Opening and Innovation on Financial Emerging Markets

I would like to thank the organisers for the opportunity to speak at this conference on "Opening and Innovation on Financial Emerging Markets". The topics that will be discussed today and tomorrow are clearly central to the issue of the role of financial markets in fostering real economic growth and welfare, and it is both an honour and a challenge to participate in this introductory panel. The title of the panel is "Regulation and Financial Markets in Asia". I will interpret this topic relatively broadly and discuss the implications of two important developments in the region, one relating to exchange rate arrangements and the other to the integration of the region's financial markets.

Before I continue I should make a disclaimer that my remarks represent my own opinions and not necessarily those of my employer, the Hong Kong Monetary Authority.

The two trends in financial and monetary relations that I will discuss are the movement towards greater financial integration on the one hand and proposals for some form of common exchange rate policy on the other. After having described the rationale behind these trends, I will argue they may not be compatible with each other in the absence of a centralised monetary policy. After suggesting that such a centralised monetary policy in the region is not likely to emerge, I will finally draw some conclusion for monetary co-operation in the region.

The goal of a financially integrated area

In the wake of the financial crisis that hit the region some 10 years ago, the desirability of financial openness was seriously questioned both in academic circles and among policy makers. Indeed, while capital account openness was maintained in jurisdictions like Hong Kong, restrictions on international capital flows were tightened in some economies, notably Malaysia. As time has passed, and as the economies in the region have become stronger and more resilient, the arguments in favour of greater financial integration have re-emerged. I will not repeat the usual arguments relating to the benefits of such integration that derived from portfolio diversification, consumption smoothing, greater competition etc. which you are all familiar with. I will instead point to two lines of reasoning, which have a particularly regional flavour. One stems from the observation that a large proportion of the high regional savings is invested in relatively low-yield assets in developed markets, only to return in the form of high-yield FDI. Why, it is asked, should the region pay the intermediation spread to developed economies rather than capturing it locally through a process of regional financial integration? The second argument is that a more integrated, and therefore larger, regional sovereign bond market can stimulate the development of a corporate bond market which may lower the cost of capital for enterprises and spur investment and growth.

A concrete outcome of this line of reasoning is the ABF initiative, which to some extent has been a driving force behind measures to eliminate obstacles to market integration in the region. What I would like to draw our attention to in this context is that market integration is a sine qua non for the creation of a regional bond market. Market integration means the equalisation of risk-adjusted returns and constraints on the choices of monetary and exchange rate policies of central banks in the integrated area.

When we look at the current situation in East Asia with regard to international capital mobility, we see significant heterogeneity across economies. Of course, there are difficulties associated with trying to measure the degree of capital mobility. For example, de facto and de jure measures may differ due to evasion of controls. I will not discuss these further here, but regardless of which measure one uses, three economies can be identified as having completely open financial markets; these are Hong Kong, Japan and Singapore. South Korea and, more recently, Malaysia are not far behind. Indonesia, the Philippines and Thailand have less open markets, and Mainland China does of course still have substantial restrictions on international capital movements. But it is important to recognise that regulations of capital movements are changing over time, and the trend is towards increasing openness, even if there are occasional reversals in this trend as witnessed in the measures introduced in Thailand in December of last year.

Proposals for co-ordinated exchange-rate policies

Whereas initiatives to financial integrations are mostly taken at the official level, proposals for some co-ordination of exchange-rate policies originate principally in academic circles and policy think tanks. The motivation and objective behind these proposals can be divided into near-term and long-term concerns. The near-term objective is to avoid misalignments among currencies in the region that may be brought about either by market forces or deliberate policy actions. Such misalignments, it is feared, could have significant negative effects on traded-goods sectors in the region.

Another motivation behind arguments for coordinating exchange-rate policies is to overcome a perceived reluctance of central banks in the region to allow their currencies to appreciate relative to the US dollar and thereby contribute to reducing the current account deficit of the US. The reluctance to permit an appreciation is said to be due to a co-ordination failure whereby no central bank would like to allow any appreciation of its currency in the absence of a similar appreciation of other regional currencies. While there might be some truth to this argument, I would point to the sizable appreciations of the Korean won and the Thai baht during 2006 as a reason why it should not be pushed too far.

Some proposals for co-ordinated exchange rate policies also have a long-term objective in mind: to pave the way for some form of monetary union in the region. I will comment briefly on this issue at the end of my remarks.

Implications for monetary policy

Proposals for the co-ordination of exchange rate policies typically involve some form of peg to a common basket, together with a band around the central parity, and a crawl. Hence the term BBC (basket, band, and crawl) given to them. It is very important to be clear about the implications for monetary policy of such exchange rate pegs in the context of integrated financial markets. If the common currency basket contains currencies external to the region, monetary policy will effectively be delegated to the corresponding external central banks. Interest rates in the region will be determined by the Fed, the ECB, or whoever represents the currencies in the common basket. If the basket contains only currencies internal to the region, then the so-called "n-1 problem" implies that monetary policy will have to be delegated either to a common monetary institution or to one of the member countries. I find it hard to envisage that either of these implications will be judged either attractive or acceptable in the foreseeable future.

The implications of a high degree of international market integration can also be viewed from a slightly different perspective. It is well known that only two of the following three conditions can be attained: complete financial integration, fixed exchange rates, and independent monetary policies. If East Asia were to adopt the first two, then the third would have to be forgone, otherwise it is likely that speculative attacks and currency crises would occur. The experience of the monetary integration process in Europe is instructive in this regard. But what are really the lessons one should draw from the European experience?

Lessons from European monetary integration

According to my reading of the record, the coexistence of the ERM (Exchange Rate Mechanism) and free capital mobility contributed importantly to the emergence of both mini and maxi exchange rate crises in Europe throughout the 1980s and 1990s. The reason was that member central banks were not initially able (or willing) to commit to giving up some monetary policy autonomy. Of course, there were countries that did give up policy autonomy: the Netherlands, Luxemburg and later Austria are good examples. These central banks had made it quite clear that interest rate policies would follow very closely those of the Bundesbank and it is not a surprise, therefore, that they were not directly affected by the ERM crisis in 1992. Other countries such as France, Italy and the UK on the other hand did not give up monetary independence completely with the result that speculative attacks and currency crises eventually followed.

Lessons from Europe also contain some more positive elements that Asian central banks and policy makers should keep in mind. Let me mention two particularly important aspects in my view. One is the important role of institutional development in the monetary integration process, and the other is the crucial importance of the adoption of a common objective for monetary policy among the central banks that participated in the integration process. Arguably it was only until the other central banks in the European system had effectively delegated the conduct of monetary policy to the German Bundesbank that the system stabilised.

An Asian approach to regional monetary co-operation.

My analysis leads me to the conclusion that Asian central banks should not follow the European approach, which involved fixed exchange rate and free capital mobility. Instead they should go for independent monetary policies to accompany the increased financial integration. The reason is that financial integration is already being pursued and the revealed preferences among central banks suggest that they are unwilling to commit to fixed exchange rates. Attempting to adopt some form of BBC scheme under these circumstances would be to invite speculative attacks and currency crises.

I would argue that co-ordination should instead focus on ultimate monetary policy objectives, such as inflation, rather than on intermediate targets such as exchange rates. Co-ordination could also involve consultations and peer surveillance of policies so as to address concerns that countries might be following beggar thy neighbour policies. Under this scheme each individual central bank would be responsible for attaining its objective but consultations and surveillance would ensure that it would not do so at the detriment of the other economies in the group. This scheme would also permit countries that so desired to proceed towards some form of monetary unification by building the appropriate institutional infrastructure to support such a process.

To summarise, the proposed Asian approach to financial integration and monetary policy would reduce the risk of currency crises, permit some mutual surveillance of policies to reduce the risk of conflict related to exchange rate movements, and allow for an evolutionary approach towards monetary unification among countries that would like to move in this direction, while at the same time it would not constrain central banks that do not wish to participate in deep integration.

How many independent central banks in Asia?

What does this imply for the idea of a monetary union in Asia? My view is that a region-wide monetary unification is a long long way away, if indeed it will happen at all. A common currency implies a common central bank, which raises important sovereignty issues. It seems very unlikely to me that the three big economies in the region will be interested in outsourcing monetary policy to an independent supranational institution.

The smaller economies in South-East Asia may conclude that a common monetary area would be in their best interest if the strategy of inflation targeting they are currently following turns out not to deliver satisfactory outcomes. But judging by the longevity of inflation targeting strategies in other parts of the world, it could very well be that the status quo will prevail for a long time even among these countries.