Is there a wave of bad debt on the horizon in Asia?

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ImageYou may want to grab your surfboard to be prepared even though this wave may not yet be visible now.  There is little (public) focus on this question in Asia at the moment and I suspect that the reason is simple – over the past ten years we have witnessed a relatively long period of stability and rapid economic growth across Asia.  Such a situation can too easily breed complacency and high levels of risk-taking by banks, as well as a more relaxed stance by the regulatory authorities. 

We have already seen this scenario play out in the United States and the current financial crisis is still unfolding at a rapid pace with a very uncertain outcome.  The recent massive debt write-downs by major investment and commercial banks have shown that the losses initially created by sub-prime mortgage crisis are continuing to grow with the IMF predicting aggregate losses of upwards of $1 trillion.  Some observers are even predicting that this financial crisis will be the worst since the Great Depression. 

The interesting dynamic to note here is that these losses are only now having dramatic impacts in the banking sector, a full year after the crisis began.  To put some facts on the table, consider the following:  Of the approximately 8,500 federally insured banks with over $13 trillion in combined assets, three smaller US banks have failed in July alone, the number of “problem banks” (pdf)  that are federally insured rose from 76 to 90 in the first three months of 2008, the quarterly earnings were the lowest since 1990, bad loans (over 90 days past due) rose by 24% in the first quarter of the year, and the average exposure of the 8,500 banks to residential mortgages, commercial real estate, and construction was 48%. 

Even though on average these banks have relatively low levels of non-performing loans (NPLs) at only a bit above 1%, the pace of the losses in the sectors the banks are most exposed to was blistering – 1500% increase in charge-offs of real estate construction and development loans from January to March 2008!  These are all possible indicators that the problems in the US banking system are really just in the early stages. 

So what does the crisis in the US have to do with bad debt in Asia?  Well, if it has taken a full year for the bad debts to begin to be realized in US banks, surely the realization of problems in Asia will also lag – the economic and financial turmoil has only just begun in the region. 

ImageAs with the US banks, the financial health of many banking systems across Asia has been relatively solid.  The level of NPLs is low (as seen in the graph at right) and other factors, such as capital adequacy, liquidity, and profitability have been on the rise.  In addition, banking supervision practices have improved since the Asian financial crisis of 1997-98. In addition, analysis indicates that Asian banks are not directly exposed to losses on sub-prime mortgage-related assets generated in the US.  

However, there are indirect and impacts and homegrown sources of risk that have emerged this year.  In many countries across Asia, there has been rapid credit expansion that has partly financed the purchase of real-estate and securities, which in many markets are far from their peaks reached in 2007.  In the most extreme case of this situation in the region, Vietnam, credit growth was up to 63% by end-March 2008 and in the first five months of 2008, the value of land and houses fell by an estimated 50-60% and the main stock exchange index dropped by 55%. 

The banks are of course also financing the manufacturing and export sectors, which are also hurting.  According to a recent news report, these firms are being squeezed by the region's deteriorating terms of trade (the price of exports, relative to imports – commodity costs have risen 23 times faster than export prices) and the higher cost of borrowing as interest rates continue to rise as the region's central banks attempt to manage increasing inflation.  Thus, their earnings capacity is weakening and may possible have an impact on their ability to repay existing loans.  This is happening in an environment in many countries in Asia that still have banks with weak risk assessment and management, limited quality reporting and disclosure standards, and ineffective corporate governance structures.  All of this will likely culminate in a wave of bad debt in Asia in the coming year or so because (as is now the case in the US) these problems of the borrowers will not show up on the balance sheets of the banks immediately. 

So, if there is a wave of bad debt coming, how large will the wave be?  Will it be a tsunami or a ripple?  This is the big unknown, but what is known is that it will pay to be prepared.  The costs of not being prepared are already large in the US based on the credit losses, as well as the potential costs to the taxpayers (which may reach over $300 billion).  The banking supervisory authorities across Asia can take a number of steps to prepare.  Such immediate steps might begin with conducting a special evaluation of the financial conditions and long term viability of systemically important banks with particular emphasis on exposures to the real estate, construction, and manufacturing and export sectors. 

The supervisory authorities could also develop plans for crisis management, procedures, public relations, and liquidity support mechanisms for banks in the event of problems; review and strengthen the legislative framework, processes, and institutional capacities for problem bank resolution including the respective roles of different institutions; and improve the coordination and communication processes among all financial regulators.  Some of the supervisory authorities are already taking actions and of course there are many more potential actions that could be taken, but these moves would be a good start.


James Seward

Senior Financial Officer

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