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Sparking Asia's financial acceleration
ASIA may be the global leader in manufacturing and trade, but it is the least financially integrated and developed of the world's major economic regions. One symptom of this is that there are more capital flows between other regions and Asia, both inbound and outbound, than flows within Asia.
Both explaining and compounding this problem, Asia's long-term savings markets - including pension systems, insurance schemes and mutual fund complexes - are underdeveloped. Only its sovereign wealth funds, including GIC and Temasek, are large in a global context.
The situation is changing, however. Over the next 10 years, we think Asia will move towards the centre stage in global financial market significance, driven by accelerating regional integration and market deepening. These twin themes have profound implications at the market, sector and stock level.
We see Asia's equity market capitalisation doubling to US$56 trillion over the coming decade. This expansion would see Asia generate over half (56 per cent) of global market cap growth, followed by North America (US & Canada) at 29 per cent and the European Union at 11 per cent.
On these baseline forecasts, Asia would overtake North America as the world's largest equity market region.
Deeper regional integration should also increase the stickiness of foreign ownership in rates, credit and foreign exchange markets and lower outsized volatility during episodes of heightened risk aversion. We think this process makes extreme market and economic dislocations such as the 1997/98 Asian financial crisis much less likely.
China's contribution to Asia's financial acceleration is already evident through initiatives such as the One Belt, One Road and Stock Connect programmes. Japan's exit from deflation, meanwhile, promises to reawaken dormant domestic interest in securities products, while its government has ambitious plans for Tokyo to play a leading role in global and regional financial market development. Other countries in the region also have a role to play, particularly those where urbanisation, household formation and technological adoption are proceeding most rapidly. Four drivers are accelerating this next phase of the region's development:
Rising income and wealth
In part, the evolution we expect is already coming naturally from rising investor wealth and sophistication as economic development takes place, leading to an increased supply of savings, and associated equity and bond market issuance.
Deepening trade and FDI links
Academic literature highlights that regional financial integration has followed pathways established through foreign direct investment and goods and services trade.
Asia has ever more highly connected supply chains and increasingly deep intra-regional FDI links, which should facilitate greater regional capital market investment.
Financial sector policy reform
A focus on the financial sector across the region has seen reforms to make legal, tax and institutional frameworks more conducive to development. These include reforms to encourage savings in pensions, mutual funds and life insurance products.
They also include exchange/regulator activity (including initiatives such as the Hong Kong-Shanghai and Hong Kong-Shenzhen A-share Connect programmes and the recently announced link-up between Bursa Malaysia and Singapore Exchange).
Most recently, China has committed to allowing foreign firms to take majority stakes in domestic financial institutions for the first tim.
A number of technological changes are working to fast-track financial development and integration, with clear examples being the move towards electronic (and mobile) banking and investment across China, as well as the Digital India trend.
The region should experience an increase in the quantum of funding from local sources and a decline in cost of equity and cost of debt premiums to global peers. This has already been occurring in corporate credit securities markets, where we estimate Asian investors now account for close to 80 per cent of new issue demand versus just 46 per cent in 2007. The same process can help Asia ex-Japan equities, which currently have 5 per cent higher return on equity than global equities, to narrow their long-standing valuation discount to global markets, with perhaps a 150 basis point reduction in cost of equity. As a result, we expect that overly conservative capital structures (such as high cash to market cap ratios) will adjust.
There is work to be done, however, particularly on the regulatory front. A proprietary scorecard developed by Morgan Stanley outlines the role policy has to play. We assess progress across eight dimensions for each jurisdiction: 1) taxation, 2) legal system and regulation, 3) market infrastructure & liquidity, 4) investor education, 5) capital account liberalisation, 6) pension system development, 7) cross-border banking flows, and 8) equity market volatility.
Overall we see Singapore, Hong Kong, Australia, and Japan (in that order) as having made the most progress, while Pakistan, Indonesia, the Philippines, China, and India are lagging. For China, the largest economy in the region, we rank market infrastructure and liquidity more highly than investor education and legal system and regulation, which require further development. For India, pension fund development and taxation reform are key areas for development.
- The writer is Chief Asia and Emerging Markets equity strategist at Morgan Stanley.