Research & Policy Briefs From the World Bank Malaysia Hub No. 15, May 2018 Financial Integration in East Asia and Pacific: Regional and Interregional Linkages Ruth Llovet Montanes Sergio L. Schmukler During the last two decades, economies in East Asia and Pacific have been integrating internationally through trade and financial investments. One trend is puzzling. Whereas most of the trade integration has been within the region, most of the financial integration has been with countries outside the region. However, a closer examination of investment types shows that the relative lack of regional financial connectivity occurs mostly in equity, bonds, and bank syndicated loans (in so-called arm’s-length investments). The region is much more connected through foreign direct investment (FDI) (through both mergers & acquisitions and greenfield investments). The Puzzling Pattern of East Asia and Pacific’s throughout the ASEAN member states. Moreover, stock Financial Integration exchanges from Indonesia, Malaysia, Philippines, Singa- pore, Thailand, and Vietnam have been working Since the early 1990s, the East Asia and Pacific region together to form the ASEAN Exchanges, aiming to has been growing faster than any other region and, by promote ASEAN capital market integration. This collabo- 2016, it had captured about 30 percent of the world’s ration created the ASEAN Trading Link, launched in economic activity, up from about 21 percent in 1990. A September 2012, which connects the region’s stock significant part of this growth has been driven by the markets, making it easier for investors inside and rapid expansion of China, whose GDP grew from around outside the ASEAN region to trade stocks listed on their 2 percent of world GDP in 1990 to about 15 percent in stock markets. Other financial cooperation initiatives 2016. aimed at fostering integration within the region include the Chiang Mai Initiative, the ASEAN Capital Markets Economies in the East Asia and Pacific region have Forum (ACMF), the Asian Bond Markets Initiative been integrating with the rest of the world in terms of (ABMI), and the Asian Bond Fund Initiative. trade and are changing the global trading patterns. Still, an important part of the expansion in East Asia and But the evidence so far suggests that the level of Pacific’s trade has been associated with a trend toward financial integration within the East Asia and Pacific regionalization. In 2016, about 60 percent of East Asia region has remained lower than its links with countries and Pacific’s exports and imports went to, or originated outside the region, contradicting the trend in trade from, elsewhere within the region. (Kim, Lee, and Shin 2008; Garcia-Herrero, Wooldridge, and Yang 2009; Lee 2010; Lee, Huh, and Park 2013; Along with increasing trade integration, many East Ananchotikul, Piao, and Zoli; ADB 2017). East Asia and Asia and Pacific economies have undertaken significant Pacific economies are more financially integrated with efforts to liberalize and expand the scope and depth of global markets than with regional ones. For instance, their financial systems. Beyond the unilateral lifting of portfolio investments within the region accounted for formal restrictions to capital flows, many East Asia and only 23 percent of East Asia and Pacific’s cross-border Pacific economies have engaged in bilateral investment portfolio investments in 2016. Part of the low level of treaties to boost their integration in global financial regional financial integration is explained by Asian markets. As of 2016, 542 of these treaties involved a economies sustaining large current account surpluses party in East Asia and Pacific. In addition, several initia- and accumulating U.S. financial assets, leading to the tives have been launched to promote regional financial so-called “global imbalances” (Bernanke 2005; Cabal- connectivity. For instance, the Association of Southeast lero, Farhi, and Gourinchas 2008; Forbes 2010). Asian Nations (ASEAN) launched the ASEAN Compre- hensive Investment Agreement (ACIA), which came into The relatively low levels of regional financial integra- effect on March 2012. The Agreement’s main objective tion seem to be at odds with the complementarity is to boost ASEAN cross-border investments by estab- between trade and financial flows, as well as with the lishing a free, open, transparent, and integrated invest- negative effect of distance on the creation of financial ment regime for domestic and international investors links (Portes and Rey 2005; Aviat and Coeurdacier 2007; Affiliation: Llovet Montanes: Development Economics Strategy and Operations, the World Bank. Schmukler: Development Research Group, the World Bank. Acknowledgement: We received very useful comments from José De Luna Martínez, Asli Demirgüç-Kunt, Norman Loayza, María Soledad Martínez Pería, Luis Servén, and participants at a seminar at the World Bank Malaysia Hub, as well as helpful edits from Nancy Morrison. This work was supported by the World Bank Knowledge for Change Program (KCP) and Strategic Research Program (SRP). The analysis presented in this Research & Policy Brief is based on the 2017 paper, “International Financial Integration of East Asia and Pacific,” by Tatiana Didier, Ruth Llovet Montanes, and Sergio L. Schmukler in the Journal of the Japanese and International Economies. Objective and disclaimer: Research & Policy Briefs attempt to synthesize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. Global Knowledge & Research Hub in Malaysia Financial Integration in East Asia and Pacific: Regional and Interregional Linkages Figure 1. East Asia and Pacific's Cross-border Investment Shares by Region a. Porfolio investments b. Syndicated loans 100 100 90 90 80 80 70 70 60 60 Percent Percent 50 50 40 40 30 30 20 20 10 10 0 0 2014 2011 2007 2008 1998 1999 2001 2002 2004 2005 2013 2015 2016 1996 2012 2006 2009 2010 2000 2003 1997 2013 2015 2016 2005 2006 2008 2009 2012 2002 2003 2011 2014 2010 2001 2004 2007 c. Mergers and acquisitions d. Greenfield investments 100 100 90 90 80 80 70 70 60 60 Percent Percent 50 50 40 40 30 30 20 20 10 10 0 0 2016 2004 2006 2008 2010 2012 2014 1998 2000 2002 1996 1990 1992 1994 2015 2012 2007 2008 2010 2005 2016 2003 2009 2011 2013 2014 2004 2006 Developed economies Developing economies East Asia and Pacific Source: Coordinated Portfolio Investment Survey (IMF), SDC Platinum, and fDi Markets. Note: This figure shows the share of developed, developing, and East Asian and Pacific economies in the value of East Asia and Pacific's cross-border investments (sent and received together). Developed economies comprise the G-7 members, excluding Japan, and 15 other Western European economies. Developing economies comprise the countries not in the East Asia and Pacific region or the developed economies group. Offshore financial centers are excluded from the sample. Lane and Milesi-Ferretti 2008). Both trade and distance To understand the compositional differences across would predict much more financial integration within investment types, it helps to partition the economies the region. with which East Asia and Pacific is connecting into devel- oped and developing economies. Most of East Asia and There is, however, a marked difference across differ- Pacific’s investments with the rest of the world occur ent financial instruments, mainly between arm’s-length with developed economies. In fact, developed econo- investments (portfolio investments and syndicated mies accounted for over 80 percent of East Asia and loans) and foreign direct investment (FDI), comprising Pacific’s interregional investments in 2016, except for mergers & acquisitions (M&As) and greenfield invest- greenfield investments, where this share was around 44 ments. percent. New Evidence to Explain the Puzzle The differences across investment types could be related to the relative underdevelopment of financial Despite the puzzlingly low levels of regional integration markets in East Asia and Pacific compared to those in in arm’s-length investments, the East Asia and Pacific developed economies. As an example, the share of region seems to be well regionally connected in terms of domestic credit to the private sector over GDP was 95 FDI (ADB 2017; Didier, Llovet Montanes, and Schmukler percent for the median developed economy between 2017). Investments within the region accounted for 1990 and 2016, but 42 percent for the median East Asia around half of East Asia and Pacific’s FDI between 2003 and Pacific economy. The size of nonbank financial and 2016, whereas this share was 23 percent in the case institutions’ assets was on average equivalent to 132 of portfolio investments and 32 percent for syndicated percent of the US GDP between 1990 and 2015, loans (figure 1). whereas it was 3 percent and 5 percent in Indonesia and 2 Research & Policy Brief No.15 the Philippines, respectively. In line with this argument, indicate a change in the geographical composition of the literature on global imbalances suggests that Asian East Asia and Pacific’s investments toward regional and economies lack enough “safe” assets in which they can developing economies. In the case of developing econo- allocate their excess savings, and thus they invest in mies, the growth in financial investments can be traced assets from developed economies. The higher degree of to expansions not only in the value of the financial financial development increases not only the availability connections (the “intensive margin”), but also in the of financial instruments to both domestic and foreign number of active connections (the “extensive margin”). savers in developed economies, but also the sophistica- The increasing role of developing economies in East Asia tion and depth of the financial markets and institutions and Pacific’s investments is part of a broader trend that that are able to invest abroad and diversify risk interna- includes the rise of developing economies in the global tionally. financial scene (World Bank, 2017; Broner et al., 2018). The development of the financial sector is a key The lack of regional connectivity in arms’-length determinant of arm’s-length investments, whereas it investments (compared to that in FDI or trade) is not an plays a less important role in FDI. This could partly issue specific to the East Asia and Pacific region (table 1). explain the larger participation of developed econo- This pattern also occurs in other developing regions mies, and thus the weaker regional integration in such as Latin America and the Caribbean, Europe and arm’s-length investments. The role of developed econo- Central Asia, and Sub-Saharan Africa. In fact, when mies is particularly important in portfolio investments compared to other developing regions, East Asia and (equities and bonds) compared to syndicated loans. Pacific stands out as the most regionally integrated Several studies suggest that, despite the growth in region across all investment types. equity and bond markets, the East Asia and Pacific’s financial sector is still not well diversified and remains However, the East Asia and Pacific region comprises a highly concentrated in the banking sector. Although wide range of economies. Consider this extreme: in 2016, capital markets in various countries in the region have Singapore’s GDP per capita was US$52,961, whereas expanded significantly, becoming rather large, in several Cambodia’s was US$1,270. Similar disparities exist with other countries they are small and characterized by low respect to the extent of their financial sector develop- liquidity, high transaction costs, and a narrow investor ment. For example, equity market capitalization of listed base when compared to those of developed countries domestic companies was 995 percent of Hong Kong’s (Lee and Park 2008; Lee 2010; Didier and Schmukler GDP in 2016, but it was only 33 percent in Vietnam. Not 2015; IMF 2015). surprisingly, the more developed East Asia and Pacific economies (as measured by their GDP per capita) As East Asia and Pacific and developing economies account for the bulk of the value of East Asia and Pacific’s continue growing, becoming richer and developing their investments. Nevertheless, their participation is more financial systems, they will start playing a larger role in important in East Asia and Pacific’s arm’s-length invest- East Asia and Pacific’s portfolio and bank investments. ments than in East Asia and Pacific’s FDI. For instance, the Although developed economies have historically more developed East Asia and Pacific economies captured the bulk of East Asia and Pacific’s investments, accounted for 92 percent of East Asia and Pacific’s inter- their role has decreased over time (figure 1). Recent regional portfolio investments between 2003 and 2016, trends, which are common to all investment types, but only 46 percent in greenfield investments. Table 1. Degree of Regional Integration by Type of Investment and Region, 2003-16 Percent East Asia Latin America Europe and Sub-Saharan Middle East and Developed Type of connection South Asia and Pacific and Caribbean Central Asia Africa North Africa economies Portfolio investments 20.29 3.08 4.18 2.70 0.02 14.80 83.60 Syndicated loans 32.28 4.88 3.12 10.99 0.84 26.27 81.12 Mergers & acquisitions 44.48 21.55 22.48 7.86 0.54 18.16 79.32 Greenfield investments 49.59 15.14 22.80 16.82 4.25 38.01 41.12 Trade in goods 59.15 18.57 30.97 17.48 5.60 13.78 64.89 Source: Coordinated Portfolio Investment Survey (IMF), SDC Platinum, fDi Markets, and Direction of Trade Statistics (IMF). Note: This table shows the share of intraregional investments in the value of the region's total cross-border investments (sent and received together) over the period 2003-16. Developed economies comprise the G-7 members, excluding Japan, and 15 other Western European economies. Offshore financial centers are excluded from the sample. 3 Financial Integration in East Asia and Pacific: Regional and Interregional Linkages Policy Implications On the other hand, greater regionalization might also pose additional risks. Because business cycles tend to be The latest developments in the East Asia and Pacific’s more correlated among neighboring countries than financial integration process could yield significant among distant ones, regionalization can limit the benefits to the region. Greater regionalization and the benefits of risk sharing. It can also lead to a larger expo- increasing presence of developing economies in East sure of a country to regional shocks and a faster spread Asia and Pacific’s investments could be a sign of East of foreign shocks once they hit one of the countries in Asia and Pacific’s strategy for diversification away from the region. Financial stability might also be negatively developed economies, which would allow the region to affected by a potential laxer regulatory and supervisory benefit from greater risk sharing. environment in developing economies relative to devel- oped economies (Klomp and de Haan 2014; Claessens Increasing regional financial integration could have and van Horen 2016). Given the cross-border nature of some specific advantages compared to a strategy of the investments, appropriate macroprudential policies global integration. First, it could reinforce economic and stronger international policy cooperation could be integration and foster growth by facilitating coordina- used to boost resilience and mitigate risks to stability tion of regulations and supervisory policies across coun- from more integrated markets. tries, given that this tends to be easier to achieve at the Initially, both the benefits and risks of regionalization regional level. 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