Rate rut: Pause or pre-emptive strike?

Both approaches carry risks.

Asia8217;s exports to Europe are already dropping,and if the crisis there engulfs a large economy such as Italy,global growth would certainly suffer. Trade-exposed countries including Malaysia and South Korea might not be able to respond quickly enough to avert a sharp economic downturn.

But a pre-emptive strike could backfire if the crisis simmers down. Global investors who were sidelined by the euro zone upheaval would jump back into markets,and money may come flooding into fast-growing,bubble-prone Asia.

Rob Subbaraman,chief Asia economist for Nomura in Hong Kong,came up with two reasons to justify a quick rate cut but six arguments in favour of caution.

Inflation may have peaked,but it remains elevated; economies in the region are performing at or near their potential growth rates; credit has expanded rapidly in the past two years; and rates are still relatively low,he pointed out.

If global risk aversion fades,Asia could once again attract massive capital inflows,increasing the potential for economic overheating,Subbaraman said. This,we reckon,is the strongest argument against large,pre-emptive easing by Asian central banks.

South Korea and Malaysia,which are both scheduled to hold interest rate-setting policy meetings on Friday,are widely expected to hold steady for now.

We would put the probability of a surprise policy rate cut in Malaysia at about 20 percent,largely because of Europe8217;s debt crisis,Chua Hak Bin,an economist with Bank of America-Merrill Lynch in Singapore,wrote in a note to clients on Friday.

Greek politicians8217; agreement on Sunday to form a unity government to approve a euro zone bailout appeared to ease the imminent threat of default and ratchet down the risk of contagion to Italy.

But investors have good reason to be wary. Europe8217;s leaders have repeatedly come up with plans that appeared to quell the crisis,only to see it flare up again weeks 8212; or sometimes just days 8212; later.

Bank Indonesia,which meets on Thursday,ranks at the top of economists8217; list of Asian central banks most likely to cut. It sprung a surprise easing move in October,and its governor said last week there was more room to lower rates.

Economists surveyed were split on whether BI would indeed cut again this week or perhaps give it another month to see how Europe progresses.

Judging by Monday8217;s report on third-quarter growth,Indonesia8217;s economy is holding up better than most in the region. Its gross domestic product rose 6.5 percent year on year,a shade slower than economists polled by Reuters had predicted but identical to the growth rate in the first half of the year.

Compare that with China,where third-quarter growth slowed to 9.1 percent year on year,from 9.5 percent in the second quarter. Next year8217;s GDP is expected to dip below 9 percent for the first time in a decade.

Thailand comes in a close second on the most likely to cut list because of severe flooding that has disrupted its auto industry and turned away tourists. The central bank has said it would hold an emergency meeting if necessary to cut rates.

WILLING BUT UNABLE

If Europe were not a factor,the rate situation in Asia would look decidedly different. The debt crisis there put a premature end to Asia8217;s tightening cycle. Since the beginning of 2010,Asia8217;s rate hikes have averaged 2 percentage points,but inflation has risen by more than 3 points,Deutsche Bank calculates.

Of the 11 countries that Nomura8217;s Subbaraman tracks in Asia,eight had inflation rates that exceeded the benchmark interest rate,another factor arguing in favor of pausing rather than easing.

Those negative real interest rates discourage traditional savings,driving money toward alternative forms of investment and heightening the risk of asset price bubbles 8212; particularly in property which is looking frothy in China,Hong Kong and Singapore.

That helps explain why China remains reluctant to lower interest rates even though its economy is slowing more sharply than Indonesia8217;s.

The buzz word out of Beijing is that it will fine-tune policy,mostly likely by pumping more money into credit-starved pockets of the economy,easing up on credit conditions for small- and mid-sized companies and perhaps reducing banks8217; record-high reserve requirements.

But China8217;s State Council said on Oct. 29 it would unswervingly maintain curbs on the housing market to cool prices.

Inflation is abating,which makes the policy choice a bit easier. The consumer price index for October,slated for release on Wednesday,is expected to show an annual rise of 5.5 percent,which would be down significantly from September8217;s 6.1 percent.

Our base case remains for 8216;selective8217; or 8216;targeted8217; easing in the near term. However,we think the government will take action if the economy 8212; including the housing market 8212; slides further,Barclays economist Jian Chang wrote in a research report on Friday.