The Four Ingredients of Full-Flavored Capital Markets
Where do capital markets come from?
Capital markets are like soy sauce, both need the right ingredients and time to “ferment”. But Asia’s capital markets are young and missing an ingredient or two. That means bank loans – not the stock or bond markets – are primary capital-raising sources. This is very different from older markets in places like Europe and the U.S. And it affects how you invest.
As the salty legend goes… about 750 years ago a Japanese priest arrived in the small coastal town of Yuasa, Japan after a trip to China, bringing with him a newfound skill for making miso (soybean paste). It was here, that soy sauce was discovered accidentally – a byproduct of the miso-making process.
Asia’s most famous condiment is a product of combining four ingredients – soybeans, wheat, salt and water – and letting it ferment over time.
Like soy sauce, a country’s capital market needs four “ingredients” and many years to “mature”. It’s also painstaking work to develop.
A capital market is a place where companies, banks and governments go to raise money. You can raise capital by (1) taking out a loan from the bank, (2) issuing a bond or (3) selling shares on a stock market.
Four “ingredients” (pillars) of capital markets
For capital markets to fully mature and develop a robust flavor that appeals to the palate of international investors, four vital “ingredients”, or pillars, are needed.
Pillar 1: Macroeconomic stability
Macroeconomic stability means a country’s economy is less vulnerable to external shocks like an oil crisis. Low and stable inflation, low long-term interest rates, low national debt relative to the GDP of the country and low deficits all protect the economy from external shocks.
Pillar 2: Sound banking system
To be “sound” a banking system needs a heavy-handed regulator that enforces a number of best practices upon the supervised banks. This regulator is usually a Central Bank, such as the Bank of Japan or the People’s Bank of China.
Pillar 3: Strong institutions
There must be established laws governing accounting, legal, regulatory, payments and settlement systems. A network of brokers to sell securities is necessary as well.
Pillar 4: Supervision and regulation
Capital markets only fully develop when they protect investors, maintain fair, orderly, and efficient markets; and facilitate capital formation. A government body like the U.S. Securities and Exchange Commission usually regulates a country’s capital markets. Its purpose is to build the public’s trust in markets.
The pillars of capital markets are interdependent
Just as you can’t make soy sauce without all four ingredients (and time to ferment), capital markets can’t exist without all four pillars (and time to develop).
For example, regulations for capital markets development (pillar 4) aren't effective if they lack the support of a solid institutional framework that protects the rights of investors and creditors (pillar 3).
In countries with economic instabilities (pillar 1), weak judicial systems (pillar 3) and/or fragile banking systems (pillar 2), even a well-designed bankruptcy law (pillar 4) won't help bankrupt firms restructure.
No capital market regulation (pillar 4), even if effective, can ensure liquid markets. Only a sound banking system (pillar 2) can do that. (“Liquidity” means it’s easy to sell a security without a change in price).
When an economy has all four pillars, capital markets can develop that everyone wants to invest in and raise capital from – like those in the U.S. and the U.K.
But all countries in Asia have at least one flawed pillar, or missing ingredient. Capital markets in this region of the world “taste” a bit different.
Asia’s capital markets are “off”
In countries that have “cracks” in one or more of their pillars, like all emerging Asian markets (save Hong Kong), the bond market and stock markets are abnormally small compared to bank credit.
But in places that have all four pillars like the U.S., the reverse is true, as you can see below. U.S. corporates mostly rely on bonds and the stock market, instead of banks, for financing.
Why do capital markets in Asia have a distinct flavor of “bank”?
Banks in Asia have an outsized influence in the region’s capital markets because the countries have followed a different economic development path from countries like the U.S.
In Asia, most countries have followed the Asian Development Model. In this model, the government directs funding to strategic export-oriented industries, making them grow.
For example, following the Korean War, South Korea wanted to grow its shipbuilding industry. So the government instructed the central bank to lend money at low interest rates to certain commercial banks that would pass the cheap credit onto companies that exported ships.
Unlike unbridled capitalism that’s popular in the West, Asian governments tend to “direct” the “free market”.
Under Asia’s bank-based system, banks “monitor” firms.
The bank-based system builds close, long-term relationships between borrower (firm) and lender (bank). This is difficult in a stock or bond market. In these markets, efficient capital allocation is a key objective and long-term relationships are not.
One advantage of raising capital via bank loans is that they are handed out on an individual basis. Bank loan borrowers can renegotiate the terms of the loan more easily, than if they raised capital on the stock or bond market.
Therefore, getting a loan from a bank is a cheaper way for a company to raise capital.
Bond markets can’t compete with banks
In contrast to large bond markets in mature economies, they remain small in Asia. In mature economies, bond financing typically accounts for about 30–40 per cent of total debt financing. In the U.S. this figure comes to about 60 percent. Compare this to emerging Asia, where only around 25 percent of total debt financing comes from bonds.
Bond financing thrives in mature economies because it is more suited for well-established companies whose operations and credit standing are well known.
In emerging markets, the corporate sector is still developing and small and medium enterprises dominate. Banks are in a better position to know the borrower’s business and assess the credit risk. This makes bank loans cheaper than raising capital on the bond market.
Another factor driving up the cost of raising capital through bonds is unreliable credit ratings.
Lack of transparency
Bond credit rating agencies in Asia are notorious for scoring political points over accuracy.
Take China for example.
Nearly 90 percent of the domestic bonds in China are given AA or above grading by domestic rating agencies. Yet it’s not uncommon for a firm rated AA to suddenly default.
In addition to questionable credit ratings, investors are wary of Asian bonds because they are illiquid, relative to the rest of the world.
Asian bonds are illiquid (difficult to sell) because a large proportion of bonds are held by banks, often due regulation. Across the region, banks hold over half of government bonds issued. While in the U.S. and Australia, that figure is less than 5 percent.
In Asian countries, state-run pensions and healthcare funds also tend to hold a lot of bonds, particularly government bonds. These types of institutions usually "buy and hold" and therefore do not promote market turnover (liquidity).
The inherent risks of bank-dominated economy
In Asia, businesses love bank loans because it takes less effort and time to raising necessary capital for expansion. But there is always risk in lending. If risk is concentrated in the banking system and not spread evenly across capital markets – as is the case in Asia – crisis can erupt and destroy an economy.
The onset of the Asian financial crisis in 1997 quickly exposed the risks that an economy faces by having the bulk of its financing eggs in the banking basket.
If something goes wrong in the banking sector, the overall flow of financing becomes restricted as there aren’t alternative financing avenues.
As an investor, understanding that certain “flavors” within Asia’s capital markets are stronger than others is key spotting opportunity and risk. Next time, we’ll tell you who is the “puppet master” of Asia’s capital markets.