McKinsey Warns of Looming Asian Debt Crisis

The Asian financial crisis of 1997 wreaked havoc on the financial systems of Thailand, Indonesia and South Korea particularly, but the effects were felt all around the globe. To staunch further bloodletting, a loan of $118 billion was cobbled together by other nations and used to re-establish official cash reserves while buying time to rebuild confidence and stability in the affected economies without causing lasting damage to those economies’ external creditors.

The entire event was a close-run thing, however, and analysts at McKinsey & Co. are seeing “ominous” signs that Asia’s financial sector is once again deteriorating under the weight of servicing existing debt, vulnerabilities in the region’s financial system and slower foreign capital inflows remain lower than their peaks in 2007.

McKinsey’s Joydeep Sengupta and Archana Seshadrinathan analyzed 23,000 corporate balance sheets from both 2007 and 2017 and found that the interest coverage ratio (EBIT divided by interest expense) fell below 1.5. At that level, companies are using a large share of their earnings to repay debt.

In 2017, companies in five countries had coverage ratios below 1.5: Australia, China, Hong Kong, India and Indonesia. Those same companies also held long-term debt equal to more than 25%. In four other countries (Malaysia, Singapore, South Korea and Thailand), at least 40% of long-term debt was held by companies with coverage ratios of less than 3, a level, McKinsey says, at which companies “are likely to struggle to repay their debt.”

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Asia’s financial systems are once again showing signs of stress. Bank margins have fallen from 12.4% in 2010 to 10% in 2018 and are on track to converge with the global average of 9%. Borrowers continue to rely on shadow banking institutions for financing because only a few bond markets have the resources to reach those borrowers.

McKinsey notes that China’s shadow-banking lending reached as much as 55% of GDP in 2017. Because that debt is largely denominated in local currency, it is unlikely to spread dangerously beyond China’s borders. Still, default risk remains high. Among the countries included in the McKinsey study, only China shows long-term debt that exceeds total equity in the financial system.

Since reaching peak global cross-border capital inflows of $12.76 trillion in 2007 and falling to a trough of just $1.88 trillion in 2009, these flows have run between $6.35 trillion and $4.12 trillion between 2010 and 2018. To some that means that the world’s financial system is less interconnected than it was in 2007 — and that’s a good thing.

In Asia, cross-border capital inflows have surpassed their 2007 level six times, reaching a high of $1.62 trillion last year. Global capital inflows to Asia have surged from 12% in 2007 to about 36% in 2018, according to Sengupta and Seshadrinathan. That increase suggests that the region’s interconnection with the global financial system remains strong.

Asian economies thus present two clear risks to global financial systems. First, they remain vulnerable to any external shock. Second, as in 1997, any crisis in Asia “could send ripple effects across the globe.”

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