How can Asia keep looming financial challenges at bay?

About two decades ago, prior to the Asian financial crisis, investor overconfidence triggered a mispricing of risk on Asia’s economic prospects. The region’s policymakers and financial markets became complacent and risk aversion dropped, causing a surge in capital inflows to Asia that resulted in overleveraged banks and corporations.

The catalyst was the surge in private sector debt – in particular, foreign currency-denominated debt. The ensuing boom created asset price bubbles and rapid credit growth.

Ten years later and despite visible policy and macroeconomic improvements, Asia was hit hard by the 2007-2008 global financial crisis, which again highlighted remaining challenges in financial markets, and financial system weaknesses in the region.

Moreover, it showed how in an era of globalized finance and tightly interconnected financial markets, risks of unbridled financial flows could lead to not only a rapid buildup of systemic risk, but also to widespread financial instability.

Today, in an environment of more benign global macroeconomic conditions, Asia’s financial architecture is stronger and more resilient than in the past. The region generally has more flexible exchange rates, higher foreign reserves, healthier financial systems, stronger regulations, and better regional financial cooperation mechanisms.

However, substantial challenges remain, and new sources of vulnerability have emerged.

At risk from rising US$-denominated debt
Asian financial systems remain bank-dominated and rely heavily on foreign currency funding. In recent years, for example, the average of outstanding US dollar-denominated international debt securities (as a percentage of total external debt) for 11 selected Asian developing economies has increased from 13 percent in 2010 to 20 percent in 2017.

If combined with excess leverage and funding risks, the prominence of US dollar-denominated debt could make the region’s foreign borrowing and exposure to foreign portfolio investment a primary source of risk. This could well translate into sharp reversals in capital flows.

Given the impact of US dollar funding conditions on emerging markets’ financial situations through financial channels, Asian policymakers should promote regional cooperation on macroprudential tools and capital flow management measures to deal with spillovers from external shocks, such as sharper-than-expected US monetary policy tightening.

Another issue is the rising levels of household and corporate debt, which are fueling concerns about unsustainable credit booms. Household debt-to-GDP-ratios, for example, in Australia and the Republic of Korea climbed from 105.8 percent to 120.9 percent and 74.2 percent to 94.4 percent, respectively, from the 4th quarter of 2008 to the third quarter of 2017.

Corporate debt-to-GDP ratios also increased significantly in several economies in the region, including Hong Kong, China; Singapore; and the People’s Republic of China. At the same time, growing loan-to-deposit ratios can be observed in Cambodia, Indonesia, and Singapore.

An additional risk for the region’s financial stability is posed by the rising levels of nonperforming loan (NPL) ratios in some economies.

Asia should be wary of spillover effect from NPL ratios
NPL ratios in Asia had been trending downward since the Asian financial crisis, particularly in Southeast Asia, where they were 3 percent or below in 2017. However, bank balance sheets in selected economies have deteriorated recently, causing a buildup of NPLs.

Multiple studies link unfavorable financial conditions—such as mounting distressed assets on bank balance sheets—with deteriorating macroeconomic conditions. Moreover, the macrofinancial impact of NPLs in one economy may spill over to other economies through various channels such as cross-border bank lending and changes in investor confidence.

The euro area’s recent experience with distressed assets shows the systemic implications of NPLs and illustrates how NPL problems can spread across financially integrated markets.

Against a backdrop of increased financial interconnectedness and procyclicality, the main financial challenge facing Asia is greater financial volatility. This may follow the path of the US monetary policy normalization, recent trends of rising private sector debt, deteriorating asset quality, continued heavy reliance on foreign currency denominated debt, and limited domestic capital market-based financial solutions.

These vulnerabilities have the potential to destabilize the region’s financial systems.

With current favorable macroeconomic conditions expected to continue, now is the time to address emerging financial challenges and further safeguard financial stability and resilience in the region. Authorities should consider establishing and implementing effective macroprudential policy frameworks and measures to address systemic risks.

New vulnerabilities have potential to destabilize financial systems
Given its heavy reliance on foreign currency denominated debt, Asia should carefully monitor rising debt and dollar funding conditions. This could help strengthen banks’ resilience to external shocks, especially during times of financial distress.

Furthermore, Asia’s crisis lessons have underscored the need for augmenting existing macroprudential policy measures by adding a foreign currency dimension—for example a foreign currency liquidity ratio. Amid the normalization of US monetary policy, this seems to be a particularly relevant way of bolstering the region’s financial resilience.

At the regional level, authorities should reinforce regional economic and financial cooperation. 
Economies would also benefit from ensuring bilateral swap arrangements as well as further strengthening of regional financial safety nets such as the ASEAN+3 Macroeconomic Research Office, the Chiang Mai Initiative Multilateralization, and the Asian Bond Markets Initiative.

Asia must also be able to effectively deal with systemically-important financial institutions to address systemic risks and the associated moral hazard problems that have become increasingly relevant to regional banks that operate across borders. Some of these will likely soon become regional systemically- important banks, too.

Finally, local currency bond markets should continue to be developed to enhance financial resilience and mobilize stable long-term finance.

While local currency bonds outstanding in ASEAN+3 economies tripled from US$6.6 trillion in 2002 to US$22.5 trillion by the end of the fourth quarter of 2017, challenges remain. Local currency bond markets, for instance, must improve market efficiency, broaden their investor base, and deepen secondary markets.

(Junkyu Lee is Principal Economist (Regional Cooperation and Integration), Economic Research and Regional Cooperation Department, ADB and, Peter C. Rosenkranz Economist, Economic Research and Regional Cooperation Department)