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Fed returns to centre stage for Asia as US yields near 3%
THE decoupling thesis - that Asia is now more immune from what goes on at the Federal Reserve - is being tested as 10-year US Treasury yields hover near 3 per cent.
Asian economies that reaped the benefits of low US interest rates - from record foreign inflows to subdued inflation - are finding that rising US yields and accompanying strength in the greenback are pushing up domestic borrowing costs, weakening currencies and fuelling capital outflows.
With Malaysia and the Philippines deciding on interest rates this week and Indonesia next week, the Fed's moves are a key factor for central bank bosses once again. That's especially true for economies dependent on foreign capital to finance their current account deficits: the Philippines, India and Indonesia. The three have the worst performing currencies in Asia this year.
Indonesia, South-east Asia's biggest economy, is at risk because foreigners own a substantial amount of domestic bonds - about 40 per cent. As the spread between US and Indonesian yields narrows, the threat of capital outflows increases as foreigners lose appetite for local assets. That's already happened with overseas investors dumping US$1.1 billion of bonds last month.
Indonesia has stronger buffers now than in 2013, when the "taper tantrum" fuelled a sell-off in the currency. While the current account deficit is set to widen, it remains low by historical standards, and the central bank has ample reserves to support the rupiah, even after they fell last month.
Radhika Rao, an economist at DBS Bank Ltd in Singapore, is among those seeing extra pressure on Bank Indonesia to hike interest rates if foreign outflows persist and the rupiah remains pressured. Governor Agus Martowardojo has made clear that the central bank wouldn't hesitate to stabilise the rupiah through rate hikes as needed.
India has seen a surge in foreign inflows in recent years, helping the rupee post its first annual rise in seven years in 2017. But with the Fed tightening policy, those inflows have slowed and in the case of the bond market, reversed. That has put pressure on the rupee, Asia's worst performing currency this year.
The drop in the rupee comes amid rising prices for oil, India's biggest import item, and concerns that a slowdown in investment flows could see the current account deficit widen from 2 per cent of gross domestic product. Those risks are fuelling speculation the Reserve Bank of India will raise interest rates.
The effect of higher Treasury yields on the Philippines is more mixed. The peso has been under strain after the current account surplus turned to a deficit and oil prices climbed. But the central bank has room to act.
With inflation breaking through the 4 per cent upper bound of its target band, policymakers are "pretty close to hiking rates", said Euben Paracuelles, an economist at Nomura Singapore Ltd. That'll put them in a better position to contain capital outflows, with the currency already gaining against the dollar on expectations of policy tightening.
A narrowing gap between 10-year Chinese government bond yields and US Treasuries erodes the attractiveness of China's bond market and puts downward pressure on the yuan, both of which run contrary to efforts to keep the currency and capital flows stable. The gap with Treasuries fell last month to its lowest level since late 2016.
For Japan, higher US Treasury yields may not be a bad thing. Finance Minister Taro Aso has said the yen will weaken against the dollar if the interest rate differential between both nations' 10-year yields reaches three percentage points. The gap is already the widest since 2007. A weaker currency increases inflationary pressures through imported goods, providing tailwinds for the Bank of Japan's 2 per cent target. It would also boost corporate profits and business investment, wage growth, employment and household spending.
South Korea is vulnerable to a reversal in capital flows if Treasuries were to sustain a push above 3 per cent. Bank of Korea governor Lee Ju-Yeol has repeatedly said the country's sufficient reserves and current account surplus will prevent any disruptive moves.
Malaysia's substantial bond holdings by foreigners - about 30 per cent - make it vulnerable when Treasury yields start to rock the differential with domestic bond yields. One advantage - the nation boasts a current account surplus of about 3 per cent of GDP, giving more wriggle room. The central bank has shown little appetite to tighten policy after labelling an interest-rate increase in January as a bid to normalise. BLOOMBERG