Covid-19 exposes Asian banks' vulnerability to US dollar funding: ADB

US dollar-denominated lending has increased across banks in high-income Asian economies, notes ADB briefing paper

The Covid-19 pandemic has unravelled global financial markets, putting Asia's financial resilience to the test, the Asian Development Bank (ADB) said on Tuesday.

As economic losses associated with the pandemic are set to rise, Asian stocks have plunged and short-term portfolio flows reversed sharply in March, putting local currencies under severe pressure.

Amid flight to safety, global demand for the United States (US) dollar soared, risking the tightening of local financial conditions in emerging Asian economies which remain heavily exposed to US dollar funding risks.

"While multiple factors are behind the surge in demand, it is a global rush to unwind carry trades that have driven a rise in global US dollar funding costs," ADB said in a briefing paper.

The London Inter-Bank Offered Rate (LIBOR) overnight index swap spread exhibiting a pattern similar to that of the global financial crisis, indicates that interbank money markets came under severe strain due to a spike in US dollar demand during the Covid-19 pandemic.

"The cross-currency basis swap widened for a number of emerging Asian currencies and to a much greater degree than it did for the euro, British pound, or Japanese yen," said ADB.

"As in past financial crises, emerging Asian financial markets and currencies have borne the heaviest brunt, reflecting their underlying structural vulnerabilities to US dollar funding risks."

Measures taken by the US Federal Reserve to establish swap lines and introduce a temporary repo facility helped arrest panic on the US dollar funding market. Despite the improved health of Asian banks relative to past crisis periods, fundamental weaknesses remain.

Post-crisis reforms have improved banking and financial soundness across many economies in Asia with stronger regulation and supervision.

However, international activity at Asian banks has increased substantially over the past two decades, the majority of it denominated in foreign currency (primarily in US dollar) -- about 80 per cent as of the third quarter of 2019.

ADB said the cross-border banking operations of Asian banks have also led to expansion on both the claims and liabilities sides.

US dollar-denominated lending has increased across banks in high-income Asian economies while dollar-denominated borrowing ticked up across emerging Asian economies, underlining the growth in underlying US dollar funding needs of Asian banks through foreign exchange swap markets.

While Asian banks' exposure to US dollar funding risks rises, currency hedging mechanisms and instruments remain underdeveloped in the region, said ADB.