Global financial conditions over the past few years have oscillated between tightening and easing as central banks shifted their monetary policy stance in response to the COVID-19 pandemic, rising inflation, and geopolitical tensions.

Easy financial conditions in major markets started to gradually reverse in late 2021 amid the rise in global inflation. Central banks, led by the US Federal Reserve (Fed), responded with forceful monetary tightening in 2022, after the spike in commodity prices triggered by the war in Ukraine in March 2022, leading to an aggressive tightening of financial conditions. Market perceptions that the Fed would reduce its pace of monetary tightening saw conditions ease somewhat after November 2022.

The regime shift from a “near-zero interest rate with ample liquidity” to one where rates are “higher-for-longer” with receding liquidity can be disruptive. And it could expose hidden and/or less-visible financial vulnerabilities, manifested in elevated bond market volatility and underperformance in US banking stocks that have yet to recover from the sharp falls in March 2023 with the collapse of the Silicon Valley Bank.

Financial markets in ASEAN+3 (comprising ASEAN and China; Hong Kong, China; Japan; and Korea) have weathered this global storm reasonably well. The effects of global monetary tightening and elevated market volatility on regional assets were notable, but varied in scale and timing.

Relative to US markets, most regional equity and bond markets experienced milder fluctuations in 2022 and 2023, partly because monetary policy tightening in the region was less aggressive than in the US because inflation was generally more moderate. Most regional currencies weakened against the US dollar, largely driven by the change in interest rate differentials as US policy rates rose at a faster pace.

ASEAN+3 authorities are facing challenges in safeguarding financial stability against the inflationary backdrop, as it is for policy makers outside the region. While financial markets consider the Fed to be close to the end of its tightening cycle, the risk of further tightening cannot be dismissed amid uncertainty over how long inflation will remain elevated. A resurgence of inflation cannot be ruled out given the strength of the US economy, its robust labor market, the El Nino phenomenon, and the risk of an escalation in geopolitical conflicts. The realignment of market expectations to the “higher-for-longer” scenario can lead to increased volatility in markets.

Banking stress in the US and Europe has had limited spillovers to ASEAN+3 markets, but risks remain. The March bank run raised significant concerns about the health of the banking system across the world. Although ASEAN+3 banks appear resilient, financial stocks still fell reflecting heightened investors’ risk aversion. The lack of recovery in US banking stocks highlights lingering investor concerns about the financial sector, as shown by elevated market betas.

Increasingly interconnected and complex financial systems, and a high degree of dollar dependence in the region could amplify financial system risks and vulnerabilities. Faster cross-border capital movement, boosted by more integrated financial markets and digitalization, could propagate shocks much faster than before.

Banks and nonbank financial intermediaries (NBFIs) could face increasing risks of deposit runs, facilitated by social media and digitalization of bank transfers. US dollar funding stress may re-emerge, as monetary and quantitative tightening in the US could combine with a sudden shift in risk sentiment to create a shortage of dollar supply.

With dollar finance increasingly channeled through NBFIs, stress could build up quickly. Lower rated financial institutions will be more vulnerable to the “sudden stop” in access to dollar liquidity that could happen amid concerns over counterparty risks.

ASEAN+3 central banks should prioritize price stability, while preserving financial stability and supporting growth. When conflicts arise between inflation and financial stability objectives, a coordinated approach involving monetary, fiscal, and macroprudential measures is warranted to achieve the right balance.

To insulate the financial system from liquidity stress amid monetary tightening, central banks should make sure that regular liquidity facilities are available for banks. In economies where NBFIs are systemically important, authorities may need to strengthen regulatory, supervisory, and risk management measures.

In emergency situations, authorities should be prepared to provide temporary liquidity support for the orderly functioning of core financial markets, in order to limit contagion to the banking system or the broader economy. A liquidity backstop for NBFIs should be carefully designed, with clear communication to avoid lending to insolvent institutions, and to strike a delicate balance between crisis prevention and moral hazard concerns.

Regional authorities should cooperate to ensure continued availability of US dollar liquidity in times of stress given that the dollar remains the dominant currency in trade, investment, and financial transactions in the region. While reducing dependence on the US dollar could contribute to regional financial stability, this objective will be a multiyear initiative which would require close regional cooperation.