One of the harsh realities of global economics is that sometimes an action that is for the good of one country is not so good for others. This is true for the planned normalization of US monetary policy: A potential winding down of the US Federal Reserve’s massive asset-buying measures, although not yet in place, has led to a sell-off in Asia’s emerging markets in recent weeks.
That is because foreign funds, which have poured money into the region over the past few years, have started pulling out to meet redemption demand back home or to take shelter in the US currency, as the Fed appears set to scale back its third round of quantitative easing (QE) as early as next month. This means that the US central bank is going to stop supplying US dollars at a very low cost to the market from which investors have borrowed to put funds into Asia for higher yields.
There is no doubt that the Fed’s QE program, plus other similar monetary easing measures adopted by Japan’s and Europe’s central banks, has created a credit bubble in Asia’s emerging economies in recent years. Therefore, the Fed’s tapering of its monetary stimulus is, as some economists have put it, akin to a “margin call” on Asia to kick start a process of greater exchange rate and stock market volatility for regional economies, especially those with sizable current account deficits or inflexible exchange rates.
No wonder the recent signs of financial instability in India and Indonesia have rekindled some people’s painful memories of the Asian financial crisis 15 years ago. More subtle, but also much more threatening, are the worries about the chaotic situations triggered by capital outflows spreading to other parts of the region, such as Thailand and Malaysia.
Even though most emerging economies in Asia have so far proved resilient, the risk of financial contagion is increasing and it could reach breaking point if investors think the same sort of currency depreciation and stock plunges will soon happen in other markets.
However, the Fed’s planned QE exit is inevitable and so is the outflow of hot money. As long as hot money continues flowing into Asia, financial imbalances will remain here. If the Fed’s unconventional program must be unwound, the questions to be asked are: When will it happen, in what form and for how long?
Moreover, caution is advised over the potentially higher volatility and more painful corrections the market may experience when the Fed starts to tighten its monetary policy with interest rate hikes.
For now, the more pressing challenge for Asian emerging markets is to make sure their financial regulations are both effective and workable. Central bankers in this region are facing the challenge of trying to adopt balanced policies that can maintain a competitive national currency without increasing inflation and can rein in capital markets without compromising economic development.
While the worst-case scenario — the re-emergence of the 1997 to 1998 Asian financial crisis — might be far-fetched at this point in time, emerging economies remain vulnerable to the combined factors of China’s economic slowdown, moderate growth in advanced economies elsewhere and the foreseeable QE exit by the Fed.
Despite there being no quick fix for all these issues, it is urgent that regional governments maintain market confidence in the short term and work hard to reinforce profit prospects supported by solid growth in the long term.