Emerging market economies, especially in Asia, are faced with the difficult choice of either racing to the top with rate hikes or to the bottom with their currencies. To their chagrin, it is becoming increasingly complicated to choose whether to fight inflation or let their currencies do the talking through depreciation.
The US Federal Reserve’s quantitative tightening and rate hikes have meant that the dollar returns more than other assets, luring capital back into the largest economy.
The Fed has little choice in the face of four-decade-high retail inflation that topped 8 percent in May. It has hiked rates by 150 basis points (bps), so far, this year and is expected to increase them by another 150-200 bps.
The US central bank has begun shrinking its balance sheet by offloading bonds worth $47.5 billion monthly, which will be increased to $90 billion after three months.
In a nutshell, it is aiming to raise real interest rates sharply so as to offset the erosion of value of money due to inflation. The Bank of England and the European Central Bank have also followed this path. What should Asia do?
Asia’s inflation tryst
Unlike the US and other advanced economies, Asian countries have had periodic inflation flare-ups. Irrespective of the source of inflation, Asian central banks have responded with tightening.
Hiking policy rates make sense as interest rates crimp demand and limit inflationary expectations getting entrenched. Further, the interest rate differential with the US remains narrow, attracting capital into the country or limiting outflow somewhat.
Now, more than ever, Asian countries will need to limit the flight of capital from their shores to the US. What makes this episode of capital flight severe is the external shocks of the coronavirus pandemic and the Russia-Ukraine war. Both events have increased risk aversion and investors have preferred to stay off Asian markets, something evident from the sharp drop in equity indices and exchange rates in the region.
The pressure on exchange rates is making the job of Asian central banks complicated since it adds to imported inflation. Much of the inflation problem is tied to energy prices and most Asian economies are net importers of energy products such as auto fuels and natural gas. Therefore, a weakening exchange rate adds to elevated inflation which erodes the value of local currency assets, exacerbating capital outflows.
Indonesia imports refined petroleum and also gas, nearly 20 percent of Thailand’s imports are fuel, Malaysia imports minerals and oil and India’s biggest import is crude oil.
“The region has high imports of energy and fertilisers. They are tackling inflation shock by managing both currency and interest rates. In an imported price shock scenario there is very little to be done beyond fiscal measures,” said Rahul Bajoria, chief economist, India, at Barclays.
But fiscal measures have their own complications. Subsidies are expensive and tax cuts tend to reduce the fiscal ability to spend when it is crucial to prop up the economy.
For instance, the subsidy burden for Indonesia and India has increased as each country aims to offset the rise in energy and fertiliser prices. Fiscal deficits are expected to soar among Asian economies, yet another red alert for capital inflows.
In short, for Asian central banks, it pays to slay the inflation beast. Bajoria believes that the balanced approach of these banks, so far, has served them well. “They are tackling inflation shock by managing both currency and interest rates,” he added.
The single biggest worry that has Asian central banks holding off on aggressive tightening is the impact it will have on the still fragile economic recovery.
True, activity has reached pre-Covid levels and in some countries even exceeded those levels. Even so, central banks are far from being confident about the sustainability of the recovery.
Even worse are the rumblings of a US recession. The Fed’s rate hikes have increased the odds of a recession in the US. The same holds true for the UK and euro-area economies.
Asian economies depend on advanced nations for capital as well as exports. A recession would mean a direct hit on exports for Asia, dragging its already dampened economic growth down further.
At such a time, a weaker currency acts as a soother to export realisations and helps support growth back home.“The expectation is that central banks in Asia would let their currency slip rather than over-hike and match the Fed’s pace,” said Abheek Barua, chief economist at HDFC Bank. “No central bank can ignore inflation. There are some more hikes to go but it would be significantly less than what the Fed can do.”
Here is another quandary. China and Japan have been accused of currency wars in the past, where the countries have deliberately kept their exchange rates weak against the dollar. A currency war that keeps exchange rates weak to boost exports would rub off on other Asian currencies as well.
Note that the Bank of Japan is the only central bank with a loose monetary policy and the yen has weakened a massive 10 percent since January. The Chinese yuan has lost 5 percent in the same period. Other Asian currencies are not far behind, down 3-6 percent. Letting exchange rates depreciate may not give an edge beyond the immediate comforting effect on realisations.That brings us to rate hikes again. Economists believe that some Asian economies would opt for aggressive rate hikes but not to the extent of the Fed. Others may still weigh the repercussions of the same and postpone tightening as much as they can. Either way, the current year would be tougher to navigate for Asia.