Higher inflation and rising U.S. interest rates are weighing heavily on Asia-Pacific economies. S&P Global Ratings expects that in regions where inflation already exceeds targets, or which are vulnerable to capital flight, central banks will be forced to raise interest rates. This describes most regional economies.

However, where neither inflation nor capital flight is a major issue, central bankers will focus on growth, we expect. This will result in a three-speed policy setting across Asia-Pacific. Many economies are likely to see significantly higher rates, some may lift rates moderately, while the rest (China and Japan) probably will not tighten at all.

Central banks start to tighten.  Following a period of very accommodative monetary policy, some Asia-Pacific central banks are starting to normalize. The Bank of Korea and the Reserve Bank of New Zealand raised rates in early 2022, adding to increases in 2021. The Monetary Authority of Singapore has twice tightened its policy since the autumn of 2021. Taiwan's central bank in March raised rates in the same week as the U.S. Federal Reserve.

As discussed in our second-quarter macroeconomic outlook, we expect policy interest rates to rise by up to 125 basis points in 2022 in parts of Asia-Pacific (see "Asia-Pacific Economic Risks, Thy Name Is Inflation," published March 28, 2022, on RatingsDirect).

Asia-Pacific's monetary policymakers will face difficult trade-offs this year. The Russia-Ukraine conflict is adding to global inflation by raising the cost of energy and other raw commodities. An increasingly hawkish U.S. Fed is tightening its policies, and most recently signaled it would significantly reduce its balance sheet.

This puts pressure on the region's central banks to raise policy rates to anchor inflation expectations, retain their credibility, support the national currency, or to head off financial instability. However, as the effect of the conflict and the U.S. Fed shift weighs on economic growth, we anticipate some central banks will tighten as little as possible, or not at all.

Ukraine conflict adds to inflation strains.  The rising costs of energy and other raw commodities put producer prices on an upward path well before the outbreak of the Russia-Ukraine conflict. Consumer inflation has generally not risen as much as in the U.S., because of a more muted recovery in domestic demand in Asia-Pacific post-COVID, and a relatively more responsive supply side.

Nonetheless, consumer inflation is already exceeding the upper bounds of central bank targets in New Zealand, South Korea, and Thailand.

The Russia-Ukraine conflict will amplify this trend. Sharp cost increases for energy and other raw commodities will drive up inflationary pressures. Our macroeconomic outlook for the second quarter projects that consumer inflation will trend up across Asia-Pacific, rising as much as 2.6 percentage points in Vietnam this year.

In the many net-energy importing economies in Asia-Pacific, higher energy prices will also weigh on import bills, and therefore on the current account. This will be particularly true for South Korea, Taiwan, and Thailand--that is, regions where net energy imports are large, as a share of GDP (see chart 3).

Chart 2

Chart 3

Risk Of Capital Outflows Weighs On Regional Currencies

The U.S. Fed's policy tightening raises the potential for capital outflows from Asia's emerging markets, hitting regional currencies. The Fed's recent reassessment of the nature of U.S. inflation has led it to anticipate a faster increase in its policy interest rate. It hiked this rate by 25 basis points in March and indicated aggressive policy to follow. We now expect seven rate hikes in total in 2022 (including a 50 basis point hike), followed by four to five in 2023 (see "Economic Outlook U.S. Q2 2022: Spring Chills," March 29, 2022).

Asia-Pacific exchange rate movements suggest that markets have so far highlighted the energy price gains and regional divergence in monetary policy outlook from that of the U.S. Fed. Traders have so far been less focused on the possibility of capital flight from vulnerable emerging markets. South Korea, Taiwan, and Thailand, the region's biggest net energy importers, have seen their currencies depreciate significantly against the U.S. dollar since the outbreak of the Russia-Ukraine conflict.

The Japanese yen has weakened sharply in recent weeks, after the Bank of Japan (BOJ) reaffirmed its commitment to its yield curve control policy. The policy targets a 10-year government bond yield of around 0%. The BOJ's reaffirmation closely followed Fed signaling that it would raise rates in the U.S., making the dollar relatively more attractive.

Nonetheless, Fed tightening may also trigger a bout of risk-aversion, hitting regional exchange rates along with other asset markets. The "taper tantrum" of 2013 shows the vulnerability of Asia's emerging markets to this dynamic, and the sudden swings in sentiment they may bring.

Foreign Exchange Moves Add Another Risk Dimension

Our assessment suggests that some Asian emerging markets could be vulnerable to capital flight this year. Foreign-exchange reserves are adequate and exchange rates are not stretched. But sharply higher energy prices would lead to significant external deficits in some economies. Also, low policy interest rates heighten the sensitivity of some regional exchange rates to Fed shifts, and fiscal deficits and debts have increased in recent years.

In 2012, India and Indonesia ran current-account deficits of 3%-4% of GDP. This made them vulnerable to the disorderly capital outflow that unfolded in May 2013, when the suggestion of U.S. rate rises triggered the taper tantrum.

As such we see a current account deficit of 3%-4% as a vulnerability threshold. Those emerging markets that are net energy importers and did not have a significant current-account surplus in 2021 are, accordingly, exposed to the risk of sharply higher energy prices.

We calculate what the 2022 current account balance would be if the only change this year were a world oil price of US$150 per barrel. In this simple scenario, the 2022 current account deficit would be above 5% in India, the Philippines, and Thailand--putting those nations at risk of capital flight (see chart 4). This exercise assumes that the prices of other energy products move in line with that of oil.

Chart 4

Chart 5

Foreign-exchange reserve adequacy among emerging markets has improved since 2013 and is generally sufficient in emerging Asia (see "How Prepared Are Emerging Markets For The Upcoming Fed Policy Normalization?" Jan. 28, 2022.) The ratio of short-term debt to foreign-exchange reserves was below 45% in end-2021 in almost all economies. But it was relatively elevated at 88% in Malaysia (see chart 5).

Unlike in 2013, currency valuations are not stretched in Asia's emerging markets. Only in China was the real effective exchange rate significantly stronger in end-February than its two-year average (see chart 6). That was different in 2013, when the Malaysian ringgit, Philippine peso, and Thai baht were relatively expensive on this metric.

Policy interest rates are lower now than in 2013, translating into a smaller differential with U.S. rates than what prevailed in 2013 (see chart 7). This could make some currencies vulnerable to selling.

Chart 6

Chart 7

Greater Use Of Local-Currency Debt Lowers Fiscal Risks

While fiscal indicators have weakened in recent years, a generally low share of foreign-currency debt (to total debt) reduces the probability of capital outflows from emerging Asia.

Fiscal trends have been unfavorable in recent years. The pandemic hit state revenues just as governments pushed up their fiscal support, driving deficits higher (see chart 8). Among Asian emerging markets, the fiscal deficit is particularly high in India and the Philippines. General government debt is high in China, India, and Malaysia (see chart 9).

However, the share of government debt denominated in foreign currencies is mostly low in emerging Asia. Only in Indonesia was it higher than 15% at the end the third quarter of 2021, and even there this level has been declining in recent years.

Trading Off Growth With Central Bank Credibility

What does this all mean for monetary policy? Several central banks will be forced to tighten. Where inflation is already exceeding targets significantly and is bound to rise further, central banks will need to respond by tightening monetary policy to anchor inflation expectations and maintain their credibility.

Central bankers in emerging markets that are vulnerable to capital outflow in the context of an increasingly hawkish U.S. Fed have little policy room. They will likely also need to tighten. These factors are reflected in the upward revisions to our forecasts for policy interest rates across the region.

Chart 8

Chart 9

But where neither is a major issue, we expect central banks to focus on supporting growth. Higher inflation, reduced purchasing power among net energy importers, and weaker export growth and confidence will weigh on economic growth. Where possible, central banks will want to tighten policy as little as possible, or not at all.

As part of China's government's shift to a greater focus on growth, the People's Bank of China in recent months lowered interest rates somewhat, cut reserve requirement ratios, and asked banks to increase lending. With omicron weighing on the economy, more easing is likely, in our view.

The BOJ 's reaffirmation of its commitment to very easy monetary policy in the week after the Fed raised its policy rate in March was another example of a central bank using all its policy space. The BOJ won't raise its policy rate any time soon, we believe. The yen weakened as a result, but that was not seen as a major problem by the central bank.

We also anticipate policy rate increases of just 50 basis points or less this year in Australia, Indonesia, Malaysia, and Taiwan.

The prospect for rate rises varies sharply. The prospect for inflation does not--every region will see higher prices.

Editor: Jasper Moiseiwitsch

Digital Designer: Evy Cheung

Related Research

• Economic Outlook U.S. Q2 2022: Spring Chills, March 29, 2022
• Asia-Pacific Economic Risks, Thy Name Is Inflation, March 28, 2022
• How Prepared Are Emerging Markets For The Upcoming Fed Policy Normalization? Jan. 28, 2022