Governments and central banks in emerging East Asia need to stay vigilant to guard against potential financial risk associated with higher interest rates, according to a report by the Asian Development Bank (ADB).

Softening inflation in the past several months has allowed most central banks in the region to hold off on further interest rate hikes, and some have started lowering rates to boost economic growth. Still, elevated price pressures, a solid job market, and robust economic performance in the United States could lead to further interest rate increases by the US Federal Reserve, according to the latest issue of Asia Bond Monitor, released today. 

The recent shift away from interest rate hikes, along with sound economic fundamentals, helped support a slight improvement in financial conditions in most emerging East Asia markets between 1 June and 31 August, according to the report. Excluding the People's Republic of China (PRC), positive investment sentiment in regional markets supported a narrowing of risk premiums, a rally in equity markets, and net foreign portfolio inflows in bond markets. In the PRC, a dimmed economic outlook weighed on domestic financial markets.

Meanwhile, interest rates in the region remained elevated. Higher borrowing costs have contributed to debt stress and bond defaults in some Asian markets over the past few months.

“Asia’s banking sector showed resilience during the recent banking turmoil in the US and Europe, but we’ve seen vulnerabilities and defaults among both public and private borrowers since last year,” said ADB Chief Economist Albert Park.

“Higher borrowing costs pose a challenge especially for borrowers with weak governance and balance sheets.”

On the other hand, a faster-than-expected decline in inflation in advanced economies, combined with a cooling in the job market and/or lessened financial stability and growth concerns, might lead to less hawkish monetary stances, the report says.

Emerging East Asia comprises member economies of the Association of Southeast Asian Nations (ASEAN); the PRC; Hong Kong, China; and the Republic of Korea.

Total outstanding bonds in the region increased 2.0% in the 3 months through June to $23.1 trillion. The expansion in both the government and corporate sectors slowed from the previous quarter. Many governments had frontloaded issuance in the first quarter of the year, while both government and corporate bonds were subject to sizeable amounts of maturities in almost all markets. 

Sustainable bonds in ASEAN plus the PRC, Japan, and the Republic of Korea (ASEAN+3) expanded 5.1% from the previous quarter to $694.4 billion, accounting for 19.1% of global sustainable bonds outstanding. ASEAN+3 remains the world's second-largest regional sustainable bond market after the European Union, although the segment only accounts for 1.9% of the group's overall bond market.

ADB is committed to achieving a prosperous, inclusive, resilient, and sustainable Asia and the Pacific, while sustaining its efforts to eradicate extreme poverty. Established in 1966, it is owned by 68 members—49 from the region.