Asia > Asia Finance Sector crofile

Asia: Asia Finance Sector crofile

2012/08/14

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Asia Finance Sector crofile

  1. Financial sector reforms can help reduce the cost of capital, spur investment, and promote rebalancing in Asi

 THE global debate on imbalances has placed “excess” savings in Asia under international scrutiny. Although the debate has centered mostly on the role of China, savings-investment balances in other countries, especially those of the Association of Southeast Asian Nations (ASEAN) including Indonesia, Malaysia, the Philippines, and Thailand, are also attracting attention.

So does Asia save too much or invest too little? The answer varies across economies: some need to reduce savings, while others need to increase investment. But what can be done to fix imbalances is relevant for most economies. Recent research (Kalra, 2010; Oura, 2008) suggests that investment in some Asian economiesmdashhere—specifically, spending by firms on capital investmentmdashhere—would be higher if financial sector reforms could reduce the cost of capital and allocate capital more efficiently. This would moderate imbalances.


 More robust systems 

Asian economies have so far weathered the onslaught of the latest global downturn with greater ease than in previous crises. Asian firms’ finances have improved significantly since the 1997 crisis. Corporate leverage has declined, and profitability and liquidity have increased. Vulnerability indicators have also improved significantly, and default probabilities in the corporate sector are lower than a decade ago. In short, there is evidence of sounder corporate financing practices and strength in a number of Asian countries hit by the crisis. Financial systems in the region are also stronger. In particular, banking systems’ financial indicators have improved over the past decade. So Asian economies can now increase investment spending to meet higher demand at home as they rebalance toward domestic sources of growth and make the most of the global upswing.

How Asian countries make use of these opportunities will depend, in part, on how well their financial systems can allocate investable funds across various investment projects, both by reducing the cost of capital and by directing funds to where they are needed most. Financial sector reforms can help with both.

 Room for expansion 

Financial systems in a number of Asian economies are still dominated by banks, with small local currency bond markets and little corporate bond issuance within those markets. Stock market capitalization is relatively low in many countries compared with advanced economies in Asia and beyond. Foreign participation in the equity and bond markets is also limited. Indeed, large movements in equity prices generated by periodic bouts of capital inflows are in part indicative of the limited depth and breadth of the stock market. All told, a number of Asian countries’ financial systems need to grow and diversify.

Asian firms do substitute among alternative debt financing options and would actively seek alternatives to bank funding if capital markets were deeper and more liquid. For example, there was a largemdashhere—but temporarymdashhere—spurt in issuance of corporate securities in local currency debt markets in the midst of the global financial crisis in 2008. At the time, these firms’ financing needs were arguably limited, and the issuance of corporate securities reflected a shift from bank financing to bond markets to take advantage of lower spreads (Kalra and Oner, 2010).

 Cost of business 

There is room for Asian financial systems to lower costs and allocate capital more efficiently. In some economies, including India, Indonesia, Malaysia, and Thailand, the cost of capital could be reduced further to levels in other banking systems in the region (Australia, Korea, New Zealand, and Singapore). Reductions in the cost of banking can be achieved through financial sector reforms to strengthen bank balance sheets, reduce nonperforming loans, and improve credit information. In addition, in countries such as Indonesia, structural reform that reduces credit riskmdashhere—for example, through clearer collateral and bankruptcy proceduresmdashhere—would also help lower lending rates.

Cost measures of economies’ banking systems are reflected in the overall cost of capital facing firms. Simple measures of the cost of capital make the point succinctly: countries with higher banking costs generally have higher cost of capital (see chart). Since equity and corporate bond markets are relatively small in a number of Asian countries, the cost of credit from banks determines the cost of capital. These measures of the cost of capitalmdashhere—encompassing cost of equity and debt capitalmdashhere—are constructed in Kalra (2010) along the lines of Ameer (2007). These are comprehensive measures of the cost of capital, which incorporate countries’ price-equity ratios, growth prospects, interest rate on debt, and corporate income tax rates.

And measures that reduce the cost of capital will, most likely, spur investment. Empirical analysis of firm-level capital spending suggests that financing costs are a key determinant of capital expenditures: a lower cost of capital is associated with higher capital spending by firms.

This holds for a range of economies in Asiamdashhere—India, Indonesia, Korea, Malaysia, Taiwan Province of China, and Thailandmdashhere—and for alternative sources of external financing of capital spending; that is, debt and equity. And capital spending is more sensitive to the cost of debt in some economies (Korea, Malaysia, and Taiwan Province of China), possibly reflecting higher stock market capitalization and significantly larger stock markets relative to gross domestic product.

 E  fficient allocation

Are there frictions in Asian financial marketsmdashhere—transaction costs that are high or make it difficult for firms to borrowmdashhere—that reforms can resolve? Frictions can arise for a variety of reasons, such as institutional structure, financial market size, and information gaps. There is evidence that such frictions impede the efficient allocation of capital across sectors and firms in Asia.

Of course, friction and financing constraints differ across sectors and countries especially when compared with more developed markets such as the United States, so that the constraints to rebalancing most likely vary across economies. And there are also differences across segments of the financial system.

For some economies, such as India and Thailand, there is evidence of friction in the financial sector as a whole and of financing constraints on firms. Elsewhere, evidence of financial friction is weaker. In Korea, Malaysia, and Taiwan Province of Chinamdashhere—which have deeper nonbanking segmentsmdashhere—financial systems seem to allocate capital more efficiently. In particular, equity and debt markets appear to do a better job than banking systems of allocating funding across sectors and firms.

But that only works for exchange-listed firms that access external financing. However, many firmsmdashhere—mostly small and medium-sized enterprises that are not listedmdashhere—in several countries are unable to access external financing through organized financial markets. For these firms, financing constraints remain acute. They rely heavily on internal sources to finance their growth. Financial sector reforms can be expected to ease financing constraints for unlisted firms.

Reform measures

Initiatives are already under way in Asian countriesmdashhere—at the national and international levelsmdashhere—to expand and reform financial systems. For example, Thailand has formulated its Financial Sector Master Plan II and Capital Markets Development Masterplan. Malaysia has recently adopted measures to further liberalize its financial sector and develop Islamic finance both in the banking sector and in capital markets. At the international level, the Asian Bond Market Initiative is an initiative of the ASEAN, China, Japan, and Korea (ASEAN+3) started in 2003. It aims to develop efficient and liquid bond markets in Asia, facilitating use of Asian savings for Asian investments. This initiative has made substantial headway in fostering local currency bond markets. And pan-Asian stock exchanges are being linked to improve the cross-border flow of capital in the ASEAN region.

Such reforms in Asia’s financial markets will make them deeper and more efficient. This in turn will help reduce the cost of capital, spur investment, and promote rebalancing in Asia.
 
GDP in the East Asia and Pacific region grew 7.1 percent in 2009, a moderate falloff from the strong 8.5 performance of 2008. But, excluding China from the East Asia aggregate, growth slowed sharply from 4.7 percent in 2008 to 1.5 percent in 2009 . Across countries results were mixed, ranging from an impressively resilient 8.7 percent gain for China to decline of 2.5 percent for Fiji. GDP also fell in Malaysia and Thailand, among middle income countries, and Cambodia among low-income countries. The dispersion of growth was a reflection of initial conditions across countries going into the financial crisis and the recession that followed. Given the importance of trade in East Asia’s global presence, these included trade partner orientation and the product composition of a country’s exports—and more fundamentally—the magnitude of fiscal and monetary stimulus applied. Lessons learned from the East Asia crisis of the late 1990s were also not forgotten in the region, and stability was supported by widespread reforms of the financial sector and private businesss environment; earlier fiscal adjustment to bring down excessive deficits, and a newfound (and healthy) caution regarding the capital account.
China’s massive stimulus package was a major factor in the country’s and region’s economic resilience. The program was centered in government infrastructure spending, combined with increases in transfers, consumer subsidies and tax cuts. The surge in government-led investment boosted overall GDP by 5.9 points in 2009, though most of the spending was financed through quasi-fiscal measures such as lending by state-owned banks. Indeed, bank lending reached 30 percent of GDP in the year and financed almost two-thirds of the stimulus.
 
Fiscal packages elsewhere in the region helped cushion effects of the crisis. Many countries went into recession with sufficient fiscal space to respond pro-actively using both fiscal and monetary measures. Fiscal stimulus measures amounted to 2 percent of GDP for the region in 2009. But fiscal deficits (2.9 percent of GDP for 2009) and government debt grew by much less than in other developing regions, reflecting a smaller deterioration in overall growth in East Asia and the relative absence of automatic stabilizers in the region. For Indonesia, where GDP advanced 4.5 percent in 2009, government spending contributed about 1 percentage point of growth. Malaysia’s fiscal deficit climbed to near 7 percent in 2009 in part due to weaker revenues, but also to large stimulus measures; while the Philippines and Thailand both undertook fiscal easing. Even low-income countries Cambodia, Lao PDR and Vietnam injected discretionary fiscal stimulus of about 3- 4 percent of GDP or more each in 2009, helping to cushion the impact of the crisis on domestic activity.
Recently, a number of central banks (notably Malaysia) have started to tighten interest rates in the face of strengthening economic activity and rising inflation expectations. But as for all developing-and high-income countries, adjustment of fiscal balances in the post-crisis era will present a challenge for policymakers and play a large role in shaping the outlook to 2012.
 
South Asia’s GDP on a calendar year basis8 began to recover in the second quarter of 2009, and GDP is projected to expand 7.6 percent in volume terms in 2010—posting the second fastest pace of growth among developing regions after East Asia and the Pacific (see line 2 of the South Asia country forecast table). This compares with a relatively modest 0.7 percentage point deceleration from 2008 to 2009, when GDP expanded 5.4 percent (down from 6.1 and 9.2 percent in 2008 and 2007, respectively). In contrast, GDP in the rest of the developing world slower by 4.6 percentage points in 2009, and indeed contracted by 6.2 percentage points, when China is excluded. (See the South Asia Economic Update at http:// go.worldbank.org/6BU9N0AZM0 for more detail).
 
Although the global financial crisis has had important consequences for economic activity in South Asia, that impact was much less pronounced than in all other developing regions save East Asia. Regional economic activity benefitted from limited exposures to the sub-prime markets and global banking systems—as the region’s financial markets are less integrated than elsewhere—and relatively resilient capital inflows, which increased as a share of GDP— from 3.6 % in 2008 to 3.9 % in 2009. Fiscal and monetary stimulus (especially in India and, to a lesser extent, in Bangladesh and Sri Lanka), supported activity as well, along with the region’s relative “niche” of trade in services, and in agricultural products—which were less impacted by the crisis than at the global level. Remittances also proved to be a key source of strength for the region during the global downturn. Reflecting the diversity of its migrant destinations and a rapid and large build-up in the stock of its migrants abroad in recent years, remittances inflows to the region expanded 4.9 percent in 2009—even as they declined by an estimated 9 percent in the rest of the developing world. And, while they are growing less quickly, remittances to the region have remained positive over the first four months of 2010.
As elsewhere in the global economy, the fall-off in activity during 2008 and 2009 (relative to pre-crisis 2007) was concentrated in the financial and industrial sectors with service and agricultural sectors less directly affected.
 
Capital inflows to the region more than halved from $134 billion in 2007 to $68 billion in 2009 (see table Net capital flows to South Asia), with net international bank and bond lending almost completely drying up. Among countries within the region, the macro- impacts of the crisis was more severe for those with weaker fundamentals and greater external vulnerabilities at the onset, including Pakistan, Maldives and Sri Lanka with significant internal and external imbalances. Ongoing conflict and post-conflict issues also hampered economic activity in Afghanistan, Pakistan, Sri Lanka and Nepal.

The rebound in activity beginning in the second quarter of 2009 and into 2010 initially reflected rebound factors, including a recovery in external demand and in consumer and investor confidence. This was followed by a rebound in capital inflows and trade activity. In addition, the end to a severe drought in Afghanistan and improving macroeconomic stabilization in the Maldives, Pakistan, and Sri Lanka—supported by IMF Stand-By Facilities reached in 2009 and late 2008—also contributed to the uptick in activity.

 
The revival of economic activity through the first half of 2010 can be observed in the fiscal year accounts of several countries. In India, growth accelerated from 5.1% in FY2008/09 (April 2008 to March 2009) to 7.7 % FY2009/10, with a relatively strong contribution from consumer and government demand reflecting expansionary fiscal and monetary policies.9 The South Asia country forecasts table presents GDP at factor cost and market prices for India. Despite lower interest rates and rising business confidence, investment grew by half a percentage point less quickly than overall GDP. Net exports and stock building also supported growth. A poor monsoon—the worst in nearly forty years, with rainfall reaching only 78% of the long-term trend—translated into very weak 0.2 percent growth in agricultural output. The services sector continues to be an important engine of growth, but the 8.5% expansion in FY2009/10 was down slightly from the rate of FY2008/09. Growth in the manufacturing sector accelerated to 10.8 percent, thus fully accounting for the pick-up in factor cost output to 7.4% in FY2009/10 from 6.7% in FY2008/09.
 
Growth has been much less dynamic in Pakistan, partly reflecting the fiscal and balance of payment imbalances that the country carried into the downturn, which limited the scope for expansionary fiscal and monetary policies. This situation was compounded by security issues, which placed additional pressures on the fiscal deficit and hampered both domestic and foreign investor confidence. Economic activity has also been undermined by structural issues, notably persistent electricity shortages. As a consequence, real GDP is estimated to have eased to 3% in FY20 10 (ending June 2010) from 3.7% growth in FY2009.
 
In Bangladesh, recovery has also been restrained by structural bottlenecks—notably energy supply—particularly in the manufacturing sector. Overall, FY20 10 (ending June 2010) GDP growth is projected to have slowed to 5.5 percent from 5.7 percent in FY2009—a fourth consecutive year of slowing GDP growth. Supply-side constraints dampened private sector investment and undermined exports (export processing zones are not immune to electricity blackouts), which have more than neutralized an expansionary fiscal policy and relatively strong household consumption growth—the latter having been supported by continued growth of remittances, and an increase in non-rice agricultural output (and hence rural incomes). As a result, capacity utilization remains low and industrial production growth weak.
 
A potentially worrisome fiscal position has developed in South Asia, as government deficits in the region have more than doubled since 2007, and at 8.8% of GDP are higher than in any other developing region. While debt-to-GDP ratios in South Asia remain much lower than in high-income Europe, bringing fiscal policy back onto a sustainable path must be a priority for the authorities in the region. Recognizing this, the Government of India has announced a medium-term adjustment plan to bring the debt-to-GDP ratio down to 68% of GDP at most by FY2014/15 from 77% in FY2009/10. Part of the recent fiscal deterioration reflects the costs of subsidies put in place in the wake of the food and fuel crisis, but not yet removed. In Pakistan the share jumped from 3.7% in FY2001/02 to 18.1 percent of GDP in FY2008/09, and in Bangladesh it rose from 1.3 percent to 9.6% over the same period. The increase was less pronounced elsewhere in the region, as in India, subsidies increased from 11.3% of government expenditures in FY2002/03 to 14.4% in FY2008/09 and in the Maldives, subsidies (including transfers) rose from 1.6 percent to 5.2% , respectively, in 2002 and 2008 (calendar years).
 
While Central Banks in the region responded to the crisis by relaxing monetary policy, the period of monetary easing appears to be coming to an end, with central banks having either started to raise rates or signaling their intentions to do so in the near-term. In India, the rebound in international commodity prices (food and fuel) and the poor monsoon have contributed to higher inflationary pressures into early-2010. However, capital inflows increased in the first half of 2010 as well, putting upward pressure on the currency and leading the Reserve Bank of India to seek a balance between raising interest rates to limit inflation, and keeping them low to limit capital inflows and currency appreciation.
 
In Bangladesh, Pakistan and Sri Lanka, inflation is on the rise, partly reflecting one-off effects from higher food and fuel prices. In Bangladesh and Pakistan, the acceleration in inflation comes despite sluggish growth, and Central Banks in both countries face the unwelcome prospect of boosting interest rates even as growth disappoints. Indeed, Bangladesh Bank increased the Cash Reserve Requirement from 5.0 percent to 5.5 percent in May and revised the FY2008/2009 GDP growth estimate down to 5.7% from 5.9%. Elevated international commodity prices—notably fuel, and in particular food prices—have also contributed to higher inflationary pressures in some of the smaller economies (including Bhutan and the Maldives). Even in Afghanistan, a period of falling prices appears to be coming to an end. In Nepal, broad money growth has also been very rapid, due in large part to strong growth in remittances. Correspondingly, inflation has been in the double digits for the last two years—again reflecting to a considerable degree increases in food prices. Monetary policy has been very accommodating, witnessed negative real interest rates.
 
In contrast, prices continue to fall in Afghanistan, but the pace of deflation eased in late-2009, buoyed by firming of housing and food prices. The monetary targets agreed with the IMF for money circulation growth were overshot—but given continued deflation, no corresponding policy action is anticipated.
 
Capital inflows into the region have picked up sharply from recent lows. Approximately $60 billion in capital (including portfolio and FDI) flowed into India in (April 2009 to March 2010), up from $7 billion in FY08. On a calendar year basis, net inflows in 2009 rose less markedly, with much of the uptick expected in 2010, when net private capital flows are projected to reach $66.5 billion for the region compared with $61.9 billion posted in 2009