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«Going Regional: How to Deepen ASEAN’s Financial Markets Maria Socorro Gochoco-Bautista and Eli M. Remolona No. 300 | January 2012 ADB Economics ...»

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ADB Economics

Working Paper Series

Going Regional: How to Deepen

ASEAN’s Financial Markets

Maria Socorro Gochoco-Bautista and Eli M. Remolona

No. 300 | January 2012

ADB Economics Working Paper Series No. 300

Going Regional: How to Deepen

ASEAN’s Financial Markets

Maria Socorro Gochoco-Bautista and Eli M. Remolona

January 2012

Maria Socorro Gochoco-Bautista is Senior Economic Advisor, Economics and Research Department,

Asian Development Bank; and Eli M. Remolona is Chief Representative, Asia and Pacific Office, Bank for International Settlements. The views expressed herein do not represent the views of either the ADB or BIS.

The authors thank Noli R. Sotocinal for excellent research assistance. The authors accept responsibility for any errors in the paper.

Asian Development Bank 6 ADB Avenue, Mandaluyong City 1550 Metro Manila, Philippines www.adb.org/economics ©2012 by Asian Development Bank January 2012 ISSN 1655-5252 Publication Stock No. WPS124542 The views expressed in this paper are those of the author(s) and do not necessarily reflect the views or policies of the Asian Development Bank.

The ADB Economics Working Paper Series is a forum for stimulating discussion and eliciting feedback on ongoing and recently completed research and policy studies undertaken by the Asian Development Bank (ADB) staff, consultants, or resource persons. The series deals with key economic and development problems, particularly those facing the Asia and Pacific region; as well as conceptual, analytical, or methodological issues relating to project/program economic analysis, and statistical data and measurement. The series aims to enhance the knowledge on Asia’s development and policy challenges; strengthen analytical rigor and quality of ADB’s country partnership strategies, and its subregional and country operations; and improve the quality and availability of statistical data and development indicators for monitoring development effectiveness.

The ADB Economics Working Paper Series is a quick-disseminating, informal publication whose titles could subsequently be revised for publication as articles in professional journals or chapters in books. The series is maintained by the Economics and Research Department.



v I. Introduction 1 II. The Recycling of Savings 3 III. The Downside of Capital Mobility 9 IV. The Role of Capital Controls 13 V. Financial Market Development in ASEAN Countries 16 A. The Asian Financial Crisis and Developments in ASEAN Depository Institutions 17

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This study identifies the key issues involved in the further development and deepening of financial markets in the Association of Southeast Asian Nations (ASEAN). For the smaller ASEAN countries, the first priority is the development of the banking system. In the larger ASEAN+3 economies, banking systems are already reasonably well-developed, while stock markets and government bond markets have evidently achieved critical mass even while remaining purely domestic markets. The tug-of-war between the geography of information in the direction of more localized markets versus the critical mass required by network externalities makes the case for regional integration stronger for corporate bond markets than for other financial markets. The study proposes three bold initiatives to develop a deep and liquid regional corporate bond market.

I. Introduction Countries in the Association of Southeast Asian Nations (ASEAN) aspire to belong to a region of high and inclusive growth and high productivity, one tied together by bonds of economic cooperation and financial integration. The experience of the 1997 Asian financial crisis demonstrated the importance of a resilient financial sector. In the aftermath of the crisis, ASEAN countries strengthened their banking systems, improved regulatory oversight, and worked to further develop their capital markets. This is one reason the financial sectors in the region escaped the most recent global financial crisis relatively unscathed and why recovery from this crisis was quicker and more robust than that in other regions.

Yet it also cannot be denied that the underdevelopment of the region’s capital markets was another reason for the resilience of the financial sector. This underdevelopment meant that exposures in the region to the subprime mortgages and other toxic assets in the United States (US) remained negligible. In the absence of deeper capital markets, the earlier regional crisis had led to high savings and the build-up of foreign exchange reserves, which served to protect the region during the more recent global crisis.1 But the cost of such protection, along with the underdevelopment of capital markets, has been high. This cost has manifested itself in persistently low investment in the region.

Low investment, in turn, has adverse implications on the region’s ability to foster inclusive growth, primarily through employment generation that normally comes with investment.

The underdevelopment of capital markets and the dependence on banks as a primary source of finance in many countries in ASEAN means that many of the poor have little or no access to finance even under noncrisis conditions. For lack of better developed capital markets, the region has been sending its savings abroad to be intermediated by the capital markets of distant financial centers. The region has also been holding its savings in the form of safe, low-yielding reserve assets, while the markets abroad turned the savings into risky, higher-return investments. Some of these investments found their way back into the region, while some of them ended up in toxic assets outside the region.

The ASEAN countries face two different challenges. For Cambodia, the Lao People’s Democratic Republic (Lao PDR), Myanmar, and Viet Nam, the challenge is to further develop their institutions and banking systems. For Indonesia, Malaysia, the Philippines, Singapore, and Thailand, it is to further deepen their capital markets without unduly 1 Nijathaworn (2011) points out that one lesson of the 1997 Asian crisis was the importance of self-insurance in the form of stockpiling foreign exchange reserves.

2 | ADB Economics Working Paper Series No. 300 exposing these markets to severe financial shocks abroad. To their credit, the second group of countries has made great strides in this regard. Their equity markets and government bond markets already exhibit remarkable depth and liquidity. This would seem to imply a two-speed track of market development, with some countries individually making their banking systems their first priority, while the others continue to deepen their capital markets. In time, the first group can try to catch up by emulating the more developed ones. But for the second group, their task is not so straightforward. The market that has remained conspicuously shallow and illiquid throughout the region is the corporate bond market. To develop this market, doing it individually is unlikely to work. It is here that regional cooperation appears most crucial.

One lesson of the 1997 Asian crisis is that bank finance can suddenly dry up. Those in ASEAN that do have banking systems have come to rely excessively on their banks.

They have ended up with bank-centric financial systems. When their banks stop lending, these ASEAN countries lack a “spare tire.” Firms have no other market to which to turn for raising debt finance. The traditional spare tire in capital markets is the corporate bond market. Indeed, when the 2008 global financial crisis brought the international corporate bond market to a halt, the domestic corporate bond markets stepped in to provide financing to a few of the larger ASEAN companies, albeit in a very limited way. A deeper market would have welcomed many more companies that were starved for funds, including ones that never did have access to the international credit markets.

Robert Lucas saw as a paradox the stylized fact that capital does not flow from rich countries to poor ones. The capital flows in the ASEAN region are even more paradoxical.

Capital in the region flows in the opposite direction—from the poor countries to the rich ones. The lack of developed financial markets accounts in part for this perversity. At their root, financial markets are arrangements for processing information that take critical advantage of the externalities found in networks of savers and investors. For largescale savings and investments, the ASEAN region seems to lack such a network. It is London and New York that harbor such networks, thus they attract the world’s savings and decide the world’s investments. The historical lock-in effects of such networks are difficult to overcome. Nonetheless, the geography of information suggests that there are fundamental disadvantages in networks that are based in distant centers. A welldeveloped network based in Asia could very well reshape the region’s pattern of capital flows and render the Lucas Paradox a thing of the past.

This study aims to identify the key issues involved in the further development and deepening of ASEAN financial markets. It argues that for the smaller ASEAN economies, the first priority is the development of the banking system. For the larger ASEAN countries, the banking systems and the capital markets are already reasonably well developed. The one important market that is still missing is a deep and liquid corporate bond market. Because the required critical mass for this market is so large, only a regionwide market would succeed. It is for this that regional cooperation would be essential.

Going Regional: How to Deepen ASEAN’s Financial Markets | 3 Section II discusses the intermediation of ASEAN savings in financial centers outside of the Asia and Pacific region and how these savings eventually end up as capital inflows to the region. This “recycling” is inefficient, since these distant financial centers have no fundamental advantage in processing the necessary information for investment decisions.

Section III discusses the issues arising out of imperfect markets and the risks of full capital mobility. The tail risks of unhindered cross-border flows involve sudden stops and current-account reversals, as well as their tendency to finance asset price bubbles that eventually lead to disruptive and costly adjustments. These costs are especially high in economies without well-developed financial markets of their own. Section IV discusses the level and process of financial development in the ASEAN region. It shows that while significant gains were achieved after the 1997 Asian financial crisis, the corporate bond markets still need to develop further. These are the markets that would make the most difference in moving toward a more efficient recycling of ASEAN savings and a more desirable pattern of capital flows. Section V presents the rationale for regional cooperation and integration. Given the prerequisites of liquidity and the scale economies that the development of bond markets entail, regional cooperation and coordination should provide the local network externalities that support market depth.

II. The Recycling of Savings Throughout the decade after the Asian financial crisis, Mohanty and Turner (2010) show that there was a general increase in savings rates in Asia. Much of the growth in savings in Asia is attributable to the People’s Republic of China (PRC), which together with Japan accounts for the bulk of savings in the region. The PRC’s average savings rate increased to 69% in 2000 to 2007 from 43% a decade earlier. An acceleration of savings was also experienced in India, from an average rate of 31% in 1990 to 1997, to 47.8% in 2000 to 2007. Other emerging economies in Asia had a marginally lower average saving rate of 31.2% in 2007 to 2010, from 33.9% in 1990 to 1997. As Asian savings increased or remained buoyant from 2000 to 2007, the equivalent figures in advanced economies generally declined further from comparatively lower levels a decade earlier. On average, the advanced economies had a savings rate of 18% for 2000–2007, lower than the average rate of 19.7% in 1990–1997. The US experienced a very low average savings rate in 2000–2007 at only 5.8% of gross domestic product, significantly lower that its 1990–1997 average of 20.9%.

ASEAN is a region of prodigious savers. From already high levels, savings in the region gradually increased at the turn of the century and accelerated after 2005. Figure 1 shows the evolution of savings and investment ratios in the ASEAN, the ASEAN together with the PRC, Japan and the Republic of Korea, as well in advanced economies. ASEAN countries generally had higher savings relative to investment rates after 1998 onward.

East Asia as a whole had higher positive savings–investment gaps since the early 4 | ADB Economics Working Paper Series No. 300 1980s. In contrast, the savings investment gaps in advanced economies was consistently negative, albeit by a marginal amount, from 1980 to 2010.

Figure 1: Savings and Investment (percent of GDP) ASEAN − Savings ASEAN − Investment ASEAN+3 − Savings ASEAN+3 − Investment Advanced Economies − Savings Advanced Economies − Investment GDP = gross domestic product.

Note: ASEAN includes Brunei Darussalam, Cambodia, Indonesia, the Lao PDR, Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Viet Nam; ASEAN+3 includes the PRC, Japan, and the Republic of Korea.

Source: Staff calculations using data from the World Economic Outlook (IMF 2011b) and the World Development Indicators (World Bank 2011).

Emerging Asia’s average investment rates did not grow as fast as its marginal propensity to save. The average rate of investment as a percentage of GDP increased by only 3.4% to 34.1% in 2000–2007 from 30.7% in 1990–1997. This implies that there is a huge gap between savings and investment rates for 2000 to 2007.

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