Integrating Asian finances Robert N McCauley Chief Representative BIS Asian Office Bank for International Settlements World Bank / Hong Kong Monetary Authority Conference “East Asian Financial Markets—the Next Frontier” Hong Kong, 22-23 June, 2006

Main points Financial integration in Asia varies across markets In bond market, risk is that regional integration takes place in offshore US dollar market, encouraging currency mismatches Policy priority: develop local currency bond market, especially corporate bond market Open local currency bond market to foreign investment to allow regional integration there?

Integration of Asian financial markets Bank credit Local currency bond Dollar bond Equity National only X Regional Global

Integration of bank credit markets Foreign bank share of domestic credit in percent

BIS-reporting banks’ claims on China & India End-September 2005, in US$ billions

Very limited role of foreign investors in local currency bond markets Typical holdings of 1-3%, although effectively higher in markets like Korea where can invest in government bond futures and interest rate swaps. Highest ratio of over 10% currently for high-yielding Indonesia. China, India limit by restrictions, others by withholding taxes. Closed markets, idiosyncratic price changes:

Return correlations btw Asian local currency bonds (ex HK, SG) and US Treasury bonds low Calculated over period January 2001 to March 2004.

Dollar bond and syndicated loan markets show regional integration 40+% of dollar bonds sold by Asian issuers bought by Asian accounts Similar fractions of syndicated loans for Asian borrowers taken up by banks from Asia

Regional purchases of international bonds issued by East Asian borrowers, April 1999 to August 2002 Issuer residence along x-axis; shares purchased by Asian investors, in percentages of amounts issued, along y-axis Sources: Asiamoney; FinanceAsia; International Financing Review; Dealogic; authors’ estimates.

Regional participation in internationally syndicated loans for East Asian borrowers, January 1999 to August 2002 Borrower residence along x-axis; supply of funds by nationality of banks in percentages along y-axis Note: Nationality breakdown by ultimate ownership of banks. HSBC and Standard Chartered were considered Hong Kong groups for this exercise. Deals where banks of only one nationality provided funds were excluded from the sample. Sources: Dealogic Loanware; authors’ estimates.  

Stock markets (ex China) moderately integrated Calculated over period January 2001 to March 2004.

Risk is that regional integration of bond markets happens in US dollar market This could entail risk of currency mismatches if firms borrow dollars to access global portfolios and to obtain longer maturities. If best firms access offshore rather than onshore funding, local currency corporate bond market left without its most liquid issues. Lower quality firms may be pushed offshore by credit risk aversion of domestic investors.

Policy imperative is to build up national bond markets in local currency Against threat of global markets “cherry-picking”, regional efforts to build up domestic bond markets: ABF2 can be seen as a case of collective learning by doing that has prodded removal of impediments as well as providing domestic investors a cost effective means to invest in local bonds. Also made crossborder investment easier through the Pan Asia fund. Sale of local currency bonds by international financial institutions has helped to increase the diversity of credit on offer in bond markets of China, Malaysia and Thailand.

Costs and benefits of allowing foreign investment in local bond markets As in equity markets, foreign investors can chase returns, possibly amplify price swings and rush for exit Higher correlation with US Treasury market? Benefits: Firms have choice other than to sell dollar bonds to tap offshore funds Greater diversity in investor base tends to improve liquidity Foreign investors stabilising bid when domestic liquidity shocks?

Net equity flows into Asia in billions of US dollars

Conclusions The key choice is what kind of fixed income market integration Asia wants: one based on the dollar markets or one based on domestic currencies. Policy-makers need to do what is necessary to ensure that their domestic bond markets, especially corporate bond markets, can support growth. Foreign investors in domestic bond markets could provide a more diverse investor base but could expose the local markets to global bond market strains and possibly large inflows and outlows. 16