Why Asia Should Deepen Its Capital Markets
Over the past half-century, many of the world’s fastest-growing economies have been located in East Asia: first Japan and the Four Asian Tigers, then China, and most recently a set of developing countries in Southeast Asia. The region’s role in global capital markets, however, has not lived up to the hype engendered by its impressive GDP performance. By some broad measures, such as the firm Y/Zen’s Global Financial Centres Index, Singapore ranks as the third-most-important financial center after London and New York. But this is largely a banking story, a theme that has marked financial market development in the region as a whole.
A breakdown of non-residents’ aggregate investment position in Singapore shows that the portfolio component (mainly stocks and bonds, the markets for which are collectively termed the “capital market”) stood at roughly $170 billion at the end of 2015. Compare that to $4 trillion for the United Kingdom and $16.7 trillion for the United States. Of course it is not surprising that Singapore attracts less portfolio investment than the largest economy in the world. But it attracts 100 times less.
Why are Asia’s capital markets so small? And, does it matter?
It has long been recognized that a key feature of any developed financial market is “depth,” typically measured by the number of open buy and sell orders across prices at a given time. In other words, developed markets are big and active, and this is no mere tautology—deep markets tend to be relatively stable due to the sheer mass of participants, their positions and trades, and crucially the liquidity and flow of information (via price signals) that these provide.
During the panel “Global Capital Markets: Deflation or Stabilization?” at the recent Milken Institute Global Conference, Mohamed El-Erian made the point that effective market depth depends on the mix of investor types. One type of investor darts in and out, chasing yield; the other is committed to betting on long-term trends in the country. It is the second type who determines effective market depth, generating the liquidity and price signals that depth brings. These factors matter most in times of turmoil—when the first investor has disappeared.
Depth brings stability, and stability attracts the committed investors who make a market deep. This is consistent with the pattern that countries with larger international portfolio debt markets tend to have more stable income flows to foreign investors (see figure). The recognition of the positive feedback loop between depth and stability does not make this virtuous cycle any easier to achieve. It does, however, shed light on why global capital markets remain concentrated in so few places, lagging behind the shifting distribution of real economic activity. It also has implications for policymakers in emerging markets and investors looking for opportunities there.
Countries with Greater Cumulative Portfolio Debt Inflows Generate Less Volatile Returns (2010-2014 quarterly)
Source and notes: Author's calculations from the IMF's International Financial Statistics. Each point represents one country; all East Asian countries with data available are labeled.
Unbalanced Capital Structures
In the late 1990s, policymakers in the region spoke often about developing local capital markets, especially bond markets. Their main motivation, however, was not that deep markets offer the benefits described above, but rather that the currency mismatch between assets and liabilities had played a key role in the 1997 Asian financial crisis. Banks had borrowed in dollars and lent in local currency, so the devaluation of local currencies caused their balance sheets to deteriorate, triggering serious ripple effects. If Asian nations developed their own capital markets, the reasoning went, more of the borrowing would be transacted in local currency, and this source of systemic risk would be eliminated.
Instead, the currency mismatch was gradually eliminated on the asset side, mainly through massive accumulation of official foreign reserves, and also on the liabilities side by changes in banks’ sources of financing. Today many countries in the region are net long the dollar, the reverse of their situation two decades ago. So when the dollar’s value goes up, local balance sheets, in aggregate, are strengthened.
Capital market development lost its place in policy conversations as the specter of currency mismatch faded. Meanwhile, East Asia’s financial centers became global powerhouses in banking, and the region became the top destination of foreign direct investment. Capital markets have grown too, but much more slowly. The end result is an unbalanced financial market structure reflected in correspondingly unbalanced capital structures at the firm level. On the debt side, borrowers face rollover risk from an overreliance on relatively short-maturity bank loans, and on the equity side the region suffers from shallow stock markets and poor liquidity.
Deepening local capital markets would expand liquidity and improve transparency, thereby attracting committed investors—for example, pension funds and sovereign wealth funds—and the stability they bring, tightening the link between fundamentals and prices. Such markets would make large borrowers’ financings more flexible and efficient, reducing their dependence on banks and potentially redirecting the provision of bank credit toward small and medium-sized enterprises and consumers.
With rapidly maturing banking and private equity markets, and vast sums of savings looking to be deployed more productively, East Asia is well poised to deepen its capital markets. But most governments in the region have lacked the political will to orchestrate this transition. It’s time for that to change.