The liberalisation and integration of domestic financial markets in Western Pacific economies

Abstract

This paper addresses the integration of domestic financial markets in Western Pacific economies – an unexamined issue in the literature of international financial integration – by exploring the relationship between money market interest rates and deposit and loan interest rates. Rules for setting interest rates on deposits and loans are derived, and these are shown to be consistent with commercial banking practice and to capture recent key developments in the banking sectors of the region. An error-correction model is used to show that the integration of domestic institutional financial markets has increased substantially over the past decade, due to pervasive liberalisation and, more recently, growing competitiveness. The adjustment of domestic institutional rates to changes in money market rates has increased, often significantly, and by the first half of the 1990s the speed and pattern of adjustment of institutional rates in most of the developing/newly developed economies of East Asia had become similar to that in economies with developed financial systems. There is also a difference between the adjustment of deposit and loan rates, with the former adjusting more rapidly. This may be explained by differences in the maturity, substitutability and transactions costs associated with loans and deposits. The riskiness of private borrowers and the poor health of the banking system were shown to have a significant, deleterious effect on the level of loan rates in the region. Country differences are analysed and implications for monetary policy, competition policy and supervision policy are noted.