As most readers of this blog know very well, many developing East Asian countries are now facing increasing economic risks as a result of the ongoing financial market turmoil in the United States and in the European Union. These risks now include a significant deceleration in exports, foreign investment, and credit at both the financial institutions level and the sovereign level. There has already been a rapid spike in the spreads on major Asian countries’ sovereign debt, which is resulting in increased borrowing costs. In addition, many East Asian countries have experienced rapid inflation and downward pressure on their currencies, and central bank actions have resulted in increased interest rates. The combination has resulted in a severe squeeze on the margins of the core elements of these economies–exporting and manufacturing is beginning to have a negative impact on inward investment. The result of these factors will likely be higher business failures and an increase in non-performing loans in the banking systems across Asia. It should be noted that beyond the banks, the other key channel of firm financing are the equity markets, which have fallen by an average of about 50% this year alone in emerging East Asian and Pacific (EAP) countries (according to the MSCI Indices). Thus, the capital markets have been effectively blocked as a channel of corporate finance for now. The ultimate combined impact of the recent events may be a decrease in economic growth and potentially, a slowdown in development progress across the East Asia and Pacific region.
The higher external borrowing costs, lower level of foreign currency inflows from investment and trade, and in some cases, the deployment of foreign currency reserves to defend local currencies will restrict the ability of governments to be able to adequately respond to potential problems in the financial sector in the short-term. Most countries in the EAP region do have a much higher level of foreign currency reserves, stronger external balances, better macroeconomic management, and relatively more stable banking systems, which stands in contrast to the crisis of 1997-98. However, the current crisis is different to the last. It is expected that this crisis will spread to Asia from the developed economies largely via indirect transmission channels described here, not immediate outflows of capital. But the end result in terms of financial sector may be quite similar with substantial bad debt in the banking system and an effective credit freeze in the markets.
Much of the problem today in terms of sovereign borrowing in particular is the perception of risk, which may not necessarily be based on the underlying macro-financial fundamentals. However, there is not a shortage of potential liquidity within the EAP region (and beyond), but it is not flowing to those countries that are in need of it at the moment. In fact, there are vast pools of liquidity that are held by various financial entities, including central banks, sovereign wealth funds, Islamic funds, and other institutions both in the EAP region and elsewhere globally, and there may be a way to harness this liquidity to support continued investment within Asia through the establishment of a regional approach to the crisis. The Ministry of Finance (MOF) of South Korea this week proposed establishing an US$80 billion regional emergency foreign exchange fund that would pool some of this liquidity in Asia, but as of now the countries in the region are not taking a fully coordinated approach.
The ultimate objective of a common approach would be to restore confidence in the underlying strengths of the economies in the region and to enable the EAP Governments to effectively respond to the short-term needs in the financial system. The approach could enable the broad assessment of the key vulnerabilities facing the financial system from the crisis in EAP countries, both from direct and indirect transmission channels. This approach could establish a comprehensive, regionally coordinated framework for responding to the financial crisis, including developing a framework for financial crisis management and resolution and the broad criteria for government intervention if and when it is needed, as well as the triggers and thresholds for specific types of actions. It could also include the coordination of the deployment of monetary policy tools, such as interest rate cuts, and create or bolster the legal framework and processes for the handling of troubled financial institutions, such as bankruptcy, liquidation, restructuring, and recapitalization. Finally, a pooled EAP financial facility could be developed (similar to the proposal by the MOF Korea) to provide short-term liquidity, if and when needed, to central banks and/or ministries of finance to support banking systems through a variety of actions. Such short-term, temporary actions could combine the core elements of the plans put forward by the United Kingdom and others, including expanding the central bank discount, purchasing non-performing assets from banks to remove them from bank balance sheets, direct investing in banks (i.e., recapitalize banks), providing guarantees for medium-term debt issued by the banks, and/or fully funding deposit insurance schemes.
The danger is that by going at it alone, countries in the EAP region may end up repeating the mistakes now being made in the EU whereby each country has taken their own unique approach to the crisis in an ad hoc fashion, which is actually causing additional market disruptions and uncertainty, as well as unforeseen negative spillovers within the EU. Only now are the UK, France and others proposing an EU-wide approach. In addition, if a comprehensive framework is applied across the region, all investors and market participants will know the approach to crisis resolution in each country if they access the funding under the Facility. Also, as each country begins to deal with the issues, as Indonesia is now doing, it may actually be signaling to the markets and investors that there are more underlying problems than what is now known, thus generating more downward pressure. If there is no comprehensive framework, then this might be a logical conclusion for outsiders to make. Therefore, Asian financial regulators, central banks, and ministries of finance now have the opportunity to become fully prepared and avoid some of the problems encountered in the US and EU responses to this crisis to date.