US Fed's Interest Hikes and its Implications on Asia Businesses

The business environment in Asia Pacific differs greatly between developed and emerging countries. Due to well-developed financial and ITC sectors, as well as favourable trade policies and tax environments, Hong Kong, Singapore, Japan, and South Korea are ranked among the top places to do business globally. Meanwhile, due to rapid manufacturing and industrial expansion, China and India are regarded as global economic growth drivers; however, bureaucratic barriers, corruption, widespread poverty, and skill shortages pose challenges to development.
 

Emerging Markets of Asia-Pacific
Emerging and frontier financial markets in the Asia-Pacific region have experienced significant changes in recent years in areas affecting regulation, market participants, and products. This collection presents perspectives from authors in local markets who provide their analysis of the history, current development, and future outlook for 11 countries: Bangladesh, Cambodia, India, Indonesia, Malaysia, Mongolia, Pakistan, the Philippines, Sri Lanka, Thailand, and Vietnam. The brief should be particularly valuable for prospective investors interested in learning about regulatory developments, market structure, and financial history in the region.

An effort to combat stubbornly high inflation
To combat inflation, the Federal Reserve of the United States decided to bite the bullet and raise lending rates by 75 basis points (bps).This is the Fed's most aggressive rate hike in 28 years. According to reports, the Fed last raised rates by 50 basis points twice in a non-consecutive cycle in mid-1994.The latest rate hike is the third since March and the first of many more to come as the world's largest economy struggles to keep inflation under control, which reached a 40-year high last week.

In March 2022, the US Federal Reserve approved a 25 basis point rate increase, its first since December 2018. It then raised interest rates by 50 basis points in May. Fed chairman Jerome Powell told a news conference that the unusual rate hike will be an exception rather than the rule going forward: “From the perspective of today, either a 50 basis point or a 75 basis point increase seems most likely at our next meeting. Clearly, today’s 75 basis point increase is an unusually large one, and I do not expect moves of this size to be common.”

Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures," the Federal Open Market Committee said in a statement. The Fed's economic outlook is also bleak, with the economy expected to slow to 1.7% growth this year.Unemployment is expected to rise to 3.7% by the end of this year and continue to rise to 4.1% by 2024.

Why is the US Fed increasing rates and what’s next?
At the end of a two-day policy meeting on Wednesday (Jun 15), US officials agreed to a 0.75-percentage-point rate hike, bringing the benchmark federal-funds rate to a range of 1.5 to 1.75 percent.This latest move, which came on the heels of a quarter-percentage-point increase in March and a half-percentage-point jump last month, marked the Fed’s most aggressive rate hike since November 1994.The Federal Reserve of the United States is stepping up its rate-hiking strategy in an effort to contain inflation, which has reached a 40-year high.It hopes to cool demand in the economy by nudging consumers and businesses to cut spending by sharply raising interest rates and making borrowing more expensive.

A Growing concern towards US Stock Markets
This grim outlook has raised concerns that the US economy could be on a tailspin to recession and that the US stock markets are set to plunge 40 per cent. However, the US had posted a strong job growth even in May, indicating a post-pandemic economic recovery even if at a moderate pace. Unemployment rates held steady at 3.6% for a third straight month in May, giving the Fed courage to pursue it aggressive interest rate upcycling.

Despite the hopeful job market performance, wages have not been able to match the rise in inflation, so households have been hard pressed to manage their budgets amid rising food and gasoline prices. Besides, the 4.1 per cent jobless rate projected for 2024 indicates that there could be more unemployment as a result of companies tightening budgets amid the rate hikes. Some analysts say that companies might have fewer vacancies rather than opting cut costs by laying off workers.

What does that mean for economic growth and financial markets in Asia?
With the Fed increasing monetary tightening, Asian central banks are likely to feel increased pressure to go with. This is because a growing interest rate differential between the United States and Asia will raise concerns about capital outflows. The rise in interest rates in the United States creates two significant headwinds for Asia's economic recovery. Rising interest rates will be more damaging to the construction and energy industries, which are more rate sensitive.

Volatility in financial markets is expected to continue. On Thursday morning, Asian markets celebrated the widely anticipated rate hike, but brewing unease eroded gains throughout the trading day. Apart from concerns about surging inflation and the risk of a US recession, worries are also brewing over the health of China’s economy following strict COVID-19 lockdowns.

A Talk about the Past
Unfortunately, without exception in the past four decades, the Fed’s tightening cycle led to economic slowdown in the United States and/or preceded financial crisis in 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 oil price shock of 1990 to lead 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 1993-1994, 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 during 1994-1995, and in Asian economies during 1997-1998. 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 2008-2009. The last tightening cycle of the US Fed during 2015-2018 was cut short as quantitative tightening led to negative market reactions. Soon afterwards the world was hit by the COVID-19 pandemic.

Interest rate hikes in the United States would exert significant impacts on Asian economies through trade, exchange rate, and financial market channels. First, higher interest rates curb aggregate demand, hence reducing external demand for Asian exports. Second, higher yields on US assets attract international investment and create strong demand for dollars. The impact of the dollar appreciation on Asia’s trade remains ambiguous. Third, the transmission of higher US interest rates through international capital markets would exert downward pressure on local investment and consumption. 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.

Challenges faced by Asian Businesses
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.Emerging market economies are expected to navigate increasingly turbulent waters ahead. An immediate challenge for the region is to strengthen macroprudential surveillance and preempt new sources of financial instability.

•First, while still manageable, inflation has picked up in many regional economies, driven by strong economic recovery, high food and energy prices, and increased shipping costs. Monetary authorities in the region need to carefully monitor the risks of higher inflation and prepare to rein in inflation expectations. Once the Fed starts 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.

•Third, expansionary fiscal policy in response to COVID-19 boosted government debt issuance in many regional economies. The prospect of US interest rate hikes could increase the cost of borrowing even before the US interest rate hikes. The risk of debt vulnerability runs high, especially for the 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 region also needs to further local currency bond and capital market development to reduce 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, authorities need to remain vigilant and prepare for a sudden change in international investor sentiment. Effective capital flow management, including foreign exchange and capital control measures, is 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 illustrate that macroeconomic stabilization policies alone are not sufficient for safeguarding financial stability. Globalized finance requires a solid global defense against financial crisis. Effective financial safety nets should have multiple layers in both crisis prevention and crisis management. This must begin with sound macroeconomic policies at the national level, more flexible and targeted assistance at the regional leveland eventually backstopped by global cooperation.

Final Notes
Finally, 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. The region’s policy makers 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.