Asian markets ready for taper

The US Federal Reserve has begun tapering its quantitative easing policy. The Fed started "tapering" or paring its bond buying in December and cut its monthly bond purchases further in January to $65 billion.

Thus far, emerging economies in Asia have taken the QE tapering in their stride. Financial markets in Asia reacted much more negatively to the fears of tapering in mid-2013 compared to the actual start of tapering. The impact of the summer "taper tantrum" was particularly acute for India and Indonesia, leading to a fall in asset prices and dampening the growth outlook in those two economies. Nevertheless, neither country - nor any other emerging economy in Asia - had a systemic crisis.

This is due not least to the fact that the fundamentals of Asia's emerging economies are now much healthier that they were in the 1990s. Debt denominated in local currencies is more common today, thus foreign exchange depreciation causes less harm to domestic balance sheets. Most economies have large foreign exchange reserves and overall comfortable foreign exchange liquidity to serve their external financing needs. External debts are better structured and less vulnerable to external shocks. And bilateral as well as multilateral agreements for currency swap facilities are in place, mitigating risks.

Since the tapering of QE began, currencies of Asia's emerging economies have held up and some stock markets (in Southeast Asia and Shanghai) have even chalked up gains from the end of 2013. Despite the benign start, vulnerabilities in Asia's emerging markets remain and potential pitfalls should be recognized and avoided.

The most crucial factor in meeting the QE tapering challenge will be preserving investor confidence in Asia's emerging markets by striking a balance between growth and macroeconomic stability with consistent policies and clear market communication. Experts seem to agree that the Fed stimulus is likely to remain substantial and the QE tapering will progress at a moderate pace in 2014, with global interest rates staying low for a while longer.

In such a situation, emerging economies in Asia on the whole should be able to cope with the QE tapering without major disruptions. However, any signal that tapering could be faster than anticipated could stoke another round of rapid and large capital outflows from emerging markets, raising risks for financial asset prices and exchange rates in Asia's emerging markets with wider impact on the economy and creditworthiness of borrowers.

As tapering of QE will tighten liquidity and raise the cost of funds, Asia's emerging markets with twin deficits - India, Indonesia, Thailand, Pakistan and Sri Lanka - could be the most challenged from the prospect of higher borrowing costs. Those that have a higher percentage of foreign investors in their capital markets - Malaysia, Indonesia, Thailand and the Republic of Korea - will be more vulnerable to a sudden change in portfolio fund flows, raising risks to financial stability in terms of exchange rate and interest rate volatility.

Since consistent policy and clear market communication is essential, domestic capital markets that can efficiently intermediate between domestic savings and investment needs will play an even more significant role. Therefore, steps to improve transparency and good governance will be essential to enhance investors' confidence.