NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Financial market integration is a central concept in international



"integration of emerging market economies into the world financial markets is generally followed by a significantly larger and more liquid equity market"

In integrated financial markets, domestic investors can buy foreign assets and foreign investors can buy domestic assets. Among countries that are fully integrated into world financial markets, assets with identical risk should command the same expected return, regardless of location.

But how does one determine exactly when a market becomes integrated? Often the date of certain regulatory changes is used as a proxy for the timing of integration of equity markets. But this can be misleading. Regulatory changes, in reality, may have little or no impact on the functioning of the capital market. There are many ways to circumvent capital controls, and thus to gain indirect access to financial markets, even when a market is technically closed to foreign investors.

Furthermore, liberalization itself can be a staggered and slow process. Investors may anticipate some policy changes. Other policy initiatives may lack credibility, and hence have little impact on markets.

In Dating the Integration of World Equity Markets (NBER Working Paper No.6724), Geert Bekaert, Campbell Harvey, and Robin Lumsdaine consider the surge of emerging markets opening up to international capital in the last decade as a natural experiment. They apply a novel method of "dating" market integration: a new statistical technique that identifies a "break" in important economic series. To determine the market integration date and to explore the economic and financial effects of market integration, they use data on a variety of financial and macroeconomic indicators for the 20 emerging markets followed by the International Finance Corporation over a period of time. Among the variables that are likely to be related to the integration process are: financial data linked to price levels; financial variables related to liquidity in the local market; capital flows to the market; financial variables linked to the co-movement of returns; and indicators on the local economic environment, including inflation rates, exchange rate volatility, and the size of the trade sector.

The authors show that integration of emerging market economies into the world financial markets is generally followed by: a significantly larger and more liquid equity market; stock returns which are more volatile and more correlated with world market returns; a lower cost of capital; improved credit ratings; real exchange rate appreciation; and increased economic growth. They find strong evidence of structural breaks in emerging equity markets, but no evidence of structural breaks in the world equity market. However, these breaks do not always correspond very closely to the dates of official capital market reforms.

Bekaert, Harvey, and Lumsdaine conclude that "actual liberalization" may not be the prime driver of change. The correspondence of the break date with regulatory reform varies greatly across the 20 countries covered in the study. For example, in Colombia and Argentina the break dates match the dates of reforms. But in Turkey, structural break dates occur substantially after the reforms.

-- Andrew Balls


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