Financial market development is critical for economic development. This chapter explores the ways by which international financial cooperation — defined broadly to include cooperation in financial market infrastructure development, regulation, as well as the advancement of cross-border financial integration — can help the countries of the Greater Mekong Subregion (which comprises Cambodia, the Lao PDR, Myanmar, Thailand, Vietnam, and the Yunnan Province of the People's Republic of China) to foster the development of domestic and regional financial markets. The next section will briefly discuss why financial markets matter for overall economic development. The following section then discusses the benefits of regional financial cooperation for financial sector development in the GMS countries.

Why financial market development matters

The global financial crisis has forcefully shown the destructive potential of finance. Instead of being a lubricator of economic growth, the financial sector is now dragging down the real economy. Yet, as counter-intuitive as it might seem at first, one of the messages that policymakers in developing countries and emerging markets should take away from the current mess is that their economies need deeper financial markets, including capital markets, not less of them.

When examining the causes of the crisis, it is important to recognize that the crisis was first and foremost a consequence of inadequate supervision and regulation of financial firms (or in part even the complete lack of regulation, as in the shadow financial sector). The crisis is a long overdue reminder that perfect markets do not exist. It is astonishing how the efficient market hypothesis could rise to such prominence given the long and well-documented history of financial manias, panics, and crashes (for example, Kindleberger and Aliber 2005; Garber 2000). Irrational behaviour and phenomena such as speculative bubbles, collective mood swings, herd behaviour, bandwagon effects, panic trading, or trading by agents caught in liquidity shortage, have been long known in financial markets. A misguided belief in the self-regulating abilities of financial markets led to the devastating consequences that we are facing today.

What is to blame are not financial markets as such, but financial markets in which actors were driven by wrong incentive structures that had completely detached from the “real economy” — not least because regulators allowed excessive risk taking and a huge shadow financial sector to develop.