The impact of foreign equity investment flows on global linkages of the Asian emerging equity markets

Abstract

Evidence of the impact of foreign equity investment flows on the global linkages of the Asian emerging equity markets is provided. Findings confirm that there is a general trend towards greater integration and this process appears to be influenced by the increasing volumes of foreign equity portfolio investment flows. The results support the widely-held view that foreign investors are return chasers and their trading behaviour is based on information drawn from recent returns available in the emerging markets. The results also confirm the price-pressure hypothesis which suggests that foreign equity investors are mainly responsible for the increases in the stock market valuations in the Asian emerging markets. In view of the findings, the Asian emerging markets may become more vulnerable to the changes in foreign investment flows and turn more volatile in future.

Notes

¹ Our choice of markets is restricted by the lack of availability of good quality and reliable daily data on other emerging equity markets.

² For instance, Taiwan increased the foreign equity ownership limit to 75% in 2000 from 50% in 1999 before removing any limit towards the end of 2000.

³ More recently, Li and Rose (2007) conducted a study using S&P's Emerging Market Data Base on 34 emerging markets where they use the ratio of global and investable indices to show the impact of foreign participation on extreme comovements for the Asia Pacific Economic Cooperation countries. However, our study offers a different perspective on the role of foreign portfolio investor's trading activity on the long- and short-run dynamics of emerging Asian markets.

⁴ There are several examples of interventions by policy makers concerned with the negative impact of foreign equity flows. For instance, Malaysia imposed capital controls in 1998 following the Asian financial crisis with an aim to control the excessive volatility that appears to have been caused by a rapid outflow of foreign capital. In December 2006, the Thai government tried to impose tough controls by requiring investors with more than $20 000 of investment to remain invested for a minimum period of 1 year or face severe penalties if this investment is removed within a year. However, the government had to reverse this decision following a steep fall in the stock market after shares suffered their worst daily fall in 16 years and closed down 14.8%.

⁵ Since our Net Foreign Equity Investment (NFEI) data represents total of all foreign portfolio investments, we use the MSCI world index as proxy of global equity returns.

⁶ Use of a nonstructural approach in linkage studies is advocated by Bekaert and Harvey (2000) who suggest that because of lack of theoretical basis, nonstructural approach should be preferred in conducting portfolio flow studies. Further, Tesar and Werner (1995) report that even in the relatively open markets, the substantial increase in cross border flows do not comply with the theoretical foundations of optimal portfolio theory due to home bias effects.

⁷ The Johansen–Juselius procedure resolves the problem of endogeneity in that we do not need to normalize the cointegrating vector on one of the variables as required in the Engle and Granger (EG) test (Cheung and Lai, 1993).

⁸ See Diebold (2004).

⁹ The first sub-period covers January 2001 to December 2003 and the second sub-period uses data for January 2004 to March 2007. The average net daily foreign equity investment rose to US$98.33 million during the period 2004–2007 compared to US$45.57 million for the period 2001–2003 (Table 1).

¹⁰ Several papers have used rolling correlations in investigating the equity markets integration. For instance, Kearney and Lucey (2004) use rolling correlations and conclude that they provide a good indication whether markets are integrated or segmented.

¹¹ On 16 October 2007, India's stock market regulator proposed restricting the use of offshore Participatory Notes (PNs). PNs are much favoured by foreign investors, especially hedge funds who have been mainly responsible for US$90 billion investment in PNs. In reaction to this news, the Indian stock market promptly fell 9%, triggering a temporary halt to trading.