Financial Integration and Financial Efficiency in East Asia

June 2005
(revised November 2005)

Hee-Yul Chai (Kyonggi University)

Yeongseop Rhee (Sookmyung University)

____________________
This paper is to be presented at the Claremont-KIEP international conference in
November 2005. The authors are thankful to Woosik Moon and seminar participants at
the KEA meeting, the KEUSA meeting, the Korean-Italian conference and the KoreanFrench conference for constructive comments. All remaining errors are of course ours.

I. Introduction
When East Asian countries started to open their financial markets, they expected that
financial integration would bring much benefit to the economies. It is widely accepted
that the complete elimination of barriers to financial integration will allow firms to
choose the most efficient sources and greater financial integration should allow a better
allocation of capital. At the same time, financial integration will allow the most
productive investment opportunities to become available to investors, and a reallocation
of funds to the most productive investment opportunities will take place.
Financial integration may also encourage financial development, leading to financial
efficiency in emerging markets. With foreign funds flowing in, the integration process
will increase competition within less developed regions and thereby improve efficiency
of their financial systems. Efficient financial system may affect economic growth
through capital and technological accumulation in a productive way. What
consequences financial integration would bring depends upon how the process unfolds.
If financial integration process goes hand in hand with the economy, we may expect a
positive scenario. Otherwise, it is difficult to draw any firm conclusion.
Recently much attention has been paid to financial integration in East Asia.
Empirical studies undertaken so far suggest that high-income countries such as Japan,
Singapore, Hong Kong are fairly integrated and there has also been fairly good progress
of financial integration in other countries along with their ongoing financial
liberalization efforts. However, they have mainly analyzed the financial integration
process in terms of wider financial globalization, and it is difficult to figure out whether
the progress in financial integration of East Asian countries is due to deepening
regionalism or to simple opening of the market. If financial integration process is to
have any meaningful implication to real and monetary integration process, East Asian
financial markets should closely be integrated with each other and at the same time
regional factor should be the main element in the integration process.
This paper aims to analyze the financial integration process in East Asia and to
identify distinctive characteristics in the process. Our results will be discussed in
comparative perspectives with Europes experience and some implications will be
drawn for regionalism in East Asia.
The remainder of the paper is organized as follows. In section II, we provide
empirical analysis on how much integrated financial markets are in East Asia, focusing
on the stock market. Section III examines whether global or regional factor is a key to
market integration in East Asia. Section IV examines what implications the financial

integration process may have for market efficiency in East Asia, comparing with the
European case. Section V concludes the paper with a brief summary.

II. Financial Integration in East Asia

1. Measures of Financial Integration
Financial integration can be defined to contain two features: free movement of capital
and integration of financial services. Free movement of capital requires financial
opening. But, there are many other obstacles to be removed if free capital movement is
to lead to integration of financial services: legal differences in the tax system, the
company law, the securities exchange law, differences in the fund transfer system,
international credit rating mechanism, efficient cross-border clearing and settlement
system, and also less explicit barriers in the form of information asymmetry, foreign
exchange risk, country risk, language, national pride.
Price-based Measures
Various measures of financial integration are broadly grouped into two categories,
price based measures and quantity based measures.1 The price based measures measure
discrepancies in prices or returns on assets caused by the geographic origin of the assets,
which constitutes a check of the law of one price. If financial integration is complete,
homogeneous assets should have the same price irrespective of the location of trading.
However, in reality, assets dont have sufficiently similar characteristics, and we need to
take into account differences in systematic risk factors and other important
characteristics.
As specific measures, much work has utilized interest rate parity condition, covered
interest rate parity (CIP), uncovered interest rate parity (UIP) and real interest rate parity
(RIP), to test for the degree of financial market integration. CIP indicates that the
difference between the spot rate and the forward rate will be equivalent to the interest
rate differential between domestic and foreign interest rates. A violation of CIP suggests
the existence of a country premium, i.e. capital controls or transactions that restrict
capital movement. UIP not only measures a country premium but also allows for an
1

For survey of the literature, see Bordo et al. (1998), Cavoli et al. (2003), ECB (2004), Fratzscher
(2001).
2

exchange rate risk premium as impediment to integration. RIP implies that real interest
rates are equalized across countries if financial market is integrated. There is a broad
consensus that while country premium has become smaller or disappeared over time,
currency premium including exchange rate risk premium is still prevalent and UIP and
RIP are often violated even in developed financial markets.
The literature on stock market integration also uses the measurement of the
influence of foreign stock markets on domestic stock market. It says that as financial
markets are more integrated, market movements are more associated with each other
and the influence of foreign markets on the domestic markets should grow higher.
Given these considerations, a simple specific measure is to examine cross-market
correlations and regional interdependence. A more systematic empirical implementation
directly estimates the explanatory power of foreign stock market returns on the domestic
stock market return.
Quantity-based Measures
A perennial problem with using price based measures is to use interest rate data
comparable across countries. However, these data are often unavailable and the
application of price-based measures may be limited. Given these concerns, much work
has explored quantity based measures of financial integration.
The simplest measure is to look at net capital flows from a country to another. If
financial markets are integrated, private capital can move essentially without restriction
and there will be huge cross border transactions in financial assets. A basic evidence for
this would be the ratio of capital flows to GDP.
Another widely used quantity-based measure of financial integration is the correlation
between national savings and investment rates, pioneered by Feldstein and Horioka
(1980). They argued that for a closed economy, the balance of payments is zero by
definition and consequently, investment and savings are equal. On the other hand, if
international financial markets are well integrated, the correlation between the two
should be low because investment can be financed by foreign capital flows.2
Some focus on the benefits of risk-sharing of financial integration to construct a
specific quantity-based measure. When an investor holds too large a share of domestic
assets and too few international assets, their consumption pattern is vulnerable towards
2

In order for the Feldstein-Horioka hypothesis about high capital mobility to hold, the domestic
interest rate has to be tied to the world interest rate so that savings and investment need not to be
correlated. This implies that real interest rates should be equalized in a highly integrated financial
market, in other words, the Feldstein-Horioka measure of financial integration is a quantity/national
income accounting corollary of the RIP (Cavoli et al. 2003, p.11).
3

domestic output. On the other hand, holding more international assets would provide an
opportunity to cushion the impact of domestic economic shocks on consumption. If they
hold an optimal international portfolio, all domestic shocks might be eliminated and
consumption would respond only to uninsurable global shocks. The empirical evidence
of this idea involves observing correlations of an individual economys consumption
growth with the foreign countrys consumption growth and with its own real national
output. Full integration of financial market and therefore complete risk sharing implies
that a countrys consumption growth should be perfectly correlated with a foreign
countrys consumption growth, whereas its correlation with own national output growth
should be negligible.
2. Empirical Analysis of Financial Integration
Since bond markets and foreign exchange markets are not well developed in East Asia
and the East Asian foreign exchange rate system is quite different from the EMU, it
would not be much meaningful to compare two regions using measures based on
interest rate parity conditions. Also, interest rate data comparable across countries are
not yet readily available for East Asian countries. Thus to compare financial integration
in two regions, we use the simplest indicator of financial integration, cross-market
correlations, mainly focusing on the stock market.
Data
The empirical analysis is conducted for 10 East Asian countries (Korea, China,
Japan, Hong Kong, Taiwan, Indonesia, Malaysia, Philippines, Singapore, Thailand) and
14 European countries (15 EU starting members except Luxembourg). The data on
stock market returns are the market indices from Datastream International and have
daily frequence from January 1991 to April 2003 for most countries and somewhat
shorter time periods for a few countries, e.g., China. The region (EA or EU) index for
each country is the weighted average of individual markets in the region excluding the
market of the country concerned.
The three sub-periods for East Asia respectively correspond to the pre-crisis period,
the crisis-period, and the post-crisis period. The three sub-periods for EU correspond to
the ERM-crisis period, the pre-Euro period, and the Europeriod.

Results
Table 1 through Table 4 show the correlations of stock market returns in East Asia
and Europe. Some important results emerge from the table concerning the degree of
financial integration.3
First, equity markets in East Asia are fairly integrated. Excluding China whose equity
market is not yet sufficiently open, the average of correlation coefficients for East Asian
stock markets with the regional market (represented as EA in Table 3) is 0.556. The
corresponding figure for Europe (represented as EU in Table 4) is 0.695. The correlation
among East Asian stock markets has increased over time from 0.493 in the beginning of
the 1990s to 0.556 recently.
Second, the correlation with the US stock market has recently increased in East
Asia. On average, the correlation coefficient was -0.366 in the late 1990s and is now
0.574 in East Asia.4 But it has decreased from 0.951 to 0.790 in Europe over the same
period. Local individual markets correlation with the US market is now almost at the
same level as that with the regional market in East Asia (EA 0.556 vs. US 0.574) as well
as in Europe (EU 0.695 vs. US 0.790).
Third, another contrasting feature is that while financial market integration within
Europe was significantly lower during the ERM crisis, the integration was significantly
higher in East Asia during the Asian crisis. Also, during the crisis period, stock markets
in the EU kept fairly positive correlations with the US market, but East Asian markets
moves in the opposite direction to the US market.

To consider that US factor affects East Asian and European markets only on the following day due to
the differences in trading time, one-day lagged US data are used for a calendar day.
Again, this number is the East Asian average excluding China.
5

<Table 1> Correlations of Stock Markets in East Asia, 1999-2003.4

CH

HK

CH

1.000

0.469

HK

0.469

IN

IN

JA

KO

ML

PH

SI

TA

TH

-0.215

0.257

-0.302

0.122

-0.325

0.138

-0.567

-0.116

1.000

0.489

0.894

0.344

0.646

0.427

0.861

0.048

0.719

-0.215

0.489

1.000

0.642

0.847

0.709

0.691

0.809

0.799

0.761

JA

0.257

0.894

0.642

1.000

0.472

0.620

0.649

0.903

0.245

0.839

KO

-0.302

0.344

0.847

0.472

1.000

0.640

0.519

0.678

0.767

0.697

ML

0.122

0.646

0.709

0.620

0.640

1.000

0.272

0.743

0.413

0.749

PH

-0.325

0.427

0.691

0.649

0.519

0.272

1.000

0.680

0.650

0.712

SI

0.138

0.861

0.809

0.903

0.678

0.743

0.680

1.000

0.444

0.859

TA

-0.567

0.048

0.799

0.245

0.767

0.413

0.650

0.444

1.000

0.544

TH

-0.116

0.719

0.761

0.839

0.697

0.749

0.712

0.859

0.544

1.000

Avg

-0.060

0.544

0.615

0.613

0.518

0.546

0.475

0.680

0.371

0.640

<Table 2> Correlations of Stock Markets in Europe, 1999-2003.4

AU

BE

DE

FI

FR

GE

GR

IR

IT

NE

PO

SP

SW

UK

AU

1.000

0.094

0.765

0.344

0.467

0.428

-0.185

0.595

0.404

0.344

0.173

0.267

0.377

0.131

BE

0.094

1.000

0.342

0.313

0.583

0.658

0.612

0.641

0.613

0.778

0.637

0.707

0.487

0.864

DE

0.765

0.342

1.000

0.654

0.820

0.759

0.159

0.777

0.784

0.699

0.585

0.614

0.713

0.491

FI

0.344

0.313

0.654

1.000

0.904

0.877

0.602

0.394

0.878

0.806

0.868

0.834

0.962

0.674

FR

0.467

0.583

0.820

0.904

1.000

0.981

0.630

0.679

0.976

0.954

0.909

0.925

0.965

0.835

GE

0.428

0.658

0.759

0.877

0.981

1.000

0.688

0.695

0.970

0.975

0.937

0.960

0.958

0.883

GR

-0.185

0.612

0.159

0.602

0.630

0.688

1.000

0.227

0.609

0.743

0.746

0.767

0.679

0.826

IR

0.595

0.641

0.777

0.394

0.679

0.695

0.227

1.000

0.687

0.704

0.524

0.620

0.531

0.627

IT

0.404

0.613

0.784

0.878

0.976

0.970

0.609

0.687

1.000

0.950

0.934

0.935

0.942

0.849

NE

0.344

0.778

0.699

0.806

0.954

0.975

0.743

0.704

0.950

1.000

0.922

0.958

0.908

0.951

PO

0.173

0.637

0.585

0.868

0.909

0.937

0.746

0.524

0.934

0.922

1.000

0.963

0.934

0.876

SP

0.267

0.707

0.614

0.834

0.925

0.960

0.767

0.620

0.935

0.958

0.963

1.000

0.927

0.924

SW

0.377

0.487

0.713

0.962

0.965

0.958

0.679

0.531

0.942

0.908

0.934

0.927

1.000

0.796

UK

0.131

0.864

0.491

0.674

0.835

0.883

0.826

0.627

0.849

0.951

0.876

0.924

0.796

1.000

0.323

0.564

0.628

0.701

0.818

0.828

0.546

0.592

0.810

0.822

0.770

0.800

0.783

0.748

<Table 3> Correlations of Stock Markets in East Asia over Time

1991-2003.4

1991-1997.6

1997.7-1998

1999-2003.4

EA

US

EA

US

EA

US

EA

US

Avg1

0.383

0.098

0.493

0.509

0.719

-0.366

0.556

0.574

Avg2

0.337

0.016

0.465

0.508

0.616

-0.467

0.494

0.612

Note: EA is the average of an individual countrys correlations with other countries in

East Asia. US is the average of an individual countrys correlations with the US.
Avg1 excludes China and Avg2 includes it

<Table 4> Correlations of Stock Markets in Europe over Time

1992.8-2003.4
Avg

1992.8-1993.7

1993.8-1998

1999-2003.4

EU

US

EU

US

EU

US

EU

US

0.700

0.937

0.523

0.517

0.953

0.951

0.695

0.790

Note: EU is the average of an individual countrys correlations with other countries in

the EMU. US is the average of an individual countrys correlations with the US.

III. Global versus Regional Influence

Although the above basic results may give a rough understanding of the financial
integration process, they are far short of understanding of whether it is due to
regionalization or globalization. Therefore, we need to identify which one between US
influence and regional influence has played a more important role in the process of
financial integration.
To compare and evaluate the relative importance of the regional factor with that of
the global factor, we need to distinguish between regional shocks originating in East
Asia and global shocks originating in the rest of the world, for which shocks from the
US market are used as proxy. Specifically, we estimate the following equation:
rit = c + iRrRt + iwrwt + iXXt + it

(1)

where rit is an individual markets index return, rRt a regional average of individual

markets returns and rwt the world market return represented by the US market. In the
equation, iR indicates the coefficient for regional influence and iw that for the global
influence. The variable X is included to reflect other factors. To allow the ARCH effects
of innovations and the possibility of volatility spillover effects as well, we formulate the
GARCH model by adding the variance equation to mean equation (1).
2it = i0 + i12it-1 + i22it-1

(2)

Table 5 and Table 6 show the estimation results for East Asia and the EU
respectively. Between two regions, there is very much difference in the relative
importance of regional to global factor. In the movement of local stock market returns,
the US is a very important force for East Asian stock markets, but it is not true within
the EU. In East Asia, the US market was the most important factor for almost all
individual markets since the 1990s except the crisis period. During the period of the
Asian crisis, the regional factor was more important for individual markets movement
in East Asia. In contrast, the EU market has consistently become the dominant force for
individual EU markets since the 1990s.

<Table 5> Global versus Regional Factor in East Asia

1991 2003.4

1991 1997.6

1997.7 - 1998

1999 2003.4

EA

US

EA

US

EA

US

EA

US

CH

-0.049

0.054

-0.098

0.097

-0.114

0.085

0.024

0.012

HK

0.440

0.387

0.277

0.522

0.883

0.421

0.646

0.267

IN

0.094

0.152

0.056

0.112

0.421

0.437

0.256

0.104

JA

0.085

0.326

0.024

0.330

0.320

0.214

0.388

0.266

KO

0.220

0.275

0.034

0.054

0.405

0.226

0.818

0.355

ML

0.177

0.165

0.143

0.265

0.852

0.473

0.228

0.101

PH

0.153

0.247

0.030

0.301

0.523

0.334

0.254

0.138

SI

0.247

0.232

0.181

0.264

0.586

0.279

0.478

0.134

TA

0.203

0.230

0.092

0.127

0.192

0.299

0.383

0.218

TH

0.274

0.170

0.211

0.280

0.693

0.138

0.441

0.092

Avg1

0.184

0.224

0.095

0.235

0.476

0.291

0.392

0.169

Avg2

0.210

0.243

0.116

0.251

0.542

0.313

0.432

0.186

Note: EA and US represent iR and iw respectively.

<Table 6> Global versus Regional Factor in Europe

1992.8 2003.4

1992.8 1993.7

1993.8 - 1998

1999 2003.4

EU

US

EU

US

EU

US

EU

US

AU

0.112

0.318

0.219

0.366

0.207

0.412

0.064

0.283

BE

0.562

0.106

0.419

0.131

0.489

0.153

0.510

0.069

DE

0.559

0.126

0.601

0.044

0.659

0.037

0.512

0.162

FI

0.940

0.249

0.424

0.265

0.866

0.240

1.184

0.301

FR

1.128

-0.005

1.597

-0.162

1.705

0.101

1.152

0.053

GE

1.104

0.039

0.944

0.199

0.925

0.281

1.273

-0.121

GR

0.316

0.238

0.225

0.054

0.132

0.119

0.322

0.176

IR

0.452

0.238

0.428

0.476

0.482

0.314

0.412

0.189

IT

0.887

-0.057

0.020

-0.005

1.039

-0.090

0.838

0.063

NE

1.099

0.044

0.902

0.008

0.035

0.008

1.144

0.067

PO

0.478

0.048

0.095

-0.031

0.573

0.057

0.444

0.037

SP

0.882

-0.110

0.864

0.070

0.942

-0.070

0.849

0.005

SW

0.895

0.139

1.307

0.191

0.908

0.051

0.880

0.170

UK

0.749

0.046

0.748

0.109

0.697

-0.027

0.781

0.085

Avg

0.726

0.101

0.628

0.123

0.690

0.113

0.740

0.110

Note: EU and US represent iR and iw respectively.

Another method to distinguish between regional and global influences on local

individual markets is a variance decomposition. The variance decomposition examine
the extent to which the error variance of the stock market of each East Asian country is
explained by local, regional, and global factors. For each East Asian market, we
construct a trivariate VAR model which includes individual markets return, regional
markets return, and the US markets return as endogenous variables. Table 7 and Table
8 present decompositions of the error variance of the stock market returns in East Asia
and Europe respectively. The implication from the tables look similar to those from

10

Table 5 and Table 6. In East Asia, the US factor plays more important role than the
regional factor in determination of the market returns. These results suggest that East
Asian financial markets have closer ties with the US market than with one another.5 One
thing to add is that in East Asia, about 90 percent of forecast error variances is
attributable to the innovation in the domestic markets, while in Europe, only half of the
variances is attributable to the domestic markets.
<Table 7> Variance Decomposition, East Asia
1991 2003.4

1991 1997.6

1997.7 - 1998

1999 2003.4

EA

US

EA

US

EA

US

EA

US

CH

0.115

0.080

0.146

0.111

0.373

2.464

0.222

0.109

HK

7.805

14.693

2.383

10.682

12.424

17.861

16.472

20.968

IN

2.538

3.178

1.020

1.891

7.100

7.102

3.073

2.763

JA

1.432

9.948

0.182

5.043

5.306

12.020

7.546

14.142

KO

2.807

6.643

0.302

0.669

3.081

5.808

9.931

13.190

ML

3.216

4.796

2.562

4.804

7.721

8.758

3.053

5.108

PS

1.836

5.290

0.614

4.616

7.334

13.086

2.597

4.705

SI

8.079

11.553

4.285

4.759

10.063

18.262

12.165

17.809

TA

1.963

4.300

0.978

1.476

2.040

10.184

4.294

6.680

TH

4.016

3.964

1.631

2.712

8.810

6.749

6.302

4.671

Avg1

3.381

6.445

1.410

3.676

6.425

10.229

6.566

9.015

Avg2

3.744

7.152

1.551

4.072

7.098

11.092

7.270

10.004

Note: The number in the table represents a decomposition of the error variance for 10
period ahead forecast when the proportions of the factors are relatively stabilized.

<Table 8> Variance Decomposition, Europe

1992.8 2003.4

EU
AU

4.041

1992.8 1993.7

1993.8 - 1998

1999 2003.4

US

EU

US

EU

US

EU

US

24.90

6.073

11.308

5.369

27.962

4.491

29.149

9.571

26.388

25.995

29.593

24.499

2
BE

28.839

23.67 23.455

The order of the variables is US, region, and local markets. The results of variance decomposition
are usually sensitive to the order of endogenous variables. When we change the order to region, US,
and domestic markets, there is slight changes in the magnitude but the basic figure does not change.
11

7
DE

22.826

16.05 13.315

2.932

28.458

15.684

21.565

19.007

3.495

4.757

23.695

25.262

23.608

22.553

26.44 47.710

6.215

39.902

21.648

53.874

32.176

11.054

30.296

27.738

40.487

35.610

7
FI

21.999

21.67
5

FR

47.536

6
GE

37.148

27.91 33.054
9

GR

3.299

6.368

1.945

0.701

4.469

5.082

3.355

8.972

IR

17.476

22.83

8.322

12.649

19.561

31.851

17.361

20.664

1.074

0.038

30.229

12.204

50.772

25.029

27.55 47.892

9.431

43.588

25.419

52.059

30.065

8.011

1.955

25.137

13.172

26.066

13.755

20.69 23.548

4.264

37.121

20.835

49.089

23.271

10.273

34.764

23.500

34.334

27.930

12.787

34.408

23.881

41.988

28.481

6.995

27.385

21.445

32.046

24.369

5
IT

38.086

16.67
6

NE

49.280

0
PO

24.297

12.34
1

SP

42.663

9
SW

32.911

24.33 22.108
9

UK

37.886

26.27 27.667
7

Avg

29.163

21.26 19.119
9

Note: The number in the table represents a decomposition of the error variance for 10
period ahead forecast when the proportions of the factors are relatively stabilized.

IV. Financial Integration and Financial Efficiency

The above comparison of financial integration process in East Asia and Europe suggests
that during the 1990s, regional factor has played an important role in EU financial
integration, while global factor has also been important in East Asian financial

12

integration. This difference may have significant consequences for financial market
development in East Asia.
One possibility is that financial integration in Europe where regional factor plays an
important role in the integration may proceed hand in hand with the regional economy.
Thus financial integration may lead to better allocation of capital, financial
development, and financial efficiency, as expected. In contrast, financial integration in
East Asia has been much influenced by the US market and may not reflect its regional
economy. When the financial market movement is deviated from economic
fundamentals, it would be difficult to expect financial market efficiency.
To examine whether financial integration is accompanied by financial efficiency in the
regions, we estimate the following equation:6
rit = iEt-1[rit] + iREt-1[rRt] + iwEt-1[rwt] + iRRt + iwwt + it

(3)

where Et-1[rt] is expectation of current returns from past information and t is an

unexpected part, i.e. a contemporary, idiosyncratic shock. This suggests that local
returns rit are determined both by the expected part of the returns which is available
from the past information on local and world markets and by the unexpected
contemporary shock which originates both locally and in the world market. When a
market is efficient, the current price has already reflected all relevant information and
will change only when the market receives new information. Since news by definition is
unpredictable, we can define the full financial efficiency as iw = i = 0 using (3)7.
To estimate (3), we need to know the data generating process for Rt and w. For this,
we introduce the following two equations
rRt = REt-1[rRt] + RwEt-1[rwt] + Rwwt + Rt
rwt = wREt-1[rRt] + wEt-1[rwt] + wRRt + wt

(4)
(5)

and assume the expectations are formed as VAR(2). By adding the following variance
equations to mean equation (3)-(5),8 we formulate the GARCH model.
2it = i0 + i12it-1 + i22it-1 + iR2Rt-1 + iw2wt-1
2Rt = R0 + R12Rt-1 + R22Rt-1 + Rw2wt-1
2wt = w0 + w12wt-1 + w22wt-1 + wR2Rt-1
6
7
8

(6)
(7)
(8)

This equation draws on Fratzscher (2001).

Fratzscher (2001) define iw as the degree of financial integration.
For relevant analysis, see Bekaert and Harvey (1997), Ng (2000), Reyes (2001).
13

Table 9 and Table 10 present the results for East Asia and the EU respectively using
the GARCH model composed of (3)-(8). We can derive several important features from
the comparison of two tables.

<Table 9> Financial Market Integration in East Asia

iR

iw

iR

iw

CH

0.987

-0.002

-0.001

0.027

-0.086

HK

0.738

0.296

0.306

0.430

0.100

IN

0.999

-0.004

0.004

0.230

-0.019

JA

0.999

0.002

0.003

0.110

0.010

KO

-0.262

1.547

-0.046

0.205

0.104

ML

1.081

-0.423

0.721

0.173

-0.008

PH

1.037

-0.112

0.619

0.137

0.034

SI

0.787

0.134

-0.159

0.241

0.078

TA

0.881

0.035

0.628

0.197

0.018

TH

0.983

-0.137

0.096

0.268

0.042

Avg1

0.823

0.134

0.217

0.202

0.027

Avg2

0.805

0.149

0.241

0.221

0.040

Note: The numbers are the average of the coefficients for 10 East Asian countries. The
numbers for variance equations are not reported.

<Table 10> Financial Market Integration in the EU

iR

iw

iR

iw

AU

1.000

0.001

0.004

0.128

0.003

BE

0.999

0.001

0.002

0.558

0.028

DE

0.997

0.003

0.005

0.582

-0.026

14

FI

0.951

-0.029

0.003

1.024

0.036

FR

1.001

-0.001

0.000

1.105

0.038

GE

0.998

0.002

-0.004

1.080

0.175

GR

0.913

-0.175

-0.231

0.298

0.007

IR

1.000

0.000

0.001

0.472

-0.011

IT

1.001

-0.001

0.001

0.900

-0.021

NE

1.002

-0.003

-0.002

1.094

0.006

PO

1.000

0.000

0.001

0.510

-0.034

SP

0.997

0.002

-0.002

0.900

-0.008

SW

1.001

-0.002

-0.002

0.880

0.027

UK

1.001

0.000

0.005

0.708

0.068

Avg

0.990

-0.014

-0.016

0.731

0.021

Note: The numbers are the average of the coefficients for 14 Euro area countries. The
numbers for variance equations are not reported.

First, in terms of market integration represented by a combination of iR and iR or

that of iw and iw, the US is still an important force for East Asian stock markets, but it
is not true in Europe. In Europe, the US market somewhat affected individual markets
until the middle of the 1990s, but the EU regional market has become the dominant
force for individual Euro area markets since the middle 1990s.
Second, an interesting contrast to note is that while the importance of expected share
based on available information, represented by iR, iw, has become significantly smaller
in Europe, it has stayed strong in East Asia. This implies that European financial market
integration has come with financial market efficiency, but a move towards financial
market integration in East Asia has not come with a transition towards market
efficiency.
Third, the above two features indicate that since East Asian markets are not yet
efficient enough, the US influence is transmitted to local individual markets through
expected channel such as iw, but the efficient European equity markets make the US
influence transmitted only through unexpected channel.
Why are there differences in the financial integration process between East Asia and
Europe? To begin with, the different experience of capital liberalization between the two
regions must be taken into consideration (Moon 2001). In Europe, due to the completion
of the Single Market Program, all countries had already completed liberalized capital

15

flows before the ERM crisis took place. The crisis worked only as a disruptive factor for
already well-integrated European markets, and the integration process has only been
strengthened after the crisis. As for many of East Asian countries, the control on foreign
equity investments was loosened only after the breakout of the Asian crisis in 1997, and
the financial integration process in East Asia is still at a beginning stage and not yet
steady and stable. Also to overcome the crisis, the crisis stricken East Asian countries
have heavily depended upon the IMF financial support and foreign capitals, in which
the US influence has been important. Consequently, the financial integration of East
Asian markets with the US has been strong.
Another answer to the above questions can be formulated in terms of exchange rate
stability. East Asian countries do not have a regional monetary arrangement and their
monetary policies are often focused on the exchange rate stability against the US dollar.
This also explains the US influence on their financial markets. However, the role of
exchange rate stability per se in Europes financial integration has to be cautiously
interpreted since other factors such as real convergence or macroeconomic policy
coordination may have been important factors explaining asset returns synchronization
in the region. As numerous studies have shown, 9 real convergence, measured by the
income correlation, has an important effect on financial integration because asset returns
reflect to some extent the business cycle. Also, macroeconomic policy coordination
leads naturally to enhanced asset returns correlation because financial market conditions
are influenced by monetary and fiscal policies. Simple exchange stability arrangements
may not be sufficient to accelerate regional financial integration.10
It must also bear in mind that a monetary arrangement is not per se sufficient
condition for financial integration. Macroeconomic policy coordination, concerted
institutional building and the establishment of efficient market infrastructure are all
required to reap the benefit of integrated financial market.

V. Conclusion
Financial integration assures market liquidity that would be absent within a segregated
market. Financial integration increases competitive pressure on exchanges and
intermediaries, and thereby reduces the transaction costs and raises incentives for
innovations. Thus, financial integration is expected to stimulate financial efficiency and
9
10

See Fama and French (1989), Ferson and Harvey (1991), Jagannathan and Wang (1996) among others.
See Chai (2003), for the interactions between the euro and Europes financial markets.
16

economic growth. On the other hand, financial integration is likely to reduce the
negative effects of idiosyncratic shocks in a currency union through cross-border
portfolio diversification and capital mobility. Thus, financial integration can allow
countries with asymmetric economic structures to form a currency union.
In this paper, we tried to describe the financial integration process in East Asia, and
identified some important features from a comparative perspective with Europe.
Empirical analysis on stock markets shows that during the 1990s financial markets have
become increasingly integrated over time in East Asia. Also, the US influence remains
strong in East Asian financial markets while it has significantly reduced in Europe
especially since the late 1990s. Another interesting difference is that financial
integration is accompanied by financial efficiency in Europe, while it is not true for East
Asia.
The differences of the integration processes between the two regions can be partly
attributed to different experience of capital liberalization. But another important cause
seems to be that the monetary integration played an important role in Europe while this
is not the case in East Asia. Besides, real convergence or macroeconomic policy
coordination, rather than the exchange rate stability per se may have been more
responsible for seemingly observed regional financial integration in Europe. The
experience in Europe suggests that the joint efforts to attain the exchange rate stability,
macroeconomic policy coordination, and concerted institution building would be
necessary to strengthen financial integration and to reap the benefit of integrated
financial market in East Asia. Without such efforts, the prospects of financial integration
in East Asia are not very promising.

17

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