China: What A Swell Party This Was as Punchbowl Leaves

naked 1, whether the punchbowl has been left at the party for too long 2, and who will be left without a chair when the capital inflow music stops? Though markets are clearly fearful that a repeat of the debilitating capital outflows period of 1994, also a Fed tightening cycle and one when bond yields rose significantly, that ultimately led to the Asia Crisis of 1997-98 is playing out; there are some vitally important structural differences that suggest that this would be a tail risk event even given the dramatic size of capital flows seen to date. The generous liquidity party may have stopped, but our core scenario is that the region avoids a ghastly hangover for several key reasons:

1. The region in general, with the exception of India and Indonesia, has moved to and remains in current account surplus compared to the period of the early 1990s.
2. The region has accumulated a significant stock of FX reserves over this corresponding period.
3. Regional initiatives such as the Chiang Mai initiative allow the pooling of these reserves and extension of swap lines if any country finds itself in the need of needing emergency funding.
4. There is not the currency mismatch between assets and liabilities that was a feature of capital inflows in the early 1990s. A feature of the QE driven liquidity ‘push’ into the emerging markets is that it has been chasing higher yield and this has fostered growth in local currency denominated debt within Asia.
5. The macro-prudential environment, particularly in the banking sector, is considerably stronger and some central banks are already taking precautionary steps to strengthen this further. Bank Indonesia is a key example here.
6. The macro backdrop we see evolving in the latter half of 2013 and through 2014 will ultimately be constructive for Asia – that is, reflation in Japan and a more durable recovery in the US.

Still, we are not ignoring the risks. Capital inflows into the emerging world have been large and Asia has attracted a disproportionately high share of them. There are asymmetrical entry and exit points for quantitative easing which mean that capital has flown into these economies more easily and outflows may prove to be more problematic. As a final overlay, we note that capital outflows and the risk of disorderly currency depreciation (possible currency and current account crises) are occurring when some economies have elevated credit cycles that may expose domestic banking and financial sectors to additional risk. It is these risks or vulnerabilities which may expose who has been swimming naked when the generous liquidity tide was all the way in.

Not surprisingly, given the seemingly greater frequency with which systemic financial crises occur (1997 and 2007), multilateral institutions have been devoting considerable attention to what are some of the early warning signals that these could be occurring. We note that both the IMF and BIS focus on dislocations in the credit cycle as useful leading indicators and use this note to benchmark the Asian economies we cover on these two measures.

1. BIS Focuses On The Speed At Which Credit Is Dislocating.

The Bank for International Settlements (BIS) suggests that when private debt as a share of GDP accelerates to a level 6% higher than over the previous decade, such an outcome usually is a symptom of serious financial distress in an economy.

2. IMF Focuses On The Duration Of Credit Dislocation

In a similar vein, the International Monetary Fund (IMF) suggests that when private credit grows faster than the economy for 3-5 years, the rising ratio of private credit to GDP usually signals some degree of financial distress.

So How Does Asia Fare On These Metrics?

First, a note of caution! The IMF and BIS have generally used these metrics to apply to the developed world. A key feature of the emerging world is that credit and leverage generally rise as an economy develops. That is, emerging markets generally display a rising credit intensity of growth aligned with financial deepening and this is generally a benign dynamic, as long as it is not taken to excess.

Read More: China Total Credit Increases $1 Trillion In Q113

Credit intensity is a term, normally in reference to the ratio of private domestic credit to GDP, used to describe the incremental change in credit required to generate one percentage point of growth. A clear feature of the emerging markets and of Asia in general is that the credit intensity of growth, which has been on a rising trend since the early 1980s, has stepped up markedly since the Asia crisis and the global financial crisis. That is, after each of these episodes, it has taken increasingly greater leverage to drive the same amount of economic growth.

A simpler way of expressing this is to simply look at the levels, that is to say that economies have become more leveraged because issuance of debt has increased faster than nominal GDP. This is perhaps too simplistic. We are interested in what is the economic impact of the marginal change in debt levels from period to period is on economic activity.

A rising credit intensity of growth is not necessarily a malignant signal. For the emerging markets in general, a rise credit intensity often goes hand-in-hand with financial deepening and is therefore a welcome signal, ultimately signalling the increased intermediation of high, often surplus, levels of savings by the domestic financial sector. Another explanation is that the relationship between credit and growth is non-linear. That is, as economies develop and their real sectors become more sophisticated, a greater quantum of credit is required to finance more elaborate economic activity and processes.

However, past a certain point, rising credit intensity may signal far less benign dynamics. The simplest explanation would be that credit transmission mechanisms start to weaken, that is, the same amount of money is simply not getting through to the real sector. The second explanation would be that there are growing externalities or leakages, that is, credit meant for the real sector is recycled back into the financial sector via investment in financial assets. Asset inflation, rather than growth, becomes the consequence of a rise in credit intensity. The final explanation is the most pernicious. After a certain point, new credit is being used to finance the obligations of the stock of credit that has built up in the past. At this point, the credit cycle will have extended well beyond anything that could be justified by economic fundamentals and actual credit dynamics will have dislocated significantly from the real sector.

This final explanation is at the heart of the early-warning metrics the BIS and IMF have attempted to establish. Past what point is a rising credit intensity of growth