By Cyn-Young Park*
Russia’s invasion of Ukraine and the subsequent energy price fallouts are testing Asia’s economic and financial resilience. Recent surges in global oil prices have fuelled inflation concerns and SWIFT sanctions have driven demand for US dollar liquidity. Meanwhile, the US Federal Reserve (Fed) has increased 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 early 2020, it has pumped liquidity into the financial system to cushion the impact of fiscal stimulus on interest rates. Its balance sheet has ballooned to nearly US$9 trillion from a pre-COVID-19 pandemic level of US$4 trillion.
On 16 March 2022, the Fed raised interest rates from 0.25 per cent to 0.5 per cent. The US economy continues to show resilience with a strong labour market despite the war in Ukraine and high energy prices. Given the elevated inflationary pressures, the Fed will likely continue to gradually reverse its ultra-low interest rate policy and reducing its balance sheet.
The Fed’s tightening cycle has historically been followed by 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 1990 oil price shock to cause a brief US recession.
In 1993, tightening led to significant rises in long-term rates and companies’ borrowing costs. While the United States avoided a recession, a sudden reversal in capital flows and the collapse of the Mexican peso followed in 1994. Later, there were financial crises across Latin America (1994–1995) and 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 Fed’s last tightening cycle in 2015–2018 was cut short due to negative market reactions. Then the world was hit by COVID-19.
The US interest rate hikes will significantly impact Asian economies through trade, exchange rate and financial market channels.
Higher interest rates will curb aggregate demand, reducing demand for Asian exports. Higher yields on US assets will also attract international investment and strengthen demand for the US dollar. The dollar’s appreciation may offset some contractionary effects on Asian trade, but high oil prices might reduce real income and slow growth. The transmission of higher US interest rates through international capital markets will exert downward pressure on local investment and consumption.
Emerging economies must navigate increasingly turbulent waters. An immediate challenge is to strengthen macroprudential surveillance and pre-empt new sources of financial instability.
Inflation has been driven by strong economic recovery, high food and energy prices and increased shipping costs. Monetary authorities need to carefully monitor the risks of higher inflation and prepare to rein in inflation expectations. Local currency depreciation — driven by widening interest rate differentials and increased risk premiums — could further complicate the inflation battle.
The extended period of low interest rates has created record-high debt in corporate and household sectors. Non-performing loan ratios have already risen in several regional economies. Financial authorities should closely monitor the risks and take early action to prevent the build-up of systemic risks. For example, preventive debt restructuring can offer companies a second chance at rehabilitating debts and provide banks more certainty in assessing debt risks.
Expansionary fiscal policy in response to COVID-19 has increased government debt. Debt vulnerability is high, especially for economies facing external debt burdens while sustaining large current account deficits and holding insufficient foreign exchange reserves. To mitigate against 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 the risk, authorities need to remain vigilant and prepare for a sudden change in investor sentiment. Effective capital flow management including foreign exchange and capital control measures is key.
Emerging economies will benefit from strengthening global and regional safety nets. Past financial crises show that macroeconomic stabilisation alone will not be sufficient for safeguarding against financial stability. Globalised finance requires a solid global defence. Effective financial safety nets should have multiple layers in both crisis prevention and crisis management. This must begin with sound national macroeconomic policies, more flexible and targeted regional assistance and eventually global cooperation.
The war has created huge uncertainty and the additional risk to global financial conditions is unpredictable. But strong economic recovery is the only way out of the crisis. Asia needs to seize the opportunities of rapid digital transformation to further boost productivity and capture gains in economic growth and employment. The region’s policymakers must promote broader and more equal access to digital opportunities by enhancing digital infrastructure and expanding human capacities through investments and reforms in education, health and public services.
*About the author: Cyn-Young Park is Director for Regional Cooperation and Integration at the Economic Research and Regional Cooperation Department, Asian Development Bank.