How the latest move from Fed affects Singapore’s economy

The Federal Reserve recently announced a cut back to its massive $85 billion monthly Quantitative Easing (QE) program after a two days policy meeting. The modest reduction of the monthly bond purchase level to $75 billion is seen as a signal on the confidence of US economy in maintaining a sustainable recovery.

The Fed’s latest move, which has been highly anticipated, will have profound impacts on Singapore given the openness nature of our economy.

Non-conventional tool

The Fed has been tapping onto non-conventional tool in its navigation process to investors since the onset of the financial crisis. One of such measures is by introducing forward guidance.

Indeed, market investors often form expectations on the interest rate level and such expectations can have impact on the real side of the economy. Influencing expectations of investors through forward guidance gives confidence and predictably in the mist of uncertainty on the policy path in the post-crisis phase.

It helps to reiterate the Fed’s communication policy and intended aims to investors to prevent huge volatility in the equity markets often due to speculation or doubt on Fed’s creditability in sustaining a low interest rate regime for the next few years.

Flow of capital

When interest rate is low due to the QE program, there has been an outflow of capital in search for higher returns. Singapore has benefited from the inflow of such capital though not without costs.

The inflow of capital has seen inflationary pressure on local economy.

Singapore has used its monetary tool by having a modest appreciation of currency to cope with inflation. With the recovery seen in US, there may be certain degree of capital outflow from Singapore back to the US in anticipation of future interest rate hike.  

A higher interest rate is often associated with a cheaper valuation of bonds due to falling bond prices. This inverse relationship means a higher yield for bond.

Investors may tend to pull out from the equity market that has been largely supported by the massive QE program. Equities may see some level of correction partly due to the expectation of higher corporate borrowing cost in future that may hurt profit and earning margin in the medium term.

Merger and Acquisition (M&A)

With equities rise to a considerable level, firms may be discouraged to engage in M&A. Often, for acquisition, firms have to pay a potential of at least 30% above the closing market equity prices.

This is too stiff a price to pay for the acquirer. A correction in the equity market induced by further prospect of tapering will allow prices to fall back to a more fundamental level.

This may encourage and boost M&A locally and in the region.

Less disruptive tapering process

The QE program beginning from 2008 has often been politically criticized as creating inflationary pressure to emerging markets especially in Asia due to money flowing to the region in search for higher returns. The tapering process if result in higher interest in the US may eventually lead to a reverse flow of capital from emerging markets back to the US.

This process is likely to be disruptive for countries like Singapore who has seen the flow of capital to its shore since the financial crisis.

However, the Fed has sufficient tools to ensure interest rate remains low and the transition to the normalization of the economy remains sound. There have been considerable excess bank reserves.

The Fed can reduce the interest paid to these excess reserves and thus provide an incentive for banks to invest their reserves into the financial market in search for higher returns. This would help to ameliorate the effect of a reduction in liquidity within the financial market during the on-going process of tapering.

While such tool may have limited effect since not all financial institutions keep reserves, it can potentially encourages banks to return to their normalize lending in the post-crisis era. This can help to project confidence to investors that tapering will not result in immediate interest rate hike and Singapore will benefit from a more predictable and certainty interest climate in the US.

Conclusion

While the Fed has begun its tapering process, Singapore has a strong financial foundation to cope with the changing external monetary policies in the post-crisis period by other nations.

It should be anticipated that further tapering in bit size is in store for the future as the growing confidence of US economic recovery gains momentum. In fact, the tapering process should be seen as a green sign for Singapore as the country stands to benefit from a stronger economic health of key economic powerhouses in the world.