Living with Higher Interest Rates: Is Asia Ready?

Abstract

The Federal Reserve (the Fed) raised its policy rate by 25 basis points on 30 June 2004 and is expected to continue a series of rate hikes in its subsequent monetary policy meetings over the next 18 months or so (US Federal Reserve Board 2004). Higher interest rates in the United States (US) can adversely affect Asian economies by reducing aggregate demand through various channels.

First, higher yields on US assets attract capital, thus reversing international capital flows. Heightened uncertainty combined with declining international liquidity and weakening currency conditions add to volatility in emerging markets, further hiking risk premia and therefore increasing the cost of capital. Second, the transmission of higher US interest rates through international capital markets yields higher domestic rates, exerting a downward pressure on domestic investment and consumption.

Global transmission of interest rates is found to be significant for developing countries (Frankel et al. 2002). Empirical evidence shows that local interest rates in Asian developing economies respond to short-term US rates in a strongly positive manner regardless of existing exchange rate regimes. Third, higher interest rates may curb global consumption spending, hence reducing external demand for Asian exports. A long period of very low interest rates created a legacy of increased leverage and inflated asset prices around the world, leaving global consumption particularly vulnerable to rate hikes.