29 - Impact of Eurozone Financial Shocks on Southeast Asian Economies

Summary

INTRODUCTION

Five years after the Global Financial Crisis (GFC), the economies of the United States and the eurozone continue to struggle, with the eurozone recovery lagging behind that of the United States.

European banks’ funding conditions have been worsening as evinced by slower bond issuance (Bank for International Settlements 2012). Worries about the health of the banking system have also led to a rash of withdrawals by bank depositors. The banking system in the United States is relatively healthier as losses have been recognized and banks have undertaken recapitalization. Nevertheless, the troubles facing European banks could also affect the liquidity situation in the United States.

Given the fragility of the financial system, what are the possible impacts of a shock to the financial system in the eurozone on the economies of Southeast Asia?

SOUTHEAST ASIA AFTER THE GLOBAL FINANCIAL CRISIS

The initial impact of the 2007/08 GFC was felt more on the real side. A huge decline in exports led to a sharp slowdown in the region's economic growth. However, this impact was short lived.

On the financial side, there was also an initial outflow of foreign capital from the region's economies. However, fund inflows resumed quickly. The region's financial system has become more resilient following the reforms carried out after the 1997/98 AFC. Nevertheless, capital inflows to the region have remained volatile.

The inflow of foreign capital to the region can be beneficial as it supplements the domestic resource base and facilitates the transfer of technological knowledge and managerial expertise from abroad. However, sudden stops and reversals in capital flows could disrupt financial systems and lead to macroeconomic instability.

An attempt to sterilize inflows will only create excess liquidity in domestic financial markets, resulting in exchange rate misalignments, and ultimately derailing economic stability and growth. Policy-makers fear that the surge in capital flows could lead to asset bubbles and exert upward pressure on the exchange rate.

Given the threat to the region's economies, governments acted quickly to implement fiscal and monetary stimulus. Higher initial policy rates compared to those in the United States and Europe provided ample room for the region's monetary authorities to reduce interest rates.

Monetary policy easing has had the desired impact of increasing bank lending in the Asian economies.