RDP 9602: Consumption and Liquidity Constraints in Australia and East Asia: Does Financial Integration Matter? 1. Introduction

This paper assesses the effect of domestic and international financial integration on consumption in Australia and selected East Asian economies – Hong Kong, Japan, Korea, Singapore, Taiwan and Thailand. The basic intuition is that when people are forward looking, they try to reduce the variability of consumption over their lifetime, and so expanding the means by which they can smooth consumption over time should reduce the dependency of their consumption on current income. A simple model of consumer choice is outlined which allows for liquidity constraints and changing real interest rates and demographics. This motivates tests for a statistically significant effect on consumption of a range of variables which proxy financial and non-financial liquidity constraints. Consumption is defined as expenditure on non-durables.

In Section 2, a model of the consumption of households is constructed based on intertemporal optimisation with demographic change and subject to liquidity constraints. Motivated by this model, an estimating equation which considers aggregation over time, aggregation over heterogeneous households, proxies for the liquidity constraint and definitions of consumption and income, is then outlined. In Section 3, this equation is estimated and the results discussed. Non-durable consumption is shown to be tied to income in all countries examined except Australia, where the innovation in non-durable consumption is unforecastable. Nondurable consumption is liquidity constrained in East Asian countries but the degree of the constraint and its source vary considerably between countries. The constraint is constant but relatively weak in Hong Kong and appears to be declining in Singapore, consistent with the extent and timing of domestic financial and capital account reform in these countries. It does not appear to have eased over time in Japan. Consumption in Korea, Taiwan and Thailand is also dependent on income, and in the latter two countries there is strong evidence that this is due to an undeveloped and controlled financial system. Section 4 discusses whether it is possible to separately identify domestic and international financial effects. Section 5 looks at two implications for welfare and policy. The conclusion summarises the results. The key findings of the paper are that financial integration affects the real economy and that the liberalisation of both the domestic financial system and the capital account appear to be necessary for households to be able to smooth consumption over the life-cycle.