Building Integrated Financial Markets 10 years after the
                        Asian Crisis




                 (Chapte...
Chapter 4
Building Integrated Financial Markets 10 years after the Asian Crisis
Jenny Corbett




I Introduction

10 years...
measures should reduce financial vulnerabilities region-wide and also improve
access to resources for investments in infra...
on what further developments are needed and on the extent to which reforms have
adequately improved the quality of financi...
Figure 1




   Source, Ghosh 2006, p 4 and 27.
   Note: The data for Thailand in this chart are not consistent with the d...
different segments of the market as shown in Table 2 which indicates that the
markets in the region are still fairly small...
Source: Burton, Tseng and Kang, 2006.



Figure 4




Source: Burton, Tseng and Kang, 2006.




Efficiency indicators also...
limitations and cross-country differences in accounting practices require caution
here) .
Figure 5




Source: IMF, Global...
World Bank’s Doing Business Indicators i.e. disclosure, director liability and
shareholder suits. These three are taken to...
GDP) and density (measured as the premium per capita). As Ghosh notes, “There is
still substantial scope for further devel...
done and how transparent, efficient and robust the region’s financial markets are
now.   3




Most assessments show modes...
Source: Cowen et al, 2006, p 39
Note: More detail is available in the same source on the specific components of each
stand...
Source: Cowen et al, 2006, p 43


Detailed survey data from Central Banks (shown in Table 4) also shows that
countries var...
Indonesia   Malaysia     Philippines    Singapore   Thailand
Risk-based supervision                                 x     ...
Source: Lindgren, Carl-Johan (May 2006), Banking Integration in the ASEAN- Region: An Overview’, ADB Manila Philippines. T...
Similarities and differences of structure


Financial systems around the world differ in many respects and comparing them ...
Figure 11




Source: Ghosh, 2006


It is not only comparison of financial systems that is difficult. Since many different...
than they do in the UK but in the rest of continental Europe they are quite small. In the
US mutual funds are an important...
the same level but on ensuring that systems are transparent and open enough to ensure
that all savers, borrowers and inves...
The challenge this poses is in the design of policies to adequately regulate the systems
and to ensure that they can inter...
cross-border transactions, involving different currencies, interest parity conditions are
used and there is a hierarchy of...
(Source:      Kawai, presentation, “Europe Meets Asia: Regional Cooperation and
Integration: Ten Years after the Asian Fin...
been a general increase in the degree of integration of money markets around the region
since the crisis. Some pairs of co...
Table 6
                                              Uncovered Interest Differential (in percent) January 1995-December 1...
Poonpatpibul, Tanboon and Leelapornchai (2006) use the same “law of one price”
motivation to report the cross-country vari...
linked to each other.    The results are not directly comparable to other interest rate
measures but broadly indicate that...
the US or the EU. Tests for the importance of news as a determinant of equity returns
also suggests that news is more impo...
stocks) of cross-border financial activity. The difficulties here are usually data.      For
developing countries the accu...
Figure 13




Source: Poonpatipbul et al, BOT, 2006

The geographical distribution of asset holdings abroad and foreign ho...
Closer examination suggests something rather different. If Japan is excluded from the
East Asian group then 17% of assets ...
Table 7
Ownership shares within the region




                                     31
Total Portfolio Asset Holdings, Year-End 2005
                                                                            ...
Small values of cross-border assets (or low shares to GDP) alone cannot necessarily be
taken to indicate low integration. ...
debt) or at least much smaller than before trade effects (equities and long term debt).
These are important indicators of ...
35
Source: Chaipat Poonpatpibul, Surach Tanboon and Pornnapa Leelapornchai, 2006, BOT .
Notes: Figures in brackets refer to t...
The authors propose a challenging explanation for these results. Under a capital asset
pricing model (CAPM) view of the wo...
service” (Kono and Schuknecht, 1998 and Parrenas, 2007).           This picture does not
suggest that the financial sector...
Source: Parrenas, 2007, p 24

Other indicators of behind-the-border liberalization give a picture of greater opening.
The ...
Source: Cited in Park and Bae, (2002).
Notes: To measure the liberalization of the domestic financial system, Kaminsky and...
Direct measures of capital account opening are also an important component of
understanding the pattern of Asia’s financia...
Figure 17




Source: Chinn and Ito, 2007, p 17


Figure 18, using the most recent version of the Chinn-Ito data, shows th...
1986-1996 A verage            1999-2005 A verage

     3

     2

     1


     0

   -1

                                ...
44
Source; H.J. Edison, F.E. Warnock, (2003)

These data show that restrictions in Asia were initially quite high and that, w...
their view this attitude shift explains why “the capital account regime, at least in some
countries in East Asia, is not a...
The literature here is extensive but mainly does not focus on this specific question, but a
few conclusions do emerge. Mos...
(IMF, 2007) suggest that domestic policies towards the financial system do have an
effect. Capital controls, institutional...
Table 8




Source: Park and Bae, 2002


An important additional feature is that while foreign bank penetration in East As...
Source: Park and Bae, 2002




Euromoney poll results in other areas also confirm the dominance of American and
European i...
the six East Asian countries secured more than 70 percent of their total international
financing from banking institutions...
Source: Park and Bae, 2002




Park and Bae further use the evidence in Table 11 to show that American and European
lead m...
Source: Park and Bae, 2002


Table 12




                             53
Source; Park and Bae, 2002
Table 13




                             54
Source: Park and Bae, 2002


A similar picture emerges from other indicators. Parrenas (2007) notes that
trends in foreign...
largely achieved through domestically-funded mergers and acquisitions. Commercial
banking has been the sector most transfo...
Source: Parrnas, 2007, P 27


Figure 22




                              57
Source: Parrenas, 2007.




                          58
Figure23




Source: Parrenas, 2007, p


Figure 24




                            59
Source: Parrenas, 2007,


These indicators of penetration by foreign financial service providers are important not
only fo...
Several recent studies (Poonpatibul et al, 2006; Yap 2007; Boao Forum Annual Report,
2007; ASEAN Secretariat and Australia...
TABLE 14 REGIONAL COOPERATION FORA



                      CENTRAL BANK COOPERATION               FINANCE MINISTRY-LED CO...
ACD   EMEAP             SEACEN   SEANZA     APEC      ASEAN          ASEAN+3      ASEM

Structure
Governors’ mtg          ...
Arrangement;    Dialogue
                                                                                    Roadmap for  ...
Building Integrated Financial Markets (Report Chapter 4).doc
Building Integrated Financial Markets (Report Chapter 4).doc
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Building Integrated Financial Markets (Report Chapter 4).doc

  1. 1. Building Integrated Financial Markets 10 years after the Asian Crisis (Chapter 4 of ADB Flagship Study) Jenny Corbett AJRC ANU This is a draft and not for quotation. 29 October 2007
  2. 2. Chapter 4 Building Integrated Financial Markets 10 years after the Asian Crisis Jenny Corbett I Introduction 10 years after the financial crisis of 1997 there is still some debate about the proximate and more fundamental causes of the crisis. There is broad consensus that at the time of the crisis, Asian financial systems were not equipped to handle the capital flows generated by rapidly changing global markets, giving rise to the “double mismatch” problem. There is much less consensus on which specific aspects of their financial systems were crucial to the multiple failures. Most economies have subsequently strengthened financial supervision and disclosure; consolidated and recapitalized financial firms; improved reserves and asset quality; and restructured non-financial firms with an eye to governance (including privatization). As a result, the region has seen considerable financial deepening and improvements in financial sector performance. The contagion of the 1990s, however, demonstrated that the quality of every financial system in the region is of overall regional concern so it is relevant to look at the range of experience across the region, not just at average performance. Some assessments of the progress in quality of the financial sectors are still gloomy but broadly there is evidence of considerable improvement. Today most Asian countries have made partial progress to more diversified financial systems but have not yet developed a full range of assets and markets of sufficient quality nor the institutions and skills to intermediate their large savings and investment flows. Reforms need to continue, along with initiatives to deepen and connect capital markets and these policies need to be coordinated with macroeconomic policies on the capital account. The initiatives required to accelerate financial development, and financial integration, are largely national, but regional cooperation can offer support, for example, by defining standards for supervision, disclosure and regulation, by helping to create settlement mechanisms, and by supporting development of a range of markets. Such 2
  3. 3. measures should reduce financial vulnerabilities region-wide and also improve access to resources for investments in infrastructure, business capacity, social needs and consumer durables. These are key steps toward achieving the long-term vision of a more closely integrated Asian capital market though they cannot guarantee stability if the global financial markets are harbouring systemic problems. This paper is designed to consider the current situation of financial integration in the East Asian region against the background of changes in financial systems since the crisis of 1997. Since the main indicators of integration reflect the extent of cross border financial flows (or the price convergence that would indicate the potential for arbitrage even if physical flows don't take place) the natural first focus is on border barriers and capital controls. There are, however, several deeper elements that also need consideration. To begin with, the questions of national treatment and market entry behind the border have an obvious impact on the activity of foreign service providers. Even deeper, and more difficult to assess, is the role played by different levels of development in the markets in the region, by variation in the quality, reliability and transparency of markets and the impact of differing regulatory systems. Despite a plethora of studies on financial integration in the region there is no clear view of how important these elements are, nor which among them rank most highly as barriers to greater financial development and integration. It is therefore difficult to give good policy advice and to identify priorities for regional cooperation. Many things can be done, but current advice does not, and cannot, reflect empirically established priorities and sequences. A more coordinated research effort to establish these is an urgent priority II Domestic improvements since the financial crisis Most analyses of the financial crisis of 1997-8 attribute a large role to financial sector weaknesses in both structure and governance. Furthermore, recent studies of the extent of regional financial integration stress the limitations created by the levels of development of domestic financial systems. There is certainly more development needed but significant changes have already taken place. There is a consensus emerging that the depth and coverage of financial markets, as represented by aggregate data, has increased significantly over the last 10 years (Ghosh/World Bank 2006; Ghill and Kharas/World Bank 2006) but less consensus 3
  4. 4. on what further developments are needed and on the extent to which reforms have adequately improved the quality of financial, governance and regulatory systems. Starting with simple quantitative measures, Asian financial systems have grown and deepened significantly since the crisis of 1997-98. World Bank data (Ghosh, 2006) show that asset growth has been remarkable across the bank, equities and even bond markets. By comparison with countries of similar income levels Asian markets are of comparable or larger size (Table 1 and Figure 2) and on some measures (e.g. equity market capitalisation in Hong Kong, Singapore and Malaysia ) surpass those of developed countries.1 Table 1 Source: Gill and Kharas, 2006, p 174 4
  5. 5. Figure 1 Source, Ghosh 2006, p 4 and 27. Note: The data for Thailand in this chart are not consistent with the data in the preceding table which is also reproduced by Ghosh on the same page as the chart. Other country data, excluding Thailand, do seem consistent. It is frequently remarked that bond markets are still small in East Asia relative to other types of finance and that the growth of bond markets has come mainly from public bond issues (frequently to restructure ailing banking systems). The data, however, suggest that the bond markets have been amongst the most rapidly growing sectors of the financial systems in the region. Dhalla (2005) claims that there are now three bond markets in East Asia (China, Korea and Malaysia) with over US$100 billion and that the world’s two largest corporate bond markets relative to GDP are in East Asia (Korea and Malaysia) Beyond the bond and equity markets, It is not easy to get data on the size of markets for the whole range of financial services that now exist in developed countries so it is difficult to tell to what extent markets in Asia have expanded in sophistication and range of services. One indicator is the size of assets of institutional investors in the 5
  6. 6. different segments of the market as shown in Table 2 which indicates that the markets in the region are still fairly small. TABLE 2 Ghosh, p 130 Assessments of the improvement in the quality and efficiency of the financial systems in the region are varied. Quantitative measures indicate significant improvement in the levels of bad debts and corporate indebtedness (see Figures 3-4) Figures 3 6
  7. 7. Source: Burton, Tseng and Kang, 2006. Figure 4 Source: Burton, Tseng and Kang, 2006. Efficiency indicators also suggest that the functions of financial markets have improved. Efficiency of the banking sector has improved in terms of costs, NPLs, return on assets and capital adequacy as indicated in Figures 5-6 (although data 7
  8. 8. limitations and cross-country differences in accounting practices require caution here) . Figure 5 Source: IMF, Global Financial Stability report, Sept 2005, cited in Ghosh, 2006, p 68 Figure 6 Source: Ghosh, 2006, p 66 In the securities markets there is also evidence of improvement in function as well as scale. Liquidity, transactions costs and informational quality are all important to the functioning of securities markets. A World Bank index of market quality shown in Figure 7 uses two indices, one of market liquidity and one of the information quality of the market. The informational quality index captures three measures from the 8
  9. 9. World Bank’s Doing Business Indicators i.e. disclosure, director liability and shareholder suits. These three are taken to measure the strength of minority shareholder protection. Combined with the liquidity measure these create a composite index of market efficiency showing that most of the region’s markets are well below average standards. Figure 7 shows some international comparisons. Ultimately the information quality of the markets is demonstrated by lack of synchronicity (i.e. the ability to distinguish individual movements of stocks within the market). In explaining the outcomes on information quality Ghosh and Revilla find that some institutional arrangements matter but many that might be expected to have an effect do not appear important. Amongst their determinants disclosure rules are very important but so are the availability of stock lending and short selling. FIGURE 7 Stock market efficiency A further important indicator of the functioning of financial systems is the development of the insurance industry since it acts not only as an alternative savings vehicle in many of these markets but also as a risk-sharing mechanism. The most commonly used measures to assess the level of development of the sector are insurance penetration (measured as the insurance premium as a percentage of 9
  10. 10. GDP) and density (measured as the premium per capita). As Ghosh notes, “There is still substantial scope for further development, particularly in China, Indonesia, the Philippines, and Thailand (Table 6.6). Distribution channels are an important factor in increasing the coverage of insurance. In most insurance markets in the region, distribution has been built on the agency sales-force model, often extending to large numbers of sales forces (with varying degrees of productivity, reflecting the extent to which agents work full- or part-time).” (p 139). The alternative model for extending insurance is for banks to market insurance products. This model, known as bancassurance, developing rapidly in Europe, is also appearing in Asia. 2 Table 3 Source: Ghosh, p 139 Despite these developments in the region over the 10 years since the crisis it is still common to find assessments that vary on the details of how much more needs to be 10
  11. 11. done and how transparent, efficient and robust the region’s financial markets are now. 3 Most assessments show modest improvements in corporate governance measures (e.g. Cowen et al, 2006, p 20, based on Asian Corporate Governance Association survey data) but several countries in the region are performing worse on measures of the general governance climate or of corruption and law and order (Kramer, 2006 and Poonpatpibul, 2006 p 41). Bank governance appears still to be an area that needs improvement in many of the region’s economies. Data from the IMF Reports on Observance of Standards and Codes provide an important addition to these qualitative data. Developing Asia (Bangladesh, India, Indonesia, the Philippines, Sri Lanka and Thailand) exhibits lower compliance with Basel Core Principles than the average for middle income countries. Most developing Asian countries were non-compliant in principles regarding information sharing between supervisors, ownership, prudential regulation and requirements, on-site and off-site supervision, remedial measures, and cross-bordering banking. In addition, no supervisor in the sample practiced consolidated supervision or incorporated country risk control. On IAIS Principles (in insurance) the group outperformed peers. The main weaknesses for insurance supervisors around the world lie in corporate governance standards, internal controls and market conduct. In general, the assessed Asian systems exhibit the same deficiencies as in other regions. In applying IOSCO principles, securities regulators were not conducting proper market surveillance and did not have adequate rules to detect and deter manipulation and other unfair practices. In the implementation of standards of the committee on Payment and Settlement Systesm (CPSS) developing Asia also lacks risk management procedures, prompt final settlement, and arrangements for security, reliability and governance ( Cowen et al, 2006, p 40). Figures 8 to 10 gives a snapshot of this information from Financial Sector Assessment Program (FSAPs) over the period 1999-2005. Figure 8 11
  12. 12. Source: Cowen et al, 2006, p 39 Note: More detail is available in the same source on the specific components of each standard assessed. One noticeable feature is that participation in both the FSAP and ROSC process is low within the region. While there have certainly been criticisms of the procedures and effectiveness of the IMF’s surveillance this is an obvious area for early decision within regional fora. Either more countries in the region should take part in these processes or regional alternatives should be created to provide similar monitoring. Figure 9 and 10 12
  13. 13. Source: Cowen et al, 2006, p 43 Detailed survey data from Central Banks (shown in Table 4) also shows that countries vary significantly in their compliance with best practice in detailed banking supervision. Table 4 13
  14. 14. Indonesia Malaysia Philippines Singapore Thailand Risk-based supervision x x x x x Consolidated supervision x x x x More effective organization, risk-focus x x x Risk focus in allocation of staff resources x x x x x Specialized staff and supervisory units x x x x x Risk-focused, targeted on-site examinations x x x x x Strengthened off-site micro and macro monitoring x x x x x Early Warming Systems (EWS) x x x x x Improved databases x x x x x New examination manuals x x x x Major training efforts x x x x x Accreditation of bank examiners x Accreditation of banks’ credit and risk managers x Incremental enforcement actions x X Prompt Corrective Action (PCA) framework x X n/a Encourage mergers and consolidation x x X x x Mandate all banks to be externally rated x Mandate all banks to be listed X Deregulate pricing and fees x X n/a x Consumer protection and education x X x Corporate governance x x X x x Require board committees x x X x x Encourage outsourcing x X Encourage institutional investors x X Remove expatriate restrictions x Remove restrictions on salaries and mobility x External auditor accreditation and rotation x X x x Coordination with other dom. supervisors x x X n/a x Coordination with for. Supervisors x x X x x : Indonesia Malaysia Philippines Singapore Thailand Strengthen competition x X x Limit new entry after X x x x crisis Liberalize entry x x x x Anti-commingling policy x Strengthen bank X x x x x governance 14 Loan classification and X x x x x provisioning Accrual of interest x
  15. 15. Source: Lindgren, Carl-Johan (May 2006), Banking Integration in the ASEAN- Region: An Overview’, ADB Manila Philippines. Table based on questionnaires and central bank websites and annual reports. 15
  16. 16. Similarities and differences of structure Financial systems around the world differ in many respects and comparing them is fraught with difficulty. Allen and Gale (2004) and Allen, Chui and Maddaloni, 2004, note that comparisons should be made across many dimensions, recognising the many functions of financial systems. Size of markets, measured by assets of particular categories, is only one aspect. They also add the allocation of household and firms’ assets and liabilities by type, the size and number of institutions, the portfolio allocations of institutional investors and aspects affecting the transmission of monetary policy, such as the operation of mortgage markets and the formation of house prices. The practitioner and policy community would add to this list disclosure systems, quality of regulation and governance. Each of these comparisons is informative about different aspects of a financial system and avoids the temptation to label systems simply as, for example, “bank dominated” or “market oriented”. Quantitative measures and simple labels say little about the efficiency and stability of financial systems which is, at the end of the day, what we care about most. Even on the simple quantitative dimensions, as noted above, while bond market development has lagged by some measures, comparisons across a wider universe show that variations in the size of bond markets are marked across developed markets as well – the role and function of bonds appear to be a major source of difference in financial markets across the globe. Corporate bond markets remain very small in the UK and Japan as well as non-Japan Asia (see Allen, Chui and Maddaloni, 2004, figure 2). The fact that bank assets still make up a relatively large share of many Asian countries financial systems is also not unusual in global terms. Ghosh notes “Despite the progress made in diversifying financial markets, the banking sector remains dominant, accounting for around 58 percent of the region’s total financial assets at the end of 2005 (down from 63 percent in 1997)” (p 27) but also shows data that imply that Asian countries (with the exception of China) are mostly not far from global averages in the ratio of bank assets to other assets when adjusted for per capita income levels (see Figure 11) 16
  17. 17. Figure 11 Source: Ghosh, 2006 It is not only comparison of financial systems that is difficult. Since many different models of financial systems persist around the globe, there is no consensus in the research literature that one system is better than another. Some systems appear to suit particular industrial structures and systems for innovation better than others, but there is no strong tendency towards convergence in type of financial system even amongst advanced, industrialized economies. Freixas et al (2004) note that while differences are frequently characterized as bank- versus market-oriented “… this distinction dos not stand up to close scrutiny” . While continental Europe has large banking markets and relatively small stock markets, it also has large bond markets. Japan not only has a large banking market but also large bond and equity markets. The US is one “market- oriented” system with large bond and equity markets but small banking markets but there are few like it. Freixas et al go on to note that “A more significant difference is the nature of financial institutions in different countries. Non-bank financial institutions, such as pension funds and insurance companies play an even greater role in the Netherlands 17
  18. 18. than they do in the UK but in the rest of continental Europe they are quite small. In the US mutual funds are an important savings vehicle while in continental Europe equity investments have frequently been channelled through banks so that equity markets and the associated nbfis are relatively small”. They conclude “Overall, financial institutions and markets have been organized on national lines and there has traditionally been little cross-border flow in financial services”. The key point is that there is still little evidence of convergence in financial market structure or in the relative importance of different financial institutions towards any one particular model. This is not to say that there is no adoption of some common practices. Most countries have moved in the direction of global standards of disclosure and some similarity in regulatory structures to protect investors. But there is an important distinction between arguing for the advantages of adopting regulatory best practice and confusing this with the need to move financial systems towards a standardized model. The conclusion is that it is natural to expect a range of financial structures in the Asian region to co-exist. Even with the greater adoption of standards of best practice in the functioning of financial systems, the region will be home to a multitude of systems that may be more or less “bank-centred”, with more or less active equity and bond markets. The variation is evident in the data already presented. The shares of investment in GDP and the contribution of investment to growth over the last 5 years has been erratic, with falls much larger in Indonesia and Malaysia than in China and the faster growing transition economies. Similarly, the development and change in financial markets is as noticeable for the variance across the region as for the overall growth. Bank assets to GDP ratios in 2005 ranged from 50% in Indonesia to 444% in Hong Kong; equity market capitalization ranged from 18% in China to nearly 600% in Hong Kong while bond markets ranged from close to 20% in Indonesia to 76% in Korea and 88% in Malaysia. The range in the assets of institutional investors to GDP (pension funds, life insurance funds and mutual funds ) was similarly wide. This variation may not only reflect differences in levels of income and development but may also reflect the structural, historical and local differences that were noted by Freixas et al across the globe. That is, these differences may prove persistent, not merely transitory. If that is the case policy attention should not be focused on trying to bring all economies in the region to 18
  19. 19. the same level but on ensuring that systems are transparent and open enough to ensure that all savers, borrowers and investors have access to the services they need to smooth their consumption through time, to maximize returns to their investment and to match the risk of their portfolios to their risk appetites. Regulation As noted above, despite the overall pattern of lower than expected financial integration and of significant barriers to entry, there is a considerable degree of foreign penetration in the region’s markets. As Table 5 shows, there have also been significant numbers of cross-border banking investments in recent years and, where these groups continue to operate in multiple markets, they pose some new regulatory and supervisory challenges. This is true in a number of other financial service areas where the role of financial conglomerates is large. TABLE 5 Source: Ghosh, 2006, Appendix 1, p 182 19
  20. 20. The challenge this poses is in the design of policies to adequately regulate the systems and to ensure that they can interact and integrate smoothly. This requires a degree of coordination and cooperation around the region that may grow exponentially if the degree of financial integration increases. III Regional Integration and Regional Interdependence (This section to be shortened and rewritten) Global versus regional integration? In recent years many studies of the causes of the financial crisis and of the changes since those years have focused on the way the region’s financial systems link with other financial systems. High profile studies have asked the question “How financially integrated are countries in the region, both globally and among themselves?” (World Bank, 2006) and many have reported (and repeated) claims that “Standard measures of financial integration indicate that inter-regional integration continues to dominate intra- regional integration” (Cowen et al, 2006). Others note that Asia is less regionally integrated than Europe in terms of finance (Lee, 2007, Eichengree and Park, 2005). In addition it is usually commented that trade integration has progressed further than financial integration. On the face of it there is multi-faceted data to support these observations althought they pose a fundamental question about what is meant by financial integration and whether it is meaningful to describe systems as “more integrated’ with some subset of the global financial system than another. If we take the statements as meaningful the big questions that remain are what are the barriers holding the region back, are there costs associated with the pattern and what policy initiatives could help. How integrated are Asia’s financial markets? Measures of financial integration are broadly divided into 3 types: price measures, quantity measures and regulatory or institutional measures. Price measures The price measures are based on assumptions that in fully “integrated”, or completely open, markets, arbitrage would bring price equality on similar assets. In the case of 20
  21. 21. cross-border transactions, involving different currencies, interest parity conditions are used and there is a hierarchy of measures with increasingly stringent assumptions and implications about the degree of integration. At the least stringent level, covered interest parity would show a basic degree of financial integration (or at least, a failure of CIP would suggest strongly that markets were not integrated) while at the top of the pyramid (least likely to hold) real interest parity would indicate not only integrated markets but also similarity of risk preferences. Some studies also look for price co-movements in other asset classes such as stock markets but here the theoretical basis is less compelling, since asset and risk characteristics may vary significantly. Even within interest parity studies the details of methods vary considerably and the fundamental question remains whether the assets being compared are truly identical as required by theory. What interest parity conditions mainly measure is the existence of some barrier to investment flows i.e. a lack of openness of financial markets. This may be due to explicit capital controls or to other barriers to foreign funds entry (or domestic funds exit) or it might be due to a lack of information and awareness of external opportunities in small countries that are “off the radar” of the international investment world. It might also be because there are few truly identical financial instruments and, at the retail level at least, the difference between a bank deposit in your home country and one abroad is likely determined by your confidence in the level of protection afforded by regulations and the ease of access to funds. Such factors may even influence assets such as wholesale money market funds. The broad picture from price based studies is that while regional interest differentials have reduced on average there is variation between countries and across market segments and the size of differentials is still significant. 21
  22. 22. (Source: Kawai, presentation, “Europe Meets Asia: Regional Cooperation and Integration: Ten Years after the Asian Financial CrisisTen Crisis” German Institute for Economic Research (DIW) and ADB Berlin, 25 September 2007. Need more information on how calculated, what countries included, covered/uncovered?, real/nominal?, scale on axes) Using correlation data there is evidence of some increased integration in price data for equity markets but not much in the money markets and in bonds. Indeed some observers conclude that integration in these areas has reduced since the crisis. The evidence is rather varied. (NEEDS TO BE REWRITTEN WITH ORIGINAL DATA) Cavoli et al (2004) survey several studies of price parities and they also recalculate the uncovered interest parities between 8 East Asian economies (Table 6). They use simple uncovered interest differentials from 6 month commercial CD rates, using the actual spot rates 6 months out in place of expected exchange rate changes, and the authors note that this constitutes a joint test of the covered interest parity condition and the currency risk premium. Thus, data issues cannot be ignored (and there are no hypothesis or significance tests offered) but these data do not appear to support a view that there has 22
  23. 23. been a general increase in the degree of integration of money markets around the region since the crisis. Some pairs of countries (Indonesia with Malaysia, Indonesia with Hong Kong, Malaysia with Hong Kong, Philippines with Malaysia; Singapore with Philippines) appear to have nearly fulfilled the UIP condition during the period 2000 to 2002 and to have come closer to UIP after the crisis than before. On average Indonesia, Singapore, Korea and China have smaller differentials after the crisis than before, though it is not clear that the simple averages are very meaningful. 23
  24. 24. Table 6 Uncovered Interest Differential (in percent) January 1995-December 1996 Foreign Counties Domestic Economy Malaysia Philippines Singapore Thailand Korea China Hong Kong Indonesia Average Indonesia 2.98 2.53 4.83 1.98 5.26 1.02 3.84 - 3.21 Thailand 1.01 0.54 2.85 - 3.27 -0.96 1.73 -1.98 0.92 Malaysia - -0.45 1.85 -1.01 2.41 -1.96 0.66 -2.98 -0.21 Philippines 0.45 - 2.28 -0.54 2.87 -1.51 1.44 -2.53 0.35 Singapore -1.85 -2.28 - -2.85 0.54 -3.79 -2.57 -4.83 -2.33 Korea -2.41 -2.87 -0.54 -3.27 - -4.37 -1.92 -5.26 -2.95 China 1.96 1.51 3.79 0.96 4.37 - 2.68 -1.02 2.04 Hong Kong -0.66 -1.44 1.23 -1.73 1.92 -2.68 - -3.84 -1.03 Source: Cavolli et al, 2004 Uncovered Interest Differential (in percent) January 2000-June 2002 Foreign Counties Domestic Economy Malaysia Philippines Singapore Thailand Korea China Hong Kong Indonesia Average Indonesia 0.04 2.8 3.3 3.6 2.04 0.6 -0.03 - 1.76 Thailand -3.38 -0.78 -0.56 - -1.76 -2.82 -3.44 -3.6 -2.33 Malaysia - 2.8 2.44 3.38 1.37 0.56 -0.07 -0.04 1.49 Philippines -2.8 - 0.02 0.78 -1.13 -2.24 -2.86 -2.8 -1.58 Singapore -2.44 -0.02 - 0.56 -0.45 -1.94 -1.55 -3.3 -1.45 Korea -1.37 1.13 0.45 1.76 - -1.31 -1.94 -2.04 -0.47 China -0.56 2.24 1.94 2.82 1.31 - -0.63 -0.6 0.93 Hong Kong 0.07 2.86 2.57 3.44 1.94 0.63 - 0.03 1.65 Source: Cavolli et al, 2004 24
  25. 25. Poonpatpibul, Tanboon and Leelapornchai (2006) use the same “law of one price” motivation to report the cross-country variation of overnight money market rates for 9 East Asian economies and note that while the dispersion fell markedly after 1999 the standard deviation remains around 3% (Figure 12). They compare this with a figure for European unsecured lending rates (Baele et al, 2004) of virtually zero after the introduction of the Euro but since neither of these studies use covered or uncovered interest differentials and therefore are not correcting for currency risks, comparisons after the introduction of the Euro (with no currency risk) are not informative. Pre-Euro deviations within Europe averaged around 2% between 1994 and 1998 so apparently Asia post crisis is rather closer to Europe pre-Euro. Baele et al add a further test, which would be useful for Asia if data were available, that compares the cross-country variation with in-country variation (i.e across banks within country) to see whether the remaining variation between countries is greater than the normal variation between banks. In Europe both are nearly the same but no information is available for Asia. Without data for the pre-crisis era in Asia it is also rather difficult to discern whether there has been an increase in this measure of integration. Figure 12 Source: Chaipat Poonpatpibul et al, 2006. Takagi (2004) uses bilateral deviations from uncovered interest parity and bilateral interest rate correlations to give a picture of which of ten Asian economies are closely 25
  26. 26. linked to each other. The results are not directly comparable to other interest rate measures but broadly indicate that a few countries stand out as much less integrated with others in the region and a few country pairs are strongly linked. Japan and Indonesia appear to have larger deviations from UIP over the period while Taiwan, Singapore and Australia have smaller ones. A few obvious pairs seem closely linked: Australia with New Zealand and Singapore with Hong Kong. The interest rate correlation data does not give the same picture however, suggesting that Australia has rather small correlations with others in the regions. Indonesia has small correlations with most others in the region (though some country pairs are exceptions) while Thailand and Singapore have high correlations. It is difficult to take away an overall sense of close regional integration in interest rate measures from this data and it averages the whole period, pre and post crisis, giving no information about trends. Ngiam (2002) is cited by Takagi as reporting that deviations from covered interest parity widened in the region after the crisis compared with before, though de Brouwer had noted a shrinking of differentials between the 1980s and 1990s. In addition to price convergence in money or banking markets, similar arguments have been made for bond and equities markets, although it is much harder to find anything like identical assets in these markets. In fact, many of the tests for co-movement or convergence of prices do not appeal strictly to the law of one price as justification but to an idea that, if markets are integrated, then the basic discount rates will converge which will cause other rates of return to move together. Ghosh (2006) shows local currency bond returns (of what type is not specified) exhibiting very low correlations between Asian region markets (China, Indonesia, Korea, Malaysia, Philippines, Thailand, Hong Kong, Singapore and Japan) in 2004 and comparisons with developed country (UK, USA, Germany) correlations of 0.8 or larger make the contrast striking. Stock market correlations tend to show a more marked picture of co-movement of prices and suggest some increase in integration after the crisis. Ghosh 2006 shows correlations of equity returns pre and post crisis for 8 Asian economies and for the group of East Asia together. For most economies the cross-correlations, and those with the group, increase after the crisis, and they are higher than correlations for the region with 26
  27. 27. the US or the EU. Tests for the importance of news as a determinant of equity returns also suggests that news is more important after the crisis, implying more efficient markets with less underlying volatility and markets that are more attune to developments in the rest of the region and the rest of the world. With the exception of Korea, Thailand and Hong Kong, however, the proportion of volatility explained by external news, even in the post-crisis period, is still considerably lower than for the EU countries even before the introduction of the Euro. There is at least general consistency with a number of studies surveyed by Cavolli et al (2006) that stock markets in the region have become more sensitive to external influences in the post crisis period although it is not easy to read a regional effect in the results. Poonpatpibul et al (2006) give a similar picture using only correlations, while Chai and Rhee (2005) give the same picture using both correlations and variance decomposition, although the results of essentially the same calculations as in Ghosh are of a completely different magnitude. They also find that there is a large difference between the proportion of variance explained locally between East Asia and Europe although they also show a reduction in local effects and an increase in external ones in the recent period. While no study does the comprehensive analysis across all the major financial markets that Beale et al (2004) are able to do for Europe (covering money markets, corporate bonds, government bonds, credit and equity), the pattern for Europe seems different from the picture that has emerged for Asia. In Europe the money market is the most integrated, government bond markets have become “significantly integrated” after the introduction of the Euro while corporate bonds are “reasonably well integrated”. Equity markets too have become more integrated while banking markets remain the least integrated and display quite high price differentials, particularly in the consumer credit sector. In the absence of detailed data for Asia all that can be said is that there is evidence of some increased integration in price data for equity markets but not much in the money markets and in bonds. Indeed some observers conclude that integration in these areas has reduced since the crisis. Quantity measures Quantitative measures capture the extent of cross-border financial flows or the extent of cross-border holdings of foreign assets and liabilities. These measures have no particular theoretical foundation but do at least show the extent of actual flows (or 27
  28. 28. stocks) of cross-border financial activity. The difficulties here are usually data. For developing countries the accuracy and coverage of cross-border capital flow data is particularly problematic, and for some asset classes almost non-existent. Nevertheless, a number of studies have tried to discern patterns of cross-border activity and have described these as reflecting the degree of integration of the markets. Ghosh (2006) focuses simply on the proportions of assets held abroad in different regions and on the sources of foreign-owned assets in the region. Both assets held abroad by the region and the stock of foreign-owned assets inside the region grew, and this is offered as evidence of increased integration with the world financial system. Ghosh notes also that intra-regional holdings of both equities and bonds have increased and that the main pattern is investment by the industrialising economies (Hong Kong, Korea and Singapore) both into each others economies and into the developing economies (China, Indonesia, Malaysia, the Philippines and Thailand) in both bonds and equities. The developing East Asian economies have become considerable owners of equities in both global markets and in the industrializing East Asian economies but do not have significant bond holdings within the region. Ghosh takes these data to support the conclusions of price data showing integration both globally and within East Asia in the equities markets but less so in the bond markets. What is not evident is how this pattern appears against any benchmarks. Are these holdings absolutely large or small and how do they compare with either some theoretical norm or other regions’ behaviour? At a minimum we need comparisons across countries and regions of the size of financial holdings relative to GDP to give some normalization (Lane and Milesi-Ferretti, 2003, Obstfeld and Rogoff). Asian economies hold, on average, assets valued at only about half the European level relative to GDP (Lee (2007, using CIPS). Different data (IFS) confirm broadly the same picture (Figure 13, Poonpatpibul et al, 2006) but there are important caveats. Compared to the US, the average of Asian economies is quite deeply integrated with the world financial system. The US has a much lower value of foreign assets to GDP than either Asia or Europe. It can be misleading, however, to talk of the degree of integration of the region as a whole, or on average. Within the Asian region there is very large variation. Hong Kong and Singapore, as regional financial centres, are much more integrated than the average European economy. Most of the other countries of the region still hold very modest foreign assets in relation to their GDP. 28
  29. 29. Figure 13 Source: Poonpatipbul et al, BOT, 2006 The geographical distribution of asset holdings abroad and foreign holdings in the host country give a more nuanced perspective on the Asian region’s engagement with external financial systems compared with Europe and the US. This is not a theoretical benchmark (which would make comparisons of countries’ holding relative to their share of world financial endowments to judge deviation from the expected portfolio allocation in a perfectly open world4) but it is a reasonable rule-of-thumb comparison. On average, Lee shows that East Asian economies held about 4.9% of their foreign portfolio assets within East Asia in 2003, while they owned 8.6% of the total foreign-held assets in the region. These compared with 57% and 62% for Europe’s holdings in Europe. (see Lee, Tables 1 and 2). Lee concludes, as do Poonpatpibul et al, that Asia is much less integrated into the world’s financial system than Europe. In corss-border bank flows Eichengreen and Park (2005) conclude the same. 29
  30. 30. Closer examination suggests something rather different. If Japan is excluded from the East Asian group then 17% of assets held abroad are held in the East Asian region compared with Europe’s 57%. In equities the proportion is 20% compared with Europe’s 53%, while in long term debt the comparison is 15% against 46% and in short term debt 18% against 59%. There is still, certainly, a large difference between Asia and Europe, but excluding Japan increases the figures by several multiples. This reflects the fact that Japan, a large, post-industrial economy is heavily invested in equivalent economies elsewhere, rather than near neighbours. It also highlights the growth in Asia’s integration in all directions since the first detailed data became available in 1997. The pattern of ownership of the regions’ liabilities is also different from the conventional view when Japan is excluded. Ownership shares jump from only 8.2% of all foreign held liabilities in East Asia to 22%. These shares are still smaller than European ownership of liabilities in Europe (at 61%) but by less of a margin. The pattern is consistent across the different portfolio investment markets but remarkably, in short term debt, Asia’s holdings of the regions’ liabilities (at 86% excluding Japan) is larger than Europe’s holdings within Europe (at 86%). On these data, the markets in which the Asian region is most “regionally integrated” in terms of its holdings of assets are first the equity markets, then short term debt and finally long term debt (ranked excluding Japan) but the international holdings of short term debt are much smaller than either of the other two and are almost entirely accounted for by Hong Kong and Singapore. In terms of the ownership of liabilities in the region, the order is reversed. The regional share is largest in short term debt, next in long term debt and least in equities. The reason is that extra- regional investors account for very large proportions of the inward portfolio investments in equities. 30
  31. 31. Table 7 Ownership shares within the region 31
  32. 32. Total Portfolio Asset Holdings, Year-End 2005 (in millions of U.S. dolloars) Ho ng (% o f (% o f Eme rg ing Ko ng , Ta iwa n , China , g lo ba l AS EAN - 5 g lo ba l As ia - 10 (% o f g lo ba l S o urc e Co untry China Ko re a S ing a po re China Indo ne s ia Ma la ys ia P hilippine s Tha ila nd Vie tna m P . R. Ja pa n India NIEs To ta l to ta l) To ta l to ta l) To ta l to ta l) Glo ba l To ta l Ho ng Ko ng , China .... 12,276 7,097 4,539 467 4,186 1,119 2,219 (c) 41,299 16,683 2,058 23,911 5.48% 7,991 1.83% 73,201 16.77% 436,570 Ko re a 1,018 -- 317 25 6 278 22 39 -- 101 1,463 291 1,360 3.12% 346 0.79% 1,807 4.14% 43,665 S ing a po re 13,746 9,039 -- 3,216 6,332 16,783 948 4,476 -- 3,177 9,020 2,415 26,000 40.19% 28,539 44.12% 57,716 89.22% 64,686 Ta iwa n , China Indo ne s ia -- 1 217 -- -- -- 5 -- -- 102 17 27 218 18.69% 5 0.39% 325 27.78% 1,169 Ma la ys ia 196 70 751 37 26 -- 10 76 -- 14 51 16 1,055 27.89% 112 2.96% 1,180 31.21% 3,781 P hilippine s 59 60 163 -- 5 44 -- 18 -- 40 19 17 282 5.81% 67 1.39% 389 8.03% 4,851 Tha ila nd 155 97 180 -- 157 19 4 -- 37 1 90 2 432 13.89% 217 6.98% 650 20.90% 3,108 Vie tna m China , P . R . Ja pa n 8,924 7,456 4,415 1,347 573 1,263 1,382 746 12 4,074 .... 2,977 22,142 1.05% 3,976 0.19% 30,193 1.43% 2,114,888 India 4 -- 5 -- -- 1 -- 1 -- -- 1 -- 9 10.92% 2 2.03% 10 12.95% 81 NIEs To ta l 14,764 21,315 7,413 7,780 6,806 21,247 2,088 6,734 -- 44,577 27,165 4,764 (% o f g lo ba l to ta l) 10.74% 8.91% 8.91% 6.80% 23.35% 41.93% 9.50% 20.88% 0.03% 39.69% 2.17% 4.18% AS EAN - 5 To ta l 409 228 1,312 38 188 63 19 94 37 157 177 62 (% o f g lo ba l to ta l) 0.30% 0.10% 1.58% 0.03% 0.64% 0.12% 0.09% 0.29% 3.17% 0.14% 0.01% 0.05% Eme rg ing As ia - 10 to ta l 15,173 21,543 8,725 7,817 6,994 21,310 2,107 6,828 37 44,734 27,342 4,826 (% o f g lo ba l to ta l) 11.04% 9.01% 10.48% 6.84% 23.99% 42.05% 9.58% 21.17% 3.21% 39.83% 2.18% 4.24% Glo ba l To ta l 137 ,4 9 3 2 3 9 ,09 6 8 3,2 13 114 ,3 5 4 2 9 ,153 5 0 ,67 7 2 1,98 5 ####### 1,16 2 112 ,3 12 1,2 5 1,4 17 113,93 8 32
  33. 33. Small values of cross-border assets (or low shares to GDP) alone cannot necessarily be taken to indicate low integration. The issue of benchmarks is crucial. By what standard do we interpret these quantitative data? The gravity model is one approach to determining whether intra-regional integration is lower than might be expected (cf Lee, 2007, Eichengreen & Park, 2005). Taking several characteristics of country pairs into account this approach considers whether bilateral financial relations are lower or higher than might be expected given the range of factors that generally explain bilateral cross- border holdings of assets (size of the two economies, distance between the two, common language, common borders and common colonial heritage). For portfolio holdings Lee finds that the extra effect of being within the East Asian region is significant. Country pairs within East Asia hold assets in each other that are 1.54 times larger than would be held by a random pair of countries. Thus there is indeed evidence of a degree of integration greater than “normal”. Furthermore, these data include Japan in the East Asian group and, as already noted, this has the effect of depressing the average proportion of assets held in the region. A similar exercise excluding Japan should give an even larger regional integration factor. The number in these estimates remains much smaller than the “Europe effect” which is on the order of 9 times the size for a random pair. The behaviour of cross-border bank claims is rather different in very simple gravity models (Eichengreen and Park, 2005) and suggests that the Asian regional effect is even greater than the effect for Europe. Once bilateral trade flows are accounted for, however, the Asian regional effects in both portfolio and bank claims become negative. This means that larger bilateral trade flows have such a large positive effect on financial flows that, once that effect is taken out, the additional effect of being within the Asian region is negative – financial flows in both Asia and Europe are lower 5 than they would be between random pairs of countries with similar bilateral trade flows. The conclusion from these studies is that there is evidence of above average financial integration amongst Asian economies, even though it is still less than between European economies, but that it may be largely explained by the degree of bilateral trade between countries in the region. Once trade is accounted for there is less integration in the region than normal and this pattern is replicated across most types of portfolio assets (equities, long-term debt and bank claims; short term debt is not so affected). Interestingly similar patterns are found in Europe – once trade is accounted for, the positive regional effect either becomes negative (in bank claims), very small (short term 33
  34. 34. debt) or at least much smaller than before trade effects (equities and long term debt). These are important indicators of what drives or impedes financial integration, to which we will return. Consumption correlations Another important aspect of the quantitative integration of the regions’ financial markets is shown by measures of correlations between consumption, savings and investments. The rationale is that integrated financial markets allow global movements of savings and investment. This should mean that investors in one country are not limited by access to only domestic savings6. Fully open capital markets and fully integrated financial systems should imply no correlation between domestic savings and investment for any individual country. Furthermore, the desire to smooth consumption can be met by access to capital markets either at home or abroad, so a related approach to measuring integration is to look for convergence of consumption paths between countries. If countries are able to smooth the path of their consumption this implies that they have access to capital markets and are able to reduce or share the risks of consumption volatility. Under perfect risk sharing the consumption growth rate of one country would equal that of the world consumption growth. There are relatively few careful attempts to analyse consumption risk sharing as an indicator of the degree of integration for the Asian region and several are quite old. Broadly the data suggest that there have always been quite high correlations between domestic investment and savings, indicating low degrees of openness before and after the crisis years (Montiel, 1994, Le, 2000, Isaksson, 2001). Performance for individual countries across the region varied considerably. The diagrams from the Poonpatpibul et al (Figure 13) give a pretty clear picture of what all variations of this analytical approach will find - a high degree of co-movement of domestic consumption with domestic production. Figure 13 34
  35. 35. 35
  36. 36. Source: Chaipat Poonpatpibul, Surach Tanboon and Pornnapa Leelapornchai, 2006, BOT . Notes: Figures in brackets refer to the growth rate between 1986 and 2004 of real consumption and real output respectively In formal tests of whether individual countries in the Asian region share risks with other regional economies or with the world (or not at all) Kim, Lee and Shin (2007) show that the pattern of regional and global risk sharing for Asia and Europe are quite different. Asian economies have a lower degree of risk sharing within the region but a higher degree of risk sharing globally than Europe. Not all countries are achieving risk sharing. Out of 10 Asian countries 4 had significant risk sharing with the region (China, Hong Kong, South Korea and Taiwan) while four had significant global risk sharing (Japan, Philippines, Singapore and Thailand). On average the Asian economies have lower overall levels of risk sharing than Europe. 36
  37. 37. The authors propose a challenging explanation for these results. Under a capital asset pricing model (CAPM) view of the world, investors should diversify their portfolios to the greatest possible extent, choosing securities with low correlation with each other and with the home portfolio. If this argument carries across to countries (and it is much more complex to make this transition) then “countries with different structures, subject to different economic shocks, with low business cycle correlation, will find it more advantageous to develop closer financial links with one another. In this regard, extensive portfolio diversification within East Asia may not be necessarily an optimal strategy, considering the homogeneity of East Asian economies.” By homogeneity, the authors mean close correlation of output growth rates within the region. This argument seems to imply that “the welfare gains for regional financial integration are lower in East Asia than in Europe” (Lee et al, 2007). This is not necessarily a wide-spread view and other estimates have set the gains from consumption risk sharing very high in Asia. As noted earlier, both quantity and price measures may be seen as measuring either integration or openness of financial systems and while the two concepts are often used interchangeably they are not quite the same. The integration measures capture the after-the-fact extent of financial trades and price movements and indirectly reflect the openness of systems to cross-border flows. Direct measures of the barriers to flows can be an important part of the picture. The distinction here is between de facto measures of openness (or the degree of integration) and de jure measures (that show whether policies restrict access to financial markets or limit capital account transactions). Direct measures of barriers There are several different interpretations of just how open Asian financial markets are, based on variations of the de jure measures. The measures most commonly capture direct capital controls but a few indicate the extent of deeper liberalization in financial sectors behind the border. Most Asian economies had made quite modest commitments on financial services by the end of the GATS round in 1997 (see Table in Appendix and Figures below). Since the GATS requires only limited capital account opening and only in so far as capital flows form an “essential part of the liberalized service” or are “related to the supply of the 37
  38. 38. service” (Kono and Schuknecht, 1998 and Parrenas, 2007). This picture does not suggest that the financial sectors in Asia have been significantly opened as a result of trade commitments7. Contreras and Yi (2004, cited by Parrena) concluded that East Asian economies’ core banking, core insurance and securities services are closed or partially closed to foreign competition while auxiliary financial services, financial data processing and other insurance services are largely open. These conclusions, drawn from study of the GATS commitments, do not sit well alongside evidence of the actual involvement of foreign providers in financial services and indicate how difficult it is to match policy statements with actual practice and outcome. Figure 14 Source: Parrenas, 2007, p 24 Figure 15 38
  39. 39. Source: Parrenas, 2007, p 24 Other indicators of behind-the-border liberalization give a picture of greater opening. The most frequently cited are the measures of Kaminsky and Schmukler (2003) that show gradual progress in liberalisation of the domestic financial systems and stock markets but much slower opening in capital markets in seven East Asian economies (Figure 16, from Park and Bae, 2002). Figure 16 39
  40. 40. Source: Cited in Park and Bae, (2002). Notes: To measure the liberalization of the domestic financial system, Kaminsky and Schmukler analyze the regulations on deposit interest rates, lending interest rates, allocation of credit, and foreign currency deposits. As additional information, they also collect data on reserve requirements. To set the liberalization dates, they focus mainly on the first two variables, the price indicators. However, they complement that information with the regulations on the last three variables, those on quantities, to have a better picture of the degree of repression of the domestic financial sector. Finally, to track the liberalization of stock markets, they study the evolution of regulations on the acquisition of shares in the domestic stock market by foreigners, repatriation of capital, and repatriation of interest and dividends. (Kaminsky and Schmukler, 2002, p 9) 40
  41. 41. Direct measures of capital account opening are also an important component of understanding the pattern of Asia’s financial integration. These are likely to be a necessary, but not sufficient, condition for greater integration. Without some such measures it is difficult to assess the effect capital controls have on the degree of integration and to consider whether they are part of a policy arsenal that could be deployed to encourage further integration. The difficulty of capturing policy change by measurable variables is well known. The choices for measurement of the extent of capital account opening are fairly limited but there are a number of different approaches. Essentially there are several variations on an index of “on-off” restrictions based on the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions and there are (fewer) measures based on the actual accessibility of parts of the financial system. The results of these studies do not give a consistent picture. Miniane (2004) concludes that there has been minimal reduction in capital account restrictions in Asia, with the exception of Korea, and that in many economies barriers rose after the financial crisis. With more disaggregated data from the same underlying IMF source Park and Bae (2002) conclude that there has been fairly steady reduction in capital account barriers in most Asian economies with the exception of Malaysia which famously imposed tighter controls in response to the crisis. Using dummy variables, however disaggregated, gives no way to distinguish which of the components drives the change in status of a particular country even though it is likely that not all components matter equally. Chinn and Ito (2007) develop a variant of the dummy variable measures of Miniane and others. They derive the principal component of four variables that include both the conventional capital account controls and also measures of the presence of multiple exchange rates, controls on current account transactions and the need to surrender export proceeds. These are expressed in terms of degrees of openness rather than whether restrictions exist, and data are available for 181 countries back to 1983. This measure has the advantage of incorporating a more extensive range of restrictions that would impact on cross-border capital movements. From Figure 9 it is clear that “the pace – and pattern – of financial opening exhibits wide regional variation. The Asian region has had relatively high levels of financial openness since the 1970s, although the rate of financial opening slowed down in the aftermath of the Asian crisis of 1997-98” (p7). 41
  42. 42. Figure 17 Source: Chinn and Ito, 2007, p 17 Figure 18, using the most recent version of the Chinn-Ito data, shows the position for individual economies in East Asian up to 2006. Individual variation within the region is noticeable, with some countries decreasing openness after the crisis. Figure 18 42
  43. 43. 1986-1996 A verage 1999-2005 A verage 3 2 1 0 -1 IND IDN US AUS SGP MYS VNM PHL HKG UK JPN PRC KOR THA -2 Source: Calculated from data available at http://www.ssc.wisc.edu/~mchinn/research.html Note: The apparent decline in openness for Australia is an artifact of the more detailed data that became available after 1996 when one component of the IMF data was provided at a more disaggregated level. This resulted in one variable that previously had been classified as no restriction becoming a restriction. In contrast to the previous figure the data are not normalized to have minimum values of zero. Edison and Warnock combine some elements of both de facto and de jure characteristics by measuring the proportion of an economy’s stock market that is available to foreign investors. Taking one minus the ratio of the investable part of the stock market to the total market capitalisation they create an index which captures not only the legal restrictions, but also the intensity of them. A higher index shows that a higher proportion of the stock market is not accessible to foreign investment – showing not merely the existence of restrictions but how pervasive they are. The data for 10 Asian countries are shown below (Figure 19) Figure 19 Edison-Warnock measure of restrictiveness of controls on stock markets 43
  44. 44. 44
  45. 45. Source; H.J. Edison, F.E. Warnock, (2003) These data show that restrictions in Asia were initially quite high and that, while they declined over the 1990s, the timing extent and evolution varied in different economies. The overall level of restriction remains quite high for most of the region. The patterns are similar to those shown by other measures: Korea, Indonesia, Thailand, Taiwan have become more open while Malaysia’s experiment with restrictions shows very clearly. The Philippines shows very little change from its quite high pre-crisis level of restriction. It is notable that India remains quite heavily restricted. However it is hard to take away from these measures the conviction expressed by Takagi and Hirose (2004, p 133) that there has been a reversal of the pre-crisis trend to great financial integration, reflecting a change in attitude globally towards a greater acceptance of moderate capital controls. In 45
  46. 46. their view this attitude shift explains why “the capital account regime, at least in some countries in East Asia, is not as open today as it was before the crisis” p 133 . Considering the mixed picture presented by different measures of de facto and de jure integration or openness, the appeal of some composite measure covering several different indices seems clear. Surprisingly, composite (multivariate) indicators of financial integration are a relatively recent development and few studies have applied this approach to Asia. Takagi and Hirose (2004) is an exception that uses principal components analysis of five dimensions of financial integration: exchange rate volatility, deviations from purchasing power parity, deviations from uncovered interest parity, trade intensity, and short term nominal interest rate correlation. They derive a single indicator of integration between pairs of countries in the Asia region and then group countries by cluster analysis to show which are more closely integrated and whether groups of closely integrated countries can be identified. They conclude that there are two groups of closely integrated economies: one group consists of Australia, New Zealand, Singapore and Taiwan while the second group covers Malaysia, the Philippines and Thailand. These groups are, however, significantly influenced by the heavy weight given to exchange rate volatility in the principal components analysis and may not be very informative. Their research was not designed to compare the degree of integration within the region against any other, nor to show changes over time, although it could be adapted to both purposes. More importantly, the choice of which underlying indicators of integration to include is crucial and there would be many competing choices available but the approach warrants further development. What drives integration? Although the extent of financial integration between the region and the rest of the world, and within the region itself, may still be open to debate, and there is still some variation in views about whether integration and openness have increased or decreased since the crisis, a picture emerges of slow, and sometimes sporadic, increase in financial integration. What can be said about the main drivers of the process? In particular, do the remaining de jure barriers explain a low level of financial integration or are other factors more important? 46
  47. 47. The literature here is extensive but mainly does not focus on this specific question, but a few conclusions do emerge. Most research suggests that removing de jure capital controls does not automatically result in increased integration although removing the Edison Warnock type restrictions on access to domestic stock markets by foreign investors does result in increased portfolio investment by foreigners. Adding capital control variables to the gravity models does not suggest that financial flows would be closer in the absence of the controls. The major explanation of degrees of financial integration seems to be trade. Countries with large trade flows will likely also have large capital flows relative to GDP. There is debate about whether finance follows trade or the reverse but it does seem that this is an important element of the difference between Asia and Europe. In so far as trade integration has been a market-driven, bottom-up process in Asia, it is probable that the same will be true of financial integration. What is much less clear is how much is actually contributed by the policy and financial structure variables that regularly turn up in lists of desirable reforms to promote greater integration. Ghosh (2006) lists the impediments to greater cross-border transactions as including withholding taxes, a lack of hedging instruments, differences in market practices and infrastructure such as trading platforms and conventions, procedures for clearance and settlement and custodian systems, differences in rating standards, national legal and regulatory frameworks and accounting and auditing practices. To this list others have added the “underdevelopment of financial markets”, inadequate financial and legal structure, low auditing and accounting standards, low transparency, weak corporate governance (Lee, 2007). Parrenas (2007) surveys several papers and picks out recommendations to improve transparency, legal systems, insolvency systems and workout procedures, competition and free entry, risk pricing undistorted by subsidies or interest rate controls, clearing and settlement systems, government bond markets and benchmark yields and the promotion of securitization. We have only limited consistent statistical evidence on which of these desiderata actually affect the extent of financial integration. Lane and Milesi-Ferretti (2007) find that financial depth and the size of stock markets have an effect but, tellingly, corporate income tax rates and the introduction of insider trading laws have no effect. Ostry et al 47
  48. 48. (IMF, 2007) suggest that domestic policies towards the financial system do have an effect. Capital controls, institutional quality, trade openness and the level of economic development affect the overall extent of openness (measured by total foreign liabilities as a share of GDP). The institutional quality index is an average of indicators covering voice and accountability, political stability and absence of violence, government effectiveness, regulatory quality, rule of law and control of corruption. The measurement of all of these is contentious and they are much bigger policy issues than simply improving financial systems, difficult as that may be. Much of the policy advice and discussion that follows here, and in other papers, is based on intuition and anecdotal evidence about what would improve financial systems, rather than on hard evidence. There is a clear need for more research on these issues. Foreign influence in regional financial systems is growing Despite the impression of a relatively slow-to-integrate region there has been a very marked increase in the degree of foreign participation in the domestic systems of the region and in some types of cross-border activity. As Park and Bae (2002) document there has been a dramatic increase in foreign ownership of banks in most emerging market economies during the second half of the 1990s. Foreign banks’ penetration was traditionally low in East Asia because of barriers to entry but this has changed since the 1997-98 crisis (Table 3 from their Table 14, reproduced below). Foreign bank control over assets of local banks jumped from less than one percent in Korea in 1994 to 4.3 percent in 1999. In Indonesia, it rose by more than ten times during the same period. On average, the foreign control in Korea, Malaysia and Thailand rose to 6 percent in 1999 from 1.6 percent five years earlier. Similarly, as a result of the lending behaviour of BIS reporting banks, foreign banks’ credit as a share of total bank credit more than doubled in Malaysia: it rose to more than 40 percent after the 1997 crisis from an average of less than 20 percent over the 1990-96 period. In the Philippines the share jumped to 35.5 percent in 2001 after a sustained decline during the first half of the 1990s and in Thailand there has been a gradual increase in foreign banks share. Foreign banks also made a substantial gain in terms of the loan market share, which reached almost the 30 percent level in Malaysia. Only in Taiwan and Korea, have foreign banks have not been able to increase their loan market shares. Much of the increase in the market share of foreign banks in the Southeast Asian countries has come from the large increase in their local currency (see Park and Bae’s Figure 4). 48
  49. 49. Table 8 Source: Park and Bae, 2002 An important additional feature is that while foreign bank penetration in East Asia is still lagging behind that in other emerging market economies, American and European banks have established a near monopoly position in providing two major services in the capital markets in East Asia: 1) underwriting in the primary market and 2) trading and consulting in the secondary market. It is hard to quantify the value of financial services and data are sparse so only data related to investment banking are presented to show the dominance of American and European financial institutions in financial services in East Asia. Western financial institutions, in particular American ones, have been by far the largest providers of financial services in global investment banking. A Euromoney 1996 “poll of polls’ showed that of the top 20 investment banks (based on a compilation of 70 Euromoney polls and league tables produced in 1995), almost all were either American or European. Six years later, this dominance remained unchanged; only one Japanese investment bank made the list (see Table 9). Table 9 49
  50. 50. Source: Park and Bae, 2002 Euromoney poll results in other areas also confirm the dominance of American and European institutions in providing the entire range of financial services (see Table 12 in Park & Bae) . US-based financial institutions led in every category of services, followed by British-based ones. No financial institution was based in Asia with the exception of Japan, and even then, the Japanese institutions were ranked last. The Euromoney poll in 2002 shows that American investment banks had increased their dominance further; Japanese investment banks have been largely driven out of the market for capital market services since 1995. Table 10 and 11 classify the capital market instruments issued in the five Asian countries during the 1991-2001 period by nationality of the lead managers or book runners who sponsored the new issues. Out of US$ 31.96 billion that was financed through capital markets for the 1998-2001 period by the six countries, 74 percent was undertaken by American and European investment banks, and 6 percent by Japanese institutions. The cumulative figures for the 1991-1997 period show almost 70 percent of the capital market financing was managed by western institutions, compared to 30 percent by East Asian investment banks. Table 5 further shows a very significant change in the structure of East Asia’s international financing. Before the 1997 crisis the East Asian countries had relied heavily on syndicated loan financing. In the early 1990s, 50
  51. 51. the six East Asian countries secured more than 70 percent of their total international financing from banking institutions. The proportion of loan financing declined gradually, and after the 1997 crisis, all of their foreign financing has come from capital markets. In managing the syndication loan financing, East Asian banks maintained a share of the market during the 1991-2001 period, reflecting the bank dominance of the East Asian financing systems. Table 10 51
  52. 52. Source: Park and Bae, 2002 Park and Bae further use the evidence in Table 11 to show that American and European lead managers accounted for more than 70 percent of all capital market financing, while Japanese institutions represented only 9 percent over 1991-2001. Table 7 lists the top 20 lead managers in the management of debt and equity issues. As they point out, the total amount underwritten shows a similar pattern of dominance by American and European institutions which represented 90 percent while the East Asian institutions only accounted for 10 percent. They report that according to Risk Magazine (November 1996), most first-tier derivative brokers and dealers were either American or European institutions when evaluated on pricing ability, market making reliability and liquidity, innovation and speed of transaction, even before the 1997- 98 crisis. No Asian region financial institution was ranked in the first tier as either active brokers or dealers of Asian derivatives. One important cause of the absence of regional players in these markets was the financial crisis and the non-performing loan problems of Japanese banks which curtailed their lending activities and caused them to withdraw from the region. Table 11 52
  53. 53. Source: Park and Bae, 2002 Table 12 53
  54. 54. Source; Park and Bae, 2002 Table 13 54
  55. 55. Source: Park and Bae, 2002 A similar picture emerges from other indicators. Parrenas (2007) notes that trends in foreign investment in East Asia’s financial services industries reflect the growing openness of the region’s markets throughout the last decade, particularly with respect to commercial presence. Figures 20-24 show the growth of foreign investment in financial services in a number of East Asian economies. Despite the overall growth, there are some variations in the importance of foreign investment (relative to domestic investment) in the restructuring of financial systems (Figure 21). In about half of East Asian economies (Thailand, Hong Kong, China, Indonesia and South Korea), foreign investment played a substantial role in the restructuring of regional financial systems, exceeding 50% of total investment in Thailand, Hong Kong and China. In the other half (Japan, Malaysia, Singapore, the Philippines and Taiwan), financial restructuring was 55
  56. 56. largely achieved through domestically-funded mergers and acquisitions. Commercial banking has been the sector most transformed by foreign investment (Figures 22-23) in part as a result of acquisitions of non-performing loan portfolios). In a few economies, however, investment in other financial services was significant. The insurance industry in China and Taiwan, and the securities industry in Hong Kong, Malaysia and China are example. There is also variety in the region in both the size and sector distribution of foreign investment, as Figure 24 shows. These data indicate that, with the exception of Thailand, foreign investment in East Asia’s financial services industry has come to play more significant roles in the insurance and securities industries, as well as in other credit institutions. Figure 24 confirms the points made by Park and Bae about the dominance of foreign lead managers. Figure 20 Source: Parrenas, 2007, p 26 Figure 21 56
  57. 57. Source: Parrnas, 2007, P 27 Figure 22 57
  58. 58. Source: Parrenas, 2007. 58
  59. 59. Figure23 Source: Parrenas, 2007, p Figure 24 59
  60. 60. Source: Parrenas, 2007, These indicators of penetration by foreign financial service providers are important not only for what they say about the extent to which financial integration is taking place but also for the challenge they pose in terms of regulation and supervision, to which we return below. IV Regional cooperation There already exist a number of regional fora in which financial issues are considered. Table 14 indicates the membership of the major government level groups and some elements of their structure. In addition there are several industry-initiated bodies that exchange information and may have a role in helping develop best practice and self- regulatory expertise. 60
  61. 61. Several recent studies (Poonpatibul et al, 2006; Yap 2007; Boao Forum Annual Report, 2007; ASEAN Secretariat and Australian Treasury (Hew et al), 2007) Dobson, 2004 and 2006) describe well the range and functions of the various regional groups that have some involvement with financial issues. As Table 14 shows, most countries in the region belong to several different groupings and many have work programs covering related (or substantially the same) areas. At present it is probably fair to say that there are enough groups tasked with collecting and sharing information between their members (although as noted in the conclusions there are still some kinds of information that could usefully be added) but, though several of them are also intended to carry out surveillance and peer review, the surveillance element is still weaker than desirable. Furthermore, there is clearly considerable overlap in the focus of several different groups. This may have desirable elements since some groups include members that bring valuable perspectives to the task but who are excluded from other groups. It does mean, however, that there can be considerable duplication of effort. It is also unnecessarily difficult to discover the different work programs and initiatives within each group relating to the same area. The compilations from which Table 14 are drawn are found in research papers or deep within annual reports. Yet this, at-a-glance description of the work being done on financial integration and market building is necessary every time a working group considers what remains to be done. In addition it would be useful to have similar information organised by topic or market segment so that it would be easy to discover under the heading say of “liquidity support” or “capital market rules harmonisation” which groups were working on what elements. Such a database would not be very difficult to compile and could be kept up-to-date by agreement across the various organisations. It could usefully reside at the ADB ARIC website. Table 14 61
  62. 62. TABLE 14 REGIONAL COOPERATION FORA CENTRAL BANK COOPERATION FINANCE MINISTRY-LED COOPERATION ACD EMEAP SEACEN SEANZA APEC ASEAN ASEAN+3 ASEM Year established 1991.2 1966.2 1956 1994.3 1967.8 1999.4 1997.9 Members 28 11 16 20 21 10 13 39 Indonesia,Malaysia, X X X X X X X X Philippines, Singapore, Thailand Brunei X X X X X X Vietnam X X X X X X Cambodia, X X(all X X X Myanmar, Lao PDR except Laos?) Hong Kong, X X ? X X Taiwan X X X X Korea X X X X X X X China, Japan X X X X X X Australia, X X X New Zealand X X X Mongolia, Nepal, ? X Sri Lanka Papua New Guinea ? X X Bangladesh, Iran, ? X Macau, India ? X X X Fiji ? X Canada, Chile, X Mexico, Russia, US EU-25 X 62
  63. 63. ACD EMEAP SEACEN SEANZA APEC ASEAN ASEAN+3 ASEM Structure Governors’ mtg 1x pa 1x pa biennial Deputies mtg 2x pa 1x pa 1x pa 1x pa 3x pa 1x pa Working level WGFM: 4x pa On a need On a need One a WGBS, basis basis need basis WGPS: 2x pa Areas of Work Financial Market X ABF 1 & 2 X X AFMM X X Development (insert others) ACBG AFMM+3 (ACBF) ABMI Payment and X BPA Settlement Banking X Supervision Surveillance X X X X X ASCU X X - Economic Review X X X X - Policy Dialogue X X X X X X Capacity Building X X X X X X X - Training X X X X X X Reseach X X X X X X Liquidity X EMEAP X CMI arrangements Repo Initiatives (finance Finance Finance related) Ministers Ministers Process; Process; Surveillance Economic Process; Review ASEAN Swap and Policy 63
  64. 64. Arrangement; Dialogue Roadmap for (ERPD); Financial and ASEAN+3 Monetary Research Integration; Group; ACMF; CMI, ABMI Exchange Linkages Task Force; Asia 100 benchmark and index Source: Poonpatpibul et al, 2006; Yap, 2007; Baoa Forum Annual Report, 2007 Notes: ACD = Asia Cooperation Dialogue; APEC=Association of Pacific Economic Cooperation; ASEAN=Association of Southeast Asian Nations; ASEM=Asia Europe Meeting; EMEAP=Executives’ Meeting of East Asia and Pacific Central Banks;SEACEN=South East Asia Central Banks; SEANZA= South East Asia, New Zealand, Australia. CMI = Chiang Mai Initiative; ABMI= Asian Bond Market Initiative; ABF = Asian Bond Fund; AFMM = ASEAN Finance Ministers’ Meeting; ACGM (ACBF) = ASEAN Central Bank Governors’ Meeting (ASEAN Central Bank Forum); ACMF = ASEAN Capital Market Forum; 64

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