The return of political and economic stability to East Asia has been tentative. The process of adjustment is proving difficult. For the medium term at least, we expect capital investment to be selective. Consequently, there will be more price and capacity discrimination in the financing available to fund these investments.

Despite the V-shaped recoveries that crisis economies have been undergoing following their plunge into recession during 1997-98, investment has remained in the doldrums (chart 1). Growth has instead been export-led (thanks to depreciated currencies) and fiscally-driven, with some evidence that consumption is also now starting to recover.

Over-investment for many years into projects of marginal commercial value in the approach to the crisis was largely the reason economies succumbed. And one of the legacies of the over-investment is a large overhang of unused production capacity that businesses are now working to eliminate.

The absorption of excess capacity has not been uniform across all countries and industries. Over the past year, some bottlenecks have started to appear. That has in turn led to an upturn in investment and in capital goods imports (chart 2), but only in Korea are capital goods imports back above pre-crisis levels.

Hesitant and patchy investment isn't the only thing holding back demand for capital goods imports and corresponding project finance. The other factor has been ample foreign exchange reserves and domestic liquidity in Asia itself ? obviating the need for an extensive search for offshore credit.

From the national standpoint, Asian economies don't need large inflows of foreign capital to make ends meet in their balance of payments. They are running large current account surpluses and have rescheduled many of their distressed debts. In other words, their locally generated savings are more than adequate to fund their now-limited investment demands.

And from an individual business standpoint, too, it has often made more sense over the past two years to borrow from a local bank, because domestic interest rates have been falling, currency strengthening, and banks have had ample cash on hand to extend credit to bankable proposals.

Still, the interest rate cycle is now beginning to turn as central banks move to combat the inflationary impulse from dearer oil imports and declining currencies; interest rates in the Philippines, for instance, have increased more than 600 bp this year. In addition, currencies have started to weaken again.

Besides, many banks are not in a position to advance project finance on any large scale; they have inadequate capital and thin profit margins, and if anything, are shrinking their loan books and investing in safe government bonds in order to restore capital adequacy and profitability.

Challenging deal-making environment...

Opportunities for project finance are returning as Asian economies encounter some capacity and domestic credit bottlenecks. In this environment, however, it is clearly more of a challenge to arrange project finance. Key established clients and premium projects can attract bank financing at reasonable levels; anyone outside that category is paying a premium relative to the rates they would have achieved pre-1987. Bank financing for the region is forecast to remain a net outflow for this year, with a small net inflow forecast for 2001.

Capital markets availability has also been very selective for both corporate and project finance. With only $7.1 billion (Yankee/Globals/144a) issued up to November 2000, funding is directed typically at companies and projects in exporting or import-competing industries that benefit from depreciated local currencies.

Secondary market pricing is a good indicator of the credit spectrum that exists in key Asian markets. At the end of November, for example, in Thailand average sovereign spreads were around 150bp against 1,062bp for corporate issues; in China and Hong Kong, average sovereign spreads were around 160bp against 1,169bp for corporates.

With constrained capacity and more discriminating pricing, project financing in Asia has returned to the more deliberate process that existed in the late 1980s. No longer can one rely on a rising economic tide to lift all boats. Investment in and lending to the region have moved a step closer to fundamentals.

Except now governments are less involved than in the 1980s in sponsoring or guaranteeing projects, as their financial resources are directed to underpinning the banking sector.

Regional governments have a critical role to play, however, in ensuring that the restructuring process continues, and that their regulatory regimes and legal avenues are transparent and consistently applied. Given the political implications of domestic industry and employment issues, it will be difficult to achieve domestic consensus with the demands from overseas creditors and investors.

Selective sector financing

One exception to lagging investment is the telecom sector, where there continues to be substantial spending on networks across the region. Apart from the usual resilience identified with this sector, investment has been spurred by factors such as low penetration rates, the award of new licences and changing technology.

However, even this sector has been and continues to be exposed in varying ways to currency depreciation, political uncertainties and oil price shocks. As well, there could be a knock-on impact from financing difficulties experienced by high-yield US and European operators and suppliers ? driven in part by financial institutions managing down their exposures to this sector.

The combined pressures of more constrained financing options and growing investment demands are translating into the need for more innovative, long-term financing. In response, export credit agencies have given significant support to telecom borrowers.

There is also growing optimism regarding the future of rail in Asia. This is in part driven by technological improvements, but also by increased impetus within Government to explore and use rail as an alternative to the simple (and arguably ineffective) option of building more roads to alleviate growing urban transport congestion.

While most rail networks within the region remain wholly Government-owned and generally loss-making, corporatisation and privatisation are becoming increasingly acceptable. The successful partial public float of MTR in Hong Kong and SRT's (Thailand) plans to corporatise into specialist business units are current examples of this shift. However, private sector rail involvement in some markets is likely to be a very long term objective.

The key to the future success of rail appears to be the ability to blend a comprehensive, interactive and interoperable rail system with specialised financing. The rail systems in Singapore and Hong Kong are held up as global showcases in this regard. Conversely, some of the light rail projects in the region are not performing to expectations.

Traditionally attractive sectors like power were impacted severely by the crisis. In the short-term, the demand in many markets remains muted and the prospect for new capacity limited; projects to improve plant efficiency and transmission and distribution are coming up, subject to the availability of financing.

However, the United Nations forecast that Asia will be the largest energy consumer by 2010, subject to ongoing reform and the introduction of competitive markets to attract investment. In that context, it remains an attractive prospect in the medium-term.

Implications for export credit agencies

In this environment, export credit agency support is more relevant to the region than it was in 1996. However, while generally speaking ECAs are more active in the region than they were in 1998 and 1999, in business terms there has not been a massive increase in support. This situation reflects many factors, most obviously long lead-times for large infrastructure projects, uncertainty attached to the ongoing restructuring of regional economies, and the need to resolve outstanding debt issues.

From EFIC's perspective, indications of support for business in Asia were up over 10% from last year to A$3.2 billion. Not all of this business will come to pass, but we consider the increase to be an early indicator of revival of investment in capital works in the region and of continued Australian interest.

Underpinning our efforts in the region is a strategy of innovation and flexibility. The crisis in Asia has made borrowers more cautious, and to remain relevant we have made the effort to respond to their individual needs in a creative manner.

For example, companies in the region often find it difficult to obtain long term finance in their local currency. The alternative, to borrow in a hard currency such as US dollars, leaves them exposed to currency risk. Currency devaluations during the Asian crisis highlighted this risk and borrowers are increasingly requiring finance that can help mitigate their exposure.

EFIC has responded by providing a local currency guarantee structure through our established export finance guarantee product.

International bank M&A activity also has helped to boost the local currency market: outstanding claims in local currency lending by local affiliates of BIS-reporting banks in developing countries has increased $110 billion from 1997.

Another key element in the recovery will be activity of private sector political risk insurers. As the region grows, so too will opportunities to tap into the expertise and capacity of those insurers.

Casting forward, the prospects for the region are good ? only timing and levels are uncertain. As an investment destination, Asia's fortunes will reflect its relative attractiveness, and the impact of the US economy's performance will have significant influence. As a market for debt financing, the key elements are restructuring and institutional reform.

For export credit agencies, the key task is to augment commercial market appetite by adding capacity in the right places ? not to lead the market down through excess capacity and risk-taking, but by taking the risks we're best placed to manage, eg. country-risk capacity.

In that context, EFIC's role will remain catalytic. We seek to offer the level and form of support necessary to attract comprehensive commercial financing solutions for our clients ? Australian exporters and investors, and borrowers in the Asia region.