Who Will be the Biggest Losers if the Fed Hikes Up Interest Rates?

In autumn 2017, the U.S. central bank (the Fed) suggested it was going on a diet. Many anticipate that it will lift interest rates as a result of policy tightening meant to cut fat from its balance sheets. Other countries, especially in emerging Asia, are starting to feel the squeeze. In the years following the 2007-2008 global financial crisis, the Fed began its quantitative easing (QE) policy, which included lowering interest rates to nearly zero.

Asia, especially emerging Asia, became a popular destination for investors seeking better opportunities. These economies were growing much faster, relative to their developed counterparts. At the time, interest rates in emerging Asia were high. This was done to curb rising inflationary pressures.

Meanwhile, market liberalization and financial sector reform was happening around the region. Once closed and difficult-to-invest-in economies, opened up, and welcomed inward capital flows.

So capital, in search of ever higher returns, surged into emerging Asia between 2009 and 2011, as you can see below.

Capital flows to Asia increased investment, which in turn contributed to Asian countries achieving increased growth levels. In turn, their new-found high growth performances attracted even more capital. A virtuous cycle of capital flows and economic growth followed.

You can see in the map below, that Northeast Asian countries like Japan, China and South Korea all received substantial capital inflows to exchange traded funds (ETFs) in 2017.

Of course, if low interest rates cause capital to pour into to emerging markets, then the opposite must also be true.

If the U.S. interest rate reaches 1.25, countries with already low interest rates, like Japan, Singapore and South Korea will become less appealing to foreign capital investment.

Once monetary policy in the United States and other advanced economies begins to normalize, capital flows should reverse.

Countries once receiving substantial foreign capital will witness slowing growth. Not to mention, all the other disruptions and complications emerging economies will experience.

But that doesn’t mean Asia will be left high and dry without foreign capital.

Countries in this region can always raise interest rates to stay competitive.

Japan remains the largest recipient of exchange traded fund (ETF) inflow in the whole of Asia, at approximately $US13,000 million. Japan’s economy is open, meaning capital can enter and leave to a certain degree.

So, the US tightening policy will in fact “force” Japan’s central bank to lift their policy rate, in order to prevent capital outflows. This will put pressure on other countries with large capital inflows such as South Korea, Hong Kong and Taiwan.

The higher the degree of capital and financial account openness, the more likely the country will be hit hard by the rise in U.S. interest rates and forced to increase their interest rates accordingly.

Unlike Japan and other open economies in Asia, China is less vulnerable to U.S. monetary policy.

Even though their interest rates are close to Americas’ and they are the second largest ETF recipients in Asia Pacific. Still, China employs capital controls, which restricts inward and outward investment. Controlling capital insulates China from the potential economic damage of rising Fed Fund Rates.

In a world of higher U.S. interest rates, open Asian economies will be hit the hardest. Closed economies, like China, will feel the squeeze less.