Academic journal article The European Journal of Comparative Economics

Further Evidence on the Determinants of Regional Stock Market Integration in Latin America

Academic journal article The European Journal of Comparative Economics

Further Evidence on the Determinants of Regional Stock Market Integration in Latin America

Article excerpt

1. Introduction

Latin American countries have established a key economic region over the past twenty years. The regional economic dynamics is substantially driven by Brazil as the sixth largest economy in the world overtaking the United Kingdom and Italy as well as by Mexico as the second largest economy of the region and the 14th largest economy in the world (August 2012). For their parts, Argentina and Chile are ranked 27th and 41st largest economies respectively. With a combined GDP of nearly 4,400 billion, this group of four fastest-growing economies in the Latin American region is located between Germany (3,600 billion) and Japan (5,800 billion). A number of studies have been devoted to these countries given their important role in world's international trade and economic growth, but the main focus was extensively on the issue of trade integration. Indeed, while Mexico is part of the North American Free Trade Agreement (NAFTA), Argentina, Brazil, and Chile (associate member) are the source of inspiration behind the creation MERCOSUR, another free trade area.

The issue of financial integration of these countries is seldom addressed, even though stock markets in Sao Paulo, Mexico City, Buenos Aires and Santiago have recently gained much attention from individual and professional investors, especially after respective governments undertook a series of structural economic and financial reforms to improve the transparency and attractiveness of their financial markets (Bekaert, 1995). In addition, existing attempts on Latin American market integration such as Bekaert and Harvey (1995, 1997), Adler and Qi (2003), and Hardouvelis et al., 2006) arbitrarily chose several financial and macroeconomic variables to model the dynamics of market integration without formally testing their economic relevance. For instance, Bekaert and Harvey (1995) propose a model allowing for time-varying world market integration of individual markets and find that increasing integration affects negatively and significantly the cost of equity. More recently, Bekaert and Harvey (2000) introduce changes in dividend yields to measure changes in the cost of equity and document that changes in dividend yields have an insignificant effect on the cost of equity. Carrieri et al. (2007) also use some arbitrary variables to model the dynamics of market integration measure which is then related to a number of factors that may explain the changes in the level of financial integration. Several studies have examined the issue of market linkages and integration outside the asset pricing frameworks. Using Geweke (1982)'s measures of feedback for different pairs of nine national equity markets, Bracker et al. (1999) show significant impacts of macroeconomic variables on the bilateral lead-lag market linkages. Chinn and Forbes (2004) find that direct trade with large economies is the only important factor explaining cross-market links whereas trade competition, bank lending and foreign investment have no significant effect. There is also evidence to suggest a weak role of macroeconomic fundamentals in explaining long-run cointegration of stock returns (Cheung and Lai, 1999).

Although past studies have permitted a better understanding of Latin American equity market integration as well as its determinants, they mainly rely on the concept of market correlation that is not directly related to the true patterns of evolving market integration. As noted by Carrieri et al. (2007), correlations are informative for portfolio allocation and management, but they do not constitute an accurate measure of diversification benefits or overall integration. In particular, Pukthuanthong and Roll (2009) show the inappropriateness of correlation as a proper measure of integration and they argue that two highly integrated markets may have a low correlation. Indeed, if returns on the two markets are affected by the same common factors but do not have the same sensitivities to all of them, the two markets are highly integrated but only weakly correlated. …

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