Asia's quest for closer regional and global financial integration is under way
The hope of better risk sharing, more efficient allocation of capital, more productive investment, and, ultimately, higher standards of living for all is propelling the drive for stronger connections between financial systems across the world. Asian economies, particularly emerging markets, are taking an active part in this quest, at both the regional and global levels. At the global level, Asia's integration with the international financial system is well advanced. At the regional level, however, integration is more limited.
In the years since the 1997–98 financial crisis, Asian governments have affirmed their intention to promote financial integration at the regional level with a view to both reducing vulnerabilities and improving the allocation of savings. A series of initiatives have been launched to boost regional self-sufficiency, ranging from information sharing to financing arrangements in foreign exchange. Governments are also taking steps to deepen regional bond markets to reduce reliance on bank financing and to shelter the regional economy from the possible repercussions of future volatile capital flows originating elsewhere in the world.
Yet, despite all these efforts, Asia's capital markets remain fragmented. Emerging Asian companies frequently raise capital in industrial country markets rather than at home, and relatively few bond issues are in Asian currencies. In other words, emerging Asian countries are not really investing in each other. Making a dent in the large unfinished agenda for financial integration poses many challenges. The encouraging news is that Asia is well positioned to forge ahead.
Where financial integration stands
Just how much progress has Asia made toward financial integration, which we define as a gradual process through which cross-border capital flows increase, financial markets' comovements become stronger, and product prices and market infrastructures converge to common standards?
One measure of financial integration is geographical reach—that is, regional versus extraregional or global linkages. Asia's integration with global financial markets is already well advanced by most standards. For example, Asia has been a major beneficiary of a surge in net private capital flows to emerging markets, home to half of the global supply of such flows in 2003 and 2004 (see Chart 1). At the same time, by accumulating large official foreign reserves, many Asian countries are major holders of advanced economies' sovereign bonds.
Other indicators, however, paint a more nuanced picture. Aggregate foreign liabilities in Asia—the combined stock of foreign direct investment (FDI), foreign loans, and foreign equity holdings—currently amount to about 65 percent of aggregate GDP, less than the amount in Latin American emerging markets (where these liabilities are nearly 80 percent), and in the United States and the euro area (where they add up to over 100 percent). In addition, there is tremendous variation among Asian countries. While in some, like the Philippines, large foreign financial liabilities are the result of official borrowing, in others, like Hong Kong SAR and Singapore, the liabilities reflect their roles as regional finance centers and a high degree of integration with the global financial market. In contrast, the relatively low ratios of foreign financial liabilities to GDP in India and China suggest that these economies are not deeply integrated with the international financial system (see Chart 2).
Limited data complicate an evaluation of regional financial integration. Information on bilateral cross-border capital flows within Asia is scant, making it difficult to assess how much cross-border investment in Asian financial markets originates in the region. That said, the low cross-border correlation of consumption growth in emerging Asia suggests untapped potential for diversification.
A second measure of integration is within asset classes—the cross-border connections among domestic banking systems, equity markets, and bond markets. This measure also shows financial integration as uneven. For banking, 2004 data show that the major foreign lender is often European or American. Japanese banks rank third, except in Thailand, where they rank first. Anecdotal evidence suggests, however, a growing interest in cross-border acquisitions, especially by Singapore banks—a trend consistent with rising outward FDI in the region.
On Asian stock markets, there are few foreign listings and even fewer regional listings. In some Asian countries, stock markets have a large international presence, but few foreign players come from neighboring countries (see Table 1). The share of foreign listings on Asian stock markets is also decreasing, as borrowers prefer to issue depositary receipts in New York or London. Foreign shareholding and trading of securities listed in Asia have grown, but few nonresident players are from the region. For example, foreign investors' participation is significant in Hong Kong SAR, accounting for more than a third of total turnover in 2004. However, only a fifth of this activity can be attributed to Asian nationals.
In bond markets, regional integration is also limited. Much of the growing foreign currency–denominated bond issuance of Asian sovereign and corporate borrowers is in U.S. dollars (see Chart 3) and is marketed outside of Asia—about 80 percent is in the United States and Europe. There is evidence, though, that Asian investors in these markets absorb large amounts of the issues. The high degree of integration of foreign currency–denominated bond markets, however, does not carry over to Asia's markets for local currency–denominated bonds. There is little evidence of Asians investing in the bonds of other neighboring economies to date, notwithstanding initiatives under way to promote cross-border holdings.
Possible rewards from integration
While already reaping the benefits of diversification through its participation in the global financial market, emerging Asia could make additional gains from more extensive intraregional ties, including the following:
Deeper and better-connected financial markets would thus benefit Asia. Its financial systems are mostly bank based, with equity and private bond markets generally smaller than those in developed economies (see Table 2). Malaysia and Korea are exceptions because their corporate bond markets, as a percentage of GDP, are among the largest in the world following the collapse of bank lending in the late 1990s. The depth of local bond markets has generally increased across Asia, however, because governments have become major issuers to finance bank restructuring and rising fiscal deficits since the financial crisis. On the other hand, stock market activity has since declined, in part because of the migration of creditworthy Asian corporates to mature markets.
In the future, trends in regional trade and abundant liquidity are likely to serve as catalysts for stronger financial linkages throughout the region. Intraregional trade currently accounts for about 40 percent of Asia's trade, an increase from less than 30 percent in the 1980s. There is room for more growth. In the euro area, for example, intraregional trade accounts for close to 70 percent of total trade. A strengthening of regional demand and trade growth will independently stimulate Asian asset markets and tighten regional interconnections. Better-linked regional financial systems could provide funding and hedging instruments to support the region's trade activities. Overall, Asia's growing intraregional trade will catalyze greater financial integration and, in turn, be stimulated by it.
On the liquidity front, there is a local overhang because of a combination of high domestic savings and low domestic investment in much of the region (see "Asia's Investment Puzzle," on page 32 of this issue), on top of recent surges in capital inflows and associated (unsterilized) intervention. As a result, Asia has become a net exporter of capital, contributing to large global imbalances in current accounts. Deeper intraregional financial integration could help allocate this liquidity intraregionally, reviving domestic investment and an orderly decline in external surpluses.
Taking the initiative
Asian policymakers have launched several initiatives to deepen domestic markets and establish a pan-Asian system for countries that lack the minimum scale needed to support liquid national financial markets. In many countries, capital account restrictions no longer stand in the way of cross-border flows. Nonetheless, additional steps are needed to foster the development of regional financial systems. Further developing capital markets requires reforms to strengthen issuers, broaden the investor base, and build market infrastructures (including clearing and settlement systems and credit-rating agencies). Banking supervisory and regulatory norms need to be on par with international best practices, and a framework for consolidated supervision needs to accompany cross-border consolidation. As in the euro area, this can be done through cooperation between national banking supervisors or through the creation of a supranational supervisory unit—perhaps limited to regionally significant financial players.
Under the aegis of ASEAN+3 (the grouping of 10 Southeast Asian Nations, joined by China, Korea, and Japan) and other forums, the focus so far has largely been on strengthening bond markets in the context of the Asian Bond Market Initiative. Governments have taken steps to extend the yield curve (notably, in Malaysia and Korea); promote larger issues of benchmark government bonds (in Indonesia, Korea, Malaysia, Philippines, and Singapore); and encourage the growth of asset-backed securities, Islamic bonds, and local currency bonds offered by multilateral development banks and Japan's Bank for International Cooperation. Two Asian bond funds have launched successfully (to invest in dollar- and local currency–denominated bonds issued by Asian sovereigns and quasi-sovereign entities). Pan-Asian bonds (collateralized bond obligations using small and medium-sized enterprises' bonds as underlying assets) have been created through collaboration between Korea and Japan; and Thailand has established the legal underpinnings for a Thai baht Asian bond. Extensive work is under way to study the scope for a regional guarantee mechanism and for a clearing and settlement system. Finally, ways to strengthen the role of local credit rating agencies are being explored.
Greater financial linkages bring benefits but also require sound policies and institutions, as well as mechanisms to contain new risks that could arise from more open financial systems. Mindful that financial integration could magnify the channels through which shocks are transmitted across borders or across asset markets within a country, Asian governments have taken steps to monitor financial system vulnerabilities and ensure a swift response in the event of a crisis. For example, ASEAN+3 countries are strengthening information sharing to better monitor short-term capital flows. Surveillance groups have also been established to provide a basis for policymakers to exchange information and to cooperate in regulatory capacities. Asian governments have established significant financial support mechanisms in the context of the Chiang Mai Initiative to cope with disruptive capital flows and maintain exchange rate stability.
Toward monetary integration?
For many Asia watchers, advances in financial integration and intraregional trade are seen as heralding eventual adoption of a regional common currency and the establishment of an Asian monetary union—following the euro model. Europe's experience shows that a monetary union imposes such stringent demands on policy coordination and institution building that Asia may well need a clear political will, sustained over generations. It is not yet close to developing this sense of common purpose. Other obstacles include a lack of common institutions, widely different economic structures, and uneven development patterns. Differences in production patterns are particularly problematic because they increase the likelihood of asymmetric shocks that call for different monetary responses at the national level—something that would be impossible within a monetary union. It is safe to say that a monetary union for Asia remains, at best, a distant goal. That said, the policy requirements for a strong regional economy also support convergence of economic conditions among its members.
For now, Asian economies are best served by exchange rate systems with adequate flexibility to cushion country-specific shocks. Although some aspects of financial integration (for example, the transformation of local markets into an all-encompassing regional market) may not be possible in the absence of a common currency, flexible exchange rate systems can facilitate ongoing efforts to foster closer regional economic ties. North America's experience with its free trade agreement underscores the benefits of flexible exchange rates and monetary policies targeting low inflation, provided that excess volatility can be contained. Notwithstanding fluctuations in their bilateral exchange rates, North American countries have developed highly articulated supply chains, large intraregional FDI flows, open capital accounts, and stable financial systems.
Right time for deeper integration
Asia has come a long way in opening its financial system and clearly understands how it can benefit from deeper financial integration. Emerging Asia is a global player in international trade and a significant recipient of net private capital flows to emerging markets. The development of regional capital markets offers significant payoffs, particularly as it supports better integration with the global financial system.
Nonetheless, many challenges remain and the policy agenda is extensive. In the course of forging the path ahead, regional policymakers will tackle difficult issues, including the appropriate sequencing of reforms; the desirable balance between domestic and regional priorities; possible trade-offs between global and regional financial integration; and the relative roles of governments and markets in shaping the process. The combination of favorable economic conditions and a clear commitment to integration can provide a fitting environment in which the policy debate can flourish—and Asia's financial integration can continue to advance.