financial integration in east asia: an empirical investigation

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Financial Integration in East Asia: An Empirical Investigation

May 2013

Hyun-Hoon LeeHyeon-seung HuhDonghyun Park

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1. Introduction

East Asia as a de facto Single Market A noticeable feature of East Asian countries’ economic

success has been the growing integration of their goods markets.

The share of intra-East Asian trade has increased from 31.7% in 1990 to 42.0% in 2008 (ADB).

East Asia’s goods markets are highly integrated and the degree of integration has been increasing over time.

In conjunction with growing de facto regional economic integration, East Asia has experienced a sustained surge of official, government-led regionalism since the Asian financial crisis of 1997-1998 (eg., ASEAN+3, ASEAN+6, FTAPP).

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1. Introduction

East Asia as a de facto Single Market

ASEAN+3 started out as a post-Asian crisis forum for fostering financial cooperation and gave rise to a number of new regional financial arrangements.

These include the network of bilateral swap agreements (BSAs) under the Chiang Mai Initiative (CMI), institutionalized policy dialogue, and the creation of the Asian Bond Funds as a first step toward a regional bond market.

Recently, the finance ministers of ASEAN+3 agreed to speed up the CMI’s multilateralization (CMIM) by means of a collectively managed reserve-pooling arrangement governed by a single contract.

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1. Introduction

East Asia as a de facto Single Market

Despite the wide range of official activities and initiatives to promote intra-East Asian financial cooperation, intra-regional trade in financial assets lags far behind remains limited.

This is especially true in comparison with the integration of the region’s real economies via the trade channel.

Put differently, there has been de facto integration of East Asian economies but this integration has largely occurred in the goods markets rather than in the financial markets.

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Previous Studies

Using the IMF’s CPIS data on bilateral holdings of financial assets, a number of studies (Kim et al., 2005; Lee, 2008;, Park and Wyplosz, 2008 and Garcia-Herrero et al., 2009) applied the gravity model used CPIS data.

They confirm that the level of financial integration among East Asian economies is low.

However, they estimate a gravity model commonly used to estimate trade in goods to estimate trade in assets.

1. Introduction

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1. Introduction

Purpose of this paper

Evaluate the degree of bilateral linkages among East Asian financial markets using a financial gravity model grounded in economic theory.

Analyze the impact of three different types of country-specific risks - political, economic and financial risks – on financial asset trade.

Draw policy implications for regional economic integration in East Asia.

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1. Introduction

Contributions of this paper

Accurately evaluate the degree of intra-East Asian financial integration by estimating theory-based financial gravity equation along the lines suggested by Martin and Rey (2004, 2006) and Coeurdacier and Martin (2006).

Offer two possible reasons for East Asia’s lower level of intra-regional financial integration.

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Table of Contents

1. Introduction

2. Size of Bilateral Holdings of Financial Assets

3. Theoretical Framework and Empirical Specification

4. Empirical Results

5. Concluding Observations

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<Table 1> Geographic Breakdown of Equity Investment in East Asia


to: from: Hong Kong Indonesia Japan Korea Malaysia Philippines Singapore Thailand

Brunei . . . . . . . .

Cambodia . . . . . . . .

China, P.R. 152,976.00 0.05 15,042.71 23,066.12 100.41 . 12,806.52 7.72

Hong Kong . 351.08 17,501.33 15,301.59 1,832.15 . 16,205.67 104.44

Indonesia 468.00 . 800.35 560.84 212.31 . 3,555.62 18.28

Japan 8,540.00 3.48 . 4,812.72 200.21 0.22 13,256.35 13.73

Korea 3,574.00 . 5,618.36 . 666.26 . 7,609.17 8.00

Laos . . . . . . . .

Malaysia 1,964.00 1.00 1,158.09 701.12 . . 8,797.74 3.67

Myanmar . . . . . . . .

Philippines 389.00 . 317.76 104.89 37.20 . 800.31 0.96

Singapore 4,285.00 5.74 6,457.25 1,264.16 2,109.78 3.30 . 256.46

Taiwan 3,603.00 0.07 3,360.24 371.10 317.56 . 3,251.26 4.49

Thailand 1,123.00 23.39 1,443.99 325.17 119.76 1.68 3,524.81 .

Vietnam 122.00 . 5.95 1,201.01 0.60 . 469.38 3.58

East Asia 177,044.00 384.80 51,706.04 47,708.72 5,596.25 5.20 70,276.84 421.34

World 514,511.00 865.61 573,469.44 104,857.60 9,422.35 185.78 176,802.94 3,300.05

EASIA/World 34.41% 44.45% 9.02% 45.50% 59.39% 2.80% 39.75% 12.77%

Year-end 2007 (million USD)

Source: IMF, Coordinated Portfolio Investment Survey (CPIS) Database

I nvest

I nvest

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<Table 2> Geographic Breakdown of Long-term Debt Investment in East Asia


to: from: Hong Kong Indonesia Japan Korea Malaysia Philippines Singapore Thailand

Brunei . . . . . . . .

Cambodia . . . . . . . .

China, P.R. 5,440.00 . 458.00 201.80 6.05 . 907.13 15.23

Hong Kong . 65.73 849.01 1,768.00 68.35 154.80 3,398.66 42.44

Indonesia . . 603.79 190.71 110.99 . 4,047.76 0.64

Japan 2,835.00 . . 540.43 19.66 11.78 2,421.17 46.71

Korea 13,125.00 8.63 8,117.29 . 294.87 169.19 10,468.36 278.22

Laos . . . . . . . .

Malaysia 3,613.00 3.04 2,031.44 240.25 . . 4,153.01 39.18

Myanmar . . . . . . . 0.09

Philippines 592.00 2.05 1,634.73 13.99 43.55 . 874.27 2.48

Singapore 2,834.00 176.82 3,871.57 345.60 89.22 497.49 . 54.16

Taiwan 1,130.00 . 55.97 116.66 4.84 . 410.67 .

Thailand 442.00 . 289.24 115.45 9.07 33.47 1,118.64 .

Vietnam 724.00 . 63.51 6.41 . . 637.62 28.89

East Asia 25,992.00 187.49 15,038.13 1,414.39 573.42 711.93 20,474.96 426.41

World 205,319.00 1,576.34 1,924,828.83 53,255.88 3,404.81 4,792.00 103,119.66 4,367.84

EASIA/World 12.66% 11.89% 0.78% 2.66% 16.84% 14.86% 19.86% 9.76%

Source: IMF, Coordinated Portfolio Investment Survey (CPIS) Database

Year-end 2007 (million USD)

I nvest

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<Table 3> Destination of Investment and Exports


from: to: East Asia World EASIA/World East Asia World EASIA/World

Hong Kong 12,946.0 94,615.0 13.7% 177,044.0 514,511.0 34.4%

Indonesia 15.8 16.6 95.2% 384.8 865.6 44.5%

Japan 8,228.4 227,351.4 3.6% 51,706.0 573,469.4 9.0%

Korea 384.8 1,299.8 29.6% 47,708.7 104,857.6 45.5%

Malaysia 698.2 1,332.0 52.4% 5,596.2 9,422.3 59.4%

Philippines 3.5 110.8 3.2% 5.2 185.8 2.8%

Singapore 15,290.4 31,318.9 48.8% 70,276.8 176,802.9 39.7%

Thailand 39.0 82.0 47.6% 421.3 3,300.0 12.8%

Total 37,606.2 356,126.4 10.6% 353,143.2 1,383,414.8 25.5%


Hong Kong 12,343.0 85,877.0 14.4% 25,992.0 205,319.0 12.7%

Indonesia 35.9 687.5 5.2% 187.5 1,576.3 11.9%

Japan 9,474.4 1,004,877.6 0.9% 15,038.1 1,924,828.8 0.8%

Korea 638.2 5,283.7 12.1% 1,414.4 53,255.9 2.7%

Malaysia 94.4 550.7 17.1% 573.4 3,404.8 16.8%

Philippines 73.9 1,641.3 4.5% 711.9 4,792.0 14.9%

Singapore 6,938.7 41,960.2 16.5% 20,475.0 103,119.7 19.9%

Thailand 9.0 327.0 2.8% 426.4 4,367.8 9.8%

Total 29,607.4 1,141,205.1 2.6% 64,818.7 2,300,664.4 2.8%


Hong Kong 99,672.6 190,322.0 52.4% 214,800.4 344,803.0 62.3%

Indonesia 32,308.6 56,336.4 57.3% 70,646.5 114,112.0 61.9%

Japan 159,697.6 403,652.0 39.6% 335,576.0 714,883.0 46.9%

Korea 67,338.8 151,039.0 44.6% 180,916.9 373,737.0 48.4%

Malaysia 48,978.1 88,203.9 55.5% 97,890.1 176,213.0 55.6%

Philippines 16,716.6 32,155.1 52.0% 30,950.5 50,483.1 61.3%

Singapore 66,425.9 121,936.0 54.5% 185,135.2 299,871.0 61.7%

Thailand 32,144.5 65,114.6 49.4% 80,735.7 152,460.0 53.0%

Total 523,282.8 1,108,759.0 47.2% 1,196,651.3 2,226,562.1 53.7%

Equity Investment Outflow (million USD)

2001 2007

Long term debt Investment Outflow (million USD)

2001 2007

Export of goods (million USD )

2001 2007

Note: East Asia includes Brunei, Cambodia, China, Indonesia, Japan, Korea, Laos, Malaysia, Myanmar, Philippines,Singapore, Thailand, and Vietnam

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Determinants of portfolio investment of East Asian countries

From Courdacier and Martin (2006)

-1εi i j j i

ijij

βL y n r QAsset =

(1+ β) τ

where, Assetij = The aggregate demand from country i agents for assets issued in country jLi = population of country i,yi = per capital income of country i,Liyi = size (GDP) of country i,nj = number of assets in country j (financial sophistication of country j),τij= transaction costs between the two countries,rj= expected return in country j,Qi= financial price index specific to country i.

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A gravity equation for trade in assets can be drawn as follows:

logAssetitj = log(ß/(1+ß)) + logLyit + lognjt + (ε – 1) logrjt – (ε – 1)logτijt + (ε – 1)logQit

A more general gravity equation for trade in assets can be shown as follows:

logAssetitj = log(ß/(1+ß)) + logLyit + logLyjt + lognit + lognjt + (ε – 1) logrit + (ε – 1) logrjt

– (ε – 1)logτijt + (ε – 1)logQit + (ε – 1)logQjt

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Baseline model

(4)

where logGDPit = log of GDP of country i in year t logGDPit = log of GDP of country j in year t Caplibit = financial market liberalization index (0-1) of country i in year t Caplibit = financial market liberalization index (0-1) of country j in year t logRetrunit = rate of return of asset country i in year t logReturnjt = rate of return of asset country i in year t EASIA= 1 if the issuing economy is an East Asian country-



logAssetijt = α + β1logGDPit + β2logGDPjt + β3logCaplibit + β4logCaplibjt + β5logRetrunit + β6logReturnjt + β7logτijt + β8EASIA + ui + uj + ut + ijt

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where r-Tradeijt = bilateral trade intensity = residual from the regression of a trade gravity

equation

Expanded model 1

(6) LogAssetijt = α+β1logGDPit+β2logGDPjt

+β3logCaplibit+β4logCaplibjt

+β5rit+β6rjt +β7logτijt + β8r-Tradeijt + β9EASIA + ui + ut+ eijt



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Expanded model 2

(7) logAssetijt = α + β1logGDPit + β2logGDPjt + β3Caplibit + β4Caplibjt + β5logrit + β6logrjt + β7logτijt

+ β8HKG_ASIA + β9JPN_ASIA+ β10KOR_ASIA+ β11SGP_ASIA + ui + uj + ut + ij

where HKG_ASIA = 1 if home is Hong Kong and partner is an East Asian country JPN_ASIA = 1 if home is Japan and partner is an East Asian country KOR_ASIA = 1 if home is Korea and partner is an East Asian country SGP_ASIA = 1 if home is Japan and partner is an East Asian country



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Expanded model 3

(8) logAssetijt = α + β1logGDPit + β2logGDPjt + β3logCaplibit + β4logCaplibjt + β5logRetrunit + β6logReturnjt + β7logτijt + β8Pol_Riskijt + β9Econ_Riskijt + β10Fin_Riskijt

+ β11EASIA + ui + uj + ut + ij

where Pol_Riskjt, = political risk of economy j Econ_Riskjt, = economic risk of economy j Fin_Riskjt = financial risk of economy j

Data: International Country Risk Guide (ICRG) Ratings by Political Risk Services (PRS)



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Data Dependent variable: bilateral cross-border equity

holdings between countries (CPIS data) Period: 2001-2007

Source countries: Four East Asian countries - Hong Kong, Japan, Korea and Singapore

Partner countries: 50 countries for which the data are available.

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4. Empirical Results <Table 4> Determinants of Cross-border Holdings of

Securities (1) Fixed

effects(2) Random

effects(3) Fixedeffects

(4) Randomeffects

GDP_i -0.295 -0.009 0.234 0.322

(0.762) (0.788) (0.819) (0.865)

GDP_j 1.483*** 1.505*** 0.275 1.280***

(0.440) (0.110) (0.526) (0.108)

Caplib_i 0.339*** 0.298** 0.126 0.127

(0.112) (0.121) (0.112) (0.111)

Caplib_j 0.018 0.209*** 0.027 0.156**

(0.072) (0.061) (0.081) (0.071)

Return_i -1.230*** -1.250*** 0.232 0.278

(0.360) (0.385) (0.580) (0.547)

Return_j 0.619** 0.513 -0.577 -0.345

(0.247) (0.323) (0.512) (0.527)

Tax_j -0.016 -0.027** -0.051*** -0.043***

(0.013) (0.013) (0.014) (0.011)

Dist -0.990*** -1.013*** -1.225*** -1.020***

(0.166) (0.159) (0.210) (0.176)

OFC 4.370*** 1.603***

(0.595) (0.546)

Comlang 1.347*** 1.314*** 1.207*** 1.125***

(0.183) (0.156) (0.248) (0.201)

Contig 1.226*** 1.138*** -2.120*** -1.385**

(0.464) (0.304) (0.782) (0.570)

Colony -1.315*** -1.208*** -2.620*** -2.351***

(0.304) (0.269) (0.416) (0.321)

EASIA 1.049*** -0.153

(0.367) (0.532)

Constant -18.290 2.266 -27.562

(24.326) (24.772) (24.378)

Source Yes Yes Yes Yes

Destination Yes Yes Yes Yes

Year Yes Yes Yes Yes

Observations 1,048 1,048 707 707

R2 0.640 0.650 0.752 0.681

Notes: Shown in parentheses are standard errors. ***, **, and * denote one, five, andten percent level of significance, respectively.

Equities Bonds(1) Fixedeffects

(2) Randomeffects

GDP_i 0.700*** 0.692***

(0.172) (0.182)

GDP_j 1.143*** 0.861***

(0.124) (0.051)

Tradelib_i -0.138 -0.138

(0.107) (0.103)

Tradelib_j 0.051 0.104**

(0.041) (0.047)

Dist -0.536*** -0.511***

(0.070) (0.076)

Comlang 0.504*** 0.531***

(0.062) (0.063)

Contig 1.454*** 1.464***

(0.205) (0.109)

Colony -0.196 -0.209**

(0.129) (0.089)

EASIA 1.417***

(0.173)

Constant -36.335*** -29.818***

(5.463) (4.963)

Source Yes Yes

Destination Yes Yes

Year Yes Yes

Observations 2,092 2,092

R2 0.551 0.787

Notes: Shown in parentheses are standard errors.***, **, and * denote one, five, and ten percent levelof significance, respectively.

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Securities (with trade intensity)

(1) Fixed

effects(2) Random

effects(3) Fixedeffects

(4) Randomeffects

GDP_i -0.212 0.040 0.331 0.438

(0.759) (0.775) (0.818) (0.867)

GDP_j 1.574*** 1.485*** 0.243 1.279***

(0.438) (0.120) (0.525) (0.106)

Caplib_i 0.320*** 0.284** 0.115 0.112

(0.112) (0.119) (0.112) (0.112)

Caplib_j 0.053 0.210*** 0.042 0.169**

(0.072) (0.064) (0.081) (0.071)

Return_i -1.124*** -1.145*** 0.223 0.266

(0.357) (0.379) (0.579) (0.541)

Return_j 0.611** 0.554* -0.522 -0.280

(0.246) (0.317) (0.512) (0.524)

Tax_j -0.018 -0.026** -0.045*** -0.038***

(0.013) (0.013) (0.014) (0.012)

Dist -1.223*** -1.267*** -1.392*** -1.242***

(0.181) (0.159) (0.225) (0.178)

OFC 4.482*** 1.127*

(0.705) (0.598)

Comlang 1.740*** 1.677*** 1.380*** 1.326***

(0.199) (0.183) (0.262) (0.219)

Contig 1.125** 1.048*** -2.192*** -1.531***

(0.462) (0.305) (0.781) (0.543)

Colony -1.379*** -1.275*** -2.599*** -2.326***

(0.302) (0.245) (0.416) (0.295)

r_Trade 0.499*** 0.511*** 0.279** 0.335***

(0.113) (0.118) (0.139) (0.122)

EASIA_d 0.328 -0.712

(0.417) (0.523)

Constant -21.146 -27.042 1.985

(24.175) (22.027) (24.715)




Observations 1,040 1,040 707 707

R2 0.650 0.669 0.753 0.695

Equities Bonds


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<Table 7> Country Pair Effects

(1) Fixedeffects

(2) Randomeffects

(3) Fixedeffects

(4) Randomeffects

(5) Fixedeffects

(6) Randomeffects

HKG_ASIA 1.193*** 2.122*** -0.230 1.337*** -0.009 -0.032

(0.312) (0.386) (0.270) (0.390) (0.107) (0.083)

JPN_ASIAa -1.117*** 0.122 -3.002*** -1.314*** 0.476*** 0.504***

(0.276) (0.334) (0.242) (0.365) (0.108) (0.083)

KOR_ASIA 1.075** 1.620*** -0.134

(0.460) (0.416) (0.087)

SGP_ASIA 1.683*** 2.694*** 0.049 1.591*** 0.983*** 0.975***

(0.294) (0.374) (0.274) (0.395) (0.108) (0.088)

Source Yes Yes Yes Yes Yes Yes

Destination Yes Yes Yes Yes Yes Yes

Year Yes Yes Yes Yes Yes Yes

Observations 1,048 1,048 921 921 2,092 2,092

R2 0.670 0.660 0.763 0.664 0.574 0.763

Equities Bonds Goods

Notes: Estimates for the control variables are not reported for brevity. Shown in parentheses are standard errors. ***, **,and * denote one, five, and ten percent level of significance, respectively.

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Securities (with country risk)

(1) Fixedeffects

(2) Randomeffects

(3) Fixedeffects

(4) Randomeffects

GDP_i -0.347 -0.189 0.219 0.341

(0.761) (0.762) (0.821) (0.881)

GDP_j 1.395*** 1.371*** 0.474 1.213***

(0.482) (0.103) (0.597) (0.087)

Caplib_i 0.345*** 0.317*** 0.127 0.125

(0.112) (0.115) (0.113) (0.112)

Caplib_j -0.021 0.017 0.037 0.115

(0.074) (0.065) (0.082) (0.070)

Return_i -1.200*** -1.184*** 0.229 0.268

(0.360) (0.384) (0.581) (0.551)

Return_j 0.645*** 0.667** -0.594 -0.286

(0.248) (0.303) (0.514) (0.520)

Tax_j -0.016 -0.030** -0.051*** -0.034***

(0.013) (0.012) (0.014) (0.011)

Dist -0.993*** -1.008*** -1.225*** -0.864***

(0.166) (0.163) (0.210) (0.183)

OFC 3.564*** 1.408***

(0.560) (0.425)

Comlang 1.351*** 1.387*** 1.203*** 1.049***

(0.183) (0.158) (0.249) (0.193)

Contig 1.222*** 1.110*** -2.121*** -0.810

(0.463) (0.320) (0.783) (0.550)

Colony -1.319*** -1.264*** -2.618*** -2.167***

(0.304) (0.271) (0.417) (0.315)

Pol_risk 0.031* 0.072*** -0.008 0.033**

(0.019) (0.016) (0.020) (0.014)

Econ_risk 0.026 0.037** -0.014 0.034*

(0.020) (0.018) (0.019) (0.019)

Fin_risk -0.010 -0.018 -0.001 -0.032***

(0.013) (0.011) (0.013) (0.011)

EASIA 1.322*** 0.379

(0.386) (0.455)

Constant -18.090 -0.894 -30.553

(24.711) (25.614) (24.807)




Observations 1,048 1,048 707 707

R2 0.643 0.716 0.752 0.742

Equities Bonds


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Summary The central objective of this paper has been to

empirically evaluate the degree of bilateral linkages among East Asian financial markets

The primary finding is that trade in financial assets of Hong Kong, Japan, Korea and Singapore with other East Asian countries is larger than predicted by the theory-based financial gravity model.

This tendency is less pronounced for bonds than for equities.


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Summary When we include intra-East Asian goods trade

intensity as an additional explanatory variable, we no longer find that intra-East Asian assets trade is bigger than assets trade between East Asia and the rest of the world.

Therefore, it is possible that our finding of disproportionately large intra-East Asian trade in assets is driven by the region’s high level of goods trade integration.

Furthermore, our country-specific results suggest that Japan, the largest investor in the region, invests more outside East Asia even though it trades goods a lot with East Asia.


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Two possible reasons why trade in financial assets remains limited in East Asia?

The underdevelopment of the region’s financial systems relative to its dynamic real economies.

Why? East Asian countries (HKG, JPN, KOR, SGN) invest more in the countries with high degree of financial market liberalization.

High country risks of many developing countries in East Asia

Why? East Asian countries invest less in the countries with high country risk (particularly, political risk)

In particular, Japan, the region’s largest investor, has a very strong tendency of investing less in the countries of high political risk.


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Policy Implications East Asian countries need to speed up the process

of the region’s financial integration which lags behind the level of trade integration.

In particular, a special effort is needed to promote the integration of the region’s bond markets, for which we find weaker evidence of integration then equity markets.

Two suggestions for the region’s financial integration

(1) More liberalization of financial market.

(2) Reduction of country risk, particularly political risk of developing countries.


Hyun-Hoon Lee([email protected])

financial integration in east asia: an empirical investigation

Documents

east asian financial

level of financial integration

asian financial crisis

financial risks

financial asset trade

financial gravity model

regional economic integration

financial gravity equation