Global financial integration has been associated with divergent patterns of real convergence and the current account in emerging markets. While countries in emerging Asia have been running sizeable current account surpluses, countries in emerging Europe have been facing large current account deficits. In this paper we test for the relevance of financial market characteristics in explaining this divergence in the catching-up process in Europe and Asia. We assume that the two regions constitute distinct convergence clubs, with the euro area and the United States respectively at their core. In line with the theoretical literature, we find that better developed and more integrated financial markets increase emerging markets’ ability to borrow abroad. Moreover, the degree of financial integration within the convergence clubs – as opposed to the state of financial integration in the global economy – and the extent of reserve accumulation are significant factors in explaining the divergent patterns of real convergence and the current account in the regions under review.
In recent years, financial factors have been identified as key determinants of current account balances in emerging markets. There is a broad consensus in the literature that underdeveloped financial markets have been an important reason for the emergence of (rising) current account surpluses in emerging Asia, serving as an explanation for the anomaly of capital flowing from poor to rich countries, in particular to the United States. There has also been support for the hypothesis that a comparatively high degree of financial integration helps explain why capital has been flowing downhill within Europe, in line with consumption-smoothing behaviour predicted by standard theory.
Against this background, we analysed whether financial factors can explain divergent current account developments in the catching-up process of emerging Europe and emerging Asia. In doing this, we took the perspective that emerging Europe and the euro area/EU15, and emerging Asia and the United States, can be perceived as two different convergence clubs. This allowed us to introduce indicators of financial integration within the convergence clubs as additional explanatory variables.
Our analysis confirms that financial market development and financial integration are important factors in determining current account balances. In line with the views on finance and the current account distilled from the literature, we find that better developed financial markets and a higher degree of financial integration are generally associated with higher current account deficits/lower current account surpluses. However, several indicators of financial development and financial integration fail to account for the divergent patterns of real convergence and the current account in emerging Europe and emerging Asia. Instead we find that the degree and institutional pattern of financial integration within the convergence clubs – together with the level of foreign exchange reserves – contribute significantly to the model's predictions of strikingly different current account patterns in emerging Europe and Asia.
From this we draw the conclusion that the character of financial integration matters when explaining patterns of real convergence and current account balances in emerging markets. Emerging Europe has not been different because it has significantly better developed financial systems or because it is financially more integrated in the global economy than emerging Asia. 38 Rather, emerging Europe has been different because its financial integration with its core has been very different than in emerging Asia. This result can be interpreted as follows:
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European integration has created a very special environment for financial sector quality in emerging Europe, which may not be captured by the standard variables. This may be the reason why their economic relevance in explaining divergent current account patterns in both regions has been rather marginal. The adoption of EU laws and directives has significantly improved financial sector quality in emerging Europe by holding the legal, regulatory and supervisory framework in emerging Europe to the same standard as in the core. Furthermore, the entry of foreign banks has also served as an instrument for improving the quality of domestic banking sectors in the region ( Mehl, Vespro, & Winkler, 2006). Indeed, foreign-owned banks have been invited to enter the region after episodes of financial crises, revealing the weaknesses of domestic banks in terms of lending techniques and governance.
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The European integration process as such may have erased – at least to a large extent – the inherent credibility gap between core and periphery identified by the new mercantilist view. This is because the very process of European integration implies that the periphery (the new EU member states as well as candidate and potential candidate countries) joins the core by accepting key European institutions, laws and governance practices. This may have given emerging Europe more leeway to run substantial current account deficits and limit reserve accumulation compared with emerging Asia, 39 and could also explain why foreign banks from the euro area/EU15 have entered the domestic banking sectors in the region. Their presence has channelled funds to the periphery on a large scale and made it easier for emerging European countries to borrow abroad, either directly from their parent banks or indirectly by establishing contacts between companies and parent banks abroad.
To conclude, a peculiar environment conducive to financial integration between core and periphery appears to have allowed emerging Europe to enter a growth path that has been driven by domestic demand, in particular by investment, partly financed by foreign savings. As a result, emerging Europe has shown substantial current account deficits as predicted by standard theory. Of course, rapid financial deepening and the associated current account deficits have important macroeconomic and financial stability implications. They have been extensively reviewed in the literature (e.g. Arcalean et al., 2007 and Eichengreen and Choudhry, 2005) as well as by international financial institutions and central banks (European Central Bank, 2006a, European Central Bank, 2006b, European Central Bank, 2006c and Banerji and Kähkönen, 2007). Thus, while the example of emerging Europe illustrates the impact of financial integration for current account developments in a process of real convergence, it does not imply that this process does not involve risks.40 At the same time, the example of emerging Europe raises the question whether a transfer of credibility, quality and confidence from the core is a precondition for emerging markets pursuing consumption-smoothing activities in a globalised financial system.
