The Impacts of Financial Integration on the Linkages Between Monetary Independence and Foreign Exchange Reserves

ABSTRACT

This paper investigates the short-run and long-run effects of financial integration on the dynamics between monetary independence and foreign exchange reserves using a GMM system estimation involving two-year non-overlapping average data (2000-2011) from 114 countries. The results indicate that the effect of foreign exchange reserves on the monetary independence is intensified by the level of financial integration. This suggests a positive spill over effect from the financial integration to the monetary policy independence. Besides, a positive implication of financial integration on monetary independence could be established when the foreign exchange reserves is at the maximum level. In addition, the comparisons between the mean of foreign exchange reserves and the threshold levels of foreign exchange reserves that neutralise the impact of financial integration indicate that on average, the foreign exchange reserves are sufficient to offset the effect of financial integration. A stable exchange rate will undermine the positive impact of foreign exchange reserves on monetary independence. Finally, the long-run and short-run impacts occur in the same direction. This paper ends with some policy implications and suggestions for future research.

KEYWORDS:

• Monetary independence
• foreign exchange reserves
• financial integration
• system GMM
• interaction term

Acknowledgement

The authors would like to thanks the editor, Prof. Sul, D.G. and the comments of the anonymous referees for their valuable inputs which have improved this research. Any remaining errors are our own responsibility.

Disclosure statement

There is no conflict of interest.

ORCID

Chee-Hong Law http://orcid.org/0000-0001-9326-7086

Chee-Lip Tee http://orcid.org/0000-0002-0572-4572

Wei-Theng Lau http://orcid.org/0000-0002-1196-5372

Notes

1 The ability of capital control in maintaining monetary independence is another heavily debated issue. In this case, You, Kim, and Ren (2014) provide evidence to support the positive impact from capital controls on monetary independence. They measure the average of these indicators to obtain the aggregate capital controls measurements. In contrast, Miniane and Rogers (2007) show that the low cost involved in evading capital controls reduce the capital controls’ strength in insulating domestic interest rates from foreign interest rates.

2 The inclusion of two-lagged dependent variable is to overcome the second-order autocorrelation issue. The same decision is made by Ziesemer (2012) and Kim (2016).

3 The data duration is decided by the availability of the data. Some data such as the financial development indicators in some European countries before 2000 are not available.

4 The United States is not included here because it is excluded from the trilemma index calculation by Aizenman et al. (2013).

5 There are possibilities that the correlation between domestic and foreign interest rate might not reflect the actual condition of monetary independence because the correlation could have been affected by different economic conditions, especially during market turbulences. However, the impact from these conditions could be minimised as the index is smoothed out by applying the three-year moving averages encompassing the preceding, concurrent, and following years (t – 1, t, t+1) of observations (Aizenman et al., 2013). Hence, the impact from different circumstance could be reduced.

6 The base country, according to Aizenman et al. (2013), is countries that have close connection with the monetary policy of a home country. Please refer to Aizenman et al. (2013) for the brief discussions of how this relationship is determined.

7 Following the suggestion of Wooldridge (2013), the variables measured in ratio form are not transformed into logarithm term.

Additional information

Funding

This work was supported by Universiti Sains Malaysia under short-term research grant [304/PSOSIAL/6313308].

Notes on contributors

Chee-Hong Law

Dr Chee-Hong Law is a senior lecturer of Universiti Sains Malaysia, Malaysia. He obtained his PhD at the University of Otago, New Zealand. His research interests are monetary economics, international economics, and financial economics.

Chee-Lip Tee

Dr Chee-Lip Tee is a lecturer of Multimedia University, Malaysia. He completed his PhD at Universiti Putra Malaysia in 2016 and conducts the research in international economics.

Wei-Theng Lau

Dr Wei-Theng Lau is a senior lecturer of Universiti Putra Malaysia, Malaysia. He received his PhD from Universiti Putra Malaysia. His research interests are mainly in capital markets and financial economics.