Chapter 10 The Future of ASEAN-5 Financial Integration

Ana Corbacho, and Shanaka Peiris
Published Date:
October 2018
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Regional financial integration is prominent on the agenda of Association of Southeast Asian Nations–5 (ASEAN-5) policymakers. The experience of the Asian financial crisis demonstrated the importance of a resilient financial system for managing volatile capital flows. It also spurred regional financial integration and cooperation. In the face of the financial crisis, national mechanisms to stem the spread of financial panic proved inadequate or ineffective. These countries have since taken steps to exploit regional economies of scale to make financial systems more efficient to cope with external shocks.

Recent years have witnessed substantial progress in regional economic integration among the ASEAN-5, and more broadly among all ASEAN economies. As a major milestone on the integration agenda, the ASEAN Economic Community (AEC) came into being in 2015. The AEC Blueprint had been the key vehicle for achieving the free flow of goods, services, investment, and skilled labor, as well as a freer flow of capital within the region. Its successful implementation led to the creation of the AEC five years earlier than the initially planned date of 2020. A successor blueprint, the AEC Blueprint 2025, lays out a 10-year vision for regional economic integration.

Financial integration is a critical component of this broader regional economic integration agenda. Recognizing that financial integration complements trade flows, in 2011 ASEAN leaders adopted a financial integration framework, envisaging a more integrated financial region by 2020. Subsequently, in the AEC Blueprint 2025, the leaders have outlined the move toward financial liberalization and freer capital flow for the next decade.

Against this backdrop, this chapter addresses three questions: (1) What is the current status of financial integration in the ASEAN-5 countries? (2) What are the key drivers of financial integration? and (3) What are the benefits and costs?

This chapter is structured as follows: After the second section takes stock of the current status of financial integration in ASEAN-5 economies, the third section analyzes the drivers of financial integration based on a financial gravity model. The fourth section explores the benefits and costs of financial integration, and the fifth section discusses the challenges the ASEAN-5 economies will confront in fostering regional financial integration and implementing policy initiatives. The sixth section draws conclusions and presents policy implications.

Current State of Financial Integration in ASEAN-5 Countries

ASEAN-5 economies are increasingly integrated in trade, both globally and regionally. Global trade integration in these economies, measured by the ratio of total trade to regional GDP, reached 76 percent in 2016 (Figure 10.1, panel 1). In fact, trade openness in this region is already higher than the average in advanced economies and other Asian countries. A closer look shows that the ASEAN-5 economies’ trade with each other accounted for a large share of their total trade. In 2015, about 60 percent of trade in ASEAN-5 countries was transacted within ASEAN Plus Three economies (Figure 10.1, panel 2).1 Intraregional trade has benefited from trade liberalization across the region (almost all goods in the region are now traded at zero tariff) and from participation in global value chains.

Figure 10.1.
Trade Integration in ASEAN Countries

Financial integration in ASEAN-5 economies has also risen, partly driven by trade. Figure 10.2 shows that ASEAN-5 overall financial integration, measured by the sum of cross-border asset and liability holdings, is quite high, lagging only that of Europe. But if financial centers such as Singapore are excluded from the sample, the overall financial integration level for the rest of the ASEAN-5 countries ranks quite low, lagging all regions except Latin America.

Figure 10.2.
International Investment Position

(Sum of assets and liabilities, percent of regional GDP, financial centers included)

Sources: IMF, Balance of Payments Statistics; and IMF staff calculations.

Note: ASEAN-5 = Indonesia, Malaysia, Philippines, Singapore, Thailand; Asia-other = Australia, China, Hong Kong SAR, India, Japan, Korea, New Zealand, Taiwan Province of China; Latin-4 = Argentina, Brazil, Chile, Colombia; NAFTA = North American Free Trade Agreement (Canada, Mexico, United States).

Given a lack of data to track all financial flows, financial integration is examined based on data from portfolio flows. Data from bank flows are used as a robustness check.2 Although foreign direct investment still dominates trade-driven financial flows, the portfolio investment position has experienced an upward trend since the Asian financial crisis, despite setbacks during 2008 (Figure 10.3, panel 1). ASEAN-5 bank borrowing has also grown, with intraregional bank borrowing growing especially fast since the global financial crisis (Figure 10.3, panel 2).

Figure 10.3.
Financial Integration in ASEAN Countries

Portfolio investment has become increasingly important over the years, as reflected in its increasing share in the total international investment position (Figure 10.4). Portfolio investment accounted for more than 20 percent of the total international investment position as of 2016, up from 12 percent in 2001. Excluding Singapore, whose banking position is especially large, from the sample, the share of portfolio investment has exceeded the share of other investment, and was below only the share of foreign direct investment.

Figure 10.4.
Composition of International Investment Position (Total Assets and Liabilities)

Sources: IMF, Balance of Payments Statistics; and IMF staff calculations.

However, the degree and pace of financial integration in ASEAN are not commensurate with those of trade integration. This discrepancy can be illustrated by comparing the intensity scores for trade and portfolio investment.3 Trade intensity of the ASEAN-5 economies during 2001–15 was higher than in all other regions (Figure 10.5, panel 1). In contrast, their portfolio investment intensity was lower than the world average, and in fact was only about one-third of their trade intensity (Figure 10.5, panel 2).

Figure 10.5.
Trade and Portfolio Investment Intensity

Sources: IMF, Coordinated Portfolio Investment Survey; IMF, Direction of Trade Statistics; and IMF staff calculations.

Note: Asia-other = Australia, China, Hong Kong SAR, India, Japan, Korea, New Zealand, Taiwan Province of China; Latin America = Argentina, Brazil, Chile, Colombia; NAFTA = North American Free Trade Agreement (Canada, Mexico, United States).

Financial integration in ASEAN-5 is lagging when using other metrics. Although the portfolio investment position (sum of assets and liabilities) was about 60 percent of GDP in 2015, this ratio would drop to about 20 percent if Singapore were excluded—which is much lower than that of Europe or North American Free Trade Agreement partners (Figure 10.6, panel 1). The share of intraregional portfolio investment is also relatively low in the ASEAN-5 economies if portfolio asset composition is considered (Figure 10.6, panel 2).

Figure 10.6.
Portfolio Investment

Drivers of Regional Financial Integration

The drivers of financial integration in ASEAN countries are examined using a financial gravity model based on cross-border portfolio investment.4 In addition to standard gravity factors, the model analyzes the role of regulatory and institutional quality as well as capital control measures.5 Empirical evidence suggests that lower regulatory and institutional quality, as well as restrictions on cross-border capital flows, negatively affect regional financial integration.

Gravity models of trade predict that bilateral trade flows will be proportional to market size and inversely proportional to distance between trading partners. The gravity relationship arises when trade costs and barriers increase with distance. Similarly, gravity models of asset trade (for example, Portes and Rey 2001) show that distance, which proxies for information asymmetry, has a negative impact on bilateral asset trade flows. Countries with geographic proximity usually have more knowledge and a better understanding of each other due to the ease of interaction; this is especially important for information-intensive financial investment.

The baseline gravity equation includes indicators for market size and information asymmetry. Two additional variables, bilateral trade volume and a common language indicator, are used as a proxy for information asymmetry. The analysis is based on a panel of 45 economies from 1990 to 2015, consisting of ASEAN economies together with representative advanced and emerging market economies.

The estimates point to the following findings (Table 10.1):6

  • Bilateral financial integration increases with trade integration. The trade coefficient shows that when bilateral trade volume increases by 10 percent, financial holdings increase by more than 4 percent. The results are especially strong for banking position. These findings are consistent with the stylized facts discussed in the previous section: financial integration has gone hand in hand with trade integration.

  • Financial integration increases with market size and common language ties. Larger market size leads to higher demand for assets and higher asset prices and, in turn, to a greater number of endogenous assets. Estimates also suggest that closer language ties lower transaction costs and foster integration.

  • Financial integration decreases with distance between countries. Countries with geographical proximity tend to be more integrated financially.

Table 10.1.Baseline Gravity Model
-1 Portfolio Assets-2 Portfolio Assets and Liabilities
GDP Borrower0.83***0.77***
GDP Lender0.110.70***
Common Language0.19***0.28***
Constant- 12.35***- 19.95***
Year EffectYesYes
Borrower EffectYesYes
Lender EffectYesYes
Adjusted R20.8250.83
Source: IMF staff calculations.Note: Standard errors are in parentheses.* p < 0.10; ** p < 0.05; *** p < 0.01.

The results suggest that institutional quality matters for regional financial integration. To examine the role of institutional quality,7 a wide range of institutional indicators are added to the baseline gravity model. They include governance quality; ease of doing business; and political, economic, and financial risks. The coefficients of all indicators are found to be positive and statistically significant, indicating that good institutional quality, including good governance and a business-friendly environment, is linked to greater financial integration (Table 10.2).

Table 10.2.Drivers of Financial Integration—Institutional Quality
-1 Portfolio Assets-2 Portfolio Assets and Liabilities
GDP Borrower0.78***0.83***
GDP Lender0.69***0.80***
Common Language0.94***0.97***
Rule-of-Law Borrower0.86***1.53***
Intra-ASEAN Dummy1.14***0.85***
Intra-ASEAN Dummy × Rule-of-Law Borrower0.42***0.71***
Rule-of-Law Lender2.49***1.47***
Intra-ASEAN Dummy × Rule-of-Law Lender-0.020.52***
Year EffectsYesYes
Adjusted R20.6360.662
Source: IMF staff calculations.Note: Standard errors are in parentheses.* p < 0.10; ** p < 0.05; *** p < 0.01.

Improvements in institutional quality promote regional financial integration. Figure 10.7 shows the positive relationship between the rule-of-law index,8 as a proxy for institutional quality, and intra-ASEAN financial integration. A reasonable explanation is that, while global investors are likely to have broader and stable relationships with high-quality clients, regional investors are more vulnerable to poor institutions, and thus benefit more from an improvement in institutional quality. It should be noted, however, that the results for ASEAN-5 economies show a high degree of heterogeneity. The positive effect of the rule-of-law index appears most significant for Thailand, the Philippines, and Singapore.

Figure 10.7.
Institutional Quality and Intraregional Financial Integration, ASEAN-5 Average

Sources: IMF, Coordinated Portfolio Investment Survey; World Bank, Worldwide Governance Indicators; and IMF staff calculations.

Finally, restrictions on capital flows undermine financial integration (Table 10.3). When the baseline gravity model is augmented with capital control measures from Fernández and others (2015), estimates show that in both equity and debt securities markets, controls restricting nonresidents’ purchase of dometic securities or restricting residents’ purchase of foreign securities have a significant negative impact on portfolio investment. These results confirm that capital controls are a barrier to trade in financial assets, similar to tariffs and quotas that impede trade of goods and services. Therefore, with continuing efforts toward liberalizing capital accounts, financial integration of ASEAN economies is set to further improve.

Table 10.3.Drivers of Financial Integration—Capital Controls
-1 Equity Market1-2 Bond Market1-3 Money Market1
GDP Borrower0.70***0.80***0.72***
GDP Lender0.21***0.21***0.20***
Common Language1.54***1.44***1.36***
Real per Capita GDP Borrower0.64***0.65***0.48***
Real per Capita GDP Lender1.90***1.85***2.01***
Nonresident Purchase Control Borrower-0.05-0.41***-0.70***
Resident Issuance Control Borrower0.130.41***0.32**
Resident Purchase Control Lender-0.80***-1.46***-1.40***
Nonresident Issuance Control Lender-0.88***-0.090.22**
Year EffectYesYesYes
Adjusted R20.5890.5950.588
Source: IMF staff calculations.Note: Standard errors are in parentheses.* p < 0.10; ** p < 0.05; *** p < 0.01.

The Benefits and Costs of Financial Integration In ASEAN-5 Countries

There are several potential advantages to financial integration. Financial integration allows consumption smoothing, risk sharing, and risk diversification. It can strengthen sources of growth in recipient countries, including through imports of capital for capital-scarce economies and technology spillover through foreign direct investment. It can increase access to finance for the poor and enhance financial inclusion. It can discipline policymakers and prevent them from adopting unsound polices that have undesirable market consequences (Kose and others 2009).

Regional financial integration could have extra benefits. Better economies of scale would make financial systems within the region more efficient. By growing and deepening local financial markets, financial integration helps develop a twin-engine financial system and reduces excessive reliance on banks in a bank-centric system. Regional financial integration can also help alleviate countries’ reliance on financial centers; this funding diversification is shown to have had a buffering effect against global shocks such as the 2013 taper tantrum (Park and Shin 2016). Moreover, regional financial integration provides incentives for regional cooperation and enhancement of multilateral safety nets (Kim, Lee, and Shin 2006; Park and Shin 2016).

Regional financial integration would help ASEAN countries better weather external shocks and spillovers. This was particularly propitious when banks in advanced economies, weakened by the global financial crisis and constrained by tighter financial regulations, began retreating to their home bases. Based on different approaches, results suggest the following:9

  • The investment position within the ASEAN Plus Three economies10 was less affected by liquidity conditions in the United States and Europe. This finding is based on US security broker-dealer sector leverage as an indicator for the US liquidity cycle, and the change in Europe’s M2 money stock for the European liquidity cycle (Tables 10.4 and 10.5).11

  • Regional investors were less likely to join global investors in pulling out of investments during the global financial crisis (Figure 10.8).

  • To test whether intraregional capital flows (capital flows to ASEAN-5 countries from ASEAN Plus Three countries) are more resilient to global shocks than capital flows from outside the region, we compared the impulse responses of the two aggregate flows to global shocks such as changes in the VIX.12Figure 10.9 shows that when there is a shock in the VIX, intraregional portfolio inflows respond less negatively than capital flows from outside. This suggests that intraregional capital flows are less likely to reverse or experience a sudden stop at times of global financial volatility.

  • There is also evidence that the influence of global shocks on regional equity markets is declining. We use a spillover index developed by Diebold and Yilmaz (2014) to analyze the interdependence of asset returns and volatilities in the ASEAN-5, China, and the United States. The index quantifies the contribution of shocks from one country’s asset returns and volatilities to another’s at different points in time. The time-varying spillover index is obtained as the generalized impulse responses, which are derived using two lags in the vector autoregression estimation and a 150-day rolling window. The results show that ASEAN-5 equity markets are affected more by one another than by the United States, whose influence is declining (Figure 10.10), partly due to greater regional financial integration. This suggests that compared with the past, these markets are likely to be more resilient in the face of global events.13

Table 10.4.Benefits of Financial Integration—US Liquidity Condition
-1 Portfolio Assets-2 Portfolio Assets and Liabilities
GDP Borrower0.31***0.17*
GDP Lender-0.030.25***
Real per Capita GDP Borrower1.55***1.26***
Real per Capita GDP Lender0.78***1.06***
Common Language0.23***0.33***
US Broker-Dealer Sector Leverage0.35***0.16***
Intra-ASEAN13 Dummy3.46***3.23***
Intra-ASEAN13 Dummy ×
US Broker-Dealer Sector Leverage-0.93***-0.82***
Borrower EffectYesYes
Lender EffectYesYes
Adjusted R20.8250.83
Source: IMF staff calculations.Note: Standard errors are in parentheses.* p < 0.10; ** p < 0.05; *** p < 0.01.
Table 10.5.Benefits of Financial Integration—EU Liquidity Condition
-1 Portfolio Assets-2 Portfolio Assets and Liabilities
GDP Borrower0.38***0.19**
GDP Lender0.040.27***
Real per Capita GDP Borrower1.39***1.22***
Real per Capita GDP Lender0.56***1.01***
Common Language0.23***0.33***
EU M2 Growth0.03***0.02***
Intra-ASEAN13 Dummy1.10***1.17***
Intra-ASEAN13 Dummy × EU M2 Growth-0.10***-0.09***
Borrower EffectYesYes
Lender EffectYesYes
Adjusted R20.8250.83
Source: IMF staff calculations.Note: Standard errors are in parentheses.* p , 0.10; ** p , 0.05; *** p , 0.01.

Figure 10.8.
Change in Portfolio Inflows, 2008

Sources: IMF, Coordinated Portfolio Investment Survey; and IMF staff calculations.

Note: ASEAN Plus Three = ASEAN-5 plus China, Japan, Korea.

Figure 10.9.
Impulse Response of Capital Flows to a Shock in the VIX

Source: IMF staff calculations.

Regional financial integration can also play an important role in facilitating economic rebalancing. ASEAN economies are salient examples of the Lucas paradox (Lucas 1990). Despite substantial development potential and large infrastructure needs, these economies were all net capital exporters with high current account surpluses, averaging about 2 percent of GDP a year during 2009–16.

The current account imbalance is affected by structural factors. The current account imbalance is a mirror image of the savings-investment gap; the desirable savings-to-investment level, in turn, is affected by structural factors that are determined or influenced by the financial system.14 Financial integration can play an important role in affecting such levels. It would lessen the need to rely on countries’ own funds and improve access to financial services, and thus provide a net boost to consumption and investment.

Figure 10.10.
Spillovers to ASEAN-5 Equity Markets

Source: IMF staff estimates.

Regional financial integration can facilitate financing of investment.15 We estimate a model based on the macroeconomic balance approach. The impact of rebalancing is assessed through the change in the current account balance to GDP (the dependent variable). Our results show that deeper financial integration, either global or regional, is associated with lower current account surpluses (Table 10.6).16 These findings are in line with those of Pongsaparn and Unteroberdoerster (2011), who show that relative to their regional peers, Indonesia, Malaysia, and Thailand would be able to rebalance in a more significant way by moving toward a level of financial integration more consistent with their fundamentals.

Table 10.6.Benefits of Financial Integration—Rebalancing
-1 Global-2 Regional-3 Both
Dependency Ratio0.32***0.33***0.33***
Fiscal Balance-0.09-0.09*-0.09*
Real GDP Growth0.050.050.05
Global Financial Integration-2.77***-0.84
Opening Balance of Net Foreign Assets-0.00**-0.00**-0.00**
Population Growth0.020.090.07
Oil Income0.96***0.97***0.97***
Regional Financial Integration-2.95***-2.15
Year EffectYesYesYes
Lender EffectYesYesYes
Adjusted R20.9080.9090.908
Source: IMF staff calculations.Note: Standard errors are in parentheses.* p < 0.10; ** p < 0.05; *** p < 0.01.

The potential costs of financial integration should not obscure the potential benefits. To quantify the overall effect of financial integration, we look into the relationship between financial integration and economic growth, applying the framework of Eyraud, Singh, and Sutton (2017). We include standard control variables such as trade openness and population growth in our regression, with real GDP growth as the dependent variable. Considering financial integration might be affected by economic growth, we use instrumental variables (IV) methods as well. The instruments used are one-period lag of the financial integration variable and capital control measures from Fernández and others (2015).

Our results show a positive and statistically significant association between global financial integration and economic growth.17 In similar estimations for regional integration, a positive but statistically weaker association is found between regional financial integration and economic growth (Table 10.7).18 However, financial integration does not necessarily guarantee net benefits if sound institutional and policy frameworks are not in place.19

Table 10.7.Benefits of Financial Integration—Economic Growth
Trade Openness-0.79-1.14*-1.17-1.03-0.69-0.99
Real GDP per Capita-2.39***-1.99***-2.12***-2.53***-1.23***-1.53***
GDP Share of Investment-0.111.631.39-0.421.73*1.64
GDP Share of Government Spending3.00**3.75***3.72***3.07**2.70**3.00**
Population Growth0.510.420.690.160.560.69
Inflation Rate0.10***0.16***0.17***0.11***0.16***0.18***
Political Risk Index0.
Global Financial Integration0.090.32**0.31**
Regional Financial Integration0.130.060.11
Year EffectYesNoNoYesNoNo
Adjusted R20.6090.440.4470.590.280.288
Source: IMF staff calculations.Note: Standard errors are in parentheses.* p < 0.10; ** p < 0.05; *** p < 0.01.

Fostering Financial Integration in the ASEAN-5: Challenges and Policy Initiatives

In 2016, all ASEAN countries endorsed the strategic action plans for ASEAN Financial Integration 2025. Building on key milestones in the AEC Blueprint 2015, the financial sector integration vision for 2025 encompasses three strategic objectives: financial integration, financial inclusion, and financial stability; and three crosscutting areas: capital account liberalization, payment and settlement systems, and capacity building (ASEAN 2015). The ASEAN financial integration framework focuses on banking, insurance, and capital market development initiatives, which are underpinned by a payment and settlement system that fosters interoperability and efficiency in cross-border payments (Table 10.8).

Table 10.8.ASEAN Financial Integration Framework
Key Milestones in AEC 2015End Goal in 2025
  • Assessed and monitored developments in the openness of the CAL regime in ASEAN; established and conducted Policy Dialogue Mechanisms and capacity-building programs to support CAL.

  • Substantial liberalization in ASEAN member states’ capital accounts.

  • Strengthened policy dialogue and information exchange mechanism on capital flow statistics and capital flow measures among AMS.

  • Created enabling environment for regional integration; facilitated the establishment of ASEAN Trading Link; and supported bond market development.

  • Interconnected ASEAN stock markets.

  • Deep and liquid ASEAN capital markets.

  • Improved access to capital markets.

  • Greater private sector engagement to understand their insights into ASEAN financial markets.

  • Increased cross-border collective investment schemes in ASEAN.

  • Negotiated, signed, and implemented packages of financial services liberalization commitments.

  • More integrated financial services sector through enhanced financial liberalization among AMS.

  • Approved the ASEAN Banking Integration Framework (ABIF); established the ABIF Guidelines; completed the signing of a Heads of Agreement between Bank Negara Malaysia and Bank Indonesia.

  • Greater role of qualified ASEAN banks in facilitating intra-ASEAN trade and investment.

  • Greater coherence of banking regulations for all AMS to support financial integration.

  • Greater regional strength in the banking sector and market confidence.

However, the ASEAN region is one of the world’s most diverse. Substantial challenges are present in fostering two key components of regional financial integration: financial sector liberalization and capital account liberalization.

Financial Sector Liberalization

Varying paces of financial liberalization and divergent regulatory frameworks among these economies have led to fragmentation, severely inhibiting regional financial integration.

  • Varying paces of financial liberalization: The financial systems across ASEAN economies are at very different stages of development. Banks in these countries are generally small by global standards. Most countries still have fragmented banking systems composed of many small financial institutions with weak financial profiles.

  • Substantial differences in regulatory frameworks and standards: Differences in investor protection, ability to resolve commercial disputes, and bankruptcy procedures appear more pronounced within the ASEAN than in other regions (Figure 10.11). Such differences could complicate cross-border mergers. As shown in the previous analysis, institutional and regulatory differences would hinder further regional financial integration.

Figure 10.11.
Comparison of Regulatory Indices

Note: ASEAN-other = Brunei, Cambodia, Laos, Myanmar, Vietnam; Asia-other = Australia, China, Hong Kong SAR, India, Japan, Korea, New Zealand, Taiwan Province of China; Latin-4 = Argentina, Brazil, Chile, Colombia; NAFTA = North American Free Trade Agreement (Canada, Mexico, United States).

Source: World Bank, Worldwide Governance Indicators; and IMF staff calculation.

Capital Account Liberalization

Except for Singapore, ASEAN economies have less open capital accounts compared with emerging markets in other regions (Almekinders and others 2015). The findings in the “Drivers of Regional Financial Integration” section in this chapter show that relaxing restrictions on cross-border capital movements supports regional financial integration.

Important regional initiatives are promoting financial integration in the ASEAN region. The focus has been on translating the AEC Blueprint 2025 into strategic action plans and work programs.

  • Capital market development: There has been progress in building capacity and infrastructure to develop and integrate the ASEAN capital markets. In Malaysia, Singapore, and Thailand, concrete measures have been put in place to harmonize disclosure requirements and broaden market links. The measures include a single gateway to all three exchanges that allows investors in one country to buy shares in the other two markets through local stockbrokers, fully harmonized prospectus disclosure requirements that allow issuers to tap all three markets with a single set of prospectuses, and a mutual recognition framework that provides fund managers with a streamlined authorization process for the cross-border offering of funds.

  • Banking integration: The ASEAN Banking Integration Framework has been adopted to achieve multilateral liberalization in the banking sector by 2020. Major banks in Malaysia and Singapore have been the most active in expanding regionally. Thai banks are also expanding, focusing more on the Greater Mekong region. Many bilateral agreements have been signed.

  • Capital account liberalization: The strategic action plan encourages countries to allow greater flows of capital inside the region to facilitate cross-border investment and lending while imposing adequate safeguards.

  • Payment and settlement systems, and financial services liberalization: Various initiatives are underway for harmonizing payment and settlement systems, with the aim of eventually facilitating payments across the region and removing restrictions on intraregional provision of financial services.

Substantial progress has been made in setting up regional institutions to enhance regional cooperation in capacity building, regional financing arrangements, and regional surveillance (Almekinders and others 2015).

  • Regional financing arrangements: In recent years the regional safety net has been substantially enhanced. A multilateral currency swap arrangement among the ASEAN Plus Three countries (Chiang Mai Initiative Multilateralization, or CMIM) was established in March 2010, and a crisis prevention facility (the CMIM Precautionary Line) has been introduced.

  • Surveillance and monitoring system: An independent regional macroeconomic surveillance unit—the ASEAN+3 Macroeconomic Research Office—has been in operation since 2011, and was converted to an international organization in 2016. The office seeks to strengthen cooperative relationships with major existing international financial organizations.

Managing Risks from Capital Flows

It is important to recognize that financial integration and greater exposure to international capital markets can also pose challenges and risks. Capital flows, including those intermediated through the banking system, can amplify domestic economic and financial cycles. Harnessing the benefit of financial integration hence requires strong policy frameworks and institutions to safeguard macroeconomic and financial stability.

Macroeconomic policies, including exchange rate flexibility, need to play a key role in the management of risks associated with capital flows. A flexible exchange rate can be a critical shock absorber in the event of capital inflow surges. Macroprudential policies, in support of sound macroeconomic policies and strong financial supervision and regulation, can increase countries’ resilience to external shocks associated with capital flows, helping contain the buildup of systemic vulnerabilities over time. Capital flow management measures can play a role under certain circumstances in responding to an inflow surge, provided they are temporary and not used to substitute for warranted macroeconomic adjustment (IMF 2012, 2017).


Financial integration of ASEAN economies should be pursued as a critical component of financial development. This chapter shows that regional financial integration in ASEAN economies not only fails to live up to their trade integration, it also lags financial integration with countries outside the region. When looking into the drivers of financial integration, the analysis finds that improving regulatory and institutional quality and reducing restrictions on capital flows can promote regional financial integration. The chapter also provides empirical evidence that regional financial integration helps ASEAN countries better weather global shocks, fosters economic rebalancing, and is associated with higher economic growth. However, the discussion also underscores the risks and challenges associated with financial integration.

When advancing financial integration, it is crucial to harness the gains while minimizing the risks. Close attention must be paid to financial stability. Opening up financial markets requires, first, stronger domestic financial systems and better macroeconomic fundamentals and, at the regional level, enhanced information sharing, stepped-up surveillance and crisis management, and a cross-country safety net. A gradual approach would therefore be appropriate for promoting regional financial integration.


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The Plus Three economies are China, Japan, and Korea.

Using bank flows in the regressions for robustness check does not alter the conclusions.

The trade intensity score is calculated as a country’s share in global trade as a proportion of its GDP share. Portfolio investment intensity score is calculated as a country’s share in the world’s portfolio assets and liabilities as a proportion of its GDP share. The intensity score formula is , in which fit is the sum of imports and exports or the sum of portfolio investment assets and liabilities for country i at time t; n is the number of countries in the sample.

Alternative financial integration measures such as banking positions are used in robustness checks.

The results are robust when banking positions are used as the measure of financial integration.

Institutional quality is found to be an important factor affecting trade in financial assets. See Papaioannou (2009) for a literature review. Ananchotikul, Piao, and Zoli (2015) find that the lack of regulatory harmonization has a more negative effect on intra-Asia investment.

This index, taken from the World Bank’s Worldwide Governance Indicators database, reflects a country’s progress in enhancing law and enforcement and building a trustworthy society. Results are similar when other institutional-quality indicators are used. The results also hold when a lagged rule-of-law index and instrumental variable (latitude, fractionalization of language and religion) are used to account for the possible endogeneity of institutional quality.

These results are in line with Park and Shin (2016).

The results are robust when the region is restricted to ASEAN (although less significant) or ASEAN-5 countries, and with or without Singapore.

Adrian, Etula, and Muir (2011) propose US security broker-dealer sector leverage (assets-to-equity) as a better liquidity measure because it is market oriented and reflects timely underlying market conditions. Bruno and Shin (2013) use this leverage as their preferred global liquidity indicator. Our results using the Chicago Board Options Exchange Volatility Index (VIX) are similar although less significant, whereas using US and EU credit-to-GDP growth as liquidity indicators also yields similar results.

Figure 10.9 shows the average of the impulse responses derived from structural vector autoregressions (SVARs) for each ASEAN-5 economy. In the SVAR there are three variables in the following order: a global factor (VIX), average real growth in ASEAN-5 economies, and capital inflows to the country under consideration. An aggregate approach using a similar SVAR with the average capital inflows to each ASEAN-5 economy yields similar results. Both intraregional and interregional capital flow data are from the IMF Coordinated Portfolio Investment Survey data set from 2002 to 2015.

Our findings that the ASEAN-5 equity markets were less influenced by the US market were similar to those of Guimarães-Filho and Hong (2017), but we found a less influence from China’s equity markets than Guimarães-Filho and Hong did.

Financial markets are, in essence, the arrangements for processing information in networks of savers and investors (Gochoco-Bautista and Remolona 2012).

Our findings that regional investors are less likely to pull out of their investments in the face of a crisis also suggest that regional financial integration is a suitable vehicle for promoting much-needed long-term investment, such as in infrastructure. Indeed, through mobilizing savings and lowering financing costs, regional financial integration has been explored as a regional approach for financing infrastructure and other development needs (Ding, Lam, and Peiris 2014; Volz 2016).

The ordinary least squares regression includes standard factors affecting the current account, such as the dependency ratio and fiscal balance, and global (regional) financial integration index (z-score). We include year and country fixed effects and use robust standard errors.

Global (regional) financial integration in Table 10.7 refers to the global (regional) financial integration index (z-score) calculated from portfolio investment data. Using z-scores calculated from foreign direct investment data has similar results. Singapore is not included in this exercise; the results are less significant with Singapore, perhaps because of Singapore’s status as a financial center and its higher stage of development.

Columns (1)–(3) evaluate the effect of global financial integration, and columns (4)–(6) show the results for intraregional financial integration. Columns (1) and (4) use ordinary least squares estimation with time fixed effects. To correct for possible endogeneity, columns (2) and (5) use two-stage least squares estimation, and columns (3) and (6) use the instrumental variable–generalized method of moments method. The instruments used are a one-period lag of the financial integration variable and capital control measures from Fernández and others (2015).

For a fuller treatment on the risks and challenges of financial integration, see Obstfeld and Taylor (2004), and Barro and Lee (2011).

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