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Chapter 9. ASEAN Financial Integration: Harnessing Benefits and Mitigating Risks

Ratna Sahay, Cheng Lim, Chikahisa Sumi, James Walsh, and Jerald Schiff
Published Date:
August 2015
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Geert Almekinders, Alex Mourmouras, Jade Vichyanond, Yong Sarah Zhou and Jianping Zhou 

Main Points of this Chapter:

  • The 10 member countries of the Association of Southeast Asian Nations (ASEAN)1 have performed very well during the past decade, with growth averaging more than 5 percent a year. The region is receiving ample foreign direct investment, but financial integration of most ASEAN economies lags behind that of other emerging market economies.
  • Further liberalization of interregional and intraregional flows of goods, services, and capital could be beneficial for growth, the creation of jobs, and inclusion in ASEAN. Most ASEAN countries are still at a relatively early stage of development and have large infrastructure gaps. In light of this, the planned further opening up of ASEAN economies can be expected to unlock growth-enhancing cross-border flows of capital, when taken in the context of reform commitments establishing the ASEAN Economic Community (AEC) by 2015, other regional and bilateral free trade agreements, and the Trans-Pacific Partnership, which continues to be under discussion.
  • ASEAN countries are, for the most part, taking a cautious approach toward further liberalization and integration. Experience elsewhere shows that financial liberalization can exacerbate prevailing domestic financial sector vulnerabilities and heighten external vulnerabilities and risks. However, while erring on the side of caution may have benefits, delays to further financial integration could hold back growth and job creation. Therefore, the ongoing work to foster a consensus on a detailed road map to ASEAN financial integration should be intensified. Actions to minimize potential adverse effects should complement this work. Accordingly, individual countries should address financial sector vulnerabilities and strengthen policy frameworks to make them more resilient to shocks. Reinforcing bilateral, regional, and global financial safety nets can also play an important role.


ASEAN is a diverse group of 10 fast-growing countries at very different stages of economic and financial development. Their populations are young and growing and have high saving rates. But investment needs are also large, related to advancing urbanization and the region’s growing middle class as well as the need to increase connectivity and provide hard and soft infrastructure. The region has witnessed an increase in trade and capital flows, both within the region and in relation to the rest of Asia and the world. ASEAN financial integration has also progressed. Direct investment has risen, cross-border banking linkages have deepened, and foreign participation in ASEAN capital markets has increased. Financial integration in ASEAN could gather steam in the years ahead, including through the establishment of the AEC in 2015 (Box 9.1). If properly phased and sequenced, and with adequate safeguards put in place, the prospect of greater ASEAN financial integration brings with it the promise of greater financial inclusion and faster real convergence in incomes per capita. These advancements could help reduce poverty and ameliorate the strong migration incentives in the region that are generated by large wage disparities.

This chapter takes stock of ASEAN’s financial integration and its prospects. More financial integration of ASEAN with other capital-abundant Asian countries, especially the “plus three” (China, Japan, and Korea), can be expected to trigger large capital flows. Strong pull forces could potentially drive large capital flows and financial integration as the less-open ASEAN member countries liberalize their capital accounts and financial sectors, resulting in important benefits for ASEAN countries’ growth and development. The chapter also reviews the AEC agenda for possible impediments to closer financial integration, including insufficient real and financial infrastructure in some countries.

Coming out of the Asian financial crisis of the late 1990s, ASEAN countries have made great strides in strengthening their macroeconomic frameworks and their external positions. Theory and experience from other geographic regions suggest that some ASEAN countries’ current account balances can be expected to become more volatile when the region’s financial integration gathers pace and barriers to cross-border flows are gradually removed. As larger current account deficits are financed by a mix of capital flows, risks will rise. The resulting increased macroeconomic volatility will need to be managed at the individual country, regional, and global levels. The bouts of volatility of cross-border capital flows since May 2013 related to the actual and prospective unwinding of unconventional monetary policies in advanced economies serve as a reminder that the region’s financial architecture is still a work in progress. In view of this, and given existing financial sector vulnerabilities in some of the low-income ASEAN countries, policymakers have been taking a cautious approach in moving forward with further financial and capital account liberalization. As they move further along with this process, ASEAN countries should continue to strengthen their macroeconomic frameworks and financial systems. They can rely on substantial quantities of international reserves and other buffers, including bilateral credit lines and regional financial safety nets (for example, the Chiang Mai Initiative Multilateralization), which could help their resilience to risk-on, risk-off cycles in capital flows.

Box 9.1.ASEAN and the ASEAN Economic Community 2015: A Brief Chronology

The Association of Southeast Asian Nations (ASEAN) is home to more than 610 million people, of whom about 100 million live below the poverty line. In its early days, ASEAN’s primary focus was reducing geopolitical tensions in the region. In 2003, ASEAN leaders decided to establish an ASEAN Economic Community (AEC) by 2020. The target date for the AEC was subsequently moved up five years. Amid growing concerns about the ASEAN region’s perceived loss of competitiveness to China and India, there was a strong desire to enhance the region’s role against the backdrop of a proliferation of free trade agreements between ASEAN and its trade partners. Accordingly, in 2007, ASEAN leaders agreed on a blueprint for an integrated AEC by 2015.

The AEC has set four main targets: (1) fostering a single market and production base with a free flow of goods, services, investment, and skilled labor, and freer flow of capital within ASEAN; (2) developing a highly competitive economic region nurturing fair competition, consumer protection, intellectual property rights, and infrastructure development; (3) attaining equitable economic development by strengthening small and medium-sized enterprises; and (4) achieving ever greater integration into the global economy. The AEC Blueprint lays out 176 priority actions, including nine related to the free flow of financial services, strengthening ASEAN capital market development and integration, and allowing greater capital mobility. An AEC scorecard mechanism was introduced in 2008 to monitor progress in achieving the milestones laid out in the blueprint and to track the priority actions undertaken by ASEAN member states, both individually and collectively.

Key initiatives to support ASEAN financial integration

Key initiatives taken to date include the following:

  • The Master Plan on ASEAN Connectivity—In 2010, ASEAN leaders adopted the Master Plan on ASEAN Connectivity. The plan’s objective is to facilitate the establishment of the AEC by 2015 by enhancing intraregional connectivity in areas such as trade, investment, tourism, and development. ASEAN Connectivity comprises three main elements: (1) enhancing physical connectivity by improving transportation, information and communication technology, and energy infrastructure; (2) improving institutional connectivity by setting up procedures to facilitate international transactions of goods, services, and the cross-border movement of skilled workers; and (3) strengthening people-to-people connectivity through sociocultural initiatives such as education and tourism within ASEAN. While improving intra-ASEAN connectivity would bring significant benefits, it also poses important challenges, including cross-border crime, illegal immigration, and environmental degradation.
  • Cross-border collaboration enhancements—Several initiatives have been taken to enhance cross-border collaboration among the various capital markets in ASEAN, including the following efforts to build capacity and infrastructure:
    • The Working Committee on Capital Account Liberalization monitors the implementation of priority actions to achieve freer flow of capital in the region in line with the AEC Blueprint.
    • The ASEAN Capital Markets Forum focuses on the harmonization of domestic laws and regulations and the development of market infrastructure with a view to integrating the region’s equities markets.
    • In April 2010, ASEAN central bank governors endorsed the creation of the Working Committee on Payment and Settlement Systems, which focuses on policy, legal frameworks, instruments, institutions, and market infrastructure.
    • In April 2011, ASEAN central bank governors endorsed the creation of the Task Force on the ASEAN Banking Integration Framework, which aims to achieve ASEAN-wide banking sector liberalization by 2020. The Working Committee on Financial Service Liberalization focuses on further liberalization of the banking and insurance sectors.
    • The ASEAN Capital Markets Infrastructure Blueprint was developed in 2013. Accordingly, the Working Committee on Capital Market Development aims to enable ASEAN issuers and investors to access cross-border ASEAN equity and bond markets through integrated access, clearing, custody, and settlement systems and arrangements.

Initiatives to strengthen regional economic surveillance and crisis management

To complement the integration initiatives, considerable progress has been made in setting up regional institutions to enhance information sharing, improve economic surveillance and crisis management, and provide a regional safety net, including the following:

  • The ASEAN Integration Monitoring Office was established in 2010 to enhance the ASEAN Secretariat’s monitoring capacity for tracking progress of regional economic integration.
  • The Chiang Mai Initiative Multilateralization (CMIM), established in March 2010 among the ASEAN+3 countries, is a multilateral currency swap arrangement that replaced the preexisting Chiang Mai Initiative’s network of bilateral swap lines.
  • A crisis prevention facility, the CMIM Precautionary Line, has been introduced.
  • An independent regional macroeconomic surveillance unit—the ASEAN+3 Macroeconomic Research Office (AMRO)—has been operating in Singapore since 2011.
  • In their New Delhi communiqué of May 2013, the ASEAN+3 Ministers of Finance and Central Bank Governors called for an “effective cooperative relationship with the International Monetary Fund (IMF) and other multilateral financial institutions in the areas of surveillance, liquidity support arrangements, and capacity development.”

Further progress in advancing regional surveillance and strengthening crisis management institutions, including their analytical capacity and cooperation with the IMF, is high on ASEAN’s agenda. In this regard, recent initiatives have included information sharing on macroprudential policies and capital flow management measures. Initiatives have also been taken to expand the scope of integration to other partners in Asia, including through the ASEAN+3 initiative and the Regional Comprehensive Economic Partnership (ASEAN+6, comprising ASEAN countries plus Australia, China, India, Japan, Korea, and New Zealand). The U.S.–ASEAN Expanded Economic Engagement initiative, agreed to in late 2012, calls for expanding trade and investment and engaging with regional institutions.

This chapter briefly takes stock of growth and trade integration in ASEAN and assesses the state of ASEAN financial integration to date. This stocktaking is followed by a discussion of the benefits of further liberalization and regional integration in ASEAN. The chapter goes on to review policy measures at the national, ASEAN, and regional levels that would help promote further safe financial development and financial integration, including in the context of ASEAN countries’ commitment to establishing the AEC.

Growth, Trade Integration, and Financial Integration in ASEAN

ASEAN countries have performed very well during the past decade. Since the turn of the century, ASEAN-wide economic growth has averaged 5¼ percent a year (weighted average), and the economies of the individual member countries have expanded by 5¾ percent a year, on average (Table 9.1). The success of most ASEAN member states has been associated with a long-standing export-oriented development strategy. As a consequence—with the exception of Indonesia, Myanmar, and the Philippines—ASEAN countries boast large trade openness, with the sum of imports and exports of goods and services exceeding 100 percent of GDP. The downside of this large trade openness was visible when the slump in international trade in 2008–09 triggered by the global financial crisis caused growth to slow in ASEAN. But this was followed by a pronounced rebound when international trade recovered (Figure 9.1).

Table 9.1ASEAN Countries: Selected Economic Indicators
IndonesiaMalaysiaPhilippinesSingaporeThailandBrunei DarussalamCambodiaLao P.D.R.MyanmarVietnam
GDP in 2013 (billions of U.S. dollars)87031327229838716161157171
Population in 2013 (millions)248.029.997.55.468.20.415.16.851.089.7
GDP per capita in 2013 (U.S. dollars)
Purchasing power parity basis (2012)14,27214,7753,80353,2668,45945,9792,1504,3353,9893,133
Poverty in 2012 (percent of population)
Below two dollars per day13.00.213.8n.a.0.7n.a.15.124.8n.a.13.5
Below national poverty line12.01.726.5n.a.13.2n.a.20.527.6n.a.20.7
Income inequality (Gini coefficient)
2012 (or latest available year)
Growth (percent)
2010–12 (average)
Inflation (percent period average)
2010–12 (average)
Fiscal balance (percent of GDP)
2010–12 (average)−1.2−4.0−1.17.0−1.117.8−3.6−1.8−3.9−3.5
Public debt (percent of GDP)
Public debt in 20102654439743129625048
Public debt in 201326583910346228614052
Of which: external debt1423186032431921
Current account balance (percent of GDP)
Gross reserves at end-2013
Level (billions of U.S. dollars)99.4134.983.2273.1167.
In months of imports5.86.811.
Trade openness in 2013 (imports plus exports in goods and services in percent of GDP)
Total trade481545335814411514111253163
Intra-ASEAN merchandise trade1138970263527602223
FDI inflows during 2010–12 (average, percent of GDP)
From within ASEAN20.
Portfolio inflows during 2010–12
From within ASEAN0.−0.2
Private credit in 2013
Growth (percent)2010165410727366613
Private credit (percent of GDP)36134361731213145391597
Number of banks in 20123119274912430835321047
Of which: foreign and joint banks241915119145122106
Sources: Bankscope; CEIC Data Co. Ltd.; country authorities; IMF, 2014 Coordinated Direct Investment Survey, 2014 Coordinated Portfolio Investment Survey, Direction of Trade Statistics September 2014, World Economic Outlook October 2014; World Bank, World Development Indicators 2014; and IMF staff calculations.Note: ASEAN = Association of Southeast Asian Nations; FDI = foreign direct investment; n.a. = not available.

Constant 2005 international U.S. dollars, except for Lao P.D.R. and Myanmar data from World Economic Outlook (nominal purchasing power parity GDP/population).

Excluding services.

Data for Vietnam refer to 2011.

Sources: Bankscope; CEIC Data Co. Ltd.; country authorities; IMF, 2014 Coordinated Direct Investment Survey, 2014 Coordinated Portfolio Investment Survey, Direction of Trade Statistics September 2014, World Economic Outlook October 2014; World Bank, World Development Indicators 2014; and IMF staff calculations.Note: ASEAN = Association of Southeast Asian Nations; FDI = foreign direct investment; n.a. = not available.

Constant 2005 international U.S. dollars, except for Lao P.D.R. and Myanmar data from World Economic Outlook (nominal purchasing power parity GDP/population).

Excluding services.

Data for Vietnam refer to 2011.

Figure 9.1Real GDP Growth


Sources: IMF, World Economic Outlook, October 2014; and IMF staff calculations.

Note: ASEAN = Association of Southeast Asian Nations.

Intra-ASEAN trade has grown rapidly, but there is scope for further regional trade liberalization with potentially important benefits for growth and employment:

  • Intra-ASEAN trade has almost quadrupled since 2000, to $630 billion in 2013. Excluding Singapore, whose large gross trade flows can cloud underlying trends in the other member countries, intra-ASEAN trade now accounts for 23 percent of total ASEAN trade, up from 21 percent in 2000 (Figure 9.2). ASEAN countries’ intraregional trade remains considerably smaller than does intraregional trade in the European Union (EU) (50 percent of total trade). Studies indicate that nontariff measures may be holding back the growth of regional trade in ASEAN (Basu Das and others 2013; World Bank 2014). The gradual removal of these nontariff measures, consistent with the Strategic Schedule in the AEC 2015 Blueprint, could provide renewed impetus to the creation of a single ASEAN market for goods and services. China’s rising importance as a trading partner for ASEAN countries reflects increasing trade in intermediate goods as ASEAN countries and China integrate to form supply chain networks (IMF 2010).
  • There are also signs that regional trade within ASEAN has become increasingly oriented to final consumer goods (Figure 9.3). This, together with a large and vibrant domestic market and a growing middle class, appears to provide the region with a potential source of resilience to global demand shocks. For instance, Cubero and others (2014) find that, besides global demand, intraregional demand is an important driver of growth in most ASEAN-5 countries (Indonesia, Malaysia, the Philippines, Singapore, and Thailand). This outcome applies less to Indonesia, which has a lower trade-to-GDP ratio and sends the bulk of its commodity-heavy exports outside ASEAN.

Figure 9.2ASEAN: Intraregional Trade and Trade with China

(Percent of total merchandise trade)

Source: IMF, Direction of Trade Statistics, September 2014; and IMF staff calculations.

Note: ASEAN = Association of Southeast Asian Nations.

Figure 9.3ASEAN-5: Intraregional Exports by Category

(Percent of total exports in each category)

Sources: UN Comtrade; and IMF staff calculations.

Typically, a country’s degree of financial integration tends to increase with its degree of trade integration. However, as noted by Pongsaparn and Unteroberdoerster (2011), compared with the rest of the world, most Asian economies’ rapid expansion into global trade has not been matched by a commensurate increase in their degree of financial integration. This is particularly the case for ASEAN economies, for which the main channel of financial integration is through foreign direct investment (FDI) flows. Pongsaparn and Unteroberdoerster (2011) estimate a model that relates the degree of financial integration, measured by countries’ ratio of capital flows to GDP, to a set of country characteristics including trade integration, relative GDP growth, interest and exchange rate movements, and exchange rate volatility. They consider a panel of 90 advanced and emerging markets. Except for the financial centers of Hong Kong SAR and Singapore, the degree of financial integration of many Asian economies is below the level predicted by the model for all economies, and in several cases falls behind the norm for Latin America and Eastern Europe.

FDI is generally regarded as a desirable form of capital inflows. In addition to capital, FDI can bring improved technology, generating knowledge spillovers that can result in total factor productivity growth in recipient countries. Moreover, though net FDI flows to emerging and developing countries do exhibit fluctuations, they have consistently been positive during the past three decades (Park and Takagi 2012). Recent trends and the outlook for FDI flows to ASEAN are favorable:

  • FDI flows to ASEAN amounted to a record high of $125 billion in 2013, up 7 percent from 2012 (Figure 9.4). Moreover, at almost 9 percent of world FDI inflows, ASEAN’s share of total global FDI is back to the level it reached during the boom years preceding the Asian financial crisis of the late 1990s (Figure 9.5).
  • The trend of rising FDI inflows, in U.S. dollar terms and in relative terms, applies equally to the group of ASEAN-4 countries (Indonesia, Malaysia, the Philippines, and Thailand), Singapore (which continues to receive half of all FDI inflows into ASEAN), and the CLMV countries (Cambodia, Lao P.D.R., Myanmar, and Vietnam) and Brunei Darussalam, which together now account for about 11 percent of FDI inflows into ASEAN.
  • Several factors may be helping to make ASEAN an attractive investment destination. Manufacturing wage costs in ASEAN have been declining relative to China, owing to divergent demographics and exchange rate movements. The favorable trend in relative wage costs is expected to continue, reflecting stronger labor force growth in ASEAN. Geopolitical considerations and ASEAN’s growing middle class could also drive more FDI into ASEAN. The U.S.-ASEAN Expanded Economic Engagement initiative calls for expanding trade and investment and engaging with regional institutions. Last, ASEAN’s commitment to form a single market and production base can be expected to reduce trade and investment barriers and provide economies of scale.
  • The World Bank (2014) finds that foreign ownership restrictions are still common in ASEAN countries, particularly in the services sector. Relaxing these restrictions could give rise to substantial productivity-enhancing FDI inflows and provide an impetus to the structural transformation and convergence of the emerging market and frontier economies in ASEAN.

Figure 9.4Emerging Asia: Nominal Foreign Direct Investment Inflows, 2000–13

(Billions of U.S. dollars)

Source: United Nations Conference on Trade and Development.

Note: ASEAN = Association of Southeast Asian Nations. CLMV = Cambodia, Lao P.D.R., Myanmar, and Vietnam. Other emerging Asia comprises Bangladesh, Bhutan, Korea, Macao SAR, Mongolia, Nepal, Sri Lanka, Taiwan Province of China, and Timor-Leste.

Figure 9.5Emerging Asia: Share of FDI Inflows, 2000–13

(Percent of world FDI inflows)

Source: United Nations Conference on Trade and Development.

Note: ASEAN = Association of Southeast Asian Nations. CLMV = Cambodia, Lao P.D.R., Myanmar, and Vietnam. FDI = foreign direct investment. Other emerging Asia comprises Bangladesh, Bhutan, Korea, Macao SAR, Mongolia, Nepal, Sri Lanka, Taiwan Province of China, and Timor-Leste.

The level of banking integration in ASEAN is rising, but from a low base, and global banks have a bigger footprint in ASEAN than do regional banks:

  • Bank for International Settlements (BIS) locational banking statistics indicate that BIS reporting banks’ cross-border exposure to Asia and ASEAN-5 countries in U.S. dollar terms increased during 2012–13. Meanwhile, deleveraging from the euro area and Eastern Europe continued, and banks’ cross-border assets in Latin America were flat in 2012–13. BIS reporting banks’ cross-border liabilities have, for the most part, changed little during 2012 and 2013. Relative to GDP, the value of BIS reporting banks’ cross-border assets trended upward in relation to Malaysia, Thailand, and Indonesia in 2012–13. It remained mostly flat in Singapore and the Philippines.
  • Bilateral banking integration is particularly low in ASEAN. ADB 2013 reports that foreign banks accounted for 18 percent of total commercial bank assets in Malaysia, the Philippines, and Thailand in 2009. The share of ASEAN-based banks in Malaysia, at 8.5 percent, was the highest among the three member states. The share was 0.4 percent in the Philippines and 3.7 percent in Thailand. Based on detailed country-by-country BIS data, Duval and others (2014) calculate that the level of bilateral banking integration in Asia has continued to lag behind the rest of the world. Their calculations echo the ADB’s (2013) finding that bilateral banking integration is particularly low among ASEAN-5 countries (Figure 9.6).

Figure 9.6Bilateral Banking Integration

Source: Duval and others (2014).

Note: ASEAN = Association of Southeast Asian Nations. Calculated as period medians of the median country pairs in each group, expressed as a percentage of the total external position with the world.

Banks are likely to be the leaders of ASEAN financial integration, given the opportunities provided by the deleveraging of European banks and the prospects of the AEC. They also remain key to financial intermediation in the region. Singapore, as one of the largest financial centers in the world, plays a dominant role in regional financial integration. Malaysian banks have also expanded abroad significantly.

Cross-border portfolio investment inflows to ASEAN countries have been rising. However, as noted by Pongsaparn and Unteroberdoerster (2011), relative to GDP, cross-border portfolio investment in Asia and other emerging markets has remained well below that of the euro area. Moreover, the bulk of Asia’s portfolio investment has remained interregional (that is, with economies outside the region), especially after adjusting for the role of Hong Kong SAR and Singapore in intermediating inflows from outside the region. In contrast, portfolio investment in the euro area is mostly intraregional.

As was the case with other emerging market economies, ASEAN economies experienced a strong pickup in portfolio investment during 2010–12, following the temporary retreat caused by the global financial crisis. Advanced economies’ unprecedented liquidity-easing measures undertaken to mitigate the effects of the global financial crisis were a key contributing factor to the acceleration of portfolio flows to ASEAN countries. ASEAN-5 economies may have received a relatively larger share of these inflows by virtue of the ongoing progress in developing local currency bond markets, the Asian Bond Markets Initiative, and the linking of stock markets in Malaysia, Singapore, and Thailand. Data on inflows in equity and bond funds for ASEAN-5 countries show that overall portfolio flows surged in the first four months of 2013 (Figure 9.7). After that, expectations of a reduction in the U.S. Federal Reserve System’s monetary stimulus (“tapering”) ignited capital outflows from the ASEAN-5 countries and many other emerging markets. An improvement in global risk appetite in the second quarter of 2014 caused capital flows to improve again.

Figure 9.7ASEAN-5: Equity and Bond Funds—Weekly Net Flows, 2008–14

(Millions of US. dollars)

Source: EPFR Global, accessed through Haver Analytics.

Note: Includes exchange-traded fund flows and mutual fund flows.

Price measures also suggest that financial integration in ASEAN, while increasing, has some way to go. Cross-border interest rate and bond yield differentials have narrowed in recent years (see Figures 9.8 and 9.9). However, these differentials remain substantial, even after controlling for exchange rate movements (ADB 2013). Comovements in ASEAN interest rates and bond yields have increased since 2010, but these comovements may also reflect increasing integration with the global market or improving fundamentals (such as lower inflation rates and differentials and improved sovereign credit ratings). Increased comovements in equity market returns, even after controlling for global factors, suggest that stock markets are more integrated than are money and bond markets.

Figure 9.8Selected ASEAN Countries: 10-Year Bond Yields


Source: Haver Analytics.

Figure 9.9One-Month Interbank Interest Rate


Source: CEIC Data Company Ltd.

Toward Further Financial Integration in ASEAN

Most ASEAN countries are still at relatively early stages of development and have large infrastructure gaps. Further liberalization of interregional and intraregional flows of goods, services, and capital could be beneficial for growth, job creation, and living standards of poorer segments of the population in ASEAN. Accordingly, the AEC is working to create a common market with “free movement of goods, services, investment, skilled labor, and freer flow of capital” (ASEAN 2008, 5). This is seen as a multiyear process, with each country, for the most part, moving at its own pace. Consistent with the “ASEAN Way” (ASEAN’s regional multilateralism based on the ideals of noninterference, informality, consultation and consensus, minimal institutionalization, non-use of force, and nonconfrontation) this means that individual ASEAN member countries can take steps toward further financial sector liberalization and capital account liberalization if and when they believe they are ready. This readiness could be a function of several factors, including adequately strengthening relevant policy frameworks and institutions, as well as achieving broadly favorable domestic economic and financial conditions. Although this flexible approach could make for a long, drawn-out process, it does ensure ownership and incentive compatibility. This is important given that considerable risks involved in further opening up the financial sector and the capital accounts have been visible around the world and are by now well documented. Various ASEAN working groups have been meeting regularly to review progress made by individual member countries and discuss next steps. For instance, the 27th meeting of the Working Committee on Capital Account Liberalization was held in Myanmar in February 2014. This gathering coincided with a meeting of the Working Committee on Capital Market Development, also in Myanmar. Given the documented risks of further liberalization, the diligence of these groups is commendable.

ASEAN Financial Sector Liberalization: What Is at Stake?

In theory, financial integration can bring important benefits to a country and a region. ASEAN countries’ financial systems remain, for the most part, bank centered, particularly in the countries at earlier stages of economic development. However, the role of insurance companies, investment funds, and pension funds is growing, particularly in Malaysia and Singapore. Financial integration can spur the development of the financial sector and product innovation. These advancements can boost growth, employment, and financial inclusion—including in the poorer regions of higher-income ASEAN members—by enhancing financial institutions’ competitiveness and efficiency. Financial integration can also help facilitate the development of larger, deeper, and more liquid markets, which can lower the cost of capital, improve resource allocation, enhance diversification of risks, lengthen the maturity of financing, and improve trading and settlement practices. It could also impose greater discipline on governments, banks, and nonbank corporations, and make the economy more resilient to shocks.

For ASEAN, an important aspect of financial integration will be that the less financially developed economies will have the opportunity to catch up with the more developed ones. Table 9.2 highlights the wide divergence in financial development among ASEAN countries. In most, the outstanding stock of credit to the private sector remains below 50 percent of GDP. These countries would stand to gain the most from increased financial integration. At the same time, these countries also currently have the highest credit growth. As discussed extensively in Chapter 7 of Schipke (2015), financial innovation and development in frontier economies and emerging market economies—when poorly supervised or unregulated—can, in some cases, negatively affect macroeconomic stability. State-owned banks continue to have a significant presence in several ASEAN countries, and often have ties to state enterprises. Some economies also engage in directed credit operations as part of their development strategies, which can impose quasifiscal liabilities and impinge on the profitability of private banks. The Asian financial crisis of the late 1990s highlighted the critical vulnerabilities to which rapid (and inadequately supervised) growth in banking and capital markets can give rise. Poor risk management, overexposure to cyclical economic activities, weak governance, and directed and connected lending are only some of the potential hazards. These problems and associated risks can be exacerbated as cross-border linkages grow, and could ultimately prove costly to output, international reserves, and public finances in the event of a crisis.

Table 9.2Credit to the Private Sector
Private Sector CreditGDP Per CapitaCredit Growth
(Percent of GDP)(U.S. dollars)(Percent)
Lao P.D.R.1422391,5944136
Sources: CEIC Data Company Ltd.; Haver Analytics; and IMF staff estimates.
Sources: CEIC Data Company Ltd.; Haver Analytics; and IMF staff estimates.

If managed well, ASEAN financial integration can play a key role in raising living standards in ASEAN’s frontier and emerging markets by spurring financial development and deepening. By contributing to the creation of ASEAN-wide financial markets, financial integration would help overcome the present fragmentation of national financial sectors caused by national regulations and standards (for example, bank supervision, rating agencies, credit bureaus, and securities commissions). The lack of mutual recognition and common disclosure requirements is also standing in the way of the creation of a common market. In this regard it is important to note that the AEC Blueprint calls for regulatory harmonization and the strengthening of policy coordination among member states. The experience in the EU during the global financial crisis underscores that it is equally important to take a regional approach to financial stability. In particular, a supranational oversight framework may be necessary in a single market for financial services, and such a framework needs to be supported by a single resolution regime with a common backstop (for example, deposit insurance).

ASEAN Financial Sector Liberalization: Reform Initiatives

The ASEAN nations continue to move toward achieving greater regional financial integration. For example, in 2013, the securities regulators of Malaysia, Singapore, and Thailand signed a memorandum of understanding to establish and implement a framework for cross-border trade of collective investment schemes. Details of the broader integration framework are being worked out. The AEC Blueprint identifies freer capital movements and financial integration as two key elements. However, it is brief on specifics such as the desirable degree of financial integration and the necessary legal, institutional, and regulatory requirements for achieving financial integration (ASEAN 2008). The ADB (2013) lays out the state of thinking among ASEAN countries on the steps needed to achieve a certain degree of financial integration during the next 10 years.

One key objective identified is that the ASEAN region should nurture globally competitive banks. Commercial banks remain by far the most important type of financial institution in ASEAN. Given that banks headquartered in ASEAN countries (“ASEAN banks”), on average, remain rather small on an international scale, this objective, referred to as the “ASEAN banking framework,” would give market access preference to ASEAN banks over other banks. By virtue of this preference, large globally competitive ASEAN banks could develop over time with a customer base large enough to support their growth, allowing theses banks to take the lead in ASEAN finance in the future. They would also be able to obtain a foothold in global banking through mergers and the acquisition of smaller banks.

The report concludes that full banking integration, such as the “single passport” system in the EU, would be too ambitious for ASEAN for the next 10 years. Instead, it proposes steps for partial banking integration over a 10-year period, with different timelines for each ASEAN member state. This partial integration would be supported by an institutional approach based on regulatory harmonization and the strengthening of policy coordination among the ASEAN member states, in line with the principles set out in the 2008 AEC Blueprint.

In addition to preferential market access for ASEAN banks, the strategy proposed (ADB 2013) includes the following elements:

  • A two-track approach for banking integration—This approach would be supported by regional harmonization of regulations. Accordingly, member states should immediately start phasing out most of the remaining restrictions on wholesale banking, while delaying the completion of the liberalization of cross-border retail banking (deposit taking).
  • A three-dimensional framework—Comprised of equal access, equal treatment, and equal environment, this framework would guide the long process of financial services liberalization in ASEAN. Accordingly, ASEAN member states should agree on a set of minimum conditions that ASEAN banks must meet to be named a Qualified ASEAN Bank and be eligible to enter into the banking sectors of other member states. These conditions should include minimum capital adequacy requirements, consolidation requirements and authority for consolidated supervision, restrictions on large exposures, and minimum accounting and transparency requirements. A similar principle of mutual recognition has also governed the EU’s “single bank license” approach, in which a bank licensed in an EU member state is also authorized to open branches in other EU countries, without any other formalities or requirements.

The proposals in ADB 2013 identify key elements of a framework for financial integration in ASEAN. But several issues still need to be addressed, including those identified below:

  • The ADB report suggests that “a carefully planned market integration process can help more ASEAN-based banks develop faster than their non-ASEAN-based counterparts” (ADB 2013, 8). This slower integration process could potentially reduce the efficiency and competitiveness gains from banking integration.2 It could also create too-big-to-fail problems that many countries, especially the United States and countries in Europe, have found to be costly to their citizens and difficult to resolve.
  • One or more member countries may want to delay, for economic or political reasons, the opening up of their markets to banks from other ASEAN countries. This desire could make it very difficult to agree on a comprehensive set of minimum conditions that ASEAN-based banks must meet to be eligible to enter into the banking sectors of other member states. One commonly mentioned solution could be for two or more countries to move ahead with opening their markets for each other’s banks. Other ASEAN countries could then join these front-runners at a later stage. This is often called the “2+x” approach.3 The 2+x approach is consistent with the “ASEAN Way.” It is incentive-compatible and would allow the front-runners to start reaping some of the benefits from increased financial integration, albeit on a smaller scale than they would in an ASEAN-wide move. The first two movers could trigger action on the part of the other ASEAN members to catch up.
  • Not only do the member states, on an ASEAN-wide basis or on a 2+x basis, need to agree to facilitate qualified ASEAN banks’ access to their banking markets, qualified ASEAN banks and local banks should be treated equally by host country supervisors. The harmonization of banking regulation should start with licensing requirements and extend to cover (1) bank accounting standards and disclosure requirements, (2) minimum capital requirements, (3) risk management, (4) prompt corrective action and resolution methods for failed banks, (5) restrictions on large exposures, and (6) anti-money laundering and consumer protection regulations.
  • Clarity is also needed regarding the institutional setup and legislative process at the regional level to ensure effective cross-border supervision and resolution.
  • The choice of organizational structure for cross-border banking groups has not been addressed explicitly. Fiechter and others (2011) conclude that one size does not fit all when it comes to choosing between subsidiaries and branches. Home authorities typically prefer a cross-border bank structure with stricter firewalls across parts of the group (the subsidiary model) when their banks expand into weaker, riskier country markets. Host authorities might also prefer the subsidiary model if conditions in their countries are better than those in the home country, to shield local subsidiaries from the parent’s potential problems. In contrast, countries with underdeveloped financial systems and weak economies may prefer regional or global banks to enter via branches that can facilitate credit services based on the parent’s strength. The quality of supervision, adequacy of information-sharing systems, and systemic importance of the affiliate for home and host financial systems also play a role in home and host preferences.
  • The modalities for collaboration between national authorities and the private sector need to be worked out. The success of financial integration hinges on active cooperation between public and private sector players. It is mostly up to national authorities to design and roll out policy reforms. However, successful implementation requires close collaboration with financial institutions and other private agents.

ASEAN Financial Sector Liberalization: Lessons from Europe

What lessons can be drawn from the European experience in establishing a single market in banking? ASEAN nations are in many ways very different from the EU countries. Unlike the EU countries, ASEAN countries have a variety of exchange rate regimes (Table 9.3). ASEAN nations are also more diverse in the stages of their economic and financial development, their political systems, and their cultural backgrounds. Europe’s recent history and its devastation from the two world wars set it apart from Asia as well, and serve to explain the desire for political unity. Despite these important differences, the EU’s experience in creating a single market for banking and the weaknesses in its approach, as exposed by the stress episodes during 2008–12, could offer some lessons for ASEAN.

Table 9.3De facto Exchange Rate Arrangements, April 30, 2014
IndonesiaFloating arrangement
MalaysiaOther managed arrangement
PhilippinesFloating arrangement
SingaporeStabilized arrangement
ThailandFloating arrangement
Brunei DarussalamCurrency board with the Singapore dollar
CambodiaOther managed arrangement
Lao P.D.R.Crawl-like arrangement
MyanmarOther managed arrangement
VietnamStabilized arrangement
Source: IMF, 2014Annual Report on Exchange Arrangements and Exchange Restrictions.
Source: IMF, 2014Annual Report on Exchange Arrangements and Exchange Restrictions.

Achieving banking integration will require strong political commitment from all ASEAN nations. It is important that ASEAN leaders clearly spell out the objective of banking integration and how each ASEAN member state, large or small, will benefit. It is equally important for leaders to clearly grasp the potential contagion and spillover risks brought on by integrated banking markets, as well as the transition and operational risks, especially for the less developed ASEAN countries. Once these risks are identified, strong policy frameworks at national and regional levels would need to be put in place to manage them properly.

Progress toward banking integration would need to be supported by sound institutional and legislative frameworks. The plan to establish a single market for ASEAN banking would need to specify (1) the minimum regulatory requirements for entry, (2) permissible banking activities that are consistent with the current stage of ASEAN development and growth objectives, (3) regional arrangements for effective cross-border bank supervision and resolution, and (4) new regional institutions that would set standards and rules and enforce national compliance with regional rules.

A harmonized set of core regulatory rules is necessary to ensure the efficient functioning of the single market. A level playing field would be difficult to ensure when rules, supervisory practices, and resolution regimes differ substantially at the national level. EU members were able to maintain considerable flexibility in the interpretation and enforcement of common EU directives, which led to wide divergences in national banking regulations. Different national rules and regulations resulted in competitive distortions and encouraged regulatory arbitrage. In particular, for cross-border financial groups, such regulatory differences went against efficient group approaches to risk management and capital allocation, and made the resolution of cross-border financial institutions even more difficult.

However, regulatory harmonization and regional coordination, as implemented in Europe and proposed by the AEC Blueprint, may not be sufficient to ensure the financial stability of a single market. The financial stability arrangements for the single market in Europe were strongly based on national financial stability frameworks. When the crisis hit Europe in 2008, the initial policy response was handicapped by the absence of robust national, and more importantly, EU-wide crisis management frameworks. The lack of ex ante and ex post burden-sharing agreements led to national ring fencing and increased EU financial market segmentation, thus reversing the progress achieved toward EU financial integration.

An ASEAN-wide framework for banking oversight may be necessary to sustain a single market for banking services. The EU crisis has shown that national decisions, even well-intended ones, can have region-wide repercussions for financial stability. Following the example of the Single Supervisory Mechanism introduced in Europe in November 2014, the future ASEAN supervisor could be responsible for the oversight of the systemic ASEAN banks. The effectiveness of a single supervisor would need to be safeguarded by giving it powers to maintain general oversight over all banks and to intervene in any bank it deems necessary. Its governance and its “will to act” would need to be robust, including by ensuring that “nationality dominance” is avoided and that a regional perspective is consistently maintained.

An effective cross-border bank resolution framework for the banks headquartered in ASEAN countries would be another critical element of an ASEAN banking integration framework. At a minimum, ASEAN nations should be advised to strengthen their bank resolution frameworks by adopting best international practices and the Financial Stability Board initiatives. When ASEAN markets for banking and financial services become fully integrated, it may be necessary to put in place a single resolution mechanism that includes a single resolution agency and a common deposit guarantee scheme, with common backstops. But as revealed by the ongoing discussion of banking union in Europe, political resistance may arise, since a single resolution mechanism may involve burden sharing, with net resources flowing from the countries with strong financial systems to those with weaker ones.

ASEAN Capital Account Liberalization: What Is at Stake?

In addition to financial sector liberalization, there is ample scope for further capital account liberalization to spur the development of ASEAN countries. Despite high overall savings in the region, investment needs are huge, including for infrastructure. Rapid urbanization and the growth of the ASEAN middle class requires improved infrastructure in urban communities, including amenities, utilities, and links between production locations and centers of domestic consumption. There is a growing need for more (and cheaper) infrastructure finance to be provided by banks and nonbank intermediaries alike, even as banks adjust their business models in response to changes in global regulatory standards.4 Closing the large education gap will also require resources. The ADB (2012) calculates that the region needs $0.6 trillion during the next 10 years. Recently, ASEAN policymakers raised the figure to about $1 trillion (for example, Purisima 2014).

Capital flows from within and outside the region could supplement domestic savings generated in individual ASEAN countries. The removal of restrictions on capital outflows from ASEAN countries could also contribute to reducing the “roundtripping” of regional savings whereby capital is moved from one ASEAN country to another ASEAN country, but indirectly, through financial centers in advanced economies outside ASEAN. For instance, owing to the fungibility of capital, some of the funds invested abroad by ASEAN central banks as they greatly expanded their holdings of official reserves after 1997–98 may have returned to the region in the form of interregional portfolio investments. The gradual relaxation of restrictions on capital outflows from ASEAN countries would likely lead to increased intraregional capital flows, in part by virtue of the commonly observed “home bias” whereby investors invest a relatively large share of their portfolios in their home countries and home regions because of familiarity and information advantages.

The pickup in cross-border financial activity in recent years, both with the rest of Asia and within ASEAN, is a testament to the pull forces driving capital flows into ASEAN. Increased ASEAN integration and openness could, in theory, unleash large flows of investment goods from capital-abundant sources, including China, Japan, and Korea, and from elsewhere within ASEAN (for example, Singapore and Malaysia). The large potential for such flows is discussed and analyzed further in the context of a simple growth model in Almekinders and others (2015). If financial integration within ASEAN and with the rest of the world is incomplete, large differences in GDP per capita (and hence output per worker) can persist, and real convergence can be slow, reflecting long-lasting differences in capital-to-labor ratios. Financial integration can help accelerate economic growth by facilitating capital deepening. Countries at early stages of development should receive the largest inflows, with large potential gains for growth, real convergence, and poverty reduction.

In the simplest case, in which there are no adjustment costs to investment and no legal barriers or informational or other impediments to international capital mobility, capital would quickly move across borders until risk-adjusted rates of return are equalized internationally. In reality, the size of capital flows depends critically on the removal of remaining barriers and the establishment of complementary public factors of production. Raising total factor productivity, as reflected in a country’s institutional development (for example, well-defined and respected private property rights, including for intellectual property, a good business climate, and so forth), is a powerful pull force for capital flows.

The simple neoclassical view of real convergence underscores the potential benefits of removing capital controls but omits the dangers lurking in improperly sequenced, rash liberalizations. The problems are well known from an extensive literature on financial crises. Among these problems is “original sin” (borrowing in foreign currency and at short maturities to finance long-lived projects) followed by sudden stops of foreign capital from emerging markets. In this case, self-insurance is an appropriate policy response. Among other things, self-insurance can involve the accumulation of international reserves and the implementation of taxation measures to internalize Pigovian externalities (Aizenman 2009; Jeanne and Korinek 2010) and the incomplete labor insurance markets present in many recipient countries (Mourmouras and Russell 2013).

The IMF’s institutional view on this issue (IMF 2012, 2013a) acknowledges the benefits of capital flow liberalization—higher efficiency in resource allocation, technological improvement, higher investment, and better consumption smoothing—while also emphasizing the risks of capital flows, including higher volatility and increased vulnerability to capital account crises. These risks are magnified for countries that are still lagging in financial and institutional development. This is an important lesson: economic development requires more advanced financial systems, which go hand in hand with greater capital flows. Accordingly, the IMF’s view on capital flows stresses that the benefits from capital flow liberalization are greatest when financial and institutional development is adequate and the macroeconomic situation is sound. There is no presumption that full liberalization is appropriate for all countries at all times.

Consistent with this approach, the ASEAN capital account integration agenda is properly gradualist in nature, emphasizing the correct sequencing of liberalization and the putting in place of regulatory safeguards to protect individual countries from capital flow volatility. The ADB (2013) defines capital account liberalization as a process of dismantling legal and administrative impediments to the freedom with which economic agents can transfer ownership claims across national borders. The wide divergence among ASEAN economies observed in the area of financial sector development extends to capital account openness. One way to compare countries’ openness and assess the scope for increasing it is to look at the various de jure indices of capital account openness used in the empirical literature (Box 9.2).5

As discussed in Chapter 10, Asian countries have had diverse experiences with capital flows since 1995, illustrating that, while the scope to remove capital account restrictions is clear, there is no guarantee that doing so will lead to a significant increase in net capital inflows. Net capital flows to ASEAN countries have been large at times, including for many years before the Asian financial crisis of 1997–98. However, on average over the period 2000–12, notwithstanding rising FDI and portfolio inflows discussed in the previous sections, only four ASEAN countries (Lao P.D.R., Cambodia, and, to a lesser extent, Vietnam and Myanmar) were net capital recipients. Remarkably, despite large infrastructure needs and development potential, Indonesia, the Philippines, and Thailand were net capital exporters, with average current account surpluses of about 2 percent of GDP a year during 2000–12 (Table 9.4). Malaysia’s net capital exports were even larger, averaging 12 percent of GDP a year during this period.

Table 9.4Current Account Balances(Percent of GDP)
Brunei Darussalam43.444.131.5
Lao P.D.R.−6.6−16.2−27.7
Source: IMF, World Economic Outlook, October 2014.
Source: IMF, World Economic Outlook, October 2014.

Box 9.2.De Jure Indices of Capital Account Openness in ASEAN Countries

The Quinn-Toyoda and Schindler indices of capital controls focus on capital account restrictions (see Vargas 2014). In contrast, the Chinn-Ito index (Chinn and Ito 2008) measures four categories of restrictions on external transactions: (1) the presence of multiple exchange rates, (2) restrictions on current account transactions, (3) restrictions on capital account transactions, and (4) requirements regarding the repatriation of export proceeds.

A comparison over time of the evolution of the Chinn-Ito index suggests that Singapore has maintained a high degree of financial openness since the early 1980s (Figure 9.2.1). Restrictions introduced about the time of the Asian financial crisis were quickly unwound. ASEAN-4 countries (Indonesia, Malaysia, the Philippines, and Thailand) maintain only a few restrictions on the buying and selling of domestic securities by nonresidents. This comparative lack of restrictiveness is reflected in relatively high de facto financial openness, measured, for instance, by the level of actual cross-border portfolio flows. However, some restrictions apply to capital account transactions by residents. Moreover, in the aftermath of the Asian financial crisis and the global financial crisis, ASEAN-4 countries introduced or intensified some restrictions on current account transactions, including those involving the repatriation of export proceeds and verification procedures for service payments.

Figure 9.2.1Chinn-Ito Index for ASEAN-4 and Singapore

Source: Updated from Chinn and Ito (2008).

According to the Chinn-Ito index, as a result of a package of liberalization measures phased in from 2001 onward, Cambodia was the second most financially open economy in ASEAN in 2011. However, capital flows mostly take the form of foreign direct investment and official grants. Portfolio inflows remain limited (low de facto financial openness) given that the relevant domestic financial markets are still being developed. Similarly, Lao P.D.R., Vietnam, and Myanmar have historically displayed relatively low financial openness. Perhaps reflecting their limited exposure to volatile portfolio flows, the CLMV countries (Cambodia, Lao P.D.R., Myanmar, and Vietnam) did not tighten their capital account restrictions with the onset of the global financial crisis (Figure 9.2.2). It should be noted that Myanmar’s 2012 liberalization and unification of the exchange rate is not yet reflected in the Chinn-Ito index shown in Figure 9.2.1.

Figure 9.2.2Chinn-Ito Index for CLMV

Source: Updated from Chinn and Ito (2008).

A comparison with other emerging market economies suggests that the ASEAN-4 countries are not as open in de jure classifications of capital account openness. Figure 9.2.3 shows the three de jure indices for 2005, the latest year for which all three indices are available. All are scaled to a common zero-to-one range, where a larger number represents a higher level of capital control openness. The bars rank the countries by their scores on the Quinn-Toyoda index. The three indices show a substantial correlation and all put the ASEAN-4 countries among the emerging market economies with less open capital accounts.

Figure 9.2.3Capital Account Openness Indices, 2005

Source: Vargas (2014).

ASEAN countries’ net exports of capital in the first decade of the 2000s reflected the accumulation of official reserves for self-insurance and precautionary purposes in the aftermath of the Asian financial crisis. As of 2015, reserves seem broadly adequate in most ASEAN countries, so there is scope for a change in the direction of intraregional and interregional net capital flows. Park and Takagi (2012) note that the tendency of most ASEAN countries to maintain relatively tighter controls on outflows has discouraged capital inflows from within ASEAN, while encouraging inflows from advanced countries outside the region.6

ASEAN capital account liberalization will be an ongoing process with the end goal of achieving a high degree of capital account openness while preserving adequate financial stability. Discussions among the member countries continue to be led by guidelines established in the AEC Blueprint: (1) ensuring an orderly capital account liberalization process consistent with member countries’ national agendas and readiness of their economies; (2) allowing adequate safeguards against potential macroeconomic instability and systemic risk that may arise from the liberalization process, including the right to adopt necessary measures to ensure macroeconomic stability; and (3) ensuring that the benefits of liberalization will be shared by all ASEAN countries.

An important challenge for capital account liberalization is to harness benefits while minimizing risks. Ishii and others (2002) recommend a gradualist approach, emphasizing the need for careful sequencing and establishment of preconditions to be observed before a country could safely move from one step to the next. As observed by Park and Takagi (2012) and ADB (2013), ASEAN countries maintain several classes of restrictions that may currently be providing legitimate safeguards against speculation and preventing the buildup of financial sector risk. These include restrictions on the offshore use of almost all ASEAN countries’ currencies and external lending in domestic currency, as well as limits on the ability of investors to hedge foreign currency risk. Some of these restrictions may need to be phased out as the region moves along the path to regional financial integration. It may be appropriate, however, to maintain these restrictions until relevant thresholds for upgrading macroeconomic and financial policy frameworks are met.7 Empirical research suggests that financial depth and institutional quality are the two most important preconditions for foreign capital inflows to have a positive effect on economic growth.

Promoting Safe Financial Integration in ASEAN

This section reviews policies that could be adopted by ASEAN countries, individually and collectively and with regional and multilateral partners, to promote safe financial integration in ASEAN. These policies would be particularly relevant for FDI inflows and banking integration. This section also considers the present state of and future prospects for regional surveillance and financial cooperation initiatives, including the ASEAN+3 Macroeconomic Research Office (AMRO) and the Chiang Mai Initiative Multilateralization (CMIM—see also Box 9.1). The section also briefly discusses (1) the lessons for Asia from the failings of European integration efforts; and (2) risk mitigation within ASEAN, including in the context of the CMIM, and the role of the IMF.

Policies to Help Enhance Financial Integration and Mitigate Risks

In the medium and longer terms, ASEAN banking links are likely to expand further as the AEC’s financial integration goals are gradually realized. As ASEAN financial systems become more open, they will become more exposed to developments abroad. The potential result of such exposure is exemplified by the difficult global economic and financial environment that developed in the aftermath of the global financial crisis. There are various aspects to this. Duval and others (2014) find that greater banking and portfolio integration between two economies reduces the economies’ output comovement in general. However, during a period of crisis (such as the global financial crisis) banking integration appears to increase the synchronization of cycles across countries. In such cases, global banks pull funds away from all countries, amplifying output comovement for countries that are financially integrated and reliant on foreign capital flows (Kalemli-Ozcan, Papaioannou, and Perri 2013).8 This points to the potential merits of regional banking integration: a greater role for regional banks could reduce the impact of financial shocks originating in advanced economies.

As noted earlier, international experience suggests that rapid bank expansion in new markets can pose challenges because bank risk management and supervisory monitoring may fail to keep pace. Uneven supervisory quality in host markets can also contribute to the masking of vulnerabilities. Although an ASEAN-wide single supervisory mechanism would be the best solution, it may not be technically and politically feasible in the near term. In fact, as of early 2015, ASEAN has not indicated that it is considering a single supervisory mechanism or forming a perfectly integrated banking sector. Instead, ASEAN countries have shown a trend toward harmonizing regulations (including in securities markets). While this harmonization takes shape, one option to mitigate risks may be greater host control over foreign branches, as is being implemented in Singapore (see next paragraph). Alternatively, risks can also be mitigated by reciprocity arrangements. The principle of reciprocity has governed banks from non-EU member states that open branches in the EU. The reciprocity principle is also a cornerstone of the Basel Committee on Banking Supervision’s framework for countercyclical capital buffers. A certain degree of harmonization—for example, in the definition of capital—is necessary for mutual recognition. Malaysia’s Financial Sector Blueprint highlights the need to further deepen home-host cooperation in supervision and crisis prevention.

In Singapore, the important role played by foreign branches creates exposure to their parent banks. The IMF’s 2013 Financial Sector Assessment Program report for Singapore (IMF 2013d) notes that Singaporean banks have large capital and other cushions and appear able to withstand major shocks. It also observes that the Monetary Authority of Singapore has adopted measures to mitigate the risks posed by the presence of the large number of foreign branches. Accordingly, the Monetary Authority of Singapore has (1) set high standards for approving foreign entrants, applying the same prudential qualifications as it applies to its own locally incorporated banks; (2) limited the number of foreign branches permitted to accept retail deposits; and (3) recently adopted a program that requires so-called qualified full banks with large retail presences to locally incorporate their retail operations. The Monetary Authority of Singapore has also established good working relationships with home supervisors of the foreign branches and proactively engages with management of the parent banks to ensure that they take responsibility for any risks or shortcomings identified in the branches’ operations.

As discussed in this chapter, with greater financial integration come risks from credit booms and volatile and unpredictable capital flows. These risks underscore the importance of sound macroeconomic management in a world of high capital mobility. If the risks originate in the banking system, it makes sense for countries to adopt macroprudential tools such as tightening conditions for housing loans or having banks hold more capital. If the risks are associated with capital flow surges, implementation of temporary capital flow management measures might prove useful. At the same time, deeper financial market development still has benefits. As Bank Negara Malaysia Governor Zeti Akthar Aziz has pointed out, mature financial systems can handle capital flows without being overwhelmed. The retrenchment of euro area banks from Asia following the global financial crisis underscores the importance of having well-developed, well-regulated, and deep financial markets in Asia as a means of absorbing external shocks.

The development of the domestic banking sector and increased banking sector integration can proceed in tandem. A key challenge for policymakers and supervisors in Asia is to design and implement policies that support an efficient and resilient integrated banking system. Harmonization of the regulatory and supervisory frameworks can accelerate the pace of financial integration. As banking sectors develop and integrate, supervisory capacity needs to keep pace with increasingly complex banking institutions and their cross-border operations. Making the most of financial integration also means establishing better global rules, such as the reforms envisaged in Basel III. Perhaps paradoxically, the various ongoing efforts aimed at enhancing regional integration could lead to greater regulatory fragmentation. Such fragmentation could happen if inadequate coordination between ASEAN and other regional integration initiatives were to result in the adoption of conflicting regulations.

Policy reform initiatives related to the creation of the AEC can have far-reaching effects on other policy fields such as domestic monetary and fiscal policy. And capital account liberalization can lead to a loss of policy independence and a resulting need to strengthen fiscal policy and structural reforms. The experience of Malaysia and Indonesia in 2013 provides strong support for the assertion made in ADB (2013, 16) that “the best strategy for living with an open capital account is to pursue sound macroeconomic policies.” In the first half of 2013, when once-large surpluses on the current account of the balance of payments narrowed significantly (Malaysia), or turned into deficits (Indonesia), international investors blamed overly loose macroeconomic policies and started to sell their asset holdings in these countries. Capital outflows from both countries subsided after the adoption of strong packages of macroeconomic policies.

Europe’s experience with financial and monetary integration of highly heterogeneous economies is relevant in thinking about the path to ASEAN (and greater Asian) financial integration. An important lesson that has emerged from Europe is that monetary and financial integration without fiscal or political integration is fraught with danger, especially when member countries are highly heterogeneous with regard to fiscal discipline, export competitiveness, institutional advancement, and other macrocritical dimensions. Unlike the euro area, ASEAN countries do not share a common currency and monetary and exchange rate policies. Therefore, exchange rate movements can help absorb shocks. Nevertheless, Asia will be well served in the future by adopting a measured, gradual, and evolutionary approach to financial integration.

Risk Mitigation within ASEAN and in Collaboration with the IMF

The growing interconnectedness between economies and financial systems is increasing the risk that national and international financial markets will be subjected to protracted bouts of instability. This is true globally as well as in the Asian region. Efforts are ongoing to strengthen the region’s safety net to address ASEAN+3 countries’ potential need for short-term liquidity if balance of payments difficulties were to arise. In this context, the ASEAN+3 Finance Ministers and Central Bank Governors, at their May 2012 meeting, adopted proposals to double the CMIM’s size to $240 billion and to introduce a crisis prevention facility. The increase went into effect in July 2014, following the required ratifications.

As is the case with other regional organizations and financing arrangements (IMF 2013b, 2013c), the IMF has long been engaged in fruitful dialogue and cooperation with ASEAN and ASEAN+3 institutions. Building on this working relationship, collaboration is being strengthened in the areas of surveillance, liquidity support arrangements, and capacity development. For example, at their May 2014 meeting, the ASEAN+3 Finance Ministers and Central Bank Governors endorsed the “Guidelines for the Further Cooperation with the International Monetary Fund.” Collaboration between the IMF and regional organizations focuses on the IMF’s macrofinancial areas of expertise. The IMF regularly presents its research and analysis at various regional forums, including its work on capital market development and capital account liberalization. Similarly, the IMF organizes joint seminars and conferences (for example, in January 2014 in Tokyo and in March 2015 in Seoul, jointly with AMRO), in which issues such as macroprudential policies in ASEAN are discussed. In addition to research and analysis, the IMF helps with regional institution building in ASEAN by sharing with AMRO its expertise gained from cross-country analyses.


This chapter highlights that further ASEAN intraregional integration (through increased trade, FDI, portfolio investment, and cross-border banking) could be an important source of growth, employment, and more inclusive development, as well as a source of resilience to shocks for ASEAN countries.

Trade and financial integration within ASEAN have increased considerably in recent years. Nevertheless, there is significant scope for further financial sector liberalization and capital account liberalization. In particular, it is well known that financial integration in Asia, and particularly in ASEAN, lags behind such integration in the rest of the world. Although this is changing (for example, Singaporean and Malaysian banks’ activities in the region are expanding), more needs to be done to address the continued fragmentation of financial systems in Asia and in ASEAN. In fact, financial integration is an important component of ongoing initiatives to create a single ASEAN market for goods and services. The Blueprint for the AEC calls for regulatory harmonization and the strengthening of policy coordination among member states. Although coordination is appropriate, the recent experience in the EU underscores that it is equally important to take a regional approach to financial stability. In particular, a supranational oversight framework may be necessary for the planned single AEC market for financial services. Europe’s experience also suggests the need to reinforce regional macrofinancial surveillance mechanisms (for example, AMRO) and regional financial safety nets (for example, the CMIM). These regional efforts are ongoing and actively supported by IMF staff, where possible.

The ongoing strengthening of regional macroeconomic surveillance and financial safety nets is welcome, but it is also important to monitor financial systems to ensure early detection of the emergence of possible vulnerabilities. ASEAN countries are at different stages of economic development, and ongoing financial integration means that countries with relatively low credit-to-GDP ratios are catching up with the front-runners. Such financial deepening is valuable but, as is well known from economic history, the resulting strong growth of credit could give rise to financial sector vulnerabilities and risks. The challenges faced by some of the ASEAN countries in the context of their domestic financial sector development need to be taken into account when decisions are made about the correct pace of ASEAN financial sector liberalization. Therefore, the diligent and careful approach taken by ASEAN countries in moving forward is appropriate. However, the ASEAN/AEC framework leaves open the possibility that more advanced economies will move faster with financial integration. Once adequate safeguards are in place, it would be in the interests of these countries to remove protectionist barriers to regional banking integration.


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The authors are grateful for helpful discussions and comments from Vivek Arora, Sanchita Basu Das, Pek Koon Heng, Heedon Kang, Hoe Ee Khor, Kenneth Koh, Jerry Schiff, Chikahisa Sumi, Shinji Takagi, and participants at a seminar in the IMF’s Asia and Pacific Department.
1Brunei Darussalam, Cambodia, Indonesia, Lao P.D.R., Malaysia, Myanmar, the Philippines, Singapore, Thailand, and Vietnam.
2Empirical research shows that the presence of foreign banks is in general associated with increased efficiency and competition in local banking sectors, as well as lower net interest margins, reduced excessive profits, and lower cost ratios (for example, Claessens and van Horen 2014).
3ASEAN (2008, 11) calls it the “ASEAN minus x” approach.
4Banks are the dominant providers of finance in ASEAN and generally rely on demand deposits for funding. They tend to focus on commercial and household lending. Maturity transformation is essential in banking, and banks would be involved more in financing long-term, risky infrastructure projects if these projects were profitable, taking into account risk, externalities, and the local public good aspects of many such projects.
5In all cases, a higher value of the index denotes a higher degree of capital account openness. A common characteristic of these indices is that the primary source of information for the indices is the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (IMF 2014). The report provides a wealth of detailed information. But it does not accompany this detail with any form of summary or bottom-line characterization of a country’s overall degree of openness or restrictiveness. The IMF also does not produce an index of its own.
6As noted earlier, because of home bias, ASEAN-based investors tend to invest a relatively large share of their portfolios in their home regions. Therefore, a relaxation of ASEAN countries’ controls on outflows could be expected to lead to a disproportional increase in capital outflows to other ASEAN countries.
7The ADB (2013) proposes, as a safeguard measure, retaining the restrictions on cross-border trading of forwards and derivatives as well as on offshore currency use.
8The impact of the ongoing deleveraging by European banks appears manageable. In fact, European bank retrenchment has represented an opportunity for ASEAN banks (and those from elsewhere in Asia). The pullout of U.S. banks from emerging markets following the Latin American debt crisis of the 1980s and the deleveraging by Japanese banks in Southeast Asia after Japan’s financial crisis in the 1990s are cautionary tales.

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