Asian central banks: Diverging on the balancing paths

As the conflict in the Middle East heads into its ninth week, ongoing disruptions to supply chains continue to have a profound impact on energy prices globally. Asian economies—for which 89% of the oil volume flowing through the Strait of Hormuz is destined—are expected to see a larger impact, with lower oil supply driving higher energy prices.

However, while this has raised inflation risks for the region—and, subsequently, the potential for interest rate hikes—expectations also appear to be weighed down by concerns over slower economic growth. Especially when compared to the rest of the world, current market pricing on forward interest rates for some Asian economies were relatively more muted, signaling a potential divergence in monetary policies ahead (Exhibit 1). In contrast, the Bangko Sentral ng Pilipinas (BSP) and Monetary Authority of Singapore (MAS) have tightened policy stances earlier this month in reaction to the economic impact from the Middle East conflict. 

To ascertain how central banks may respond to this energy shock, it is prudent to note the varying sensitivity to economic growth, price stability, and foreign exchange (FX), which in turn could lead to respective central banks’ monetary policy response. In the next section, we will assess the Asian economies’ impact across these channels.

Growing on fiscal

Broadly speaking, the terms-of-trade shock from higher energy prices could affect growth through a reallocation of fiscal spending from capital spending to subsidies, a decline in consumers’ purchasing power, and a squeeze in corporate margins from higher input costs. In the case of Indonesia and Malaysia, which extend fuel subsidies to consumers, they could face a higher subsidy bill, putting upward pressure on the fiscal deficit against a backdrop of weak revenue collection (in the case of Indonesia) and low cash buffers, even though the impact on consumer spending could be more limited. 

In India, the government has cut special excise duties on both petrol and diesel to alleviate losses for government-owned oil marketing companies (OMCs) as retail prices have remained steady despite higher crude oil prices.

While this is good news for consumers, the excise cuts could pressure the government’s fiscal position if oil prices linger at current levels for longer.

North Asian and developed economies are on a relatively better footing. Higher average household income has meant that the spending on impacted goods (fuel and food) as a share of total real income is lower, as well as a lower fuel weight in the consumer price index (CPI) basket (Taiwan: 2.4%, Singapore: 3.8%, Korea: 3.9%, other EM Asia: 4.8%-12.4%). Higher levels of oil stockpile inventory in Japan, Korea, and Taiwan add another line of defense to buffer growth, while the robust artificial intelligence (AI)-related tech upcycle provides a strong offset to the external hit, which could keep the risk around growth balanced at this juncture. Even if the fiscal space is somewhat limited, the steady tech-sector tax receipts could provide some buffer. The recent upside risk to growth in Korea could drive upward pressure on medium-term inflation expectations, prompting a hike late this year.  

Inflationary pressures

The second channel of the negative terms of trade shock is via inflation. While central banks typically do not respond to supply-side inflationary shocks through rate hikes, they could if inflation expectations become unanchored. Among Asian economies, the Philippines is likely to face a relatively strong inflation pass-through, given the knock-on impact on domestic fuel and food prices. In line with its strong tilt towards price stability, the Philippines central bank last week hiked the policy rate in a move to anchor inflation expectations, with the possibility of further rate hikes if headline inflation remains above the 3% target, in line with markets’ pricing. The MAS earlier this month tightened its policy stance through the steepening of the S$NEER slope in a move to curb imported inflation. Should inflationary pressures linger, we will not rule out a further tightening move later this year. Even as inflation risks have risen in India, the Reserve Bank of India (RBI) is likely to remain put despite markets currently pricing in two hikes given that inflation expectations remain anchored alongside a still-robust growth backdrop.

Spot the outliers

The final piece of the divergence in central bank responses likely lies in relative currency performance. Entering March, weakness in Asian currencies was already broad-based due to their lower yield nature, softer domestic demand, and various idiosyncratic factors. And the Middle East conflict, with Asian economies taking an asymmetric hit on growth over inflation, has further exacerbated this weakness. 

Given the largest energy trade deficits as a percentage of gross domestic product (GDP), pressure on the South Korean won (KRW), Philippine peso (PHP), and Thai baht (THB) was most pronounced; these currencies declined by as much as 6.1%, 5.8%, and 5.1%, respectively, compounded by other domestic factors (e.g., outsized equity outflows in Korea, local political uncertainty in the Philippines, and a weaker tourism outlook in Thailand). Even though the recent series of ceasefire extensions has helped recoup some losses and could cushion expectations for further deterioration in the near term, most Asian currencies are still trading meaningfully cheaper (Exhibit 2). Most notably, compared to long-term average levels against the U.S. dollar (USD), the Indian rupee (INR), Japanese yen (JPY), Indonesian rupiah (IDR), and KRW still screen at over 20% discounts. 

Although not all central banks are on equal footing when it comes to supporting exchange-rate stability, some have already intervened heavily. With meaningful depletion of FX reserves—most notably in Thailand, with an approximately 5% drawdown—this also opens the door for some to consider strengthening their currencies, potentially even through interest rate hikes.

That said, economies with a relatively more resilient current account position could see currencies fare stronger versus those with deficits (IDR, INR, PHP). Domestic policies targeted at curbing excessive currency volatility may ease the near-term risks of an imminent rate hike.

From India’s recent measures to tackle speculative trading (by tightening onshore banks’ FX net open positions and NDF offerings), to Korea’s ongoing reforms to enhance retail participation in domestic markets (through tax benefits under the Reshoring Investment Accounts scheme) and the Bank of Japan’s numerous verbal interventions, these may continue to buffer extensive depreciations. By contrast, growing pessimism over Indonesia’s market accessibility status review and the recent downgrade of its sovereign credit rating outlook may outweigh any short-term measures, leaving its currency more vulnerable.

Investment implications

In the absence of a sharp deterioration in the situation or any fresh external shocks, a confluence of the aforementioned factors likely dictates the interest rate path ahead for most Asian economies. Any new hints from this week’s Federal Reserve meeting could also alter the broader outlook.

Nevertheless, with markets increasingly pricing in outsized hikes across Asia, opportunities are emerging. Currently, our investment bank economics team expects one hike in Korea, two in Japan, three in the Philippines, and no changes in the rest of Asia. This makes the shorter end of Asian fixed income more attractive should market pricing reverse, although duration in Asia is relatively more at risk given the potential for more fiscal support from governments. The uneven reactions expected from Asian central banks should also see growing discrepancies, rewarding dynamic positioning. As for equities, sectors with higher net margins (e.g. 11.6% for APAC tech vs 10.8% for the base index) could help buffer a prolonged impact on input prices, while structural themes such as AI-related tech sectors should see tailwinds outlasting temporary shocks from geopolitics.

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