In its latest Asia and Pacific Regional Economic Outlook report, the IMF warns that this could cause dislocation in local currency markets and have knock-on effects on banks’ lending in the region. Since 2009, investors from advanced economies have built up substantial positions in Asian markets, particularly in Indonesian and Korea sovereign debt markets, putting the region at significant risk if panic in global financial markets were to occur.
“The risks of a sudden liquidation of these positions could trigger a loss of confidence, spreading contagion from bond and equity markets to the currency markets,” the report states.
Signs of the region’s vulnerability emerged in September, when Asian currencies suffered their biggest loss in more than 14 years as local equity markets unexpectedly plunged and the Asia-Dollar index lost 4.3%.
The risk of a rapid liquidation in positions is particularly great in Asia due to the expansion of so-called ‘crossover’ investors in Asia – funds benchmarked against a mature market index but invested in Asian emerging markets to boost returns – in recent years.
With these investors able to cut positions more quickly than dedicated funds that are benchmarked against a regional index, the region is very vulnerable to a loss of confidence triggered through external events in Europe.
The report also cites that contagion could occur directly through Asian currency markets themselves, as long and carry-trade positions are unwound.
Hedge funds, in particular, in recent years have increased their exposure to Asian growth through the currency markets rather than in local debt and equity markets, to boost returns via embedded leverage in derivatives.
“The high leverage in currency derivatives makes investors more vulnerable to a broader loss of confidence” the report states.
The IMF revised down its annual growth forecast in Asia since its last economic outlook report. Growth in the region for this year was estimated at 6.3%, down from the previous 6.8% forecast in April.
The fund highlighted that the near-term risks to the forecast are now “tilted decidedly more to the downside than they were six months ago” due to the escalating uncertainty in the eurozone as well as the slower-than-anticipated recovery in advanced economies more generally.
“A worsening of the financial turbulence in the euro area poses an extreme downside risk for Asia,” the report states. “The panic sell-offs across Asian financial markets and safe-haven flows into Japan that occurred when European troubles intensified in August/September demonstrate there is no place to hide.”
Risks to the banking sector
Asian markets may also suffer from a reduction in liquidity from European banks seeking to shore up their balance sheets, the report states.
Although Asian banks have cut exposures to European banks and sovereigns since May last year, the region is still at risk to contagion occurring through the repatriation of liquidity of European banks. Foreign banks operating in the region could sell assets, not roll over maturing loans and cut credit lines in Asia, if they faced large losses at home.
These measures would have a sizeable impact in Asian economies that have large exposure to European and US banks. According to the report, Australia, Malaysia, Taiwan and Korea would be the four most exposed countries in the event of such cutbacks.
“Although the dollar funding pressures in August and September were below the levels experienced in 2008, a [similar] loss of liquidity in cross-currency swap markets would disrupt bank funding, as many banks rely on this market to fund dollar assets and meet regulatory currency matching requirements,” it states.