Is India's Stock Market Integrated with Global and Major Regional Markets?[Dagger]

Author:Raj, Janak

The stock market in India has witnessed a rapid growth, led by reforms, since the early 1990s and the surge in foreign portfolio capital flows. This study investigates as to how the Indian stock market is integrated with global markets of the US, the UK and Japan and major regional markets in Asia such as Singapore and Hong Kong. The study uses the popular multivariate cointegration model to... (see full summary)



Stock markets of Emerging Market Economies (EMEs) have emerged as the major channel for integration with global and regional markets, led by globalization, deregulation and advances in information technology. Growing financial integration of the EMEs has been fostered by the rapid increase in the cross-border mobility of private capital inflows due to investors seeking portfolio diversification and better yield, growing reliance of nations on the savings of other nations, and shift in the leverage preference of companies from debt to equity finance. There exists a generalized perspective on the association of financial integration with several benefits, including development of markets and institutions and effective price discovery leading to higher savings, investment and economic progress (Mohan, 2006). At the same time, linkages among financial markets can pose various risks such as the contagion and the associated disruption to economic activities, which were evident during the crisis in Asia in the late 1990s. More recently, in January 2008, national stock markets declined sharply in the wake of credit market developments in the US. Economists have, thus, realized that it is useful for countries to monitor the progress of financial markets' interdependence for better policy-making.

Recognizing the critical importance of the subject, numerous studies in the applied financial literature have engaged in measuring international integration of national stock markets across several developed and emerging market economies. In the copious literature, however, studies that focused on India's stock market are rather scarce,1 despite various stylized facts suggesting, prima facie, the growing linkage of the Indian market with global and major regional markets in Asia during the reform period, beginning in the early 1990s.2 Illustratively, the Bombay Stock Exchange (BSE) of India has emerged as the largest stock exchange in the world in terms of the number of listed companies, comprising several large, medium and small firms. With a market capitalization of $1.8 tn in 2007, the BSE has become the 10th largest stock exchange globally and come closer to advanced economies in terms of the ratio of market capitalization to Gross Domestic Product (GDP). In terms of transaction cost, the Indian stock market compares with some of the developed and regional economies. With the objective of internationalizing, several Indian companies have opted for listing on the stock exchanges of other countries, especially global markets of the US and the UK. Ten major Indian companies listed on the New York Stock Exchange account for 19% weight in the benchmark 30-scrip stock price index of the BSE. There are also some Indian companies currently listed on the London Stock Exchange. Foreign capital flows have made a crucial contribution to the growth of India's stock market. India has become a major destination, accounting for about a fourth of total portfolio capital inflows to the EMEs group. There are 1,247 foreign institutional investors participating in India's stock market. The purchase and sales activities of such investors account for three-fourths of the average daily turnover of India's stock market. Since foreign investors operate in a number of countries at the same time, their operations are expected to have contributed to the integration of Indian stock market with other markets. Moreover, India has engaged in various bilateral trade and economic cooperation agreements with several countries and regional groups across Asia, Europe and America.

In this milieu, several issues arise. Is the Indian stock market integrated with global and regional markets? What is the extent of such market integration? Which regional and global markets have dominant influence on India's stock market? While seeking answers to these questions is the major objective, we also have the motivation for contributing to the literature the experience of a leading emerging market economy like India. Following the dominant perspective in the applied finance literature, this study uses correlation and the Vector Error Correction Model (VECM) to gauge the extent of integration of India's stock market with global markets such as the US, the UK and Japan and major regional markets such as Singapore and Hong Kong, which are key financial centers in Asia.

Stock Market Integration Hypothesis

In the theoretical literature, financial market integration derives from various postulates such as the law of one price (Cournot, 1927; and Marshall, 1930), portfolio diversification with risky assets (Markowitz, 1952), capital asset pricing model (Sharpe, 1964; and Lintner, 1965) and arbitrage pricing theory (Ross, 1976). Despite the distinguishing features, these postulates share a common perspective: if risks command same price, then correlation of financial asset prices and the linkage among markets come from the movement in price of risks due to risk aversion of investors. Deriving from these theoretical postulates, financial integration, at the empirical level, is studied using several de jure and de facto measures, though the latter reflecting upon the actual degree of market linkages has been more popular (Prasad et al., 2003; and Yu et al., 2007). Following the seminal works of Engle and Granger (1987), Johansen (1988) and Johansen and Juselius (1990), numerous studies, beginning with Taylor and Tonks (1989), and Kasa (1992), and subsequently, Chowdhry (1994), Masih and Masih (2002), and Chowdhry et al. (2007), among several others, in the applied finance literature have used the cointegration hypothesis for assessing the international integration of financial markets, until Taylor and Tonks (1989) and Kasa (1992) relied on correlation and regression analyses to gauge the nature of price convergence and international portfolio diversification across markets (Levy and Sarnat, 1970; Agmon, 1972; Panton et al., 1976; and Solnik et al., 1996). Taylor and Tonks (1989) showed that cointegration technique is useful from the perspective of the international capital asset pricing model. Kasa (1992) suggested that the short-term return correlation among stock markets is not appropriate from the perspective of long horizon investors driven by common stochastic trends. A cointegration model is useful since it not only distinguishes but also captures the interaction between the long-run and short-run nature of linkage among financial markets. Given the wide popularity of the cointegration hypothesis, we refrain from rehashing the algebra of this methodology. What is striking about the empirical literature is that studies on the subject have brought to the fore various useful perspectives relating to price equalization, market equilibrium, market efficiency and portfolio diversification (Chowdhry et al., 2007). In order to facilitate the empirical analysis, a brief discussion on these perspectives is presented.

The Cointegration Hypothesis

The cointegration hypothesis has a generalized and statistical perspective on equilibrium dynamics among economic and financial variables. It begins with non-stationary variables with time varying mean and variance properties. If the non-stationary variables are integrated of the same order, typically the random walk or the first order integrated processes, then they may follow the path of equilibrium in the long run or share a cointegration relation, i.e., a linear combination of them could be a stationary process. Within the framework of VECM of Johansen and Juselius (1990), the cointegration space may not be unique; there can be 'r' cointegrating relationships among 'n' non-stationary variables. In the extreme case, if r = 0, then the variables are not cointegrated and they do not follow a long-run equilibrium path. Similarly, if r = n, then the cointegration and error correction dynamics are redundant for the system of variables. In practice, there can be single or multiple but less than 'n' number of cointegration relations. According to Gonzallo and Granger (1995), the evidence of cointegration among national stock indices implies equilibrium constraints, which preclude the cointegrated indices diverging too far away from each other in the long run. Such constraints transpire because these indices share common stochastic trends or the driving forces underlying their mutual growth over extended time horizons. In contrast, a lack of cointegration suggests that stock markets have no long run link and stock prices in different markets can diverge without bound or a trend. Stock market integration entails that the markets are exposed to similar risk factors and thus, common risk premium (Ahlgren and Antell, 2002). The existence of a single long-run cointegration among stock market prices would imply that the unique long-run equilibrium path bounds markets. The cointegration test results are stronger, stable and more robust when there is more than one significant long-run vector (Johansen and Juselius, 1990; and Dickey et al., 1991). This is because, for 'r' cointegrating vectors, there are (n-r) common stochastic...

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