Actions by the US and other authorities are helping, but stresses in the global financial system persist.
I recently attended a seminar of Central Banks in the East Asia-Pacific Region and the Euro Area, and thought readers might be interested in where we stand currently in the continuing turbulence in the financial markets, and the responses of the authorities so far.
We now seem to be facing a situation where the stresses in the global financial system, especially that of the US, are affecting the normally smooth flow of financial intermediation, acting as a drag on economic activity and affecting the asset quality of financial institutions. There is a danger that this may become a self-reinforcing process, although obviously we all hope that it will not.
A great deal now depends on how conditions in the US housing market develop and how banks respond to a much more challenging environment. On the housing market, there are signs that the adjustment may be more protracted than first thought: falling house prices, rising mortgage delinquency rates, and an increasingly large overhang of unsold homes. The important question for those concerned with financial stability is whether, during the course of this adjustment, the viability of individual financial institutions, or even the financial system, comes under stress.
To the extent that the Hong Kong experience is relevant, it took housing prices almost six years to bottom out following the crash that accompanied the Asian financial crisis in 1997, adjusting downwards by a total of 65% on average. Obviously the dynamics of the housing markets in different jurisdictions differ, as does the ability of the household sector to service mortgages which may be in – and moving further into – negative equity, particularly if the economy is slowing. Household savings in the US cannot exactly be described as high, at least not high enough to give much comfort to those concerned about whether the household sector has the necessary staying power to ride out the problems in the housing sector.
The US authorities are making tremendous efforts to contain the so-called "jingle mail" phenomenon – a phrase used to describe the arrival of house keys posted back to banks by owners who can no longer service their mortgages. The list of measures taken and being discussed is long and wide-ranging, covering legislation (including the recent passing of the Housing and Economic Recovery Act of 2008 by the US Congress), and action at the lending and mortgage-institution levels. We must hope that these efforts are successful but the battle is still very much on with foreclosure filings up by 53% year on year in June and most home-price indexes showing further falls.
As for the banks' response to the more challenging environment, the Fed is obviously providing a lot of help, bravely venturing into uncharted areas, as the situation has clearly moved beyond the point where concerns about moral hazard were uppermost. Other central banks in the developed markets have also taken similar steps. The increased involvement of central banks in providing different types of financial support should help to avoid, or at least reduce, the occurrence of any more events like the Bear Stearns and Northern Rock incidents as the financial system adjusts to the new conditions, although the risk remains. It is comforting to see, for example, that the sharp quarter-end spikes in the spread between the three-month LIBOR and the three-month T-Bill yield that we saw in the last three quarters were more muted at the end of the second quarter of this year.
Obviously, however, all is not well yet, and the emerging markets in Asia continue to observe developments with some trepidation. There are three areas of concern. First, as the deterioration of asset quality becomes more extensive and not just limited to sub-prime-related financial instruments, the holdings of such assets by Asian financial institutions may become problematic. As far as Hong Kong is concerned, this is not a serious concern, since the exposure of local banks to sub-prime-related assets is small compared with their overall assets, and they remain well capitalised and have high levels of liquidity.
Second, as the stress on international financial institutions of the developed markets continues, the availability of external finance for emerging markets in Asia may diminish. With this coming at a time when inflation and other concerns are risking a reversal of capital flows into Asia, financial problems may emerge. Recent developments in Vietnam are a useful reminder of such risks. There has also been talk in the financial markets about capital outflows from some Asian economies because of concerns about inflation and current-account deterioration among others, requiring some central banks to intervene in the foreign-exchange markets to stabilise exchange rates.
Third, with the US economy slowing, effects through the trade channel are a real possibility.
How these concerns will play out remains to be seen. No doubt the authorities responsible for financial stability in the region will be monitoring developments with care.
In the next Viewpoint, I will look at some of the lessons that the emerging economies can learn from the recent problems.
Joseph Yam
7 August 2008
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