1 Financial Integration in East Asia: An Empirical Investigation May 2013 Hyun-Hoon Lee Hyeon-seung Huh Donghyun Park

2 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 (eg., ASEAN+3, ASEAN+6, FTAPP).

3 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.

4 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.

5  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

6  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.

7 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.

8 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

9 Geographic Breakdown of Equity Investment in East Asia 2. Size of Bilateral Holdings of Financial Assets

10 Geographic Breakdown of Long-term Debt Investment in East Asia 2. Size of Bilateral Holdings of Financial Assets

11 Destination of Investment and Exports 2. Size of Bilateral Holdings of Financial Assets

12 3. Theoretical Framework and Empirical Specification  Determinants of portfolio investment of East Asian countries From Courdacier and Martin (2006) where, Asset ij = The aggregate demand from country i agents for assets issued in country j L i = population of country i, y i = per capital income of country i, L i y i = size (GDP) of country i, n j = number of assets in country j (financial sophistication of country j), τ ij = transaction costs between the two countries, r j = expected return in country j, Q i = financial price index specific to country i.

13 3. Theoretical Framework and Empirical Specification  Determinants of portfolio investment of East Asian countries A gravity equation for trade in assets can be drawn as follows: A more general gravity equation for trade in assets can be shown as follows:

14 Baseline model (4) where logGDP it = log of GDP of country i in year t logGDP it = log of GDP of country j in year t Caplib it = financial market liberalization index (0-1) of country i in year t Caplib it = financial market liberalization index (0-1) of country j in year t logRetrun it = rate of return of asset country i in year t logReturn jt = rate of return of asset country i in year t EASIA= 1 if the issuing economy is an East Asian country - 3. Theoretical Framework and Empirical Specification  Determinants of portfolio investment of East Asian countries logAsset ijt = α + β 1 logGDP it + β 2 logGDP jt + β 3 logCaplib it + β 4 logCaplib jt + β 5 logRetrun it + β 6 logReturn jt + β 7 logτ ijt + β 8 EASIA + u i + u j + u t +  ijt

15 where r-Trade ijt = bilateral trade intensity = residual from the regression of a trade gravity equation Expanded model 1 (6) LogAsset ijt = α+β 1 logGDP it +β 2 logGDP jt +β 3 logCaplib it +β 4 logCaplib jt +β 5 r it +β 6 r jt +β 7 logτ ijt + β 8 r-Trade ijt + β 9 EASIA + u i + u t + e ijt 3. Theoretical Framework and Empirical Specification  Determinants of portfolio investment of East Asian countries

16 Expanded model 2 (7) logAsset ijt = α + β 1 logGDP it + β 2 logGDP jt + β 3 Caplib it + β 4 Caplib jt + β 5 logr it + β 6 logr jt + β 7 logτ ijt + β 8 HKG_ASIA + β 9 JPN_ASIA+ β 10 KOR_ASIA+ β 11 SGP_ASIA + u i + u j + u t +  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 3. Theoretical Framework and Empirical Specification  Determinants of portfolio investment of East Asian countries

17 Expanded model 3 (8) logAsset ijt = α + β 1 logGDP it + β 2 logGDP jt + β 3 logCaplib it + β 4 logCaplib jt + β 5 logRetrun it + β 6 logReturn jt + β 7 logτ ijt + β 8 Pol_Risk ijt + β 9 Econ_Risk ijt + β 10 Fin_Risk ijt + β 11 EASIA + u i + u j + u t +  ij where Pol_Risk jt, = political risk of economy j Econ_Risk jt, = economic risk of economy j Fin_Risk jt = financial risk of economy j Data: International Country Risk Guide (ICRG) Ratings by Political Risk Services (PRS) 3. Theoretical Framework and Empirical Specification  Determinants of portfolio investment of East Asian countries

18 4. Empirical Results  Data Dependent variable: bilateral cross-border equity holdings between countries (CPIS data) Period: Source countries: Four East Asian countries - Hong Kong, Japan, Korea and Singapore Partner countries: 50 countries for which the data are available.

19 4. Empirical Results Determinants of Cross-border Holdings of Securities

20 4. Empirical Results Determinants of Cross-border Holdings of Securities (with trade intensity)

21 4. Empirical Results Country Pair Effects

22 4. Empirical Results Determinants of Cross-border Holdings of Securities (with country risk)

23 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. 5. Concluding Observations

24 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. 5. Concluding Observations

25 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. 5. Concluding Observations

26 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. 5. Concluding Observations

Hyun-Hoon Lee