Tarisa Watanagase: Emerging markets in financial globalization -
striking the right balance for liberalization
Luncheon address by Dr Tarisa Watanagase, Governor of the Bank of Thailand, at the
conference "Asian Banking - Challenges and Opportunities", San Francisco,
6 September 2007.
* * *
Madam President and CEO of the Federal Reserve Bank of San Francisco,
Distinguished Participants,
Ladies and Gentlemen,
I am delighted to be here, among this distinguished gathering of policymakers, financial
experts, and keen watchers of Asian banking developments, to deliver a message on the
prospects for economic growth and stability in Asia. Given Asia's diversity, I would like to
focus my talk today on Asian emerging markets' experience and challenges going forward. In
particular, I would like to highlight to you the near-term challenges of coping with rapid
exchange rate appreciation and volatile capital flows and the need for a more flexible
economy for better financial resiliency over the medium to long term. I will also touch on the
implications for the banking sector, which is the predominant financial sector in most
emerging markets.
One decade after the crisis, emerging Asia is vibrant. They also look less vulnerable to
financial disturbances. Asian emerging markets are learning to live with heightened
uncertainty in the world where the extent and the whereabouts of the risks are unclear, and
which necessitates that every player manages his own risk better. In this highly integrated
world, small open Asian economies want to take advantage of financial globalization to
promote sustained increase in living standards. Over time, they wish to move from
incomplete financial market to a better world of risk-sharing, risk absorption, and
diversification. But there is tension to be managed in the short run. Under Bretton Woods II,
in which much of Asia is still tightly linked to the fortune of the US dollar, and in the context of
ongoing "global imbalances," emerging markets need to strike a balance between financial
stability and financial development. In particular, when our markets and institutions are still
developing, the struggle between financial integration and financial stability, enterprise and
prudence, requires from us a deft balancing act.
Ladies and Gentlemen,
From a historical perspective, today's emerging markets are unique in their common
experience. This uniqueness is twofold. On the one hand, it is quite apparent that our
openness has gained us immense benefit from global economic integration, the
phenomenon denied to advanced economies when they started off. At the same time, and as
a result of our openness, small developing economies face risks and volatilities that
accompany financial globalization, the scale of which advanced economies never had to face
in their early stages.
In fact, sustained increase in living standards is a relatively new economic phenomenon to
emerging markets. Having experienced modern economic growth after 1950, we are late
comers. And having much to benefit from being late, it took us a much shorter time to treble
our per-capita income than today's advanced economies did between 1800 and 1950.1
Indeed, international difference in living standards has declined over the latter half of the
twentieth century as a result of emerging markets' fast-pace and sustained growth. During
the past 20 years, the world's income gap has narrowed even faster. It cannot be by sheer
coincidence that this period has also witnessed growing international trade and financial
integration and the entrance of China, and subsequently India, into the comity of trading
nations.
Along these high growth trajectories, emerging markets' aggregate real income and
consumption are an order of magnitude more volatile than advanced economies (both in
terms of levels and growth rates). Not only is consumption more volatile in emerging
markets, but it is also more volatile in relation to income. In fact, over the business cycle,
consumption is around 40 percent more volatile than income for emerging markets, while it is
less volatile than income for advanced economies. The unique volatility outcomes can be
attributed to a distinct set of macroeconomic shocks which are specific to emerging markets
or their propagation mechanism, or both.2 I think that the extraordinary volatility in real
aggregate consumption and income can be partially attributed to episodes of financial
instability that occur not infrequently in emerging markets. In fact, these bouts of extreme
instability have disrupted the potential growth trends, which in some cases have taken years
to recover. On the whole, these episodes may be associated with too much financial
liberalization too soon.
The unique global backdrop, as well as the economic outcomes in terms of growth and
volatility that I have just shared with you, presents a real dilemma and at times tension in
emerging Asia. And nowhere is this tension more palpable than it is in the realm of exchange
rate and capital account regimes. While benefits from trade integration are appreciated and
shared by billions the world over, net benefits from international financial integration have not
been so apparent in Asia and emerging economies in general. This is consistent with an
observation that Asian emerging markets rely increasingly more on trade integration because
it is judged to be a safer mode of risk-sharing with the world. As a result, while the pace of
financial integration has far outstripped trade integration in advanced economies, it has only
managed to keep pace with trade integration in emerging markets.3
Ladies and Gentlemen,
Asian economies and policymakers have come a long way in their attitude toward
macroeconomic risk management since 1997. Countries have taken unilateral actions to
promote economic and financial resiliency.
Having appreciated the evidence that macroeconomic stability provides an environment that
is conducive for sustained growth, Asian emerging markets have continued to pursue fiscal
discipline and more flexible exchange rates on the whole.
The result is improved fiscal balances and better public debt structure, which is heavy toward
longer maturities and domestic-currency denominated. Monetary policy's first priority is to
achieve long-term price stability, and in certain countries, Thailand included, central banks
actively pursue explicit inflation targets.
To be sure, countries have made efforts to ensure stronger prudential regulation and
supervision of banks. The evidence is mixed on this front, but increasingly, more countries
are adopting risk-based supervision and international accounting standards, including Basel
II and IAS 39. A number of Asian emerging economies have also achieved significant
consolidation and modernization of their financial institutions. They have built up new legal
and information infrastructure to strengthen the foundation for financial system capacity for
crisis prevention and resolution. In some countries, new foreclosure laws, bankruptcy laws,
debt restructuring mechanisms, and credit bureaus, which were absent before 1997, are now
in place. Public and private efforts have stepped up significantly to expand the capital
markets domestically as well as regionally. Across the region, policymakers are sharing
knowledge and expertise to ensure efficiency and pragmatism in the implementation of
policy.
Most obviously, Asian countries have also built up international reserves to a multiple of
short-term external debt or other traditional measures of potential claims on reserves. They
have also relied less on foreign debt financing and shifted more toward equity securities and
direct investment.4 This shift in the pattern of capital flows demonstrates to some extent
advances in equity market development and corporate governance in the region.
For a few countries, reserve accumulation partly constitutes a deterrent to the repeat of the
last extreme episode of instability in 1997. As an added benefit, a relatively well-developed
system of prudential banking regulation has also helped these countries avoid speculative
pressures on their exchange rates.
As far as financial integration is concerned, there have been selective and timely capital
account restrictions and liberalization on both inflows and outflows over the years. Much of
this caution derives from the bitter lessons from the 1990s. But, even so, it is worth
mentioning that, measured by total foreign assets and liabilities as a percentage of GDP, the
trend from Bangkok to Seoul is that of more financial integration over the past 20 years.5
Ladies and Gentlemen,
These changes in policies and risk awareness make it less likely that financial market
disturbances will trigger a sharp and broad-based dent to real economic outcomes.
But, it may be a slight overstatement to declare that Asia as a whole has become resilient to
shocks and disturbances today. In a sense, the impressive heights of Asian international
reserves may be construed less as an indication of fundamental strength than as an
indication for needed progress toward modern monetary policy framework. In addition to that,
the size of accumulated global financial vulnerabilities that may unwind in the near future is
by most measures unprecedented; the extent and the whereabouts of the risk concentration
are unclear. And as a result, circumstances of greater macroeconomic adversity may yet
again put to test emerging markets' ability to adjust.
The pressing and practical challenges emerging Asia faces in the near term are three-fold.
Indeed, the three challenges are inter-related. They are "hot money" inflows and large inflows
in general, pressure for rapid domestic currency appreciation, and finally, the potential loss of
monetary autonomy in the sense of independent interest rate policy.
Having done the right thing over the past 10 years, Asian emerging markets have become
darlings of international investors and have had ample access to funds at favorable cost -
although the more powerful underlying reason may ironically be a medium-term flight from
US dollar assets since 2002. With large capital inflow comes pressure for these currencies to
appreciate. In this experience, some currencies appreciate faster than others. In fact, those
that surrender most of their monetary autonomy or maintain restrictions on cross-border
capital flows need not feel immediate pressure to appreciate. But those that have come
further along the liberalization road have to face a different music.
Rapid appreciation in the exchange value of the currency renders part of the domestic
industries less competitive in the global markets. It is true that with this appreciation,
commodity imports such as fuel and energy as well as metal and raw materials have become
more affordable despite rising world price trends. But these benefits are spread-out while the
cost is centered on labor-intensive, high domestic-content primary sectors, such as
agriculture and low-end manufacturing. As a result, even for net primary commodity
importing economies, the nature of the problem is as much political economy as it is
economic. There are strong and vocal constituencies in emerging markets that are averse to
currency appreciation and part of them averse to variability in the exchange rate itself.
Meanwhile, hot money, or indeed large inflows in general, can fuel asset prices and
encourage excessive risk-taking behavior. Central banks may wish to counter that excess in
the interest of financial stability. If the central bank chooses to maintain a high interest rate
stance, the pressure on the currency to appreciate will likely mount.
Not unlike today's political economy in advanced countries, emerging market politics also
risks being less favorable to openness, but more partial to protection of selected industries or
protectionism in general.
As such, I hope you appreciate that, when it comes to policy, there is risk in change as well
as in inertia. This is the fundamental challenge we face.
Since the challenge going forward requires significant ability for emerging economies to
adjust flexibly, what has brought us here may not deliver us safely to prosperity.
Beyond getting the fundamentals right and strengthening them, the solution package we
seek must help reduce the distortions perpetuated on our economies. These distortions
impose real costs and hinder our chances to become more resilient going forward. This
solution package must by default and by design be broad-based.
Allowing the competitive pressure and incentive to operate is undoubtedly the best way to
foster investment in physical and human capital, as well as innovation and risk-taking, all of
which are crucial to long-term productivity growth. They are also crucial for a flexible and
resilient economy. But policy and regulations still have a role to play. The imperative here is
to improve on policy and regulation design that can help deal with market excesses.
On an appropriate degree of financial openness through time, there is little consensus today,
even among leading academic economists. The key here is prioritizing liberalization and
reforms. But the right pacing and sequencing of capital account liberalization in one country
may not be solution for the next.
In order to outline capital account policy priority, I think policymakers in emerging economies
should underline the fact that big market events that pose systemic risks tend to reflect
collective mistakes in which most market participants are offside in the same direction. So, to
reduce the chance of prolonged financial misalignment with economic fundamentals, the
priority for emerging markets may lie in improving the flows and quality of financial
information, corporate and public governance, as well as legal infrastructure to allow in
different players and views.6 With players of different views and risk appetites in the market,
we have a better chance that the financial system will undergo constant self-correction.
Crashes in asset price will also likely be less prolonged and the ensuing economic cost less
devastating.
Emerging markets not only require stronger financial intermediaries and better supervisors,
but also access to deeper and more liquid capital markets. Our own financial markets may
not be deep enough soon enough, but those who are ready for it should not be encumbered
from having access to the world financial markets. Emerging economies that can manage the
risks have benefited from liberalized inflows in the past, but some of these economies may
benefit more if their citizens can unload domestic systematic risk abroad.7 Timely outflow
liberalization may help smooth emerging market's consumption and income, a significant
welfare improvement.
Set in this light, the immediate implications for Asian banks from the challenges that I have
outlined earlier may initially be the deterioration in the quality of their loan portfolios, including
potentially higher non-performing loans. But over time, in response to structural changes
undertaken by other economic sectors as well as increasing disintermediation and
competition from both domestic and foreign players, we should observe stronger and more
competitive banks in emerging markets. This transformed well-supervised, prudent and
enterprising banking sector will remain crucial to the dynamism of Asia.
Ladies and Gentlemen,
Extraordinary emerging market income and consumption volatility may be the result of
macroeconomic shocks, their propagation mechanism as well as policy and institutional
setup, but it can be ameliorated by better risk sharing with the world. In this
welfareenhancing endeavor, international financial integration on top of ongoing trade integration
can play an important role.
To end my talk today, let me share with you briefly the approach taken by Thailand. The
Bank of Thailand has sought a balanced approach to managing capital flows under flexible
exchange rate. We also undertake concomitant reforms in the area of financial system and
market development. These initiatives are closely related and progress in one requires
progress in the others.
In building a resilient economy, prudent fiscal and monetary policy does help. As an
automatic stabilizer, flexible exchange rate also helps. But, prudent macroeconomic
management alone will not raise people's living standard in the long run. We need a balance
between prudence and enterprise or the ability to take risky action and make sound
decisions on the part of the business sector. Otherwise, we risk either having a stagnant,
inefficient economy or building a fast-growing one on a bubble; neither of which we can
afford.
Hence, the priority is the need to design a system that allows for constant self-correction -
one that also lets the economy regain its strength quickly after a severe negative shock. That
system should be underpinned by a strong link to the world economy, which will encourage
innovation and efficiency. The competitive markets should operate under a clear rule of law
with good governance. In support of them, we need an effective and honest government and
supporting institutions that focus on improving resiliency of the economy and sustainable
long-term economic growth.
Ladies and Gentlemen,
Advanced economies do have economic, if not also strategic, interests in the success of
Asian emerging markets. An Asia that is well-adjusted and integrated into the world markets
will add prosperity and stability to the world economy for years to come.
References
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No. 1, pp. 173-204.
2. Aguiar, M. and G. Gopinath (2007). "Emerging market business cycles: The cycle is the
trend," Journal of Political Economy, Vol. 115, pp. 69-102, February.
3. Bannier, C. E. (2005). "Big elephants in small ponds: Do large traders make financial
markets more aggressive?", Journal of Monetary Economics, Vol. 52, No. 8, November, pp.
1517-1531.
4. Henry, P. B. (2006). "Capital account liberalization: Theory, evidence and speculation,"
NBER Working Paper 12698, National Bureau of Economic Research, Cambridge MA,
November.
5. Kose, A., E. Prasad, and M. Terrones (2005), "Growth and Volatility in an Era of
Globalization," IMF Staff Papers, vol. 52, pp. 31-63, International Monetary Fund,
Washington D.C..
6. Lane, P. R. and G. M. Milesi-Ferretti (2006). "The external wealth of nations Mark II:
Revised and extended estimates of foreign assets and liabilities, 1970-2004", Working Paper
WP/06/09, International Monetary Fund, Washington D.C.
7. Parente, S. L. and E. C. Prescott (1999). Barriers to Riches, Third Walras-Pareto Lecture,
University of Lausanne, Switzerland, October.