As articulated by Cavoli, Rajan, and Siregar (2004) in their survey of East Asian financial integration, financial integration is a multidimensional process closely associated with development of financial markets. During the period following the Asian financial crisis of 1997, many Asian economies modernized their financial sectors and strengthened linkages with the financial sectors of other economies in the region. This has led to considerable maturation of many of the region's domestic capital markets, its local-currency bond markets in particular. Intra-regional financial sector policy coordination has likewise strengthened, as demonstrated by the ongoing development of regional arrangements for macroeconomic monitoring and liquidity support. Nevertheless, there remains significant variation in the degree to which the region's domestic capital markets have matured and integrated with others in the region and beyond.
In my recent paper I argue that, while the pace of regional integration of financial markets in Asia's emerging economies has accelerated in recent years, these markets remain more integrated with global financial markets than with other financial markets in the region. However, it is important to note that there is considerable variation in the progress achieved in intra-regional financial integration, both across individual economies and across the various subgroupings of economies that comprise emerging Asia. In particular, the ASEAN-4 subgrouping (Indonesia, Malaysia, the Philippines and Thailand) made the most visible progress in the degree of regional financial integration compared with other regional economies including the newly industrializing economies or NIEs (Hong Kong, China; the Republic of Korea; Singapore; and Taipei,China).
On the whole, emerging Asia is both a net saver and ironically, a net capital exporter. The fact that developing countries in the region export their overall excess savings to advanced economies runs counter to what economic theory would suggest. For whatever reason, the region’s financial systems have been unable to effectively channel its surplus savings into intra-regional development financing, while inadequate funding for development is leading to a high cost of capital for financing development, and in turn, reliance on external funding, which increases the region’s vulnerability to changes in external market conditions and shifts in international investor sentiment.
Despite the progress in regional financial integration achieved thus far, full integration of the region’s capital market is incomplete. Both fragmentation of the region’s capital markets and limited availability of regional financial products continue to hinder efficient allocation of the region's financial resources available from its considerable savings. Thus, improving intra-regional financial allocative efficiency by increasing the region's degree of financial integration will require loosening of restrictions on capital accounts, adopting common financial transactions standards at the regional level, and establishing region-wide financial infrastructure that can better support cross-border financial transactions.
That said, the impacts of previous financial crises on the region's financial markets underscore the fact that such financial integration increases the exposure of financial markets in emerging Asian economies to greater volatility in financial market returns driven by externally generated crises. As a result, the greater openness that financial integration entails must be counterbalanced by appropriate regulatory supervision at all levels, including the level of the individual economy, the region, and the global financial system as a whole. The study also finds that spillovers of volatility generated within the region to other emerging Asian economies tend to increase during periods of market distress.
Ensuring financial stability while at the same time furthering capital market development and financial integration requires that policy-making addresses several key issues. First, at the level of the individual economy, sound macroeconomic management and prudential regulation are critical to maintaining investor confidence. Second, increasing allocative efficiency as it pertains to financial resources and improving the resiliency of the region's domestic financial systems requires that the achievement of deep and liquid domestic capital markets remains a long-term overall goal at the regional level. Specific measures for achieving this objective include broadening the investor base; encouraging greater diversity in the financial products offered; improving the legal, regulatory, and institutional framework at both the domestic and regional level; upgrading governance and transparency; and establishing sound market infrastructure and institutions. Finally, regional cooperation initiatives in information sharing, monitoring and surveillance, and financial crisis management including establishment of a regional financial safety net could help improve financial stability given the increased spillovers of regional market volatility.