Attractive growth opportunities in Asia will support currencies and yields despite a narrowing rate differential with the FOMC.
With the US FOMC having started its rate easing cycle, central bankers across emerging markets (EMs) are also getting ready to adjust policy. At the end of this cycle, policy rates across the region are likely to be much closer to the fed funds rate than is typical through history. While partly a consequence of the higher starting point for the fed funds rate in this cycle, the smaller spreads also reflect fewer capacity constraints given the efficiency and connectivity of Asia and consequently less inflation pressure. This will have implications for growth and economic development, and could see currencies sustainably appreciate against the US dollar.
Since the beginning of the pandemic, monetary policy has been comparatively looser in Asia than in the US. Initially, central banks in India, the Philippines and Indonesia all cut rates by more than the US FOMC. These central banks, as well as the Bank of Thailand then raised rates by far less during the post-pandemic tightening: the FOMC’s 525bps of rate rises compares to the Philippine Bangko ng Pilipinas’ 450bps, the Bank Indonesia’s 275bps, the Reserve Bank of India’s 250bps and the Bank of Thailand’s 200bps. This has left spreads to the federal funds rate at their lowest levels since before the 2008-09 Global Financial Crisis.
Moreover, current policy rates are arguably too high for current domestic conditions. While growth is strong in aggregate, domestic consumption growth is tracking below the trend pace over the 10 years prior to COVID in all of these economies except India. Consumption in Indonesia is 4ppts below where this trend would have led to had COVID not occurred, Thailand around 5ppts below and the Philippines circa 6ppts lower. Investment is also weak in all of these countries except for India. This enduring underperformance has limited the pass through of global price pressures and led to the build up of a degree of slack amongst households and related businesses, with aggregate growth instead being held up by government expenditure and export growth.
Given this slack and the fed funds rate’s higher starting point, we expect EM Asia’s central banks to follow the US FOMC lower through the coming easing cycle, keeping spreads between EM policy rates and the FOMC comparatively low versus history. This means capital flows into these economies will need to be driven by growth prospects not yield differentials. These opportunities are found in both the region’s domestic markets and its export sectors.
Growth in EM Asia can be catalysed by public expenditure. Governments have ample fiscal space thanks to manageable debt liabilities and the potential to expand the tax base as the economy grows. There is justification for EM Asia’s nations to embark on strong investment agendas given young and growing populations as well as their increasing importance in global production chains. Households should also benefit from this strength in government expenditure and exports, fuelling consumption. Consumption below pre-COVID trends implies there is already some pent-up demand still to flow through.
Importantly, real effective exchange rates – the value of a currency against the weighted average of currencies of major trade partners adjusted for inflation – have held steady through the pandemic and recovery. This has provided some certainty for inflation and trade despite some weakening in US dollar bilaterals more recently. This is likely to remain the case going forward, albeit with some variation. That should allow the region to focus more on the development of comparative advantages, efficiency and diversifying export markets instead of simply being a mass-volume, low-cost exporter to the US.
That said, the region’s currencies remain sub-par against the US dollar and other developed-world currencies, providing an opportunity arguably to grow share in these markets as well. Note that this is not only applicable to manufacturing and mining but to tourism as well, broadening the benefits from trade to a wider population. Further foreign investment will also be incentivised by this trend and the deeper cross-border relationships it fosters.
The lasting uncertainty created by the pandemic and its inflationary consequences may therefore, in time, create structural strength in Asia’s developing economies. This should in turn incentivise long-term investment in the region over short-term carry trades built on risk premia.
The building out of industry and greater two-way trade also stands to reduce concern over cyclical volatility and the immaturity of regional capital markets. While the uptrend in the region’s currencies against the US dollar is likely to prove shallow, recurring improvement in capacity and productivity should stand the region in good stead and drive a longer term uptrend – a shift that will mitigate tradeable inflation risks and reflect slowly improving global purchasing power and financial stability across these countries. The outlook for Asia’s economies and currencies is therefore bright.
 are also getting ready to adjust policy. At the end of this cycle, policy rates across the region are likely to be much closer to the fed funds rate than is typical through history. While partly a consequence of the higher starting point for the fed funds rate in this cycle, the smaller spreads also reflect fewer capacity constraints given the efficiency and connectivity of Asia and consequently less inflation pressure. This will have implications for growth and economic development, and could see currencies sustainably appreciate against the US dollar.){kind=link}