Financial markets have been turbulent in the past year. Severe price corrections have hurt segments such as crypto currency-related assets and high-tech companies. More recently, the collapse of a few small regional banks in the US unleashed a firestorm on the banking sectors in the US and Europe.
Although calm seems to have returned to financial markets, it would be complacent to think that we can avoid more episodes of stress. This is because a new set of financial dynamics is operating as a result of a permanent tightening of monetary conditions and the reduced sparkle in the world economy. Asian economies cannot be immune to this rougher new environment but will, in the main, be resilient, we believe.
Major central banks are now committed to a long period of tighter monetary conditions
What has changed?
After underestimating the surge in inflation, major central banks are now committed to a long period of tighter monetary conditions, a sharp reversal of the easy money the world has enjoyed since the 2008 global financial crisis.
Interest rates will be higher with only a small likelihood of policy rate cuts anytime soon. As policy makers reverse central banks’ quantitative easing, liquidity will progressively diminish as well.
Central banks will still intervene if a big shock threatens a downward spiral in the financial sector. But they will do so only in extreme situations and will be more targeted in their actions, being careful not to encourage financial market participants to think that there was a central bank backstop to bad investment decisions.
In addition, some of the upbeat fundamentals that encouraged investors to price assets optimistically are weakening. The huge impetus to global growth and commodity prices from China’s dramatic transformation is over – Chinese economic expansion will not exceed an average of around 4% a year in the coming decade, a far cry from the double-digit pace of past years.
The financial imbalances and speculative investments of the past decade will be exposed
It is highly unlikely that India or some other emerging economy can ever replace what China had offered in its heady days. The extraordinary synergies and cost efficiencies released as globalisation flourished are also being at least partly reversed as protectionism and inward-looking policies take their toll. Climate change and the intensifying frictions between the US and China also make for highly unpredictable downside possibilities.
The net result is a new asset pricing regime. Higher long-term interest rates must mean lower valuations of a range of assets, including equities and real estate. Downward pressure is likely in many asset classes as a result.
The financial imbalances and speculative investments of the past decade will be exposed as monetary conditions tighten further. We should expect more episodes of financial turbulence from time to time.
Impact on Asian economies
Most Asian economies are well integrated into global trading and financial systems, so a rougher world environment cannot be good for them. Still, we think Asia will be mostly resilient.
First, tighter money and higher risks could hamper global economic growth prospects, putting a dampener on consumer and business capital spending that help to drive Asia’s exports of intermediate goods and electronic components.
The metrics of financial soundness in Asian economies are relatively good
However, outside of China, Asian economies will still benefit from foreign investment as production is relocated out of China in search of geo-politically safer and cheaper production bases. Intra-Asian trade is also expanding, partially offsetting the slow growth in trade elsewhere. A big wave of infrastructure spending is also underway, which will help to bolster Asian economic vitality even with a slower China and a more unpredictable world.
Secondly, financial stresses will make for volatile equity, bond and currency markets in Asia – but the downsides can be mostly contained. As a result of the lessons learned in the Asian crisis of 1997-98, Asian financial institutions are strongly capitalised and more rigorously supervised.
The metrics of financial soundness in Asian economies are relatively good – such as the ratio of liquid assets to short-term liabilities, non-performing loan ratios, regulatory capital ratios and the net open position in foreign exchange.
Most Asian economies comfortably exceed the International Monetary Fund’s minimum baselines for foreign exchange reserve adequacy. Central banks have also taken pains to build credibility with financial markets and to communicate well with investors.
The bottom line?
The consequences of this new asset pricing regime will unfold in the coming one or two years, instigating more financial stresses and imposing a drag on global economic activity. Asian economies will take a hit – but their relatively good fundamentals should enable most of them to maintain their resilience.