The six potential triggers for a crisis are a faster-than-expected rate hike by the US Federal Reserve; a resurgent US dollar; a major emerging markets corporate default; a large RMB devaluation; an inflation shock in Asia and political instability.

"The level, but even more so, the speed, of the rise in the ratio of private credit to GDP across much of Asia since 2008, is disconcerting, " Subbaraman said.

"Loan growth has recently slowed in several countries, but so too has nominal GDP growth, and hence in most of Asia the credit-to GDP ratios continue to rise.

"The debt build-up has fuelled property market booms, and while property prices have started to correct in some countries, they remain elevated in China, they have risen to all-time highs.

"Unsurprisingly, cheap credit has fuelled Asia's outsized financial cycle, which now appears to be in a late stage judging by the rise in the region's debt-servicing ratio, even though interest rates have fallen further.

"Another tell-tale sign of the mature stage of the financial cycle is the rising share of debt held by firms that do not earn enough to cover their interest payments.

"Accurately forecasting the timing of financial crises is likely to remain an elusive goal, but the vast literature now shows that it is possible to build early warning systems that can help assess the build-up of risks of future financial crises.

The early warning system was developed by Nomura using the rich treasure trove of research undertaken by leading central bankers over the past 20 years including a paper co-authored by the new governor of the Reserve Bank of Australia Philip Lowe.


Lowe and the head of the economic department at the Bank for International Settlements, Claudio Borio, wrote a seminal paper in 2002 that "it may be possible to recognise the build-up of one set of vulnerabilities that foreshadows banking distress with a reasonable degree of confidence, although the exact timing of the crises remains unpredictable".

They found that it is possible to construct two indicators – the deviation from trend, or "gaps", in private sector credit-to-GDP and real equity prices – that predict financial crises fairly well.

The early warning system measures deviations of five key variables from their long run trends. These "gap measures" are focused on the following variables: ratio of private credit to GDP, real equity and property prices, private sector debt service ratios and real effective exchange rates.

Nomura collected data from 30 countries including 10 emerging market economies in Asia, 10 emerging market economies outside of Asia and 10 developed market economies. The list did not include Australia.

Subbaraman said that if the credit-to-GDP ratio or the debt service ratio rises well above its long-run trend (opening up a large positive gap) it could be a sign that borrowers are overextended.

"Similarly, if real property or equity prices rise significantly above trend it could indicate frothiness in asset markets; or if the real effective exchange rate appreciates sharply above trend it could signal a loss of competitiveness or too-strong capital inflows fuelling lax domestic financial conditions."

The results of Nomura's running the early warning indicator numbers are quite stark.

Subbaraman said it is "plain that the risk of a financial crisis in Asia ex-Japan is rising and is at its highest point at any time since the 1997 Asian crisis.


The signal for a crisis is now at 189 compared to 216 just before the start of the start of the Asian crisis in the second quarter of 1997.

At is peak in 1998 the warning indicator in Asia was 277.

"The risk of a financial crisis in China and Hong Kong, in particular, has risen very sharply," Subbaraman said.

"In China, the number of signals had been at, or near zero, from the late 1990s up to fourth quarter of 2012, but in the past 12 quarters has skyrocketed to 44 (out of a maximum 60).

"Since the early 1990s, in our global 30-country sample only eight countries have experienced signals rising to 44 or higher, and in seven of the eight the strong signals were just before, or in, the midst of crises," he said.

"Moreover, China's latest data (Q4 2015) is before the debt-fuelled property market boom early this year.

"In Hong Kong, the latest number of signals (42) almost matches the peak number during the Asian crisis."

Subbaraman said the number of signals has also been rising in Indonesia, Malaysia, the Philippines, Singapore and Thailand, and in all five countries the number is at the highest level since the Asian crisis.


To illustrate the vulnerabilities in China here are its key "gap measures": credit-to-GDP 29.6 percentage point deviation from long run trend, property gap 15.2, equity gap 9.4 and real average exchange rate gap 11.4.

The report concludes that there are three reasons why the financial cycle reversal in Asia will be abrupt.

"First, China – the world's second-largest economy to which the rest of Asia is very exposed – is flashing the strongest early warning signs," the report said.

"Moreover, this is based on data up to fourth quarter 2015, before the resurgent credit and property market booms that we have seen this year.

"Second, history repeatedly shows us that when a financial cycle boom turns into a bust, the result is typically a much deeper and longer recession – a balance-sheet recession rather than the garden-variety business-cycle recession.

"And third, our early warning indicators are flashing signals at a time when interest rates in Asia are at, or near, record lows – an ominous predicament should they start to rise."