From puddle to pool: Deepening Asian markets
Markets, the economist Willem Buiter once said, are like very noisy small children. “You have to pay attention to them but you shouldn’t take them too seriously.” It is good advice. The solid performance of Indonesian markets over the past few years — mainly equities but also currencies, bonds, and real estate — has been admirable, with investors still paying a premium for exposure to the country. But financial markets can be complacent. In this case, they are perhaps underpricing the risk of a major eurozone shock to emerging Asia.
Many say that Indonesia will not be particularly affected by these faraway fires since exports to Europe are minimal and domestic consumption comprises more than 60% of national output.
But trade is just one link; finance is the other. Here, the fate of Europe is highly relevant to Indonesia. Did you know, for instance, that European banks hold claims worth around 15% of total outstanding loans to Indonesia as of early 2012? Or that, foreign investors, many of whom are also affected by investments in Europe, own some 60% of Indonesian shares and about 33% of all local government debt? Any capital flow disruption could be problematic. Regulators, akin to parents, must be vigilant — they must see what small, noisy children cannot.
Foreign asset ownership
The broader problem is that Indonesians don’t own enough of their own assets. During this European crisis, foreign bankers have demonstrated significant “home bias.” They reduce international exposure to protect market share in core markets. After all, their families, networks and professional lives are at home. Ultimately, the solution is to deepen local capital markets, ensure more permanent capital, and reduce volatility (in short, to create our own “home bias”).
This is not to be mistaken with the wave of empty protectionism sweeping the globe. Protectionism is seeking to build a higher wall by destroying your neighbors’, but deepening capital markets amount to building a stronger foundation that would strengthen all walls should disaster strike.
While necessarily a long-term target, this has immediate relevance. European banks are bloated, need to reduce leverage, and some of the assets they will sell are Indonesian. For a smooth transition, there need to be buyers, ideally local ones.
One example shows the problem’s scale: by how much are European banks deleveraging? French bank Credit Agricole, which has an exceptionally strong deposit-taking franchise in rural France, showed 1.7 trillion euros of tangible assets on its March 31 2012 balance sheet. By comparison, its tangible common equity was 27.2 billion euros. So the leverage ratio (tangible assets/tangible common equity) is a whopping 63 times. By contrast the equivalent ratio for, say, BNI in Indonesia as of December 2011 is eight times.
But who would lend to Credit Agricole? This is a bank that would be insolvent if its asset base fell in value by 2%. The answer is apparently other banks. Asian banks have historically been more conservative, relying more on consumer deposits and less on overnight loans from other banks (probably because wholesale funding is more expensive and more volatile here.)
Europe has been the opposite. But now that wholesale funding has become more expensive, European banks have three choices: either raise more capital from private investors, sell assets to reduce leverage and/or turn to their government for capital — in many cases, “all of the above.”
There is so much to sell. The eurozone banking sector, which has $41 trillion in total balance sheet assets, is 2.5 times larger than even the US system (at $16 trillion). If there are more sellers than buyers, prices fall, and funding for businesses and consumers in Asia is squeezed.
Japan banks look for assets
In the midst of this big, rainy cloud, there are fortunately two silver linings. First, Japanese banks appear to have finished a two-decade-long deleveraging cycle and are keen to increase assets again. So they are a source of demand for assets that European banks are keen to sell.
Second, local banks are also buying. For Indonesia, where credit by the banking sector/GDP is on the low side, local banks are a promising source of demand.
But we can’t rely on luck to ensure a smooth adjustment process. Regulators must try to grow local capital markets. The data show that Asian capital markets are vastly smaller than those in Europe and America. Within Asia too there are vast differences, with Southeast Asia lagging East Asian ones.
Why aren’t we bigger? First, finance officials have been reluctant to create a deep asset class denominated in local currency, since that would raise currency values, rendering exports less competitive (even though in the long term, businesses would benefit from cheaper capital).
Also, politically connected banks tried to stifle development of the local bond market, including through odd accounting standards and capital controls on foreign investment. Even Asia’s famous budget surpluses, while admirable, also have been an impediment to developing bond markets since there are fewer government bonds available for investors.
ASEAN has tried to deepen bond markets, and there are basically now three challenges, according to a recent study by the Asian Development Bank. First, it needs to follow through with existing projects (e.g. it must standardize corporate issuances; encourage market-makers to provide liquidity; and develop the credit-default-swap market.) Second, it must establish an ASEAN +3 zone of free capital mobility. Third, it must create more liquidity in these markets by changing what may be accepted as collateral at banks.
In Indonesia, particularly, the challenge is to develop the local bond market. ORIs (Obligasi Ritel Indonesia) allow small investors to hold local debt and reduce reliance on foreigners but could grow more.
These goals are incremental, technical and small. But the ultimate aim of deepening capital markets is massive. It would reduce volatility and better insulate Indonesia from external events. Ultimately, if the boom is to last, Asian financial markets need to be driven by Asian investors themselves.