The Working Paper series is a continuation of the formerly named Discussion Paper series; the numbering of the papers continued without interruption or change. ADBI's working papers reflect initial ideas on a topic and are posted online for discussion. Some working papers may develop into other forms of publication.

No abstract

India and China both carried out banking sector reforms in the 1990s. Despite taking a gradual approach, India's reforms have been the more comprehensive and have been implemented at a faster pace than in China. India's experience suggests that the following four issues would be relevant in China's future reform agenda: (1) privatizing the wholly state-owned commercial banks (WSCBs) and introducing measures to improve corporate governance; (2) removing Government intervention to make WSCBs more commercially oriented; (3) reducing the dominance of WSCBs by rationalizing weak banks and downsizing large WSCBs; and (4) if adopted, relaxing the stringent statutory liquidity requirement, which seems to discourage banks from lending. There are also lessons to be learned from India's reforms. First, the entry of new banks should be promoted provided they are sufficiently capitalized and are technology-oriented. Second, diversification of banks' business should accompany interest rate liberalization in order to compensate for the expected decline in net interest income and prevent banks from taking excessive risks. Third, strict regulations should be introduced to prevent connected lending.One of the features of the East Asian financial crisis was that short-term, massive foreign capital inflows, which were largely intermediated by domestic banks, greatly exposed them to both currency and maturity mismatches (so-called "double mismatch"). Sudden shifts in market sentiment driven by the burst of bubbles revealed the vulnerability of these banking systems and triggered a reversal of capital flows, easily leading to a currency crisis and a banking crisis. The occurrence of these "twin crises" in East Asia deepened the economic downturn by generating a free fall of the exchange rate and expanding the local currency value of foreign debt.Since the crisis, a consensus has been emerging among policy makers, academicians and media that avoiding a serious double mismatch is one of the most important policy objectives to prevent another crisis in the near future and thus, strengthening the soundness of the banking system in the borrower country is essential * Associate Professor of Keio University and Visiting Scholar to the Asian Development Bank Institute, Tokyo.

India’s financial and capital market reforms since the early nineties have positively impacted on the performance of the banking sector and the capital market. Based on the 5,000 firm-level database, this article shows that high-quality firms—defined as those that are profitable, have access to the commercial paper market and face relatively stable profitability—have reduced the proportion of loans further in 1997-2001 as compared with the period of 1992-96. This tendency strengthened during the period when the IPO requirement was tightened and the stock-market boom collapsed (so that many firms increased recourse to bank loans). This indicates that the capital market has succeeded in differentiating high-quality firms from low-quality ones, thereby making it cheaper for the former to raise funds from the market. Given the frequent cases of malpractice and price riggings, however, the government still needs to make continuous efforts to improve the infrastructure by strengthening penalty associated with malpractice, tightening accounting and auditing standards, and providing timely and precise information.

Japan has endeavoured to develop its capital Tokyo as one of the top global financial centres. Japan’s advantages are the sheer size of its economy (the third largest in terms of gross domestic product), the status of the Japanese yen as the third international currency after the United States dollar and the euro, and large financial and capital markets with abundant capital. Tokyo has the potential to become a regional financial centre that transfers excess capital to emerging Asian economies. This vision has not fully materialized because Japan’s financial investment continues to be destined towards the United States and Europe and in the form of relatively safe debt securities. Moreover, Japan’s capital remains largely risk-averse, contributing to lack of diversity in domestic capital markets and limited provision of risk capital to the world. This chapter takes an overview of Japan’s financial and capital market developments.