Integration of Financial Markets over past 25 years - Essay Example

Integration of Financial Markets over past 25 years Introduction Objective The paper is aimed at analyzing the degree of financial integration in various areas of financial markets and tries to study the impact of such financial market integration reflected within the stock market, exchange rates and bond markets (Bordo and Murshid, 2002). This does not imply that this study is going to aim at a detailed analysis of the historical movement of the process of financial integration. It uses historical facts and present situations to make a judgmental analysis. Rationale & Importance Over the past 25 years, a very high rate of growth of financial transactions. The world has become a smaller place and globalisation has contributed towards the growth of international credit as a result of international integration of the goods and services market and the growing presence of multinational companies. The GNP has seen more than twice growth in the share of imports and exports for most nations which in turn brought about a large increase in international lending and borrowings for the purpose of addressing the needs of current account transactions (Bekeart, Harvey and Lumsdaine, 2002). Open financial markets have been regarded as an opportunity for expansion of investor’s portfolio diversification scope and therefore has a higher potential for greater risk adjusted return. For the country, smooth consumption is allowed and saves them from potential shocks. Financial flows also results in flow of capital with potential welfare gains and growth and international risk sharing. The costs of financial integration might also be as drastic as its benefits. Countries run the risk of reversal of capital flows and the risk of increased volatility through a largely open capital market. The recent financial crisis has been an example of the drawbacks of financial integration worldwide where the financial meltdown in one country has impacted the complete global economy. Although there was some misalignment of fundamentals, the financial crisis has brought focus to the instability inherent within the financial markets as a result of the financial integration process. This calls for a stronger regulatory supervision and more stubborn financial systems (Agénor, 2001). Structure of paper The paper is organised beginning with a discussion on operational significance of international financial markets and moves on to evaluate determinants of foreign exchange markets for the long run and the short run. The paper also analyses the international stock exchange and its role and reflection on the financial integration. Further, issues related to FDI in international financial integration are reviewed. The conclusion summarises the findings and views expressed within the paper. Operational significance of international financial markets Financial market integration has been accelerated over the past 20 year for numerous reasons. The end of control exercised on foreign exchange has allowed for free capital flows between countries. Deregulation of markets has resulted in removal of barriers for both the financial service users as well as providers. The improvement in the field of telecommunications has made information availability far simpler (Henry, 2000). One can easily sit at his/her desk and know the bond prices operating in a different country or any other place. The advancements made within the financial technology like introduction of swaps and derivative instruments has made available, higher opportunities to take advantage of. The FNMA or the US Federal National Mortgage Association is responsible for harnessing the demand for international debt instruments. Continuous issue of new interest rate swaps and new issues have been held responsible for the integration of the debt instruments securities market (Bekeart, Harvey and Lumsdaine, 2002). Study by (Kawai, 2006) also shows that bond market deepening can be estimated with the increase in the number of bonds outstanding in relation to the GDP of a country. The study showed that Malaysia outperformed other 45 Asian nations in bond market performance. The degree of integration in the financial markets was stronger. The Bond markets represent a certain degree of credit worthiness as suggested by the ratings associated with each bond instrument. They also have a certain time lag associated with them. The bond is sold as a swap instrument and despite this; each bond instrument values the same in each country when converted in home currency terms. This is the reason why integration in the bond market is rather limited (Bhattacharya and Daouk, 2002). The market for merger and acquisitions has also come under the financial integration scanner since the 1980s. In 1985, about 89.4% of the global mergers were restricted to hold within United States and involved at least one party, either the buyer or the seller coming from the US. This percentage came down to 58.8% in 1995 and by 2001; the percentage of US involvement went down to 48.8% and stood at 43.6% in 2013 (Carrieri, Errunza and Hogan, 2007). The market for mergers requires willingness of interested parties, financial availability, knowhow of transactions and a suitable financial environment among other things to be successful. Such mergers become difficult in countries like Germany and Japan where companies have significant cross shareholding patterns. Such ownership pattern has also changed over the years and foreign direct investments are being taken over quickly. Role of International Stock Exchange The international stock exchange serves the purpose of buying and selling of securities in the international markets and also serves the purpose of regulating, assisting and controlling the markets (Christiansen and Koldertsova, 2008). It serves the purpose of investment by individuals and organizations who want to invest their savings and excess funds in securities (Arestis, Demetriades and Luintel, 2001). The international stock exchange offers the scope to investors to make investments in foreign companies and take higher risk in order to benefit from higher gains due to exchange rate differentials and interest rate benefits (Chinn and Meredith, 2004). It is important to note that the exchanges do not engage in the buying and selling activities, they merely provide a platform for setting of prices. The bond market provides a platform for buyer and seller of debt securities and helps in determining the prices of these securities and the associated interest rates. The bond market has doubled in its size since 2000 and provides high liquidity levels to large multinationals (Busch, Christensen and Nielson, 2011). The bond market serves the purpose of diversification of the equity portfolio of large corporate and is relatively safer investment choice. The volatility within the bond market is a reflection of the economic and monetary policy of the country (Taylor, Peel and Sarno, 2001). Integration of International Stock Exchange and Bond Markets Stock market integration has come across as the most important changes as a result of the financial integration process. The increase in globalization has banished the traditional image of a stock market being an open outcry system to a more integrated and sophisticated nature of the exchange (Aggarwal, 2002). Integration projects and advance made in telecommunications have also contributed largely towards opening newer avenues for doing business (Chittedy, 2009). The recent period has observed a phase of rapid restructuring and transformation. Financial integration has seen a whole host of mergers and alliances and also cooperative agreements within the stock exchange market in order to raise the value of these stock exchange markets (Cybo-Ottone et al., 2000). The development of stock market and its integration has been studied by many and some studies do support the theory of an existence of a world stock market. Earlier studies have demonstrated by way of analyzing the closing stocks of different developed nations like UK, USA, Japan, France and Germany that the interdependence of stock markets increased after the 1987 crash of stock markets worldwide (Wong et al., 2004). The major functions of the international stock exchanges involves providing a ready market for speculators and investors to manage their investments and take benefits out of international investing, providing necessary information regarding the on demand market prices and allowing for estimation of value, safeguarding investor activities, adjusting the market equilibrium, allowing for liquidity maintenance and promoting saving habits among individuals (Majid et al, 2009; Chen, Firth and Rui, 2002). The past decades have seen quite a few researches being conducted in the field of the study of interrelationship between the stock markets of different nations. The indices in early years did not reveal significant results because of low degrees of financial integration within countries. In a study by Naeem, (2002) stock market correlation between the eastern countries like Sri Lanka, Pakistan, India, Bangladesh and the developed nations like United States and UK was conducted by using the co-integration analysis of monthly data between 1994 and 1999. Such results revealed the absence of any integration and linkages between South East Asian nations and the developed countries. This implied that risk minimization attempt could be made through investments in Asian nations for risk diversification. However, in another study between the Asian nations including Pakistan, Bangladesh, India and Sri Lanka by Narayan, Smyth and Nandha, (2004) revealed that Pakistan’s stock market were determined by long run stock price movement of India, Sri Lanka and Bangladesh. Post liberalization, the BRICA nations (Brazil, Russia, India, China and Argentina) January 2002 till February 2009 and the results showed that BRICA countries has significant impact from US markets (Aktan et al., 2009; Ali, Butt and Rehman, 2011). A study of network analysis between stock market of nations by Cetorilli and Peristiani, (2009) reported that rise in the trend of globalization has created important political events and motivated an even strong growth of economies among the emerging nations which in turn has led to greater capital pools infusing liquidity within the capital markets and high importance on corporate governance. The case of UK and Japan can be cited here whose stock exchanges have gone to dominate the market trends because of the globalization process in the past two decades (Furusawa and Hideo, 2007). Figure 1: Aggregate secondary market trading volumes for top eight destinations except US (Source: Cetorilli and Peristiani, 2009) Issues with FDI In case of developing nations, FDI has become the single and the largest source of external finance. FDI causes spillover effects in four major ways namely, new market opportunities, gains in productivity, transfer of technology and new process introduction. FDI is viewed as a channel that distributes income from the developed to the developing nations. However, the impact of FDI can be quite different in the sectors within which FDI invests. Alfaro, (2003) finds out that FDI in primary sector is deterring while that in manufacturing sector yield positive results. FDI in the services industry is ambiguous in terms of effect on growth. It is a general view that FDI brings in technological growth from developed to the developing nations. However, the case of FDI is more efficient in well developed nations than the developing countries. It was found in the study by Alfaro et al, (2006), that FDI in highly developed countries generated thrice as much economic benefit when compared to FDI in developing nations. Balamurali and Bogahawatte (2004) emphasize on the need to promote international competitiveness and introducing reform in trade policies for diversification of export promotion instead of import substitution regime to attain accelerated economic growth in developing nations. FDI brings inflow of capital in nations that portray national competitive advantage. This in turn increases foreign flow of capital and leads to financial integration among nations (Neuhause, 2006). Conclusion In summary, financial integration can provide an opportunity for the capital markets across the world to allow for a better allocation of savings into investments and this has brought about more sophisticated financial instruments that allow for a better management of financial risks. The financial liberalization process has also been held responsible for such development in financial integration. However, financial liberalization is also held responsible for bringing new challenges within the financial system that has impacted countries globally. The situation has an alternate view of strengthening the financial management systems and the global regulatory and legal framework which shall contribute towards better financial management architecture. This shall call for a role adoption and active role play by central banks, authorities and regulatory bodies (Zenasni and Benhabib, 2013). Reference List Agénor, P. R., 2001. Benefits and Costs of International Financial Integration: Theory and Facts. Paper presented at conference on Financial Globalization: Issues and Challenges for Small States, Saint Kitts, March 27-28. Aggarwal, R., 2002. Demutualization and corporate governance of stock exchanges. Journal of Applied Corporate Finance, 15(1), pp. 105-13. Aktan, B., Mandaci, P. E., Kopurlu, B. S. and Ersener, B., 2009. Behaviour of emerging stock markets in the global financial meltdown: Evidence from bric-a. African Journal of Business Management, 3 (7), pp. 396-404. Alfaro, L., 2003. Foreign Direct Investment and Growth: Does the Sector Matter? Working Paper, Harvard Business School, April. Alfaro, L., Chanda, A., Kalemli-Ozcan, S. and Sayek, S., 2006. How Does Foreign Direct Investment Promote Economic Growth? Exploring the Effects of Financial Markets on Linkages. NBER Working Paper, 12522, September. Ali, S., Butt, B. Z. and Rehman, K. U., 2011. Comovement Between Emerging and Developed Stock Markets: An Investigation Through Cointegration Analysis. World Applied Sciences Journal, 12 (4), pp. 395-403. Arestis, P., Demetriades, P. O. and Luintel, K. B., 2001. Financial Development and Economic Growth: The Role of Stock Markets. Journal of Money, Credit & Banking, 33(1), pp.16-41. Balamurali, N. and Bogahawatte, C., 2004. Foreign Direct Investment and Economic Growth in Sri Lanka. Sri Lankan Journal of Agricultural Economics, 6(1), pp. 37-50. Bekeart, G., Harvey, C. and Lumsdaine, R., 2002. Dating the integration of World Equity markets. Journal of Financial Economics, 65, pp. 203-247. Bhattacharya, U. and Daouk, H., 2002. The world price of insider trading. Journal of Finance. 57, pp.75-108. Bordo, M. D. and Murshid, A. P., 2002. Globalization and Changing Patterns in the International Transmission in Financial Markets. NBER Working Paper, 9019. Busch, T., Christensen, B. J. and Nielson, M. O., 2011. The role of implied volatility in forecasting future realized volatility and jumps in foreign exchange, stock, and bond markets. Journal of Econometrics, 160(1), pp. 48–57. Carrieri, F., Errunza, V. and Hogan, K., 2007. Characterising World Market Integration through time. Journal of Financial and Quantitative Analysis, 42(4), pp. 915-940. Cetorilli, N. and Peristiani, S., 2009. Prestigious Stock Exchanges: A Network Analysis of International Financial Centers. Federal Reserve Bank of New York Staff Reports, 384, August. Chen, G. M., Firth, M. and Rui, O.M., 2002. Stock market linkages: Evidence from Latin America. Journal of Banking and Finance, 26, pp. 1113-41. Chinn, M. D., and Meredith, G., 2004. Monetary policy and long-horizon uncovered interest parity. International Monetary Fund Staff Papers, 51. Chittedy, K. R., 2009. Global Stock Markets Development and Integration: with Special Reference to BRIC Countries. Paper Presented at Issues in Finance and Economic Development in Developing Countries during Globalization Era. New Delhi, 6-7 November. Christiansen, H. and Koldertsova, A., 2008. The role of stock exchanges in corporate governance. Financial Market Trends, 1, pp. 1-32. Cybo-Ottone, A., Di Noia, C. and Murgia, M., 2000. Recent developments in the structure of securities markets. Brookings-Wharton Papers on Financial Services. Furusawa, T. and Hideo, K., 2007. Free Trade Networks. Journal of International Economics, 72, pp. 310-335. Henry, P. B. 2000. Stock Market Liberalization, Economic Reform and Emerging Marekt Equity Prices. Journal of Finance, 55, pp. 529-564. Imbs, J., Ravn, M. O., Mumtaz, H., and Rey, H., 2003. Nonlinearities and real exchange rate dynamics. Journal of the European Economic Association, 1, pp. 639-649. Kawai, M. 2006. Financial Integration and Bond Market Development in East Asia. OECD-ADBI 8th Round Table on Capital Market Reform in Asia, October 11-12, Tokyo. Majid, S., Meera, A., Omar, M. and Aziz, H. A., 2009. Dynamic linkages among ASEAN-5 emerging stock markets. International Journal of Emerging Markets, 4(02), pp. 160-184. Naeem, M., 2002. Stock Market Linkages:Evidence from South Asia. Paper presented at The 2002 South and Southeast Asia regional meetings of the econometric society at Lahore University of Management Sciences, Lahore. Narayan, P., Smyth, R. and Nandha, M., 2004. Interdependence and dynamic linkages between the emerging stock markets of South Asia. Accounting and Finance, 44, pp. 419-439. Neuhause, M., 2006. The impact of FDI on economic growth: an analysis for the transition countries of Central and Eastern Europe. Heidelberg: Physica Verlag. Taylor, M. P., Peel, D. A., and Sarno, L., 2001. Nonlinear mean-reversion in real exchange rates: towards a solution to the purchasing power parity puzzle. Journal of International Economic Review, 42, pp. 1015-1042. Wong, W. K., Penm, J., Terelle, R. D. and Lim, K. Y. C., 2004. The Relationship between Stock Markets of Major Developed Countries and Asian Emerging Markets. Journal of applied mathematics and decision sciences, 8(4), pp. 201–218. Zenasni, S. and Benhabib, A., 2013. Foreign Direct Investment, Financial Integration, and Growth: Panel Data Analysis for North African Countries. Paper presented at 12th Annual GEP Postgraduate Conference 2013, University of Nottingham, United Kingdom, March 25-26. Read More