Asian Crisis

Is ASEAN prone to Another Financial Crisis: Risk and Policy Challenge?
♣

Bandid Nijathaworn

1.

Introduction

The last twenty years have been eventful for the economies of ASEAN in terms of financial crisis and policy management. Since the 1990s, the region had gone through two major financial crises, one as a region where a crisis began while the other as a recipient of a major crisis. Both provide the ASEAN economies with a wide range of valuable policy experience for assessing the region’s capacity to prevent and manage future financial crises that may arise. This paper, which is intended as a complement to a larger chapter of an ADBI report on cooperating macroeconomic policy and finance, sets out to explore the issue of how prone the ASEAN economies are to another financial crisis in the next two decades. The question is legitimate given the region’s past record of financial vulnerabilities and crises, and the likelihood of future financial crises in parallel with the rising importance of Asia as source of global growth and the deepening of financial globalization worldwide. In doing so, the paper identifies financial crisis risks that ASEAN economies may be facing in moving to the year 2030, and suggests areas for policy reform, both at the national and the regional levels, to mitigate such risks, including ways to improve the resilience of the ASEAN countries against possible future financial crises. The paper will focus on four sets of issue. The first is the financial crises experience of the ASEAN countries of the last twenty years as a basis for assessing possible future crisis risks and the policy challenge. This is presented in Section 2, in the form of a summary of key policy lessons learned from ASEAN’s past experience with financial crises. The second issue is an assessment of possible future financial crisis risks that ASEAN economies may be facing to year 2030, discussing separately the domesticallyinduced, or the internal risks, and the externally-driven risks as well as the broad implications of those risks for policy. This is presented in Section 3.

A background paper for an ADBI study on ASEAN 2030: Growing Together for Shared Prosperity, February, 2012.

♣

2

The third issue is the risk exposure of individual ASEAN economies to the financial crisis risks identified in Section 3 and the policy implications of such risks at the national level, especially market regulation and the capacity of the domestic financial institutions to manage such risks. This is presented in Section 4. And the fourth issue is the prospects for enhancing ASEAN policy collaboration and financial corporation as ways to strengthen the region’s capacity to manage shocks in the context of the evolving international and regional financial architecture. This is done in Section 5, while Section 6 concludes.

2.

Lessons learned for ASEAN from Previous Crisis Encounters

Financial shocks happen, and they will likely occur with greater frequency going forward as the process of financial globalization deepens and the structure of financial markets in the ASEAN economies becomes more complex as a result of increased interconnectedness and increasingly complicated financial innovation. To assess risk of future financial crises for ASEAN economies, as well as their abilities to manage the risks, it is imperative that one starts by stepping back and drawing lessons from past crisis experience. As previously noted, the last twenty years have been most eventful for ASEAN, marked by a build-up of region-wide macroeconomic vulnerabilities in the early 1990s which culminated in the Asian financial crisis in the late 1990s; a frantic period of crisis resolution and economic and financial restructuring to mid-2000s; and last but not least a period of managing contagion and the spillovers from the global financial crisis of 20072009 while ensuring economic recovery. In short, ASEAN economies have gone through two major crises in the last twenty years, first as the region where a crisis began and second as the region affected by a major crisis. The policy experience gained from these crisis encounters and a good sense of what matters most from such experience should prove valuable in assessing future crisis risks as well as enhancing the abilities of the ASEAN countries to manage the risks either individually or as a group. In this section, we discuss the financial crisis experience of the ASEAN countries in terms of key lessons learned, specifically with respect to: (1) sources of financial crisis risk that have been most relevant to ASEAN given the region’s levels of financial market developments and openness; (2) important factors that have contributed to the resilience of the ASEAN economies against such risks and financial shocks; and (3) strengths and weaknesses of the past policy response in mitigating and managing the risks. These lessons, which are subjective but widely recognized, reflect a common understanding at this time of what matters most for emerging markets with respect to policy to manage risk of financial crisis and the contagion. In this paper, we single out three policy lessons which apply unequivocally to the ASEAN economies. Lesson I. The first lesson is that no country is above crisis. The financial crisis in Asia in late 1990s, which was an emerging markets crisis, and the recent global financial crisis, in which the epic-center is in the advanced economies, show that financial crisis can happen in any country if the conditions for a crisis are met. It could be a large or small country, a

3

developed or developing economy, and with or without a well-developed financial system. The conditions for crisis can be domestic or external: the former includes fiscal and financial sector-led crises while the latter includes balance of payments and foreign exchange-led crises. For ASEAN, both domestic and external sources of risk are equally important because of a high degree of financial openness in some of the ASEAN economies relative to the shallowness of their financial markets. The situation is exacerbated further by the increasingly limited abilities of domestic policy, banks and financial system, and the regulatory environment, to deal effectively with large cross-border capital flows, which make a number of ASEAN countries particularly susceptible to the external forces setting the conditions for crisis. This is the case of Indonesia, Malaysia, Philippine, Singapore, Thailand, and Vietnam. As for the financial crisis risk most relevant to ASEAN, the key external risks have been and will continue to be sharp changes in the term of trade, collapse of global demand, threats to financial stability from large and persistent capital inflows, and sudden stops and reversals of foreign capital linked to extreme financial markets uncertainty and volatility, Such risks are linked for the most part to the global and regional financial integration. The importance of such risks for individual ASEAN economies will vary according to their levels of financial markets development and openness. For example, the financial markets of Myanmar, Laos, and Cambodia have been well shielded from the recent financial crisis thanks to the restrictions of their capital accounts while their output declines synchronized well with the rest of ASEAN, indicating the collapse in global demand as a more important source of external shock to these economies. As for the internal source of risk that leads either to a fiscal-led crisis or to a financial sector-led crisis, the key is the policy risk. It is evident from the experience of the past two crises that poor policy can sow the seeds of crisis through a build-up of unsustainable financial imbalances, while better policy can help the economy avoid major imbalances and build greater resilience against shocks and capital outflows. In short, to be or not to be in a crisis is largely a matter of policy choice. Such choice is shaped unequivocally by the domestic, regional, and global policy frameworks. This is the first lesson. Lesson 2. The second lesson is that financial crisis is, without exception, rooted in excessive debt and leverage. This places the public sector and the financial system at the forefront of policy in preventing and managing crisis. Public debt-induced crisis is typically the result of a poorly- managed fiscal policy, which invariably leads to unsustainable debts of central government or public corporations. Private debt-induced crisis, on the other hand, is linked to excessive credit extension by domestic and foreign financial institutions that lead to unsustainable debt positions of firms and households. The strong growth in domestic credit is encouraged by a combination of large and persistent capital inflows, loose monetary policy, misaligned incentives in the financial industry, and lax financial regulation and supervision. Signs of financial stress preceding the crisis often manifest in large and persistent current account deficits, an overvalued exchange rate, and high and rising inflation and ballooning asset prices. A crisis breaks out either when the confidence of market on the abilities of the debtors to meet their financial obligations changes, or

4

when markets have doubts about the abilities of policy to bring the imbalance down to a sustainable level. In both cases, it is the change in confidence that triggers or turns an unsustainable situation into a crisis. That is lesson two.

Lesson 3. The third lesson is that, to help the economy avoid the build-up of large imbalances and improve its resilience and capacity to deal with shocks, the policy efforts must be directed at four areas. The first is greater economic and price flexibility to provide the economy with means and ability to adjust to shocks. Important in this context are exchange rate flexibility, price flexibility, and labor market flexibility, all of which are best promoted through a more extensive use of market mechanism, rather than regulation or control, in the allocation of resources. The second area is the self-insurance policy against financial crisis risk through policies that promote strong external position via a sustained current account balance, low levels of external debt, and adequate levels of international reserves. For ASEAN, the importance of having a large enough level of reserves has been clearly demonstrated in the recent global financial crisis when strong reserve positions have allowed the ASEAN economies to successfully absorb shocks from the global financial crisis. More being preferable to less, in addition to current account surpluses, the size of the country’s international reserves for the most part reflects the degree of flexibility with which capital flows have been managed. The third area is the resilience and the efficiency of the domestic financial sector. For ASEAN, the past two crises show clearly that a robust and strong financial sector is important to the ability of the economy to adjust to shocks and to pre-empt threats to financial stability that is a precursor to a financial crisis. Important in this context are policies that ensure good fundamentals in the financial system especially banks in terms of adequate profitability, strong capital base, effective risk management practice, and robust financial regulation and supervision framework. The fourth and final area is the disciplined conduct of fiscal and monetary policies, sine qua non for ensuring a sustained economic growth with stability, hence immunizing the economy against the risk of domestically-induced crisis. The key challenge here lies in the strength of the domestic policy institution that allows policy to be focused on achieving a balance between growth and price and financial stability while taking into account the longer-term implications of the short-term policies. The three lessons mentioned thus put policy at the heart of the efforts to prevent and manage financial crisis. To date, the ASEAN economies, as a group, have made considerable progress on policy reform in enhancing economic flexibility, pursuing selfinsurance against shocks, reforming the financial system, and maintaining discipline in the conduct of macroeconomic policy. However, for the majority of ASEAN countries, the reform agenda remains unfinished and needs to continue further to give the economies of ASEAN a stronger backstop against risks of possible future financial crisis, the subject which we now turn.

5

3.

Assessment of Possible Financial Crisis Risk for ASEAN Economies

This section focuses on an assessment of possible future financial crisis risks that ASEAN may be facing to year 2030, and the implications of such risks for policy. Financial crises do happen and twenty years is a long enough time horizon for risks of financial crisis to crystallize. The key question then is what forms will the next crisis take, and, to mitigate such risk, what will be the implications for policy. To answer this question, the paper looks at both the internal and the external sources of risk and then focuses on the financial crisis risks most relevant to ASEAN going forward in the context rapid regional growth, continued deepening of structural change and urbanization in Asia, and increasing financial globalization in the region. Although the financial crisis risks chosen may be subjective, the intention here is not to predict the next crisis events, but to pinpoint the forms of financial crisis risk that are likely to be most important for ASEAN so that we can focus on their implications for policy. And while some of the risks identified may seem more relevant today than others because of the current policy challenge, their relevance as important potential long-term crisis risks are what matter. Altogether we look at five most plausible financial crisis risks, three domestic and two external. 3.1 Internal Crisis Risk

For the internal risk, the paper takes the failure of policy to achieve a proper postcrisis rebalancing as the next crisis-setting conditions for ASEAN. The failure of policy, which would be reflected in unsustainable imbalances, could come from two most plausible financial crisis risks. The first is fiscal activism linked to government policy to promote public investment and welfare-related expenditures that is financed by heavy public sector borrowings. Successive years of fiscal deficits that result could build up to unsustainable levels of public debt. This is a classic fiscal-led financial crisis. The second is a classic boom-bust type of crisis where policy failure lies in poor management of capital inflows and the financial sector, giving rise first to excessive leverage and credit growth that boost economic growth but eventually precipitate asset price bubbles and threats to financial stability. Over time financial fragility develops in the form of high domestic inflation, large chronic current account deficits, increased reliance on short-term capital to finance the deficits, and steadily depreciating exchange rate that needs to be supported by intervention and the concomitant loss of central bank’s reserves. This is a classic balance of payments crisis that can subsequently lead to a banking crisis if the asset quality of the banking sector is severely impaired in the process. The third internal financial crisis risk is not related to policy but to the loss of confidence that prompts abrupt reversals of foreign capital flows. Such reversals can be triggered either by change in the domestic factors such as deteriorating political situation, or by change in the global financial markets conditions. The key factor is the scale of the outflow relative to the capacity of the central bank to cushion the impact by running down official reserves. During the process, if the outflow is large and persistent, the domestic financial markets will be affected through pressure on liquidity, short-term interest rates,

6

risk premium, and exchange rate volatility. These can disrupt the normal functioning of the financial markets.

3.2

External Crisis Risk

As for the external risk, the paper focuses on the major global risks that can lead to a sudden dry-up of global liquidity and/or an abrupt slowdown in global growth that may adversely affect the ASEAN economies and require policy response to cushion the impact. This paper takes a view that while the possibility of a prolonged weak recovery or a double-dip recession of the major economies exists, it is not deemed to be a major crisis risk for ASEAN judging from the abilities of the ASEAN economies to have successfully weathered similar global growth downturns in the past, most recently the global financial crisis of 2007-09. Instead, the paper focuses on two externally-driven financial crisis risks that have a high likelihood of occurring, with a possible strong and direct impact on ASEAN financial markets and economies. The first is a financial market-led type of crisis similar to the sub-prime crisis where market correction to failures to meet financial obligations in one segment of the global financial market leads to extreme price volatility, the drying up of liquidity, and systemic confidence effects that paralyze other financial markets across the globe. Possible candidates for such market disruption in the period ahead are the sovereign debt markets of the PIIGS, the US, the UK, and Japan, all of which can come under significant pressure if the policy to address fiscal sustainability is not pursued. Because of the complexity of sovereign debt linked to its impact on bank capitalization and a problem of different rate of relative productivity/competitiveness across countries in the longer-term, the impact of such disruption to the global financial markets can be large and long-lasting. All the key markets and countries probably will not be spared. For ASEAN, the key impact will be through the real and financial channels, affecting international trade, liquidity, investment position of government and financial institutions, and access to the funding markets abroad. The second is shocks linked to a disorderly burst of speculative bubbles in commodities triggered possibly by an unexpected sharp slowdown of the Chinese economy, leading to lower demand for commodities and thus sharp correction in commodities prices. This will in turn lead to an abrupt unwinding of speculative positions on commodities and currencies of commodity-exporting countries. The key transmission channel in this case will be market liquidity, change in the terms of trade, and the impact on balance sheets of corporations. 3.3 Crisis trigger and Interactions

The above are the five financial crisis risks considered in the paper to be most relevant for ASEAN going forward - in terms of the likelihood of crisis and the possible impact on the ASEAN economies. But before we move on, there are two important points that must be noted. The first is that financial crisis risk on its own may not necessarily lead to crisis. This is because, while financial crisis risk can lead to a build-up of unsustainable vulnerabilities in the economy, for a crisis to happen there needs to be a trigger that turns

7

the underlying vulnerabilities which are well-recognized by the market into a crisis. In most cases, the trigger is found in a factor or a policy commitment that in the run-up to the crisis has helped anchor or uphold confidence of financial markets with respect to the underlying problem. Once the anchor is gone, market confidence plunges and a crisis sets in. Therefore, for a crisis to happen, three things must be in play. The first is the financial crisis risks along the line we have identified, which, if not properly managed, can lead to a build-up of serious financial vulnerabilities in the economy that sets the stage for a crisis. The second is the trigger which usually takes the form of a policy commitment that has been successfully tested in the past, in upholding the confidence of financial markets in spite of the underlying vulnerability. And the third is the breakdown or the activation of the trigger that changes market confidence and sets off a crisis. In the case of the Asian financial crisis, the financial crisis risk was a typical boombust cycle of the type we identified earlier, i.e. a build-up of large external deficits and high levels of indebtedness. The trigger was the policy commitment to maintain a stable exchange rate. The trigger went off when the stable exchange rate collapsed, forced on by speculative attacks of currencies. The global financial crisis of 2007-2009 was also of the boom-bust variety. The crisis began with bubbles in a number of major housing markets across the globe, with the global banks, especially in the US, became overstretched and severely weakened. The trigger in this case, as understood by the market, was the policy commitment to support banks to restructure and ride out the crisis. In the event, the trigger was activated following the Lehman collapse. And as to the ongoing European sovereign debt, the financial crisis risk is clearly the fiscal-led crisis of the type we have also discussed. Debts have grown to high and unsustainable levels in a number of European countries. The trigger, again as understood by market, is the commitment of the Euro-system to implement economic restructuring and reform in the high debt economies to bring the debt down to a more sustainable level within the current structure of the Euro-system. To recap, the preceding discussion shows clearly that policy plays an important role as a financial crisis risk. Indeed, in a financial crisis, policy can both instigate the initial vulnerability that sets the stage for a crisis, and turns the vulnerability into a full-blown crisis through reneging on policy commitment. The second point that must be noted is that, while financial crisis risks on their own can lead to financial vulnerability that sets the stage for a crisis, the interactions between them, especially between the internal and the external crisis risks, can further reinforce and significantly amplify the dynamic of financial vulnerability, thereby hastening the likelihood of crisis. This is the case of a shock on shock, or a double whammy, that suddenly exacerbates the already fragile situation. In the past, there were many instances that the outburst of financial crisis, or the activation of the trigger, was hastened by the interactions of crisis risks. Indonesia in 1998 went into a full-blown crisis when market confidence on the already fragile macroeconomic situations was aggravated by the fast developing domestic political

8

situations that led to the resignation of President Suharto. In the case of Mexico, the rise of US interest rates in the early 80s also played an important role in bringing forward a financial crisis in Mexico because of the effects it had on accelerating capital outflows, given Mexico’s already fragile balance of payments situations.

Table 1. Possible Interactions of Financial Crisis risk

External Crisis Risk Financial-Market Failure (Risk 4) Fiscal-led (Risk 1) Boom-Bust type (Risk 2) Abrupt reversals of capital (Risk 3) Burst of major bubbles (Risk 5)

Domestic Crisis Risk

× × × ×

X denotes possible amplification of risk

Table 1 illustrates possible interactions of the financial crisis risks identified in the paper. For example, an unexpected sharp slowdown in the Chinese economy (Risk 5) would also lead to a collapse in global growth which, in turn, could instigate abrupt reversals of capital from the ASEAN economies (Risk 3). It would also worsen the fiscal crisis risk (Risk 1) as the subsequent domestic output decline would reduce government revenue and weaken the capacity of the government to service debt. Another example is the fallouts from a major financial market failure (Risk 4) which - if it happened - could prompt sudden stops and reversals of foreign capital from the ASEAN economies (Risk 3), and abruptly end a capital inflows-led boom. Such sudden stops of capital flows could result in a balance of payments crisis (Risk 2). 3.4 Broad Implications of Crisis Risk for Policy

We turn now to the issue of policy implication and look at the broad implications of the financial crisis risk identified for policy in the ASEAN economies. This is depicted in Table 2, which focuses on the implications of the five financial crisis risk identified for the four key policy areas discussed.

9

Table 2. Broad Implications of Financial Crisis Risk for Policy

Economic and Price flexibility Domestic Risk • Fiscal-led • Boom-Bust type • Abrupt Reversals of Capital •

Policy SelfFinancial Insurance Sector Policy Reform

Disciplined Macroeconomic Policy •

• •

• •

• •

External Risk • Financial market failure • Burst of major bubbles

• •

• •

• •

• •

As can be seen, the five financial crisis risks identified do have implications for all the four important policy areas that we highlighted. As for external risk, an effective management of external financial crisis risks points clearly to the importance for the economy of having adequate policy capacities in all the four policy areas, i.e., economic and price flexibility, self-insurance policy, financial sector reform, and disciplined macroeconomic policy. Managing internal crisis risks, on the other hand, will require a more selective focus of the policy efforts. But what stands out from Table 2 is that disciplined conduct of macroeconomic policy is an indispensible element for the economy to remain resilient against all risks of a financial crisis. In the next section, we will look at the implications of the five financial crisis risks for policy at the individual ASEAN economies level. The discussion will begin with an assessment of the financial crisis risk that will be most relevant for individual ASEAN economies, the subject we now turn.

4.

Risk Exposure of Individual ASEAN economies and Implications for Policy

As noted earlier, financial crises do happen, and twenty years is a time horizon long enough for the five financial crisis risks that we have identified to crystallize. In this section, we discuss the financial crisis risks that are most relevant to each ASEAN economies and their implications for policy. The view taken here is that in the long-run all

10

the five risks will probably be important and relevant for all ASEAN economies, given the speed of globalization that is taking place. But in a more immediate term, for a particular economy, some crisis risks will be more relevant than others given the initial source of vulnerability and the level of financial openness. Amongst the ASEAN economies, Cambodia, Myanmar, and Laos do have a more limited degree of financial openness compared to the rest of ASEAN. This means for these economies, domestic vulnerability will likely be a relevant source of crisis risk than financial contagion from abroad.

4.1 Identification of crisis risk for individual ASEAN economies Table 3 summarizes the current state of the ASEAN economies in terms of indicator of vulnerability to assess the ASEAN economies’ initial strength and vulnerability. As can be seen, the macroeconomic states of the ASEAN6 economies at this time are relatively robust, with current account surpluses, strong external reserve positions, low to moderate public debt, and relatively healthy banking sector in terms of capital adequacy and NPL. The CMLV economies, on the other hand, exhibit more challenges given the high twin external and fiscal deficits, supported by moderate to low levels of gross official reserves. Fiscal sustainability also looks to be a potential key policy issue for a number of ASEAN economies given the initial high levels of public sector deficits. The challenge will also be in managing the financial sector and the associated risk of bubbles given the rapid monetary growth currently observed across all ASEAN economies. From the data, Vietnam, Cambodia, and Laos do require a close monitoring on their macroeconomic developments going forward, while Malaysia, Philippines, and Thailand stand out for a medium-term fiscal challenge amongst the ASEAN6 economies.

Table 3. ASEAN Economies: Indicator of Vulnerability

Current Account Balance1 ASEAN 6 Brunei Indonesia Malaysia Philippines Singapore Thailand 47.0 5.8 7.0 4.8 17.8 3.6

Gross Reserves2

Public Debt1

Fiscal Balance3

Monetary Growth4

Capital adequacy5

NonPerforming Loans6 7.8 3.2 3.5 4.5 2.3 5.0

3.9 6.3 6.9 NA 5.7 9.9

na 26.3 62.3 50.5 na 45.4

17.0 -0.2 -7.0 -3.6 -1.9 -3.6

17.4 13.9 7.8 11.6 10.6 6.6

16.8 19.3 15.1 15.3 16.5 15.7

ASEAN 4 Cambodia Myanmar Laos Vietnam

-11.2 -1.0 -15.4 -8.1

3.1 8.1 2.6 3.3

30.1 7 31.1 7 53.9 7 47.5

-7.4 -3.5 -7.8 -8.2

12.9 22.3 16.7 19.6

27.8 na na 8.2

5.2 na na 3.0

11

Sources IMF Staff Report 2010. Latest available yearly number. 1. as percent of GDP 2. 3. 4. 5. 6. 7. month of imports Overall balance, in percent of GDP, for 2009/10 budget year Broad Money Growth, year on year Regular capital to risk-weighted assets As ratio of loans External debt

On the basis of the initial vulnerability discussed, the paper moves on to identify the financial crisis risks most relevant for each ASEAN economies, focusing on the five financial crisis risks identified. This is summarized in Table 4, in form a subjective riskmapping of the financial crisis risks to the individual ASEAN economies. And on the basis of the risks mapped to the individual economies, the implications for policy at the national level are discussed. This is depicted in Table 6, in the context of the four key policy areas described in Section 2. Below is our summary of the key points on the financial crisis risks and the policy implications important for each ASEAN economies going forward, starting with the ASEAN6.

Table 4. Financial Crisis Risks and the ASEAN Economies
Risk 1 Fiscal-led Crisis ASEAN 6 Brunei Indonesia Malaysia Philippines Singapore Thailand ASEAN 4 Cambodia Myanmar Laos Risk 2 BoomBust type Risk 3 Abrupt Reversals of Capital Risk 4 Financial market failure Risk 5 Burst of major bubbles

× × ×

× × × × × ×

× × × × × ×

× × × × × ×

× × × × × ×

・
× × ×

・
× × ×

12
Vietnam Source: See Text

×

×

×

×

Table 5. ASEAN: Implications of Crisis Risk for Policy
Economic and Price flexibility ASEAN 6 Brunei Indonesia Malaysia Philippines Singapore Thailand ASEAN 4 Cambodia Myanmar Laos Vietnam Self-Insurance Policy Financial Sector Reform Disciplined Macroeconomic Policy

× × × × × × ・ × × × ×

× ×

× × × × × × × × × ×

× × × × × × × ×

× × × ×

Given the high degree of financial openness, lingering risks in the global economy, and the ongoing challenge in managing capital flows, all the five financial crisis risks identified in the paper will continue to be relevant for all the upper-middle income ASEAN4 economies, namely Indonesia, Malaysia, Philippine, and Thailand. Externallyinduced crises, Risk 4 and 5, will impact the ASEAN4 economies through both the real and the financial channels because of their relatively open economies. And while risk of abrupt reversals of foreign capital, Risk 3, is applicable to all the ASEAN4, the risk is particularly pivotal for Indonesia and Thailand given the recent experience of large capital outflow impacts in the former and the possibility that future political situations in the latter

13

can affect investor confidence. On the other hand, risk of a boom-bust type crisis, Risk 2, will continue to be central to all the ASEAN4 economies on account of the openness of their economies, the expanding and rapidly growing financial markets, and the potential for continued strong growth. As for risk of fiscal-led crisis, this is an added risk for Malaysia and Philippine on account of the presently high fiscal deficits, and a potential risk for Thailand going forward as public sector investment gains stronger momentum. Financial crisis risk confronting Singapore and Brunei will be of a different form to the rest of ASEAN owing to the exceptional strength of their external positions. Because of a relatively small domestic sector and strong fiscal position, contagion of the externallyinduced global or regional crisis, Risk 3, 4, and 5, will be an important source of crisis risk for Brunei, in addition to the slump in the oil market which is a unique risk for Brunei given the economy’s total dependency on oil. Similarly, given its openness, the status of Singapore as a financial centre, and its track record of effective forward-looking macroeconomic policy, Singapore will be exposed mostly to the externally-induced crisis risks i.e., Risk 3, 4, and 5. Nonetheless, a crisis linked to a domestic property market boom cannot be overlooked on account of the increased importance of Singapore as a global business destination and location. For CMLV economies, the relevant financial crisis risks are more straight-forward. Limited openness to global financial markets means that CMLV economies will be wellshielded from the financial contagion of a global crisis, leaving output decline and change in the term of trade to be the main channel of contagion of a global crisis. And because of the prominent role that the public sector plays in these economies, a fiscal-led crisis remains a central key risk, while risk of a boom-bust type of crisis is higher in economies where financial markets are rapidly developing as is the case of Cambodia and Vietnam. Specific to Vietnam, given the economy’s high degree of integration to the global economy, all the five financial crisis risks will be relevant for Vietnam similar to the case of the ASEAN4 economies.

4.2

Implications for Policy

Implications for policy follow directly from our discussion of the crisis risks above. The implications are summarized in Table 5, indicating areas of policy reform most fundamental to the prevention of crisis in each economy on account of the risks identified. For the ASEAN4, strengthening the financial sector, maintaining disciplined macroeconomic policy, and increasing the flexibility of the economy and prices remain important areas of policy reform. Although financial reform is ongoing in all ASEAN4 economies, the efforts must continue unabated. Next, fiscal consolidation to ensure a medium-term sustainability is a priority in Malaysia and the Philippine while selfinsurance through a further strengthening of gross international reserves can be beneficial for Indonesia and Philippine, given the likelihood of a more expansive financial contagion linked to future externally-induced global crises. For Brunei, continuing with financial sector reform and increasing economic and price flexibility is an important priority for increasing the economy’s capability to deal with external shocks. Continuing with financial system strengthening and increasing economic flexibility will also be a relevant policy focus for Singapore in view of its role as the region’s financial centre that needs to

14

have ample capacity to adjust to shocks and maintain financial markets stability in the event of a major global crisis. For CMLV, although there are less crisis risks to consider compared to the rest of ASEAN because of the limited degree of openness of their economies, likelihood of a crisis is always there and can take on a more complicated form as CMLV economies become more integrated with the global economy. Hence, we see all the five key policy areas to be relevant and important for the CMVL economies going forward. Therefore, a key policy challenge for CMLV is to improve the policy capacity to deal with risk of crisis in all the four policy areas, while conditioning the policy on capital account liberalization on the progress made on these important policy reforms. The policy implications noted above relate directly to the crisis risks identified for individual economies. At a broader level, however, other common policy challenges will likely emerge with time as the context of crisis prevention becomes more global and the crisis risk becomes increasingly financial in nature. The first is the importance of financial stability as a policy objective and the need for the ASEAN authorities to further strengthen their capacities on macro-prudential policy as a crisis prevention tool. The second is a regular review of the key assumptions underlying the working of the economy and the financial sector so as to avoid policy risk or mistake arising from an outdated or wrong policy framework. And the third is resiliency of the banking sector. This will require a close monitoring and timely stress-testing of banks as a regular supervisory exercise.

5.

Scope for ASEAN Cooperation in Preventing and Managing Crisis.

It has been argued throughout this paper that the key contingency against future financial crisis is for ASEAN to strengthen its policy as a way of enhancing the region’s abilities and capacities to deal with financial crisis risk, which in the future can take a variety of forms. To this end, the preceding section discusses the areas of domestic policy reform most relevant to the individual ASEAN economies in the context of the financial crisis risks identified. While this is well and good, there is a strong possibility that the deepening of financial globalization in the ASEAN region in the next twenty years can overtake and seriously undermine the effectiveness of domestic policy and contingencies designed today to cope with future financial crises. Hence, it may be important for policy makers to look beyond domestic policy for an effective way to manage crisis risk. In this section, we look at this possibility. The section discusses ways that financial cooperation amongst the ASEAN economies can contribute to increasing the region’s policy capacity, effectiveness, and preparedness against crisis risks. Specifically, it explores the scope that exists to strengthen further ASEAN financial cooperation in the areas of macroeconomic surveillance, financial safety-net, and policy collaboration, in the context of the evolving regional financial architecture. 5.1 The evolving regional financial architecture

An obvious key benefit of regional financial cooperation to counter risk of financial crisis is that it allows economies that face common external risk and shocks to pool resources and build collective institution and framework that can effectively prevent crisis or allow the crisis to be better managed. To this end, resources can be pooled for

15

information exchange, for macroeconomic surveillance and policy dialogue, for policy collaboration in the form of common regime setting, and for developing a regional financial safety-net that offers exceptional financing to economies in time of crisis. The benefits from such regional cooperation will be particularly large for smaller economies where national policy response may be inadequate to deal with shocks that are of global nature or of global proportion. For ASEAN, financial cooperation has a long history. It dates back to 1977 when the first ASEAN financial cooperation took shape in the form of a swap arrangement between the central banks of ASEAN to provide liquidity to member facing a balance of payments problem. This arrangement, known as ASEAN Swap Arrangement or ASA which is still operating, is not supported either by a macroeconomic surveillance or by a policy dialogue between members, and hence had no role to play in the Asian financial crisis of the late1990s. Nevertheless, ASA has been a precursor to a number of important financial cooperation projects that followed, including the establishment of the ASEAN infrastructure fund, the ASEAN exchange linkage, negotiations among members on financial liberalization, and the current synchronization of national plans on banking and capital account liberalization to accelerate ASEAN financial integration, to support the ASEAN Vision 2015. Following the Asian financial crisis in the late-1990s, in recognition of the need for the Asian region to strengthen regional financial cooperation as part of a multi-pronged strategy to prevent future crisis, governments of ASEAN and those of China, Japan, and South Korea, launched a network of bilateral swap arrangements under the Chiangmai Initiative (CMI) as a means to provide exceptional financing for Asian member countries in time of crisis. A parallel regional policy dialogue was also launched in 2000. To date, CMI has grown to become a key financial safety-net facility for Asia with a multilateral pool of USD 120 billion i.e., CMIM, supported by a formal process of policy dialogue and a permanent regional secretariat. ASA meanwhile has grown into a larger facility of USD 2 billion, but its role as a financial facility has been overshadowed by a larger CMIM. The global financial crisis of 2007-2009 provided ASEAN with an opportunity to test-run CMI as a regional financial facility against crisis. Although designed to be the region’s premium facility for exceptional financing, the CMI facility was not used during the recent global financial crisis even though there were genuine needs for financial assistance by CMI members. The key inhibiting factors have been the design of the CMI drawdown that links the last 80 percent of the eligible drawdown to an IMF program. This makes CMI a less practical option for securing timely short-term liquidity facility. Also, there were innate fears among smaller economies of ASEAN about the dominating role that the larger ASEAN+3 economies could play in the CMI activation process. These fears were not tested in the recent crisis because there was no demand for CMI by the smaller ASEAN economies. As it turns out, the non-activation of CMI instead served to strengthen the role of the large ASEAN+3 economies as potential providers of financial assistance in time of crisis through bilateral swaps. In the event, CMI members that needed financial assistance drew on non-regional sources of emergency financing, while others chose to reinforce the IMF and strengthen their financial positions there.

16

Such experience of CMI limitation as a regional safety-net facility at time of stress points to the needs to revamp the existing CMIM facility and its activation process so as to make it more attractive and practical as an emergency financing option for the economies of Asia. On this, a number of improvements can be made. First, CMIM can be made more expansive and more impactful by substantially increasing its size and lengthen the duration of contributions. Second, the dominance of the larger plus three countries in CMIM’s decision-making and activation processes can be lessened with larger future incremental contributions coming from ASEAN countries. And third, the delinked portion to the IMF should be increased. All these will help making CMIM more attractive and more accessible as a regional financing facility. On the other hand, without such improvements, the region will lack an effective regional financial arrangement that offers real protection to the regional economies against risk of crisis and contagion. More importantly, the experience also builds a strong case for ASEAN to step up its own regional financial cooperation to supplement the CMI facility. Such financial cooperation must aim to enhance the abilities and the capacities of the ASEAN economies as a group in preventing and managing crisis in ways that add value to domestic policy and complement the existing CMIM facility, as well as the international financial arrangements. 5.2 Developing ASEAN financial safety-net facility

Let us take ASA and the existing macroeconomic surveillance by the ASEAN Secretariat as a starting point. The most direct way for ASEAN to enhance its own capacity to deal with financial crisis is arguably through developing its own financial safety net mechanism against crisis. An ASEAN’s own safety-net mechanism will provide the region with an additional source of emergency financing at time of crisis, which will be particularly important for the smaller ASEAN economies. Such access will become even more crucial if the existing CMIM limitations remain. To move from ASA to a full-fledged ASEAN financial safety-net facility, the first step is to strengthen the ASA in terms of the size of the facility. Its size should be large enough to comfortably support the needs for exceptional financing of two smaller ASEAN economies at the same time. To complement CMIM, the new ASA must be designed as a short-term facility with quick disbursements that offers exceptional financing only for liquidity purposes. For the ASEAN5, the new ASA designed along this line will be useful as a short-term financing facility to meet sudden and unexpected liquidity needs, given the strength of their economies and their relative strong international financial positions. For the rest of ASEAN, the new ASA will be an important source of short-term bridge financing that can be made available more quickly prior to other long-term exceptional financing that is tied to policy adjustment when the need for such adjustment arises. This type of short-term financing facility will work well as a complement to the existing CMIM facility, which is of a longer-term nature given its linkage to IMF program. The second step to turn the current ASA into a proper financial safety-net facility is to link the newly-designed ASA to the existing ASEAN macroeconomic surveillance process. This linkage will provide the ASEAN economies with a regional policy process more suited as a crisis prevention mechanism, comprising an exceptional financing arrangement that is supported by a credible and effective macroeconomic surveillance.

17

Modality of the linkage between surveillance and exceptional financing can be designed in ways that transform ASA into a timely and predictable source of short-term financing. In parallel, ASEAN macroeconomic surveillance must extend its focus to include perspective on possible financial crisis risk and threats to the ASEAN economies. Such arrangement will complement well with the existing CMIM. The third step to transform the current ASA into an ASEAN financial safety net facility is to formalize the newly-designed ASA and the macroeconomic surveillance into an independent policy process of the ASEAN finance ministers that benefits all the ASEAN economies. The central elements of the new ASEAN policy process will be macroeconomic surveillance, policy dialogue and collaboration, and ASA activation when the need arises. This new policy process can be housed within the current ASEAN Secretariat for budget and operational purposes, but report directly to the finance and central bank deputies for policy deliberation, and finally to the ASEAN finance ministers for consideration. Such arrangement will give ASEAN finance ministers their own policy mechanism and resource to act jointly against risks of financial crisis in ways that complement the existing financial architecture both at the regional and the international levels. In addition to the progress already made on ASEAN financial cooperation, this paper shows that there is a prospect for ASEAN to further advance financial cooperation that will contribute to a stronger policy mechanism for the region to deal with risk of future financial crisis. In this context, the paper proposes a formalization of the existing ASA and the ASEAN macroeconomic surveillance into a single comprehensive regional policy process that will allow ASEAN leaders to act jointly in a more effective manner against risk of financial crisis. The proposed policy process combines the existing ASEAN macroeconomic surveillance with the newly-designed ASA into a full-fledged financial safety-net facility for ASEAN in ways that complement the existing CMIM. Apart from providing ASEAN with its own source of emergency financing, in addition to CMIM, this new mechanism will also provide ASEAN with a platform to discuss policy collaboration, while acting as an alternative source of emergency financing in case of continued limitations of CMIM and other regional financing facilities.

6. Conclusion This paper sets out to explore the issue of how prone the ASEAN economies are to another financial crisis in the next few decades. This is achieved by identifying the financial crisis risks most relevant for the ASEAN economies to the year 2030 and suggesting areas for policy reform, both at the national and at the ASEAN levels, to mitigate such risks, including ways to improve the resilience of ASEAN against future crises. The paper begins by looking at the financial crisis experience of ASEAN in the last twenty years in terms of the key policy lessons learned. Three lessons are singled out in the paper as important for assessing and managing future crisis risk. The first is policy both in reducing the likelihood of self –induced crises and in building greater resilience against shocks and contagion from the externally-led crisis. The second is the role that excessive debt and leverage play in a financial crisis, the dynamic of which is determined by ways in which the government, the financial system, foreign capital, and investors

18

contribute and react to the crisis risk, as well as trigger its onset. The third lesson is the areas of policy that are key to avoiding crisis risk and to building resilience and capacity of the economy to deal better with shocks emanating from outside. Next, the paper identifies five most plausible financial crisis risks that likely to be most relevant for ASEAN to the year 2030. They are: (1) a fiscal-led crisis linked to greater fiscal activism by government; (2) a classic boom-bust type of crisis that results from failure to properly manage capital inflows and the financial sector; (3) a crisis resulting from failure to manage abrupt reversals of capital flows; (4) crisis instigated by contagion from another global financial market-led crisis similar to the 2007-2009 global crisis; and (5) crisis that results from failure to manage shocks linked to a disorderly burst of global speculative bubbles. While the five crisis risks chosen can be subjective, they provide a comprehensive reference point to discuss the implications for policy with respect to crisis prevention. In the paper, the five financial crisis risks point clearly to the importance for the economy of having adequate policy capacities in all the four key policy areas, namely, economic and price flexibility, self-insurance policy, financial sector reform, and disciplined macroeconomic policy. At the individual country level, the five crisis risks are relevant for the upper-middle income ASEAN4 economies given their high financial openness and the current challenge in managing capital flows. Indonesia and Thailand are found to be more susceptible to the capital outflows risk on the basis of recent experience, while a fiscal-led crisis can potentially be an added risk for Malaysia and Philippine on account of the currently high deficits. And crisis risk relevant for Singapore and Brunei will mostly be external, in the form of contagion from a global crisis, given the relatively small domestic sectors in these two high income ASEAN economies. A limited openness to global financial markets mean that, for CMLV economies, the most relevant crisis risks will be internal, especially the fiscal-led crisis. Possibility of a boom-bust type of crisis in these economies will increase as their financial markets become more developed and more open to foreign capital. It follows from our view of crisis risk that strengthening the financial sector, maintaining disciplined macroeconomic policy, and increasing economic and price flexibility remain important areas of policy reform for the ASEAN4 economies, with fiscal consolidation a priority for Malaysia and the Philippine. Self-insurance to strengthen gross official reserves can be beneficial for Indonesia and the Philippine in the longer-term given the likelihood of a more expansive future financial contagion, while financial sector reform as well as economic and price flexibility will be the relevant areas of policy for Brunei and Singapore to focus on. As for CMLV countries, our view is that all the four policy areas are relevant and important. Finally, to enhance the capacity of ASEAN to deal more effectively with future risk of crisis in addition to the domestic policy reform, the paper sees a strong merit in advancing ASEAN financial cooperation to develop ASEAN’s own financial safety-net facility in parallel with improving the existing CMIM. This is not going to be a new or repetitive effort since it involves a strengthening and a linking of the already existing ASA and the ASEAN macroeconomic surveillance into a more comprehensive policy process that can usefully act as an additional crisis prevention mechanism. The relevance of this new ASEAN mechanism as a self-insurance facility for the region will be increasingly recognized as we move forward into a bigger role that the ASEAN economies will play in the global economy.