The Group of Seven finance ministers’ initiative to encourage development of local capital markets in Asian and other emerging markets should be applauded. It highlights a problem bedevilling many countries in Asia and one that handicaps their ability to push for long-term high, sustainable growth.
Immature and illiquid domestic capital markets damp domestic investment and increase reliance on foreign financing. The resulting underinvestment is reflected in large current account surpluses. Often overlooked, however, is the broader impact of poorly developed debt markets on regional economic and monetary policymaking. A big issue facing many Asian countries – and an important concern for Standard & Poor’s in assessing sovereign creditworthiness – is the extent of their monetary flexibility, in particular their ability to respond to inflation.
Current account surpluses, capital inflows and concerns over export competitiveness complicate monetary policymaking across the region. These pressures have prompted many Asian central banks to engage in foreign exchange intervention, in order to damp their currencies and maintain international competitiveness.
Currency intervention, however, carries a price. It injects liquidity into domestic money markets, raising the risk that interest rates could fall below the level judged to be appropriate for low inflation. So governments have tended to resort to “sterilisation” operations – usually through the issuance of government or central bank debt securities – in order to mop up excess liquidity from money markets.
In these circumstances, where domestic interest rates are relatively high, central banks suffer a negative “cost of carry” on their foreign exchange holdings. Their monetary flexibility is constrained because further rises in domestic interest rates bring increased losses for the authorities – a problem keenly felt in the Philippines, Korea and Thailand.
Driven partly by these concerns, Thailand took the dramatic step of introducing controls on capital inflows last December. The move only temporarily halted the rise of the Thai baht but had longer-lasting effects for Thai companies, which have experienced higher financing costs since then. The costs of this policy are likely to outweigh the benefits of a more competitive exchange rate.
Even with domestic interest rates still some way below US dollar rates, China’s huge foreign exchange reserves – already the largest before the unexpected surge recently – have also created a monetary conundrum. Despite capital investment running ahead too rapidly for the authorities’ comfort, official interest rates have been raised by only 1.08 percentage points since 2004. Apart from fears of attracting more capital inflows, the People’s Bank of China was probably also concerned about the cost of carry on its foreign exchange holdings.
Capital inflows related to the ongoing yen carry trade and limited currency appreciation in China, the main benchmark against which other Asian countries measure their trade competitiveness, mean that Asian central banks are unlikely to stop their intervention activities any time soon. This increases the risk that they will be unable to respond effectively to mounting economic pressures.
Yet solutions are available, if the political will is there. In particular, governments can pave the way for future liberalisation of exchange rates.
The non-tradable sector, especially domestic services industries, should be opened up to greater competition and excessive regulatory restrictions dismantled. And there is a need to promote vibrant local capital markets.
Underdeveloped capital markets in Asia impede the efficient use of domestic savings. Introducing more liquid capital markets will increase flexibility, make prices more responsive to structural changes and facilitate a rational distribution of resources. Local bond markets can be stimulated by deregulation, opening markets to foreign investors, independent credit research and greater financial innovation.
It is no surprise that two of the fastest growing, highest income earning and highest rated Asian economies – Hong Kong and Singapore – are among the most liberal, with the most robust capital markets. The G7 recognises the chances for others to emulate this success – and it is important for the stable growth of the region that they do so.
The writer is executive managing director and head of Asia-Pacific, Standard & Poor’s