India and South Asia are yet to embrace the gains to industrial and income growth through fully embracing the regional economic links that have made East Asia such a dynamic centre of world trade and economic growth, though it too is being drawn along with the momentum of Asian integration.
By some measures, East Asia is a more highly integrated economy, despite its diversity, than Europe or North America, and more open regionally and globally. East Asia’s trade and economic integration are a product of commitment to open trade regimes, covering the vast bulk of industrial, resource and energy goods, though with significant exceptions in agriculture, and regimes that are more open to foreign investment than in many other parts of the world. East Asian economies, measured against the benchmark of a trade frontier of global efficiency in trade achieve more of their potential income through international trading than the economies of the European Union or those of the North American Free Trade Area. East Asian economies achieve 56 per cent of their trade potential on average, compared with 48 per cent for the European economies and 44 per cent in North America. Notably, East Asian economies do that without being members of a preferential trade arrangement or economic union, but primarily under the most-favoured-nation trading rule of the multilateral trading system. One element of that system, the Information Technology Agreement, which bound restrictions on electronic goods and componentry to zero or very low levels, has played a powerful role in driving economic integration over the past twenty years.
Yet there are some dimensions on which Asian integration lags badly. Asia’s intraregional trade might account for more than 50 per cent of global trade. But foreign direct investment, at under 40 per cent of global investment flows, is lower, and the region accounts for only around 6 per cent of global portfolio investment. Measured in terms of capital market integration, Asia’s market-driven economic integration is distinctly lopsided. In one sense, as Shinji Takagi argues, this outcome is not surprising. Finance is little affected by distance, whereas for trade distance matters critically. Money should flow to a financial centre that offers the smallest intermediation costs and to a country that offers the highest risk-adjusted returns, regardless of the location. But in another sense the imbalance between trade and capital market integration in Asia underlines both the under-development of Asia’s financial markets and their closed-ness. Thus, for China’s reforms going forward, the two front-end challenges are financial market reforms and capital account liberalisation.
The integration of Asia’s financial markets remains important unfinished business.
Some reckon that there’s no case in theory for preferring regional over global financial integration. But the empirical fact is that higher levels of regional financial transactions bespeak the benefits of better-developed and more open regional financial markets — markets that are able to intermediate national and international savings so as to deliver more productive investments and higher levels of income. As a region integrates in trade and production, information is created through face-to-face contacts and efficiently interwoven economic activities. The nature of asymmetric information that characterise financial transactions, means that local information can generate more productive regional financing deals. If markets and institutions are sufficiently developed, then there will be some ‘home bias’ within Asia favouring regional financial transactions. This is likely to be the case even where global transactions offer absolute advantage. The clear lack of home bias in capital flows within Asia suggests that there are a lot of barriers affecting financial markets that prevent them from operating efficiently in generating productive capacity and meeting the region’s financing needs.
In this week’s lead essay, Barry Eichengreen notes that the financial crisis of 1997-98 in Asia, and then the global credit crisis of 2008–09, raised new questions about the connection between financial development and economic growth. ‘The Asian crisis’ he argues, ’caused observers to ask whether the region’s bank-based financial systems maximised brute-force capital accumulation at the cost of efficiency and stability. This then led to a push to develop securities markets at the national and regional levels. The 2008–09 crisis centred on the advanced economies then cast doubt on securities markets as efficient allocators of resources and on the efficacy of universal banks combining commercial and investment-banking functions. It is not infrequently asked whether China is going down this same dangerous road as it deregulates its financial markets, facilitating the rapid growth of its shadow banking system, and as it liberalises its capital account with the goal of internationalising the renminbi’.
Eichengreen concludes that too much emphasis has been put upon the distinction between Anglo-Saxon-style ‘securities-based financial markets and bank-based systems that are said to typify the pattern of financial market development in Asia. In either system the way in which the government intervenes can hinder the development of an efficient financial structure suited to the needs of the economy. In China and India today, the favoured state-owned banks, and the underdevelopment of private banking that serves investment by private enterprises is a huge distortion in these markets. And their insulation from international markets is another. As Eichengreen says, in all financial systems there needs to be a close connection between government and financial markets to ensure that the institutional framework creates a level playing field within which financial institutions and markets develop and financial stability can be maintained.
As Eichengreen concludes, the question is not whether to finance through banks or other financial markets: Asian needs both, more competitive based banking systems and more complete financial markets.
Peter Drysdale is Editor of the East Asia Forum.