Asia Pacific Economics Rise in Real Rates – Why It Feels Like the 1990s :: Morgan Stanley Research

Asia Pacific Economics
Rise in Real Rates – Why It
Feels Like the 1990s
Speedier rise in US real rates and dollar pushing
Asia to lift its real rates: We have for some time been
highlighting the challenges that the rise in US real rates
and the appreciation of the US dollar will pose for Asia.
However, the pace at which US real rates have risen
and the appreciation of the US dollar against Asia and
EM currencies have clearly been a surprise to us. The
speedier rise in US real rates and dollar has now pushed
Asia to lift its real rates at a time when its GDP growth
has already been slowing. This pro-cyclical tightening, in
our view, is only increasing the headwinds to the
region’s growth.
Is the rise in real rates temporary? We believe that we
are at the beginning of the cycle of a rise in the US dollar
and rates, implying that the upward pressures on real
rates in Asia will likely remain as a trend. We believe the
key factors that will drive real rates in Asia will be trends
in the US dollar, real rates and trade balance.
In this context, we think the correct historical guide to
evaluate developments in the current cycle will be the
mid-1990s cycle – when US real rates moved up along
with a decline in its trade deficit amid an appreciating
dollar.
An environment of rising real rates and moderate
GDP growth will likely be less supportive for risk
assets. We believe that real rates would rise even as
AXJ GDP growth is moderating. In other words, we are
now entering into a different economic environment as
compared to the last 11 years, where real GDP growth
was maintained at high levels while real rates were low.

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Asia Pacific Economics:
Rise in Real Rates – Why It Feels Like the 1990s
Pro-cyclical Tightening Raises Six Key Questions
We have for some time been highlighting the challenges that
the rise in US real rates and the appreciation of the US dollar
will pose for Asia. However, the pace at which US real rates
have risen and the appreciation of the US dollar against Asian
and EM currencies have clearly been a surprise to us. Since
May 2013, US 10-year bond yields have risen by ~120 basis
points as the US economy sustains capex-driven growth.
The speedier rise in US real rates and dollar has now pushed
Asia to lift its real rates at a time when its GDP growth has
already been slowing – in other words, a pro-cyclical tightening
of monetary policy.
We think this is only increasing the headwinds to the region’s
growth – particularly considering the rapid buildup of leverage in
the region over the past few years when real rates were kept low.
In our conversations with clients, we infer the following
questions in view of these recent macro developments:
1) Why are real rates rising in Asia?
2) What are the implications of rising in real rates and which
economies are more exposed?
3) Is the rise in real rates temporary?
4) Why is this cycle similar to 1995-2001?
5) How does Asia compare now versus the 1990s?
6) What is the end game for Asia?
The depth of the current growth slowdown is likely to be
shallower than in previous episodes of rising real rates – but
the recovery, when it happens, is also likely to be less vigorous.
The region now has to contend with weaker demographic
trends and the pickup of the US economy not as a leveraged
consumer but as a reindustrializing competitor.
1) Why are real rates rising in Asia?
We cite a combination of two factors:
a) The region’s excess saving, after having steadily risen from
2001 to a peak in 2007, has fallen back to 2001 levels.
b) As a result of an improving US economy and market
expectations of Fed tapering, interest rates in the US have
been steadily rising, adding to the upward pressures on
interest rate trends in Asia

2) What are the implications of rising in real rates
and which economies are more exposed?
The exogenous rise in real rates will constitute a pro-cyclical
monetary tightening for all the countries in the region. This will
weigh on credit growth and domestic demand and accelerate
the pace of formation of non-performing loans in the banking
system. Rising real rates will imply an increase in the cost of
capital and debt burden of borrowers.
Moreover, an environment of rising real rates with moderating
GDP growth tends to be less supportive of risk assets, which
would further depress domestic consumer/corporate confidence.
Overall, this suggests downward pressures on the region’s
growth outlook. (For a more detailed discussion, please see
Asia Pacific Economics: Rise in Real Rates - What Does It
Mean For AXJ?, May 29, 2013 and Asia Pacific Economics -
Understanding AXJ's Exposure to Rising Dollar and Real
Rates, June 21, 2013).
We use a three-factor framework to assess individual
country exposure to this trend of rising real rates/dollar:
1) Reliance on external sources of funding,
2) Increase in domestic leverage ratios
3) Starting point of real interest rates
Our analysis suggests that within AXJ, countries with current
account deficits or close to balanced current accounts will face
greater immediate pressures due to funding risks (Exhibit 2).
Countries that have levered up meaningfully over the past few
years when real rates were low will also be exposed (Exhibit 3).
These metrics indicate that India, Indonesia, Australia,
Thailand, Hong Kong and Singapore will be most exposed.
The adjustment in countries with CADs has taken place more
quickly and suddenly, and we expect that to continue. Yet the
continued upward pressures on real rates in the region will
slowly but surely be felt across the region.
3) Is the rise in real rates temporary?
We believe that we are at the beginning of the cycle of a rise in
the US dollar and rates (see FX Pulse: The USD Bull Is Back,
August 15, 2013 and FX Pulse: Taking USD Projections Higher,
June 6, 2013), implying that the upward pressures on real rates
in Asia will likely remain as a trend. We believe that the key
factors that will drive real rates in Asia will be the trend in the US
dollar, real rates and trade balance. The trend in US real rates
will influence capital flows and hence real rates trend in Asia.
4) Why is this cycle similar to 1995-2001?
In this context, the developments in the current cycle have
largely mirrored those from the mid-1990s to 2001, in our view
(Exhibits 4-5). In this cycle, like that in 1995 to 2001, as US real
rates moved up along with a decline in its trade deficit, the
dollar appreciated – forcing Asian currencies to weaken and
Asian real rates to rise.
We believe the rate hike cycle in the US during 2004-06 is not
comparable. During that period, the US trade balance
continued to widen and the dollar continued to weaken

5) How does Asia compare now versus the 1990s?
Applying the same framework – 1) reliance on external sources
of funding, 2) increase in domestic leverage ratios, and (3)
starting point of real interest rates – we assess whether Asia
will be more or less exposed in this current cycle as compared
to the cycle in the 1990s (see Exhibits 6-7 on pages 5 and 6).
• Asia is now less reliant on external sources of funding.
• Current account balances are in better shape now than in
the 1990s, save for India and Indonesia.
• External indebtedness is also lower in most countries.
• The higher level of FX reserves and more flexible
exchange rates, mean that most countries in the region
are better placed in this cycle.
• However, the faster pace of buildup in leverage and the
lower starting point of real rates suggest a need for greater
adjustment