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World Bank/Hong Kong Monetary Authority Joint Conference East Asian Financial Markets - the Next Frontier Keynote Remarks of Kenneth G. Lay, Vice President and Treasurer (Acting), World Bank Hong Kong, 22 June 2006
Mr. Yam, distinguished guests, colleagues and friends. Good morning. It’s a privilege for me to be here in Hong Kong with such an impressive gathering of government and private sector policy-makers and practitioners. I’d like to open with special thanks to Mr. Yam for his remarks this morning, and to him and his colleagues at HKMA for partnering with my own institution in hosting this conference. This is the second time we’ve enjoyed such a collaboration with the Monetary Authority: Many of you will recall the Emerging Asian Bond Market study of 11 years ago. We valued our partnership with HKMA then, and we do so now, in an environment in the region that has changed in so many ways in the intervening years. The centerpiece of today’s conference is an even more ambitious regional study, covering a full range of issues in financial sector development. The title - East Asian Finance: Road to Robust Markets - captures well the breadth of the work and the journey it documents - a journey that’s very far underway despite a few detours over the last decade. It also gives us shorthand insight into the ultimate destination: efficient, stable and transparent financial markets offering the best possible support for sustained growth and prosperity. The timing of the report, and this meeting, is good. In the nine years since the 1997 financial crisis, the region largely has put behind it the difficult period of post-crisis consolidation and restructuring. Clearly, as reflected in initiatives such as the Asian bond market project and bond funds 1 and 2, the region has returned to the longer-term tasks of broadening, deepening and harmonizing markets. And there’s another reason the timing is good: East Asian governments have accumulated over $1.6 trillion in foreign exchange reserves, providing tremendous support for market confidence and stability. This could be a cause for complacency - an invitation to sit back and enjoy the status quo. Fortunately there is little evidence of that, especially not among the leaders in the field assembled here today. On the macroeconomic front, for example, since 1997 East Asian countries have made remarkable progress in adopting sound policies; the reduction in the foreign debt share in countries’ liabilities portfolios is just one important indicator. Even so, as the present study so thoroughly documents, a great deal remains to be done. In the remainder of my remarks I’ll note a few of what I believe have been the most significant developments of the past several years, as well as the principal challenges going forward. As often happens, progress made and challenges remaining are two sides of the same coin.
Key Developments What have been some of the key developments? I mentioned a moment ago the accumulation of $1.6 trillion in foreign exchange reserves. Understandably, this has received tremendous attention in the markets and the press. Perhaps even more importantly, however - and certainly with far less fanfare - the reserves build-up has been more than matched in the East Asian financial sector at large, which now accounts for around $9.6 trillion in assets. Financial sector assets in East Asia are almost a quarter of that of the US financial markets, and half that of Japan. These are remarkable figures. The level of financial assets, and the accumulation of reserves, provide a good cushion against volatility in the international financial environment and provide an important resource for the region in meeting its financing needs in the years ahead. A closer look at the data and analysis in the report, however, begins to suggest where the challenges lie. The first of these is to build diversity in the range of institutions and products available for savings and intermediation. Diversity in this area is a characteristic that in fully-developed economies underlies both the stability and the efficiency of the financial system. In East Asia, the banking sector and the products it offers continue to dominate, accounting for fully $5.5 trillion, or 60% of total financial assets. Although the bond and equity markets have grown in with the growth of East Asian economies in the years since the crisis, in relative terms they have moved up only 3% (from 37% to 40%). Having said this, however, the absolute growth in the securities markets has been impressive. The East Asian bond market by end-2004 totaled over US$1.4 overall. Three of its domestic markets - China, Korea, and Malaysia – each total more than US$100 billion in market capitalization. And the two largest corporate bond markets in the world relative to GDP are in Korea and Malaysia. With the sheer volume of resources now available comes significant scope for rapid evolution in financial intermediation in the region. This will be essential to meet East Asia’s ambitious objectives in infrastructure, address larger and more complex corporate financing needs, accommodate the rapidly evolving financial requirements of consumers and better service cross-border business activity.
Continuing Agenda What needs to be done to make this happen? With countries in the region having made tremendous improvements in strengthening the already-dominant banking sector, the key objective now has to be to grow the other components of the financial markets. Building the securities markets and other forms of investment and intermediation would enhance financial sector efficiency and stability in at least three ways:
Of course, diversity alone is not enough. Each of the constituent parts of the system also has to be transparent and prudently regulated, to gain the confidence of participants on both sides of the market. And the playing field needs to be as level as possible – otherwise, risks and opportunities will tend to migrate to corners of the market based on disparities in the regulatory burden, and not the business fundamentals.
Priorities for Attention If these objectives are clear, what are the priority activities that will get us there? Swati Ghosh, the lead author of the flagship study, will focus on them in more detail in the next presentation. But let me get things started with just a few further observations: First, development of equity and bond markets will need to remain a top priority. The role of equity markets varies widely across countries in the region, with those in Hong Kong, Singapore, Korea and Malaysia playing an important role, and those in the other countries (the Philippines, Indonesia and Thailand) having the potential to play a much more important role than they do at present. On the bond side, despite recent growth in markets overall, the corporate bond sector still has considerable scope for enlargement. To keep the momentum going, policy-makers will have to stay focused on several important areas:
Second, as emphasized in the report, there is a real concern that risk will shift from stronger private banks to public banks and from banks to the more weakly - regulated non-bank financial institutions. Using default swaps, credit risk can redistribute in the financial system in such a way that it concentrates in weaker – and especially public – banks, or in lightly-regulated sectors in the market. This obviously is not a concern unique to East Asia – it has been a preoccupation of policy-makers worldwide as the CDS market has burgeoned over the past several years. These concerns have arisen even in markets in which pricing of credit risk is relatively efficient. In markets without well-developed pricing capacity, the potential for problems is that much greater. One part of the solution is to ensure consistent regulatory treatment of these risks across the different sectors of the market. This was one of the major preoccupations of the Basle I accords more than ten years ago – while not the results were not perfect in many respects, securities and banking regulators recognized and addressed the need for a consistent approach. The same needs to be accomplished in areas such as insurance regulation. Third, regional integration continues to be important to deepen the financial systems of East Asia. Since the financial crisis, region-wide collaborations have accelerated, including the Chiang Mai initiative for bilateral currency swaps and the Asian bond funds that I mentioned in passing earlier in my remarks. The bond funds have brought together EMEAP members to pool $3 billion in reserves for investment in US dollar and local currency-denominated bonds. It’s difficult to overstate the benefits of integration. I mentioned a few moments ago the importance of broadening the investor base. Let me give a concrete example from my own experience. When the World Bank introduced the first global bond in 1989, it effectively integrated the euro and US domestic market for our paper. This immediately brought diversification benefits, because the buy side of the transaction included euro and domestic investors who were pursuing quite different strategies. The result was great execution in the primary offering. But, more importantly, the newly diversified investor base resulted in a bid-offer spread for that issue in the secondary market that was half what it had been for earlier euro and Yankee issues, and for much larger ticket sizes. And that liquidity lasted far longer into the life of the issue than before. The effort took extensive work, though, particularly with the Federal Reserve. We needed to link the euro clearing systems and the Fedwire in a way that would speed up and reduce costs for trades between euro and domestic investors. The deal also required a willingness on the part of Wall Street and the City to adapt their own customary behavior to facilitate cross-border trading in the issues. These last two points highlight an important lesson for cross-border integration efforts: Much of the “heavy lifting” has to be done at home, through the adoption of often-controversial policy measures and changes in market convention in the domestic market. This actually turns out to be the harder task – getting agreement among countries and international issuers and intermediaries on an integration objective is relatively easy in comparison. Role of the World Bank In closing, let me turn for a moment to our own institution and its role in the process. The Bank is at heart a cooperative operating three businesses on behalf of its members: An emerging market bank, an extensive knowledge business focused on development-related topics, and a strategic services business that helps individual members and the international community develop and implement strategies to promote sustainable growth and broad participation in it, or to address problems of regional or global concern. This third part of our business includes our convening power – the ability to bring together to address a problem the full range of interested public and private parties. Our members draw on each of these businesses to varying degrees depending on their situation and needs – some are interested in bundled packages of financing and expertise, others simply in gaining access to the knowledge base. And our wealthiest members are often interested mainly in using our convening power to address global issues. But the overall “value proposition” is simple and compelling: The banking business offers members financing, risk management and credit enhancement tools on terms that most could not otherwise achieve in the market. Even at these prices, our banking activity generates enough return to fund our members’ access, almost always for free, to first-rate knowledge and strategic services. To put some of this in perspective, incidentally, you may be interested to know that the banking business, at least in the IBRD and IDA part of the group, accounts for only about a quarter of our administrative expenses. By far the largest portion goes for the knowledge and strategic businesses. By this measure, we’re not a bank with a knowledge business attached, as widely believed – instead, we’re a major global knowledge resource funded by relatively modestly-scaled, $100 billion bank! Our role in efforts to develop and integrate the East Asian financial system is a perfect example of the World Bank value proposition in action: As bankers, we provide financing to support financial sector reforms in some countries. In others, we provide investment services, the fees on which fund capacity-building in reserves management. In still others, our activity as an issuer has contributed to market development – notably IBRD’s recent ringgit deal, and IFC’s in yuan. The report we’re discussing today is a flagship example of our knowledge and strategic businesses in action: World Bank experts brought to bear their own knowledge in the field, based on the Bank’s global reach and experience. And they’ve collaborated widely across the region to assemble the view and experience of policy-makers and market participants. Other examples abound – World Bank experts, for example, are working actively with stock exchanges and regulators in the region to strengthen corporate governance conventions and benchmark them against international best practice. I’ll now close with a brief return to the collaboration theme: The work that will be presented to you today would not have been possible without a true partnership among many agencies in the region. Their contributions, in the form of background papers, brought an important perspective and insight to this work, which I know will resonate as you get into it. In addition to flavoring and coloring the main piece, their papers are published in a separate volume to the main study. We are indeed very grateful for their important contribution and partnership in this effort, and we look forward to our continued collaboration. My colleagues and I very are looking forward to the discussions. Thank you.
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