: Super User; Philippines; 24 January 2012; Hits: 1194

Uniform cut in Interest Rates Unlikely

SHOULD Asian nations cut interest rates in order to head off an expected economic slowdown this year? Countries such as Australia and Thailand have already begun the process. Others widely regarded as preparing to follow suit include Vietnam and the Philippines.

Europe’s protracted sovereign debt crisis has hurt Asian exports and caused growth across the region to slow. A slowdown in China could accelerate the trend.

Lowering interest rates can be an effective means of revitalising a slowing economy. Cheaper money encourages both consumers and businesses to borrow, thus stimulating domestic demand. It is an especially attractive option when global financial markets are becoming increasingly leery of financing deficit spending.

The response of Asia’s central banks, however, is unlikely to be uniform. The problem is that a country cutting interest rates will risk a fall in the value of its currency. A weaker currency can stimulate exports, of course. But with global demand already sluggish, the impact is likely to be muted. Imported inflation, on the other hand, can have serious consequences for macroeconomic stability, particularly for countries already struggling to contain price pressures. Most Asian currencies weakened last year.

The point was illustrated earlier this month, when fears of imported inflation prompted the central banks of both South Korea and Indonesia to avoid lowering borrowing costs.

Of the two countries, Indonesia probably has more to fear from any move to lower interest rates. Partly due to the global strengthening of the US dollar, the currencies of both nations lost 6 per cent to 7 per cent of their value in the last six months of last year. In Jakarta’s case, however, the trend was exacerbated by the decision of Bank Indonesia to cut interest rates in October and November.

South Korea and Indonesia are also struggling to contain domestically generated inflation. Last month, the South Korean government raised electricity charges after ailing state-owned Korea Electric Power reported a loss for the first nine months of the year. Policy confusion – the result of competing political priorities – is adding to the problem. Responding to the influential farming lobby, Seoul recently began culling cattle to keep local beef prices high.

Annual inflation in South Korea stands at about 4 per cent – 1 percentage point higher than the average of the past decade. “I’m sure that the Koreans would love to cut interest rates... but given the persistent inflationary pressures, the best choice is to hold on for a little bit,” Seoul’s Daewoo Securities fixed income analyst Yoon Yeo Sam told Bloomberg earlier this month.

National Assembly elections are due in April and presidential elections are slated for December. This suggests that the South Korean government will be looking for a quick way to stimulate the economy. The results of mayoral elections last October have already made it clear that young voters are fed up with rising prices and unemployment.

The alternative to lower interest rates is some sort of fiscal stimulus. Indeed, the finance ministry admitted as much last month when it announced that the government planned to spend 70 per cent of its budget in the first half of this year, much of it focused on creating jobs.

Expect an additional Keynesian style deficit-spending package in the second or third quarter. With an external debt to gross domestic product ratio standing at a moderate 33 per cent, Seoul can afford to try spending its way out.

Bank Indonesia’s decision to keep interest rates unchanged came after a government plan to contain fuel subsidies threatened to spur inflation. Prices have been falling in recent months, but they are officially expected to accelerate this year. Official projections suggest an annual inflation rate of 6 per cent.

Unlike South Korea, however, Indonesia faces contradictory pressures. Keeping borrowing costs low would help President Susilo Bambang Yudhoyono’s government boost investment. He is targeting annual average GDP growth of 6.6 per cent for the remainder of his term ending in 2014.

That said, Indonesia is in an even better position than South Korea to raise money to finance deficit spending. With a public debt to GDP ratio of just 25 per cent, Indonesia obtained an investment grade rating on its sovereign debt from Fitch Ratings last month.

Other countries in the region may be less well positioned. But that does not mean that they lack options. As a result of several years of good growth, even a country such as the Philippines has been mulling the idea of introducing additional fiscal measures. Talk of a general reduction in interest rates across the region this year may therefore be premature.

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Key Political Risks

President Benigno Aquino has stepped up efforts to lure foreign investors into the country, so far without much success. The country continues to be hobbled by widespread corruption and several long-running insurgencies.

However, the government has had some success in reducing the budget deficit. The president also remains popular with voters.

WHAT TO WATCH FOR:

Extent to which foreign and domestic investors show interest in big ticket infrastructure projects.
Increased spending on the air force and navy to counter Beijing's territorial claims in the disputed Spratly Islands. The issue could become an important point of contention at the East Asia forum in Indonesia in November.
The implementation of the "framework agreement" between Manila and the insurgent Moro Islamic Liberation Front announced in early October. If all goes well, a final peace deal may be signed by 2016.