Over the past year it has been a tale of two worlds: boom across Asia and many emerging regions, in contrast to an ever deepening financial crisis in the West. Yet the economic and financial fallout is unlikely to be bounded by geographical borders, as years of globalization have placed Asia closer to the global economy, not further away. Yet, firm domestic demand and years of financial reform will allow the region to cope better with the financial fall-out from the West.
But what are the longer-term lessons that Asia and other emerging economies should take from the financial problems now being seen in the West?
One of the many lessons of the 1997-1998 Asian economic crisis was the need to deregulate the financial sector at a speed best suited to domestic needs. Ahead of that crisis, a number of countries had deregulated too quickly for their own good, and often without the appropriate institutional infrastructure to support such effort. One speed did not fit all. Another notable point was that a number of the crisis-hit countries were solvent, but not liquid, with South Korea being the clearest example.
Since their crisis, Asian economies have boosted their resilience and ability to withstand future shocks. Foreign exchange reserves across the region have surged. There is greater emphasis on fiscal discipline and on the credibility of monetary policy. This summer’s rise in inflation has tested and, in many cases, proved central banks’ credibility. This places them in a better position to cope with problems now. Furthermore, most Asian economies have not witnessed the surge in debt seen in many Western economies in recent years. Thus, Asian economies, especially across the household sector, do not need to deleverage in the way in which the US has to now.
But as recession and the financial backlash hit hard in the US, it is important that emerging economies do not receive the wrong message. It would be wrong if emerging economies thought they should stop, or even reverse, deregulating their financial sectors. Two wrongs do not make a right.
The fact that there have been financial problems in the US should not prevent deregulation across Asia. Deepening and deregulating financial sectors would help the region to achieve its potential by tapping the emergence of a debt-free middle class and unlocking their spending and investment power.
A crucial lesson from the current turmoil is that financial developments must take place in a sensible way, which can be divided into three key and inter-related areas: risk, liquidity and pro-cyclical factors.
First, risk management. The inappropriate pricing of risk was a major cause of the crisis. The impression that credit risk was being distributed across different investor bases, via innovative derivative products, and that this would reduce systemic risk was at best a mirage. The biggest culprits were the financial firms themselves, but the incentive structure for credit rating agencies did not help. From the perspective of regulators, the need to keep up with product innovation and cross-border cooperation is also crucial.
Second, the management of liquidity risk, particularly in times of stressed conditions, needs to be addressed. As banks lose trust and hoard cash, the idea that central banks can always maintain a liquid money market is now being severely tested. Liquidity is king.
Third, pro-cyclical factors clearly contributed to the crisis, including inappropriate central-bank policy and the incentive structure within firms. One can think of this as equivalent to adding fuel to an already burning fire.
Asian countries — and emerging markets — must look to develop their financial sectors to allow high savings to be translated into increased investment, to allow people to borrow against future income, and firms to access markets when they need. Yet, the pace of this development needs to be managed carefully. With a more risk-averse world, policy consistency and predictability will be rewarded. In contrast, U-turns and policy reversals will undermine investor confidence. Rather than seeing the current episode as a threat to the region, this is in fact an opportunity to reflect on the progress made by Asia in the past decade.
Finally, a telling feature of the crisis has been the desire for Western financial firms to seek capital injections from sovereign wealth funds, a number of which are based in Asia. Although some of these investments have fallen in price, the telling issue is that this is a further sign of how the balance of economic and financial power is shifting from the West to the East. And in coming years, it would be no surprise if Asian firms become more international in their ambitions, but they will be better placed to achieve this using the foundation of stronger domestic financial markets.
Gerard Lyons is chief economist and group head of global research at Standard Chartered Bank.
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