Asia's craving for debt

Debt in Asia is now a source of much concern as its surge since 2009 could create external and internal turmoil, says CP Chandrasekhar.

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TO many Asian countries, the financial crisis of 1997 is a bad nightmare best forgotten. The fact that some of them have since then accumulated large foreign exchange surpluses is seen as insurance enough to prevent another such occurrence. But moving to such conclusions may be running ahead of the evidence - that for some time now, debt in Asia that could create external and internal turmoil has been rising fast, and accelerating since 2009 in particular.

Interestingly, this trend has not been commented on much till recently. However, a recent study from the Bank for International Settlements (Stefan Avdjiev and Elod Takats, 'Cross-border bank lending during the taper tantrum: the role of emerging market fundamentals', BIS Quarterly, September 2014) points to the dangers implicit in that attitude.

The study suggests there are reasons why emerging market economies' (EMEs) debt exposure should not be ignored. First, the outstanding stock of cross-border bank claims on EMEs stood at more than $3.6 trillion at the end of 2013 - roughly as large as the stock of all portfolio investment in EMEs. Second, during the taper tantrum, cross-border bank lending to EMEs slowed sharply, with its growth rate dropping to 2.5% in the second and third quarters of 2013 from around 10% over the previous two quarters. And, third, it is not just factors in the source countries that explain fluctuations in bank loan inflows, but characteristics in the recipient countries such as the current account deficit.

A look at the evidence with respect to Asian emerging markets suggests that the exposure to debt is a source of concern here as well. To start with, outstanding international bank claims have risen fourfold in the developing Asia-Pacific from $503.5 billion at the end of the first quarter of 2005 to $2,164 billion at the end of the second quarter of 2014. In fact, in four of the nine years, starting with the year ending the first quarter of 2005, the annual increase in international bank claims in eight leading Asian emerging markets exceeded the highest annual increment of $212 billion in portfolio inflows to those countries, with the increase peaking at $393 billion in 2010-11.  International bank claims in these countries fell by $110 billion in 2008-09. In the developing Asia-Pacific as a whole, while exposure rose by between 30% and 40% a year during 2006 to 2008, it fell by 17% in 2009 and has recorded much lower growth rates since. Thus volatility in bank exposure is considerable, making it a cause for concern.

This volatility is a matter for concern also because of the destination-country and source-country concentration of these international bank claims. The three countries in which international bank claims in the Asia-Pacific are concentrated are Hong Kong (which serves as a financial hub), China and India in that order. Over the years, Hong Kong and China together have accounted for between 47-70% of aggregate exposure in the developing Asia-Pacific, with the figure exceeding 50% in all but one. There are signs of a shift in exposure from Hong Kong to mainland China in recent years, encouraged no doubt by liberalisation of banking in the mainland. If India is added to these countries, the share of the three in developing Asia-Pacific exposure has fluctuated between 66% and 82% since 2005.

Given the role that local developments can have in inducing volatility and the danger of contagion signalled during the 1997 crisis, this concentration of debt exposure is disconcerting. More so because banks owned by residents in two countries, the US and the UK, account for the bulk of the exposure, varying from 43% to 50% of the total during this period. In time developments like interest rate increases in the US, which are still expected though they did not occur during the December 2013-October 2014 taper, can prove more damaging than could have been during that period. This does suggest that policymakers in Asia-Pacific EMEs must not merely drop their complacency and think of ways of limiting and reducing their exposure to foreign finance, but also take account of their growing exposure to debt besides portfolio investment.

What is more disconcerting is that associated with this increase in foreign bank exposure in Asian EMEs is a huge increase in the overall exposure to debt of the private - corporate and household - sector. The increase in domestic liquidity that foreign inflows of debt and other financial flows result in, seems to provide the basis for a boom in the credit accessed by the domestic private sector from foreign and domestic sources. 

This signals a reversal of the tendency to reduce debt and repair balance sheets that began immediately after the Southeast Asian crisis in 1997. Stated otherwise, the effects on Asian debt of the 1997 and 2008 crises, or the one that primarily affected a few countries in the Asia-Pacific region and the other that affected the centres of developed capitalism, have been very different. While the former was followed by debt reduction, the latter, the 2014 issue of the IMF's Regional Outlook notes, was followed by a rise in corporate leverage in emerging Asia, which 'may represent a "fault line".'

While there have been multiple sources from which this debt was incurred, bank credit remained the dominant and important source. Consider, therefore, the ratio of domestic bank credit to the private sector (BCPS) to GDP across the main EMEs in the region, viz., China, India, Indonesia, Korea, Malaysia, Singapore and Thailand. In terms of a point-of-time picture, in 2013, Indonesia and India recorded relatively lower bank credit to GDP ratios of 34% and 53% respectively, while the others had notched up ratios that stood well above 100% (varying from 121% in Thailand to 140% in China, with the rest distributed in between).

These substantial differences in the level of exposure are also accompanied by differences in trends over time in the ratio of BCPS to GDP. Indonesia is again an outlier, with its lower absolute ratio being accompanied by relatively moderate increases in that ratio, of around 30% during both 2000-07 (before the global crisis) and 2008-13. The remaining countries fall into two categories. On the one hand, India and South Korea saw relatively large increases in credit to the private sector during 2000 to 2007 of 61% and 87% respectively, followed by either a low increase (7% in the case of India) or a fall (of 9% for Korea) during 2008-13. On the other hand, Thailand, Malaysia, Singapore and China recorded a fall in the ratio in the first period, followed by a significant increase in the second. In sum, if a generalised statement is to be made for the period since 2000, it would be that except for Indonesia that has been an outlier, the rest have been characterised by relatively high levels of bank credit outstanding and by much volatility, with periods of bank credit expansion giving way to periods of moderation or contraction or vice versa.

When seeking to understand these trends, it may be useful to keep three features of the region in mind. First, all emerging markets in the region have been liberalising regulations governing their financial sectors and easing monetary policy, both of which have increased the flexibility of the banking sector when making lending decisions. This provided the basis for an important commonality across the region: expansion-contraction or even boom-bust cycles in credit provision, which all of these countries (except Indonesia) have experienced to differing degrees. An over-enthusiastic banking sector is forced to correct because of either balance sheet stress or a full-fledged crisis. Second, liberalisation came earlier to Southeast Asia, which then experienced the financial crisis in 1997 that left China and India relatively unaffected. So India's credit boom and China's moderation during the first period require explanations that are independent of the last major crisis that affected the Asian region. Third, in the aftermath of the 1997 crisis Southeast Asian countries adjusted differently in terms of both the restructuring of the banking sector and the regulation of capital flows, leading to the variations in experience that are observed.

China and India (besides South Korea) are now the target of particular attention because they have been registering rapid increases in their private credit to GDP ratios over different periods since 2000. China leads in terms of the level of the ratio of credit to GDP and has registered a continuous increase in the same except, interestingly, during 2003 to 2008 when the ratio fell, precisely during the years when it rose in India. However, according to a McKinsey and Co report, China's debt increased almost fourfold between 2007 and 2014, having risen from $7 trillion to $28 trillion.

Bank credit to the private sector has exploded since the global financial crisis, as part of the government's stimulus effort. This has led to growing concerns about the state of the banking system because of its exposure to the housing market bubble and to local government financing vehicles that have borrowed to invest in huge projects without the appropriate revenue model to meet the interest and amortisation commitments involved.

As for India, though the level of its BCPS ratio is much lower than in other Asian emerging markets (except Indonesia), it too experienced a sharp increase in the ratio during the high growth period between 2003 and 2008. As a result, signs of stress in bank balance sheets and fears of increased default and speculative bubbles in property and other markets now pervade discussion in these two countries as well.

Overall, therefore, while there are significant differences in the volume and growth of bank exposure to the private sector across Asian emerging markets, they are all confronted with signs of bank fragility due to overexposure to a few markets such as the retail sector (especially housing), to real estate and capital-intensive projects in infrastructure and industry. In all these countries, therefore, debt is now a source of much concern, as the projects financed have not been faring well.                                         

CP Chandrasekhar is an economics professor at Jawaharlal Nehru University in New Delhi.

*Third World Resurgence No. 293/294, January/February 2015, pp 20-21