Article: Southeast Asian stock market linkages:

evidence from pre- and post-October 1997.

Article from:
ASEAN Economic Bulletin
Related
Article date:
articles
April 1, 2003

Author:
Daly, Kevin James
Copyright
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I. Introduction

In late 1997 and early 1998, several countries in East and Southeast Asia
observed precipitous falls in their exchange rates, following the collapse of
the Thai baht's peg in July 1997. It is widely believed that the rapid spread of
the currency and stock market crisis, from one country in the region to
another, was due to contagion effects, where the occurrence of the currency
crisis in one country increases the probability of a similar crisis in another
country. With respect to stock market linkages, a critical tenet of the Efficient
Market Hypothesis is that stock markets in different countries display
relatively low correlations, based on the notion that most economic
disturbances are country-specific. The latter reinforces the concept of
international diversification, which aims to substantially reduce portfolio risk
and increase expected returns. In an environment where contagion exists, a
negative shock in one or multiple markets would be followed by an increase in
correlations, undermining much of the rationale for international
diversification.

This study investigates the inter-relationships between Southeast Asian stock

markets over a period from 1990 to 2001; the time-frame of the investigation
is divided into two sub-periods covering the pre- and post-1997 Asian financial
crisis. The main question this study attempts to answer concerns the likely
effects that the 1997 financial crisis may have had on the long-run
relationship between the Southeast Asian stock markets at the centre of the
Asian financial crisis. Within the context of financial markets in Southeast
Asia, the study examines whether the crisis arising in one country induces
investors to reduce asset holdings in other countries, even if the latter were
not initially affected.

Several explanations have been put forward to explain why contagion effects
arose in what were formally known as the Asian Tiger economies. One
explanation, which has been influential in recent discussions, is based on the
observation that there has been rapid integration of trade and capital markets
between the economies of Southeast Asia. According to this view, contagion
effects arose when shocks to one economy were transmitted to other
economies that were linked to the former by trade and finance. For a
contemporary discussion of both the theory and evidence refer to Ferraz,
Ocampo, and Yamazawa (2003).

On a broader level, there exist volumes of studies offering explanations for

the causes of the Asian financial crisis, among them being: the presence of
crony capitalism, poor corporate governance and the lack of financial
regulation, ineffective exchange rate regimes, and moral hazard. Here a very
brief overview of these explanations is provided. Poor corporate governance
and lack of financial regulation has been considered by some commentators
to be the primary reason for the Asian financial crisis. Montes (1998) points to
liberalization of the domestic banking sector in particular, removing foreign
exchange controls, interest rate restrictions, and the lifting of credit ceilings
as being responsible for the financial crisis. Inappropriate exchange rate
regimes among the worst-affected countries of Southeast Asia over the crisis
period have also been blamed for the onset of the crisis. For instance, Hutson
and Kearney (1999) point to the inappropriateness of these countries
following managed floating regimes tied to the U.S. dollar, given that intra-
regional trade, investment, and financial linkages have strengthened
significantly throughout Asia in recent years. According to Krugman (1998),
moral hazard may have occurred in debtor countries where governments
provided credible implicit or explicit guarantees to financial institutions and
companies. Most Asian corporate and personal bankruptcy laws remained
almost unchanged--and rarely used--since colonial times. Weak laws
prevented creditors from liquidating insolvent companies and securing assets.
As a result, non-performing loans escalated, as is documented in Ferraz,
Ocampo, and Yamazawa (2003). Non-performing loans give rise to adverse
microeconomic effects via: (i) debt-overhang phenomenon, which deters new
investment by debtors, even when economic prospects are good; (ii) asset
substitution effect, which induces debtor firms to take on more risky projects;
and (iii) increases in agency costs to monitor debtors' improper actions.
Moreover, the macroeconomic effects of non-performing loans occurs through
a vicious circle between deflation and income transfer from debtors to
creditors, deepening further the recession into which the economy is heading.

II. Background

Economists have developed a straightforward approach to measuring

contagion across stock markets. They compare the correlation (or covariance)
between two stock markets during a relatively stable period (generally
measured as a historic average) to that during a period of turmoil (directly
after a shock occurs). Contagion is defined as a significant increase in the
cross-market correlation during the period of turmoil. If two markets are
moderately correlated during periods of stability and one market sustains a
shock, which has ripple effects leading to significant increase in market co-
movement, this would constitute contagion. Alternately, if correlations
between stock market indices do not increase significantly, then any high
level of market co-movement suggests strong real linkages exists between
the economies. Based on this approach, contagion implies that the cross-
market linkages are fundamentally different after a shock, while
interdependence implies no significant change in cross-market relationships.

Evaluating if contagion occurs is important for several reasons. Firstly, a

critical tenet of investment strategy is that most economic disturbances are
country-specific, such that correlations between stock market indices are
relatively low. International diversification should therefore substantially
reduce portfolio risk and increase expected returns. If contagion occurs after a
negative shock, however, then market correlations would increase, which
then undermines much of the rationale for international diversification.
Secondly, many models of investor behaviour are based on the assumption
that investors react differently after a large negative shock. Understanding
how individual behaviour changes in good and bad states is a key to
understanding how shocks are

South East Asian countries (China, South Korea, Japan and Taiwan) have been the object
of economic discussions over the past decade. This began in the nineties where experts
called these countries ‘economic miracles'. However, in the late nineties, these countries
begun underperforming after the vulnerabilities of their economical and political reforms
were exposed. In the late nineteen nineties, the Asian crisis sparked off a lot of debate
about the problems of the South East Asian economic and political agenda. Many experts
began prescribing new approaches that would deal with the crisis. Some of them
prescribed reformist agendas that would prepare these south East Asian countries for
future effects of globalization. The essay shall examine the legitimacy of these
prescriptions and give recommendations on the way forward. (Winters, 2000)

How East Asia performed before the economic crisis

The forces of globalization propagated East Asia's economic success. Globalization in this
context refers to the unprecedented mixing of cultures, technology, manpower and
resources from different parts of the world; a phenomenon brought on by Information
Technology, the end of communism and the shift towards free market forces. The overall
effect of globalization within the South East Asian countries was a rapid increase in the
standards of living for a large portion of the region. It also led to increased literacy levels
within the countries hence a high quality labor force. On top of this, the South East Asian
economies boasted of better health. (Sell, 2000)

Two major ‘recipes' were crucial to the economic success of the early nineties. These were
summarized in the World Bank report (1993) known as the East Asian miracle. The two
issues were; solid macro-economic policies and government intervention. The report
studied the overall patterns used by eight South East Asian countries and found that these
respective governments did the following. First, they reduced fiscal spending and
encouraged greater savings. Those savings were then redirected into infrastructural
development and export growth. The South East governments demonstrated to the world
just what could occur when the government collaborated with the private sector with the
aim of improving their economy. Besides this, the government introduced flexibility within
the labor markets and also changed their credit markets. It should be noted that this latter
aspect was the object of great debate after the Asian crisis.

South East Asian countries reaped the benefits of these reforms because their capital flow
increased adversely as was seen in GDP growth rates of close to five point five percent
annually. Additionally, these countries could also boast of greater foreign investments and
increased productivity within their local environments. Because of the savings culture
adopted in the fiscal markets, the countries could provide stable economic environments
for greater exportation. This was the point at which major sectors of their economies
began opening up to the world. One particular area that depicts these changes was the
industrial sector. However, some critics assert that these policy reforms brought on the
problems that the country experienced in the late nineties because they ended up
benefiting the elite. (Higgot, 1999)

Causes of the South East Asian crisis

Globalization was the key factor propellant of the South East Asian economic and political
boom yet at the same time, it was one of the major reasons for its downfall. Through
globalization, the South East Asian countries began operating in extremely competitive
markets. The countries that had traditionally dominated the world markets were facing
threats from these emerging economies. Consequently, the traditional countries started
making their own changes. They did not want to be displaced by the emerging economies.

Despite the latter fact, there was another more serious reason that cased the 1997
Southeast Asian crisis. This was the susceptibilities of the Asian markets' macro economic
forces. Many critics have asserted that the South East Asian models was very effective at
mobilizing resources but was very poor at controlling those resources that needed to be
controlled. For instance, there were no set regulatory mechanisms for choosing the most
productive areas of the economy. As matter of fact, key industries were left out in these
capital allocations thus leading to plummeting prices and poor service delivery. Examples
here include the energy sector and the telecommunications sector. One cannot undermine
the importance of these two areas to the economy yet the Asian continent had been very
poor at implementing changes here. As a result, the countries could not eliminate the
underperforming sectors of the economy thus allowing them to drag other parts of the
system too. (Rhodes, 1997)

Other critics also assert that the Asian economies missed the mark when it came to local
manufacturers and businesses. The countries had tried protecting their local manufacturers
while at the same time promoting exportation. This increased the level of assets within the
country without due consideration as to which assets were more profitable to the
respective countries. Most of them grew their economies but failed to consider the issue of
equity.

Possible reforms
Some experts have suggested reforms that could assist South east Asian countries in the
process of restoring back their past economic successes. However, suggestions made by
these experts were not well received by the Asian counterparts. Part of the reason for their
lukewarm response is because the South East Asian model of economic and political
reform created a system that encouraged elites within the system. These elites wanted to
maintain their positions and they have the capacity to do so. Consequently, suggesting
reforms through aggressive economic and political transformation will be extremely
difficult to implement owing to these powerful elites. (Winters, 2000)

As if this is not enough, some of the changes that accompanied the opening up of the
South east Asian economies have gone a long way in emerging the local pollution. The
economic and political models adopted prior to the Asian crisis brought about intellectual
interactions among members of these Asian countries thus exposing them to the benefits
of globalization. This means that locals within those states are actually happy with the
effects of globalization and could therefore resist any reformist agenda that can threaten
to change the nature of the current system. Taking an example of a fast food company
such as McDonald's, South East Asian compatriots have enjoyed the services of this food
outlet and actually want it to remain there. This therefore brings in the argument on true
effects of globalization. Globalization is not a threat to South East Asian countries because
multinationals from other countries come and force their way into local markets; on the
contrary, it is a threat to these Asian countries because their consumers have seen the
benefits that emerge from it and now want to continue benefiting from it. Consequently,
imposing economic and political reforms that are designed to counter such effects would
meet stiff resistance from the South East Asian locals. (Lee, 1999)

Some economists have also suggested that imposing a strong and totally different
economic system would also bring problems because the major problems behind the crises
emerge from allocation of capital to areas that do not yield effective returns. Examples of
such sectors include;

• Corporate governance
• Rule of law
• Eliminate corruption
• Dispose of underperforming loans
• Create reforms within banks
• Allocate capital effectively
• Etc
Some of the latter reforms seem better said then done. This is because implementing
some of the reforms mentioned above would require rigorous transformation of the
economic sector which as was seen earlier could bring about stiff resistance from vested
interests there.

The role of good governance in revitalizing South east Asian economies

Some experts have suggested that the major problem behind the South East Asian political
system is the fact that there are inherent corrupt systems. This means that attracting
foreign investors within such systems is very difficult because they face the danger of
issuing or receiving resources based on their relationships rather than on economics. This
makes their markets unpredictable and discourages investments. Such experts have even
cited countries such as Singapore that have done very well in the international markets.
They have been able to make their mark because of their zero tolerance on corruption.
(Cerny, 1997)

Another suggestions made by South Asian critics is the fact that their governance
structures with regard to IT and capital flow have not been in tuned with changes in the
policy. These critics assert that in order for South East Asian countries to boost their
economies, they should not merely focus on gathering capital but should do this against
the backdrop of policy changes. They also add that Information Technology cannot be
regarded as an agent for change alone if it does not operate within the confines of political
and social changes.

While these arguments may be correct, one cannot help but see some of the faults that
can spring from imposing such systems upon the South East Asian countries. It should be
noted that within these countries, the issue of political governance has been associated
with economic governance. Underhill (2000) asserts that trying to separate these two
categorizes within the South East Asian context would be an exercise in futility. It would
therefore be necessary to look at the two types of systems together. In the South East
Asian context, it would be extremely difficult separate those two entities yet this is the
underlying principle behind the reformist agenda brought forward by South east Asian
critics. The underlying principle behind these suggestions is a neo-liberal system with
separate entities of political and economic governance. However, imposing such a system
upon the South East Asian countries would meet stiff opposition. This is because it would
be creating a market-centered approach to the economy.

Additionally, assertions by South East Asian critics about adopting a neo-liberal market
approach would fail drastically owing to the non-existence of compatible structures within
those countries. It should be noted that each country has its own unique political and
economic models. This models do not just happen overnight. They are as a result of the
historical phases that those respective countries have undergone. Even the United States,
which is keen on imposing its political reforms to the South East Asian region, did not just
find themselves in those governance structures; they got there through some systematic
steps inherent in their own history. Due to this reason, prescribing aggressive reforms to
the South East Asian continent without considering their governance institutions can be
deemed unrealistic. (Beeson et al, 2000)

Some of the changes that occurred prior to the crisis created some strong systems that
eventually characterized their political and economic environment. One such case is the
issue of elite control. Therefore, imposing neo-liberal reforms in South East Asia can only
be effective if these changes were not present. However, because they exist and they are
there to stay, it would be difficult to change them. The reasons why those changes are
likely to resist change within the South East Asian arena is because those same groups
were responsible for the success of the emerging economies in the early nineties.
Consequently, South east Asian governments and societies alike owe these groups some
form of loyalty for bringing about the changes that characterized the early nineties even
when those changes are no longer relevant.

A reformist agenda within the South East Asian countries is likely to fail owing to the fact
that most South East Asian countries have deep seated institutional reforms already.
Taking the example of Japan, this country adopted a developmental model of governance.
The country realized that it was not in a position to be laid back about the governance
approach. They had developed at later stages compared to their Western counterparts.
Consequently, in order to remain competitive, there was a need to create a push within
the system. This would only be possible by direct government intervention in the markets.
The reform agenda proposed by South East Asian critics centered on creating liberal
markets where decisions should be made solely on market forces. By instructing such
reforms, this would be going against some of the developmental aspects of the South East
states and would therefore solicit friction from the latter countries. (Beeson, 2001)

In line with the latter arguments, it will also be difficult to impose some of the suggestions
surrounding the neo-liberal systems because there are massive cases of immigrations
within the South East Asian region. For instance, many Chinese have relocated to other
parts of the South Eastern region. Woo Cummings (1998) estimates this number at around
fifty million. The large dispersion rates of the Chinese people have been facilitated by their
huge population size and also by the need to cushion themselves against the hostilities of
the external market. The overall result of such a system is that many Chinese capitalists
have prospered in the South Eastern region. They utilize their prior contacts to access
resources and penetrate regional markets. In this regard, it would be very complicated to
try and fight such a complex network yet this is the basis of the reformist agenda
suggested by critics.

Political systems within the South east Asian countries have a large part to play in term of
the overall success of the reformist agenda. This is because political systems in these
regions have tended towards authoritarianism. While one cannot assert that this may no
be out rightly visible; there are hints of this political system of governance in various
avenues. For instance, in China and Japan, their governments are used to having control
on economic systems. The capitalists that have the capacity to drive the economy also
happen to be political entities. Consequently, trying to pursue a system that is tailored on
a liberal approach would not be very realistic owing to the fact that it can meet stiff
resistance from such political systems. The South East Asian political governments are
deemed as superior to civil society and therefore trying to empower the latter would not be
plausible in the region. (Searle, 1999)

There are certain dynamics within the South Eastern political context that would make it
extremely difficult to adopt a western style reform agenda. This is because of the nature of
operation of the Non Government Organizations. In the Western context, NGOs act as
separate entities to the state and therefore have the capacity to affect the economic and
political landscape of Western states without soliciting interference from the respective
governing bodies. However, in the Asian context, the same features do not apply. As a
matter of fact, NGOs characterize government preferences. This is actually the notion
behind government owned NGOs. One of the problems that spring from such an approach
is that no external bodies can interfere in government regulation. In fact, this principle of
government superiority directs some of the regional bodies formed for those respective
countries. It has been found that South East Asian bodies have a principle of no
interference in the internal affairs of another countries. Consequently, imposing a reformist
agenda in such a stringent political arena would be an exercise in futility the power of the
state overrides all other influences and would therefore not be feasible with the South East
Asian operating environments. (Suzuki, 2000)

Conclusion
Every country in the world follows their political and economic path. These paths may be
relevant and successful at certain points but may not be applicable in other circumstances.
However, they still form part of the political and social institutions in those countries. It
would therefore be unfair to impose another country's economic systems upon another
system yet this is the basis behind the reformist arguments proposed for South East Asian
countries. The latter country's political and social structures would not be favorable for
Western-style liberal market structures and therefore such reforms would fail drastically.

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