Is Asia Ready for an End to QE?

Figure 1. Stock Prices and QE Timeline. <a href="" target="_blank">View enlarged graph</a>.
Figure 1. Stock Prices and QE Timeline. <a href="" target="_blank">View enlarged graph</a>.

By Cyn-Young Park (朴信永)

Asian stock markets have been under pressure recently from an announcement by the US Federal Reserve that “quantitative easing”, or QE as it is commonly referred to, is likely to be tapered off in the near future.

Asian stock markets have been under pressure recently from an announcement by the US Federal Reserve that “quantitative easing” or QE as it is commonly referred to, is likely to be tapered off in the near future.

This relatively unconventional monetary policy ―which involves purchasing bonds or other financial assets directly from commercial banks and other private institutions to increase the monetary base― was introduced in November 2008 at the height of the global financial crisis  to try to fend off an economic slump.

As a monetary tool, QE was always meant to be temporary, since each bond purchasing program results in a significant expansion of the US Federal Reserve’s balance sheet. Now with the fear of a recession dissipating and the economy showing signs of gradual recovery, the prospect of an end to QE is just around the corner. 

The news came on June 19, 2013, when Federal Reserve Chairman Ben Bernanke announced that there was likely to be a "tapering" of QE later this year. It was, of course, noted that any final decision will be contingent upon continued signs of economic strengthening, especially in employment. 

Speculation that the policy may soon end saw the yield on US Treasury 10-year notes shoot up, bolstered also by robust economic and employment data. The higher yields on US Treasuries prompted an unwinding of the “carry trade”—a practice involving borrowing funds in US dollars to invest in higher return emerging market assets. 

Emerging Asia has previously seen a surge of large inward capital flows, especially short term funds, on the back of its relatively strong growth prospects in the post-global financial crisis economic environment. Clearly cheap funding costs in the global market played a part in this. 

The Federal Reserve’s announcement prompted a quick selloff in Asian stock markets and further declines may well be in store as the yields on US Treasuries continue to rise and as foreign investors exit the region. Although there is no clear timeline for a scaling back of QE, higher returns on US assets pose a short-term risk for emerging Asian markets. 

Identifying and monitoring the factors that cause financial stress and affect emerging markets has not been easy, but a growing number of economic studies have used a financial stress index (FSI) as a continuum and contemporaneous measure of the severity of financial crises. 

In a recent paper, I co-authored with Rogelio Jr. Mercado, we proposed a FSI for emerging Asia. The paper examines the determinants of financial stress in emerging market economies and traces the transmission of financial shocks emanating elsewhere, using the index.

Note: Values computed as unweighted average of individual country FSI. Emerging Asia includes People’s Rep. of China; Hong Kong, China; India; Indonesia; Rep. of Korea; Malaysia; Philippines; Singapore; and Thailand. Monthly average data of banking sector price index and the benchmark stock price index were taken from DataStream. The data were converted to year-on-year returns by taking the difference between current period and last year’s price index both in natural logarithm form. Monthly data for both foreign exchange and foreign reserves are taken from national sources and CEIC database. Sovereign debt data refers to yield differentials between long-term (short-term) domestic government and long-term (short-term) US Treasury bonds in basis points. Monthly average data on sovereign debt spreads were taken from national sources accessed through CEIC Database. Episodes of financial stress refer to one unit deviation from the long-term trend computed using HP filter. Source: Authors’ estimate.

Our index suggests that expectations for a wind back of QE and associated uncertainty add to financial stress in emerging Asia. The index inched up in June this year as the likelihood of a near-term tapering off of QE increased. 

In addition, although the FSIs for most emerging Asian economies edged down a bit in July (note we don’t have the regional aggregate for the month yet due to incomplete data), huge uncertainty lies ahead. 

Our study reaffirms some earlier stylized facts, including the transmission of financial shocks from advanced to emerging market economies, and the adverse impact of high global interest rates on emerging markets. Higher global interest rates tend to increase domestic financial stress in emerging market economies, suggesting tighter conditions in international credit markets can adversely affect domestic financial conditions.

Along with the trend towards integration, financial activity has become increasingly global in recent years. The growing cross-border nature of banking and financial services underscores the need for coordinated oversight of international financial institutions and markets, along with policy coordination, to safeguard global financial stability. 

At this point, it remains to be seen to what extent a scaling back of QE will impact financial market conditions in emerging Asia. What is clear, however, is that there will be some knock-on effect and it would be desirable for the Federal Reserve and Asian financial authorities to keep the channel of consultation and discussion open in the tapering process.