Aurora Borealis
1 January 2014 CFA Institute Journal Review

Financial Markets and International Risk Sharing in Emerging Market Economies (Digest Summary)

  1. Heather K. Traficanti

Over the last decade, emerging market economies (EMEs), especially those economies with more developed financial markets, have experienced an increase in portfolio equity liabilities as a result of more company listings and increased foreign investments. The author focuses on the foreign liability side of international investments and analyzes international risk sharing, the effectiveness of hedging economic capital gains, and stock market performance as a means to stabilize EMEs.

What’s Inside?

On a country-specific basis, the author considers the cyclicality of capital gains in the equity markets of emerging market economies (EMEs) and examines cross-country variations in the patterns to determine the reasons for varying levels of international risk sharing. Using a sample of 21 EMEs, the author analyzes their hedging potential in an environment where domestic capital markets are partially owned by foreign investors. He also conducts a panel analysis of 22 EMEs that provides statistically significant evidence of the pro-cyclicality of capital gains in domestic stock in the short and medium term.

How Is This Research Useful to Practitioners?

The author analyzes stylized facts about the external capital structure of EMEs and notes that the ratio of foreign portfolio equity liabilities to GDP has increased from 1996 to 2007. The most significant increases occurred in Brazil, China, and Russia; the ratio is the highest in Hong Kong at 209% of GDP and Singapore at 92% of GDP. Two notable conclusions of this research indicate that, first, EMEs’ portfolio equity and foreign direct investment liabilities have hedging potential, and second, the growth in stock market capitalization has increased exponentially, thereby enhancing investment opportunities for global investors.

The author conducts a panel analysis on a country-by-country basis and performs regression estimation using least squares. His goal is to establish the direction and degree of the co-movement between output growth and real rates of capital gains. The results indicate a statistical significance at the 1% level for the pro-cyclicality of capital gains in the domestic markets of a majority of the countries studied.

Furthermore, the country analysis indicates statistically significant pro-cyclical co-movements between GDP growth and stock market returns. Countries with the highest idiosyncratic coefficients are China at 20.43%—suggesting a more than 20% equity market capital gain rate for a 1% increase in GDP expansion—India at 7.87%, Brazil at 6.76%, and the Czech Republic at 6.27%.

The target audience for this research would be economic professionals working in the European Central Bank, US Treasury Department, International Monetary Fund, or at universities.

How Did the Author Conduct This Research?

The author’s data are assembled from 21 EMEs in a time series from 1996 to 2010. He uses MSCI domestic and global price indices to calculate rates of capital gains and the World Bank Financial Development and Structure Dataset to obtain domestic stock market capitalization. Constant price gross domestic product and consumer price index data for individual countries are from Haver Analytics, and the World Bank’s World Development Indicators are used to determine output per capita. To achieve consistency for all of the calculations, the author constructs year-end to year-end rates for stock market capital gains growth, real GDP, and inflation. He also notes that the regression specifications use cumulative three-year real rates, which are more suited to EMEs’ business cycles.

Although the country-specific analysis reveals pro-cyclicality of capital gains, implying the effectiveness of hedging capital gains, countries with greater stock market capitalizations are hedged more effectively by foreign investors. The author also confirms international risk sharing among EMEs in the sample because of higher country-specific productivity and growth risk.

Abstractor’s Viewpoint

The research is limited because the time series only spans 1996–2010, and the underlying data are at an annual frequency because of the empirical focus on cyclical factors. The dataset did not include three-year specifications on a country-by-country basis because the information was not available. Furthermore, the research focuses only on the foreign liability side of international investments rather than incorporating a more complete treatment of foreign assets, exchange rates, and bilateral considerations.

The author effectively leverages prior research and delves deeper into an analysis of financial markets and international risk sharing in EMEs. Although the concepts presented are for a technical audience, the author organizes the subjects in chronological order and thoroughly details the assumptions underlying the method of empirical study. In addition, he breaks down the cyclical properties of domestic stock markets by using panel and country analyses, respectively. The author could have made the analysis more robust by including other classes of assets, but focusing on the foreign liability side simplifies the research.

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