(Bloomberg) -- The decoupling thesis -- that Asia is now more immune from what goes on at the Federal Reserve -- is being tested as 10-year U.S. Treasury yields hover near 3 percent.
Asian economies that reaped the benefits of low U.S. interest rates -- from record foreign inflows to subdued inflation -- are finding that rising U.S. yields and accompanying strength in the greenback are pushing up domestic borrowing costs, weakening currencies, and fueling capital outflows.
With Malaysia and the Philippines deciding on interest rates this week and Indonesia next week, the Fed’s moves are a key factor for central bank bosses once again. That’s especially true for economies dependent on foreign capital to finance their current account deficits: the Philippines, India and Indonesia. The three have the worst performing currencies in Asia this year.
Here’s how some of Asia’s biggest economies are affected by higher Treasury yields, starting with the three economies already being pressured:
Southeast Asia’s biggest economy is at risk because foreigners own a substantial amount of domestic bonds -- about 40 percent. As the spread between U.S. and Indonesian yields narrows, the threat of capital outflows increases as foreigners lose appetite for local assets. That’s already happened with overseas investors dumping $1.1 billion of bonds last month.
Indonesia has stronger buffers now than in 2013, when the “taper tantrum” fueled a selloff in the currency. While the current account deficit is set to widen, it remains low by historical standards, and the central bank has ample reserves to support the rupiah, even after they fell last month.
Radhika Rao, an economist at DBS Bank Ltd. in Singapore, is among those seeing extra pressure on Bank Indonesia to hike interest rates if foreign outflows persist and the rupiah remains pressured. Governor Agus Martowardojo has made clear that the central bank wouldn’t hesitate to stabilize the rupiah through rate hikes as needed.
India has seen a surge in foreign inflows in recent years, helping the rupee post its first annual rise in seven years in 2017. But with the Fed tightening policy, those inflows have slowed and in the case of the bond market, reversed. That has put pressure on the rupee, Asia’s worst performing currency this year.
The drop in the rupee comes amid rising prices for oil, India’s biggest import item, and concerns that a slowdown in investment flows could see the current account deficit widen from 2 percent of gross domestic product. Those risks are fueling speculation the Reserve Bank of India will raise interest rates.
The effect of higher Treasury yields on the Philippines is more mixed. The peso has been under strain after the current account surplus turned to a deficit and oil prices climbed. But the central bank has room to act.
With inflation breaking through the 4 percent upper bound of its target band, policy makers are “pretty close to hiking rates,” said Euben Paracuelles, an economist at Nomura Singapore Ltd. That’ll put them in a better position to contain capital outflows, with the currency already gaining against the dollar on expectations of policy tightening.
A narrowing gap between 10-year Chinese government bond yields and U.S. Treasuries erodes the attractiveness of China’s bond market and puts downward pressure on the yuan, both of which run contrary to efforts to keep the currency and capital flows stable. The gap with Treasuries fell last month to its lowest level since late 2016.
For Japan, higher U.S. Treasury yields may not be a bad thing. Finance Minister Taro Aso has said the yen will weaken against the dollar if the interest rate differential between both nations’ 10-year yields reaches 3 percentage points. The gap is already the widest since 2007. A weaker currency increases inflationary pressures through imported goods, providing tailwinds for the Bank of Japan’s 2 percent target. It would also boost corporate profits and business investment, wage growth, employment and household spending.
South Korea is vulnerable to a reversal in capital flows if Treasuries were to sustain a push above 3 percent. BOK Governor Lee Ju-Yeol has repeatedly said the country’s sufficient reserves and current-account surplus will prevent any disruptive moves. Although Korea’s 10-year government bond yields have been lower than that of the U.S. for a few months, foreign investors have increased holdings of South Korean bonds this year as tensions with North Korea appear to wind down.
Like Indonesia, Malaysia’s substantial bond holdings by foreigners -- about 30 percent -- make it vulnerable when Treasury yields start to rock the differential with domestic bond yields. One advantage -- the nation boasts a current account surplus of about 3 percent of GDP, giving more wriggle room. The central bank has shown little appetite to tighten policy after labeling an interest-rate increase in January as a bid to normalize.
©2018 Bloomberg L.P.