Asia-Pacific Capital Markets : Integration and Implications for Economic Activity

The apparent success of several East Asian countries in sterilizing capital inflows stands in apparent contradiction to the finding of high capital mobility. This paper argues that previous studies examining money market rates may be misplacing their focus, since most lending is mediated through (sometimes regulated) banking systems. Evidence on the degree of substitutability is presented. A simple open- economy macro model, incorporating bank credit, is used to motivate several tests. Capital inflows are found to affect bank lending, in cases where the degree of substitutability is high, and hence the ease of sterilization low. Second, whether bank lending is an important variable in determining changes in economic activity is assessed. The data suggest that the link between money and investment is weaker than the corresponding link involving bank credit. Finally, we find that rapid expansion of bank lending in the previous two years is also associated with increases in the bank lending- interest rate spread, a proxy for risk