Fed policy a risk for Asia's recovery

Editor's note: The US Federal Reserve makes decisions with the sole aim of boosting the US economy. By doing so, the Fed disrupts the international financial systems and causes immense harm to developing countries, including Asia's emerging economies. Three experts share their views on the issue with China Daily.

The fight against the COVID-19 pandemic has left a large imprint on the US Federal Reserve's balance sheet. Since the outbreak of the pandemic in early 2020, the Fed has purchased a wide range of assets and pumped liquidity into the US financial system to cushion the impact of the pandemic and fiscal stimulus on interest rates.

As a result, its balance sheet ballooned to nearly $9 trillion, compared with the pre-pandemic level of $4 trillion. To put this number in perspective, the added $5 trillion in the Fed's assets is roughly the same size of total overseas claims by Asian banking systems.

With the extraordinary fiscal and monetary policy support, the US economy has staged a strong recovery since the third quarter of 2020. The economy grew 5.7 percent in 2021, which is the highest annual growth since 1984. Domestic demand has been rising even faster. By any measure, the US economy now runs on its full capacity. The unemployment rate has fallen below 4 percent and inflation climbed to 7.9 percent.

Besides, despite the Russia-Ukraine military conflict creating considerable economic uncertainty, the Fed raised its policy rate on March 16, the first time since 2018, to curb inflation.

Unfortunately, the Fed's tightening cycle has often preceded economic slowdown and financial instability in the United States and emerging market economies. Between 1980 and 1982, monetary tightening led to a recession. Interest rate hikes between 1986 and 1989 triggered the savings and loan crisis and later, combined with the subsequent oil price shock in 1990, led to a brief recession in the US.

The Fed embarked on tightening in 1993, leading to significant rises in long-term rates and companies' borrowing costs. While the US avoided a recession during this tightening cycle in 1993-94, a sudden reversal in capital flows and the collapse of the Mexican peso in December 1994 led to a series of financial crises in several Latin American countries in 1994-95 and Asian economies in 1997-98.

Worse, monetary tightening between 2004 and 2007 pricked the bubble in the US housing market and pushed the global economy into a financial crisis and an economic recession in 2008-09. The last tightening cycle of the US Fed during 2015-18 was cut short as quantitative tightening led to negative market reactions. Soon afterward, the world was hit by the COVID-19 pandemic.

Interest rate hikes in the US have significant impacts on Asian economies through trade, exchange rate, and financial market channels. For example, higher interest rates curb aggregate demand, and hence reduce external demand for Asian exports.

Also, higher yields on US assets attract international investment and create strong demand for dollars. This increases the dollar funding cost for Asian economies who need to borrow from overseas for their investment, while the impact of the dollar's appreciation on Asia's trade remains ambiguous given the weakening global demand.

And the transmission of higher US interest rates through international capital markets would exert downward pressure on local investment and consumption. In fact, empirical evidence shows that local interest rates in Asian developing economies respond to short-term US rates in a strongly positive manner regardless of existing exchange rate regimes.

Although emerging market economies are expected to navigate increasingly turbulent waters, an immediate challenge for the Asian region is to strengthen macro prudential surveillance and preempt new sources of financial instability.

First, while still manageable, inflation has picked up in many economies in the region, driven by high food and energy prices, increased shipping costs, and depreciating currencies. So monetary authorities in the Asian region need to carefully monitor the risks of higher inflation and take measures to rein in inflation expectations. With the Fed raising interest rates, local currency depreciation driven by widening interest differentials could further complicate the inflation battle.

Second, an extended period of very low interest rates has created a legacy of record-high debt in both corporate and household sectors. As the authorities lift regulatory relief and forbearance measures while monetary policy support wanes, there will be lagged effects of COVID-19 on corporate defaults and loan losses.

Nonperforming loan ratios have already risen in a number of regional economies, albeit from a low base. Hence, financial authorities should closely monitor the risks and take early actions to prevent the buildup of systemic risks. For instance, preventive debt restructuring can offer companies a second chance at rehabilitating debts and help banks assess the debt risks with more certainty.

Third, thanks to the expansionary fiscal policy in response to the pandemic, governments in many regional economies increased their debt issuance. So the risk of debt vulnerability runs high, especially for economies facing high external debt service burden while sustaining large structural current account deficits and holding insufficient foreign exchange reserves.

In order to mitigate external vulnerabilities, more proactive public debt management is needed, for example, by lengthening the maturity structure and building a more sustainable debt service profile. The Asian region also needs to accelerate local currency bond and capital market development to reduce its reliance on external debt financing and improve financial resilience.

Fourth, massive and at times highly volatile global capital flows can disrupt the region's macroeconomic and financial stability. With the imminent changes in the US monetary policy stance, capital flows to the region could reverse with the risk of sudden stops. Although the region's strong growth outlook and healthy external positions mitigate the risk, the authorities need to remain vigilant and prepare for a sudden change in international investors' sentiment. In this regard, effective capital flow management including foreign exchange and capital control measures are key to that preparation.

Fifth, emerging market and developing economies in the region would benefit from strengthening the global and regional safety net arrangements to support crisis prevention and management.

Past financial crises show that macroeconomic stabilization policies alone are not enough to safeguard financial stability. Globalized finance requires a solid global defense against financial crises. So effective financial safety nets should have multiple layers of both crisis-prevention and crisis-management, which must begin with sound macroeconomic policies at the national level, more flexible and targeted assistance at the regional level, and eventually backstopped by global cooperation.

And sixth, strong economic recovery is the only way out of the crisis. Asia needs to seize the opportunities arising from rapid digital transformation to further boost productivity and capture potential gains in economic growth and employment.

As such, the region's policymakers must promote broader and more equal access to digital opportunities by enhancing digital infrastructure and expanding human capacities, especially for the poor and disadvantaged, through investments and policy reforms in education, health and public services.

Park Cyn-Young is a senior economist with the Asian Development Bank. The views don't necessarily reflect those of China Daily. 

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