The Cost of Stock Market Integration in Emerging Markets

• Author: Xin Zhang,Kee‐Hong Bae
• Date: 01 February 2015
• Published date: 01 February 2015
• DOI: http://doi.org/10.1111/ajfs.12079

The Cost of Stock Market Integration in

Emerging Markets*

Kee-Hong Bae

Schulich School of Business, York University

Xin Zhang**

School of Management, Fudan University

Received 17 September 2014; Accepted 23 December 2014

Abstract

We find that stock markets more integrated towards global markets experienced larger price

drops during the 2008 financial crisis. The negative relation between the crisis period return

and the degree of stock market integration is evident only in emerging countries. We show

that the withdrawal of foreign equity investments during the crisis period does not contribute

to the negative relation between the crisis period stock return and the degree of stock market

integration. Instead, the negative relation arises because integrated emerging markets experi-

ence increased exposure to the negative global shock during a financial crisis. We obtain sim-

ilar results when the 1997 Asian financial crisis is used as an experimental setting.

Keywords Stock market integration; Financial crisis; Foreign equity flow; Market exposure;

Asset pricing

JEL Classification: F36, G12, G15

1. Introduction

But despite our commitment and our support for financial integration, we also had

to learn —with the experience of the past 4 years in mind —that financial inte-

gration and financial stability do not always go hand in hand. Indeed we have wit-

nessed that in a financially integrated market risks can spread and spillover to other

*We thank the discussant, Kyuhyong Kim, and the participants at the 9th International Con-

ference on Asia-Pacific Financial Markets. Bae gratefully acknowledges research support from

the Schulich School of Business at York University. Zhang gratefully acknowledges research

support from the School of Management at Fudan University and the University of Hong

Kong-Fudan University IMBA Joint Research Fund. All errors are our own.

**Corresponding author: Xin Zhang, School of Management, Fudan University, 670

Guo Shun Road, Shanghai 200433, China. Tel: +86-21-2501-1144, Fax: +86-21-6564-3203,

email: xin.zhang@fudan.edu.cn.

Asia-Pacific Journal of Financial Studies (2015) 44, 1–23 doi:10.1111/ajfs.12079

©2015 Korean Securities Association 1

segments of the financial market, increasing the likelihood of contagion of financial

fragilities and systemic risks.

Gertrude Tumpel-Gugerell

Member of the Executive Board of the European Central Bank

Stock markets around the world have become increasingly globalized and inte-

grated due to financial deregulation together with technological developments that

have reduced transaction and information costs. Many studies have documented the

benefits of stock market globalization/integration. These include a decrease in the

cost of capital (Bekaert and Harvey, 2000; Henry, 2000a), an increase in real invest-

ment (Bae and Goyal, 2010; Chari and Henry, 2008; Henry, 2000b; Mitton, 2006),

and economic growth (Bekaert et al., 2001, 2005, 2011a). Recent literature has also

documented the benefit of an improved information environment associated with

stock markets opening up to foreign equity investments (Bae et al., 2012, 2006).

There is now ample evidence on the benefit of stock market integration; how-

ever, limited attention has been paid to potential costs associated with stock market

integration. The most pressing concern for policy makers associated with opening

stock markets to foreign equity investors is the “come and go” nature of foreign

“hot money.” Opening local stock markets to global portfolio investors may lead to

volatile capital flows that result in increased stock market volatility (Baele, 2005;

Korinek, 2011; Magud et al., 2011). Stiglitz (1998) called for greater regulation of

capital flows, arguing that “... developing countries are more vulnerable to vacilla-

tions in international flows than ever before.” Even the International Monetary

Fund (IMF), an early advocator of financial integration, has changed to a more cau-

tious stance toward financial integration. In an IMF report, Prasad et al. (2003)

argued that integration can harm poor countries as it makes them more susceptible

to fluctuations in the global financial market.

In this study, we examine the potential cost of stock market integration to glo-

bal equity markets. We investigate if integrated stock markets suffer disproportion-

ately during a financial crisis. Using the measure of equity market integration

developed by Pukthuanthong and Roll (2009), we show that stock markets more

integrated to global markets experience larger price drops during a financial crisis.

During the subprime crisis of 2008, the buy-and-hold return (BHR) of a country

index is negatively correlated with the degree of equity market integration of the

country. The evidence indicates that one standard deviation increase in the degree

of stock market integration is associated with a decrease of 23.1% in the buy-and-

hold return during the crisis period (an annualized return of 15.4%). A partition of

the sample countries into developed and emerging markets shows that the negative

relation between stock market integration and price drops during the crisis period

manifests only in emerging markets. There is no negative effect of stock market

integration on the crisis period stock returns in developed markets.

The negative relation between stock market integration and crisis period stock

returns raises the question of what causes it and why such a relation exists only in

K.-H. Bae and X. Zhang

2©2015 Korean Securities Association