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Beware the systemic zombies roaming in Asian markets

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A passerby walks past an electric monitor displaying various countries' stock price index outside a bank in Tokyo, Japan, 22 March 2023 (Photo: Reuters/Issei Kato).

In Brief

It’s only when the tide goes out that we discover who’s been swimming naked. It’s an old gag, but the financial implications of this are becoming all too apparent as the world hits a bout of financial turbulence.


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Both inflation and interest rates have been at rock bottom for more than a decade in most advanced economies. Both are now back up again with a vengeance, and that’s causing headaches for Asian economies in three key areas.

The first is financial instability. As interest rates rise in advanced economies, particularly the United States, financial capital flows out of Asia’s developing countries and into the advanced economies where returns are higher.

This puts Asia’s developing economies in a squeeze. They can either raise interest rates to keep capital in their economies despite the negative impact of rate rises on growth, or they can let the capital leave and suffer from the reduced long-term investment they need for economic development.

Things can get much worse more quickly for Asian economies with foreign denominated debt: Sri Lanka is a prime example. As foreign capital leaves their economies, their exchange rates fall against an already rising US dollar. If their debts are denominated in US dollars — the original sin in finance — the consequence is brutal: their debts get bigger while their ability to service those debts shrinks.

The second headache for Asian economies — both developed and developing alike — is so-called zombie firms. Politicians don’t like to confront the fact, but the failure of businesses is normally a good thing.

If a business is unproductive and uncompetitive, it will be knocked out of the market by more innovative rivals. The workers and capital employed in those old businesses are soaked up into the innovative new business. The outcome is that the economy’s resources — capital and labour — are being used more productively, resulting in higher wages and growing living standards.

Decades of low interest rates and cheap money may have slowed this process of what economist Joseph Schumpeter called ‘creative destruction’. The result is zombie firms: businesses which should be dead but, thanks to ultra-low interest rates, continue to survive and are a drag on potential growth.

As interest rates and inflation rise, more businesses will fail. The rate of businesses failing in the US is 2.5 times higher than before the pandemic. This is a good thing. But policymakers need to beware of the ‘systemic zombie’.

This is the third big headache facing Asian economies. If a zombie firm has systemic implications for the rest of the economy or financial system, then the collapse of that zombie could have big economy-wide consequences. In China, the worry is about the solvency of the real estate sector, but there are more important zombie firms to worry about. The situation where this is most likely to occur is where the ‘zombie firm’ is a ‘zombie bank’.

The collapse of the Silicon Valley Bank and the troubles facing Credit Suisse and a handful of other banks are cases in point. The normalisation of monetary policy with rising interest rates and inflation is intimately linked to the challenges we are seeing.

All banks are inherently risky. But Silicon Valley Bank was in another league.

Banks are inherently risky because their business model is based on a maturity mismatch. They borrow short-term by taking deposits from customers and lend long-term through products like 25-year mortgages. If enough depositors pull their money out at the same time — a bank run — the bank collapses.

This risk is managed by the banks themselves and by government regulators. In the case of Silicon Valley Bank, both failed to act sufficiently quickly.

The bank developed a portfolio that was extremely risky by being overwhelmingly exposed to a single sector in the economy (the tech sector) and a single type of client (start-ups) who had deposits far in excess of what is insured by regulators. By parking the deposits in long-term government bonds and other types of debt, they failed to hedge their one-way bet on interest rates remaining low.

The regulators, in turn, failed to notice this huge accumulation of risk, failed to respond early and failed to be properly prepared with a regulatory framework that would stop a panicked bank run in the first place.

The experience of Silicon Valley Bank and Credit Suisse provide important lessons to Asian economies.

Faced with these three headaches — financial instability, zombie firms and banking pressures — Asia’s economies need to get their regulatory houses in order. At the heart of this is tighter surveillance and better crisis response.

Surveillance means that, unlike with the Silicon Valley Bank, regulators can monitor risks in the banking system before they materialise. Asian regulators have invested heavily in such surveillance since the Asian financial crisis. But now is the time to test those institutions through scenario planning and stress test exercises.

Crisis response means that Asian regulators have a regulatory framework in place that can stop a crisis from spreading and getting worse. It means that if a bank suffers a liquidity crunch, the central bank can step in quickly to support it, or if a bank suffers a solvency crisis, it can be resolved without causing systemic damage to the rest of the financial system.

In this week’s lead article, Masahiko Takeda considers these challenges in the context of Kazuo Ueda assuming his new role as Governor of the Bank of Japan this month.

Japan, says Takeda, is facing three critical challenges.

First, Japanese authorities may have become addicted to ultra-loose monetary policy but now that the output gap has closed in Japan, it would be a good time to test the patient’s resilience to a gradual reduction in heavy medication.

Second, the latest Japanese financial system report found that some financial risks are close to the highest level since records began in 2002, specifically the risk to financial institution’s balance sheets (especially those of regional and local banks) from a 100-basis point upward shift in the yield curve.

And third, rising interest rates could also have significant implications for Japan’s unprecedented public debt. Takeda warns that a mere 100 basis point upward shift in interest rates would increase the government’s annual debt servicing costs, reaching 3.6 trillion yen, or 15 per cent of consumption tax revenue this year, by 2026.

Takeda’s warning is simple: the longer you use sedatives, the harder it is to live without them.

Asia’s economies need to start preparing now.

The EAF Editorial Board is located in the Crawford School of Public Policy, College of Asia and the Pacific, The Australian National University.

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