Tokyo, global financial centre renaissance

Capital market estuaries, abundance vs risk-free, the Asia opportunity

Estuaries and abundance

Estuaries equal natural abundance. The ecosystem that forms around a natural estuary is built on abundance and constant opportunity. Contrast this to the watering hole for arid lands, where a survival ecosystem evolves under conditions of scarcity. High risks are taken with full awareness, understood as necessary for survival. Contrast this, and the analogy of estuaries to a third type of ecosystem, one built up around canals. The artificial man-made waterways built to sustain predictable life in an area not naturally endowed with persistent water. An attempt to construct man-made abundance.

These three scenarios are common in the physical world and have attracted the build-up of civilisation over periods of time immeasurable. They therefore make for powerful analogies to communicate what it means to have a free-market economy with an open capital account, floating currency, pro-business regulation, and faith in the market as a natural capital allocator. This of course is the estuary.

The life that evolves around an estuary is not risk-free. In fact, the larger and deeper the mouth of the river, the larger the predators that can enter. I grew up on such an estuary, teaming with salmon that fed on herring & smelt, who were then similarly preyed upon by seals and sea lions. And, every once in a while, an orca—or killer whale—would swim into the harbour and eat the seals and sea lions. Such were the risks in a rich, deep, and bountiful estuary.

Abundance brings constant opportunity and infinite gains for the disciplined, the experienced, the respectful. Abundance is more valuable than risk-free. Risk-free without opportunity is still a life of scarcity and harsh survival.

Large, liquid capital markets with open capital accounts & floating currencies do not eliminate risk, they reduce certain types of risk. They reduce trading liquidity risk, position size risk, currency conversion risk, etc. These risks are replaced with other forms of risk like counterparty risk, trend reversal risk, overvaluation risk, etc. But these are tradable risks. Tradable vs non-tradable risks are everything in financial markets.

This is why, even with abundance, you need regulation, a central bank backstop, and predictable, reliable, proven rule of law. The estuary creates the base of abundance (liquidity, market depth, broad participation) and well-calibrated market oversight improves participant safety as they attempt to extract their gains.

The watering hole (controlled markets) and man-made canal (markets dependent on regulatory & tax incentives alone) attempt to allocate scarcity or artificially create abundance, but they can never achieve the relative risk profile of a natural estuary. This is why London and New York have dominated global financial markets for many many decades, and why the only real prospective member of this elite club was Tokyo.

Asia needs a global financial centre

As long as I have lived and worked in Asia, one country or another was making a play to become the most important global financial centre in the region. The Tokyo, Hong Kong, Singapore rivalry was well known and experienced by many during the 90s. In the end, Tokyo withered on the vine during its deflation phase. Hong Kong was hit by legal regime change when it integrated with China. And Singapore, settled on a few niche sub-sectors like wealth management, asset storage, multi-currency & derivatives trading.

However, Tokyo is the natural estuary. It has the massive primary & secondary market for bonds & equities, a reserve currency, deepest market in Yen crosses, the global mega-banks, huge pension funds, giant sovereign wealth fund, and a G5 central bank. All the natural endowments. Attracting the global investment banks and asset managers back to Tokyo and reconstructing the participant diversity prevalent in the early 90s is an achievable objective for Japan. With that comes the trading volumes.

The open capital account, the floating exchange rate, and reliable rule of law are there. Global reserve currency role is there. It is simply a matter of time before industrial policy efforts rejuvenate this natural global financial centre.

Singapore has consistently punched above its weight. It has built the man-made canals and incentives to foster abundance where a tiny little island economy would normally not succeed. It is one of the fascinating features of financial markets and global wealth storage; it can flow anywere. The world has varying degrees of prerequisites for allocating financial wealth at layer 1 risk level, layer 2, and in certain cases ‘all in’. But once these allocations reaches a certain size, underlying constraints of that financial centre begin to restrict, such as exposure to regime change, natural disaster risk, geopolitical risk, skilled labour pool size, etc. Custody domicile risk trumps familiarity and preference.

Hong Kong, on the other hand, falls into the watering hole category. Under British colonial rule, it did not. It was much more similar to Singapore. However, once it was absorbed into China’s legal sphere, it became part of the controlled ecosystem of the watering hole.

You can come and drink as you like, and the water looks amazingly attractive during the heat of the day, but everything you do will be visible. Every known predator can destroy you, if inclined.

You may be allowed to freely come and drink 100 times, but that does not eliminate the risk that you are attacked on occasion 101. This risk is known and accepted by all that come to the watering hole. Not a tradable risk.

These fundamental differences at the base of financial centres are important to understand, as too many people view current financial centre growth or volumes and their underlying power as the same. Or they use simple size metrics as the most important comparison. I also found it fascinating as DeFi and crypto took off a few years back, that innovators sought to code into existence various aspects of what I am describing in physical terms here.

Just having a bid/offer spread and a slick settlement tool doesn’t give you price discovery and market depth. It takes a collection of fundamental elements to create a large, liquid, diverse, trusted global market centre. And, it takes a whole other set of factors to perpetuate that trading depth for decades. Only then does trading volume translate into power.

Wealth stays home . . . mostly

The majority of national wealth is stored onshore by stable developed countries, almost 95% (here). Whereas, wealthy nations in a dangerous regional environment, eg, Latin America & Gulf Region, can store up to 60% of their wealth offshore. The natural estuaries and home-made domestic canals dominate, with the strange anomaly that Hong Kong is an incremental safe haven from mainland China. It may be a watering hole analogy for the world, but it is the safest perceived watering hole available to mainland Chinese.

Understanding how rare these fundamental dynamics are that make a truly organic, estuary-like global financial centre, Tokyo should be targeting regional dominance. While China is busy making Hong Kong into a global precious metals hub, Tokyo should be promoting capital market development, asset management expertise, and all forms of derivatives trading. It needs to attract more global wealth home.

This would be one of its strongest industrial policy power plays against China. This is a domain where China won’t attempt to compete because it is never willing to accept the loss of control necessary to attract the world’s market-trading capital. Japan is. It is an incumbent. It is an estuary. It has the natural domestic players to provide ballast and to capture opportunity from foreign participants deepening their local markets. It has massive domestic wealth to manage at higher ROC levels.

Global financial centre surveys look at current trading activities and apply high weights to factors that are in the ‘canal’ category, ie, current government incentives (low taxes, light regs). They misses the essential point that true potential for a regional financial centre to become powerful and global depends on its domestic market wealth & size. English proficiency, for example, is often cited as a factor limiting Tokyo’s ascent, when this can easily be addressed through a skilled-worker visa program for the financial industry and changes to the national education curriculum. Policies can be amended, a massive domestic market either exists or does not.

Japan’s relative size to Singapore and its starkly different legal regime to HK/China make it an easy regional winner, if it is willing to aggressively target the industry. When compared to the endless battles between London, Frankfurt, Paris for Europe’s regional crown, the competitive landscape in Asia is uniquely favourable for Tokyo.

Recognising its natural endowments is the first step in industrial policy. Structuring a 10-year plan to achieve the goal is what policy bureaucrats do best.

Japan has more than the world cup to win. They need to win their global financial centre status back!