East Asian Capital Markets Integration: Steps Beyond ABMI by Andrew Sheng and Kwek Kian Teng

1
East Asian Capital Markets Integration Steps
Beyond ABMI by Andrew Shengand Kwek Kian Teng
Advancing East Asian Economic Integration
Conference 22-23 February 2007, Bangkok
2
Outline

• I. Introduction.
• II. Review of Trade Integration in Asia.
• III. Review of Financial and Capital Markets in
  Asia.
• Roadblocks in the East Asia Capital Markets.
• Key Challenges Beyond Asian Bond Markets
  Initiatives.
• Concluding Thoughts.

3
I. Introduction

• July 2007 will mark the 10th Anniversary of the
  Asian Financial Crisis. Following the Crisis,
  the ASEAN Finance Ministers Meeting in Manila in
  April 1999 decided to aim for wider ASEAN3
  cooperation.
• Since then, many measures, such as the Asian Bond
  Markets Initiative and Chiangmai swap
  arrangements have been launched to considerable
  fanfare.

4
I. Introduction

• In earlier Jakarta paper, we suggested that
  despite good intentions, it has proved difficult
  to integrate Asian Bond Markets due to
  bureaucratic differences within countries and
  between countries.
• The framework can be extended to Asian capital
  market integration.
• This paper uses Network Theory and Douglass
  Norths new institutional framework to understand
  how to move towards the Process of Asian Capital
  Market Integration.

5
Regional Integration Improved

• Conditions for better regional integration has
  improved since Asian economies have emerged
  beyond "original sin (Eichengreen and Hausman,
  1999), i.e. that most countries cannot borrow
  internationally in their own currencies, to
  significant accumulation of financial reserves
  and assets.
• In addition, they also learnt the lesson of
  balance sheet weaknesses (the double mismatch
  problem that plagued the Asian crisis economies),
  so that the share of foreign currency denominated
  debt has declined rapidly, and FX reserves have
  grown significantly.
• Foreign capital continues to pour-in through
  exchange traded funds, rise of private equity,
  hedge funds, product innovation (eg Islamic
  finance) and Demutualization of Exchanges - have
  all pushed for greater capital market
  integration.
• However, trade integration has occurred in
  advance of financial integration.

6
Barriers to Integration

• However, there are still many roadblocks in
  building a matured and vibrant regional capital
  market in East Asia.
• The QUESTIONS are Why, But How, What, For
  Whom?
• Need to go back to basics-
• Purpose of Capital Market Integration
• Common Principles Standards
• Common Products
• Common Platforms
• Shared Incentives
• Reducing Transactions Costs Risks
• Sharing Benefits

7
II. Review of Trade Integration in East Asia

• East Asia regional integration is driven by trade
  integration.
• East Asia has done well in developing world class
  export sectors and industries, and emerged as
  Global Manufacturing Supply Chain since the Asian
  Financial Crisis 1997/98.
• Largest increase in trade networking in the world
  (measured by Trade Connectivities total trading
  partners for exports and imports),
• Largest trade openness (measured by total trade
  per GDP).
• Larger share of total trade/world trade compared
  to NAFTA.

8
Trade Integration in East Asia has Strengthened
Increasing Trade Connectivities as Percentage of
World Trading Partners
Source COMTRADE Database
9
Trade Integration in East Asia has Strengthened
ASEAN registered largest increase of 34 for
trading partners, followed by East Asia of
10.4.
10
Increasing Trade Openness in East Asia
Source COMTRADE Database and International
Financial Statistics
11
III. Review of East Asia Financial and Capital
Markets

• The success in East Asian exports and high
  savings created a high level of net foreign
  asset position due to current account surplus,
  plus from high inflow of FDI, and FPI .
• This success created two distinct phenomena
• (i) Excess reserves hoarding creating Asia as
  the Net Exporter of Capital and causing global
  imbalance (Lane and Milesi-Ferritti, 2006).
• (ii) Recycled savings back into Asia, creating
  the Total Equity Return Swap effect (Dooley,
  Folkerts-Landau and Garber, 2003).
• East Asias sterling growth in exports brought in
  high accumulation of foreign reserves, and
  created a situation where East Asia is both an
  exporter of manufactures and services and capital
  (Lane and Milesi-Ferritti, 2006).
• At end of 2004, Asia has a net position of 30
  of GDP (US2.7 trillion), whereas Europe had a
  net liability of 9.3 of GDP (US1.2 trillion),
  and NAFTA had a much larger net liability of
  22.9 of GDP (US3.1 trillion).

12
Asia is now Net Creditor to US and Europe (US
trillion)
Source World Bank Financial Structure Dataset,
February 2006
13
Domestic Financing in East Asia is Bank-Dominated
Source Asia Bond Monitor November 2004
14
Equity, Bond, Insurance Pension Markets Remain
Relatively Under-Developed
Sources CEIC data World Bank, Financial
Structure Dataset, February 2006
a. Bank Deposits/GDP b. Stock Market
Capitalization/GDP c. Public and Private
Bond Market Capitalization/GDP d. Life and
Non-Life Insurance Premium Volume/GDP
1. 1992 data 2. 1994 data 3. 1995 data
4. 1996 data 5. 2003 data. n.a. denotes
not available
15
Post-Asian Financial Crisis 1997/98 Reforms

• Increasing Financial Integration and Cooperation
  in East Asia Capital Markets.
• Bilateral foreign exchange swaps.
• Regional economic surveillance.
• Regional Asia bond market
• The 2000 Chiang Mai Initiative (CMI) on regional
  swaps.
• ASEAN Surveillance Process (ASP).
• The 2003 Asian Bond Market Initiatives (ABMI).
• The Asian Bond Fund Initiatives (ABF1 and ABF2
  created in 2003 and 2004 respectively).
• The 2005 FTSE/ASEAN Index Series to help
• standardise market indices.
• Of late, the proposals for Asian Monetary Fund,
  Asian Currency Index
• appear to surface in different forms.

16
IV. Roadblocks in Deepening the East Asia Capital
Markets

• Shallow and lack of integration due to
• Large differences in market practices,
  institutional development and regulatory
  standards, laws and processes.
• High transactions costs.
• Barriers to entry and regulatory obstacles to
  financial innovation.
• Conflict between national interests
  (protectionism) vs integration (openness).
• Bureaucratic differences and lack of cooperation
  between public and private interests.
• No common philosophy and roadmap to integration.

17
Roadblocks in Deepening the East Asia Capital
Markets

• Some capital markets in Asia still some distance
  away from four key functions efficient resource
  allocation, good price discovery, sound risk
  management and effective corporate governance.
• Are capital markets protecting investors
  property rights fairly, efficiently and
  transparently?
• If not, then even domestic investors will try to
  put funds abroad (in developed markets) because
  they protect property rights better, with lower
  transaction costs and give higher liquidity.

18
Regional Equity Integration Lagging behind
Regional Trade Integration

• The global market capitalization for all stock
  markets was US42 trillion in 2005.
• Stock market capitalization for East Asia is 16
  (US 6.7 trillion) of world market cap in 2005.
• Market cap for ASEAN is barely 2 in 2005.
• The world market is still heavily dollar-based,
  where domestic blue chips are preferred to be
  traded in New York and London, than in their home
  markets.

19
Absolute Value of Market Capitalisation (US
Million)
Source World Bank
20
East Asian Capital Market remains small
East Asia 16.1
ASEAN 1.4
EU 26.2
EUZone 17.5
NAFTA 43.2
USA 39.5
UK 6.8
Source World Bank
21
East Asian Market Indices Lagging Behind Weak
and Negative Correlation in Pre-Crisis Equity
Market Interdependency
Source World Federation of Exchanges
22
Market Indices in East Asia are
SynchronizingHigher and Stronger Correlation in
Post-Crisis Equity Market Interdependency
Source World Federation of Exchanges
23
East Asian Debt Markets Still Relatively
Shallow and Lack Integration

• In terms of debt markets
• The scale of regional bond market expanded more
  than 4.5 times (annual amount) in 2005.
• In terms of its ratio to GDP, it rose from 16.5
  to 48.0 during these eight years.
• However, the U.S. dollar and the Euro still
  dominate the international bond markets.
• Together, they amount to around 90 of total
  issues in the first quarter of 2005.
• (Source Sakakibara, 2006)

Source Sakakibara (2006) based on data from Asia
Bond Monitor, March 2006
24
V. Key Challenges Beyond ASIAN Bond Markets
Initiatives

• Major obstacle to Market Integration is due to
  huge differences in Initial Conditions
• Huge differences between OECD level economies
  (Japan, Korea, Singapore, Hong Kong, Taiwan) and
  EMCs such as Cambodia, Laos, Myanmar and Vietnam
  (CLMV).
• Huge differences in financial asset wealth
  (Japanese financial assets double rest of Asia
  put together).
• Which currencies to use? USD, Euro, Yen or
  Asian currency unit?

25
Re-thinking Asian Integration Architecture,
Principles, Process, Outcome

• We have to go back to basic principles for
  integration
• Why should we integrate?
• For Whom should we integrate?
• How should we begin process of integration?
• We now use Network Theory and Douglass Norths
  Institutional Framework to think about process
  of integration.
• Change is about mindsets.

26
Process of Economic Change is Institutional and
Organizational Evolution this has an
Architecture

• All economies and markets are path dependent,
  based on initial conditions shaped by geography,
  demography, history and culture.
• Different institutions and organizations evolve
  differently in response to changes in environment
  (competition/warfare, globalization, global
  warming etc) and to social beliefs about how to
  respond to these changes Douglass North
  Understanding the Process of Economic Change,
  2005.
• Organisationsare groups of individuals bound by
  some common purpose to achieve objectives.
• Institutions affect the performance of the
  economy by their effect on the costs of exchange
  and production. The major role of institutions
  in a society is to reduce uncertainty by
  establishing a stable (but not necessarily
  efficient) structure to human interaction.
  North (2005).

27
Process of Economic Change is Institutional and
Organizational Evolution this has an
Architecture

• Markets are networks and network behaviour
  conforms to certain power laws.
• Whether each member joins an institutional or
  organization depends on the ultimate Network or
  Institutional Architecture and the benefits/risks
  or costs to the member.

28
Network Characteristics Babarasi Linked,
Plume Books 2003

• Metcalfs Law - the "value" or "power" of a
  network increases in proportion to the square of
  the number of nodes on the network (this explains
  motivation for network integration or expansion).
• Nodes do not link at random there is a
  preferential attachment coefficient
• Networks grow through linkages and have a
  scale-free, self-organizing behaviour
• Networks exhibit winner-take-all power laws
  where highly linked hubs dominate in number of
  links, whereas small nodes have few links
• Self-organizing behaviour is collective survival
  behaviour risks are distributed throughout the
  network to avoid risk concentration
• If markets are networks, then markets are shaped
  by the competition between hubs for links with
  nodes. The final outcome depends on what benefits
  the nodes (members) derive from links. Markets
  are always in transition or in motion.

29
Centralised (Star) Network Dominant Player
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
Centralised Network
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
30
Decentralised Network Several Larger Hubs
more choice
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
Network C
Network B
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
Network A
MARKET
Network D
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
31
Distributed Network Internet no key hub
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
MARKET
32
Preferential Linkage vs Network Altruism

• Nodes do not join hubs at random they do so
  because the hub provides superior benefits
  relative to costs (relative to other hubs), ie
  they have preferential linkage because of network
  altruism Example of Hotmail, then Yahoo and
  Google expanding networks through free service.
• Nodes have huge information asymmetry, which are
  the differences between resources, stock of
  knowledge, experience and costs of searching for
  right alliance.
• Hubs are able to provide Network Altruism due
  to the Cluster Effect economies of scale,
  superior technology, standardization and low
  transaction costs that attract preferential link
  by smaller nodes.
• Nodes enjoy such Altruism, but fear that the
  dominant hub may exploits its monopolistic powers
  and tax them, so that they hedge also link with
  other hubs with less obvious benefits. In other
  words, node-hub linkage suffers from the same
  Principal-Agent trust dilemma (how does the node
  know that the hub will not betray its trust?.
• Hence, every network must have its rules of the
  game in which the players all obey rules that
  create social good and prevent free rider or
  social losses. Although Hub can provide that
  enforcement benefit cheaply, there must be a rule
  to check and regulate the regulator.
• In other words, before integration can begin,
  there must be a process to find out what
  benefits, costs, and areas of commonality can be
  shared, including products, platforms, rules, who
  to enforce and what checks and benefits are there
  for everyone.

33
Applying Network Theory to Capital Markets

• Capital Markets act as hubs to facilitate links
  and flows at lower transaction costs with better
  protection of property rights

Inflow
Outflow
Transmitter Capital Market Hub
SOURCE Node
SINK Node
Supplier of Capital
User of Capital
Node-link-hub reduces transaction costs and
brings benefits to all users
34
Networks are Consistent with Norths
Institutional Change Framework

• Norths institutional and organizational
  development is path dependent. Each node seeks
  to develop according to its own interests
  (adaptive efficiency or survival).
• Networks link together to share common beliefs,
  benefits or reduce risks and overcome common
  threats.
• Hence, network architecture matters whilst star
  network is efficient, smaller nodes fear that the
  dominant hub will extract monopolistic powers and
  tax them.
• Consequently, the process of integration depends
  on game theory of each member (node) evaluating
  whether to join a particular group (ASEAN,
  ASEAN3, ASEAN6 etc), versus joining other
  groups (APEC, NAFTA, EU etc).
• In the end, it is about identifying common
  interests and recognising self-interest (what are
  the benefit/risks of integration into a larger
  network?).
• Larger hubs will therefore has to engage in
  Network Altruism (providing benefits to smaller
  nodes in order to attract them into their
  network).

35
Five Degrees of Separation

• Common Vision vs Winner-Take-All
• Common Standards and Common Rules whose rules?
• Principal-Agent Dilemma how to align
  incentives?
• Lower Transaction Costs how to lower barriers
  to network transactions with each other?
• Common Processes how to achieve institutional
  convergence?

36
(1). Common Vision vs Winner-Take-All

• Network effects of Winner-Take-All work against
  integration, because smaller nodes fear market
  dominance.
• Having a single person or one countrys vision of
  what Asian market integration is all about does
  not work. We need a shared vision.
• That Vision could be common standards,
  principles, products or platform must be owned
  by all potential members.
• Since we do not know what that Vision is like, we
  must begin the Process of consultation,
  cooperation and learning to work together and to
  trust each other (Sheng, EABER Op-Ed 2006).

37
Network Disparity requires Altruism

• For Network Integration to work, the larger
  members must demonstrate Altruism by contributing
  to alleviate disparities with smaller and poorer
  members. Example Germany funding 1 of EU
  budget for various EC subsidies.
• Contributions should aim at increasing public
  goods for network as a whole, e.g. education,
  basic health, communications, environmental
  protection, etc. This would include building
  common infrastructures.

38
(2). Common Standards

• Markets need common standards for greater
  efficiency.
• Example The creation of single market for the
  European Union has made Europe the fastest
  growing mergers and acquisitions. In 2006, five
  of the worlds top ten mergers and acquisitions
  took place in Europe and the value of the
  European deals exceeded those in America for the
  first time (The Economist, January 27 2007).
• Competition between markets are also about
  competition in standards, e.g. HDVD vs Blu-ray
  standards.
• For example, one of the vulnerabilities in Asia
  is that we have one global supply chain with two
  standards, dollar and yen (see next chart).
• There are too many national currencies, national
  rules, and regulations, and different market
  standards!
• This will require regulators and policy-makers to
  become less protective of their domestic markets
  from competition.

39
Moving towards Common Standards

• Moving towards Common Standards involves two
  possible paths harmonization (as practised by
  EU) or Mutual Recognition (recognizes the current
  national disparities but each works towards
  converging some Common Standards).
• There are now global standards of regulation,
  monetary and corporate governance, that is
  Financial Stability Forums Core Standards, so
  there is less need for separate Asian Standards.
• However, unless Asians work together, Asians do
  not have sufficient clout or influence to change
  or modify global standards.
• Advantage of working towards global standards is
  that there is choice of both regional and global
  integration.

40
The Asian Financial Network
The Asian Financial Network
Yen Standard
Dollar Standard

• Main hub of the Asian Supply Chain Network
• Bank dominated system
• Provided Yen funding to the Asian Network Economy

• Provider of credit financing to the Asian Supply
  Chain Network in its role as leading consumer
  with the best credit standing.
• Provider of the global dollar standard.
• Leading banker of Asias external savings.

41
(2). Common Standards the Domestic Dimension

• To ensure Common Standards in financial sector,
  there requires the coordination of the all
  regulations and laws by the three governing
  bodies (1) Ministry of Finance, (2) Central
  Bankers and (3) Securities Regulators of the East
  Asia governments.

Holy Trinity
Coordination of Fiscal Policies Tax Codes
Coordination of Banking Regulations
Ministries of Finance
SINK
SOURCE
Securities Regulators
Central Bankers
Coordination of Exchange Rate Policies
Coordination of Securities Regulations Common
Standards of Accounting
Coordination of Market Information
Implementation of Common Laws
42
(3). Principal-Agent Dilemma alignment of
incentives

• We cannot avoid the most efficient exchanges is
  to go through a hub. For example, which is Asian
  Time-Zone Financial Hub?
• Asian markets fear that the Winner-Take-All hub
  would take away their domestic liquidity, rather
  than remembering that networking may increase
  liquidity in all Asian markets.
• Hence, we need to align incentives to cooperate
  by (different options)-
• Having common ownership of the Hub
• Allowing development of several Hubs, with each
  specializing in different products and services
• Winner Hub distributing greater public goods and
  showing more Network Altruism
• A commonly agreed mechanism to ensure that
  Principal-Agent can resolve disputes when
  benefits and interests are not aligned (eg
  surveillance?)

43
(4). Lowering Transactions or Friction Costs

• Markets that are free or become dominant in
  global trading are also efficient because they
  have the lowest transactions/friction costs for
  exchanges and transactions, i.e. market
  participants are free to transact with relatively
  few legal or regulatory obstacles or barriers.
• Many of the barriers or friction costs to higher
  liquidity are due to regulatory or protective
  barriers that create market segmentation and
  therefore lower efficiency.
• There is a need to identify a sequencing of
  convergence of transactions costs so that Asian
  network effects are maximized. Each market has
  to identify the key barriers and friction costs
  and work with others to reduce these costs,
  taking into consideration the network benefits.
• In a sense, competition between markets ensure
  that each will work towards these objectives.
• Example the demutualization of exchanges have
  made them more commercial and profit oriented.
  Each market also knows that those markets with
  lowest friction costs and highest protection of
  property rights would gain the largest market
  share and liquidity.

44
(4). Common Platforms encourage
interconnectivity and interoperability

• Common technology is now readily available, as
  well as G-30 Basle/IOSCO standards for real-time
  platforms (common trading and clearing and
  settlement/payment systems) that can work
  together in real time and generate huge common
  liquidity and high transparency.

Transmitter Common Platforms Infrastructure
Inflow
Outflow
SOURCES
USERS
Promoting efficient institutional infrastructure,
market infrastructure
45
Room to Improve Financial Infrastructure
Indicators of Quality of Financial
Infrastructure 0 to 10 scale, higher is better
Source de Brouwer, Kawai and Rosengard (2003)
n.a. denotes not available
46
(5). Common Processes

• Market networks are about building market
  institutions that would involve political, and
  social-cultural change. It is also about change
  management.
• We need to change the common beliefs so that
  Asians can share common values, so that Asian
  institutions, organizations can emerge to shape
  the future Asian capital market.
• This is a process that must take into
  consideration political perceptions and realities.

47
Using Threat of External Competition To Raise
Domestic Adaptive Efficiency and Robustness

• Change Management requires massive coordination
  of many jurisdictions - of balancing vested
  interests, building coalitions, changing laws,
  standards, and ultimately market and bureaucratic
  behaviour.
• Each economy has responsibility to
• Using international rules and standards to raise
  and enforce domestic market standards, codes, and
  rules of the game and
• put in place the property rights infrastructure
  of a market economy that is fair, transparent,
  robust, flexible, and efficient.
• The first step of process reform begins at home!

48
Getting to Shared Objectives, Common Principles,
Products and Platforms require Process of
Discovery

• Globalization has created choice from domestic
  markets to regional markets and global markets.
• We do not know what the final architecture and
  form of Asian Capital Market Integration will be
  like.
• So, we must begin a process of search, through
  working together.
• THE PROCESS IS THE PASSAGE.
• This paper is a preliminary work-in-progress
  towards that Process for the Capital Markets.

49
VI. Concluding Thoughts

• Economic Development is a Process that is path
  dependent.
• We need to recognize that the US and European
  markets have achieved dominant network effects of
  Winner-Take-All, in both their time-zones, but
  also in shaping the standards (US dollar and
  Euro) as well as the rules of the game (Financial
  Stability Forum Core Standards, including
  accounting standards).
• If Asia wants to achieve global status, the
  region must move to global standards, processes
  and practices because of global competitive
  forces. It must develop superior standards and
  protection of property rights to even compete
  with the other standards.
• We have to be realistic that information and
  initial condition asymmetry (political and
  cultural differences) within Asia is so huge that
  there is no common mindset, nor shared vision for
  serious regional capital market integration.

50
VI. Concluding Thoughts

• The journey of a thousand miles begins with the
  first step.
• Those who hope to gain most from greater regional
  integration, particularly the richer and more
  advanced economies with stronger institutional
  capacity need to play a much larger role in
  helping develop the Asian capital market network
  as part of Asian regional development.
• Changing institutional structures itself requires
  vision, mission, resources and determination to
  make that change. This is about leadership.
• Who in Asia has the vision, mission and will to
  make that change?

51
THANK YOU
Questions to as_at_andrewsheng.net and
ktkwek_at_um.edu.my