- Those with high and short-duration debt stock are highly vulnerable
- The spillover from policy tightening has substantial international dimensions
- Some complex interlinkages may not be fully appreciated by markets
- Some degree of financial instability may be embedded in quantitative tightening
- Asia is not immune from policy tightening spillover, but its buffers are ample
Commentary: QT and Asia
The US Federal Reserve may be reaching the end of its monetary policy cycle, but the impact of both the 500bps 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.
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. Additionally, tighter policy would affect households’ balance-sheet 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 ensure, unemployment would rise, and inflation would fall with weakening demand.
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 GDP, 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 global financial crisis.
Second, the international dimension. 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, a number of 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, has been particularly prescient in identifying the fault-lines in global finance in the past two decades. A relevant insight from his research is the notion of spillback (Raghuram Rajan: Towards rules of the monetary game (bis.org). Under this, 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 be needing to tighten otherwise. Last year, even as many economies were barely coming out of the pandemic and had large, lingering output gaps, had to nevertheless tighten policy, short of which they would have experiences sharp capital outflows. Pulled by the US, these economies had to pursue demand moderating policies, which in turn caused exports by 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 US big tech companies, as 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 (Liquidity Dependence and the Waxing and Waning of Central Bank Balance Sheets | BFI (uchicago.edu). 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 SVB in March) or during a recession as incomes and profits dwindle. Banks and nonbank financial institutions with duration mismatch may find available liquidity tighten, 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 are likely to see more such instances going forward.
How is Asia placed to deal with these risks? First, Asian banks, which overwhelmingly dominate financial intermediation in the region. All major Asian economies have deposit insurance schemes, introduced since the 97/98 Asian Financial Crisis. Their coverage limits are also set high enough to ensure that the majority of deposit accounts (>90%) are fully insured. In a recent publication, DBS strategist Chang Wei Liang points out that lower interest rate volatility and smaller investment holdings also limit scope for unrealized losses in the banking book (Asian banks: Better insulated from contagion risks (dbs.com.sg). 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 in fairly sound footing. A few countries in South and South-East Asia have experienced currency and funding stress in the past year, but among the larger emerging market economies in Asia, the imbalances appear manageable, as per our analysis. We don’t find any instance of large saving-investment imbalance presently. Domestic public debt ratios are by no means low, but by and large, 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 real exchange rate trend, we find no glaring evidence of misalignment either, 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
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