SO, what happens when US interest rates rise next year?
Well, if last summer is of any indication, then one would know what to anticipate when the US Federal Reserve (Fed) tightens its money further by raising interest rates.
Asia’s resilience to capital flight will likely be put to the test again as the expected change in the US monetary policy will improve US bond yields, hence, attracting global money flows.
What this means for Asian economies, including Malaysia, is that hot money will flow out and move back to advanced economies. The consequences of this will be volatility in the financial markets and depreciation of the currencies of Asian economies.
That is the trend we witnessed between June and September last year, after the Fed announced last summer its intention to begin scaling back its US$85bil-per-month bond-buying, or quantitative easing (QE), programme by end-2013, causing US bond yields then to spike.
And the same, according to most economists, is to be expected when talks of the Fed raising interest rates intensify in the months ahead.
In its global economic prospects report, the World Bank says a 100-basis-point increase in long-term US bond yields could potentially result in a 50% drop in capital inflows to emerging economies, leading to lower investment and growth.
The World Bank, hence, warns emerging economies against complacency, as there is a risk of capital flows reversing quickly when US interest rates rise.
“As a knee-jerk reaction among fund managers to a turnaround in developed economies’ interest rates, a reversal of capital flows from emerging economies such as Malaysia will likely take place,” says Alliance Research chief economist Manokaran Mottain.
On a positive note, he tells StarBizWeek: “But ultimately, when the dust settles, I think investors will look at the interest-rate differential between emerging and developed economies when considering where to put their money.”
Global markets had initially thought the Fed would start tapering its massive stimulus programme – aimed at keeping long-term rates low to kick-start growth and hiring in the United States – by September 2013, but that did not happen until three months later in December.
At the current QE-tapering pace of US$10bil a month, the Fed seems poised to end its bond-buying programme by October 2014.
So, the next focus is on when will the US raise its interest rates that have been maintained at super-low levels of 0%-0.25% for the past six years to support its weak economy.
Future US rates
Some economists expect that to happen as early as the second quarter of 2015, while others believe it will only take place in the second half of next year.
According to the International Monetary Fund (IMF), the Fed “may have scope to keep US interest rates super low past mid-2015”, citing future US growth could disappoint if the country’s interest rates rise too quickly.
The fund on Thursday cut its US growth forecast for 2014 to 1.7% from the earlier projection of 2%, but left its 2015 forecast unchanged at 3%.
But Fed chairman Janet Yellen (pic) had warned last week that US interest rates could rise “sooner than expected”, as the world’s largest economy had continued to show signs of encouraging improvement after being hit in 2008/09 by the worst global financial crisis since the Great Depression of 1929.
Meanwhile, market attention is also on the Bank of England, which looks set to raise its benchmark interest rate from the current record low of 0.5%, as economic growth also seems to have become more entrenched in the United Kingdom.
The Malaysian Institute of Economic Research (Mier) in its recent briefing on Malaysia’s economic outlook says the country, along with other emerging economies, remain susceptible to the risk of destablising capital outflows amid monetary policy changes by advanced economies.
The think tank’s executive director Dr Zakariah Abdul Rashid says: “Capital flows are in a state of instability due to global portfolio reallocation (from emerging economies) back to advanced economies amid potential policy adjustments.”
In its recent report, Public Investment Bank also points out that the eventual monetary tightening on the back of continued economic improvement in advanced economies “will be a bane to global market” due to hot-money outflows.
Hot money inflows
Easy-money policies in the developed economies, particularly in the United States, in recent years have fuelled dollar-carry trades to Asian economies as investors chase higher yields.
While there had been several bouts of capital outflow from Asian economies – the most serious of which happened last year – hot money has started pouring into the region once again in recent months.
According to the World Bank, the rebound in capital inflows to emerging economies started in March, as evidenced by the rally in their capital markets.
“In part, the recovery in flows reflects a resurgence in carry trade investments, with investors borrowing at low rates in high-income countries to earn higher returns in middle-income countries,” it points out.
Clearly, concerns of eventual interest-rate hikes by developed economies have yet to kick, while QE-tapering anxiety has long subsided.
For instance, MIDF Research’s fund flow report for the week ended July 18 showed global liquidity continued to flow into Asian equities in recent weeks, with foreign money inflow remaining particularly strong in South Korea, Indonesia and Thailand.
MIDF pointed out that data from the seven Asian exchanges that it tracked, namely Malaysia, Indonesia, Thailand, Indonesia, the Philppines, South Korea, Taiwan and India, showed that funds classified as “foreign” bought in net aggregate US$1.67bil worth of stocks for the week ended July 18. In the preceding week, net foreign inflows in those markets totalled US$2.63bil.
According to several brokers, global funds have also bought into the region’s debt markets, in particular Malaysian bonds, following the recent interest rate hike by Bank Negara.
Year-to-date, most regional currencies have also strengthened, as data from Bloomberg shows.
In Asia, the countries most affected by the sudden pullback in foreign capital last summer were India and Indonesia on account of their twin deficits. Their governments have been running on fiscal deficits, and both countries have huge and widening current account deficits, which reflect their dependence on external financing.
Malaysia and Thailand were not spared from having their financial markets and currencies battered last year, even though they did not have the so-called “twin deficits”. Both countries have fiscal deficits, but their current accounts were in surplus, albeit had then appeared to be deteriorating then in the eyes of investors.
Will the same countries be among the more vulnerable to the risk of capital outflow when US raise interest rates?
Bank Islam Malaysia Bhd chief economist Mohd Afzanizam Abdul Rashid says the more vulnerable countries will still be those with twin-deficit problems.
“In this regard, Indonesia and India would become clear targets,” Afzanizam says, pointing to the countries’ high import bills that contribute to current account deficits, and high subsidy bills that contribute to persistent fiscal deficits.
“Malaysia, on the other hand, appears to be in good shape as the country is still enjoying current account surplus balance although the magnitude is smaller compared to previous years,” he notes.
Afzanizam points out that Malaysia’s dwindling current account surplus should not be a cause for concern, as the rise in the country’s imports bills is driven by capital goods, which means it is going to building productive capacity.
“In that context, Malaysia will unlikely be heavily penalised by the foreign funds,” he argues.
But there are economists who feel differently.
ANZ Research, for one, told CNBC last month that Malaysia could be more vulnerable to large capital outflows this round when the Fed tightens its monetary policy, than Indonesia and India.
The Australia-based investment banking group said the most likely targets this round would be countries with excessive foreign ownership of government debt (read: Malaysia), while pointing out that both India and Indonesia had put in efforts to rein in their budget and current account deficits in response to last year’s problems.
The IMF says policymakers should anyhow be prepared for renewed volatility in the days ahead. It says the key to shoring up the domestic economy lies in “robust balance sheets that withstand investor scrutiny at times of acute risk aversion” and “strong policy frameworks, which will typically include prudent fiscal policy, a credible inflation target, and exchange rate flexibility as the first line of defence against external shocks”. And that is certainly an advice that needs to be heeded.
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