Economic Integration:
Relationship between trade and financial integrations in ASEAN+3

Charosporn Chalermtiarana
Ph.D. Program
Graduate School of Asia Pacific Studies, Waseda University

The idea of Economic Integration is spreading world-wide in recent years. From the experienceof European Union, steps of integration process have been introduced. First, pursues trade
linkage for enhancing demand and productivities of integrating countries. Then, making wider
access to source of funds for production, members are going forward to support Foreign Direct
Investment (FDI) flows. At present, not only trade and investment financing by FDI, but alsobank credits, and portfolio investment in capital markets are in concern.
Most of the countries Asia, as a huge source of capital of the world at present, are exportoriented which means that the economies of this region are depending on trade. However, theuse of accumulated capital cannot be efficiently used by production activities in the region.
Thus, it is necessary to understand the relationship between trade and finance, what is themechanism of them, in term of Asian framework.

Relationship between international trade and financial sector
The interactions between trade openness, financial integration, specialization, and businesscycle synchronization are complex. In theory, trade both in goods and in financial assets may
affect the cross-country synchronization of business cycles. Intense bilateral trade will tend toaccompany highly correlated business cycles in a wide range of theoretical models, ranging
from multisector international models with intermediate-good trade, to one-sector versions witheither technology or monetary shocks. The impact of financial integration on cycle
synchronization, in turn, is not unambiguous. On the one hand, limited ability to borrow andlend internationally hampers the transfer of resources across countries and can increase GDPcorrelations. But on the other hand, if investors have imperfect information or face liquidity
constrains, limiting capital flows can actually decrease GDP correlations, as investors herd, orwithdraw capital from many destinations simultaneously (Imbs 2004).
In the old time, financial sector started its role when banking system established to be theintermediary of capital flows both as creditor who provides credits to producers and as the placewhere people keep their wealth. It is the same concept when trading expanded throughout theworld. Traders need credits to run their business. At present, there are many financial products

to facilitate international trade such as remittance process which will transfer payment between
countries, Bill of Exchange (B/E) and Letter of Credit (LC) which use as guarantor of payments,etc. At the same time, banks also take a role as the place to store trade surplus, by accumulating
foreign currencies. Besides banking system, there are also alternative for traders to raise funds.
The development of capital markets, bonds and equities, including their derivatives are choices
for business managements while it is also good opportunity for capital owners to invest theirresources.
The needs of international finance on international trade can be shown in theoretical models.
Both Ricardian and Heckscher- Ohlin model can easily show the role of financial sector oninternational trade flows (Beck, 2003). Empirical studies show that direction of trade flows
generally coincide with those of asset flows. To simplify the mechanism by using the concept of
IMF’s Balance of Payment, there are 5 channels that foreign currencies are able to flow into
country, namely current account which presents trade flows, FDI, portfolio investment which
includes bonds and equities, loans from financial institutions, and credits and others from nonfinancial sector. There is theoretical work by Kletzer and Bardhan (1987) showed that evenwhen technology and endowments are identical between countries and economies of scale areabsent, moral hazard considerations in the international credit market under sovereign risk anddifferences between countries in the domestic institutions of credit contract enforcement underincomplete information may lead to one country facing a higher interest rate or rationed credit
compared to another. This may lead to differences in comparative advantage in processed goods
requiring more working capital, market costs, or trade finance. The more sophisticatedmanufactured finished products require more credit to cover selling and distribution. Therefore,
the role of external finance is getting more and more important, in order to facilitate
international trade.
An equilibrium model of Weiss (1980), focused on international trade, payments and asset
flows showed that relationship between asset and changes in the relative prices of consumption
goods of different countries and exchange rates, and return to alternative capital assets, may all
be explained as arising from unexpected changes in the state of long-term expectations in one
country relative to those in its trading partner.
There are many papers studied about the effect of trade integration and financial integration on
economic growth, many of them support that these two parts of economic integration are
helping in promoting growth. Though most of them estimated the effect on growth by eachintegration, it is possible to assume that trade integration and financial integration can work
together to stimulate more growth.
The study of Guerin (2006) found that Regional Trade Agreement (RTAs) helps to reducetransaction cost and geographical patterns of trade and portfolio investment are similar to thoseof FDI.
It is plausible to believe that countries service their foreign debts at least in part to avoid thereduced trade that typically follows international default. By using gravity model to find therelationship between trade and financial credits, Rose and Spiegel (2002) found that there ispositive effect of bilateral trade on bilateral lending patterns and confirmed the hypothesis thatinternational trade patterns determine lending patterns. Debtors tend to borrow more fromcreditors with whom they share more international trade ties. Besides, there is also a significant
effect of increasing 1 percent in trade, bilateral lending increases over 0.5 percent (keep otherthings being equal).

Economic Integration in ASEAN+3
Looking more specifically into Asia, trade integration, known as ASEAN Free Trade Area(AFTA), established in 1992 with main objective to eliminate tariff barriers among member
countries (that meet a 40 percent ASEAN content requirement), by using framework of theCommon Effective Preferential (CEPT), further the aim to integrate Asian economies into asingle production base and expanding market demand. To the extended, the East Asian region
has long enjoyed market-driven integration not only through trade, but also through FDI. Indeed,
FDI reforms in regional countries have contributed to the development of export platforms in
the region.
Intra-regional trade share (to total trade)%4239.39

40
38
36

37.80
37.56

37.33
36.54

37.07

39.58

37.89

39.16

35.37

34

33.15

32
30
28
1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Source: ARIC, ADB

On the other hand, the Asian Financial Crisis raised awareness on two fronts. One, countries
needed to strengthen their domestic financial sectors in order to handle the efficient absorptionof capital inflows and meet the financial intermediation needs of high-growth development.
Two, countries needs to develop the institutional capacity to contain cross-country contagionand resolve common financial problems. Addressing both national and regional aspects offinancial integration will provide additional scope for regional financial cooperation andcoordination (Chow et al, 2005.) Minister of Finance of ASEAN member countries signed

“Ministerial Understanding of ASEAN Cooperation in Finance” in 1997 in order to develop andpromote cooperation in the area of finance for the benefit of members.

Intra-regional Portfolio Investment
3.5

70000

3.11

2.97

32.5

2.51
2.54

60000
50000

2400001.530000

120000

0.5

10000

02001
2002
2003
Total Portfolio Investment Assets, in million US dollars

02004
Portfolio Share, in percentage

Source: ARIC, ADB

The development of economic integration in Asian region is on an expansion trend, both tradeand finance, but they are doing such process separately IMF Working Paper (2006) showed that
intra-regional exports (in percent of GDP) rose from average 17.7 percent during 1985-1991 to28.7 percent during 1999-2004 and intra-regional imports (in percent of GDP) rose from 20.6
percent to 28.7 percent during the same period, while Asia’s international cross-border portfolio
investment is amounted only 2.25 percent of Asia’s GDP in 2004 and also the same small
amount of cross-boarder bank borrowing and lending. Lee (2008) pointed out three constrains ofEast Asian financial integration. First, underdevelopment of financial markets must hinder trade
in regional securities between different economies. Second, to enhance the degree of regional
financial integration, continuous efforts are needed to advance capital control liberalization. The
most important is the deregulations and opening domestic financial systems. It is still true that anumber of countries in East Asia remain behind the capital market liberalization process byrelying frequently on capital controls. Third, lack of financial and monetary cooperation for
exchange rate stabilization among regional currencies causes higher exchange rate volatility that
hampers financial integration. Financial integration in East Asia is much weaker than that inother regions, after controlling for the degree of international trade integration, suggests that
there are other structural and institutional impediments to financial integration that need to beaddressed by policies, particularly designed to promote the growth of Asian financial markets.
The big gap between trade and financial integration showing in Asian region brought a questionthat “Is there any relationship between trade integration and financial integration?” especially in
Asian region, and if there is one as expected, “how to promote financial integration to the samelevel as trade integration?” , to carry to the final result of promoting economic growth within theregion.

As a result of Economic Integration in East Asia, Rana (2006) found that increasing in trade andfinancial integration in region leads to a synchronization of business cycles. Formal analysis ofinterrelationship between trade and financial integration is not possible because of the absenceof data. However, the close nexus between trade and FDI in the region and emerging linkages in
the financial sector suggests that such relationship should be positive.
Also there is a debate on degree of financial integration among East Asian countries. By using
data on level of financial openness, country has financial opening with advanced countries than
one another (Park and Bea, 2002), Contradict with using bond financing and loans syndicateddata which showed that East Asian financial markets are more integrated (McCauley, Fung andGadanecz, 2002).
2001

2002

2003

2004

2005

Trade/bil.USD

1,208

1,335

1,633

2,035

2,321

Ln(trade)

14.0

14.1

14.3

14.5

14.6

Portfolio/bil.USD

85.6

81.2

116.5

147.6

187.9

Ln(Portfolio)

11.4

11.3

11.7

11.9

12.1

By using only ASEAN+3 regional data (source: ARIC, ADB) correlation between intra-regional
trade and intra-regional portfolio investment is about 0.98, high enough to suspect that there isquite close relationship between trade integration and financial integration in this region.
However, there is no strong evidence showing the linking and how these two integration work at
the same time.

Methodology
To examine the relationships between trade integration and financial integration among member
countries by using bilateral data, the gravity model is the selected approach. Many studies
support this model for its ability on explaining bilateral trade and financial flows such as Portes
and Rey (2005), and Shin and Yang (2006) etc.
The ordinary gravity model explanatory variables are income (GDP) of ASEAN+3 member
countries, population, and geographical distance between countries. This research uses modelshowing in Lee (2008) as a base model. To the extent of estimating trade integration andfinancial integration effects on each other, the basic equations of this research are as follow;
ln(Portfij)=β0+β1ln (GDPi)+β2ln(GDPj) +β3ln(GDPi/Popi)+β4(GDP j/Popj)+β5lnDistij+ β6Borderij +β7ln(Tradeij) + δYeart+εij(1)ln(Tradeij)=β0+β1ln (GDPi)+β2ln(GDPj) +β3ln(GDPi/Popi)+β4(GDP j/Popj)+
β5lnDistij+ β6Borderij +β7ln(Portfij) + δYeart+εij(2)Where i and j denote economies, Portfij denotes bilateral portfolio investment from country i tocountry j, Tradeij denotes bilateral trade from country i to country j, GDP is real GDP, Pop ispopulation, Dist is the distance between i and j, Border is a binary variable which is unify if iand j share land border.
The observation group is datasets of ASEAN+3 member countries. Noted that, financial
integration normally can be divided in 4 parts, FDI, cross-border credits, cross-border portfolio
investment, and exchange rate cooperation, there is a limitation of representative variable. In thefirst step, this research selected bilateral portfolio investment dataset to run the regression.
To examine the inter-link, the first equation focuses on estimation of bilateral trade effects onbilateral portfolio investment, while the second equation estimates the effect of bilateral
portfolio investment on trade.
The model uses portfolio investment dataset from IMF’ Coordinated Portfolio Investment
Survey (CPIS), bilateral trade from IMF’s International Financial Statistics (IFS), GDP andpopulation datasets from World Bank statistics, and the other variables from Rose and Spiegel(2004). The period that will be examine in this research is from 2001 to 2005 due to thelimitation of portfolio investment data which began to collect in 1997 for the first time andstarted annual collection in 2001 onwards.

Regression Result
In this research, the tests have been conducted yearly without concerning on lagging effect fromindependent variables. There is possibility that explanation power may include endogenous ticproblem. Besides the result from 2001 information, the regressions showed that both bilateral
trade and bilateral portfolio investment affect on each other. The more bilateral trade increases,
the more bilateral portfolio investment rises and vice versa. However, the change in bilateral
trade affects on more than 50 percent of bilateral portfolio investment while bilateral portfolio
investment change affects less than 20 percent of the change of bilateral trade. These results canbe implied that bilateral trade and bilateral portfolio investment have positive relation between
each other, especially the link from trade to portfolio investment. On the other hand, it seems
that bilateral portfolio investment has some influence on bilateral trade but there are also someother factors that will effect bilateral trade more.

Regression Result
Equation (1)R-squared
Adjusted R-squareStandard Error
Equation (2)R-squared
Adjusted R-squareStandard Error

Regression Result
Equation (1) ln(trade)
2001
2002
2003
2004
2005
Equation (2) ln(Proft)
2001
2002
2003
2004
2005

2001

2002

2003

2004

2005

0.823249 0.815811 0.753015 0.737332 0.693997
0.800753 0.792787 0.724673 0.708147 0.658882
1.453205 1.329066 1.75418 1.864969 1.836788
0.792296 0.821643 0.799827 0.769041 0.709484
0.765861 0.799349 0.776856 0.743379 0.676147
0.533297 0.582184 0.589417 0.708173 0.74607

Coefficient

Std. Error

t-Statistic

Prob.

0.361005095
0.79288283
0.737756088
0.984575319
0.971313739

0.364193042
0.286073905
0.369160436
0.307728522
0.289650872

0.991246544
2.771601381
1.998470082
3.199493221
3.353394842

0.325906233
0.007558014
0.050128195
0.002156388
0.001375985

0.048618014
0.152137884
0.08329329
0.141965998
0.160250913

0.049047348
0.05489169
0.041678528
0.044371401
0.047787666

0.991246544
2.771601381
1.998470082
3.199493221
3.353394842

0.325906233
0.007558014
0.050128195
0.002156388
0.001375985

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