By DOMINIC BARTON
From The McKinsey Quarterly
Last year marked the 10th anniversary of the beginning of the Asian financial crisis, a collapse brought on by macroeconomic imbalances that exposed fundamental weaknesses in Asia's corporate and financial sectors. The sequence of events that began with the Thai baht's collapse in July 1997 ultimately cost the region tens of billions of dollars and led many observers to speculate about an impending "lost decade" in Asia.
Today, after a remarkable 10 years of transformation, Asia's financial system is substantially deeper and more robust than it was in 1997. Sitting atop an enormous rising economic tide, it is poised to benefit from a host of factors, including the rise of China and India, the re-emergence of Japan, robust intraregional trade, enormous infrastructure-financing needs and the opportunities presented by increasingly powerful Asian sources of capital. Asia appears set to play an important role in the world's financial system over the coming decade -- a true third partner in the global triad, along with Europe and the United States.
But it would be foolhardy to believe that Asia has been immunized against imbalances, shocks and dislocations. The sheer pace of growth and financial innovation across the region makes it inevitable that imbalances will build and shocks occur. Asian risk-management systems may have improved, but they have not become fully mature in just a decade.
Asian regulators and CEOs of financial-services companies have concerns about the coordination of central banks, regulators and government ministries -- both within and among the region's countries. Asian financial institutions face ever-stiffer competition for talent at a time when their activities are becoming increasingly complex. And worrying signs of asset bubbles are emerging in China, Hong Kong, Indonesia, Singapore and Vietnam.
The Asian financial system will achieve truly global stature only if a number of critical improvements and initiatives, which should put the region on a stable path for the next decade, are implemented over the next two or three years. It has a very good chance of maintaining its momentum and emerging as a global leader, but it will take concerted effort to build on the progress of the recent past.
YESTERDAY AND TODAY
During the next 10 years, the region is poised to rival Western Europe as a pool of financial-services revenues. From 2005 to 2015, Asia could contribute more than 27 percent of projected global growth in financial services, up dramatically from the 13 percent of 2000 to 2005. Asia's share of global revenues could easily rise from 20 percent in 2005 to more than 25 percent by 2015.
Given the blow the region suffered in 1997 and 1998, this is a remarkable outlook. But to achieve it, Asia's executives and policy makers must recognize the value of the reforms left unfinished from the Asian crisis -- and work to complete them.
The contours of the Asian financial crisis are broadly understood. In the years leading up to 1997, enormous short-term foreign funds flowed into a variety of longer-term investment opportunities, with the assumption that exchange rates were essentially fixed. Much of that funding passed through structurally weak and underdeveloped banking systems into equally weak corporate sectors.
This flood of relatively cheap foreign funds generated speculation in real estate and other sectors, fueled by strong direct and indirect links between banks and corporations. Net foreign reserves were largely negative or just barely positive in many Asian countries. When the baht collapsed, it quickly became clear that linkages among them were much denser than regulators understood. Few, for example, realized that South Korean merchant banks, guaranteed by South Korean commercial banks, had been providing significant loans to Thai property developers and buying Indonesian derivatives.
Ten years later, many of Asia's key micro and macro metrics have improved dramatically. Exchange rates, once mostly fixed, are now mostly flexible or floating. (China remains the significant exception.) Ratios of foreign-exchange reserves to short-term debt are better in all Asian countries. The composition of foreign funding in Asia has shifted and improved: Short-term lending from foreign banks has been halved as a percentage of GDP -- to 4 percent, from 8 percent -- and the proportion of loans in local currencies has risen from 16 percent in 1995 to 42 percent in 2006.
Economic growth is strong across the region, and interest rate differentials are on the whole lower than or similar to those in the United States.
At the micro level as well, there has been broad improvement. Banks are considerably more profitable and efficient than in the years before the crisis. Since the late 1990s, the proportion of national banking assets owned or tightly controlled by the state has decreased. In many countries, national banking systems have become much more open to foreign competition. In South Korea, for example, foreign banks control more than 10 percent of total assets, up from 2.7 percent in 1997.
Banking systems have also consolidated dramatically, and if recent trends continue the region is likely to become home to a greater proportion of the world's most significant financial institutions. Already, four of the top 10 banks, by market capitalization, come from Asia. Over the next 10 years, we believe that the underlying growth of Asian markets will propel even more into the top ranks.
(We should recall that Japanese banks were dominant globally in the late 1980s. The difficulties they subsequently encountered at home and abroad offer lessons to Asia's emerging financial leaders. Some are taking steps to avoid such difficulties: Certain Chinese banks, for example, have formed joint ventures and partnerships with foreign institutions and are focusing on building up their capabilities.)
