A new crisis for Asia’s emerging economies?

Countries around the globe have been nervously paying attention to the world’s advanced economies. Many have still not been able to embark on a sustainable path of recovery since the global financial crisis.

The United States, the euro zone, the United Kingdom and Japan essentially exhausted conventional monetary policy measures by guiding their policy interest rates to almost zero. These economies have now been dosed with unconventional measures, including large-scale asset purchases and quantitative easing.

While the advanced countries have been struggling to jumpstart their economies, others, especially emerging market economies, have become good investment destinations for international investors. Until recently, policy makers in emerging market economies had to manage this influx of ‘hot money’ and the related danger of currency appreciation, which could harm the trade competitiveness of these export-dependent economies. The appreciation pressure was mitigated by foreign exchange interventions — but despite sterilisation efforts, these measures started to create inflationary pressures in some countries. Thus, many emerging market economies faced the trade-off of stabilising their currency values or retaining monetary autonomy and restraining inflationary pressure.

More recently, the tide of the world economy seems to have changed. The US and Japanese economies have started showing some signs of recovery, while the euro debt situation seems to have stabilised. This has created a different type of dilemma for many emerging market economies. On the one hand, the recovery of advanced economies is beneficial because they are important trading partners after all. On the other hand, recovery in the advanced world could change the direction and volume of capital flows. A number of emerging market economies that are particularly dependent on external capital, such as Brazil, India, Indonesia, South Africa, and Turkey—the ‘Fragile Five’—already experienced a rapid depreciation of their currencies last year. All this poses the question: could Asia’s emerging market economies be facing a similar situation to the one immediately before the Asian financial crisis?

Overall, this does not appear to be the case. The economies that experienced financial crises in the 1990s (principally Indonesia, South Korea, Malaysia and Thailand) experienced persistent, sizeable current account deficits. Now, all these economies, and others in the region, have much better current account balances; and except for Indonesia they have significantly increased their reserve holdings, reflecting their precautionary motives. The growth of both private credit creation and stock market capitalisation, which can be good predictors of asset markets overheating, is also mostly contained compared to the pre-Asian crisis period. In addition, capital inflows have not been as strong this time round: on average these economies have experienced moderate outflows of capital since the beginning of the 2000s. And along with the high level of international reserve holdings, the pressure on foreign exchange markets is not high. Furthermore, in terms of open macro policies, in the framework of the trilemma hypothesis, Asian EMEs on average have higher levels of monetary autonomy and exchange rate flexibility than in the pre-Asian crisis years of the 1990s. Economic indicators and policy management therefore paint a rather benign picture.

Yet it has also been argued that financial globalisation has now made domestic asset prices and interest rates more vulnerable to developments in capital markets abroad — if domestic financial markets are more susceptible to international factors, this could help decouple short-term and long-term interest rates. In fact, in recent years, the correlation of long-term interest rates between Asian EMEs and the United States has been rising while the correlation of short-term rates does not show such a trend. The results of an empirical exercise I have conducted suggest that the greater amount of net capital inflows would weaken the link between short-term and long-term interest rates. Further, EMEs with more open or more developed financial markets tend to face a greater deal of decoupling of short-term and long-term interest rates when they are exposed to more net capital inflows. Thus, while monetary policy makers have more direct control over short-term interest rates, long-term yields are more affected by global factors if the domestic market is open to international investors. Because long-term interest rates affect both financial and real activities more directly, a decoupling of these rates could also mean policy makers have a harder time in managing both macroeconomic and financial stability.

What does this mean for regional economies?

First, as they become more open to cross-border capital flows, policy makers need to be aware of these increased difficulties. Second, despite the possibility of losing their grip on longer-term yields, it may be some time before this happens, because regional economies are still working on financial liberalisation. And, third, there is still room for financial development as well.

Asian emerging market economies are expected to continue to develop their financial markets in an effort to catch up with Japan and other industrialised countries. While China is on its way to catching up with Japan, and even the United States, in terms of market size, the United States is still the sole winner in terms of stock market total value. More importantly, China and other emerging market economies have lagged behind industrialised countries in the capitalisation of private bond markets. Considering that only well-developed financial systems provide deep and liquid private bond markets, this should be a priority for Asian economies.

All this suggests that, at present, the possibility of losing control over longer-term interest rates is less of an issue for Asian economies, because their financial systems are still based on short-term financing. But this also means that Asian emerging economies are facing an interesting dilemma. While they want to develop financial markets to finance longer-term needs, if that happens, their control over longer-term interest rates will become a greater issue.

Hiro Ito is professor of economics at Portland State University. This article digests a paper presented to the Thirty-Sixth Pacific Trade and Development Conference at the Hong Kong Monetary Authority in Hong Kong.