Countries in Asia Prepare for European Debt Crisis Fallout

Sources:

Agence France-Presse: Asian Countries Cut Rates amid Global Economic Woe

FT: Indonesia Slashes Interest Rates by 50 Basis Points

WSJ: Asia—Pacific Economies Gird for Turbulence

WSJ: Some Asian Economies Reflect Strains

Countries throughout Asia and the South Pacific have responded to the European debt crisis and waning global demand by lowering their benchmark interest rates. Australia, China, Indonesia, Pakistan, and Thailand have all decreased benchmark interest rates in recent months, and Malaysia, New Zealand, Singapore, and South Korea are considering other policies to inject more money into their economies.

The use of monetary policy to spur spending and economic growth represents a shift in policy for many of these countries. In recent years, these countries have experienced robust economic growth and have been primarily concerned with curbing high inflation. This concern has led them to maintain high interest rates to decrease the money supply—and thereby inflation—by making saving more attractive and borrowing more expensive. However, the once-rising inflation rate is now falling in many of these countries and economic growth has also decreased. It is this reversal in growth that has convinced many of the countries to change course.

The benchmark interest rate is the rate of return on new government-issued bonds. In theory, lowering the benchmark interest rate can decrease the value of a country’s currency and spur its export industries, which is an effective way to generate economic growth. For example, if Indonesia lowers its benchmark interest rate, demand for Indonesian bonds will fall because they are not as profitable as before. Since investors use the Indonesian currency (rupiah) to buy government bonds, when demand for the bonds falls so does demand for the currency, which lowers its value in accordance with supply and demand principles. If the rupiah costs less on the foreign exchange market, it will be cheaper for businesses in the United States, for example, to buy the rupiah required to pay Indonesian manufacturers for their goods. The lower currency value will, therefore, jumpstart Indonesian export industries and generate economic growth.

A lower benchmark interest rate also has an effect domestically. When interest rates are lower, saving is less attractive and borrowing is cheaper, which encourages people to spend their money rather than save it. The additional spending increases overall demand and economic growth.

Some analysts question whether policies aimed at increasing economic growth at the risk of increased inflation are necessary. Although economic growth rates have fallen of late, a recent Asian Development Bank report indicated that Asian countries are still on pace for 7.5% growth in 2011. These analysts believe that this level of growth is appropriate given the global economic downturn, and think that preventing the potentially destabilizing effects of inflation on food and commodity prices should be the countries’ priority.

Whether this policy shift represents a temporary response to worsening conditions in Europe or a more prolonged transformation of Asian monetary policy remains to be seen. There is no doubt, however, that Asia’s path forward will be closely observed and scrutinized by the global community.