Asian Perspectives on Financial Sector Reforms and Regulation

8. Financial Deepening and Financial Integration in Asia: What Have We Learned?

197 The 1997 Asian financial crisis revealed the weaknesses of the region’s financial sectors. It had devastating impacts on the banking sector in some countries, most notably Indonesia, Thailand, and Republic of Korea. At the center of the crisis were currencies mismatches and maturity mismatches throughout the region. A currency mismatch occurs when residents of a country have assets in the local currency but liabilities in a foreign currency. Such was the case in many economies in Asia at the onset of the crisis. Banks and corporations with liabilities in dollars were not adequately hedged against a possible change in the exchange rate. In addition, many of them also had large short-term liabilities relative to their assets. So when the region’s local currencies experienced large depreciations against the dollar their assets were no longer sufficient to service their liabilities. Introduction It should be noted that, before the crisis, most economies in the region adopted fixed exchange rates. Such an exchange regime provided holders of dollardenominated liabilities with an implicit guarantee against a sudden and large depreciation of local currencies vis-à-vis the dollar. Hence banks and corporations borrowed only in dollars, without adequately insuring themselves against exchange rate volatility. Moreover, they often borrowed short term to meet their Financial Deepening and Financial Integration in Asia: What Have We Learned? raymond atje 8 The author would like to extend thanks to Widdi Mugijayani for excellent research assistance. 12689-09_CH08-rev2.qxd 10/5/11 2:21 PM Page 197 198 raymond atje long-term investment needs and, therefore, created a double mismatch: currency and maturity mismatches. In contrast, the recent global financial turmoil has had relatively mild impacts on Asian financial sectors. It signifies a number of things. First, it suggests limited exposures of the region’s financial institutions to subprime mortgage-related securities . This in turn reflects, in part, the relatively low level of financial deepening or financial development, especially among the region’s emerging economies. In the case of Indonesia, for instance, none of the country’s banks have a significant, if any, presence abroad. In addition, these banks do not undertake significant investment activities—for example, issuing and selling securities in capital markets . Second, it may also suggest an improved soundness of the region’s financial institutions, especially in the aftermath of the Asian financial crisis. The finance literature indicates that financial development—that is, increased provision of financial services with a wider choice of services available to all levels of society—seems to be linked to real development. Yet the exact nature of the link remains unclear. The question about the direction of causation and the exact way by which one variable influences the other are not altogether resolved. One would expect that causation runs both ways. Consider the effect of the real side on finance. It seems natural to assume that a rich financial structure is a general good: wealthier societies will tend to set up more sophisticated financial arrangements . Nowadays even banking has become highly technological. Sophisticated technology is being used in a wide range of banking activities, such as payments and assets transfer, calculation of the pricing of complex financial instruments, processing of data and their application to market transactions, and risk management. But there may be another reason for the line of causation to run from the real to the finance side. Richer societies tend to use more complex technology, so that investment opportunities are more specialized, which in turn leads to greater information gaps between borrowers and lenders. Greater information gaps may dictate the need for more elaborate financial arrangements.1 Another way to think of it is that an advanced economy with a set of specialized investment opportunities needs a well-informed financial sector that will channel funds to best users. The reverse direction of causation from the financial to real side is better understood . A well-developed financial system raises the rate of return to savings in most states of the world and for that reason also induces people to save.2 Moreover, in addition to allowing risk diversification on the part of savers, financial markets facilitate risk diversification for projects that will effect technological change. 1. This line of reasoning is captured in Obstfeld (1994). He argues that growth depends on the availability of an ever-increasing array of specialized but inherently risky production inputs and that this requires portfolio diversification. 2. However, because of income and substitution effects, the effect of a higher return to...