Financial Integration in Asia

Abstract

We estimate a FAVAR model to evaluate the degree of financial integration in Asia. Integration are assumed to be driven by one unobservable regional index factor that measures intra-regional integration within the Asian countries, and four observable country factors that measures inter-regional integration with the Asian region. The unobservable regional index factor is extracted by Kalman filter. We performed forecast error variance decomposition to examine the sources of integration forces with the Asian interest rates.The main findings are that the majority of the interest rate commonality is driven by inter-regional integration where the US and EU are the two dominant factors. For Indonesia, however, Japan is the largest contributor to explaining its interest rate variability. There is limited intra-regional integration as indicated by the contribution from the regional factor and China also accounts for a rather small share of interest rate movements. When we focus on the post-2002 period, the contributions from the regional and China factors become increasingly important. Although the increase is small and the explanatory power remains modest.