Federal Reserve risks exposing old vulnerabilities in emerging Asia

The populist leaders of India, Indonesia and the Philippines won office with promises of massive spending to upgrade their nation’s roads, railways and ports. Doing so, the thinking goes, would supercharge economic growth and emulate China’s success.

India’s Prime Minister Narendra Modi intends to spend a record $60 billion on infrastructure this fiscal year. Philippine President Rodrigo Duterte set an infrastructure spending goal of 7 percent of gross domestic product, while Indonesian leader Joko Widodo has added 7,000 kilometers of new roads and four new airports and last week vowed more.

In a global landscape starved of yield, foreign investment has poured in to help fund the ambitions, lured by young populations and some of the world’s fastest rates of economic growth. As a sign of their resilience, the trio have even shaken off interest rate hikes by the Federal Reserve, something that has tripped up many a developing nation in the past.

But now the Fed is set to embark into uncharted territory by shrinking its $4.5 trillion balance sheet and old vulnerabilities are starting to resurface. The problem the three nations face is that, unlike China, they lack the industrial, export and domestic savings bases needed to fund their plans.

To dig foundations and pour cement, heavy equipment must be imported, weakening current accounts just as faster growth is also swelling imports. And the cost of the projects is pressuring budget deficits, leaving the governments heavily reliant on foreign cash.

"Stepping up infrastructure investments in these large Asian emerging markets will likely widen the current account deficit and increase external debt," said Chua Hak Bin, a Singapore-based senior economist with Maybank Kim Eng Research. "Depending on the form of external financing, some emerging markets could become more sensitive to volatile foreign capital flows and currency mismatch risks."

Policy Risk There are already signs of that strain in foreign-exchange markets. The Philippine peso is Asia’s worst performer against a lackluster greenback this year, down more than 3 percent. Indonesia’s rupiah is the third-worst, while India’s rupee is in the middle of the Asian pack.

With the world’s top central bankers gathering at the Jackson Hole mountain retreat in Wyoming this week, any comments signaling a faster-than-anticipated normalization in developed-world policies could sharpen investors’ minds on the potential fallout.

When compared to other major emerging markets like Brazil, South Africa, Turkey and Russia, the economies of India, Indonesia and the Philippines look in relatively good shape, said Rob Subbaraman, chief economist for Asia ex-Japan at Nomura Holdings Inc.

"Policymakers are aware of the risks of capital outflows, which helps explain their continued build-up of foreign exchange reserves," he said. And not all deficits are bad -- if the financing is for productive purposes, that should lure more investment and boost growth, he said.

The Asian Development Bank estimates emerging economies in the region need to invest as much as $26 trillion through 2030 to build transport networks, boost power supplies and upgrade water and sanitation facilities.

And overall debt levels remain low by global standards. So for now at least, foreign investors continue to underpin expectations for growth rates above 5 percent.

Much will hinge on what happens with the U.S. dollar. If it remains weak, there may be no cause for concern, said Alicia Garcia Herrero, Hong Kong-based chief economist at Natixis. Even if the greenback strengthens, the three have room to increase interest rates to keep foreign capital from leaving, she said.

Lingering problems with its banking system and a stronger currency make India the most exposed to global tightening among the three, she said, followed by Indonesia. A weaker peso has already helped the Philippines adjust. While the risk of serious disruption appears low, "balance sheet reduction is new and it is hard to foresee the consequences," she said.