Role Of Financial Integration In Asia

In this paper, it is hypothesized that inefficient and segmented financial markets in Asia prevent effective intermediation between Asia's large savings and Asian investment needs. In the absence of effective financial markets with significant penetration throughout the region, Asian financial markets are mostly outwardly oriented. Massive savings from net export surpluses flow out of Asia through a few Asian financial centers to global financial centers, such as New York and London. This process is inefficient in addressing Asia's investment needs and creates a range of serious problems from capital flow management, negative carrying costs, and poor investment signals, to difficulties in monetary policy and shallow and volatile markets, among others. It also unnecessarily embeds monetary and exchange policy decisions made in Washington, London, or Frankfurt into the savings-investment process in Asia. Efforts to build stronger and more relevant integrated financial markets in Asia can thus address such serious issues, and also facilitate the real economic adjustments needed to support Asia's development.

2.1 Impediments to Intra-Asian Regional Investments

Why are Asian financial markets and private sector companies failing to adequately contribute to regional investments? Some of the answers can be found in several areas where there are impediments to effective cross-border flows of investment capital in Asia. One major impediment is that, despite reforms, there is still a deficiency in appropriate legal, regulatory, and governance frameworks that encourage cross-border investment and mitigate political, legal and regulatory risks. Many potential investors may fear that cross-border investments are too risky, with uncertain prospects to recover funds or resolve commercial disputes in the absence of any dispute settlement mechanisms. Concerns about political uncertainties or discrimination against foreign investors might also impede capital flows. Development of commercial and legal codes and conflict resolution frameworks, such as those envisioned in the Economic Research Institute for ASEAN (ERIA) East Asian Community blueprint, can contribute greatly to mitigating these concerns and creating an enabling environment.⁴ Progress dealing with legal and governance impediments to cross-border investment is needed.⁵ Linking Asian capital markets such as stock and bond markets can facilitate cross-border investment.

Inhibiting the development of viable infrastructure projects are difficulties in design, cost estimation, and technical preparation of bankable cross-border, or regional⁶, infrastructure projects. Difficulties also arise in gaining full understanding of all potential risks involved (such as political, socio-economic, operational, and financial), and the pricing those risks. Cross-border projects are more complex in many dimensions and are often of larger scale compared to national projects. A long, expensive, and technically demanding process is required to prepare infrastructure projects that will appeal to international investors and offer profits. Feasibility studies for large cross-border projects require considerable financial outlays and determining the criteria for sharing these expenses among participating countries is challenging. Cross-border infrastructure projects are typically non-rival and/or non-excludable and can be fronted by entrepreneurs, or governments, with possible assistance from International Financial Institutions (IFIs) and Multilateral Development Bank (MDBs) such as ADB or the World Bank. Difficulties in locating funding for technical preparations, lack of expertise, lack of project implementation capacity, and the absence of a prioritized program for development are among the major impediments to effective cross-boarder project implementation.

Traditional infrastructure financing—government financing through debt or bonds—has severe limitations. Most Asian debt is financed through bank loans, but these loans are limited in tenor and expose projects to refinancing risks. The past reliance on government funding of infrastructure has stunted the growth of private bond markets and financing, and only now that demand for private participation exists,⁷ are the tools to support private funding being built. Funding can be facilitated by building effective capital markets, but often must also be supplemented by public investment initiatives and guarantees to promote the desired types of infrastructure investment. This requires efficient and stable financial markets that provide investment signals promoting the most productive use of capital for infrastructure.

Many of the reasons for the financial sector in Asia having failed to provide the needed support for infrastructure finance were discussed in depth in the 2008 OECD-ADBI Roundtable on Capital Market Reform in Asia and some key conclusions taken from that discussion are summarized in Box 1 [ PDF 27.5KB | 1 page ]. Overcoming financial sector impediments to encourage efficient flows of private capital, in conjunction with supportive official investment, guarantees, and concessional finance, is a necessary component for addressing regional infrastructure investment needs and the financing gap.

High capital intensity of cross-border projects implies a high debt service ratio, long pay-off periods, and uncertainty of the forecast traffic volumes or demand. This requires availability of appropriate and innovative financial instruments in the financial markets. Equity investment is an efficient method for sharing risk between public and private sectors for long tenure, cross-border projects. However, several Asian countries do not allow equity investment by foreign companies in certain infrastructure sectors. The private sector would then have to bear a higher risk in the form of a debt position in order to participate in infrastructure projects in these countries (van der Geest and Nunez-Ferrer 2010).

Improvements are apparent, but the pace lags behind the potential and important current needs remain unserved. Many countries in the region need to do more to enhance the operations and efficiency of their financial markets, but resources for facilitating these efforts are often limited. Moreover, the culture of capital market investment needs to be substantially strengthened. Overcoming financial sector impediments and aspects of financial packages are covered in greater detail later in this paper.

2.2 Regional Financial Integration – A Regional Approach to Financing Infrastructure

The financing of cross-border infrastructure inherently demands a regional perspective, because projects that involve more than one country introduce risks that single country projects do not face and the financing comes from different economies. It is useful to review this situation from the perspective of an integrated Asian economy rather than as the sum of needs of individual Asian countries. The regional approach must take into consideration exchange rates, inflation, and interest rates, as well as benefit and cost valuation issues over time.

Assessing Asia-wide infrastructure costs and benefits on a consistent basis, uninfluenced by varying configurations of exchange rates, national inflation rates, and interest rates, is advantageous, because funding costs and the discounting of project costs and services benefits are affected.⁸ Premiums for exchange rate risk and country risk will affect the cost of borrowing for infrastructure. Differences in inflation performance between countries also affects the cost of infrastructure development, with countries that have a history of high inflation facing elevated borrowing costs as inflation premiums are built into borrowing rates. Considering inter-temporal infrastructure costs is also important, because the structure of the individual economies will change as infrastructure systems are developed and countries become increasingly integrated into the regional economy, and the valuation of infrastructure costs and benefits will change as the infrastructure evolves.

New institutions and markets will be needed to tap savings within the region, to lure private and public foreign capital, and direct them to priority infrastructure projects throughout the region. The most efficient application of capital infrastructure development will involve significant intra-Asia flows of capital because individual country programs may be at odds with the optimal regional arrangement, given differences between countries in domestic savings and infrastructure needs, and likely externalities in benefits of infrastructure development that are not captured on a national basis. The new regional institutions and markets could be structured in two ways: either effectively integrated across the region or converged in practice through collaborative national efforts.

Each factor mentioned above suffers from the absence of efficient bond markets in Asia, which is a tool for tapping long-term capital for use in building infrastructure that usually involves long time frames. Long-term bond rates are affected by inflation and exchange rate premiums, which vary from country to country. Moreover, without convergence to efficient common bond pricing between economies, their respective capital markets will remain separate, which hinders borrowing of large capital and the reallocation of capital to the most productive infrastructure projects. Also, without a common bond rate, discounting the value of future benefits and costs is difficult.⁹

Based on these considerations, the question arises whether a basket measure of currency requirements for infrastructure investment should be constructed to provide a cross-country, temporally consistent method of project valuation in different Asian countries.¹⁰ A basket could be constructed according to size of the economies, regional purchasing power parity, or based on the costs of technical inputs for development of Asian infrastructure, among others. This paper, therefore, will examine currency risk exposures of lenders and borrowers in cross-border infrastructure projects under different types of currency basket arrangements.¹¹

Many of the issues presented in this sub-section were also faced when the euro was created. In the European experience, a virtual currency (the European Currency Unit, ECU) was initially used to denominate official cross-border transactions, but it eventually evolved to serve as the basis for a real, single currency (the euro) to which the exchange rates of individual economies were irrevocable linked. Also, in Europe a major program was put in place to fully integrate national financial markets into a single market, which until the onset of the financial crisis was notably successful in erasing differences in national risk premiums.¹² A full monetary union approach as in the case of Europe is an option, but other approaches that would achieve similar benefits must be explored, as a monetary union is not generally considered feasible in the Asian context.

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