View: RBI policy should be contingent on recovery, inflation and Omicron, not US Fed behaviour – The Economic Times

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Drawing on the experiences of the previous cycles, there are more similarities with the 2003-07 cycle, rather than 2013. Asian central banks are expected to proceed with a gradual pace of policy normalisation, which should be contingent on the recovery of their economies, inflation dynamics and implications of the Omicron variant, rather than being heavily influenced by the Fed policy path.

Markets expect the first full US Federal Reserve rate hike by July 2022, with a total of 2.6 hikes priced in for 2022 and 4.8 hikes by end 2023. This repricing of the Fed policy path has led investors to ask if this will force a tightening of financial conditions in Asia.

Drawing on the experiences of the previous cycles, there are more similarities with the 2003-07 cycle, rather than 2013. Asian central banks are expected to proceed with a gradual pace of policy normalisation, which should be contingent on the recovery of their economies, inflation dynamics and implications of the Omicron variant, rather than being heavily influenced by the Fed policy path.

When Taper is the Trigger
There are four reasons why this Fed tightening is similar to the 2003-07 cycle for Asia and India. One, for understanding the impact on Asian financial conditions, the key variable is US 10-year real rates. In the 2003-07 cycle, market-based 10-year real rates remained in a narrow range in the subsequent 12-month period when the Fed began lifting rates. Whereas in 2013, once the Fed guided for a start to its tapering in May, US 10-year real rates rose by 135 basis points (bps) in just two months.

In this cycle, despite the tapering announcement and the recent hawkish tilt by Fed officials in hinting at more rate hikes in 2022 and 2023, US real rates have remained largely range-bound since end-July 2020. Morgan Stanley’s rates strategy team sees US 10-year real rates rising to -0.3% by Q4 2022, which implies a modest 70-odd bps rise from here. Moreover, US GDP growth is expected to average 4.2%. This expected tightening, just like in 2003-07, will not weigh heavily on the US growth trajectory.

Two, the external demand backdrop is also similar to the 2003-07 cycle. US domestic demand was strong, and its current account deficit (CAD) continued to widen until Q4 2006. This external macro setup led to a boom in Asia’s and India’s exports. In 2013, global trade growth was very weak, given deleveraging headwinds in developed market economies.

In this cycle, global trade has recovered sharply and Asia’s export recovery has already been the fastest in the four most recent cycles. Moreover, global GDP growth and trade growth is expected to remain strong over the next two years, ensuring a strong external demand backdrop for Asia and India.

Three, productivity dynamic in Asia and India is also similar to the 2003-07 cycle. The export boom then translated to a significant uplift in the region’s capex cycle. That kicked off a virtuous productive growth cycle for Asia, allowing policymakers to withdraw policy support countercyclically. The rise in interest rates did not disrupt the growth cycle, as capex and productivity growth were lifting the neutral rate. In the 2013 cycle, policymakers had persisted with forceful stimulus, and as rates rose, it triggered an adjustment phase for the region.

In this cycle, we see Asia’s productivity dynamics improving significantly. Over the next two years, external demand conditions should remain strong – the right kind of fuel for Asia’s growth engine. The virtuous feedback loop of strong external demand and positive spillover effects to capex should engender a self-sustaining cycle.

Spend More, Spend Better
One key difference, though, is that the transmission of stronger exports and capex growth to consumption growth is still being held back by Covid restrictions. However, with vaccinations picking up to cover more than 80% of the eligible population in 11 out of 12 economies in the region by February 2022, consumption growth should recover more meaningfully next year, subject to developments on the Omicron variant.

Four, macro stability indicators were in good shape, driven by a positive productivity dynamic in the 2003-07 cycle. In 2013, most macro stability indicators were deteriorating or becoming stretched. Current account balances across the region were deteriorating, particularly in India and Indonesia. Inflation was similarly running high, which eroded the real rate buffers that the region had with the US.

In the current cycle, while the rest of the world is facing inflationary pressures from a confluence of demand and supply factors, Asia’s inflation dynamics have been well-behaved, because wage growth is still running below its pre-Covid path. Fiscal policy was actively used in the region to make up for the shortfall in demand, but the nature of spending has been tilted towards capital expenditure and focused more on enhancing productivity for the most part and less on transfers. Moreover, real rate differentials in Asia vis-a-vis the US are at a multi-year high (also because US inflation is elevated).

These conditions explain why Asian currencies have been relatively stable in H2 2021. With these buffers in place, the pace of rate hikes in the region will likely depend more on domestic conditions rather than be driven by the Fed’s policy normalisation. In India, the RBI is expected to raise effective policy rates by 150 bps to restore adequate real rate buffers.

The risk is a sharper and faster rise in US 10-year real rates. If it materialises, India and Indonesia would likely be the most exposed. While we expect central banks in both countries to hike rates over 2022 and build real rate buffers, the risk is that the pace of central bank actions could be slower than expected, or inflation could surprise to the upside.

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