Joseph Yam: Asian finance
Speech by Mr Joseph Yam, Chief Executive of the Hong Kong Monetary Authority, at the Swiss
National Bank Event, International Centre for Banking and Monetary Studies, Geneva,
9 November 2004.
* * *
Introduction
I am delighted to have been invited to speak here at the International Centre for Banking and
Monetary Studies in Geneva. I understand that you have in the past had many lectures from central
bankers from Europe and the United States, but no one yet from Asia. I therefore feel particularly
honoured to be the first Asian central banker to speak to you. This is timely, since banking and
monetary developments in Asia have been receiving increasing international attention, particularly
after the Asian financial crisis of 1997-98. I realise, of course, that monetary union in Europe must
have been the monetary event of the past decade, in terms of occupying the time of academics and
practitioners in the field, particularly in Europe. It has also had a large impact in the financial landscape
of other economies, as I am sure the many members of the Swiss financial community that are here
today would agree.
But with the successful birth of the euro, I hope we can all devote a little more time to Asia. I am
confident that giving greater attention to Asia will turn out to be a most fruitful venture. Indeed, I would
argue that such initiatives are now of strategic importance to the future of the global financial system. I
very much hope that I can convince you today why this is so. As I shall demonstrate later, the financial
significance of Asia is indisputable. Yet, in many parts of Asia, financial intermediation, which is so
important to promoting economic growth and development, remains elementary. There is I think an
urgent need for Asia to harness its substantial financial resources for promoting growth and
development but also for minimising Asia's vulnerability to financial instability. With financial
globalisation, the ability of Asia to get this right has significant implications for global finance. I also
hope that I can, at the same time, raise your interest in some of the specific monetary and financial
issues that we are tackling, in the region as a whole and in individual economies, with a special
emphasis on China, including Hong Kong, where I come from.
Asian finance
Let me begin with a description of Asian finance, as I see it. There are six characteristics I would like
to draw your attention to. The is the of Asia. As I mentioned earlier, this is
first financial significance
phenomenal. It is easy to appreciate this by pointing to some impressive numbers, such as those
relating to the amount of foreign reserves held by Asian economies and the amount of portfolio and
foreign direct investments going into, or coming out of, Asia. Indeed, there are seven economies
holding foreign reserves in excess of US$100 billion and all seven of them are in Asia1. Together they
hold a total of over US$2 trillion of foreign reserves, which have doubled over the short period of only
three years. The sheer size of these foreign reserves and the business opportunities they make
available have greatly enhanced the level of sophistication in their management. Increasingly, such
management is making use of advanced financial instruments and expert services offered by
international investment banks, and is much more alert to shifts in short-term trends in currencies as
well as in interest rates.
Private-sector savings in Asia are also very substantial, given the high savings rate, which is generally
in double digits and, for some, as high as 30% to 40%. Although the management of private sector
savings in Asia is generally a lot less sophisticated by comparison, it is being increasingly
institutionalised, along with the introduction of provident funds, and is managed by professionals,
becoming increasingly active in the international markets. Over half of the new issues of US Treasury
securities are now taken up by Asian economies. And Asia is now a large net exporter of portfolio
capital. For nine emerging Asian economies (excluding Japan), the amount was a net US$225 billion
in 2003.
The second characteristic of Asian finance is, by contrast, the lack of sophistication in domestic
financial intermediation. The effective channelling of savings into investments is crucial for the
promotion of economic growth and development. This is something that developed markets with
advanced financial systems take for granted. Yet, in a significant part of Asia, notwithstanding its
financial clout, a significant part of domestic savings is still put under mattresses. A convenient and
effective channel that could be used to absorb these savings, in a manner that commands the
confidence of those who save, does not exist. Where some form of financial system exists for
facilitating the important process of financial intermediation, it is usually a system that suffers from a
preponderance of banks. This lack of diversity in the financial intermediation channels is widespread in
Asia; and frustratingly so, particularly for those with responsibility for promoting such diversification, for
the sake of efficiency as well as financial stability. The market capitalisation and turnover of domestic
debt and equities, in absolute terms as well as relative to GDP, is generally low when compared with
corresponding numbers in the developed markets. This is so even in Hong Kong, the pre-eminent
international financial centre in the region. The domestic debt market there, in terms of the amount of
debt outstanding in the domestic currency, is only about 45% of GDP, although this is partly the result
of a long history of fiscal discipline.
The emerging markets of Asia are aware of the important need for financial system development. This
brings me to the third characteristic, which concerns the development strategies being adopted.
Although these vary between different economies, having regard to the domestic circumstances, one
underlying strategy common to all is financial openness. Financial systems are opened up, for the
participation of domestic and foreign financial intermediaries, with a view to obtaining efficiency gains
through greater competition and importing financial expertise. This has generally been a success,
although specific problems have been encountered. A feature of these problems has been that, at
times, the profit motive and the enthusiasm of financial intermediaries, not necessarily just the foreign
ones, might prevail to such an extent as to undermine the public interest of ensuring effective financial
intermediation. The problems might also have been the result of ineffective regulation of financial
markets and supervision of financial intermediaries, and inadequate regard to the basic purpose of the
financial system. One example, and it is only appropriate that I should use an example from Hong
Kong, is the closure of the Hong Kong stock market in 1987. This was done in the interest of the
financial intermediaries who were about to be hit badly by the world-wide crash that occurred overnight
because they had taken large and concentrated positions in stock futures. The closure of a secondary
market, which provides the liquidity for attracting primary market activity that channels additional
savings into investments, was blatantly wrong and seriously damaged the credibility of the stock
market as a channel for financial intermediation. The damage was temporary, as it turned out, and
confidence was eventually re-established, but not without much soul-searching and many market
reform measures.
Such problems notwithstanding, it is clear that emerging markets in Asia are enthusiastic in embracing
financial openness. To be sure, such willingness has not been entirely voluntary. Neither has the pace
with which openness is being pursued. For relatively small domestic markets, there is understandably
a lack of attraction for the large and sophisticated international financial intermediaries. And so there
may be special privileges or incentives offered, at the risk of creating structural distortions in the
financial system, as enticement for the esteemed presence of the household names of international
finance. More important, individual jurisdictions have been, whether of their own free will or under
pressure, pursuing financial openness, not just in respect of the financial system, but also in respect of
the international mobility of capital. This they do so, in some cases, perhaps prematurely, by reference
to their ability to manage the associated risks to monetary and financial stability on a continuous basis,
in keeping with the demands arising from the changing scene, and changing risks, of international
finance. As a result, the path towards financial openness has not been a smooth one, and diversions,
although of a defensive nature, have been rather frequent lately. This is an aspect to which I shall
return later.
Let me turn first to how financial openness has been manifested in the dynamics of financial
intermediation in Asia: this is the fourth characteristic of Asian finance that I wish to talk about. High
public-sector and private-sector savings, less developed financial systems and financial openness
have affected financial intermediation in two ways. First is a relative shift of dependence on foreign
savings, as against domestic savings, as a source of funding domestic (fixed and portfolio)
investments. Second is reduced availability of such funding, as evidenced by Asia being a net exporter
of capital. To be sure, there has correspondingly been more efficient allocation and use of scarce
funding on a global basis, made possible by the freer mobility of capital and the freer convertibility of
currencies. But there has also been a change in the dynamics of financial intermediation in Asia, in
that there is a process of recycling of Asian funds through the developed markets back into Asia that
has become quite significant. And not only is it significant, it is also quite potent and demanding.
Whether we like it or not, the behaviour of foreign savings in the hands of foreign financial
intermediaries is quite different from that of domestic savings. To start with, they are more volatile than
domestic savings and more sensitive to shifts in market sentiment and in macro-economic policies, to
a degree that has proven, in the Asian financial crisis of 1997-98, to be brutally destabilising. Given
also the existence of some forbearance, in terms of, for example, the disclosure of activities and the
maintenance of concentrated positions, in the interest of sustaining the presence of foreign financial
intermediaries and foreign savings, there is a much greater likelihood of market overshooting. This
may at times be so serious as to lead to general panic, as herd instinct, following the sometimes
deliberately transparent actions of the renowned market leaders, takes hold. This then results in
problems of systemic dimensions, threatening financial meltdown and serious disruptions to financial
intermediation and economic activities. Furthermore, the revolution in information technology, working
through financial innovation, has greatly increased the potency of international capital, particularly
portfolio capital. There is no doubt that the dynamics of international finance have become much more
demanding than before, for an emerging market in Asia, and elsewhere, that embraces financial
openness. This is so in respect of all areas of macro-economic policies, including exchange rates,
which I shall also address later, and all aspects of financial market structure. Domestic
macro-economic problems, considered to be benign one day, all of a sudden can become malignant
the next, triggered possibly by some strange events, and then sharp, destabilising reversals of capital
flow ensue.
The new dynamics, of course, present difficult challenges for the maintenance of monetary and
financial stability, and this is the fifth characteristic of Asian finance worthy of note. The dilemma
between financial openness and the maintenance of monetary and financial stability is a real one, and
a harsh one under globalisation, particularly for those who are less well endowed. Here I am
specifically referring to those with financial markets that are small relative to the amount of
international portfolio capital that can be mobilised by foreign investors, and those acting for them, but
big enough to whet their appetite for profit. Arguably, the market discipline imposed on
macro-economic policies of emerging markets may de facto be more stringent than those imposed on
developed markets. Indeed, what is acknowledged by many as an unsustainable, large current
account deficit has been sustained in the United States for some time now, no doubt for a lot longer
than if one of equivalent size relative to GDP were run by an emerging market.
To be sure, there is consensus on the need for greater macro-economic discipline, robust institutions
and market structures, as a defence against monetary and financial instability. There has been much
progress, for example, on improving corporate governance, and I do not wish to belittle the serious
efforts made at this important micro level, through the promotion, and the interaction, of individual,
regulatory and market disciplines. There is also much greater discipline in pursuing prudent
macro-economic policies, to the extent of attracting criticisms of excessive conservatism, particularly in
respect of the running of substantial current account surpluses and the accumulation of large foreign
reserves. I am sure these independent efforts of individual jurisdictions, reflecting their different
pre-occupations, arising from different domestic circumstances, will, in the fullness of time, ease their
tasks in the maintenance of monetary and financial stability. But the questions that should be asked
are whether they are sufficient; and if not, what is. These are issues that have been occupying our
minds post-Asian financial crisis, for I certainly do not wish, in the case of Hong Kong, to mobilise once
again, in whatever other form or guise, in the type of high-profile intervention in the stock market we
organised in 1998. But there is, as yet, no regional consensus on the need for a long-term solution
and what it might possibly be.
Meanwhile, it is a fact that there has recently been a discreet drift, or at least temporary diversions, in
the smaller emerging markets of Asia away from financial openness. They seem to have become
more ready than before to regulate the outflow and inflow of funds, through a variety of formal or
informal measures. The measures fall into two categories and are applied, where considered
appropriate, selectively, targeting a specific group of market participants, for example non-residents, or
activities of a specific purpose, such as those considered speculative. The first of these limits the
convertibility of the domestic currency, in either direction, and the second limits the ability of banks to
expand their assets or liabilities denominated in the domestic currency. So far these have proven to be
helpful in maintaining monetary and financial stability after the crisis of 1997-98, and, most important,
have not undermined the flow of foreign direct investments. Perhaps this will become the new
paradigm approach to monetary and financial stability in Asia, but elsewhere I have chosen to call this
a "band aid" approach. Coming from Hong Kong, the freest economy in the world, where by law we
are not allowed to impose any foreign exchange control policies and our currency must be freely
convertible, I am reluctant to accept ad hoc limitations to financial openness. But I can quite
understand the plight of other emerging markets in Asia. When the undesirable elements of
international finance assume a predatory character and look us fiercely in the eye there is simply a
need for self-defence, and temporary or discreet changes in the rules of the game are at times
effective.
Let me turn to the sixth characteristic of Asian finance that I wish to draw your attention to, and this
concerns exchange rate policy. You are, no doubt, aware of the fact that the exchange rates of
currencies in Asia have become more flexible, as an outcome of the financial crisis of 1997-98.
Whether or not this is a desirable outcome remains to be seen, although my view probably represents
the exception rather than the mainstream opinion. I say this not for the purpose of justifying the
maintenance of a fixed exchange rate for the Hong Kong dollar. I shouldn't have to. The fixed
exchange rate has served Hong Kong very well and, with currency board arrangements and a very
flexible economy, I do not see any insurmountable difficulty in sustaining it. And I recognise the
theoretical attraction of having an additional degree of freedom in economic adjustment. In practice,
however, there must be doubt about whether, in view of the possibility of severe exchange rate
volatility and overshooting, this is a luxury that all economies can afford. There is also the question of
whether the relationship between the current account balance and the exchange rate is always the
same across different economies so that exchange rate adjustments are a panacea for correcting
external imbalances. Regrettably these questions are simply not asked, or, if asked, they are drowned
by political noises that appear to be made on the basis of narrow, political concern over bilateral,
rather than multilateral, trade imbalances.
In any case, flexible exchange rates for many currencies in Asia does not necessarily mean exchange
rates determined freely by the market, as proponents would have it. As it turns out, more flexible
exchange rates in Asia have meant exchange rates being determined in a flexible manner by the
authorities, through intervention, controls and restrictions, at levels that are considered in their best
interests. And their best interests, whatever they are, seem for the time being to be manifested in the
substantial accumulation of foreign reserves. Perhaps reserve accumulation is the objective. And I can
understand why, if this is the case. The comfort of substantial ammunition for coping with the
recurrence of financial turmoil has become essential for emerging markets in Asia. But exchange rate
and other supporting policies that promote the accumulation of foreign reserves, intentional or
otherwise, are questionable in terms of their sustainability, just as we all question the sustainability of
the current global imbalance, or rather, the sustainability of the US external imbalance. They are,
arguably, the two sides of the same problem.
From whichever side you are looking at it, a problem that is considered unsustainable will, of course,
be corrected, sooner or later, and the questions we all would like to have answers to are how, and how
violent or benign the inevitable market adjustment might be. I am afraid I do not have answers to these
questions. But I just would like to point out, in this connection, that the style of management of foreign
reserves, when the exchange rate of the domestic currency is flexible, is likely to be more proactive
than is otherwise the case, in terms of for example currency allocation. Managers of foreign reserves
are ultimately held accountable to the people they serve, and the amounts, as I pointed out at the
beginning of this survey on Asian finance, are getting to be very large indeed. They are, possibly,
large enough to make a difference to the dynamics of the global markets for foreign exchange and for
major classes of financial instruments, and enough to make a lot of people with the relevant
responsibilities feel uneasy.
Asian monetary co-operation
Indeed, this survey, focusing on six characteristics of Asian finance, represents, to me at least, a
rather unhappy state of affairs. Asian finance is in a fragmented state, understandably though, given
the many currency jurisdictions present, each adhering to the Asian tradition of minding one's own
business. To be sure, the desire to pursue and maintain financial openness, in view of the potential
and demonstrated benefits to growth and development, is still strong. But many have become weary,
worried, cautious or shocked to varying degrees by the experience of financial globalisation that came
with financial openness and intensified by the revolution in information technology. From a regional
perspective, it does seem that Asian finance is organised in such a way that, instead of harnessing its
financial strength to its advantage, it finds itself in a position of vulnerability to financial instability. It is
with this sentiment that I turn now to the subject of Asian monetary co-operation.
Some would argue that the fragmented state of Asian finance, to the extent that it is an issue, is
merely a reflection of the diversity of Asia, in terms of history, geography, culture, stages of economic
development, size distribution, political structure, degree of economic and financial openness, etc.
Indeed, Asia is a very heterogeneous group of economies. In the richest economy, per capita GDP, if
this is an appropriate measure of richness, is about 180 times that of the poorest. By contrast, in the
euro area it is only about four times. And if one assesses the emerging markets of Asia against the
Maastricht criteria, one can conclude rather conveniently that Asian monetary co-operation, implying
Asian Monetary union, is a non-starter. This is even more so considering the virtual absence of labour
mobility and the existence of large patches of different degrees of restrictions in capital mobility.
But the important thing to realise is that the degree of trade integration, and therefore the degree of
interdependence among Asian economies, is very high. About half of total trade in Asia is
intra-regional. This is more or less the same as the proportion of Europe's intra-regional trade to total
trade when the Treaty of Rome was signed. And intra-regional trade within Asia has been growing
rapidly - a trend that is likely to continue in the foreseeable future. There is considerable vertical
integration of the production process in Asia, driven by foreign direct investment flows within Asia and
outsourcing of the process to the area possessing the comparative advantage. China is increasingly
serving as the manufacturing powerhouse of Asian exports, while other Asian economies supply the
raw materials, semi-manufactured goods and machinery. Admittedly, the larger part of intra-regional
trade in Asia, 56% according to our internal estimates2, is related to processing trade, some of which
is to meet demand from the developed economies in North America and Europe. But this reliance on
the demand from the developed markets is likely to decrease over time, as rapid economic growth
within the region promises to provide a sustainable impetus, helped by the dismantling of trade
barriers and the establishment of free trade agreements within the region.
This high and increasing degree of trade integration and regional interdependence has clearly not
been matched by a corresponding degree of financial and monetary integration. It is, of course,
arguable whether there is a need for such correlation or causal relationship, and if so, whether the
market can be relied upon to produce the optimum arrangements in due course without official sector
involvement. My view is that monetary integration is desirable and, given the role of the state in the
monetary system, cannot be achieved by market forces. I hope that, looking at the matter from a
European perspective, you agree with me. The fact of the matter is that diversity or fragmentation
leads to individual vulnerability, and interdependence is synonymous with contagion, particularly
financial contagion. This is notwithstanding the low degree of financial integration and varying degrees
of financial openness. The ingenuity of the financial community can be relied upon to establish
financial linkages, where there is none officially allowed, through which what appears to be
unmanageable financial risks can be managed and, consequently, financial contagion can be readily
transmitted. The emerging markets of Asia provide fertile ground for financial innovation. For example,
we hear often that the Hong Kong financial markets provide a perfect hedge, or more modestly, a
proxy hedge, for risks in the Mainland of China or the region. There is an element of truth in this. After
all, this is one of the roles of an international financial centre. But it does mean that, in Asia, the
dynamics of financial contagion can be quite complex. For example, financial crises do not necessarily
erupt and manifest themselves at source - somebody sneezes and others get pneumonia.
So, it is only prudent that Asian monetary co-operation should be on the agenda of discussions on
Asian finance, and I have been urging for greater co-operation for some time. I am therefore glad that
there has been increasing attention given to the subject in recent years. But, in terms of actual
co-operative initiatives, progress has been slow and the scope rather narrow. To be fair, there is
consensus on the need for diversification of financial intermediation channels, for enhancing efficiency
and financial stability, and this consensus has been manifested in co-operative efforts to develop the
bond markets in Asia. There are three clusters of initiatives:
•
The first is the APEC Initiative on the Development of Securitisation and Credit Guarantee
Markets, which is spearheaded by three APEC member economies, namely, Hong Kong,
Thailand and Korea, and sponsored by the World Bank;
•
The second is the Asian Bond Market Initiative (ABMI) of the ASEAN+3 forum; and
•
The third is the Asian Bond Fund initiative of EMEAP, comprising eleven central banks in the
region, which has successfully launched ABF1, denominated in US dollars and has been
working hard on ABF2 to be denominated in domestic currencies.
There is inevitably competition among these forums, some overlap on the issues being addressed and
use of different strategies. In Asia there is no political or institutional framework comparable to the one
in Europe for taking a more focussed approach and for co-ordinating efforts. But all the initiatives have
the common aim of addressing the structural impediments to the development of bond markets,
including for example harmonising standards and practices, and creating the necessary regional
financial infrastructure to facilitate this much needed development. There is momentum built up and I
am hopeful that we should see significant progress made in the years to come.
But I think the long-term solution to the problems of Asian finance lies in co-operation in respect of
currency arrangements. If, as I argued, financial market fragmentation in Asia leads to individual
vulnerability to financial instability, and through contagion regional vulnerability, then one intuitive
solution is to integrate the fragmented markets through some form of monetary union. Admittedly, a
monetary union does not remove all sources of financial instability in the region, which could arise
from volatile business cycles, for example, boom and bust induced by inappropriate policies, and
moral hazard induced, for example, by implicit government-guarantee of bad credit. But it does take
care of financial instability associated with volatile capital flows and the associated large swings in real
exchange rates. But, as of now, this is still not an item on the agenda of Asian monetary co-operation,
at least in any official forum that I am aware of. As far as I can recall, there have only been some
limited efforts of mutual assistance:
• The first is the collection of EMEAP bilateral swap facilities that provide US dollar liquidity
secured against US Treasury securities that were put together in November 1995, which
have not been used;
• The second is the idea originating from Japan in 1997 for an Asian Monetary Fund, which
did not go beyond being an idea; and
•
The third is the collection of ASEAN+3 bilateral swap arrangements (between the US dollar
and domestic currencies) under the Chiang Mai Initiative, which involve the assumption of
credit risks.
There is, in fact, continued scepticism towards any form of monetary union in Asia. Perhaps this is
because the structure of the European model - the only successful example - requires convergence as
a pre-requisite. As I mentioned earlier, in many respects, Asia is much more heterogeneous than
Europe, so that convergence realistically will take time, even if there is agreement to converge. But my
view is that since it takes so long - 50 years in the case of Europe - we'd better start at least the
thinking process early, hadn't we? And we can also afford to be imaginative if it is something that aged
people like us won't see in our lifetime. The flexibility of Asia is well recognised. We only have to look
at how individual economies bounced back after the Asian financial crisis. Perhaps they are flexible
enough for convergence to be forced onto them by just plunging in. And to ease the way, how about
an interim arrangement that provides intra-regional exchange rate stability through hard pegs to a
synthetic, floating Asian currency unit? Perhaps the International Centre for Banking and Monetary
Studies has wise observations to offer. I myself have found it difficult and a little frustrating to go
beyond articulating the problems and the unsustainable nature of Asian finance, raising interests and
asking questions.
China
Let me now turn to China. I notice that there is considerable interest in the international financial
community in the banking and monetary developments there. This is understandable, given the sheer
size of China and, particularly for Asia, where China is now a most important component of an
economically integrated region. As I argued earlier, interdependence is synonymous with the
transmission of financial shocks, particularly financial contagion. It is therefore in the interests of others
in Asia to understand China, where the dilemma between pursuing financial openness and the
maintenance of financial stability is a most difficult one to resolve. The ability of China to get it right in
meeting the many challenges of this task has serious implications for all. And, as I also argued earlier,
the dynamics of Asian finance are such that financial crises do not necessarily occur or be most
serious at source. The task confronting China is, arguably, a task for others in Asia as well. Whether
one adopts the inward-looking attitude of trying to limit possible contagion to the domestic market, or
becomes more proactive in contributing, through appropriate assistance and co-operation, to the
effective performance of that task in China, or both, is a matter of choice for individual jurisdictions. For
Hong Kong Special Administrative Region, which is part of China but operates different banking and
monetary systems under the arrangement of "One Country, Two Systems", we are too close to the
Mainland to afford to be inward looking. Indeed, from the business perspective and being the
international financial centre of China, we must position ourselves for and try and make the best of the
opportunities that come with the inevitable process of financial liberalisation of the Mainland. So we
spend much of our time and attention on monetary and financial issues on the Mainland. But I must
still confess an occasional inability to understand exactly what goes on there.
With a high savings rate, rapid economic growth, and the attraction of an emerging market of
mammoth dimensions and ample opportunities, the Mainland of China can afford to adopt a cautious
approach to financial liberalisation. Even with continuing, tight capital controls, there is no lack of
foreign direct investments. The size and strength of the economic magnet of Mainland China are such
that it has become, for a number of economies in the region, one of the largest trading partner and
destination for outward direct investment. Foreign portfolio investments into the Mainland of China, to
the extent that these opportunities are available, for example, in the stock market of Hong Kong, are
also in great demand. With an abundance of domestic savings (the savings rate is around 30% to
40%), the emphasis is on financial sector reform, to enhance the efficiency of domestic financial
intermediation, in order to sustain growth and development, rather than to attract an inflow of foreign
savings. And the d