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Financial Integration in Asia

Author(s):
Leslie Teo, David Cowen, Hemant Shah, Ranil Salgado, and Alessandro Zanello
Published Date:
August 2006
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I. Globalization of Production and Financial Integration in Asia2

A. Introduction

Over the years, Asian economies have depended heavily on global and regional trade. Asian trade growth in the past two decades, in fact, has outperformed regional GDP as well as global trade in all broad forms—goods, services, exports, or imports—averaging over 10½ percent a year (in U.S. dollar terms).3 As a result, the region’s share of world trade has risen substantially. In addition, trade openness, as measured by the ratio of goods and services trade to GDP, has increased in nearly all countries in the region and, on average, is higher than in most other regions of the world. Intraregional trade has grown even faster, roughly doubling as a share of GDP over the same period. In recent years, this has been spurred by vertical integration of production networks and supply chains, especially reflecting the integration of China with the rest of the region and the world.

Table I.1.Trade Openness(In percent of GDP)
ExportsImportsTotal Trade
199020051990200519902005
U.S.9.210.210.616.019.826.2
Euro Zone27.937.627.636.155.573.7
Japan10.614.89.813.320.428.1
Emerging South Americ1a24.830.718.826.743.657.4
China14.837.912.032.226.870.0
India7.220.59.325.316.445.8
Indonesia23.838.124.434.348.272.4
Korea, Rep. of27.842.228.939.656.781.8
Malaysia74.6121.972.698.4147.2220.3
Philippines25.945.231.653.157.598.3
Thailand36.676.245.278.381.8154.5
Vietnam32.671.530.979.863.6151.3
Source: IMF,World Economic Outlook.

Argentina, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, and Venezuela. Simple average.

Source: IMF,World Economic Outlook.

Argentina, Brazil, Chile, Colombia, Ecuador, Paraguay, Peru, Uruguay, and Venezuela. Simple average.

By contrast, financial integration has been more sluggish, particularly regionally. As discussed in the last high-level seminar, Asia’s financial integration with the world is well advanced by some measures, including net private capital flows, foreign participation in some markets, and stock market correlations (IMF, 2005b). By other measures, however, the picture is mixed. For example, total financial liabilities in Asia (the combined stock of foreign direct investment (FDI), foreign loans, and equity holdings) is typically lower than in other regions of the world. Moreover, intraregional financial integration—for example, measured directly by cross-border capital flows or indirectly by cross-border correlation of consumption growth—has been more limited than elsewhere. Consequently, Asian economies appear to have become more integrated with countries outside the region than within the region. At the same time, the region generates substantial net saving (that is, domestic saving exceeds domestic investment), and countries have been accumulating large stocks of foreign reserves. This has resulted in the financial sectors of developed countries in Europe and North America serving as financial intermediaries for the Asian economies, with relatively more stable outbound official flows and more volatile inbound private flows.

The main aim of this paper is to document recent trends and patterns in trade and financial integration at the regional level and explore potential linkages, or the lack thereof, between the two. The analysis is complicated by limited bilateral data on cross-border financial flows, as well as nonfactor services. As such, the paper is primarily descriptive. In Section B, the paper briefly depicts recent patterns in bilateral trade. Section C gives an overview of some measures of intraregional financial integration, including portfolio flows (both equity and debt securities) and bank borrowing and lending, as well as comovements in financial markets. In Section D, the paper examines possible linkages between the real and financial integration, including by reviewing studies of other regions, particularly Europe. Section E has some concluding remarks.

B. Intraregional Trade Flows and Production Linkages

The rise in intraregional trade flows in Asia has been a hallmark of the region’s rapid growth and greater interdependency over the past two decades. Among the major economies in the region, intraregional exports (as a share of total exports) rose from an average of 44 percent during 1985–91 to 52 percent during 1999–2004. The overall rise has been particularly dramatic for the Republic of Korea and Taiwan Province of China, with sizable increases also for Japan, Singapore, and the Philippines. Intraregional imports also increased (as a share of total imports) from 46 percent to 49 percent over the same period. The major exception to these trends is China. There, both the share of exports and imports in the region fell, although China’s import intensity in Asia during 1999–2004 remained above the group average.

Table I.2.Intra-Asia Trade, 1985-2004 1/2/
1985-911992-981999-20041985-911992-981999-20041985-911992-981999-20041985-911992-981999-2004
Exports to AsiaImports from AsiaExports to AsiaImports from Asia
(In percent of total export or imports)(In percent of own GDP)
Industrial Asia
Japan32.041.945.126.230.738.33.23.84.82.62.84.1
Australia60.368.865.242.545.951.07.69.89.86.07.49.3
New Zealand51.859.957.948.753.061.911.313.413.210.611.814.1
Emerging Asia
Newly industrialized economies
Korea18.036.941.517.524.630.35.19.913.65.06.59.9
Hong Kong SAR47.053.057.575.183.484.447.259.473.575.393.4107.2
Singapore53.858.863.863.262.355.975.378.495.388.582.983.2
Taiwan Province of China35.350.356.734.847.053.816.019.626.215.818.324.8
Other emerging economies
China64.859.250.161.454.252.48.411.011.57.610.012.2
India24.728.928.732.427.233.21.22.32.81.52.23.3
Indonesia67.562.964.440.442.933.212.915.419.97.810.110.2
Malaysia44.748.050.433.439.040.726.738.352.220.131.042.1
Philippines23.227.143.049.055.645.74.17.320.08.614.221.3
Thailand43.350.454.372.668.656.310.617.830.018.123.531.1
Average (unweighted)43.649.752.245.948.849.017.722.028.720.624.228.7
Sources: IMF, Direction of Trade Statistics (DOTS) and International Financial Statistics (various edtions).

Asia as defined in the IMF’s DOTS, or East Asia and the Pacific and South Asia (including Afghanistan and Pakistan).

Based on own-country reported values of exports and imports in U.S. dollars, including re-exports.

Sources: IMF, Direction of Trade Statistics (DOTS) and International Financial Statistics (various edtions).

Asia as defined in the IMF’s DOTS, or East Asia and the Pacific and South Asia (including Afghanistan and Pakistan).

Based on own-country reported values of exports and imports in U.S. dollars, including re-exports.

On both the export and import side, the rise in intraregional trade has brought a shift in trade patterns, most dramatically for the newly industrialized economies (NIEs), which have seen trade among themselves and with industrial Asia shift to other parts of emerging Asia (especially China). The major exception is Singapore, where exports to other NIEs and industrial Asia continue to be driving forces in its intraregional trade. China itself has also seen a rise in the share of trade growth (both exports and imports) attributable to emerging Asia, but this has been overshadowed by larger falls in shares of industrial Asia and the NIEs, leading to some moderate reduction in the relative importance of the region as a whole to China’s trade.

Table I.3.Share of Trade Growth Attributable to Sub-Regions and Rest of World 1/

(As a percentage of period-to-period growth) 2/

JapanAustraliaNew ZealandHong Kong SARKoreaSingaporeTaiwan
92-9899-0492-9899-0492-9899-0492-9899-0492-9899-0492-9899-0492-9899-04
Exports
Industrial Asia1.32.223.815.538.120.97.35.54.83.09.011.39.06.3
NIEs32.023.129.610.218.63.15.55.419.510.918.024.642.924.0
Other emerging economies25.439.123.325.412.620.041.962.625.933.330.739.212.339.8
of which: China7.036.36.116.42.712.338.357.513.526.63.114.30.833.3
Other Asia0.80.94.81.95.13.82.10.13.22.35.02.33.44.7
Total Asia59.565.481.453.074.447.956.873.653.449.562.777.467.774.9
Rest of the world40.534.618.647.025.652.143.226.446.650.537.322.632.325.1
Imports
Industrial Asia3.82.013.77.734.026.914.10.48.56.620.2-12.428.122.2
NIEs10.89.811.112.16.37.817.812.74.410.311.212.910.018.6
Other emerging economies33.658.920.739.015.032.546.380.217.329.028.162.815.137.1
of which: China19.843.89.621.38.020.239.965.99.918.33.126.54.818.6
Other Asia1.71.14.96.21.12.00.50.00.90.80.92.01.44.3
Total Asia49.971.950.465.056.369.278.693.331.246.660.365.354.582.2
ROW50.128.149.635.043.730.821.46.768.853.439.734.745.517.8
Total trade
Industrial Asia2.42.118.410.836.024.510.93.06.74.614.62.519.013.8
NIEs22.716.019.811.412.16.012.08.912.110.614.620.325.621.4
Other emerging economies29.049.821.933.713.827.544.271.121.631.329.448.013.838.5
of which: China12.640.38.019.45.517.039.161.511.822.83.118.82.926.4
Other Asia1.21.04.84.53.02.71.20.12.11.62.92.22.44.6
Total Asia55.368.964.960.364.960.768.383.142.548.261.572.960.878.3
Rest of the world44.731.135.139.735.139.331.716.957.551.838.527.139.221.7
ChinaIndiaIndonesiaMalaysiaPhilippinesThailand
92-9899-0492-9899-0492-9899-0492-9899-0492-9899-0492-9899-04
Exports
Industrial Asia19.914.34.30.614.416.93.47.63.98.617.216.3
NIEs28.021.713.210.526.322.332.223.418.431.623.113.0
Other emerging economies3.85.48.311.313.729.010.822.98.117.59.428.3
of which: China2.36.45.18.83.09.51.26.32.711.5
Other Asia2.52.06.77.14.01.53.01.71.40.45.54.8
Total Asia54.343.532.529.558.469.749.555.631.758.055.262.4
Rest of the world45.756.567.570.541.630.350.544.468.342.044.837.6
Imports
Industrial Asia22.518.26.73.423.4229.54.57.56.010.229.36.6
NIEs34.326.29.410.017.8-95.426.126.522.431.714.58.8
Other emerging economies6.110.910.113.912.8-203.59.748.59.226.110.857.1
of which: China4.36.74.0-102.82.621.02.28.52.828.7
Other Asia0.50.91.51.61.3-27.90.51.35.612.43.31.6
Total Asia63.356.227.629.055.3-97.240.983.738.468.757.974.1
ROW36.743.872.471.044.7197.259.116.361.631.342.125.9
Total trade
Industrial Asia21.116.25.52.218.4-0.64.07.65.19.123.513.3
NIEs30.823.911.410.222.532.029.124.520.831.618.611.7
Other emerging economies4.88.19.112.813.348.110.331.88.820.510.237.4
of which: China3.36.64.618.02.813.51.87.12.716.9
Other Asia1.61.54.23.92.83.91.81.61.10.54.43.8
Total Asia58.349.730.229.257.083.545.265.435.861.756.666.1
Rest of the world41.750.369.870.843.016.554.834.664.238.343.433.9
Source: IMF, Direction of Trade Statistics (various editions).

Based on U.S. dollar value of exports and imports reported to the International Monetary Fund.

For 1992-98, change measured from the period 1985-91; for 1999-2004, change measured from the period 1992-98.

Source: IMF, Direction of Trade Statistics (various editions).

Based on U.S. dollar value of exports and imports reported to the International Monetary Fund.

For 1992-98, change measured from the period 1985-91; for 1999-2004, change measured from the period 1992-98.

Growth in intra-Asia trade has been driven primarily by growth in intra-industry trade, as noted in the IMF’s Asia-Pacific Regional Outlook (2005a). This change largely resulted from vertical specialization in output and production relocation across borders in Asia, with much of the growth coming in the export of intermediate goods to ultimately feed global demand (Fukao et al., 2003; and MAS, 2005). It contrasts with the European Union (EU), where the growth in intra-industry trade has been driven more by horizontal rather than vertical product differentiation and concentrated on the export of final goods for domestic demand. China’s emergence as a processing giant has been key to these developments, causing a sizeable shift in regional trade pattern (see Zhang et al., 2005).4 However, over time, some movement is expected towards horizontal integration, as China’s economy further develops and production moves up the supply chain, bringing another possible realignment in regional trade. Consistent with vertical specialization, China has become a significantly larger factor in explaining the rise in intraregional trade for industrial Asia and the NIEs (except Singapore). The same holds for emerging and developing Asia economies, which on the one hand may be in direct competition for the processing trade and/or have similar factor endowments to China, but on the other have become important suppliers of primary and secondary inputs.

Table I.4.Intra-industry Trade (IIT) in the EU and Emerging Asia(In percent of total trade)
Emerging AsiaEuropean Union
Horizontal IITVertical IITHorizontal IITVertical IIT
19964.716.628.537.5
19976.117.826.138.9
19985.120.026.540.0
19995.124.626.240.6
20007.623.725.840.0

The evidence is less clear whether the growth in intraregional trade has been aided by trading blocs. Ng and Yeats (2003) and Abraham and Van Hove (2005) find that ASEAN has played only a minor role in expanding intra-East Asian trade (although the latter’s findings suggest that China’s entrance into ASEAN could give intra-group trade a major boost and attract FDI into group economies). Focusing on the ASEAN-5, the importance of intra-group trade (vis-à-vis Asia as a whole) has only increased moderately in the past 20 years (actually declining for Malaysia). Consistent with this observation, the IMF’s Asia and Pacific Regional Economic Outlook (2006) notes that members of regional trade agreements (RTAs), especially ASEAN, have a high degree of openness with non-members in the Asia region (compared with RTAs outside Asia), explaining their relative importance to trade growth. A main reason cited for this difference is that regional trade integration in Asia followed a long period of unilateral liberalization in the 1980s and 1990s, with regional integration paralleling multilateral liberalization in a number of countries, all conducive to trade creation.

Table I.5.Intra-ASEAN Trade 1/
1985-911992-981999-20051985-911992-981999-2005
Exports to ASEAN-5Imports from ASEAN-5
(In percent of own GDP)
Indonesia2.03.75.11.42.23.3
Malaysia15.221.224.910.315.219.5
Philippines1.42.87.22.34.27.2
Singapore33.234.839.234.035.838.9
Thailand3.36.49.95.06.58.7
(In percent of Asia total exports or imports)
Indonesia18.520.933.015.523.025.6
Malaysia51.549.046.356.955.747.7
Philippines26.329.333.934.037.536.1
Singapore38.543.246.844.244.341.2
Thailand27.627.728.131.436.233.0
(In percent of global total exports or imports)
Indonesia7.59.011.010.414.416.5
Malaysia17.219.118.825.426.724.0
Philippines12.916.315.57.910.215.5
Singapore24.326.926.223.826.126.3
Thailand20.019.015.813.618.217.9
Source: IMF, Direction of Trade Statistics (various editions).

ASEAN-5 only (Indonesia, Malaysia, the Philippines, Singapore, and Thailand).

Source: IMF, Direction of Trade Statistics (various editions).

ASEAN-5 only (Indonesia, Malaysia, the Philippines, Singapore, and Thailand).

C. Intraregional Financial Flows

Standard measures of financial integration indicate that inter-regional integration continues to dominate intraregional integration. Financial integration is measured using a number of approaches in the economic literature. Generally, these are divided into three categories: quantity-based measures, price-based measures, and institutional/regulatory measures. This section examines evidence on the first two categories of measures, including by examining recent trends in cross-border financial flows and stocks and co-movements of interest rates, bond yields, and stock prices. As noted above, bilateral financial flows and stock data are limited, with gaps in both time and country coverage, thus complicating the assessment of financial integration at a regional level. Additionally, price co-movements could reflect common factors and/or similarities in fundamentals, rather than the degree of integration.

Indirect measures also suggest limited regional financial integration in Asia. Financial integration allows countries to diversify asset holdings and, in theory, sources of income, and thus shift income risks to other parts of the region or world. This suggests that the volatility of consumption relative to income should decrease with increasing financial integration, and also that consumption patterns should be more correlated across countries that are more integrated. However, empirical studies (such as Mercereau, 2005) find that consumption growth in most Asian countries has a low or negative correlation with that in other Asian countries. This compares with a correlation of about 0.6 among Euro area countries.

In terms of overall financial flows, Asia has benefited from the surge in net capital flows to emerging markets in recent years, with the stock of foreign investment in Asia increasing substantially. The region received roughly a half of the global supply of net private capital flows during 2003–2004, although the pace of inflows slowed in 2005. Indeed, based on the IMF’s Coordinated Portfolio Investment (CPIF), Asia’s foreign portfolio investment liabilities rose by 91 percent during 2001–2004 to US$1.9 trillion (8 percent of the global total or 19 percent of Asia’s GDP), with equity securities increasing at a faster rate than debt securities and reaching almost two-thirds of the total.

Figure I.1Net Private Capital Flows to Emerging Markets

(In billions of U.S. dollars)

Source: IMF, World Economic Outlook

1/ WEO definition of emerging Asia, which includes developing Asia plus NIEs.

2/ In 2003, the People’s Bank of China used $45 billion of official reserves to recapitalize two state-owned banks. In gross terms, private capital flows to Asia were considerably higher.

During the same period, Asia has also become a major portfolio investor in global markets. Based on the CPIF, Asia’s cross-border portfolio investment assets increased by 66 percent to US$2.8 trillion (over 12 percent of the global total or 29 percent of Asia’s GDP) during 2001–2004. In terms of composition of the flows, Asia’s stock of equity securities increased at a faster rate than of debt securities, but still amount to only about a quarter of the total.

Figure I.2.Asia’s Foreign Portfolio Assets and Liabilities, by Type

(In billions of U.S. dollars)

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

Figure I.3.Asia’s Foreign Portfolio Liabilities, by Origin

(In percent of Asia’s GDP)

Source: IMF, CPIS.

Figure I.4.EU15’s Foreign Portfolio Liabilities, by Origin

(In percent of EU15’s GDP)

Source: IMF, CPIS.

Figure I.5.Asia’s Foreign Portfolio Assets, by Region

(In percent of Asia’s GDP)

Source: IMF, CPIS.

Figure I.6EU15’s Foreign Portfolio Assets, by Region

(In percent of EU15’s GDP)

Source: IMF, CPIS.

Although growing in absolute terms and as a share of GDP, Asia’s intraregional cross-border portfolio investment is relatively small. For example, Asia’s portfolio liabilities to other Asian countries amounted to only 2¼ percent of Asia’s GDP in 2004, less than one-third the liabilities to either North America or the European Union (EU)—for each region about 7¼ percent of Asia’s GDP.5 Moreover, liabilities to these two regions rose by a larger amount during 2001–2004 than intraregional liabilities. A similar pattern holds for Asia’s portfolio assets. Asian investments in either North America or the EU—at almost 10 percent of Asia’s GDP each in 2004—were roughly four and a half times that within Asia, although intraregional asset holdings by Asia grew faster than inter-regional holdings during 2001–2004.6 By contrast, in the EU, intraregional portfolio liabilities and assets dwarf liabilities and assets to any other region and have also been the main source of growth in cross-border flows for the region (particularly as a share of the region’s GDP).

The same basic pattern holds for cross-border bank borrowing and lending, with Asian countries dependent more on inter-regional flows than intraregional flows.7 Global cross-border claims by Asian banks roughly doubled during 1999–2005, but claims on Asia grew by a slower rate than claims on either North America or the EU, and through 2005, claims on Asia remained smaller than claims on these other two regions. Similarly, European or North American bank claims on Asia were larger and grew faster than Asian bank claims on Asia. By contrast, cross border bank flows within the EU are primarily intraregional.

Figure I.7Asian Banks’ Foreign Claims, by Region

(In billions of U.S. dollars)

Sources:Bank for International Settlements(BIS) or national authorities.

Figure I.8.Foreign Banks’ Claims on Asia, by Origin

(In billions of U.S. dollars)

Sources:Bank for International Settlements(BIS) or national authorities.

Figure I.9.Foreign Banks’ Claims on ASEAN, by Origin

(In billions of U.S. dollars)

Sources:Bank for International Settlements(BIS) or national authorities.

Figure I.10.Foreign Banks’ Foreign Claims on EU15, by Origin

(In billions of U.S. dollars)

Sources: Bank for International Settlements(BIS) or national authorities.

Evidence from price measures of financial integration also suggests that financial remains low, albeit increasing (ADB, 2005). First, although cross-border interest rate and bond yield differentials have narrowed in recent years, these differentials remain substantial, even after controlling for exchange rate movements. Co-movements in Asian interest rates and bond yields have increased in recent years, but this could also reflect increasing integration with global markets and/or improving fundamentals (such as lower inflation rates and differentials and improved sovereign credit ratings). Co-movements in equity market returns, even after controlling for global factors, suggest that stock markets are more integrated than money and bond markets.

Nonetheless, there has been evidence, primarily anecdotal, of increasing integration of some financial services—namely banking and asset management. Cross-border acquisitions in the banking sector have increased, particularly with a number of purchases by Singapore banks in recent years. This trend is consistent with rising intraregional FDI flows in the financial sector. Also, asset managers and hedge funds have been shifting aggressively into the region—especially to Hong Kong SAR and Singapore—albeit generally from a low base. In other areas, such as insurance, integration has been more limited.

D. Intraregional Trade and Financial Integration: The Linkages

This section touches upon on links between trade and financial integration. It contrasts with the previous two sections, which have highlighted the dissimilarities between intraregional trade and financial integration within Asia. While trade and production integration have proceeded at an apparently rapid pace, financial integration has been relatively sluggish in Asia. Moreover, this picture differs from that in the EU, where financial integration in recent years has been comparatively swift. Overall, the available evidence suggests that trade integration and financial integration are closely linked, although perhaps stronger within the EU and, for Asia, with other regions than intraregionally.

A number of recent research papers suggests that finance follows trade. The results, however, may be influenced by the available data, with creditor data primarily non-Asian. Several channels have been suggested:

  • In Rose and Spiegel (2002), a theoretical model is based on the notion that an interruption in international trade (“the penalty”) acts as an enforcement mechanism for sovereign debt repayment. With such a penalty, the authors show that in equilibrium the pattern of cross-border borrowing favors the creditor with higher bilateral trade volumes with the debtor. The paper also provides empirical evidence supporting the model, using bilateral bank lending data (for BIS-reporting banks) as the dependent variable from 20 (primarily non-Asian) creditor countries to 149 debtor countries during 1989–1999.
  • Forbes and Chinn (2003) find that bilateral bank lending and trade competition are significant determinants of cross-country linkages (although results differ over asset markets and model specifications), but bilateral FDI is not. The paper investigates real-financial linkages by determining the extent to which bilateral trade flows and FDI, among several factors, can explain financial market returns across countries. Specifically, the authors look at the cross-country linkages between five large economies (France, Germany, Japan, the United Kingdom, and the United States) and 40 developed and emerging economies over the period 1986–2000.8 Overall, they find that import demand appears to be the most important determinant in their model of cross-country linkages in both stock and bond markets, specifically how shocks to the world’s largest economies affect local financial markets (even when controlling for capital account restrictions). The results are most significant for the period 1996–2000, suggesting the linkages are increasing over time. These results also suggest that real factors such as trade intensity may have a strong influence on financial returns, irrespective of the degree of financial integration.
  • Eichengreen and Park (2004) analyze why there has been less financial integration in Asia than in Europe. The paper addresses this issue by performing a case study of cross-border bank lending (using the BIS data) in Asia and Europe. The results indicated that different levels of economic development in the two regions (namely, per capita income, even after controlling for economic size in the creditor and debtor countries) are an important factor in explaining differences in bilateral claims. In addition, other differences that are largely predetermined from the point of view of policy (these include typical gravity model variables, such as distance between countries, common language, and sharing a land border) are significant factors. Controlling for these differences, some specifications suggest that Asia is better integrated financially than Europe. Nonetheless, the authors find evidence that Asia is less financially integrated because the region has done less to promote the growth of intraregional trade than has Europe (for example, the establishment of a common market). The results also indicate that capital controls—particularly, ones that have been maintained for longer periods—and the underdevelopment of financial markets and institutions in potential lending countries have been impediments to regional financial integration. The paper, however, also cautions that quick liberalization could increase financial vulnerability.

By contrast, other papers indicate that trade follows finance:

  • Several papers (for example, Fukao et al., 2003; and Zhang et al., 2005) find that FDI plays an important role in determining trade. As noted in Section II (above), these investments have especially spurred intra-industry trade, particularly vertical intra-industry trade in East Asia and especially China in recent years. Essentially, cross-border investment flows have followed differences in comparative advantages and factor endowments between countries and led to the increased integration, through supply chains and production networks.
  • Ronci (2004) suggests that external financing helps determine trade, particularly during crises. The paper shows that disruptions to external trade financing (short-term credit for trade, based on OECD data) explains the fall in trade flows during crisis episodes, after controlling for other factors that may affect trade volumes (such as domestic and external demand, exchange rates, and relative prices). However, the effect is fairly small, except when there is a banking crisis, which could also affect domestic trade financing.

On this basis, we attempt to establish a link between trade and financial integration for a set of Asian economies. Using annual data on economy-to-economy trade flows from the IMF’s Direction of Trade Statistics and portfolio assets (equity and debt securities) from the IMF’s Coordinated Portfolio Investment Survey (CPIS), we seek to determine whether these data are positively correlated and, if so, what might be the causal association. To some extent, one might expect the level of bilateral trade flows and financial assets to be strongly correlated, if countries conduct trade in each other’s currency.9 However, this is not always the case for intra-Asian trade, which for some economies is conducted in a third (internationalized) currency. We note the CPIS data are limited to 2001–2004 and do not cover portfolio investments from China, India, and Taiwan Province of China.10 In addition, by definition, it excludes FDI and bank lending—important sources of regional financing. On this basis, the following observations can be made:

  • Generally speaking, intraregional levels of trade flows and portfolio investment are positively correlated in Asia. The correlation is fairly strong in each economy, except Japan and Thailand. For both countries, especially Japan, the addition of data from the EU and United States causes the correlation coefficients to become significantly more positively correlated. This observation also holds among the industrialized economies in Asia, suggesting that inter-regional links appear to be even stronger for Asian countries compared with intraregional links—not surprising given global orientation of the most of the region’s major economies.
  • To broaden the measure of financial integration to capture regional bank lending, we add BIS- and individually-reported data on gross bank claims to portfolio asset for the largest money center economies in the region—Japan, Hong Kong SAR, and Singapore. Here, our results do not change significantly, suggesting portfolio investment, despite limits to its size, provides a good measure of financial links in the region.
  • At the same time, it is unclear whether trade leads finance, or vice-versa. Owing to the lack of time series data, we limit our analysis to a one-period lag—looking at both levels and changes in trade flows and portfolio assets. Here, no clear signs emerge on causality, although levels rather than changes exhibit stronger positive correlation.11
  • Finally, the annual trade flows and financial flows (or changes in financial assets) appear to have significantly lower positive correlation. Still, the average for the region is positive, but less than that when more global data are included.

Table I.6.Intra-Asia Trade and Finance 1/(correlation coefficients)
AustraliaHong

Kong SAR
IndonesiaJapanKoreaMalaysiaNew

Zealand
PhilippinesSingaporeThailandAverage
ASIA 2/0.6910.4190.3170.1580.5770.6800.8420.8010.5900.2640.534
(including bank lending) 3/0.1990.3320.553
ASIA+EU+USA 3/0.7980.8130.4630.9310.8070.7420.6750.7770.6760.5760.726
(including bank lending) 3/0.7350.9530.630
ASIA (-1) (trade leads finance)0.6790.4100.2840.1210.5510.6400.8340.8160.4990.2770.511
ASIA (+1) (trade lags)0.6610.4080.3220.1560.5980.7660.7560.8050.4980.2630.523
Trade (level) to Δfinance0.7470.2670.1620.0990.1800.4760.595-0.0780.680-0.0130.312
Trade (level) (-1) to Δfinance0.7370.2240.1360.0450.1430.4340.583-0.0770.617-0.0140.283
Trade (level) to Δfinance 4/0.4510.2460.4770.5370.6400.2550.5420.2310.3620.1610.390
Trade (level) (-1) to Δfinance 4/0.4440.2320.4830.5170.6220.2470.5400.2400.3230.1720.382
Sources: IMF, Coordinated Portfolio Investment Survey (various editions); and staff estimates.

Based on annual trade and portfolio (equity and debt securities) flows for the period 2001-2004.

Defined here as Australia, Hong Kong SAR, Indonesia, Japan, Korea, Malaysia, New Zealand, Philippines, Singapore, and Thailand (portfolio data not available for China, India, and Taiwan Province of China).

Correlation coefficients based on total trade and portfolio investments from and gross external bank claims of reporting economies.

Includes the EU and United States.

Sources: IMF, Coordinated Portfolio Investment Survey (various editions); and staff estimates.

Based on annual trade and portfolio (equity and debt securities) flows for the period 2001-2004.

Defined here as Australia, Hong Kong SAR, Indonesia, Japan, Korea, Malaysia, New Zealand, Philippines, Singapore, and Thailand (portfolio data not available for China, India, and Taiwan Province of China).

Correlation coefficients based on total trade and portfolio investments from and gross external bank claims of reporting economies.

Includes the EU and United States.

E. Concluding Remarks

This paper reviews the degree’s of trade and financial integration in Asia and their possible association. Generally speaking, interregional links appear to be stronger for Asian countries than intraregional links, suggesting that regional policymakers need to further strengthen economic ties to garner the full benefits of increased globalization and regional integration. To this end, both trade and financial integration are proceeding in the region in a multilateral and bilateral context. World Trade Organization (WTO) commitments weigh heavily on both goods and services (including financial services), and regional and bilateral trade agreements—existing and prospective—hold some promise of delivering further gains. At the regional level, financial integration is being further enhanced by initiatives aimed at harmonizing financial regulations, developing financial infrastructure, and deepening financial markets, as well as promoting a degree of monetary cooperation—most notably through the Asian Bond Market Initiatives and Chiang Mai Initiative.

Still, in East and South Asia, both trade and financial integration face a number challenges. On the trade side, the proliferation of preferential trade agreements runs, in principle, the risk of being economically inferior to nondiscriminatory trade liberalization on a most-favored-nation basis and slowing any movement toward a larger Asian common market. So far, little evidence of trade diversion has emerged in the region, although the risk remains that regional trade agreements could become a substitute for multilateral trade liberalization. On financial integration, challenges also loom large, including potentially the limited complementarity of the region’s economies, excess reliance on bank financing, and protecting their local systems political interest.

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1

Brian Bell, Mali Chivakul, Robert Flood, Akito Matsumoto, and Yuji Yokoburi also contributed to this paper.

2

Prepared by David Cowen and Ranil Salgado.

3

In this paper, the Asia region refers to Australia, China, India, Hong Kong SAR, Japan, the Republic of Korea, New Zealand, Taiwan Province of China, and the 10 Association of Southeast Asian Nations (ASEAN) countries. Industrial Asia refers to Australia, Japan, and New Zealand. Emerging Asia refers to the newly industrialized economies (the Republic of Korea, Hong Kong SAR, Singapore, and Taiwan Province of China), as well as China, India, and the ASEAN-4 (Indonesia, Malaysia, the Philippines, and Thailand).

4

For the 12 Asia-Pacific economies examined in Zhang et al. (2005), about three-quarters of the increase in total intra-industry trade (IIT) with China can be explained by vertical IIT during 1999–2001. This finding is consistent with results for emerging Asia in Fukao et al. (2003), who find on average that 78 percent of the rise in total IIT in the region during 1996–2000 is due to vertical ITT.

5

In the figures, North America or NAFTA is defined as Canada, Mexico, and the United States, while the European Union or EU15 is defined as Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxemburg, the Netherlands, Portugal, Spain, Sweden, and the United Kingdom.

6

In terms of the composition of the assets and liabilities, Asia’s intraregional equity and debt assets and liabilities are both small compared with their respective inter-regional counterparts. Similarly, Asian intraregional flows to sub-regions of Asia—for example, the ASEAN countries—are small compared with flows from the European Union or North America.

7

Cross-border bank flow data are for BIS-reporting banks only. The bilateral data for reporting banks in Asia are published by BIS for only Australia, Japan, and Taiwan Province of China. Data for Hong Kong SAR and Singapore were obtained from the relevant national authorities.

8

Included in this group are Australia, China, Hong Kong SAR, India, Indonesia, the Republic of Korea, Malaysia, New Zealand, Philippines, Singapore, and Thailand.

9

We initially focus on the stock rather than flow of financial assets, to see whether economies are acquiring financial positions in each other. However, stock data are not adjusted for valuation changes that might cause asset positions to fluctuate.

10

In addition, there are several gaps in the data for the countries listed above. Specifically, the CPIS has no reported data in 2004 for investment from Australia to Indonesia and the Philippines, and from Indonesia to Hong Kong SAR. In each case, we use the previous year’s data.

11

This result also holds when EU and U.S. data are included.

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