Suman Bery: Fear of finance

What are India's interests in Asian financial integration

In a speech to the Hindustan Times Leadership summit two years ago, the then Prime Minister, Atal Bihari Vajpayee, articulated a vision for the future of South Asia. Drawing upon the experience of European integration, he spoke expansively not only of enhancing trade among the countries of South Asia, but also, in time, of their integration into a common currency area.

Similarly in a recent speech in Tokyo, the deputy chairman of the Planning Commission, Montek Ahluwalia, declared, "India espouses a vision of an Asian Economic Community, which encompasses ASEAN, Japan, China, South Korea, and India""the five pillars which may form the initial core to drive Asia's emergence as the epicentre of the global economy."

While Mr Ahluwalia's speech focused more on integration through trade and investment, he also cited the possible benefits from greater financial integration, in part to facilitate better use of the region's massive foreign exchange reserves for creating regional "public goods", particularly infrastructure.

Irrespective of India, official initiatives to foster greater financial integration in East Asia have been under way for some time now. These initiatives originated in the financial crises of 1997, which revealed both weaknesses in national structures of financial risk management and substantial dependence for their resolution on the major Western powers (particularly the United States) acting through the International Monetary Fund.

The regional initiatives taken so far fall well short of moves towards a common currency. They have included developing swap lines between the region's central banks to pool resources against a speculative attack (the Chiang Mai initiative), and efforts to develop a region-wide market for local currency bonds.

The political support for these efforts has come from the grouping known as ASEAN+3, a forum that brings together the leaders of the ten ASEAN countries and those of Japan, China and Korea. Given this momentum, and given Indian aspirations to be a bigger player in the Asian economic space, Indian decision-makers will in due course have to take a view on whether and in what way they should participate in these discussions and arrangements.

What economic arguments should guide them? To answer this question, one needs to choose between two rather different perspectives on the situation in Asian financial markets today. The more common narrative runs as follows: Asia is the source of a large part of the world's surplus capital; it also has good growth prospects and immense unmet needs for investment in infrastructure.

Yet, owing to the inadequacies of regional capital markets, these surplus savings are being diverted to finance the current account deficit of a profligate United States. Enhanced financial integration within the region will, it is asserted, solve this problem, keeping Asian savings close to home, to finance Asian investment.

There is, however, an alternative interpretation of current developments, which leads to rather different conclusions. On this view, Asia (in this case East and South-East Asia, rather than South Asia) suffers from two key weaknesses: an overdeveloped export sector and an inadequately developed domestic financial sector [this synthesis draws on various articles by Martin Wolf in the Financial Times, as well as speeches and writings by Andrew Sheng, chairman of the Hong Kong Securities and Futures Commission (www.hksfc.org.hk ).

Sheng in turn refers to (and endorses) the widely discussed views of a group of economists at Deutsche Bank's Research Department led by David Ffolkerts-Landau]. The overdeveloped export sector has led to strong pressures to maintain undervalued exchange rates, particularly vis-à-vis the US dollar. At the same time underdeveloped financial sectors have led to colossal and systematic waste of national savings.

On this view, the US current account deficit is not the "fault" of the United States; as Martin Wolf has argued, in many ways the US is passive in the determination of its real exchange rate, in that its current account adjusts to accommodate the capital being made available to it.

Second, the unnaturally high savings rates of East Asia almost certainly in part reflect the low ex post return that savers have received as a result of poor risk management by their financial institutions, in much the way that the low household savings rates in the US partly reflect the superior efficiency of that country's financial system.

Andrew Sheng attributes the poor record of Asia's financial systems (Singapore and Hong Kong excluded) to the mercantilist economic model pioneered with much success by Japan, and copied elsewhere in the region. This model depended on mild financial repression, through a combination of interest rate controls and government sanctioned oligopoly in banking.

While these systems were successful in generating growth, there was inevitably a cost in terms of efficiency. This cost was represented by the poor ex post returns to savers alluded to above, and the fiscal costs of bailing out bankrupt banks.

Given the poor performance of the Asian financial sector in risk management, Sheng (and others) argue that Asia voluntarily chooses to use the US as a financial intermediary, placing short-term debt in US markets, while receiving risk capital (in the form of direct and portfolio investment) in return. Sheng makes two interesting calculations in this regard.

The first is that the US financial sector earns roughly 8-11 per cent for these risk management skills (this being the difference between the yield on treasuries and that on direct and portfolio investment). The second, more startling calculation, is that a 2.5 per cent return in US dollars is actually a higher return than the true return earned on bank deposits in the Asian crisis countries, if one takes into account the cost of non-performing loans and depreciation against the dollar.

Coming full circle, what does all this imply for India and for our participation in efforts at regional financial integration? I would make several points.

First, we should recognise that our economic model has not been mercantilist. As a consequence, we have a more balanced economy as between domestic and external demand (although clearly our manufacturing sector needs to be stronger). We therefore are better able to manage a flexible exchange rate, and we should continue to do so.

Second, we should recognise that the outcomes that we currently see in Asia primarily reflect weaknesses in domestic financial systems, and that these weaknesses in turn reflect decades of state-sponsored protection of the financial sector.

Integration that chooses to entrench this protection is likely to be both unsustainable and harmful in the long run. Our interests are better served by joining an initiative that stimulates competition, particularly in banking. But this is unlikely to happen on a regional basis.

Third, given the depth of skills of our diaspora in investment banking and our own signal success in the reform of capital markets, it is likely that we would in time end up with a less bank-dominated financial system than other parts of Asia, and could in time provide risk management services to Asia, at lower cost than intermediation through US firms. Here too, greater competitiveness coupled with sound regulation is the way ahead.

In sum, Asia as a whole has to learn new tricks. It has mastered manufacturing and logistics to a point where it is making its former masters squirm. But finance has been its Achilles' heel. Now it has to master a new and more subtle set of skills. India is well-placed to provide these services, but primarily by developing its own financial markets and stimulating competition than through complicated regional agreements.

The author is Director-General of the National Council of Applied Economic Research. The views here are personal