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Economic Research: Emerging Asia's Recovery Can Withstand A Reflation Trade

Not all U.S. yield shocks are created equal. S&P Global Ratings expects that the reflation lifting yields will affect Asian emerging markets' financial conditions and growth less than during the "taper tantrum" of 2013.

U.S. yields are rising mostly due to expectations of higher growth, rather than fears of imminent tightening, or monetary-policy shock. This time around, initial conditions in Asia are sturdier than they were in 2013. Current account surpluses, low inflation (for the most part), higher real interest rates, and fatter foreign-exchange reserve buffers give regional policymakers more flexibility. Even if capital outflows pick up, this lowers the odds that central banks will be forced into untimely measures that could strangle the recovery before it gathers steam.

Still, this does not mean we can relax. The effect of US$1.9 trillion in stimulus on U.S. inflation and rates remains uncertain. Markets can react in a non-linear way if inflation expectations surge above central bank targets and imminent tightening is priced in. In this case, we may see real yields (rather than inflation expectations) jump and the U.S. dollar appreciate at the same time. In our view, this would trigger disorderly capital outflows from Asia's emerging markets. India and the Philippines are the most vulnerable at the current juncture.

The 2021 U.S. Yield Shock--A Reflation Trade So Far

We highlight three important factors that determine vulnerability to external financial conditions in Asia and which are relevant today.

  • The nature of the shock. Yields can rise for more than one reason; some are more dangerous than others. Yields can rise because investors expect higher real interest rates, higher inflation, or require a higher risk premium. More than one of these factors may be moving at the same time.
  • Initial conditions. The most important of which is the fundamentals--including the current account and interest rates--in the countries hit by the shock.
  • The policy response. Particularly whether policies need to adjust in a way that can hurt domestic growth.

In our view, the nature of the shock is relatively benign, at this stage. So far in the cycle based on inflation-linked U.S. treasury bonds, markets are pricing in higher inflation more than higher real interest rates. Investors may be expecting stronger economic growth (and hence upward pressure on inflation in the future), the so-called "reflation trade." Investors might also be anticipating a Federal Reserve more tolerant of higher inflation.

In contrast, the 2013 taper tantrum was driven most by expectations of higher real interest rates and was not accompanied by rising hopes for global growth. In other words, it was a classic monetary shock which tightened financial conditions by raising the real cost of U.S. dollar credit. Chart 1 shows the evolution of the real yield and breakeven inflation.

Chart 1

image

This difference--between a reflation trade now and a monetary shock then--is important. Asia is the engine of global growth and if investors are more positive on growth, they are likely to be more positive on Asia. In turn, this may keep capital flowing to the region's emerging markets (EMs) even if higher U.S. yields do slow flows down.

Things can change quickly, of course. The Fed now focuses more on average inflation, which means past undershoots of the target could be compensated by overshoots in the future. If investors believe that the Fed has made a mistake in letting inflation get out of hand, then one of two things might happen, both negative for financial conditions in Asia. First, investors could require a higher risk premium on U.S. bonds. We might reasonably expect this to make investors more cautious more broadly, including on their Asian exposures. Second, investors might surmise the Fed will undo their mistake by hiking policy rates quickly, causing real yields to rise and again hitting Asia.

Initial Conditions Providing Some Protection

We believe that Asian economies are better cushioned against external shocks than during the taper tantrum of 2013.

First, emerging Asia's current accounts are mostly in surplus, in contrast to some big deficits in 2013. Thailand's weak tourism sector contributed to a deficit in late 2020, but current account balances were positive through most of the year and will likely return to surplus in 2021. This means economies are not as reliant on net external funding to power imports and investment. Of course, these surpluses in some cases reflect depressed economies, with high saving and low investment, and this should change as things get back to normal. For now, however, this will act as buffers to tighter global financial conditions.

Central banks have also built up buffers in the form of foreign exchange (forex) reserves which could be deployed for interventions if needed. They had been increasing their reserves following experiences during the Asian Financial Crisis, but the trend has continued since the taper tantrum. Central banks in India and Thailand have been more aggressive in building up reserve buffers, while Malaysia is the only member of the group where forex reserves have declined.

Table 1

External Positions Are Stronger Now Going Into The Taper Tantrum
Current account balance (% of GDP) Forex reserves (bil. US$) Real effective exchange rate gap (%)
Q1 2013 Q4 2020 Apr 2013 Jan 2021 Apr 2013 Jan 2021
India -4.43 2.96* 263 547 -2.38 -1.24
Indonesia -3.27 0.36 101 132 2.42 0.54
Malaysia 5.05 5.14 136 104 5.98 -0.6
Philippines 5.13 4.59* 72 98 5.83 3.12
Thailand -5.61 -1.60 169 243 8.07 0.29
*For India and the Philippines, current account balances are for Q3 2020. The real effective exchange rate is the trade-weighted exchange rate corrected for relative inflation. The real effective exchange rate gap is the difference between the BIS real effective exchange rate and its trend levels, calculated as the average of the Hodrick-Prescott filter and the Chirstiano-Fitzgerald asymmetric band-pass filter. The current account is the seasonally adjusted current account balance as a percent of seasonally adjusted nominal GDP. Sources: Bank for International Settlements, IMF, national statistical agencies, central banks, and S&P Global Economics.

Second, inflation in most cases remains low. This means that central bankers may be more tolerant of letting the currency depreciate in the event of capital outflows--while this could add to inflation, it will be less likely to force it well above inflation targets. If inflation was high, as it was in 2013, central bankers might hike policy rates, damaging domestic growth, rather than let the currency depreciate and add to inflationary pressures.

Third, real policy interest rates are higher in Indonesia, a key casualty in 2013. Policy rates are the anchor for market interest rates across the yield curve and the higher they are, the larger the buffer when investors compare rates across countries. Elsewhere, real rates are in some cases lower than in 2013 (see table 1). Overall, despite monetary easing last year, real policy rates in the region are not too far below normal, or long-run average, levels. This is because rate cuts were catching up with falling core inflation as domestic demand collapsed. We think there is room for monetary policies to remain accommodative, and hence central banks will be less likely to tighten policy in response to external funding conditions.

Table 2

Real Policy Rates Not Far Below Normal Levels
Inflation (%) Real policy rate (%)
Apr 2013 Feb 2021 Apr 2013 Feb 2021
India 8.49 5.03 0.97 -1.89
Indonesia 4.86 1.38 0.43 2.25^
Malaysia 1.72 -0.25* 1.62 1.08*
Philippines 2.21 4.66 -2.67 -2.53
Thailand 2.42 -1.17 1.58 0.46
*For Malaysia, inflation and real rate data are for January 2021. For Indonesia, effective short term interest rates are used as the current policy rate was not the main policy rate in 2013. Note: Inflation is computed as year on year change in headline consumer price index. Real policy rates computed as policy rate less core inflation. Sources: National statistical agencies, central banks, and S&P Global Economics.

Conditions were markedly different going into the taper tantrum in 2013. Excitement about emerging markets was high after the financial crisis (helped by the effects of China's massive stimulus). Quantitative easing at a global scale was new and encouraged a search for yield. External financial conditions had eased markedly and led to increased capital inflows to emerging economies [1]. These economies in turn saw widening current account deficits and higher inflation.

When in May 2013 the Fed indicated it might dial back its quantitative easing program, conditions in the emerging Asian economies were ripe for an episode of external funding stress. The period between May and September 2013 saw a reversal of capital flows and forced tightening in external balances in affected economies. Currencies and bonds sold off, while implied volatilities on forex rates spiked as investors rushed to hedge their currency exposures. Within the region, India and Indonesia were hit hardest. These two economies were among the "Fragile Five" of the hardest-hit global emerging markets comprising of India, Indonesia, Brazil, Turkey, and South Africa.

Table 3

Currencies Depreciated And Bond Yields Rose During The Taper Tantrum
Changes in key indicators between May 21, 2013 and Sept. 30, 2013
10-year gov't bond yield (ppt) Exchange rate vs US$ (%) Forex implied volatility (ppt) Forex reserves (bil. US$)
Indonesia 2.5 (18) 8.8 -10.1
India 1.6 (13) 5.9 -9.6
Malaysia 0.6 (8) 3 -3.1
Philippines 0.6 (6) 1.9 1.1
Thailand 0.6 (5) 1.1 -5.6
Note: Forex reserves change computed between April and October 2013. Forex--foreign exchange. ppt--Percentage points. bil.--billion. Sources: Bloomberg, International Monetary Fund, S&P Global Ratings Economics.

In response to this external stress, central banks in India and Indonesia tightened monetary policy and domestic liquidity conditions, using a combination of tools including policy rates and unsterilized forex intervention. All central banks except the Bangko Sentral ng Pilipinas (BSP) in the Philippines intervened substantially on the forex markets.

The Reserve Bank of India (RBI) raised the marginal standing facility rate by 200 basis points in July 2013 while leaving the policy rate unchanged. This increased the penalty for any banks needing to tap the central bank for overnight liquidity. The RBI noted that the liquidity tightening measures were aimed at checking undue volatility in the forex market.

Bank Indonesia (BI) raised the headline policy rate by 75 basis points over June and July 2013 from 5.75% to 6.50%. In addition, the bank increased the frequency of forex interventions, squeezing domestic rupiah liquidity. In September 2013 BI tightened macroprudential measures on consumer and residential loans, and moderately tightened reserve requirements for banks.

Some Economies Are More Vulnerable To External Funding Pressures

Today, the economies with lower buffers against external shocks are India and the Philippines. Both economies have seen inflation rise in recent months. Real policy rates are below long-run average levels, eroding the return buffers. Capital may be quicker to leave and the central banks may have to respond by raising policy rates. One mitigating factor for both countries is that current accounts are stronger relative to normal levels. However, normalizing growth will raise investment demand, increase external funding requirements, and push current account balances into deficits.

Malaysia and Thailand check the boxes for relatively strong external positions and are hence more resilient. Inflation is low, real policy rates are positive at long-run average levels, real exchange rates are at trend, and there are large current account surpluses (notwithstanding what we think is Thailand's temporary deficit at the end of 2020).

This does not mean they are insulated from any external shocks. Typically, any sharp capital outflow pressure initially hurts all emerging economies with little differentiation. However, the magnitude of stress may be lower and external pressure should dissipate faster due to the strong external position.

Indonesia is better positioned now relative to the taper tantrum. The current account balance is positive and the real policy rate is still high. However, the country remains vulnerable, due to undifferentiated funding pressure on emerging markets, and a high share of foreign ownership of public debt, at over 25% still among the highest across global emerging markets.

A Weak Renminbi Among Risks To Watch For

The dangerous combination for Asia would be quickly rising U.S. real yields, as opposed to rising inflation expectations, and a rapidly appreciating U.S. dollar--especially if this started to move the dollar-Chinese renminbi exchange rate, which has become more of a currency anchor for the region's emerging markets.

Rising global yields present a clear risk for funding conditions, monetary policy, and the recovery in emerging Asia. However, considering the reflationary nature of the trend so far, improved initial conditions, and a likely measured policy response, Asia is less vulnerable to a funding shock that could derail the nascent economic recovery.

Related Research

This report does not constitute a rating action.

Asia-Pacific Chief Economist:Shaun Roache, Singapore (65) 6597-6137;
shaun.roache@spglobal.com
Asia-Pacific Economist:Vishrut Rana, Singapore + 65 6216 1008;
vishrut.rana@spglobal.com

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