The Covid-19 pandemic has been unraveling global financial markets and testing Asia’s financial resilience. There is little doubt that the pandemic will trim global growth. It could cost the global economy between US$2 trillion to US$4.1 trillion dollars, or between 2.3% and 4.8% of global gross domestic product, through negative impacts on tourism, business travel, consumption, and investments. Across the region, stock markets have crashed, currencies tumbled, and short-term capital has taken flight, underscoring the fragile market sentiments.

Asian banks are increasingly vulnerable to debt held in United States dollars. Photo: Joshua Hoehne

Amid the flight to safety, global demand for the US dollar has soared, spurring a rise in dollar funding costs. This in turn leads to tighter local financial conditions in emerging Asian economies which remain heavily exposed to US dollar funding costs and exchange rate volatility.

The global reliance on short-term dollar funding was the Achilles’ heel of the international monetary and financial system more than a decade ago—and it still is. Non-US global banks have become major intermediaries of US dollar-denominated cross-border lending and international debt issuance. Prior to the global financial crisis of 2008, European banks had sharply increased their US dollar-denominated lending to emerging market economies, with subsequent massive deleveraging of European banks causing financial stress to emerging market borrowers.

Despite visible improvements in Asia’s banking sector health and resilience since the sweeping reforms following the Asian financial crisis more than two decades ago, our research has found that  vulnerabilities to disruptions in global dollar funding markets remain.

First, a sudden squeeze in dollar funding liquidity associated with unwinding of carry trades by non-US global banks can quickly spill over to emerging market borrowers, as evidenced during the global financial crisis. Second, some high-income Asian economies have now replaced European banks in credit expansion to emerging Asian economies. When high-income Asian economies face financial distress arising from high dollar funding costs, they will be forced to curtail their lending to emerging Asian economies, amplifying and propagating financial shocks to regional economies. Lastly, during times of financial stress, emerging market borrowers are also typically vulnerable to capital flow and exchange rate volatility.

To address this vulnerability to US dollar debt during times of crisis, regional policy makers in Asia need to take bold actions now to strengthen crisis preparedness and mitigate the impacts through better management of global and regional financial safety net arrangements. At this stage, one cannot discount the possibility of continued financial turmoil, and of some countries experiencing financial crises.

With nearly three billion people currently under lockdown, there is an eminent risk of many economies entering a vicious cycle, starting from defaults and bankruptcies in the private sector, leading to a credit crunch or even a financial crisis. This would exacerbate Asia’s vulnerability to US dollar funding, amplifying negative spillovers to financial markets.

However, given Asia’s strong underlying economic fundamentals, timely and appropriate policies can help avoid a prolonged recession and steer towards a swift V-shaped recovery.

The first step should be to place the highest policy priority on sustaining market confidence and ensuring adequate liquidity. Maintaining macro-financial policies that are supportive of the economy and markets is key, while ensuring that emergency monetary and fiscal support measures are deemed sustainable. Containment efforts and large-scale stimulus packages by central banks and governments can significantly decrease the probability of a recession.

Second, emerging market economies should consider central bank swap lines to arrest market panic at a time of extreme financial volatility. The Fed has standing swap lines with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank and the Swiss National Bank. On 19 March, it announced the establishment of temporary dollar liquidity-swap lines with nine additional central banks in the region, including Australia, the Republic of Korea, New Zealand, and Singapore.

On 31 March, it also introduced a temporary repurchase agreement facility to a broader group of foreign central banks and other international monetary authorities by allowing them to convert their US Treasury holdings into US dollars on a short-term basis. These agreements may ease market panic, while adequate foreign-exchange reserve holdings also help support market confidence and contribute to financial stability.

Third, regional cooperation for financial safety net arrangements through the Chiang Mai Initiative Multilateralization and additional regional bilateral swap lines can also bolster market confidence. Strengthening the capacity of this initiative can shore up defense against dollar liquidity shortages. Likewise, strengthening the ASEAN+3 Macroeconomic Research Office’s surveillance capacity would help detect and prevent buildups of vulnerabilities.

Fourth, in the medium to long-term, the development of vibrant local currency bond markets can help address the currency and maturity mismatches of Asian financial systems. The ASEAN+3 Asian Bond Markets Initiative helps promote the development of regional capital markets. Greater availability of local currency long-term securities can reduce the need for short-term dollar funding needs.

The Covid-19 pandemic has highlighted Asian banks’ vulnerability to US dollar funding. But it also provides an opportunity for regional financial cooperation to regain reform momentum to address the issue over the long-term.

This post is based on the note: The Covid-19 Pandemic Exposes Asian Banks’ Vulnerability to US Dollar Funding

Cyn-Young Park is Director for Regional Cooperation and Integration, Economic Research and Regional Cooperation Department, ADB.

Peter Rosenkranz is Economist, Economic Research and Regional Cooperation Department, ADB.