10th SEC Thailand Anniversary Seminar: How Can NBFIs Play a Greater Role in a Bankbased Economy

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10th SEC Thailand Anniversary Seminar How Can
NBFIs Play a Greater Role in a Bank-based Economy

• The Future of Capital Market Development In East
  and South East Asia
• Andrew Sheng
• Chairman
• Securities and Futures Commission
• Hong Kong

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Outline

• Where are our capital markets today?
• How has Asian growth strategy shaped our
  financial systems?
• How have our financial markets performed their
  four key functions of resource allocation, price
  discovery, risk management corporate
  governance?
• What are implications of global financial
  landscape changes on Asian financial markets?
• What conditions are required for regional
  integration?

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Asian Contrasts

• Asia - More than half of global population, but
  only 1/3 of global GDP and 1/4 of world exports ,
  but only 16 of global market cap 7 ex-Japan
• High savings - FX reserves exceed US1 trillion,
  but still importing capital
• Asia accounts for 25 of global FX trading US
  19 and EU 53
• Insufficient internal growth engines, still
  awaiting growth from US and Europe

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Asia in Global Economy (GDP, of world, 2001)

MSCI
PPP-GDP Exports Population Weighting
Japan 7.3 6.0 2.1 9.38 4 Tigers 3.3 9.4 1.3 1
.82 China 12.1 4.0 21.0 0.26
India 4.7 0.9 16.7 0.12 Other
Asia 5.4 4.5 14.5 1.57 Total ASIA 32.8 24.8 55.6
13.15 US 21.4 13.6 4.6 55.30 EU 19.9 37.7 6.2 17
.14 Others 25.9 23.9 33.6 14.41 TOTAL 100.0 100.0
100.0 100.00 Excluding Australia and New
Zealand Source IMF, World Economic Outlook,
April 2002
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Asia still Dependent on Bank Financing ( of
GDP)

Bank Assets Equity
Market Bond Market 1998 2001 1998 2001
1998 2001 China 139 160 25 45 12 28 Hong
Kong 214 215 206 313 32 28 India 69 133 24 26 21 2
8 Japan 145 139 64 55 101 153 Korea 233 233 35 46
53 67 Singapore 220 243 112 135 20 41 Taiwan 226 2
62 97 104 41 20 Thailand 176 134 30 32 23 39 Germa
ny 273 155 51 58 97 90 US 65 63 158 136 141 148
Remark 1999 figure Sources FIBV, CEIC,
Bloomberg, various central banks and government
websites
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Asias Financial Structure

• The financial system is a derivative of the real
  sector
• Dualist mercantilist model drove Asian
  development
• Development led by highly efficient export
  sector open to international competition
• Financed by protection of domestic natural
  resources, services and financial sectors
• Banking system protected from foreign
  competition, mobilised bulk of savings and was
  guided in lending
• Fish-trap mentality welcomed FDI, and delayed
  capital account opening, resulting in periodic
  asset bubbles
• Stock markets were short-term speculative and
  also restricted foreign listings
• Corporate sector was state- or family-dominated,
  so corporate governance reflected ownership
  behaviour

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Key Resource Allocation Issues

• Too much savings in Asian banking systems 80
  140 of GDP, compared with 60 in US
• Lack of credit culture, and collateral-based
  lending behaviour, coupled with excess liquidity
  caused by fish-trap policies fuelled property
  and stock bubbles
• Huge NPLs represent waste of savings NPL
  resolution cost up to 50 of GDP in Asian crisis
  economies
• Development of bond, equity and derivative
  markets would help to diversify risk away from
  banking system and impose greater market
  discipline in the intermediation of savings

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Poor Price Discovery

• Openness to trade meant that traded consumer
  prices were stable at competitive global prices
• But capital controls and supply distortions, eg
  lending/listing guidelines led to distortion in
  key financial prices, eg excessively low domestic
  interest rates relative to risks and high PE
  ratios
• Bank herding with cheap loans fuelled property
  asset bubble, and small free float fuelled stock
  prices
• Credit risk not properly priced with bank spreads
  of 1.5 2 points with NPLs at between 1050
  of total assets
• Bond spreads have recovered close to pre-crisis
  levels, although NPLs have not been cleaned up
• PE ratios remained around 80 in Japan, as the
  Nikkei 225 plunged from 38,000 to 10,000. China
  peaked around 60 in 2001, now down to 30
• Mispricing meant that large Asian savings wasted
  in inefficient investments

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Weak Risk Management

• Asian Crisis showed lack of risk diversification
  avenues as savings were concentrated in banking
  system and residents were not allowed to hold
  foreign assets
• Bank-dominated systems with high NPLs and
  relatively low capital carried high moral hazard
  risks through explicit/implicit deposit insurance
  
• Lack of specialist and derivative markets, such
  as venture capital, futures and options markets,
  point to need to develop a wide range of
  financial instruments and markets, and allow
  participation of different types of specialist
  market intermediaries
• Choice of financial instruments improves asset
  allocation, and allows the hedging of market
  risks that in turn increases the risk-bearing
  capacity of the economy and, hence, growth

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Weak Corporate Governance

• Structure of Asian markets reflect failure of
  financial markets to check against poor corporate
  governance
• Need to upgrade accounting, auditing and
  disclosure standards to improve checks and
  balances on corporate governance
• Dominance of SOEs or close corporate-bank
  relationships marginalised minority shareholder
  interests
• Domestic institutional investors have close links
  with corporations, while foreign investors not
  inclined to impose governance
• Entry barriers to foreign strategic investments
  protected domestic companies from
  takeovers/restructuring
• Preference for merger of failing institutions
  than liquidation or opening up to foreign
  participation.

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Self-discipline, Regulatory Discipline and Market
Discipline

• Corporate governance requires all three
  disciplines to provide checks and balances for
  healthy companies
• Self-discipline works if controlling shareholders
  have high integrity and treat minority
  shareholder fairly
• Regulatory discipline acts as backstop when
  management and board lack integrity and ethics,
  by setting out clear rules and through effective
  enforcement
• Market discipline works best because global
  competition demands management professionalism
  and observance of global standards of quality,
  code of conduct and accounting and disclosure
  rules
• Markets buy or sell stocks based on company
  performance benchmarked against transparent
  global standards.
• Enhance management accountability to
  shareholders.

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Globalization means Dualistic Domestic Sectors
are also Marked to Market

• Consolidation of Financial Intermediaries
• Advances in technology, de-regulation, and WTO
  opening of domestic markets means huge
  competition to domestic financial institutions
  from large complex financial institutions
  offering banking, insurance, asset management
  derivative services
• Ability of domestic policies to protect domestic
  financial sectors limited as-
• WTO and IMF rules push for market opening
• Sophisticated domestic investors seek global risk
  diversification
• Liquidity begets Liquidity
• Smaller domestic players do not have same capital
  base, technology and market reach as global
  giants
• Improvements in accounting and disclosure means
  domestic inefficiencies are revealed as NPL etc
• Smaller players are marginalized

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Trends in Domestic Exchanges

• Vertical Consolidation - Exchanges are
  demutualizing to align interests with market
• They are also merging or cooperating with
  Clearing Houses to optimize fixed investment
  economies of scale
• Horizontal Consolidation Exchange merge or ally
  with each other to optimize geographical and
  product reach
• Accenture estimates that merger of trading,
  clearing and settlement in Europe may
  concentrate liquidity and reduce clearing and
  settlement costs by US1 bn annually

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Global Three Time Zone Market

• New York (US12.8 trn or 50 of global market
  cap) now services global Latin American capital
  markets
• European financial markets consolidating under EU
  and euro
• Asia has tremendous savings, but fragmented
  financial markets
• Asias capital markets still retail driven -
  insufficient local institutional investors
• Liquidity begets liquidity in a virtuous circle
  that benefits issuers, investors, intermediaries

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East Asian Miracle is Demographically Driven
Source Jeffrey G. Williamson, Demographic Shocks
and Global Factor Flows
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Aging Population requires efficient Pension and
Retirement Fund Management

• North Asia aging, slowing growth and requiring
  more retirement funding
• South-east Asia still young, but must avoid North
  Asian retirement funding mistakes time to
  develop deep and well diversified retirement
  institutional funds
• If retirement funds have over-priced bonds and
  equity, the retiring generation pay for this
  generations funding mistakes
• Deep and well-diversified retirement funds will
  develop institutional savings, improve liquidity
  of bond and equity markets, and play role in
  corporate governance
• Existing retirement funds allow policy makers
  option to cover up mistakes e.g. retirement
  funds helping in corporate rescue

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Relationship between Third World OECD

• The Third World OECD in two different
  demographic cycles former has labour surplus
  capital shortage, while latter has scarce labour
  capital surplus.
• However, Asia has both labour surplus capital
  excess, but excess is funding OECD markets
• Would policy makers allow labour and capital
  markets to make intergenerational transfers?
• How can Asia institutionalise savings within Asia
  for better resource allocation?
• Source Jeffrey G. Williamson, Demographic Shocks
  and Global Factor Flows

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Implications for Asian Market Models

• Asian market distortions and barriers hindered
  its ability to intermediate its own savings and
  manage risk
• Yen/ swings caused huge revaluation gains/losses
• Surpluses flow to US and Europe which return as
  FDI or portfolio flows
• Risks remain concentrated in domestic economies
• Japan is largest market, but financial market is
  relatively inward looking
• China has law of large numbers and demand
  economies of scale, but banking and enterprise
  reform still at a global selective opening
  stage
• ASEAN markets are small, and face huge external
  entry pressure, with concerns about
  marginalization
• AU/NZ have sophisticated systems but not
  integrated with rest of Asia
• Non-integration is not an option unless one
  wishes to be disconnected from global markets

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Conditions for Regional Cooperation

• Bank Reforms must go on - NPLs remain a drag
• Raise Corporate Governance standards - with focus
  on market discipline
• Higher standards of Transparency Disclosure
  move to IAS, IAuS, IDS
• People - higher skills for investment banking,
  asset management and risk management
• Pricing - spreads have to reflect risk
• Products - wider choice for better risk
  management
• Platform - better inter-connectivity,
  inter-operability and common standards
• Political Will willingness to open up to
  regional cooperation

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Improving Market Liquidity a Priority

• Asias segmented markets fragment liquidity
• Negative feedback effects of declining liquidity
  bad for capital markets
• Liquidity depends on common products, common
  rules and common markets
• Can we afford marginalization?
• Are we ready to adopt international best
  practices, codes, and standards?
• We have common competitive threats, but do we
  have common goals?

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Global Markets and Standards

• If one wants to be part of global market, one has
  to play by global rules and standards
• Africa and Latin America have fallen behind, as
  inward looking strategies retard their
  competitiveness in trade and financial services
• Global financial markets are a network of local
  markets, and are as strong as the weakest link
• For successful integration, equivalent standards
  are needed to ensure stable, orderly and fair
  markets
• US and EU today set standards for global markets.
• Asia can be free riders on these standards, as
  long as we can meet all the pre-conditions.
• Can we work toward common Asian standards?

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Which Asian Standard?

• Asia has no common voice to influence these
  standards. To have a say, we first need to have
  critical mass to do proper research and lobby.
• Current forums not conducive to common voice
• ASEAN 3 not representative of Asia as long as
  major players such as Australia and HKSAR not
  included?
• We should recognize that domestic interests
  out-weigh regional interests
• But we must have common forum to debate these
  issues, not political but technical
• Standardize for liquidity, differentiate for
  value added

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Phased Approach?

• There is suggestion that four markets -
  Australia, HKSAR, Japan and Singapore - work at
  free trade in services first, before integrating
  with others
• Not sure that phased approach will work, because
  it causes greater market differences and tensions
• More realistic to have common forum for technical
  discussion first
• Asian BIS or AMF probably too politically charged
• Probably Asian Financial Institute more likely to
  be the common forum for debate of issues,
  standards, goals and processes
• EU integration indicates that it was not possible
  to cooperate unless there there are not only
  common goals, but also common channels of
  discussion at operational level. Asia lack
  latter.

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Conditions for Increasing Liquidity

• Common Products
• Are Asian exchanges willing to cross-list?
• Inter-operability
• Common trading and clearing rules
• Are they willing to share technology and
  standards?
• Low transaction cost
• Standard tax rates, services and operations
  through common networks and infrastructure
• Inter-connectivity
• Willingness to allow connections through common
  custodians, common participants and
  intermediaries
• Free flow of capital by residents and
  non-residents

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First Steps in a Long Journey

• While direction ahead may seem obvious, getting
  there is dependent on sovereign decisions which
  are not easy to make
• Requires recognition that it is win-win and not
  win-lose, or Nash equilibrium for our markets.
• AFI will make journey easier if Asia has an
  independent and non-profit making research
  institute that studies Asian issues from an Asian
  rather than a national perspective.
• The conduct of research on issues with strategic
  significance for Asia would deepen our
  understanding of the implications of global
  developments and provide a basis for objective
  debate on win-win solutions for us.
• Such cooperation would help in capacity building
  for the region and in building trust, which is
  essential if we are to be able to work together
  for the good of our markets.

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Concluding Thoughts

• Asian dualist model must be re-written to
  globally efficient and regionally fitting
  model, where markets perform their functions
  well, inherent risks are reduced
• Priority is to improve corporate governance,
  where trust is rewarded, and fraudulent behaviour
  is punished
• The quality of all players has to be enhanced to
  improve the quality of our markets
• Non-integration is not an option, but we have to
  play by global standards and rules
• We can cooperate to set our own standards, have a
  say in international standards, and work together
  to improve the liquidity of our markets
• Or we can continue with our own individual agenda
  and see continued marginalization of our markets