With the Fed persisting on raising rates in the next several months after its jumbo 75bps rate hike and Asian inflation accelerating, Asian central banks that choose to hold rates or trail the Fed substantially are de-prioritizing the inflation fight by letting their FX weakens versus the USD, absorbing more inflationary pressures on the import side. With Southeast Asia demand normalizing, supply shocks lingering, inflationary pressures heating, whether central banks can afford to let FX weaken and swim against the global tide of rising rates is increasingly being questioned. 

Amongst the three central banks that are most behind the curve – Thailand, the Philippines and Indonesia, the Philippines is the most vulnerable to FX weakness from an inflation point of view. It is the largest food importer in Asia, with about 2% of GDP deficit in food trade bill, not to mention its 3% of fuels’ deficit, pushing the trade deficit to a historic low so far in 2022. Yet, despite the peso weakening sharply against the USD in the past week, worst in Asia by -2.8% and inflation accelerating to 5.4%YoY in May, the new governor signaled that it’ll raise rates very gradually by only 25bps not just in June but in the future and trail the Fed. Meanwhile, Thailand signaled it will hold rates until Q4 2022 at 0.5% with CPI at 7.1%YoY in May and doubled down on market interventions through price caps, profit sharing of refiners and subsidies to fight inflation. Indonesia, too, has refrained from raising rates and relied more on fiscal support to fight inflation by increasing its subsidy budget, which is unlikely to be enough.

Leaning heavily on fiscal support worsens fiscal positions and still is limited in its ability to keep the lid on inflation. Thailand inflation accelerated to 7.1%YoY in May despite subsidies while the Baht weakens, fueling inflation through the import side, as energy remains its big Achilles’ heel. Market control measures such as profit sharing and price caps will either erode profit margins or lead to lower supply and shortages as incentives to produce decline. For the Philippines, the President appointing himself head of Agricultures suggests that more support, such as subsidies, are coming.

Beyond relying mostly on fiscal to fight inflation, widening interest rate differentials with the Fed leads to investors hesitating to invest and may pull capital as they fear fiscal slippage, higher inflation and ultimately rate hikes down the road. Data shows capital outflows especially for bonds are tightening financial conditions even if rates remain on hold. 

Monetary policy is a stone that kills two birds – which not only arrests the slide in FX that prevents further importing of inflationary pressures, but also can help with making it attractive for capital inflows via front-loading of inevitable interest rate hikes. And this is particularly key for emerging Asian economies that are very exposed to inflation through high imports of essentials such as the Philippines, and to a lesser extent Thailand, although mostly through its large food surplus (% of GDP) offsetting a huge fuel deficit of 5.2% of GDP. Even Indonesia, which has a surplus of commodity export and gaining both in trade and revenue faces a big bill of subsidy that leads to a bigger deficit. 

In short, the Philippines is most affected by a weakening of the peso due to high deficit of food and fuels’ imports, followed by Thailand and Indonesia to a much lesser extent. Indonesia net fuel surplus shields some but its widening fiscal bill and high exposure to USD debt makes it vulnerable to swimming against the Fed tide.

Source: Natixis Asia Research