One of the reasons the rupee has remained under pressure has been the reduced role of European banks in India and the emerging Asia region as a whole. This has affected the flow of both long-term commercial borrowings as well as short-term trade credit, and has taken a toll on the overall balance of external payments. The International Monetary Fund’s (IMF’s) regional economic outlook released in April 2012 focuses on this aspect, and considers the possible effect of a sharp escalation in Europe’s problems on financial flows to emerging Asia.
A few things need to be borne in mind. First, the exposure of European banks is significant. Going by Bank of International Settlements data, European banks have an exposure of around euro 148 billion to the Indian markets and around $1.3 trillion to the major Asian economies (like China, Hong Kong, India, Indonesia, Malaysia, South Korea, Philippines, Singapore and Thailand) as of end-2011. Second, European banks have significantly reduced their exposure to emerging Asia over the past year. The IMF’s calculations show that, in the third quarter of 2011 alone, claims of European banks on emerging Asia dropped by about 0.5 per cent of the region’s GDP over the previous quarter — this is by no means a piffling amount. They would have dropped further in the last couple of months. Third, European banks are also actively involved in complex project financing operations and it might not be quite easy to find substitutes for these kinds of specialised “products” among local banks. Finally, the availability of trade credit remains particularly vulnerable to a pull-out by European banks since they have been active lenders in the area.
However, things could have been much worse if it were not for domestic banks that have healthy balance sheets and have the potential to ramp up lending without running into capital constraints. Also, larger regional banks have stepped up cross-border activity. Japanese banks, for instance, have increased their exposure to India and have filled the gap left by “deleveraging” European banks.
That said, we need to be prepared for another “Lehman moment” if the European banking system does seize up as the crisis intensifies. A good way to start thinking about this is to get a handle on how Western banks’ lending to Asia was affected by the Lehman episode. The IMF’s calculations show that, as the banking system in the US and Europe went into rigor as Lehman collapsed, euro-zone and UK banks reduced their Asian exposures by 37 per cent and 21 per cent respectively from peak levels.
Why did credit supply in Asia not collapse then? There are two reasons. Asian banks were underleveraged relative to their Western peers and, thus, could quickly escalate their lending to partly compensate for the drop in supply from the West. The second factor in Asia’s comparative insulation was the aggressive policy response by central banks. Central banks used a number of measures like direct infusion of liquidity both in local and foreign currency, expansion of deposit insurance, sharp cuts in policy rates, relaxing mark-to-market rules, introducing special assistance for small and medium enterprises (SMEs) and secure swap-lines from the US Federal reserve.
How effectively can policy counteract the impact of another shock? The IMF strikes a fairly optimistic note, pointing out that “Asia’s policymakers still have ample room to respond aggressively to a sharp deleveraging of foreign banks arising from a euro-area shock”. That said, with current real interest rates significantly below historical averages, the room for policy rate cuts is far more limited than in the post-Lehman phase. However, some of the more “micro” measures such as using swap-lines with the Fed or providing special assistance for SMEs and trade finance could be revived. There has also been some degree of regional pooling of emergency assistance after the Lehman crisis and this could work as an additional support.
The Fund’s assessment of the ability of local banks to provide an effective buffer in the event of a crisis is also heartening. For one, capital adequacy is higher than regulatory norms almost through the region and the fraction of non-performing loans are low. The IMF calculates the capital adequacy ratios for four different shock scenarios and concludes that even if local banks were to compensate substantially for the fall in foreign currency credit, capital ratios on the whole would remain above regulatory norms. That said, tier-I capital ratios would be done to the wire and individual banks in different countries could become extremely vulnerable.
The bottom line is that, as with the Lehman crisis, Asian banks and credit markets are relatively insulated and a shock from Europe is unlikely to lead to an Asian collapse. However, this buffer may not protect financial markets entirely. The “risk-off” trade that will invariably follow a shock will, in all probability, pull financial assets down. Thus, the stock market and currencies will be hit hard if Europe comes to the boil. How much the impact will be is a function of how deftly policymakers react. In India, at least, the confidence in the ability of policymakers to respond forcefully to an adverse turn of events seems to have waned over the past couple of years — and weak sentiment remains the critical risk. But then, it often takes a crisis to get the government and the central bank to brush aside the cobwebs and take some difficult decisions.
The authors are with HDFC Bank. These views are personal
