East not only area at risk from Asian flu

There has been much talk in recent days about the risk of the "Asian flu" now affecting markets and economies in the far east spreading to the rest of the world. The most immediate concerns surround the financial sector in the far east and the risk of deepening liquidity problems. Already a number of the Asian economies have run into serious financial problems, fuelled by unsustainable levels of investment and bank lending.

The latest to hit a problem - South Korea - is by far the most significant. One of the biggest economies in the region is now seeking financial support from the International Monetary Fund. Hit by a flurry of corporate failures, South Korea has followed the pattern of other Asian economies and has been hit by a crisis of confidence and a sharp currency depreciation. Japan has tried to distance itself from the problems of the Asian Tigers. And it is different, as a major creditor economy at a much later stage of development. But it cannot insulate itself entirely. The sharp fall in other currencies in the region is affecting the yen and threatens to cut the prices the regions' exporters get for their goods. And Japan is a major lender to the other Asian economies now hit by financial problems. The fear is that Japanese institutions will start to withdraw credit from the other troubled Asian economies, leading to further problems and a downward spiral driven by a lack of liquidity.

This comes as Japan's own financial problems move into the spotlight. The collapse of Yamaichi highlights the problems of the Japanese financial sector, caused by years of working in an antiquated structure which allowed bad inter-company debts to build up. In the case of Yamaichi, racketeering also played a part, as bad debts were hidden.

The initial response of the Bank of Japan has been to promise financial support to stop a market liquidity crisis, while the Japanese government is considering spending public money to prop up the financial sector. But the unanswered questions concern whether the entire financial sector in Japan now faces a crisis and whether policymakers in Japan can deal with what lies ahead?

These problems could transmit to the West through lower demand for exports from Asian economies and a depressed level of inward investment. Most worrying, in the short-term, however, is the fear that major Japanese financial institutions may start to liquidate some of their holdings of investments in the West - particularly US treasury bonds - to shore up their ailing balance sheets.