ASIAN ECONOMIC INTEGRATION REPORT 2017THE ERA OF FINANCIAL INTERCONNECTEDNESS: HOW CAN ASIA STRENGTHEN FINANCIAL RESILIENCE?

Cyn-Young ParkDirector of Regional Cooperation and IntegrationEconomic Research and Regional Cooperation Department Asian Development Bank

Second Ministerial Conference on Regional Economic Cooperation and Integration: 21-24 November 2017 | United Nations Conference Center, Bangkok

Key messages Asia leads the global trade growth recovery; yet

structural factors of global trade slowdown still at play

Asian financial markets continue to be integrated more globally than regionally

20 years after the Asian financial crisis, Asian policy makers need to remain vigilant, deepen financial reforms, and strengthen regional cooperation for financial regulation and safety nets

Rapid financial globalization should be carefully managed; pockets of vulnerability remain while regulatory policy gaps leaving room for a buildup of financial imbalances.

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Asia’s Monthly Trade Value and Volume

y-o-y = year-on-year.Note: Asia includes the People’s Republic of China; Hong Kong, China; India; Indonesia; Japan; the Republic of Korea; Malaysia; Pakistan; the Philippines; Singapore; Taipei,China; Thailand; and Viet Nam.Source: ADB calculations using data from CEIC; CPB Netherlands Bureau for Economic Policy Analysis, World Trade Monitor. https://www.cpb.nl/en/data (accessed October 2017).

Recent data point to a trade recovery

‐20

‐15

‐10

‐5

0

5

10

15

20

25

0100200300400500600700800900

1,000Jan‐14

Mar‐14

May‐14

Jul‐1

4

Sep‐14

Nov

‐14

Jan‐15

Mar‐15

May‐15

Jul‐1

5

Sep‐15

Nov

‐15

Jan‐16

Mar‐16

May‐16

Jul‐1

6

Sep‐16

Nov

‐16

Jan‐17

Mar‐17

May‐17

Jul‐1

7

%, y‐o‐y

$ billion

Trade value (left) Trade value growth (right) Trade volume growth (right)

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Asia’s Intra- and Inter-subregional Trade Shares (%)

Source: ADB calculations using data International Monetary Fund. Direction of Trade Statistics (accessed July 2017).

Intraregional trade integration deepens

0 10 20 30 40 50 60 70 80 90 100

20002010201520162000201020152016200020102015201620002010201520162000201020152016

Cen

tral A

sia

Eas

t Asi

aS

outh

Asi

aS

outh

east

Asi

a

The

Pac

ific

and

Oce

ania

Intra-subregion Inter-subregion Rest of the world

Asia’s value chain linkage with the global economy slowed

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Components of Gross Exports (%)

66.5 67.1 67.0

60%

70%

80%

90%

100%

2014 2015 2016PDC RDV FVA DVA GVC partcipation rate

a: World

61.7 61.3 61.1

60%

70%

80%

90%

100%

2014 2015 2016PDC RDV FVA DVA GVC partcipation rate

b: Asia

DVA = domestic value added, FVA = foreign value added, RDV = returned value added, PDC = purely double-counted terms. Source: ADB calculations using ADB Multi-Regional Input-Output Tables, and methodology by Wang, Wei, and Zhu (2014).

Asia's cross-border assets grow

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FDI = foreign direct investment; * = data as of December 2015.Notes: FDI assets refer to outward FDI holdings. Bank assets refer to bank claims of Asian economies. Asia includes all 48 ADB regional members for which data are available as of December 2016.Sources: ADB calculations using data from International Monetary Fund. Coordinated Portfolio Investment Survey. http://cpis.imf.org (accessed September 2017); International Monetary Fund. Coordinated Direct Investment Survey. http://cdis.imf.org (accessed February 2017); and Bank for International Settlements. Locational Banking Statistics. https://www.bis.org/statistics/bankstats.htm (accessed May 2017).

Asia

$11.5trillion2010

17.4%21.8%

29.4%$15.6trillion2016

25.7%

22.5%23.3%*

28.5%31.4%

Bank: $3.4 trillionIntraregional: 16.3%

Debt: $3.6 trillionIntraregional: 11.9%

FDI: $2.5 trillionIntraregional: 35.3%

Equity: $2.0 trillionIntraregional: 24.2%

Bank: $4.4 trillionIntraregional: 21.4%

Debt: $4.0 trillionIntraregional: 15.3%

FDI: $3.6 trillion*Intraregional: 39.4%*

Equity: $3.5 trillionIntraregional: 19.0%

Financial stress up in response to global and regional shocks

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-1.5

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Jan-00 Mar-01 May-02 Jul-03 Sep-04 Nov-05 Jan-07 Mar-08 May-09 Jul-10 Sep-11 Nov-12 Jan-14 Mar-15 May-16

Developing Asia Financial Stress Index

Episodes FSI Average FSI

GFC 1st Greek bailout

Euro crisis Taper Tantrum

PRC currency devaluation

US Policy Normalization

Brexit

US Fed rate hike

Note: Based on principal components analysis. Includes People's Republic of China; Hong Kong, China; India; Indonesia; Rep. of Korea; Malaysia; Philippines; Singapore; Thailand; Viet NamSource: ADB calculations using data from Bloomberg, CEIC, and Haver Analytics (all accessed September 2017).

‐0.32Pre‐GFC

0.48GFC

0.13Post‐GFC

Jun-17

‐0.15Post‐

Normalization

The Era of Financial Interconnectedness: How Can

Asia Strengthen Financial Resilience?

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Key lessons drawn from past crisis experiences

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• Rapid financial globalization—timing and sequencing of financial liberalization should be carefully managed;

• Maintaining sound macroeconomic fundamentals is a prerequisite for economic and financial resilience;

• Deepening and broadening financial systems is essential to boosting both financial efficiency and resiliency;

• Greater regional cooperation efforts are needed to reinforce regional financial safety nets for financial resilience.

Asia’s financial health improved but pockets of vulnerability remain

• Significant challenges remain, along with unresolved financial market and system weaknesses.

• Remaining regulatory policy gaps also leave room for a buildup of financial vulnerability.

• Asia’s policy makers must remain vigilant, while continuing to deepen financial reforms.

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Structural weaknesses remain

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Limited capital market-based financing solutions such as long-term local currency bond markets

Continued heavy reliance on foreign currency- (US dollar-) denominated debt

Corporate Financing as % of GDP—Emerging Asia (excluding HKG and SIN)

0

20

40

60

80

100

120

1996 2006 2016Corporate BondsStock Market CapitalizationBank Credit

Share of outstanding international debt securities denominated in US dollars (in %) – Pre- AFC vs. latest

PRC

INOIND

KOR

MALPHI

THA

Avg

100

40

50

60

70

80

90

100

40 50 60 70 80 90 100

2017

Q1

1996Q2

Recent trends to signal financial fragility

• Rising private-sector debt and leverage—combined with the rapid growth of shadow banking—increase financial fragility

• Deteriorating bank asset quality can have potential macrofinancialfeedback effects

12Source: Bank for International Settlements (accessed September 2017)

-60

-40

-20

0

20

40

60

12/9

509

/96

06/9

703

/98

12/9

809

/99

06/0

003

/01

12/0

109

/02

06/0

303

/04

12/0

409

/05

06/0

603

/07

12/0

709

/08

06/0

903

/10

12/1

009

/11

06/1

203

/13

12/1

309

/14

06/1

503

/16

12/1

6

PRC IND KOR INO MAL THA

Deviation of Credit-to-GDP from Long-Run Trend (%)

0

50

100

150

200

250

300

350

1996

Q2

2006

Q2

2016

Q4

1996

Q2

2006

Q2

2016

Q4

1996

Q2

2006

Q2

2016

Q4

1996

Q2

2006

Q2

2016

Q4

1996

Q2

2006

Q2

2016

Q4

1996

Q2

2006

Q2

2016

Q4

1996

Q2

2006

Q2

2016

Q4

1996

Q2

2006

Q2

2016

Q4

1996

Q2

2006

Q2

2016

Q4

PRC HKG INO IND JPN KOR MAL SIN THA

Households Non‐financial corporations

Credit to Private Sector–Selected Asian Economies(% of GDP)

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Economy 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Afghanistan 49.9 4.7 5.0 4.9 7.8 12.1 15.2Armenia 6.0 8.0 17.5 24.4 9.9 5.4 2.1 1.9 2.4 2.4 4.3 4.9 3.0 3.4 3.7 4.5 7.0 7.9 9.3Azerbaijan 28.0 21.5 15.1 9.5 7.2 3.5 4.7 6.0 5.7 4.5 4.4 5.3Kazakhstan 11.9 8.4 4.3 3.3 2.4 2.7 7.1 18.9 20.9 20.7 19.4 19.5 12.4 8.0 7.9Kyrgyz Republic 10.1 30.9 30.9 13.4 13.3 11.2 8.0 6.2 3.6 5.3 8.2 15.8 10.2 7.2 5.5 4.5 7.1Tajikistan 11.3 4.8 5.4 9.6 7.4 7.2 9.5 13.2 20.4 19.1

Korea, Rep. 5.8 7.4 8.3 8.9 3.4 2.4 2.6 1.9 1.2 0.8 0.7 0.6 0.6 0.6 0.5 0.6 0.6 0.6Mongolia 7.2 17.4 11.5 5.8 4.2 5.3 5.0 7.5 8.5PRC 28.5 22.4 29.8 26.0 20.4 13.2 8.6 7.1 6.2 2.4 1.6 1.1 1.0 1.0 1.0 1.1 1.7 1.7

Bangladesh 40.7 41.1 34.9 31.5 28.1 22.1 17.5 13.2 12.8 14.5 5.8 9.7 8.6 9.4 8.4India 15.7 14.4 14.7 12.8 11.4 10.4 8.8 7.2 5.2 3.5 2.7 2.4 2.2 2.4 2.7 3.4 4.0 4.3 5.9 7.6Maldives 20.9 17.6 17.5 14.1 11.1Pakistan 20.7 19.5 22.0 19.5 23.4 21.8 17.0 11.6 9.0 7.3 7.4 9.1 12.2 14.7 16.2 14.5 13.0 12.3 11.4 11.1

Indonesia 48.6 32.9 34.4 31.9 24.0 6.8 4.5 7.3 5.9 4.0 3.2 3.3 2.5 2.1 1.8 1.7 2.1 2.4 3.0Malaysia 4.1 18.6 16.6 15.4 17.8 15.9 13.9 11.7 9.4 8.5 6.5 4.8 3.6 3.4 2.7 2.0 1.8 1.6 1.6 1.7Philippines 4.7 12.4 14.6 24.0 27.7 14.6 16.1 14.4 10.0 7.5 5.8 4.6 3.5 3.4 2.6 2.2 2.4 2.0 1.9 2.0Thailand 42.9 38.6 17.7 11.5 16.5 13.5 11.9 9.1 8.1 7.9 5.7 5.2 3.9 2.9 2.4 2.3 2.3 2.7 2.9

Central Asia

East Asia

South Asia

Southeast Asia

NPL ratios picking up in some Asian economiesBank Nonperforming Loans (% of gross loans)

Notes: White cells denote a nonperforming loan ratio below 5%, yellow between 5% and 10%, and orange above 10%. Blank cells indicate data are unavailable.Sources: ADB calculations using data from Bank of Mongolia; and World Bank. World Development Indicators (accessed October 2017).

New challenges to Asia’s financial stability

Asian financial markets have grown more interconnected both intra-regionally and across the globe over the past 20 years;

A more interlinked global banking network can spur the transmission of financial risk from advanced to emerging economies;

A buildup in NPLs can yield macro-financial feedback effects, with possible spillover effects in increasingly interconnected financial markets.

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Asian financial markets have become more interconnected regionally and globally

A heightened financial interconnectedness can transmit shocks across borders

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Impact of direct and indirect banking exposures to the crisis-affected countries on capital outflows during the GFC

*** = significant at 1%, ** = significant at 5%. Robust standard errors in parenthesis. Coefficients for the control variables are not shown for brevity. Source: Park and Shin (2017).

Variables

Without Control Variables

With Control Variables

(1)Outflows

(2)Outflows

(3)Outflows

(4)Outflows

Direct exposure of banking sector

0.257***(0.075)

0.282***(0.078)

0.228**(0.085)

0.253***(0.086)

Indirect exposure of banking sector

0.722**(0.285)

0.359(0.269)

Buildup of NPLs can affect real sector and spill over through macrofinancial linkages

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Source: Lee and Rosenkranz (2017)

Estimated Impulse Response Functions to a Shock in the NPL Ratio

Macrofinancial feedback effects: Empirical findings show that an increase in NPLs leads to a reduction in credit supply, a rise in unemployment, and slowdown in overall economic activity

Systemic implications: NPL shocks can transmit across borders through macrofinancial linkages

Policy considerations for enhancing financial resilience

A key lesson drawn from recent crises is the urgent need to strengthen macroprudential regulation and supervision

Further developing local currency bond markets across the region is key to enhancing financial resilience and mobilizing long-term finance

Growing regional banking activities and institutions—possibly of systemic importance—underpin the need to discuss regional regulatory cooperation, including resolution mechanisms for interconnected regional banks

The region should consider reviewing and strengthening existing financial safety nets against potential contagion and spillover effects

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Thank You!

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