Is there financial integration in the equity markets of the European Union?

Abstract

Both casual observation and empirical research suggest that developed equity markets around the world, including the major European markets, are now highly integrated. Financial integration is a key goal of the European Union (EU) and was one motive for the adoption of the euro. In this article, we examine how far the process of financial integration has gone in the equity markets of the EU. We use an econometric methodology that permits us to measure the equity market convergence while allowing for a range of possible time paths, and for heterogeneity across countries. Our tests reject the hypothesis of overall convergence in the European equity markets. We do, however, find evidence of convergence within three distinct and economically meaningful subgroups of European markets. We find no evidence that the Euro has hastened equity market convergence amongst its members, above and beyond the broader global trends of lowered institutional and legal barriers and market liberalization.

Notes

¹The major institutional driving force for financial integration is the Financial Services Action Plan drawn up as part of the Lisbon Agreement in 2000.

²Moreover, Corhay et al. (1993) found a common stochastic trend among five major European stock markets over the period 1975 to 1991. Rangvid (2001) identified an increasing number of cointegrating relationships between European stock markets in the last three decades and concluded that these markets have experienced a process of convergence.

³See, for example, Chow and Abbott (1993), Darbar and Deb (1997), Francis and Leachman (1998), Hardouvelis et al. (2006), Meric and Meric (1997), Serletis and King (1997), Malliaris and Urrutia (1996) and Geersing et al. (2008).

⁴They also argue that there need not be a connection between financial integration, where similar assets in different countries display the same risk-adjusted expected returns, market efficiency, where asset prices fully reflect all information and cointegration. They argue that in a dynamic general equilibrium asset pricing model, the relationship between these three concepts depends on fundamental similarities in technology, preferences and endowments.

⁵Menzly et al. (2002) derive a similar structure from a DSGE model, where the loadings on the stochastic trend and actual dividends vary with the business cycle, increasing during peaks and decreasing during troughs.

⁶Notice that here we consider the case where heterogeneity in the transitional path is given by the decaying rate a_i, this is, the most interesting case for empirical applications. The function L(t)=log (t) is to be preferred in terms of asymptotic power, as argued by Phillips and Sul (2007).

⁷In cases in which there is considerable volatility in the observations, Phillips and Sul (2007) recommend the use of the average over a window in the later part of the sample.

⁸The evidence from the Monte Carlo experiments in Phillips and Sul (2007) suggests the use of 50% critical values (i.e. sign test). In the empirical application, we choose a conservative position with ς=0.3.

⁹Estonia is excluded from the analysis given the limited data availability.

¹⁰The construction of these indices ignores recent trends towards the merging of stock markets. In 2000, Euronext arose out of the merger of the stock exchanges of Amsterdam, Brussels and Paris. In 2001, the Portuguese exchanges joined Euronext.

¹¹An additional appendix with data details, coverage and mnemonics is available from the authors upon request.

¹²See Rubin (1976) for some discussion of this implication of the MRA condition.

¹³The smoothing parameter is set to 14 400, the standard value with monthly series.

¹⁴The panel in the analysis is unbalanced, and when new countries enter the analysis, they might be very far from the average of the countries already present in the analysis, causing an increase (jump) in the cross-sectional variance which might seriously reduce the power of the test. This seems to be the case for the ‘pharmaceutical and bio’ sector.

¹⁵We perform ADF tests for a unit root of the cross-sectional average of each market and for all of them there is evidence in favour of a unit root with drift.

¹⁶Detailed tables for all the markets are available from the authors on request.

¹⁷We consider Slovakia as an outlier even though the clustering procedure of Phillips and Sul (2007) would include it in the second convergence group.

¹⁸This result is not influenced by the inclusion of Poland.