Spillover effects of unconventional monetary policy on Asia and the Pacific

Spillover effects of unconventional monetary policy on Asia and the Pacific

On August 2015, the People’s Bank of China devalued the yuan with the aim of appreciating the currency against the US dollar. On October 2015, the European Central Bank signaled the intention to pump more liquidity into the eurozone economy. On October 2015, the Federal Reserve postponed its intention to conduct tapering on its monetary policy. Over the last 24 months, the dollar has been up nearly 10% against a major currency index of its trading partners. Emerging market economies have been facing disappointing growth, more volatile foreign exchange rates, and low inflation due to the slowdown in economic activities and the sharp decline in commodity prices. Moreover, the growth of debt in emerging countries has increased dramatically compared to advanced economies. Since 2009, the average level of private credit as a proportion of gross domestic product (GDP) has increased from around 75% to 125%. These stylized facts highlight deep uncertainties and downside risks in Asia. Measures of regional financial integration, capital market deepening, and emerging market banking systems must be carefully evaluated.

Vulnerability to sudden changes in market mood and reliance on demand from the systemic five economies has been another source of challenges for economies in Asia and the Pacific. The taper tantrum, i.e., the expectation that the Fed would wind down asset purchases in summer 2013 triggered financial market turmoil in the fragile five economies of Brazil, India, Indonesia, South Africa, and Turkey. These countries experienced large capital outflows and a sharp rise in the credit default swap spread. Several factors characterized the vulnerabilities in these countries, such as significant current account deficit problems, political uncertainty, and large shares of foreign holdings in the local bond and stock markets. The concerns of the fragile five created short-term financial stress for other Asia and the Pacific economies as well. In addition, global investment funds become more selective, with investment decisions conditional on the economic fundamentals of each Asian economy. Expectations of a series of interest rate hikes after the Fed meeting and the announcement of a macroeconomic indicator also resulted in exchange rate volatility. The low growth in advanced economies also translated into lower external demand, which had been a major growth engine for the majority of the Asian economies. The neighborhood effect of the People’s Republic of China’s growth slowdown also created a significant negative impact on Asian exports and economic sentiment, which slowed down economic activities. The People’s Republic of China’s growth slowdown had large implications not only on trade but also on commodity prices. This further suppressed the export receipt of many Asian countries, which mainly export agricultural products, commodities, and crude oil.

Recently, as the global economy has shifted from crisis to recovery mode, changing global growth patterns have created new forms of global spillovers. Asia and other emerging market economies are slowing in a synchronized manner. In contrast, the United States (US) has started to wind down its extraordinary monetary policy stimulus and slowly raise its interest rate. Monetary policy normalization in the US has profound implications for global financial conditions and capital flows. The normalization could tighten financial conditions in global financial markets as interest rates and the yield rise with the improvement in economic outlook. However, an uneven economic recovery in advanced economies could pose some uncertainty for global financial markets. Meanwhile, the recovery in the European Union and Japan remains slows, but is improving. The uneven recovery and monetary policy divergence in advanced economies creates significant uncertainty for developing Asia. The continued easing in the European Union and Japan could potentially cause a large swing in the exchange rates of major currencies, which could affect emerging economies with balance sheet vulnerability and large foreign exchange exposures. The natural impact this has on economies depends on their strength and policy frameworks, such as their current account balances, reserves, and the depth and development of their financial markets, etc. The implications for trade are yet to be seen. The economic recovery of advanced economies could translate into higher external demand, which would improve economic activities in Asia. This could also hopefully help to offset the negative impacts of tighter financial conditions going forward.

There is also rising concern over financial stability after the policy normalization of the advanced economies. Corporate sectors in the majority of emerging economies issued more external debt after the global financial crisis (GFC). This debt is mostly denominated in US dollars, which could make countries more vulnerable to rollover risk and interest rate and exchange rate risk. The countries would be vulnerable to US dollar appreciation because of the large amounts of US dollar denominated debt, with income streams mostly in local currency. The issue of debt could also be affected by the maturity mismatch, by struggling to rollover foreign currency short-term debt funding, while relying on long-term funding revenue. There remain concerns as to whether these private external debts will put local financial systems at risk of crises after the Fed begins to raise rates.

We develop a panel vector auto regression (VAR) model for the Asia and the Pacific region, for a time period covering data from Q1 2000 until Q1 2015. We split the overall sample into two subsets: the pre-crisis sample (Q1 2000–Q4 2006) and the post-crisis sample (Q1 2009–Q1 2015). Similar to Huber and Punzi (2016), we identify unconventional monetary policy (UMP) shocks with a shadow interest rate, as estimated by Leo Krippner (2013).

We find that the Asia and the Pacific region has responded to the advanced economies’ actions with accommodative monetary policy. Such lower interest rates were coupled with currency appreciation, asset price inflation, and strong movements in capital flows. Foreign investors have shifted their preferences for Asia and the Pacific bonds. If prior to the GFC the global saving glut hypothesis (i.e., Asian savings flight to the US) was one of the major effects on the booming US house prices, it is clear that a reverse effect has dominated after the GFC: funds flight to the Asia and the Pacific region is putting pressure on asset prices, leading to financial vulnerability.

Quantitative easing actions generate clear business cycle synchronization with co-movements in real GDP and interest rates. The low perception of market uncertainty leads foreign investors to hold more liabilities in the Asia and the Pacific region. These findings shed light on the recent discussion opened by Hélène Rey (2015) on “dilemma,” no longer “trilemma,” since central banks appear to have lost their monetary policy independency even under floating exchange rates.

Huber, F., and M. T. Punzi. 2016. Evaluating the outcomes of unconventional monetary policy in the housing market during the zero lower bound. WU Working Paper.
Krippner, L. 2013. Measuring the stance of monetary policy in zero lower bound environments. Economics Letters 118 (1): 135–138.
Rey, H. 2015. Dilemma not Trilemma: The global financial cycle and monetary policy independence. NBER Working Paper 21162. Cambridge, MA: NBER.

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Maria Teresa Punzi

About the Author

Maria Teresa Punzi is an assistant professor at the Institute for International Economics and Development, WU Vienna University of Economics and Business.
Pornpinun Chantapacdepong

About the Author

Pornpinun Chantapacdepong is a research fellow at the Asian Development Bank Institute.
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