contents:

FOREIGN EXCHANGE (FOCUS ON THE SINGAPORE MARKET)

    Currency Conversion

    Types of Foreign Exchange Transactions

    Exchange Market Equilibrium

    The Eurocurrency Market

    International Financial Centres

    Appendix A: Hedging and Arbitrage

    The International Monetary System

        Evolution of the modern system

        Which is best: Fixed or Floating?

    Asia-Pacific Exchange Arrangements

    Banking

    Stockmarkets

    Asian Bonds

    The Competition

    Mobilising Capital for Infrastructure

    Where Will the Money Go?

APPENDIX B:     THE ASIAN FINANCIAL CRISIS

FOREIGN EXCHANGE (FOCUS ON THE SINGAPORE MARKET)¹

A marketplace where one currency is converted into another is called a 'foreign exchange market'. The 'exchange rate', or price at which one currency is traded for another, is determined by market forces of supply and demand, with a role for governments in influencing supply and demand or even setting a price. In China's 'command economy', until recently there was no free foreign exchange market, only an illegal (black) market and a government-controlled market for approved transactions where the price of the local currency (renminbi) was fixed. Singapore has an efficient market for foreign currencies, though the value of the local Singapore dollar is managed by the Monetary Authority of Singapore (MAS).

An efficient foreign exchange market enables companies based in different countries to engage in financial transactions with each other to settle obligations resulting from international business. The total money involved in international trade and international investment today is tremendous, but participants in the global foreign exchange market (see Figure A) engage in a volume of currency trading that is many multiples of the volume of the international business which currency trading is designed to support. This is because about 95% of currency trading is done by commercial banks just to 'make the market'.

With 95% of the foreign exchange market consisting of this so-called 'interbank' market, this leaves only 5% for the banks' customers. Major customers in the Singapore market include multinational corporations and trading companies, speculators, money brokers, and major institutions such as the MAS and the Singapore International Monetary Exchange (SIMEX).

The MAS guides and stabilises the price of the Singapore dollar through its monetary policy --its control of money supply and hence inflation; but also the MAS engages in buying and selling its own currency on the open market. The policy in Singapore is what the International Monetary Fund categorises as a 'flexible managed float', whereby the MAS maintains the value of the Singapore dollar at a desired level relative to a 'basket' of the currencies of its main trading partners including the United States, Japan, Malaysia, and several other countries. Neither the basket nor the trading formula are publicised.

Figure A shows the average daily turnover in four cities which are usually the top centres in the world on a given day. Other major centres include Hong Kong, Frankfurt, Zurich, and some others. (Hong Kong ranked 5th with an average daily turnover valued at US$90 billion in the 1995 survey. The survey is compiled by the Bank of International Settlements of Basle, Switzerland, from statistics gathered from central banks around the world on their banks' trading on a particular day.)

Besides the immensity of the foreign exchange market and dramatic growth in the trading volume over time, Figure A reflects the respective ranking of the major financial centres. London was the original home for the Euro-dollar market and is perennially the number one foreign exchange centre in the world.² New York and Tokyo have occupied 2nd and 3rd spots for decades, but Singapore has been catching up --see endnote ³. On 1st June 1978 the Singapore government removed foreign exchange controls, allowing the market to develop freely. Even before then, foreign exchange dealings had always been actively transacted to support the large volume of international commercial activities.

Figure B shows the currency compositon in the Singapore foreign exchange market. The market is primarily an 'offshore' market, not involving the local currency --nor, in many cases, local business. This is considered desirable by the government (MAS), with its policy emphasis on developing Singapore as an international financial centre. The MAS also is averse to the internationalisation of the local dollar, seeking to prevent foreign speculators from cornering sufficient resources to defeat MAS exchange rate policy. (This has been a problem of the British pound sterling and the US dollar for many decades.)

Figure B also shows the most important currencies for the Singapore market, ie, the US dollar, German deutschemark, and Japanese yen (with the British pound sterling, Swiss franc, and many other currencies trading to a lesser extent). The global foreign exchange market has the same hierarchy of important currencies.

Most currency trading in the world is in exchange for the US dollar. In many markets for example, the Indonesian rupiah would not trade directly for the Japanese yen. Rather, the yen is traded for the dollar which is then traded for the rupiah, ie, the US dollar is 'vehicle currency'. Figure C shows an illustration of such 'cross trading' to obtain the exchange rate of the yen versus the Korean won.

The rate at which one currency is traded for another, the 'exchange rate', may be quoted at banks by either the direct or indirect method. (See Figure D.) The direct and indirect rates are simply reciprocals of each other. A direct quote is the local currency price for one unit of foreign currency. The indirect quote is the foreign currency price for one unit of local currency. Most countries adopt the direct convention, but the United Kingdom, for example, uses indirect. To illustrate: Since both Singapore and the United States use the direct method, the Singapore quote for the US$ exchange rate is 1.4240, while simultaneously US banks would quote the same exchange rate as 0.7022.

Finally, a technical detail is illustrated in Figure D. In reality, there is never only one exchange rate as we see in academic treatments, rather there are always two rates: a 'bid' and an 'offered' rate. The bid is the rate that the bank pays for the foreign currency, and the offered is the rate the bank buys foreign currency. The difference between the prices the bank bids and offers is called the margin or the spread, which simply represents the bank's trading profit per unit. (In interbank jargon, spread is in terms of 'points'.) But for purposes of theoretical discussion we generally speak in terms of one rate, called a mid-rate.

An important function of the foreign exchange market is to provide a mechanism to protect against the risk of change in the prices of currencies. This foreign exchange risk can result in hugh losses for companies with obligations or assets in different currencies. The risk protection mechanism involves utilising so-called forward or swap transactions.

First we must distinguish these two types from the more straightforward spot transaction. The spot exchange rate is the price for immediate delivery. For example, a Japanese tourist visits a Jakarta bank and exchanges yen for rupiah to spend in local shops. Most currency transactions are for spot exchange.

Forward transactions, while ostensibly a small proportion of the overall volume on the market, actually provide the management tool to control risk and therefore these transactions are of great consequence to managers of multinational corporations. A forward contract is a foreign exchange transaction at a specified future rate and at a specified future date, ie, it fixes the price (forward exchange rate) for future delivery. Since many foreign exchange obligations do not require immediate settlement (using a spot exchange), the future price of currencies is of utmost concern to managers. To avoid the risk of a change in the relative value of currencies in which they operate, managers would like to fix the price by means of a forward contract.

A currency option is simply the right to buy a forward exchange contract. The premium (cost) of the option is cheaper than the cost of purchasing the forward contract itself. An option purchased to cover foreign exchange risk provides the possibility of not actually exercising the option --in other words, covering the foreign exchange position is optional. Options are an instrument traded in the financial futures market of Singapore (SIMEX --see below).

The purpose of forward exchange is twofold: The primary purpose is to protect (hedge) trade transactions or other assets and liabilities against a change in foreign exchange rates. An illustration of hedging in the forward market is in Appendix A.

A second, implicit purpose of forward exchange is to speculate, if we believe actual future spot rates will move contrary to forward rates provided by the banks --which indeed happens. The impact of speculation can be quite devastating, as illustrated by the market crash in Southeast Asia in the summer of 1997 (described later).

An opportunity to engage in arbitrage may also present itself if foreign exchange rates and interest rates are not in equilibrium --see next section.

A currency swap is a simultaneous purchase and sale of foreign exchange for two different value dates, such as a combined spot and forward transaction. In this way, no net foreign exchange position need be taken. As an illustration, assume Apple Computer assembles its computers in the United States but buys the computer screens from Japan. Apple also sells some of its finished products to Japan. If the screens cost 110 million yen, at a spot rate of 110 yen/$, Apple must convert 1 million US$ today. Assume the bank quotes the forward rate at 100 yen/$, at which future time Apple knows it will be selling its finished product to Japan for Y110 million (a figure selected for convenience). Apple buys the Y110 million at spot for US$1 million, and simultaneously sells the Y110 million forward. The price of the forward sale is 110/100 = $1.1 million. He has engaged in a swap transaction to settle both the payable and the receivable in yen, ending up only with the home currency, US$. Since the yen is selling at a premium on the forward market, Apple makes more dollars than it paid (although the opposite could just as well occur). The important point is, no exchange risk was incurred.

A currency futures contract is identical in principal to a forward contract. The distinction between a forward and a futures market is in terms of standardisation and marketability only. To illustrate, we utilise the case of the Singapore International Monetary Exchange (SIMEX), Singapore's financial futures market. SIMEX was established in December 1983 and by 1992 ranked 17th in the world by contract volume.

SIMEX offers financial futures not only in certain exchange rates but also interest rates, bonds, commodities, and stock indices. It deals, for example, in contracts for specified exchange rates, including the US$/yen rate. These contracts have a standard unit size of 12.5 million yen and standard maturities at set days in the month. Thus, speculators or hedgers purchase yen (or US$) in multiples of 12.5 million yen, at the market price, and sell it back any time at the new market price. A feature of a futures contract is that it can be sold on the market before maturity --thus, it is very marketable, unlike forward contracts. Many participants in the market are investors and speculators, providing liquidity for the market.

SIMEX thus provides both standardisation and marketability. A forward contract, in contrast, is negotiated with a bank to meet individual business needs for a particular currency, amount, and future date required.

The global foreign exchange market is the network of banks, brokers and dealers, etc, all interconnected 24 hours a day through global telecommunications and computerisation into one integrated market. Exchange rates are determined by the demand and supply of currencies. Quotes are kept uniform through interbank coordination and a process called covered interest arbitrage. Arbitrage as a general concept means buying low and selling high any time there is a price discrepancy. An illustration of covered interest arbitrage is in Appendix A.

Appendix A demonstrates that the percent difference between spot and forward exchange rates must be in equilibrium with the difference in national interest rates. The possibility of arbitrage forces a constant market equilibrium, such that the forward rate becomes a predictor of the future spot rate.

The proportionality between interest and exchange rates is called the International Fisher Effect, which can be expressed by the following formula (for ‘direct quote’ basis):

(St - So)/So x 100 = id - if

In this formula: St is the spot rate predicted for the future at time "t", and So is the current spot rate; id is the domestic interest rate, and if is the foreign interest rate.

Another theory about the determination of exchange rates is Purchasing Power Parity. This theory holds that international price differentials determine changes in exchange rates, such that an increase(decrease) in domestic inflation must result in a proportional depreciation(appreciation) in the exchange rate to keep the domestic and foreign prices of goods in a similar relationship.

However, many other factors besides inflation and interest differentials affect exchange rate movements, including the balance of payments, as well as the many roles of governments impacting the supply/demand conditions of a currency such as monetary and fiscal policy, exchange controls, or the government’s foreign exchange reserves. Also, certainly market psychology and market speculation can play a big role in exchange rate determination.

A Eurocurrency is any currency banked outside its country of origin, for example, a Japanese yen or US dollar time deposit in Singapore. The prefix 'Euro' reflects the European origins of the market. Today Eurodollars constitute about two-thirds of the market, but Euroyen and many other currencies are common, and the market includes many centres outside Europe.

Major participants in the market include commercial banks, central banks, multinational corporations, supranational agencies such as the World Bank, and affluent individuals. Bank accounts are for savings or time deposits rather than demand deposits, and deposits and loans tend to be large.

The original Eurodollar market started around the 1950s when holders of dollars began to deposit them in European banks, especially in London. Depositors included European central banks, multinational enterprises, and hostile communist governments afraid to put dollars in US banks which might be seized by the US government. The Eurodollar market was given additional impetus in the 1960s when the US government tried to limit international lending by US banks, and by various international events that were to unfold in the modern era, such as the ‘oil crises’ of the 1970s when Arab governments needed to deposit US dollars received from their oil exports. With the advent of ‘floating’ exchange rates from approximately the late-1970s, a new era of active foreign currency transactions led to tremendous expansion of both the Eurocurrency market and foreign exchange market (as reflected in Figure A).

The major attraction of the Eurocurrency market is the difference in interest rates compared with home market rates in the currency. Banks are able to offer slightly higher returns for depositors and lower rates for borrowers, because of the large transactions but also due to lack of government controls and their attendant costs. Of course, lack of government regulation is both an advantage and a problem --for one thing, capital flight cannot be easily prevented by governments.

Figure F shows the immense size and rapid growth of the Eurocurrency market. The Eurocurrency market in Asia originated in Singapore and was given the generic name Asiadollars.

The first Asiadollar account was established by the Singapore branch of the Bank of America in October 1968 to attract US dollar liquidity from the multinationals and fund loans in the region. The Singapore government in 1968 made the interest from such non-resident accounts tax-free, later reducing the tax on income derived from loans from 40% to 10%. In 1969 eight more so-called Asian Currency Units (ACUs) were licensed to set up in Singapore.

Initially, funds were re-deposited in London because of lack of demand for Eurocurrency loans in the region. Gradually an interbank market developed, as more international banks set up in Singapore. After the establishment of the Monetary Authority of Singapore in 1971 to oversee financial institutions and policy, foreign bank licensing was liberalised to promote offshore⁴ banking services. The arrival of more banks brought loan portfolios as well as financial expertise. They used their ACUs in Singapore to meet the loan requirements generated by their branches elsewhere in the region.

The first Asiadollar bond was a $10 million issue by the Development Bank of Singapore in December 1971, guaranteed by the government. In the mid-1970s Japanese banks and corporations dominated the Asiadollar bond market in Singapore, but it has since broadened to include even African and South American issuers.

International (or offshore) financial centres provide the major markets for Eurocurrencies. International financial centres generally have one or more of the following attributes:

--a large supply of and/or demand for Eurocurrencies

--a favourable regulatory environment

--good communications and supportive services

--an efficient and experienced financial community

--economic and political stability.

Some of the world's key international centres are Bahrain, the Caribbean (such as the Cayman Islands), Hong Kong, London, New York, Singapore, Tokyo, and Zurich. London is the premier centre with both a large domestic as well as offshore market. In recent years, liberalisation in Japan is enabling Tokyo to become a financial centre at par with London and New York, but financial activities still have a domestic focus. The Cayman Islands is really only a booking centre for recording offshore transactions to take advantage of secrecy and favourable taxation --little actual banking activity takes place. Singapore is the main international centre of Asia due to its strategic time-zone and location at a crossroad of international financial flows, strong worldwide telecommunications links, and an efficient regulatory regime that protects investors without unduly restricting financial institutions.

Many Asian countries have a more or less outspoken ambition of developing as a regional financial centre. The financial centre of China will for many years to come be Hong Kong, but China is grooming Shanghai for possible replacement duties. Malaysia declared the tiny island of Labuan an official Offshore Centre in 1990, offering low taxes and other incentives for foreign financial institutions, with much of the infrastructure in place by the end of 1996. The Thai government has a master plan to turn Bangkok into a regional financial centre by 2000. Many other cities, including Taipei, have similar aspirations, but continuing curbs on capital flows with China obviously limit Taiwan's chances. South Korea will have full liberalisation coming into effect after 1997, allowing the free flow of capital.

Emerging global trends are changing the nature of competition among financial centres. Cyberspace has made such dramatic changes in the availability of information and worldwide communications that physical presence in a financial centre may become less important. As profit margins are squeezed, only the most cost efficient centres will survive the intense competition. The institutional make up is changing. Exchanges like SIMEX are formidable competitors to banks in providing financial services. Investment funds --the pooling of money into large funds under professional management-- have been given incentives to attract them to Singapore to help provide sophisticated financial services. Increasing intra-regional trade and regionalisation of Singaporean firms is increasing the demand for more complex financial services. The major tasks ahead are to regionalise capital market activities and to develop a regional one-stop shopping concept for all financial support services like legal, audit and technological services.

The International Monetary System

The "international monetary system" refers to the way in which individual national currencies form a worldwide system of exchange arrangements. An historical perspective is important to understanding the current system.

The Gold Standard inherited from the previous century (the practice of pegging currencies to gold and guaranteeing convertibility) had been finally abandoned in the 1930s. In the closing days of World War II, a conference was held in Bretton Woods (USA) to design a new system. The Bretton Woods system fixed all foreign exchange rates to the US dollar, and the dollar was fixed, and convertible, to gold. The conference also created the International Monetary Fund (IMF) as the main custodian of the Bretton Woods system, and the World Bank to provide development financing. (These institutions, along with the GATT, played a major role in the world economy, contributing to the tremendous expansion of international trade, investment, and payments in the post-war era. They are still important today.)

The Bretton Woods system collapsed in the early 1970s. Selling pressure against the US$ forced the US government to abandon $-convertibility to gold; ultimately the dollar was allowed to "float", ie, the value of the US$ was determined by market forces.

Today, approximately a quarter of a century after the demise of the Bretton Woods system, the debate rages on as to whether "floating" exchange rates or, alternatively, "fixed" exchange rates are better for the world economy. Today we are neither here nor there --we have a so-called "managed float". Exchange rates are determined within the context of an international system as depicted in Figure G, where each member of the IMF is classified according to its particular policy.

Most textbooks reserve considerable space to cover the historical failures of attempts to achieve exchange stability, especially the post-war Bretton Woods regime. However, events of the 1990s seem far more significant. In 1992 the British pound sterling and Italian lira were forced by speculators to leave the European Monetary Union (a regime of fixed rates among members); during 1994 African currencies pegged to the French franc were also forced to devalue; in December 1994 the Mexican peso collapsed under speculative pressure, sending emerging markets worldwide into a tailspin; and in 1997 several Southeast Asian currencies suffered a similar fate. The Asian currency crisis is given detailed coverage, later.

At the time of the Bretton Woods conference, the international consensus was in favour of a fixed-rate system. Fixed rates would impose discipline and stability, to avoid the general economic chaos of the inter-war years when the world community had witnessed the Great Depression with the associated trade wars, competitive devaluations, high unemployment and inflation, and financial collapse.

Fixed rates require disciplined national monetary policies. If, for example, a country expanded its money supply too rapidly, ie, allowed price inflation and/or overspending by government, this would lead to a trade deficit and an outflow of foreign exchange. To maintain the fixed exchange rate, the country would either have to sustain the outflow of its foreign exchange reserves indefinitely, or tighten its monetary and/or fiscal policies.

By maintaining fixed exchange rates, the world trade and investment environment would be more stable, and there would be less concern for hedging against the risk of a change in foreign exchange values. However, if a country was seen as allowing a payments deficit to persist without taking necessary measures, speculators would treat this as an opportunity to sell that country’s currency at the fixed price. If selling pressure is strong enough, it forces a devaluation of the currency, and speculators cover their bets by buying back at the lower price --making potentially hugh profits. Thus, if countries have insufficient reserves to defend their currencies, and do not institute necessary policy changes to reverse their deficit, this actually invites speculation.

Floating rates allow monetary policy autonomy because there is no requirement to maintain a fixed exchange rate. There is more freedom to, for example, engage in expansionary monetary policy. Such inflationary policy leads to uncompetitive prices for exports, and the resulting trade deficit causes the currency to depreciate. Exchange rate depreciation will then correct the deficit.

Advocates of floating rates favour national autonomy in monetary policy. Governments wishing to stimulate their economies to increase economic growth and employment may do so, at the cost of currency depreciation. Similar reasoning applies for governments wishing to contract their economies to reduce inflation --they should expect currency appreciation.

The major problem with floating rates (besides lack of monetary discipline and exchange stability) is the uncertainty and volatility associated with such variable exchange rates. Currency market fluctuations have been quite dramatic during the last two decades since the demise of the Bretton Woods fixed-rate system. Few really believe this volatility reflects rational market behaviour; rather, market psychology reflecting expectations of a currency depreciation tends to bring more sellers onto the bandwagon. In the end the destabilising effects of speculation can damage a country’s economy by distorting prices of traded goods or even causing a real recession as business moves elsewhere.

On the other hand, the recent turmoil in Southeast Asian currency markets demonstates that foreign exchange market instability may be caused by fixed, rather than floating rates. This is our concluding topic (see Appendix B).

However, before that, one final argument concerning floating rates must be addressed. Until now, we have accepted the conventional logic that a floating rate will cause an adjustment in a trade imbalance, ie, a depreciating currency will reduce imports and increase exports and thus eliminate a deficit.

This did not seem to hold in the case of the depreciating US$ (and appreciating Japanese yen) which was the prevailing trend from 1971-95 except during the early 1980s. Japan’s appreciating yen was not associated with a declining trade surplus, nor was the depreciating US$ associated with a declining trade deficit --indeed quite the opposite. The reason for this anamoly is as follows: A higher yen caused price deflation through reduced cost of imports. Low prices erased the effect of the yen appreciation. A higher yen further reduced domestic spending, especially through declining investment in trade-related sectors unable to sell overseas with the high yen, in turn reducing imports in these industries. A high yen was also associated with a deflationary monetary policy (higher interest rates), which depressed domestic demand. All of these factors held imports down and boosted exports. Finally, the high yen also led to more foreign direct investment, resulting in more exports of capital and intermediate goods. Thus, a strong yen existed alongside a growing trade surplus, which is counter-intuitive.

The United States was the opposite case. The explanation for the persistent American trade deficit could not be attributed to a strong dollar since the dollar had long been in decline. Rather, there was an entirely different problem --low level of savings.

The IMF classifies the Japanese currency as floating freely. Because the yen is one of the most commonly traded currencies in the world, the Bank of Japan cannot really hope to effectively control market trading. Most Southeast Asian currencies, on the other hand, are less internationalised, ie, they are more confined to local business transactions and so are relatively closely-held by domestic financial institutions. Thus, even though Malaysia and the Philippines are classified by the IMF as allowing a free float for their currency, both countries have in reality attempted a ‘managed float’ --at least until the currency crisis of the summer of 1997.

The currency crisis has been a watershed event in East Asia’s development. In an oft-cited study published in 1993 by the World Bank, macroeconomic stability was identified as a key element of East Asian success. This macroeconomic stability was largely based on stable exchange rates linked to the US$. Now that formula for success has become unraveled.

Asian economic growth and the associated expansion of intra-Asian direct investment was largely predicated on a rather fortuitous circumstance that prevailed among exchange rates in the region, which promoted the "flying-geese" pattern of trade and investment. The strength of the Japanese yen relative to the dollar since 1985 facilitated Japanese foreign direct investment into Asian countries (whose currencies followed the US$). Yen investments in turn created greater economic growth in the region, which spurred more trade and investment. This virtuous cycle was interrupted when the US$ instead appreciated. The US$ began to slowly turn around after hitting a low of 80 yen in the spring of 1995, and by the summer of 1997 the US$ was appreciating rapidly against virtually every major currency in the world.

Thailand and Malaysia had large current account deficits since long before the crisis actually hit the markets, but policy-makers were confident that the deficits would be balanced with inflows in the capital account. Grand development projects expanded the deficits, with much of the growth financed by US$ denominated debt.

Exports growth subsided as the dollar began to strengthen in 1996, especially in Thailand which had the most rigid exchange rate. The IMF classified the Thai baht as a "pegged" currency. This meant it was fixed in value to the exchange rates of a "basket" of currencies dominated 80% by the US$, the other 20% being the yen and the German deutschmark.

As the US$ went up dramatically in 1997, Thai exports stalled. US$ debts were piling up, as the economy was expanding and exchange risk not a concern. Much of the foreign debt financed a building boom in the ballooning property market. During May and June selling pressure built up against the Thai baht, and finally on July 2nd the baht was allowed to float. The Bank of Thailand had squandered most of their reserves, at $40 billion among the highest in the world. By the time the Bank abandoned the peg to the US$, pundits estimated they had only $4bil left counting commitments for forward sales. On July 28th the IMF was called for help, resulting in a $17 billion loan package. The IMF demanded austerity as a condition for its aid --to increase taxes and scale back spending. Interest rates had been high to prop up the baht, crippling property developers, their financiers, and some manufacturers. Another IMF condition was no more government subsidy to bail out bankruptcies, and many firms were forced to close. However, the baht continued to drop, leading to precipitous falls in the stock market as investors liquidated and joined the exodus from the Thai baht.

Speculation then shifted to other regional currencies. Some countries were nearly as guilty as Thailand of high foreign borrowing and current account deficits, using too much of these loans to finance a property bubble, and dollar-linked currencies contributing to a slowdown in exports. Even the most healthy economy, Singapore, was effected through intra-regional trade and investment relationships.

Is macroeconomic stability, which was credited so much for Asia-Pacific success since the mid-1980s, gone forever? Or would high interest rates, high inflation, and currency volatility plague Southeast Asia as it has done and continues to do in so many emerging economies? Stable exchange rates linked to the US$ contributed to the East Asian economic "miracle", as yen appreciation since 1985 led to a surge of Japanese investment in the region, an export boom, and considerable technology transfer and industrial upgrading. Foreign investment came to Southeast Asia both for purposes of "outsourcing", or offshore production to export to the world market, and for purposes of market access to the growing purchasing power of regional consumers. Now the boom in regional markets had come to an abrupt end.  Currency devaluation may boost exports to the USA and Europe, but the import content kept export prices high.  In any case, exchange instability discourages potential investors in export industries.

Southeast Asian countries may try once again to return to the old "managed float" regime of regulating their currencies to control volatility and maintain an appropriate purchasing power. However, government intervention in foreign exchange markets has been largely discredited by this experience. The defenses the region put in place in response to the attack on the Mexican peso ("repurchase agreements" between central banks to provide mutual support of regional currencies) were not successfully employed to stem speculation. After the Southeast Asian currency debacle, there was talk of creating an Asian Monetary Fund (an IMF-type institution funded and operated by Asian countries).

(See Asian Financial Crisis.)

THE ASIAN CAPITAL MARKET⁹

Asian finance boomed in the 1990s, until the Financial Crisis.   This section covers that golden era (up to summer 1997).

Robust investment in Asia's emerging financial markets was a driving force behind the region's accummulation of large foreign exchange reserves. Combined reserves held by central banks in Asia were reported¹⁰ at $609 billion (the European Union had only $343 billion), with the Bank of Japan having far the largest share at over $200 billion. The Economist (see endnote¹¹) reported the top ten holdings, which included six Asian countries: Japan (1st, with as much reserves as the 2nd and 3rd places combined); Taiwan (2nd); China (4th); Singapore (5th); Hong Kong (6th); Thailand (10th). (Thailand depleted its reserves during the summer of 1997 --see previous endnote.)

Three main forces propelled financial development in Asia (excluding Japan which is considered already developed):

1. Despite domestic savings rates in Asia averaging 32-35% since 1987, investment needs were growing even faster. The demand for capital was immense for emerging economies in Asia, most notably for infrastructural development. Power blackouts in the Philippines, traffic jams in Bangkok, impassible roads in China, long waiting lists for telephones in India, all attest the poor infrastructure in developing Asia that needs urgent attention. The Asian Development Bank estimated that Asia (excluding Japan) would need $1 trillion in new investment in infrastructure for the 1990s --35% for China alone. That forecast was coming to fruition: For example, on 13 August 1996 a Taiwanese group led by one of the island's largest firms, Formosa Plastics, announced a $3.8 billion deal for thermal power stations in Fujian province --which added 50% to Taiwanese net investment commitments for the year in China.

The needs for financing are obviously still there.  However, demand for capital will not recover until the capital markets themselves recover to meet the shortfall between domestic savings and investment.

2. Capital has flowed in from private investors rather than simply from commercial and official loans. One advantage of private investors is that they often manage their own financing. For example, the Formosa Plastics deal was self-financed, which explains China's interest despite difficulties in the China-Taiwan relationship during 1996.

During the decade 1987-96 foreign direct investment in Asia increased dramatically, and the coming decade (since about 1993) was increasingly the era of portfolio investment. Inflow of portfolio investment in China in 1992 was a mere 3.5% of FDI levels, but by 1993 it reached 24%; by the year 2000 the proportion was projected to be half-half.

3. National governments were well aware even before the Crisis of a need to revamp banking services and capital markets. Relatively more developed countries such as Malaysia and Thailand need to expand capital markets to create more financing alternatives for corporate borrowers to supplement their traditional reliance on bank loans. China, Vietnam and India need to relax the heavy hand of government in nationalised banks and state-directed lending.

New stock exchanges are being opened and banks deregulated. Expanded financial markets will meet the demand for capital by attracting more sustainable flows of domestic savings and foreign investment. Lack of stable long-term investment in Mexico led to a flight of capital which caused a severe market crash in 1994/95 (see endnote ¹²).

Asian banks had been growing very successfully and making profits through the mid-1990s, largely due to the immense pool of funds made available by high domestic savings rates. Relative dominance by banks facilitated government-directed financing in the early years. Furthermore, governments intervened in support of their domestic banking industry by owning banks or by guaranteeing loans made in compliance with industrial policy. Today, however, local banks are facing new competitive pressures.

Disintermediation is an important emerging phenomenon. Instead of employing banks as intermediaries to obtain their loans, borrowers are going straight to capital markets to issue their own debt instruments. This trend is in tandem with securitisation, whereby enterprises repackage into marketable securities anything on their balance sheet that provides a regular income stream --from housing mortgages to trade obligations.

Similarly, investors are putting their money in the capital markets instead of only investing in bank accounts. For example, in India mutual funds are gaining on the banks as a receptable of funds. Banks thus lose their traditional role of middle-man between borrowers and lenders.

In this way the raising of capital revolves less and less around traditional bank lending and increasingly around the capital markets --particularly bond securities. In Singapore, large state-owned firms and statutory boards, which used to rely on borrowing from the postal and savings banks, are now actively encouraged to raise money through bond markets.

Financial liberalisation in many Asian countries is allowing foreign banks to enter the competition. Thus, the Asian banking community is under pressure; but most banks were still doing well until the 1997-98 crash. Their success was due to the entrance of new savers and new borrowers still demanding their services. Peasants from the countryside were becoming newly rich, and they tend to save in the traditional way, in local banks. Small and medium-sized enterprises were emerging in great numbers to meet the opportunities in Asia's dynamic economies, and these firms are not sophisticated or reputable enough to float new securities themselves.

Liberalisation allowed local banks to diversify and compete freely in new businesses. Furthermore, the theoretical benefits of liberalisation are actually coming into play, ie, the bracing winds of competition are forcing local banks to modernise and compete with the capital markets and with the best banks in the global industry. The big commercial banks in Malaysia and Singapore have added investment-banking and stock-broking arms.

The fashion of the 1990s has been 'going regional'. To illustrate: by opening up new branches in early 1996 in such exotic locations as Vietnam, India, and Labuan, Singapore's Keppel Bank raised the total number of its regional branches to nine. As a rule, however, most retail banking is a local business, so foreign banks do mostly trade finance for their own companies. Most of the regional business for Keppel Bank is with its owner, Keppel Corporation, to support its foreign business in those countries. Foreign banks seldom aim at the local retail market, rather do investment banking and asset management.

Stockmarket capitalisation in Asia (excluding Japan) increased from $195 billion in 1987 to $1000 billion in 1994, just before the Mexico crisis. Asia's share of the global equity market is rising to match its big share of the world economy. The largest markets as of September 1994 were in Hong Kong, Malaysia, Taiwan, South Korea, Thailand, Singapore, India, China, and Indonesia in that order. In terms of number of companies listed, India is far the biggest --India under British rule established its first stockmarket in the 19th century.

One cinderella story was the Jakarta stockmarket, established in 1977, which had only $68 million capitalisation by 1987 despite rapid economic growth. That year the government simplified listing requirements, allowed foreigners to buy 49% of listed companies, and boosted the market with various other measures. By September 1994 it had increased to $45 billion --the world's fastest growing market during that period. The lesson seems to be that effective government legislation can work wonders.

Capital markets in Asia thus are set to recover strongly, once the crisis in confidence is over.  With large privatisation flotations, markets can continue to expand and mature. The privatisation of Singapore Telecoms in 1993 increased market capitalisation by 20%. Issues for major infrastructure are planned for the future --privatisation is demanded by the IMF. As Asia's rumour-driven equity markets mature, they will lose some of their notorious volatility.

The year 1993 was a watershed --it was the year international investment funds flocked to Asia (besides being a bull-market year). American outflows to foreign stockmarkets increased by four times. Risk of market volatility should be reduced by portfolio diversification into Asia where market movements have not correlated with New York.

But did portfolio diversification actually reduce risk, as it is supposed to? High-flying global markets tended to be risky even before the Asian Financial Crisis of 1997-8.  The Taiwan market fell by 80% in the early 1990s. Shenzhen's B share market (for foreign investors) lost 50% in the first half of 1994, and Shanghai's A market (for local investors) crashed 40% in two days in October 1994. The Mexico blow-out at the end of 1994 had much wider international repercussions that certainly burned a few fingers. Indeed, emerging markets are more volatile, for legitimate reasons:

1. Investors are still groping for fair values. Market prices anywhere, after all, have no binding rules of value; and emerging markets have an insufficient track record to legitimise given price levels.

2. Small investors and syndicates are relatively dominant, rather than professional investment houses that tend to be more rational and more stable in their investment behaviour.

3. Regulation is generally weak, and manipulation more possible. In thinly traded markets, major players can control the market to an alarming degree.

In the early 1990s Thailand, Malaysia, India, and China established 'securities and exchange commissions' in the model of the American SEC. Singapore is attempting to develop institutional investor organisations, which helps stability.   Now the urgency of reform is top priority, to reinforce supervision and improve transparency in markets.

Besides volatility, another consideration that might threaten the development (by omission) of emerging stockmarkets is the increasing tendency of large firms to seek overseas listings in the major established markets of the world. This threatens least-established markets that may have long-term potential such as China and India, despite strong growth and government incentives. In the first half of 1994 Chinese firms raised $2.4 billion in the Hong Kong market, nearly 6 times more than in China's own markets.

Economic reforms made India's stockmarkets among the best performers in 1994, but there were many problems. Absence of screen-based trading on the Bombay stock exchange delayed settlement of transactions for months. Because of this, foreign investors traded mostly in Indian shares that have overseas listings; thus smaller Indian firms cannot easily attract capital.

In 1991 debt issuers in developing Asia (including government bodies) raised $2.7 billion in international bond markets; in 1993 the figure rose to $13 billion, compared to only $5.2 billion raised by Asian companies through share offerings. Despite this impressive expansion, Asian bond financing is way behind most advanced countries. Firms have not attempted bond issues to any significant extent (with the exception of South Korea), only governments and large banks. In the United States 45% of companies' funds are raised through the bond market; Asian firms other than Japanese raise less than 1% (the Japanese figure is 4%).

The Asian Development Bank spurred development of the regional bond market with their own 'dragon bond' issues in 1991. Dragon bonds are donominated in major international currencies and were mostly floated in the Hong Kong market. The breakthrough will be when the growing pool of Asian wealth is tapped by local currency bonds from local companies in a number of countries. The Economist asserted that Asian issuers may be in a stronger position now to raise debt capital through bonds, after long years of steady, low-inflationary growth. However, the Financial Crisis has dealt a severe blow to financial market development.

Even when the Crisis subsides, problems will be difficult to overcome. The Japanese hardly present an example to follow, with commercial banks retaining their grip on companies' debt financing. Anyway, Asians traditionally do not like debt. Another problem is lack of active secondary market trading. And governments in the region have a reputation for making the purchase of government bonds compulsory for banks and other financial institutions, turning the bond market into a form of forced savings rather than investment.

Governments are trying to boost their bond markets just as they did the stockmarkets in the 1980s. In the 1990s Thailand, Malaysia, Indonesia and India required credit ratings of companies and established ratings agencies. With an active bond market, Asian corporations and governments for the first time could issue bonds, even in their own currency which eliminates exchange risk. Such bonds are an appropriate means to finance infrastructural projects because bond markets specialise in the long maturities demanded of infrastructure investments.

Financiers are struggling to make money in Asia, in what had become (before the Crisis) the most competitive market in the world. They faced high overheads due to very high office rentals and other escalating costs, and the fierce competition made it a low margin business. Some bankers suspect their competitors of under-pricing bond issues in China to build relationships and market share.

Who will win? A market shakeout may be in the stars, unlike the markets in North America, Europe, and Japan which are relatively settled. Fewer competitors means fatter profits for the winners. The Economist looks at five contenders:

The Americans have most of the big institutional funds. Their size gives them deep pockets to withstand the competition. An American base provides access to the world's biggest pool of capital. With global connections and experience, and a reputation for strong salesmanship, Americans are the team to beat.

But can the Americans adjust to do things the 'Asian way'? Peregrine of Hong Kong is an example of a regional competitor that built up its connections, and these parlay into relationships in China's vast market for capital.

Other Hong Kong financiers are also in the running. Jardine Fleming and Hong Kong & Shanghai Bank's Wardley subsidiary have Asian knowhow and international presence. But in the case of Jardine Fleming, its parent is Jardine Matheson, with a long dark history that goes back to the opium trade in the last century. The political risk facing formerly British colonial companies is a formidable obstacle since China's takeover of Hong Kong in 1997.

What about the Japanese, such as Nomura Securities Co with its Asian identity and presence? Japan's persistent payments surplus needs recycling, just as the Arab petrodollars of two decades ago financed Third World development. However, Japan's economic problems at home are holding its financial groups back. Japanese financial institutions are lagging in Asia's financial revolution. Their past schooling in Japan's government-guided financial system may make them innately conservative. Japanese bankers stick to their big customers --80% of their project financing deals involve a Japanese construction company or supplier.

Singapore's financial centre offers a few candidates. Overseas Chinese Banking Corp (OCBC) and Development Bank of Singapore (DBS) are expanding their research and diversifying into brokering and underwriting in the region.

Private sector infrastructure projects are proliferating in recent years. Privatisation of government utilities is turning over many formerly government monopolies to the private sector. Another formula called build-operate-transfer allows contractors to build projects and share the revenues with the government agency.

The three main sources of financing are commercial banks, stockmarkets, and bond markets. Banks are less likely to come up with such long-term loans. Commercial banks are anyway leery of loans to government development projects because of the bad experience with the so-called Debt Crisis of the 1980s where loans to Third World governments resulted in tremendous write-offs.

Sharemarkets have become an important source of long-term finance for infrastructure, initially from privatisation share flotations by government utilities. However, only since the 1980s have government agencies begun issuing shares in a big way, and the track record of privatised utility shares is spotty. Not all investors benefit equally if political insiders get the best access to shares.

Bond issues are very appropriate for raising large sums with long periods of time before payback, which fits infrastructure investment well. The sluggishness of the Asian bond market detracts from this choice however. Also, if we presume then that the issuer is a government, political risk must be considered. Besides, government enterprises are frequently poorly run, and subsidised. Financial support may not be forthcoming if citizen customers of the infrastructure are not expected to pay full price.

Political risk aside, there is also a foreign exchange risk. Foreigners will often be lending in dollars or other international currency, but eventual revenues will be in the local currency. Currencies in countries like Indonesia tended to depreciate in value (even before the Crisis) and may become worth much less for purposes of paying back the financiers.

A final consideration is environmental risk. On a 15-20 year horizon, what if the 'greens' become more powerful by the time the project comes on stream, and they inspire an environmental sensitivity quite absent today? Such an eventuality can cause delays or other operational problems.

Who will get the funding, presuming capital sources are not infinite? The Economist lists a few criteria to judge country attractiveness to investors (besides potential growth):

--ease of capital flow into and out of a country,

--access to financial markets,

--currency convertibility,

--financial and political stability,

--legal and regulatory environment,

--transparency of business procedures, and

--reliability and wealth of local partners.

How about China? Gordon Wu, of Hopewell Holdings, has a long track record of doing business in China, including the first private power project in Shenzhen in 1987 and a $1.2 billion toll road completed in 1994. However, Wu is moving elsewhere because the Chinese are giving him problems. China is inundated with so many offers of capital that it is placing constraints on investors, like official limits on utility profits. Despite having 14 signed letters of intent from various Chinese provinces, Wu has switched his attention to India where his company commenced construction in September 1994 on two power stations for $12.6 billion. With all the long-term potential of the China market, investors complain of the difficulties of actually making progress.

There are real problems with the Chinese financial scene. State-owned enterprises (SOEs) are financed by Chinese banks at interest rates lower than inflation, which give SOEs a negative cost of capital. The resulting profligacy of the SOEs fuels inflation, as they continue to lose money and swallow up available financing. Rather than throwing millions of people out of work, the Chinese government continues to offer credit to loss-making state enterprises. In the meantime a market-driven financial system of banks, stock and bond markets cannot develop if funds are misallocated. "Something like 70% of bank loans to industry still go to the state sector."¹³ Furthermore, the authorities are delaying convertibility of the currency because of concerns about capital flight estimated at $10 billion a year.

India, though slower growing and more recently attempting economic reform, already had more developed commercial banking, stockmarkets, and legal system. Yet India has problems similar to China. Banks have a burden of bad debts to SOEs, which by Indian law cannot fire workers. Even so, India's state sector is much smaller than China's, and its more market-driven economy is channeling resources more efficiently.

Before the Financial Crisis, Southeast Asia's more developed financial markets were the easiest game around. Inflation and interest rates were low, currencies convertible, and the banking system so liquid that domestic banks were usually joint venture partners on projects.

It is evident that Asian financial institutions are not standing still and are potential means for mobilising debt and equity, once capital inflows return.

Decision: Choose the lowest cost hedge; or no hedge and take the risk!