The U.K may have voted to exit the EU, throwing markets into in a tizzy, but Asia should come through this episode with only a few scratches. The trade exposure to the U.K. is minimal for most Asian economies. The risks to direct bank financing from U.K. financial institutions appear manageable. The impact of currency swings -- in particular a stronger yen -- are harder to judge, tightening financial conditions for emerging markets in the region. Still, the fragility of the West, economically as well as politically, is a reminder that Asia cannot count on an export rebound any time soon to lift ailing growth. Reforms are urgently needed to put local demand growth on a more sustainable path.
Here is how to think about Brexit's impact on Asia: three areas matter. First, trade. Exports to the U.K. might be hit by a weaker pound, slowing growth locally. That is broadly manageable. For most economies, the direct export exposure to the U.K. was less than 1% of gross domestic product in 2015, except for Vietnam (2.4%), Hong Kong and Singapore, with numbers for the latter two flattered by their status as regional transshipment hubs. Of course, if Brexit reduces demand across the whole EU as well, the impact on Asia will prove more significant. For example, Vietnam, Hong Kong, Singapore, Taiwan, and Thailand have quite high exposure to the wider EU, at above 5% of GDP, and even South Korea and China, at more than 3%, are also materially exposed.
Second, bank lending. It has become customary in recent years to think of portfolio flows as a major source of emerging market financial vulnerability. However, bank lending often proves quite sticky, especially equity financing, during periods of financial volatility. Moreover, portfolio flows to a large extent originate from the U.S., Japan, or intra-Asia, while flows from the U.K. are intermediated through London, but only to a small extent originate from British savers. It is also not clear whether a weaker pound (or weaker euro if economic stress were to spill into the wider EU) would necessarily lead to precipitous capital outflows from Asia, especially if expectations remain that the pound could weaken further.
What really matters in this context is bank lending. During the Asian Financial Crisis, for example, it was the withdrawal of international bank financing that put a squeeze on local borrowers. How worried should we be about this? Not overly. First, in many economies, bank lending from the U.S. and/or Japan is more important than that from the U.K. Second, the vast majority of U.K. bank lending to Asia (especially Hong Kong, Singapore and Malaysia) is accounted for by institutions that finance their operations via local deposits, which sharply reduces the risk of a lending squeeze. Elsewhere, exposure is often in the single digits when measured as a share of GDP.
However, look closely and a broader risk becomes apparent. Note that in a number of markets Japanese banks (for Australia, Indonesia, Malaysia, Thailand, and Vietnam) and U.S. banks (for Australia, India, South Korea, and Taiwan) provide sizable cross-border loans.
This brings us to our third area, currency swings. Suppose the yen and U.S. dollar appreciate sharply, and for a prolonged period, against other currencies. This could lead banks (and some portfolio investors, for that matter) to pull funds out of emerging Asia, tightening financial conditions in the process.
In this context, there are two policy decisions from an Asian perspective that need to be watched especially closely. First, the Bank of Japan. If Japan's central bank stands idly by, without intervening directly in foreign exchange markets, and forgoes further easing, either next week at an extraordinary policy meeting or at its scheduled meeting in July, the yen could soar, pulling funds back into Japan and hurting lending and portfolio investment in places like Australia, New Zealand, Indonesia, Malaysia, and South Korea.
Second, the People's Bank of China. If the dollar starts to appreciate, the question becomes whether Chinese officials will allow their currency to rally with the greenback, or let it fall behind. Fears over material yuan weakness could then quickly reverberate around the region, causing other currencies to fall, possibly by a greater degree. This, in turn, could push up local borrowing costs and hurt growth, which often remains highly credit dependent. Better hope that China will keep things as steady as possible.
So, what is the bottom line? Well, you might not be able to tell from the immediate market reaction, but Asia is in a reasonably strong position to withstand the latest tremors from Europe. Still, Brexit highlights the fragility of demand in the West. Exports will not be a reliable growth driver for Asia in the foreseeable future. Officials thus need to focus on strengthening domestic demand and make it sustainable. Rate cuts and fiscal stimulus packages are no longer enough. Only structural reforms can wean Asia off its credit dependency and reinforce investor confidence. Asia has plenty of homework to do. Better get on with it.
Frederic Neumann is co-head of Asia Economics Research at HSBC.