Andrew SHENG

1
Deepening and Integrating Private Capital Markets
Session 3 A Framework for Developing Capital
Markets Process, Sequencing and Options
3rd APEC Policy Dialogue Workshop on Financial
Sector ReformMelbourne, Australia 9 May 2007
by Andrew SHENG Wai Kuen TAN Kian Teng KWEK
2
Outline

• Introduction
• Regional Initiatives on Capital Market Reform in
  Asia
• National Strategies for Capital Market Reform in
  Asia
• Rethinking APEC Financial Reform and Integration
• 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
5

• III. National Strategies for Capital Market
  Reform in Asia

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Post-Crisis Imperative - Strengthen Domestic
Financial Systems to Prepare for Globalization
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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
• Excess reserves hoarding creating Asia as the
  Net Exporter of Capital and causing global
  imbalance (Lane and Milesi-Ferritti, 2006)
• 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 had 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)

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Asia is now Net Creditor to US and Europe (US
Trillion)
Source World Bank Financial Structure Dataset,
February 2006.
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Domestic Financing in East Asia is Bank-Dominated
Despite the lessons of the Asian crisis and
efforts to develop bond and equity markets, the
Asian financial system remains bank-dominated,
with still fledgling bond markets, speculative
stock markets, and relatively small insurance and
pension and social security systems.
Source Asia Bond Monitor, November 2004.
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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
• 1994 data
• 1995 data
• 4. 1996 data
• 5. 2003 data.
• n.a. denotes not available.

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Absolute Value of Market Capitalization (US
Million)
Source World Bank.
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East Asian Capital Market Remains Small
East Asia (16.1)
EuroZone (17.5)
ASEAN (1.4)
EU (26.2)
NAFTA (43.2)
USA (39.5)
UK (6.8)
Source World Bank.
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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) based on data from Asia
Bond Monitor, March 2006.
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• IV. Rethinking APEC Financial Reform and
  Integration

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Although APEC economies are now more resilient
and growth has recovered, financial sector
development remains problematic

• Pace of financial deepening uneven within APEC
  economies, with a number of economies still with
  elements of exchange controls, high
  bank-dominated financial systems and relatively
  shallow bond and capital markets
• Uneven development in domestic financial systems
  mean that asset bubbles are forming in several
  economies due to excess domestic liquidity and
  another round of influx of capital flows to high
  growth economies
• Unless financial systems are strengthened to
  international standards, risk that another round
  of capital flow shocks could exacerbate current
  vulnerabilities

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How to Strengthen Domestic Financial Capital
Markets to Facilitate Integration?

• There are still many fundamental issues which
  impede APEC capital market integration,
  including
• Wide Disparity in Country Conditions and state of
  financial development
• Different regulatory standards
• Different policies and approaches, in particular
  whether to allow greater foreign entry in
  financial sector
• Bureaucratic differences within and between
  countries
• Although there is agreement that a pre-condition
  to Capital Market Integration is convergence in
  market standards, very little work has been done
  on how to advance capital market development that
  facilitates integration, bridging regional
  efforts and national aspirations

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Review of Current Thinking on Regional Financial
Integration in Asia
Kawai (2004) If regional integration of trade
can take place why not capital market
integration?
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de Brouwer and Allan (2005)
de Brouwer and Allan (2005) on practical way to
advance economic and financial integration 3
steps to promote cross-border activity
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Re-thinking APEC IntegrationArchitecture,
Principles, Process, Outcome

• What are the functions of the capital market?
• Why should we integrate?
• For Whom should we integrate?
• How should we begin process of integration?
• CHANGE IS ABOUT MINDSETS

We have to go back to basic principles for
integration
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Four Functions of Capital Market
Capital market is a system to transact and
protect property rights of all participants over
the whole demographic cycle!!!
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Multi-Tier Financial System from Savings to
Users
Bank loans
Risk transfer
Securities markets
Individuals
Companies
Funds
Personal investment accounts
Sales
Product creation
Source Nomura Institute Capital Markets Research.
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McKinsey Financial Products Meet Investor Needs
Buy turn

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

Dynamic Investors

• Mutual funds

• Pension funds - defined contribution

Buy hold

• Active traders and arbitrators/ proprietary
  trading desks

• Banks

• Depth of investment capacity

• Breadth of investment objectives
• Product innovation

• Seek high relative returns above benchmark

• Retail investors

• Seek high absolute returns

• Seek safe, predictable, average returns

• Alternative Investors
• Specialized funds
• High networth individuals
• Investment banks

• Pension funds- defined benefits

• Employ variety of strategies to minimize risks

• Match future liabilities with investment income

• Insurance companies

Examples
Role
Investment objectives
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Why should APEC Markets Integrate?

• Globalization in Financial Markets has
  accelerated 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
• Converging global rules through WTO, IMF and FSF
  - there are now global standards of accounting,
  corporate governance, financial regulation, trade
  and commerce to benchmark the performance of
  individual economies and markets
• 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)
• APEC has huge potential and savings, but if we do
  not work together, smaller markets could be
  marginalized
• We need to find a way of working together

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Roadblocks to Deepening APEC 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 co-operation
  between public and private interests
• No common philosophy and roadmap to integration

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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 controls, 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 more efficient use

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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.

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APEC Menu of Policy Options (Davis 2006)
We need a tool for policy makers to sequence
policy reforms within the constraints of domestic
political, social and institutional realities

• Framework for Proposed Menu
• Part 1
• Identifying Intermediate Objectives of Financial
  Reform
• Part 2
• Identifying Core Financial Infrastructure
  Requirements
• Part 3
• Specifying a Set of Institutional Initiatives
  for Implementation

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APEC Menu of Policy Options (Davis 2006)
Each of the above could be implemented in
separate MODULES, supported by Technical
Assistance
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V. Institutional Framework to Move the Process of
Capital Market Reform and Regional Integration

• Macro Foundation
• Micro Foundation
• Sequencing
• Bounded Constraints

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Gurley and Shaw Financial Deepening

• Gurley and Shaw (1955) pointed to the importance
  of financial deepening, since the growing role of
  NBFI was stimulated in part by the opportunities
  for intermediation created by monetary policy
  measures that placed specific restrictions on
  banks
• Growth in income and wealth stimulate the demand
  for financial services. Controls and restrictions
  on financial intermediaries create the incentives
  for further financial intermediation. New
  products and financial intermediaries emerge by
  arbitraging these regulatory barriers. In a
  globalized environment, foreign financial
  intermediaries play this arbitrage role
• This paper attempts to explain the institutional
  aspects of financial deepening

Source Gurley, John and Edward Shaw
(1955). "Financial Aspects of Economic
Development." American Economic Review. 45
515-38.
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• MACRO FOUNDATION
• From IMF FSAP approach to
• National Self-Review

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Source FSAP Experience and Issues Going
Forward, Stefan Ingves, Economic Forum, 16
December 2003
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FSAP Three Pillars of Financial Stability

• Pillar I Macro Environment Policies

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FSAP Pillar II on Supervision and Regulation
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FSAP Pillar III on Property Rights Infrastructure
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• MICRO
• FOUNDATION

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Eight Elements of Institutional Building
INSTITUTIONAL DESIGN
STRUCTURE
PROCESSES, PROCEDURES
CODES, RULES, LAWS
STANDARDS
KNOWLEDGE INTENSITY
PROPERTY RIGHTS
PEOPLE
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Efficient Markets Have Robust Property Rights
Infrastructure (PRI)

• Central Registry of property rights e.g.,
  land registry, share registry
• Trading Engine e.g., 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 rights disputes

? Effective judiciary, enforcers police,
regulators, enforcement agencies, accounting,
legal and financial intermediaries are all part
of PRI
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Change through Knowledge Intensity

• Changes in
• Product
• Process
• Standards and rules of game
• Organizational Unit (new institution)
• Institutional Framework (Architecture of
  organizations)

• Since change supersedes old knowledge and
  value, vested interests whose franchise and
  value are hurt would resist change
• Karacadag, Sundrarajan Elliot (2003)
  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

are all Changes in Knowledge Intensity,
requiring new skills, new knowledge and new
experience
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Institutional Trade-offs

• 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
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Process of Economic Change is Institutional and
Organizational Evolution - Douglass North

• 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
  - North Understanding the Process of Economic
  Change, 2005

• Organizations are 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)

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Institutions have Network Characteristics - They
Develop by Linking with Other Networks

• Local markets are Local Area Networks and Global
  Markets are LANs linked through Internet or
  specialist networks e.g., SWIFT for payments
• Networks display Winner- Take- All
  characteristic, since the larger the network, the
  greater the value of Network (Metcalfs Law)

• Globalization has created co-operation and
  competition between local economies or
  markets/networks, with linked-through common
  standards, products, processes or goals (e.g.,
  regional or global organizations)
• Each domestic economy evolves in different shape
  or direction, depending on its own history,
  culture, laws and institutional legacy.
  Developing a financial system therefore needs a
  strategy between local needs and a global fit

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Markets have Architecture Trade-off between
Efficiency vs Robustness
Decentralized Network
Distributed Network
Star Network
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Local vs Global/Regional Objectives have Six
Degrees of Separation
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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,
  co-operation 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

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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

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• 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

Fischer, 2001
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Pragmatic Approach towards Regional Integration
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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

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Sequencing is an Art and Country-Specific

• 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

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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.
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How to Sequence?
In the absence of a theoretical basis on how to
sequence, a practical rule of thumb is a variant
of Occams Razor.

• When in doubt
• do the easiest and non-controversial first,
  before the toughest
• identify the major obstacle, the removal of
  which yields the biggest benefit and weigh up the
  risks and costs of tackling such obstacles

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Stanley Fischer (2006) onSequencing Rules of
Thumb
In terms of the Type of Capital Flow, the
principles of liberalization are
In terms of Which Sectors to liberalize

• To liberalize inflows before or simultaneously
  with outflows
• To liberalize long-term capital flows before
  short-term flows
• To liberalize foreign direct investment before
  portfolio investment

• First, the Business Sector
• Second, Individuals
• Third, the Financial Sector

Source Stanley Fischer, Financial Market
Liberalization, Keynote Address, OECD Forum 2006
on Balancing Globalization, Paris, May 2006.
54
Process of Institutional and Organizational Change

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

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Capital Market Reform Process
To build APEC Capital Market Reform Process
FOCUS FOCUS FOCUS
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Bounded Constraints
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Institutional Trade-offs and Bounded Constraints
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Bounded Constraints in Institutional Change

• Financial Resources
• Human Resources (People Institutions)
• 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 Constraints (whether it is possible to
  assemble a team that is able to implement,
  co-ordinate and push through reforms)

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Raising Domestic Adaptive Efficiency and
Robustness

• Regional Integration will require massive
  co-ordination 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
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VI. Concluding Thoughts

• Capital Market Development is an important
  pre-condition of regional integration
• Can be beneficial, but
• Also adds risks of contagion if not carefully
  implemented
• The Reform Process is much more complex than
  previously understood
• Involves both policy and institutional context of
  policies
• A political economy question of prioritization,
  bounded constraints and implementation capacity

• The richer and more advanced economies with
  stronger institutional capacity can play a much
  larger role in helping develop the APEC capital
  market network in spirit of altruism
• 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
61
THANK YOU
Questions can be directed to as_at_andrewsheng.net
wktan23_at_streamyx.com ktkwek_at_um.edu.my