Introduction
Overview
In recent decades, international financial markets have experienced a notable rise in equity-market linkages, driven by global integration and the swift transmission of information across borders This phenomenon allows shocks in one country to impact other markets, even those without direct interdependencies or geographical proximity The literature has evolved to address this issue, particularly as financial crises have increasingly spread rapidly to the global market.
Early research on equity-market linkages primarily attributed them to international trade, financial connections, and fundamental economic factors However, during the 1990s, a series of global crises prompted scholars to question the adequacy of these fundamental explanations As a result, attention shifted towards factors related to irrational behavior, including liquidity issues, imperfect information, and multiple equilibria, highlighting the complexity of global market interconnections.
Emerging equity markets are often characterized as incomplete, fragile, and illiquid, suffering from governance weaknesses, inadequate regulations, and heightened investor vulnerability (Antoniou, Ergul & Holmes 1997; Daly 2003; Kallinterakis 2009) As a result, these markets exhibit greater sensitivity to shocks compared to developed markets Nevertheless, the impact of crises on emerging markets varies significantly due to their differing sizes, structures, and levels of development (Forbes & Rigobon 2002; Marcal et al 2011; Kenourgios & Padhi 2012).
The Global Financial Crisis (GFC), which began in the United States in mid-2007, is regarded as one of the most significant financial crises in history Its severity and worldwide impact have led to comparisons with the Great Depression of the 1930s.
The Global Financial Crisis (GFC), which intensified in mid-2008 and led to significant declines in global equity markets until early 2009, has profoundly impacted both advanced and emerging markets While many studies have focused on major emerging markets, there is a need to investigate the effects of the GFC on small and young emerging markets, especially given their increasing appeal to international investors seeking diversification Understanding how the GFC has influenced these markets and their connections to the global economy is crucial, particularly for those with high growth rates and potential returns.
This thesis aims to explore the effects of the Global Financial Crisis (GFC) on the Vietnamese equity market and its connections to international markets The Vietnamese equity market was chosen for three key reasons: first, foreign indirect investment surged from US$115 million in 2005 to US$6.2 billion in 2007, indicating greater global integration Second, despite significant growth in market capitalization, the Vietnamese market suffered a decline of over 60% by the end of 2008 due to the GFC, highlighting concerns about its vulnerability and co-movement with global markets Lastly, there is a notable lack of empirical research on the Vietnamese equity market, particularly regarding the GFC's impact and its relationship with global equity markets.
This thesis addresses four key issues related to the research objective, beginning with an exploration of the impacts of the Global Financial Crisis (GFC) on the Vietnamese equity market, highlighting significant changes in the market environment during the crisis By reviewing existing literature, we identify factors within the Vietnamese equity market that may affect its cross-market linkages Additionally, we investigate the presence of long-run and short-run linkages between the Vietnamese market and global markets Finally, we analyze the effects of the GFC on equity-market linkages during vulnerable periods, noting the significant changes that occurred.
1 Further discussions of the GFC can be found in Chapter 2 of this thesis
This article explores three key connections between the Vietnamese market and global markets, emphasizing the transmission mechanism of shocks from the Global Financial Crisis (GFC) to both Vietnamese and international markets.
This chapter outlines the essential aspects of the thesis, including the background (section 1.2), research questions and methodology (section 1.3), scope and contribution (section 1.4), and overall organization (section 1.5).
Background
Early definitions of 'financial crisis' focused on banking panics, suggesting that such crises stem from a sudden drop in money supply, which significantly impacts economic activities (Friedman & Schwartz, 1963) Subsequently, researchers expanded this definition to encompass various types and patterns of financial crises (Minsky, 1972; Kindleberger, 1978; Minsky, 1982), while also considering the role of asymmetric information in these events (Gertler, 1988; Mishkin).
According to Mishkin (1992), a financial crisis is defined as a disruption in financial markets that results in the inefficient allocation of funds, ultimately diverting overall economic activity from its equilibrium state.
Research has extensively documented the consequences of financial crises, highlighting their detrimental effects on the economy Mishkin (1992) notes that such crises lead to issues like adverse selection and moral hazard, ultimately resulting in a decline in aggregate economic activities Hahm and Mishkin (2000) further elaborate on the crisis process, identifying two key stages: the lead-up to a currency crisis and the transition from a currency crisis to a broader financial crisis Numerous studies, including those by Ariff and Abubakar (1999), Fallon and Lucas (2002), Okumus and Karamustafa (2005), and Claessens et al (2010), provide additional insights into the various impacts of financial crises.
Adverse selection issues arise when lenders inadvertently select borrowers with poor credit risk, leading to potentially negative outcomes Additionally, moral hazard problems stem from conflicts of interest between lenders and borrowers, where lenders face risks due to borrowers engaging in undesirable behaviors For a deeper exploration of the implications of financial crises, please refer to Chapter 2 of this thesis.
The Global Financial Crisis (GFC), one of the most significant market events in financial history, began in the United States in mid-2007 due to the subprime mortgage crisis According to Dabrowski (2010), the crisis quickly spread to advanced economies such as Ireland, the United Kingdom, Iceland, and Spain by early 2008, and later affected emerging markets like Hungary, Latvia, and Romania between mid-2008 and early 2009 Claessens et al also highlight the rapid transmission of this crisis across global markets.
In early 2008, many advanced economies and nations with strong financial connections experienced significant losses, leading to a global crisis that spread to other countries by the third quarter of the same year This crisis had a profound impact on the global economy, prompting countries like Hungary, Iceland, and Ukraine to seek emergency assistance from the International Monetary Fund to stabilize their economies A detailed analysis of the global financial crisis's effects on the economy is provided in a study by Shahrokhi (2011).
The Global Financial Crisis (GFC) has various causes, with Claessens et al (2010) identifying factors such as asset price bubbles, current account deficits, increased international financial integration, and reliance on wholesale funding Allen and Carletti (2010) attribute the crisis to loose monetary policy and global imbalances, while Jickling (as cited in Shahrokhi, 2011) lists 25 causes, including imprudent mortgage lending, a housing bubble, and excessive leverage Cheung, Fung, and Tsai (2010) highlight the crisis's impact, noting sharp declines in asset prices, liquidity issues for banks, and significant changes in relationships between advanced and emerging markets Allen and Carletti (2010) provide a comprehensive overview of the causes and consequences of the GFC.
Equity-market linkage involves the interaction between equity markets, allowing investors to enhance their risk-adjusted returns by diversifying their portfolios across different markets This concept is grounded in two key theories: the purchasing power parity theory, which asserts that the relative prices of identical goods should equilibrate to reflect their purchasing power across markets, and the modern portfolio theory, which emphasizes the significance of risks, returns, and correlations in the construction of investment portfolios.
Investors can potentially achieve higher returns through international diversification, as supported by research from Elton & Gruber (1997) and Gklezakou & Mylonakis (2010) Despite being based on simplifying assumptions, these theories are fundamental to modern finance and asset management practices.
The existing literature on equity-market linkages primarily focuses on three key types: co-integration, causality, and contagion Co-integration and causality reflect the fundamental long-run and short-run relationships among equity markets, respectively In contrast, contagion describes how shocks are transmitted between markets during crises, marked by a notable increase in the correlation of market volatilities (Forbes & Rigobon 2002; Corsetti, Pericoli & Sbracia 2005) Together, these three types of linkages provide a comprehensive understanding of cross-market interactions.
In early studies on global equity-market linkages, most researchers explain linkage sources with regard to fundamental linkages such as trade and finance links (Kearney 2000; Phylaktis
& Ravazzolo 2002; Pretorius 2002; Khalid & Kawai 2003) However, in the 1990s as global markets experienced a series of crises, other sources of linkages - known as irrational linkages
- emerged such as imperfect information, investor sentiment and multiple equilibrium (Dornbusch, Park & Claessens 2000; Karolyi 2003) 5
Recent research highlights the limitations of modern finance theories in real-world scenarios, particularly during financial crises, where correlations among global equity markets tend to rise (Cheung, Fung & Tsai 2010; Chakrabarti 2011) This underscores the importance of understanding equity-market linkages in crisis situations for both researchers and practitioners In light of the severe and multifaceted impacts of the Global Financial Crisis (GFC), numerous studies have focused on its effects on advanced economies and major emerging markets with strong interconnections.
This thesis investigates the impact of the Global Financial Crisis (GFC) on small and emerging equity markets, focusing on their connections to global equity markets The primary aim is to understand how these markets, characterized by their size and youth, were affected by the GFC in comparison to larger US markets.
3 See Chapter 2 for a more detailed discussion of these theories
4 In case volatilites of markets increase simultaneously during times of crisis, an interdependent linkage is suggested
5 Multiple equilibrium relates to changes in the expectations of investors that are subject to multiple equilibriums
Research questions and methodology
The Vietnamese equity market, recognized for its rapid growth and commitment to global integration, has become increasingly appealing to foreign investors in recent years However, the market faced significant downturns during the Global Financial Crisis (GFC) from 2007 to 2008 This thesis aims to explore the effects of the GFC on the Vietnamese equity market, addressing key research questions to achieve this objective.
The Global Financial Crisis (GFC), which began in the United States, rapidly affected global markets, outpacing previous financial crises Numerous studies highlight the significant repercussions of the GFC on equity markets worldwide (Claessens et al 2010; Dabrowski 2010; Kurth 2011; Samarakoon 2011; Sen 2011) However, most research has focused on advanced and major emerging markets closely linked to the US economy, leaving young emerging markets like Vietnam largely unexamined This thesis aims to explore the specific impacts of the GFC on the Vietnamese equity markets.
Question 1: To what extent has the GFC affected the Vietnamese stock market?
Globalisation has facilitated international capital movements and advancements in information technology, allowing foreign investors to diversify their portfolios for better risk-adjusted returns As global equity markets, especially in advanced economies, become more interconnected, investors are increasingly turning to emerging markets for diversification The Vietnamese equity market has gained recognition as a rapidly developing emerging market, attracting significant foreign investment interest However, with just over a decade of operation, research on the linkages between the Vietnamese equity market and global markets remains limited This thesis investigates the existence of equity-market linkages between Vietnam and global markets.
This thesis explores the two primary connections in financial markets—co-integration, which indicates a long-term relationship, and causality, signifying a short-term relationship We specifically analyze these linkages between the Vietnamese equity market and global equity markets, leading to the formulation of two key research questions.
Question 2: Does a co-integration relationship exist between and among the Vietnamese and other selected equity markets?
Question 3: Is there a causal relationship between and among the Vietnamese and other selected equity markets?
Research indicates that equity-market linkages are not static and can fluctuate, particularly during crises (Bollerslev 1990; Engle 2002; Forbes & Rigobon 2002; Corsetti, Pericoli & Sbracia 2005) The Global Financial Crisis (GFC) has notably intensified its impact on global equity markets due to its severity and widespread effects Consequently, the GFC may lead to unforeseen alterations in global market connections This thesis also explores whether the relationships between the Vietnamese market and other selected markets have transformed as a result of the GFC.
Question 4: Do the co-integration and causal relationships between Vietnam and other selected markets change over the GFC period?
This thesis explores how the Global Financial Crisis (GFC) impacted Vietnam and other markets, focusing on the significant volatility changes experienced during this period Researchers are particularly interested in the timing and mechanisms of the GFC's effects on the global market While previous studies have examined shock propagation in established equity markets, there is a noticeable gap in research concerning emerging thin markets like Vietnam This issue is specifically addressed in the thesis's fifth and final research question.
Question 5: Did the GFC transmit a shock to the Vietnamese stock market and other selected markets? If yes, how and where did the shock originate?
To answer the research questions above, we employ several research models and techniques:
This article examines the effects of the Global Financial Crisis (GFC) on the Vietnamese equity market by analyzing changes in market environment factors before and after the crisis It considers various market-level elements, including regulations, performance, and the investor base Furthermore, the thesis highlights the market-environment factors in the Vietnamese equity market that could impact cross-market linkages.
The article employs empirical models to examine market linkages between Vietnamese and global markets, categorized into two primary groups The first group consists of co-integration tests that assess long-term co-movements, utilizing methods such as residual tests, tests accommodating structural breaks, and vector autoregressive (VAR) models The second group encompasses causality tests, including pair-wise and multivariate Granger tests, which investigate short-term linkages and impacts Additionally, further analyses using the VAR model are conducted to evaluate how shocks in one market affect others and to explore the causal relationships among market variances within the dynamic structure of equity markets.
This thesis investigates the effects of the Global Financial Crisis (GFC) on the co-integration and causality relationships between the Vietnamese and global markets using a pre- and post-analysis technique The study divides the analysis into three distinct periods: pre-crisis, crisis, and post-crisis By comparing empirical findings from the pre- and post-crisis periods, the research aims to highlight the impacts of the crisis, with the periods defined through a visual inspection of equity market movements.
The article examines contagion tests utilizing the multivariate autoregressive conditional heteroskedasticity (MGARCH) model to analyze the transmission effects of the Global Financial Crisis (GFC) on the Vietnamese market and other markets It employs both constant and dynamic conditional correlation tests to assess the time-varying correlations between market pairs, while also incorporating pre- and post-analysis techniques in the evaluation process.
Table 1.1 below provides a summary of the research models employed in the thesis
Table 1.1: Research models in the thesis
Relationship Research model Empirical testing model
(long-run linkage) Co-integration tests
Bivariate co-integration tests based on residual Bivariate co-integration tests based on VAR model Bivariate co-integration tests allowing for structural breaks
Multivariate co-integration tests based on VAR models
(short-run linkage) Causality tests
Pair-wise Granger causality Multivariate Granger causality based on VAR model VAR analysis (impulse response function and variance decomposition)
Contagion effect MGARCH Constant conditional correlation
Scope and contributions
This thesis explores the effects of the Global Financial Crisis (GFC) on the Vietnamese equity market, utilizing secondary data from Vietnamese government sources and respected international organizations like the World Bank, the International Monetary Fund, and the World Federation of Exchanges However, due to limited sector-level data, the analysis focuses exclusively on the GFC's impacts at the market-environment level.
This study analyzes the connections between the Vietnamese market and global markets by examining equity market indices from countries that have been significant sources of foreign direct investment (FDI) in Vietnam in recent years The selected indices include the VN-Index (Vietnam), Hang Seng Index (Hong Kong), TWSE Composite Index (Taiwan), Strait Times Index (Singapore), KSE Composite (Korea), Nikkei 225 Stock Average (Japan), S&P 500 Composite Index (US), KLSE Composite Index (Malaysia), and SET Index (Thailand).
The time series data was collected from DataStream, covering the period 28 July 2000–31
December 2010, and comprises 2721 observations for each series The first day in the period
6 The study sample is discussed in more detail in Chapter 4
The study focuses on the Vietnamese equity market, beginning on its first trading day and encompassing the entire duration of the Global Financial Crisis (GFC) To analyze the impact of the GFC on market linkages, the study period is categorized into three distinct sub-periods.
- the pre-crisis period 28/7/2000–31/8/2008, comprising 2111 observations for each series
- the crisis period 1/9/2008–28/2/2009, comprising 130 observations for each series
- he post-crisis period 1/3/2009–31/12/2010, comprising 480 observations for each series
With the research objectives and research questions discussed above, this thesis makes the following contributions:
The Vietnamese equity market is relatively young, resulting in limited research, particularly regarding the impacts of the Global Financial Crisis (GFC) and its connections to the global market This thesis aims to fill this gap by offering new empirical insights into global equity-market linkages within the context of a developing equity market.
While numerous studies focus on global equity market propagations, there is a notable lack of research on emerging markets like Vietnam This thesis aims to fill that gap by offering empirical insights into how shocks from the Global Financial Crisis (GFC) impact such young and less liquid markets.
The empirical findings on the connections between the Vietnamese market and selected international markets offer valuable insights for policymakers, State Bank officials, and international portfolio managers These results highlight the degree of interlinkages, which can guide policymakers in monitoring global monetary policies and managing the market effectively Additionally, State Bank officers can gain insights from the impact of the Global Financial Crisis on Vietnam's equity market, strengthening their supervisory and monitoring capabilities Furthermore, international portfolio managers can leverage the identified market linkages to optimize the benefits of international portfolios that incorporate these markets.
Organisation
This thesis is organised into six chapters as follows:
This chapter offers a comprehensive overview of the thesis, summarizing key issues identified in the literature, along with the research questions and methodology employed Additionally, it outlines the scope of the study and highlights the contributions made by the thesis.
Chapter 2: A review of financial crises and equity-market linkages
This chapter offers a comprehensive review of equity-market linkages, especially during financial crises It begins by outlining the background of financial crises, including their definitions, causes, and consequences, with a specific emphasis on the Global Financial Crisis (GFC) The chapter then explores key definitions and foundational theories related to equity-market linkages, highlighting significant themes that have emerged in the literature A detailed review of empirical research on these themes is also presented Lastly, the chapter examines the effects of financial crises on equity-market linkages, focusing on both empirical findings and the research methodologies employed in existing studies.
Chapter 3: The Vietnamese equity market: pre- and post-Global Financial Crisis
This chapter explores the Vietnamese equity market's background and the effects of the Global Financial Crisis (GFC) on it The impacts are categorized into three key areas: market regulations, market development, and the investor base Additionally, it examines the factors within the market environment that affect cross-market linkages between Vietnam and other markets.
Chapter 4: Data collection and research methodology
This chapter is divided into two sections The first section outlines the data and sample utilized in the thesis, detailing the study period and the data-processing methods employed Additionally, it includes a preliminary analysis of the data.
12 is given Second, the techniques used to conduct the empirical testing models are discussed and justifications for the selected models are given
Chapter 5: Empirical estimations with models
This chapter presents empirical findings on the equity-market linkages between Vietnamese and global markets, utilizing co-integration, causality, and contagion tests It also examines the effects of the Global Financial Crisis (GFC) on these linkages by comparing results from the pre-crisis and post-crisis periods.
This chapter outlines the key findings of the thesis, highlighting their significance for policy-makers, State-Bank officials, and international fund managers Additionally, it addresses the limitations of the research and proposes directions for future investigations.
Literature on Financial Crises and Equity-market Linkages
Overview
This chapter examines the equity-market linkages between Vietnamese and global markets, as initially outlined in Chapter 1 It focuses on whether these connections are influenced by the Global Financial Crisis (GFC) and reviews existing literature to uncover commonalities among global equity markets Furthermore, it investigates how these linkages may evolve during times of crisis.
This chapter offers a comprehensive review of equity-market linkages, focusing on definitions, foundational theories, and the effects of financial crises It is structured into six sections: Section 2.2 outlines the background of financial crises, detailing their definitions, causes, and consequences Section 2.3 defines global equity market linkages and explores foundational theories, identifying their sources to clarify their nature Section 2.4 addresses key issues from prior studies on equity-market linkages and common methodologies for testing these connections The impact of financial crises on equity-market linkages is examined in Section 2.5, while Section 2.6 provides a concluding summary of the chapter.
Background to financial crises
Over the last two decades, the global economy has experienced a series of financial crises Examples include the 1994 peso collapse in Mexico, the 1997 financial crisis in Asia, the
The 1998 bond-market collapse in Russia, the 1999 Brazilian currency crisis, and the 2007 subprime crisis in the US exemplify financial crises that began in specific countries and subsequently affected neighboring and global markets This section offers a systematic review of financial crises, discussing their definitions, causes, and consequences, with a particular emphasis on the Global Financial Crisis (GFC).
Financial crises have distinct origins in sectors such as banking, currency, real estate, and bonds, leading to various definitions over time Friedman and Schwartz (1963) specifically define a financial crisis as a banking panic, emphasizing that it arises from a sharp decline in the money supply, which severely impacts economic activities This definition highlights the connection between financial crises and banking panics but is limited as it primarily reflects a monetarist perspective (Mishkin 1992).
Kindleberger (1978) and Minsky (1972, 1982) laid the groundwork for understanding financial crises, exploring their nature and occurrence patterns They highlighted the correlation between significant asset price declines and subsequent disruptions in the overall economy However, critics argue that their analyses are overly generalized and lack a comprehensive theoretical framework detailing the fundamental causes of financial crises (Mishkin 1992; Rosser, Rosser, and Gallegati 2012).
Gertler (1988) offers a comprehensive perspective on financial crises, emphasizing the role of asymmetric information and financial structure He posits that asymmetric information can cause inefficiencies in financial markets, significantly impacting real economic activities However, this view lacks a cohesive framework for understanding financial crises, particularly in explaining the potential benefits of government interventions during such events.
More recently, Mishkin (1992, p.118) discusses the nature of financial crises based on the asymmetric information framework to provide a precise definition of a financial crisis as follows:
A financial crisis disrupts financial markets, exacerbating issues of adverse selection and moral hazard, which hinders the efficient allocation of funds to the most promising investment opportunities.
7 Asymmetric information implies that information is not available equally to all parties in a market It may result in two problems: adverse selection and moral hazard in each transaction
A financial crisis is characterized by the inability of financial markets to allocate funds efficiently, resulting in a significant deviation from economic equilibrium This situation typically involves a sudden and sustained shift in financial market conditions and asset prices This widely accepted definition is supported by research from scholars such as Hahm and Mishkin (2000), Kwack (2000), and Barrell and Davis (2008).
Crises typically stem from shocks in specific markets, leading to widespread repercussions across global markets This phenomenon has garnered significant interest from researchers aiming to understand the causes and implications of such crises (Allen and Gale 2004; Yang and Lim 2004; Marcal et al 2011; Rosser, Rosser, and Gallegati 2012).
The varying levels of economic and institutional development across markets lead to different explanations for financial crises, often tied to specific events For example, Dornbusch et al (1995) identify increased capital flows and a rigid exchange rate as key factors in the 1994 Mexico crisis, while Malliaris and Urrutia (1992) attribute the 1987 Russia crisis to both macroeconomic and microeconomic weaknesses Additionally, Timmer (2001) and Yang and Lim (2004) explore several triggers of the 1997 Asian financial crisis, including a quasi-fixed exchange rate set by governments to reduce exchange-rate risks, moral hazard issues stemming from close ties between government, banks, and firms, and financial panics caused by herd behavior among foreign investors leading to significant capital withdrawals.
Pasquariello (2008) identifies various sources of crises, highlighting macroeconomic and microeconomic weaknesses, monetary policy issues, coordination challenges among investors, and the influence of large traders and speculators Additionally, herding behavior and the interplay between stock and foreign exchange markets contribute to the emergence of crises, as noted in the research by Chan-Lau and Chen.
In 1998, a review highlighted four key factors that can trigger financial crises: fundamentals, expectations, multiple equilibria, and moral hazard These studies collectively suggest that various elements can serve as potential sources of a financial crisis.
Recent crises have increasingly originated in emerging countries, as noted by researchers like Daly (2003) and Billio and Pelizzon (2003), who attribute these crises to underdeveloped financial markets, significant reserve capital deficits, and weak governance Furthermore, Timmer (2001) highlights that the recent turmoil in emerging markets stems from delayed adaptations in their financial frameworks to align with the changes brought about by financial-market liberalizations.
Financial crises arise from both domestic financial market weaknesses and external factors Researchers are particularly interested in the sequence of events that lead to these crises According to Mishkin (1992), a typical financial crisis in the US begins with triggers such as rising interest rates, stock market declines, and increased uncertainty These factors contribute to adverse selection and heightened moral hazard issues, ultimately resulting in a downturn in overall economic activity This model has been widely accepted and corroborated by various studies, including those by Hahm & Mishkin (2000) and Mishkin & Leeds (2006).
Figure 2.1: The sequence of events of a financial crisis
Hahm and Mishkin (2000) build upon Mishkin’s model to present a two-stage framework for understanding the progression of a financial crisis, which begins with vulnerabilities in the oversight of banking systems and financial markets in emerging economies This initial stage leads to speculative attacks on the currency, resulting in depreciation and potential collapse Consequently, both financial and non-financial institutions face challenges such as adverse selection and moral hazard, impairing their ability to operate effectively.
Adverse selection and moral hazard problems worsen
Seventeen channel funds significantly influence the economy, potentially resulting in a collapse of economic activity This model is commonly employed to analyze the impacts of crises originating in emerging market countries, in contrast to those from advanced market nations Additionally, research conducted by Barrell and Davis supports these findings.
The 2008 Global Financial Crisis (GFC) led to a significant collapse of asset structures, prompting ongoing discussions among researchers regarding its policy implications across various countries The severity of the GFC continues to influence academic discourse, highlighting the lasting impact of the crisis on global economies.
Equity-market linkages
The integration of equity markets in the global economy is driven by the liberalization of trade, services, and financial markets This section explores the connections between equity markets, beginning with an overview of these linkages and continuing with a discussion of relevant theories and sources.
2.3.1 Overview of equity-market linkages
In recent decades, global equity markets have become increasingly integrated due to the easing of international trade restrictions, financial deregulation, and advancements in information technology According to Watson (as cited by Kearney and Lucey, 2004), international market integration can be categorized into three stages: internationalisation, securitisation, and liberalisation, based on the extent of foreign involvement in host countries Internationalisation and securitisation pertain to market development through indirect and direct finance, respectively, while liberalisation signifies the removal of barriers to international trade, services, and finance.
Research indicates a significant relationship between market integration and market linkage, suggesting that increased equity market integration leads to stronger market correlations (Johnson and Soenen 2002; Billio and Pelizzon 2003b; Aggarwal and Kyaw 2005) However, empirical studies reveal a more intricate reality, as evidenced by Ghosh, Saidi, and Johnson (1999), who found varying influences among Asia-Pacific markets, with some dominated by the US and others by Japan, while a few remained independent Additionally, Syriopoulos and Roumpis (2009) highlight that Balkan equity markets are primarily influenced by developed markets over the medium to long term, yet are more closely tied to neighboring markets in the short term.
Equity markets exhibit various types of linkages, which can be categorized into two primary groups The first group encompasses fundamental linkages that relate to market levels and volatilities, including co-integration, as highlighted in studies by Huang, Yang, and Hu (2000), as well as Yin and Xu (2003) and Aggarwal.
This thesis examines the effects of the Global Financial Crisis (GFC) on equity-market linkages, focusing specifically on contagion rather than interdependence It discusses three primary types of market linkages: co-integration, causality, and contagion Contagion is defined as a significant increase in cross-market linkages following a market shock, while interdependence refers to a high degree of linkages among all states of the world economy The research draws on various studies that explore the impacts of market shocks and cross-market linkages during turbulent periods.
Co-integration, introduced by Engle and Granger in 1987, refers to the long-run co-movement of non-stationary time series variables They propose that if a combination of two such variables results in a stationary series, these variables are considered pair-wise co-integrated over the long term.
Co-integration in equity markets suggests that while two markets may diverge in the short term, they tend to move together over the long term This concept was further developed into a multivariate co-integration framework by Johansen in 1988 and later by Johansen and Juselius in 1990.
Co-integration has been extensively studied across various domains, including macroeconomic factors, commodity goods, equity markets, foreign-exchange markets, and bond markets, with significant contributions from researchers like Maki (2003), Narayan and Narayan (2010), and others This concept plays a crucial role in understanding market efficiency and predictability, as highlighted by the work of Moore and Copeland (1995) and Kellard (2006).
The concept of causality, introduced by Granger in 1969, posits that a causal relationship between two variables exists when the past values of one variable can enhance the prediction of another This lead-lag relationship is based on the assumption that current values can be explained by their own lagged values and those of another variable Early research suggested that this causal relationship was primarily relevant in the short run (Gupta, 1987) However, Granger expanded this concept in 1988 to encompass multivariate causality, incorporating co-integration relationships, thereby allowing for the examination of both short-run and long-run linkages.
Causality has been explored across various fields, including macroeconomic factors, commodity goods, and equity markets Research by Hsiao, Hsiao, and Yamashita (2003) utilized Granger causality tests to examine the relationship between GDP growth rates and stock-price indices in the US and Asia-Pacific, revealing no significant causal link in GDP growth but a strong unidirectional causality from the US to regional stock indices Similarly, Hong and Setaputra (2010) found significant influences from the US on five ASEAN markets between 1992 and 2006, with minimal impact from ASEAN markets on the US These findings underscore the implications of predictability and causality in economic relationships.
The term "contagion," originally used in chemistry to describe the spread of medical diseases, has evolved since the late 1990s to refer to the international transmission of economic shocks, particularly following the collapse of the Thai baht, which led to significant declines in exchange rates across several countries (Claessens & Forbes, 2001).
The literature on contagion explores varying definitions, with Daly (2003) and Forbes and Rigobon (2002) characterizing it as a notable rise in correlation among equity markets during crises, while Cuadro-Sáez, Fratzscher, and Thimann (2009) and Phylaktis and Lichuan (2009) contribute to the ongoing debate on the concept.
In 2000, the term "financial contagion" was used to describe the heightened cross-market linkages following a shock in one country, emphasizing the interconnectedness between markets rather than just strong bilateral ties A thorough examination of financial contagion is provided by Pericoli and Sbracia (2003), who outline five distinct definitions of contagion and contextualize them across various scenarios.
The World Bank outlines three key definitions of contagion, frequently referenced in scholarly research The first, a broad definition, describes contagion as the cross-country transmission of shocks or spillover effects, without focusing on crisis periods The second definition narrows this down, defining contagion as the transmission of shocks beyond what economic fundamentals can explain, indicating overall economic vulnerability during crises The third, more restrictive definition emphasizes shock mechanisms among countries specifically during crises, akin to the 'shift contagion' concept by Forbes and Rigobon In studies of contagion related to crises, researchers often utilize the second and third definitions This thesis will adopt the third definition to analyze the effects of the Global Financial Crisis (GFC) on equity markets.
2.3.2 Theory of equity-market linkages
International equity-market linkages are grounded in two key theories: purchasing power parity (PPP) and modern portfolio theory (MPT) This section delves into the intricacies of these theories, highlighting their significance in understanding global market dynamics.
Purchasing power parity (PPP) is one of the oldest theories in finance According to Karim
(2011), the theory evolved from studies by the School of Salamanca in Spain in the sixteenth
A review of equity-market linkages
As discussed above, equity-market linkages can be classified into three groups according to their relationships This section reviews emerging issues regarding these relationships
Empirical studies on co-integration have been extensive, covering various market classifications such as advanced, emerging, and mixed markets (Huang, Yang, and Hu 2000; Daly 2003; Lucey and Voronkova 2008; Cheung, Fung, and Tsai 2010; Huyghebaert and Wang 2010) Recent research, particularly by Syllignakis and Kouretas (2011), has concentrated on the linkages between advanced and emerging markets Furthermore, the findings on co-integration among equity markets are influenced by factors such as the specific markets analyzed, the time periods studied, and the methodologies employed (Fernández-Serrano and Sosvilla-Rivero 2001; Gupta and Guidi 2012).
Studies on equity market linkages often focus on markets selected for their trade relationships and foreign direct investment For example, Ghosh, Saidi, and Johnson (1999) explore the co-integration between the US and Japan, as well as various Asian Pacific markets such as Hong Kong, India, Taiwan, Korea, Malaysia, Singapore, the Philippines, and Thailand, due to the significant investment and trading partnerships between the US and Japan.
Daly (2003) explores equity market linkages in Southeast Asia, highlighting the rapid integration of trade and capital markets among regional economies Similarly, Lucey and Voronkova (2008) investigate the connections between Russian and Central and Eastern European equity markets, emphasizing Russia's role as a significant trading and direct investment partner in the region.
A study by Ghosh, Saidi, and Johnson (1999) investigates the long-term relationships between developed markets in the US and Japan and various Asia-Pacific markets The findings reveal that while a long-run relationship exists between the US, Japan, and several regional markets, Thailand and Taiwan do not exhibit co-movement with the others The authors attribute these differing results to the unique macroeconomic linkages present in each country.
Lucey and Voronkova (2008) analyze the co-integration relationships between Russian and global equity markets from 1995 to 2004, discovering a lack of significant long-term connections between the Russian market and both regional and developed markets Their findings indicate that the Russian equity market was largely isolated from international markets during this timeframe.
A study by Aloui, Aùssa, and Nguyen (2011) highlights the growing interest in equity market co-movement due to the globalization of capital markets Their findings suggest that recent research indicates an increase in co-integration among equity markets, driven by liberalization and globalization trends Furthermore, studies by Cheung, Fung, and Tsai (2010) and Huyghebaert and Wang suggest that the long-term relationships between global equity markets may change over time.
The variation in financial and banking system liberalization, along with the removal of trade and service barriers among emerging countries, may explain differing co-integration relationships However, research indicates that these relationships can change over time, as evidenced by studies conducted by Ghosh, Saidi, and Johnson (1999), Lucey and Voronkova (2008), and Cheung, Fung, and Tsai (2010).
Various testing models are utilized to explore co-integration relationships, with Glezakou and Mylonakis (2010) highlighting the evolution of co-integration tests from traditional regression analysis (Agmon, 1972) to those based on the VAR model (Engle).
Three commonly used co-integration tests include those based on residuals, VAR models, and those accommodating structural breaks Researchers have noted inconsistencies in the results of these tests, attributing the mixed outcomes to variations in study periods, data frequency, and research methodologies (Fernández-Serrano and Sosvilla-Rivero 2001; Gupta and Guidi 2012).
Since Granger's introduction of causal relationships between markets in 1969, there has been a growing interest among researchers in this area Studies have categorized these relationships into three main types: developed markets, emerging markets, and mixed markets For instance, Khalid and Kawai (2003) explored the causal connections among foreign-exchange, stock, and interest-rate markets across nine East Asian countries, revealing some evidence of causality among these markets, though the findings did not strongly support causal linkages specifically among the stock markets.
Two prevalent testing models for causality are the pair-wise Granger causality, introduced by Granger (1969), and the multivariate Granger causality, proposed by Engle and Granger (1987) These models are extensively utilized in research (Huang, Yang, and Hu 2000; Sander and Kleimeier 2003; Yin and Xu 2003; Au Yong, Gan, and Treepongkaruna 2004) For example, Huang, Yang, and Hu (2000) applied pair-wise Granger causality to analyze the causal relationships among the US, Japan, and the South China Growth Triangle (SCGT) stock markets from October 1992 to July 1997, revealing that the US market significantly influences the SCGT markets more than Japan, with a notable bi-directional relationship between the Shenzhen and Shanghai stock exchanges Similarly, Hsiao, Hsiao, and Yamashita (2003) employed both pair-wise and multivariate causality tests, finding a mono-directional relationship from the US to Japan, Korea, and Taiwan, but not China, during the period from September 2001 to December 2002 Additionally, vector autoregression (VAR) analyses, including impulse response functions, are commonly used to explore the interdependence among equity markets.
The analysis employs a variance decomposition method to assess the significance of each market's variances in predicting the expected variances of a specific market Empirical findings from VAR analyses substantiate the understanding of causal relationships among the markets studied, as demonstrated in the works of Eun and Shim (1989), Hsiao, Hsiao, and Yamashita (2003), and Yang and Lim (2004).
Contagion, a relatively new concept compared to co-integration and causality, has gained significant attention from researchers, particularly in the context of recent crises Studies have explored contagion at various levels, including cross nations, markets, industries, and products For instance, Phylaktis and Lichuan (2009) analyze contagion among global equity markets in Europe, Asia, and Latin America from 1990 to 2004, revealing distinct sector-level contagion patterns that vary by region Notably, their findings indicate that the financial sector does not show contagion effects with the US in Europe and Asia, but does exhibit such effects in Latin America.
Empirical testing models of contagion exhibit significant variation due to the multiple definitions of contagion Pericoli and Sbracia (2003) categorize these tests into two groups: the first examines the transmission of shocks between countries, while the second investigates structural breaks in correlation Additionally, Ahlgren and Antell contribute to this discourse by exploring further aspects of contagion dynamics.
In 2010, a co-breaking analysis utilizing the VAR model was conducted to examine contagion effects Dungey et al (2005) provide a comprehensive review of various contagion models, highlighting empirical testing methods such as correlation and variance (Forbes & Rigobon 2002), the factor model (Bekaert, Harvey & Ng 2005; Corsetti, Pericoli & Sbracia 2005), the VAR approach (Favero & Giavazzi 2002), and dynamic conditional correlation (Engle 2002).
8 If variables have a break in their conditional means but their linear combinations do not have the break, they are said to be co-breaking
Impacts of financial crises on equity-market linkages
The globalization of financial markets has significantly impacted investors' risk management and portfolio diversification strategies Additionally, recent financial crises have unexpectedly changed the linkages within global equity markets.
Numerous studies have examined the effects of crises on equity-market linkages, categorizing them by specific events such as the 1997 Asian Financial Crisis, the 1998 Russian financial crisis, and the 2007 Global Financial Crisis While many researchers, including Cheung, Fung, and Tsai (2010) and Huyghebaert and Wang (2010), document significant impacts of these crises on market connections, some studies, like Kenourgios and Padhi (2012), find negligible effects For instance, Cheung et al (2010) report increased co-movement between the US market and those of Hong Kong, Japan, China, Australia, and Russia during the Global Financial Crisis, whereas Kenourgios and Padhi (2012) observe no co-integration between Argentina and the analyzed markets during its crisis from 1999 to 2000 These findings suggest that different crises can lead to varying impacts on long-term relationships within global equity markets.
In analyzing long-run relationships between global equity markets during crises, two primary research approaches are employed The first approach involves co-integration analysis, dividing data into pre- and post-crisis periods for comparative evaluation For example, Daly (2003) utilized bivariate and multivariate co-integration tests to examine market linkages among several countries from 1990 to 2001, revealing no significant increase in co-integration among Southeast Asian stock markets post-crisis The second approach considers structural breaks in time series data due to crisis impacts, as explored by various researchers Azad (2009) identified long-term relationships among China, Japan, and South Korea markets, while Huang, Yang, and Hu (2000) applied the Gregory and Hansen model to study co-integration amid structural breaks from the Asian Financial Crisis, finding no evidence of co-integrating relationships among the SCGT markets, despite increased intra-regional trade.
Causal relationships play a vital role in risk management and portfolio diversification for investors, as they illustrate the interactions and interdependence among equity markets During crises, numerous studies have investigated how these causal relationships shift among global equity markets (Cheung, Fung & Tsai 2010; Gklezakou & Mylonakis 2010) Most of these studies utilize pre- and post-analysis techniques to assess the crisis's impact on causal relationships (Malliaris and Urrutia 1992; Cheung, Fung and Tsai 2010; Huyghebaert and Wang 2010) Additionally, several researchers have examined the effects of crises on causal relationships through impulse response functions and variance decomposition, aiming to understand the dynamic influence of one market on others (Yang and Lim 2004; Chuang, Lu and Tswei 2007).
Numerous empirical studies highlight a marked increase in market interdependencies during times of crisis For instance, Cheung, Fung, and Tsai (2010) analyze the connections between the US market and those of the UK, Hong Kong, Japan, Australia, Russia, and China from January 3, 2003, to April 3, 2009 Their research reveals a growing influence of the US market on these countries during the Global Financial Crisis (GFC) of 2007-2009 Similarly, Glezakou and Mylonakis also contribute to this understanding of market dynamics during turbulent economic periods.
(2010) indicate evidence in favour of dominant influences of the US equity market towards other developed markets during the GFC
Some studies indicate that crises may have limited effects on the causal relationships between markets For instance, Malliaris and Urrutia (1992) examined six major stock markets—US, Japan, Hong Kong, London, Singapore, and Australia—and found no lead-lag relationship before and after the October 1987 crisis, although some directional relationships emerged during the crisis month In contrast, Dooley and Hutchison (2009) reported no predictability between US equity prices and Mexican equity prices in the first two phases of the Global Financial Crisis (GFC), but noted that in the third phase, the US market became a significant predictor of the Mexican market.
Research on contagion in global equity markets reveals varied approaches, with some studies focusing on individual crises (Naoui, Liouane, and Brahim 2010; Wang 2011; Gupta and Guidi 2012) and others analyzing multiple crises (Forbes and Rigobon 2002; Dungey et al 2007; Kenourgios, Samitas, and Paltalidis 2011) Despite the existence of various contagion models, empirical results remain inconsistent Forbes and Rigobon (2002) utilize unconditional correlation coefficient tests to explore contagion effects across multiple markets during significant crises, including the 1997 East Asian crisis and the 1994 Mexico crisis.
The 1987 US stock-market crisis revealed a complex relationship between global markets, highlighting interdependence rather than mere contagion Research by Corsetti et al (2005) utilized a single-factor model to demonstrate that while some contagion was present, significant interdependence among the markets under examination persisted during times of crisis.
In their 2010 study, researchers analyzed the correlation dynamics between 11 Asian stock markets and the US stock market, revealing significant contagion effects from the US to individual Asian markets starting in late 2007 However, they found no evidence of such contagion during the Asian Financial Crisis (AFC) This highlights a notable difference in market behaviors during these two distinct periods.
34 findings on contagion is often explained by a difference of research methods associated with different definitions of contagion
Research shows that the effects of crises on equity-market linkages are varied and often inconclusive These linkages are influenced by the specific crises being analyzed, the timeframes of the studies, and the methodologies employed.
Chapter conclusion
Financial crises can begin in one country and spread to regional and global markets, leading to severe and unexpected consequences Research indicates that these crises impact not only individual equity markets but also the interconnectedness among global equity markets, including long-run co-integration relationships, short-run causal relationships, and the contagion effect To analyze these equity-market linkages and the influence of crises, various empirical models and research methods are recommended, such as co-integration tests, causality tests, and contagion tests.
The Global Financial Crisis (GFC) was distinct from past crises due to its unique origins and severe impact on the global economy This chapter provides a systematic review of equity-market linkages and relevant empirical models, offering insights into research methods and empirical findings discussed in Chapters 4 and 5 of this thesis.