RDP 9506: The Liberalisation and Integration of Domestic Financial Markets in Western Pacific Economies 7. Conclusion

This paper addresses the integration of domestic financial markets – an unexamined issue in the literature of international financial integration – by exploring the relationship between money market interest rates and deposit and loan interest rates. Rules for setting interest rates on deposits and loans were derived, and these were shown to conform to banking practice and capture recent key developments in the banking sectors of Western Pacific economies, namely progressive deregulation and liberalisation, increasing competitiveness and episodic deterioration in the quality of loan assets.

The modelling shows that the integration of domestic institutional financial markets has increased substantially over the past decade, due to pervasive liberalisation and, more recently, growing competitiveness. The adjustment of domestic institutional rates to changes in money market rates has increased, often significantly, and by the first half of the 1990s the speed and pattern of adjustment of institutional rates in most of the developing/newly developed economies of East Asia had become similar to that in economies with developed financial systems. There is also a difference between the adjustment of deposit and loan rates, with the former adjusting more rapidly. This may be explained by differences in the maturity, substitutability and transactions costs associated with loans and deposits. The riskiness of private borrowers and the poor health of the banking system were shown to have a significant, deleterious effect on the level of loan rates in the region.

There are a number of policy implications that flow from this analysis. First, when monetary policy is implemented by indirect monetary management techniques, its effectiveness is significantly enhanced when institutional interest rates are liberalised: the transmission from the money market to institutional markets is considerably more rapid when the latter markets are deregulated. Regulation can be market conforming, and the gains from deregulation are obviously smaller in this case, but most regulations have been non-conforming. All the economies examined had substantially liberalised institutional interest rates by the mid 1990s, although this does not preclude the authorities from using non-market influence over rates. Second, competition in banking is crucial, both to securing greater rewards for savers and lower costs for borrowers, and to ensuring that innovations in money market interest rates are transmitted to institutional rates. There is still considerable progress to be made in this area, particularly in dissolving cartels and oligopolistic behaviour in the Korean, Taiwanese and some South-East Asian economies. Third, sound bank management and effective prudential supervision are necessary conditions to securing a lower level of lending rates given funding costs. There is again still a considerable way to go in this regard for most economies, but Hong Kong, Singapore, Malaysia and Thailand stand out as striking examples of success.