Anne O. Krueger

Takatoshi Ito

English

Research Papers in Economics

This PDF is a selection from an out-of-print volume from the National Bureau
of Economic Research
Volume Title: Financial Deregulation and Integration in East Asia, NBER-EASE
Volume 5
Volume Author/Editor: Takatoshi Ito and Anne O. Krueger, Editors
Volume Publisher: University of Chicago Press
Volume ISBN: 0-226-38671-6
Volume URL: http://www.nber.org/books/ito_96-1
Conference Date: June 15, 1994
Publication Date: January 1996
Chapter Title: Introduction to "Financial Deregulation and Integration in East
Asia, NBER-EASE Volume 5"
Chapter Author: Takatoshi Ito, Anne O. Krueger
Chapter URL: http://www.nber.org/chapters/c8556
Chapter pages in book: (p. 1 - 5)Introduction 
Takatoshi Ito and Anne 0.  Krueger 
One of  the striking trends in the international economy over the past several 
decades has been the increased mobility and volume of capital flows. It is esti- 
mated that the daily volume of international financial transactions now exceeds 
the annual value of global GNP. 
Increased financial mobility has been both a cause and a result of increasing 
financial integration of the global economy. With greater integration, domestic 
financial markets are increasingly affected by world events. Dialogue among 
the major countries’ governments increasingly focuses on the appropriateness 
of each others’ policy stances with regard to monetary, interest rate, and ex- 
change rate policy. 
Capital flows motivated by  interest rate differentials used to be limited to 
industrial countries. However, in the 1990s, some developing countries, now 
called “emerging markets,” became a popular destination for direct and portfo- 
lio investment from industrial countries. For example, net capital flows from 
industrial countries to developing countries are estimated to have increased 
from less than $15 billion in 1990 to more than $100 billion in 1993. There 
are at least three reasons for this rapid change. First, those developing countries 
with high growth and current account surpluses obviously became attractive 
investment opportunities because of their high potential capital gain and likely 
currency appreciation.  Second, industrial countries suffered recessions,  and 
their interest rates came down substantially. Third, large institutional investors 
in the United States started to diversify into international investment opportu- 
nities. 
Simultaneously, regulation of  domestic financial markets, which in earlier 
Takatoshi Ito is senior advisor in the Research Department of the International Monetary Fund 
and  a research associate of  the National Bureau of  Economic Reasearch. Anne 0. Krueger is 
professor of economics at Stanford University and a research associate of the National Bureau of 
Economic Research. 
I 2  Takatoshi Ito and Anne 0.  Krueger 
years appeared both  feasible and consistent with efficient  economic perfor- 
mance, has been greatly affected. Decisions regarding changes in interest rates 
in any large national capital have immediate effects on financial conditions in 
all other countries; efforts to control interest rates in such circumstances can 
lead  to large financial flows between  countries. That, in  turn,  can limit  the 
efficacy of  monetary  policy  instruments aimed at domestic macroeconomic 
balances. 
In part because earlier types of regulation no longer effectively achieve their 
intended result because of increased financial integration, and in part because 
those regulations that appeared to serve their purpose earlier now appear to 
impinge on the efficient functioning of financial markets, countries around the 
world have been engaged in widespread financial deregulation. 
Nowhere has this trend been more pronounced than in the countries of East 
Asia. Japan has assumed its role as a major creditor nation only within the past 
two decades. Moreover, with its large current account surpluses, the challenges 
of  managing of its own domestic macroeconomic  aggregates have changed 
greatly.  Simultaneously,  the  East  Asian  newly  industrialized  economies 
(NIEs), which began their rapid development in an era when capital markets 
were less integrated, have faced the dual task of liberalizing their markets in 
response to their own growth as well as to the changing international economy. 
Deregulation itself has proved challenging, both because of increased inter- 
dependence and because deregulation inevitably affects the functioning of the 
macroeconomy in ways that are not  well understood. In  a number of  cases, 
deregulation has affected the behavior  of exchange rates, interest rates, and 
capital flows in unanticipated ways. 
As deregulation spreads to emerging markets, these countries start to enjoy 
the benefits and pay the costs of being linked to the world capital market. As 
the economic prospects of a country become brighter, capital suddenly flows 
into the country and may provide  scarce resources for more investment and 
growth. However, the capital flows may  appreciate the currency so that the 
competitiveness of export industries suffers, or may cause expansions of do- 
mestic credit that result in inflation.  Integration  in the world capital market 
makes the policy options very different from before. 
The fifth NBER-East  Asia Seminar on Economics focused on financial de- 
regulation and integration in the East Asian region, with a view to understand- 
ing how deregulation is affecting those markets and to improving knowledge 
of  the ways  in which financial  integration is affecting responses  to various 
policies in the countries of the region. 
The papers presented at the conference, which are collected in this volume, 
cover a wide variety of  aspects of  this topic-deregulation  per se, exchange 
rate behavior under alternative regimes, responses of capital flows to deregula- 
tion and integration, behavior of individual types of capital flows (such as di- 
rect foreign investment), and so on. As a group, the papers demonstrate both 3  Introduction 
the  widespread  nature of  deregulation and the challenges that deregulation 
presents, especially because of the mobility of capital between countries. 
The first two chapters in this volume focus on the interrelationship between 
domestic financial changes and the international economy more generally. As 
already mentioned, deregulation and integration have been global phenomena, 
affecting countries in Europe, North America, South America, as well as Asia. 
Some of the phenomena are general, and lessons from other parts of the world 
are applicable to Asia as well. 
In chapter 1, McKinnon and Pill consider a problem associated with a num- 
ber of policy reform efforts, that is, what they term “excessive” capital inflows. 
When policy reforms are credible, people may want immediately to increase 
their consumption in anticipation of higher future real incomes, and the result 
is a sharp deterioration in the savings-investment balance, financed by a large 
increase in capital inflows (which would not have happened  in earlier years 
when there was little capital mobility). McKinnon and Pill believe that it is 
financial market failures that do not brake these large inflows, so that there has 
been financing even for very risky projects and a sharp deterioration in banks’ 
balance sheets. This situation is intensified when (implicit or explicit) deposit 
insurance for banks creates a moral hazard problem. The authors believe that 
the authorities should not deregulate controls over capital flows or financial 
institutions at too early a stage of the policy reform process because of these 
problems and should seek ways to reduce capital inflows to appropriate levels. 
Chapters 2, 3, and 4 examine various aspects of the determinants of capital 
flows between countries. In chapter 2, Eaton and Tamura examine the roles of 
the United States and Japan in trading with and investing in various countries 
in the Asia-Pacific region. They use a gravity model to ascertain the determi- 
nants of U.S. and Japanese flows, using variables  such as population, factor 
endowments, per capita incomes, and distance. They find that Japan and the 
United States relate to other countries in the region in similar ways, although 
Japan’s lack of natural resources affects trading patterns and the U.S. current 
account deficit has limited the U.S. role as a provider of capital. 
Wei, in  chapter 3, examines the origins and the effects of  foreign direct 
investment (FDI) in China. A first finding is that FDI comes overwhelmingly 
from overseas Chinese, and not from the countries that have been suppliers of 
foreign capital to other economies in the region. He then proceeds to relate 
differences in growth rates of  Chinese cities to the magnitudes of capital in- 
flows and finds that they contribute significantly to cross-city differences in 
growth rates and also the rate of growth of Chinese exports. 
Kohsaka’s analysis in chapter 4 focuses on the capital flow links among the 
countries of Asia. He finds that there has been considerably greater financial 
integration among countries in the region in recent years. Moreover, both for- 
eign direct and portfolio investment into Southeast Asian countries grew rap- 
idly during the 1980s, but the major source of increase was from the NIEs of 4  Takatoshi Ito and Anne 0.  Krueger 
East Asia, rather than from Japan, although Japan remained a large supplier of 
capital to the region. The turnabout in the role of the NIEs from capital recipi- 
ents to capital suppliers is the major  structural change that took place with 
respect to capital flows in Asia in the 1980s. 
Chapters 5 and 6 focus on particular aspects of Japanese financial markets. 
Fukuda investigates the determinants of the invoice currencies of Japanese ex- 
ports and imports. He finds that there is a very low fraction of Japanese exports 
where invoices are denominated in yen, even in transactions in East Asia, con- 
trasted with practices in Europe and the United States. Using sectoral data on 
invoice currencies, Fukuda relates this practice to Japanese exporters’ strategy 
of pricing-to-market, absorbing exchange rate risk so that they do not lose mar- 
ket share when the yen increases in value. On the import side, the low fraction 
of yen-invoiced goods is attributable to the high fraction of primary commodi- 
ties, such as oil, in Japan’s imports and the practice of pricing those commodi- 
ties in U.S. dollars. 
Horiuchi analyzes some aspects of Japanese financial liberalization in his 
paper. He examines liberalization of the corporate bond market, which reduced 
the reliance of Japanese firms on bank financing. Horiuchi shows that the man- 
ner in which liberalization was carried out created a new distortion in the fi- 
nancial system. The distortion was the restriction of the right to issue convert- 
ible bonds to large well-established  firms, thus preventing  some firms that 
could have employed  additional capital with a high rate of  return from ob- 
taining it, and permitting managers of the large established firms to enjoy addi- 
tional perquisites. 
Lin, Lee, and Huang, in chapter 7, use the experiences of both Korea and 
Taiwan to investigate the macroeconomic policy  implications of  export-led 
growth. The paper contends that monetary, fiscal, and exchange rate policies 
were influenced and in fact disciplined by the pursuit of an export-led growth 
strategy. Sound fiscal policy, however, is identified as an important way to give 
more freedom to other policy instruments within the overall goal of keeping 
export industries competitive. Although the central banks in Taiwan and South 
Korea were legally “independent,” they accommodated the need for develop- 
ment funds; thus inflation rates were relatively high during the years of high 
economic growth. 
In chapter 8, Yang and Shea begin by  noting that Taiwan’s rate of inflation 
was very low-3  percent, on average-during  the  1980s despite average an- 
nual growth of the money supply of around 20 percent. They develop and test 
a quarterly model, incorporating money demand for stock and real estate trad- 
ing and the level of imports (itself a function of  the appreciation of the NT 
dollar) and conclude that these two phenomena explain the relative stability of 
Taiwanese prices. 
Chapters 9 and 10 analyze the financial liberalization of the Korean econ- 
omy. In chapter 9, Park provides a survey of financial policies and liberaliza- 
tion in Korea since the early  1980s. He shows that, to date, the impact of fi- 5  Introduction 
nancial  deregulation  in  Korea  has  been  primarily  on  nonbank  financial 
institutions. He examines the savings-investment balance and interest parity 
conditions in an effort to ascertain the degree to which Korean financial mar- 
kets have become integrated with the rest of the world and concludes that there 
is still significant capital immobility. Park’s analysis suggests that the barrier 
to increased financial efficiency in Korea is now the banking system itself, and 
that its deregulation could result in significant increases in efficiency. 
In chapter 10, Nam examines the bank-business relationship in Korea. He 
argues that while the “principal  transactions”  bank  system in  Korea helped 
carry out credit controls and avoided excessive concentration of banks, it also 
hampered the autonomous development of bank-business cooperation, of the 
type that occurs in Japan’s main bank system. Nam predicts that with the liber- 
alization of Korean bank credits, the largest corporations will have bargaining 
power with the banks, while smaller established companies will be restricted 
to an exclusive relationship with one bank. While Korean industrial groups are 
quite similar in structure to their Japanese counterparts, the relationship be- 
tween a group and a bank in Korea is very different from that in Japan, affect- 
ing the outcome of liberalization processes. 
Chapters 11, 12, and 13 examine aspects of financial liberalization in Singa- 
pore and its neighboring countries. In chapter 11, Woo and Hirayama examined 
the possible reasons for the freedom in interest rate policy, namely, deviations 
of the domestic interest rate from the U.S. dollar interest rate. Three episodes 
of government interventions in the foreign exchange markets in Indonesia, Ma- 
laysia, and Singapore at various times are cited for creating enough uncertaint- 
ies to cause risk premia, a wedge between the domestic and foreign interest 
rates. In chapter 12, Tse and Tan use the interest parity condition between Sin- 
gapore and the Eurodollar market to test the effect of deregulation. They find 
that deregulation was associated with a marked reduction in the divergence of 
interest rates from uncovered interest parity, which is consistent with the view 
that the degree of capital mobility increased as deregulation progressed. 
In the final chapter, Ngiam surveys the process of deregulation of the Singa- 
pore financial market, including the evolution of  SIMEX, the Asian  Dollar 
Market, the Singapore stock market, the Asian Dollar Bank Market, and Forex. 
He then evaluates the prospects for Singapore’s emergence as a financial center 
for the region. While financial deregulation has made Singapore more compet- 
itive as a financial center, the fact that Hong Kong and Japan are also deregulat- 
ing means that competition to become the financial center of the region is in- 
creasing. 
This volume provides a good picture of the overall status of financial mar- 
kets in Japan, China, Korea, Taiwan, and Singapore. All countries in the re- 
gion-as  in much of the rest of  the world-are  in the process of  financial 
deregulation, and none has completed the transition. Both the analysis and the 
empirical results provide evidence of the complexity of the process of financial 
deregulation and the challenges it poses for policymakers everywhere. 

Financial Deregulation and Integration in East Asia, NBER-EASE Volume 5

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