Despite a sense of optimism at the Asian Development Bank's 43rd annual meeting last month, Asia-watchers warn that there may still be trouble ahead due to a disruptive influx of foreign capital. Writer Michelle Price

"One year ago, we met in crisis. Today, we meet in hope." These were the opening words of Haruhiko Kuroda, president of the Asian Development Bank (ADB), at the opening session of the institution's 43rd annual meeting, held last month in the Uzbekistan capital, Tashkent.

Mr Kuroda's understated address belied the simmering sense of optimism prevalent in Tashkent, where the region's policy-makers were able to congratulate one another on a job well done and a catastrophe averted. Indeed, the irrepressible Asia region has staged a roaring recovery during the past year, fuelled by extraordinary fiscal and monetary stimulus, amounting to more than $950bn, according to data from Bloomberg. In addition, the latest International Monetary Fund (IMF) adjusted forecast says the region is set to post a growth rate of some 7.1% for both 2010 and 2011.

Remarkable though this comeback may be, few Asia-watchers believe that the region can relax: for as the meeting's discussions bore out, the outlook for Asia is mixed and a period of instability cannot be ruled out.

It's not contagious

Recent events in Europe - principally the unprecedented bailout of Greece by the EU and IMF - are one source of potential volatility.

The deterioration of industrialised countries' fiscal positions is a threat to the global economic outlook, despite Asia's return to near full health, warns the ADB. "Asian countries rely on the global economic outlook for demand and stability, and if there is a further deterioration in the situation - or in investor perceptions on European sovereign risk - that will affect the global economy and it may have a significant impact on the Asian recovery," says Jong-Wha Lee, the development bank's chief economist. Heightened investor sensitivity towards sovereign risk is also likely to widen credit default swap spreads on those Asian economies in a relatively weaker fiscal position, he says. This would include the likes of Japan, Sri Lanka, Vietnam and Pakistan.

But few market-watchers anticipate fully fledged, if any, contagion. Asia's exposure to sovereign debt is very limited, says Mr Lee, who also cites what he describes as the more "sensitive" subject of decoupling, a theory that - despite falling out of vogue in the immediate aftermath of the financial crisis - was raised on more than one occasion at this year's meeting. Both bankers and economists have suggested that the Asian financial markets - to a greater or lesser extent - will be able to decouple from those of the G-7 countries as the region's recovery becomes entrenched. "There are financial linkages, but you can decouple a bit," says Mr Lee. "We've initiated our recovery faster than industrial countries and we can maintain our financial system [to be] relatively resilient from the global financial markets."

cp/91/Leejongwha.jpg

Jong-Wha Lee, ADB's chief economist

The rebalance of power

Global investors evidently agree. According to the Institute of International Finance, net private flows to Asia rose from $171bn in 2008 to $191bn in 2009, signalling what many onlookers believe to be a more or less permanent shift in the balance of global economic power to the Asia region - and such inflows are set to accelerate to $273bn in 2010. Masahiro Kawai, dean of the Asian Development Bank Institute (ADBI), a Tokyo-based think-tank and subsidiary of the ADB, says that the combination of high growth, combined with low levels of regional government debt and the prospect of future rate rises - compared with ongoing low interest rates in the West - will continue to attract high volumes of liquidity to the region.

But this is not unequivocally good news. For one thing, many economists and some investors are now concerned that the majority of Asian economies are moving too slowly on tightening monetary policy. A reluctance to raise interest rates, combined with persistently high levels of government spending, are fuelling inflation in several markets, warns the ADB. In light of the region's now well-established recovery, bankers at this year's meeting urged the region's central banks to unwind stimulus measures and undertake substantial rate hikes of up to 100 basis points (bps).

The situation is made all the more urgent due to the massive influx of foreign capital which is broad based and includes bank-lending, direct and portfolio investment, and short-term hot money. According to Gerard Lyons, chief economist at Standard Chartered, this trend is laying the groundwork for what he describes as a "slow train crash" in the region. In a report published by Standard Chartered Bank days before the ADB meeting, Mr Lyons argued that many countries in emerging Asia simply do not have the structural capacity to absorb this liquidity, meaning it is likely to seep into inflationary investments such as equity and real estate.

This trend is the single biggest medium-term threat to regional stability, many warned in Tashkent. "The challenge for Asia is how to deal with massive capital inflows: making a mistake could lead to domestic inflation, asset bubbles and overheating," says Mr Kawai. "It's good that these economies attract a lot of capital due to their fundamental health but they should not be complacent, because receiving large amounts of capital can be very destabilising."

The region's major markets, India, China and to a lesser extent Indonesia, already show signs of overheating, with bubbles apparent in high-end property markets in Hong Kong, Taiwan, mainland China and the Mumbai commercial property sector. In April, meanwhile, Indonesia's central bank warned that prices on the country's stock market now exceed the market's fundamental value.

The region's central banks are beginning to act, however. Most notably, the People's Bank of China announced on the first day of the ADB meeting that it will raise the deposit reserve requirement ratio for the majority of financial institutions for the third time this year, by 50bps, while the Reserve Bank of India raised rates for the second time in a single month in late April.

But it may be too late for some markets, where mini-bubbles now look to be deflating: statistics from the week ending May 9, published in the Beijing News, show commercial residential property prices slumping a staggering 9.6% week on week. According to one Beijing-based analyst, this may suggest the bubble is fit to burst.

cp/91/KawaiMasahiro.jpg

Masahiro Kawai, dean of the Asian Development Bank Institute (ADBI)

Capital what?

Long-term policy responses to capital inflows will vary according to each market. But deepening Asia's capital markets and encouraging currency appreciation are two necessary preventative measures, says Mr Lyons. He doubts, however, that governments will act decisively on either issue. "They probably will not be able to deepen capital markets quickly enough," he says. "China is keeping its currency undervalued so others will follow suit, meaning policy-makers will have to impose a whole load of other policies."

The ADBI's Mr Kawai argued in Tashkent that these should include monitoring a number of key indicators, such as domestic financial sector foreign debt and foreign currency exposure, as well as tracking the lending and liabilities of foreign financial services firms operating in the region.

In what is arguably one of the more controversial suggestions to emerge from this year's meeting, several key economists suggested that capital controls might be necessary in the medium term. Writing in the ADB's Asian Development Outlook 2010, Mr Lee suggests that "carefully designed capital controls" would help guard against disruptive short-term capital flows.

"Capital controls are seen as a possible policy option, but if you have capital controls it's not clear how the markets will penalise you," says Mr Lyons. There are some positive examples where controls designed to deter volatile speculative inflows have been a success: economists cite Brazil's move last year to impose a 2% capital tax on foreign portfolio investments. A similar move by Thailand in 2006, however, caused the market to tank. "The markets are asymmetric: the bigger countries are allowed to get away with things that smaller countries cannot get away with," says Mr Lyons.

Policy-makers among the larger Asian markets are entertaining the idea. The central banks of Indonesia and India have discussed the feasibility of using capital controls, while Taiwan's central bank governor, Peng Fai-nan, has repeatedly stressed the benefits of capital controls in preventing foreign exchange instability. In South Korea, meanwhile, the central bank has publicly acknowledged the need to guard its financial system against so-called 'speculators'.

Lender of last, last resort

But quite what constitutes carefully designed controls remains unclear. Not until very recently has the IMF - for which a canon of economic liberalisation has long been open capital accounts - been prepared to consider medium-term capital restrictions, says Mr Lyons, and the fund remains unclear on how such controls might operate. Through its seat on the World Economic Forum's Global Agenda Council, Standard Chartered is proposing a code of conduct under which the IMF can assist emerging economies by instructing them on which capital controls to use and when, reports Mr Lyons.

Undoubtedly, however, any attempt on the part of the deeply unpopular IMF to interfere in this manner will be met with resentment, if not outright protest. Indeed, there were few kind words for the IMF at this year's meeting, where the fund was accused of outright favouritism towards Western economies regarding the conditions of historical bailouts.

Not for the first time in his career, Japan's former vice-minister of finance, Eisuke Sakakibara, reportedly used the meeting to call again for the creation of an Asian Monetary Fund, describing the IMF as the very "last" agency to which an Asian sovereign would turn in the event of a future crisis.

Such open ill-feeling towards the IMF bodes badly for the fund's bid to become the lender of last resort in the region, and serves only to underline the difficulties that undoubtedly lie ahead for Asia, given the ever-urgent need to coordinate monetary policy measures.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter