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Signs of stress in the Asian financial system
THE Asian debt crisis of 1997 devastated the region for many years, and was felt in markets throughout the world. The last tremors of the 2008 global banking crisis are still resonating. Now, financial media and other observers question whether rising debt levels in Asia can trigger a new crisis. Unfortunately, the signs are ominous, and the health of the real and financial sectors is deteriorating.
Three fundamental stress conditions seem to be building throughout Asia:
- The real sector: Corporations and households are accumulating high levels of debt.
- The financial system: Lower margins, higher risk costs, and continued dependence on banks and shadow-banking institutions for loans pose risks.
- Capital inflows: Inflows into Asia have increased dramatically since 2008.
Whether these conditions will trigger a new crisis remains to be seen. Since 1997, financial regulators have become wary, and safeguards have been put in place. Yet governments and businesses must monitor potential triggers carefully, and take adequate preventive action.
SIGNS OF STRESS IN THE REAL SECTOR
Corporate balance sheets show very high stress levels. We analysed 2007 and 2017 financial data from more than 23,000 companies across 11 countries in the Asia-Pacific and more than 13,000 companies in the United Kingdom and the United States.
The results were sobering. In 2017, Australia, China, Hong Kong, India and Indonesia had more than 25 per cent of long-term debt held by companies with an interest coverage ratio (ICR) of less than 1.5, a level where corporations are using a predominant share of their earnings to service their long-term debt. The situation is particularly stark in China and India where 37 per cent and 43 per cent respectively of long-term debt is held by corporations with ICR less than 1.5.
In Malaysia, Singapore, South Korea and Thailand, at least 40 per cent of long-term debt was held by companies with ICR of less than 3, a level where corporations are likely to struggle to service their debt.
FINANCIAL SYSTEM VULNERABLE
Cracks are appearing again in the Asian financial system: lower margins, higher risk costs and increased lending by non-bank financial intermediaries.
Margins at Asian banks are shrinking, and return on average equity has fallen from 12.4 per cent in 2010 to 10 per cent in 2018. Adding to the worrying signs, the impact of high leverage among corporations and households is already apparent across emerging Asia. Risk costs were especially burdensome in China, India, Indonesia and Thailand, and have increased by 25 basis points (bps), 107 bps, 13 bps and 21 bps respectively since 2014.
The growth in lending by non-bank intermediaries, especially in China and India, also generates greater risks. In 1997, the Asian financial crisis was partly triggered when merchant banks in South Korea were caught in a severe credit squeeze. Analysts have estimated that lending by China's shadow banking sector reached 55 per cent of gross domestic product (GDP) in 2017.
In India, around 2014, as defaults showed signs of growing, banks reduced lending but non-bank financial intermediaries continued to lend. The Reserve Bank of India, India's central bank, estimates that 99.7 per cent of nonbank finance companies (NBFCs) and housing companies make long-term loans against short-term funding. Any failure to make repayments as debt instruments come up for redemption can trigger a crisis. This is already evident; the shadow lender Infrastructure Leasing & Finance Services (IL&FS) has defaulted on interest payments to bond holders. The ripple effects of this are being felt across the system. Rating agencies have downgraded debt issued by multiple NBFCs; many pension funds have announced that they have exposure to debt issued by the affected NBFCs.
SURGING CAPITAL INFLOWS POSE RISK
Global cross-border capital inflows - foreign direct investment, loans, portfolio equity, and debt - have shrunk by about two-thirds from just before the 2008 global financial crisis. However, inflows into 20 Asian countries have topped pre-crisis levels five times in the last 10 years, and have risen further to US$1.6 trillion in 2018.
In a fascinating shift, the share into Asia of global financial inflows surged from about 12 per cent in 2007 to about 36 per cent in 2018. It is worth noting two vulnerabilities. First, more than 40 per cent of inflows continue to be foreign loans that are highly volatile. Second, in a few countries, including Indonesia, half or more of corporate debt is denominated in foreign currencies.
WHAT COULD TRIGGER A CRISIS?
A few triggers could amplify the risks that Asia faces. Stakeholders should closely monitor interest rate trends and overall global economic developments, such as slower growth and ongoing trade tensions.
A 2018 MGI report modelled the impact of a 200 basis point increase in interest rates on corporate bonds at risk of default. The results for India and China were alarming. In India, the share of at-risk bonds outstanding of non-financial corporates would increase from 18 per cent to 27 per cent, and in China from 24 per cent to 43 per cent.
Moreover, sectors such as industrials and real estate would suffer disproportionately from an increase in interest rates. Industrials comprise more than half the stressed debt in China and Hong Kong, and nearly a third in Australia and India. Also, a global economic slowdown, ongoing trade tensions and geopolitical tensions could harm corporate and household earnings across Asia, increasing the region's vulnerability.
While our analysis suggested no evidence of immediate risk, global asset-price bubbles are another potential stress factor. Recent years have seen explosive growth in global private markets, with assets under management totalling about US$5.8 trillion in 2018 and global private-equity deal multiples near all-time highs at 11.1; this is despite the fact that a large share of investments are going into companies with limited track record of profitability.
PREPARING FOR A SLOWDOWN OR POTENTIAL CRISIS
Financial crises can be anticipated, and corporations, banks, and policymakers can prepare better than they have in the past. Less obviously, financial crises can also be a moment of strategic opportunity. Companies quick to pivot wisely in response to a crisis by, for instance, setting a new strategic direction and taking advantage of new opportunities have emerged stronger and even dominant.
Divesting underperforming businesses early creates greater financial flexibility for companies as they enter a crisis, providing an opportunity to acquire assets that peers are dumping. Corporations that launch or accelerate digital transformations to increase earnings through the cycle and drive revenue growth during the recovery are also more likely to emerge as winners.
Finally, banks and non-bank intermediaries should re-evaluate credit risk, strengthen their capital position and manage any liquidity mismatches proactively.
- Joydeep Sengupta is a senior partner in McKinsey's Singapore office where Archana Seshadrinathan is a senior expert.
The writers wish to thank Dominic Barton a nd Diana Goldshtein for their contributions to this article.