Accepted Manuscript

Title: The nexus between financial integration and real

economy: Solow-growth model concept

Authors: Md. Saifur Rahman, Farihana Shahari

PII: S0275-5319(16)30436-6
DOI: http://dx.doi.org/doi:10.1016/j.ribaf.2017.07.062
Reference: RIBAF 752

To appear in: Research in International Business and Finance

Received date: 25-11-2016

Accepted date: 3-7-2017

Please cite this article as: Rahman, Md.Saifur, Shahari, Farihana, The nexus between
financial integration and real economy: Solow-growth model concept.Research in
International Business and Finance http://dx.doi.org/10.1016/j.ribaf.2017.07.062

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The nexus between financial integration and real economy: Solow-Growth Model
Concept

Md. Saifur Rahman1, Farihana Shahari2

1
Curtin Business School, Curtin University, Sarawak, Malaysia
masaifur@yahoo.com or masaifur@curtin.edu.my
2
Department of Finance, International Islamic University Malaysia, Malaysia
farihana_shahari@iium.edu.my
 

Abstract
This paper aims to investigate the nexus between financial integration and the real economy
in ASEAN+3 economies based on the concept of Solow-Growth Model. The equity indices
as a proxy for financial markets are collected from each ASEAN+3 members and are
segmented between two periods; before and after the financial cooperation agreement period.
The finding presents several outcomes; 1) no cointegration nexus is found in the system
during the pre-agreement periods; 2) the markets are found cointegrated during the post-
agreement period, 3) financial integration is found to influence the real sectors of ASEAN+3
economies. Finally, this study offers policy implications to improve financial integration for
stabilizing the real economy.

Keywords: Financial integration, ASEAN+3, Real economy, Generalized Method of

Moments (GMM)

JEL classification: E24, E44, F3 and G15

1 
 
1. Introduction
Ample of earlier studies focused on financial markets in the area of ASEAN region e.g.
examining whether or not equity markets of these regions are integrated. The study of Majid,
el. al. (2009) examined the degree of integration among the ASEAN-5 stock markets dividing
the period between pre-and post-financial crisis period. The financial markets during post-
crisis period were found more integrated. They argue that the economies engaged in the intra-
regional financial activities extensively and it leads to the improvement of market integration.
Furthermore, the studies of Worthington and Higgs (2007), Oh, et. al. (2010), Chen et al
(2009) and Wang (2010) examined the equity market integration in general and found the
improvement of equity market integration among the ASEAN equity markets. These studies
did not show whether the cooperation agreement among the ASEAN+3 has advanced the
financial integration which might reflect the real sectors of the regional economies.

The financial integration improves the cross-border capital movement, investment and
financial information (Beiney and Candelon, 2011). It improves the financial systems and
intra-regional financial transaction. It facilitates the efficient capital allocation, regional
capital accumulation and improves the productivity (Yuhn, 1997; Bai and Zhang, 2012).
Moreover, it ensures the free capital movement which contributes to the long-run growth of
the real economy. The theory of Solow-Growth Model can be applied in this regards.
According to this theory, capital accumulation improves the economic growth and overall
real economy. The intra-regional capital allocation and regional capital accumulation
improve the regional investment and productivity. The interesting concept of this theory has
not been explored empirically in the earlier study. Therefore, based on the concept of Solow-
Growth Model, this study explores the nexus between financial integration and the real
economy in ASEAN+3 economies.

The ASEAN+3 economies have implemented several policies in order to improve the
financial integration. Chiang Mai Initiatives, Asian bond markets, regional bond fund and
regional reserve pooling mechanism are few of those that are adopted to improve the
financial integration (Spiegel, 2009). These initiatives have been considered in this study to
examine whether they have any form of impact on the financial integration and real economy.
Unlike previous studies, this study aims to examine a specific objective, the degree of
cointegration among ASEAN+3 financial markets and nexus between financial integration
and the real economy. The finding of this study can be used as a signal to integrate or
disintegrate their financial markets considering the influence of market integration on the real
economy. In this regards, if the market integration is found to influence real economy
positively, it will be meaningful to focus on integration among the regional financial markets.

2 
 
If the markets have the lack of integration or are weakly integrated, the policy makers have to
improve the market integration for stabilizing the financial system and improving the real
economy.

There are numbers of studies that examined the financial market integration in ASEAN
region. To contribute to the extent of earlier study, this study finds the gap of earlier study
through specific literature studied in ASEAN region. Most of the studies just showed the
degree of integration among ASEAN stock markets. They just indicated whether stock
markets of this region are more or less integrated during the post-crisis period in comparison
with pre-crisis periods. The study of Oh, et. al., (2010) investigated the integration among
Asian stock markets. The study showed that Asian stock markets are weakly integrated over
the period from January 1987 to December 2007. The analysis of the study failed to discuss
why equity markets of ASEAN regional are weakly integrated. They did not show whether
ASEAN+3 economies have any form of regional economic tie that may lead to the
improvement of equity market integration. The similar results were provided by the study of
Chambet and Gibson (2008), Lim (2009) and Guidi and Gupta (2013). The study indicated
that stock markets in ASEAN region were not integrated into the long-run relationship. A
further extension of the earlier study is required in order to contribute towards the regional
economic bloc. The financial bloc, ASEAN+3 which is the major contributor to the Asian
economies is not studied sufficiently. Neither empirical study except for Rahman et al (2015,
2016) indicated whether ASEAN+3 financial markets are integrated, nor suggests whether
further initiatives are required in order to develop regional tie among the equity markets.

A recent study by Chien, Hee, Hu and Hu (2015) examined the level of integration between
ASEAN-5 and China markets in which a single cointegrating vector is identified which
means these markets had a weak level of integration. Interestingly, the study shows a
significant improvement of market integration over the periods. The study argues that the
equity markets improved the integration due to deregulation and liberalization policies, but
failed to identify what kind of market policies are behind the market improvement. The study
of Narayan and Smyth (2004) and Syriopoulos (2011) clarified the argument. They stated that
Free Trade Area (FTA) agreement between them enforces to deregulate the market
restrictions and improves the integration among equity markets. The trade policy integrates
the financial markets because it requires the financial dealing for which financial markets are
liberalized (Bilgin, 2010; Fujiwara and Takahashi, 2012).

This study has considered further literature devoted on the nexus between financial
integration and the real economy. Most of the previous studies found the positive influence of
financial integration on the real economic factors, e.g. economic growth. Financial
integration in the European economies is found to improve the economic growth in the study
of Masten (2008). When markets are integrated, the movement of foreign cash flows across
the border increases. The foreign capital is used either in the trading or production industries
which contribute to improving the economic growth. The similar finding is found in the study
of Nicolòa and Juvenal (2014), and Misati, Ighodaro, Were and Omiti (2015). Their finding
indicated that close relationship among financial markets increases the GDP growth in the
COMESA and SADC regions.

The earlier studies show a clear gap which is bridged in the study. A number of studies
examine the financial market integration in multiple bloc or regional groups, but surprisingly,
very few studies have empirically justified whether financial markets of ASEAN+3 are
integrated and it influences the real economy. Most of the studies showed the relationship

3 
 
between financial integration and economic growth, but this study extends the investigation
to show the nexus with unemployment rate, money supply, and consumer price index.
Therefore, this study has several implications in bridging the gap of earlier studies.

The arrangement of this study is as follows. The data and variables are discussed details in
section 2 followed by estimation techniques in section 3. The analysis of findings is
discussed in section 4 while concluding remarks along with suggestions and policy
implications of the study are described in section 5.

2. Data and variables

The data series and source used in this study are provided in the following Table 1:

Table 1: Source of data

Country Index
Philippines Philippines equity exchange composite
Indonesia Jakarta equity exchange composite
Malaysia Bursa Malaysia KLCI
Korea Korea equity exchange composite
Japan Tokyo equity exchange
China Shanghai equity exchange
Thailand MSCI
Singapore MSCI

Firstly, financial integration among the ASEAN+3 equity markets is examined for which
daily equity data series have been collected over the period from 6 February 1992 to 30 June
2015. The dataset has been further segmented between the pre-agreement period (March
1992- November 1997) and post-agreement period (30 May 1997-30 June 2015). The
ASEAN+3 financial cooperation agreement was formed immediately after the Asian financial
crisis and adopted numbers of initiatives in order to integrate the regional financial markets
through inter-governmental cooperation. Therefore, the data period is segmented to justify
whether governmental cooperation leads to the financial integration after the agreement
period. The equity indices have been considered for examining the financial integration for
several reasons. The equity markets in the region are highly influenced by the shocks of
regional countries. The market shock in one economy immediately affects the equity price of
other economies. The market participant in that equity markets also reacts to the market
shocks. Therefore, the equity indices have been widely used to measure the degree of
financial integration (Guidi & Gupta, 2013; Bentes, 2015; Maghyereha, Awartani & Hilu,
2015). Following them, the study adopts equity indices for investigating the financial
integration.

Secondly, the nexus between financial integration and the real economy is explored for which
intra-regional portfolio equity share has been used as a proxy of financial integration. The
higher portfolio equity share implies the higher degree of integration among the regional
markets. The real economy is represented by Money supply (M2), Consumer Price Index
(CPI), Gross Domestic Products (GDP), Unemployment Rate (UR). Both proxies of financial

4 
 
integration and the real economy are collected from IMF Coordinated Portfolio Investment
Survey facilitated by World Bank and ADB. The data period covers the period from 1990 to
2015 which has been divided into the pre-agreement period (1990-1997) and post-agreement
period (1998-2015). The sample period further has been averaged in order to satisfy the
condition of GMM estimation technique that requires the sample period (N) to be more than
sample period (T).

3. Estimated models
The study employs Cointegration test proposed by Johansen and Juselius (1990) to examine
the financial integration. This method is more applicable in the case where the variables
involved in the model are not covariance stationary in the level but they are stationary in the
first differences. There are several steps that must be performed in order to examine the
existence of cointegration among the indicators. First, test the order of the integration of each
index in the model. In this study, therefore, the stationarity of each series was tested using the
Augmented Dickey-Fuller (1979) (ADF) and the Phillips-Perron (1992) (PP) unit root test as
the following:

Δ α α γ ∑ Δ ε (1)

Δ α α γ ε (2)

Where, the ?? represents the stock index, ???? and ?? are constant terms, t is the time
period, the intercept and time trend that may be added, Δ represents the first difference
operator, ??t is the white noise residual, and ?? is the number of lagged values. Second, the
study identified the appropriate (optimal) lag length for the specified model based on a
sequential log likelihood ratio (LR) test as in Lütkepohl (2005). Third, choosing the
appropriate model regarding the deterministic components in the multivariate system based
on the information criteria. Following the practice in standard econometric literature, a
typical VAR (k) model can be formulated as:

∆ П ∑ г ∆ (3)

Where, Xt ( , , ...) denotes an nx1 vector of I(1) country stock index and the selected
other countries’ stock indices. ∆ Xt are first difference of all indices I(0), гi represents n x n
coefficient matrices, П is a long-run coefficient matrix, k is the number of lagged values and
εkt is the error terms. IV) Fourth, determine the rank of П or the number of cointegrating
vectors. Johansen and Juselius (1990) and Johansen (1988) proposed two likelihood ratio
(LR) statistics, namely, trace statistic (λtrace) and the maximum eigenvalue (λ max) test for
examining the rank of matrix Пi or the number of cointegration(s) using the following
equations:

λ ln 1 λ (4)

λ ln 1 λ (5)

Where, T is the sample size and λ is the largest eigenvalue of the Пi matrix obtained from
the equation (3). The null hypothesis of trace test is that the number of cointegrating vectors
is less than or equal to r, and the alternative hypothesis is that r matrix is of the full rank (r =

5 
 
n) cointegrating vectors. However, the null hypothesis in the max-eigenvalue test is, r =1, and
the alternative hypothesis is that the rank is more than one (r >1) (Brooks, 2003). The
rejection of null hypothesis indicates the presence of cointegration relationship. This study
limits the discussion to cointegration relationship among the ASEAN+3 equity markets. Once
the cointegration relationship is established among ASEAN+3 economies, this study
proceeds the investigation to explore whether the financial integration influences on their real
economy.

To investigate the influence of financial integration on the real economy, this study employs
the system General Methods of Moment (GMM) developed Blundell and Bond (1998) and
Blundell et al (2000). This model is the most suitable for the small samples of this study. The
specified GMM model can be formed as follows:

yi,t  yi,t1  xi,t  i,t |   1 | .................. (6)

 i,t  i  vi,t
Where,

Here, yi,t is the indicator of real economic variables; Money supply (M2), Consumer Price
Index (CPI), Gross Domestic Products (GDP), Unemployment Rate (UR) in year t. yi,t1 is the
lagged value of dependent economic variables, xi,t indicates the financial integration
variables. The financial integration is represented by the proxy variables; intra-regional
portfolio equity share. i and t indicate the indicators and time respectively. The GMM
estimation technique is adopted in this study because it is suitable one that fits with panel
data. The GMM deals with lagged panel data that cannot be solved through OLS. The
autocorrelation problem is removed through instrument variables that GMM deals with.
According to Kpodar (2007), this technique can be used to solve the problems of causality
inverse, biases and omitted variable. The biases resulted from the omission of explanatory
variables is eliminated through this technique, and finally, it provides the better estimation of
the parameters of endogenous variables. Through the instrumental variables, it tackles the
correct estimation even in the case of measurement errors.

Hypothesis development
Several hypotheses have been developed in order to respond to the objectives of this study.
The hypotheses are developed and described as follows:

H1: The degree of financial integration has improved during the post-crisis period.

Based on the earlier study, Majid, et al (2009) and Rahman, et al (2015), this study expects
that the degree of financial market integration among ASEAN+3 has improved during the
post-agreement period. Multiple financial initiatives are adopted by the ASEAN+3
economies for the common interest of the regional economies. The financial markets are
positively reacted by the implemented initiatives of the financial bloc. Hence, it is assumed
that financial integration has improved the degree of financial integration.

H2a: Financial integration influences the GDP growth positively

6 
 
A positive relationship is expected between the financial integration and the GDP growth as
stated in the hypothesis H2a. Since ASEAN+3 receives a significant amount of foreign
capital when markets are integrated, capital investment and deposits in banking sectors, these
foreign capital inflows indirectly contribute to the expansion of the production sector. The
production expansion increases the GDP growth and improves the economic growth. This
hypothesis is suggested based on Herrmann and Winkler (2009) and Leila (2011) who
showed the positive relationship between the financial integration and the GDP growth.

H2b: Financial integration influences the unemployment rate negatively

The hypothesis H2b expects the negative relationship between the financial integration and
the unemployment rate. The financial markets in regionally integrated economies become
efficient and competitive in which one can offer low production costs. The low cost of
production attracts more foreign capital and expands business activities. The new firms and
industries hire more labors and reduce the unemployment rate (Sarkar and Amor, 2011).
Hence, this research expects a negative relationship between the financial integration and the
unemployment rate. This hypothesis is proposed based on the study of Levchenko, et. al,
(2009) who showed that financial integration reduces the unemployment rate.

H2c: Financial integration influences the money supply positively

The hypothesis H2c expects that the financial integration influences the money supply
positively. When the financial markets are integrated, the financial regulations on foreign
capital flows are relaxed (Bonfiglioli, 2008). The foreign financial institutions and investors
become more attracted for the capital investment which increases the money supply to the
invested countries in the financial bloc.

H2d: Financial integration influences the consumer price index positively

As discussed earlier, financial integration induces the foreign capital inflows whereby the
money supply in the local economy increases. The higher increment of the money supply
increases the income level and purchasing power of households. This hypothesis H2d expects
that the financial integration actually has a positive influence on the consumer price index
(Masten, 2008).

4. Analysis of findings
To test the hypotheses, the findings are presented in two segments; first, investigation of
financial integration estimated by Johansen multivariate cointegration test and second,
examining the influence of financial integration on their real economy estimated by GMM
approach.

The cointegration test requires all data series to be I(1) which can be tested by Unit Root test.
This study uses two unit root tests such as ADF and PP for testing the stationarity (the results
are available on request). The null hypothesis of no unit root problem in both ADF and PP is
not rejected at the level form, while is rejected at the first difference. It implies that the data
series in both pre and post-agreement periods are I(1). The I(1) data series allows employing
the Johansen Cointegration test.

Table 2: Results of multivariate cointegration test

Pre-agreement period Pre-agreement period

7 
 
 H0 H1 λ max 95% CV λtrace 95% CV λ max 95% CV λtrace 95% CV
r=0 r=1 57.548 58.434 184.111 197.371 61.578 58.434* 220.603 197.371*
r≤1 r=2 33.938 52.363 126.563 159.530 50.057 52.363 159.025 159.530
r≤2 r=3 27.610 46.231 92.625 125.615 38.939 46.231 108.968 125.615
r≤3 r=4 20.942 40.078 65.015 95.754 25.424 40.078 70.029 95.754
r≤4 r=5 16.573 33.877 44.074 69.819 15.338 33.877 44.606 69.819
r≤5 r=6 14.373 27.584 27.500 47.856 11.712 27.584 29.268 47.856
r≤6 r=7 7.133 21.132 13.128 29.797 11.159 21.132 17.556 29.797
r≤7 r=8 5.896 14.265 5.994 15.495 5.902 14.265 6.396 15.495
Note: *denotes rejection of null hypothesis at the 5% significance level. r indicates the number of
cointegration(s) relationship. The lag number is selected based on AIC, where a number of the lag
number during the pre-agreement period is 1 and during the post-agreement period is 3.

Does the degree of integration among ASEAN+3 economies has increased during the post-
crisis period? The estimated result in Table 2 answers the question relying on the λ max and
λtrace statistics. The null hypothesis of λ max and λtrace against alternative hypothesis cannot be
rejected, meaning that no cointegrating vector is identified in the system. It indicates that the
stock markets as a whole do not maintain cointegration relationship during the pre-agreement
period. This finding is supported by that of Wurgler (2000), Majid et al (2008) who failed to
show the financial linkage among the ASEAN economies during the pre-crisis period. The
lack of financial integration can be explained by the country-specific restriction and absence
of regional cooperation. Most of the countries emphasized on the financial development
focusing on the individual interest, instead of regional or common interest. For example,
China had close linkage with Taiwan and Hong-Kong (Wang and Schuh, 2002; Guillaumin,
2009), Malaysia had a strong tie with US and Japan (Majid et al, 2008), where Singapore had
strong trade linkage with US (Cheung and Mak, 1992). This individual country-specific
relationship perhaps causes the lack of integration among the ASEAN+3 financial markets
during the pre-agreement period.

On the other hand, the null hypothesis of both λ max and λtrace at maximum one is rejected
during post-crisis period. It indicates the presence of one cointegrating vector in the system
meaning that the stock markets of ASEAN+3 are cointegrated. This result supports the
hypothesis H1, meaning that the degree of financial integration increases during the post-
agreement period. This result is consistent with Hinojales and Park (2011) and Rahman et al
(2015) who show the improvement of financial integration in East Asian economies during
post-crisis period. However, the improvement of financial cointegration during the post-
agreement period can be explained by the inter-governmental initiatives such as deregulation
of country specific restrictions, regional reserve pooling system and local currency-
denominated bond markets. These initiatives reflect on the regional financial activities, where
the intra-regional traders and investors find the financial markets convenient for the cross-
country financial dealings after the initiatives are implemented. The reflection of these
financial initiatives on the real economic sectors (intra-trades and intra-investments) is shown
in Table 2:

8 
 
 Table 3: Bilateral-trade share among member economies
Japan South Korea China Malaysia
pre-agreement post-agreement pre-agreement post-agreement pre-agreement post-agreement pre-agreement post-agreement
1990 1995 2008 2009 2010 2011 1990 1995 2008 2009 2010 2011 1990 1995 2008 2009 2010 2011 1990 1995 2008 2009 2010 2011
Japan 5.59 6.24 5.75 6.11 6.20 6.30 3.48 7.42 17.38 20.48 20.67 20.59 2.09 3.51 2.57 2.61 2.75 2.93
South 21.95 18.63 10.35 10.22 10.32 9.94 0.00 6.21 19.53 20.24 21.02 20.30 1.61 2.05 1.82 1.71 1.75 1.54
Korea
China 14.47 20.44 10.42 10.37 9.97 9.38 0.57 6.04 7.27 7.07 6.95 6.71 1.05 1.19 2.09 2.35 2.49 2.47
Malaysia 19.73 20.07 11.52 10.91 11.42 11.44 3.59 3.43 4.23 4.10 4.54 3.86 2.01 2.38 10.98 13.01 12.54 13.15
Singapore 14.83 14.64 6.47 6.01 6.15 5.74 2.59 3.56 4.60 5.15 4.88 4.79 2.54 2.80 9.84 10.12 10.56 10.38 13.29 17.27 11.99 11.51 11.78 11.45
Indonesia 34.34 24.97 16.10 13.31 14.57 13.95 4.94 6.23 6.02 6.04 6.91 7.71 3.12 3.76 10.10 11.95 12.31 12.90 1.14 4.16 5.77 5.86 6.14 5.62
Thailand 2.54 3.83 3.26 3.38 3.77 3.69 2.55 2.33 2.95 2.88 3.09 3.02 24.98 22.11 15.04 14.26 15.44 14.50 3.01 3.40 5.49 5.68 5.63 5.41
Philippines 18.96 19.79 13.53 14.23 13.70 14.19 3.44 4.09 5.16 5.88 5.69 6.08 1.15 1.90 9.15 8.25 9.69 11.23 1.96 2.05 4.14 3.68 3.61 3.45

Singapore Indonesia Thailand Philippines

pre-agreement post-agreement pre-agreement post-agreement pre-agreement post-agreement pre-agreement post-agreement
1990 1995 2008 2009 2010 2011 1990 1995 2008 2009 2010 2011 1990 1995 2008 2009 2010 2011 1990 1995 2008 2009 2010 2011
Japan 2.74 3.83 2.23 2.37 2.28 2.14 3.40 3.10 2.92 2.75 3.01 3.09 2.54 3.83 3.26 3.38 3.77 3.69 0.89 1.36 1.19 1.29 1.30 1.20
South 1.90 3.32 2.86 3.09 2.58 2.74 1.88 2.36 2.23 2.19 2.55 2.83 1.01 1.26 1.17 1.12 1.19 1.28 0.54 0.79 0.94 1.04 1.04 1.00
Korea
China 2.46 2.45 2.05 2.17 1.91 1.73 1.07 1.24 1.23 1.28 1.44 1.66 1.06 1.20 1.61 1.73 1.78 1.78 0.25 0.46 1.12 0.93 0.93 0.89
Malaysia 18.88 16.23 13.10 12.81 12.46 12.74 1.12 1.44 3.79 4.08 4.06 4.41 2.96 3.24 5.15 5.68 5.74 5.54 0.94 0.73 1.41 1.11 1.83 1.24
Singapore NA NA 8.09 7.81 7.51 7.98 4.53 5.46 3.71 3.54 3.45 3.28 0.86 1.25 1.85 1.97 2.47 1.67
Indonesia 6.68 7.12 13.01 12.09 11.57 11.66 0.78 1.67 3.75 3.68 4.10 4.28 0.45 0.78 1.05 1.38 1.32 1.19
Thailand 7.39 8.59 4.82 4.64 4.04 4.20 0.62 1.05 3.29 2.96 3.44 3.81 0.49 0.71 1.62 1.68 1.92 1.60
Philippines 3.53 4.97 8.05 7.67 11.77 8.46 1.23 1.63 2.01 2.69 2.52 2.75 1.45 2.67 4.11 4.53 5.31 4.95
Source: IMF Directions of Trade Statistics. Note: Trade share is the percentage of trade with a partner to total trade of a country/region. A
higher share indicates a higher degree of integration between partner countries/regions
 

9 
 
 Table 4: Bilateral FDI share among member economies
Japan South Korea China Malaysia
pre-agreement post-agreement pre-agreement post-agreement pre-agreement post-agreement pre-agreement post-agreement
1996 1997 2005 2008 2009 1996 1997 2005 2008 2009 1996 1997 2005 2008 2009 1996 1997 2005 2008 2009
Japan 11.81 1.80 0.45 12.58 1.51 0.04 -0.87 0.09 0.71 -2.55 -0.27 0.12 -0.12 0.09 2.58
South Korea 0.74 0.27 3.17 27.01 27.01 0.16 0.11 0.02 1.36 1.36 17.40 16.03 -19.8 -4.73 -4.73
China 15.71 16.64 14.26 28.49 5.50 389.64 48.14 81.27 139.27 15.70 N/A 14.28 96.24 1.65 5.41
Malaysia 4.60 5.00 1.19 4.50 0.65 12.76 1.06 0.24 0.30 0.96 0.47 1.28 0.16 1.14 0.12
Singapore 2.54 4.96 0.29 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A
Indonesia N/A N/A 3.37 8.92 1.20 N/A N/A 3.76 8.26 0.47 N/A N/A 2.44 10.18 6.33 N/A N/A 37.81 6.80 3.95
Thailand 2.23 5.20 6.40 15.66 3.64 5.31 0.66 0.47 3.63 0.61 0.18 -0.35 0.10 0.11 0.39 0.56 0.44 10.21 0.34 1.05
Philippines 2.26 1.52 0.13 0.46 0.84 7.13 1.13 0.00 1.39 0.08 0.15 0.23 0.00 0.00 -0.06 0.51 0.19 0.55 0.01 0.03
Singapore Indonesia Thailand Philippines
pre-agreement post-agreement pre-agreement post-agreement pre-agreement post-agreement pre-agreement post-agreement
1996 1997 2005 2008 2009 1996 1997 2005 2008 2009 1996 1997 2005 2008 2009 1996 1997 2005 2008 2009
Japan -3.70 152.39 5.49 -1071.3 4.11 N/A N/A 0.02 0.82 0.01 1.09 -3.11 -1.25 0.14 0.57 -5.56 N/A 0.75 1.09 N/A
South Korea 4.83 20.33 2.85 16.28 16.28 N/A N/A 0.11 0.00 0.00 0.05 0.05 0.34 0.07 0.07 0.04 N/A -0.18 16.99 16.99
China 281.91 1345.95 19.65 -1729.2 19.52 N/A N/A 23.77 283.47 4.97 34.66 N/A 18.11 3.19 1.18 N/A N/A 99.95 48.98 30.92
Malaysia 151.20 805.97 9.30 -498.01 3.06 N/A N/A 9.61 N/A N/A 0.30 1.48 10.12 7.07 -9.00 5.02 1.05 4.83 4.83 4.83
Singapore N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A
Indonesia N/A N/A 6.61 -895.54 5.50 N/A N/A 0.19 1.95 1.24 N/A N/A N/A 1.16 0.28
Thailand 34.55 162.23 9.62 -65.70 3.12 N/A N/A 0.29 0.41 -0.22 1.14 5.84 -2.92 7.16 4.92
Philippines 5.43 65.34 0.11 -50.91 0.09 N/A N/A 0.00 0.64 N/A 0.79 1.41 -0.40 0.20 0.00

Source: UNCTAD FDI database, Note: Foreign direct investment (FDI) share is the percentage of regional FDI inflows to total FDI from the
investing region. A higher share indicates a stronger preference for the region and a higher degree of integration

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Table 3 and 4 presents the bilateral trade shares and bilateral Foreign Direct Investment (FDI)
respectively of each ASEAN+3 member countries. The intra-regional trades and investment
have increased during post-agreement periods after several initiatives have been
implemented. China’s trade share with member economies was very low, but it has
substantially increased during the post-agreement period compared to pre-agreement periods.
The deregulation of capital control and regional initiatives contributed to the development of
intra-regional trades. The similar result is reflected on the intra-regional FDI, where most of
the countries’ investments are toward China. The statistics indicate that China is the most
potential investment economy for all of the member economies and so their investment in
Chain is the highest. The cheap labor cost and other low investment costs may explain why
China receives the high investment (Buckley et al, 2007, 2008; Li, et al, 2012) Though China
is the targeted investment country for other members, remaining economies also receive the
significant amount of investment which indicates that the ASEAN+3 member economies are
more integrated during the post-agreement period.

Financial integration and real sectors

The result in Table 5 shows the nexus between financial integration and real economy during
the pre-agreement period. It indicates whether the financial integration influences the real
sectors. The estimated coefficient of financial integration is insignificant in explaining CPI
and unemployment rate. It implies that they do not respond to the change of financial
integration. CPI and Unemployment rate might change by the domestic money supply and
productivity respectively instead of financial integration. The financial markets during the
pre-agreement period are segmented and are not cooperative among the regional economies.
Most of the real economic sectors are influenced by the individual country’s shock, rather
than regional shocks. Hence, the hypotheses H2b and H2d are not supported. Furthermore,
the real economic indicators, money supply, and GDP growth are found negatively correlated
with financial integration. This is an unexpected finding that does not support the hypothesis
of the study. This finding is consistent with that of Sarkar and Amor (2011) who showed an
insignificant relationship between financial integration and GDP growth. However, the
capital outflows can be inferred as a reason of negative relationship between financial
integration and money supply & GDP growth.

Table 5: Findings of GMM estimation: during pre-agreement period

CPI M2 GDP Unemployment
Constant 2.379** 0.051 0.082** 3.020***
(0.024) (0.008) (0.012) (0.000)
Lagged (t-1) 0.562*** 1.009*** 0.670 0.370***
(0.023) (0.000) (0.275) (0.000)
Financial integration -0.011 -0.002** -0.305*** -0.127
(0.880) (0.019) (0.000) (0.670)
# countries 8 8 8 8
# observations 56 56 56 56
Note: the figure is estimated coefficient found on GMM technique. The figure in the parenthesis is the
p-value, where *, ** and *** indicates the 1%, 5%, and 10% level of significance.

The empirical finding during the post-agreement period in Table 6 indicates that financial
integration influences the real economy substantially. The estimated coefficient of financial
integration is positive and significant in explaining the GDP growth. It indicates that financial
integration develops the GDP growth. Financial integration improves the financial systems
and market transparency which attract foreign investment (Bekaert, Harvey, and Lundblad,
2001). The foreign investment resulted from financial integration thus improve the GDP

11 
 
growth. The finding of this study complies with that of Rahman et al (2015) who show a
positive relationship between financial integration and economic growth. Moreover, financial
integration maintains the positive relationship with the consumer price index. It indicates that
increase in financial integration leads to the increase of overall price level. The finding
supports the hypothesis and implies that the financial integration increases the income level
through the creation of additional investment and jobs which perhaps lead to the increase of
price level (Nicolòa and Juvenal, 2014).

Table 6: Findings of GMM estimation: during post-agreement period

CPI M2 GDP Unemployment
Constant 0.071 0.033 3.408 0.447
(0.848) (0.635) (0.000) (0.726)
Lagged (t-1) 0.347* 0.999*** -0.318** 0.938***
(0.071) (0.000) (0.013) (0.000)
Financial integration 0.067** 0.002 0.149** -0.022*
(0.038) (0.277) (0.028) (0.080)
# countries 8 8 8 8
# observations 56 56 56 56
Note: the figure is estimated coefficient found on GMM technique. The figure in the parenthesis is the
p-value, where *, **, and *** indicates the 1%, 5%, and 10% level of significance.

In addition, the estimated coefficient of financial integration is significant and negative in

explaining the unemployment rate. The result indicates that increase of financial integration
reduces the unemployment rate. It explains the employment of local people by the foreign
investment. The financial integration motivates the inflows of foreign investment. It increases
the income level of local people who are employed in the foreign-invested companies and
hence financial integration reduces the unemployment rate (Levchenko, et. al, 2009; Sarkar
and Amor, 2011). Inversely, the result does not have any influence on the money supply
during the post-agreement period. It implies that financial integration does not influence
money supply because foreign capital is invested in such sectors that reduce the employment
rate but does not increase the money supply. The foreign capital may be invested in
constructing roads, hospitals and other welfare sectors that do not increase the money supply,
rather contributes to improving the employment rate, GDP growth, and CPI. The summary of
hypothesis testing is presented in Table 7:

Table 7: Result of hypothesis testing during post-agreement period

Hypothesis Finding
H1: The degree of financial integration has improved during the Supported
post-crisis period.
H2a: Financial integration influences the GDP growth positively Supported
H2b:Financial integration influences the unemployment rate Supported
negatively
H2c: Financial integration influences the money supply positively Not supported
H2d: Financial integration influences the CPI positively  Supported

Discussion of the finding

The empirical finding of this study shows interesting results. The financial integration has a
close relationship with the real economy. Financial markets with lack or weak cointegration
do not influence the real economy, while with higher cointegration influence the real
economy significantly. The result shows that financial markets were not cointegrated during
12 
 
the pre-agreement period in which real economy did not respond to the change of financial
integration. Contrary, the financial markets of ASEAN+3 are cointegrated during the post-
agreement period and have a significant influence on the real economy. The similar finding
can be observed in the study of Leila (2011), Herrmann and Winkler (2009) and
Mmolainyane and Ahmed (2015) who showed the significant relationship between financial
integration and the real economy. This relationship can be explained by Solow-Growth
Model that states that capital accumulation improves the economic growth and overall real
economy (King and Levine, 1993; Kenourgios and Dimitriou, 2014). Financial integration
ensures the free capital movement which improves the income level and contributes to the
long-run growth of the real economy.

The robustness of the findings is tested through autocorrelation, partial autocorrelation,

heteroskedasticity and normality tests (results are available on request). The null hypothesis
of autocorrelation and heteroskedasticity is not rejected which means the models used in this
research are correctly specified. Moreover, Sargan test and second order autocorrelation are
performed in order to justify whether the GMM technique is correctly specified. The null
hypothesis of valid over-identifying restriction is not rejected in any of the variables means
instrumental variables are valid. Furthermore, the null hypothesis of second order hypothesis
of no autocorrelation is not rejected. It indicates that the findings of GMM are free from both
of invalid instrumental identification and autocorrelation.

5. Conclusion
Johansen cointegration test and GMM econometric techniques have been used for two phases
of the investigation. Johansen cointegration test is used for examining the financial
integration among the ASEAN+3 financial markets, while GMM is used to investigate the
nexus between financial integration and the real economy. The findings of the study are as
follows: 1) financial markets of ASEAN+3 are not integrated during the pre-agreement
period; 2) the degree of market integration improves and maintain cointegration relationship
during the post-agreement period; 3) financial integration is found to maintain a close
relationship with real economic sectors. Finally, the majority of the real economic sectors are
found to be significantly influenced by financial integration during the post-agreement period
in which financial markets improves the degree of relationship.

Moreover, this paper offers fruitful policy implications for the regional economies. Since the
financial market integration maintain solid nexus with real economic sectors, this study
strongly recommends the policy makers to develop the financial integration further to
strengthen the real economy. The policy makers can adopt the following suggestions in order
to develop the integration; firstly, relaxation of country-specific barriers on capital markets so
that the intra-regional capital flows smoothly. Secondly, high-income economies of
ASEAN+3 are suggested to play the key role in integrating the other low-income economies
by providing technical and physical assistance. Finally, the ASEAN+3 regional bloc is
suggested to strengthen the regional swap fund to develop the market integration.

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