The US Federal Reserve may be reaching the end of its monetary policy cycle, but the impact of both the 500 basis points of rate hikes and trillion-dollar-plus withdrawal of liquidity will be felt for a long time. Granted, monetary conditions are not overly restrictive by historical comparison, and the Fed’s balance sheet remains extraordinarily large, but the pace of adjustment has been remarkable. There are bound to be consequences.
But the consequences need not be seismic and destabilising – at least that’s what policy-makers would hope. Policy tightening would push down the price of risky assets as risk-free asset yields rise; it would also shrink firm-level profitability as the cost of debt financing rises. Tighter policy would affect households’ balance sheets through the asset price channel as stocks and bonds lose value, denting their consumption plans and sentiment. Fixed-asset investment would face headwinds as the cost of project financing rises. The economy would slow, financial market froth would dissipate. Below-trend growth would ensue, unemployment would rise and inflation would fall with weakening demand.
Bumps in the road
How can things go wrong? First, consider the traditional channels of possible destabilising adjustment. If the debt stock is large, and it is very large in many sectors and economies, the sharp rise in debt service cost could come with a troubling rise in credit risk. The real estate sector, a big driver of gross domestic product, is particularly vulnerable. If stock and other financial markets are in bubble territory then policy tightening can cause it to pop, with a degree of unravelling that is rarely predictable. The starkest reminder of this type of dynamic is the 2008 financial crisis.
Second, US policy tightening affects the cost and quantity of global liquidity, which then manifests in the rising cost of hard currency borrowing, currency market selloff, imported inflation and widening of credit spreads. As seen in 2022, several emerging market economies with high degrees of macroeconomic vulnerability found themselves tipping into financial crisis just as the Fed tightened.
Third, there could be complex interlinkages and causalities not fully appreciated by markets and policy-makers. Raghuram Rajan, professor at University of Chicago and former governor of the Reserve Bank of India, has been prescient in identifying the fault-lines in global finance in the past two decades. He has raised the notion of spillback in his recent research. US policy tightening – as it pushes up the dollar and causes inflation to be exported to the rest of the world – forces policy tightening in economies that may not need to tighten otherwise. Last year, many economies had large, lingering output gaps. Although they had barely emerged from the pandemic, they had to nevertheless tighten policy otherwise they would have experienced sharp capital outflows. Pulled by the US, these economies had to pursue demand-moderating policies, which in turn caused their imports from US companies to suffer.
This is the essence of spillback: the partial consequences of a country’s policies as they flow back to the source country. Spillback is particularly material for the big US tech companies, as more than 50% of their revenues come from the rest of the world.
Another insight from Rajan and his co-researchers is the concept of liquidity dependence. The argument is that, while monetary operations related to quantitative easing and quantitative tightening may be mirror images of one another (bond purchase versus selling/redeeming bonds), for the economy at large, there are inherent asymmetries that can cause financial instability.
QE works through the increase in bank reserves, which then leads to a rise in banks’ demandable liabilities (deposits and credit lines). But when QT ensues and reserves are shrunk, there is no simple mechanism under which these liabilities shrink. They can shrink through deposit flights (as seen in the case of Silicon Valley Bank in March) or during a recession as incomes and profits dwindle. Banks and non-bank financial institutions with duration mismatch may find available liquidity tightens, leading to a loss of confidence among market participants and a rise in systemic risk. We have already seen this year that such developments can occur, and we could see more such instances going forward.
How is Asia placed to deal with these risks?
First, look at Asian banks, which overwhelmingly dominate financial intermediation in the region. All major Asian economies have deposit insurance schemes, introduced since the 1997-98 Asian financial crisis. Their coverage limits are set high enough to ensure that the majority of deposit accounts (more than 90%) are fully insured. DBS strategist Chang Wei Liang has pointed out that lower interest rate volatility and smaller investment holdings also limit scope for unrealised losses in the banking book. Furthermore, a greater degree of government ownership and sponsorship for Asian banks provides confidence about shock absorption capacity.
Second, at the macro vulnerability level, Asian economies appear to be on sound footing. A few countries in South and Southeast Asia have experienced currency and funding stresses in the past year, but among the larger emerging market economies in Asia, DBS has found the imbalances are manageable. We don’t find any instance of large savings-investment imbalance at the country level presently. Domestic public debt ratios are by no means low but, by and large, they did not explode during the pandemic years. More crucially, external debt ratios are largely under check in the region, as are debt service payments due this year and next. Examining the real exchange rate trend, we find no glaring evidence of misalignment, nor do we find foreign exchange reserves held at the region’s central banks inadequate.
Given its substantial trade linkages, Asia won’t be able to decouple from an impending slowdown in western economies, but the destabilising potential of QT need not be grave. On a relative basis, there are plenty of economies elsewhere in the emerging market universe that are far more vulnerable to QT.
Most crucially, the region has an offset in the making; as the West slows, China and the rest of region are still in the middle of post-pandemic re-opening, with plenty of pent-up demand boosting regional travel, tourism and events. Dealing with QT will be challenging, but Asia is not helpless when it comes to absorbing the potential shocks.
Taimur Baig is Managing Director and Chief Economist, DBS Group Research.