RDP 9506: The Liberalisation and Integration of Domestic Financial Markets in Western Pacific Economies 1. Introduction

It is hardly surprising that economists who are interested in analysing international financial integration focus primarily on the relationship between interest rates on internationally traded financial instruments such as money market instruments and government and corporate bonds. This is a major part of international financial integration but it is not the whole story. The macroeconomic impact of international financial integration also depends on the extent of domestic financial integration – that is, the integration of domestic institutional interest rates such as deposit and loan interest rates with domestic money market rates – which itself turns on the regulatory and competitive structure of domestic financial markets. This is particularly important in assessing the international financial integration of Western Pacific economies since domestic financial markets in these countries are in very different states of development.

Accordingly, this paper focuses on the changing relationship between the money market interest rate and deposit and lending interest rates in the Western Pacific economies of Australia, Hong Kong, Indonesia, Korea, Japan, Malaysia, the Philippines, Singapore, Taiwan and Thailand.^[1] The analysis centres on the integration of retail with wholesale markets, or, alternatively stated, with the relationship of non-traded with traded financial instruments.

Section 1 motivates the analysis of domestic integration by examining the relative depth of money markets and institutional markets in each country. Section 2 provides a brief summary of institutional arrangements and changes in each country, and notes that substantial liberalisation, greater competitiveness and occasional deterioration in asset quality are three characteristics of banking systems in the region. Section 3 derives a set of simple pricing rules for deposits and loans in a regulated market and in a free market to provide an analytical framework to assess the interactions between money market and institutional interest rates. The rules highlight the importance of competition, financial liberalisation and the permanency of money market interest rate shocks in analysing the changing relationship between money market and institutional interest rates, and so capture the salient features of banking systems in the region. Term structure effects are also shown to be relevant since the effect of a change in the money market rate on institutional rates depends on the permanence of changes to the money market rate. Section 4 presents correlation coefficients and an error-correction model for money and institutional interest rates, and reveals how the relationship between them has changed over time.^[2] A discussion of the results and country developments are given in Section 5. The paper is summarised and three policy implications are stated in the conclusion.

Footnotes

New Zealand and Papua New Guinea are part of this region but are not considered since data of sufficient length were not available. [1]

A version of this paper which contains discussion of econometric issues and tables reporting full results of unit root tests and error-correction tests is available on request from the author. [2]