By RGE Monitor

The prognosis for Asia’s financial sector in 2009 is relatively better compared to other emerging economies and also compared to the region’s own experience in 1997-98. Even so, further GDP contractions and asset market corrections are likely as the external environment continues to deteriorate and domestic demand falters.

Asian economies do have fewer mismatches in external debt, lower imbalances in the government, corporate and banking sector balance sheets than their counterparts in emerging Europe, and as a whole used less leverage. Fortunately, ample foreign exchange reserves held by most countries in the region – even before the introduction of Fed swap lines and the IMF’s short-term liquidity facility – fully cover short-term debt and minimize the threat of a financial crisis. Intra-Asia swap agreements are helping provide liquidity to Asian countries with less ample reserves.

However, given the exposure of Asian economies to exports and to global liquidity, Asia is unlikely to lead the global economic recovery, being reliant instead on resumption of demand from the US Even so, solid macro fundamentals and a greater capacity to take fiscal and monetary measures will help Asian emerging economies recover faster and stronger, as compared to others. Those countries able to take on more aggressive fiscal and monetary responses, will outperform – but some of the recent responses including those of China risk exacerbating, not reducing overcapacities and domestic imbalances.

There are five critical areas of risk for Asia’s financial markets in the coming months:

1. Asset markets will witness further corrections
Equities: Corporate earnings are yet to fully reflect the slowing sales in domestic and foreign markets and financing issues faced by firms. This implies equity market valuations are less appealing than they seem. Markets heavy on exports, commodities, banking, real estate and consumer durables stocks are being most affected.

Real estate: exposure is the soft spot for Asia. With financing shortages and slowing domestic demand, further correction in real estate prices is expected in 2009. Commercial real estate is only now coming under significant pressure, especially in Asia’s financial centers but with the retrenchment of corporations further declines are likely, having a knock-on effect on construction.

Currencies: Deleveraging and easing capital flows will continue to take its toll on Asian currencies even as the export contraction weighs on the external balances of many and constrains countries from allowing currencies to appreciate. The deterioration of the global economy and need for dollar liquidity in Asia and globally will continue to support the dollar in the near-term.

With both equity and property markets yet to hit a bottom, banks will face rising delinquencies and non-performing loans.

2. Government debt will continue to grow
Fiscal stimulus spending and lower tax revenues are narrowing fiscal balances, pushing up government debt and financing needs. Bond issues have already been increased in the Philippines, India, Indonesia and Vietnam.

While rising bond issues make yields attractive, investor interest in Asian bond markets might remain low in 2009 given the risk of domestic growth slowdown, credit crunch and rising bond issues in developed countries (considered a ’safer-haven’).

Credit ratings of India and Taiwan have been downgraded on growing fiscal vulnerabilities while ratings remain ‘on watch’ for South Korea, Indonesia, Philippines, Thailand, Malaysia and Vietnam. Risk of sovereign default in Asia remains extremely low even in the case of Pakistan, where the IMF may step-up its rescue. In the case of Indonesia, the ADB may join in offering guarantees on bonds.

3. External debt will remain a risk
Currency and maturity balance sheet mismatches among firms and banks have declined since the 1997-98 crises. However, South Korea, Indonesia and Vietnam’s corporate and banking sectors remain vulnerable to short-term and foreign-currency external debt.

South Korea scores the lowest in the region on financial sector health. It has the highest loan-to-GDP ratio in Asia (of over of over 130%) with foreign-currency mismatches from bridge financing, and close to US$24.5 billion of foreign-currency short-term debt maturing in 2009, of which over half is held by branches of foreign banks. Currency swap lines with US, Japan and China only provide a band-aid. Asset quality is deteriorating rapidly as NPLs doubled in 2008 to 1.11% of total loans while delinquencies grew 46% y/y in December 2008, leading banks to curtail credit growth. Net interest margins (NIMs) are falling as the increase in long-term, high-rate bank funding via time deposits and bonds offset the Bank of Korea’s policy rate cuts. A government-backed bank recapitalization fund may provide some relief when it begins capital injections in March. But this may be offset by Japanese fiscal year-end repatriations, which could have Japanese investors refusing to rollover the US$1.98 billion of Korean short-term foreign-currency debt due in March.

Depreciating currencies pose additional risk to roll-over debt in South Korea, Indonesia and Pakistan. But swap lines with the Fed and with Asian central banks, as well as funds from multilateral agencies reduce the risk of default.