International Review of Economics and Finance 9 2000 299–322
The relationship between developed equity markets and the Pacific Basin’s emerging equity markets
Baekin Cha
a,
, Sekyung Oh
b
a
Korea Institute of Finance, 7th Fl., KFB Bldg., 4-1, 1-Ga, Myong-Dong, Chung-Gu, Seoul, 100-021, Korea
b
Kunkook University, 93-1, Mojin-Dong, Kwangjin-Gu, Seoul, 143-701, Korea Received 8 October 1998; accepted 4 October 1999; revised 14 June 1999
Abstract
Using a trivariate vector autoregression VAR model with a proper control for hetero- scedasticity, this paper investigates the relationships between the two largest equity markets
in the world—the U.S. and Japan—and the four Asian emerging equity markets: Hong Kong, Korea, Singapore, and Taiwan. Evidence indicates that the links between the developed
markets and the Asian emerging markets AEMs began to increase after the stock market crash in October 1987, and have significantly intensified since the outbreak of the Asian
financial crisis in July 1997.
2000 Elsevier Science Inc. All rights reserved.
JEL classification: G15
Keywords: Asian emerging markets; Asian financial crisis; Vector autoregression
1. Introduction
The predominant feature of the stock market crash of October 1987 was its global scale. Equity markets around the world reacted to the collapse of the Dow Jones
Industrial Average of the New York Stock Exchange with their own versions of a crash. Based on this phenomenon, scholars and market participants have developed
an increasing interest in examining the relationships among national equity markets.
Various methods have been used in this study. For example, Eun and Shim 1989 use vector autoregression to study the interdependence among world equity markets
and find evidence of the U.S. market leading worldwide trends. Arshanapalli and Doukas 1993, using a cointegration analysis, also report an increasing degree of
Corresponding author. Tel.: 1822-3705-6313; fax: 1822-3705-6309. E-mail address
: bichasun.kif.re.kr B. Cha 1059-056000 – see front matter
2000 Elsevier Science Inc. All rights reserved.
PII: S1059-05600000057-5
300 B. Cha, S. Oh International Review of Economics and Finance 9 2000 299–322
interdependence among world capital markets since the Crash. While many other researchers report similar results [see, for example, Brady 1988; Hamao, Masulis,
Ng 1991; and Cheung Ng 1992], other researchers, such as Malliaris and Urrutia 1992 argue that there are no lead-lag relationships for the major market indices
either before or after the Crash.
Recently, the speed of integration among world capital markets seems to have accelerated, due to the gradual lifting of restrictions on capital flows and the relaxation
of exchange controls in many countries. Major progress in computer technology and telecommunications has also expedited the international flow of information and
lowered transaction costs. Recent trends of economic unification and regionalization have created various economic blocs that have also contributed to the integration of
world capital markets.
Many researchers suggest that the substantially increased use and integration of international stock markets has also enhanced the efficiency of global financial mar-
kets. For example, Bailey 1990 examines the effect of U.S. monetary shocks on the Pacific-rim stock markets and shows that the stock indices of countries with relatively
few barriers to investment flows exhibit stronger reactions than those with strict capital flow controls. Kohers and Kohers 1995 find that 11 European stock markets are
linked with both each other and the rest of the world, and that the presence of these distinct systematic relationships has increased overall market efficiency so that
abnormal returns are less common in these markets today.
The studies mentioned above have mainly focused on the interdependence among stock markets of the developed countries such as the U.S., Japan, and Western Europe.
Although the Asian stock markets are currently suffering from the recent financial crisis, the importance of stock markets in the AEMs has still grown tremendously in
recent years.
More recent studies have investigated stock market correlations between developed countries and AEMs. Cheung and Mak 1992 find that the U.S. market is a global
factor, affecting both developed and emerging markets. Liu and Pan 1997 investigate the mean and volatility spillover effects from the U.S. and Japan on the four AEMs
Hong Kong, Singapore, Taiwan, and Thailand. Using data from 1984 to 1991, they find that the spillover effects increased substantially after the Crash of October 1987,
and that the U.S. market is more influential than the Japanese market in transmitting returns and volatilities to the four AEMs. Wu and Su 1998 report that returns in
large markets lead to returns in small markets and that the Japanese market has a fairly strong influence on other markets in cases where the U.S. impact is isolated.
While it is a common belief that the U.S. stock market is the single most influential market in the world, in a study of Asian markets, examining the impact of the Japanese
stock market is also important.
The Asian financial crisis, which originated in Thailand in July 1997 and spread into Indonesia and Korea, did not restrict its impact to Asian markets. Stock markets
around the world appear to have been significantly impacted by the Asian crisis. Furthermore, these shocks were transmitted throughout world markets faster than
ever before. Considering the effect of the 1987 crash on the interrelation of stock
B. Cha, S. Oh International Review of Economics and Finance 9 2000 299–322 301
markets, it would be interesting to analyze how the crisis altered the relations between markets of developed countries and AEMs.
This paper empirically investigates several aspects of the influence of the U.S. Japanese markets on Asian markets. The paper seeks to determine the size of the
impact, the speed of transmission, and which market, the American or Japanese, has the greater influence. Presumably, the influence from the U.S. and Japan would be
different depending on whether an AEM had been a victim of the financial crisis or not. It is likely that the stock market of a crisis country might have become more
sensitive to unexpected movements of the U.S. and the Japanese stock markets than that of a country which had escaped crisis. To test this hypothesis, we compare the
case of Korea, which was hit hard by the financial crisis, with Hong Kong, Singapore, and Taiwan, which successfully averted a crisis.
As mentioned above, the greater a country’s restrictions on international capital flows, the lesser the degree of integration between that country’s stock market and
the world stock markets. A number of Asian countries have put strict restrictions on foreign ownership, which has the effect of blocking foreign direct investment and
other foreign exchange transactions. While Singapore and Hong Kong opened up their stock markets early and have guaranteed almost free capital flows without any
restrictions,
1
Korea and Taiwan have historically imposed many restrictions on foreign ownerships.
2
Since the financial crisis began, Korea has lifted most restrictions on foreign direct investment and foreign ownership, and it will be very interesting to
examine whether such deregulation has caused any change in the channel through which the Korean stock market is influenced by the American and Japanese stock
markets.
3
In investigating the issues mentioned above, this paper uses the vector autoregres- sion VAR method with a proper control for heteroscedasticity. The VAR model is
particularly well suited for our purpose since it avoids the problems inherent in the single-equation method yet still yields useful econometric evidence with which to
examine the relative importance of the two major markets on the AEMs.
The rest of the paper is organized as follows: Sections 2 and 3 describe the data and the methodology employed, respectively. Section 4 presents the empirical results,
and Section 5 concludes the paper.
2. Data
