• Damage in Asia from current crisis could be substantial
• Asia can weather the storm if it acts correctly
• The key is to unblock money markets and reinforce confidence
• Depositor protection and liquidity support are in play
• Lower inflation also leaves room for expansionary policies
• Economies with strong fiscal positions can pump-prime
• Intra-regional trade, liquidity arrangements are underway
• Tight USD supply pushes local currencies to weaken
• Long-term prospects remain positive for the region
• Selected OTGs published on China, Africa, Europe and the UK
• Plus focuses on FX and Commodities
  

Synopsis

Time to pull together

Overview: Crisis avertable by collective acts
Asian economies could sustain substantial damage from the current global credit crisis, but the downside is manageable. For now, the most urgent task is to safeguard the banks and improve money market liquidity. Falling inflation will allow macro policies to be relaxed across the region. Asia should avoid a beggar-thy-neighbour approach and consider intra-regional policy co-ordination in areas like trade and liquidity arrangements.

Africa: Examining Africa's vulnerability-Part I: A fiscal report card for African economies
The current global turmoil will affect sub-Saharan Africa through two main transmission mechanisms: the financial-market effect and the real-economy effect. Although many African currency markets have sold off in recent days, sub-Saharan markets ex-South Africa remain amongst the most illiquid of emerging or pre-emerging countries, granting them a certain degree of resilience to the global crisis. The region's lack of deep financial linkages with the rest of the world has meant that the financial-market effect of the crisis has been fairly limited. It is the real-economy impact that is of greater concern.

Middle East: GCC: Soft landing
Expect the events that are unfolding in the US and the rest of the world to impact the GCC. The region has benefited immensely from the benign global economic environment of the past three years, and it is therefore more than likely to be impacted by the currently deteriorating environment. Domestically, the overheating of GCC economies poses an additional challenge. However, there are fundamental positives. Our view is that we are likely to see a soft landing in GCC economies in coming months -- but a landing nonetheless.

FX: Crunch time
The US credit crunch is reaching unprecedented extremes. While this may sound like a perfect recipe for a USD crash, we expect to see the USD continue its ascendency, at least in the short term. Spiking risk aversion will keep emerging-market currencies under pressure through 2008 and likely into H1-09. For now, the most vulnerable currencies are those either over-leveraged or heavily dependent on foreign liquidity to finance large current account deficits. But growth shocks to open economies are the next key risk.

Commodities: Dark days for demand
Commodity prices have dropped on a combination of investor de-leveraging, deteriorating demand prospects, and dollar strength. Demand for commodities is already suffering, and we expect further weakness. Supply cutbacks will help in come cases, but overall there will be downward pressure on prices. Longer-term, the story of secular demand growth for commodities due to the development of key economies like China and India remains intact.

Selected On-The-Ground reports of the past month:
China: Can it escape the global firestorm? And should it 'save' America?
EU: Rescuing the banks
UK: Desperate times, desperate measures

Forecasts and Sovereign risk tables

OVERVIEW

Nicholas Kwan
Regional Head of Research, Standard Chartered Bank (Hong Kong) Limited, +852 2821 1013
Nicholas.Kwan@standardchartered.com

• Damage in Asia is substantial, but remains manageable
• The key is to unblock money markets and reinforce confidence
• More than ever before, Asia needs to work together

Crisis avertable by collective acts

More challenging times ahead
More than a year into the financial tsunami, damage in Asia is substantial, but remains manageable. Equity prices from India to China are down by 30-70% from their recent peaks, but part of that should be attributed to the cyclical excesses experienced before the tsunami hit home. Asian currencies have fluctuated sharply against the majors, with some skidding to decade lows. Yet no major payment problems or FX market disruptions are evident. The choking of selected Asian money markets, prompted by escalated counterparty risk and liquidity shortages, is worrisome. But the elevated Asian money market rates of recent months remain a far cry from the shock waves suffered during the 1997-99 Asian financial crisis (AFC). Confidence is weakened, as underlined by a recent mini-bank run in Hong Kong, though sentiment there is typically sensitive and volatile. The fact that the HKD is still trading mostly on the strong side of its USD peg implies that investor confidence is still much stronger than during previous crisis periods.

However, what we have experienced is far from the end. The real challenges are yet to come and are likely to be tougher. Usually, the outbreak of a crisis is the most shocking time, but the most challenging time comes some time later, when damage to the economy bites deeper. During the AFC, the initial shock took more than a year to unfold, completed by Hong Kong's market intervention and Malaysia's capital controls. But the most challenging time arguably was in 1998-99, when the crisis-hit economies sank deep into recession. Given Asia's improved economic fundamentals, we believe the region could fare better than in previous crises, but this would require the region to have learned the right lessons and to act together in the challenging times ahead.

Top priority: unblock money markets, reinforce confidence
For the major industrial economies, the strong actions taken by the authorities over the past week have at least saved their financial systems from immediate collapse. But the fire is far from out, and a long, hard process remains to put their financial houses back in order. For Asia, this presents a window of opportunity to fortify our defences. The most urgent task is to safeguard the banks and improve money market liquidity, especially in two key areas: depositor protection and the reduction of money market counterparty risks. The former is to ensure stable funding of banks, which still dominate Asia's financial sector. The latter is to sustain flows of short-term liquidity among banks and corporates, which are key in the absence of deep long-term funding markets in Asia.

With the major industrial economies increasing protection for bank depositors, some Asian central banks have also raised, or considering raising, their protection. Fortunately, given the relatively small exposure of Asian banks to toxic US assets, and the more restrictive cross-border exchange environment in Asia, the threat of massive deposit migration - either across institutions or across borders - remains limited. But complacency can be ill-afforded. In Hong Kong, a mini-bank run led to some short-term migration of deposits among banks. Given current market conditions, it is important that Asian authorities take a close look at their deposit insurance schemes to ensure that depositors are comfortable with their coverage.

Led by the People's Bank of China, more and more Asian central banks are shifting their policy focus from fighting inflation to supporting growth, with progressive easing of their monetary grip through lower policy rates and reduced reserve ratios. This is encouraging and should help to cushion the expected economic downturn going forward. But these measures themselves will not resolve the imminent liquidity problems in the money markets, which are caused by heightened counterparty risk and massive USD de-leveraging. Similarly, measures to relax access to discount windows may only offer last-resort comfort, not immediate relief.

Other than direct injection of liquidity (both local currency and USD), as done by Hong Kong, Taiwan, Korea, and others, Asian authorities may have to look into the possibility of providing counterparty risk protection to unblock their money markets. This is not without difficulty, especially for highly open economies with a large presence of foreign banks, many of which are the source of current higher counterparty risks. Unless external resources or support were secured, such as USD funding support from the Fed, it would be difficult for individual Asian authorities to resolve the USD funding and money market liquidity issues before key financial markets are stabilised.

Fortunately, most Asian authorities are sitting on sizeable foreign reserves and are still running healthy, albeit deteriorating, external payment balances. Yet there are still weak links in the chain where net reserves are small and/or current account deterioration is sharp. To reduce the risk of contagion, Asian authorities need to pool their resources to form a stronger common defence. As indicated by the initiatives of Korea and Japan, there is a need for an Asian emergency fund to be put in place, probably under the pretext of the ASEAN+3 (China, Korea, and Japan) multilateral FX swap facilities. While the practical details may take time to draw up, the mere endorsement of such a regional effort by key Asian authorities could offer a much-needed boost to confidence, which is critical at a time of stress - especially when conventional international last-resort lenders like the IMF and the US are apparently overwhelmed.

Stop the witch hunt
Once liquidity is restored in money markets and confidence is reinforced, the risk of individual Asian economies falling victim to the current witch hunt for the next Iceland could be significantly reduced. Notwithstanding improved economic fundamentals over the past decade, there are still weaknesses in selected Asian economies that make them look vulnerable. Among the more common concerns is banking sector health, given the critical role of banks in Asia's financial systems. A few indicators are particularly under focus:

1. Loan-deposit (LD) ratios, which reflect banks' dependence on non-deposit wholesale funding. Here, Korea's 140% stands out as the highest among its East Asian peers. However, including certificates of deposit (CDs) issued by banks, Korea's LD ratio is substantially lower at 103%, according to the Korean authorities. CDs are subject to reserve requirements in Korea and are largely distributed through retail channels.
   
   
2. Non-performing loans (NPLs) and capital adequacy ratios (CAR). While Indonesian banks have the highest NPLs among their Asian peers, they are also the best-capitalised in the region. Given the limitations of cross-country comparison due to data definition differences, it is perhaps more important to note that for both indicators, Indonesia has made clear improvements over the years. Korean banks score well on both indicators.

Another area of concern is external payment positions, specifically the short-term foreign funding situation. Again, Korea attracted much attention with its sizeable short-term foreign debt of USD 187.7bn outstanding at end-March 2008, of which 83%, or USD 156bn, was bank liabilities. However, according to the Korea Financial Supervisory Services, while Korean banks had USD 235bn of foreign currency liabilities at end-August, they also had USD 229bn in foreign currency assets, meaning that net foreign funding of domestic lending was marginal. More broadly, the country's foreign debt is well-covered by its foreign exchange reserves, which amounted to USD 264bn at end-March.

The real battle: de-leveraging and domestic demand
Beyond the initial crisis management phase, the focus is likely to shift from the financial industry to the real economy. Here, improved regional co-operation is also needed. With the major industrial economies facing massive de-leveraging and sliding into recession, Asian economies are likely to face a sharp falloff in their exports in coming months, if not quarters. A sensible response is to stimulate domestic demand to support growth, as evident from the recent actions of Japan, China, Korea, and a few others. Given the solid fiscal position of most Asian governments, their ability to pump-prime the economy should not be underestimated.

However, there is still a risk that some governments may resort to a beggar-thy-neighbour policy of sharp currency devaluation to inflate their economies. This could be destabilising or detrimental to regional financial stability. To reduce this risk, Asia needs to co-operate and communicate more closely and, even better, stimulate regional demand and integration by accelerating intra-regional trade and investment. While this is unlikely to fully offset the decline in demand from Asia's traditional export markets in the US and EU, which together still account for over 40% of Asia's exports, it could cushion the downturn and provide a more sustainable solution to the bigger problem of global imbalance in the longer run. Again, this requires the region's largest economies to take the lead by stimulating their economies and opening their markets to regional peers. The Asian financial crisis may have been a wake-up call for Asia to work together; the current turmoil is likely to be the first test of how effectively Asian economies can help each other.

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