OverviewSince the East Asian financial crisis; sec II ie.,

OverviewSince the early 1960s, the Asian economies transformed from rural-based developing structure, underwent industrialization and sustained rapid economic growth. It includes Japan; the Four Tigers ie., Hong Kong, Taiwan, Singapore, South Korea; and NIE’s (newly industrializing economies) of South-east Asia ie., Indonesia, Malaysia and Thailand. Its magnificent success in the economic history is no less than “miracles”. However, a period of financial crisis gripped East Asia in 1997 due to financial contagion following the devaluation of Thai currency baht. South Korea suffered severely with negative growth, falling GDP, burdening foreign debts, and stock market crash, along with Thailand and Indonesia. As a lesson, the East Asian Economic Crisis of 1997-98 reflected the necessity of developing financial stability to support trade and investment. Subsequently by 1999, the economies have been recovering and East Asia now has emerged as a significant net exporter of capital to the rest of the world.An East Asian Renaissance: Ideas for Economic Growth published by The World Bank in 2007 points out the remarkable changes in the East Asian economies since the crisis with increasing regional integration and socio-economic transformation. It also highlights the necessary developmental strategies that the East Asian economies should adopt, to address and counter the emerging problems in the domestic sphere ranging from rising inequality to corruption. The following assigned essay deals with chapter IV, namely Finance of Indermit Gill and Homi Kharas’s An East Asian Renaissance: Ideas for Economic Growth. This particular chapter deals with the changing structure of finance in the East Asian region and takes into account of the challenges that needs to be addressed for continuous growth, improved trade and innovation. The chapter consists of 3 sections with a conclusion: sec I ie., From Breakdown to Buildup deals with pre-Crisis 1997-98 and the factors that caused the East Asian financial crisis; sec II ie., The Pattern of Global and Regional Financial Integration highlights the nature of international capital flows, FDI, Foreign Exchange Reserve accumulation and regional financial cooperation; and lastly sec III ie., Toward More Robust Domestic Financial Markets discusses about the financial market reforms, particularly banking and securities markets.Production networks mentioned in the first half of sec I, mentions of Global Production Networks (GPN) operating worldwide through cross-border financial services. However, such cross-border services and transactions may lead to currency risk and credit risk. Thus, governments and local banks acted as a vehicle to minimize currency risk and credit risk. In case of East Asia, production networks developed rapidly after the Plaza Accord in 1985, which recognized the Japanese yen against US dollar. Japan was also the first country to adopt offshoring. Since then, Japanese banks and foreign investors played a crucial role in the development of East Asian production networks.The other half of section I points out the possible factors that caused the East Asian financial crisis of 1997-98.East Asia suffered from a major capital reversal during the crisis because of :-Outflow attributed to Japanese banks,Depreciation of the Japanese yen against the US dollar,Fall in the Nikkei stock index increased the loan-capital ratio of major Japanese banks.The crisis coincided with growth in international capital markets. With bank lending, portfolio flows from abroad increased in response to rising local equity markets. Weak supervision of local banks and poor credit culture among the severely affected economies. Monitoring and oversight function which is supposed to be associated with bank credits was also absent in many East Asian economies.Therefore, many observers outlined three necessary steps to be corrected. They were:- need for a more reliable mechanism to ensure foreign exchange predictability; need for more effective mechanism to price credit risk;need for a more thorough corporate governance to reduce agency problems.Frankel in 1999 came up with three desirable goals that East Asian policy makers tried, known as “impossible trinity” –They tried to shift towards capital account convertibility to ease the flow of capital and production networks.They tried to fix the exchange rate to minimize foreign exchange risk.They tried to pursue an easy monetary policy to encourage investment and maintain growth.The nature of international capital flows has changed noticeably since the crisis in section II. Across East Asia, FDI has been important for capital formation and technology upgradation. Geographical proximity and market size are the significant determinant of FDI location.Subsequently, FDI flows declined in absolute value as the GDP and trade fell during 1997-98 crisis – FDI collapsed only in Indonesia, whereas in Korea and Thailand the level of FDI increased after the crisis as a result of mergers and acquisitions (M&A) from the economic reforms. Recently Hong Kong, Korea, Singapore and Taiwan have become a major source of FDI in the region. Key concerns outlined by the World Bank – macroeconomic risk, regulatory and policy risk, availability of skills, infrastructure quality and corruption. Thus, management in about 20% firms in East Asia feels that access to finance is a major obstacle.At the time of crisis, most analysts concluded that ensuring macroeconomic policy and healthy domestic banking system are the important components to reduce the likelihood of capital flow reversals. A more effective integration of domestic capital markets is suggested in the form of –Practically, possibility of regional integration is more likely to occur than global integration. For this, Portes and Rey in 1999 highlighted the importance of information asymmetries in capital market integration. According to the survey of IMF, value of foreign portfolio investment in stocks and bonds coming to East Asia rose from 9% in 1997 to 14% in 2003. To estimate econometrically the movement of equity returns in a country with equity movements in another country is perhaps a different way of looking at the integration. This approach has been used for East Asia by Kharas, Aldaz-Carroll and Rahardja in 2007 for two periods: pre-Crisis and post-Crisis. Post-crisis, the equity markets in East Asia showed great integration with the region and with US-Japan as well.Foreign exchange reserves provide a way to reduce the risk of a sudden capital flow reversal. East Asia accounts for about one-half of global reserve accumulation in the world – China and Japan as the leading device, Korean and NIE’s reserves expanded significantly since the crisis. Asia’s accumulation of reserves stems from a desire to maintain stable and competitive exchange rates to export as a solution to the crisis of 1997-98. Some of the various explanations of the accumulation of reserves resulting in different policy implications are –The precautionary approach links the accumulation of reserves directly to the exposure to volatility, capital fights and sudden stops.The mercantilist approach views the accumulation of reserves as a leftover of an industrial policy that may impose negative externalities on trading partners.The third explanation focuses on the risk properties of foreign exchange reserves held largely in liquid investments and foreign portfolio capital which is risk-bearing.Besides foreign exchange reserves, the other options to reduce the risk of sudden capital flow reversal are –Chiang Mai InitiativeEst. in May 2000 under ASEAN+3, the central banks of the 13 ASEAN+3 countries agreed to make lines of credit available to each other in any event of financial crisis, providing timely data provision, regional surveillance through regular exchanges, monitoring of capital flows. The Chiang Mai Initiative represents a desire to reduce the need for individual country self-insurance by creating a regional reserve-pooling mechanism and warning mechanism to guard against financial contagion. Development of regional bond fundThe Asian Bond Fund help the region diversify from bank lending to bond financing by reducing constraints and introducing low-cost products on the supply side, raising investor awareness, and broadening the investor base on the demand side.The first Asian Bond Fund was contributed by 11 member governments of the Executives’ Meetings of East Asia-Pacific Central Banks. Each govt. provided about 1% of its reserves to a fund of US$1 billion for purchasing US$ sovereign and semi-sovereign bonds of 8 of the member economies.The second Asian Bond Fund, est. in December 2004 witnessed the mandate of the new fund ie., US$2 billion (doubled the first Asian Bond Fund) to invest in selected domestic currency sovereign and quasi-sovereign bonds of the 8 economies. The second fund comprises 2 components valued at US$1 billion each –The Pan-Asian Bond Index Fund is a single bond fund and the money has been divided according to predetermined criteria – size of the local market, turnover ratio in the market and a market openness factor.The Fund of Bond Funds is a two layered structure consisting of a parent fund that invests in 8 single-market subfunds. The parent fund is limited to investments by central banks that are members of the Executives’ Meetings of East Asia-Pacific Central Banks.After the rapid growth of financial markets in East Asia since the crisis, significant financial market reforms have been undertaken as given in section III. Banks have been restructured and recapitalized, regulation have been strengthened, healthier balance sheets of businesses and expansion of consumer lending by banks for greater revenue base.BankingIn East Asia, the banking sector in present is much healthier than it was during the crisis. Average level of state ownership in the top 10 banks has decline, while the average foreign ownership has increased instead. Such modifications improved the efficiency of the system (One measure of efficiency = ratio of operating costs to total assets). Hong Kong banks have the lowest operating costs, while Indonesia and the Philippines have higher operating costs. Low operating costs have also permitted banks to improve their financial stability and robustness. Both Indonesia and Thailand had nonperforming loan ratios of 48% and 45% in 1998, which by 2005 came down to 7.6% and 8.3%. Similarly in Korea as well the ratio has fallen to 1.2% only.Post-crisis, corporate customers of banks on the other hand also reflected healthier balance sheets. By 2004, Korea’s leverage ratios declined to 49%, Thailand by 47% (earlier 94%), while Indonesia still remained high as of 68% (earlier 71%). Banks in East Asia have been improving their balance sheets by cutting back on credit to the private sector which goes mostly to customers rather than to corporates. In 2004, consumer lending accounted for 49% of total credit in Korea, 53% in Malaysia, 30% in Indonesia and 17% in Thailand. Thus, the nature of banking system in East Asia has definitely changed where banks are now engaged in a no. of investment activities and lending to households.Securities MarketsSince 1997, securities markets have grown incredibly in the East Asian region. Stock market capitalization sky-rocketed to US$2.3 trillion, and bond markets upto US$1.5 trillion. Hong Kong and Singapore have well-developed markets; while China, Indonesia and the Philippines have significantly weaker systems. Korea and Malaysia have relatively large bond markets; Thailand on the other hand experienced one of the most rapid growth rates. Smaller corporates are unable to access securities markets because of their small size; therefore liquidity in their paper is low. Here, liquidity is the key determinant of efficiency. Without liquidity, the market is unable to develop. East Asia can be described as a region with high liquidity due to sizable amount of domestic savings generated.The Conclusion of this chapter points out the necessity of corporate bond market, financial structure and firm performance, and need for risk management in financial markets.Till date, a healthy corporate bond market is required to manage risk through higher pricing, and bring about a more diversified set of investors to the market.In East Asian financial markets, development of securities markets is important because the financial structure exerts an influence on firm performance.Bank credits: For small incremental innovations, bank lending is efficient enough as the bank appraise the new technology adequately and can afford to lend greater sums.On the other hand, banks become conservative when innovations are more significant. Here, capital markets are preferred which clusters a firm of group investors who believe in new technology, and provide long-term capital.Thus, bank credits stand for incremental innovation, while capital markets are suited for radical technological change.In case of East Asia, financial markets have shifted its focus to risk allocation rather than resource allocation. The economies are now less vulnerable to sudden shifts in investor behavior due to the financial structure shifted towards FDI and diversified financing sources. However, there are still some economies possessing weakness. Credit risks remain as a major constraint. Capital markets have not developed rapidly enough to offer viable alternative source of funding. Therefore, the region has to address the imbalance through regional cooperation, and to develop equity and bond markets for more effective risk sharing both in domestic as well as global markets.About the AuthorIndermit Gill is the Director for Development Policy at DEC unit of the World Bank. He joined the World Bank in 1993 and was the Director of the World Development Report 2009: Reshaping Economic Geography.Most importantly, he introduced the concept of the “middle income traps” to describe how developing economies stagnate after reaching a certain level of income.Homi KharasBefore entering the Brookings Institution in 2005, he spent his 26 years at the World Bank, serving as the Chief Economist for the World Bank’s East Asia and Pacific region. Out there along with Indermit Gill, he developed the concept of “middle income traps”. He is now a Senior Fellow and Deputy Director in the Global Economy and Development program of the Brookings Institution.AnalysisUnlike the other books published on the rapid industrializations of EA of early 1970s and financial crisis of 1997-98 such as East Asian Miracle, “The East Asian Crisis and the Globalization Discourse” (Review of International Political Economy) and “The Asian Debt and Development Crisis of 1997: Causes and Consequences” (World Development), this particular book An East Asian Renaissance: Ideas for Economic Growth touched upon the future agenda of East Asian’s middle income economies. The assigned chapter “Finance” exactly looks upon the development of regional integration through accelerating trade, finance and technology linkages. Led by China, the East Asian economies now are gearing up for the challenge of domestic integration affected by growing corruption and increased income inequalities, which is further addressed in the chapter “Cohesion” and “Corruption” of the same book. Conclusion”Finance” as a chapter highlighted almost all the potential components – ranging from production networks to FDI, accumulation of foreign exchange reserves and regional financial cooperation, and significant market reforms; undertaken in the East Asian economies post-Crisis. The chapter not only dealt theoretically but also compared amongst the EA countries through surveys from certified sources.Going against Alan Greenspan’s famous remark “East Asia had no spare time” pointing to the Crisis and its brutal aftermaths, the present scenario reflects the opposite but not full-fledged.