New Asian Crisis Looms and This Time the Fed Is to Blame

Oct 30, 2013

New Asian Crisis Looms and This Time the Fed Is to Blame

MICHAEL J. CASEY

Don’t look now, but another Asian crisis may be brewing–courtesy of the U.S. Federal Reserve.

A paper recently published by the Bank of International Settlements–a multilateral club of monetary authorities that includes the Fed–noted that central bank bond-buying, or “quantitative easing,” has made dollar-based loans so cheap that Asian companies are ramping up their borrowing in greenbacks. The paper’s authors fear that once the Fed and the Bank of Japan eventually turn off their liquidity taps, rising dollar interest rates will leave these Asian debtors unable to pay back the money.

That should trigger uncomfortable memories of the debt and currency “death spiral” of 1997-98, when plunging local currencies fueled a crisis in Asia that spread financial contagion around the world.The BIS study focuses on South Korea, Hong Kong and China. But it is China, the world’s second-largest economy, that deserves the most attention. Despite the constraints imposed by capital controls, foreign-currency loans in China grew by a whopping 35% in the 12 months to March 2013, according to the researchers, Robert N. McCauley of the BIS and Dong He of the Hong Kong Monetary Authority. That’s more than twice the 15% growth in loans denominated in Chinese yuan–a pretty alarming statistic given how worried everyone has become about those yuan-denominated loans to construction-obsessed Chinese municipalities.

Much–but not all–of the foreign borrowing in China is funded by local banks with onshore foreign-currency deposits. It’s also likely that Chinese companies are using a large chunk of it to finance operations in offshore subsidiaries. That would mean much of the borrowing is never converted into yuan and therefore wouldn’t trigger Beijing’s capital controls. On the surface, this seems like a more stable situation than was the case in Thailand and Indonesia before 1997, when dollars were borrowed to finance local-currency expenditures, creating a mismatch that became unmanageable when the home currencies plummeted.

Yet Messrs. Dong and McCauley still worry about “substantial financial stability risks–not so much currency mismatch risks, but rather maturity and liquidity risks associated with dollar funding” in Asian economies. And for this they cite the dollar shortages of 2008 and 2009, when a failure to renew short-term loans led to paralysis in global trade.

But it is the parallels with the Asia crisis and the lessons that experience offers for our understanding of the current phase of the global economic cycle that send the biggest warning signal. The authors note that the Fed is already facing a “difficult exit from very accommodative policy over the next several years,” much as it was also going through tightening process in 1997 until the Asian crisis disrupted it with the turmoil that was unleashed in world markets. They suggest that “financial instability in East Asia” could produce even worse “blow-back effects” to large economies this time because the region “has stronger trade links to North America and Europe today than it had 15 years ago.

No one can say precisely how such contagion would play out. But for the sake of argument, we could imagine the Hong Kong subsidiaries of major European banks suffering heavy losses, for example, as one mainland Chinese debtor after another misses payments on foreign debts. And from there, it’s just one step before the euro crisis roars back to life as investors start worrying about the undercapitalized banks of the common currency region and their holdings of shaky governments’ bonds.

The foreign exposures to this Asian debt buildup aren’t trivial. In China alone, foreign lending now stands at about $880 billion. While that’s still only 8.5% of total Chinese debt, it’s way up from 5.3% in 2009, according to the researchers. What’s more, dollar debt has a magnified capacity to trigger a credit crisis because foreign lenders can ignore government directives to roll over bad debtors’ loans–unlike the state-run banks. This is why defaults on foreign loans have often been the catalyst for Chinese credit episodes in the past, notes David Hoffman, managing director of The Conference Board’s China Center for Economics and Business.

Some of the dollar-borrowing represents a long-term bet on the appreciation in the yuan. But the BIS paper shows that the biggest driver is the Fed’s massive quantitative-easing program, which pumps $85 billion into the global economy each month and which is creating easy credit conditions in foreign countries whose economic conditions don’t warrant them.

We’ve already seen the extreme volatility that the mere hint of a reduction in Fed bond-buying created in emerging markets over the summer–the Indian rupee, for instance, dropped 20% versus the dollar between the beginning of May and the end of August–as all the “hot money” spurred by previous rounds of QE high-tailed out of those countries’ bond and money markets. Just imagine the damage when the Fed actually does something.

The Federal Open Market Committee is highly unlikely to acknowledge such concerns when it releases a post-meeting statement this afternoon, one that will almost certainly retain the $85 billion-per-month operation. But for the sake of global stability, let’s hope it is at least taking them into account for policy planning–that is, if it’s not already too late.