Commentary / Japan

Deepening financial integration in Asia

by Sayuri Shirai

The Asia-Pacific region has experienced a rapid increase in its capital markets with resultant greater cross-border portfolio investment inflows since the early 2000s. Momentum began to build especially after the 2008-2009 global financial crisis. The subsequent unconventional monetary easing adopted by advanced economies to cope with the crisis have contributed to promoting this development. Following an outflow of portfolio investment in the initial stage of the crisis, the region has witnessed a new wave of cross-border portfolio inflows from investors in the United States and Europe in search of higher yields. Apart from the management of foreign reserves, moreover, the region has increasingly allocated its accumulated savings to foreign securities.

The post-crisis, cross-border portfolio investments in the Asia-Pacific region have the following characteristics. First, equity has been a dominant source of investment inflows to the region notwithstanding efforts to develop bond markets in emerging Asia since the early 2000s. The exception is Australia, where portfolio inflows have been largely in the form of debt securities. Limited capital inflows to debt securities issued by emerging Asia may be attributable to the still early stages of bond market development in terms of size and liquidity, as well as higher returns on equity.

Second, in contrast, debt securities have remained the dominant foreign assets held by the region. This mostly reflects Japanese investors’ preference toward debt securities. Other Asia-Pacific economies have invested more heavily in foreign equity.

Third, the region’s portfolio investment inflows and outflows have remained overwhelmingly biased against the U.S. and Europe; and the linkages have strengthened further.

Meanwhile, intra-regional portfolio-based financial integration has been rapidly growing at the center of China with closer linkages with Hong Kong and Singapore. As a gateway to China, Hong Kong has strengthened its role in providing portfolio capital (especially equity) to China, accounting for over 40 percent of China’s external portfolio liabilities and exceeding the levels of the U.S. and Europe.

This reflects various liberalization measures undertaken by China including the Shanghai-Hong Kong Stock Connect in 2014, the Shenzhen-Hong Kong Connect and the China Interbank Bond Market Direct Access Scheme in 2016, and the Bond Connect in 2017 — in addition to the RMB Qualified Foreign Institutional Investor (RQFII) Scheme in 2011. Singapore also increasingly plays a role as an equity investor toward China as well as to Japan, South Korea and other ASEAN economies. Intra-ASEAN integration has also been noticeable.

Interestingly, Japan, despite largest abundant domestic capital and external portfolio investment, has been relatively inactive in promoting capital market financial integration in the region in contrast to the growing presence by Japanese banks in regional lending activities. Japan’s funds remained predominantly exposed to the U.S. and Europe with large, deep, high-rated debt securities markets and diverse foreign exchange hedging tools.

Beside these two destinations, Australia has become Japan’s preferred investment destination in terms of debt securities. Recently, Japan’s cross-border equity investment has risen reflecting search for higher yields by institutional investors and the portfolio reform on the reserves managed by the Japanese Government Pension Investment Fund that promoted a shift from debt securities to equity.

In contrast, Japan’s households have maintained half their financial assets in cash and deposits despite a virtually-zero interest rate. In recent years, their incomes have grown moderately but their resultant surpluses have been increasingly allocated to deposits, away from securities and insurance products. These trends are worrisome due to the adverse impacts of such risk-averse investment behavior on the pace of households’ financial asset accumulation and hence on the sufficiency of post-retirement revenue. Households urgently need to diversify their financial assets by paying greater attention to returns.

On this front, the agreement between Prime Minister Shinzo Abe and Premier Li Keqiang at the Japan-China summit this month on strengthening financial integration is a welcome event. Japan potentially benefits substantially from a further access to Chinese capital markets — through utilizing the RQFII quota of 200 billion renminbi, enabling Japan’s financial institutions to engage actively in securities transactions in China, establishing a RMB clearing house in Japan, and re-introducing the bilateral JPN- RMB swap arrangement. Greater portfolio investment from Japan to the region may deepen the intra-regional financial integration which has been lagging far behind the well-developed intra-regional trade-production networks.

Sayuri Shirai is a professor of economics at Keio University, a former BOJ board member and the author of “Mission Incomplete: Reflating Japan’s Economy.”