Monetary policy normalization in the United States to affect Asia-Pacific growth

The normalization of monetary policy in the United States, which began with the tapering of quantitative easing by the Federal Reserve at the beginning of this year, may have a significant impact on economic growth in Asia-Pacific developing countries.

Survey 2014 estimates that in a worst-case scenario, the effects of financial market turbulence due to the next stage of normalization, which is widely expected to be a hike in interest rates by the Federal Reserve, could cut annual GDP growth by as much as 0.7 to 0.9 percentage points in India, Malaysia, the Russian Federation, Thailand and Turkey.

The growth-reducing impact would be worse if the financial volatility needs to be addressed with monetary tightening in Asia-Pacific economies. This could see annual output increase moderate by 0.8-1.3 percentage points in the most affected countries, with the additional impact of the tightening being felt most by the Russian Federation’s economy, followed by that of Indonesia.

Asia-Pacific emerging economies witnessed a bout of capital outflows in January 2014 as the Federal Reserve began reducing its $85 billion monthly monetary stimulus in slabs of $10 billion per month. This led to large falls in equity markets, particularly in Turkey and India.

The region’s markets had already seen an outward flow of capital in the second half of 2013, triggered by anticipation that the tapering, announced by the Federal Reserve earlier in the year, would start in September 2013. Stock market capitalization in seven Asia-Pacific economies fell by $323 billion in August 2013, from the preceding month.

Although there is uncertainty about the timing of the second stage in normalization that would see interest rates gradually being raised from zero, indications from the Federal Reserve show that it as likely to begin in 2015. A mismatch between market expectations on the timing, pace and magnitude of the normalization and the actual policy announcement, or even speculation about the timing of the announcement, could lead to financial market turbulence, as happened in mid-2013.

Financial volatility triggered by the normalization decision will affect growth in emerging Asia-Pacific economies through at least two channels: (i) a rise in corporate borrowing rates amid tighter financial liquidity and heightened systemic risk premiums; and (ii) the effect of deteriorating market confidence and increased economic uncertainty on consumer spending and fixed investment.

Survey 2014 uses a macroeconomic simulation exercise to analyze the impact of financial market turbulence on economic growth in selected Asia-Pacific developing economies under a “high-case” and a “low-case” scenario. The former assumes uncertainty about the timing of the start of the policy normalization leading to financial sector shocks similar to those observed from May to August 2013. The scenario is also feasible when normalization is as expected but policy responses in affected economies are viewed as too slow or ineffective.

Fixed investment growth, under this scenario, is expected to fall the most in Indonesia, Malaysia, the Russian Federation and Thailand, slowing industrial output and increasing job losses. Rising unemployment and borrowing costs, accompanied by higher inflation linked to currency depreciation, would affect household spending with annual private consumption growth estimated to be 0.7-2 percentage points lower relative to the baseline. A “low-case scenario” involves the market factoring in the normalization due to clarity in communication on the change.