A contractionary monetary policy shock usually results in lower stock prices in small, open, Asia-Pacific markets. Stock prices converge to the baseline faster in economies with a more open stock market and higher capital mobility. There is also lower short-term stock market volatility in such markets. Although exchange rate shocks tend to immediately affect stock prices, a stock price shock results in only a gradual variation in exchange rates.
How Is This Research Useful to Practitioners?
The author investigates the short- and long-run dynamics between exchange rates and stock prices as well as the path through which monetary policy shocks affect these markets in small, open economies. He looks at four major, small, open economies in Asia Pacific—Hong Kong, Singapore, South Korea, and Taiwan—over the 1999–2016 period. It is to be noted that the stock market capitalization of these four markets accounts for more than 30% of stock exchanges in the Asia-Pacific region. Exchange rates are considered to be an important element in the transmission mechanism of monetary policy.
The author provides evidence that the impacts of monetary policy shocks on stock prices are contemporaneous for all four economies and that stock prices converge to the baseline quickly in markets with higher economic freedom and higher capital mobility (i.e., Singapore and Hong Kong). Furthermore, exchange rate shocks cause lower short-run volatility in Singapore and Hong Kong, although the long-run convergence to the baseline in all four markets takes nearly the same amount of time. The author also finds that an exchange rate shock causes an immediate change in the stock prices in the markets under review. Exchange rates only move gradually after a stock price shock. The impact tends to be more pronounced in markets with a more open stock market and higher capital mobility.
Portfolio managers, traders, and investors interested in investing in emerging and frontier markets will find the conclusions of this research useful. Small, open economies tend to differ, and the impact of exchange rate or stock price shocks cannot be generalized in each economy. Much depends on the degree of economic freedom as well as capital mobility in the particular market.
How Did the Author Conduct This Research?
The author accounts for possible dual endogeneity—when an explanatory variable is correlated with the error term—among stock prices, exchange rates, and monetary policy using Geweke’s linear feedback measures as well as a structural vector autoregressive model. He conducts the study using stock prices, exchange rates, monetary policy, industrial production indexes, and consumer price indexes in Hong Kong, Singapore, South Korea, and Taiwan. The data consist of monthly observations over the 1999–2016 period. Pre-1999 data are excluded, given potential implications of the Asian financial crisis. US short-term interest rates and consumer price index are used as proxy measures for the monetary policy and financial market of a major, large, open economy.
According to the author’s findings, stock prices and exchange rates play important roles in the transmission of monetary policy in small, open economies. Feedback from stock price shocks to exchange rate changes is much higher than that from exchange rate shocks to stock price changes in all four markets. So, stock price shocks may be important in explaining exchange rate movements in the long run.
Stock prices in Singapore and Hong Kong are also found to be less sensitive to contractionary monetary policy shocks than in the two other markets studied, and they recover to the baseline within a shorter period of time. In the case of a stock price shock, exchange rates stabilize at different magnitudes in all four economies, but the responses are more significant in Singapore and Hong Kong.
Abstractor’s Viewpoint
The exchange rate is commonly regarded as a key element in the transmission of monetary policy in small, open economies. Monetary policy shocks tend to affect stock prices in small, open economies in the Asia-Pacific region. Much depends on the economic freedom and capital mobility in each market.
The author looks at only four markets in the Asia-Pacific region, which may not be representative of the region. Additionally, the author notes that the stock market capitalization of these four economies accounts for only 30% of stock exchanges in Asia Pacific, which suggests that the four markets may not necessarily represent the region. Furthermore, data prior to 1999 have not been taken into account, given possible distortions associated with the Asian financial crisis. This limitation creates some bias, in my view.
It would have been interesting to see whether the findings would apply over a longer period (e.g., 25 years). A few other markets might also be considered. The findings, nonetheless, remain interesting. Investors can potentially expect lower stock market volatility in the short run in the case of economies with a higher degree of economic freedom and capital mobility. Furthermore, any stock price shock is expected to have only a gradual impact on exchange rates.