Factors Necessary to Improve Capital Markets in Asia

Above I mainly focused on issues related to reform of the global financial architecture at various levels. As the global economic crisis began in the US and other developed countries, the analysis was mostly focused on those countries. In this section, the discussion moves to application to Asia.

4.1 The Need for Better Financial Markets in the Region

As finance is the oil that makes the real economy run, improving financial markets in the region is essential. Market growth may be considered from three perspectives: the supply, demand, and institutional aspects of financial markets. First, Asian countries have generally had high savings rates, at least compared to other developing countries. Given the region's growth prospects, demographics, institutional characteristics, and savings behavior, it is likely that this supply of savings will continue to be high over the medium-long term.

So where have these savings been going? Before the 1997 Asian crisis, a large share was invested in speculative markets such as real-estate ventures. A considerable amount also went overseas, especially to the US but also to Europe, only to come back to Asia in the form of short-term bank lending. The lack of financial instruments and capital market information reduced the options offered to savers in Asia, be they households or institutions such as pension funds. The highly developed financial markets outside the region, which were deemed low-risk and characterized by economies of scale, made it all too easy to avoid the hard choices and institutional reform needed to rectify this.

Second, in recent decades Asia has been the most dynamic region in the world with a very strong demand for credit. Infrastructure demand in particular is expected to grow significantly in the future. Moreover, as most Asia economies now have fiscal deficits, they are being forced to find cheap and innovative ways of raising funds, or at least there is a much higher incentive to do so. This strong demand for investible funds will no doubt persist over the medium-long term. Further, from a political point of view, Asian economies have been nervous about such a high reliance on intermediation outside the region, a nervousness that was all too justified in light of the global economic crisis.

How has the region been able to finance its investments? To date it has mostly been through bank lending. Outside the financial centers of Japan and the Asian newly industrialized economies, equity markets tend to be thin, highly-volatile, and illiquid; fixed income markets are even less developed, particularly corporate debt markets in the developing Asian economies. While a strong reliance on bank lending is not necessarily an impediment to longer-term economic development—the continental European financial model, for example, is based much more on bank intermediation—it strongly limits the options available to firms and places a greater strain on the banking system…as well as creating a disproportionate reliance on the banking system for the health of the economy (which can, among other things, cause moral hazard problems in itself, as was evident during the Asian crisis).

This lack of diversity in investment vehicles in many Asian economies has been burdensome for the larger companies and public-sector equities facing limited sources of funds at home; either they work through the local banking system or they try to tap international markets, listing directly or via the bond markets. This strengthens the liquidity and efficiency of developed-country markets but to the disadvantage of local development. Moreover, small companies, and especially start-up companies (so important in the information and communication technology age) can be left out of the system completely, as banks have a natural tendency to rely on larger, more established clients and venture capital markets are generally absent. The lack of a reliable yield curve in many developing Asian economies has been a perennial problem for corporate issues.

Thus, the huge supply of savings and strong investment demand in Asia was (and is) directly or indirectly intermediated outside the region, or if it took place inside the region, it was done mostly through the local banking system. The shortcomings of such a situation are obvious; most importantly, it makes the system entirely dependent on the banking system and creates high-exposure to the actions of market participants of, and the economic performance in, countries outside of the region. It also develops a tendency toward double-mismatches. The global economic crisis has affected Asia through not only the real-side effects of decreases in export demand but also the financial channels, including the wealth effect, trade finance, and the drying up of international liquidity.

The processes for addressing immediate problems of the banking system due to the Asian crisis have been generally successful—e.g., in increasing foreign partnerships in the sector, new business lines and other forms of asset diversification, greater transparency, and improved supervisory and regulatory systems (Adams 2008). Policymakers in the region have also turned their attention to market diversification and deepening issues, but with less success. Nevertheless, most countries have enacted or have plans for reforms designed to deepen equity markets, and to create deeper and more liquid bond markets (discussed more fully in Section V). In this sense, the Asian crisis, though extremely costly in terms of social and economic costs, had a positive side in that it is forcing governments to expand capital markets and strengthen financial systems, thereby increasing the potential for future sustained growth and, hopefully, mitigating the effects of any future crisis. As Robert J. Shiller notes in his influential book, Irrational Exhuberance (2000: 228–229):

Given that speculative bubbles tend to occur, their eventual bursting may indeed be on balance a good thing. The Asian financial crisis of 1997-98, sparked by the withdrawal of world investors from Asian markets, may be viewed not as a crisis in the long-term sense but as a sanity check that prevented what might have turned out to be a more disastrous speculative bubble from ever developing.

Of course, today Shiller would no doubt say that the lack of a “sanity check” in the OECD countries did, indeed, lead to disastrous speculative bubbles.

The need to finance emerging government deficits in the region, robust demand for infrastructural projects, and ambitious business plans of many private-sector companies make the development of asset markets a natural priority, though a major challenge. According to numerous recent studies, including those conducted by the ADB Institute in Tokyo, ADB in Manila, and the Asia-Pacific Economic Corporation, much remains to be done in strengthening the local markets. To summarize briefly some of the findings from these reports, market impediments include: lack of reliable yield curves and liquidity in the markets; lack of local institutional investors that are active in the market; underdeveloped clearing and settlement systems; weak protection of intellectual property; and insufficient protection and fiduciary responsibilities. As I argue in this paper, the global economic crisis will require new financial and regulatory frameworks. In this sense, development of local and sub-regional financial markets reform should be undertaken in the context of the emerging “best practices” framework, which hopefully will be superior to the previous one.

While developing asset markets in Asian developing economies are mainly a challenge for local governments, there is a strong case to be made for concerted development and regional integration of these markets.

4.2 Financial Cooperation to Date

There exist many excellent reviews of surveys of financial cooperation in the Asian region, including Henning (2002), de Bouwer (2005), ADB (2008), and Hamanaka (2009). The review here is a cursory one. But before beginning, I would note that, while formal trade agreements in Asia are more numerous and advanced than financial arrangements, it is notable that real-sector and financial cooperation are developing simultaneously in Asia. The normal sequencing—e.g., in the case of the European Union (EU) and the North American Free Trade Agreement (NAFTA)—has trade cooperation deepening well before financial cooperation. In part, this reflects the timing of Asian regionalism: Asian regionalism took off after the Asian crisis, and given the financial nature of that crisis, cooperation in this area was only natural. However, it also reflects the recognition of the importance of financial cooperation in bolstering real-sector competition and economic growth.

One might trace the first modern initiative in favor of monetary/financial cooperation in East Asia under the Association of Southeast Asian Nations (ASEAN)+3 framework to be the original “Miyazawa Plan,” which was initiated by Japan during the Asian crisis to create an Asian Monetary Fund to supplement the IMF. The plan was opposed by the IMF and the US, but eventually led to the establishment of currency swap arrangements among East Asian countries (basically bilateral swaps between Japan and individual countries at first) at ADB's annual meeting in May 2000 (also known as the “Chiang Mai Initiative”). These swaps have grown in terms of nominal values and the agreement was upgraded in May 2009 to be the “Chiang Mai Initiative Multilateralized” (CMIM), in which the swap arrangements have been multilateralized and the total value has risen to US$120 billion in the form of an “Asia Fund” facility. Indeed, the CMIM seems to be similar to what was envisioned in the Asian Monetary Fund. While multilateralization of the Chiang Mai Initiative was proposed well before the demise of Lehman Brothers and the onset of the global economic crisis, uncertainties related to the unfolding of the sub-prime crisis in the US gave it momentum.

The Executives' Meeting of the East Asia and Pacific Central Banks (EMEAP) is a forum of regional central banks whose goal might be characterized as ultimately developing an “Asian BIS” (Hamanaka 2009). Like APEC itself, it began essentially as a Japanese initiative and its first meeting was held in Tokyo in February 1991. It was institutionalized in July 1996. It meets semi-annually and is mainly a forum for dialogue, exchange of information, and other technical matters. It has three working groups—i.e., financial markets, payment and settlement systems, and bank supervision—which essentially parallel the BIS; however, it does not have a formal secretariat.

Under the EMEAP, the first Asian Bond Market Fund (ABF-1) initiative was launched in June 2003 with an investment of US$1 billion in Asian bonds (de Brower 2005). This was followed in April 2004 with ABF-2, which was created in 2005 and invested in local currency denominated bonds with initial seed money of US$2 billion. The ABF initiatives are managed under the auspices of the BIS and are funded through pools of reserves of the EMEAP central banks. While the value of investments under the ABF framework is trivial compared to the stock of foreign exchange reserves in the region, this fledgling process constitutes an interesting initiative particularly in its purchasing of locally denominated bonds (and counter the “original sin” problem in international finance). Nevertheless, many barriers exist to the development of the ABF, both in terms of cross-border impediments (e.g., capital and foreign exchange controls, regulatory barriers, and delivery and settlements problems), and local-market impediments (e.g., taxes, regulatory fragmentation, and insufficient market infrastructure).

There are a number of other cooperative groups in the region, including the ASEAN+3 Finance Ministers Meeting (ASEAN+3 FMM) and the APEC Finance Ministers Meeting process. Established in the wake of the Asian crisis, the ASEAN+3 FMM focuses on financial sector cooperation, surveillance (including monitoring of capital flows), and policy dialogue. The Chiang Mai Initiative was developed as part of the ASEAN+3 FMM, as was the Asian Bond Market Initiative. The Economic Review and Policy Dialogue (ERPD) was created mainly to strengthen cooperation in the area of regional surveillance and foster dialogue on global, regional, and national economic developments. In May 2005, the ASEAN+3 Finance Ministers integrated and enhanced the ERPD with the Chiang Mai Initiative framework.

The APEC Finance Ministers' Meeting was first convened in 1994 as a one-time event, but under US influence was extended as a discussion forum on a regular basis (Hamanaka 2009). It henceforth became a “process” and is now aptly called the APEC Finance Ministers' Process (FMP). The FMP provides an annual forum for APEC member economies to exchange views and information on regional macroeconomic and financial developments and on national and regional policy priorities. Partners include ADB, the Inter-American Development Bank, the World Bank, and the APEC Business Advisory Council.

In short, at the Asia-Pacific and Asian levels, there exist a number of forums dedicated to dialogue, exchange of information, and technical interaction. However, concrete initiatives in the form of applied financial cooperation initiatives are less impressive, with the exception of the CMIM.

At the subregional level, ASEAN has been fairly active in the area of finance, though obviously real-sector integration takes a priority. The Ministerial Understanding on ASEAN Cooperation in Finance (March 1997) sets out the broad goals for cooperation in diverse areas of finance and macroeconomics, including banking, capital markets, insurance matters, taxation and public finance, as well as in exchanging information on developments affecting ASEAN countries in various multilateral and regional organizations. Realizing the importance of developing capital markets in the region, the ASEAN finance ministers endorsed a Finance Work Programme designed to deepen capital markets in ASEAN. In the Joint Ministerial Statement of the Fourth ASEAN Finance Ministers Meeting (25–26 March 2000), the ministers agreed that ASEAN should "…further strengthen corporate governance practices, including transparency and disclosure, and establish a regional framework for the development of the ASEAN bond market. Our aim is to develop and deepen ASEAN's capital markets, particularly bond markets." On 15 December 1997, the ASEAN heads of government focused on the need to move toward greater regional cohesion and economic integration, as expressed in the ASEAN Vision 2020 statement. In this document, they pledged, among other things, to maintain regional macroeconomic and financial stability through closer cooperation in terms of monetary and financial policies. The next year (15 December 1998) in Viet Nam they agreed to the "Ha Noi Plan of Action," which calls for: (1) maintenance of financial and macroeconomic stability; (2) strengthening of the financial systems; (3) liberalization of financial services; (4) intensification of cooperative efforts in monetary, tax, and insurance matters; and (5) developing ASEAN capital markets.

The ASEAN Economic Community (AEC) was formally launched in January 2007 and is slated for completion (for the ASEAN-6) by 2015. The AEC Blueprint,¹⁵ which delineates the areas to be included in the AEC program, has four principal areas of focus: creation of a single market and production base; a more “competitive economic region”; “equitable economic development”; and enhanced integration in the global economy. Measures related to capital markets are included under the “single market and production base” and promise a “freer flow of capital.” In fact, most concrete measures really refer to concerted efforts to develop national capital markets, rather than any grandiose regionally-integrated market. In fact, while the blueprint does include harmonization of standards, some aspects of mutual recognition (e.g., with respect to professionals working in the area), and measures to broaden the base of ASEAN debt issuance, the approach is a cautious one, with references to the need to maintain stability, adequate safeguards, and promote liberalization carefully.

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