Zeti Akhtar Aziz: Global financial stability and the internationalisation of
financial systems in emerging economies
Speech by Dr Zeti Akhtar Aziz, Governor of the Central Bank of Malaysia, at the
EuromoneyQatar Conference "Global financial stability and the internationalisation of financial systems
in emerging economies", Doha, 11 December 2012.
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It is my honour to be here in Doha to speak at this Euromoney-Qatar Conference on "Global
Finance Re-designed". I wish to thank the Qatar Central Bank for the invitation to speak at
this event. In this current global environment, the unprecedented and wide ranging global
policy responses have yet to produce financial stability and a sustainable recovery of the
global economy.
The intensification of the globalization of finance in this decade has resulted in an even more
connected and interdependent world. While the financial systems and economies in most
parts of the world felt the effects of the recent global financial crisis, it has not discouraged
the pace of internationalization of financial systems, in particular, in emerging economies. My
address this morning will be on financial stability and the internationalization of financial
systems in emerging economies. My remarks will cover the benefits and challenges of such
internationalization, the lessons that can be drawn from the recent global financial crisis, the
Malaysian experience on the internationalization of our financial system.
Benefits and challenges of internationalisation of financial systems
While there are significant benefits from internationalization of financial systems, the resulting
increased international financial integration brings with it new risks and challenges. The case
for increased financial liberalization and internationalization maintains that it would foster the
development of a more efficient and robust financial system. While the resulting more
competitive financial system will enhance the efficiency in the financial intermediation
process and contribute towards reducing the cost of intermediation, the supervisory oversight
needs to ensure over competition does not result in the mispricing of risk with adverse
consequences on financial stability.
Other benefits are the increased opportunities for technology transfer, new expertise and
greater innovation and new product offerings. Increased foreign participation in the domestic
financial markets would also contribute to increased liquidity and more competitive pricing in
the domestic financial markets and encourage a more efficient allocation of capital within the
economy. It is also maintained that it will contribute to the expansion and development of the
domestic financial markets in particular, the capital market, proving an important access for
financing of investment activity. With the more efficient functioning of domestic financial
markets, it would also improve the transmission mechanism of monetary policy.
Meanwhile, the increased capital inflows following the capital account liberalization
represents another source of financing that would contribute towards increased investment
and growth. It will allow jurisdictions with surplus funds to be channelled to those regions with
productive investment opportunities and thus contribute towards a more efficient allocation of
funds across international borders. The stronger cross border financial linkages has the
potential to enhance international trade and investment opportunities. It allows countries to
leverage on the respective comparative advantage and complementarities to reinforce
mutual growth. This would be important in the current environment to facilitate cross border
economic activity.
The liberalisation of the capital account in the form of removing restrictions to foreign
exchange transactions would also increase the flexibility of managing such foreign exchange
transactions. This would increase the potential to better manage its associated risks, while
the increased efficiency gains would also reduce the cost of doing business. Finally, it is also
argued that in a more liberalised environment, there would be greater market discipline which
would in turn promote financial stability in the domestic financial system. This however, relies
on a sufficient level of disclosure and transparency to allow the efficient functioning of the
markets.
The internationalization of financial systems is however, not without risks and challenges.
The risk of contagion following from the increased connectivity increases significantly, in
terms of the extent and speed. The contagion can result from external events and
developments that can range from failure of large and important international financial
institution to the eruption of wars or political incidents that have regional or global
repercussions. Meanwhile, global developments including from global policy spillovers have
also resulted in more volatile capital flows. The increased openness of the financial system
also increases the vulnerability to economic cycles in other parts of the world. The increased
interdependence of financial systems and economies and the contagion effects can be
expected to be among the significant outcomes of financial internationalization.
Financial liberalization could for example amplify further the implications of financial stress
from other parts of the world on the domestic financial system. It could also accentuate and
amplify asset bubbles and boom bust cycles. Other implications are that it could contribute to
the widening of income disparities and also to the marginalization of domestic financial
institutions if they are not able to perform in a more competitive environment. Finally, volatile
capital flows may not only affect the efficient functioning of the financial markets but could
result in misaligned exchange rates that do not reflect underlying fundamentals. These
potential risks and vulnerabilities continue to be a challenge not only to emerging economies
but also to the more developed financial systems and economies.
Lessons from the financial crisis
While there are benefits to be gained from the internationalization of financial systems, the
risks to financial stability have also increased immensely. The risks generally emanate from
the greater prospects for contagion following the greater degree of interdependence. These
risks would be even more pronounced in emerging economies in which financial systems
have yet to become more developed and matured. To be better positioned to reap the
benefits from internationalization of financial systems in emerging economies, the crisis
provides us with several lessons. Firstly, is to recognize that the different parts of the
domestic financial system is highly interconnected. This also includes those parts that may
not be under the regulatory capture. Financial stress in a specific segment may no longer be
confined to that segment but may rapidly be transmitted to the rest of the financial system.
Thus, a piecemeal policy response would not be sufficient. It would require a comprehensive
response to ensure that such stressed conditions does not evolve into a major financial
crisis.
Secondly, the build-up of risks to financial stability need to be identified early. Pre-emptive
action would reduce the cost of the crisis on the financial system and the economy. Third, the
regulatory authorities need to be accorded the necessary powers to manage the risks to
financial stability. Fourth, the optimal policy mix may not only include policy actions to
address immediate term issues but would also need to simultaneously address the
underlying structural problems. Fifth, is to give recognition to the importance of enabling
conditions that will render the implemented policies to yield the desired outcomes. Finally, to
facilitate effective policy decision making there needs to be a platform and governance
process for policy coordination across agencies within an economy and for this to be
extended for regional and international collective action.
Following the recent global financial crisis, the policy response at the national level has been
extensive and on an unprecedented scale. While there has been wide ranging financial
reforms at the international level to strengthen the resilience of the financial sector, the cross
border dimension of policy-making has not been as extensive. This is despite the swift
spread of financial and economic shocks throughout the global economy and international
financial system following the eruption of the financial crisis in 2008.
Despite these increased challenges, the institutional arrangements for policy cooperation and
coordination have yet to reach the levels that are commensurate with the degree of global
economic and financial integration. While the individual efforts by any single economy is vital,
it can no longer guarantee global financial stability. Emerging economies that are more open
and integrated with the global economy and international financial system are the most
affected by these developments. The crisis has forcefully demonstrated the importance of the
international dimension of policy.
Finally, a consequence of financial crisis that deserves increased attention is the widening of
income disparities within economies. The recent crisis has worsened this trend given the
conditions of high unemployment in many parts of the world. At the national level, the
development of inclusive financial systems and the development of social safety nets will
contribute to containing this trend.
Financial internationalisation and the Malaysian experience
In pursuing financial sector liberalisation to transition to a more internationalised financial
system, Malaysia adopted a gradual and sequenced approach. This was to ensure that the
necessary preconditions were in place so that the benefits of increased financial
internationalisation would be realised, while ensuring that the associated risks inherent to a
more open economy and internationally integrated financial system could be effectively
managed.
Seven preconditions were identified as being important to this process. The first was to
accord priority to building the capacity of the intermediaries in the financial sector, and to
strengthen their resilience and competitiveness. At the time of the Asian financial crisis,
Malaysia had a highly fragmented banking sector with more than seventy banking
institutions, many of which were small and highly vulnerable. During the financial crisis, a
major restructuring exercise was undertaken. This was followed by an industry-wide merger
exercise, prompted by an increase of the capitalisation requirements. The restructuring
strengthened the balance sheets of the banking institutions, while the consolidation produced
larger and stronger financial groups.
The second was to undertake financial reforms which focused on the transition to a more
market-oriented financial system. This involved interest rate reforms that would support the
more efficient pricing of financial products and services. The more competitive environment
that was generated became an important driver of efficiency gains and innovation in the
financial system.
Equal attention was also given to the development of the financial infrastructure, in particular,
the payment and settlement system and the modernization of the legal framework to give
greater clarity to the legislation governing the financial sector. This involved seven new
legislation that have been enacted in the areas of central banking, the payments system,
money services, deposit insurance, and the regulation of the banking, insurance, Islamic
finance, development financial institutions and cooperatives. This has given greater certainty
and predictability in the functioning of the financial system.
Importance was also given to strengthening the surveillance capabilities of the Central Bank
and the effectiveness of the regulatory and supervisory regime. This involved the transition
from a rule-based regulation to an enhanced principle-based regulation regime with focus on
governance practices and risk management. This was reinforced by the shift to a risk-based
supervision. The supervisory oversight has however continued to remain intrusive, with a
pre-emptive intervention framework to ensure that the potential risks to financial stability
would continue to be addressed including in a more regionally and internationally connected
financial sector.
In parallel with these efforts was the development of the securities market. From a financial
system in which there was an over-reliance on the banking system for financing, the financial
system has now become more diversified with greater access to financing from the bond and
sukuk market. The domestic securities market has now evolved to become a vibrant part of
the Malaysian financing ecosystem, and has served to disperse the concentration of risk in
the financial system thereby contributing towards preserving financial stability. The Malaysian
securities market has expanded significantly to become the largest in the ASEAN region.
Malaysia also made significant investments in talent development for the financial services
sector. Given its significance in defining performance and resilience of the financial sector,
comprehensive institutional arrangements have been put in place for all levels of the
industry; at the entry point, at the working and specialist levels, at the professional level and
at the leadership levels including for the boards of financial institutions.
Finally, as the financial system became more regionally and internationally more integrated,
regional financial stability arrangements have also been established. These included
advancing collective initiatives in the areas of regional surveillance, the development of
regional financial markets and payments infrastructure, and cross-border supervision.
Forums for assessment of risks to regional financial stability have also been initiated, and
work on establishing an integrated crisis management and resolution framework for the
region is in progress. As part of these initiatives, a regional support mechanism has also
been established.
With these pre-conditions in place, Malaysia commenced initiatives to internationalise our
financial system beginning 2003. The internationalisation of the financial sector entailed the
advancement in two main areas; financial sector liberalisation and capital account
liberalisation. In pursuing greater regional and international financial integration, the aim was
to enhance the diversity of the financial system in terms of its product offerings, to improve
further the competitiveness of the financial system and to strengthen our economic linkages
with the region and other parts of the world.
The financial sector liberalisation involved increased foreign entry and participation in our
financial system. New licences were issued to foreign conventional and Islamic banking
institutions, while the minimum foreign strategic stakes in the insurance and takaful industry
were increased. Increased operational flexibilities were also accorded to the existing foreign
banking institutions in the financial system which now account for about 30% of the banking
system. At the same time, the foreign participation in our securities market was liberalised in
2007 to allow foreign corporations to raise financing either in domestic or foreign currency.
The capital account liberalisation throughout the first decade in the 2000s has involved the
progressive removal of restrictions on foreign exchange administration rules. This
liberalisation was intensified after 2005, taking into account the state of readiness of the
financial system and the economy to manage the consequential increased cross border
financial flows. In July 2005, Malaysia migrated from a fixed exchange rate regime to a
flexible exchange rate regime to accord greater flexibility to adjust to changing structural
conditions in the region and the global economy. With the progressive dismantling of
restrictions, businesses now had the flexibility to manage their financial exchange exposures.
This encouraged two way capital flows and contributed towards stabilising the volatile capital
flows to our economy.
Finally, in addition to being accorded with the necessary powers in the new legislations, the
policy toolkit of the Central Bank has also been expanded to address the potential build-up of
financial imbalances and its risks to financial stability following increased internationalisation.
This includes macro-prudential and supervisory measures to collectively address the
underlying causes of financial stability. A platform has also been established for the greater
coordination among policy makers within the country, among the regulators and the public
sector.
Conclusion
Let me now conclude my remarks. While many lessons can be drawn from the various
episodes of financial crisis experienced by the world economy, there is no one approach to
the liberalization and internationalization of financial systems. Its success depends on the
prevailing circumstances and the state of readiness of financial systems and the economy
and its capacity to manage its associated risks. Premature internationalization can result in
highly destabilizing conditions. The liberalization process also needs to be pragmatic, taking
into consideration the different objectives that need to be achieved. With sufficient
development of the financial infrastructure, the safeguards and the buffers, emerging
economies have every potential to participate in a more internationally integrated financial
system that will facilitate mutually reinforcing global growth and development.