Ebook Financial Markets in East Asia and Europe during the Global Financial Crisis
When the Asian financial crisis erupted in July 1997, an increase in regional financial market comovements followed. Even though the regional increases in covariances and correlations were the largest in East Asia during this period, similar increases occurred in Europe as well (Chakrabarti and Roll, 2002). Numerous studies have shown that financial crises tend to spread across country borders and financial markets often move more closely together during such episodes. However, each financial crisis is unique in its own way, and the recent financial crisis originating in the US subprime market is no exception. While there are a number of different explanations for the Asian financial crisis, most economists seem to agree that excessive lending practices in the US property market combined with a rapid expansion of complex financial products were among some of the main reasons behind the recent crisis.
These financial products typically bundled, among other things, mortgages together and made it more difficult to value them and resulted in banks relaxing their lending practices even more. The spread of the subprime crisis is also different from previous crises. Originating in the subprime sector, it soon spread through the US financial system and then onward to the European financial sectors, where financial institutions were exposed to the sudden and severe increase in defaults. Most Asian countries, on the other hand, have primarily been affected through real economy channels rather than via a spread among countries’ financial sectors. Not only developing countries such as China, Thailand and Vietnam but also advanced countries including Japan were affected by sudden shortfalls in their previously booming export sectors. However, even though the spread of the crisis has occurred through different channels, it has affected firm values in most countries around the world. This raises some important questions for policymakers and international investors alike: How closely are regional financial markets related? Is there a significant difference between market integration in Europe and Asia? If such a difference exists, is it similar to the differences seen during the Asian financial crisis, or are we witnessing a different evolution of dynamic regional market linkages?
In this paper, we incorporate both time-varying correlations and time-varying copulas to analyze the dynamic nature of regional financial market integration in Europe and East Asia. Three main features of this study separate it from Chakrabarti and Roll (2002) and other related studies. First, we focus on the recent global financial crisis that started in the US. Second, we add copulas and tail dependence analysis. This improves our understanding of dependence structures across regional equity markets. Third, we extend Chakrabarti and Roll’s original methodology by looking at how each country relates to the rest of its region. This enables us not only to look at regional market integration, but also to determine which countries experience the most significant changes in terms of regional comovements in times of global financial turmoil. Besides comparing and extending Chakrabarti and Roll’s initial results on the Asian financial crisis to the current crisis, this paper complements initial studies on the overall effects of the current crisis on global equity markets. For instance, Bartram and Bodnar (2009) take a broad view of the impact of the crisis on global equity markets. Their focus is mostly on the direct effect in terms of stock price declines, even though they also include a preliminary discussion on market correlations.
Our findings show that regional volatility and comovements differ from those during the Asian financial crisis. Europe is more affected during the global financial crisis with higher volatility and covariance. However, regional correlation in East Asia also increased quickly from an initial low level at the onset of the crisis. Overall, the correlation patterns indicate increased levels of comovements during the crisis period compared to the pre-crisis period. Regional tail dependence remains relatively stable in both regions, with Europe exhibiting a much higher level of average tail dependence both before and during the crisis. A number of markets experience a strong downturn in average tail dependence during 2008, followed by an equally fast and strong increase. The results have important implications for investors who seek to diversify their regional portfolios. While diversification is usually seen as beneficial for international investors, our findings indicate that the benefits of such diversification have been of limited value during the global financial crisis. As financial integration increases, markets move more closely together. This limits the ability to decrease portfolio risk by diversification across markets. The results show that this is true for both East Asia and Europe during a crisis that actually started out as far away as the US.
The rest of the paper is structured as follows: Section 2 discusses related literature, focusing on time-varying market integration and previous research on contagion effects during times of financial crisis. Section 3 describes the methodology. Section 4 first introduces the data and then presents the empirical results. Results are discussed on a regional as well as country regional level. Finally, Section 5 concludes the paper and offers some suggestions for future research.
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