Chapter

IV. Asian Equity Markets: Growth, Opportunities, and Challenges

Published Date:
October 2006
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Asian equity markets have grown significantly in size since the early 1990s, notwithstanding the turbulence that surrounded the late 1990s Asian financial crisis. Asian equity market development has been driven by strong international investor inflows, growing regional financial integration, capital account liberalization, and structural improvements to markets. In the wake of the recent sell-off, valuations and risk-adjusted returns seem to be broadly in line with comparator markets and with the economic outlook. The development of equity markets provides a more diversified set of channels for financial intermediation to support growth while bolstering financial stability. At the same time, as highlighted by recent corrections, the increasing role of stock markets potentially changes the nature of macroeconomic and financial stability risks, as well as the policy requirements for dealing with these risks.22

The Emergence of Asian Stock Markets

Asian equity markets are sizeable and fast growing. Since 1990, Asia’s capitalization has more than doubled in U.S. dollar terms to $13.7 trillion, 30 percent of world capitalization. Excluding Japan and Australia, it has risen almost tenfold. The financial hubs of Hong Kong SAR, Singapore, and Japan dominate the region, accounting for two-thirds of Asian equity assets. Markets in some other countries, such as India, Malaysia, and Taiwan Province of China, are also sizeable. But, for the most part, market capitalization remains well below industrial country levels.

Comparison of Equity Market Size in Asia and Other Emerging Markets, 2005

(In percent of GDP)

Sources: CEIC Data Company Ltd; S&P, Emerging Market Database; IMF, APDCORE and WEO databases; and IMF staff estimates.

Growth in Depth of Equity Market, 1990-20051

(In percent)

Sources: CEIC Data Company Ltd; S&P, Emerging Market Database; IMF, APDCORE and WEO databases; and IMF staff estimates.

1 Change in market capitalization to GDP.

2Data on Indonesia starts in 1993; data on China, South Africa, and G7 start in 1992; data for Russia starts in 1996.

The growth in Asian markets has been accompanied by improved liquidity and breadth. Since 1990 market liquidity (share turnover) has more than doubled in relation to GDP, while turnover velocity (share turnover/market capitalization) has risen almost four-fold. Market breadth (the percentage of market capitalization and turnover accounted for by the ten largest companies—a higher figure implies greater concentration) is now better in Asia than in other emerging markets, although worse than in industrial countries.

There is, however, considerable diversity within this broad picture. Equity markets in China and Indonesia remain illiquid and small relative to the size of their domestic economies, with growth trailing the rest of the region. The Philippines and Hong Kong SAR markets are dominated by relatively few firms. Other markets in the region are generally very small and highly illiquid. In Bhutan, for example, the 16 listed companies trade twice a week; in 2005 there were 65 trades, involving only 8 of the 16 listed companies. In Sri Lanka, total equity and corporate bond market capitalization is only around 10 percent of GDP, with only a few active stocks.

Equities are also a large share of financial assets in the region, accounting for about half of assets (deposits, stocks, and bonds). Nevertheless, as a share of assets, equities, except for those in India, have yet to recover to pre-Asia crisis levels. However, it also reflects the fact that bank loans continue to be the most important source of finance for Asian corporates.

While Asian finance remains bank-dominated, stock markets are an important source of corporate finance. In 2005, emerging Asia companies tapped equity markets for some $814 billion in new capital through initial and secondary public offerings. However, issuance activity is highly concentrated within the region; Hong Kong SAR accounted for almost half the total. Overall, equities provide around 10 percent of corporate finance in emerging Asia, but this compares favorably with 3.7 percent in emerging markets excluding Asia.

Equity derivatives have flourished in a few markets in Asia. On Asia’s exchanges, trading in Asian equity derivatives has mushroomed from $16.5 trillion in 2002 to $40.3 trillion in 2005, and now represents 36 percent of worldwide equity derivatives turnover by notional value.23 This mainly represents very rapid growth in Korea’s market, which thanks to contract specifications and a trading environment that are friendly to retail investors, hosts the world’s most active derivatives market. In 2005, its daily turnover totaled some $151 billion, or almost 34 percent of worldwide trading (83 percent of trading in all of Asia). By comparison, the average daily turnover in all of Western Hemisphere, including the U.S. and Brazilian markets, was about $168 billion in 2005. India’s equity derivatives market is also significant in size, and Hong Kong SAR has the world’s most active equity warrants market. Equity derivatives markets are much less well developed in other Asian countries, even ones where cash market activity is strong. Variations in derivatives markets development relate to differences in the operational and legal infrastructure (Fratzscher, 2006).

Global Exchange-Based Trading of Equity Derivatives in 2005

(By notional amount)

Source: Respected countries’ exchanges.

1Emerging Asia includes India, Korea, Malaysia, Hong Kong SAR, and Taiwan POC.

2Mature Market Asia includes Japan, Australia, New Zealand, and Singapore.

Indicators of Stock Market Activity, 2005
Market CapitalizationTurnover1IPOsSecondary Public OfferingsNo. of Listed SharesMarket CapitalizationTurnoverTurnover Velocity2Market Cap of Top 10 companies3Turnover Value of Top 10 Companies4
In billions of U.S. dollarsIn percent of GDPIn percent
Emerging Asia4,684.8421.034.646.813,40391.78.29.042.434.3
China563.867.30.73.31,37725.33.011.925.116.1
India1,060.850.43.315.85,797136.86.54.835.311.4
Hong Kong SAR1,046.549.021.317.01,135588.927.54.751.643.8
Korea717.6159.72.22.61,61690.520.122.340.238.7
Singapore318.38.13.91.6686270.06.82.539.239.2
Taiwan POC475.973.80.22.1696137.521.315.534.926.5
Indonesia81.52.50.40.633629.50.93.053.254.1
Malaysia183.72.91.10.91,019140.52.21.636.826.8
Philippines112.10.40.50.4237114.80.40.360.857.2
Thailand124.47.01.12.650473.74.15.647.128.8
Other Emerging Market2,124.063.64.424.21,63069.82.13.051.360.4
Brazil482.116.42.08.938160.82.13.452.448.8
Chile131.33.40.51.9246115.23.02.645.649.6
Mexico239.24.50.10.032631.10.61.963.570.5
Russia544.671.1
South Africa563.917.90.013.0373235.87.53.244.191.7
Turkey162.821.31.80.430444.95.913.150.841.4
Industrialized30,968.32,783.297.6188.013,654155.113.99.029.926.8
US519,554.41,989.456.3130.95,434156.615.910.223.721.7
UK3,053.4106.223.317.33,091138.74.83.540.929.6
Japan7,546.4640.424.63,415165.114.08.518.117.3
Australia814.147.218.115.21,714115.06.75.837.138.6
Sources: Federation of World Exchanges; IMF, WEO database; and IMF staff estimates.

Average daily trading volume (total value of share trading divided by number of trading days).

Defined as the ratio of stock turnover to stock market capitalization.

Shows the part represented by the 10 most capitalized domestic companies in domestic market capitalization.

Shows the part represented by the 10 most traded companies in share trading value.

US secondary public offering only includes NYSE.

Sources: Federation of World Exchanges; IMF, WEO database; and IMF staff estimates.

Average daily trading volume (total value of share trading divided by number of trading days).

Defined as the ratio of stock turnover to stock market capitalization.

Shows the part represented by the 10 most capitalized domestic companies in domestic market capitalization.

Shows the part represented by the 10 most traded companies in share trading value.

US secondary public offering only includes NYSE.

Factors driving the development of Asian equity markets include:

International Investor Diversification

Equity flows into emerging Asia have soared. By end-2004, international investors had placed some $638 billion in emerging Asia equity markets—a twelve-fold increase over 1990s levels.

Portfolio Assets Held by Non-Residents in Emerging Markets

In percent of GDP

Non-Resident Equity Investments, 2004

In percent of GDP

Accordingly, emerging Asian markets now capture three-quarters of global equity investments in emerging markets, up from about half in 1992. One underlying factor is the explosion of flows from dedicated emerging market equity funds, whose assets have grown at rates in excess of 54 percent per year since 2000. With assets of some $125 billion, such funds are important investors in the region. But this figure understates the presence of global investors, as Asian markets likely capture a significant share of the much larger assets managed by global investment funds.

Dedicated Asia and Global Equity Funds

(In billions of U.S. dollars)

International investors now play a key role in many Asian markets. Such investors are concentrated in markets such as Korea, Hong Kong SAR, Taiwan Province of China, India, and Singapore, with portfolio allocations to ASEAN countries relatively small. However, even in countries in which foreign holdings of stock are relatively small, they may still own a large fraction of the free float (the amount available for trading). In India, for example, while foreigners own 20 percent of Morgan Stanley Capital International (MSCI) stocks, and less of the total market, they hold over 80 percent of the MSCI free float.

Stock Holdings by Investor Type1(In percent)
IndividualsDomestic InstitutionalForeign
China6949
Hong Kong SAR302736
India1688
Japan202724
Korea181140
Malaysia20
Singapore12970
Taiwan POC48616
Thailand621028
Simple average25.115.932.3
Source: HSBC analysts estimates at end-2005.

The numbers do not add to 100 percent because ownership by government, banks and corporates are omitted as they are generally longer-term holders and do not represent part of the free float.

Source: HSBC analysts estimates at end-2005.

The numbers do not add to 100 percent because ownership by government, banks and corporates are omitted as they are generally longer-term holders and do not represent part of the free float.

Financial Integration within Asia

Intraregional equity portfolio flows nearly tripled over 2001–04 to $113.6 billion. Today, such flows account for over 15 percent of total inflows to countries in the region, up from under 10 percent in 2001. While rising, intra-regional flows remain small relative to flows from Asia to the rest of the world. For example, Japan channels about 7 percent of its external portfolio investment to Asia. Capital account liberalization has facilitated the increase in cross-border flows both within the region and from abroad.

Equity Market Integration1

(Share of S&P/IFC Investable in percent of S&P/IFC Global)

Sources: Datastream; and IMF staff calculations.

1 End-period. End June data for 2006. The measure follows Edison and Warnock (2003). S&P/IFC Investable equities are a subset of S&P/IFC Global equities, and exclude shares that are not legally accessible by foreign investors.

Cross-Border Equity Security Investment, 2004(In billions of U.S. dollars)
Investment from
US and CanadaIn percent of totalEU15In percent of totalAsiaIn percent of totalRest of worldIn percent of totalTotalIn percent of total
Investment to
US and Canada180.46.3%809.019.2%284.138.0%425.248.9%1698.719.5%
(In Percent of Total)10.6%47.6%16.7%25.0%100.0%
EU151252.143.5%2340.255.5%201.326.9%400.546.1%4194.148.1%
(In Percent of Total)29.9%55.8%4.8%9.5%100.0%
Asia649.422.6%472.911.2%113.615.2%17.92.1%1253.914.4%
(In Percent of Total)51.8%37.7%9.1%1.4%100.0%
Rest of World797.727.7%596.814.1%148.519.9%25.42.9%1568.318.0%
(In Percent of Total)50.9%38.1%9.5%1.6%100.0%
Total2879.6100.0%4218.9100.0%747.5100.0%869.0100.0%8715.0100.0%
(In Percent of Total)33.0%48.4%8.6%10.0%100.0%
Source: IMF, Coordinated Portfolio Investment Survey.
Source: IMF, Coordinated Portfolio Investment Survey.

Growing Domestic Institutional Investor Base

Between 2000 and 2004, domestic mutual funds, pension funds, and insurance companies’ assets doubled to just over 36 percent of emerging Asia GDP.24 This development has been spurred by the need to provide retirement savings vehicles in light of aging populations as well as by the liberalization of regulatory controls on investments by public pension funds. In some countries, a large share is invested in equities. Nonetheless, the sector still holds major potential for growth, as it remains small relative to developed countries (U.S. institutional investors’ assets comprise 160 percent of GDP; McKinsey Global Institute, 2006a and 2006b).

While domestic institutional investors play large roles in some markets, in some cases structural barriers may hinder their participation (Ghosh 2006). These include restrictions on the types of investments that can be made by insurance and pension companies; competition from government guaranteed savings schemes; crowding out by public defined benefit pension plans; legislative hurdles; and fragmentation due to the dominance of small players. Accordingly, in such markets, retail investors account for the bulk of exchange trading (about two-thirds in China, and about 85 percent in India; McKinsey Global Institute, 2006a and 2006b). That said, structural barriers to the participation of institutional investors will likely be reduced over time, as some countries are beginning to establish new pension systems and liberalize controls on public institutional investors’ asset allocation.

Improvements in Market Infrastructure and Governance

Efforts over the past decade have improved the technical market infrastructure, as well as corporate governance (see Ghosh, 2006). Most countries in the region have developed electronic clearing and settlement systems. As for corporate governance, the formal rules and regulations governing corporations across the region are in general quite strong, but surveys of investor perceptions suggest weaknesses in implementation (Cheung and Jang 2005).

Market Infrastructure Scores
China92.5A-
Indonesia68.5A-
Korea97.3A+
Malaysia93.3A+
Philippines92.4A
Thailand93.6A
Hong Kong SARA+
SingaporeJapanAA-
JapanA+
Sources: GSCS; and Thomas Murray.1

GSCS compares the settlement efficiency of markets, incorporating average trade size, local market interest rates, the proportion of trades that fail, and the length of time for which they fail. 100 represents the highest score. Thomas Murray produces ranking of post-trade risk exposures according to various criteria of clearing and settlement, safekeeping, and asset servicing. The ratings follow alpha scale form AAA to C.

Sources: GSCS; and Thomas Murray.1

GSCS compares the settlement efficiency of markets, incorporating average trade size, local market interest rates, the proportion of trades that fail, and the length of time for which they fail. 100 represents the highest score. Thomas Murray produces ranking of post-trade risk exposures according to various criteria of clearing and settlement, safekeeping, and asset servicing. The ratings follow alpha scale form AAA to C.

Performance of Asian Emerging Stock Markets

This section examines three aspects of Asian emerging-market equity performance over recent years, namely price performance relative to other markets, trends in volatility, and correlations with global and regional markets.

Price Performance

Over the past five years, Asian emerging markets have outperformed mature markets but lagged other emerging markets. Overall, stock prices generally remain well below pre-Asia crisis peaks, whereas equity indices in Latin America, emerging Europe, and Middle East exceed their 1990’s highs (perhaps boosted by higher oil prices or expectations of EU accession).

As discussed in past issues of the Regional Economic Outlook, the run-up in Asian stock prices has reflected good economic fundamentals. Economic growth has been strong in a number of countries, in the context of a robust global expansion, notwithstanding periodic spikes in oil prices. Moreover, corporate profits have been solid.

Rising Asian stock prices have also coincided with a period of low U.S. interest rates. U.S. interest rates affect Asian equities by affecting portfolio choices of global investors; they provide a benchmark safe return for global investors and are used to discount future cash flows from equities. In addition, higher U.S. rates sometimes coincide with moves by global investors toward more defensive postures, sending riskier assets such as emerging Asian equities lower. As a third channel, changes in the U.S. monetary stance may signal a turning point in the U.S. economy, with potential implications for growth in its trading partners. Indeed, turning points in Asian equity prices do seem to correspond, albeit rather loosely, to shifts in U.S. short-term rates.

Equity Prices

(Jan. 3, 2000 =100 for MSCI USD index (LHS), US rate in percent (RHS))

Source: Bloomberg LP.

Volatility

Asian emerging market equity volatility remains a few percentage points above the levels attained in the first half of the 1990s. Looking at country-specific data, however, the increase seems to be mostly limited to Indonesia and Taiwan Province of China, and to a lesser extent Korea. Higher volatility in some countries compared with the early 1990s could reflect the opening-up of Asian markets to foreign investment, but evidence on this score is mixed.25 In principle, the increase in openness means that Asian markets are more exposed to global volatility and shifts in investor sentiment.26 However, while openness has increased in the markets where volatility has risen, it has also increased in markets where volatility is basically unchanged, or lower. Moreover, volatility seems to have trended down during this decade, despite rising financial integration.

Equity Price Change Volatility1(In percent)
Developed WorldEmerging MarketEmerging Europe, Middle East, and AfricaLatin AmericaEmerging Asia
1990-9510.513.621.722.614.5
1996-200012.115.920.124.520.5
2001-06 (May)13.114.419.120.218.2
Sources: Bloomberg LP; and IMF staff calculations.

Annualized 3-month rolling standard deviation of daily price changes. Based on MSCI USD index.

Sources: Bloomberg LP; and IMF staff calculations.

Annualized 3-month rolling standard deviation of daily price changes. Based on MSCI USD index.

Equity Price Change Volatility1(In percent)
IndiaIndonesiaKoreaMalaysiaPhilippinesTaiwan POCThailandHong Kong SARSingapore
1990-9520.317.524.418.922.519.533.225.321.3
1996-200027.652.745.636.929.518.327.942.929.3
2001-06 (May)20.430.029.613.022.228.125.624.117.5
Sources: Bloomberg LP; and IMF staff calculations.

Annualized 3-month rolling standard deviation of daily price changes. Based on MSCI USD index.

Sources: Bloomberg LP; and IMF staff calculations.

Annualized 3-month rolling standard deviation of daily price changes. Based on MSCI USD index.

Correlation with Global and Regional Markets

Asian equity markets have become more synchronized with global markets since the early 1990s. The same is true for emerging markets as a group, suggesting that globally rising integration may be at play. Indeed, Asia’s correlation with developed markets has moved closely with the overall correlation of emerging market economies. Correlations have also risen significantly for individual Asian countries, in some cases quite dramatically.

The Asian market “beta” versus world markets has also increased over time. Notably, the beta for the S&P/IFC global index has risen by more than that for the investable index. This is consistent with the idea that rising market integration could be lifting return correlations. In particular, as the share of internationally tradable stocks in the global index rises, the share held in global portfolios should rise, and thus its exposure to global market developments should increase.

Overall, returns from Asian equity markets have performed well and in some cases have become less volatile, notwithstanding increased integration into world markets.

Correlation with Developed Equity Markets1

(In 12-month rolling)

Sources: Bloomberg LP; and IMF staff calculations.

1 Based on MSCI USD index 3 month MA of daily percent price change.

EM Asian Equity Beta vis-a-vis World Equity

(In five-year rolling)

Sources: Datastream; and IMF staff calculations.

Box 4.1.Capital Flows to Emerging Asia: How Volatile Are They?1

Volatility of capital flows has been a policy concern for many years in Asia’s emerging market economies, and drew renewed attention during the bout of market volatility in May-June 2006. Although the benefits of greater capital mobility in terms of enabling a more efficient allocation of savings and consumption smoothing are well recognized, there is a widespread perception that capital flows have become increasingly volatile. Significant risks to macroeconomic stability can ensue from such volatility, in particular if regulations are weak or distortionary and the financial or macroeconomic environment is fragile.

Notwithstanding rising volumes and greater swings in US dollar terms, the intrinsic volatility of capital flows does not appear to have increased. The average standard deviation of net capital flows across nine emerging Asian economies steadily increased from less than $1 billion (1976-1980) to nearly $9½ billion (2000-04). However, the coefficient of variation, which scales the standard deviation in US$ term of capital flows by the size of flows, has been lower after the Asian financial crisis than in the 20 years preceding it in six out of eight countries.

Moreover, Asian countries have undertaken policies which have succeeded in reducing vulnerabilities to capital market volatility. Countries’ vulnerability to risks—including disruption of trade, domestic financial markets, or exchange rate markets—can be roughly gauged by looking at trends in volatility scaled by key macroeconomic indicators. Average volatility as a share of GDP rose from about 2 percent (1976-1980) to about 4 percent (2000-04). However, volatility as a percent of gross official reserves—capturing a central bank’s capacity to smooth attendant foreign exchange market volatility—peaked in the early 1990s at about 30 percent, before declining to 10 percent in recent years. This, of course, largely reflects the effort by a number of Asian countries to self-insure against potential volatility in financial markets. Volatility has also remained broadly constant or declined relative to the growth of trade or monetary aggregates, the latter reflecting the risk posed by capital flight to the banking system or credit supply.

Coefficient of Variation of Net Capital Flows(Over indicated period)
1976-962000-04
China1.20.9
Hong Kong SAR0.8
India0.70.4
Indonesia0.51.4
Korea1.90.9
Malaysia1.21.5
Philippines1.00.5
Singapore13.10.4
Thailand1.10.7
Median1.10.8
Average (unweighted)2.60.8
Sources: IMF, International Financial Statistics; and staff calculations.
Sources: IMF, International Financial Statistics; and staff calculations.

Emerging Asia does not compare unfavorably with advanced economies, which are widely regarded as benchmarks given their relatively strong institutions and sophisticated markets. While volatility of net capital flows in percent of GDP has consistently been higher for emerging Asia than advanced economies, the gap has narrowed in recent years. Moreover, mirroring Asia’s trade dependence, volatility has been noticeably lower in terms of total trade. In terms of gross official reserves, emerging Asia stands out as having very low volatility.

Emerging Asia: Volatility of Net Capital Flows by Different Scales1

(Unweigthed average of standard deviation of annual flows over previous 5 years)
(Unweigthed average of standard deviation of annual flows over previous 5 years)
(Unweigthed average of standard deviation of annual flows over previous 5 years)
(Unweigthed average of standard deviation of annual flows over previous 5 years)
(Unweigthed average of standard deviation of annual flows over previous 5 years)
(Unweigthed average of standard deviation of annual flows over previous 5 years)

Sources: IMF, International Financial Statistics; and staff calculations.

1 Emerging Asia includes: China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, Philippines, and Singapore. Small advanced economies include: Australia, Austria, Belgium, Denmark, Finland, Ireland, Netherlands, New Zealand, Norway, Spain, Sweden, and Switzerland.

Emerging Asia and Advanced Economies: Volatility of Net Capital Flows by Different Scales1

(Unweighted average of standard deviation of annual flows over indicated period)
(Unweighted average of standard deviation of annual flows over indicated period)
(Unweighted average of standard deviation of annual flows over indicated period)
(Unweighted average of standard deviation of annual flows over indicated period)

Sources: IMF, International Financial Statistics; and staff calculations.

1 Emerging Asia includes: China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, Philippines, and Singapore. Small advanced economies include: Australia, Austria, Belgium, Denmark, Finland, Ireland, Netherlands, New Zealand, Norway, Spain, Sweden, and Switzerland.

Looking at types of flows, volatility arises primarily from portfolio flows. The coefficient of variation for net portfolio flows has generally been higher than for net FDI and other flows (including bank debt), both across countries and over time. However, net other flows also show substantial volatility in some countries which, given their large size, could become problematic under conditions of financial stress. It is noteworthy that the coefficient of variation is higher for net FDI than for net portfolio flows for Hong Kong SAR and Singapore in recent years, and for Korea both before and after the Asian financial crisis. One explanation may lie in the bulkiness of FDI. In Singapore, the recent sharp increase of investments abroad as part of public sector diversification efforts may be another factor.

Coefficient of Variation by Type of Flows(Over indicated period)
1976-962000-04
Net FDINet portfolioNet otherNet FDINet portfolioNet other
China1.41.74.10.230.49.9
Hong Kong SAR14.01.11.8
India2.32.40.80.10.90.7
Indonesia1.21.80.71.72.20.5
Korea2.11.82.51.20.73.5
Malaysia0.914.02.50.64.20.3
Philippines1.13.30.90.85.60.7
Singapore0.92.39.30.80.11.6
Thailand1.01.61.20.66.00.6
Median1.12.31.20.81.70.7
Average (unweighted)1.33.92.52.52.61.2
Sources: IMF, International Financial Statistics; and staff calculations.
Sources: IMF, International Financial Statistics; and staff calculations.

Broad-based capital account liberalization may contribute to lower aggregate volatility. There may be a diversification effect that comes with broader-based capital account liberalization, as long as different types of capital flows are not highly correlated. The Asian experience suggests that the intrinsic volatility of net capital flows has tended to decline as the capital account has become more open. As mentioned above, in six out of eight countries the coefficient of variation of net capital flows has fallen below pre-Asian crisis levels. In five of these six countries the degree of capital account openness has increased as suggested by the ratio of gross capital flows in percent of GDP. However, capital account liberalization does have the potential to leave countries exposed during more extreme periods of financial turbulence. In this context, a gradual approach to capital account liberalization, and the appropriate sequencing in tandem with other reforms to strengthen market efficiency, have generally played a stabilizing role. Recent examples of a broadening of capital account liberalization include Korea, where restriction on FDI flows were lifted after the crisis; China, where a outflow restrictions have been gradually relaxed; and India where sector-specific controls on FDI have been gradually lifted.

Change in Volatility of Net Capital Flows and Openness

(Percent change between 2000-04 and 1976-96)

Sources: IMF staff calculations.

1 The main author of this box is Olaf Unteroberdoerster.

Valuation of Asian Markets

Most Asian markets show historically moderate valuations. Even in cases where historical price-earnings (PE) ratios exceed averages for earlier in this decade, PE ratios are generally much lower than pre-Asia crisis highs. Dividend yields (dividend/price; a higher figure implies a more modest valuation) are similarly moderate, by and large. That said, a few markets (India, Sri Lanka) have valuations well above recent averages.

Price-Earnings Ratio1(Period average)
2006 end-July2006 H12001-06Pre-1997 high2
India20.421.415.931.9
Sri Lanka19.620.612.514.0
Taiwan POC15.818.929.733.0
Singapore16.116.517.921.4
Philippines15.516.318.928.0
Hong Kong SAR16.915.416.917.1
Malaysia15.815.117.730.9
China15.414.015.220.2
Indonesia13.913.812.624.7
Korea10.912.011.931.4
Thailand9.610.523.821.9
World16.217.220.931.73
EM Latin America12.513.813.117.93
EM Europe & Middle East15.015.414.925.73
Sources: Datastream; and IMF staff calculations.

Based on MSCI country index.

Highest annual average between 1990-97. Each economy can have different data starting point.

Historical high since 1995.

Sources: Datastream; and IMF staff calculations.

Based on MSCI country index.

Highest annual average between 1990-97. Each economy can have different data starting point.

Historical high since 1995.

Dividend Yields1(Period average)
2006 end-July2006 H12001-06Pre-1997 high2
India1.31.21.71.0
Sri Lanka1.91.63.31.0
Korea1.81.71.91.3
Philippines2.22.21.70.7
China2.32.32.32.0
Singapore2.82.52.21.2
Malaysia2.82.82.31.0
Indonesia3.02.93.41.5
Hong Kong SAR2.93.13.22.9
Thailand4.03.62.82.0
Taiwan POC4.03.82.40.9
World2.22.12.01.43
EM Latin America2.72.43.22.23
EM Europe &Middle East2.12.71.91.63
Sources: Datastream; and IMF staff calculations.

Based on MSCI country index.

Lowest annual average between 1990-97. Each economy can have different data starting point.

Historical low since 1995.

Sources: Datastream; and IMF staff calculations.

Based on MSCI country index.

Lowest annual average between 1990-97. Each economy can have different data starting point.

Historical low since 1995.

The expected real dividend growth implied by current valuations also appears to be generally in line with medium-term GDP growth forecasts. Comparing expected real dividend growth extracted from dividend yields with GDP growth shows only a few instances where equity-market valuations imply levels of dividend growth that are out of line with medium-term WEO projections.

Implied Dividend Growth Rate, 2006 1(In percent)
Hong Kong SARIndiaIndonesiaKoreaMalaysiaPhilippinesSingaporeTaiwan POCThailand
WEO projection4.77.16.44.85.96.04.44.85.4
Implied dividend growth5.57.5−0.37.23.44.95.52.61.8
Sources: Bloomberg LP; and IMF staff calculations.

Calculations are based on average data from Jan. to Jun. in 2006 unless otherwise specified. Discount factor is domestic long-term rate deflated by CPI, plus a 6 percent risk premium. Implied dividend growth rates are calculated following the Gordon valuation model: Pt = Dt (1 + gt) / (rt + ρt − gt); where Pt is equity price; Dt is dividend; rt is the real interest rate; gt is the real dividend growth rate; and ρt is the risk premium.

Sources: Bloomberg LP; and IMF staff calculations.

Calculations are based on average data from Jan. to Jun. in 2006 unless otherwise specified. Discount factor is domestic long-term rate deflated by CPI, plus a 6 percent risk premium. Implied dividend growth rates are calculated following the Gordon valuation model: Pt = Dt (1 + gt) / (rt + ρt − gt); where Pt is equity price; Dt is dividend; rt is the real interest rate; gt is the real dividend growth rate; and ρt is the risk premium.

Ex-post risk-adjusted returns in EM equity investments also do not suggest that markets are overvalued. Based on the Sharpe ratio, which measures excess returns per unit of risk (volatility, as measured by the standard deviation), Asian risk-adjusted returns have been basically in line with those in emerging markets in other regions, as well as U.S. high-yield bond returns. This is consistent with a comparison of excess returns (over a risk-free benchmark rate), which have been broadly similar to those in non-Asian emerging markets. As one important caveat, this does not provide definitive evidence, on its own, that Asian markets are not overvalued—it cannot be ruled out that many emerging markets are out of line with fundamentals. But along with the aforementioned valuation measures, it does provide some evidence that recent performance has not been grossly out of line with fundamentals.

Sharpe Ratio

Sources: Bloomberg LP; and IMF staff calculations.

1S&P/IFC investable indices in USD, total returns.

2Merrill Lynch bond index, total returns.

Excess Return1

(In percent, period average)

Sources: Bloomberg LP; and IMF staff calculations.

1 Annualized daily excess return over 3 month US treasury yields.

2S&P/IFC investable indices in USD, total returns.

3Merrill Lynch bond index, total returns.

To sum up, equity markets do not generally show signs of overheating. Following the repricing in markets earlier this year, equity valuations seem to price in a baseline for growth broadly consistent with the WEO baseline.

However, in the event that growth came in lower than this scenario—say, in the event of a global or regional slowdown—valuations would probably adjust. Accordingly, exploration of the relationship between equity prices and economic activity is useful to provide some forward-looking perspective on the development of equity markets, and to shed light on the attendant possible policy implications.

Equity Prices and Economic Activity

There are a number of relationships between equity prices and the real economy.

Equity prices are leading indicators of future changes in economic activity, because stock prices reflect the present discounted value of expected future dividends (and thus expected future growth). Beyond this passive channel, however, there are five main channels whereby equity prices may affect real activity (Morck, Schleifer, and Vishny, 1990)

  • Wealth effects: Under the life cycle/permanent income hypothesis, higher asset prices raise individuals’ lifetime wealth, leading to higher spending (potentially most significant in countries where stock ownership is more prevalent among households).

  • The financing or cost of capital channel: Rising stock prices lower the cost of new capital relative to existing capital, spurring investment.

  • The financial accelerator or credit channel: When credit markets are imperfect, asset price fluctuations can impact borrowing capacity by affecting borrowers’ wealth and the value of assets pledged as collateral (Kiyotaki and Moore, 1997 and Bernanke, Gertler and Gilchrist, 1999). These dynamics affect the finance premium on loans, and thus influence investment and consumption. If borrowers are highly leveraged, changes in net worth arising from moves in asset prices can disproportionately impact real variables, working to propagate and amplify macroeconomic shocks.

  • Balance sheet effects and financial fragility: Asset-price swings affect financial institutions’ net worth by affecting the valuation of asset portfolios, as well as the health of borrowers as noted above (thus potentially boosting non-performing loans). Severe asset-price crashes can cause intermediaries to cut back credit, potentially dampening aggregate demand. Large shocks can cause feedback into corporate and household income, further weakening intermediaries and prompting further asset-price declines, especially when intermediaries are highly leveraged.

  • Confidence effects: To the extent that equity prices signal faster growth of future real incomes, they can also influence consumption. Likewise, stock market changes may provide entrepreneurs with information about market expectations of future demand, thus influencing investment decisions.

Empirical research suggests that the financial wealth channel could be significant in Asia. In Japan and Australia—both of which have large stock markets and retail investor bases—the marginal propensity to consume from wealth is estimated at 2–3 percent and to 7.4–14.5 percent respectively (Slacalek, 2006). However, Slacalek’s estimates for Australia appear to be large particularly relative to those derived from other studies. For example Dvornak and Kohler (2003) finds that the long run wealth effect, including the housing and stock market effects, is 4 percent. Kuralbayeva and N’Diaye (2006) find that in Malaysia, Hong Kong SAR, Indonesia, and Korea, a 10 percent rise in real stock prices increases private consumption by about 0.2–0.3 percent, similar in magnitude to estimates for industrialized countries (see IMF 2000, and Slacalek, 2006). As one caveat, using stock price indices to proxy household wealth may overstate wealth effects, because stock prices are leading indicators and because retail investment in some markets is low (Slacalek, 2006).

The 1997 Asia crisis illustrates how financial accelerator types of effects can contribute to financial and economic volatility, especially through real estate. Among the mechanisms surrounding the crisis, large capital inflows allowed financial intuitions to intermediate a large supply of funds to their credit constrained customers. This in turn drove up stock and property prices, raising the net worth of borrowers and easing their borrowing constraints and allowing them to become highly leveraged. In Thailand, for example, borrowers could fund up to 70–80 percent of the value of collateral, making borrowers vulnerable to asset-price declines (Edison and Miller, 2000).

This analysis raises the question: how large are equity holdings in Asia? The answer can provide a perspective on the size of potential balance sheet and accelerator effects in Asia. That said, a few caveats are in order before proceeding; data are fragmentary, and indirect effects on the real economy through confidence and a worsening of corporate financing conditions and financial stability can also be important.

Available data suggests that households’ direct holdings of equities remain small by international standards, but are rising with efforts to promote private institutional saving. Households’ aggregate net worth range from lows of 10 percent of GDP in some low-income countries to in excess of 300 percent of GDP in higher income countries. As a rule, only a small portion of this wealth is directly held in stocks, as households generally prefer relatively safe instruments such as bank deposits and government securities.27 In India, almost three quarters of household financial wealth is held in a combination of cash, bank deposits and government securities (available data omit potentially important holdings of nonfinancial wealth, such as gold); in Japan the ratio is about 60 percent and in Korea about one-third. In contrast, households’ direct holdings of shares generally account for less than 10 percent of household wealth. Taking indirect holdings via institutional investors into account, however, raises household exposure to equity to one-fifth to just over one-half of total household net worth, a figure that is sizeable in relation to GDP in several countries.

While still moderate, rising equity holdings are making household wealth more sensitive to market movements. Direct equity holdings are over twice as volatile as holdings of deposits, reflecting swings in market valuation.28 That said, indirect holdings via institutional investors are less volatile than direct stock holdings perhaps reflecting restrictions on investments by institutional investors such as pension funds.

Non-Public Sector Investments in Equity Markets
China1IndiaJapanKorea2Singapore3Taiwan POC
Net holdings in percent of GDP, 2005 4
Total non-public sector investments in securities
markets56.34.584.9-9.4135.864.6
Households56.33.4113.37.2130.2188.3
(in percent of total household assets)18.235.537.255.023.6
Mutual Funds0.113.8
Shares0.134.17.233.5123.5
Derivatives0.0
Insurance1.646.1{ 30.035.245.2
Pensions1.631.661.65.8
External Portfolio investment0.01.50.0
Financial Institutions1.15.99.642.4−17.9
Mutual Funds
Shares1.15.99.613.5−17.9
Derivatives
Insurance25.5{ 0.5
Pensions
External Portfolio investment3.5
Sources: CEIC Data Company Ltd; CMIE, Business Beacon; China Human Development Report; Singapore Department of Statistics; and Monetary Authority Singapore.

For China, total wealth invested in all types of financial assets in 2002.

In Korea, foreign investors hold some 11.3 percent of GDP in Korean stocks. If these and the holdings of the government sector is included, total stock market assets in the economy is about 6 percent of GDP.

For Singapore, household and corporates holdings reported by the departments includes securities in addition to shares. To remove the securities component, the table assumes that the corporate sector share issue is equally divided between the financial and household sectors.

2004 for Singapore, Taiwan POC and Thailand. For Thailand flows into financial assets in 2004.

Sources: CEIC Data Company Ltd; CMIE, Business Beacon; China Human Development Report; Singapore Department of Statistics; and Monetary Authority Singapore.

For China, total wealth invested in all types of financial assets in 2002.

In Korea, foreign investors hold some 11.3 percent of GDP in Korean stocks. If these and the holdings of the government sector is included, total stock market assets in the economy is about 6 percent of GDP.

For Singapore, household and corporates holdings reported by the departments includes securities in addition to shares. To remove the securities component, the table assumes that the corporate sector share issue is equally divided between the financial and household sectors.

2004 for Singapore, Taiwan POC and Thailand. For Thailand flows into financial assets in 2004.

Household Balance Sheet Volatility Measures
IndiaJapanKoreaSingapore
(2000-05)
Volatility1
Household Wealth0.200.040.070.06
Deposits0.310.040.060.03
Securities (non-share)0.390.150.05
Share holdings0.530.230.020.20
Mutual Funds0.47
Insurance0.290.020.040.25
Pensions0.060.100.09
Sources: CEIC Data Company Ltd; Business Beacon; Singapore Department of Statistics; and IMF staff estimates.

The standard deviation divided by the mean for the period.

Sources: CEIC Data Company Ltd; Business Beacon; Singapore Department of Statistics; and IMF staff estimates.

The standard deviation divided by the mean for the period.

The financial sector’s direct exposure to equity markets also appears relatively limited. Except in Taiwan Province of China, where domestic financial institutions are net issuers, direct holdings of shares are relatively small, generally less than 10 percent of GDP and under 1 percent of total net assets. As such, financial institutions do not appear to be unduly vulnerable to direct losses arising from downward movements in the value of their stock holdings.

In sum, an equity market correction, in and of itself, would seem unlikely to have a major macroeconomic impact in Asia. Outside a few markets, valuations do not seem overly lofty. Moreover, available data suggest that households’ and financial institutions’ direct exposures to equity markets are generally modest. In addition, while equity markets play a growing role in corporate finance, Asian financial systems remain bank-dominated. That said, an equity market correction could be significant if it were triggered by broader macroeconomic or financial stress—say, slowing global growth, or widespread financial fragilities—and in turn would exacerbate the impact of such stress on Asian countries. In addition, indirect exposures through institutional investors are nonnegligible and growing in some countries, and over time could increase households’ exposure to asset-price cycles.

Policy Implications

The growth and development of well-functioning equity markets conveys long-run economic benefits to Asia. It provides an efficient savings vehicle for retail and institutional investors, helping to diversify their financial holdings. Moreover, the increased diversity of funding sources for corporations can make Asian financial systems more robust to shocks. Davis (2001) finds that when active securities markets supplement the banking system, corporate financing is more stable during both economic downturns as well as banking and securities market crises. Moreover, empirical studies find that well-developed stock markets can support long-run economic growth.

That said, the aim of reaping the maximum benefit from the growth of equity markets, while managing the risks, has both microeconomic and macroeconomic policy implications. On the microeconomic side, the growing role of equity markets puts a premium on well-functioning market trading, clearing and settlement systems, transparency, and corporate governance. Given that the technical infrastructure seems well developed, a main challenge going forward may be expanding over time the capacity to handle a high volume of transactions (Ghosh, 2006). (See also Box 4.2, which discusses the role of institutions and markets in fostering financial integration.)

Box 4.2.Fostering Financial Integration and Economic Stability1,2

What are the market infrastructure and regulatory frameworks needed to reap the benefits—and contain the risks—of financial integration in Asia? What are the next steps for institutional reform and development?

Strengthening Capital Markets

The integration of Asian financial markets with the global financial system is well advanced. By contrast, intraregional financial investments are surprisingly low. Asian policymakers have recognized the importance of strengthening capital markets and many initiatives have been launched at the national and regional level to deepen domestic markets and establish pan-Asian markets. Areas for further reforms include:

  • Developing Institutional Investors. Reforms aimed at strengthening the investor base by increasing the role of institutional investors—asset managers, insurance companies, and pension funds—can have a profound impact on the development of regional capital markets. Pension reforms are a key as historically pension funds in Asia have been state-sponsored and defined benefit.

  • Strengthening Corporate Governance. The prevalence of controlling holdings of companies by families or other corporations continues to place importance on the protection of minority shareholders. There is also a need for cost effective legal channels for shareholders seeking redress to ensure that rights can be practically enforced. Takeover codes are an important element to ensure a fair market for corporate control and examples such as the Hong Kong SAR and Singapore Codes on Takeovers and Mergers provide useful models. Finally, the role of the Board of Directors in protecting shareholder rights is fundamental and more training and guidance for this role is also needed.

  • Improving Transparency. Increased transparency and accountability through moving to a common financial reporting framework—the International Financial Reporting Standards (IFRS)—is another key reform. To ensure the consistent application of IFRS, external audit of financial statements should preferably be based on the International Standards on Auditing.

Building Market Infrastructures

In many Asian countries, market infrastructures have been developed nationally but, for the most part, regional systems and linkages are rudimentary. The remaining agenda includes:

  • Enhancing Market Depth and Liquidity. Further steps to improve transparency, encourage diverse participants, and develop derivative markets could enhance depth and liquidity in capital markets. For instance, although primary issuance markets for bonds have been developing rapidly since 1997, there is poor liquidity in most secondary markets.

  • Building Regional Clearing and Settlement Systems. Domestic clearing and settlement processes are well-developed in many

    Asian markets, so attention could focus on establishing regional linkages.

  • Establishing Regional Credit Rating and Benchmarks. The development of a regional risk rating agency should also be facilitated, as a means of ensuring standardized ratings and more complete coverage.

Harmonizing Rules and Practices

An important agenda is to address differences in laws, regulations, and tax treatments that prevent investors—from both within and outside Asia—from building pan-regional portfolios. This is a difficult task, requiring close collaboration among countries and assistance from international institutions and agencies, but it has the potential to produce large payoffs. This involves:

  • Strengthening Implementation of Global Standards and Best Practices. Within regulatory and supervisory frameworks, nonbank financial institutions and capital markets deserve emphasis. These are key if institutional investors—insurance companies and pension funds—and capital markets are to become more integrated. In addition, weaknesses in the prudential and supervisory framework for banking still need to be addressed.

  • Reviewing Taxes on Financial Products and Services Across the Region. Consideration could be given to the benefits of more harmonization of taxes on capital market transactions. Such taxes may come in the form of transaction taxes and stamp duties; taxes on dividends and capital gains; and withholding tax.

Removing Impediments

The removal of capital and exchange controls could increase cross-border flows and competition. Rules in some countries, including limits on foreign ownership and associated rights, still inhibit cross-border flows. In many countries, existing prudential requirements bias investment toward domestic assets. Reforms could include:

  • Further Liberalizing Capital Flows. While capital accounts in many Asian countries have been gradually liberalized, further steps could be taken to relax restrictions on cross-border investments while maintaining appropriate prudential safeguards.

  • Liberalizing Financial Services and Prudential Regulation. Further liberalizing the financial services sector would be beneficial as controls and limits remain on ownership shares, voting rights, licenses, and branch networks. Another reform is to reexamine prudential limits on pension funds’ and life insurers’ investments which may have inadvertently biased investment domestically, and to government securities.

Minimizing Risks

Greater financial integration brings about new risks that have to be anticipated and managed, especially as institutions and individual invest in new markets and instruments. Aside from the risks arising from potential currency mismatches and country exposures, risks also arise for institutions that are increasingly active in a variety of financial sectors and regions. At a minimum, managing the risks associated with greater integration involves:

  • Moving Towards Risk-Based Supervision. Risk-based supervision is needed to effectively manage risks from more sophisticated institutions and products. This is particularly true in banking, where many Asian countries intend to adopt the Basel II framework. Effective implementation will require capacity building both for supervisors and domestic banks, as well as enhanced cross-border cooperation to avoid regulatory arbitrage or unexpected risk migration.

  • Addressing Cross-sectoral and Cross-border Issues. Consolidated supervision—and close cooperation among sector supervisors—is needed to deal with risks from diversified financial groups. With deeper cross-border linkages, improved cross-border supervision and cooperation is also increasingly important.

1 The main author of this box is Leslie Eng Sipp Teo.2 Based on a background paper prepared by ICM and MFD staff for the 2nd IMF-MAS High Level Seminar on Asian Financial Integration held in Singapore on May 25, 2006.

Low liquidity in some markets may reflect issues of transparency and corporate governance. These issues generate information asymmetries and the risk of adverse selection (when trading against better-informed investors), and accordingly foster high bid-asked spreads and limited trading activity. While de jure transparency and corporate governance have improved over time, investor perceptions suggest gaps in the application of existing frameworks.

The growth of equity markets also has potential implications for prudential regulation and supervision, which exist at the boundary of micro- and macro-financial stability. Appropriate regulation and supervision of institutions active in equity markets is essential for sound functioning of equity markets. Equally important is a firm understanding and strong management of equity exposures among financial institutions, so that equity-market volatility does not engender broader financial spillovers (see Korea’s Financial Stability Report (October 2005). For example, in financial systems where banks are active in stock markets, stress testing of equity market exposures—as done in the Monetary Authority of Singapore’s Financial Stability Review (December 2005)—is important to limit the risk that an equity-market correction could create fragility in the banking system, potentially causing banks to rein in lending and giving rise to a credit crunch.

Another, more controversial macroeconomic policy question is whether—and if so, how—monetary policy should respond to asset-price fluctuations. For economies in emerging Asia, where the direct macroeconomic impact of stock prices may be limited, this could be largely a question for the future. Nevertheless, it is well agreed that equity prices are an important input to monetary policy decision-making, because they reflect the market’s assessment of future economic prospects. It is also relatively uncontroversial that current and past equity-price developments may appropriately be factored into monetary policy, because such developments influence consumption and business investment through their effects on household wealth and the cost of capital.

Still actively debated is whether monetary policy should respond preemptively to the emergence of imbalances in equity and other financial markets. One school of thought contends that, especially in an environment of low inflationary pressures, accommodative monetary policy settings can feed financial imbalances (White 2006). The long-run buildup and sudden unwinding of such imbalances can seriously impair financial and macroeconomic stability. In addition, moral hazard could arise if central banks’ mandates for macroeconomic (and sometimes financial) stability oblige them to ease in response to busts (Schinasi 2006 discusses the role of central banks in promoting financial stability). By this view, central banks have a motive—if not an obligation—to respond to such imbalances.

The more conventional school holds that monetary policy is too blunt an instrument to restrain financial imbalances—prudential policy is a better tool (Bernanke, 2002). Even trying to do so could inflict major economic damage. Moreover, financial bubbles are too difficult to identify, even in hindsight. Accordingly, mistakenly tightening in response to a fundamentals-driven asset price boom (reflecting, say, productivity-enhancing technological innovation) could choke off potential growth. These considerations seem particularly relevant for Asian emerging markets countries, where structural changes complicate the relationship between monetary policy and asset prices, as well as between asset prices and economic activity. This would imply a reliance on prudential measures as a first line of defense against the macroeconomic effects of financial imbalances. While these issues will no doubt remain actively debated, the continued growth of financial markets will over time make them of increasing importance to policymakers.

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