Growing risks to sovereign creditworthiness in Asia

KimEng Tan

Asia-Pacific economies have so far escaped the credit crises in the US and Europe, but they are facing another familiar roadblock: rising debt. Could this lead to a full-blown Asian credit crisis?
An Asia-Pacific credit crisis remains unlikely. But debt levels in key Asia-Pacific economies are much higher today than they were just five years ago. Betting that they can avoid the law of gravity to stay safely at these elevated levels indefinitely doesn’t seem wise.

The saving grace for Asia-Pacific countries is that some structural factors lower the risks to financial and macroeconomic stability. Total credit extended to non-financial entities in the region remains lower than in most parts of Europe. Corporate borrowings partly support economic activities outside of their home countries. And the importance of asset-heavy industries in some countries raises the overall level of credit but increases financial risks less than headline numbers imply. Credit risk for Asia-Pacific banks is also more diversified than in some of the advanced economies where credit crises hit.

Have risks to sovereign ratings across Asia-Pacific waned?
Not necessarily. Rising debt levels mean that risks to sovereign creditworthiness in Asia-Pacific economies have increased. The unusually easy global monetary conditions today may be magnifying financial and economic risks by increasing leverage further or discouraging prudent early deleveraging. And the conditions that supported robust economic growth in the region could turn less supportive in the future. For example, economic growth may slow if China’s economic rebalancing does not proceed smoothly.

In the current circumstances, a lack of regulatory vigilance could create possible financial instability. More than before, continued economic and financial stability in Asia-Pacific will require greater awareness of the risks. Otherwise, we could find the credit crisis complete its global tour by revisiting the region.

Has debt risen beyond safe levels?
Many Asia-Pacific countries are more indebted today than they were six to seven years ago. Financial institution lending now stands well above the levels in the mid-2000s. The credit-to-GDP ratios in a few of these economies are also high relative to peers at similar income levels.

The strength of corporate bond issuances in recent years has been positive for domestic capital market development. However, the debt burden for issuers could also have increased. Total debt in the economy could have risen beyond safe levels if the non-financial sector already borrows heavily from financial institutions. Rising debt, compared with income (using nominal GDP as a proxy), is a key indicator of increased financial risk. It suggests that the debt level has risen relative to the ability to service it.

An increase in leverage leaves an economy more vulnerable to adverse economic and financial developments. Recessions cause more business failures and greater output loss in an economy that has higher leverage, all else being equal. Financial shocks that sharply increase interest rates or reduce credit availability also cause more damage where leverage is higher.

In China, the surge in debt that local-government-related companies owed in 2008 to 2010 has caused significant unease. Similarly, the spikes in debt of Vietnamese state-owned enterprises (SOEs) and in the real estate sector have also been a focus of investor anxiety. Household debt is rising in Korea, while in Australia and New Zealand it’s still high relative to income despite recent declines in that ratio.

Has the region’s economic and financial resilience weakened?
Somewhat yes, despite the qualities that kept a financial crisis at bay. Real estate downturns may be less of a threat to financial institutions in the key economies than they were in the worst-hit developed economies. Nevertheless, credit losses can still increase rapidly if general economic conditions weaken materially. The top concern is that China’s growth could slow sharply before the developed economies recover sufficiently to contribute to maintaining moderate growth. The slowdown is likely to have a material negative effect on economic activities across the Asia-Pacific.

In this scenario, declining economic activity could expose current weaknesses associated with credit growth in the past decade or so. We believe the unexpectedly low default rate among Chinese local SOEs is unlikely to persist. Nonperforming loans in Vietnam could rise further. And household debt delinquencies in Australia, Korea and New Zealand may accelerate sharply as labour market conditions weaken. The importance of external wholesale funding for banks in these economies could exacerbate the pressure they face if their household loan books see increasing losses.

Even in Hong Kong and Singapore, where household leverage remains modest, a sharp rise in unemployment could damage banks’ asset quality. Due to the steep and rapid increase in home prices in recent years, housing affordability has worsened. Some new homeowners may have taken on mortgages that are large relative to their financial assets and income. Were such borrowers to lose their jobs, especially if interest rates were to rise from current low levels, defaults on mortgage payments may soon follow.

Will stronger global liquidity feed risks?
The current global economic situation increases existing financial risks. Easy monetary policy stances in the world’s largest economies have brought short-term interest rates down to very low levels. Long-term interest rates have also declined significantly. One reason for this is the widespread belief that developed countries’ central banks will maintain low policy interest rates for a prolonged period. Another is the well-anchored inflation expectation in many countries. The search for higher yields has therefore led many international investors to put more funds in Asia. The sharp increase in foreign holdings of government bonds in several Asian economies is a reflection of this.

Low interest rates and plentiful deposits have also led banks in Asia to become more eager to increase the size of their loan books. Fierce competition has depressed retail interest rates sharply and compressed profit margins. Apart from offering interest rates that are barely profitable, some have also significantly lengthened the repayment period of some loans. Banks hope to encourage borrowers to take up larger loans by reducing the size of regular payments.

Without regulatory vigilance, persistently strong global liquidity could erode the balance sheet of banks and borrowers alike. Asset bubbles could easily arise in any Asia-Pacific economy with home prices that are already high relative to household incomes.

KimEng Tan is a Singapore-based senior director and analytical manager for Standard & Poor’s sovereign analytical team in Asia-Pacific

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