the U.S. start to offer higher yields again, such capital flows can easily reverse themselves and wreak havoc on emerging market currencies, which can in turn spread quickly to the real economy.
This is what happened in 2013 when the Federal Reserve telegraphed that it would be winding down its quantitative easing program, causing yields on U.S. Treasury bonds to go up. This event became known as the Taper Tantrum. As supposedly “safer” assets in the U.S. were now expected to increase their yields, it caused a sudden stop in capital flows to emerging markets that had fairly severe contractionary effects on countries running big current account deficits. What’s to stop that from happening again if yields on U.S. Treasury bills go up in the near future?
There are steps emerging markets can take in order to make the most of capital inflows, while insulating themselves from the volatility of capital flight. Indonesia’s central bank began monetizing billions of dollars of public debt in 2020. That means that while foreign investors are buying some of it, the central bank holds a lot as well and this should give it some degree of control in the event of a sudden sell-off.
Macroprudential policies that direct capital toward productive investment, such as infrastructure or business loans, rather than fueling the expansion of consumer credit bubbles, also tend to help. In Thailand, where the government is by its very nature wary of capital inflows strengthening its currency, much of its recent borrowing has been very short-term in nature, possibly reducing its exposure to long-term volatility.
Perhaps these steps will prevent a repeat of the Taper Tantrum. But the fact remains that when yields on U.S. bonds begin to inch up again, it is likely this will cause capital flows to shift and could touch off another round of capital flight in emerging markets that have borrowed to fund fiscal stimulus during the pandemic. This underscores the duality of foreign capital as both an important tool of growth and as a source of volatility. Whether monetary authorities have learned enough from 2013 and taken sufficient steps to maximize growth while reducing potential volatility remains to be seen.