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Measuring time-varying capital mobility in East Asia
China Economic Review 15 (2004) 281 – 291
Measuring time-varying capital mobility in East Asia Lixing SUN Institute of Policy and Planning Sciences, University of Tsukuba, Tsukuba, Japan Accepted 16 July 2003
Abstract This paper examines the dynamic capital mobility in East Asia’s newly industrialized economies (NIEs). We propose an alternative measure of capital mobility based on an intertemporal current account model that is developed by Shitaba and Shintani [J. Int. Money Financ. 17 (1998) 741]. We present the time-varying parameter estimates to illustrate the different processes of financial liberalization in these developing countries. The results indicate that capital is much more mobile over time, corresponding to the liberalization policies. Our findings are sharply in contrast to the previous studies, which show the lower degree of capital mobility either in developed or in developing countries. D 2003 Elsevier Inc. All rights reserved. JEL classification: C22; D91; F32 Keywords: Capital mobility; Intertemporal current account model; Kalman filter technique; NIEs
1. Introduction International capital mobility is a well-documented phenomenon after financial deregulation and capital account liberalization pursued in developing countries since 1980s. Increasing integration of capital markets has promoted the surge of private capitals of developed countries inflowing to developing countries. Capital inflows stimulate investment and economic growth in the recipient countries, allow intertemporal smoothing in consumption, and thus raise welfare across countries. At the same time, they also increase the vulnerability of the recipients to a sudden reversal of capital inflows. Therefore, how to investigate the evolution and magnitude of capital movements has become more and more prominent in light of the debates regarding the optimal response to capital inflows in East Asia after the recent Asian crisis.
E-mail address: [email protected] (L. Sun). 1043-951X/$ - see front matter D 2003 Elsevier Inc. All rights reserved. doi:10.1016/j.chieco.2003.07.003
282
L. Sun / China Economic Review 15 (2004) 281–291
Several papers have focused on how to measure the degree of international capital mobility. As pointed out by Frankel (1992), Montiel (1993), and Obstfeld (1995), two major measurements have been frequently used in the existing literature. One is to compare the correlation between national saving and investment rates, and the other is to compare the returns on financial assets in different countries. In a seminal paper, Feldstein and Horioka (1980) propose that if international capital markets are well integrated, the saving –investment correlation should be low, because investments can be financed by foreign savings. On the contrary, the correlation will be high under the low capital mobility, because domestic investments have to be financed by domestic savings in this case. Low mobility will occur when there are risks involved in investing abroad and official restrictions on capital movements. Feldstein and Horioka (1980) and their followers find statistically significant, large positive correlations between saving and investment rates for OECD countries, both in cross-section and in time-series studies.1 According to their arguments, these findings are strong evidences against the null hypothesis of perfect capital mobility, namely, the mobility is considered to be low. Baxter and Crucini (1993) and Obstfeld and Rogoff (1996), among others, have listed several skeptical arguments against the validity of interpreting the correlation between saving and investment rates as a measurement of the degree of capital mobility.2 Feldstein and Horioka’s (1980) approach is not explicitly based on a theoretical model, because the saving – investment regressive equation cannot be directly derived from a theoretical model. Therefore, the saving– investment correlation is difficult to make an obvious economic interpretation for capital mobility. We need a theoretical model to measure the degree of capital mobility. In addition to Feldstein and Horioka’s (1980) approach, the degree of capital mobility is also examined by interest rate arbitrage, which focuses on the relationship between capital flows and interest rate differentials, because international movements will equalize the return between domestic and foreign assets of the same type, eventually. Chinn and Frankel (1994), Marston (1995), and Obstfeld and Taylor (1998) have utilized the covered interest differential measurement and shown a higher degree of the capital mobility in developed countries. Unfortunately, forward exchange rate markets are either extremely sparse or nonexistent in most developing countries, so we cannot use the covered interest differential measurement, but have to use the uncovered interest rate arbitrage instead. Edwards and Khan (1985) present a theoretical model that postulates the domestic market-clearing interest rate to be a weighted average of the hypothetical interest rate under the perfectly open case and the hypothetical interest rate under the financial autarky.3 The weight parameter serves as an index of capital mobility. The hypothetical interest rate under financial autarky is derived from the money market equilibrium 1 See Dooley, Frankel, and Mathieson (1987), Bayoumi (1990), and Tesar (1991) for cross-country studies, and Frankel (1986) and Obstfeld (1986), among others, for time-series studies. 2 For the detailed interpretation of SI correlation, see Obstfeld and Rogoff (1996, pp. 162 – 163). 3 For more detailed explanations of interest rate determination identity, see Edwards and Khan (1985) and Haque and Montiel (1990).
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condition under that hypothetical situation. The uncovered interest parity condition is used to derive the hypothetical interest rate under the perfectly open case. Reisen and Yeches (1993) have extended this method to include a risk premium and applied their method to the Republic of Korea and Taiwan by using time-varying parameter estimation. Their findings indicate a low degree of capital mobility for both countries and no trend toward more financial openness in Korea during 1980s. The possible reason for the low degree of capital mobility is that their estimated results are based on the use of the actual depreciation rate to replace the expected depreciation, so they do not account for ex ante uncertainty of exchange rate. The actual ex post uncovered interest differential can be decomposed into the covered interest differential, exchange rate risk premium, and forecast error.4 Only when the exchange rate market is efficient will the forecast error have an expected value equal to zero. Therefore, under their perfect foresight measurement of the depreciation rate, the forecast error problem would be found easily. The interest rate determination approach has been widely used to examine international financial integration by evaluating the cross-border interest rate linkage. However, the macroeconomic impact of international financial integration also depends on the extent of domestic financial integration, that is, the integration of domestic institutional interest rates such as deposit and lending rates with domestic money market rates. As noted by Chinn and Dooley (1995), most empirical studies examining money market rates linkage lead to a false inference, because a large quantity of foreign capitals to domestic firms is mediated through domestic bank lending, and the bank lending rate might be independent in East Asia with regulated domestic financial markets. In this sense, we also need an alternative model to measure dynamic capital mobility to reflect the process of capital account liberalization and domestic financial deregulation. Shitaba and Shintani (1989) present such an alternative measure based on an intertemporal capital account model. They apply the basic idea of life-cycle permanent income hypothesis in the closed economy to the open economy. They assume two hypothetical cases in a small economy. One is a case of financial autarky (abbreviated to FA), where the representative agent consumes the country’s net output for a specific period. The other is a case of perfect international capital mobility (abbreviated to PM), where the representative agent chooses the net foreign asset optimally to maximize lifetime utility. Actual consumption is assumed to be a weighted average of consumption in these two extreme cases. The weight parameter is defined as the degree of capital mobility. Their approach primarily characterizes the intertemporal optimal behavior of private consumption. As the openness in both capital account and domestic financial system is necessary for consumers to be able to smooth out their consumptions over time, the approach, in this regard, is a more appropriate measurement of capital mobility corresponding to the liberalization policies adopted by the individual governments. Shitaba and Shintani (1989) apply the model to OECD countries by using general method of moments (GMM), but they find a low degree of capital mobility in some developed countries including the United States and Japan.
4
i ius Ds=(i ius fd)+(fd Dse)+(Dse Ds), where (Dse Ds) denotes forecast error.
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L. Sun / China Economic Review 15 (2004) 281–291
In this paper, we use the intertemporal current account model to the developing countries because the small country assumption used in the model is more likely to be satisfied in the developing countries rather than in the developed countries. Instead of the constant parameter estimation, we use Kalman filter technique in the analysis. Ogawa (1990) also used the same technique to show the time-varying estimates on the fraction of liquidity-constrained households in the context of a closed economy permanent income model, which reflects the cyclical fluctuation in Japan, but we present time-varying estimates to show the dynamic development of capital mobility in small open economies, that is, East Asia’s newly industrialized economies (NIEs) in the study. Furthermore, we attempt to illustrate the different extents to financial liberalization in these countries by a comparison of their estimates. This paper is organized as follows. Section 2 outlines the theoretical model and econometric methodology. Section 3 describes the data briefly. Section 4 reports the estimation results. Section 5 presents the concluding remarks.
2. The model and empirical methodology The alternative dynamic model, which is based on the intertemporal optimization of the representative agent’s behavior, is postulated by Shitaba and Shintani (1989). They consider two hypothetical cases, that is, perfect international capital mobility and financial autarky of a small country. In the extreme case of perfectly international capital mobility, they assume the representative agent to maximize the lifetime utility function with respect to net foreign asset, subject to the country’s budget constraint in a small open economy. The optimal consumption behavior of the representative agent follows the permanent income model. In the other extreme case of financial autarky, they assume that the representative agent’s consumption to be restricted by national current net output. The actual situation is supposed to be somewhere between the above two extreme cases of hypothetical perfect capital mobility and the hypothetical financial autarky. In other words, this case implies that capital is mobile but not perfectly so across countries. Accordingly, the actual consumption of the representative agent is shown as follows. Ct ¼ ð1 kÞCtp þ kCta ¼ ð1 kÞCtp þ kXt
ð1Þ
where Ctp, Cta, Xt are consumption under perfect capital mobility, consumption under financial autarky and the country’s net output, respectively. X t is defined as Xt u Yt It Gt. k is considered to represent the degree of international capital mobility (0 V k V 1). In the extreme case of k = 0, Ct coincides with Ctp so that the consumption behavior of the representative agent becomes that of the PM agent. In the other extreme case of k = 1, Cta coincides with Xt so that the consumption behavior of the representative agent becomes that of the PA agent. Thus, the more freely the capital moves internationally, the smaller is the value of k.
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In order to eliminate an unobservable term, Ctp, in Eq. (1), they derive the following equation from examining the change in aggregate consumption. DCt ¼ ð1 kÞet þ kDXt
ð2Þ
This is the estimation equation in our paper. In order to obtain a series of time-varying estimates for k, as well as (1 k), we apply the Kalman filter recursive procedure into Eq. (2) as follows. DCt ¼ kt DXt þ lt
ð3Þ
where lt=(1 kt)et. The Kalman filter method requires a priori specification of the movement of the timevarying parameter. We assume the following simple transitional process. kt ¼ Akt1 þ gt
ð4Þ
In the following empirical analysis, the parameter A is assumed to be 1.
3. Sample countries and the data We choose NIEs—the Republic of Korea, Hong Kong, Taiwan, and Singapore—as our sample countries in the paper. We are interested in these countries because NIEs have implemented significant capital account liberalization and domestic financial deregulation during the last two decades. A large number of empirical studies have paid much attention to measure the degree of capital mobility in these countries, but the findings are quite different. This paper attempts to compare our empirical findings derived from the alternative dynamic model with those of previous studies. We discuss our time-varying estimates corresponding to the evolution of liberalization policies adopted by the individual governments in these countries to verify the reliability of our method.
Table 1 Tests for a unit root Countries
Korea Hong Kong Taiwan Singapore a
Sample period
1980:1 1986:1 1981:1 1985:1
1997:4 1997:4 1997:4 1997:4
Augmented Dickey – Fuller test
Phillips – Perron test a
DX
DC
DX
DC
9.09550** 14.4443** 13.43891** 5.38119**
10.30228** 7.07643** 7.05956** 3.76236**
12.79584** 7.09879** 8.27608** 2.77744
8.37578** 10.01673** 42.39995** 2.09970
The critical values for sample size 50 at 1% and 5% significance levels are 3.58 and 2.93, respectively (Enders, 1995, p. 419). ** Significant at the 1% level for a one-sided test.
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The data are quarterly.5 All the data, except for Taiwan, are obtained from the IMF’s International Financial Statistics, December 1998 (CD-ROM). Taiwan’s quarterly data are available from the national statistical web site of Bureau of Statistics, Taiwan, the Republic of China. The sample period for each country differs, depending on the availability of the data, as shown in Table 1.
4. Empirical findings As noted above, this paper aims to present the time-varying estimates of the degree of capital mobility in NIEs. From our estimates, we attempt to show how freely the capital moves internationally and reveal the different degree of capital mobility in the region. We interpret our empirical results corresponding to the development of domestic financial market reforms and policy responses to capital flows, which have been implemented by individual governments in these sample countries. At the start, we perform a unit root test to check whether the data series for explained and explanatory variables in Eq. (2) is stationary. We use two different types of unit root tests proposed originally by Dickey and Fuller (1979) and later by Phillips and Perron (1988). The results of the tests are shown in Table 1. The results appear to reject the null hypothesis of a unit root for all the variables.6 Thus we can assume that these variables are stationary. Next, we estimate the parameter k in Eqs. (3) and (4), and then present the time-varying parameter estimates, which correspond to 1 k rather than k in Figs. 1 – 4. As explained before, a larger value of k represents a lower degree of capital mobility, so our figures intuitively illustrate the exact extent of dynamic capital mobility, that is, 1 k, in these sample countries. Also, we plot Ordinary Least Squares (OLS) constant parameter estimates with 95% approximate intervals based on the assumption of normal distribution to examine the significant variability of capital mobility roughly over the observation period. Our empirical findings can be summarized as follows. It becomes clear, from the results of the Kalman filter estimation, that the capital mobility has increased significantly in East Asia. As has been well known, Singapore and Hong Kong are two of the most financially developed economies in East Asia, except for Japan. Our results just indicate a higher degree of capital mobility in Singapore than in others, although Hong Kong does not show a high degree as expected until early 1990s. It is not surprising, because domestic banking industry was cartelized until 1995 and domestic deposit and loan rates segmented somewhat from international and domestic monetary markets in Hong Kong.
5 The annual data frequency for Singapore is changed to quarterly data by using RATS source command ‘‘Distrib.src,’’ since the quarterly data are not available. 6 Ambiguous results for Singapore’s data have been found. The result of the augmented Dickey – Fuller test appears to reject the null hypothesis of a unit root at 1% significant level, whereas the result of the Phillips – Perron test fails to reject the null hypothesis even at 5%. Nonetheless, we assume the data are approximately stationary.
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Fig. 1. The degree of capital mobility in Republic of Korea.
The degree of capital mobility seems to be lower in Taiwan, which might imply that repressed domestic financial systems and controls on the capital account are stronger than those of other sample countries during our sample period. The structural change in capital mobility has been found at 1989– 1990. Our findings can be explained by the effects of Taiwan’s financial reforms, such as the liberalization of domestic interest rates implemented in 1989.
Fig. 2. The degree of capital mobility in Hong Kong.
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Fig. 3. The degree of capital mobility in Taiwan.
As for the Republic of Korea, the degree of capital mobility has increased gradually since the early 1980s, and remained at a higher level during the second half of the 1980s. In contrast to our findings, Reisen and Yeches (1993) show a declined trend in capital mobility since the mid-1980s in Korea. Besides the difference between their approach and ours, the plausible reason for the lower degree of capital mobility derived from their
Fig. 4. The degree of capital mobility in Singapore.
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empirical analysis might be that they use an ex post actual depreciation rate to measure the expected foreign return in the interest rate determination model. As mentioned earlier, the forecast error problem may easily arise in the case. Furthermore, we find that the degree of capital mobility in Korea seems to show a little stagnation during the early 1990s and a sharp increase since 1995. We might interpret it as follows. During the early 1990s, the Republic of Korea faced a surge of capital inflows. The monetary authorities took various measures to sterilize the expansionary effect of capital inflows on the growth of monetary aggregates, which caused an increase in domestic interest rates.7 The increasing level of nominal interest rates thus deteriorated domestic financial liberalization. On the other hand, the structural change of capital mobility in the mid-1990s might be attributed to the implementation of the ‘‘Three-Step Financial Market Reform Plan,’’ which was issued by Korea’s government at the end of 1993. In particular, with the aim of participating in the OECD organization in 1996, further liberalization of domestic financial system and capital account proceeded faster in the mid-1990s.
5. Concluding remarks This paper has used an intertemporal current account model (developed by Shitaba and Shintani, 1989) of a small open economy to measure the degree of capital mobility. Shitaba and Shintani (1989) used the model for developed countries and present the constant parameter estimates of the degree of capital mobility by using GMM. However, few studies have been made to use this model to measure the degree of capital mobility in developing countries. In the study, we apply it to East Asian developing countries. Specifically, we use Kalman filter technique to present the time-varying parameter estimates of the degree of capital mobility in NIEs. Our time-varying parameter estimates illustrate the different processes of capital accounts and domestic financial liberalization in the region. Our empirical results indicate that the degree of capital mobility has been increasing substantially in these countries. A high degree of capital mobility is shown in Singapore, Hong Kong, and the Republic of Korea, whereas the degree of capital mobility in Taiwan appears to be a little lower. The findings imply that financial regulation and capital controls still remain a fair characteristic in Taiwan during the analysis periods. On the other hand, the results also suggest that liquidity constraints have eased greatly in the other countries, as a result of financial deregulation and capital account openness. It should be noted that the intertemporal current account model used in the analysis is supposed to be used to examine the case for nondurable consumption because the model is derived from the life-cycle permanent income hypothesis, which implies that consumption follows a random walk. However, consumption expenditures on durables do not exhibit a random walk behavior. In the analysis, we measure aggregate consumption including expenditure on durable goods because the data for nondurable consumption only are not available. It may create a bias for our estimates somewhat; nevertheless, the share of
7
For example, monetary stabilization bonds (MSBs) was actively issued in 1993.
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durable consumption in total households’ consumption is considered to be small in these developing countries. Iscan (2002) has extended the model by explicitly introducing durable goods into it. The extended version implies that a permanent decrease in net output leads to a decline in aggregate consumption and a temporary current account surplus, whereas the baseline model suggests it has no impact on the current account, because nondurable consumption is less sensitive to net output under perfect capital mobility. Their empirical analysis for Canada indicates that the extended model appears to improve the performance of the baseline model by using annual data; nevertheless, for quarterly data with a shorter time period, none of the models’ performance is decidedly superior as they noted. Our further research can focus on how to apply the extended model to make robust our empirical analysis in the paper.
Acknowledgements The author is particularly indebted to Makoto Ohta for his insightful discussions. Eiji Fujii, Elliott Parker, and two anonymous referees are also gratefully acknowledged for their valuable and helpful comments and suggestions. The views expressed in the paper, along with any remaining errors, are entirely those of the author.
References Baxter, M., & Crucini, M. J. (1993). Explaining savings – investment correlations. American Economic Review, 83, 416 – 436. Bayoumi, T. (1990). Saving – investment correlations: Immobile capital, government policy, or endogenous behavior? IMF Staff Papers, 37, 360 – 387. Chinn, M. D., & Dooley, P. (1995). Asia-Pacific capital markets: Measurement of integration and the implications for economic activity. NBER Working Paper, 5280, 1 – 37. Chinn, M. D., & Frankel, F. A. (1994). Financial links around the Pacific Rim: 1982 – 1992. In R. Glick, & M. Hutchison (Eds.), Exchange rate policy and interdependence perspectives from the Pacific Basin ( pp. 17 – 47). Cambridge, New York, Melbourne: Cambridge University Press. Dickey, D., & Fuller, W. (1979). Distribution of the estimators for autoregressive time series with a unit root. Journal of American Statistic Association, 74, 427 – 431. Dooley, P., Frankel, J., & Mathieson, D. (1987). International capital mobility—what do saving – investment correlations tell us? IMF Staff Papers, 34, 503 – 530. Edwards, S., & Khan, M. S. (1985). Interest rate determination in developing countries: A conceptual framework. IMF Staff Papers, 32, 377 – 403. Enders, W. (1995). Applied econometric time series. New York: John Wiley & Sons. Feldstein, M., & Horioka, C. (1980). Domestic saving and international capital flows. Economic Journal, 90, 314 – 329. Frankel, J. (1986). International capital mobility and crowding-out in the US economy: Imperfect integration of financial markets or of good markets? In R. Hafer (Ed.), How open is the US economy? (pp. 33 – 67). Federal Reserve Bank of St. Louis. Lexington, Mass., and Toronto: Health, Lexington Books. Frankel, J. (1992). Measuring international capital mobility: A review. American Economic Review, AEA Papers and Proceedings, 82, 197 – 202. Haque, N. U., & Montiel, P. (1990). Capital mobility in developing countries: Some empirical tests. IMF Working Paper, 117, 1 – 29.
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Iscan, T. B. (2002). Present value tests of the current account with durables consumption. Journal of International Money and Finance, 21, 385 – 412. Marston, R. C. (1995). International financial integration: A study of interest differentials between the major industrial countries. Japan-U.S. Center Sanwa Monographs on International Financial Markets. Cambridge, New York, Melbourne: Cambridge University Press. Montiel, P. (1993). Capital mobility in developing countries: Some measurement issues and empirical estimates. World Bank Debt and International Finance Policy Research, Working Paper, 1103, 1 – 33. Obstfeld, M. (1986). Capital mobility in the world economy: Theory and measurement. Carnegie – Rochester Conference Series on Public Policy, 24, 55 – 103. Obstfeld, M. (1995). International capital mobility in the 1990s. In P. B. Kenen (Ed.), Understanding interdependence: The macroeconomics of the open economy ( pp. 201 – 261). Princeton: Princeton University Press. Obstfeld, M., & Rogoff, K. (1996). Foundations of international macroeconomics. Cambridge, Mass., London: MIT Press. Obstfeld, M., & Taylor, A. (1998). The great depression as a watershed: International capital mobility over the long-run. In M. D. Bordo, C. Goldin, & E. N. White (Eds.), The defining moment: The great depression and the American economy in the twentieth century. NBER Project Report series ( pp. 353 – 402). Chicago and London: University of Chicago Press. Ogawa, K. (1990). Cyclical variations in liquidity-constrained consumers: Evidence from macro data in Japan. Journal of Japanese and International Economies, 4, 173 – 193. Phillips, P., & Perron, P. (1988). Testing for a unit root in time series regression. Biometrica, 75, 335 – 346. Reisen, H., & Yeches, H. (1993). Time-varying estimates on the openness of the capital account in Korea and Taiwan. Journal of Development Economics, 41, 285 – 305. Shitaba, A., & Shintani, M. (1998). Capital mobility in the world economy: An alternative test. Journal of International Money and Finance, 17, 741 – 756. Tesar, L. (1991). Saving, investment and international capital flows. Journal of International Economics, 31, 55 – 78.
Measuring time-varying capital mobility in East Asia Lixing SUN Institute of Policy and Planning Sciences, University of Tsukuba, Tsukuba, Japan Accepted 16 July 2003
Abstract This paper examines the dynamic capital mobility in East Asia’s newly industrialized economies (NIEs). We propose an alternative measure of capital mobility based on an intertemporal current account model that is developed by Shitaba and Shintani [J. Int. Money Financ. 17 (1998) 741]. We present the time-varying parameter estimates to illustrate the different processes of financial liberalization in these developing countries. The results indicate that capital is much more mobile over time, corresponding to the liberalization policies. Our findings are sharply in contrast to the previous studies, which show the lower degree of capital mobility either in developed or in developing countries. D 2003 Elsevier Inc. All rights reserved. JEL classification: C22; D91; F32 Keywords: Capital mobility; Intertemporal current account model; Kalman filter technique; NIEs
1. Introduction International capital mobility is a well-documented phenomenon after financial deregulation and capital account liberalization pursued in developing countries since 1980s. Increasing integration of capital markets has promoted the surge of private capitals of developed countries inflowing to developing countries. Capital inflows stimulate investment and economic growth in the recipient countries, allow intertemporal smoothing in consumption, and thus raise welfare across countries. At the same time, they also increase the vulnerability of the recipients to a sudden reversal of capital inflows. Therefore, how to investigate the evolution and magnitude of capital movements has become more and more prominent in light of the debates regarding the optimal response to capital inflows in East Asia after the recent Asian crisis.
E-mail address: [email protected] (L. Sun). 1043-951X/$ - see front matter D 2003 Elsevier Inc. All rights reserved. doi:10.1016/j.chieco.2003.07.003
282
L. Sun / China Economic Review 15 (2004) 281–291
Several papers have focused on how to measure the degree of international capital mobility. As pointed out by Frankel (1992), Montiel (1993), and Obstfeld (1995), two major measurements have been frequently used in the existing literature. One is to compare the correlation between national saving and investment rates, and the other is to compare the returns on financial assets in different countries. In a seminal paper, Feldstein and Horioka (1980) propose that if international capital markets are well integrated, the saving –investment correlation should be low, because investments can be financed by foreign savings. On the contrary, the correlation will be high under the low capital mobility, because domestic investments have to be financed by domestic savings in this case. Low mobility will occur when there are risks involved in investing abroad and official restrictions on capital movements. Feldstein and Horioka (1980) and their followers find statistically significant, large positive correlations between saving and investment rates for OECD countries, both in cross-section and in time-series studies.1 According to their arguments, these findings are strong evidences against the null hypothesis of perfect capital mobility, namely, the mobility is considered to be low. Baxter and Crucini (1993) and Obstfeld and Rogoff (1996), among others, have listed several skeptical arguments against the validity of interpreting the correlation between saving and investment rates as a measurement of the degree of capital mobility.2 Feldstein and Horioka’s (1980) approach is not explicitly based on a theoretical model, because the saving – investment regressive equation cannot be directly derived from a theoretical model. Therefore, the saving– investment correlation is difficult to make an obvious economic interpretation for capital mobility. We need a theoretical model to measure the degree of capital mobility. In addition to Feldstein and Horioka’s (1980) approach, the degree of capital mobility is also examined by interest rate arbitrage, which focuses on the relationship between capital flows and interest rate differentials, because international movements will equalize the return between domestic and foreign assets of the same type, eventually. Chinn and Frankel (1994), Marston (1995), and Obstfeld and Taylor (1998) have utilized the covered interest differential measurement and shown a higher degree of the capital mobility in developed countries. Unfortunately, forward exchange rate markets are either extremely sparse or nonexistent in most developing countries, so we cannot use the covered interest differential measurement, but have to use the uncovered interest rate arbitrage instead. Edwards and Khan (1985) present a theoretical model that postulates the domestic market-clearing interest rate to be a weighted average of the hypothetical interest rate under the perfectly open case and the hypothetical interest rate under the financial autarky.3 The weight parameter serves as an index of capital mobility. The hypothetical interest rate under financial autarky is derived from the money market equilibrium 1 See Dooley, Frankel, and Mathieson (1987), Bayoumi (1990), and Tesar (1991) for cross-country studies, and Frankel (1986) and Obstfeld (1986), among others, for time-series studies. 2 For the detailed interpretation of SI correlation, see Obstfeld and Rogoff (1996, pp. 162 – 163). 3 For more detailed explanations of interest rate determination identity, see Edwards and Khan (1985) and Haque and Montiel (1990).
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condition under that hypothetical situation. The uncovered interest parity condition is used to derive the hypothetical interest rate under the perfectly open case. Reisen and Yeches (1993) have extended this method to include a risk premium and applied their method to the Republic of Korea and Taiwan by using time-varying parameter estimation. Their findings indicate a low degree of capital mobility for both countries and no trend toward more financial openness in Korea during 1980s. The possible reason for the low degree of capital mobility is that their estimated results are based on the use of the actual depreciation rate to replace the expected depreciation, so they do not account for ex ante uncertainty of exchange rate. The actual ex post uncovered interest differential can be decomposed into the covered interest differential, exchange rate risk premium, and forecast error.4 Only when the exchange rate market is efficient will the forecast error have an expected value equal to zero. Therefore, under their perfect foresight measurement of the depreciation rate, the forecast error problem would be found easily. The interest rate determination approach has been widely used to examine international financial integration by evaluating the cross-border interest rate linkage. However, the macroeconomic impact of international financial integration also depends on the extent of domestic financial integration, that is, the integration of domestic institutional interest rates such as deposit and lending rates with domestic money market rates. As noted by Chinn and Dooley (1995), most empirical studies examining money market rates linkage lead to a false inference, because a large quantity of foreign capitals to domestic firms is mediated through domestic bank lending, and the bank lending rate might be independent in East Asia with regulated domestic financial markets. In this sense, we also need an alternative model to measure dynamic capital mobility to reflect the process of capital account liberalization and domestic financial deregulation. Shitaba and Shintani (1989) present such an alternative measure based on an intertemporal capital account model. They apply the basic idea of life-cycle permanent income hypothesis in the closed economy to the open economy. They assume two hypothetical cases in a small economy. One is a case of financial autarky (abbreviated to FA), where the representative agent consumes the country’s net output for a specific period. The other is a case of perfect international capital mobility (abbreviated to PM), where the representative agent chooses the net foreign asset optimally to maximize lifetime utility. Actual consumption is assumed to be a weighted average of consumption in these two extreme cases. The weight parameter is defined as the degree of capital mobility. Their approach primarily characterizes the intertemporal optimal behavior of private consumption. As the openness in both capital account and domestic financial system is necessary for consumers to be able to smooth out their consumptions over time, the approach, in this regard, is a more appropriate measurement of capital mobility corresponding to the liberalization policies adopted by the individual governments. Shitaba and Shintani (1989) apply the model to OECD countries by using general method of moments (GMM), but they find a low degree of capital mobility in some developed countries including the United States and Japan.
4
i ius Ds=(i ius fd)+(fd Dse)+(Dse Ds), where (Dse Ds) denotes forecast error.
284
L. Sun / China Economic Review 15 (2004) 281–291
In this paper, we use the intertemporal current account model to the developing countries because the small country assumption used in the model is more likely to be satisfied in the developing countries rather than in the developed countries. Instead of the constant parameter estimation, we use Kalman filter technique in the analysis. Ogawa (1990) also used the same technique to show the time-varying estimates on the fraction of liquidity-constrained households in the context of a closed economy permanent income model, which reflects the cyclical fluctuation in Japan, but we present time-varying estimates to show the dynamic development of capital mobility in small open economies, that is, East Asia’s newly industrialized economies (NIEs) in the study. Furthermore, we attempt to illustrate the different extents to financial liberalization in these countries by a comparison of their estimates. This paper is organized as follows. Section 2 outlines the theoretical model and econometric methodology. Section 3 describes the data briefly. Section 4 reports the estimation results. Section 5 presents the concluding remarks.
2. The model and empirical methodology The alternative dynamic model, which is based on the intertemporal optimization of the representative agent’s behavior, is postulated by Shitaba and Shintani (1989). They consider two hypothetical cases, that is, perfect international capital mobility and financial autarky of a small country. In the extreme case of perfectly international capital mobility, they assume the representative agent to maximize the lifetime utility function with respect to net foreign asset, subject to the country’s budget constraint in a small open economy. The optimal consumption behavior of the representative agent follows the permanent income model. In the other extreme case of financial autarky, they assume that the representative agent’s consumption to be restricted by national current net output. The actual situation is supposed to be somewhere between the above two extreme cases of hypothetical perfect capital mobility and the hypothetical financial autarky. In other words, this case implies that capital is mobile but not perfectly so across countries. Accordingly, the actual consumption of the representative agent is shown as follows. Ct ¼ ð1 kÞCtp þ kCta ¼ ð1 kÞCtp þ kXt
ð1Þ
where Ctp, Cta, Xt are consumption under perfect capital mobility, consumption under financial autarky and the country’s net output, respectively. X t is defined as Xt u Yt It Gt. k is considered to represent the degree of international capital mobility (0 V k V 1). In the extreme case of k = 0, Ct coincides with Ctp so that the consumption behavior of the representative agent becomes that of the PM agent. In the other extreme case of k = 1, Cta coincides with Xt so that the consumption behavior of the representative agent becomes that of the PA agent. Thus, the more freely the capital moves internationally, the smaller is the value of k.
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In order to eliminate an unobservable term, Ctp, in Eq. (1), they derive the following equation from examining the change in aggregate consumption. DCt ¼ ð1 kÞet þ kDXt
ð2Þ
This is the estimation equation in our paper. In order to obtain a series of time-varying estimates for k, as well as (1 k), we apply the Kalman filter recursive procedure into Eq. (2) as follows. DCt ¼ kt DXt þ lt
ð3Þ
where lt=(1 kt)et. The Kalman filter method requires a priori specification of the movement of the timevarying parameter. We assume the following simple transitional process. kt ¼ Akt1 þ gt
ð4Þ
In the following empirical analysis, the parameter A is assumed to be 1.
3. Sample countries and the data We choose NIEs—the Republic of Korea, Hong Kong, Taiwan, and Singapore—as our sample countries in the paper. We are interested in these countries because NIEs have implemented significant capital account liberalization and domestic financial deregulation during the last two decades. A large number of empirical studies have paid much attention to measure the degree of capital mobility in these countries, but the findings are quite different. This paper attempts to compare our empirical findings derived from the alternative dynamic model with those of previous studies. We discuss our time-varying estimates corresponding to the evolution of liberalization policies adopted by the individual governments in these countries to verify the reliability of our method.
Table 1 Tests for a unit root Countries
Korea Hong Kong Taiwan Singapore a
Sample period
1980:1 1986:1 1981:1 1985:1
1997:4 1997:4 1997:4 1997:4
Augmented Dickey – Fuller test
Phillips – Perron test a
DX
DC
DX
DC
9.09550** 14.4443** 13.43891** 5.38119**
10.30228** 7.07643** 7.05956** 3.76236**
12.79584** 7.09879** 8.27608** 2.77744
8.37578** 10.01673** 42.39995** 2.09970
The critical values for sample size 50 at 1% and 5% significance levels are 3.58 and 2.93, respectively (Enders, 1995, p. 419). ** Significant at the 1% level for a one-sided test.
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The data are quarterly.5 All the data, except for Taiwan, are obtained from the IMF’s International Financial Statistics, December 1998 (CD-ROM). Taiwan’s quarterly data are available from the national statistical web site of Bureau of Statistics, Taiwan, the Republic of China. The sample period for each country differs, depending on the availability of the data, as shown in Table 1.
4. Empirical findings As noted above, this paper aims to present the time-varying estimates of the degree of capital mobility in NIEs. From our estimates, we attempt to show how freely the capital moves internationally and reveal the different degree of capital mobility in the region. We interpret our empirical results corresponding to the development of domestic financial market reforms and policy responses to capital flows, which have been implemented by individual governments in these sample countries. At the start, we perform a unit root test to check whether the data series for explained and explanatory variables in Eq. (2) is stationary. We use two different types of unit root tests proposed originally by Dickey and Fuller (1979) and later by Phillips and Perron (1988). The results of the tests are shown in Table 1. The results appear to reject the null hypothesis of a unit root for all the variables.6 Thus we can assume that these variables are stationary. Next, we estimate the parameter k in Eqs. (3) and (4), and then present the time-varying parameter estimates, which correspond to 1 k rather than k in Figs. 1 – 4. As explained before, a larger value of k represents a lower degree of capital mobility, so our figures intuitively illustrate the exact extent of dynamic capital mobility, that is, 1 k, in these sample countries. Also, we plot Ordinary Least Squares (OLS) constant parameter estimates with 95% approximate intervals based on the assumption of normal distribution to examine the significant variability of capital mobility roughly over the observation period. Our empirical findings can be summarized as follows. It becomes clear, from the results of the Kalman filter estimation, that the capital mobility has increased significantly in East Asia. As has been well known, Singapore and Hong Kong are two of the most financially developed economies in East Asia, except for Japan. Our results just indicate a higher degree of capital mobility in Singapore than in others, although Hong Kong does not show a high degree as expected until early 1990s. It is not surprising, because domestic banking industry was cartelized until 1995 and domestic deposit and loan rates segmented somewhat from international and domestic monetary markets in Hong Kong.
5 The annual data frequency for Singapore is changed to quarterly data by using RATS source command ‘‘Distrib.src,’’ since the quarterly data are not available. 6 Ambiguous results for Singapore’s data have been found. The result of the augmented Dickey – Fuller test appears to reject the null hypothesis of a unit root at 1% significant level, whereas the result of the Phillips – Perron test fails to reject the null hypothesis even at 5%. Nonetheless, we assume the data are approximately stationary.
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Fig. 1. The degree of capital mobility in Republic of Korea.
The degree of capital mobility seems to be lower in Taiwan, which might imply that repressed domestic financial systems and controls on the capital account are stronger than those of other sample countries during our sample period. The structural change in capital mobility has been found at 1989– 1990. Our findings can be explained by the effects of Taiwan’s financial reforms, such as the liberalization of domestic interest rates implemented in 1989.
Fig. 2. The degree of capital mobility in Hong Kong.
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Fig. 3. The degree of capital mobility in Taiwan.
As for the Republic of Korea, the degree of capital mobility has increased gradually since the early 1980s, and remained at a higher level during the second half of the 1980s. In contrast to our findings, Reisen and Yeches (1993) show a declined trend in capital mobility since the mid-1980s in Korea. Besides the difference between their approach and ours, the plausible reason for the lower degree of capital mobility derived from their
Fig. 4. The degree of capital mobility in Singapore.
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empirical analysis might be that they use an ex post actual depreciation rate to measure the expected foreign return in the interest rate determination model. As mentioned earlier, the forecast error problem may easily arise in the case. Furthermore, we find that the degree of capital mobility in Korea seems to show a little stagnation during the early 1990s and a sharp increase since 1995. We might interpret it as follows. During the early 1990s, the Republic of Korea faced a surge of capital inflows. The monetary authorities took various measures to sterilize the expansionary effect of capital inflows on the growth of monetary aggregates, which caused an increase in domestic interest rates.7 The increasing level of nominal interest rates thus deteriorated domestic financial liberalization. On the other hand, the structural change of capital mobility in the mid-1990s might be attributed to the implementation of the ‘‘Three-Step Financial Market Reform Plan,’’ which was issued by Korea’s government at the end of 1993. In particular, with the aim of participating in the OECD organization in 1996, further liberalization of domestic financial system and capital account proceeded faster in the mid-1990s.
5. Concluding remarks This paper has used an intertemporal current account model (developed by Shitaba and Shintani, 1989) of a small open economy to measure the degree of capital mobility. Shitaba and Shintani (1989) used the model for developed countries and present the constant parameter estimates of the degree of capital mobility by using GMM. However, few studies have been made to use this model to measure the degree of capital mobility in developing countries. In the study, we apply it to East Asian developing countries. Specifically, we use Kalman filter technique to present the time-varying parameter estimates of the degree of capital mobility in NIEs. Our time-varying parameter estimates illustrate the different processes of capital accounts and domestic financial liberalization in the region. Our empirical results indicate that the degree of capital mobility has been increasing substantially in these countries. A high degree of capital mobility is shown in Singapore, Hong Kong, and the Republic of Korea, whereas the degree of capital mobility in Taiwan appears to be a little lower. The findings imply that financial regulation and capital controls still remain a fair characteristic in Taiwan during the analysis periods. On the other hand, the results also suggest that liquidity constraints have eased greatly in the other countries, as a result of financial deregulation and capital account openness. It should be noted that the intertemporal current account model used in the analysis is supposed to be used to examine the case for nondurable consumption because the model is derived from the life-cycle permanent income hypothesis, which implies that consumption follows a random walk. However, consumption expenditures on durables do not exhibit a random walk behavior. In the analysis, we measure aggregate consumption including expenditure on durable goods because the data for nondurable consumption only are not available. It may create a bias for our estimates somewhat; nevertheless, the share of
7
For example, monetary stabilization bonds (MSBs) was actively issued in 1993.
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durable consumption in total households’ consumption is considered to be small in these developing countries. Iscan (2002) has extended the model by explicitly introducing durable goods into it. The extended version implies that a permanent decrease in net output leads to a decline in aggregate consumption and a temporary current account surplus, whereas the baseline model suggests it has no impact on the current account, because nondurable consumption is less sensitive to net output under perfect capital mobility. Their empirical analysis for Canada indicates that the extended model appears to improve the performance of the baseline model by using annual data; nevertheless, for quarterly data with a shorter time period, none of the models’ performance is decidedly superior as they noted. Our further research can focus on how to apply the extended model to make robust our empirical analysis in the paper.
Acknowledgements The author is particularly indebted to Makoto Ohta for his insightful discussions. Eiji Fujii, Elliott Parker, and two anonymous referees are also gratefully acknowledged for their valuable and helpful comments and suggestions. The views expressed in the paper, along with any remaining errors, are entirely those of the author.
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