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51

COUNTRIES VIS-A-VIS JAPAN

IMAD A. MOOSA*

La Trobe University

RAZZAQUE H. BHATTI

University of Azad Jammu and Kashmir

This paper presents some empirical evidence on the degree of integration between

the goods and financial markets of Japan and six Asian countries. The evidence is

obtained by testing two international parity conditions using unconventional

specifications: uncovered interest parity (UIP) and ex ante purchasing power parity

(PPP). The results of cointegration tests are strongly supportive of the two conditions

over the period 1980-1994. The paper concludes that Asian goods and financial

markets have reached a high level of integration. [G14]

1. INTRODUCTION

Over the last fifteen years, most Asian countries are thought to have achieved a

high degree of integration among their markets for goods, capital and foreign

exchange. This is because most of these countries deregulated and liberalised their

domestic markets during the 1980s. Financial liberalisation has been undertaken for

the purpose of increasing the efficiency of the domestic financial system by

liberalising interest rates, reducing controls on credit, enhancing competition among

financial institutions and encouraging the creation and development of money and

capital markets. For example, Singapore largely liberalised its financial sector and

abolished capital controls in the mid 1970s, while Hong Kong, Japan, Malaysia and

the Philippines embarked on the liberalisation scheme in the early 1980s. On the

other hand, Korea undertook more gradual measures towards financial liberalisation

which were intensified in the second half of the 1980s. Together with this move

towards the liberalisation of domestic financial markets, most Asian countries also

undertook measures to relax international capital controls and to adopt more flexible

exchange rate arrangements. For example, Japan moved to the flexible exchange rate

system in 1973, while Malaysia and Singapore began to experiment with controlled

floating in the early 1970s. Furthermore, most of the other Asian countriessuch as

Korea, the Philippines, Singapore and Taiwanmaintained fixed exchange rate

*We are grateful to three anonymous referees for their comments on a previous version of

the paper. We would also like to thank Lee Smith for her inquisitive reading of the paper and

52

arrangements by pegging their currencies to the U.S. dollar following its float in 1971.

However, these arrangements were abolished when most of these countries delinked

their currencies from the U.S. dollar in preference for controlled floating of the

effective exchange rate (Korea in 1980, the Philippines in 1984 and Taiwan in 1979).

Moreover, by the early 1980s, Singapore eliminated virtually all restrictions on capital

flows while Malaysia abolished almost all controls on international capital flows that

were not financed by local borrowing.

The extent of international market integration greatly affects the behaviour of

exchange and interest rates across countries, which in turn have crucial implications

for the degree to which the domestic monetary authorities can pursue independent

monetary policies. There is little dispute over the proposition that the more integrated

the international markets for goods, capital and foreign exchange the more limited is

the scope for pursuing independent domestic monetary policies. For example, if

goods and capital move around to eliminate the differential between prices and

interest rates across countries, then the domestic monetary authorities will have no

control over their real exchange and interest rates relative to those of other countries,

limiting the impact of their stabilisation policies. Therefore, it is necessary for policy

makers to take full account of the possible repercussions of international market

integration.

The objective of this paper is to examine integration between the Japanese

markets and those of six Asian countriesHong Kong, Korea, Malaysia, the

Philippines, Singapore and Taiwanover the period 1980-1994. The remainder of

the paper is organised as follows. Section 2 gives a brief description of the

hypotheses used to test the extent of market integration, while section 3 presents the

specification of the models to be tested. Section 4 deals with the data, methodology

and the results of empirical testing, and we end up with some concluding remarks in

the final section.

2. THE HYPOTHESES

Economists have employed several procedures to test (capital) market integration

and capital mobility, two terms that are often used interchangeably.1 The degree of

international market integration can be tested directly by comparing nominal and real

returns on comparable goods and financial assets across countries. Direct testing to

determine the degree of international market integration can be carried out by

examining the validity of various international parity conditions: purchasing power

parity (PPP), covered interest parity (CIP), uncovered interest parity (UIP) and real

The two terms are often used interchangeably because it is plausible to postulate that

capital moves more freely if capital markets are integrated. However, a careful reading of the

literature, as manifested by Goldstein et al. (1991) and Frankel (1993), reveals that while

capital mobility is not a necessary condition for market integration, the latter is conducive to the

former, while the former is a sufficient condition for the latter.

1

53

interest parity (RIP). While the PPP condition is based on a comparison of the returns

on identical goods, the other conditions are concerned with the returns on perfectly

substitutable financial assets across countries. Moreover, while CIP and UIP pertain

to nominal returns on financial assets denominated in different currencies, RIP

pertains to real returns. It must be noted that while PPP is a measure of integration

between goods markets, CIP and UIP indicate the degree of integration between

financial markets, and RIP is a joint measure of goods and financial market

integration.2

The extent of market integration can also be tested indirectly by examining the

degree of correlation between national saving and investment. The indirect test of

international market integration is found in the work of Feldstein and Horioka (1980)

and Feldstein (1983) who argue that in an internationally integrated financial market,

potentially infinite capital flows eliminate differentials among nominal and real rates

of return on identical assets, implying that a shortfall of saving in one country is

unlikely to restrict its volume of investment therein. This is because perfect mobility

of capital breaks the link between national saving and national investment and,

therefore, a fall in private saving or a deficit in the current account in a country is

unlikely to crowd out investment by raising the real cost of borrowing: rather, this

country can then borrow sufficient funds at the going world interest rate to make up

the difference. However, Frankel (1992) argues that there are several problems with

the saving-investment criterion: (1) the presence of cyclical movements may result in

strong correlation between national saving and investment; (2) national saving may

become endogenous if governments respond incipient current account imbalances

with policies to change public (or private) saving in such a way as to reduce the

imbalances; and (3) the correlation between saving and investment is reduced when

large countries are excluded from the sample, implying that the world real interest

rate will not be exogenous if the domestic country is large enough in world financial

markets (see also Tobin, 1983 and Murphy, 1984). The Feldstein-Horioka findings

have also been challenged by Bodman (1995) who re-examined the puzzle using

cointegration analysis and produced strong time series evidence for capital

m o b i l i t y .3

Aggarwal and Mougoue (1993) have proposed a test for a limited definition of

financial integration which they applied to Asian countries vis-a-vis Japan. The test is

based on a finding of cointegration, or otherwise, between the currencies of Japan, on

one hand, and Hong Kong, Malaysia, the Philippines and Singapore on the other.

2

Several testing techniques and model specifications have been used in conjunction with

these criteria. For example, Modjtahedi (1987) tested RIP using linear dynamic stochastic

representations, Boothe (1991) combined UIP with the term structure of interest rates, Moosa

and Bhatti (1995) tested RIP in a time varying parametric framework, while Moosa (1995)

tested both UIP and ex ante PPP using recursive and rolling regressions.

3

Bodman (1995:38) distinguishes between studies of capital mobility based on the

Feldstein-Horioka methodology and those based on rates of return by distinguishing between

real and financial capital.

54

This test, however, is not a test for financial market integration in the broad sense but

rather a test for the existence of a yen bloc.4

This paper follows the direct approach to testing the degree of international market

integration. The degree of integration between goods markets is determined by

examining ex ante PPP, while integration between financial markets is determined by

examining UIP. The reason why this approach is adopted is that we are interested in

financial rather than real capital which is implied by the Feldstein-Horioka analysis.

Moreover, although RIP can be used as a test for the simultaneous integration of

capital and goods markets, the empirical failure of this condition cannot be readily

interpreted as implying the lack of integration of capital markets, goods markets or

both. Thus, more insight is gained by testing the two constituent components of RIP

(UIP and ex ante PPP) which indicate capital and goods market integration

respectively.5

3. MODEL SPECIFICATION

The UIP and ex ante PPP conditions are modelled along the lines proposed by

Bhatti and Moosa (1994, 1995) using specifications in levels rather than the

conventional first differences. This specification is conducive to employing

cointegration analysis while avoiding the spurious regression problem.6 Since these

specifications are derived in Moosa and Bhatti (1994, 1995) the treatment here will be

rather brief.

The UIP hypothesis postulates that in the presence of perfect capital mobility with

no capital controls, transaction costs and risk premia, the expected rate of change of

the spot exchange rate will be exactly equal to the nominal interest rate differential on

perfectly comparable financial assets denominated in different currencies across

countries. This condition is given by

(1 + )i = (1

+S e )(1 + )i

(1)

One important implication of a finding of cointegration between these currencies is that the

foreign exchange markets in these countries are cross-sectionally inefficient. This is because

according to Grangers Representation Theorem, cointegration implies and is implied by a valid

error correction representation. Since the latter includes a lagged error correction term, this

implies the possibility of predicting changes in one currency on the basis of changes in another

currency, an indication of cross-sectional inefficiency (see Moosa and A1-Loughani, 1994).

5

See Moosa (1995).

6

See, for example, Bodman (1995:46). Differencing, which renders the underlying

variables stationary and makes it possible to use conventional test statistics, became a

widespread econometric procedure following the rise of the popularity of the Box-Jenkins

methodology. The problem with this procedure, however, is that differencing causes a loss of

information, a problem that can be avoided by applying cointegration analysis to level data.

4

55

is the expected rate of change

of the spot exchange rate (where the spot exchange rate, S, is defined as the domestic

currency price of a unit of the foreign currency). The alternative specification is

derived by solving equation (1) for the expected spot exchange rate, Se (rather than the

expected rate of change of the spot exchange rate,

) to obtain

Se = F

(2)

where = S[(1 + i) / (1 + i*)] is the interest parity forward rate which is equal to the

actual forward exchange rate, F, if and only if the CIP condition holds precisely.7

Let us now re-rewrite equation (2) as

ste + 1 = ft

(3)

where ste + 1is the logarithm of the expected spot rate and

ft is the logarithm of the interest

parity forward rate. By allowing for the behaviour of the risk premium and

incorporating the rational expectations hypothesis the model can be written in a

testable form as8

st+1 = 0 + 1 ft + t+1

(4)

where t+1 is an error term reflecting the impact of news, and 0 is a constant term

reflecting the value of the risk premium as well as other factors such as transaction

costs. The UIP condition holds in a strong form if the restrictions 0 = 0 and 1 = 1

are not rejected.

The ex ante PPP hypothesis, which has been developed by Roll (1979) and Adler

and Lehman (1983), postulates that the expected rate of change in the nominal

exchange rate tends to be equal to the expected differential in inflation rates across

countries over the same holding period. Based on this hypothesis, Bhatti and Moosa

(1994) proposed a view of the exchange rate determination process which postulates

that if the nominal exchange rate moves to equalise the expected domestic and

foreign inflation rates, then the equilibrium nominal exchange rate is determined not

7

Equation (2) represents UIP in a deterministic form because it can be obtained by

combining CIP (F = ) with the unbiasedness hypothesis (F = Se).

8

The rational expectations hypothesis is incorporated by specifying the actual value of the

exchange rate to be equal to the expected value plus a random error.

56

only by current relative prices, but also by the expected real exchange rate. The ex

ante PPP relationship, which is based on intertemporal commodity arbitrage, is

given by

e

e

st+1

= pt+1

- pe

t+1

(5)

where st+1 is the expected change in the logarithm of the spot exchange rate and

e

e

pt+1 (pt+1) is the expected change in the logarithm of the domestic (foreign) price

9

level. By incorporating the rational expectations hypothesis we obtain

st+1 - pt+1 + pt+1 =u t+1

(6)

where ut+1 is a composite expectations error term. By writing equation (6) in levels

and rearranging we obtain

st = pt - pt +s t+1 +p t+1

- pt+1

(7)

st = + (p - p )t + qt+1 + vt

(8)

where qt+1 is the ex post real exchange rate (defined as qt+1 = st+1 + p*t+1 Pt+1)

realised at time t + 1 and vt is an error term that partially reflects expectations errors.

The hypothesis that the nominal exchange rate is determined not only by the current

price ratio but also by the expected real exchange rate will hold if the coefficient on

the expected real exchange rate, qt+1, is statistically different from zero. The other

relevant coefficient restrictions are = 0, = 1 and = 1.

An important issue here is that the specification of equations (4) and (8) embody

the hypotheses of risk neutrality and rational expectations. Economists have normally

attributed the failure of market efficiency to risk aversion (i.e. the existence of risk

premium) rather than to the failure of rational expectations. This tendency can be

attributed to two reasons: (i) it is difficult to conceive that market agents are irrational

(in the spirit of neoclassical economics), and (ii) testing the rational expectations

e

Hence pt+1

(p e

t+1) is approximately the expected domestic (foreign) inflation rate.

57

hypothesis is not an easy task because it requires the availability of survey data. The

failure of market efficiency normally leads economists to model the risk premium

either explicitly or as a function of the variance of exchange rate movements (Taylor,

1995). It is worth noting in this respect that the rational expectations hypothesis is not

necessary for testing the models represented by equations (4) and (8). If expectations

are formed in such a way that the error is stationary (as opposed to white noise as

required by the rational expectations hypothesis), then cointegration in models

involving expectational variables will imply cointegration in the models involving the

corresponding observed variables (equations 4 and 8). This is one more advantage of

using cointegration analysis, and hence of specifying the models in levels.

4. DATA, METHODOLOGY AND EMPIRICAL RESULTS

Testing the hypothesis of international market integration is carried out on the

basis of the UIP and ex ante PPP relationships implied by equations (4) and (8)

respectively. The sample data consists of quarterly observations on exchange rates,

consumer prices and 3-month treasury bill (or 3-month deposit) rates of Japan and six

other Asian countries - Hong Kong, Korea, Malaysia, the Philippines, Singapore and

Taiwan. The data sample, which covers the period extending between 1980:1 and

1994:4, was obtained from the IMFs International Financial Statistics as reported by

Datastream. The short-term interest rates used to test UIP are 3-month deposit rates

for Hong Kong and Malaysia and 3-month treasury bill rates for Taiwan, the

Philippines and Korea. To make the rates comparable, we have used the 3-month

deposit rate and the 3-month Gensaki rate for Japan.

Cointegration analysis is a technique that seems to be tailor-made for testing these

parity conditions as long-run relationships while allowing for short-run deviations

from equilibrium.10 In this case equations (4) and (8) can be viewed as attractors

towards which the points representing combinations of the underlying variables tend

to return to following a disturbance. The mechanism which moves the points towards

the attractor, thus re-establishing and maintaining equilibrium, is financial arbitrage in

the case of UIP and commodity arbitrage in the case of ex ante PPP. We may sum up

the advantages of using cointegration analysis in this study as follows: (i) it enables us

to avoid the loss of information resulting from differencing while distinguishing

between spurious and genuine long-run relationships, (ii) it produces superconsistent

estimates of the regression coefficients, and (iii) the stringent requirement of white

noise expectations errors can be replaced by the less stringent requirement of

stationary errors.

Before testing for cointegration, unit root testing is carried out to determine the

order of integration of the variables under investigation. For this purpose, the DickeyFuller (1979) test is used. As applied to the time series, yt, the statistic is the t

10

One of the earliest applications of cointegration anlysis was testing PPP (e.g., Taylor,

1988).

58

m

yt = + yt-1 +

y

i

+ vt

t-i

(9)

i=1

Since the augmentation terms are added to remove serial correlation, the criterion

that is adopted to determine the order of the augmented Dickey-Fuller test (the

value of m) is that it should be the smallest number necessary to remove serial

correlation.11

Testing for cointegration is carried out by applying the Phillips-Ouliaris

(1990)

tests to the residuals of the cointegrating regressions (4) and (8).

These tests, which were originally proposed by Phillips (1987), are more robust to a

wide variety of serial correlation, time dependent heteroscedasticity and regime

changes. The calculation of these statistics is based on the auxilliary regression

v t = v t-1 + tu

(10)

If

statistic is given by

Z = N( - )1 - (1 / 2)(sT2 - V2s)(N -2

2 -1

t-1 )

(11)

N

sV2 =

-1

2

t

(12)

and

N

sT2 = N-1

ut2 +

2 -1N

w sk

s=1

ut ut-s

t=s+1

(13)

11

Too many augmentation terms will make equation (9) over-parameterised and reduce the

power of the test.

59

Zt =

1/2

2

v t-1

( - )/s

1 T - (1/2 )(

sT2

2

Vs) sT

statistic is given by

-2

N

v 2t-1

12/

-1

(14)

Phillips and Ouliaris (1990) have demonstrated that these tests have limiting

distributions which are free of nuisance parameters and which, in the general case, are

the same as those of the Dickey-Fuller and t tests in the highly restrictive case of iid

errors.12 The critical values are tabulated in Phillips and Ouliaris (1990).13

A problem that will arise if the underlying variables are nonstationary is that

although the OLS estimates of the coefficients are superconsistent if the variables are

cointegrated, they are not fully efficient and their standard errors will not be

asymptotically normal. Therefore, the hypotheses implied by the coefficient

restrictions cannot be tested on the basis of the conventional t statistics. This problem

can be solved by correcting the conventional standard errors along the lines proposed

by West (1988). With respect to equation (8) this correction requires dividing the

conventional t statistics by s / (0) where

(0)=

1

N

vt2

i=1

m

(15)

and

m

[1

s = (0) + 2

j=1

-| j|/(m

v v

+ )]1

t t+| j |

(16)

t+| j |+1

increase the efficiency, in which case the conventional t statistics will be valid (see

Lim and Martin, 1995 for an excellent survey of these methods).14

When the estimates of sT2 are based on the first difference, vt, instead of vt, the resulting

test statistics are known as Z and Zt.

13

Haug (1992) provides another set of critical values for the

statistic.

14

These procedures, however, do not allow us to test for the restrictions jointly. Because of

the nonstationarity of the underlying variables the Wald test is also not appropriate. A possible

procedure to use for this purpose is the Johansen (1988) test, but this test has two important

12

60

The results of unit root testing, which are shown in Table 1, are consistent in

indicating that all of the variables underlying equations (4) and (8) are I(1). The

Table 1.Testing for Unit Root ()

Country

Hong Kong

Korea

Malaysia

Philippines

Singapore

Taiwan

Variable

Level

First Difference

st

st+1

1.35

1.04

1.21

1.56

0.35

1.26

0.70

0.20

1.07

0.57

0.58

0.39

0.74

0.46

0.54

1.47

1.19

1.53

0.10

1.10

1.00

0.82

0.99

0.89

2.18

1.51

1.08

0.98

1.42

0.35

7.07*

6.93*

6.99*

7.01*

3.02*

7.34*

7.14*

7.07*

7.20*

4.18*

6.66*

6.52*

6.11*

6.59*

4.66*

7.44*

7.24*

7.44*

7.45*

3.44*

6.16*

6.04*

6.14*

6.01*

4.58*

8.01*

7.47*

7.26*

7.69*

5.32*

qt+1

(p p*)t

st

st+1

qt+1

(p p*)t

st

st+1

qt+1

(p p*)t

st

st+1

qt+1

(p p*)t

st

st+1

qt+1

(p p*)t

st

st+1

qt+1

(p p*)t

Note: * Significant at the 5% level. The 5% critical value is 2.86 (Davidson and MacKinnon,

1993, Table 20.1, p 708).

shortcomings: the difficulty of interpreting multiple cointegrating vectors (likely to arise in the

case of ex ante PPP) and, more importantly, the sensitivity of the results with respect to the

specification of the underlying VARs (the maximum lag, the inclusion of a constant term,

seasonal dummies, etc). Because of these problems we only report the results of the West test.

61

results of cointegration and coefficient restriction tests, which are presented in Table

2, are highly consistent in lending strong support to UIP and ex ante PPP in all cases,

except for the Philippines in which case the null hypothesis of no cointegration among

the nominal exchange rate, the price ratio and the expected real exchange rate is not

rejected. Moreover, the restrictions implied by UIP (0 = 0 and 1 = 1) and ex ante

PPP ( = 0, = 1, = 1) are not rejected, as judged by the West (1988) corrected t

statistics, in all cases but one (the Philippines).

The results presented in this study on the basis of unconventional model

specifications are more supportive of the two international parity conditions than the

bulk of studies based on conventional specifications. Studies of UIP by, inter alia,

Gaab et al. (1986), Taylor (1987, 1989), and Mayfield and Murphy (1992) produced

results which were generally unsupportive of the hypothesis, unlike the results

produced by Bhatti and Moosa (1995) which indicated that UIP performed reasonably

well in the long run. Similarly, when the PPP model is augmented by the expected

real exchange rate, the results are more supportive of the hypothesis than studies

based on the conventional restricted specification (e.g., Taylor, 1988).

These empirical results must be interpreted with caution and by bearing in mind

some problems associated with the testing techniques and the sample size. The first

problem pertains to the power of unit root and cointegration tests as applied to our

data. The power of these tests is likely to be reduced because of: (i) small-sample

bias, (ii) structural breaks, and (iii) transaction costs acting as thresholds. Small

sample bias arises because the test statistics have asymptotic properties. Monte

Carlo simulations by Banerjee et al. (1986) have shown that small-sample bias is

related to (1 - R2), implying that one should cast doubt on results obtained from

cointegrating regressions having small R 2 (which is not the case here anyway).

Economists have normally circumvented this problem by using data covering a long

period of time and/or using more sophisticated, less conventional techniques

(Taylor, 1995).15 Solving sample-size related problems by using a large sample, if

available, is likely to introduce the problem of structural breaks. With respect to

this study, the possibility of structural breaks could arise because of the measures of

financial deregulation implemented at different points in time which may be

difficult to pinpoint. Given the small sample used in this study, it is not possible to

examine the effect of structural breaks through split samples. However, it is

possible to deal with this problem by using the unit root test proposed by Perron

(1989) which allows for structural breaks whose timing must be known precisely.

Moreover, the Phillips-Ouliaris

statistics can handle heteroscedasticity resulting

from regime changes.

Another relevant problem has been highlighted by Pippenger and Goering (1993),

For example, in testing PPP by detecting mean reversion in the real exchange rate, Abuaf

and Jorion (1990) increased the power of their tests by applying systems estimation (SUR) to a

long time series, while Diebold et al. (1991) employed fractional integration. Both of these

studies produced evidence in favour of PPP.

15

62

63

64

who examined the power of unit root tests in detecting mean reversion in the presence

of transaction costs. Their conclusion is that the power of unit root tests may fall

dramatically if applied to what they described as threshold processes, where the

threshold is defined by the band representing transaction costs. More specifically,

they concluded that the results of unit root or cointegration tests of economic

relationships implied by arbitrage (e.g., UIP and ex ante PPP) may well be useless in

uncovering the long-run economic relationships between variables in the presence of

transaction cost.16 It is the case, however, that because of the sheer volume of

transactions in the foreign exchange and money markets, the resulting economies of

scale give rise to high transacting efficiency and hence small costs, leading to a

narrow band and a smaller threshold.

What is the relevance of these problems to our results? It must be stressed that the

message here is that these problems reduce the power of the tests to reject the null of

no cointegration and hence to detect market integration. Since the null of no

cointegration is not rejected in one case only (ex ante PPP for the Philippines), this

may be interpreted as implying the strength of market integration which is indicated

by the results of the tests despite the presence of these problems. It could also be the

case that the failure to detect integration between the goods markets of Japan and the

Philippines is due to these problems.

5. CONCLUSIONS

This paper has examined UIP and ex ante PPP as direct tests for the degree of

market integration between Japan and other Asian countries over the period 1980:1 1994:4. The results obtained from residual-based cointegration tests strongly support

the validity of long-run UIP and ex ante PPP in almost all cases. Moreover, the West

(1988) corrected t statistics turned out to be supportive of the coefficient restrictions

implied by the two hypotheses.

The results presented in this study provide stronger evidence for the parity

conditions than what is found in the literature. The positive evidence indicates that

the results of testing international parity conditions are affected not only by the

length of the data sample or the testing technique, but also by model specification.

More importantly, these results are consistent with and confirm the conventional

wisdom that there is a high degree of integration among Asian goods and financial

markets.

16

The basis of this postulation is that the longer the time the process spends inside the

threshold, the longer the time the process behaves as a random walk, reducing the power of the

test in detecting mean reversion. On the other hand, when the process makes the transition

outside the threshold, the faster the speed of adjustment the stronger the signal of mean

reversion which will lead to an increase in the power of the test (p 475).

65

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