U.S. Rate Increases Complicate Some Asian Strategies

By Philip Bowring - International Herald Tribune

HONG KONG - Asian countries are unlikely to complain about the strength of the U.S. economy. But the consequent buoyancy of the dollar is at least forcing discussion of monetary and exchange-rate policies in the region.

Asian currency weakness and interest-rate increases, where they have occurred, have been more the result of domestic problems than of the actions of Alan Greenspan, the chairman of the U.S. Federal Reserve Board.

Nonetheless, Asian authorities are again having to balance the needs of economic recovery with market needs for proof of domestic financial stability.

This is not 1997, when the dollar's strength was an important immediate cause of the financial crisis of an Asia that had huge short-term dollar debts. Those debts have been drastically reduced or rescheduled. Nowhere, even in Indonesia, are they now a major problem for short-term economic management.

The dollar's strength is also most marked against the euro rather than the yen. The South Korean won, Thai baht and Philippine peso are now floating; the Malaysian ringgit is pegged at a rate that is still highly competitive. Only for Hong Kong, with its U.S.-level interest rates but still deflating economy, is a strong dollar a major burden.

But Asia has still not entirely weaned itself from its past dollar fixation. The Philippine central bank raised interest rates by a full percentage point to support the peso, which had fallen 4 percent against the dollar this year but only 1 percent in the past month. The rate rise was dismal news for an economy struggling to regain momentum, where investment

demand is so weak that the nation is running an unnecessarily large current-account surplus.

For historical reasons, the Philippines tends to think more in terms of the dollar than its neighbors. Even so, its rate rise set off suggestions that others would follow suit.

So far, they have not. Though the baht has also fallen, the Thai central bank indicated that low rates remained essential to the revival of the economy and an improvement in the health of the banking system. Indonesia's central bank declined to push up its benchmark paper rate, implicitly acknowledging that the 10 percent decline of the rupiah over the past few weeks had been due more to lack of confidence in its government than to U.S. rate increases.

In South Korea, a sharp rise in corporate bond yields has been due to renewed concerns over the high debt levels of the chaebol, or conglomerates. Interbank interest rates have been stable, and the won's slight decline against the dollar has caused little concern. The won is back up to near its level of January.

These steady Asian responses have been given weight by Australia's Reserve Bank. Its governor has, at least for now, decided to view the Australian dollar's tumble as part of a global trend and not raise rates - even though inflation risks are higher in Australia than in most of Asia.

Nonetheless, Asia cannot take a wholly benign view of the situation. Capital is continuing to flow from the region, as indicated by the recent retreat of foreign equity investors. Much of the outflow in the past two years has been repayment of short-term dollar debt, financed by huge current-account surpluses. That process is well advanced, so there should be scope for continuing to stimulate domestic demand without creating balance-of-payments problems.

But a continuing capital outflow caused by interest-rate differentials could upset that calculation. Asia still needs equity capital to restructure its corporate and banking sectors. A combination of currency weakness and domestic banking concerns could stifle inflows and thus become a self-fulfilling prophecy.

Nor can currencies be allowed to slide too far when global inflation is starting to rise again. Domestic inflation may be negligible, even in South Korea where the rebound in demand has been strongest, but energy-led import prices cannot be forgotten.

Given improved demand in Japan and China as well as in Europe, there is reasonable hope that Asia can come through any U.S. downturn - whenever it finally arrives - relatively unscathed.

There are big cushions of reserves and plenty of scope for consumption-led domestic growth. But there is a real concern that the United States will have further inflation-driven interest-rate increases, followed by a hard landing.

That carries a significant risk of forcing Asia governments to rein in their loose monetary policies before domestic demand growth has become self-sustaining and banking systems have been fully stabilized. Nor is there much scope left for public-sector stimulus. Budget deficits now need to be reduced, even while big injections into the financial sector are still needed in South Korea and Thailand, and more government money is likely to be funneled into corporate rescues in Malaysia.

Asian recovery is not yet at risk. Governments can continue to pursue easy monetary policies and not worry too much about exchange rates. But just as the revival has been speedier than expected, so the dangers of failing to make the transition from export-led to domestic-led growth are increasing with every U.S. rate increase.