Dynamic Financial Linkages of Japan and ASEAN Economies: An Application of Real Interest Parity

To examine the validity of real interest parity (RIP), this study provides empirical evidences concerning the dynamic linkages of real interest rates among ASEAN-5 and the mean reversion behaviors of real interest differentials of ASEAN-5.vis-à-vis Japan during the post liberalization era (1984-1997). The upshots of our findings are four-fold. First, there were co-movement of ASEAN real rates in the long run and dynamic causalities in the short run, which explicitly indicated a monetary inter-dependency among the ASEAN tigers. Second, most of the forecast error variance of real interest rates in own country can be attributed to other ASEAN-4’s innovations (more than 50%), which partly explain the contagion effects during Asia crisis 1997/98. Third, the real interest differentials are mean reverting over time, implying that RIP holds between Japan and ASEANs (except Singapore). Forth, the half-lives are reported at approximately 6 to 11 months, which reflect the considerably small deviations from RIP. All together, the findings constitute towards regional financial integration with the Japan’s leading role being confirmed. To great extent, this would support the recent proposal of Currency Union with Japanese Yen taken as common currency.