The IMF released a working paper “Drivers of Financial Integration – Implications for Asia” which is highly relevant given that deeper intraregional financial integration is prominent on Asian policymakers’ agenda despite the fact that financial integration lags behind trade integration and that Asian economies maintain stronger financial links with the rest of the world than with other economies in the region. The paper concludes that financial integration in Asia could be enhanced through policies that lower informational frictions, continue to buttress trade integration and capital market development, remove restrictions to foreign flows and bank penetration, and promote a common regulatory framework.
Ever since the Asian financial crisis, Asian policymakers have embarked in a number of initiatives to foster regional cooperation and financial integration. This drive has been motivated to a large extent by the desire to enhance resilience against the vagaries of global financial markets by developing a local-currency denominated bond market and beefing up regional reserves. The “Manila Framework” was developed in 1997 as a “ new framework for enhanced Asian regional cooperation to promote financial stability”. Other important steps toward regional financial integration include liquidity support arrangements through the Chiang Mai Initiative Multilateralization, the Asian Bond Fund, the Asian Bond Market Initiative, and financial forums such as the Association of Southeast Asian Nations Plus Three and the Executives’ Meeting of East Asia–Pacific Central Banks. The Association of Southeast Asian Nations (ASEAN) has also outlined plans to foster capital market integration, including by building capital market infrastructure and harmonizing regulations.
In spite of these efforts, though, the empirical evidence indicates that regional financial integration lags behind trade integration and that Asian economies maintain stronger financial links with the rest of the world than with other economies in the region.
This paper takes a fresh look at the status of financial integration within Asia and at possible factors hindering progress, focusing on portfolio investment and banking claims. More specifically, it attempts to address the following questions: how financially integrated are Asian economies within the region? Has Asia’s regional financial integration increased? And how does it compare to other regions? What are the drivers of financial integration? And, hence, what are the implications for Asian policymakers pursuing deeper regional financial integration?
To answer these questions we first review recent trends in the share of cross-border holdings of portfolio investment assets and bank claims within Asia compared to outside the region. Next, we estimate the home bias—that is, the tendency to invest more in one’s home country than abroad—in Asia and other regions. Then, through a gravity model, we study the main drivers of financial integration—focusing in particular on the role of regulations—and use the results to draw implications for Asia.
The paper finds that the degree of financial integration within Asia has increased, but remains relatively low, especially when compared with Asia’s high degree of trade integration. Moreover, financial linkages within Asia are less strong than those within the euro area and the European Union, but tighter than those in Latin America. The home bias is found to be particularly strong in Asia, limiting cross-border financial transactions within the region.
The gravity model estimates indicate that cross-border portfolio investment assets and bank claims increase with the size and sophistication of financial systems and the extent of trade integration. In addition, restrictions on cross-border capital flows, informational asymmetries, barriers to foreign bank entry, and differences in regulatory and institutional quality create obstacles to financial integration.
Hence, initiatives to advance Asian policymakers’ agenda toward deeper regional integration could include steps to further promote financial market development and trade linkages, and reduce informational asymmetries through increased financial disclosure and reporting requirements. Lowering regulatory barriers to capital movements and foreign bank entry, as well as harmonizing regulation, especially for investor protection, contract enforcement, and bankruptcy procedures, appear particularly important.
Note: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
