Market chaos could affect development in emerging Asia

Source: MSCI Barra Indices

This year has been a wild ride in the capital markets across emerging Asia. As of Oct. 31, the major developing country stock markets in the region have fallen by over 50 percent this year alone, continuing a rapid decline that began in October 2007. These rapid declines have wiped out approximately US$2.2 trillion in value from the beginning of the year to the end of the third quarter, according to data from the World Federation of Exchanges. Despite these massive declines, it does not seem like the stock market downturns have (yet) damaged the real economy. Some investors get burned and some financial institutions lose money, but there is no meltdown as has been the case in the U.S. and Europe. So, what’s the big deal?

The big deal is that aside from bank financing and corporate debt, the other key channel of firm financing across Asia are the equity markets. The use of equity financing by firms in the major emerging markets in the region has grown rapidly and the forms of domestic corporate financing reveal this. Among the six major emerging markets in Asia, the average use of equity financing is over 36 percent (see graph below).

Source: Asian Development Bank, AsianBondsOnline. Data as of end-March 2008.

Because of the massive declines in the equity markets, the stock market is now effectively blocked as a channel of corporate finance. If up to one-third of a corporation’s financing is no longer available, this will probably become a major constraint to their future operations! The closure of the markets to new fundraising is clear. According to Thomson Reuters’ recent Q3 Equity Capital Markets Review, Asian Initial Public Offerings (excluding China A-shares) totaled US$17.3 billion from 160 issues, a 58.8 percent decline from the same period in 2007. The number of withdrawn IPOs was 33 valued at $11.3 billion (as compared to 10 at $3.1 billion in all of 2007).

Governments in Asia are not asleep. In fact, there has been a lot of activity across the region. Circuit breakers tripped in Indonesia on Oct. 7, sending trading to a halt as the market slid 10 percent for the second time in a week. A similar mechanism briefly stopped trading in Japan on Sept.15, and circuit breakers are now in place in the Philippines and Thailand. Some Asian regulators, wary of higher volatility and steeper declines in share prices, have narrowed the trading bands in their markets (Taiwan and Vietnam) or curbed short sales (Australia, Indonesia, Korea, Taiwan, and Vietnam). China moved against the grain by authorizing short sales in the hope that any market activity will result in net buying. China, Malaysia, and Taiwan have also gone to the extent of conducting stabilization and quasi-stabilization fund operations.

Because much of this market turmoil has been affecting stock markets that are in relatively early stages of development, the result may be backward progress for capital market development in the region. The regulatory authorities are receiving the blame for stock market crashes, but they have been trying to limit the market declines. However, this episode will likely make the regulators much more cautious in approving new public share offerings and new forms of securitization and structured financial products, and this could hinder future market development. As I noted in a previous post, no one would advocate creating sub-prime types of securities in these markets, but the concern is that all new or emerging products will be stopped. 

Also, many of the markets that have been hardest hit, including China and Vietnam, are characterized by a high proportion of retail (i.e., individual) investors. In China, a report by the China Securities Regulatory Commission found that in 2007, small investors with less than RMB 1 million (about US $143,000) in cash or shares equivalent, accounted for 99 percent of total number of accounts on the main stock exchange (the Shanghai Stock Exchange), 74 percent of total trading volume, and 41 percent of total market capitalization. Therefore, these individual investors will not likely be willing to participate in the markets again for quite some time, either directly or indirectly via mutual funds and other vehicles. Beyond the retail investors, the institutional investors, such as pension funds, insurance companies, mutual funds, etc., have become very risk averse and are turning away from the equity markets.

Firms -- the engines of income and employment creation -- are now less able to get the financing they need to maintain or expand operations and investors no longer have an alternative to banks. This basic situation leads me to believe that the current market chaos is already having a negative impact on overall financial sector development across emerging Asia. This in turn will result in slower economic growth prospects. What to do about the situation might be a topic for another day.