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Our results also suggest that the four source economies invest more in offshore financial centres, which are usually lightly regulated low-tax jurisdictions. Finally, the four East Asian economies do not invest more in countries with colonial ties. Above and beyond these effects, do the four East Asian economies hold more equities and bonds issued by other East Asian economies than predicted by the theory-based financial gravity model?

This pertains to the central objective of our empirical analysis, which is to evaluate the degree of financial integration among East Asian countries In the equity equation, the EASIA dummy is positive and significant in the random effects model. More specifically, the estimated coefficient of 1. For comparative purposes, Table 5 shows the estimates from a comparable regression for goods trade The table shows that the four East Asian countries export more to the countries that are larger in size, more open in international trade and geographically closer, and share common language, common border and colonial experience It is interesting to note that the EASIA dummy in the goods export equation yields far larger estimates than in the equity equation of Table 4.

Specifically, the four East Asian countries export per cent more goods to East Asian than to rest of the world 19 Thus, East Asian financial markets are less integrated with each other than East Asian goods markets More specifically, while our evidence suggests that Japan, Korea, Hong Kong and Singapore trade disproportionately more. Nevertheless, our results imply that although intra-East Asian financial integration is weaker than intra-East Asian trade integration, it is still strong enough so that the four East Asian countries buy more equities from East Asia than the rest of the world even after we control for the other determinants of international trade in financial assets.

As noted earlier, bilateral trade linkage might influence bilateral investment linkage, and hence Table 6 reports the results when we include the residuals of the dependent variable obtained from running the gravity equation for goods trade Equation 5. This indicates that countries that trade more with each other invest more in each other. Including the bilateral trade intensity variable does not appear to substantially affect the estimates of most explanatory variables. That is, once we control for the strong trade linkages among East Asian countries, we no longer uncover evidence of financial integration.

The evidence of intra-East Asian financial integration we found in our baseline regressions may thus be largely driven by trade integration. Our finding is similar and consistent with the results of Lee and Garcia-Herrero et al. Having estimated the aggregated tendency of the four East Asian economies' cross-border holdings of equities and long-term bonds, we examine whether our aggregated estimates for the EASIA dummy in the baseline specification are dominated by any particular source economy.

To do so, we include country-pair dummies, for example, Japan-East Asia, Korea-East Asia and so forth for equities and bonds as in 7. Table 7 reports the results of estimating 7. We do not show the estimates of the other control variables to highlight the most relevant results. In terms of equities, Korea, Hong Kong and Singapore appear to hold more equities issued in other East Asian countries, as indicated by their positive and significant East Asia dummies.

On the other hand, Japan does not invest disproportionately more in East Asian equity markets. In fact, for Japan, the East Asia dummy is negative and significant for the two-way fixed effects estimation. This tendency becomes even clearer in the case of bonds. Japan holds smaller amounts of long-term bonds issued by other East Asian countries.

In contrast, the other three countries hold greater amount of intra-regional long-term bonds than predicted by the gravity model random effects. For goods exports, the estimated coefficient for the Japan-East Asia dummy variable is consistently positive and significant in both specifications. Thus, Japan is unique in that it trades heavily within East Asia but invests heavily outside the region.

Many studies attribute the fact that East Asia's financial integration substantially lags its trade integration to the underdevelopment of its financial systems. However, few studies examine the role of country-specific risk in cross-border investment. Countries with stronger overall governance and institutions entail lower political, economic and financial risks from the viewpoint of foreign investors.

Monetary and financial integration in East Asia : the relevance of european experience

Conversely, high degree of risk aversion among foreign investors goes a long way toward explaining the failure of countries with weak governance and institutions to attract foreign investment. The economic risk rating is used to assess a country's current strengths and weaknesses. The financial risk rating aims to measure a country's ability to repay its foreign liabilities. What is especially relevant for developing countries and hence most of East Asia is political risk, which refers to the risk that the returns to investment may suffer as a result of political changes or political instability.

Therefore, we extend our baseline model by adding the three different categories of country risks to the financial gravity equation as follows:.

Estimates for the control variables are not reported for brevity. Originally, the political risk index is based on points, financial risk on 50 points and economic risk on 50 points. For the sake of comparability, the original indices of economic risk and financial risk are multiplied by two, so that each of these three measures ranges from zero - indicating minimum risk - to - indicating maximum risk. We include political, economic and financial risk in our regressions. Table 8 reports the results obtained from running equation 8 to assess how different categories of country risk are associated with cross-border capital flows.

Inclusion of the country risk variable does not appear to substantially affect the estimates of the explanatory variables.

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In terms of the equity equations, reported in columns 1 - 2 , political risk is positive and significant in all cases, and its estimated coefficient ranges from 0. The estimates imply that a point reduction in the political risk index is associated with a three to seven. Data Sources for further details on these three categories of risk. Economic risk also appears to be positively associated with equity investment random effects. Somewhat puzzlingly, financial risk is negative although not significant.


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In terms of the long-term bond equations, reported in columns 3 - 4 , political risk is still positive and significant for random effects, but yields a negative, yet. Our estimates for economic risk show a similar pattern. Financial risk is negative and significant for random effects although it is insignificant for fixed effects.

This implies that East Asian economies do not adequately take into account the financial risk of the economies in which they invest bonds. The central objective of this paper was to empirically evaluate the degree of bilateral linkages among East Asian financial markets. According to conventional wisdom, East Asia has already reached an advanced level of trade integration, or integration of goods markets, but lags far behind in terms of financial integration, or integration of financial markets.

The primary contribution of our study to this empirical literature is to measure the degree of intra-East Asian financial integration more accurately and rigorously by using a gravity model grounded in economic theory. That is, we use a gravity model that is more appropriate for trade in financial assets than the standard gravity model used for trade in goods. More specifically, we estimate a theory-based financial gravity model along the lines suggested by Martin and Rey , and Courdacier and Martin The primary finding that emerges from our empirical analysis is that trade in financial assets, that is, equities and bonds of Hong Kong, Japan, Korea and Singapore with other East Asian countries is larger than predicted by the theory-based financial gravity model.

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A preliminary look at the data, in particular the low share of intra-East Asian equity and bond holdings relative to the share of intra-East goods trade, supports the conventional wisdom that intra-East Asian financial integration remains limited. However, our evidence from more rigorous in-depth empirical analysis indicates that East Asian countries trade more assets with each other than with the rest of the world when we control for the standard determinants of cross-border capital flows such as market size, rate of return, financial openness, tax rate, geographical distance, and other relevant source and investor country characteristics.

The tendency for East Asian countries to trade more financial assets with each other is more pronounced for equities than for bonds.


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At a broader level, we find that the propensity of East Asian countries to trade more with each other is much more pronounced for goods than for financial assets, which lends support to the conventional wisdom that the region's financial integration lags behind its high level of trade integration. While it is tempting to interpret our finding that East Asian countries' trade in financial assets is larger than the levels predicted by the financial gravity model as evidence of intraregional financial integration, we must interpret this finding with a great deal of caution.

In this connection, it should be emphasised that when we include intra-East Asian goods trade intensity as an additional explanatory variable, we no longer find that intra-East Asian assets trade is bigger than assets trade between East Asia and the rest of the world. Therefore, it is possible that our finding of disproportionately large intra-East Asian trade in assets is driven by and reflects the region's high level of goods trade integration.

Furthermore, our country-specific results suggest that Japan, the largest investor in the region, invests more outside East Asia even though it trades goods a lot with East Asia. Therefore, the salient implication of our findings for East Asian policymakers is that they should continue to promote the. Deeper financial integration will contribute to the formation of bigger, broader, deeper, more liquid and more efficient financial systems, which will safeguard the region from external financial shocks and pave the way for a growth that relies more on higher productivity.

Our results suggest that fundamental determinants of cross-border investment such as market size, financial openness, rate of return, and a number of other source and destination country characteristics go a long way toward explaining purchases of foreign equities and bonds by the four East Asian countries.

The broader implication for policymakers from this broader finding is that to the extent that they can influence those fundamentals, they can play a significant role in promoting intra-East Asian financial integration.

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Therefore, the high collective power of the explanatory variables in our financial gravity equation estimations is promising for the ability of policymakers to foster integration. Specific policy options to speed up financial integration among Asian countries include removing remaining obstacles to cross-border investment, creating regional financial products such as regional index funds, addressing differences in credit rating, accounting and auditing standards as well as legal and regulatory frameworks, and setting up a regional credit rating agency to improve credit risk assessment.

Finally, while explanations of East Asia's lower level of intra-regional financial integration relative to its advanced trade integration have centred on the underdevelopment of the region's financial systems relative to its dynamic real economies, country-specific risk is another potential impediment to closer intra-regional financial linkages. Our empirical analysis yields a clear positive relationship between cross-border investment and political risk.

More specifically, the lower the level of a country's political risk, the more capital inflows it attracts. This finding is stronger for equities than bonds.

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Therefore, a reduction in political risk across the region will be conducive for an expansion of intra-regional trade in financial assets. This is plausible since one major reason for why East Asian countries continue to invest heavily in the advanced economies despite low returns is their political stability. While more research needs to be carried out on the role of country-specific risks, reduction of those risks, in conjunction with financial development, will give a big push to the process of financial integration in East Asia. Return is annualised one-year monthly return with adjustment to exchange rate fluctuation.

Exchange rate of return is annualised one-year monthly return against the US dollar, calculated with data from Thomson Reuters. Return is annualised one-year monthly return. It is comprised of the following 12 components: government stability, socioeconomic conditions, investment profile, internal conflict, external conflict, corruption, military in politics, religious tensions, law and order, ethnic tensions, democratic tensions, democratic accountability and bureaucracy quality.

It consists of the following five components: foreign debt as a percentage of GDP, foreign debt services as a percentage of exports and goods and services, current account as a percentage of exports of goods and services, net international liquidity as months of import cover, exchange rate stability.

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