Investigating the Effect of U.S. Monetary Policy Normalization on the ASEAN-4 Economies

Author Name Willem THORBECKE (Senior Fellow, RIETI)
Research Project East Asian Production Networks, Trade, Exchange Rates, and Global Imbalances
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This Non Technical Summary does not constitute part of the above-captioned Discussion Paper but has been prepared for the purpose of providing a bold outline of the paper, based on findings from the analysis for the paper and focusing primarily on their implications for policy. For details of the analysis, read the captioned Discussion Paper. Views expressed in this Non Technical Summary are solely those of the individual author(s), and do not necessarily represent the views of the Research Institute of Economy, Trade and Industry (RIETI).

International Macroeconomics (FY2011-FY2015)
East Asian Production Networks, Trade, Exchange Rates, and Global Imbalances

The 1997-98 Asian Financial Crisis (AFC) devastated Thailand, Indonesia, and other members of the Association of Southeast Asian Nations (ASEAN). Real output fell by 11% in Thailand and 14% in Indonesia in 1998 after growing by more than 7% per year in both countries between 1970 and 1996. The crisis was triggered by capital outflows that caused ASEAN exchange rates to depreciate and the net worth of domestic firms with foreign currency liabilities to tumble. As firms' retained earnings fell, their debt/equity ratios soared and they lost access to credit. These businesses soon exhausted their working capital and were forced to curtail production. Small firms suffered disproportionately because they had less collateral and less access to credit than large firms did.

Given the dislocation experienced during the AFC, many are concerned that capital outflows from ASEAN triggered by U.S. monetary policy normalization now will cause renewed difficulties. To shed light on how these capital outflows are affecting ASEAN economies, this paper investigates the response of a cross section of stock prices to news of the Federal Reserve's policy normalization. Theory posits that stock prices equal the expected present value of future cash flows. Thus, by examining the response of stocks in different sectors to news about monetary policy normalization, one can learn something about what sectors of the ASEAN economies are most exposed to changes in U.S. monetary policy.

The results indicate that capital-intensive industries in Indonesia and Malaysia, especially those associated with the natural resource sector, are harmed by news of Fed tapering. The insurance and finance sectors in ASEAN are also adversely affected. Finally, small companies in Indonesia and the Philippines, which might have more trouble accessing credit, are harmed both by news of monetary policy normalization and by depreciations of the local currency.

Indonesia and Malaysia may be able to attract long-term investment into capital-intensive industries by enforcing private contracts, providing consistent and coherent enforcement of laws and regulations at all governmental levels, and in other ways pursuing a market-friendly environment. ASEAN countries should also seek to develop vibrant finance and insurance sectors that employ state-of-the-art risk management techniques. This could help them to withstand pressures from capital outflows and from other sources. One way to do this is through ASEAN financial integration, which offers the potential to develop more efficient financial markets that can make economies in the region more resilient. Indonesia and the Philippines can improve the access of small firms to finance by encouraging competition among commercial banks, privatizing state banks, and allowing foreign banks to enter.

This paper then investigates other impacts of capital flows on ASEAN. One key opportunity arises as capital outflows trigger exchange rate depreciations and improve the price competitiveness of exports. To gauge this effect, this paper estimates price and income elasticities for ASEAN exports. The results indicate that a 10% depreciation would increase labor-intensive exports from the Indonesia by 6%, from Malaysia and the Philippines by 8%, and from Thailand by 3% (please see Table 1).

One danger associated with capital flows arises as capital exits to seek higher returns elsewhere and foreign direct investment (FDI) into ASEAN falls. Attracting FDI plays an important role in promoting development in Southeast Asia. To attract FDI, ASEAN should seek to lower the cost of transferring production to their countries. While each country needs to do different things in this regard, three important steps for all are resisting corruption, improving infrastructure, and focusing on education.

Fed policy normalization and the attendant capital outflows thus pose both difficulties and opportunities for ASEAN countries. This episode should be viewed as one more turn in the long and winding road toward economic development in Southeast Asia.

Japan has a strong interest in a healthy and vibrant ASEAN. One step toward this would be to increase the volume of trade in Asia and the world. Japan specializes in technologically advanced products while ASEAN specializes in labor-intensive goods. Other countries in Asia have comparative advantages in other areas. Free trade agreements that could increase the volume of trade globally or at least in Asia could promote the gains from trade according to the theory of comparative advantage. High quality investment treaties in Asia could also promote FDI and lead to further trade and development in the region.

Table 1. Effect of a 10% Exchange Rate Depreciation on Labor-Intensive Exports
Exports from
Exports from
Exports from
Exports from
the Philippines
Exports from
+7.6% +5.7% +8.0% +7.9% +3.0%
Source: Calculations by the author.