Caged Tiger: The Transformation of the Asian Financial System

The following is the executive summary from an ANZ report entitled Caged Tiger: The Transformation of the Asian Financial System. It was written by ANZ chief economist Warren Hogan. The full report can be read here.

1.1 THERE WILL BE NO ASIAN CENTURY WITHOUT AN ASIAN FINANCIAL TRANSFORMATION

The ‘Asian Century’ is upon us. Asia’s economy already accounts for a quarter of global economic output, up from 17% two decades ago. ANZ expects Asia’s share to rise to 35% in 2030 and to be over half the world economy by 2050. The United States (US) and Europe, which currently account for around half the world’s economic output, could see their share fall to less than a quarter by mid-century. This is a tectonic shift in the global economic landscape.

Yet with the exception of Japan and the newly industrialised economies, Asia’s rapid industrialisation of the past two decades has not been matched by an extensive development of its financial system. Many Asian countries have relatively closed and highly regulated financial systems, with a dominant bank sector and heavily managed exchange rates.

While this financial model may have helped some nations reach this point in their economic development, it will not be appropriate for the next stage of continued economic growth. The financial systems of many Asian economies must be reformed, deregulated and opened up to global markets.

To build out a consumer-based high-income economy, an efficient and transparent financial system is critical. Consumers, small businesses and large corporations need to have confidence in the system as well as improved access to capital and modern financial management products. Without further substantial development of the financial system many Asian countries risk being caught in what development economists call the ‘middle income trap’.

Financial development is just one part of what is required to drive societies through middle income status. Other factors include improving legal and governance structures, rising political freedoms and ongoing economic reform in other sectors of the economy. But fundamentally, an Asian Century now requires a profound transformation of the Asian financial system.

1.2 THE ASIAN FINANCIAL SYSTEM IS UNDER-DEVELOPED

The policy response to the Asian Financial Crisis (AFC) of 1997 left many economies in the region with tighter capital controls, more regulated domestic financial systems and managed (or fixed) exchange rates.

High savings rates across the region, combined with a strictly controlled financial system and managed exchange rates, resulted in the build-up of large foreign exchange (FX) reserve portfolios at many Asian central banks. This has meant that the Asian surplus of the past 15 years has been ‘recycled’ back into the international financial system via official portfolio flows rather than the investment decisions of private individuals and institutions. These portfolio flows have mostly been purchases of US and other developed nations’ government bonds by central banks.

The ‘trapping’ of the Asian surplus in FX reserve portfolios has resulted in a much slower financial development than would have been the case if the private sector had played the primary role in allocating those savings. At the same time the financial systems of the US and Europe, swollen with external liquidity, became much larger than required by their underlying economies. This global financial imbalance was a significant, though not exclusive, cause of the Global Financial Crisis (GFC), and is only now beginning to slowly reverse.

Rebalancing the global economy, avoiding the middle-income trap in Asian economies and Asia’s financial transformation will be among the most powerful forces in the global economy over the decades ahead. The Chinese Government has recognised the urgency of reform and is now fast tracking financial liberalisation and the opening up of the domestic financial system to international capital flows.

Asia’s financial system will grow rapidly and the interaction of Asian capital with the rest of the international financial system will change radically. Instead of the benign flow of official capital into deep, liquid government bond markets, particularly US treasury bonds, Asia’s private sector will have a much bigger role in allocating Asian savings around the world.

This will mean an explosion of Asian private portfolio capital flows (both into bonds and equities) and a much greater role for Asian direct investment in other countries. For example, the outstanding stock of Chinese Foreign Direct Investment (FDI) into other countries was around US$500 billion in 2012. This could rise towards US$10 trillion in 2030. Chinese private portfolio flows into global bond and equity markets could increase by US$1.3 trillion a year for the five years following the opening up of the Chinese financial system. But just as significantly, these flows will not go into existing asset classes like US treasuries to the same degree, with important implications for Europe and the US.

1.3 ASIA’S FINANCIAL SYSTEM WILL DOMINATE INTERNATIONAL MARKETS BY 2030

If Asian governments can continue to follow a path of economic reform, maintain strong growth rates and productivity and commit to further financial liberalisation, the total Asian financial system could account for around half of the global system by 2030 (up from around 22% now). While some of this is due to the growth in the underlying economy, a good proportion will be a result of financial deepening that will result from the financial reform process.

Banks will still dominate Asian financial services for the foreseeable future but there will be spectacular growth in capital market activity. Our modelling suggests:

––Asian (excluding Japan) bond markets will grow to be six times their current size over the next 15 years to match the size of US debt markets.
––The RMB market will dominate in Asia not only because of the size of the Chinese economy but also because it will be a regional funding currency.
––China’s debt markets are forecast to grow from around US$4 trillion in 2013 to around US$27 trillion in 2030.
––The equity market capitalisation across the Asian (excluding Japan) region is also expected to explode, rising from US$9 trillion to almost US$55 trillion by 2030.
––The Chinese banking system is likely to overtake the size of the US system by 2020.
––The Asian financial system is on track to be bigger than the US and Europe combined by 2030.
––China will be the dominant market in Asia, accounting for around half of Asia’s financial assets by mid-century.
––By 2030, China’s financial system could be more than twice as big as that in the US.

1.4 IMPLICATIONS OF GROWING ASIAN CAPITAL MARKETS

The rise of the Renminbi (RMB) capital markets is a clear implication of this Asian financial transformation. The Chinese currency and capital markets will dominate regional financial markets within 15 years. And as we approach the middle of the Asian Century, the RMB will become a genuine rival to the US dollar as a global reserve currency.

While the US will retain its reserve currency status for decades to come, the US and European financial systems are likely to grow relatively more slowly than in recent history. Indeed, we believe there is the potential for these financial systems to contract in real terms over the next decade.

Price discovery in financial markets, in the sense of the most influential trading zones for price setting, will gradually shift towards Asia. At the very least, we will see financial asset price volatility increasingly occur through the Pacific time zone rather than the Atlantic time zone. No more sleepless nights for Asia’s FX traders in the future! It will be traders in London having to get up at all hours to respond to unexpected economic data and policy events.

All of this will mean a rapid development of Asia’s financial centres. Shanghai will rival New York as a financial centre for a large domestic economy as well as an international hub. Singapore is likely to increase its importance given its critical role in South-East Asia. Second-tier centres will emerge; Hong Kong and Tokyo will remain important while Seoul, Mumbai and Sydney will grow strongly.

Asia’s financial institutions will become increasingly important in global finance. Chinese banks are already some of the largest in the world but their presence has only just started to be felt in global markets. This will change as they play a growing role in finding investment opportunities for Chinese savings in the world economy.

The potential for wealth management institutions to grow, initially in North Asia but throughout the region is significant. For the still emerging and demographically young nations of ASEAN,1 this financial transformation offers increased access to long-term capital critical for funding the economic infrastructure required for the next stage of their development.

1.5 ASIA’S FINANCIAL TRANSFORMATION WILL HAPPEN AS PART OF A BROADER REFORM PROCESS

The opportunities are big and so are the risks. The international experience with financial system deregulation and capital account liberalisation is replete with examples of capital flow surges creating wide current account deficits, asset price bubbles and large banking system losses.

Government policy will therefore be crucial in mitigating any problems as Asia develops a large, open and sophisticated financial system. Policies will need to be developed across a wide range of areas, including developing strong institutions such as independent central banks, a strong regulatory and supervisory system, as well as the wider legal and cultural changes needed for a modern financial system.

As financial deepening occurs, the repercussions are broad and significant. For example, Initial Public Offerings (IPOs) remain the principal vehicle for transferring state ownership to private ownership and so a succession of the world’s largest IPOs in Asia can be expected in coming years. IPOs are likely in financial services, energy, telecommunications and infrastructure, sectors currently dominated by large state-owned enterprises.

The implications of much larger investment pools, particularly in China, are also dramatic as FDI into regional markets expands. The sheer scale of this investment wave will inevitably make it higher profile, raising regulatory and political implications. Foreign ownership in many economies, even developed ones like Australia, remains sensitive.

For example, in 2010, around 2.5% of the value of China’s FDI was invested in Australia. Even if that percentage remains unchanged, the higher total level of Chinese FDI could lead to over A$200 billion FDI into Australia, or about 15% of our forecast Australian Gross Domestic Product (GDP), by 2030 – above the current levels of US direct investment.

The challenges are immense, not least in China, a powerhouse of the region. The good news is that China has already made steady progress on implementing a strong structure for its financial system. But the decisions Chinese policymakers make in coming years will be of great importance to the global financial system.