Global financial crisis : implications for ASEAN.
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Reproduced from Global Financial Crisis (Singapore: Institute of Southeast Asian Studies, 2009). This version was obtained electronically direct from the publisher on condition that copyright is not infringed. No part of this publication may be reproduced without the prior permission of the Institute of Southeast Asian Studies. Individual articles are available at

GLOBAL FINANCIAL CRISIS

The Institute of Southeast Asian Studies (ISEAS) was established as an autonomous organization in 1968. It is a regional centre dedicated to the study of socio-political, security and economic trends and developments in Southeast Asia and its wider geostrategic and economic environment. The Institute’s research programmes are the Regional Economic Studies (RES, including ASEAN and APEC), Regional Strategic and Political Studies (RSPS), and Regional Social and Cultural Studies (RSCS). ISEAS Publishing, an established academic press, has issued almost 2,000 books and journals. It is the largest scholarly publisher of research about Southeast Asia from within the region. ISEAS Publishing works with many other academic and trade publishers and distributors to disseminate important research and analyses from and about Southeast Asia to the rest of the world.

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Report No. 6

GLOBAL FINANCIAL CRISIS Implications for

INSTITUTE OF SOUTHEAST ASIAN STUDIES Singapore

First published in Singapore in 2009 by ISEAS Publishing Institute of Southeast Asian Studies 30 Heng Mui Keng Terrace Pasir Panjang Singapore 119614 E-mail: [email protected] Website: bookshop.iseas.edu.sg All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the Institute of Southeast Asian Studies. © 2009 Institute of Southeast Asian Studies, Singapore The responsibility for facts and opinions in this publication rests exclusively with the contributors and their interpretations do not necessarily reflect the views or the policy of the publisher or its supporters. ISEAS Library Cataloguing-in-Publication Data Global financial crisis : implications for ASEAN. (ASEAN Studies Centre report, no. 6) 1. ASEAN. 2. Financial crises—Southeast Asia. 3. International finance. I. Institute of Southeast Asian Studies. ASEAN Studies Centre. II. Series. JZ5333.5 A9A85 no. 6 2009 ISBN 978-981-230-918-1 (soft cover) ISBN 978-981-230-919-8 (PDF) Typeset by Superskill Graphics Pte Ltd Printed in Singapore by Seng Lee Press Pte Ltd

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CONTENTS

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Preface Lead Article • Global Financial Crisis and Implications for ASEAN • Masahiro Kawai Dean, Asian Development Bank Institute Commentaries by • Charles Adams Visiting Professor at the Lee Kuan Yew School of Public Policy National University of Singapore

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V. Anantha-Nageswaran Chief Investment Officer for Asia-Pacific, Bank Julius Baer & Co. Ltd., Singapore

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Michael Lim Mah Hui Senior Fellow, Asian Public Intellectuals’ Program, Nippon Foundation

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Pradumna B. Rana Senior Fellow, Nanyang Technological University

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Lim Chin Professor, NUS Business School, National University of Singapore

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Article • What ASEAN Must do to Cope with the Crisis: Act Together to Maintain Confidence in the Underlying Strength of the Region’s Economies • Sanchita Basu Das Visiting Research Fellow and Lead Researcher for economic affairs in the ASEAN Studies Centre at the Institute of South East Asian Studies (ISEAS)

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About the Contributors

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PREFACE

We in the ASEAN Studies Centre at the Institute of Southeast Asian Studies in Singapore have compiled in this volume a lead article, five commentaries on it, and a previously published article about the current global financial crisis, its implications for the Association of Southeast Asian Nations (ASEAN), and what ASEAN can do about it. We thus hope to contribute to the analysis of the crisis, to the mitigation of its impact, and to the search for an eventual solution. Such a solution necessarily entails transboundary cooperation, global cooperation and regional cooperation. Masahiro Kawai, Dean of the Asian Development Bank Institute in Tokyo, contributed the lead article. Using the Internet, we requested leading authorities on the subject to comment on the lead article and on the theme of the discussion. We publish here comments by Charles Adams of the Lee Kuan Yew School of Public Policy, National University of Singapore; V. AnathaNageswaran, Chief Investment Officer for Asia-Pacific at Bank Julius Baer; Michael Lim Mah Hui, a former banker, author and professor and currently a Senior Fellow in the Asian Public Intellectuals Program of the Nippon Foundation; Pradumna B. Rana, Senior Fellow at the Nanyang Technological University in Singapore and formerly a Senior Director at the Asian Development Bank; and Lim Chin, a Professor of Economics at the Business School of the National University of Singapore. The commentaries were also circulated on the Internet.

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In addition, we have included an article, “What ASEAN Must Do to Cope with the Crisis”, by Sanchita Basu Das of the ASEAN Studies Centre and a Visiting Research Fellow at the Institute of Southeast Asian Studies. We have done so with the kind permission of the Business Times, where the article first appeared. Rodolfo C. Severino Head, ASEAN Studies Centre Institute of Southeast Asian Studies Singapore

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GLOBAL FINANCIAL CRISIS AND IMPLICATIONS FOR ASEAN Masahiro Kawai Dean, Asian Development Bank Institute 31 October 2008

Introduction The world economy is currently experiencing the worst global financial crisis since the Great Depression. Over the last two months, we have witnessed the failures and collapses of major financial institutions in the United States (U.S.) and Europe and massive coordinated actions by their authorities to inject liquidity into money markets and to restore confidence in their financial systems. While the effectiveness of these measures remains to be seen, the policies of industrialized countries affected by acute financial crises are now heading in the right direction. Most recently, strong calls have been made for significant reform of the global financial system. The Group of Eight (G8), joined by major emerging economies such as China, India, and Brazil, will hold a series of global summits beginning in November to forge a new system aimed at preventing financial crises and maintaining global financial stability. With the spread of the U.S. subprime mortgage crisis to the rest of the U.S. financial system and other industrialized-country financial markets, a significant slowdown in economic growth has taken place in the United States, Europe, and Japan. The crisis has moved from the financial sector to the real economy.

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This paper focuses on the implications of the ongoing global financial crisis and economic downturn for emerging Asian economies, particularly for Association of Southeast Asian Nations (ASEAN) countries.

Causes of the Global Financial Crisis The ongoing global financial crisis was triggered by the eruption of the U.S. subprime crisis in the summer of 2007 and the subsequent liquidity and confidence crisis that has spread on a global scale and peaked in September and October 2008. The crisis is the result of both market and regulatory failures. The U.S. subprime crisis was created by (i) a prolonged period of abundant liquidity; (ii) excessive, imprudent lending in the subprime sector; (iii) lack of adequate prudential regulation over financial institutions; and (iv) the bursting of the housing price bubble. Abundant liquidity was provided by the U.S. Federal Reserve’s lax monetary policy adopted from January 2001 to June 2004 in response to the 2001 recession, which lowered the cost of borrowing for households and allowed financial institutions to leverage aggressively their balance sheets. Foreign capital inflows also allowed Americans to finance their spending, particularly for housing purchases. Americans financed their excessive spending through foreign borrowing, by running an average current account deficit of 6 per cent, as a ratio to gross national product (GDP), during 2003–07. U.S. financial institutions intermediated abundant liquidity into consumer credits and mortgages, which were converted into mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs). The search for high yield fuelled investor demand for these innovative, complex structured products with the help of the AAA ratings afforded by credit rating agencies. As

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long as housing prices continued to rise, creditors felt safe in lending on appreciating collateral, which in turn fed housing demand and prices, peaking in mid-2006. Financial sector supervisors and regulators could not detect or limit excessive risk-taking, especially in the rapid and sustained build-up of leverage by non-regulated investment banks and hedge funds. Once housing prices started to fall in the summer of 2006, subprime defaults began to rise and spread even to prime loans and other consumer credits. Many financial institutions began to be affected, particularly those with large exposures to subprimerelated structured products, leading to a series of failures of several large U.S. financial institutions (Bear Stearns, American Insurance Group, Lehman Brothers, Washington Mutual, etc.). As a result, transactions in global inter-bank markets began to freeze due to the perceived rise in counter-party risks, exacerbating the liquidity problem even for healthier financial institutions. Reflecting the severe risk aversion and lack of trust in the financial markets, the London Interbank Offered Rate (LIBOR) shot up. The differential between the overnight LIBOR and the federal funds rate spiked to over 300–400 basis points in October 2008, while the TED spread — the difference between the threemonth LIBOR and the three-month U.S. treasury bill rate — also spiked. With recent declines in these spreads, dollar liquidity shortage is abating, but the deleveraging of U.S. and European financial institutions is now creating a forceful, large-scale credit market contraction globally.

Implications of the Global Financial Crisis for Asia Many economists, including myself, have argued that the spillover effects of the U.S. subprime mortgage crisis on the Asian financial and real economic activity have been and will be relatively limited,

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and that the growth prospects of Asian economies will remain robust. Asian financial institutions’ exposure to subprime-related products was limited due to three factors: (i) they were lagging behind global financial institutions in incorporating highly complex financial innovations into their business models; (ii) many of them were cautious in investing in high-risk, high-return instruments — such as MBSs and CDOs — after experiencing their own financial crises ten years ago; and (iii) their authorities have strengthened prudential supervision and regulation and risk management practices in their respective financial sectors. For example, Japanese banks fully implemented Basel II beginning in March 2007, ahead of the European Union and the United States. In addition, Asian banks and non-bank financial institutions are fundamentally sound, with well-capitalized balance sheets, low non-performing loan (NPL) ratios (less than 5 per cent), small exposure to real estate, and limited off-balance activities. Recent developments, however, are raising concerns about the resilience of Asian financial and economic conditions. The global financial crisis is more acute and the real sector impact is likely more severe than had been hoped for. According to the recent updated forecast by the International Monetary Fund released in early October, economic growth in advanced countries will be close to zero until at least the middle of 2009, while the relatively high economic growth in emerging and developing countries will slow to substantially lower rates than in the recent past. In China, figures for the third quarter showed an annual growth rate of 9 per cent, well below the 2007 record of 11.9 per cent, suggesting that the global financial crisis has begun to affect the country’s real economy. India’s growth is also expected to decelerate from 9.3 per cent in 2007 to 6.9 per cent in 2009. Similarly, ASEAN countries will slow down from 6.5 per cent in

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2007 to below 5.0 per cent in 2009. Indeed, the global financial crisis could send the world economy into a recession. The acute global financial crisis and looming slowdown in the industrialized economies have had first round effects on Asia’s financial markets through capital flow channels and are beginning to exert second round effects on the real economy through trade channels. Before the outbreak of the U.S. subprime crisis, most Asian economies had faced the problem of receiving too much private capital inflow, which potentially could have undermined macroeconomic and financial sector stability. Today, private capital inflows are dwindling and in some countries these inflows have stopped or even reversed: the global financial crisis has already induced capital outflows from many emerging Asian economies, thereby causing currency depreciation and sharp falls in stock market prices. One of the reasons for this is that many U.S. financial institutions have been trying to secure needed cash and capital by deleveraging their over-extended balance sheets — that is, by selling both domestic and foreign assets. As a result, many Asian countries are now facing steeply rising risk premiums and their access to the international capital markets is severely curtailed. Particularly vulnerable to this new development are countries that had enjoyed large capital inflows with large current account deficits, large external debt, and high inflation rates. The slowdown of the industrialized countries is beginning to have negative effects on Asia’s real economic activity through trade channels. The rapid growth of Asia’s intra-regional trade observed over the past decades — driven largely by trade in parts and components within regional production networks — has been supported by the region’s exports of finished manufactured products to world markets. Expansion of exports

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to the U.S. and European markets has been essential for Asia’s sustained growth. The prospect of weak demand for emerging Asia’s products — due to the downturn of U.S., European and Japanese economic growth — could slow its exports and foreign direct investment inflows, further reducing Asia’s economic growth. In addition, countries with traditionally large remittance inflows from overseas workers — such as India, Philippines, Vietnam, and Indonesia — may face declining remittances from abroad. Economic slowdown in industrialized economies could reduce demand for foreign workers in these economies, causing a large drop in remittances. And workers may return home to find that home markets may have difficulty re-absorbing them.

Asian Responses Asian policy-makers have taken several responses to the global financial crisis and looming global economic downturn. To protect banking systems, some economies in the region (like Hong Kong, Malaysia, and Singapore) have emulated what the United States and some European countries recently did, that is, have guaranteed the repayment of customer deposits held with authorized institutions. Korea has unveiled a US$130 billion package to guarantee short-term foreign bank loans. Several economies (Philippines and Singapore) are considering to ease the mark-to-market accounting rules so that declines in asset values — such as prices of equity — held by banks will not cause a severe credit crunch. With the sharp decline in prices of oil and other commodities and the slower growth prospect, some countries have seen room for easing monetary policy to increase liquidity in the system without exacerbating inflation. China, India, and Korea have cut the benchmark interest rates, while Bangladesh, China, India,

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Indonesia, and Pakistan have reduced reserve requirements on deposits. A few countries have decided to boost fiscal spending to offset the declining growth. Other countries with fewer resources — such as Indonesia, Philippines, and Pakistan — have started informal discussions with international financial institutions for precautionary financial packages to stabilize their economies, avoid balance-of-payments crises, or rescue financial institutions facing liquidity problems. Although these measures have been uncoordinated, there is now a strong sense in Asia of the urgent need to minimize the negative impact of the global financial crisis and economic downturn on Asia’s financial sectors and real economy. A key strategy so far has been to maintain the confidence in the financial market, prevent the emergence of financial crises, and maintain growth.

Policy Recommendations for ASEAN ASEAN’s policy response to the crisis has so far involved individual, national strategies, without coordinated action. The European Union’s approach suggests that coordinated policy action is not an easy task as country situations are different. Nonetheless, it is time for ASEAN to adopt a series of coordinated actions to jointly respond to the global financial crisis and economic downturn. In particular, by maintaining healthy financial sectors that are capable of intermediating savings for investment — particularly for small- and medium-sized enterprises — ASEAN can contribute to Asian and global financial stability. By stimulating domestic demand to compensate for the slowdown in external demand, ASEAN can rebalance sources of growth. In this way, ASEAN and wider Asia can become a reliable engine of a global rebound from the current crisis and slowdown.

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ASEAN governments should work together to jointly achieve three key objectives: (i) maintaining financial market stability and confidence; (ii) supporting regional economic growth; and (iii) stepping up efforts in regional monetary and financial cooperation. First, it is essential to preserve financial sector stability both at the national and regional levels. National measures include: the enhanced monitoring of systemically important financial institutions; addressing dollar liquidity shortages to prevent a domestic liquidity crisis; and preparing contingency frameworks for a possible systemic crisis (liquidity injection, deposit guarantees, removal of NPLs, and bank recapitalization). At the regional level, ASEAN may set up an “Asian Financial Stability Dialogue” — an Asian version of the Financial Stability Forum — together with China, Japan, and Korea or in a wider Asian context, to help monitor the region’s financial market — by using early warning systems, and develop a plan of action in response to the immediate challenges of the global financial crisis. This forum — to be created among finance ministries, central banks, and financial market regulators and supervisors — can also serve to promote longer-term financial market development and integration, establish standards for governance and transparency, and improve investor confidence. Second, facing the risk of significant economic slowdown, ASEAN countries may take joint, pre-emptive actions to shore up domestic demand through expansionary macroeconomic policies. With inflationary pressure abating, monetary policy easing is a plausible option. With sound fiscal space, a fiscal stimulus package is a viable option focusing on physical infrastructure to support growth and social safety nets to protect the socially vulnerable. One way for ASEAN countries to boost fiscal spending is to jointly establish an infrastructure investment fund together with

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other Asian countries — and possibly with Asian Development Bank support — and to accelerate the pace of various planned projects for high-quality infrastructure investment so that the region can expand aggregate demand, and at the same time invest for future productive capacity. This is even more important as private capital inflows are shrinking under the global financial conditions. In this way, ASEAN and broader Asia can shift the primary engine of growth from external demand to regional demand. Third, ASEAN countries should work with other ASEAN+3 members to strengthen macroeconomic surveillance (through the Economic Review and Policy Dialogue, ERPD) and the Chiang Mai Initiative (CMI). The focus should be on enhancing the effectiveness of ERPD and speeding up the CMI multilateralization process as well as expanding the size of a multilateral CMI beyond the agreed US$80 billion and reducing its links with IMF programmes. The details of the scheme — including how much each country should contribute to the fund and its decision-making process — have to be agreed upon as soon as possible. ASEAN and the “+3” countries should also consider creating a professional secretariat to support the enhanced ERPD and a multilateral CMI. The new high-level Macroeconomic and Finance Surveillance Office to be set up in the ASEAN Secretariat can play an important role in implementing a credible regional surveillance mechanism as part of the multilateral CMI. Finally, looking beyond the current global financial crisis and economic difficulty and considering the rising degree of economic interdependence among Asian economies, ASEAN needs to undertake greater policy coordination with other Asian economies — particularly in the area of exchange rate policy. Once global financial stability is restored, one can expect the resumption of large capital inflows into Asia which remains the dynamic growth

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centre of the world economy. To manage such capital inflows and maintain macroeconomic and financial-sector stability, it will be important to allow sufficient exchange rate flexibility while preserving relatively stable intra-regional exchange rates. This requires coordinated exchange rate management to allow greater rate flexibility vis-à-vis outside currencies — such as the U.S. dollar and the euro — and exchange rate stability vis-à-vis regional currencies. To initiate such exchange rate policy coordination, it would be useful to introduce an Asian Currency Unit index as a monitoring indicator. We are entering a very important period in global financial history. There will be a series of global summits to reform the global financial architecture in order to prevent future crises like the one we face now and to put into place a new system that more closely reflects the current distribution of economic and financial power. ASEAN will have to work closely with other Asian economies — like China, India, and Japan — so that its views are fully reflected in any discussion of the reform agenda in global forums, such as the G-8 process.

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COMMENTARIES In Response to lead article, “Global Financial Crisis and Implications for ASEAN”, by Masahiro Kawai

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Commentary by Charles Adams

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Commentary by Charles Adams, Visiting Professor at the Lee Kuan Yew School of Public Policy, National University of Singapore. There are a number of issues to consider: (i) the likely impact of the unfolding crisis on the region; (ii) how countries can best respond to the crisis; and (iii) the nature of any regional policy coordination that might be helpful. Kawai’s paper provides a very useful framework for thinking about these and related issues. By its nature, however, the paper is only a starting point and it will be important at the next stage to address the effects of the crisis on the region more explicitly, the broader macroeconomic context in which policy responses should be considered, and under what conditions some degree of policy cooperation or coordination might be useful in helping sustain regional growth. Even though the region has already witnessed some of the negative consequences of unilateral action (blanket guarantees), the case still has to be made that regional policy coordination at this juncture is both desirable and feasible. Let me admit upfront that, like everybody else, I have no real sense of how deep and severe the crisis will be and the extent of spillovers to the region. Consensus forecasts for the region are starting to be marked down but regional growth is still expected to be quite robust in 2009; against this, however, consensus forecasts tend to be lagging rather than leading indicators and the advanced economies have recently started to slow sharply, even if the recent news on global credit markets has been somewhat more positive. Against this background, my sense is that there is a non-trivial risk that spillovers from the global crisis could be very large and, in the extreme, that they might lead to severe dollar liquidity problems and dysfunctional local credit markets.

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At a minimum, we are probably going to see a relatively sharp and possibly long-lived regional slowdown, even if the consensus forecasts are still not quite there. And one should not discount the possibility of a number of local toxic assets and surprises appearing as growth in the region slows. These would be related to recently elevated property and asset prices, sharp increases in consumer credit, and investor diversification into a range of new and exotic instruments. Before considering some of the specific policy measures the region might take, it is useful to recall that the current crisis has much to do with the global current account imbalances. As a result, macro policy responses inside and outside the region will need to be directed not only to cushioning output during the global slowdown but, equally importantly, to ensuring the reduction in the global current imbalances. Countries with large current account surpluses should face no policy inconsistency between supporting domestic demand and reducing imbalances. But the situation is more difficult in the case of countries with large current account deficits. Across the region both macroeconomic and structural policies will be needed to facilitate global rebalancing. Specific policy actions and measures that might be considered at the national level given the risks include: •





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Daily monitoring and assessment of financial market conditions, exchange rates, credit markets, capital flows and trade credit. Very short-term domestic and foreign and domestic currency liquidity support operations. Capital injections and restructuring, if needed. Provisions of foreign currency liquidity to other countries

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in the region either via currency swaps or co-financing operations with the IMF. Possible short-term monetary and fiscal stimulus measures if feasible, with plans for unwinding as circumstances permit. Short- to medium-term domestic structural reforms to help rebalance private demand and saving. Short- to medium-term enhancements in the regional financial architecture.

The need for the various measures will obviously depend on the severity and duration of the crisis, and the degree to which regional financial systems become impaired. In principle, existing institutional arrangements may suffice if the crisis does not involve more than a sharp and short-lived cyclical slowdown in growth. In such a case, the focus at the national level will need to be on the mix of monetary, fiscal, and structural policies to help sustain growth while reducing global imbalances. Clearly, countries across the region differ in the amount of fiscal and monetary space available and in the need for fiscal stimulus. And some countries in the region may face credibility problems if they unilaterally embrace fiscal stimulus policies. Unlike in the major industrial countries where the effectiveness of monetary policy is being challenged by dysfunctional financial systems, monetary policy still has traction in the region. With inflationary pressures easing, the scope for monetary relaxation across the region appears to be increasing but at different rates across countries; in some instances, currency weakness may limit the scope to ease monetary policy. In cases where monetary and fiscal stimulus is applied, it should be in the context of an explicit medium-term policy framework consistent with fiscal sustainability and low and stable

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inflation. Given large differences across the region in how countries are likely to be affected by the crisis, it is unlikely that there will be a one-size-fits-all stimulus package around which coordination could take place. Should financial sector problems in the major countries worsen further and spill over to the region’s financial markets, additional action may be needed to forestall a bigger crisis. Increased attention will need to be paid in those circumstances to threats to domestic financial stability. One approach would be for each country to set up a Crisis Monitoring and Management Group (CMMG). The group could comprise midto senior-level officials from central banks, finance ministries, and financial regulators in each country. Such a group would have three main functions: (a) high frequency monitoring of financial markets, conditions and of systemically important institutions; (b) providing input into the design of appropriate financial and other responses to financial pressures; (c) liaising and sharing information with similar groups in other countries. Stepped-up regional economic and financial cooperation might be helpful in such a case and might relax constraints faced by individual country action; it would need, however, to be considered on a case-by-case basis. In any event, information sharing and policy dialogue would be especially important in such circumstances but regional policy responses would need to be consistent with global policy requirements. Looking beyond the current pressures, the region will need to consider strategies for the removal of some of the extraordinary measures taken during the crisis. These measures include blanket guarantees, short-selling restrictions, and capital controls. The intention to remove such measures when circumstances permit might usefully be communicated to markets and, might perhaps, be coordinated across countries.

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Commentary by V. Anantha-Nageswaran, Chief Investment Officer for AsiaPacific, Bank Julius Baer & Co. Ltd., Singapore. The comment by the dean of the Asian Development Bank Institute on the global financial crisis and the implications for ASEAN touches on all the important aspects of the crisis, its impact on ASEAN and on how ASEAN must deal with it. As he correctly puts it, the first impact came from the financial side (capital flows) and the second impact is coming from the real side (trade flows). One important lesson for ASEAN is to acknowledge that this global financial crisis is not about U.S. subprime mortgages or their securitization or about credit default swaps. It is about excessive risk-taking lured by cheap money globally. Most nations, corporations, households and housewives are guilty of that. Hence, to declare the crisis an American export to the world and absolve oneself of any guilt over reckless and risky behaviour would store up trouble for the future and guarantee another crisis. Owning responsibility for the crisis is the first step towards its resolution.

Financial Literacy Financial liberalization is not in the same league as motherhood, apple pie and trade liberalization. Its benefits are ambiguous and its costs are substantial. Hence, many developing countries that have been seduced by academics into liberalizing their financial markets for esoteric investment ideas from international bankers must pause and rethink. One of the things that received the least attention is the issue of financial literacy not just among consumers but also among sellers of financial products. It is one thing to understand the bare

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technical essentials of how financial products are priced but it is another thing to be able to place them in the global context. In other words, it is not enough if sellers of financial products are able to explain how the product could lose money for investors based on narrow and technical considerations but be able to assign subjective probabilities on the product producing negative returns in the event of global markets turning sour. After all, in recent events, financial openness and technological advancements have made global markets highly correlated. Globally, there is just one market for risky assets. That increases the riskiness of many products sold in the market. They are whipsawed not just by domestic factors but also by global developments. Hong Kong real estate prices drop when Icelandic banks fold up. In this context, it is interesting to note that October 2008 was an unusual month but not “abnormal” for global stock markets. Writing for Eurointelligence website, Paul de Grauwe and his co-authors show that Dow Jones index had daily returns that are five standard deviations above the threshold of zero per cent not less than seventy-three times in the last eighty years. Daily returns generated from normally distributed random shocks are above or below five standard deviations from the mean only once in 7,000 years. It is clear that stock returns are anything but normal. Yet, most financial derivatives are based on the assumption that returns on financial assets are normally distributed. Hence, it is no surprise that more often than not, both clients and sellers are caught by surprise by the losses generated by such products. They lack the perspective on factors that impinge on the delivery of the promised performance of their products. Hence, financial literacy has to go beyond its narrow confines of textbook concepts.

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Ageing Societies and Leverage The urgency and the importance of financial literacy are further compounded by the rapidly ageing societies in Asia. It may not be immediately relevant for ASEAN with the exception of Singapore but it is important for East Asia. Ageing societies find themselves growing more slowly on average than before and this leads to lower interest rates on both savings and borrowings. This leads to withdrawal of bank deposits and enhanced borrowings. Thus, not only households take undue risks with their personal balance sheets in an ageing and slowgrowth society, but they also weaken the banking system by making it more reliant on the unpredictable and unstable money market rather than on deposit funds. One of the lessons policy-makers and regulators in ASEAN must impress upon the public in ageing societies is that deployment of leverage to artificially defy the natural law of diminishing returns in such societies is folly and ultimately self-defeating. Being in harmony with nature and its laws is not just an issue of environment and ecology. It is a philosophy of life.

Limits to Export-led Growth Third, it is important for ASEAN to recognize the limits of exportled growth. Between 2003 and 2007, when global growth conditions were more propitious, there were enough opportunities to wean their economies away from external dependence. Prosperity dulled such thoughts. Now, they have no choice. ASEAN together with other Asian nations must sit down and decide what kind of future they wish to build for themselves. Growth based on domestic demand would involve making citizens feel less insecure about their future and retirement and would involve exchange rates that reflect fundamentals and not

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policy-makers’ preferences. Right now, many ASEAN countries (Indonesia, Thailand and Malaysia) are unable to use monetary policy effectively to counteract the economic slowdown that is setting in. The reason is that in good times they were slow to raise interest rates adequately and quickly for fear of hurting growth and for fear of allowing their currencies to appreciate. Unsurprisingly they have less monetary policy freedom now to stimulate their economies when they desperately need to do so. In the 1980s, Asian economies were not dependent on exports to the United States. In fact, the correlation of Asian export to U.S. non-oil imports was around 20 per cent. That is why when the U.S. stock market struggled in the aftermath of the October 1987 crash until end-1990, Asian stocks did not suffer. In fact, they delivered significantly superior and positive returns to investors compared to S&P 500 that remained relatively flat for more than three years up to December 1990. That correlation rose to 30 per cent in the 1990s and further to 80 per cent this decade. Consequently, there has been no decoupling in Asia from U.S. macro and market trends. Asia has remained a leveraged play on the American business and market cycles. In many respects, the crisis presents an opportunity for Asia to wean itself off American financial capitalism that has caused so much grief to America itself and reliance on American consumer. That would not only set Asia up as an autonomous economic area but would also provide pensioners in the region and outside a viable diversification option. Thus, a multi-polar world is not just good for geopolitical stability but also for the stability of the global economy and financial markets.

ASEAN+3 is not Asia Finally, for Asia to become a meaningfully important economic area, it is about time that ASEAN does not confine its dialogue to

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ASEAN+3 but extends it to include India whose monetary policy framework of 2002–07 could serve as a good role model for smaller ASEAN nations.

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Commentary by Michael Lim Mah Hui, Senior Fellow, Asian Public Intellectuals’ Program, Nippon Foundation. I read with interest Kawai’s excellent comments on the current financial crisis and agree with most of his points and arguments. I wish to expand on them and get to a deeper level to examine the fundamental-structural causes of the crisis. Beyond the unbridle deregulation and liberalization regime that enabled and encouraged financial players to come up with all sorts of financial innovations, there are three fundamental causes of increasing fragility and instability in the financial sector. These are the current account imbalances between the United States and the rest of the world, the wealth and income imbalance that is a consequence of free market growth, and the sectoral imbalance between the financial and real economy. While the various measures that are now undertaken by the central banks worldwide to unclog the financial system and to prevent its total collapse have been helpful, they do not address its inherent financial fragility and instability. In fact, while offering palliative solutions, they may just work to create another larger bubble down the road. It is well documented that excessive liquidity either from loose monetary policy and/or rapid capital inflows invariably leads to a loosening of credit discipline and unsustainable asset bubbles, especially in the property and stock markets. This happened in Japan, Southeast Asia and the United States today. In the latest case, it was the savings of the emerging countries via current account surpluses that ironically funded the consumption binge in the United States. Despite rapid economic growth in the United States and many other countries in the last three decades, wealth and income

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are more unequally distributed. Between 1970–2006 in the United States, the share of GDP going to capital rose from 27 per cent to 43 per cent while the share of GDP going to labour declined from 60 per cent to 56 per cent. The same story goes for China, where the share of GDP going to labour fell from 53 per cent to 41 per cent (1998–2005). This factor is important to grasp because while the majority of people do not have enough to consume, much of the income and wealth is concentrated in the very rich who have excess savings and are constantly chasing for higher yields. To satisfy their demands, financial engineers invent new and complicated products to meet the risk appetite of those with excess savings. On the other hand, the growth of the financial sector and debt explosion allowed even those without adequate means to consume beyond their means. Cheap and easy financing encouraged households to invest in properties and to borrow on their properties. Finally, in the last three decades, there has been a significant shift in the structure of many advanced economies, particularly the U.S. financial sector has come to overshadow the real productive sectors. This is evidenced from a few indicators. Between 1950–2004/05, the share of GDP accounted for by the financial sector rose from 11 per cent to 20 per cent while that of the manufacturing sector dropped from 30 per cent to 12 per cent; the share of corporate profits of the financial sector went from 10 per cent to 40 per cent while that of the manufacturing sector plummeted from 50 per cent to under 10 per cent. Between 1974 and 2006, total U.S. debt rose eighteen times, while domestic financial debt rose fifty-five times and non-financial corporate debt increased eleven times. This brings us to an important point, namely the degree of leverage undertaken by the financial sector facilitated by deregulation and financial engineering that enabled the financial

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sector to earn such high rates of return. Return on equity is always boosted with leverage. While non-investment commercial banks are normally leveraged ten times, investment banks on Wall Street doubled their leverage on average from fourteen times to thirty times made possible by a 2004 Securities and Exchange Commission ruling. Leverage is like drug addiction — it gives you a sense of exhilaration when market goes up but sends you to the abyss when market goes down. We are witnessing the impact of this process now. Any remedial measures and policies should be informed by proper diagnosis. If the above arguments are acceptable, then certain policy implications follow. A few are suggested here. Most central banks have been focused on price stability, and to a lesser extent growth and employment. But all have been errant on controlling asset price stability and content with only picking up the pieces after the bubble has burst. It is becoming clearer the social costs to taxpayers in cleaning up the mess exceed the costs of anticipating and deflating such bubbles before they burst (not to mention the inequity where the benefits of booms are privatized while the costs of busts are socialized). In other words, central banks should adopt a counter-cyclical rather than pro-cyclical stance, a lean-against-the-wind approach rather than a cleaning-the-debris approach. Minsky presciently noted that stability breeds instability. In periods of long growth, low interest rate and financial stability, financiers and borrowers are lulled into confidence, risk premium is lowered and risk appetite is increased. One way to smooth out bubble booms and busts is for regulators to require banks to adopt “dynamic provisioning” when their assets grows quickly, as is done by the Bank of Spain.

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We have argued that an important source of instability and fragility is excessive leverage and speculation in the financial sector. Serious consideration should be given to increasing capital gains tax on a progressive basis (that is, increasing with shorter periods of holding). This will not only reduce speculation but also provide a source of revenue for governments, part of which can be used for financial relief efforts. Financial players have managed to circumvent regulations through off-balance-sheet activities, over-the-counter activities, and shadow-banking activities. Unfortunately all these products and activities are intimately connected to the regulated banking system through contingent guarantees and counter-party trading. It is these shadow-banking activities that have sucked banks into the financial vortex. Hence regulators have to bring the players in the shadow-banking system into their ambit. The level of leverage by hedge funds and private equity funds should be reviewed and controlled. Since these activities are fully globalized, a new financial architecture that requires international coordination and regulatory powers should be set up. Otherwise, the players will find ways of taking advantage by moving from strict regulatory regimes to lax ones. A beggar-thy-neighbour policy is not constructive in the long run. While the European authorities are more open than the United States to an international framework, Asian nations can build on and strengthen their present efforts at coordination and regulation. With the increase in capital markets (bond and equity), the role and structure of rating agencies should be reviewed. There is undeniably a conflict of interest when rating agencies are paid by issuers of securities. One way of reducing this would be for rating agencies to be paid by investors and also from a general pool of

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fund paid by issuers. This way the rating agencies are not beholden to any particular issuer. Much has been written about restructuring the incentive and compensation structure of financial executives. The current compensation structure encourages immediate rewards for excessive risk-taking. While the details can be debated, the principle should be established that rewards be aligned to responsibilities and performance over a longer time horizon rather than just one year. Making huge amount of loans or trades and getting rewarded immediately and not taking responsibility for them going bad at a later time encourages risky behaviour. According to the New York State comptroller, financial groups paid out US$33 billion in bonuses even as the financial industry racked up hundreds of billions dollars of losses. Some of these measures may seem radical. But we are not living in ordinary times and this is not an ordinary financial crisis. Simply implementing conventional policies like lowering interest rates, increasing liquidity, recapitalizing banks, etc. without addressing the fundamental causes of financial instability could just be setting up the stage for a replay of a bigger crisis in the future.

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Commentary by Pradumna B. Rana, Senior Fellow, Nanyang Technological University.

The Impacts of the Global Financial Crisis on Asia — The Role of ASEAN

Introduction The relatively benign subprime mortgage crisis (SMC) in the United States, which began in August 2007, spread to other types of financial institutions and started to affect the real economy. In September/October 2008, it metastasized globally through the capital flows and the trade channels and started to derail economies all around the world. The crisis has thus become the first truly global financial crisis (GFC) of the twenty-first century. Many predict that the eventual toll of the crisis could be very high, next only to that of the Great Depression of the 1930s when the unemployment rate in the United States rose to 25 per cent. The U.S., U.K. and the Eurozone are already in a recession. The IMF projects that the GDP of the major industrial countries will — for the first time in many years — shrink in 2009. The relatively robust, although much downgraded, performance of the developing countries especially in Asia, while upholding the world economy will not be enough to prevent a global recession in 2009. These trends, according to the IMF, will start to slowly reverse only towards the end of 2009 or early 2010. The Asian countries were relatively unscathed by the SMC during the early stage of the crisis. This was because Asian banks were less exposed to the toxic assets that were engineered and crafted in the United States. Also their financial sectors were relatively resilient — thanks to the reforms implemented during and after the Asian financial crisis (AFC) of 1997–98.

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The indirect effects of the GFC are now starting to affect the Asian countries. Foreign capital inflows are drying up as foreign institutions withdraw funds to meet redemptions back home. There has also been a rational flight to safety exacerbated by irrational panic similar to, but as yet of a lesser magnitude than, what was experienced at the time of the AFC. Demand for Asian exports has also slowed dramatically because of the synchronized global economic slowdown. Singapore and Hong Kong, which are very open economies, are already in a recession. For the first time since 2001, Japan is in a recession. Some say that Asia is facing problems of historic proportions. Against the above background, this paper (i) briefly reviews the causes of the SMC and the GFC; (ii) outlines the impacts of these crises on Asia; (iii) and highlights the responses by Asian countries and role that ASEAN could play.

Causes of the SMC and the GFC The proximate cause or the trigger of the SMC was the bursting of the housing bubble in the United States during the summer of 2007 when subprime defaults began to rise and foreclosures increased. It then spread to prime loans and other types of consumer credit. Other types of financial institutions, especially those with large exposures to subprime related structured products, also became affected leading to a series of failures of several large financial institutions (for example, Bear Stearns, American Insurance Group, and Lehman Brothers). The real economy also started to be affected. The root causes of the SMC were, however, policy mistakes in the United States, the global imbalances, and the weaknesses in the regulation and supervision of the financial sector in the country.

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A number of policy mistakes were made during the past three decades. First, after the bursting of the dot.com bubble in 1999–2000, the U.S. Federal Reserve ran a loose monetary policy for several years. The federal funds rate dropped from 5.98 per cent in January 2001 to 1.73 per cent two years later and stayed at about that level until 2005. This fuelled a credit boom in the United States. Second, the repeal of the Glass-Steagall Act in 1999 during the Clinton Administration opened the gates for U.S. banks to take on the full range of risky assets (securities, derivatives, and structured products) either directly on the balance sheets or indirectly through off-balance-sheet conduits. This worked well in Germany and the other European countries, but not in the United States where investment banks were generally outside the preview of regulators. So commercial banks and investment banks went into complex derivative securities and also extensively leveraged their operations. The existing regulatory system could not catch investment banks. The large and growing imbalances — the current account deficits in the United States and surpluses in Asia — and the recycling of Asia surpluses through purchase of U.S. treasuries, added further fuel to the credit boom in the United States. It is interesting to note that the often repeated warnings that the global imbalance could lead to a disorderly adjustment of the dollar (for example, by the IMF) did not materialize as the dollar is still viewed as an international reserve asset and a safe haven. That is reason why the United States is experiencing a financial crisis but not a currency crisis. The credit boom made possible by the imbalance led, however, to a build-up of vulnerability in the United States by fuelling the housing boom and extension of credit to subprime lenders (people who did not meet credit quality requirements).

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The weak regulatory and supervisory systems in the United States were also at fault. Banks and savings and loans provided money to home buyers through mortgage loans. In the bygone era, these financial institutions would have held on and collected interest and repayments. In the modern era, banks and S&Ls (savings and loans companies) repackaged mortgage loans into bundles of mortgage-backed securities (MBSs) and sold them to investors including investment banks. MBSs in many cases were repackaged (other types of stocks were also added) into collateralized debt obligations (CDOs) and sold to investors. Financial institutions did not hold on. This led to excessive and irresponsible mortgage lending and to moral hazard. Allen Greenspan, the chief of the Federal Reserve system for eighteen years of this boom period, confessed that he had faith that financial institutions were prudent enough to make sure that they were not lending money cheaply to people who could not pay it back. But this is exactly what happened. There was also excessive leveraging and incentive compensation so that CEOs of financial institutions got very high salaries. Credit rating agencies were also at fault. They gave high ratings to investment banks based on history, not possible default risks of new instruments. The SMC spread globally especially in September 2008, as banks holding toxic assets, engineered in the United States, faced difficulties. In addition to this direct effect, there was the indirect effect due to the capital flows and the trade channels. Before the outbreak of the SMC, many emerging markets were receiving abundant amounts of private capital and discussions focused on the possibility of such inflows undermining the macroeconomic and financial sector stability. Since then, such inflows have dried up leading to huge asset price depreciations and collapse in demand. Capital is being sucked back into the developed countries

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to restore damaged balance sheets, meet margin calls, and accommodate large withdrawals. The synchronized slowdown in the industrialized countries has also had a negative impact on real economic activity of emerging markets through the trade channel as import demand in the industrial world for their exports has collapsed. The SMC, therefore, turned into a GFC. Summing up, aside from the global imbalance problem where the responsibility is shared between the United States and the rest of the world, the SMC and the GFC are “crisis made in and exported by Wall Street”. This is unlike previous crises which originated mainly in the emerging markets. As the Indian finance minister said recently, “Emerging countries were not the cause of the crisis, but they are among the worst affected victims”.

The Impacts of the SMC/GFC on Asia The direct impact of the SMC on Asian countries was limited because the exposure of Asian banks to subprime assets was low. Of the US$500 billion written off by banks globally in the year to August 2008, Asian financial institutions (including those in Japan) accounted for only 5 per cent. The financial health of Asian banks is also much better than a decade ago. The average capital-adequacy ratio for Asian banks stands at a healthy 12 per cent and Tier-1 capital ratio which was around 5 per cent in Indonesia and Malaysia in 1997 has increased to 10 per cent. Since the AFC, significant progress has been made in improving risk management systems, regulatory and supervisory systems, and corporate governance. Within the region, vulnerability is the highest in the case of Australia and Korea as they have high loan/deposit ratios — 125 per cent as compared to the Asian average of 90 per cent.

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The indirect impacts of the SMC/GFC on asset markets in Asia have been high. Since the beginning of this year, stock markets (in U.S. dollar terms) have tumbled (mainly in past two months) by about 58 per cent in Indonesia and India, followed by Singapore and Thailand where they fell by about 50 per cent, and in Malaysia and Taiwan by about 40 per cent. The Chinese stock markets have been the worst performer in the region falling by over 65 per cent. Asian stock markets have fallen more than say the Dow Jones index which fell by 31 per cent. Asian currencies have also taken a beating. The September economic outlook reports from the ADB and the IMF suggest that the impact of the GFC will be broadly limited to a decline in import demand by industrial countries for Asian manufactured exports along with a diminution in the flow of official and private capital. In Asia this will be reflected by sagging exports and industrial production and an increase in unemployment. The September growth forecasts for 2008 and 2009 from these two institutions are, however, not much lower than the actual growth out-turn of the previous two years. However, with recessionary trends deepening in the industrial world, the forecasts for Asian countries are bound to be downgraded sharply in the future outlook reports from these institutions in line with the outlook seen by the private sector.

Asian Responses and the Role of ASEAN In an attempt to promote greater financial stability in the context of the GFC, various Asia countries have announced full deposit insurance guarantees for a number of years (Hong Kong, Taiwan, Australia, and Singapore). Also to rebalance economic growth, many Asian countries have announced cuts in interest rates (for example, China has cut interest rates three times since September

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and twice lowered the reserve requirement) and fiscal stimulus packages (China, Japan, Australia, Korea, and Malaysia). Singapore also presented an expansionary pro-business package in its latest budget. Among the stimulus packages, China’s twoyear US$600 billion package accounting for 16 per cent of its GDP is the biggest, bigger than the U.S. package of $860 billion which accounts for 5 per cent of its GDP. One-half of this amount is to be spent on infrastructure development including airport, highways and railways and the rest on social welfare, environment, and technological innovation. Although it is uncertain how much of this is new money and how much is already in the pipeline, the stimulus package seeks to maintain the economic growth rate at over the psychological mark of 8 per cent. In Asia, so far, there has been no need to either recapitalize banks or to bail them out by removing toxic assets. These cannot, however, be ruled out in the future as clouds continue to darken in the horizon. If so, Asian countries should use their massive reserves that has been accumulated over the past decade — at a high cost, for they were invested mostly in low-yielding treasuries — to inject liquidity in their countries. This could be done by auctioning foreign exchange reserves to deficit institutions. China holds about US$2 billion of reserves and Asia as a group (including Japan) holds two-thirds of the world’s reserves. Most of the actions taken by the Asian countries, so far, have been at the individual country level. There is an urgent need to also coordinate policy actions and take joint actions at the regional level. ASEAN as the central and the most institutionalized grouping in Asia can play an important role in this regard. The level of economic interdependence among Asian countries, especially the East Asian countries, is high and growing. Intra-regional trade

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among the ASEAN+3 countries is about 55 per cent of their total trade because of the vertical division of labour through the establishment of regional production networks centered on China. The level of financial integration, although low, is also starting to increase. Policy coordination will rule out beggar-thy-neighbour type policies and at the same time help reverse the crisis of confidence in the region. ASEAN could work closely with other Asian countries to sensitize the need for policy coordination and come up with joint actions on policies. Policy coordination does not mean identical policies, but broadly consistent policies at the regional level. As the GFC continues to affect the region, Asia should coordinate attempts to promote economic growth and financial stability and come out with joint announcements of expansionary monetary, fiscal, and financial sector measures. A coordinated response from Asia will be more effective than unilateral actions. Although policy coordination could be conducted informally, support of an institutional arrangement where policy-makers could meet and hold discussions among each other could be useful. Such an institutional arrangement in Asia could be the ASEAN+3 Economic Review and Policy Dialogue (ERPD). Under this process, finance ministers of the ASEAN+3 countries meet once a year and their deputies twice a year for two days a time to (i) assess global, regional, and national conditions and risks; (ii) review financial sector (including bond markets) development and vulnerabilities; and (iii) other topics of interest. The valueadded of regional policy dialogues is that countries tend to be more frank with each other in a regional forum and they focus on issues of common interest. The GSF has enhanced the case for strengthening the ASEAN+3 ERPD so that policies are implemented in a coordinated manner. ASEAN could work

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closely with Japan, China, and Korea to make this happen. Among the steps required are (i) to move the dialogues which are in the “information sharing” stage to a “peer review” and eventually to a “due diligence” stage; (ii) to include central banks governors in the meeting of finance ministers; and (iii) to monitor the region’s financial markets and their vulnerabilities by using an early warning system (EWS) system. and develop action plans to meet the regulatory and supervisory challenges in the financial sector. The membership of the strengthened ASEAN+3 ERPD should also be expanded to include India which is a member of the East Asia Summit. A recent ADB study has proposed the establishment of an Asian Financial Stability Dialogue — an Asian version of the Financial Stability Forum — to bring together all responsibilities (including finance ministries, central bank authorities, and other financial regulators and supervisors) to address financial market vulnerabilities, regulations, and efforts at integration, as well as to engage in dialogue with the private sector. ASEAN could help build a consensus on establishing the Asian Financial Stability Forum. The ongoing efforts to establish a self-managed reserve pool by multilateralizing the bilateral swaps under the ASEAN+3 Chiang Mai Initiative should be expedited. Last 2007, the ASEAN+3 finance ministers had, in principle, agreed to establish the scheme and the details are to be agreed by May 2009. The GFC has made the establishment of the ASEAN+3 self-managed reserve pool and augmenting its resources (say doubling) more urgent as roughly one-half of the resources of IMF of US$250 billion has either been committed or is close to being committed to countries like Iceland, Ukraine, Hungary, Belarus, Pakistan, and other European countries that are lined up. Hence Asia should use its massive reserves to

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shield itself from the GFC. ASEAN could help expedite the establishment of a self-managed reserve pooling the region. As Kawai (this volume) has suggested, Asian countries should also jointly boost fiscal spending by pooling reserves and establishing an infrastructure investment fund together with the ADB and accelerate spending on the various planned projects for high-quality infrastructure development. ASEAN could help. This is a useful suggestion as infrastructure bottlenecks pose a major constraint in many countries in the region. Given the limited resources available at the IMF there are ongoing efforts to get China to lend a part of its reserves to the IMF. Japan recently agreed to lend US$100 billion to the IMF. So far, China’s response has been lukewarm and China has taken the position that the best action that it can take to support the global economy is to keep its own economy growing strongly. Any such lending by China should be conditional on raising the quota of China and India and the other emerging markets at the IMF. Presently, China’s quota at the IMF is 3.7 per cent and Germany’s is 6 per cent although China will soon overtake Japan at the third largest economy. The U.S. quota is 17 per cent. Europe, as a group, holds about 39 per cent and Japan 6 per cent. Asian countries together have 25 per cent. It is encouraging that efforts to reform the global financial architecture are being spearheaded at the G-20 which has representation from emerging markets rather than the G-7/G-8 which is dominated by a narrow group of industrial countries. This, in a sense, is historic. As expected, the recently concluded first meeting of the G-20 in Washington D.C. set in a motion a number of “big picture” reforms,1 but took a few concrete steps. More actions on the “big picture” reforms are to be taken at the forthcoming meetings including the next one in April 2009 when

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the new U.S. administration will have taken over. Asian representatives at the G-20 (Japan, China, Korea, India and Indonesia) should present Asian views and perspectives at these meetings. ASEAN could help in developing a consensus on these matters. While the previous managing director of the IMF had placed a high priority on the reform of IMF quota to make the IMF a more legitimate global institution, actions on quota reforms appear to have subsided under the present managing director.

Conclusion Asia is experiencing a crisis of unprecedented proportions not due to its excesses but those of Wall Street. Economic conditions in Asia are expected to worsen further before they start to improve. Asia should use its massive reserves and other policy tools to shield itself and help the world. Actions are required at the national, regional, and the global levels. So far, actions have been taken mainly at the national level. ASEAN as the central and most institutionalized regional grouping in Asia could proactively sensitize and help build a consensus among Asian policy-makers on the need to coordinate policies at the regional level and urge them to come out with joint policy statements. Coordinated Asian responses will achieve much more significant results than unilateral country-level policies. ASEAN could work closely with Japan, China, and Korea in strengthening the ASEAN+3 ERPD and in establishing the Asian Financial Stability Dialogue. ASEAN could also support and lobby for India’s membership in the various ASEAN+3 initiatives. After all India is already a member of the East Asia Summit. ASEAN could support and expedite the establishment of the self-managed reserve pool in Asia with augmented resources and a regional reserve pool for infrastructure development. Finally, ASEAN could also coordinate with the Asian

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members of G-20 to develop a consensus and ensure that Asian views and perspectives are properly reflected in ongoing discussions on the reform of the international financial architecture.

Note 1.

These include strengthening the derivatives market; reducing the pro-cyclicity of regulatory policies; reviewing global accounting standards; reviewing compensation practices of financial institutions; reviewing the mandates, governance, and resource requirements of international financial institutions, and; broadening the membership of the Financial Stability Forum.

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Commentary by Lim Chin, Professor, NUS Business School, National University of Singapore.

Preamble The great Financial Tsunami of 2008 would be recorded as the biggest global financial crisis since the Great Depression. From the epicentre of global finance, the credit default shock in the subprime housing market sent financial shock waves, toppling major financial institutions, freezing up credit markets, melting down global stock markets, and now threatening to plunge the world into a prolonged economic recession. The trigger may have been the housing bust in the United States, but the scale of the damage can be traced to market failures such as moral hazard, imperfect corporate governance and regulatory failures that are embedded in the current financial system. Since the 1980s, deregulation unleashed the explosion of financial derivatives, and together with international capital flow, the modern financial system was supposed to make the financial system more efficient. It is able to provide needed liquidity to borrowers and at the same time it meets the needs of lenders who have different appetites for risk and terms of lending. In times of calm, this system has proven to be quite efficient; it had expanded investment and economic growth in the global economy. But when a major credit shock occurs, it can also inflict untold damage on the world economy.

Impact on Asia The first shock wave brought down several major financial institutions in the United States because of their direct exposure to credit default risk in the mortgage-backed securities (MBS).

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Some major European banks were also exposed, but much of Asia was spared in this round of damage because of limited direct exposure to MBS. The second shock wave came about soon after when fear and uncertainty of counter-party risks led to panic. The flight to the safety of the U.S. bond markets caused a freeze in the credit market and a meltdown in stock markets. In this round, Asia’s financial and stock markets were not spared as they were hit by the risk of illiquidity that results from deleveraging and the reverse flow of funds to the United States. The third shock wave is the transmission of real economic shocks. Falling asset prices depress consumption and credit squeeze put a halt to investment; together they cause economic slowdown, depress output and raise unemployment. Both the United States and most of Europe are already in recession and they constitute the largest bulk of Asia’s export markets. Asia is bracing itself now to cope with a global recession. Thus, regardless of whether an economic shock originates in Asia (during the 1997 Asian financial crisis) or at the epicentre (during the 2008 global financial crisis), Asia gets hit all the same. The reason is that capital flows respond in a predictable manner to relative risk and returns, and it pays no attention to where the shock emanates. In both crises, Asia’s financial markets and economy suffer from the same reverse capital flow to the financial epicentre. The challenge to Asia is to find ways to soften the economic recession and to shield itself from such liquidity risk in the future. In fact, the 1997 crisis had prepared Asia well for this crisis. Over the decade, many of the Asian economies that suffered during that crisis had been prudent in their economic housekeeping,

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have recovered with healthy growth rates, and have built up a strong foreign reserve position to weather exchange rate collapse in this crisis. However, it cannot shield itself from the effects of a global recession. Clearly a global problem requires a global solution.

Global Response: G-20 Summit Immediately after the great stock market meltdown in October 2008, twenty world leaders from all leading industrial powers such as the United States, Japan, Germany, United Kingdom, France, Italy, Canada, Russia (the original G-8), plus twelve other emerging economies including China, South Korea, India, Argentina, Brazil and Saudi Arabia — together representing nearly 90 per cent of world GDP — assembled in the weekend of 14–15 November in Washington D.C. to find broad solutions to soften global recession and to repair the financial system. They arrived at three broad agreements. First, all economies should unleash their fiscal instruments such as tax rebates and government expenditure to counter falling consumption and investment. Second, the final stage of the protracted Doha round of WTO trade negotiations — which was stalled by farm negotiations between the United States and India and China — must be brought to a closure by the end of 2008 to counter any protectionists tendencies. Third, the current financial system needed repair badly. It was proposed that accounting standards must be more accurate and transparent, credit rating agencies must be scrutinized, hedge funds may have to be regulated, and that “supervisory colleges” be created to provide oversight of the world’s top financial institutions. A further summit, perhaps in April 2009, would be necessary to flesh the details of the new financial architecture.

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How Should ASEAN Respond? Thus far, some members have unilaterally responded to restore confidence in the banking system, and have made plans to stimulate demand using fiscal instruments. Kawai suggested that it may be more effective for the group to respond in a more coordinated fashion in their fiscal policies. He suggested a joint infrastructure investment fund, financed by ASEAN together with other Asian countries and possibly with Asian Development Bank support, to accelerate high quality investment projects. This would certainly be a huge confidence booster to the region and also the world economy. However, the difficulty is in the financing. The tension between national and regional interest would pull heavily toward the latter to make such a proposal not viable unless funding comes from external sources, a prospect that seems quite unlikely to materialize under the current recession. As for Kawai’s suggestion of a joint regional effort in monetary and financial cooperation, it is clear from the experiences of the 1997 and the 2008 crises that sufficient foreign exchange reserves are needed to shield members from the adverse effect of reverse capital flow. Given that IMF has lost much credibility in the region after its performance during the Asian financial crisis, the recent MOU to create the CMI $80 billion swap facility for ASEAN by ASEAN+3 members is an efficient way of providing regional insurance facility against the risk of illiquidity. This together with the Federal Reserve’s dollar swap facility of US$30 billion each with the central banks in Singapore and South Korea should add more insurance for ASEAN in the future. In the new financial architecture, IMF is expected to be armed with more reserves and hopefully, it can be more effective this time around in dealing with Asia, now that its executive board is expected to include more Asian members. Furthermore, if the proposed “supervisory

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colleges” to monitor the top banks were to be set up, ASEAN would likely be consulted. It is here that ideas should evolve on how ASEAN could contribute to make financial monitoring and supervision more effective. Lastly, his suggestion for coordination in the management of exchange rates within ASEAN is controversial and I think not viable. The suggestion to have a more stable intra-ASEAN exchange rate regime combined with more flexible ASEAN rates against the major currencies brings to mind the experience of the exchange rate mechanism (ERM) in Europe prior to the formation of the euro. The tension between national economic interests and regional interest to keep a stable exchange rate between one another is bound to lead to crises similar to the ones experienced in the ERM.

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The article was published on the Business Times Editorial Page on 31 October 2008.

WHAT ASEAN MUST DO TO COPE WITH THE CRISIS: Act Together to Maintain Confidence in the Underlying Strength of the Region’s Economies Sanchita Basu Das

The current financial crisis has reached perilous proportions. The depth of the crisis can be gauged from the fact that the cost of the rescue package proposed by the U.S. Federal Reserve and the Treasury Department has been estimated at close to US$1 trillion, which is equivalent to ASEAN’s combined gross domestic product (GDP). According to some analysts, this cost can go up further since the financial turmoil is expected to continue way into 2009. Over the last few weeks, governments have pumped billions of dollars into troubled banks while central banks around the world have injected huge amounts of cash into the money markets to spur lending and save the world from a systemic crisis. Nevertheless, the uncertainty in the stock markets prevailed, wiping out millions of dollars in the process. The financial turmoil is fast spreading, and the trickle-down effect can be felt in the rest of the world, including ASEAN economies. The Asian Development Bank (ADB) in its 2008 outlook reported that ASEAN is expected to grow 5.4 per cent this year, compared to 6.5 per cent in 2007. But with the financial instability taking its toll on the G-3 economies — the United States, Europe

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and Japan — it would not be a surprise if ASEAN’s GDP growth turns out to be lower. Despite the belief of decoupling, around 20 per cent of ASEAN exports still head for the U.S. economy. Hence, any retrenchment of U.S. consumer spending will take a bite out of ASEAN’s export story. ASEAN also felt a setback in terms of losing investors’ wealth. The stock markets across the region faced panic selling, reflecting the sentiment of the falling global capital markets. The market capitalization (the simple average of the Malaysia, Indonesia, Singapore and Thailand stock markets) has declined 32 per cent in the first three quarters of 2008, vis-à-vis a 26 per cent drop in the global average. Not surprisingly, investors have been pulling out from the region. In the Philippines, foreign portfolio investments registered a net outflow of US$521.7 million in the first nine months of 2008 — a sharp reversal from net inflows of US$3.4 billion in the same period in 2007. In addition, the ASEAN commercial banks are slowly finding it difficult to meet the credit requirements of industry and trade. In its October meeting, Thailand’s central bank kept its benchmark interest rate unchanged after two increases since July to bolster confidence in the economy and to end further liquidity tightening. So what must ASEAN do? At the outset, one can say that there is an underlying similarity of the current financial crisis in the United States and Southeast Asia’s financial troubles during the 1990s. Both are due to poor management of the finance and banking sectors of the economy and unsound monetary policies. The ongoing upheaval is not only due to the introduction of complex new financial products but also an inadequate risk assessment system and a lack of capital to absorb losses. However, for ASEAN, so far the banking system seems stable and the central banks have not implemented any drastic measures.

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The Monetary Authority of Singapore (MAS) has tried talking up the economy, with the assurance that its banking system is sound and the government will intervene if necessary. For now, it has only shifted its foreign exchange rate policy to a “zero per cent appreciation” from a “modest and gradual appreciation” to try to boost the competitiveness of the country’s exports. Also, the policy-makers have guaranteed deposits and a few Singapore banks have agreed to compensate investors who bought structured products linked to Lehman Brothers. Similarly, Bank Indonesia has remained upbeat about fundamentals, assuring that its banking system is sound and the government will intervene if necessary. With Indonesia having been one of the worst-hit Asian economies during the 1997 financial crisis, authorities there have raised the guarantee on bank deposits to two billion rupiah (US$184,000) and tried to ease tight money market conditions with an injection of liquidity. The stock market was closed for three days, and a 10 per cent limit imposed by the stock exchange on price swings has helped underpin the market. More recently, Malaysia’s government promised to inject US$1.4 billion into the ailing stock market to help it weather the financial crisis.

Resilient Banking Systems Earlier, in an ASEAN finance ministers meeting, it was stated that the region’s banking systems are resilient and economic fundamentals sound. ASEAN’s economic growth may suffer from the global financial crisis but banks are not at risk and no regionwide measures are necessary to stave off any systemic threats. Nonetheless, ASEAN as a grouping should take a common approach to maintain confidence in the underlying strength of the economies in the region and should support the individual

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governments to effectively respond to the short-term needs of the financial system. This approach could enable a broad assessment of the key vulnerabilities facing the region and hence could establish a regionwide coordinated framework for responding to the financial crisis. It could include a coordinated use of monetary policy tools, such as interest rate cuts, and create a legal framework for handling troubled financial institutions. Finally, a pooled ASEAN financial facility could be developed to provide short-term liquidity, if and when required, to central banks or finance ministries to support banking systems through a variety of activities. Such short-term actions could be in line with measures in other affected countries or regions across the world like purchasing non-performing assets from banks and removing them from bank balance sheets, direct investment in banks, providing guarantees for medium-term debt issued by the banks, etc. As the current financial crisis is different from the last one, it is expected that this crisis will spread to ASEAN through indirect channels, other than direct capital outflows. While the economies are already facing a deceleration in exports, the contagion could also spread to inward foreign investment and credit markets. All this would eventually slow economic growth and possibly slow down the development process across the region. Hence ASEAN should be ready with a preventive coordinated approach so that the region can boost economic growth and ease worries on the global financial crisis.

The author is a Visiting Research Fellow and the lead researcher for economic affairs in the ASEAN Studies Centre at the Institute of Southeast Asian Studies (ISEAS). These are her personal views.

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ABOUT THE CONTRIBUTORS

Masahiro Kawai (lead article author) joined ADBI in January 2007 after serving as Head of ADB’s Office of Regional Economic Integration (OREI) and Special Adviser to the ADB President in charge of regional economic cooperation and integration. Prior to this, he was a Professor at the University of Tokyo’s Institute of Social Science. He also worked as Chief Economist for the World Bank’s East Asia and the Pacific Region from 1998 to 2001, and was Deputy Vice Minister of Finance for International Affairs of Japan’s Ministry of Finance from 2001 to 2003. He was an Associate Professor in the Economics Department of Johns Hopkins University, and later as an Associate and Full Professor at the Institute of Social Science, University of Tokyo. He served as a consultant at the Board of Governors of the Federal Reserve System and at the International Monetary Fund, both in Washington, D.C. He was also Special Research Adviser at the Institute of Fiscal and Monetary Policy in Japan’s Ministry of Finance, and a visiting researcher at the Bank of Japan’s Institute for Monetary and Economic Studies and at the Economic Planning Agency’s Economic Research Institute. Kawai has published a number of books and numerous articles on economic globalization, regional financial integration and cooperation in East Asia, including lessons from the Asian crisis, and the international currency system. He earned his B.A. and M.A. degrees in Economics from the University of Tokyo’s Faculty of Economics and M.Sc. degree in Statistics and Ph.D. in Economics from Stanford University.

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Charles Adams (commentator) is a Visiting Professor at the Lee Kuan Yew School of Public Policy, National University of Singapore. Previously he worked at the International Monetary Fund for twenty-five years, including five years in Tokyo as Deputy Director of the IMF’s regional office for Asia and the Pacific. He holds a Ph.D. from Monash University, Australia. V. Anantha-Nageswaran (commentator) was born in Chennai in 1963. He graduated with a Postgraduate Diploma in Management (MBA) from the internationally reputed Indian Institute of Management, Ahmedabad in 1983. He obtained a doctoral degree in Finance from the University of Massachusetts in 1994 for his work on the empirical behaviour of exchange rates. Between 1994 and 1999, he worked for Union Bank of Switzerland (now UBS) and Credit Suisse in Switzerland. He launched the Libran Global Macro Fund in January 2005. The fund invested globally across asset classes. It was wound up in June 2006, due to adverse market conditions. In July 2006, he joined Bank Julius Baer & Co. Ltd. in Singapore. He is the Chief Investment Officer for Asia-Pacific and is responsible for research, portfolio management and financial products. Bank Julius Baer is a Swiss financial institution and manages both institutional money and offers private banking services to high networth individuals globally. He is an angel investor in many start-up companies in India. He is one of the directors of the NPS Indian International School in Singapore. He teaches International Finance to MBA students at the SP Jain Centre for Management in Singapore. He writes a weekly column for MINT, an Indian financial daily on Tuesdays and is a frequent guest at all the major international television networks.

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Michael Lim Mah Hui’s (commentator) professional background spans thirty years as an international banker and academician. He worked in major international banks that included Chemical Bank (now JPMorgan Chase) in New York and Tokyo, Credit Suisse First Boston in Singapore and Hong Kong, Deutsche Bank in Singapore and Jakarta, Standard Chartered Bank in Jakarta, and the Asian Development Bank in Manila. Prior to his banking career, he taught Political Economy and Sociology at Duke University, Temple University and the University of Malaya. He has published several books and manuscripts: The Ownership and Control of the 100 Largest Corporations in Malaysia (Oxford University Press, Kuala Lumpur, 1981); Transnational Corporations from Developing Asian Economies (ESCAP/UNCTC Publications Series B No. 7, United Nations, 1985); “Women and the Industrialization Process in Asia: Close-up Study of the Thai Textile Workers” (a report submitted to the Social Development Division of the Economic and Social Commission for Asia and Pacific, Bangkok, 1986.) More recently he has written extensively on the present global financial crisis. His articles have appeared in the Bangkok Post, the Philippines Inquirer, the Edge, the Department of Economic and Social Affairs, U.N., the Third World Resurgence, the Levy Economics Institute, and the Journal of Applied Research in Accounting and Finance. He received his B.A. (Honours) in Economics from the University of Malaya, a Master’s degree in International Affairs, a Master’s degree in Sociology, and a Ph.D. in Development Studies from the University of Pittsburgh. He is now a Senior Fellow in the Asian Public Intellectuals Program of the Nippon Foundation. Pradumna B. Rana (commentator) is currently a Senior Fellow at the Nanyang Technological University in Singapore. He was the Senior Director of the Asian Development Bank’s (ADB’s) Office

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of Regional Economic Integration which spearheaded the ADB’s support for regional cooperation and integration in Asia. He joined the ADB in 1983 and held senior positions at the research and various operational departments. Earlier he was a Lecturer at the National University of Singapore and the Tribhuvan University (Nepal), a researcher at the Institute of Southeast Asian Studies in Singapore, and a consultant to the World Bank in Washington D.C. He obtained his Ph.D. from Vanderbilt University where he was a Fulbright Scholar, and a Master’s in Economics from Michigan State University and Tribhuvan University where he was a gold medalist. He has published widely in the areas of Asian economic development and integration, Asian financial crisis, business cycle co-movements, early warning systems of financial crisis, and policy reforms in transition economies. These include several books and articles in international scholarly journals including Review of Economics and Statistics, Journal of International Economics, Journal of Development Economics, Journal of Asian Economics, World Development, Developing Economies, and Singapore Economic Review. Currently, he is coauthoring a book on South Asia: Rising to the Challenge of Globalization and co-editing books on Pan-Asian Integration: Linking East and South Asia (Palgrave Macmillan, forthcoming) and National Strategies for Regional Integration (ADB, Manila, forthcoming). Lim Chin (commentator) is an Economist with the NUS Business School. His publications on behaviour of the firm and of markets facing uncertainty, public economics, and urban economics appear in leading academic journals such as such as American Economic Review, Journal of Economic Theory, Rand Journal of Economics, Economica, European Economic Review, Canadian Journal of Economics, Journal of Public Economic Theory, Economics

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Letters, and Transportations Research. He has consulted widely for both private corporations and government bodies and also the World Bank. He is currently a member of the Market Surveillance & Compliance Panel (MSCP) of Singapore’s New Energy Market, an independent body set up to monitor and enforce compliance with the Market Rules and to ensure efficiency and fairness in the wholesale electricity market.

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