Fed unwind will impact Asia differently this time

THE Federal Reserve has said it is ready to start raising rates and withdrawing liquidity. Rates remain near zero for now, but when the tightening begins, we expect it to be swift.

The Fed will likely raise rates eight times over the next two years and reduce their bond holdings by US$1.5 trillion by the end of next year.

Emerging market investors often recall the taper tantrum of 2013, when they learnt that the Fed was putting the brakes on its easing. This led to a surge in US treasury yields, and an exodus of capital from emerging markets.

But investors worrying about capital outflows from emerging markets this time may be looking in the wrong place.

Very little money has flowed into emerging market equities and bonds in recent years, despite the Fed doubling its balance sheet to US$9 trillion.

This is very different from the 2009-2013 period, when the Fed's quantitative easing policies drove over US$500 billion into emerging market assets, exposing them to the Fed's liquidity whims.

The exception this time is China which has experienced large inflows, but this is in large part due to increased market access and the country's inclusion in major global indices, rather than due to the Fed's easing measures.

Investors have largely ignored other emerging market assets in recent years, as growth prospects in these markets weighed on interest in equities. On the debt front, investors have been deterred by strained government balance sheets and currency volatility.

But this does not mean emerging markets will not be affected by the Fed balance sheet unwind.

Fed-driven liquidity has still reached emerging markets in the aftermath of Covid-19. It has just not come through capital flows this time, but through international trade flows. This is particularly true for Asia, where Asian exports have been strongly correlated with the growth of the Fed's balance sheet.

The answer to why Fed liquidity has travelled to emerging markets differently this time lies in US fiscal policy. While the Fed engaged in aggressive quantitative easing after the global financial crisis, their balance sheet expansion had little impact on US fiscal policy post-2009, with government spending remained unchanged through to 2013.

The Fed's easing functioned primarily through what former Fed Governor Ben Bernanke called the "portfolio balance effect". As the Fed purchased more government bonds, private investors shifted away from them, and into higher yielding assets. This drove capital flows to emerging markets.

Things have been different this time round. The Fed's balance sheet expansion has been closely linked to fiscal measures. Its bond purchases in the past two years financed a sharp increase in US government spending on Covid stimulus. Close to half of the incremental government spending trickled down to households. Arguably therefore, half of the Fed's newly created liquidity has gone into US consumer pockets in the past two years.

In turn, the Covid handouts have driven US consumers to sharply increase spending on personal goods. And with Asia functioning as the world's manufacturing hub, US dollars have flowed East, particularly into ASEAN which has captured a growing part of global value chains.

Emerging market investors should therefore keep an eye on the US consumer and Asian exports in the upcoming cycle, as they track the impact of the Fed unwinding its balance sheet. While consumer confidence is still high by pandemic standards, there are already signs of softening in US retail sales and consumer reluctance to spend on durable goods in the presence of rising prices.

If rising rates and a declining Fed balance sheet dampen US consumer demand for goods, this will matter greatly for Asia.

The writer is Asia macro strategist at Deutsche Bank AG