Context

Financial integration

Financial integration is a country’s financial connectedness with other countries. Greater financial integration tends to increase capital flows and equalise prices and returns on traded financial assets in different countries.1

Financial integration and open capital markets offer significant benefits to an economy (see Table 10.1). A number of studies have shown financial integration has positive direct and indirect effects on a country’s economic growth.2 However, the GFC has reminded us of the risks of contagion from integration with economies experiencing volatility. The international regulatory response to the crisis has, in part, aimed to reduce the interconnectedness of the global financial system and increase its resilience to shocks.3 Although the risks are real, there remain long-term benefits from financial integration.

Table 10.1: Benefits and challenges from financial integration4

Benefits of financial integration Challenges from financial integration
Broadens funding sources and improves access to financial services Greater exposure to negative external shocks and risks from contagion
Opens up domestic market to competition which can have efficiency gains Cross-border supervision and enforcement challenges
Greater risk sharing through global diversification and more efficient allocation of global capital Adverse effects from potential higher volatility in capital flows, effects on asset prices and the financial system’s ability to manage volatility
Foreign direct investment facilitates skill and technology transfers between countries
Portfolio investment and foreign bank lending can contribute to the deepening of the domestic financial market

Assessing Australia’s level of integration

There is no single accepted measure of a country’s level of financial integration. Two common approaches are used:

  1. Quantitative — assessing levels of international capital and financial flows or price correlation across markets.
  2. Comparative — surveys or studies comparing features of different economies.

A recent IMF paper considered that preferred quantity-based measures include gross stocks of foreign assets and liabilities as a ratio to GDP.5 This is shown for some countries in Chart 10.1.

Chart 10.1: Financial integration across selected comparator countries6

This chart compares the level of financial integration across a selection of comparator countries.  The chart ranks the level of financial integration across the selected countries by foreign assets and liabilities as a share of own GDP for 2013.  The ranking of countries in the chart from most integrated to least is: Hong Kong, Singapore, United Kingdom, Canada, United States, Euro Area, Australia, Japan, New Zealand, Russia, China, Indonesia and India.  Hong Kong, Singapore and the United Kingdom all have the sum of foreign assets and liabilities as share of GDP well above 10 while the remaining countries are clustered below 4.

Source: FSI calculations using ABS, IMF, Thomson Reuters, national sources.

Australia is mid-ranking by this measure of financial integration. Unsurprisingly, Australia does not rank as highly as the global financial centres of the United Kingdom, Hong Kong and Singapore. However, Australia ranks close to Canada, a country with a similar economy in terms of size, wealth and governance systems,7 with Canada also having the advantage of being geographically co-located to the world’s largest economy.

Australia has benefited from financial integration with the global financial system. Financial reforms of past decades have delivered the basis for sounder macroeconomic policy, more diversified portfolios for Australian investors and the development of tools for hedging risk.8 Opening Australia’s borders to foreign goods, services and capital played a critical role in productivity growth.9

Today, Australian banks and other entities raise foreign funding and invest in foreign assets.10 Foreigners’ willingness to fund Australia’s longstanding current account deficit has supported Australia’s growth, with international financial flows freeing firms’ investment decisions from domestic financing constraints.11 The Australian dollar is the fifth most traded currency internationally.12

Australia’s financial sector as a proportion of its economy is large by international standards. It was the largest sector in the Australian economy in 2012–13, representing 8.7 per cent of gross-value added.13 However, financial services exports only represent a small proportion of Australia’s trade, accounting for around 4.5 per cent of total trade in services at the end of 2013.14

Australia’s main financial relationships are with Europe and the United States. These are the markets where Australia raises capital and makes foreign investments — with around three-quarters of corporate bond issuance conducted offshore, predominantly in the United States.15 While much of Australia’s funding is conducted offshore, Australia also provides a funding source for foreign companies. In March 2014, 36 per cent of total issuance of non-government bonds were ‘kangaroo bonds’ issued by foreign entities in the Australian domestic market.16

Although Australia has elements evidencing sound financial integration, there are both opportunities and challenges on the horizon. Although the focus of merchandise trade has shifted to the Asian region, financial flows are yet to follow in a substantial way. The pattern of integration is being influenced by cross-border digital connectivity. International rules and regulations will also reshape the level and direction of that integration.

Integration trends — Growth of Asia

Since the Wallis Inquiry, the weight of the world’s economic activity has been shifting to our region.

Although Europe and the United States are likely to continue to be critical financial markets for Australia, as Asia becomes increasingly middle class and urbanised its share of the global economy is forecast to overtake that of the advanced17 economies (Chart 10.2).

Chart 10.2: Past and forecast shift in economic weight

This chart shows the share of world output as a percentage of world GDP for various areas and countries between 1950 and now, and provides predictions to 2050.It shows:• Advanced economies falling from 68% in 1950, to 66% at the time of the Campbell Inquiry (1980), 64% at the time of the Wallis Inquiry (1997), 48% now and forecast to fall to 34% by 2050• Asia from about 12% in 1950, 18% at the time of the Campbell Inquiry, 27% at the time of the Wallis Inquiry, 39% now and forecast to rise to about 52% by 2050• China from about 4% in 1950, 2% at the time of the Campbell Inquiry, 7% at the time of the Wallis Inquiry, 18% now and forecast to rise to about 26% by 2050• India rising from 2% in 1950, 3% at the time of the Campbell Inquiry, 5% at the time of the Wallis Inquiry, 7% now and forecast to rise to about 13% by 2050

Source: Treasury projections.18

In the next decade, Asia is forecast to account for more than half of world growth.19 Asia also has an increasing share of world trade. Presently, four of Australia’s top five trading partners are in Asia.

This presents significant opportunities and challenges for the Australian financial system. One of the largest anticipated regional financial system developments will be the liberalisation of China’s capital account, and the gradual easing of restrictions on trading in the onshore Chinese currency market by firms from outside of China.20 At present, China has the largest proportion of world trade, but a currency that is not actively traded.

China has announced a program for relaxing currency and capital controls. In addition to stepped foreign exchange liberalisation, other financial system reforms planned include:

  • Ending mandatory low-interest payments on deposits in China
  • Allowing deeper competition in banking
  • Allowing limited foreign bank entry and a Shanghai free-trade zone for financial services
  • Expanding capital control schemes, including the Renminbi Qualified Foreign Institutional Investor (RQFII) scheme, which will allow renminbi (RMB) raised offshore to be invested in listed Mainland bonds and equities, Qualified Foreign Institutional Investor (QFII) and the Shanghai-Hong Kong Stock Connect scheme

As China continues to free up capital controls, a significant proportion of the resultant increase in both portfolio and direct investment flows is likely to be within this region.21

Following China in terms of economic size is India. India’s financial system has the potential to provide similar opportunities and challenges for Australia, requiring us to build capacity and develop financial system architecture to connect with India’s economic transformation. World Bank modelling suggests that by 2020 China and India together will serve as nearly twice the engine for growth as the United States and the Euro zone combined.22

There are also rapid changes underway in Association of Southeast Asian Nations (ASEAN) countries.23 If ASEAN were a single country, it would be the fifth largest economy in the world, with a combined GDP of $US3.9 trillion in 2013, in purchasing power parity terms. By 2030, ASEAN is projected to be the equivalent of the fourth largest economy.24

What does this mean for Australia?

Currency and capital account liberalisation, and growth in the Asian region generally, are expected to intensify during the decade following this Inquiry. This is likely to have wide-ranging implications for the Australian financial system, some of which are already being observed:

  • Potentially significant amounts of Asian direct and portfolio investment moving into markets around the world, including Australia
  • Increasing payment of physical trade using RMB
  • Deeper capital markets developing in Asia

As capital liberalisation incrementally expands, Asia is likely to become a more important source of funding, especially for portfolio investment. Australian banks and non-financial corporates are increasingly likely to raise funds in RMB and other Asian currencies.25 Asian financial markets will also become a more important investment destination for Australians.

Some financial centre jurisdictions have a clear timetable for adapting their market and payment infrastructure to deal with changes in the region.26 The next section discusses the continued Government engagement that will be required to ensure Australian businesses, and all financial system users, can access the opportunities presented by these developments.

Improving integration

The Inquiry supports efforts to drive greater financial integration, provided it is not at the cost of appropriate standards for financial stability and conduct. The Inquiry sees scope to enhance productivity in the Australian financial services sector through increasing competition, diversity and depth of offering, which would benefit the broader economy and users of Australia’s financial system.

This chapter focuses on the following elements:

  • Impediments that can be removed or adjusted to accommodate integration, where benefit to the economy as a whole can be demonstrated. This might include removing tax, regulatory or other impediments.
  • Identifying where continuing Government involvement and engagement is necessary to facilitate integration with Asia.
  • Enhancing domestic regulatory processes to have better regard to international regulatory activity.
  • Better coordinating industry, regulators and whole-of-Government. This is seen by most stakeholders as an important element in realising the benefits and managing risks presented by a globally integrated financial system.

1 De Brouwer, G 2005, ‘Monetary and Financial Integration in Asia: Empirical Evidence and Issues’ Asian Economic Cooperation and Integration: Progress, Prospects and Challenges, Asian Development Bank, Manila.

2 Epaulard, A and Pommeret, A 2005, ‘Financial Integration, growth and volatility’, IMF Working Paper, WP/05/67, IMF, Washington. and Kose, A, Prasad, E, Rogoff, K and Wei, S 2009, ‘Financial Globalisation: A reappraisal’, IMF Staff Papers, vol 56, no.1, IMF, Washington.

3 James, E, McLoughlin, K and Rankin, E 2014, ‘Cross-border Capital Flows since the Global Financial Crisis’, RBA Bulletin, June, RBA, Sydney.

4 Based on remarks by Yellen, J 2011, Reaping the Full Benefits of Financial Openness, address to Bank of Finland 200th Anniversary Conference, 6 May, Finland.

5 Kose, A, Prasad, E, Rogoff, K, Wei, S 2009, ‘Financial Globalisation: A reappraisal’, IMF Staff Papers, vol 56, no.1, IMF, Washington.

6 *Indicates data for 2012.

7 Ciuriak, D 2012, Canada-Australia commerce: enhancing the relationship, a report for the Canadian Council of Chief Executives, Australian Industry Group, Sydney, page 1.

8 Lowe, P 2014, Some implications of the internationalisation of the Renminbi, opening remarks to the Centre for International Finance and Regulation Conference on the Internationalisation of the Renminbi, 26 March, Sydney.

9 For further discussion see Banks, G 2005, Structural reform Australian-style: lessons for others?, presentation to the IMF, World Bank and OECD, May.

10 See detailed discussion of these flows in the Funding chapter.

11 Bank for International Settlements (BIS) 2011, Annual Report 2010/11, BIS, Basel, page 33.

12 Reserve Bank of Australia (RBA) 2014, Developments in Foreign Exchange and OTC Derivatives Markets, RBA, Sydney, viewed 21 June 2014.

13 Australian Bureau of Statistics (ABS) 2013, Australian System of National Accounts, cat. no. 5204.0, ABS, Canberra.

14 ABS 2014, International Trade in Goods and Services, cat. no. 5368.0, ABS, Canberra.

15 Reserve Bank of Australia, 2014, First round submission to the Financial System Inquiry, page 25.

16 Reserve Bank of Australia (RBA), 2014, Statistical table: Debt Securities Outstanding — D4, RBA, Sydney, viewed 19 June 2014.

17 For definition see International Monetary Fund (IMF) 2014, World Economic and Financial Surveys World Economic Outlook Database—WEO Groups and Aggregates Information, IMF, Washington, viewed 24 June 2014.

18 Based on IMF and Conference Board data, as well as Maddison, A 2010, Statistics on world population, GDP and GDP per capita, 1-2008 AD, Historical Statistics, Groningen Growth and Development Centre, viewed 21 June 2014. Based on purchasing power parity adjusted GDP.

19 Treasury 2013, Long-term international GDP projections Working Paper 2013-02, Commonwealth Government, Canberra, viewed 21 June 2014.

20 For an overview, see Reserve Bank of Australia (RBA) 2013, ‘Developments in Renminbi Internationalisation’, RBA Bulletin, June Quarter, RBA, Sydney, viewed 21 June 2014.

21 A number of reports note these developments: see for example ANZ 2014, Caged Tiger: the transformation of the Asian financial system, ANZ, Sydney, viewed 21 June 2014 and Centre for International Finance and Regulation (CIFR) 2014, Internationalisation of the Renminbi: Pathways, Implications and Opportunities Research Report, CIFR, Sydney, viewed 21 June 2014.

22 The World Bank 2011, Global Development Horizons 2011: Multipolarity: The New Global Economy, World Bank, Washington, viewed 21 June 2014.

23 Association of Southeast Asian Nations (ASEAN) member states: Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Philippines, Singapore, Thailand and Vietnam. For a description of Australia’s trading relationship see Department of Foreign Affairs and Trade (DFAT), Economic Fact Sheet, DFAT, Canberra, viewed 21 June 2014.

24 Based on International Monetary Fund (IMF) 2014, World Economic Outlook, IMF, Washington, viewed 21 June 2014, and Treasury 2013, Working Paper 2013-02, Long-term international GDP projections Working Paper 2013-02, Treasury, Canberra, viewed 21 June 2014.

25 For example, in April 2014, Hancock Prospecting Pty Ltd issued CNH 2 billion bonds, through lead managers Bank of China (Sydney Branch), ANZ, CBA, NAB, Royal Bank of Scotland (RBS) and Westpac.

26 See for example City of London Corporation 2014, London as a centre for renminbi business, City of London Corporation, London, viewed 21 June 2014.