9 Aug, 2011

Bulwarks Up, Asia Confronts Pros & Cons of Financial Globalisation

Imtiaz Muqbil

Recurring financial crises are again exposing Asia to the pros and cons of globalisation and will lead to a stepped-up search for indigenous solutions and protective measures against currency fluctuations and volatile short-term capital flows. The August issue of the Asian Capital Markets Monitor, released by the Asian Development Bank (ADB) this week, says:  “Financial integration and contagion are two sides of the same coin: while a virtuous cycle in good times, greater integration also reduces the defense against negative shocks.

“Financial crises underline the risks of financial integration. For emerging Asia, the 2008–2009 global financial crisis once again exposed the vulnerability of its financial markets to worldwide turmoil. Although crisis spillovers were relatively limited (the region had little direct exposure to US subprime mortgages or other “toxic” assets), continuing finance sector development in Asia suggests the next crisis could be more damaging. Thus, a reassessment is called for in evaluating the next steps for emerging Asia’s financial integration.”

According to the monitor, “The ebb and flow of capital to emerging Asia during the 2008/09 global financial crisis reignited the debate over the costs and benefits of financial openness and liberalization.

“In theory, freer capital mobility enhances welfare— it promotes more efficient allocation of financial resources. Yet large and volatile capital flows are risks and present challenges to emerging market economies. For example, large short-term capital flows have historically disrupted domestic monetary policy, destabilizing financial systems and economic growth.”

It says that although emerging Asia’s capital markets have shown great resilience over the past year, but the recent sharp sell-offs in response to economic uncertainty in the US and eurozone underscore the need for stronger policies to boost investor confidence and reduce excessive volatility.

“Emerging Asian markets remain vulnerable to abrupt changes in global investor sentiment,” said Iwan Azis, Head of ADB’s Office of Regional Economic Integration, which prepared the report. “The knock-on effects from events in the US and Europe will go far beyond portfolio returns, as a weakening global economy will hurt our exports.”

Environment More Volatile

The Asia Capital Markets Monitor, ADB’s annual assessment of the performance and outlook for the region’s equity, bond and currency markets, says the global financial environment has become more volatile in recent months—with investors unnerved by the weakening global economy, US and European debt troubles, and political unrest in the Middle East and North Africa.

While emerging Asia’s markets have not been immune to these developments, the region’s strong fundamentals and interest rate differentials with advanced economies are expected to reignite capital inflows to the region later this year.

“While freer capital mobility is welfare-enhancing in theory—as it promotes better and more efficient allocation of financial resources—large and volatile capital flows are risks and present challenges to emerging market economies,” warns Mr. Azis.

Large short-term capital flows have historically disrupted domestic monetary policy, destabilized financial systems and dented economic growth, the report says.

The Asia Capital Markets Monitor covers 11 economies of emerging Asia: the People’s Republic of China; Hong Kong, China; India; Indonesia; the Republic of Korea; Malaysia; the Philippines; Singapore; Taipei,China; Thailand; and Viet Nam.

Fears of a global growth slowdown and worries over US and European debt have seen credit spreads on emerging Asian sovereign bonds widen since March. However, the appetite for sovereign debt paper remains resilient given the region’s relatively sound fiscal positions and positive growth outlook. Emerging Asian borrowers issued $29.5 billion of G3 currency-denominated bonds in the first quarter of 2011, up from $24.5 billion over the same period in 2010.

Equity markets continued to rebound from the global economic crisis, supported by upbeat prospects for the regional economy, strong corporate profits, and a lack of attractive yields in advanced economies. In 2010, most of emerging Asia’s currencies appreciated—their biggest gains since 2006—aided by strong capital inflows attracted by the prospect of widening growth and interest rate gaps with advanced economies. The Malaysia ringgit led the gains with an 11% rise against the US dollar. Despite some recent moderation, the report says the upward trend should continue.

Downside Risks Loom Large

While noting growth in emerging Asia is forecast at a robust 7.9% in 2011 and 7.8% in 2012, the report warns that downside risks loom large as monetary authorities across the region step up their fight against inflation amid increased global economic uncertainty and heightened financial volatility.

Despite visible improvement in the depth and breadth of emerging Asia’s capital markets, persistent vulnerabilities to external shocks suggest the region’s collective efforts are necessary to enhance market resilience. “Providing deep and liquid markets with strong market infrastructure is essential to support the region’s financial development and integration,” he said.

In a remarkable admission, the report claims that “very little is known about the factors driving different types of capital flows to emerging Asia and how they affect volatility.”

It says, “Effectively managing capital flows has resurfaced as a major policy concern for much of emerging Asia since the global financial crisis. Understanding the forces behind capital flow volatility is essential when designing a policy framework that can effectively manage capital flow volatility and its disruptive potential.

“The composition of capital flows significantly affects financial volatility. Empirical evidence also suggests that short-term capital flows, e.g., from bank lending and portfolio investments, tend to be more volatile than long- term flows, such as foreign direct investment (FDI). However, very little is known about the factors driving different types of capital flows to emerging Asia and how they affect volatility.”

At the same time, the report urges that “determinants of capital flows should be clearly understood when considering financial liberalization or the introduction of capital controls.

“The relative importance of “push” and “pull” factors in driving international capital flows is a source of heated debate. If the size and volatility of capital flows are determined by push factors (external conditions such as a decline in interest rates in advanced economies or recessions), emerging market economies may find it difficult to regulate capital inflows individually.

“However, if capital flows depend largely on pull factors (domestic conditions that attract capital for economic growth), then adopting appropriate policies may help influence the size, type, and volatility of capital flows. Unfortunately, empirical evidence to date is largely mixed, leaving the debate unresolved despite the important policy implications regarding financial liberalization and capital controls.”

The full report can be downloaded here.

The following are the report’s Conclusions and Policy Implications

1) Understanding the degree and dynamics of financial integration in emerging Asia is important for shaping national policies, not only for economic growth and development but also for financial stability.

The degree of regional and global financial market integration is an increasingly important issue for Asia’s policy makers. It implies the potential benefits of consumption-smoothing and risk sharing across borders, and is also important when assessing the potential costs of financial contagion. As Asia’s financial markets further integrate—both within and beyond regional boundaries—cross- border transmission of shocks and the risk of financial contagion also increase. Empirical results also suggest that the risk of financial contagion is higher during crises.

2) Emerging Asia’s equity markets— particularly those tightly linked to global markets—are vulnerable to abrupt swings in global investor sentiment, potentially increasing capital flow volatility.

Consistent with earlier studies on Asian financial integration, global news remains an important driver for Asian equity market returns and volatilities. It appears the degree of intraregional integration, though increasing, continues to lag behind the region’s global integration. Correlations between Asia’s equity markets and with global markets have increased substantially over time. However, the extent to which an individual market reacts to a regional shock remains more limited than its sensitivity to a global shock.

3) In contrast, Asia’s local currency bond markets remain largely fragmented; while protecting markets from external shocks, the fragmentation hinders provision of adequate market liquidity.

In many emerging Asian economies, local currency bond markets are much smaller than domestic equity markets. Given their relative underdevelopment, these bond markets also remain fragmented. Their limited degree of integration may actually help the region during market turmoil, as they remain largely unaffected by external shocks, either regional or global. However, Asia’s underdeveloped local currency bond markets fail to provide an effective alternative funding source for companies. In emerging Asia — where financial systems have traditionally been dominated by banks — the financial infrastructure and legal framework for debt markets have been slow to develop. Auditing and accounting standards remain below par in many emerging market economies, with low levels of transparency and weak governance further hampering the development of local currency bond markets.

4) Maximizing the net benefits of financial openness and integration is a key policy challenge for emerging markets.

Rapid financial liberalization must be accompanied by measures to ensure effective use of foreign capital. In principle, capital flows can bring many benefits to an economy. For example, higher inflows can increase investment, reduce the cost of capital, and transfer technology, which can contribute to raising the long-term growth of an economy. However, empirical evidence on the benefits of free capital flows has been patchy. In reality, costs associated with unbridled capital flows are often huge. Many previous crisis episodes follow a period of massive capital inflows, inflating property and stock market bubbles. Further, capital inflows have been volatile and procyclical. Emerging market economies tend to experience capital outflows precisely when they most need capital. There are several essential preconditions for financial liberalization that can render capital flows beneficial to an economy. These include sound macroeconomic policies and frameworks, a high level of financial development, and effective institutions and good governance.

5) Emerging Asia should continue strengthening its macroeconomic management and macroprudential supervision to attract stable and long- term capital flows.

To maintain investor confidence, sound macroeconomic management and effective prudential supervision are vital. The primacy of pull factors as determinants of capital flows and volatility also underpins the importance of domestic macroeconomic management and sound fiscal and external positions. Most emerging Asian economies today are better prepared to manage asset price bubbles and capital inflows—thanks to the reforms and restructuring following the 1997–1998 Asian financial crisis. Nonetheless, the recent global financial crisis demonstrated that the risk assessment and management capabilities of Asia’s financial systems remain insufficient and require further reform. One of the reform priorities is to develop a systemwide macroprudential supervisory framework to prevent a buildup of systemic risk. Where necessary, measures to harness volatile capital flows need to be considered as part of a comprehensive macroprudential supervisory framework. These measures may include minimizing the inflows of speculative capital and promoting longer term and more stable flows to meet the region’s investment needs.

6) Despite visible improvement in the depth and breadth of emerging Asia’s capital markets, major vulnerabilities persist, suggesting more effort is needed to improve market resilience.

The 1997–1998 Asian financial crisis ignited significant capital market development and regional integration. The rationale came from a shared understanding that vibrant capital markets and better developed domestic financial systems were essential for channeling Asia’s huge savings into productive investments. Despite the progress made, there remains a full agenda to foster deeper and more liquid domestic capital markets, including broadening the investor base; encouraging development of more diverse and innovative local financial products; improving legal, regulatory, and institutional frameworks; upgrading governance and transparency; and establishing market infrastructure and institutions that are more sound.

7) In particular, developing vibrant local currency bond markets is essential to promoting efficient allocation of Asia’s vast financial resources.

The development of local currency bond markets has the potential to mitigate the global shortage of sound and liquid financial assets, lessen the probability that currency depreciation will morph into a full-blown financial crisis, reduce the massive inflows into US debt securities, and, hence, begin to unwind global imbalances.

8 ) The 1997/98 and 2008/09 crises highlight Asia’s vulnerability to financial instability arising from rapid financial globalization, large and unfettered short-term capital flows, exchange rate volatility, and the lack of crisis control mechanisms.

National mechanisms to stem the spread of financial panic proved largely inadequate, ineffective, and inefficient given massive deleveraging in advanced economies, tight international liquidity, and recession. Large and at times volatile capital flows seem to have motivated emerging market economies to further accumulate reserves, thereby exacerbating global imbalances. Exchange rate flexibility helps smooth the edges, as holding vast reserves has its own costs. Emerging Asia’s policy makers could work together on three major areas to secure monetary and financial stability: (i) strengthening regional economic surveillance; (ii) strengthening regional institutions for crisis prevention and management; and (iii) deepening regional capital markets, particularly through local currency bond market development. The recent establishment of the ASEAN+3 Macroeconomic Research Office in support of the Chiang Mai Initiative Multilateralization reserve pooling arrangement is a vital step forward.9 There may also be merit in exchange rate policy dialogue, particularly within East Asia, as efforts accelerate to deepen and broaden regional trade and investment.

9) Asia must take greater responsibility in the ongoing process of reforming the global financial architecture by actively participating in all levels of governance.

The absence of an effective global mechanism to manage the international monetary system exposed serious problems during the global financial crisis. Swap agreements with developed and financially strong emerging economies, regional reserve pooling, and access to funding from international financial institutions offer several options in managing short- to medium-term debt and financial flows. However, Asia would clearly benefit from strong regional and subregional mechanisms to support regional financing arrangements, policy coordination, mutual surveillance, and monitoring. These can all eventually become a part of the global financial architecture. To help achieve this, Asia needs to take greater responsibility in correcting global macroeconomic and structural imbalances, while playing a proactive role in ensuring macroeconomic and financial stability globally.