The past two decades have witnessed profound changes in financial markets, and equity markets in particular, in form of greater international financial integration as documented, among others, by Lane and Milesi&Ferretti (2006). Naturally, financial market integration needs market liberalization in order to be accomplished in terms of assets substitutability conditions and perfect mobility. The mobility is perfect in the absence of capital and transactions control, institutional barriers and transaction cost. In this paper we focus on equity markets and model financial liberalization, and the consequent market integration, through a fall in portfolio holding costs. The latter can be associated with the drop in fixed banking commissions and the effects of mergers among stock exchanges observed in advanced countries during the last 20 years.
We maintain that understanding how financial integration alters the transmission of monetary policy shocks is a relevant avenue of research for both policy makers and scholars to the extent i) an increasing number of countries lift the strains of regulation on stock exchanges across the world and ii) changing transmission channels of monetary policy have important implications for the inflation&output trade&off and for the appropriate monetary policy response to asset prices, if any. We devote particular attention to stock prices because they play an important role in the transmission of monetary policy to the real economy, but the investigation of the consequences of financial integration on the monetary transmission channels is still scant in the literature.
One could argue that because financial integration makes markets more complete changes in the ot cial interest rate are more readily transmitted to the whole term structure with a strenghtening of the asset price channel of monetary policy (see for instance Visco 2007). While this seems reasonable, in principle we can not exclude that portfolio adjustments and risk&sharing considerations could lead to a different conclusion.
Having this in mind, we attempt to address the question of whether and how equity market liberalization and international integration can influence the effects of monetary policy shocks on equity prices and real variables. In this study we first investigate the issue theoretically and then attempt to find evidence in the case of Australia.
We proceed to build a two&country DSGE model with endogenous portfolio choice in the spirit of the recent contributions by Devereux and Sutherland (2006, 2007). We introduce incompleteness of financial markets by assuming that investors face portfolio holding costs, which depend on the degree of market liberalization and on the market where equities are purchased. In particular, we argue that when markets are strongly regulated and the level of competition among trading firms is low, investors incur a cost on asset holdings. Similarly to Martin and Rey (2004), we think of such a cost in terms of banking commissions and variable fees. Not only, if markets are only partially open to international trade, purchasing abroad entails an extra cost related to the acquisition of information on an unfamiliar market. As consequence, we assume that a domestic agent faces a certain cost on his/her holdings of domestic assets and an higher cost on holdings of foreign assets. As noted in Tille and van Wincoop (2008), the presence of these costs implies that financial markets are incomplete, even if the number of assets equals the number of shocks. To solve the model we follow their approach and assume that the cost is of second order, i.e. small enough to conduce to a well behaved portfolio allocation. Similarly to their model, since investing across border entails a (extra) cost with respect to domestic investment, the model predicts home bias in portfolio holdings.
To study the effect of financial integration on the monetary policy transmission, we generate impulse responses to a monetary policy shock before and after a fall in portfolio holding costs, which can be thought as consequence of the liberalization of the domestic equity market and, more in general, of a process of global financial integration.
An implication of the model is that the reaction of equity prices and some real variables, like output and real exchange rate, to domestic monetary shocks becomes weaker, in terms of impact and persistence, once equity markets are liberalized. Since the dynamics of the model are driven by consumerspbehavior, we conjecture that the fall in the portfolio holding costs, by bringing the model closer to an environment of complete markets, widens the opportunities of risk&sharing. This reduces the need for portfolio reallocation in the face of the shock and therefore lowers the impact on equity prices.
To investigate whether a similar pattern is present in the data, we estimate rolling Vector Autoregressions (VARs) on Australian data. We identify monetary policy shocks with the sign restriction identification strategy developed recently by Canova and De Nicolo (2002).
The particular choice of the country is suggested by the fact that Australia has gradually liberalized its equity market industry. From the relaxation of restrictions on banking institutions in the early 1980ps, which increased competition among trading firms, to the abolishment of fixed commission in 1983 and the government enforcement of merger of all stock exchanges in 1987, the liberalization took lace at a gradual pace through out the 1980ps. Last but not least, Australia has high quality data during all that period.
The contribution of this paper is twofold. It provides empirical evidence that the effect of monetary policy shocks on asset prices has changed over time and suggests a theoretical explanation for it relying on the increased equity market liberalization and integration.
The remainder of the paper proceeds as follows: Section two provides a brief liter& ature review of two&country DSGE models with endogenous portfolio choice. Section three describes the main building blocks of the open economy model (the detailed derivation is in Appendix A) with the solution for optimal portfolio and the modelps impulse responses to a monetary policy contraction under falling portfolio holding costs. Section four describes the estimation strategy and the evidence from Australia. Section five concludes.
