IMF warns of US and eurozone problems ‘spilling over’ into Asia

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By:
Lianna Brinded
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The International Monetary Fund’s latest report warns of a macroeconomic and financial spillover in Asia, as it forecasts a slowdown in the area’s growth, while increasing the number of downside risks

The IMF has warned the market that global outlook uncertainty, driven by the eurozone’s sovereign debt crisis and problems in the US, could have a strong detrimental effect on Asia.

In the IMF’s latest report, October 2011 Regional Economic Outlook for Asia and the Pacific, the group also revised down its second quarter 2011 predictions for growth in Asia, mainly as a result of weakening external demand, while also highlighting the increased level of downside risks.

It says that growth in Asia will be slightly lower in 2011/12 than forecast in April, but the expansion should remain healthy, supported by domestic demand, and inflation is expected to recede modestly after peaking this year.

“While growth is said to slow, it did say that domestic demand has been generally resilient, and overheating pressures remain elevated in a number of economies, with credit growth still robust and inflation momentum generally high,” states the IMF.

“Nevertheless, risks for the Asia and Pacific region are also decidedly tilted to the downside. The sell-off in Asian financial markets in August and September underscores that an escalation of euro area financial turbulence and a renewed slowdown in the US could have severe macroeconomic and financial spillovers to Asia.”

The IMF added that the downside risks to “growth amid persistent overheating pressures present Asian policymakers with a delicate balancing act, as they need to guard against risks to growth but also limit the adverse impact of prolonged easy financial conditions on inflation and balance sheet vulnerabilities.”

There are three main points within the 55-page report that have caused the IMF to revise down growth prospects for Asia and, of course, highlight the risks of a spillover.

Firstly, the IMF says that the liquidation of foreign investor positions is a major concern.

“Since 2009, investors from advanced economies have built up substantial positions in Asian markets, including Indonesia and other Asian sovereign debt markets,” states the IMF.

“A sudden liquidation of these positions could trigger a loss of confidence, and contagion could spread from bond and equity markets to currency and other markets.

“‘Crossover’ investors in Asia – funds that are benchmarked against a mature market index but engage in investments in Asian emerging markets to boost returns – have expanded in recent years and they could cut positions more quickly than dedicated funds that are benchmarked against a regional index.”

Secondly, with the global financial crisis continuing – now with more of a focus on sovereign debt concerns – the IMF has highlighted worries over the repatriation of liquidity by European banks.

“Asian banks have cut exposures to European banks and sovereigns since May 2010, but contagion could still occur through foreign banks, which could sell assets, not roll over maturing loans, and cut credit lines in Asia if they face large losses at home,” the IMF states.

“Such cutbacks could have a sizeable impact in Asian economies that have large exposures to European and US banks.”

Lastly, the loss of market liquidity in key derivative markets has caused great concern to the IMF. “Contagion could also occur through Asian currency markets, as long and carry-trade positions are unwound,” states the IMF.

“Hedge funds, in particular, in recent years have increased positions in currencies rather than in local debt and equity markets, where they can take advantage of embedded leverage in derivatives to boost returns.

“Although dollar funding pressures in August and September remained well below their 2008 peak, high leverage in currency derivatives makes investors vulnerable to a broader loss of confidence.

“A loss of liquidity in cross-currency swap markets – as in 2008 – could be particularly disruptive and spill over to bank funding, as many banks rely on this market to fund dollar assets or to meet regulatory currency matching requirements, notably in Korea and Japan.”