International Experience

This section investigates issues concerning the development of integrated financial markets in Asia and their role in financing regional infrastructure investment in Asia. It includes lessons for Asia from financial market integration initiatives in Europe and Latin America, covering both the creation of a single integrated market and policy investments that promotes infrastructure. It also looks at the potential for using the resources held in Sovereign Wealth Funds (SWFs) and mobilizing funds from Islamic Financial Markets.

3.1 The European Union

The integration of European financial markets to support infrastructure development in Europe provides important lessons for Asia. Here, the pros and cons of different types of integrated regional financial markets supporting infrastructure development are compared with a base line of no integration and reliance on individual country markets to promote infrastructure.

The European Monetary Union (EMU) (also called the Euro area) was created in 1999 based on the Maastricht Treaty signed in 1992. It was the culmination of a long process of economic, political, and social integration that began shortly after World War II. The process of financial sector integration in the EU since 1999 can be divided into four stages:

• Stage 1: In 1999, the Euro area monetary union was created with the euro as the single common currency. The euro was used as a virtual currency or accounting unit in all member countries. The exchange rate of each national currency was irrevocably fixed against the euro, a single monetary policy was introduced and run by the European Central Bank (ECB), a common exchange rate and international reserves policy was created, and a euro-based clearing system was set up, among many other actions. The key goals at this stage were implementation of a common monetary and exchange policy.
• Stage 2: In 2002, the existing national currencies were retired and the euro entered circulation as a physical currency in all member countries. The changeover was quick and smooth. This fostered integration of currency markets, with free use of the currency throughout the union and elimination of national borders for currency.
• Stage 3: The successful launch of the euro permitted the ECB to refocus attention to actively promote creation of a single financial market in which there would effectively be no national borders for financial markets in Europe. An example is the Single European Payments Area (SEPA) that seeks to make retail and business cross-border transactions in Europe as easy and cheap as domestic transactions.
• Stage 4: Geographic expansion of the union began with Greece joining the Euro area in 2001. In 2004, the EU expanded eastward and into the Mediterranean to bring aboard 10 new members. Bulgaria and Romania joined the EU in 2007. Slovenia, Malta, and Cyprus have also already joined the Euro area and Slovakia joined in 2009. All the new EU countries are legally committed to join the monetary union once they meet a set of rigorous entry requirements.

3.1.1 Financial Market Integration

The steps toward greater financial sector integration in Europe are multifaceted and complex. Many institutional and policy changes were introduced and harmonized between all member countries and with union-level institutions.

The European Currency Unit (ECU) began in 1975 as the European Unit of Account (EUA) to serve the purpose of having a standardized accounting value for projects involving multiple European countries, such as the European Development Fund. Following the breakup of the Bretton Woods agreement in 1971, European countries lacked fixed exchange rates to denominate transactions between countries or for community-wide purposes. A common measure was needed to set the budget for the European Economic Community, for settlements between countries, and for administering the Common Agricultural Policy and pricing agricultural commodities. Moreover, the measure of value also needed to serve as a measure of future values in order to measure investments and their costs and returns over time (EC 1984).

In the early days of the EMU, implementation of the single monetary policy required integration of money markets and markets in short-term capital and creation of a common system of clearing in the new currency, all backed up by institutions applying and enforcing common standards in all member countries. This was mandatory to ensure monetary control and permit transmission of monetary policy impulses throughout the Euro area. After that initial stage, new actions and institutions began to be put into place in order to complete the integration of European long-term capital markets and retail financial markets (Trichet 2006). Box 2 [ PDF 44.7KB | 1 page ] details the levels and types of European programs and institutions supporting financial integration.

This integration is a sign of the EMU's success. Furthermore, Ehrmann et al. (2007)¹³ found that the creation of the union fostered significant integration of financial markets, creating significant improvements in the functioning of financial markets with the convergence in the levels and co-movements of long-term sovereign bonds, in bond yield responses to common shocks, and in long-term inflation expectations built into bond yields toward the rates of the countries with lowest inflation expectations. The integration of financial markets in the Euro area has brought down and stabilized bond yields by eliminating exchange rate risk and creating confidence that the common monetary policy will achieve low inflation throughout the union. Further contributing to the convergence are three additional elements integral to the European economic environment: general macroeconomic convergence and stability, government fiscal restraint, and financial sector stability.

To support macroeconomic convergence and stability, European authorities moved toward more intensive policy coordination and the strengthening of national institutions through strong regulatory oversight. These actions, although indirect, create a system of strong national institutions within the regional framework that facilitated cross-border investment and market integration.¹⁴

3.1.2. European Development Banking

Although strong financial markets in Europe enable capital markets to finance much of the infrastructure requirements, Europe has a number of programs to provide more direct funding of priority infrastructure, with emphasis on supporting funding in poorer regions or areas with special needs. Box 3 [ PDF 28.7KB | 1 page ] illustrates one innovative program to guarantee loans to support transportation infrastructure development. The European efforts show that even in a region with ample capital market funding, special efforts are needed to directly provide lending for infrastructure or to provide a range of enhancements to investors to prompt their investment. Another broad conclusion is that great flexibility and use of sophisticated financial engineering techniques are required to construct financial incentive packages that make infrastructure projects attractive to potential investors. Extending the European model to Asia suggests that both an efficient regional integrated market and continuing official assistance are needed to support infrastructure development.

If similar approaches were attempted in Asia, new, well-capitalized institutional arrangements may be needed to emulate the results achieved in Europe, and continuing sources of concessional funding will be needed to cover the costs of incentives and guarantees. Also, Asian development institutions can—as is done in Europe—serve as a source of technical expertise and assistance in building local bond markets. The importance of development banking and concessional incentives is likely to be especially important over the next several years because of the current crisis in financial markets, which has made many investors hesitant to make commitments.

3.1.3. Relevance of the European Financial Integration Program for Asia

The EMU places strong emphasis on development and integration of the financial markets, which may hold lessons for how markets should develop in Asia to support infrastructure finance and support financial market efficiency in general. What lessons can be drawn for Asia from the EMU experience?

Foremost is the aggressive nature of the programs to integrate financial markets in Europe. The efforts are explicitly tied to promoting innovation and competitiveness for the financial sector and to support the general economy. Improvements in the financial sector are seen as directly contributing to the productivity and competitiveness of Europe in the world economy. Asian financial systems are starting from a less competitive position and will need to make continuing improvements to not fall further behind.

The European system also directly addresses the diverse risks that can inhibit cross-border investment through the introduction of the euro, which eliminates currency risks in cross-border transactions. In Asia, by contrast, infrastructure projects denominated in national currencies have currency risks affecting (1) investors via loss on investments denominated in a foreign currency; (2) servicing costs of projects that increase if the national currency depreciates, and (3) cross-border projects where a relative exchange rate change for one country could jeopardize the project. The long-term nature of infrastructure investment increases the probability of experiencing such exchange rate risks. Europe, through its wide range of oversight, market-building efforts, and policy lending and guarantees, is also effectively addressing other key risks including country risk, default risk, interest rate risk, and traffic risk (the danger that start-up traffic is insufficient to service debts).

Moreover, within the integrated European system, effective oversight of individual member countries through review of macroeconomic and fiscal policies is used to promote and achieve the benefits of integration and avoid possible collective destabilization. Asia is also slowly working to build and expand its economic oversight and policy dialog systems. The recent strengthening of the Chiang Mai Initiative (CMI)¹⁵ and the recommendations of ADB Institutes' (ADBI) capital flows management project¹⁶ are clear steps in the right direction that hopefully will be further advanced. Potentially, an Asian financial market oversight system or Asian Financial Markets Stability Forum could contribute to stronger and less volatile financial markets for Asia.

An enforcement arm in the Euro area makes member countries abide by strict rules governing individual country economic and fiscal policies, which are embodied in their convergence indicators, to create conditions conducive to overall macroeconomic and fiscal stability. Such a transnational enforcement tool does not exist in Asia. An alternative would be to develop a set of Asian convergence indicators that would be published, thus using market discipline through disclosure as a tool to promote greater convergence.

Europe applies many common standards and codes by regulation, but they often represent the local application of internationally accepted standards, such as those in the fields of accounting, banking supervision, or payments systems. An alternative for Asia would be to promote and support regional adoption of international standards and codes, or adoption and establishment of a common Asian standard and codes. Asian adoption of international standards is largely done locally, and although Asia is not at a point where a transnational body can create and impose its own standards, more aggressive steps should be taken to coordinate across Asian countries to bring all systems in the region individually and collectively up to high levels of compliance with international standards. An Asian Financial Stability Institution could provide leadership in this regard.¹⁷

Concessionary financing of incentives to promote bond markets would also be needed. This could involve developing private insurance firms or a public infrastructure insurance firm to cover the various types of insurance or guarantees involved. A major challenge would be to generate the necessary capital infusion and annual receipt of contributions to the pool for concessional financing.¹⁸ This pan-Asian entity would need to have some sort of oversight function of the instruments and entities it insures, and therefore would collaborate with securities and insurance supervisors.

Clearing and payments infrastructure development should be a high priority, as it was in Europe. The initiatives on clearing systems of the Association of Southeast Asian Nations (ASEAN) ministers in the 2007 ASEAN Economic Community Blueprint appear to have advanced well and efforts can be made to move them to the implementation stage.

Creating cross-border adjudication mechanisms would also contribute to the success of regional integration. This is difficult in the absence of an overarching legal framework as exists in Europe, but wherever possible common codes and documentation should be developed. This convergence is being pursued aggressively in relation to trade and customs documentation, and a similar emphasis in the financial sphere would be welcome.¹⁹ A legal working group could be created (as was done in Europe) to explore areas of convergence in a legal framework to support financial market development.

3.1.4. Lessons for Asia

The listing of programs and experiences in the previous subsections indicates the seriousness of the European effort to promote a high degree of integration of national financial markets within the EMU. Many gains in efficiency are envisioned and cuts in costs of maintaining separate financial markets have been estimated by the ECB to be equal to several percent of GDP. Direct actions were taken to strengthen integration and the common overarching legal and institutional framework also contributed importantly.

Such results are desirable goals for Asia as well in its efforts to promote financing for infrastructure development. The European experience shows that creating the best situation for Asia, where it could use its vast savings for regional infrastructure development, would involve eliminating barriers and frictions in cross-border financial flows so that funds move to where they are most productive, reducing currency-risk for cross-border finance through policy dialog and recommendations that effectively reduce exchange rate volatility between the Asian currencies, creating stable inflation expectations to eliminate inflation premiums in national bond issues, and reducing national risk premiums embedded in national bond prices. This would involve both reduction in sovereign risk due to poor government fiscal management and a reduction in general country bond premiums by building expectations of general macroeconomic and financial sector stability.

Providing access for all national investment projects to deep and liquid markets so that there is price discovery, competitive pricing, limited volatility, a range of tenors, and comparable financing costs for infrastructure development in each country would also be needed. Achieving this would imply that investors and borrowers throughout Asia would have unrestricted access to regional financial centers, with a collateral system and surety of cross-border settlement, as such liquidity can be generated only in larger, concentrated market centers or through internet trading.

Another necessary component would be the building of comparable market indices. The yield curves of separate Asian financial markets should begin to converge over time and a broad range of maturities should be available in order to most effectively encourage cross-border and regional investment.

The aforementioned tasks add up to a heavy agenda, but it is one that Asia should seriously consider, because in addition to supporting infrastructure investment, such initiatives would increase policy effectiveness, create more effective markets that support growth, save costs, and, importantly, create a financial system that could be more competitive in relation to financial markets in Europe and America. Promoting financial market integration and bond market development has gained increasing traction because of the need to rebalance Asian economies and increase the use of regional savings to support Asian investment priorities. Also, there is a need to build effective and resilient financial markets that open up a wider range of funding options and provide greater overall financial stability.

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