Executive Summary

1 As an integral part of its development strategy, Singapore has maintained an open capital (as well as current) account, in which there is virtually no restriction on movements of portfolio capital and direct investment. The paper is concerned with evaluating the extent to which the liberal exchange control regime has led to, from an economic stand point, a perfect integration of the Singapore financial market with the rest of the world.

2 The study employs three macroeconomic benchmarks for evaluating the degree of financial market integration, namely:

(i) the international parity conditions which is concerned with the equality of nominal and real expected returns on financial assets denominated in different currencies as a result of arbitrage activities in the financial and the goods markets;

(ii) the degree to which domestic saving is correlated with investment and the extent to which capital movements allow a country to smoothen its consumption over time;

(iii) the closeness of a country's consumption growth with the consumption growth of the rest of the world as a consequence of consumption risk diversification.

3 The empirical results indicate that movement of funds between the domestic and the ACU interbank markets has resulted in the covered and uncovered interest parity relationship holding for the short term nominal Singapore Dollar and the US Dollar interest rates. The fact that uncovered interest parity holds indicates not only the absence of regulatory barriers to capital mobility but also the absence of aversion to exchange rate risk, which is one of the major sources of portfolio 'home bias'. However, the analysis indicates that real interest parity condition for the short-term interest rate does not hold, mainly on account of the failure of the purchasing power parity relationship. The departure from PPP relationship is a result of the imperfect integration of the goods market, rather than the absence of integration among the money markets.

4 Focusing on a broader definition of capital mobility that includes both short-term and long-term funds, the analysis shows that there is no correlation between the country's saving and its investment, as would be the case if there is perfect international capital mobility. With an open capital account, any excess domestic saving over investment would tend to move out of the home country. Likewise, an increase in domestic investment will tend to be financed by external sources, and not necessarily by domestic saving. A complementary analysis also indicates that capital movement freely offset the difference between domestic saving and investment in a manner that allows the country to smoothen its consumption profile in response to shocks.

5 Finally, the paper tests the most stringent criteria for financial integration which requires not only complete capital mobility but also the existence of state-contingent financial markets so that individuals in different countries can fully hedge their country-specific risks. On the assumption that the preferences are identical across different countries, the criteria implies that consumption growth across countries are perfectly correlated. Given the onerous assumptions underlying the test of financial integration, it is not surprising that the empirical results reject the hypothesis of perfectly correlated consumption growth across countries, even though capital is fully mobile across borders.

6 Overall, the empirical findings support the notion that Singapore's financial market is integrated with the rest of the world. The recent financial sector reform measures can be expected to further increase the integration of the country's financial market by encouraging greater mobility of capital and by reducing various sources of 'home bias' among foreign investors with respect to Singapore-issued securities and the local investors' bias towards foreign securities.