Asia and the New Financial Paradigm

1. Asia and the New Financial Paradigm Joseph E. Stiglitz Seoul, Korea November 14, 2007

2. Globalization • Has created global banking institutions and other global financial institutions • Facilitating movements of capital from areas of capital abundance to areas of capital scarcity • Facilitating global adoption of “best practices”

3. Banking (and other Financial Institutions) are Information Industries Gathering, processing, and disseminating information Deciding on which projects should be undertaken (i.e., who is creditworthy) Monitoring (ensuring that funds are used appropriately) Enforcing (collecting money due, terminating credit) Banks are like the Brains of the Economy

4. A Strong Financial Industry is Important • Both for allocating resources within a country • And for allocating resources between countries • And as a source of income • High information rents • Several countries’ successes have been based on their financial sector

5. Financial Institutions • Financial institutions not only “intermediate” between savers and investors • Helping ensure savers get highest returns for their investment • Helping investors get capital at lowest cost • But financial institutions also help manage risk • Transferring risk from those less able to bear risk to those more able to bear risk • With new products designed for the risk profile of investors and savers

6. What is Required for a Successful Financial Center? • Performing these roles requires information about both savers and investors • High technology for gathering, analyzing, transmitting information • Highly skilled people • Highly networked people and institutions • Security • Legal frameworks • Regulatory environment • Institutions that can be trusted

7. Rapid Changes in Global Financial Structure • Changing “industrial organization” • Changing sources of funds • Changing technology • Changing knowledge base • Changing global security

8. 1. Changing Industrial Organization • Supply Chain Economics: Globalization of manufacturing has entailed breaking up production process into many stages • Taking advantage of local comparative advantages for each stage of the production process • But using best globally available “appropriate” technology at each stage

9. But successful supply-chain economics is information intensive Requires knowledge of global technologies Requires knowledge of local supply-side conditions Requires knowledge of demand-side

10. Most Importantly • Requires coordination • Linking each stage to final product • Based on customer’s needs and preferences • Many forms of “industrial organization” • Vertically integrated • But given importance of local information, relatively rare • Various forms of contracting

11. So, too, in Finance • Financial markets intermediate between savers and investors • With globalization, savers and investors can be scattered all over the world • But savers and investors in different parts of the world have different needs and opportunities • This is why local information is so important

12. 2. Changing Sources of Funds • Asia has become major source of global savings • US savings rate has been zero or negative • Especially as other countries have built up huge reserves • Yet, money is sent from Asia to money centers in West, and then lent back • Large margin—difference between interest rates received and interest rates paid • With much of the risk borne by Asia • Exchange rate risk • Interest rate risk • Exemplified by East Asia crisis

13. 3. Changing Technology and Knowledge • Finance has become IT intensive • Success requires best available IT technologies for gathering, processing, and disseminating information • But these technologies are global technologies, accessible anywhere in the world

14. 4. Changing Knowledge Base: Globalization of Human Capital • Knowledge has become global • With rapid changes in comparative advantages • More engineering, science graduates in Asia than in Europe and US combined • The knowledge required for running a successful financial institution has become global • No one has a “monopoly” on good practices — or on bad practices

15. America’s Mortgage Problem • Should have realized the deep problems facing American economy • Growth for past 5 years has been highly dependent on real estate • Large numbers of individuals had taken out mortgages in excess of 80% of value of property, with “teaser” rates involving negative amortization for first 2-3 years • In expectation of continuing low interest rates and perpetually rising housing prices • So they could refinance their mortgages • Not sustainable in the long run

16. That Which is Not Sustainable Will Not Be Sustained… Only issue was when bubble would break And when it broke, how deep and long the resulting real estate crisis would be And what would be the form of government intervention The bubble has now broken

17. The Double-Edged Sword of Securitization • Risks spread around the world • France, Australia, others affected directly • Many more affected indirectly as a result of change in risk premium (Indonesia) • More people affected, but impact on US reduced • Banks do a better job at ascertaining creditworthiness, monitoring, enforcement • Security markets often free-ride on information provided by banks • Securitization created new problems of information asymmetry • Renegotiation (debt-restructuring) more difficult • Parallel to problem in sovereign debt markets

18. Clear inadequacies in America’s regulatory system But problems have spread around the world Innocent victims even in countries that did not buy the “toxic” mortgages In East Asian crisis, IMF and US Treasury: Talked about lack of transparency Told countries to raise interest rates Said there should be no bail-out of “bad firms” Argued that the problem was inadequate regulation

19. In sub-prime mortgage crisis: Lack of transparency was cause of credit crunch — no one knew where toxic mortgages were hidden Fed lowered interest rates Bailed-out banks by purchasing mortgages IMF cautioned against need for new regulations, dangers of over-reaction Clear double-standard

20. 5. Changing Global Security • Sound legal and regulatory framework is essential for depositors and savers to have confidence • America no longer viewed as “safe haven,” especially for investors from Middle-East • With repeated financial crises (1987, 1999, 2007) and scandals, lack of confidence in American regulatory structure • But off-shore banking centers are increasingly under attack

21. New Global Landscape for Finance • Changes just described imply that the old “architecture” of the global financial system no longer makes sense • New financial centers are arising • Different centers will perform different functions • Intermediating between different savers and investors • Malaysia • Singapore

22. Key to Success Mixing global and local knowledge Global technology — best available IT technologies for gathering, processing, and disseminating information Global practices — best techniques for marketing Innovation — new financial products and risk management

23. But the Most Important Information is Still Local • Especially concerning small and medium-sized enterprises • Ascertaining creditworthiness • Monitoring • Concerning nature of markets • Problems highlighted by sub-prime mortgage crisis • Many international firms bought these mortgages, without evidently understanding details of American market • They were among those most adversely affected

24. Knowing needs of customers With internet banking, relationship between banks and customers has weakened Securitization has also weakened links Knowing circumstances of customers Is firm facing a temporary problem, a short term cash-flow problem Or is there a more fundamental problem?

25. Localization of information provides a limit on globalization Countries where international banks have largely taken over local banks have faced problems Drying up of credit for small and medium-sized enterprises Lower growth rates But the problems are not inevitable And this helps explain why there will be a multiplicity of financial centers

26. Combining Global and Local • At the same time, competition occurs at global level • Success requires best of global technologies and global practices • Including those required to ascertain creditworthiness, monitoring, enforcement • And those required to meet needs of savers • New and appropriate financial instruments

27. Challenge is to Combine Global and Local Information • Rich ecology of institutional arrangements • Some international banks serving multinational corporations and large domestic clients • A few international banks developing international expertise in some specialized markets • Some international banks acquiring local information by buying local banks • Most firms engaged in only part of supply chain — with contracting relationships with other parts of the supply chain

28. Living with Globalization • Challenge for each financial institution is to ascertain its dynamic comparative advantage, to locate itself within this ever evolving ecology • Some will become international banks or international financial institutions

29. But Most will Have a Particular Niche • Part of the global financial “supply chain” • Linking themselves with other firms and financial institutions and with global securities markets • Success, as always, entails information about these other financial institutions • And knowledge of global securities markets and their limitations • Using local knowledge and information • But taking advantage of global best practices and global technologies

30. Challenge for Each Firm • Not only to figure out their dynamiccomparative advantage • What their particular “niche” should be • But to develop the supply-chain relationships required for success • Answering these questions is Information intensive • best “fits” • Identifying those who have best information about local supply and demand side conditions and are using that information best

31. Combining Global Knowledge and Local Knowledge • And simultaneously to draw upon best of global knowledge and practices • Including knowledge and practices for managing local information • New instruments • New technologies

32. Successful Financial Centers • Same logic applies to successful financial centers • Different financial centers need to find their niche within a rich ecology of financial centers • Some common ingredients of success • Technology • Infrastructure • Human capital, including: • Knowledge of the industry • Location — to obtain “local information”

33. These are among the ingredients which Korea already has But there are other ingredients that may be needed to acquire — or at least to acquire the reputation that one has these Network of long-standing relationships Including networking with other financial centers Which can form the basis of trust, so essential in financial markets Strong, well designed regulatory and legal frameworks Protect investors and savers Without imposing excessive transaction costs

34. Seoul within Asia • Given the changing global landscape, it is inevitable that the locus of finance will shift towards Asia • The question is only how much • And how fast • And the extent to which Western financial institutions will transform themselves into Asian financial institutions

35. New centers are emerging, importance of old centers is changing Shanghai, Hong Kong, Singapore

36. There is an Important Role for Seoul to Play • Korea’s earlier development demonstrated that what mattered was not static comparative advantage, but dynamic comparative advantage • The questions that need to be asked are: • What will Asia’s financial markets look like 25 years from now? • What niche will Seoul eventually play? • And what can Seoul do now to play that role?