If these risks are real, what should we do? These are vital questions for every investor, financial risk manager and executive whose business is impacted by Asia. Financial contagion is the propensity for a financial crisis affecting a specific country or market to spread across borders or trading networks. Financial crises often propagate rapidly with more devastating consequences than are attributable to simple cause and effect mechanisms. Sometimes, contagion spreads through channels of real economic or financial interdependence. Investors, having suffered a shock in one market, may reallocate their portfolios to take account of new risk preferences and new correlation assessments. Or financial agents may be so weakened that they are forced to forgo opportunities or cut back operations in an otherwise profitable market. At other times, seemingly unconnected regions or markets may be infected because of investor psychology, such as herding behavior, or asymmetric information flows that distort normal market responses to changing conditions.

Close study of economic data suggests that, at the beginning of the third quarter of 2008, the United States is not in recession. Housing and motor vehicle industries have been adversely affected. While housing is clearly in a cyclical downturn, rising fuel prices have hurt motor vehicles sales. But these elements have not dragged the US into recession as other areas, particularly computer electronics, have shown strong growth. Analysis of funds flows in the US shows non-financial corporate borrowing has continued to hold up, but household borrowing has been affected. Looking at the financial sector, total borrowing declined dramatically in the first quarter of 2008, but the reduction was concentrated in a few market segments. Commercial banks and securities dealers also faced liquidity issues, causing the Federal Reserve to institute a new term auction facility for banks and a new terms securities lending facility for primary dealers.

The downturns in US housing and motor vehicles are not likely to seriously affect China and Hong Kong. However, if weakness spreads beyond these sectors and consumer spending falls in a worsening economy, China’s export sector will be more broadly affected. The portion of the US-China balance of trade that these industries represent, while significant, is not of such proportion as to put Chinese economic growth at risk from declining exports. As for financial linkages, while Hong Kong and Chinese commercial banks had some exposure to subprime and asset-backed securities, these have been comfortably absorbed. Accordingly, the case for propagation through real economic or financial independence is weak. A note of caution should be sounded, because even though banks in China and Hong Kong appear to have adequate levels of capital and good returns on equity by international standards, the long-term loan-to-deposit ratio at Chinese banks grew substantially in 2007 and the loan duration structure was not ideal.

As banking in China is dominated by the Big Five state-sponsored banks, the sector is potentially more susceptible to shock than in the US or Western Europe. To some extent, this vulnerability extends to Hong Kong because of the importance of Chinese banks in the local markets. Of greater importance than economic or financial interdependence is the risk of transmission of financial shocks because of investor psychology and herding behavior. The US markets and the Shanghai and Hang Seng markets are much more correlated than before. Movements in the S&P 500, the Shanghai Stock Exchange A Share Index and the Hang Seng Index show a market linkage between the US and, to a lesser degree, European global capital and stock markets and Chinese and Hong Kong markets, especially as regards large-scale movements. These seem more attributable to psychological factors affecting investor behavior than to real economic or financial factors. Financial market disruptions can of course have economic effects as, for example, when stock market declines adversely impact loan to capitalization ratios and trigger credit tightening by lenders.

So, how resistant are China and Hong Kong to financial shock? The banking and securities industries in Greater China are subject to institutional vulnerabilities that could impact their ability to resist global financial contagion. These financial systems have been strengthened. For example, studies show Chinese equity securities markets are more capable of absorbing price shocks now than 10 years ago and that bid-ask spreads have improved considerably. Capital positions of major banks have also improved, loan portfolios have been pruned and payment systems modernized. Hong Kong now has one of the most sophisticated real-time gross settlement platforms of any financial market, while China has improved its payments systems. Nevertheless, in China in particular, the broker-dealer industry remains relatively under-developed and under-capitalized and risk management is generally weak. Also, the Chinese stock markets suffer excess volatility.  

Investors, risk managers and executives need to take account of these vulnerabilities in scenario assessment and stress-testing. Studies of the response of leading U.S and European global investment banks to the subprime credit crunch reveal weaknesses in risk management systems that relied too heavily on misleading historical correlations and out-dated paradigms. In addition, risk was compartmentalized rather than assessed on a comprehensive institution-wide basis. These mistakes ought not to be repeated.

Published by PROJECT M in December 2008