Tsinghua University Graduate School of Economics and Administration

1
Tsinghua UniversityGraduate School of Economics
and Administration

• Lecture 3/08 Developing Capital Market Process,
  Sequencing or Integration?
• By
• Andrew SHENG
• Adjunct Professor
• March 2008

2
Outline

• Introduction
• Regional Initiatives on Capital Market Reform in
  Asia
• National Strategies for Capital Market Reform in
  Asia
• Rethinking Asian Integration
• V. Institutional Framework to Move Process
  of Capital Market Reform and Regional Integration
• - Macro Foundation
• - Micro Foundation
• - Sequencing
• - Bounded Constraints
• VI. Concluding Thoughts

3
I. Introduction

• July 2007 marks 10th Anniversary of the Asian
  Financial Crisis.
• In these last 10 years, considerable effort
  undertaken by various regional groupings to chart
  program of financial reform for Asia to promote
  sustainable growth and financial stability
• ASEAN Finance Ministers Meetings
• ASEAN 3 (China, Japan Korea)
• EMEAP Central Banks
• East Asia Summit (which brings together ASEAN
  3, Australia, India New Zealand) and
• APEC

4
II. Regional Initiatives on Capital Market Reform
in Asia

• ASEAN Finance Ministers
• 2003 ASEAN Roadmap for Financial and Monetary
  Integration.
• 2005 Agreement to develop an interlinked
  ASEAN securities market
• by 2010.
• 2005 FTSE/ASEAN Index Series to standardise
  market indices in the region.
• ASEAN3 (China, Japan ,Korea)
• 2000 Chiang Mai Initiative regional
  mechanism for a multilateral ASEAN Swap
  Arrangement and a series of Bilateral Swaps to
  address short term regional liquidity
  difficulties.
• 2003 Asian Bond Market Initiative (ABMI) to
  promote the issuance and trading of bonds within
  region.
• 2004 Asian Bond Online Website.
• Executives Meeting of East Asia-Pacific Central
  Banks (EMEAP)
• Asian Bond Fund (ABF1 launched in 2003 and
  ABF 2 in 2005).
• Asia-Pacific Economic Forum (APEC)
• Finance Ministers Process focusing on a
  range of policy and capacity building
  initiatives, including financial reform.

5

• III. National Strategies for Capital Market
  Reform in Asia

6
Post-Crisis Imperative - Strengthen Domestic
Financial Systems to Prepare for Globalization

• Lessons of Asian Crisis
• Private sector over-leveraged
• Domestic financial system vulnerable to DOUBLE
  MISMATCH (borrow short, lend or invest long,
  borrow FX, lend or invest in local currency).
• To avert another crisis, measures included
• Strengthening supervision, restructuring domestic
  banks and allowing entry of foreign financial
  institutions to strengthen competition and skills
• Build-up of foreign exchange reserves, progress
  removal of exchange controls and move towards
  more flexible exchange rates,
• Adoption of FSF Core Standards in monetary and
  fiscal policies, accounting and corporate
  governance improve transparency and harmonize
  legal and regulatory framework with international
  standards
• Greater interest in regional cooperation and
  working with IFIs to strengthen surveillance and
  preventive measures.

7
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).

8
Asia is now Net Creditor to US and Europe (US
trillion)
Source World Bank Financial Structure Dataset,
February 2006
9
Domestic Financing in East Asia is Bank-Dominated
Source Asia Bond Monitor November 2004
10
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
11
Absolute Value of Market Capitalization (US
Million)
Source World Bank
12
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
13
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
14
Four Functions of Capital Market

• Resource Allocation
• Allocate resources efficiently to maximize
  welfare
• Price Discovery
• Generate transparent price signals consistent
  with efficient use of resources
• Risk Management
• Encourage good risk management that diversifies
  losses and profits
• Corporate Governance
• Promote sound corporate governance that provides
  proper incentives.
• Financial system is a system to transact and
  protect property rights of all participants over
  the whole demographic cycle!!!

15
Multi-Tier Financial System - from savings to
users
Bank loans
Risk transfer
Securities markets
Individuals
Companies
Funds
Personal investment accounts
Product creation
Sales
Source Nomura Institute Capital Markets Research
16
McKinsey Financial Products meet Investor Needs

• Buy turn

• Market depth and long term funding
• Facilitate global allocation of capital

• Dynamic

• Mutual funds

• Pension funds - defined contribution

• Buy hold

• Active traders and arbitrators/ proprietary
  trading desks

• Banks

investors

• Seek high relative returns above benchmark

• Breadth of investment objectives
• Product innovation

• Depth of investment capacity

• Retail investors

• Seek high absolute returns

• Seek safe, predictable, average returns

• Alternative Investors
• Specialized funds
• High net worth individuals
• Investment bank

• Pension funds -defined benefits

• Employ variety of strategies to minimize risks

• Match future liabilities with investment income

• Insurance companies

• Examples

• Role

• Investment objectives

17
Globalization of Financial Markets

• Globalization due to
• Demography - Aging Population seeks higher
  returns and diversified risks through investing
  in Emerging Markets.
• Information Technology - lowering cost of
  transactions and improving transparency.
• Financial Deregulation and Innovation - reducing
  friction and improving risk management.
• Regulatory Arbitrage - rise of Hedge Funds and
  Private Equity improves market turnover, creates
  competition to improve issuer performance but
  creates new challenges.
• Financial Markets are exhibiting market
  concentration in key hubs with three Time Zones
  (New York, London and Asia).
• Asia needs to find a way of working together or
  face marginalization.

18
Roadblocks to Deepening Asian 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.

19
Savings drift to those Capital Markets that
protect property rights with high transparency
and low transaction costs

• Some capital markets in APEC 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, despite exchange control, domestic
  investors try to put funds abroad (in developed
  markets) because they protect property rights
  better, with lower transaction costs and give
  higher liquidity.
• Hence, priority is to develop effectiveness of
  domestic financial systems to put domestic
  savings to use more efficiently.

20
Guiding Policy Makers in Policy Choices (Davis
2006)

• Financial sector reform requires
• suitable set and sequencing of country-specific
  reform measures
• political commitment despite influential vested
  interests
• wide support from stakeholders (government
  officials, financial institutions and users of
  financial services)
• effective financial reform is about policy
  initiatives which set in motion a desirable and
  manageable process of private sector reactions,
  than about making changes focused on achieving
  some idealized financial sector structure.

21

• VI. Re-thinking Process of Capital Market Reform
  and Regional Integration

22
Source FSAP Experience and Issues Going
Forward, Stefan Ingves, Economic Forum, 16
December 2003
23
Eight Elements of Institutional Building
Incentives
Governance
INSTITUTIONAL DESIGN
STRUCTURE
Efficiency
Robustness
Adaptability
Vertical/Silo Processes
Horizontal or Coordinating Processes
PROCESS, PROCEDURES
Interconnectivity/Interoperability
Accounting Auditing Rules
Disclosure Laws
Tax Codes
CODES, RULES, LAWS
STANDARDS
IOSCO Regulatory Standards
Ownership
Corporate Governance
Transparency
FSF Core
KNOWLEDGE INTENSITY
Information Access
Experience
Learning
Education
PROPERTY RIGHTS
Low Transaction Cost
Fair Enforcement
Fair Enforcement
Fair efficient Judiciary
Transparency
Ownership
PEOPLE
Shared Values
Knowledge/ Experience
Shared Values
Beliefs
Incentives
Mindset
24
Efficient Markets Have Robust Property Rights
Infrastructure (PRI)

• Central Registry of property right eg land
  registry, share registry
• Trading Engine eg stock exchange
• Clearing, settlement and payment infrastructure
  clearing house and payment system
• Regulated intermediaries
• Rules of Game norms, standards, codes,
  regulations, law
• Enforcement infrastructure enforcement costs
  should not exceed benefits to market
• Independent and transparent judiciary to
  adjudicate property right disputes
• ? Effective judiciary, enforcers police,
  regulators, enforcement agencies, accounting,
  legal and financial intermediaries are all part
  of PRI

25
Institutional Tradeoffs
The ideal quadrant is the Northeast, and worst is
Southwest.  The Northwest quadrant is efficient
but fragile, the Southeast quadrant is robust
(protected) but inefficient.
EFFICIENCY
ROBUSTNESS
26
Markets have Architecture Tradeoff between
Efficiency vs Robustness
Star Network Decentralized Network Distributed
Network
27
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 APEC market integration is all about does
  not work. We need a shared vision.
• That Vision (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 in an
  environment of mutual trust
• Smaller markets need to negotiate from position
  of strength hence strengthening domestic market
  to regional or global standards is common goal.

28
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 that smaller EU
  members enjoy.
• Contributions should aim at increasing public
  goods for network as a whole, such as education,
  basic health, communications or environmental
  protection. This would include building common
  infrastructures, providing training and knowledge
  transfer.

29

• Sequencing
• Financial Market reform needs to consider the
  Impossible Trinity
• Open capital account, pegged exchange rate and
  independent monetary policy are impossible.
• Macro-policy reforms cannot be conducted
  independent of weak institutional framework

30
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 of Discovery.

31
Pragmatic Approach towards Regional Integration

• Integrating through Strength rather than Weakness
• Globally, financial markets are being integrated
  through multinational banks, fund managers and
  investment houses/private equity funds
• Technology is enabling the creation of
  Alternative Trading Systems to bypass national
  exchanges to avoid unnecessary friction costs
  and other barriers to free flow of capital.
• Smaller markets have a choice
• GLOBALISATION REGIONALISATION
  MARGINALISATION
• Take no action and become marginalized
• Pursue domestic reforms and enter into bilateral
  ties within and outside the region
• Open up to being cherry picked by larger
  exchanges outside the region
• Become collectively a new force and part of
  larger Hub in global markets

32
Sequencing of Institutional Change

• How should one sequence institutional change?
• Institutional change occurs through changes in-
• Product
• Process
• Standards and Rules of Game
• Organizational Unit (new institution)
• Institutional Framework (Architecture of
  organizations)
• Change could be externally forced through
  environmental change or competition or internally
  driven, via vertical or horizontal integration.
• Irrespective of purpose of change, the benefits
  of change should outweigh the costs of change,
  including a risk calculation.

33
Common Sequencing Rules of Thumb

• Do easy ones first, difficult ones later.
• Liberalize trade first, before liberalize
  financial sector.
• Reform enterprise sector first, before reform
  banks/capital market.
• Strengthen supervision first, before opening
  capital account.
• Liberalize FDI first, before FPI
• Concentrate on reforms that -
• Improve Corporate Governance
• Strengthen Risk Management
• Remove price distortion
• Improve Resource Allocation
• Lower Transaction costs
• Improve Competition and Transparency

34
Sequencing is a Process Policy, Products, then
Institutions

• Clarify Policies and Objectives before engaging
  in institutional and product reform.
• Sort out conflicts in macro-policies fiscal,
  monetary, trade and capital account.
• Examine the institutional context of policies
  can policies be implemented without institutional
  change?
• Consider catalytic products, processes or
  institutions that take reform/learning to next
  level.
• Keep in mind the political economy of reforms
• The need for ownership
• Trade-offs with Vested Interests
• Implementation Capacity
• Getting public support

35
Process of Institutional and Organizational Change

• Clarify Principles and Objectives.
• Stock-take or Diagnostic of Existing Conditions,
  benchmarked against international standards,
  codes and rules, and Institutional Gaps.
• Prioritization according to Bounded Constraints.
• Pick one or two Quick-wins, plus Killer
  Application that is either vital building block
  or stumbling block to market development.
• Create Implementation Team to deliver Quick Wins
  and Killer Applications.
• Implement with Allies and Partners in
  Transparent, Open, Inclusive manner.
• Evaluate Results against Principles and
  Objectives and move onto next phase.

36
Change through Knowledge Intensity

• Changes in-
• Product
• Process
• Standards and rules of game
• Organizational Unit (new institution)
• Institutional Framework (Architecture of
  organizations)
• are all Changes in Knowledge Intensity, requiring
  new skills, new knowledge and new experience.
• Since change supercedes old knowledge and
  value, vested interests whose franchise and
  value are hurt would resist change.
• Karadeg, Sundarajan Elliot characterize product
  sequencing as moving from simple products (money
  and foreign exchange) towards more
  complex/knowledge intensive products
  (derivatives).
• Simple products (e.g. foreign exchange trading)
  can easily move offshore. Complex products with
  high local knowledge intensity, such as equity
  are less portable.

37
Sequencing and Hierarchy of Domestic Financial
Markets towards higher value creation and
knowledge intensity

• Asset-backed
• securities and
• derivatives
• Corporate bond and
• equity markets
• Government bond market
• Treasury bill market and
• foreign exchange markets
• Money market

Source Karacadag, Sundrarajan Elliot, 2003
38
Capital Market Reform Process
To Build APEC Capital Market Reform Process

• DIAGNOSIS
• People
• Property Rights
• Standards
• Codes, Rules, Laws
• Process, Procedures
• Structure
• Institutional Design

• BOUNDED
• CONSTRAINTS
• People-Skills Lacking
• Legal System Non-
• Protective of Property
• Rights
• Limited Technology
• Infrastructure

• GAP ANALYSIS
• People-Skills ??
• Property Rights ?
• Standards ?
• Processes
• Infrastructure ??

OPTION ANALYSIS
FOCUS FOCUS FOCUS
39
Institutional Tradeoffs and Bounded Constraints
40
Bounded Constraints in Institutional Change

• Financial resources.
• Information resources (skills availability).
• Ownership (buy in not only by the implementing
  agency, but also vested interests and the public
  generally).
• Political or Bureaucratic Constraints (in the
  sense that certain amount of political capital
  and bureaucratic goodwill will have to be
  sacrificed in order to achieve reform).
• Capacity constraint (whether it is possible to
  assemble a team that is able to implement,
  coordinate and push through reforms).

41
Raising Domestic Adaptive Efficiency and
Robustness

• Regional Integration will require 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
• Use 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!
  This requires a change in mindset for all
  parties.

42
VI. Concluding Thoughts

• Capital Market Development is an important
  pre-condition of regional integration, because it
  can be both beneficial, but also add risks of
  contagion if not carefully implemented.
• The Reform Process is much more complex than
  previously understood, because it involves both
  policy and institutional context of policies a
  political economy question of prioritization,
  bounded constraints and implementation capacity.
• There is every advantage for those who hope to
  gain most from greater regional integration,
  particularly the richer and more advanced
  economies with stronger institutional capacity,
  to play a much larger role in helping develop the
  APEC capital market network.
• Changing institutional structures itself requires
  vision, mission, resources and determination to
  make that change. This is about leadership.
• This paper attempts to articulate the Process of
  Capital Market Strengthening by adopting a
  focused approach towards policy, product and
  institutional choice.

43
THANK YOU
Questions to as_at_andrewsheng.net