Asia’s ‘Taper Tantrum 2.0’ Bears Chinese Fingerprints

China’s stumble is shining a spotlight on something investors convinced themselves wasn’t a serious problem: Asian debt levels.

With Asia’s biggest economy slowing to a crawl in the April-to-June period—growing just 0.4% year-on-year—the region’s Covid-19-related borrowing binge these last two years is now a clear and present danger.

Clearly, news that the U.S. economy contracted at a 0.9% annualized rate in the second quarter thickens the plot. So is the global inflation surging and the Federal Reserve’s tightening cycle. But East Asia spent the last decade recalibrating trade flows in China’s direction. Now, the region’s main growth engine is sputtering.

This dynamic makes Asia’s pandemic era debt surge a clear and present danger. According to the International Monetary Fund, emerging Asia’s share of total global debt is now at least 38% from 25% before Covid-19 hit.

This, the IMF warns, is “raising the region’s susceptibility to changes in global financial conditions.” Trouble is, these conditional shifts are coming from all directions: dwindling Chinese demand; inflationary fallout from Russia’s attack on Ukraine; rising U.S. interest rates; tightening credit spreads.

And then there’s the dollar problem. Episodes of extreme dollar strength tend to hit Asia with greater force than other regions. The Fed’s aggressive 1994-1995 rate hikes set in motion the 1997 Asian financial crisis. As currency pegs to a surging dollar became impossible to defend, Asian governments devalued.

Now, the dollar’s rally is refocusing attention on that period—and the 2013 Fed “taper tantrum.” The IMF points out in a new report that “emerging market economies in Asia, excluding China, have experienced capital outflows comparable to those in 2013, when the Federal Reserve hinted it might taper bond buying sooner than previously expected, causing global bond yields to rise sharply.”

These outflows, the IMF says, have been “especially large” for India: $23 billion since Russia’s invasion of Ukraine. Some of Asia’s more advanced economies also have seen capital flee to dollar assets, including South Korea and Taiwan. These dynamics are apt to intensify as the Fed puts more rate hikes on the scoreboard and geopolitical tensions shake markets.

The big question is whether there are more Sri Lanka’s out there. A few years ago, the South Asian nation was an emerging-market investment darling. Surging inflation, though, shined a bright spotlight on government ineptitude and corruption.

In the political chaos, Sri Lanka’s pandemic debt binge proved unsustainable. That cost Colombo access to global capital makers, necessitating a default on its external obligations.

In a recent CNBC interview, Krishna Srinivasan, the IMF’s Asia-Pacific head, warned that economies at risk include Laos, Mongolia, Maldives and Papua New Guinea. In Laos, for example, inflation is surging at a nearly 24% pace. Prices in Mongolia May top 12%, while the Maldives’ debt-to-GDP ratio remains around the 100% level viewed as dangerous for developing economies.

“So, there are many countries in the region which are facing high debt numbers,” Srinivasan says. “And some of these countries are in debt distress territory. And so that’s something which we have to watch out for.”

Unfortunately for Asia, the hits from China are likely to keep on coming. Fitch Ratings, for example, notes that if there is additional pandemic-related disruption in China, it could damage the creditworthiness of Asian governments via channels from trade to tourism to financing.

“China is the biggest export market for most Fitch-rated APAC sovereigns and territories,” says Fitch analyst Thomas Rookmaaker. “It is also an important supplier of intermediate products whose availability could be interrupted, affecting regional exports. Many Asian economies have a high degree of trade openness, amplifying the effect on their GDP.”

It follows that “weaker near-term regional growth prospects would weigh on sovereign credit metrics,” Rookmaaker adds. The worry, he notes, is how Chinese weakness may compound Asia’s already gaping budget shortfalls. As Rookmaaker explains, “fiscal consolidation could be delayed or reversed due to slower growth or the use of fiscal stimulus to offset external headwinds.”

Think of this as shock upon shock. First came Covid-19. Then Russia’s war in Ukraine. Next, slower Chinese growth. The fallout could, as Rookmaaker explains, “exacerbate credit risks in frontier markets, potentially eroding their political and institutional stability.”

This is not to give the U.S. a pass. Asia is about to pay the price for Jerome Powell’s disastrous stint as Fed Chairman since early 2018. First, he caved to political pressure from former President Donald Trump to cut rates when the U.S. least needed it. Then Powell largely sat back in 2021 as inflation surged.

As Powell plays catch-up on consumer prices surging at a 9.1% pace, the worst in 40 years, Asia is directly in harm’s way. The region’s debt overhang makes it even more vulnerable as the two biggest economies lose momentum. This Taper Tantrum 2.0 could be a very messy affair.