Global Financial Crisis - United...

Global Financial Crisis

Implications for ASEAN

This is a preliminary report. The final report will be published as a book.

Global Financial Crisis

Implications for ASEAN

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© 2008 Institute Of Southeast Asian Studies, Singapore

November 2008

Contents

Introduction…………………………………………………………………………………1

Lead Article

• Global Financial Crisis and Implications for ASEAN………………………………3

o Professor Masahiro Kawai Dean, Asian Development Bank Institute

Commentaries by

o Professor Charles Adams ……………………………………………………….11 Visiting Professor at the Lee Kuan Yew School of Public Policy National University of Singapore

o Dr. V. Anantha-Nageswaran …………………………………………………….15 Chief Investment Officer for Asia-Pacific, Bank Julius Baer & Co. Ltd, Singapore

o Dr. Michael Lim Mah Hu ………………………………………………………19 Senior Fellow, Asian Public Intellectuals’ Program, Nippon Foundation

o Dr. Pradumna B Rana ………………………………………………………….23 Senior Fellow, Nanyang Technological University

o Professor Lim Chin …………………………………………………………….31

Professor, NUS Business School, National University of Singapore

Article

• What ASEAN Must do to Cope with the Crisis ……………………………………..35

o Sanchita Basu Das Visiting research fellow and lead researcher for economic affairs in the ASEAN Studies Centre at the Institute of South East Asian Studies (ISEAS)

About the contributors …………….……………………………………………………..39

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INTRODUCTION

We in the ASEAN Studies Centre at the Institute of Southeast Asian Studies in Singapore

have compiled in this volume a lead article, five commentaries on it, and a previously

published article about the current global financial crisis, its implications for the Association

of Southeast Asian Nations (ASEAN), and what ASEAN can do about it. We thus hope to

contribute to the analysis of the crisis, to the mitigation of its impact, and to the search for an

eventual solution. Such a solution necessarily entails transboundary cooperation, global

cooperation and regional cooperation.

Professor Masahiro Kawai, Dean of the Asian Development Bank Institute in Tokyo,

contributed the lead article. Using the Internet, we requested leading authorities on the

subject to comment on the lead article and on the theme of the discussion. We publish here

comments by Dr. Charles Adams of the Lee Kuan Yew School of Public Policy, National

University of Singapore; Dr. V. Anatha-Nageswaran, Chief Investment Officer for Asia-

Pacific at Bank Julius Baer; Dr. Michael Lim Mah Hui, a former banker, author and professor

and currently a senior fellow in the Asian Public Intellectuals Program of the Nippon

Foundation; Dr. Pradumna B. Rana, senior fellow at the Nanyang Technological University

in Singapore and formerly a senior director at the Asian Development Bank; and Professor

Lim Chin, a professor of economics at the business school of the National University of

Singapore. The commentaries were also circulated on the Internet.

In addition, we have included an article, “What ASEAN Must Do to Cope with the Crisis”,

by Sanchita Basu Das of the ASEAN Studies Centre and a visiting research fellow at the

Institute of Southeast Asian Studies. We have done so with the kind permission of The

Business Times, where the article first appeared.

RODOLFO C. SEVERINO Head, ASEAN Studies Centre Institute of Southeast Asian Studies Singapore

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Global Financial Crisis and Implications for ASEAN Masahiro Kawai, Dean, Asian Development Bank Institute

31 October 2008

Introduction

The world economy is currently experiencing the worst global financial crisis since the Great

Depression. Over the last two months, we have witnessed the failures and collapses of major

financial institutions in the United States (US) and Europe and massive coordinated actions

by their authorities to inject liquidity into money markets and to restore confidence in their

financial systems. While the effectiveness of these measures remains to be seen, the policies

of industrialized countries affected by acute financial crises are now heading in the right

direction.

Most recently, strong calls have been made for significant reform of the global financial

system. The Group of Eight (G8), joined by major emerging economies such as China, India,

and Brazil, will hold a series of global summits beginning in November to forge a new

system aimed at preventing financial crises and maintaining global financial stability.

With the spread of the US subprime mortgage crisis to the rest of the US financial system and

other industrialized-country financial markets, a significant slowdown in economic growth

has taken place in the US, Europe, and Japan. The crisis has moved from the financial sector

to the real economy. This paper focuses on the implications of the ongoing global financial

crisis and economic downturn for emerging Asian economies, particularly for Association of

Southeast Asian Nations (ASEAN) countries.

Causes of the global financial crisis

The ongoing global financial crisis was triggered by the eruption of the US subprime crisis in

the summer of 2007 and the subsequent liquidity and confidence crisis that has spread on a

global scale and peaked in September and October 2008. The crisis is the result of both

market and regulatory failures.

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The US subprime crisis was created by (i) a prolonged period of abundant liquidity, (ii)

excessive, imprudent lending in the subprime sector, (iii) lack of adequate prudential

regulation over financial institutions, and (iv) the bursting of the housing price bubble.

Abundant liquidity was provided by the US Fed’s lax monetary policy adopted from January

2001 to June 2004 in response to the 2001 recession, which lowered the cost of borrowing for

households and allowed financial institutions to aggressively leverage their balance sheets.

Foreign capital inflows also allowed Americans to finance their spending, particularly for

housing purchases. Americans financed their excessive spending through foreign borrowing,

by running an average current account deficit of 6%, as a ratio to gross national product

(GDP), during 2003 � 2007.

US financial institutions intermediated abundant liquidity into consumer credits and

mortgages, which were converted into mortgage-backed securities (MBSs) and collateralized

debt obligations (CDOs). The search for high yield fuelled investor demand for these

innovative, complex structured products with the help of the AAA ratings afforded by credit

rating agencies. As long as housing prices continued to rise, creditors felt safe in lending on

appreciating collateral, which in turn fed housing demand and prices, peaking in mid-2006.

Financial sector supervisors and regulators could not detect or limit excessive risk taking,

especially in the rapid and sustained buildup of leverage by non-regulated investment banks

and hedge funds.

Once housing prices started to fall in the summer of 2006, subprime defaults began to rise

and spread even to prime loans and other consumer credits. Many financial institutions began

to be affected, particularly those with large exposures to subprime-related structured

products, leading to a series of failures of several large US financial institutions (Bear

Stearns, American Insurance Group, Lehman Brothers, Washington Mutual, etc.). As a result,

transactions in global interbank markets began to freeze due to the perceived rise in

counterparty risks, exacerbating the liquidity problem even for healthier financial institutions.

Reflecting the severe risk aversion and lack of trust in the financial markets, the London

Interbank Offered Rate (LIBOR) shot up. The differential between the overnight LIBOR and

the federal funds rate spiked to over 300 � 400 basis points in October 2008, while the TED

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spread—the difference between the three-month LIBOR and the three-month US treasury bill

rate—also spiked. With recent declines in these spreads, dollar liquidity shortage is abating,

but the deleveraging of US and European financial institutions is now creating a forceful,

large-scale credit market contraction globally.

Implications of the global financial crisis for Asia

Many economists, including myself, have argued that the spillover effects of the US

subprime mortgage crisis on the Asian financial and real economic activity have been and

will be relatively limited, and that the growth prospects of Asian economies will remain

robust. Asian financial institutions’ exposure to subprime-related products was limited due to

three factors: (i) they were lagging behind global financial institutions in incorporating highly

complex financial innovations into their business models; (ii) many of them were cautious in

investing in high-risk, high-return instruments—such as MBSs and CDOs—after

experiencing their own financial crises ten years ago; and (iii) their authorities have

strengthened prudential supervision and regulation and risk management practices in their

respective financial sectors. For example, Japanese banks fully implemented Basel II

beginning in March 2007, ahead of the European Union and the US. In addition, Asian banks

and non-bank financial institutions are fundamentally sound, with well-capitalized balance

sheets, low non-performing loan (NPL) ratios (less than 5%), small exposure to real estate,

and limited off-balance activities.

Recent developments, however, are raising concerns about the resilience of Asian financial

and economic conditions. The global financial crisis is more acute and the real sector impact

is likely more severe than had been hoped for. According to the recent updated forecast by

the International Monetary Fund released in early October, economic growth in advanced

countries will be close to zero until at least the middle of 2009, while the relatively high

economic growth in emerging and developing countries will slow to substantially lower rates

than in the recent past. In China, figures for the third quarter showed an annual growth rate of

9%, well below the 2007 record of 11.9%, suggesting that the global financial crisis has

begun to affect the country’s real economy. India’s growth is also expected to decelerate

from 9.3% in 2007 to 6.9% in 2009. Similarly, ASEAN countries will slow down from 6.5%

in 2007 to below 5.0% in 2009. Indeed, the global financial crisis could send the world

economy into a recession.

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The acute global financial crisis and looming slowdown in the industrialized economies have

had first round effects on Asia’s financial markets through capital flow channels and are

beginning to exert second round effects on the real economy through trade channels. Before

the outbreak of the US subprime crisis, most Asian economies had faced the problem of

receiving too much private capital inflow, which potentially could have undermined

macroeconomic and financial sector stability. Today, private capital inflows are dwindling

and in some countries these inflows have stopped or even reversed: the global financial crisis

has already induced capital outflows from many emerging Asian economies, thereby causing

currency depreciation and sharp falls in stock market prices. One of the reasons for this is that

many US financial institutions have been trying to secure needed cash and capital by

deleveraging their overextended balance sheets—that is, by selling both domestic and foreign

assets. As a result, many Asian countries are now facing steeply rising risk premiums and

their access to the international capital markets is severely curtailed. Particularly vulnerable

to this new development are countries that had enjoyed large capital inflows with large

current account deficits, large external debt, and high inflation rates.

The slowdown of the industrialized countries is beginning to have negative effects on Asia’s

real economic activity through trade channels. The rapid growth of Asia’s intraregional trade

observed over the past decades—driven largely by trade in parts and components within

regional production networks—has been supported by the region’s exports of finished

manufactured products to world markets. Expansion of exports to the US and European

markets has been essential for Asia’s sustained growth. The prospect of weak demand for

emerging Asia’s products—due to the downturn of US, European and Japanese economic

growth—could slow its exports and foreign direct investment inflows, further reducing Asia’s

economic growth.

In addition, countries with traditionally large remittance inflows from overseas workers—

such as India, Philippines, Vietnam, and Indonesia—may face declining remittances from

abroad. Economic slowdown in industrialized economies could reduce demand for foreign

workers in these economies, causing a large drop in remittances. And workers may return

home to find that home markets may have difficulty reabsorbing them.

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Asian responses

Asian policymakers have taken several responses to the global financial crisis and looming

global economic downturn. To protect banking systems, some economies in the region (like

Hong Kong, Malaysia, and Singapore) have emulated what the US and some European

countries recently did, i.e., have guaranteed the repayment of customer deposits held with

authorized institutions. Korea has unveiled a US$130 billion package to guarantee short-term

foreign bank loans. Several economies (Philippines and Singapore) are considering to ease

the mark-to-market accounting rules so that declines in asset values—such as prices of

equity—held by banks will not cause a severe credit crunch.

With the sharp decline in prices of oil and other commodities and the slower growth prospect,

some countries have seen room for easing monetary policy to increase liquidity in the system

without exacerbating inflation. China, India, and Korea have cut the benchmark interest rates,

while Bangladesh, China, India, Indonesia, and Pakistan have reduced reserve requirements

on deposits. A few countries have decided to boost fiscal spending to offset the declining

growth. Other countries with fewer resources—such as Indonesia, Philippines, and

Pakistan—have started informal discussions with international financial institutions for

precautionary financial packages to stabilize their economies, avoid balance of payments

crises, or rescue financial institutions facing liquidity problems.

Although these measures have been uncoordinated, there is now a strong sense in Asia of the

urgent need to minimize the negative impact of the global financial crisis and economic

downturn on Asia’s financial sectors and real economy. A key strategy so far has been to

maintain the confidence in the financial market, prevent the emergence of financial crises,

and maintain growth.

Policy recommendations for ASEAN

ASEAN’s policy response to the crisis has so far involved individual, national strategies,

without coordinated action. The European Union’s approach suggests that coordinated policy

action is not an easy task as country situations are different. Nonetheless, it is time for

ASEAN to adopt a series of coordinated actions to jointly respond to the global financial

crisis and economic downturn. In particular, by maintaining healthy financial sectors that are

capable of intermediating savings for investment—particularly for small- and medium-sized

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enterprises—ASEAN can contribute to Asian and global financial stability. By stimulating

domestic demand to compensate for the slowdown in external demand, ASEAN can

rebalance sources of growth. In this way, ASEAN and wider Asia can become a reliable

engine of a global rebound from the current crisis and slowdown.

ASEAN governments should work together to jointly achieve three key objectives: (i)

maintaining financial market stability and confidence; (ii) supporting regional economic

growth; and (iii) stepping up efforts in regional monetary and financial cooperation.

First, it is essential to preserve financial sector stability both at the national and regional

levels. National measures include: the enhanced monitoring of systemically important

financial institutions; addressing dollar liquidity shortages to prevent a domestic liquidity

crisis; and preparing contingency frameworks for a possible systemic crisis (liquidity

injection, deposit guarantees, removal of NPLs, and bank recapitalization).

At the regional level, ASEAN may set up an “Asian Financial Stability Dialogue”—an Asian

version of the Financial Stability Forum—together with China, Japan, and Korea or in a

wider Asian context, to help monitor the region’s financial market—by using early warning

systems—and develop a plan of action in response to the immediate challenges of the global

financial crisis. This forum—to be created among finance ministries, central banks, and

financial market regulators and supervisors—can also serve to promote longer-term financial

market development and integration, establish standards for governance and transparency,

and improve investor confidence.

Second, facing the risk of significant economic slowdown, ASEAN countries may take joint,

preemptive actions to shore up domestic demand through expansionary macroeconomic

policies. With inflationary pressure abating, monetary policy easing is a plausible option.

With sound fiscal space, a fiscal stimulus package is a viable option focusing on physical

infrastructure to support growth and social safety nets to protect the socially vulnerable.

One way for ASEAN countries to jointly boost fiscal spending is to establish an infrastructure

investment fund together with other Asian countries—and possibly with Asian Development

Bank support—and to accelerate the pace of various planned projects for high-quality

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infrastructure investment so that the region can expand aggregate demand and at the same

time invest for future productive capacity. This is even more important as private capital

inflows are shrinking under the global financial conditions. In this way, ASEAN and broader

Asia can shift the primary engine of growth from external demand to regional demand.

Third, ASEAN countries should work with other ASEAN+3 members to strengthen

macroeconomic surveillance (through the Economic Review and Policy Dialogue, ERPD)

and the Chiang Mai Initiative (CMI). The focus should be on enhancing the effectiveness of

ERPD and speeding up the CMI multilateralization process as well as expanding the size of a

multilateral CMI beyond the agreed US$80 billion and reducing its links with IMF programs.

The details of the scheme—including how much each country should contribute to the fund

and its decision-making process—have to be agreed upon as soon as possible. ASEAN and

the “plus-3” countries should also consider creating a professional secretariat to support the

enhanced ERPD and a multilateral CMI. The new high-level Macroeconomic and Finance

Surveillance Office to be set up in the ASEAN Secretariat can play an important role in

implementing a credible regional surveillance mechanism as part of the multilateral CMI.

Finally, looking beyond the current global financial crisis and economic difficulty and

considering the rising degree of economic interdependence among Asian economies, ASEAN

needs to undertake greater policy coordination with other Asian economies—particularly in

the area of exchange rate policy. Once global financial stability is restored, one can expect

the resumption of large capital inflows into Asia which remains the dynamic growth center of

the world economy. To manage such capital inflows and maintain macroeconomic and

financial-sector stability, it will be important to allow sufficient exchange rate flexibility

while preserving relatively stable intraregional exchange rates. This requires coordinated

exchange rate management to allow greater rate flexibility vis-à-vis outside currencies—such

as the US dollar and the euro—and exchange rate stability vis-à-vis regional currencies. To

initiate such exchange rate policy coordination, it would be useful to introduce an Asian

Currency Unit index as a monitoring indicator.

We are entering a very important period in global financial history. There will be a series of

global summits to reform the global financial architecture in order to prevent future crises

like the one we face now and to put into place a new system that more closely reflects the

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current distribution of economic and financial power. ASEAN will have to work closely with

other Asian economies—like China, India, and Japan—so that its views are fully reflected in

any discussion of the reform agenda in global forums, such as the G8 process.

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Commentary by

Charles Adams, Visiting Professor at the Lee Kuan Yew School of Public Policy,

National University of Singapore

In response to ASEAN Studies Centre Theme 1 lead article, Global Financial Crisis and

Implications for ASEAN, by Masahiro Kawai

There are a number of issues to consider: (i) The likely impact of the unfolding crisis on the

region; (ii) How countries can best respond to the crisis; and (iii) the nature of any regional

policy coordination that might be helpful. Professor Kawai’s paper provides a very useful

framework for thinking about these and related issues. By its nature, however, the paper is

only a starting point and it will be important at the next stage to more explicitly address the

effects of the crisis on the region, the broader macroeconomic context in which policy

responses should be considered, and under what conditions, some degree of policy

cooperation or coordination might be useful in helping sustain regional growth. Even though

the region has already witnessed some of the negative consequences of unilateral action

(blanket guarantees), the case still has to be made that regional policy coordination at this

juncture is both desirable and feasible

Let me admit up front that, like everybody else, I have no real sense of how deep and severe

the crisis will be and the extent of spillovers to the region. Consensus forecasts for the region

are starting to be marked down but regional growth is still expected to be quite robust next

year; against this, however, consensus forecasts tend to be a lagging rather than leading

indicators and the advanced economies have recently started to slow sharply even if the

recent news on global credit markets has been somewhat more positive. Against this

background, my sense is that there is a non-trivial risk that spillovers from the global crisis

could be very large and, in the extreme, that they might lead to severe dollar liquidity

problems and dysfunctional local credit markets. At a minimum, we are probably going to see

a relatively sharp and possibly long-lived regional slowdown, even if the consensus forecasts

are still not quite there. And one should not discount the possibility of a number of local toxic

assets and surprises’ appearing as growth in the region slows. These would be related to

recently elevated property and asset prices, sharp increases in consumer credit, and investor

diversification into a range of new and exotic instruments.

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Before considering some of the specific policy measures the region might take, it is useful to

recall that the current crisis has much to do with the global current account imbalances. As a

result, macro policy responses inside and outside the region will need to be directed not only

to cushioning output during the global slowdown but, equally importantly, to ensuring the

reduction in the global current imbalances. Countries with large current account surpluses

should face no policy inconsistency between supporting domestic demand and reducing

imbalances. But the situation is more difficult in the case of countries with large current

account deficits. Across the region both macroeconomic and structural policies will be

needed to facilitate global rebalancing.

Specific policy actions and measures that might be considered at the national level given the

risks include:

• Daily monitoring and assessment of financial market conditions, exchange rates, credit

markets, capital flows and trade credit.

• Very short-term domestic and foreign and domestic currency liquidity support

operations. Capital injections and restructuring, if needed.

• Provisions of foreign currency liquidity to other countries in the region either via

currency swaps or co-financing operations with the IMF.

• Possible short-term monetary and fiscal stimulus measures if feasible, with plans for

unwinding as circumstances permit

• Short to medium term domestic structural reforms to help rebalance private demand

and saving.

• Short to medium term enhancements in the regional financial architecture

The need for the various measures will obviously depend on the severity and duration of the

crisis, and the degree to which regional financial systems become impaired. In principle,

existing institutional arrangements may suffice if the crisis does not involve more than a

sharp and short-lived cyclical slowdown in growth. In such a case, the focus at the national

level will need to be on the mix of monetary, fiscal, and structural policies to help sustain

growth while reducing global imbalances. Clearly, countries across the region differ in the

amount of fiscal and monetary space available and in the need for fiscal stimulus. And some

countries in the region may face credibility problems if they unilaterally embrace fiscal

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stimulus policies. Unlike in the major industrial countries where the effectiveness of

monetary policy is being challenged by dysfunctional financial systems, monetary policy still

has traction in the region. With inflationary pressures easing, the scope for monetary

relaxation across the region appears to be increasing but at different rates across countries; in

some instances, currency weakness may limit the scope to ease monetary policy.

In cases where monetary and fiscal stimulus is applied, it should be in the context of an

explicit medium-term policy framework consistent with fiscal sustainability and low and

stable inflation. Given large differences across the region in how countries are likely to be

affected by the crisis, it is unlikely that there will be a one size fits all stimulus package

around which coordination could take place. Should financial sector problems in the major

countries worsen further and spill over to the region’s financial markets, additional action

may be needed to forestall a bigger crisis. Increased attention will need to be paid in those

circumstances to threats to domestic financial stability. One approach would be for each

country to set up a Crisis Monitoring and Management Group (CMMG). The group could

comprise mid to senior level officials from central banks, finance ministries, and financial

regulators in each country. Such a group would have three main functions: (a) High

frequency monitoring of financial markets, conditions and of systemically important

institutions; (b) Providing input into the design of appropriate financial and other responses to

financial pressures; (c) Liaising and sharing information with similar groups in other

countries. Stepped up regional economic and financial cooperation might be helpful in such a

case and might relax constraints faced by individual country action; it would need, however,

to be considered on a case-by-case basis. In any event, information sharing and policy

dialogue would be especially important in such circumstances but regional policy responses

would need to be consistent with global policy requirements.

Looking beyond the current pressures, the region will need to consider strategies for the

removal of some of the extraordinary measures taken during the crisis. These measures

include blanket guarantees, short-selling restrictions, and capital controls. The intention to

remove such measures when circumstances permit might usefully be communicated to

markets and, might perhaps, be coordinated across countries.

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Commentary by

V. Anantha-Nageswaran, Chief Investment Officer for Asia-Pacific, Bank Julius

Baer & Co. Ltd, Singapore



The comment by the Dean of the Asian Development Bank Institute on the global financial

crisis and the implications for ASEAN touches up on all the important aspects of the crisis,

its impact on ASEAN and on how ASEAN must deal with it.

As he correctly puts it, the first impact came from the financial side (capital flows) and the

second impact is coming from the real side (trade flows).

One important lesson for ASEAN is to acknowledge that this global financial crisis is not

about US sub-prime mortgages or their securitization or about credit default swaps. It is about

excessive risk-taking lured by cheap money globally. Most nations, corporations, households

and housewives are guilty of that. Hence, to declare the crisis an American export to the

world and absolve oneself of any guilt over reckless and risky behaviour would store up

trouble for the future and guarantee another crisis. Owning responsibility for the crisis is the

first step towards its resolution.

Financial literacy

Financial liberalization is not in the same league as motherhood, apple pie and trade

liberalization. Its benefits are ambiguous and its costs are substantial. Hence, many

developing countries that have been seduced by academics into liberalizing their financial

markets for esoteric investment ideas from international bankers must pause and re-think.

One of the things that received the least attention is the issue of financial literacy not just

among consumers but also among sellers of financial products. It is one thing to understand

the bare technical essentials of how financial products are priced but it is another thing to be

able to place them in the global context. In other words, it is not enough if sellers of financial

products are able to explain how the product could lose money for investors based on narrow

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and technical considerations but be able to assign subjective probabilities on the product

producing negative returns in the event of global markets turning sour.

After all, in recent events, financial openness and technological advancements have made

global markets highly correlated. Globally, there is just one market for risky assets. That

increases the riskiness of many products sold in the market. They are whipsawed not just by

domestic factors but also by global developments. Hong Kong real estate prices drop when

Icelandic banks fold up. In this context, it is interesting to note that October 2008 was an

unusual month but not “abnormal” for global stock markets.

Writing for Eurointelligence web site, Paul de Grauwe and his co-authors show that Dow-

Jones index had daily returns that are five standard deviations above the threshold of zero

percent not less than 73 times in the last eighty years. Daily returns generated from normally

distributed random shocks are above or below five standard deviations from the mean only

once in 7000 years.

It is clear that stock returns are anything but normal. Yet, most financial derivatives are based

on the assumption that returns on financial assets are normally distributed. Hence, it is not a

surprise that more often than not, both clients and sellers are caught by surprise by the losses

generated by such products. They lack the perspective on factors that impinge on the delivery

of the promised performance of their products. Hence, financial literacy has to go beyond its

narrow confines of textbook concepts.

Ageing societies and leverage

The urgency and the importance of financial literacy are further compounded by the rapidly

ageing societies in Asia. It may not be immediately relevant for ASEAN with the exception

of Singapore but it is important for East Asia.

Ageing societies find themselves growing more slowly on average than before and this leads

to lower interest rates on both savings and borrowings. This leads to withdrawal of bank

deposits and enhanced borrowings. Thus, not only households take undue risks with their

personal balance sheets in an ageing and slow-growth society but they also weaken the

banking system by making it more reliant on the unpredictable and unstable money market

rather than on deposit funds.

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One of the lessons policymakers and regulators in ASEAN must impress upon the public in

ageing societies is that deployment of leverage to artificially defy the natural law of

diminishing returns in such societies is folly and ultimately self-defeating. Being in harmony

with nature and its laws is not just an issue of environment and ecology. It is a philosophy of

life.

Limits to export-led growth

Third, it is important for ASEAN to recognize the limits of export-led growth. Between 2003

and 2007, when global growth conditions were more propitious, there were enough

opportunities to wean their economies away from external dependence. Prosperity dulled

such thoughts. Now, they have no choice. ASEAN together with other Asian nations must sit

down and decide what kind of a future they wish to build for themselves.

Growth based on domestic demand would involve making citizens feel less insecure about

their future and retirement and would involve exchange rates that reflect fundamentals and

not policymakers’ preferences. Right now, many ASEAN countries (Indonesia, Thailand and

Malaysia) are unable to use monetary policy effectively to counteract the economic

slowdown that is setting in. The reason is that in good times they were slow to raise interest

rates adequately and quickly for fear of hurting growth and for fear of allowing their

currencies to appreciate. Unsurprisingly they have less monetary policy freedom now to

stimulate their economies when they desperately need to do so.

In the 1980s, Asian economies were not dependent on exports to the US. In fact, the

correlation of Asian export to US non-oil imports was around 20 percent. That is why when

the US stock market struggled in the aftermath of the October 1987 crash until end-1990,

Asian stocks did not suffer. In fact, they delivered significantly superior and positive returns

to investors compared to S&P 500 that remained relatively flat for more than three years up

to December 1990. That correlation rose to 30 percent in the 1990s and further to 80 percent

this decade. Consequently, there has been no de-coupling in Asia from US macro and market

trends. Asia has remained a leveraged play on the American business and market cycles.

In many respects, the crisis presents an opportunity for Asia to wean itself off American

financial capitalism that has caused so much grief to America itself and reliance on American

consumer. That would not only set Asia up as an autonomous economic area but would also

provide pensioners in the region and outside a viable diversification option. Thus, a multi-

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polar world is not just good for geopolitical stability but also for the stability of the global

economy and financial markets.

ASEAN + 3 is not Asia

Finally, for Asia to become a meaningfully important economic area, it is about time that

ASEAN does not confine its dialogue to ASEAN + 3 but extends it to include India whose

monetary policy framework of 2002-07 could serve as a good role model for smaller ASEAN

nations.

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Commentary by

Michael Lim Mah Hui, Senior Fellow, Asian Public Intellectuals’ Program, Nippon

Foundation



I read with interest Dr. Kawai’s excellent comments on the current financial crisis and agree

with most of his points and arguments. I wish to expand on them and get to a deeper level to

examine the fundamental-structural causes of the crisis.

Beyond the unbridle deregulation and liberalization regime that enabled and encouraged

financial players to come up with all sorts of financial innovations, there are three

fundamental causes of increasing fragility and instability in the financial sector. These are the

current account imbalances between the U.S. and the rest of the world, the wealth and income

imbalance that is a consequence of free market growth, and the sectoral imbalance between

the financial and real economy.

While the various measures that are now undertaken by the central banks world wide to

unclog the financial system and to prevent its total collapse have been helpful, they do not

address its inherent financial fragility and instability. In fact, while offering palliative

solutions, they may just work to create another larger bubble down the road.

It is well documented that excessive liquidity either from loose monetary policy and/or rapid

capital inflows invariably leads to a loosening of credit discipline and unsustainable asset

bubbles, especially in the property and stock markets. This happened in Japan, Southeast Asia

and the U.S. today. In the latest case, it was the savings of the emerging countries via current

account surpluses that ironically funded the consumption binge in the U.S.

Despite rapid economic growth in the U.S. and many other countries in the last three decades,

wealth and income are more unequally distributed. Between 1970-2006 in the U.S., the share

of GDP going to capital rose from 27 percent to 43 percent while the share of GDP going to

labor declined from 60 percent to 56 percent. The same story goes for China, where the share

of GDP going to labor fell from 53 percent to 41 percent (1998-2005). This factor is

important to grasp because while the majority of people do not have enough to consume,

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much of the income and wealth is concentrated in the very rich who have excess savings and

are constantly chasing for higher yields. To satisfy their demands, financial engineers invent

new and complicated products to meet the risk appetite of those with excess savings. On the

other hand, the growth of the financial sector and debt explosion allowed even those without

adequate means to consume beyond their means. Cheap and easy financing encouraged

households to invest in properties and to borrow on their properties.

Finally, in the last three decades, there has been a significant shift in the structure of many

advanced economies, particularly the U.S. Financial sector has come to overshadow the real

productive sectors. This is evidenced from a few indicators. Between 1950- 2004/5, the share

of GDP accounted for by the financial sector rose from 11 percent to 20 percent while that of

the manufacturing sector dropped from 30 percent to 12 percent; the share of corporate

profits of the financial sector went from 10 percent to 40 percent while that of the

manufacturing sector plummeted from 50 percent to under 10 percent. Between 1974 and

2006, total U.S. debt rose 18 times, while domestic financial debt rose 55 times and non-

financial corporate debt increased 11 times.

This brings us to an important point, namely the degree of leverage undertaken by the

financial sector facilitated by deregulation and financial engineering that enabled the

financial sector to earn such high rates of return. Return on equity is always boosted with

leverage. While non-investment commercial banks are normally leveraged 10 times,

investment banks on Wall Street doubled their leverage on average from 14 times to 30 times

made possible by a 2004 Securities and Exchange Commission ruling. Leverage is like drug

addiction – it gives you a sense of exhilaration when market goes up but sends you to the

abyss when market goes down. We are witnessing the impact of this process now.

Any remedial measures and policies should be informed by proper diagnosis. If the above

arguments are acceptable, then certain policy implications follow. A few are suggested here.

Most central banks have been focused on price stability, and to a lesser extent growth and

employment. But all have been errant on controlling asset price stability and content with

only picking up the pieces after the bubble has burst. It is becoming clearer the social costs to

taxpayers in cleaning up the mess exceed the costs of anticipating and deflating such bubbles

before they burst. (Not to mention the inequity where the benefits of booms are privatized

while the costs of busts are socialized.) In other words, central banks should adopt a counter-

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cyclical rather than pro-cyclical stance, a lean-against-the wind approach rather than a

cleaning-the-debris approach.

Minsky presciently noted that stability breeds instability. In periods of long growth, low

interest rate and financial stability, financiers and borrowers are lulled into confidence, risk

premium is lowered and risk appetite is increased. One way smooth out bubble booms and

busts is for regulators to require banks to adopt “dynamic provisioning” when their assets

grows quickly, as is done by the Bank of Spain.

We have argued that an important source of instability and fragility is excessive leverage and

speculation in the financial sector. Serious consideration should be given to increasing capital

gains tax on a progressive basis (i.e. increasing with shorter periods of holding). This will not

only reduce speculation but also provide a source of revenue for governments, part of which

can be used for financial relief efforts.

Financial players have managed to circumvent regulations through off-balance-sheet

activities, over-the-counter activities, and shadow banking activities. Unfortunately all these

products and activities are intimately connected to the regulated banking system through

contingent guarantees and counter-party trading. It is these shadow-banking activities that

have sucked banks into the financial vortex. Hence regulators have to bring the players in the

shadow banking system into their ambit. The level of leverage by hedge funds and private

equity funds should be reviewed and controlled.

Since these activities are fully globalized, a new financial architecture that requires

international coordination and regulatory powers should be set up. Otherwise, the players will

find ways of taking advantage by moving from strict regulatory regimes to lax regulatory

regimes. A beggar-thy-neighbor policy is not constructive in the long run. While the

European authorities are more open than the U.S. to an international framework, Asian

nations can build on and strengthen their present efforts at coordination and regulation.

With the increase in capital markets (bond and equity), the role and structure of rating

agencies should be reviewed. There is undeniably a conflict of interest when rating agencies

are paid by issuers of securities. One way of reducing this would be for rating agencies to be

paid by investors and also from a general pool of fund paid by issuers. This way the rating

agencies are not beholden to any particular issuer.

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Much has been written about restructuring the incentive and compensation structure of

financial executives. The current compensation structure encourages immediate rewards for

excessive risk taking. While the details can be debated, the principle should be established

that rewards be aligned to responsibilities and performance over a longer time horizon rather

than just one year. Making huge amount of loans or trades and getting rewarded immediately

and not taking responsibility for them going bad at a later time encourages risky behavior.

According to the New York State Comptroller, financial groups paid out $33 billion in

bonuses even as the financial industry racked up hundreds of billions dollars of losses.

Some of these measures may seem radical. But we are not living in ordinary times and this is

not an ordinary financial crisis. Simply implementing conventional policies like lowering

interest rates, increasing liquidity, recapitalizing banks etc. without addressing the

fundamental causes of financial instability could just be setting up the stage for a replay of a

bigger crisis in the future.

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Commentary by

Pradumna B Rana, Senior Fellow, Nanyang Technological University



The Impacts of the Global Financial Crisis on Asia – The Role of ASEAN

I. Introduction

The relatively benign sub-prime mortgage crisis (SMC) in the US, which began in August

2007, spread to other types of financial institutions and started to affect the real economy. In

September/October 2008, it metastasized globally through the capital flows and the trade

channels and started to derail economies all around the world. The crisis has thus become the

first truly global financial crisis (GFC) of the 21st century. Many predict that the eventual toll

of the crisis could be very high, next only to that of the Great Depression of the 1930s when

the unemployment rate in the US rose to 25 percent. The US, UK and the Eurozone are

already is a recession. The IMF projects that the GDP of the major industrial countries will -

for the first time in many years - shrink next year. The relatively robust, although much

downgraded, performance of the developing countries especially in Asia, while upholding the

world economy will not be enough to prevent a global recession next year. These trends,

according to the IMF, will start to slowly reverse only towards the end of 2009 or early 2010.

The Asian countries were relatively unscathed by the SMC during the early stage of the

crisis. This was because Asian banks were less exposed to the toxic assets that were

engineered and crafted in the US. Also their financial sectors were relatively resilient - thanks

to the reforms implemented during and after the Asian Financial Crisis (AFC) of 1997-1998.

The indirect effects of the GFC are now starting to affect the Asian countries. Foreign capital

inflows are drying up as foreign institutions withdraw funds to meet redemptions back home.

There has also been a rational flight to safety exacerbated by irrational panic similar to, but as

yet of a lesser magnitude than, what was experienced at the time of the AFC. Demand for

Asian exports has also slowed dramatically because of the synchronized global economic

slowdown. Singapore and Hong Kong, which are very open economies, are already in a

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recession. For the first time since 2001, Japan is in a recession. Some say that Asia is facing

problems of historic proportions.

Against the above background, this paper (i) briefly reviews the causes of the SMC and the

GFC (ii) outlines the impacts of these crises on Asia (iii) and highlights the responses by

Asian countries and role that ASEAN could play.

II. Causes of the SMC and the GFC.

The proximate cause or the trigger of the SMC was the bursting of the housing bubble in the

US during the summer of 2007 when subprime defaults began to rise and foreclosures

increased. It then spread to prime loans and other types of consumer credit. Other types of

financial institutions, especially those with large exposures to subprime related structured

products, also became affected leading to a series of failures of several large financial

institutions (e.g., Bear Stearns, American Insurance Group, and Lehman Brothers). The real

economy also started to be affected.

The root causes of the SMC were, however, policy mistakes in the US, the global imbalances,

and the weaknesses in the regulation and supervision of the financial sector in the country.

A number of policy mistakes were made during the past three decades. First, after the

bursting of the dot.com bubble in 1999-2000, the US Fed ran a loose monetary policy for

several years. The Federal Funds rate dropped from 5.98% in January 2001 to 1.73% two

years later and stayed at about that level until 2005. This fueled a credit boom in the US.

Second, the repeal of the Glass-Steagall Act in 1999 during the Clinton Administration

opened the gates for US banks to take on the full range of risky assets (securities, derivatives,

and structured products) either directly on the balance sheets or indirectly through off-balance

sheet conduits. This worked well in Germany and the other European countries, but not in the

US where investment banks were generally outside the preview of regulators. So commercial

banks and investment banks went into complex derivative securities and also extensively

leveraged their operations. The existing regulatory system could not catch investment banks.

The large and growing imbalances – the current account deficits in the US and surpluses in

Asia – and the recycling of Asia surpluses through purchase of US Treasuries, added further

fuel to the credit boom in the US. It is interesting to note that the often repeated warnings that

the global imbalance could lead to a disorderly adjustment of the dollar (for example, by the

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IMF) did not materialize as the dollar is still viewed as an international reserve asset and a

safe haven. That is reason why the US is experiencing a financial crisis but not a currency

crisis. The credit boom made possible by the imbalance led, however, to a build up of

vulnerability in the US by fuelling the housing boom and extension of credit to sub-prime

lenders (people who did not meet credit quality requirements).

The weak regulatory and supervisory systems in the US were also at fault. Banks and savings

and loans provided money to home buyers through mortgage loans. In the bygone era, these

financial institutions would have held on and collected interest and repayments. In the

modern era, banks and S&Ls repackaged mortgage loans into bundles of mortgage-backed

securities (MBSs) and sold them to investors including investment banks. MBSs in many

cases were re-packaged (other types of stocks were also added) into collateralized debt

obligations (CDOs) and sold to investors. Financial institutions did not hold on. This led to

excessive and irresponsible mortgage lending and to moral hazard. Allen Greenspan, the

Chief of the Federal Reserve System for 18 years of this boom period, confessed that he had

faith that financial institutions were prudent enough to make sure that they were not lending

money cheaply to people who could not pay it back. But this is exactly what happened. There

was also excessive leveraging and incentive compensation so that CEOs of financial

institutions got very high salaries. Credit rating agencies were also at fault. They gave high

ratings to investment banks based on history, not possible default risks of new instruments.

The SMC spread globally especially in September 2008, as banks holding toxic assets,

engineered in the US, faced difficulties. In addition to this direct effect, there was the indirect

effect due to the capital flows and the trade channels. Before the outbreak of the SMC many

emerging markets were receiving abundant amounts of private capital and discussions

focused on the possibility of such inflows undermining the macroeconomic and financial

sector stability. Since then, such inflows have dried up leading to huge asset price

depreciations and collapse in demand. Capital is being sucked back into the developed

countries to restore damaged balance sheets, meet margin calls, and accommodate large

withdrawals.

The synchronized slowdown in the industrialized countries has also had a negative impact on

real economic activity of emerging markets through the trade channel as import demand in

the industrial world for their exports has collapsed. The SMC, therefore, turned into a GFC.

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Summing up, aside from the global imbalance problem where the responsibility is shared

between the US and the rest of the world, the SMC and the GFC are “crisis made in and

exported by Wall Street”. This is unlike previous crises which originated mainly in the

emerging markets. As the Indian Finance Minister said recently “Emerging countries were

not the cause of the crisis, but they are among the worst affected victims”.

III. The Impacts of the SMC/GFC on Asia

The direct impact of the SMC on Asian countries was limited because the exposure of Asian

banks to sub-prime assets was low. Of the $500 billion written off by banks globally in the

year to August 2008, Asian financial institutions (including those in Japan) accounted for

only 5%. The financial health of Asian banks is also much better than a decade ago. The

average capital-adequacy ratio for Asian banks stands at a healthy 12% and Tier-1 capital

ratio which was around 5% in Indonesia and Malaysia in 1997 has increased to 10%. Since

the AFC, significant progress has been made in improving risk management systems,

regulatory and supervisory systems, and corporate governance. Within the region,

vulnerability is the highest in the case of Australia and Korea as they have high loan/deposit

ratios – 125% as compared to the Asian average of 90%.

The indirect impacts of the SMC/GFC on asset markets in Asia have been high. Since the

beginning of this year, stock markets (in US dollar terms) have tumbled (mainly in past two

months) by about 58% in Indonesia and India, followed by Singapore and Thailand where

they fell by about 50%, and in Malaysia and Taiwan by about 40%. The Chinese stock

markets have been the worst performer in the region falling by over 65%. Asian stock

markets have fallen more than say the Dow Jones index which fell by 31%. Asian currencies

have also taken a beating.

The September economic outlook reports from the ADB and the IMF suggest that the impact

of the GFC will be broadly limited to a decline in import demand by industrial countries for

Asian manufactured exports along with a diminution in the flow of official and private

capital. In Asia this will be reflected by sagging exports and industrial production and an

increase in unemployment. The September growth forecasts for 2008 and 2009 from these

two institutions are, however, not much lower than the actual growth outturn of the previous

two years. However, with recessionary trends deepening in the industrial world, the forecasts

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for Asian countries are bound be downgraded sharply in the future outlook reports from these

institutions in line with the outlook seen by the private sector.

III. Asian Responses and the Role of ASEAN

In an attempt to promote greater financial stability in the context of the GFC, various Asia

countries have announced full deposit insurance guarantees for a number of years (Hong

Kong, Taiwan, Australia, and Singapore). Also to rebalance economic growth, many Asian

countries have announced cuts in interest rates (for example, China has cut interest rates three

times since September and twice lowered the reserve requirement) and fiscal stimulus

packages (China, Japan, Australia, Korea, and Malaysia). Singapore is considering an

expansionary pro-business package in its next budget which has been advanced by a month to

January 2009. Among the stimulus packages, China’s two-year $600 billion package

accounting for 16% of its GDP is the biggest, bigger than the US package of $860 billion

which accounts for 5% of its GDP. One-half of this amount is to be spent on infrastructure

development including airport, highways and railways and the rest on social welfare,

environment, and technological innovation. Although it is uncertain how much of this is new

money and how much is already in the pipeline, the stimulus package seeks to maintain the

economic growth rate at over the psychological mark of 8%.

In Asia, so far, there has been no need to either recapitalize banks or to bail them out by

removing toxic assets. These cannot, however, be ruled out in the future as clouds continue to

darken in the horizon. If so, Asian countries should use their massive reserves that has been

accumulated over the past decade - at a high cost, for they were invested mostly in low-

yielding treasuries – to inject liquidity in their countries. This could be done by auctioning

foreign exchange reserves to deficit institutions. China holds about $2 billion of reserves and

Asia as a group (including Japan) holds two-thirds of the world’s reserves.

Most of the actions taken by the Asian countries, so far, have been at the individual country

level. There is an urgent need to also coordinate policy actions and take joint actions at the

regional level. ASEAN as the central and the most institutionalized grouping in Asia can

play an important role in this regard. The level of economic interdependence among Asian

countries, especially the East Asia countries, is high and growing. Intra-regional trade among

the ASEAN+3 countries is about 55% of their total trade because of the vertical division of

labor through the establishment of regional production networks centered on China. The level

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of financial integration, although low, is also starting to increase. Policy coordination will

rule out beggar-thy-neighbor type policies and at the same time help reverse the crisis of

confidence in the region. ASEAN could work closely with other Asian countries to sensitize

the need for policy coordination and come up with joint actions on policies. Policy

coordination does not mean identical policies, but broadly consistent policies at the regional

level. As the GFC continues to affect the region, Asia should coordinate attempts to promote

economic growth and financial stability and come out with joint announcements of

expansionary monetary, fiscal, and financial sector measures. A coordinated response from

Asia will be more effective than unilateral actions.

Although policy coordination could be conducted informally, support of an institutional

arrangement where policy makers could meet and hold discussions among each other could

be useful. Such an institutional arrangement in Asia could be the ASEAN+3 Economic

Review and Policy Dialogue (ERPD). Under this process, Finance Ministers of the

ASEAN+3 countries meet once a year and their Deputies twice year for two days a time to (i)

assess global, regional, and national conditions and risks (ii) review financial sector

(including bond markets) development and vulnerabilities, and (iii) other topics of interest.

The value-added of regional policy dialogues is that countries tend to be more frank with

each other in a regional forum and they focus on issues of common interest. The GSF has

enhanced the case for strengthening the ASEAN+3 ERPD so that policies are implemented in

a coordinated manner. ASEAN could work closely with Japan, China, and Korea to make this

happen. Among the steps required are (i) to move the dialogues which are in the “information

sharing” stage to a “peer review” and eventually to a “due diligence” stage (ii) to include

central banks governors in the meeting of Finance Ministers and (iii) to monitor the region’s

financial markets and their vulnerabilities by using an early warning system (ESW) system.

and develop action plans to meet the regulatory and supervisory challenges in the financial

sector. The membership of the strengthened ASEAN+3 ERPD should also be expanded to

include India which is a member of the East Asia Summit.

A recent ADB study has proposed the establishment of an Asian Financial Stability Dialogue

– an Asian version of the Financial Stability Forum – to bring together all responsibilities

(including finance ministries, central bank authorities, and other financial regulators and

supervisors) to address financial market vulnerabilities, regulations, and efforts at integration,

- 29 -

as well as to engage in dialogue with the private. ASEAN could help build a consensus on

establishing the Asian Financial Stability Forum .

The on-going efforts to establish a self-managed reserve pool by multilateralizing the

bilateral swaps under the ASEAN+3 Chiang Mai Initiative should be expedited. Last May,

the ASEAN+3 Finance Ministers had, in principle, agreed to establish the scheme and the

details are to be agreed by next May. The GFC has made the establishment of the ASEAN+3

self-managed reserve pool and augmenting its resources (say doubling) more urgent as

roughly one-half of the resources of IMF of $250 billion has either been committed or is

close to being committed to countries like Iceland, Ukraine, Hungary, Belarus, Pakistan, and

other European countries that are lined up. Hence Asia should use its massive reserves to

shield itself from the GFC. ASEAN could help expedite the establishment of a self-managed

reserve pooling the region.

As Kawai (this volume) has suggested that Asian countries should also jointly boost fiscal

spending by pooling reserves and establishing an infrastructure investment fund together with

the ADB and accelerate spending on the various planned projects for high-quality

infrastructure development. ASEAN could help. This is a useful suggestion as infrastructure

bottlenecks pose a major constraint in many countries in the region.

Given the limited resources available at the IMF there are on-going efforts to get China to

lend a part of its reserves to the IMF. Japan recently agreed to lend $100 billion to the IMF.

So far, China’s response has been lukewarm and China has taken the position that the best

action that it can take to support the global economy is to keep its own economy growing

strongly. Any such lending by China should be conditional on raising the quota of China and

India and the other emerging markets at the IMF. Presently, China’s quota at the IMF is 3.7%

and Germany’s is 6% although China will soon overtake Japan at the third largest economy.

The US quota is 17 percent. Europe, as a group, holds about 39 percent and Japan 6 percent.

Asian countries together have 25 percent.

It is encouraging that efforts to reform the global financial architecture are being spearheaded

at the G20 which has representation from emerging markets rather than the G7/G8 which is

dominated by a narrow group of industrial countries. This, in a sense, is historic. As expected,

the recently concluded first meeting of the G20 in Washington DC set in a motion a number

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of “big picture” reforms1, but took a few concrete steps. More actions on the “big picture”

reforms are to be taken at the forthcoming meetings including the next one in April 2009

when the new US administration will have taken over. Asian representatives at the G20

(Japan, China, Korea, India and Indonesia) should present Asian views and perspectives at

these meetings. ASEAN could help in developing a consensus on these matters. While the

previous Managing Director of the IMF had placed a high priority on the reform of IMF

quota to make the IMF a more legitimate global institution, actions on quota reforms appear

to have subsided under the present Managing Director.

IV. Conclusions

Asia is experiencing a crisis of unprecedented proportions not due to its excesses but those of

Wall Street. Economic conditions in Asia are expected to worsen further before they start to

improve. Asia should use its massive reserves and other policy tools to shield itself and help

the world. Actions are required at the national, regional, and the global levels. So far, actions

have been taken mainly at the national level. ASEAN as the central and most institutionalized

regional grouping in Asia could pro-actively sensitize and help build a consensus among

Asian policymakers on the need to coordinate policies at the regional level and the urge them

to come out with joint policy statements. Coordinated Asian responses will achieve much

more significant results than unilateral country-level policies. ASEAN could work closely

with Japan, China, and Korea in strengthening the ASEAN+3 ERPD and in establishing the

Asian Financial Stability Dialogue. ASEAN could also support and lobby for India’s

membership in the various ASEAN+3 initiatives. After all India is already a member of the

East Asia Summit. ASEAN could support and expedite the establishment of the self-managed

reserve pool in Asia with augmented resources and a regional reserve pool for infrastructure

development. Finally, ASEAN could also coordinate with the Asian members of G20 to

develop a consensus and ensure that Asian views and perspectives are properly reflected in

on-going discussions on the reform of the international financial architecture.

1 These include – strengthening the derivatives market; reducing the pro-cyclicity of regulatory policies; reviewing global accounting standards; reviewing compensation practices of financial institutions; reviewing the mandates, governance, and resource requirements of international financial institutions, and; broadening the membership of the Financial Stability Forum.

- 31 -

Commentary by

Lim Chin, Professor, NUS Business School, National University of Singapore



Preamble

The great Financial Tsunami of 2008 would be recorded as the biggest global financial crisis

since the Great Depression. From the epicenter of global finance, the credit default shock in

the subprime housing market sent financial shock waves, toppling major financial

institutions, freezing up credit markets, melting down global stock markets, and now

threatening to plunge the world into a prolonged economic recession.

The trigger may have been the housing bust in the U.S., but the scale of the damage can be

traced to market failures such as moral hazard, imperfect corporate governance and

regulatory failures that are embedded in the current financial system. Since the 1980s,

deregulation unleashed the explosion of financial derivatives, and together with international

capital flow, the modern financial system was supposed the make the financial system more

efficient. It is able to provide needed liquidity to borrowers and at the same time it meets the

needs of lenders who have different appetites for risk and terms of lending. In times of calm,

this system has proven to be quite efficient; it had expanded investment and economic growth

in the global economy. But when a major credit shock occurs it can also inflict untold

damage on the world economy.

Impact on Asia

The first shock wave brought down several major financial institutions in the U.S. because of

their direct exposure to credit default risk in the mortgage-backed-securities (MBS). Some

major European banks were also exposed, but much of Asia was spared in this round of

damage because of limited direct exposure to MBS.

The second shock wave came about soon after when fear and uncertainty of counterparty

risks led to panic. The flight to the safety of the U.S. bond markets caused a freeze in the

credit market and a meltdown in stock markets. In this round, Asia’s financial and stock

- 32 -

markets were not spared as they were hit by the risk of illiquidity that results from

deleveraging and the reverse flow of funds to the U.S.

The third shock wave is the transmission of real economic shocks. Falling asset prices

depress consumption and credit squeeze put a halt to investment; together they cause

economic slowdown, depress output and raise unemployment. Both the U.S. and most of

Europe are already in recession and they constitute the largest bulk of Asia’s export markets.

Asia is bracing itself now to cope with a global recession.

Thus, regardless of whether an economic shock originates in Asia (during the 1997 Asian

Financial Crisis) or at the epicenter (during the 2008 Global Financial Crisis), Asia gets hit all

the same. The reason is that capital flows respond in a predictable manner to relative risk and

returns, and it pays no attention to where the shock emanates. In both crises, Asia’s financial

markets and economy suffer from the same reverse capital flow to the financial epicentre.

The challenge to Asia is to find ways to soften the economic recession and to shield itself

from such liquidity risk in the future. In fact, the 1997 crisis had prepared Asia well for this

crisis. Over the decade, many of the Asian economies that suffered during that crisis had been

prudent in their economic house keeping, have recovered with healthy growth rates, and have

built up a strong foreign reserve position to weather exchange rate collapse in this crisis.

However, it cannot shield itself from the effects of a global recession. Clearly a global

problem requires a global solution.

Global Response: G-20 Summit

Immediately after the great stock market meltdown in Oct 2008, 20 world leaders from all

leading industrial powers such as U.S. Japan, Germany, UK, France, Italy, Canada, Russia

(the original G8), plus 12 other emerging economies including China, South Korea, India,

Argentina, Brazil and Saudi Arabia—together representing nearly 90 percent of world GDP--

assembled in the in the weekend of Nov 14-15 in Washington D.C. to find broad solutions to

soften global recession and to repair the financial system. They arrived at three broad

agreements.

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First, all economies should unleash their fiscal instruments such as tax rebates and

government expenditure to counter falling consumption and investment. Second, the final

stage of the protracted Doha round of WTO trade negotiations--which was stalled by farm

negotiations between the U.S. and India and China-- must be brought to a closure by the end

of the year to counter any protectionists tendencies. Third, the current financial system

needed repair badly. It was proposed that accounting standards must be more accurate and

transparent, credit rating agencies must be scrutinized, hedge funds may have to be regulated,

and that “supervisory colleges” be created to provide oversight of the world’s top financial

institutions. A further summit, perhaps in April 2009, would be necessary to flesh the details

of the new financial architecture.

How should be ASEAN respond?

Thus far, some members have unilaterally responded to restore confidence in the banking

system, and have made plans to stimulate demand using fiscal instruments. Kawai suggested

that it may be more effective for the group to respond in a more coordinated fashion in their

fiscal policies. He suggested a joint infrastructure investment fund, financed by ASEAN

together with other Asian countries and possibly with Asian Development Bank support, to

accelerate high quality investment projects. This would certainly be huge confidence booster

to the region and also the world economy. However, the difficulty is in the financing. The

tension between national and regional interest would pull heavily toward the latter to make

such a proposal unviable unless funding comes from external sources, a prospect that seems

quite unlikely to materialize under the current recession.

As for Kawai’s suggestion of a joint regional effort monetary and financial cooperation, it is

clear from the experiences of the 1997 and the 2008 crises that sufficient foreign exchange

reserves are needed to shield members from the adverse effect of reverse capital flow. Given

that IMF has lost much credibility in the region after its performance during the Asian

Financial Crisis, the recent MOU to create the CMI $80 billion swap facility for ASEAN by

ASEAN+3 members is an efficient way of providing regional insurance facility against the

risk of illiquidity. This together with the Federal Reserve’s dollar swap facility of $30 billion

each with the central banks in Singapore and S. Korea should add more insurance for

ASEAN in the future. In the new financial architecture, IMF is expected to be armed with

more reserves and hopefully it can be more effective this time around in dealing with Asia

- 34 -

now that its executive board is expected to include more Asian members. Furthermore, if the

proposed “supervisory colleges” to monitor the top banks were to be set up, ASEAN would

likely be consulted and it is here that ideas should evolve on how ASEAN could contribute to

make financial monitoring and supervision more effective.

Lastly, his suggestion for coordination in the management of exchange rates within ASEAN

is controversial and I think not viable. The suggestion to have a more stable intra-AEAN

exchange rate regime combined with more flexible ASEAN rates against the major currencies

brings to mind the experience of the Exchange Rate Mechanism (ERM) in Europe prior to the

formation of the EURO. The tension between national economic interests and regional

interest to keep a stable exchange rate among each other is bound to lead to crisis similar the

ones experienced in the ERM.

- 35 -

The article was published on The Business Times Editorial Page on October 31, 2008

What ASEAN Must do to Cope with the Crisis Act together to maintain confidence in the underlying strength of the region's economies

Sanchita Basu Das

The current financial crisis has reached perilous proportions. The depth of the crisis can be

gauged from the fact that the cost of the rescue package proposed by the US Federal Reserve

and the Treasury Department has been estimated at close to US$1 trillion, which is equivalent

to ASEAN's combined gross domestic product (GDP).

According to some analysts, this cost can go up further since the financial turmoil is expected

to continue way into 2009. Over the last few weeks, governments have pumped billions of

dollars into troubled banks while central banks around the world have injected huge amounts

of cash into the money markets to spur lending and save the world from a systemic crisis.

Nevertheless, the uncertainty in the stock markets prevailed, wiping out millions of dollars in

the process. The financial turmoil is fast spreading, and the trickle-down effect can be felt in

the rest of the world, including ASEAN economies.

The Asian Development Bank (ADB) in its 2008 outlook reported that ASEAN is expected to

grow 5.4 per cent this year, compared to 6.5 per cent in 2007. But with the financial

instability taking its toll on the G-3 economies - the US, Europe and Japan - it would not be a

surprise if ASEAN's GDP growth turns out to be lower. Despite the belief of decoupling,

around 20 per cent of ASEAN exports still head for the US economy. Hence, any

retrenchment of US consumer spending will take a bite out of ASEAN's export story.

ASEAN also felt a setback in terms of losing investors' wealth. The stock markets across the

region faced panic selling, reflecting the sentiment of the falling global capital markets. The

market capitalisation (the simple average of the Malaysia, Indonesia, Singapore and Thailand

stock markets) has declined 32 per cent in the first three quarters of 2008, vis-à-vis a 26 per

cent drop in the global average.

Not surprisingly, investors have been pulling out from the region. In the Philippines, foreign

portfolio investments registered a net outflow of US$521.7 million in the first nine months of

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2008 - a sharp reversal from net inflows of US$3.4 billion in the same period last year. In

addition, the ASEAN commercial banks are slowly finding it difficult to meet the credit

requirements of industry and trade. In its October meeting, Thailand's central bank kept its

benchmark interest rate unchanged after two increases since July to bolster confidence in the

economy and to end further liquidity tightening.

So what must ASEAN do? At the outset, one can say that there is an underlying similarity of

the current financial crisis in the US and South-east Asia's financial troubles during the

1990s. Both are due to poor management of the finance and banking sectors of the economy

and unsound monetary policies. The ongoing upheaval is not only due to the introduction of

complex new financial products but also an inadequate risk assessment system and a lack of

capital to absorb losses.

However, for ASEAN, so far the banking system seems stable and the central banks have not

implemented any drastic measures.

The Monetary Authority of Singapore (MAS) has tried talking up the economy, with the

assurance that its banking system is sound and the government will intervene if necessary.

For now, it has only shifted its foreign exchange rate policy to a 'zero per cent appreciation'

from a 'modest and gradual appreciation' to try to boost the competitiveness of the country's

exports. Also, the policymakers have guaranteed deposits and a few Singapore banks have

agreed to compensate investors who bought structured products linked to Lehman Brothers.

Similarly, Bank Indonesia has remained upbeat about fundamentals, assuring that its banking

system is sound and the government will intervene if necessary. With Indonesia having been

one of the worst-hit Asian economies during the 1997 financial crisis, authorities there have

raised the guarantee on bank deposits to two billion rupiah (S$284,000) and tried to ease tight

money market conditions with an injection of liquidity. The stock market was closed for three

days, and a 10 per cent limit imposed by the stock exchange on price swings has helped

underpin the market.

More recently, Malaysia's government promised to inject US$1.4 billion into the ailing stock

market to help it weather the financial crisis.

Resilient banking systems

Earlier, in an ASEAN Finance Ministers meeting, it was stated that the region's banking

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systems are resilient and economic fundamentals sound. ASEAN's economic growth may

suffer from the global financial crisis but banks are not at risk and no region-wide measures

are necessary to stave off any systemic threats.

Nonetheless, ASEAN as a grouping should take a common approach to maintain confidence

in the underlying strength of the economies in the region and should support the individual

governments to effectively respond to the short-term needs of the financial system.

This approach could enable a broad assessment of the key vulnerabilities facing the region

and hence could establish a region-wide coordinated framework for responding to the

financial crisis. It could include a coordinated use of monetary policy tools, such as interest

rate cuts, and create a legal framework for handling troubled financial institutions.

Finally, a pooled ASEAN financial facility could be developed to provide short- term

liquidity, if and when required, to central banks or finance ministries to support banking

systems through a variety of activities. Such short-term actions could be in line with

measures in other affected countries or regions across the world like purchasing non-

performing assets from banks and removing them from bank balance sheets, direct

investment in banks, providing guarantees for medium-term debt issued by the banks, etc.

As the current financial crisis is different from the last one, it is expected that this crisis will

spread to ASEAN through indirect channels, other than direct capital outflows. While the

economies are already facing a deceleration in exports, the contagion could also spread to

inward foreign investment and credit markets.

All this would eventually slow economic growth and possibly slow down the development

process across the region. Hence ASEAN should be ready with a preventive coordinated

approach so that the region can boost economic growth and ease worries on the global

financial crisis.

The author is a visiting research fellow and the lead researcher for economic affairs in the

ASEAN Studies Centre at the Institute of South East Asian Studies (ISEAS). These are her

personal views.

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About the contributors

Charles Adams (commentator). Charles Adams is a visiting Professor at the Lee Kuan Yew

School of Public Policy, National University of Singapore. Previously he worked at the

International Monetary Fund for twenty-five years including five years in Tokyo as deputy

director of the IMF's regional office for Asia and the Pacific. He holds a PhD from Monash

University, Australia

V. Anantha-Nageswaran (commentator). V. Anantha-Nageswaran was born in Chennai in

1963. He graduated with a Post-Graduate Diploma in Management (MBA) from the

internationally reputed Indian Institute of Management, Ahmedabad in 1983. He obtained a

doctoral degree in Finance from the University of Massachusetts in 1994 for his work on the

empirical behaviour of exchange rates. Between 1994 and 1999, he worked for Union Bank

of Switzerland (now UBS) and Credit Suisse in Switzerland. He launched the Libran Global

Macro Fund in January 2005. The fund invested globally across asset classes. It was wound

up in June 2006, due to adverse market conditions. In July 2006, he joined Bank Julius Baer

& Co. Ltd. in Singapore. He is the Chief Investment Officer for Asia-Pacific and is

responsible for research, portfolio management and financial products. Bank Julius Baer is a

Swiss financial institution and manages both institutional money and offers private banking

services to high networth individuals globally. He is an angel investor in many start-up

companies in India. He is one of the Directors of the NPS Indian International School in

Singapore. He teaches International Finance to MBA students at the SP Jain Centre for

Management in Singapore. He writes a weekly column for MINT, an Indian financial daily

on Tuesdays (www.livemint.com) and is a frequent guest at all the major international

television networks.

Michael Lim Mah Hui (commentator). Michael Lim Mah-Hui’s professional background

spans 30 years as an international banker and academician. He worked in major international

banks that included Chemical Bank (now J.P. Morgan Chase) in New York and Tokyo,

Credit Suisse First Boston in Singapore and Hong Kong, Deutsche Bank in Singapore and

Jakarta, Standard Chartered Bank in Jakarta, and the Asian Development Bank in Manila.

Prior to his banking career, Dr. Lim did research in and taught Political Economy and

Sociology at Duke University, Temple University and the University of Malaya. He has

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published several books and manuscripts: The Ownership and Control of the 100 Largest

Corporations in Malaysia, (Oxford University Press, Kuala Lumpur, 1981); Transnational

Corporations from Developing Asian Economies. ESCAP/UNCTC Publications Series B

No.7, United Nations, 1985; Women and the Industrialization Process in Asia: Close-up

Study of the Thai Textile Workers (a report submitted to the Social Development Division of

the Economic and Social Commission for Asia and Pacific, Bangkok, 1986.) More recently

he has written extensively on the present global financial crisis. His articles have appeared in

the Bangkok Post, the Philippines Inquirer, the Edge, the Department of Economic and Social

Affairs, U.N., the Third World Resurgence, the Levy Economics Institute, and the Journal of

Applied Research in Accounting and Finance. Dr. Lim has a multi-disciplinary background in

finance, economics and politics. He received his B.A. (Honors) in Economics from the

University of Malaya, a Masters in International Affairs, a Masters in Sociology, and a Ph.D

in Development Studies from the University of Pittsburgh. He is now a Senior Fellow in the

Asian Public Intellectuals Program of the Nippon Foundation.

Pradumna B. Rana (commentator). Pradumna B. Rana is currently a Senior Fellow at the

Nanyang Technological University in Singapore. He was the Senior Director of the Asian

Development Bank’s (ADB’s) Office of Regional Economic Integration which spearheaded

the ADB’s support for regional cooperation and integration in Asia. He joined the ADB in

1983 and held senior positions at the research and various operational departments. Earlier he

was a Lecturer at the National University of Singapore and the Tribhuvan University (Nepal),

a researcher at the Institute of Southeast Asian Studies in Singapore, and a consultant to the

World Bank in Washington D.C. He obtained his PhD from Vanderbilt University where he

was a Fulbright Scholar and a Masters in Economics from Michigan State University and

Tribhuvan University where he was a gold medalist. He has published widely in the areas of

Asian economic development and integration, Asian financial crisis, business cycle co-

movements, early warning systems of financial crisis, and policy reforms in transition

economies. These include several books and articles in international scholarly journals

including Review of Economics and Statistics, Journal of International Economics, Journal of

Development Economics, Journal of Asian Economics, World Development, Developing

Economies, and Singapore Economic Review. Currently, he is co-authoring a book on South

Asia: Rising to the Challenge of Globalization and co-editing books on Pan-Asian

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Integration: Linking East and South Asia (forthcoming Palgrave Macmillan) and National

Strategies for Regional Integration (forthcoming ADB, Manila).

Lim Chin (commentator). Professor Lim Chin is an economist with the NUS Business

School. His publications on behavior of the firm and of markets facing uncertainty, public

economics, and urban economics appear in leading academic journals such as such as

American Economic Review, Journal of Economic Theory, Rand Journal of Economics,

Economica, European Economic Review, Canadian Journal of Economics, Journal of Public

Economic Theory, Economics Letters, and Transportations Research. He has consulted

widely for both private corporations and government bodies and also the World Bank. He is

currently a member of the Market Surveillance & Compliance Panel (MSCP) of Singapore’s

New Energy Market, an independent body set up to monitor and enforce compliance with the

Market Rules and to ensure efficiency and fairness in the wholesale electricity market.

Masahiro Kawai (lead article author). Masahiro Kawai joined ADBI in January 2007 after

serving as Head of ADB's Office of Regional Economic Integration (OREI) and Special

Advisor to the ADB President in charge of regional economic cooperation and integration.

Prior to this, Mr. Kawai was a Professor at the University of Tokyo's Institute of Social

Science. Mr. Kawai also worked as Chief Economist for the World Bank's East Asia and the

Pacific Region from 1998 to 2001, and as Deputy Vice Minister of Finance for International

Affairs of Japan's Ministry of Finance from 2001 to 2003. Mr. Kawai began his career as a

Research Fellow at Brookings Institution and then as an Assistant and Associate Professor in

the economics department of Johns Hopkins University. Afterwards, he served as an

Associate and Full Professor at the Institute of Social Science, University of Tokyo. He

served as a consultant at the Board of Governors of the Federal Reserve System and at the

International Monetary Fund, both in Washington, DC. He was also Special Research

Advisor at the Institute of Fiscal and Monetary Policy in Japan's Ministry of Finance, and a

visiting researcher at the Bank of Japan's Institute for Monetary and Economic Studies and at

the Economic Planning Agency's Economic Research Institute. Mr. Kawai has published a

number of books and numerous articles on economic globalization, on regional financial

integration and cooperation in East Asia, including lessons from the Asian crisis, and on the

international currency system. He graduated with his B.A. and M.A. degrees in Economics

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from the University of Tokyo's Faculty of Economics. He earned his M.S. degree in Statistics

and Ph.D. degree in Economics from Stanford University.

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The Institute of Southeast Asian Studies was established as an autonomous organization in 1968. It is a regional research centre for scholars and other specialists concerned with modern Southeast Asia, particularly the many-faceted problems of stability and security, economic development, and political and social change.

The Institute’s research programmes are the Regional Economic Studies (RES, including ASEAN and APEC), Regional Strategic and Political Studies (RSPS) and Regional Social and Cultural Studies (RSCS).

The ASEAN Studies Centre of the Institute of Southeast Asian Studies in Singapore is devoted to working on issues that pertain to the Association of Southeast Asian Nations as an institution and a process, as distinct from the broader concerns of the Institute with respect to Southeast Asia.

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