Author: Cyn-Young Park, ADB
Russia’s invasion of Ukraine and the subsequent energy price fallout is testing Asia’s economic and financial resilience. Recent spikes in global oil prices have fueled inflation fears and SWIFT sanctions have boosted demand for US dollar cash. Meanwhile, the US Federal Reserve (Fed) raised interest rates for the first time since 2018 to curb inflation.
COVID-19 has left a large imprint on the Fed’s balance sheet. Since the start of 2020, it has injected liquidity into the financial system to cushion the impact of fiscal stimulus on interest rates. Its balance sheet has climbed to nearly US$9 trillion from a pre-COVID-19 pandemic level of US$4 trillion.
On March 16, 2022, the Fed raised interest rates from 0.25% to 0.5%. The US economy continues to show resilience with a strong labor market despite the war in Ukraine and high energy prices. Given elevated inflationary pressures, the Fed will likely continue to gradually reverse its ultra-low interest rate policy and shrink its balance sheet.
The Fed tightening cycle has always been followed by an economic slowdown in the United States and emerging 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 cause a brief recession in the United States.
In 1993, the tightening led to significant increases in long-term rates and corporate borrowing costs. While the United States avoided a recession, a sudden reversal of capital flows and the collapse of the Mexican peso followed in 1994. Later there were financial crises in Latin America (1994–1995) and in Asia (1997–1998).
Monetary tightening between 2004 and 2007 pricked the US housing market bubble and pushed the global economy into recession in 2008-2009. The last Fed tightening cycle in 2015-2018 was cut short due to negative market reactions. Then the world was hit with COVID-19.
US interest rate hikes will have a significant impact on Asian economies through trade, exchange rates and financial markets.
Higher interest rates will dampen aggregate demand, reducing demand for Asian exports. Higher yields on US assets will also attract international investment and strengthen demand for the US dollar. Dollar appreciation could offset some contractionary effects on Asian trade, but higher oil prices could reduce real income and slow growth. The transmission of higher US interest rates through international financial markets will put downward pressure on local investment and consumption.
Emerging economies must navigate increasingly turbulent waters. An immediate challenge is to strengthen macroprudential oversight and anticipate new sources of financial instability.
Inflation was fueled by a strong economic recovery, high food and energy prices and rising shipping costs. Monetary authorities should carefully monitor upside risks to inflation and prepare to control inflation expectations. The depreciation of the local currency – driven by widening interest rate differentials and rising risk premia – could further complicate the battle against inflation.
The prolonged period of low interest rates has created record indebtedness in the corporate and household sectors. Non-performing loan ratios have already increased in several regional economies. Financial authorities should closely monitor risks and take early action to prevent the build-up of systemic risks. For example, preventive debt restructuring can offer companies a second chance to rehabilitate their debts and give banks more certainty in assessing debt risks.
Expansionary fiscal policy in response to COVID-19 has increased public debt. Debt vulnerability is high, especially for economies facing external debt burdens while maintaining large current account deficits and holding insufficient foreign exchange reserves. To mitigate external vulnerabilities, more proactive public debt management is needed.
Highly volatile global capital flows can disrupt macroeconomic and financial stability. Although the region’s overall healthy growth outlook and external positions mitigate risk, authorities should remain vigilant and prepare for a sudden shift in investor sentiment. Effective management of capital flows, including foreign exchange measures and capital controls, is essential.
Emerging economies will benefit from strengthened global and regional safety nets. Past financial crises show that macroeconomic stabilization alone will not be enough to guarantee financial stability. Globalized finance requires strong global defence. To be effective, financial safety nets must be multi-layered, both in crisis prevention and crisis management. This must start with sound national macroeconomic policies, more flexible and targeted regional assistance and, ultimately, global cooperation.
The war has created enormous uncertainty and the additional risk to global financial conditions is unpredictable. But a strong economic recovery is the only way out of the crisis. Asia must seize the opportunities of rapid digital transformation to further boost productivity and reap the gains in economic growth and employment. Policymakers in the region must promote broader and more equitable access to digital opportunities by improving digital infrastructure and developing human capacities through investments and reforms in education, health and public services.
Cyn-Young Park is Director of Regional Cooperation and Integration in the Economic Research and Regional Cooperation Department of the Asian Development Bank.
An earlier version of this article first appeared here to Asia Development Blog.