East Asia's Financial Integration Progressing but Still Low - ADB Report

HONG KONG, CHINA  - East Asia's financial integration is making progress, but remains at a low level, held back by institutional and regulatory barriers, according to a report released today by ADB.

Cross-market differentials in interest rates and bond yields are declining, but are still significant; while intraregional cross-border portfolio investment is growing, yet is small relative to East Asia's total cross-border portfolio flows, says the November issue of Asia Bond Monitor (ABM).

The report examines local currency bond market development and the status of financial integration in the Association of Southeast Asian Nations member countries, plus the People's Republic of China (PRC), Japan, and the Republic of Korea.

The report finds there are still significant differences in the openness of East Asia's economies, with Japan; Singapore; and Hong Kong, China leading the way with no or minimal restrictions on cross-border investment, while the Republic of Korea is also opening up. In other East Asian economies, however, there are various restrictions on cross-border capital flows, particularly on residents investing abroad, the report says.

East Asian financial markets have advanced significantly, ABM says, but many remain underdeveloped, especially bond markets, again with considerable variations across the region.

The report says that despite strong growth since the 1997 Asian financial crisis, emerging East Asian local currency bond markets remain small relative to OECD averages for both government and corporate segments. Total local currency bonds outstanding worldwide stood at US$44 trillion at the end of 2004, with the US accounting for 44%, the EU15 for 26%, and Japan for 20%. The share for emerging Asia was only 3%, less than half of its 8% combined share of Global GDP.

Most emerging East Asian bond markets are illiquid. For example, in 2004, the annual turnover ratio for local currency government bonds was 0.7 for Indonesia; about 2.0 for PRC, Malaysia, and Thailand; and a little over 3.0 for the Republic of Korea and Singapore, compared with about 24 for US Treasuries.

Many of the region's local currency bond markets are held back by structural weaknesses, including limited varieties of fixed income securities, a narrow investor base, lack of derivative markets, weak creditor rights, and poor disclosure practices.

The relatively small size, low liquidity, and structural weaknesses of the region's financial markets hinder financial integration, as these limit investor choice, increase transaction costs, and lead to high perceived risks, the report says.

"Developing mature local currency bond markets is an essential step in strengthening individual financial systems in East Asia and fostering greater financial integration across the region," says Masahiro Kawai, Head of ADB's Office of Regional Economic Integration (OREI). "Although we have made good progress, there is still a long road ahead."

In addition to declining cross-market interest rate and bond yield differentials, the report also cites evidence that East Asia is making progress in financial integration, including increasing cross-market co-movements in money markets and bond markets; East Asian investors' significant purchases of US dollar- and euro-denominated debt instruments issued by East Asian issuers; and East Asian Banks' participation in the region's syndicated loan markets.

"Regional cooperation is important in facilitating East Asian financial integration," says ABM. Monetary and financial cooperation has indeed moved forward, especially under the ASEAN+3 Finance Ministers' Process, including the Asian Bond Markets Initiative (ABMI). Another important initiative is the launch of Asian Bond Funds by the Executive Meeting of East Asia-Pacific Central Banks (EMEAP). These efforts should be applauded, and accelerated.