The role of financial markets in sustaining economic growth in Asia
Remarks by Tommaso Padoa-Schioppa, Member of the Executive Board of the ECB,
at the Citigroup and Japan Society “Policy and Markets” Program,
New York, 20 April 2004.
The economic textbook tells us that financial markets, or, more broadly, the financial system, matter for growth as they can produce an efficient allocation of resources from savers to productive investors. They also dilute risk by spreading it across a large pool of economic agents and by so doing they reduce the costs of economic failure. In other words, financial markets can reduce both the probability of systemic instability, and, if a systemic crisis does occur, its cost. The textbook also tells us that financial markets evolve over time, accompanying the development of the real side of the economy, in a progression beginning with exclusive reliance on bank finance, moving gradually towards equity finance, then corporate bond markets and ultimately to securitisation.
For the sake of my presentation, the term Asia includes three groups of countries, identified on the basis of their nature as either industrial or emerging market economies, and of whether they have recently suffered a financial crisis, i.e. a dramatic collapse in the functioning of their financial system. These three groups are Japan, China and the East Asian countries. Given the differences among them, I will focus here on the two less dissimilar groups: China and East Asia.
Having set the theory and the definitions straight, the relevant question for a policy maker is the following: how should Asian financial markets evolve to support growth to its full potential? To such a complex question I suggest a deceivingly simple reply. The whole structure of the financial system, from the banking sector to securities markets, together with its link to the international financial markets through the capital and financial account, must be adjusted to the stage of development of the economy. In particular, what the most recent experience of the Asian countries has taught us is that the linear evolution of the financial system from bank-based to market-based in a domestic context that I outlined before must be complemented by a second, international dimension, along the process of integration of the domestic financial markets in the global financial system. Ultimately, the desired outcome is one of full international financial liberalisation.
Let me elaborate on this proposition before turning to the recent Asian experience. On balance, Asian countries have been a model of integration in the global economy among emerging market economies, with large gross flows on both the current and the capital account. Integration brings obvious benefits, but it is also poses risks. When the capital and financial account is liberalised, a country must be able to stand the test of mobile capital flows, and the higher volatility of financial rather than trade flows makes management of this side of the balance of payments especially difficult. Moreover, for emerging market economies, openness to capital flows is a challenge irrespective of whether the countries are net exporters or importers of capital, because in either case gross private inflows are an important resource to growth.
A sound financial sector is crucial to make flows of capital more stable and hence more conducive to domestic growth. On the domestic side, strong supervision and regulation of the domestic financial system are an essential precondition to guarantee that financial intermediation directs domestic and foreign savings to the most profitable investment projects. By building investors’ trust, good domestic regulation can also contribute to dampen volatility at times of crisis, when fear of losses would otherwise induce international investors to discount their investments in emerging market economies more heavily. On the external side, international financial liberalisation is a logical step in the progression from a closed to an open economy and is likely to imply a shift from a fixed to a more flexible exchange rate. When a country has reached a point where macroeconomic and financial conditions are sound, restrictions on the market determination of the exchange rate do not improve the country’s position in the eyes of international investors, and may burden the domestic economy with the cost of limited flexibility.
We have now the key elements to analyse the recent history of Asia. I will be selective in my glance at this history, and will restrict myself to some developments in the financial sector, both in its domestic and international dimension.
In the East Asian crisis of the late 1990s, a number of banking failures and currency shocks produced a severe fall in GDP and inflicted large costs to the domestic economy of several countries. Today, the outlook has improved significantly, as domestic production and consumption have largely recovered. These countries have tackled the root of their crisis - the financial and corporate sector weaknesses combined with macroeconomic vulnerabilities - by implementing comprehensive reforms of the banking and financial system. On the domestic side, this included setting up an appropriate institutional framework, removing nonviable institutions and strengthening viable ones, improving prudential regulations and banking supervisions and promoting transparency in financial market operations.
But this was not sufficient, as the crises were not purely domestic in nature. The East Asian countries were highly integrated in the global economy, depended on large and mobile international capital flows and had formally or informally fixed exchange rates. As a consequence, the international dimension of the financial sector had to be an integral component of the response to the lessons of the crises.
The experience of the East Asian countries is possibly the most dramatic among the three groups of countries that compose my map of Asia today, but its message is not irrelevant to the other ones. China has not been hit by the crisis of the late 1990s, but even in the absence of any such dramatic developments the considerations made above apply. In fact, one may wonder whether China’s growth would have been either more stable or more robust had its financial sector been stronger. This is not to belittle the progress made by China in dealing with its financial system. For example, a significant development was the recent creation of the China Banking Regulatory Commission (CBRC), entrusted with the regulation and supervision of financial institutions. The Commission is now striving to reduce non performing loans and also to align financial institutions’ indicators to international standards.
In general, it should be kept in mind that in all countries careful consideration of the international dimension of the domestic financial system is needed. Indeed, in all Asian countries participation to the global economy puts additional pressure on policy makers to find the correct balance between domestic growth, financial intermediation and international financial liberalisation.
In this respect, let me briefly share with you my experience as a European, because I think it can help understanding the points made above for the case of Asia.
In several ways, the prevailing growth experience of many Asian countries mirrors that of European countries in the Bretton Woods period. At that time, the US dollar served as the numeraire currency for the whole world and anchoring their currencies to the American one allowed the European countries to subordinate growth of domestic demand to the absorption rate in the centre country. This was the most promising growth strategy at that stage of Europe’s development, and it was capable of promoting convergence of the European periphery to the American centre. Later on, however, as European living standards rose and intra-European trade expanded, the European block de-linked from the dollar and moved to floating exchange rates and adopted the Deutsche Mark as a regional anchor. Eventually, it created its own currency.
The history of the Asian countries over the last two decades shares certain similarities with the one of Europe in the third quarter of the twentieth century. The Asian growth model has been export-oriented and based on exploiting comparative advantages as successive countries have moved up the product cycle. As Japan developed in the post-war period, beginning with labour-intensive products, it gradually moved into capital- and then technology- intensive activities. As it matured along the product cycle, room was left for other economies in the region to fill the gap. This started in the mid-1960s with the newly industrialised economies in Asia. The other ASEAN countries followed next and then, by the 1990s, it was the turn of China. Along this development path, alignment with the US dollar was the most reliable anchor for monetary policy and supported the growth engine. This continues today, when the US dollar still serves as the anchor currency for the majority of Asian currencies.
Eventually, however, as living standards in Asian countries converge to those in the US, international financial liberalisation must come in those countries that have so far not liberalised. As already mentioned, the majority of countries have strengthened their financial sector, and are on the way to increase the depth diversification of their domestic financial markets. But the international dimension begs the question of the efficiency of the capital and financial account liberalisation, including the choice of the exchange rate mechanism. Convergence of Asian countries toward a fully developed and liberalised financial system will most likely require more flexibility in exchange rates.
If it is to be expected that exchange rate flexibility is the long-term outcome of the growth process currently undergone by Asian countries, as it was in Europe, then financial systems need to be prepared. Indeed, a change in the management of the exchange rate regime requires careful consideration of the structural conditions in the domestic economy. Improvements in the strength of domestic financial institutions and the liquidity and diversity of financial markets need to be made first. Once this is achieved, fully liberalised financial systems can foster sustainable economic growth at its full potential.