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  • 1. Preliminary draft (Version 2007/07/06) Regional Cooperation on the Integration of Asian Financial Markets1 by Hongzhong Liu2, Haiqing Zheng3 Abstract The paper first reviews the current state of Asia’s financial cooperation on the integration of Asian financial markets and the underlying obstacles, then raises countermeasures accordingly. We find that despite the progress, the integration is still very limited. The obstacles include diversity and heterogeneity, capital account controls, lack of infrastructures, geopolitical rivalry and lack of anchor financial center, among which capital account is an essential factor. Active measures should be taken to conquer these obstacles and create favorable conditions for the further integration of Asian financial market. The specific suggestions are as follows: bilateral and multilateral efforts are needed to enhance regulatory cooperation; ABMI can play the role of cultivating the bond market on the supply side and ABF the demand side and private sector involvement is the key to the regional bond market; and the cooperation between stock exchanges and cross listing are the main ways of stock market cooperation. 1 The first draft for the Emerging Asian Regionalism: Ten Years After the Crisis” Technical Workshop on 19-20 July 2007, Bangkok, Thailand. We are grateful to Prof. Peter Petri, Giovanni Capannelli and Jenny Corbett for their comments. 2 Hongzhong Liu, Professor of finance, Department of International Finance, Fudan University, hzliu@fudan.edu.cn 3 Haiqing Zheng, Department of Finance, East China Normal University, haiqingzheng@hotmail.com. 1
  • 2. Contents 1. Introduction………………………………………………………………………………3 2. Current state of financial cooperation…………………………………………………5 3. Obstacles to financial integration……………………………………………………..20 4. Creating conditions for financial market integration……………………………….. 27 5. Possible New Measures for Strengthening Financial Market Cooperation……… 37 6. Concluding remarks……………………………………………………………………..46 References………………………………………………………………………………….51 Appendix ……………………………………………………………………………………60 Figures Figure 1 A Market Linkage Model ………………………………………………….…….57 Figure 2 Efficiency of Equity Markets…………………………………………………….57 Tables Table 1. Listed Chinese Enterprises in Eight Main Markets …………… ………….…58 Table 2. Foreign Participation in the Stock Market (2004) ………… …………………58 Table 3. Structure of Financial Systems …………………………………………...……59 2
  • 3. Table 4. Freedom Index of Capital Markets……………………………………………..59 Appendix table 1. Parameters Calculations For Countries …………………………...62 Appendix table 2. Risk sharing Gains by Country …………………………….…….…63 1. Introduction The financial crises that first hit Thailand in mid 1997 and then spread to other countries in the region have given a valuable lesson not only for the crises-hit countries, but also for other countries. The unprecedented scale of the crises has caused enormous damages to the East Asian countries. To resolve the crises, each individual crises-hit country took several policy measures, among others widening the intervention band, abandoning the fixed and managed float exchange rate regimes, resuming capital controls, restructuring their corporate and banking sectors, and even going to the IMF for financial assistance. Nevertheless, what have been done by each crises-hit country to resolve the financial crises was proved less effective shows that there is an urgent need to strengthen regional financial cooperation and integration. There is a broad consensus among countries in the region that collective response is needed to overcome and prevent the crisis. Regional financial market development is a main policy objective set up after the crisis, aiming to strengthen financial market deepening within the region. With an integrated financial market, investors in the region will have a larger market to allocate portfolio and diversify risks, while the borrowers will have more financing 3
  • 4. channels. In this way, investors perfectly pool all idiosyncratic country-specific risks. With such an allocation, a country’s domestic private consumption is affected only by uninsurable global shocks, more smoothed as a result. However, Asian financial markets are segmented and fractured, more globally than regionally integrated (Cavoli, Rajan and Siregar, 2004; Eichengreen, 2005; Kim, Lee and Shin, 2006). The degree of the regional financial integration is still very low and does not show the tendency of increasing with the time. But our study showed that on the contrary to the low degree of financial integration, the potential welfare gains of risk sharing from financial integration are huge among most East Asian countries. On average, risk- sharing gains are 1.2 percent of permanent consumption in a 10-year horizon and increase to 4.11 and 7.61 percent with 30- and 50-year horizons, respectively. These welfare gains for East Asian countries are larger than those for OECD countries. Van Wincoop (1999) finds that risk-sharing gains from OECD countries range from 1.1 percent to 3.5 percent for 50-year horizon. Prasad et al. (2003) show that the welfare gains are less than 3 percent for OECD countries. We can see this result from the appendix. On the other hand, East Asian countries have accumulated huge amounts of foreign reserves. Therefore, how savings can be better mobilized for regional investments has become an important issue facing East Asian countries. Regional financial market, especially a regional bond market, can serve as a good way to mobilize the savings. Over the past few years, East Asian policymakers have undertaken several major initiatives to foster regional financial integration, particularly 4
  • 5. in the bond market, as a means to deepen and integrate financial markets and mobilize the international reserves. Progress in cooperation has also been made in financial supervision, stock market and derivatives market. However, There is substantial scope and need for financial market development, conformance and harmonization. The remainder of this paper is organized as follows. Section 2 reviews the current state of financial cooperation, including financial regulatory cooperation; bond market cooperation, stock market cooperation and derivatives market cooperation. Section 3 discusses the impediments to the financial integration in Asia, namely, diversity of member countries, low financial openness, lack of infrastructures, geopolitical rivalry and lack of leading financial center pushing the integration. Section 4 analyzes the conditions for financial market integration, which are deepening economic integration, further capital account liberalization, infrastructures building and development strategy of financial centers. Section 5 raises suggestions on possible new measures for strengthening financial market cooperation. Section 6 offers the conclusion and draws the policy implications for current financial cooperation in Asia. 2. Current state of financial cooperation Ten years after the 1997 financial crisis have seen obvious progress in cooperation on financial supervision, stock market and derivatives market. Despite 5
  • 6. the progress, financial cooperation in Asia is still at its early stage and financial integration is still rather limited. 2.1 Financial Regulatory Cooperation There is much progress on bilateral financial regulatory cooperation, which takes the main form of signing bilateral MOUs. The core of the multilateral regulatory cooperation in Asia is the EMEAP (Executives’ Meetings of East Asia-Pacific Central Banks) for central banks and the IOSCO for capital markets. The former provides a place for exchange of opinions and experiences concerning monetary policies, as well as settlement systems for securities. The latter is a global organization, providing a good model for regulation cooperation by its MMOU. Its Asia-Pacific Regional Committee (“APRC”), the regional sub-group for Asia, exchanges opinions on issues inherent to the region, playing a role in improving the surveillance capabilities in securities markets in individual countries (Mori, 2004). And there are also important proposals such as Asian BIS and Asian Financial Institute. 2.1.1. Bilateral Regulatory Cooperation Under the promotion of International Organization of Securities Commissions (IOSCO), signing Memorandum of Understanding (MOU) has become an effective ways for bilateral regulatory cooperation among securities regulators. Statistics show that securities and futures regulators in 90 countries and regions of IOSCO members 6
  • 7. signed more than 1000 MOUs for bilateral cooperation4. Asian economies also signed series of bilateral MOUs with economies within and without the region. Taking China for example, China Securities Regulatory Commission have signed 37 MOUs of Regulatory Cooperation with regulatory authorities in 34 countries and regions by June 2007, including Hong Kong, China, Singapore, Japan, Malaysia, Korea, Indonesia, Thailand, Vietnam and India within the region5. China Banking Regulatory Commission Regulatory Commission have signed MOUs of Regulatory Cooperation or bilateral Regulatory Cooperation agreements with regulatory authorities in 24 countries and regions by May 2007, including Hong Kong, China, Singapore, Korea, Macao, Thailand within the region6. Hong Kong, China Securities and Futures Commission has concluded 44 formal cooperative arrangements with 33 overseas regulators for the purposes of exchange of information and investigation assistance, among which Mainland China, Macao China, Indonesia, India, Japan, Malaysia, the Philippines, Singapore, Taipei,China, Thailand are within the region7. The principles of MOUs cover subject matter, confidentiality, implementation procedures, the rights of persons subject to an MOU request, consultation, public policy exception, types of assistance, permitted uses, participation by the requesting authority and cost- sharing. The strength of MOUs is that they facilitate the exchange of information by accommodating differences between regulators and by responding to changing legal environments. On the promotion of investor protection and the integrity of the securities and futures markets, signing MOUs will ensure more effective supervision 4 See Qiu Yonghong, Bilateral Cooperation and Coordination on Securities Regulation. http: //www.esnai.net 2006-4-24. 5 See http://www.csrc.gov.cn. 6 See http://www.cbrc.gov.cn. 7 http://www.sfc.hk/sfc/html/EN/aboutsfc/cooperation/cooperation.html. 7
  • 8. while avoiding potential duplication and possible conflicts that can arise from the application of differing regulatory practices. 2.1.2. Multilateral Regulatory Cooperation A. The IOSCO MMOU (IOSCO Multilateral Memorandum of Understanding Concerning Consultation and Cooperation and the Exchange Of Information) is the first global information-sharing arrangement among securities regulators. The IOSCO MMOU sets a new international benchmark for cooperation critical to combating violations of securities and derivatives laws. Applicants to become signatories to the IOSCO MOU must undergo a rigorous screening process to verify their ability to cooperate as provided in the IOSCO MOU. As of June 2007, forty-one countries and regions have completed this screening process and signed the IOSCO MMOU, including China, Hong Kong, China, India, Malaysia, and Singapore. Fifteen countries and regions have been accepted as signatories to Annex B8 of the IOSCO MMOU, including Indonesia, the Philippines, Chinese Taipei.China and Thailand9. Altogether, nine Asian economies have become or have committed to become a Signatory to IOSCO MMOU, thus providing a model for regional regulation cooperation. But Japan, the world's second-largest and Asian largest economy, does not appear on the list of signatories in IOSCO's statement, which will hamper the formation of a regulatory cooperation framework. 8 IOSCO members who complete the screening process but are found to lack the legal authority to fully comply with the terms of the IOSCO MMOU will be invited to become signatories to Annex B of the IOSCO MMOU, provided that they express their commitment to obtaining the necessary legal authority to become full signatories. 9 http://www.iosco.org/library/index.cfm?section=mou_siglist. 8
  • 9. B. Asian BIS and An Expanded EMEAP-ProposalⅠ. Fraser (1995) proposed Asian BIS, which means central banks in the Asian region should cooperate more closely with one another modeling broadly on what the BIS does. He suggested four areas where EMEAP central banks might cooperate more closely and develop some of their functions, including information and experience sharing on macroeconomic policy, particularly in the context of the challenge to maintain growth and control inflation in the face of rising and potentially volatile cross-border capital flows, and managed exchange rates; similar information and experience sharing in the area of supervision of the banking and financial systems, in what is a diverse and rapidly changing environment in Asia; the development of contingency plans to deal with crises and the provision of reserves management and other central banking services to member central banks. All the above functions are something which the BIS currently does but which could easily be provided by a regional institution. Rajan (1999) holds that an expanded EMEAP would build on its close links with BIS and IMF and the establishment of Asian BIS could be the second step that after the strengthening of EMEAP. Girardin (2004) argues that the scope of EMEAP would be widened by focusing on its original goals of enhancing regional financial and monetary cooperation as well as by offering support for currencies in the region facing speculative pressures and an Asian BIS would bear two responsibilities: to develop region-wide banking and financial standards and codes consistent with international best practices, and to monitor their implementation. 9
  • 10. C. Asian Financial Institute (AFI)-Proposal Ⅱ. Eichengreen (2001, 2002) advocates the establishment of an Asian Financial Institute (AFI) on the platform of ASEAN+3. The AFI would provide technical assistance to national agencies seeking to strengthen prudential supervision and regulation. It would run training programs for bank inspectors, securities and exchange commissioners, and accountants, exploiting economies of scale and scope by enrolling students from all of its members, and encouraging the efficient pooling of knowledge and expertise. It would provide reserve management, clearing and settlement services to member central banks, not unlike the central banking services that the Bank for International Settlements provides to its members. In addition, the AFI could be a venue for the negotiation of regional agreements on capital and liquidity standards and regulatory processes intended to promote the stability of banking systems, and of standards for information disclosure, securities listing and corporate governance designed to promote the development of regional financial markets. 2.2 Bond market cooperation A regional bond market is expected to strengthen the region’s financial system with better utilization of aggregate savings in the region and minimize the risk of maturity and currency mismatches. A regional financial cooperation project-the Asian Bond Market Initiative- has been launched, aiming at developing the bond market on the supply side. In the meantime, EMEAP is attending to the demand side by 10
  • 11. establishing an Asian Bond Fund with members’ foreign reserves for the purpose of securing regional demand for bonds. 2.2.1. Asian Bond Markets Initiative (ABMI) The ASEAN+3 Asian Bond Markets Initiative (ABMI), which was endorsed at the ASEAN+3 Finance Ministers Meeting in Manila, the Philippines on 7 August 2003, aims to develop efficient and liquid bond markets in Asia, enabling better utilization of Asian savings for Asian investments. It would also contribute to the mitigation of currency and maturity mismatches in financing. Activities of the ABMI focus on the following two areas: (i) Facilitating access to the market through a wider variety of issuers; (ii) Enhancing market infrastructure to foster bond markets in Asia. At the ASEAN+3 Finance Ministers Meeting (AFMM+3) on August 7, 2003, six voluntary working groups (WG) on the ABMI have been established to address key areas of bond market development, namely, (i) WG1 New securitized debt instruments, (ii) WG2 Credit guarantee and investment mechanisms, (iii) WG3 Foreign exchange transactions and settlement issues, (iv) WG4 Issuance of bonds denominated in local currencies by Multilateral Development Banks (MDBs), foreign government agencies, and Asian multinational corporations, (v) WG5 Rating systems and information dissemination on Asian bond markets, and (vi) WG6 Technical assistance coordination. Since the establishment of the six WGs, comprehensive efforts have been made to develop the region’s bond markets. ASEAN+3 officials have conducted regular dialogues and discussions among themselves as well as with academics, 11
  • 12. think tanks and the private sector to exchange views through various meetings, seminars, forums and symposiums. Concrete outcomes are also being achieved, such as the issuance of local currency denominated bonds by MDBs in the region. AFMM+3 on 15 May 2004 in Jeju, Korea confirmed the establishment of a Focal Group (FG) to coordinate the work of ABMI working groups. The immediate focus of the FG is to monitor the progress of the ABMI working groups and to coordinate their future action plans. 10 2.2.2. Asian Bond Fund (ABF) Two Asian Bond Funds have been launched using a portion of EMEAP’s international reserves. The first of these funds, the Asian Bond Fund 1 (ABF1), pooled US$1 billion of reserves and invested in U.S. dollar-denominated government and quasi-government bonds of eight ASEAN+3 countries. The second (ABF2), of US$2 billion, actually consisted of nine separate funds: a Pan Asian Bond Index Fund (PAIF) and eight single-country funds. ABF2 is investing in local currency denominated sovereign and quasi-sovereign bonds. Its aim is to give both retail and institutional investors access to local bond markets in the region in a transparent and cost-effective manner. According to Sohn (2007), the rationale for broadening and deepening regional bond markets can be two-fold. First, the establishment of the ABF ultimately aims to bring back the huge amount of Asian foreign reserves that were traditionally saved in Europe or in the U.S. to be used in bond investments throughout Asia. Secondly, the ABF intends to shield the region from the external 10 http://asianbondsonline.adb.org/regional/asean_plus_three_asian_bond_market_initiatives/overview.php. 12
  • 13. vulnerabilities by building more robust and diversified local capital markets. The dominant view of those supporting Asian bond market expansion is that the Asian financial crisis would have been less severe if local bond markets had been more developed and financial intermediation in the crisis-affected countries had not been so heavily concentrated on banks. 2.3 Stock Market Cooperation 2.3.1. Bilateral Cooperation Shimizu11 suggested a market linkage model (see figure1): Australian and Singapore exchanges, Singapore Exchange and the Tokyo Stock Exchange have already implemented the above type of arrangement. On December13, 2001, Singapore Exchange Ltd (SGX) and Australian Stock Exchange Ltd (ASX) announced that the ASX-SGX co-trading linkage, the first such facility in the world, will go live from 20 December 2001. Investors in Australia and Singapore will be able to co-trade selected securities in each other's market directly, through brokers in their own countries, whenever the respective markets are open. The possibility of a linkage between the Tokyo and Singapore stock exchanges was stated in the announcement by the two stock exchanges. On October 1, 2001 Singapore Exchange Limited (SGX) and the Tokyo Stock Exchange (TSE) announced plans to pursue a strategic alliance. The two exchanges will explore initiatives relating to cross access arrangements for the co-trading and clearing of 11 Shimizu http://www.oecd.org/dataoecd/5/61/33735778.pdf. 13
  • 14. products listed on both exchanges, new product development, marketing, information technology development and information sharing. The Tokyo Stock Exchange spent about $304 million to buy a 4.99 per cent stake in the Singapore Exchange Limited in June 2007, the latest move in a scramble by global bourses to forge ties and consolidate12. This will help attract more Japanese companies to list in Singapore, which would make it more convenient for Singapore investors. On 31 August 2005, the Tokyo Stock Exchange and Korea Exchange signed “Memorandum of Intent” to discuss the promotion of cross-border securities trading between two countries. Tokyo Stock Exchange, Inc. (TSE) and Korea Exchange, Inc. (KRX) signed a Memorandum of Understanding (MOU) on the "Market Alliance Project" on July 7, 2006. The purpose of the MOU is to set forth a framework for performing activities in which the two exchanges will cooperate with each other in developing and fostering a favorable environment for the facilitation of cross-border capital flow between Japan and Korea. Those activities may include supporting promotional activities for both TSE and KRX markets, investor relations activities of companies from both countries, continuous feasibility studies on co-trading arrangements between TSE and KRX, etc. By implementing cooperative activities in a more specific manner, the two exchanges look forward to building a closer partnership with each other and advancing the cross-border capital movement in the Asian region.13 12 Tokyo bourse buys 4.9 pc of Singapore exchange. http://www.khaleejtimes.com/DisplayArticleNew.asp? xfile=data/business/2007/June/business_June470.xml&section=business&col=. 13 Tokyo Stock Exchange, Inc. and Korea Exchange, Inc. sign a Memorandum Of Understanding (MOU) on "Market Alliance Project". http://www.tse.or.jp/english/news/200607/060707_a.html. 14
  • 15. 2.3.2. Multilateral Cooperation According to the Joint Ministerial Statement of the 9th ASEAN Finance Ministers’ Meeting held in Vientiane, 6 April 2005, ASEAN committed to develop an interlinked ASEAN securities market by 2010 to promote greater integration of our capital markets. Through harmonizing market standards and practices, and facilitating cross- border market access, ASEAN aimed to create a large integrated market similar to that of trade in goods that would promote much greater liquidity and wider variety of financial instruments. As for the stock exchange cooperation, there are several federations in Asia. East Asian Stock Exchanges Conference (EASEC) was founded in 1982 as an informal organization, whose object was to promote friendship and to facilitate the exchange of information among member exchanges. In 1990, East Asian Oceania Stock Exchanges Federation (EAOSEF) was founded as an official international federation of stock exchanges. EAOSEF changed its name to Asian and Oceania Stock Exchanges Federation (AOSEF) in 2005 and expanded its member to 17 stock exchanges. The recent topics in AOSEF include scheme studies for cross-border trading, corporate governance Information business. In 2002, Tokyo Stock Exchange intended to cooperate with stock exchanges of 10 Asian cities such as Shanghai, Shenzhen, Hong Kong, China, Taipei,China on the research of financial market integration. According to the proposal, the priority is to construct a system for the mutual free transactions of stock and bonds listed in the 11 stock exchanges. The second thing is to promote the cross listing for a same 15
  • 16. enterprise, devise unified standards of listing and information disclosures and jointly develop new financial products. There are other forms of cooperation among independent supervision organizations in securities industry. The first is Asian Securities Forum14, conferring annually to discuss regional cooperation of securities market in Asia and for securities industry officials from the region to exchange views. Asian Securities Analysts Federation15 is the second example, which was established to promote the interests of the investment community of Asia and Oceania and to encourage and assist the development of the profession of securities analysts through interchanges of ideas and coordination of policy among member societies. Financial institutions also play an active role on stock market cooperation. For example, five major Asian Securities Houses16 from four Asian economies formed the first Pan-Asian online stock exchange network, Asian Stock Exchange Network in April 2000, which enabled investors to trade online in their different markets through a single Internet channel by early June 2000. By allowing investors to access multiple markets would help investors create and preserve wealth in a cross-border environment, which will promote the steady development of the regional capital market from a long-term view. 2.3.3.Cross Listing There are increasing activities of large foreign stocks listed outside countries of 14 Including 14 Members from Asia and Oceania. 15 Including 14 Members from Asia and Oceania as of June 25, 2007. 16 The five security houses include Tai Fook (Hong Kong, China), Dongwon Securities (South Korea), Capital Securities (Taipei,China), Aizawa Securities (Japan) and Japan Asia Securities Group (Japan). 16
  • 17. their domicile all over the world. For example, many big names in emerging economies are listed on the NYSE both in the forms of shares and ADRs. Eighty-one Chinese companies got listed in main eight overseas markets, raising 20.4 billion US dollars in 2005. The figures were 86 and 44 billion US dollars respectively in 2006 (see table 1).17 According to the statistics from Hong Kong, China, a total of 340 mainland-based companies have been listed in Hong Kong, China, raising a total capital of 1.1 trillion Hong Kong, China dollars. The total market capitalization of these companies has accounted for 40% of that of Hong Kong, China market. Besides raising capitals, the listing in Hong Kong, China urges these mainland-based companies to improve their business operations and apply international standards and practices (Shang, 2006). By August 2006, 105 mainland-based companies have been listed in Singapore Stock Exchange (SGX), with capitalization of 28.4 billion Singaporean dollars, 6%of the total capitalization. The daily value traded accounts for 15% that in Singapore Stock Exchange. Thirty seven percent of the 738 firms listed on SGX and its junior Sesdaq board were foreign as at the end of May, according to the report.18 However, according to IMF Asia-Pacific Regional Outlook (September 2005), a few stock markets in the region have attracted a large international presence, but not from Asia. On the demand side, while foreign participation has become significant in some markets, few non-resident players are from Asia. In Hong Kong, China SAR trading by nonresidents represented more than a third of total turnover in 2004, but 17 Annual report on Chinese listed enterprises, 2006. http://www.cnotcbb.com.cn/News/HYNews/200701/20070131084727.html. 18 http://www.3009.cn/Article/2006104214247-1.htm. 17
  • 18. only a fifth of this activity could be ascribed to Asian nationals. In Japan, Thailand and Korea, stock markets have also been benefiting from a large international presence, with foreign shareholders accounting for almost 30 percent of total turnover, but again, with only a few of them reportedly from another Asian country. On the supply side, at least 95 percent of listed companies on Asian exchanges are of domestic origin, as opposed to about 85 percent in the United States and in the euro area. Furthermore, recent years have witnessed a notable delisting of foreign companies from Asian exchanges, probably at the profit of a listing in New York or London through depositary receipts. Limited cross listing is likely to have exacerbated the home bias in residents’ equity portfolios that, with few exceptions, are heavily weighted toward domestic stocks. Against this background, the high correlation of stock market indices in the region is likely due to the fact that they often share American and European investors as their main source of foreign capital, rather than to bilateral linkages (see table 2).19 2.4 Derivatives Market Cooperation Asian derivatives markets accounted for one-third of the worldwide foreign exchange and over 40 per cent of equity derivative trading by 2005 (Basu & Bappaditya, 2006). As for foreign exchange trading, derivative trading is concentrated in the region’s financial centers - Japan, Singapore, Hong Kong, China SAR (de Brouwer, 2003). Singapore takes the leadership in the region for index futures trading based on stock trading in other economies. In 1986, SIMEX, which later was merged 19 Asian and Pacific Department, IMF, 2005. 18
  • 19. by Singapore Exchange (SGX), first introduced the Nikkei 225 Index Futures. By 1990, Nikkei 225 Futures grew to be the world's largest stock index futures product, surpassing Chicago's S&P 500 Futures and continues to be one of the world's leading stock index futures products. SIMEX introduced MSCI Taipei,China index futures in January 1997. The futures contract is based on the Taipei,China index. Both were introduced ahead of the two economies’ own launches. CNX Nifty (India) Index futures was launched in September 2000. FTSE/Xinhua China A50 Index was introduced in September 2006, which is also ahead of China’s own launch. Up to now, the stock index products that Singapore launched cover the main Asian stock markets such as Japan, Hong Kong, China SAR, India, Mainland China, Taipei,China POC. Asian Pacific Association of Derivatives (APAD), set up in 2004, is an organization comprising academics, practitioners as well as regulators operating in the derivative markets in the Asia Pacific region. The main objective of this association is to promote research on and increase knowledge of the use of derivative securities and markets. The APAD is ably supported by the Korea Stock Exchange (KRX), the Bombay Stock Exchanges (BSE) and the National Stock Exchanges of India (NSE), as well as, other exchanges in the Asia Pacific region. APAD will held its 4th Annual Conference on June 20-22, 2007 at the Management Development Institute (MDI) in Gurgaon, India. Its topical areas included derivatives and asset pricing, financial risk management using derivatives, credit risk modeling and management, commodity risk management, regulatory challenges. APAD 19
  • 20. provides an exchange platform for the derivatives industry and promotes the cooperation of Asian derivatives markets. 3. Obstacles to financial integration Obstacles to financial integration can be analyzed from multiple perspectives such as economic, political and international relations perspectives, here we mainly focus on economic perspective. 3.1 Diversity of Member Countries Asian countries differ widely in terms of their stages of economic development and domestic financial markets. Per capita incomes and trade openness vary more dramatically than in Europe and North America, other regions where there is considerable momentum for regional integration. Per capita incomes range from $218 in Myanmar to $36500 in Japan at current prices in US Dollars in 200420. Exports as a share of GDP range from more than 100 percent in city states like Singapore and entry port centers like Hong Kong, China to a mere 13.6 per cent in Japan in 2004. In Asia, where financial systems have been largely bank-oriented, securities markets have been relatively less developed and vary widely in terms of size and efficiency. The role of equity markets varies widely across countries in the region, 20 http://www.un.org. 20
  • 21. however (see table 3). Those in Hong Kong, China SAR, Singapore, Korea, and Malaysia play an important role, and those in the other countries have the potential to play a much more important role than they do at present. Comparisons with countries at similar per capita income levels outside the region suggest that Asia’s equity markets have room to improve their efficiency (Figure 2). Hong Kong, China SAR, Korea, Malaysia, and Singapore have the most efficient markets in the region— although Korea ranks in the third highest quartile and the remainder rank only in the median range of a global sample of 85 economies. In the bottom quartile are Thailand, Indonesia, the Philippines, and China. According to de Brouwer (2002), the developed markets of the region (Japan, Singapore, Hong Kong, China SAR) perform well by international standards; most of the others (like Korea, Malaysia, Taipei,China POC and Thailand) are average, and a couple (like Indonesia and the Philippines) looks dismal. The possible causes include inadequate financial and legal structure, low auditing and accounting standards and weak corporate governance. Diversity and heterogeneity within East Asia can constitute a serious impediment to regional financial cooperation. Economies in the region have different policy objectives and priorities, thus having desire to maintain national sovereignty over economic policies—fiscal, monetary, exchange rate, financial and structural. This preference for national policy independence would make closer economic policy coordination and financial cooperation more difficult (Kawai, 2004). 3.2 Low Financial Openness 21
  • 22. Some national economies and financial systems remain heavily regulated-China and the new members of ASEAN are examples-while others are extensively deregulated -Singapore and Hong Kong, China SAR are world leaders in this regard. In some countries in the region, a sizable proportion of shares remain inaccessible to cross-border investors. As of end-2004, foreign investors had no access to around 42 percent of the stock market in the Philippines, 41 percent in China and 36 percent in Thailand. This, coupled with the fact that in some economies a sizable proportion of shares is closely held (around 28 percent in China, 30 percent in Indonesia, 40 percent in the Philippines, and 21 percent in Thailand), means that in some cases only a small percentage of shares is freely available to would-be investors21. Restrictions on capital account transactions and on entering foreign financial institutions must be an impediment to the process of financial integration involving these economies. Table 4 is the International index of capital controls reported in the Economic Freedom of the World 2006 Annual Report. The index reflects the restrictions on the freedom of citizens to engage in capital market exchange with foreigners—index of capital controls among 13 IMF categories and is based on the number of capital controls levied. The zero-to-10 rating is constructed by taking 13 minus the number of capital controls divided by 13 and multiplied by 10. The higher the figure, the fewer capital controls the country levied. From the table, we can see Asian economies vary greatly in the freedom of 21 Asian and Pacific Department, IMF, 2005 22
  • 23. capital market, which can be categorized into the following: (i) Japan, Hong Kong, China and Singapore, which share high degree of freedom in their capital market transactions with little capital mobility restrictions; (ii)South Korea, Thailand, Malaysia and the Phillippines, whose financial restrictions were greatly relaxed after financial liberalization in 1980s but experienced a reverse trend after 1997 financial crisis; (iii) China, India and Indonesia, who started financial liberalization later than the above countries with rather strict financial restrictions. The following points are noteworthy: (i) most economies tightened the financial market restrictions after 1997 financial crisis (by comparing the 1995 and 2000 figures due to the lack of 1997 figures) particularly the crisis-hit economies like Malaysia. (ii) the degree of of the capital market restrictons does not show the trend of declining in recent years except in Japan. This will constitute an important impediment to the financial market integration in Asia. 3.3 Lack of Infrastructures Efficiency of Asian financial markets would hinge on well-developed regional systems of payment, clearing, settlement and depositary services that ensure real time gross settlement with delivery versus payment for cross-border transactions. Depth and liquidity of Asian securities will also improve if regionally specialized rating agencies are established. At present, the requisite infrastructures for regional financial market hardly exist and it may take years to build them. Cooperative efforts 23
  • 24. at the regional level for integrating different local clearing and settlement systems in different countries are needed, but may not be easily organized and may not succeed even if they are organized. Creation of Asian bond markets, however, may serve as a conduit through which regional cooperation to coordinate financial infrastructures can be achieved (Park and Park, 2003). Liu and Ferri (2001) show that corporations in developing countries are discriminated against in credit rating by global credit rating agencies in that these ratings are very much bound upward by their sovereign ratings regardless of their domicile. Firms in developing countries are rated low because their sovereign ratings are low, which is mostly caused by the poor quality of institutions and information disclosure. 3.4 Geopolitical Rivalry Another key factor that might significantly affect Asia’s cooperative efforts is interstate political dynamics. The potential rivalry between China and Japan for regional hegemony, and political tensions between Japan and its Northeast Asian neighbors over history issues and disputed islets are good examples in point. This is a significant political challenge facing East Asia. China and Japan have different interests and hence different strategies for economic integration in East Asia (Park and Yang, 2006). China is a super military power in the world; it is still a developing economy with a huge gap to narrow in terms of technological and industrial 24
  • 25. sophistication vis-à-vis Japan. Although China has been growing rapidly, it has a long way to go before catching up with Japan. Also, the fact that China and Japan have utterly different motives for taking part in the summit makes it unlikely that such a grand vision will be realized any time soon. Japan has been promoting integration among the “ASEAN+6”, known as the members of the East Asian Economic Summit instead of ASEAN+3. Chinese leaders now regard ASEAN+3, instead of the East Asia Summit Group, as the region’s most important multilateral forum. ASEAN has made great efforts in pushing the Asian economic and financial integration, while with the principles of ASEAN playing a central role and keeping ASEAN characteristics. Although ASEAN is influential as a regional organization, its economic and political power, especially that of respective country, falls far behind of China and Japan. In addition, ASEAN members and China, both developing countries and dependent on American market, are competitive in terms of FDI, trade and the structures of exporting countries. And there are still territory disputes among China and ASEAN members. 3.5 Lack of Leading Financial Center Pushing Financial Integration Tokyo, Hong Kong, China and Singapore are the three important regional financial centers in Asia, but there is no leading financial center pushing the financial integration. Tokyo has the second-largest stock market after New York and is by far the 25
  • 26. largest financial center in Asia, with a stock market capitalization of $4,614 billion trading an average of 1,540 million shares per day (Nakamoto, 2007). But even as other economies have seen their capital markets surge since 1990, such growth in Japan has been anemic. Having comprised a third of global market capitalization in 1990, Japan’s market capitalization is now less than one-tenth that of the world, $49,900 billion. Part of the problem is that, while the country was caught up in a prolonged financial crisis, its capital markets failed to keep up with global developments in key areas. In a stark sign of Tokyo’s decline, the number of foreign companies listed on the Tokyo Stock Exchange has plummeted from 125 in 1990 to just 25 in 2007. That is a fraction of the 446 foreign listings in New York and the 315 in London (Nakamoto, 2007). As of May 2007, Hong Kong, China Stock Exchange has total securities market capitalization of a record sum of $1,715 billion and ranks 6th place by market capitalization in the world and the 2nd largest in Asia (Nakamoto, 2007). The HKSE has 4338 stocks listed on the exchange with the market turnover of HK$4,520.4 billion (US$ 0,582.2 trillion) in 2005.22 Close to 50% of this market cap and turnover is attributable to Mainland enterprises. The exchange also has a leading derivatives market in the Asia-Pacific region with the daily turnover of 103.332 contracts per day that has increased by even 30% from 2004. The Singapore Exchange has approximately 659 companies listed on its exchange, and has a market capitalization of $398.4 billion. It is a highly international exchange, with 40 percent of its market capitalization coming from foreign 22 http://www.advfn.com/StockExchanges/about/HKSE/HongKongStockExchange.html. 26
  • 27. companies. The Singapore Exchange is also well known for its trading in a variety of derivative securities via SGX-DT. It was the first exchange in Asia to offer equity index futures, and now offers the world's widest range of Asian index futures. Singapore is also a major wealth management center in Asia, offering an array of services through the many financial institutions based here. As at end-2005, total funds managed out of Singapore amounted to over S$720 billion. Singapore's corporate bond market has grown significantly. Consisting of both Singapore dollar denominated bonds and other foreign currencies denominated bonds, it has increased four-fold since 1998, and total outstanding volume stood at over S$137 billion as at end-2005.23 Although Asia has three important regional financial centers, it still lacks an anchor country or financial center that can mediate financial transactions within the region, helping to attract regional investors into the regional securities markets. These three centers were serving Asian borrowers and lenders well before financial market opening got underway in the region. However, they were essentially outposts of major international capital markets in advanced countries. Thus, they may have gravitated more toward linking financially Asian economies with advanced economies, than integrating them with one another (Kim, Lee and Shin, 2006). 4. Creating conditions for financial market integration 4.1 Deepening Economic Integration 23 Singapore International Financial Center Gateway to opportunities in Asia and beyond. http://www.mas.gov.sg/index.html. 27
  • 28. The available evidence suggests that trade integration and financial integration are closely linked. A number of recent research papers suggest that finance follows trade. Forbes and Chinn (2003) find that import demand appears to be the most important determinant in their model of cross-country linkages in both stock and bond markets, specifically how shocks to the world’s largest economies affect local financial markets (even when controlling for capital account restrictions). The results suggest that real factors such as trade intensity may have a strong influence on financial returns, irrespective of the degree of financial integration. Eichengreen and Park (2004) find evidence that Asia is less financially integrated because the region has done less to promote the growth of intra-regional trade than has Europe (for example, the establishment of a common market). Asia’s trade openness has increased over the years and most countries in the region have experienced high trade growth resulting in increased shares in world trade. The aggregate share of emerging Asia in world trade has increased from about 13 percent in 1990 to 20 percent in 2004. Over the past two decades, its share of total trade nearly doubled to about 41 percent, a level comparable to that in NAFTA countries. Over the same period, the number of emerging Asian countries with another country in the region as main partner has increased from zero to four24. Asia has had a successful history of intra-regional trade liberalization. Signing of FTAs such as the ASEAN Free Trade Area (AFTA), the South Asian Free Trade Area (SAFTA), China –ASEAN FTA, China-ASEAN FTA and many other bilateral FTAs will 24 Asian and Pacific Department, IMF, 2005 28
  • 29. act as an incentive for regional financial cooperation. 4.2 Further Capital Account Liberalization Researchers have found capital account liberalization has a positive role in the integration of financial markets. Chelley-Steeley and Steeley (1999) find that the abolition of exchange controls helped equity markets to become more closely integrated in Europe. Eichengreen and Park (2005) provide evidence that a lower level of capital market liberalization and an underdevelopment of financial markets and institutions particularly in potential lending countries are the main factors contributing to the difference between the intra-Europe and intra-East Asia integration in the cross-border bank lending market. Trairatvorakul (2001) argues that cross-border flows of capital in these markets should be liberalized to enable participating markets to fully benefit from the regional capital market or some kinds of stock exchanges alliances. The success of exchanges alliances would require unrestricted two-way cross-border transactions. If a Thai investor cannot buy shares on the Hong Kong, China stock exchange but a Hong Kong, China investor can buy shares on the Thai exchange, the full reciprocal benefits cannot be realized. In this case, Hong Kong, China investors can sell for higher returns between Hong Kong, China and Thai markets while Hong Kong, China brokers can enjoy increasing revenues from broker channels of equities investments. On the other hand, the opportunities of Thai investors and brokerage houses are 29
  • 30. limited to the national market only. However, quick liberalization could increase financial vulnerability. Therefore, further steps could be taken to relax restrictions on cross-border investments while maintaining appropriate prudential safeguards. The liberalization should be realized in a correct order and in a step-by-step manner. 4.3 Infrastructures Building In order to complement ongoing initiatives of financial market cooperation, it is essential to establish regional infrastructures such as clearing and settlement systems, credit rating agencies and credit enhancement and guarantee systems. 4.3.1. Linking Clearing And Settlement Systems The consolidation of trading, clearing and settlement in the European Union is expected to reduce clearing and settlement costs by around $1 billion a year (Sheng, 2001). Clearing and settlement processes are well developed in some Asian markets, while still rudimentary in other countries. And all the existing infrastructures for clearing and settlement remain highly fragmented, so attention could focus on establishing regional linkages. Previous studies show that most markets in Asia have fairly advanced clearing and settlement processes and are increasingly adopting Delivery versus Payment (DVP) systems. In addition, the development of supranational clearing and settlement systems would improve the liquidity of regional financial markets and help attract more regional investors. There has been much 30
  • 31. discussion in the past on the possibility of creating an International CSD (Central Securities Depositories) for Asia (AsiaClear), though could also be given to working with existing ICSD's such as Euroclear to develop a cost-efficient global service without needless infrastructure replication. Obviously, steps to develop regional links should be driven by a viable commercial case (Cowen, Salgado, Shah, Teo and Zanello, 2006) 4.3.2. Regional Credit Rating Agency The development of a regional credit rating agency should also be facilitated, as a means of ensuring standardized ratings and a more complete coverage. Most countries in the region have well developed rating agencies, among which many affiliated with the major international agencies (Moody’s, S&P, and Fitch). The standards being used by these agencies are similar and it should be reasonably straightforward to adopt unified rating standards across the region. The convergence of current national rating agencies into stronger regional rating agencies may also be beneficial in terms of economies of scale and standardization. To reach the goal of regional standardization, the Association of Credit Rating Agencies in Asia (ACRAA) was organized in September 2001. Currently, it has 22 credit agencies as members from 12 economies in the region including: Bangladesh, China, India, Indonesia, Japan, the Republic of Korea, Malaysia, Pakistan, the Philippines, and Thailand. Its objective is to exchange information, experiences, and skills among credit rating agencies in Asia to enhance their role in providing reliable market information. It also 31
  • 32. aims to undertake activities to promote (i) the adoption of best practices and common standards that ensure high quality and comparability of credit ratings; and (ii) the development of capital markets in Asia and cross-border investment throughout the region. ACRAA can be an ideal platform to promote the cooperation among credit rating agencies in Asia and formation of a regional credit rating agency. 4.3.3.Credit Guarantees Many Asian bonds are likely to belong to the junk bond category by the standard of the international bond market. A large number of East Asian firms do not have credit ratings good enough to issue bonds in the domestic bond market let alone international bond markets. As a result, even in the securitization scheme, the amount of funds that can be raised through senior bonds is likely to be quite limited. Therefore, combination of securitization and credit enhancement mechanisms is considered as a model for the Asian bond market and to reduce the gap between borrowers’ credit standing and investors’ requirements. Liu and Ferri (2001) propose mechanisms of credit enhancement and guarantee as a short-run measure. If private credit insurance institutions are not efficient so that a vast majority of firms in East Asia do not have access to the credit improvement mechanisms at reasonable prices, then one can make a care for the official sector involvement. However, if government sponsored credit improvement institutions are managed in a loose manner, then the government involvement runs the risk of creating moral hazard problems, which will interfere with financial reform and 32
  • 33. institution building in individual East Asian countries. Park and Park (2003) suggest credit guarantees to increase the portion of securities that can be absorbed by the market and to enhance the creditworthiness of bond issues by guaranteeing on timely payment of interests and principals. However, the existing credit guarantee agencies may not be suitable for providing credit guarantees for regional bonds. Park and Park (2003) give the following example: Japan Bank for International Corporation (JBIC) cannot provide credit guarantees on corporations or SPCs. JBIC can only guarantee bonds denominated in the Japanese yen. Asian Development Bank and JBIC are restricted from providing guarantees to bonds issuers from advanced economies. As a result, regional securitization deals involving issuers from Japan or Korea cannot get credit guarantee services from these official sector agencies. Private credit guarantee agencies in general prefer dealing with credit risk alone and as a result are reluctant to provide currency swaps together with credit guarantees while more effective schemes for regional bonds may require currency swaps to overcome the currency mismatch problem in addition to credit guarantees. Private guarantee agencies might also have limited capacities to provide guarantees. In order to provide credit guarantee services for Asian bond markets more efficiently, Park and Park (2003) propose to establish an international organization to provide regional credit guarantees. The operational mode (mono-line or multi-line) and the governance structure (an international agency or a private company) need to be discussed and negotiated. The regional guarantee agency may also provide currency swaps. 33
  • 34. Rhee (2004) points out that the PECC Finance Forum discussed an idea of creating an Asian Bond Bank (ABB) to support credit enhancement program for small and medium-sized enterprises (SMEs) and sovereign and quasi-sovereign borrowers. The ABB is modeled after municipal bond banks in the United States and Canada, both of which have successful track records. Sohn (2007) also proposes the credit guarantee and enhancement program as an immediate agenda tailored for SMEs and for bridging the credit gaps of sovereign and quasi-sovereign borrowers from the region. 4.4 Cooperation and Coordination among China, Japan and ASEAN Heterogeneity and diversity are not the ultimate impediment to regional financial cooperation, but political will is more crucial. Yet it doses not mean that geopolitical rivalry is insurmountable. In recent years, regional financial cooperation has been largely insulated from diplomatic and political competitions among countries in the region. This situation can be dubbed as “hot economics and cold politics” (Sohn, 2007). Despite the frosty political relations between Japan and its Northeast Asian neighbors, the three economic powerhouses of the region, China, Japan, South Korea, have managed to keep intergovernmental financial cooperation on track. However, from a long-term view, cold politics must constitute impediment to the economic and financial cooperation in Asia. Therefore, China and Japan might come to realize that despite the differences in their strategies, China and Japan together 34
  • 35. are the key to developing a common political will in East Asia. Sakakibara (2001) argues that the role of China and Japan in East Asia ’s integration process is synonymous with that of France and Germany in Europe’s integration process. Similarly, the Kobe Research Project report submitted to the fourth gathering of the finance ministers of the Asia-Europe Meeting (ASEM Finance Ministers’ Meeting) held in Copenhagen in July 2002 states that “It is essential for the Japan-China cooperation, as a core in East Asia, to lead the process of economic and financial integration, as the France-German alliance played a central role in the integration and cooperation process in Europe”(Park and Yang, 2006). In the current situation of “hot economics and cold politics”, the role of ASEAN is significant in Asian financial cooperation. But ASEAN might act as a coordinator and propellant for cooperation between China and Japan. The ASEAN+1 cooperation model (ASEAN+Japan and ASEAN+China) provides a good platform for this coordination and propelling. At the same time, ASEAN may not overemphasize its central role despite its rich experience in regional cooperation. Only by considering the interests of most Asian countries, could Asian cooperation make progress. 4.5 Development Strategy of Financial Centers The well-developed three financial centers need to integrate and work together with others in the region to develop and integrate their markets to best-practice 35
  • 36. levels. In March 2007, the City of London published another report on 46 financial centers worldwide. It confirms London and New York as the two leading global financial centers and puts Hong Kong, China in the third place. The report says Hong Kong, China performs well in all the key areas, especially in regulation – which was also rated by respondents to its survey as a major component in considering the competitiveness of a market. The report concludes that Hong Kong, China is a real contender to become a genuinely global financial center. It is interesting to note also that while there was no clear leader among the Asian centers in the 2005 report, the latest analysis suggests that Hong Kong, China leads the way from Singapore and is well ahead of other Asian centers including Tokyo (Fong, 2007). As the leading world financial center, Hong Kong, China can attract more Asian companies to be listed in Hong Kong, China and play the role of integrating Asian equity markets. According to Nakamoto (2007), the Tokyo Stock Exchange is in dire need of a systems upgrade. The TSE’s credibility was severely dented last year when the system crashed after being hit by an unexpected flood of orders. Meanwhile, the regulatory burden and cost of having to translate documents into Japanese and meet Japanese accounting standards, which are different from international standards, have discouraged foreign listings. But perhaps the most critical problem is that Japan’s financial markets do not offer investors the range of financial products available in New York or London. Partly as a result, there is a surplus of domestic funds chasing too few investment opportunities, which in turn has made spreads so 36
  • 37. tight that the market is unattractive to foreign funds that want higher yields. As an international financial center, Singapore offers financial institutions a pro- business environment, excellent infrastructures, cost competitiveness, a highly skilled and cosmopolitan labor force and is strategically located in a region of opportunities. The Singapore Exchange is trying to become the center of futures and derivative trading in Asia, by introducing wide range of derivative products including stock index futures, foreign exchange futures. There are 100 hedge funds in Singapore managing about $6 billion in total assets.25 5. Possible New Measures for Strengthening Financial Market Cooperation 5.1 Financial Regulatory Cooperation We hold the opinion that through financial regulatory cooperation, the participating economies should strengthen the efficiency of financial regulation and enhancing the capability of resisting external shocks in the financial markets, thus promoting the regional financial stability and development. Based on the above goal, we think two legs are needed: The first is to continue the bilateral regulatory cooperation by signing MOUs and developing mutual visit system and information exchange system by the regulatory agencies. With bilateral MOUs, both home and host supervisors will work together to ensure effective oversight. Efficient cooperation and information sharing requires that 25 http://www.cvca.com.hk/cvcamonthly/detail.asp?ArticleID=87&sYear=2006&sMonth=9. Source: Bloomberg 37
  • 38. each supervisor is equipped with strong risk assessment capability, clear prudential regulations and ability to take remedial measures. The second is the multilateral efforts, i.e. to establish a regulatory cooperation institution to improve the regulation rules and practices to ensure regulation effectiveness and promote regional financial stability. Cooperation between supervisors is especially important when dealing with problems or issues faced by regionally or globally active financial institutions (Cowen, Salgado, Shah, Teo and Zanello, 2006). The regulatory cooperation institution should simplify and harmonize listing and licensing requirements, accounting standards, settlement and clearance, and taxation. But it is not possible to adopt common standards, practices, and regulatory frameworks at current stage, it may be possible to work towards mutual recognition, as has been the initial approach in financial integration in Europe. This is more easily done with economies that have respected and trusted regulatory frameworks. This is not just a challenge between the more developed and less developed financial markets in the region. Integration and mutual recognition is in fact more easily done between Australia, Singapore and Hong Kong, China SAR, than between them and Japan (de Brouwer, 2003). As for the institution, we agree with the Eichengreen’s idea of AFI. The AFI would have the role of developing and implementing common regional prudential measures in the financial area. He also envisions an enforcement role for the institution. However, extending to the AFI the responsibility for regional harmonization on these issues may be going too far. 38
  • 39. 5.2 Bond Market Cooperation 5.2.1. Enhancing the Role of ABMI in Promoting Asian Bond Market. Activities of the ABMI can be strengthened in the following two areas: (1) Cultivating the bond market by promoting three-level bond issuers, i. e. government, big enterprises and SMEs. A robust primary and secondary bond market in Asia requires a wide variety of issuers and products that could be addressed by encouraging: Sovereign bond issuance by Asian governments to establish benchmarks; Asian government financial institutions to issue bonds in Asia to meet their financing requirements; The creation of asset-backed securities markets, including collateralized debt obligations (CDOs); Bond issuance in the region by multilateral development banks and government agencies; Bond issuance in the region for funding foreign direct investment in Asian countries. (2) Enhancing market infrastructure through the continued work of working groups. To develop efficient and deep domestic and regional bond markets, there must be an environment conducive to active participation by both issuers and investors. Besides the infrastructures analyzed in Part Four, the following additional issues merit further consideration: Facilitating foreign exchange transactions and addressing settlement issues on cross-border transactions; Enhancing capacity building by conducting market research and technical assistance programs to promote policy dialogue and human resources development among member countries; and examining legal and institutional infrastructure, such as company laws, 39
  • 40. securities transaction laws and tax laws.26 5.2.2. Improving the Operation of ABF Pan-Asia Bond Index of ABF2 is designed to provide a benchmark structure for tracking pan-Asian performance; the idea is that investors will find it more attractive to purchase a security that represents claims on a basket of regional bonds, which will enable them to take bets on the regional economy while diversifying away idiosyncratic national risk (however, ABF2 also entails the establishment of a series of national bond funds). A constraint on exporting this model is that it requires the elimination of restrictions on the participation of foreign investors. Thus, to facilitate development of the initiative, Asian economies had to liberalize access to its markets for PAIF portfolio managers, and PAIF was given permission by the governments to invest in both exchange traded bonds and inter-bank traded bonds and to freely repatriate the proceeds. But the most serious limitation of this model is that the regional bond funds in question are all concentrating on sovereign and quasi- sovereign securities. Presumably this does not mean that central banks will invest directly in portfolios of corporate securities in some future Asian Bond Fund 3, but rather that private sector managers, impressed by the performance of PAIF, will be moved to create a similar index of corporate securities. After successfully launching two Asia Bond Funds, EMEAP is preparing for the launch of ABF 3. The conditions of ABF3 will be different from the previous two. ABF3 will be serving a special purpose: providing credit support for Asian sovereign bonds 26 http://asianbondsonline.adb.org/regional/asean_plus_three_asian_bond_market_initiatives/overview.php. 40
  • 41. and other bonds that do not receive good crediting to promote the securitization of bank assets in the region. This will help the regional bond market develop to a new stage and enhance the confidence of private sector in the credit quality. The goal of ABF3 will be to facilitate further securitization of bank assets in Asian-Pacific developing economies for investors to choose from. This is what the central banks are particularly concerned, who are seeking ways to reduce the dependence on the financial institutions and develop capital markets27. ABF need to make further efforts in term of size, investment area and currency- denominations. Compared to the foreign reserves in Asian economies, we hold the position that the size of ABF can be enlarged, attracting more participation of the governments by better management. At the same time, the investment of the fund should be expanded to the corporate bonds of high credit. The expansion of local currency-denominations of bonds and the introduction of currency-basket bonds is another effort ABF should make. But the issuance of currency-basket bonds involves the problem of interest distribution such as the choice of currency basket, the weights of the currency and coordination of exchange rates. 5.2.3. Private Sector Involvement in Asian Bond Market It should be noted that private sector involvement is key to the development of regional bond markets, since market participants are the users of such markets. There should be regular dialogue between the public and private sectors on the national as well as regional level. Impediments to cross-border transactions of bonds 27 0xford Analysis, The Prospect of ABF 3. http://www.ddcei.gov.cn/html/2006011014021711058.html. 2006-01-10 41
  • 42. must be identified specifically through such dialogue. The public sector must carefully listen to the private sector when exploring new infrastructure projects such as a regional credit guarantee mechanism or regional securities settlement system. In particular, the public sector should be mindful of the risk of crowding out the private sector. An efficient bond market needs both the involvement of the government and the extensive participation of the private sectors. Transactions in the capital markets are extremely complicated and even the authorities cannot necessarily keep up with the speed of change. That is why the involvement of the private sectors is so important. In the initial stage of promoting the bond market, government can enhance the issuer’s credit by providing financing, but its role should be kept within market catalyst and not be persistent. The government-funded Asian Bond Fund should not be the prime investor in the regional bond markets, but it can play the role of market leader, leading the private investors to input more capital in the regional bond market and push the development of bond market. However, the fact in Asia is that a negative cycle has inhibited support from the private sector for closer financial cooperation. Mutual portfolio investment has not developed in Asia, and most of the portfolio investment is through European and American markets. The vicious cycle works as follows. There are not enough infrastructures to invite mutual investment in the region. This leads to lack of investment and that, in turn, chills the effort to create infrastructure for mutual investment in the region. Mori (2004) analyses the reasons why investment in Asian 42
  • 43. government bonds by Japanese institutional investors is very limited. It is not because it is difficult to purchase the bonds, but because confidence in Asian currencies has not recovered completely and because they fear that costs involved in the transactions-for example, the selling cost-will be too high due to the lack of market liquidity. Settlement is another concern. The cost of buying and selling securities is much higher than investing in European or American securities. High cost leads to less investment in the region. As a result, most investments by Japanese institutional investors and retirement funds flow to European and American markets, whereas there is hardly any investment in Asian markets . Therefore, the private and public sectors must make joint efforts to break this negative cycle and to increase investment in Asia. These efforts will include the above-mentioned building of infrastructures, removal of obstacles that inhibit private investment and increasing the liquidity of the bond market. 5.3 Stock Market Cooperation 5.3.1 Cooperation Between Stock Exchanges Recent years have seen increased links between stock exchanges with a typical example of NYSE Euronext, a combined market value of about 27 billion dollars. In Asia, there has also been a shift to initiatives which link developed markets. The Australian and Singaporean stock exchanges have agreed to mechanisms by which investors use their local exchange to access and buy stocks in the other exchange, 43
  • 44. with their local exchange acting as intermediary and trustee. This enables domestic investors-be it the householder or the institutional investor -to access foreign stocks, boosting both investment opportunities and the potential supply of funds. The Market Alliance MOU between Tokyo Stock Exchange and Korea Exchange will provide an excellent opportunity to enhance further cross-border capital flow in the region and will probably lead to a strategic alliance among the stock exchanges in North-Eastern Asia, which would provide investors and other market participants with greater value and more diverse services. The Japan-Singapore New Age Economic Agreement provides for both those countries to do the same thing (but, as discussed below, it only half delivers this). It is straightforward to close the triangle by extending it to Australia and Japan and then introduce Hong Kong, China SAR as the next partner. This process can then be extended to other countries, within and without the region, in the process bringing the region’s less well developed financial markets up to the standards of the more developed ones. 5.3.2 Cross Listing Cross listing is another alternative to tap funds outside national capital markets and integrate regional financial markets. From the viewpoint of market efficiency, cross listing may be able to boost up interests in domestic market as it enhances the visibility of local shares in the eyes of foreign investors. The possibilities for price arbitrage across markets can expedite price discovery process and promote the corporate governance. From the viewpoint of market integration, cross listing can 44
  • 45. have a positive impact on the degree of financial market integration. Karolyi (2003) measures the dynamics of the growth and expansion of international cross-listings through American Depositary Receipts (ADRs) in emerging equity markets around the world and evaluates its impact on their development and integration with world markets. He finds that the increasing number of new ADR programs, their market capitalization and trading volume in those countries are positively associated with the pace of international capital flows and greater market integration, but, at the same time, adversely impact the size and liquidity of the home markets. In the reality, Asian economies, particularly those with developed financial markets, are taking actions to create conditions for the expansion of cross listing. Takatoshi Ito (2007), a member of the Council on Economic and Fiscal Policy of Japan, suggested Japan needs to do more to make Japan's own capital markets more attractive and efficient, so as to attract foreign companies such as Chinese companies to make their initial public offerings and cross-listings on the Tokyo Stock Exchange, which currently tend to list their stocks in Hong Kong, China, Singapore and London. He holds that it would provide Japan's savers28 with easier access to some of the world's most attractive investment opportunities29. Singapore Exchange Limited (SGX) also set up its goal of boosting the city-state as a regional financial center. It aims to have more than half of its listings be foreign firms by 2012, principally from China and Southeast Asian countries such as Vietnam and Indonesia. SGX aims to attract companies with a market capitalization of up to 28 Japan has the largest stock of household saving – about 1,500,000bn Yen ($12,500bn) – most of it is locked in very safe assets or low-yielding bank accounts, bearing near-zero interest rates. 29 On April 26, 2007, Asia Media got listed in Tokyo Stock Exchange, the first Mainland-based company which listed in Tokyo Stock Exchange 45
  • 46. three billion dollars (1.95 billion US) to list on the exchange. SGX head of listing Lawrence Wong expected that on June 21, 2007, “This may happen within the next five years.” 30 According to the Financial Times report on June 17, 2007, Hong Kong, China Chief Executive Donald Tsang has endorsed proposals to begin trading Hong Kong, China and Shanghai-listed shares on each other's exchanges. Tsang was the most senior official to voice support of cross-border trading mechanisms such as depositary receipts that could link the world's fifth and sixth-largest stock markets by market capitalization. These proposals will help Shanghai modernize the market and integrate an external international global market in Hong Kong, China and a regional market in Shanghai, thus providing a model for the financial market cooperation in the region. 5.4 Derivative Market Cooperation (To be added). 6. Concluding remarks The 1997 financial crisis in East Asia has set off the awareness to enhance financial cooperation in the region. The region has gained the political will from the individual countries as they realize the importance of enhancing resilience and utilizing the excess savings/financial resources that the region possesses. Therefore, 30 http://nz.news.yahoo.com/070621/8/oq7.html. 46
  • 47. measures have been taken at a regional level and progress has been made in financial market integration since the crisis, including the regulatory cooperation, bond market cooperation, stock market cooperation and derivatives market cooperation. Despite the progress, the integration is still very limited and there is considerable room for improvement in Asia’s financial cooperation. Impediments to Asian financial cooperation could be categorized from different perspectives. Due to the diversity and heterogeneity, member economies will have the preference for national policy independence and feel reluctant to make efforts to promote financial cooperation. The capital account control is an essential factor because fixing some problems such as building infrastructures won’t necessarily integrate markets if capital accounts are still tightly controlled. Infrastructures are particularly important for the development of regional bond market. From the political point of view, the Sino-Japan rivalry constitutes a major obstacle to the integration process. Although Asia has three important regional financial centers, it still lacks an anchor financial center that can mediate financial transactions within the region, helping to attract regional investors into the regional securities markets. But financial integration is a dynamic process and Asia is on the way to a further integration. Active measures should be taken to conquer these obstacles and create favorable conditions for the further integration of Asian financial market. Deepening trade integration will act as an incentive for regional financial cooperation. Further capital account liberalization is considered to have a positive role in the integration of financial markets, but the liberalization should be realized in a correct order and in a 47
  • 48. step-by-step manner since quick liberalization could increase financial vulnerability. Regional infrastructures include clearing and settlement systems, credit rating agencies and credit enhancement and guarantee systems, which are all necessary for well-developed domestic and regional financial markets. China and Japan might come to realize that despite the differences in their strategies, China and Japan together are the key to developing a common political will in East Asia. ASEAN might act as a coordinator and propellant for cooperation between China and Japan. The three financial centers might make further efforts to shoulder the responsibility of attracting more regional funds and financing more companies in the region by providing facilities for cross listing and more hedging products. Bilateral and multilateral efforts are also needed as regards to regulatory cooperation, i.e. signing more MOUs and establishing a regulatory cooperation institution to improve the regulation rules and practices, such as AFI. For the bond market, ABMI can play the role of cultivating the bond market by promoting three- level bond issuers and introducing more debt products and enhancing market infrastructure through the work of working groups. The successful launching of ABF1 and ABF2 promised prospects for the creation of a regional bond market, but the ABF needs to be improved in terms of size, investment area and currency-denominations. Private sector involvement is the key to the development of regional bond markets. As for the stock market integration, the cooperation between stock exchanges has become a world trend and there are also actions between developed markets in Asia. Cross listing is what already on the wheel, whereas currently all the stock exchanges, 48
  • 49. especially those of the developed economies are making great efforts to attract companies from other economies in the region to list in their markets. Derivative market cooperation is still at its initial stage, since domestic derivative markets in most economies are undeveloped yet. Since the financial integration is in the stage of early and uneven development, we have our own ideas about how financial cooperation should be progressed in Asia. Our suggestion is to adopt the principle of sequencing. The developed markets already started to take bilateral actions on market alliances between Singapore and Australia, Singapore and Tokyo and, Tokyo and Korea. Then we can prospect that after the success of bilateral efforts, other economies will join sequentially. That makes it possible to go ahead with partial integration without waiting for all impediments to be removed everywhere. Of course, this means that the economies with the less developed financial markets need to work harder to upgrade and integrate their markets and systems. We think there are incentives for both developed and less developed markets to move. Developed markets will provide investors and other market participants with greater value and more diverse services by market cooperation. Less developed markets cannot achieve financial market integration with tight capital account control, thus being excluded from the benefit of market integration. They can gradually join the process of integration as capital account control is lessened with the development of financial market and economic integration. In this way, less developed markets maybe even learn from early mistakes and feel easier to catch up. 49
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  • 56. Rochester Conference Series on Public Policy 1995, 42(June): 95–143. Trairatvorakul, Prasarn. What are the Prospects for a Regional Capital Market in East Asia? Forum on East Asian Financial Cooperation, Hong Kong, China, 11 September 2001. van Wincoop, E. Welfare Gains from International Risk Sharing[J]. Journal of Monetary Economics, 1994, (34): 175-200. van Wincoop, E. How Big Are Potential Welfare Gains from International Risk Sharing?[J]. Journal of International Economics, 1999, (47): 109-135. Figure 1 A Market Linkage Model 56
  • 57. Source: Shimizu, http://www.oecd.org/dataoecd/5/61/33735778.pdf Figure 2 Efficiency of Equity Markets 57
  • 58. Table 1 Listed Chinese Enterprises in Eight Main Markets Markets 2006 2005 Funds Numbers of Funds raised Numbers of raised IPOs (US$M) IPOs (US$M) NASDAQ 527.07 6 718.84 7 New York Stock 480.55 3 395.70 1 Exchange Hong Kong, China Main 41,284.14 39 19,012.72 37 Board Hong Kong, China 227.49 6 74.74 8 Growth Enterprise Market (GEM) Singapore Main Board 1,336.79 24 201.83 20 SESDAQ 11.55 2 23.94 6 Tokyo Stock Exchange 0.00 0 0.00 0 AIM 130.42 6 62.09 2 Sum 43,997.99 86 20,490.32 81 Source: Annual report on Chinese listed enterprises, 2006, http://www.cnotcbb.com.cn/News/HYNews/200701/20070131084727.html. Table 2 Foreign Participation in the Stock Market (2004) (In percentage point) Foreign shareholder Share of foreign listings activity1 Singapore 3.9 Japan 28.7 1.3 Hong Kong, China SAR 36.0 0.9 Philippines … 0.9 Taipei,China POC 11.3 0.7 Malaysia … 0.4 China2 2.7 - India 20.7 - Korea 22.5 - Thailand 28.9 - Source: Asia-Pacific Regional Outlook—September 2005 , IMF , Asian and Pacific Department 1 In percent of trading. 2 Shenzhen. Table 3 Structure of Financial Systems (percent of GDP) 58
  • 59. Economy Bank assets Equity market Bonds outstanding capitalization 1997 2005 1997 2005 1997 2005 China 124.6 163.1 11.2 17.8 12.9 24.4 Indonesia 31.1 49.8 12.2 28.9 1.9 19.6 South Korea 37.9 93.5 8.1 91.2 25.2 76.2 Malaysia 100.9 159.4 93.2 138.0 57.0 88.0 Philippines 56.1 63.2 37.7 40.4 22.4 36.7 Thailand 79.7 103.6 15.1 70.1 7.1 40.8 Hong Kong, 205.1 444.6 234.5 593.6 26.0 46.6 China SAR Singapore 122.0 185.4 110.8 220.4 24.7 68.2 Source: Ghosh(2006) Table 4 Freedom Index of Capital Markets   1980 1985 1990 1995 2000 2001 2002 2003 2004 China 0 2 5 5 0.8 0.8 0.8 0.8 0.8 Hong Kong, 10 10 10 10 9.2 9.2 8.5 8.5 8.5 China India 0 0 0 0 0 0 0 0 0 Indonesia 0 0 0 0 1.5 1.5 1.5 1.5 1.5 Japan 2 5 8 8 7.7 7.7 7.7 8.5 8.5 Malaysia 5 5 5 5 0.8 0.8 0.8 0.8 0.8 Philippines 2 2 2 5 0.8 0.8 0.8 0.8 0.8 Singapore 8 10 10 10 5.4 6.2 6.2 6.2 6.2 South Korea 0 2 5 5 0 1.5 1.5 1.5 1.5 Taipei,China 2 2 5 5 - - - - - Thailand 2 2 2 2 1.5 1.5 1.5 1.5 1.5 Sources: Economic Freedom of the World 2006 Annual Report. http://www.freetheworld.com/release.html Appendix: Welfare gains from financial market integration 59
  • 60. Following van Wincoop (1994, 1999), we estimate potential welfare gains when each East Asian country attains perfect risk sharing with other Asian countries in the region. As shown in Kim, Kim and Wang (2003), Kim, Kim and Levin (2003) and van Wincoop (1999), potential welfare gains positively depend on the degree of risk aversion, time discount factor, and persistence and volatility of output shocks. Welfare gains negatively depend on the cross-country correlation of output shocks. 1. Benchmark model Following van Wincoop (1999), we assume that there are N symmetric countries with complete asset markets and each country i maximizes the following utility function: cit−γ H 1 V = E ∫ e− β t dt (1) 0 1− γ where H is the time horizon (number of years), γ is the risk aversion parameter, ci is aggregate consumption. Endowment yi follows a random walk with drift, dyit = µ yit dt + σ yit dzi (2) Where zi is a standard Brownian motion and, ω = dzi dz j (i ≠ j ) represents the correlation between innovations of endowment growth rates of two different countries. Under autarky, domestic consumption is equal to domestic endowment and the 60
  • 61. expected utility becomes yi10 γ 1 − e −ψ T − V= , where (3) 1− γ ψ ψ = β + (γ − 1)( µ − 0.5γσ 2 ) Under complete asset markets, country-specific risks are perfectly diversified and consumption in each country is equal to the average world endowment: J cit = yit = ∑ yit / J w 1 In the complete markets with the same endowment process in (2), consumption in each country follows approximately a random walk with variance 1 1 σ W = σ 2 ( + (1 − )ω ) 2 2 J J Welfare gains are measured by changes in permanent consumption  e − H ( r − µ )  0.5γ dσ 2 gains ≈ − 1 − H (r − µ )   (4)  1 − e− H ( r − µ )  r − µ  Where µ = µ − 0.5γσ denotes the risk adjusted growth rate and dσ = σ W − σ 2 2 2 2 is the change in the variance of consumption growth rate when moving from autarky to the economy with complete asset markets. r = β + γ µ is risk free interest rate. 2. Data and parameters calculation In order to implement (4), we need to have estimates of the risk-free interest rate, risk-adjusted growth rate, rate of relative risk-aversion, the standard deviation of 61
  • 62. country endowment growth, and the correlation between endowment growth rates. Since we are interested in potential gains from additional risk sharing we use consumption rather than output data to measure the endowments. Consumption data may already reflect a certain degree of risk sharing today. Time series consumption for 9 East Asian economies are constructed from annual data for consumption over the period 1970 to 2000 in Penn World Table. Following van Wincoop(1999), we compute the real interest rate using annual data on money market rates from the IFS for the sample economies and subtracting the CPI inflation rate. Throughout this paper we setγ=3. This is the average of the estimates reported in Friend and Blume (1975), and referred to by Shiller and Athanasoulis (1995) as representing ‘‘a consensus by many who work in this literature’’.31 See the calculation results of parameters calculation in the appendix table1. Appendix table 1 Parameters Calculations For Countries γ r σW 2 σ2 dσ 2 µ µ China 3 0.0231 0.0823 0.0780 0.0018 0.0028 -0.0010 Hong Kong, 3 0.0231 0.0823 0.0769 0.0023 0.0036 -0.0013 China Indonesia 3 0.0231 0.0823 0.0668 0.0067 0.0103 -0.0036 Japan 3 0.0231 0.0823 0.0790 0.0014 0.0022 -0.0008 South Korea 3 0.0231 0.0823 0.0790 0.0014 0.0022 -0.0008 Malaysia 3 0.0231 0.0823 0.0685 0.0060 0.0092 -0.0032 Philippines 3 0.0231 0.0823 0.0797 0.0011 0.0018 -0.0006 Singapore 3 0.0231 0.0823 0.0792 0.0013 0.0021 -0.0007 Thailand 3 0.0231 0.0823 0.0771 0.0022 0.0034 -0.0012 Source: Calculated from data from IFS and Penn World Table. 3. Welfare Gains 31 van Wincoop, 1999,P116 62
  • 63. Appendix table 2 reports each economy’s potential welfare gains from perfect risk sharing within the region. The numbers represent percentage gains in certainty equivalent consumption level when countries move from the current state to perfect risk sharing. As shown in equation (4), risk-sharing gains are positive function of time horizon T. The potential welfare gains that each country can achieve exhibit differently. Among all the economies, Indonesia can achieve the highest welfare gains, while the Philippines can achieve the lowest. Interestingly, Japan and South Korea share the same welfare gains due to the similar standard deviation of consumption, 0.0470218 and 0.0470203, respectively. The last row reports the average risk sharing gains that each country can achieve by engaging in perfect risk sharing with all other East Asian countries in the sample. On average, risk-sharing gains are 1.2 percent of permanent consumption in a 10-year horizon and increase to 4.11 and 7.61 percent with 30- and 50-year horizons, respectively. These welfare gains for East Asian countries are larger than those for OECD countries. Van Wincoop (1999) finds that risk-sharing gains from OECD countries range from 1.1 percent to 3.5 percent for 50-year horizon. Prasad, et al. (2003) showed that the welfare gains are less than 3 percent for OECD countries. One important reason why potential welfare gains for East Asian countries are larger than those found in developed countries is mostly because of low degree of current risk sharing and a high volatility of consumption. Appendix table 2 Risk sharing Gains by Country 10-year horizon 30-year horizon 50-year horizon China 0.82 2.85 5.29 63
  • 64. Hong Kong, China 1.04 3.60 6.70 Indonesia 2.93 9.95 18.30 Japan 0.64 2.22 4.13 South Korea 0.64 2.22 4.13 Malaysia 2.62 8.90 16.41 Philippines 0.51 1.78 3.31 Singapore 0.60 2.07 3.86 Thailand 0.99 3.43 6.37 7.61 Average 1.20 4.11 Source: Calculated from data from IFS and Penn World Table. 64