The Debate on Financial Regulation: Some Lessons for Asia

1. The Debate on Financial Regulation: Some Lessons for Asia

2. Asian specificity • Asian emerging markets are seen as having displayed a degree of resilience and an element of robustness in the aftermath of the financial crisis. • The crisis is not seen as Asian because financial regulation prevented exposure to toxic assets and because of the recapitalization of the banking sector after the Asian crisis. • Often taken to mean that the debate on re-regulation is not of much relevance to them.

3. Ignores financial liberalization • Financial liberalization has been implemented by all developing countries, and though done to differing degrees is as a tendency that is very similar in all. • All these countries are moving or have moved to a Basel-type regulatory framework, which implicitly involves reduced structural regulation and regulatory forbearance. • Replication of the Anglo-Saxon model of the 1980s and beyond.

4. Financial expansion and external liberalization • Ever since the 1970s, attempts by financial firms to evade domestic regulation has involved global spread, which had developing countries as counterparties. • Developing countries themselves attempted to use this “opportunity” to deal with balance-of-payments constraints by changing rules with regard to cross-border capital flows and exchange rate determination.

5. Need for structural liberalization: 1 • If liberalization is to be successful in attracting international liquidity it becomes necessary to allow entry of the carriers of capital. • Done in the name of enhancing competition by easing entry—but involves permitting acquisitions as well, leading often to concentration rather than increased competition.

6. Need for structural liberalization: 2 • With entry of the carriers of capital, demands for changes in the financial environment and regulatory framework to correspond to those in the parent countries increases. • Increasingly the structure of markets, institutions and instruments are reshaped to replicate the imported “model”. • Dismantles the specific financial structures in these countries to generate less regulated markets.

7. What does this do? • In the developed countries the crisis has challenged mainstream perceptions on the functioning of financial markets and the efficacy of regulatory regimes • Has reform created new vulnerabilities in developing countries as well?

8. Impact of dependence on capital flows • Integration had increased capital inflows in the form of direct investment, portfolio capital and debt well before the 1997 crisis. • The decline after the crisis was quickly reversed and we had a capital surge since 2003.

9. Capital flows to developing countries • Net external financing flows which had fallen from $360.1 billion in 1997 to $173.5 billion in 2002, have since risen sharply to $785.5 billion in 2006. • While foreign direct and portfolio investment increased from $153.8 billion in 2002 to $446.7 billion in 2006, net external borrowing rose from $10.9 billion in 2001 to 294.5 billion in 2006.

10. Capital flows to developing countries • Total flows touched a record $571 billion n 2006, having risen by 19 per cent on top of an average growth of 40 per cent during the three previous years. Relative to the GDP of these countries, total flows, at 5.1 per cent, are at levels they touched at the time of the East Asian financial crisis in 1997. • Private debt and equity inflows, which had risen by 50 per cent a year over the three years ending 2005, increased a further 17 per cent in 2006 to touch a record $647 billion. • Is this process benign.

11. Revival of the credit spiral • Net private debt and equity flows to developing countries had risen from a little less that $170 billion in 2002 to close to $647 billion in 2006, an almost four-fold increase over a four-year period. • Net private equity flows, which rose from $163 billion to $419 billion, dominated the surge, but net private debt flows too increased rapidly. Bond issues rose from $10.4 billion to $49.3 billion and borrowing from international banks from $2.3 billion to a huge $112.2 billion. • Net short-term debt, has risen from around half a billion in 2002 to $72 billion in 2006.

12. Foreign bank presence • At the time of the East Asian crisis (mid-1997), the international asset position of banks resident in 23 countries reporting to the Bank of International Settlements stood at $8.6 trillion after adjusting for local assets in international currencies. By June 2007, when 40 countries were reporting, this had risen to $29.98 trillion.

14. The supply-side scenario 2 • Non-bank financial firms—pension funds, insurance companies and mutual funds—had emerged as important intermediaries. • The total financial assets of institutional investors stood at $46 trillion in 2005. Of this, insurance firms accounted for close to $17 trillion, pension funds for $12.8 trillion and mutual funds for $16.2 trillion. • The US dominated here with $21.8 trillion of institutional investors’ assets. UK $4 trillion. • Total assets more than doubled between 1995 and 2005 from $10.5 trillion in the US and $1.8 trillion in the case of the UK.

15. New markets and instruments • In 1992, the daily volume of foreign exchange transactions in international financial markets stood at $820 billion, compared to the annual world merchandise exports of $3.8 trillion or a daily value of world merchandise trade of $10.3 billion. • 2004 Triennial Survey of Foreign Exchange and Derivatives Market Activity shows: the average daily turnover (adjusted) in foreign exchange markets stood at $1.9 trillion. • About 2 per cent relative to real economic activity across the globe. But in 2003, the value of world merchandise exports was only $7.3 trillion.

16. Trade in derivatives • Average daily volume of exchange traded derivatives amounted to $4.5 trillion in 2004. In the OTC derivatives market, average daily turnover amounted to $1.2 trillion at current exchange rates. • Thus total derivatives trading stood at $5.7 trillion a day, which together with the $1.9 trillion daily turnover in foreign exchange market adds up to $7.6 trillion. This exceeds the annual value of global merchandise exports in 2003.

17. Other signs of systemic risk • Ten countries (out of 135) accounted for 60 per cent of all borrowing during 2002-04, and that proportion has risen subsequently to touch three-fourths in 2006. • In the portfolio equity market, flows to developing countries were directed at acquiring a share in equity either through the secondary market or by buying into initial public offers. IPOs dominated in 2006, accounting for $53 billion of the $96 billion inflow. But here too there were signs of concentration.

18. Concentration in flows

19. Expected vulnerability • Capital reversal in times of crisis because of need to sell assets to meet payments commitments or cover losses in the developed countries • For example, over the year ending January 2009, the Reserve Bank of India estimates that the net outflow of FII capital amounted to $23.7 billion. Large when seen in relation to the estimate made by the RBI that the total stock of inward investment in equity securities stood at 103.8 billion at the end of December 2007. That stock had fallen to $80 billion by the end of September 2008.

20. Impact on stock markets • One consequence of capital outflow was a collapse of India’s stock markets, because capital inflow had earlier triggered a speculative bubble in both stock and real estate markets. • Instability in stock and currency markets led by FII investments.

21. Sensex and Cumulative FII

22. Possibly a Pan-Asian Problem

23. The critique • Focus of the critique of financial liberalisation has been on exernal liberalisation. • Seen to have resulted in an increase in external vulnerability and financial fragility in developing countries • Corroborated by the spate of financial crises during the 1990s, by which time adjustment to the debt crises had substantially liberalised financial markets

24. Transformation of financial structures • A parallel fall-out is the transformation of financial structures, defined as the markets, institutions and instruments that define the financial system. • Given the common framework, tendency is to homogenise financial structures across developing countries • Make them resemble some idealised Anglo-Saxon model of transparent and efficient markets

25. Financial crises in EMEs • Fragility comes not only from opening up of capital accounts to encourage the inflow of capital. • By institutionally transforming the financial sector in these countries liberalization unleashes a dynamic that endows the financial system with a poorly regulated, oligopolistic structure, which could increase the fragility of the system.

26. The underestimated threat • Greater freedom to invest, including in sensitive sectors such as real estate and stock markets, ability to increase exposure to particular sectors and individual clients, freedom to expand exposure to retail credit markets for purchases of housing, automobiles and durables, and increased regulatory forbearance all lead to increased instances of financial failure. • Consequence is structural contagion.

27. The reality of structural contagion • Countries seeking to attract capital have to liberalize their financial policies in two ways: • Provide space for the carriers of capital or foreign institutions • Relax regulations relating to the markets, institutions and instruments that constitute the financial structure to provide an appropriate environment to global firms • Allows for the proliferation of financial institutions and instruments and in the practice of risk transfer through processes such as securitization • Makes growth dependent on credit financed consumption and investment.

28. Impact 1: Credit Expansion • Consider financially stable India during the 9 per cent growth phase: • Rapid pace of expansion of total bank credit. • The ratio of outstanding bank credit to GDP initially declined from 30.2 per cent at end-March 1991 to 27.3 per cent at end-March 1997. • Over the next decade, and especially since 2005, the ratio of bank credit to GDP more than doubled to reach about 60 per cent by end-March 2008.

29. Impact 2: Pattern of lending • Retail loans, which witnessed a growth of around 41 per cent in both 2004-05 and 2005-06, have been one of the prime drivers of the credit growth in recent years, despite a moderation of the growth rate to 30 per cent in 2006-07 and 17 per cent in 2007-08. • Sharp increase in the retail exposure of the banking system, with overall personal loans increasing from slightly more than 8 per cent of total non-food credit in 2004 to close to a quarter by 2008.

30. Maturity profile • Steady rise in the proportion of short-term deposits maturing up to one year since March 2001. Deposits maturing up to one year increased from 33.2 per cent in March 2001 to 43.6 per cent in March 2008. • At the same time, the share of term loans maturing beyond five years increased from 9.3 per cent to 16.5 per cent. While this could imply increased profits, the increased asset liability mismatch has increased the liquidity risk faced by banks.

31. Implications • One important consequence of this transformation of banking was excessive exposure to the retail credit market with no or poor collateral. This resulted in the accumulation of loans of doubtful quality in the portfolio of banks. • A significant but as yet unknown proportion of this can be “sub-prime”. According to one estimate, by November 2007 there was a little more than Rs.400 billion of credit that was of sub-prime quality.

32. Sensitive sectors • Exposure of the banking system to the so-called “sensitive” sectors, like the capital, real estate and commodity markets at the end of financial year 2008 was 21 per cent of aggregate bank loans and advances, with the figure comprising an 18.4 per cent contribution of real estate, 2.5 per cent contribution of the capital market and a small 0.1 per cent from commodities.

33. Off balance sheet exposure • Off-balance sheet (OBS) exposure has increased significantly in recent years, particularly in the case of foreign banks and new private sector banks. The ratio of OBS exposure to total assets increased from 57 per cent at end-March 2002 to 363 per cent at end-March 2008. • The spurt in OBS exposure is mainly on account of derivatives whose share averaged around 80 per cent.

34. Increase in securitisation • Finally, the Indian financial sector too had begun securitizing personal loans of all kinds so as to transfer the risk associated with them to those who could be persuaded to buy into them. • As the US experience had shown, this tends to slacken diligence when offering credit, since risk does not stay with those originating retail loans.

35. Implication • Conventional indicators notwithstanding the banking sector is not all safe. • Credit stringency, generated by financial fragility, the exodus of capital from the country for example or the uncertainties generated by the threat of default of retail loans that now constitute a high proportion of total advances could freeze up retail credit and curtail demand.

36. Impact on real economy • Since growth in a number of areas such as the housing sector, automobiles and consumer durables had been driven by credit-financed purchases encouraged by easy liquidity and low interest rates, the curtailment of credit provision by a damaged or cautious financial sector could adversely affect growth. • What then explains the post-crisis recovery?

37. Note the revival in Capital Inflows

38. Asia: The main attractor of equity

39. Bank credit to private sector

40. Some questions • Another liquidity-driven and credit-financed boom? • Does strucutural weakness lie below the ostensible financial strength of Asia and its robust recovery? • Does developing Asia too have a stake in the reform and restructuring of the financial sector and the framework of financial regulation?

41. The Chinese case • In 1986, reform of the non-bank financial sector resulted in the creation of a number of trust and investment companies, and financial intermediaries such as leasing companies, pension funds and insurance companies. • Subsequently, foreign banks were allowed to begin business for the first time.

42. China: Credit-led recovery

43. Recent changes in finance • The changes in the financial system accelerated after 2008, when to provide more stimulus the government allowed or encouraged more “informal” credit flows that went through new shadow banking intermediaries. • In addition to trust companies and private banks, which are not regulated but are registered businesses with established offices, there has been a proliferation of underground operators, providing largely unsecured loans at high rates. • Evenlarge local state-owned firms whose main business was not finance are now expanding into operating guarantee companies, pawnshops and trusts, arbitraging their own access to cheap loans to lend out at many multiples of the official interest rates.

44. The demand side • On the face of it, China’s household sector appears to be not excessively leveraged at all – rather, they are substantial net financial savers. However, China’s official financial statistics still do not cover shadow banking entities. But even without these, the data indicate that the ratio of liabilities to assets has been rising quite rapidly.

46. Real estate • Much of new credit went into the overheated housing market, associated not just with a construction boom but with urban real estate prices that are now the highest in the world for cities like Shanghai and Beijing. Even formally, direct loans from Chinese banks for real estate and housing increased significantly in the previous two years.

48. Financial inter-linkages • The growing but opaque interlinkages between the formal credit system and the world of shadow banking a problem. • Formal banks are also more attracted to indirect lending that generates at least double or triple the official 6.5 per cent one-year lending rate, and can even go up to 30-70 per cent in underground banks. • In the first half of 2011, the most profitable activity of state-owned banks was not lending to businesses but funding trusts and underground banks.

50. Implication • Structural contagion has its consequences • Banking practices and activities of non-banking companies begin to resemble the “model”. • Outcome could be increased fragility unless regulation not restored. • Further, the capacity of the financial system to serve as an instrument for inclusive development undermined.