October 16, 2015 7:00 pm JST
Bernhard Kotanko and Jason Ekberg

'Financial deepening' can bring economic progress to Asia

Financial markets have a critical role to play in any economy. They support growth by effectively routing capital to productive investments, offering opportunities to investors for wealth accumulation and increasing overall stability within the economy by diversifying sources of financing.

     "Financial deepening" describes a process of widening funding access, diversifying investment options, improving market infrastructure and providing risk-management solutions. Efficient and deep financial markets are a prerequisite for macroeconomic growth and prosperity.

     To illustrate this point, as part of "Financial Deepening in Indonesia," our recent report with Indonesia's Mandiri Institute, we estimated the potential economic gains of successful deepening for Southeast Asia's largest economy at $600 billion by 2030 and a 15% improvement in per capita income. 

     Financial deepening would also be the most effective response to the recent volatility in Asian financial markets, especially in foreign exchange, commodities and equities. While the turbulence has been linked to a global recalibration in capital flows in reaction to U.S. interest rate policy, U.S. capital tightening and China's transition toward private consumption and services, deeper financial markets would also help stabilize markets and advance the macroeconomy in Asia.

Deep and wide     

A program of financial deepening needs to be comprehensive. It needs to reach across all dimensions, including capital users and providers, intermediaries, instruments, market infrastructure and regulatory and legal frameworks. It also needs to spread across all asset classes, specifically bonds, equities, forex and money markets.

     A move toward financial deepening also needs to be inclusive, bringing together all stakeholders in an orchestrated approach: regulators, the central bank, government bodies, financial services players and consumer interest groups.

     The process needs to be actionable, too. This means implementing a sequence of tangible improvements rather than getting stuck in one grand, but theoretical, design.

     All Asian countries are already running programs to promote financial deepening. Indonesia is likely the country with the shallowest financial markets across a range of criteria. China, too, has a long path ahead in opening up its capital account and fostering financial deepening. In contrast, Malaysia and Singapore are already well-advanced.

     For bond markets, developing a liquid local currency bond market is particularly important. Several countries have invested in building up the government yield curve systematically. Most notable is South Korea, which was the first country to generate accurate expectations by announcing forecasts of its financing needs. In 2000, it introduced the "Fungible Issue System," which standardized bond terms across different issues and tranches, easing investor access.

     Singapore also took a similar approach on promoting credible corporate bond issuances. For example, the Singapore Housing Development Board invited international organizations such as the World Bank's International Finance Corp. to issue bonds locally.

Removing roadblocks     

On the capital provider side, the aim of deepening is to remove restrictions that prevent the investor base from growing. For instance, Chile introduced a market reform program between 2000 and 2010 to encourage insurance companies and institutional investors to invest in local bonds. Market infrastructure is critical in facilitating trading and risk mitigation. Good examples for this enhancement are the Bond Exchange program in South Africa and the Bond Market Association in Thailand.

     Thailand also set a good example when it built an effective primary dealer system to ensure adequate liquidity, appointing nine primary dealers back in 2000.

     Finally, allowing and promoting a full suite of trading and hedging instruments is critical for efficient risk management. For example, the Reserve Bank of India introduced credit default swaps in 2011, combined with a transparent reporting mechanism to provide foreign institutional investors with much-needed hedging opportunities.

     There have been various approaches in different countries to strengthen stock markets, on the capital user and provider side. A common theme has been to encourage large state-owned enterprises to list. Singapore is a prominent example, with 16 new listings and 15 public offerings of shares between 1985 and 1996.

     Insurers, pension funds and international institutional investors are typically the main target groups attracting capital providers into equities markets. South Korea's Foreign Investment Act of 1997, Framework Act of 2004 and Trust Business Act of 2005 are prominent examples of actions that have led to diverse capital provision; the proportion of shares held by foreign investors reached 35% by 2013.

     Market infrastructure and intermediaries and the introduction of a full suite of financial instruments, especially derivatives, also play a critical role in the financial deepening of stock markets.

Broadening the range

When it comes to forex markets, most already have liberalized exchange controls. The current focus is therefore on enabling a broader range of financial instruments, especially the hedging of forex risk. India, Thailand and Malaysia have all introduced swaps, caps/collars and forward rate agreements, as well as the necessary market infrastructure to handle them.

     In money markets, the main priorities are around designing a wide array of products, developing a short-term interest rate benchmark and encouraging participation from nonbank players.

     Many countries in Asia have come a long way in modernizing their markets, but now need to adapt their policies to the recalibration of the global financial scene, especially Malaysia, Thailand, Singapore and South Korea. Other markets are still relatively shallow and should use the recent financial market unrest as a catalyst for accelerated progress. This is especially true of Indonesia and China, which has embarked on the journey of opening its financial markets. Further financial deepening in these Asian nations will be rewarded with better financial and economic stability, as well as enhanced growth.

Bernhard Kotanko is partner and head of Asia-Pacific at management consulting company Oliver Wyman. Jason Ekberg is partner and market head of Indonesia at the company.

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