As Fed rate hike looms, Asia policy remains market friendly

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Fearing a return of what he called the "deflationary mindset," fostered by a weak economy and falling energy prices, Bank of Japan Governor Haruhiko Kuroda was pledging last week that "there was no limit" to what his printing presses could do to keep inflation above 2 percent.

He is not bluffing. Markets are right to take him seriously. Over the last twelve months, markets handled the avalanche of yen liquidity by taking the Japanese currency down 19 percent against the dollar and 11 percent in trade-weighted terms.

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During that period, the Nikkei 225 was pushed up 13.4 percent. That sounds like a lot, except perhaps to those proverbial Japanese housewives dabbling in global investing. They faced a whopping 36 percent opportunity cost by staying in yen: a 17 percent return on the S&P 500 and a 19 percent gain on the yen/dollar exchange rate. The dollar-based investors also incurred a 6 percent loss on their yen portfolios.

Prudent policies in China and South Korea

By contrast, China is emphasizing prudent credit policies as the country focuses on employment and structural reforms. Beijing says that its job creation target for this year has been met, and seems eager to see further deleveraging in real estate, state-owned companies and local governments.

After PBOC cuts rate, what's next?
After PBOC cuts rate, what's next?   

I expect additional easing in the coming months, most probably in the form of special measures to prop up mortgage lending. But there is scope for more than that – if needed. With an inflation rate of 1.6 percent and short-term interest rates in excess of 4 percent, the current credit stance is roughly neutral, leaving quite a bit of room for more supportive policies.

Aggressive monetary easing in China is not necessary and won't happen. Pay no attention to market observers envisaging large credit flows to avoid the "economic collapse" and the "financial system's meltdown." That is arrant nonsense.

South Korea also has plenty of room for policies to support the economy. Seoul's current account surplus of 5.4 percent of gross domestic product (GDP), a budget surplus of 0.5 percent of GDP and a declining inflation offer a large scope for easier monetary and fiscal policies.

The calibration of the policy mix depends on the desired configuration of internal and external balances. At this point, I think that Seoul's looser fiscal policy could support growth and employment, while a steady monetary policy aims at inflation control and exchange-rate stability.

South Korea's economy looks good. Growth accelerated to an annualized rate of 3.5 percent in the third quarter, and the unemployment rate has declined somewhat since the beginning of the year. I am, therefore, guessing that, based on numbers for productivity and labor supply, the economy may already be operating close to its noninflationary potential.

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In view of that, caution may be in order. Any further stimulus measures seeking a permanently higher economic growth in South Korea may need a careful consideration.

Indonesia is the only major East Asian country where interest rates were raised in mid-November to anchor inflation expectations following a 30 percent increase in subsidized fuel prices. Markets have shrugged off the rate hike, but it remains to be seen whether the investment appeal of this preemptive measure will prevail over the prospects of a weakening economy.

Accelerating growth of consumer prices since last August still left inflation in October (4.8 percent) within the official target of 4.5 ±1 percent. Apart from that, real short-term interest rates of 2.5 percent and rupiah's roughly stable exchange rate indicate a moderate amount of monetary tightness. It is, therefore, possible that Jakarta may not need further interest rate increases in an environment of restrictive fiscal policies and an expected slowdown of aggregate demand.

Limited effect of Fed's expected rate increases

The question is: How will the current policy setup and growth dynamics in these four largest East Asian economies react to tighter monetary policies in the United States?

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The key assumption here is that rising interest rates in the vast dollar currency area will draw capital flows away from East Asia and the rest of the developing world.

The answer to the question posed depends on the plausibility of this assumption. Note that the assumption implies that most – if not all – incoming foreign investments in these countries are "hot money" – highly speculative and instantly reversible short-term bets.

What if that is not true? Indeed, with its prodigious growth potential and increasingly sound economic policies East Asia remains one of the most important destinations for stable direct and portfolio investments.

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Now, back to the main question.

Of the four countries discussed in this paper, only Indonesia needs to import foreign savings of about 3 percent of GDP (approximately $25 billion) to square the books. Whether Indonesia will have to pay more (with higher yields on its assets) to foreign investors to get the funds it needs depends on the credibility of its economic policies and political governance.

China and South Korea are large net creditors to the rest of the world. Their external accounts would, therefore, benefit from rising yields on their dollar-denominated assets. Japan presently has a roughly balanced external position and, assuming better ties with China, it could soon revert to its traditional surplus on current overseas transactions.

Investment thoughts

China, Japan and South Korea – a quarter of the world economy – are set to maintain easy credit conditions for the foreseeable future. Adding in the E.U., more than half of the global economy will continue to run market-friendly monetary policies well after the U.S. (one-fifth of the world economy) begins its long process of interest rate normalization.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.