Comparative Financial Systems: Financial Liberalisation, The Black Market Exchange Rate and Demand for Money in South Korea, Taiwan and Thailand

Central to the unbridled economic success of the Pacific-Rim countries is their financial liberalisation from 1981 to 1990, their ratio of M2/GDP (measure of the depth of the financial sector) is as large as the M2/GDP of the OECD economies. The Pacific-Rim countries have also been moving --albeit at different speed-- to liberalise their equity and bond markets and integrate them more closely into international financial markets. This paper first summarises the most essential aspects of the financial liberalisation and innovation process in Thailand, Taiwan and South Korea. Second, it tests at various stages of financial liberalisation for an appropriate overall functional form of demand for money for each country, using the Box-Cox extended auto-regressive model with data from January 1970 through June 1989. Black market exchange rate is used in the model as a key variable, instead of a conventional variable of the official exchange rate. The empirical results confirm that real income, expected inflation and expected inflation and expected depreciation in the black market exchange rate are appropriate scale and opportunity cost variables in the long-run money demand function, especially for South Korea. In addition, depreciation in the black market exchange rate is found to be a negative effect on the demand for money in all cases, but there is no empirical evidence to indicate that the black market exchange rate influences the demand for money differently over the period before and during the on-going financial liberalisation process. Therefore, the Pacific-Rim countries in this study must carefully select an appropriate exchange rate policy to support their economic goals because (a) the black exchange rate is significant to their economies, and (b) neither a decline in the black market nor an alignment of the black market and official exchange rates will occur as long as the financial liberalisation has not reached maturity and/or exchange rate control still exists.