The recent bank turmoil in the US has awakened ghosts of past financial crises. While the likelihood of a fully-fledged crisis seems limited, it cannot be ruled out. Policymakers in the region must act now to shield their economies from possible negative spillovers.

High inflation last year prompted central banks in advanced economies to respond by rapidly raising interest rates. In the US, the Federal Reserve (Fed) increased interest rates aggressively from a very low base.

This Fed tightening is the fastest since the famous Volcker hiking cycle of the early 1980s and steeper than that started in mid-2004, which precipitated the subprime mortgage crisis eventually morphing into the global financial crisis of 2007-2008. As the global monetary tightening cycle gathered pace, financial fragilities resurfaced and financial institutions incurred losses on fixed-income assets.

In March, elevated risks of financial instability led to the failures of two medium-sized banks in the United States. While prompt policy support by the Fed and European Central Bank brought some calm, heightened uncertainty continues to permeate the banking sector across the globe. The episode revived memories of past financial crises as stock markets and consumer expectations remain jittery. 

Although the risk that we may be witnessing a period of financial turmoil in the US and Europe that may spill over into developing economies in Asia is currently small, it still warrants attention from policymakers.

Financial sector tensions in advanced economies are typically quickly transmitted globally, as fears of contagion spread, investors' sentiment sours, financial institutions withdraw funds from risky assets, and capital flows shift away from economies considered more vulnerable. Asia would not be immune to these spillovers, which could lead to significant financial market stress and slower growth in the region as well.

In a scenario in which bank lending standards tighten at about half the scale observed during the global financial crisis, the effects are sizeable, according to the Asian Development Outlook (ADO) 2023. Simulations suggest this would subtract a total of one percentage point from growth in the People's Republic of China this year and next, and half a percentage point in the rest of developing Asia.

In addition to the potential impact associated with slower growth, financial turmoil in the US and Europe could also extend to global financial turmoil that brings financial instability or even a fully-fledged financial crisis in the region. This will affect disproportionally more vulnerable groups, increase inequality and long-term unemployment, and leave in their wake persistent damage to the productive capacity of economies—thus, hampering progress on development goals.

In the short-term, risk monitoring across the financial sector and sound macroprudential regulations— such as requiring greater bank capitalisation when cyclical systemic risk is increasing—can be effective pre-emptive measures.

To address short-term liquidity difficulties, regional economies can also rely on local currency swaps, US dollar liquidity through swaps between central banks, and the Chiang Mai Initiative Multilateralisation—a regional currency swap arrangement. All these instruments underscore that an internationally coordinated response to periods of financial turmoil has become more important than ever.

Strengthening macroeconomic fundamentals is critical. Improving institutional quality and macroeconomic stability increases economic resilience in the face of financial turmoil.

Economies ranking high on these features also attract and retain more foreign direct investment, which helps lower financial stability risks as foreign direct investment is more stable than portfolio investment—particularly during crisis episodes.

Economies with high external debts should work towards mobilising more domestic resources and do so more efficiently. For instance, many Asian economies are highly dependent on value-added tax revenues, but these are typically relatively low as a share of gross domestic product, owing to various tax exemptions. Reforms aimed at rationalising value added tax exemptions would boost fiscal revenue and reduce tax distortions. 

Fostering financial sector development will also reduce exposure. For instance, deeper local currency bond markets supported by domestic institutional investors decrease dependency on external borrowing and can channel savings into domestic assets, decreasing currency risk. More liquid currency hedging markets also limit external risk and provide better trade financing.

Developing economies in Asia can, therefore, rely on a variety of tools to deal with the potential spillovers from the current financial turmoil. Policymakers in the region should act to strengthen financial systems. A severe crisis, though unlikely, could have significant consequences.

Arief Ramayandi is principal economist at the economic research and regional cooperation department at the ADB. Irfan A Qureshi is an economist, Matteo Lanzafame is a senior economist and Yuho Myoda is an economist.