This article first appeared in Forum, The Edge Malaysia Weekly, on November 30 - December 6, 2015.

With the US Federal Reserve virtually certain to raise rates in December, the focus is on what impact this policy shift will have on our economies. To many, it is a given that the US dollar will strengthen because further easing in the eurozone and Japan makes the US dollar more attractive than other major currencies. Interest rates are also seen as set to rise across the globe as higher US rates draw capital away from other markets.

But things are never as straightforward as that. Much will depend on the actual path the American economy will take, what other major central banks will do and other factors, such as geopolitics. Taking these into account, we believe the US dollar may not appreciate as rapidly as some fear, while the rise in long-term rates could well lag behind the improvement in economic activity. Still, the net result is likely to be more stresses in emerging economies in Asia.

Where is the US economy headed?

There are several features of the US economic rebound that we need to consider.

First, the cyclical momentum is likely to surprise on the upside because improvements, albeit gradual currently, in the credit, labour and housing markets will feed off each other to amplify an initially modest growth rate into a much stronger one. Falling unemployment is slowly returning bargaining power to workers, so we should expect accelerating wage growth in the coming year. Moreover, businesses are likely to interpret the Fed move as signalling its confidence in the durability of the recovery, prompting them to regain some of their missing animal spirits and start investing in new capacity again. All these factors — rising wages and a turnaround in capital spending — will have powerful multiplier effects on economic growth.

Second, US inflation may well surprise on the upside in 2016, given rising wage pressures, reduced slack in the economy that will improve pricing power and the fading away of the effect of falling oil prices.

Third, the presidential and congressional elections in 2016 are likely to be bitterly fought, given the extreme partisanship in the country. This means the focus will shift to structural weaknesses in the US economy — especially the desultory growth in median household incomes — which have produced an angry electorate looking for simple solutions. Each side has radically different policy proposals to address these structural weaknesses — the Republicans believe reducing taxes and deregulation will do the trick, while the Democrats favour more aggressive redistributional measures as well as a big push on infrastructure spending. Both sides will be tempted to offer populist nostrums while also bashing foreign trading partners for unfair trade practices.

In other words, the US economy is likely to grow faster and inflation could pick up, but a good part of the electorate will not feel the progress, opening the way for election noises that would create uncertainty for businesses while also encouraging more protectionism. Far from raising rates in the ultra-cautious way that markets currently expect, the Fed will be forced by rising inflation to tighten policy faster.

Could the eurozone and Japan outperform expectations?

Both the eurozone and Japan certainly face mighty challenges, including deflationary pressures, huge public debt burdens, an ageing population and over-regulated product and factor markets. But these constraints are long term in nature and do not preclude a cyclical recovery that is reasonably strong.

In Japan, the economic contraction in 3Q2015 was more due to an inventory correction rather than weakness in final demand. In fact, with wages beginning to rise more strongly and businesses stepping up equipment orders, the economy is set to grow faster from this quarter.

Similarly, the latest purchasing manager surveys in the eurozone show business activity and employment creation expanding at the fastest pace in more than four years. A weaker euro, further monetary easing next month, gradually improving bank lending as the financial crisis ebbs and continued low oil prices will help boost eurozone activity.

In short, better-than-expected economic performance in the eurozone and Japan could imply that their central banks will not need to be as aggressive in monetary easing in 2016 as investors currently expect. Moreover, the growth differential between these two economies on the one hand and the US on the other may not widen as much as expected. And that means that the euro and yen will not depreciate as much against the US dollar, as many now perceive. However, the US dollar is likely to see another bout of appreciation against emerging-market currencies.

Political risks will also have an impact

The tragic events in Paris and the ensuing terrorist scares are symptoms of a deeper political malaise — a Middle East political configuration whose breakdown is just beginning, with much more trouble to ensue; trouble that will spill over into Europe and Asia. There is no reason to believe that Asian nations are immune to the sort of terrorism just witnessed in Paris — the mischief makers have been building terrorist cells in Southeast Asia for some time and have seen how just a small group of them can gain disproportionate propaganda benefits that will help them recruit even more adherents.

While the media’s attention is on the recent terrorist incidents, instability is also brewing further afield — in eastern European countries such as Ukraine and Moldova, in the Caucasus region involving Armenia and Azerbaijan, in Central Asian countries such as Uzbekistan, in the South China Sea and in the Korean peninsula.

These political dislocations will have financial consequences:

•    There will be more demand for safe-haven assets such as US and German bonds. In other words, while higher policy rates should push up short-term rates in the US, long-term rates may not rise in tandem. This effect will be all the stronger if current account surpluses grow in China, the eurozone and Japan, prompting these countries to invest their surpluses in US assets; and

•    As political and economic pressures grow in the Persian Gulf region, there will be increasing pressures on the countries of the Gulf Cooperation Council, led by Saudi Arabia, to reconsider their currency pegs to the US dollar — tying their currencies to an ever-strengthening dollar will only add to their woes. Such moves could add to perceptions of risk in emerging markets.

Conclusion: Challenges for Emerging Asia

Pulling together these various factors, we believe the following patterns will become evident in Asia.

First, as prospects in the US, Europe and Japan improve relative to developing economies in Asia, there will be another rebalancing of investment portfolios in favour of developed markets, spurring further capital outflows from Asia. This will be the case if we are right in believing that the Fed will be compelled by higher-than-expected growth and inflation to raise rates more aggressively than expected.

Second, we are likely to see local currencies depreciate further against the US dollar.

Third, once the Fed raises rates and removes the overhang of uncertainty, central banks in Asia will feel freer to act. We see some degree of policy easing in countries such as India and Indonesia, for instance.

Fourth, as currencies depreciate and local liquidity tightens, however, domestic interest rates are likely to rise in Asia unless there are aggressive monetary policy actions to prevent that. In Singapore, for instance, the Swap Offer Rate is now at its highest level since early 2009 — with a lag, that rise will translate into higher mortgage and other lending rates.

Fifth, as local currencies weaken and liquidity tightens, financial stresses are likely to emerge:

•    The Bank for International Settlements has warned of large increases in foreign currency debt accumulated by companies in emerging economies, including Asia. More recently, the BIS found a worrying decline in profitability among large emerging-economy borrowers, suggesting a rising risk of defaults; and

•    Moreover, the past seven years of easy money have produced high valuations in assets such as real estate and equities across emerging Asia. As domestic interest rates rise and liquidity tightens, these valuations are bound to correct, adding to the stresses above.

Finally, while stronger global growth should support prices of commodities that are correlated to the economic cycle such as oil, coal, base metals and rubber, we should not expect such a rebound to be meaningful because it is unlikely that China, the biggest consumer of these items, will recover strongly. We see this more as a positive: For too many years, countries in the region such as Indonesia, enjoyed “lazy” growth — surging commodity prices drove income growth with no real need for policy reforms to address structural weaknesses. Now, without the crutch of commodity prices, policymakers will be forced to do the heavy lifting they shirked in the past, which will be good for long-term growth.

In short, while the likely Fed rate increase in December of just 25 basis points might seem small, its repercussions will be complex and widely felt. Asian economies will face more pressures, but those whose political, policy and economic fundamentals were well managed will have less to fear than others.

Manu Bhaskaran is a partner and head of economic research at Centennial Group Inc, an economics consultancy

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