Sowing the seeds of change
17 October 2017
Developed Asian economies have come a long way since external imbalances triggered a calamitous financial crisis 20 years ago. More flexible exchange rates, deeper domestic capital markets and more robust financial sector supervision have reduced the region’s external imbalances (see Chart 8). Indeed, despite an evaporation of global liquidity during the 2008 crisis, the region coped relatively well. The cycle since has been characterised by healthy growth, fuelled in large part by China’s aggressive expansion, and ample liquidity, due to the Federal Reserve and other developed economy central bank’s pursuit of unconventional policies. The question is whether these favourable conditions have bred excesses that are likely to be exposed in the event of deterioration in monetary conditions?
The most obvious consequence of developed economies’ policy settings has been the rapid debt accumulation in the region fuelled by ultra-low long term borrowing costs and substantial capital inflows. Is this a problem? Those areas where debt accumulation has been most rapid have largely been underpinned by healthy revenue or income dynamics. The growth in corporate indebtedness in Singapore in recent years has been striking, jumping nearly 70 percentage points (ppts) as a share of GDP since 2007. However, since 2015 the pace has slowed in line with a moderation in corporate earnings. Likewise, household debt accumulation in Korea has jumped nearly 20ppts as a share of GDP since 2007. Here too, the pace has been slowing due to a combination of tighter macro-prudential regulations and softer household income profiles (see Chart 9). In both cases, defaults have been low. Typically, the affordability of newly accumulated debt is given precedence when evaluating debt sustainability, as healthy dynamics here can facilitate loan evergreening or appropriate refinancing. However, this approach risks downplaying the implications of the rising debt stock, which potentially offers a more malign threat. Indeed, there are two reasons we think the stock measures should have greater prominence. First, borrowing costs have been deliberately distorted by central bank balance sheet expansion and are vulnerable to a shock if policy dynamics were to shift. Secondly, private sector deleveraging efforts in the region have been limited to-date despite favourable conditions, suggesting the window for a correction may be longer. This latter point is important as current debt provisioning looks ample, while there is little imminent threat from central bank normalisation given the go slow approach. The need to avoid policy mistakes may be sustained for some time.
Despite persistent and highly accommodative policy settings, there is little evidence of financial stability risk in Japan. Of the 14 financial activity indicators monitored in the Bank of Japan’s financial system heatmap, none have deviated significantly from their trends. Unsurprisingly, we therefore think the major risk from a balance sheet unwind comes in the form of a spike in long-term borrowing costs. The loss of liquidity and price discovery in the Japanese government bond market has also made the Bank of Japan nervous about volatility in response to balance sheet adjustment. For now, these bolster the current yield curve control framework. However, at some point a governor should be appointed who is capable of grabbing this bull by the horns.