Monday, 12 September 2011

Stock Market and Asset Bubble: Lessons learned for Cambodia

Finance Minister Keat Chhon at the official launching of stock trading at Cambodia Stock Exchange in April 2012 at Canadia Center, Phnom Pneh

Everyone can easily answer the two following questions, but we often encounter different answers and perspectives about Cambodia’s economic development. “Will the establishment of “Cambodian Stock Exchange” in July 2011 benefit the whole economy?” and “What policy measure the Government and Central Bank need to enforce to prevent asset bubbles and stock market crash after its opening?” In answering the questions, first we look into the relationship between stock market and asset bubble, Japan’s experience in its economic and financial development and how this will apply to economic and financial sector in Cambodia.

In theory, the opening of stock market and its development has positive effect on the whole economy of a developing country. Levine and Zervos (1995) argued that there is a strong empirical association between stock market development and long-run economic growth. Furthermore, it has no immediate negative effects on macroeconomic situation. Kim & Singal (2000) also conclude that after the opening of stock market, stock returns increase immediately without simultaneous increase in volatility, inflation or an appreciation of exchange rates. The increase in stock returns is caused by surge in demand for buying securities, which is good for quick mobilization of resource for investment.   

However, there are advantages and disadvantages in the opening of capital market. Careful policy measures from the government and central bank is needed if they wish the development of stock market to be a success.  Claessens (1995) argues that foreign equity investment can be beneficial to developing countries because of its risk-sharing characteristics and effects on resource mobilization and allocation. Stock market has four main roles (i) a vehicle for raising capital for firms; (ii) diversification of investment (iii) a screening and monitoring mechanism; (iv) a complement to stability of the financial system.  However, constraints to further increasing the flows and expanding the benefits are macro-instability, poorly functioning stock markets, and insufficiently open financial markets and lack of transparency.

The “speculative bubble” is a major cause of the financial market crash and has become a recurrent crisis if there is no strict regulation on banking and financial activities. Generally, speculative bubble means a trade in products or assets with inflated values. Given the speculative bubble, the role of central bank must be promoted and sound monetary and financial policy is needed to maintain macroeconomic stability. Binswanger (1999) argue that the relaxation of the financial constraint such as the high level of financial innovations related to deregulation, globalization, and high competition in the financial sector, and easy credit greatly enhance the emergence of speculative bubbles on the stock market. Financial innovation led to possibilities of risk diversification on a global scale. Thus, level of confidence on financial investment is increased with this development. The increase in financial investment possibilities also attracted large amount of money which are not directly used for purchasing consumption or investment goods, which is good for the real economy. In contrast, they are diverted to invest heavily in financial assets, which he defines as “financial hoarding.” Speculative bubble has become an integral part of highly developed economies and it is not a temporary phenomenon.  To deal with the problem of speculative bubble, Binswanger outlines two ideas. First, only bubbles which in the long-run move more or less in line with real economic activities are sustainable. If bubbles are too volatile and frequently burst, the destabilizing effect on the economy will probably outweigh potential benefit. Second, the potential of a new big crash of the whole bubble economy may be considered a new kind of systematic risk. Therefore, high confidence in the financial sector and positive expectations about the future economy are of crucial importance. Therefore, the “sustainable bubble economy” needs to be back by central bank as well as by economic policy in order to help to maintain optimism about the long-run economic development potential. 

Most studies have acknowledged the relationship between asset price bubble and stock market development and the crucial role of central bank to closely supervise and regulate financial activities, especially on the real estate sector. Hunter, Kaufman, and Pomerleano (2003) also express their concern over asset price bubbles which could make macroeconomic instability. They call for a sound monetary, regulatory, and international policies to avoid the harmful effect of bubble burst. Asset price bubble is a sophisticated problem which could not be easily identified. However, financial systems that have strong supervisory and regulatory institutions and macroeconomic stability before the onset of the bubble tend to survive a bubble’s collapse better than systems that do not. Transparency minimizes moral hazard and potential agency problems. Development and enforcement of accounting and auditing standards, including the quality of disclosure and the frequency and means of dissemination, are desirable. Strong regulatory and supervisory institutions are always the best line of defense. So, it is essential to maintain the creditability of the central bank so that it will be able to carry out its core function (maintaining macroeconomic stability). Furthermore, there should be strict bank regulation to prevent loan concentration to real estate sector, which accumulate the bubble.

Last but not least, Paul Davidson (2009) supports Keynes’s arguments on government intervention in the free market economy. He argues that we need appropriate regulation banking and financial markets in order to have a sustainable capitalist system. Big government intervention is necessary in maintaining stability of the banking and financial market.  In contrast, deregulation of the banking system and financial markets (free market) is a major cause for the global financial crisis recently since deregulation lead to accumulation of risky financial investment, causing bubble and burst. I think his argument is right since Japan also suffered the bubble burst and financial crisis in the 1990s due to its financial deregulation and easy monetary policy in the 1980s (Nakaso, 2001).  After a spectacular 1980s economic boom, Japan's real estate and stock markets crashed, throwing the economy into a prolonged recession and bank failures. The evolution of the Japanese financial system after the World War II is a good example of the modernization of financial sector, not only for its success, but also for the failure of maintaining the stability of the financial system after the deregulation during the 1970s, which led to uncontrollable financial innovations and asset price bubble in the real estate sector.
Now let’s have a look to economic and financial situation in Cambodia. The establishment of stock market is good for both short-term and long-term economic growth. The Cambodian government hold 55% of ownership of the CSX while the Korean Exchange controls the rest of the share. Three public enterprises (Phnom Penh Water Supply, Telecom Cambodia, and Sihanoukville Autonomous Port) will soon get listed in the new bourse. However, the issue on the timing of operating the stock exchange in Cambodia is still under hot debate due to the repercussions of the global financial crisis, uncertainty, and lack of confidence on the new stock market. While the government has taken some preparatory steps, including enacting some necessary laws and regulations and establishing a Securities and Exchange Commission, a lot of the prerequisites are still missing. Domestic savings remain low, partly due to the low level of public financial literacy and confidence in the banking and financial system. Other problems include a narrow investor base, problematic compliance with transparency and corporate governance standards, lack of laws and regulations governing e-commerce, absence of security intermediaries and rating agencies, and lack of skilled human capital. Without these prerequisites in place, operating the stock exchange is quite difficult or even impossible. It is better for Cambodia to make enough preparation in term of regulatory framework, information technology (IT) and human resource, on banking and financial sector before the establishment of the stock market. We do not need an unstable capital market which could easily crash after its opening just for only one or two year. If it crash, Cambodia’s economy would plunge into a deep recession.  

So, Cambodia has many challenges ahead, all of which will be confronted systematically. The main challenges are lack of relevant regulatory frameworks (e-commerce, etc.) human and institutional capacity, and lack of financial resource. It still needs some time to complete the legal framework to increase the creditability of its banking and financial sector. Cambodia should not rush to open the trading operations of the stock market (it is expected to start stock tradings on the beginning of 2012) if there is still lack of regulatory framework and human resource in this area. The on-going consequence of the global financial crises have resulted in a decline in demand for Cambodia’s export and have increased financial and fiscal risks, presenting Cambodia with new, unexpected challenges. So, the Government of Cambodia should take systematic and sequenced measures to mitigate the negative impact of the crises on its financial and economic system. Furthermore, there are fears of systematic risk and speculative bubbles after the opening of the new bourse, which may undermine the public confidence on the future of its young economy and financial sector in Cambodia. 

Credibility of central bank, National Bank of Cambodia (NBC), and public confidence in the banking and financial sector is an integral part that contribute to the success and sustainability of the new stock market. Furthermore, the Government should maintain the optimism of long-term economic growth through sound macroeconomic policy and political stability. NBC should have strict financial supervision and regulation on bank lending to the real estate sector, which may cause asset bubble. This strict policy is for the prevention of financial hoarding and the speculative bubble, which may develop after the opening of stock market and subsequent economic boom in the short-run period. I think the recent increase in saving and deposit in the banks is a good evidence of public confidence in the banking sector. However, transparency level is still limited although it has been improved by the Government and the private sector.

Riel or US Dollar in the Cambodia Stock Exchange is still a hot debate among economists in Cambodia while SECC is still conducting assessment on this issue. The private sector prefers the use of US Dollar while NBC and the Government wish to pursue the policy of “de-dollarization” by promoting the use of local currency (Riel) in the new bourse. Nevertheless, it may be weird for a sovereign country like Cambodia to not use its currency in the financial market, especially the Cambodia Stock Exchange, which may represent Cambodia financially on the international market.
In conclusion, Cambodia is in the process of modernization of its financial sector with the establishment plan of the Cambodia Stock Exchange in 2011. However, Cambodia faces systematic challenge in opening the new stock exchange. Behind this challenge, there are fears of systematic risk and speculative bubble, which the Cambodian Government should take into account. Given the two issues, the Government should maintain the optimism of long-term economic growth through sound macroeconomic policy and political stability. In line with this, the National Bank of Cambodia, as the Central Bank, should promote strict financial supervision and regulation and heavy capital control, especially at the initial stage after the establishment of the new bourse. Last but the most importance, creditability of the Central Bank, trust, and public confidence in the banking and financial sector should be enhanced and maintained by the Government and the Central Bank since it serves as the backbone of the macroeconomy and financial stability.

Japan's lost decade (1990s) after the burst of the asset bubble which accumulated in the 1980s


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