But what are the priorities? The best way to answer this question is to look at the data. In work for a recent ERIA project, research was conducted to check where shocks come from. Are financial markets the villains? Does financial integration promote the synchronicity of business cycles in economies in the region?
This relationship could actually work in either direction. Standard international business cycle models predict that greater financial integration should lead to lower synchronicity because of the opportunities to diversify risk, while models of contagion suggest a positive relationship.
Research in the ERIA project finds that a higher level of financial integration is not associated with an increase in business cycle synchronicity. This suggests that the business risk smoothing opportunities created by integrated financial markets dominate the contagion effects. Deeper financial integration, in other words, provides a buffer between economies that are integrated in other ways.
This result is important in the current debate, where it is often feared that the downside of greater financial integration is that it can pose risks to stability. It is also consistent with new research that argues that greater integration is not the problem on its own, but when a too-rapid liberalisation of financial markets interacts, for instance, with certain distortions in the economy such as weak and lax supervisory regulations as well as problems of credibility and enforcements of contracts, these distortions are magnified and financial instability problems arise.
Shocks to economies remain, of course, and the next question is how have they been absorbed? Research in the ERIA project was undertaken to measure how much of the change in a country’s domestic income (an income ‘shock’) is absorbed by offsetting movements in income from abroad (income risk sharing) and how much is offset by a change in national saving. Both of these changes can protect consumption from having to adjust to short-term changes in income. For countries in the region it was found that the current level of consumption smoothing is rather low. Most of the reduction in variation in consumption compared to income (23 per cent) comes via the use of credit markets (i.e. from changes in national savings) while capital markets (i.e. access to the international financial system) account for very little (2 per cent). These results mean that a very large part of changes in GDP (75 per cent) that lead to changes in consumption is not smoothed.
Our interpretation of this research is that the benefits of financial integration are not being fully utilised. There is room for welfare gain from greater financial openness in the region. On the other hand, this research suggests that constructing new ‘top-down’ institutions, such as systems for monetary integration, are not a priority. Those institutions are very difficult to establish efficiently in the presence of the range of country differences that are also identified in this research. Instead, of more value in the immediate term is to identify the impediments to the consumption-smoothing role that integrated capital markets might play. In other words, there is greater value in further work on a ‘bottom-up’ approach to integration, including action at the national economy level but supported by regional cooperation.
Despite this skeptical finding about large-scale institution building related to financial markets at this stage of the region’s development, there remains a rich agenda for regional cooperation. Within the region, there are not only significant country differences in experiences, but also a wide range of experiences of various sorts of institutional structures in financial markets and their links with local corporate structures. There is a lot of experience to share in well-designed capacity building programs backed up by good research.
Jenny Corbett is a professor of economics at The Australian National University and executive director of the Australia-Japan Research Centre (AJRC). Christopher Findlay is head of the School of Economics at The University of Adelaide.
It is an interesting study and useful findings.
A few quick questions:
1. The finding that a higher level of financial integration is not associated with an increase in business cycle synchronicity: does that have anything to do with either different output structures associated with different stages of their economies i.e. diversity in their output structures, would the results vary according to the degree of output similarity? And how long is the data for: is there any potential of delayed impacts?
2. Consumption smoothing of the 23, 2 and 75 effects of the three factors: how do the 23 and 2 correlate with the proportions of domestic and overseas financing? Do they vary with countries’ saving and consumption patterns, i.e. the a quarter smoothing offset by saving ratios, or the degree of finance availability or easiness? Also, how does that reflect effects of expectations and error corrections?
3. How can social engineering learn from mechanical engineering, such as shipbuilding, by including some cushioning mechanisms, like some apartments in large ships (I do not know if they have that, but some movies suggest they have those,) so if some parts of a ship are damaged, they may be contained to a certain degree? Could global and regional financial architecture include such mechanisms, so it can contain shocks from spreading?