Asia Rising

Asia Rising

 

Thursday, Sep. 13, 2007 By PAUL MCCULLEY AND RAMIN TOLOUI , Time

Though the plot is the same 10 years later, a different actor is playing the lead. In 1997, Asian countries sent ripples through the global financial system, beginning with Thailand's devaluation of the baht after a collapse of the nation's real estate bubble. In 2007, it is the U.S. and its subprime mortgage borrowers causing the greatest disturbance in credit markets in a decade. At the root of the turmoil is aggressive lending to American home buyers who previously were unable to obtain credit. Financial engineers pooled these loans together and sold off pieces representing different presumed levels of risk. In the process, the nonbank financial institutions buying these "structured credit products" ? hedge funds and other supposedly sophisticated players ? replaced banks as the engines of credit creation in recent years. Unlike banks, however, these institutions lack deposit insurance and do not have direct access to central bank lender-of-last-resort safety nets. When the quantitative models used to measure default risk on the new mortgage-backed instruments vastly underestimated actual delinquencies, many of these investors found themselves with unexpected losses. Concern about just how far these losses extend ? and whether major financial institutions are at risk ? has caused global stock and bond markets to tremble in recent weeks as investors sold assets to raise cash. This presents a particularly thorny problem for policymakers. Central banks have used special injections of liquidity to prevent key interbank credit lines from seizing up. But the U.S. Federal Reserve has few levers to pull when it comes to the non-bank sector that is at the epicenter of the contraction. Many investors are betting that the Fed will have to do more, including making large cuts in interest rates, to restart credit creation and prevent further damage to the economy. A decade ago, the world also looked to Washington ? and, specifically, the International Monetary Fund (IMF) ? for deliverance from the financial turbulence. This was immortalized in a photograph of IMF chief Michel Camdessus peering over the shoulder of then Indonesian President Suharto, as the latter signed his country's agreement to receive IMF loans.

The memory of that image endured. Resolving never to relive such bitter experiences, Asian governments have since adopted fiscal, monetary and exchange-rate policies to sustain large trade surpluses. These policies create their own set of international and domestic problems, but they have also produced a situation in which Asian countries are now some of the largest creditors in the world, rather than the debtors they were back in 1997. This is one reason that many see Asia playing a role in the way out of the current financial mess. The massive trade surpluses of Asian countries have accumulated, in large part, in the coffers of the region's central banks. These reserves have been invested primarily in U.S. Treasury debt and other low-risk securities. As the reserves have swelled, there has been a growing call to boost the returns generated by these large stocks of assets. Asian private capital is also accumulating rapidly and can be put to work. Because of these developments, Asian countries possess an extraordinary reservoir of money to allocate to new investments.

During periods of financial stress, such pools of capital are integral to stabilizing the markets. Leveraged investors ? those that have borrowed funds to purchase assets ? are being forced to liquidate their holdings as the value of their collateral falls amid the financial market sell-off. It is the un-levered capital, like that in Asia, that can step in when the market decline is overdone to purchase assets that will generate an attractive return going forward.

Sophisticated investors are well aware of the opportunities presented by the current volatility. For example, amid the recent panic, the yields available on the corporate bonds of some companies with good prospects have shot up alongside those of weaker firms. Many investors who had stayed on the sidelines for some time, given the lofty valuations of stocks and corporate bonds, have now begun to take the opportunity to add selectively to their portfolios. It is likely that market turbulence will continue to test the discernment and fortitude of investors. Whether and how quickly the large pools of Asian capital rise to the challenges and opportunities presented by the new environment will have an important influence on global financial markets in the weeks and months ahead.