Global Linkages Conference
Pre-Conference
Washington, DC, April 25-26, 2002
International Monetary Fund, Room 2-530

The International Monetary Fund organized a conference on “Global Linkages” in Washington, D.C. January 30-31, 2003. Prospective contributors were invited to a pre-conference on April 26, 2002 in Washington, D.C. where they made a 20 minute presentation of their proposal. The purpose of this pre-conference was to facilitate an exchange of ideas among researchers and to ensure that papers are mutually complementary. Attendance at the pre-conference was by invitation only.

Agenda
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The Role of ADRs in the Integration of World Equity Markets
G. Andrew Karolyi (Fisher College of Business, Ohio State University)

This paper proposes to measure the dynamics of the growth and development of the ADR market for a number of developed and emerging equity markets around the world and to evaluate its importance for the integration of world equity markets and on the gains from international diversification. The first step will be to generate proxies for these dynamics that include the number of new ADR programs (overall and by type), trading activity in ADR stocks (number and value of shares traded) and the dollar value of new capital raising activity through ADR programs. These data are available from various databases, including the Bank of New York ADR database, for over 40 markets around the world. The second step evaluates whether these dynamic proxies impact the joint dynamics of the returns, volatility and correlations across markets. We will use a generalized dynamic covariance (GDC) multivariate autoregressive conditional heteroscedastic (GARCH) model to estimate the time variation in the conditional correlation between U.S. and various foreign market indices, including mimicking portfolios of foreign indices that employ U.S. traded securities, such as country funds, ADRs, exchange-traded funds (Errunza, Hogan and Hung, 1999). The key question is whether the growth and development of the ADR market is associated with a significant increase in the correlation of U.S. and foreign market portfolios, such that these markets are more internationally integrated and such that most of the benefits from international diversification dissipate.

What Explains Daily Equity Flows to Emerging Markets
René M. Stulz (Fisher College of Business, Ohio State University)

We show that, in a simple model with investors with log utility, the home bias and past returns that are informative for non-resident investors imply that a country experiences net equity inflows when its stocks experience unexpectedly high returns. Further, small countries may experience net equity inflows when stocks in the rest of the world experience unexpectedly high returns. We investigate these predictions of our model using daily data for net equity flows for nine countries and find support for these predictions. In our sample, net equity flows increase with stock returns in the host country and increase with stocks returns in other countries, especially with stock returns in the U.S. Though there is some evidence that net equity flows forecast future returns, our model predicts this result even though non-resident investors are less well-informed than resident investors.

The Center and the Periphery: The Globalization of Financial Turmoil
Graziela Kaminsky (George Washington University) and Carmen Reinhart (IMF)

This paper examines what is the essential ingredient for emerging market turbulence to spread around the world. It constructs indices of globalization and evaluates the effects of turmoil in three crisis-prone emerging markets: Brazil, Russia, and Thailand. The findings indicate that turbulence in those countries only spread globally when it affects asset markets in financial centers. Otherwise, it just affects countries in the same region. We also find that fragility in financial institutions is at the core of high world globalization, while economic and monetary policy news contributes to create regional turmoil.

The Determinants of U.S. Investors' Holdings of Emerging Market Equities
Hali Edison (IMF) and Frank Warnock (Board of Governors)

We examine the determinants of U.S. investors' holdings of emerging market equities using security-level data from the 1997 Benchmark Survey of U.S. Holdings of Foreign Securities. The analysis takes off from Kang-Stulz (1997) and Dahlquist-Robertsson (2001), both of which use as explanatory variables firm-level financial data from the Worldscope database.  Given the segmented nature of emerging markets and that the U.S. is an important cross-listing destination, we expand the analysis by asking how capital controls and cross-listings affect holdings, drawing on the results of Ahearne et. al. (2000) and Edison and Warnock (2001).  The capital controls variable is the firm-level equivalent of the IFC Investable measure described in Edison and Warnock (IMF WP/01/180). Similar to Kang-Stulz and Dahlquist-Robertsson, the dependent variable is yit = ω itF/ω itM - 1, or the ratio of security i's weight in U.S. portfolios to its weight in world market capitalization (minus one).  If the dependent variable equals zero, U.S. holdings of security i are exactly in line with ICAPM predictions, whereas positive (or negative) values indicate an overweighting (or underweighting) in U.S. portfolios.  The holdings data are as of December 31, 1997.  We limit the analysis to emerging market stocks from nine Latin American and Asian Tier 1 countries in the SP/IFC Emerging Market Database; those stocks not in Worldscope will be dropped. The explanatory variables are as follows: (i) firm-level financial data from Worldscope, including market capitalization (foreign investors may prefer large stocks), measures of financial health (such as the ratio of current assets to current liabilities), return on assets, percent of shares closely held, etc.; (ii) firm-level investable weight from EMDB; (iii) country-level variables such as those in the La Porta et al papers; and (iv) dummy variables for cross-listings and inclusion in MSCI indexes.

A Decomposition of Trade and Financial Linkages Over Time
Kristin J. Forbes (US Treasury) and Menzie Chinn (University of California, Santa Crus)

This paper decomposes trade and financial linkages into their component parts and then measures the importance of these different channels in transmitting shocks across countries. More specifically, the analysis measures 2 types of trade linkages: bilateral trade flows and competition within specific industries. Industry-specific competition is measured with a new series of trade competitiveness statistics based on 4-digit SITC export information for each country in the world. The paper also considers 4 types of financial linkages: international bank lending, investment in stock markets, investment in bond markets, and foreign direct investment. The paper takes a historical perspective, examining if the strength of the 6 different linkages has changed over time.

Firm-Level Evidence on Global Integration
Robin J. Brooks (IMF) and Marco Del Negro (Federal Reserve Bank of Atlanta)

This paper explores the extent to which companies in developed and emerging markets are becoming more integrated into the global economy. Using a new firm-level data set on financial and balance sheet variables, it uses a dynamic factor model to quantify to what degree companies are linked to the global business cycle through, for example, international sales, cross-border asset holdings and by raising capital overseas. This will permit a disaggregated assessment, by country and industry, of how important trade and financial linkages are in the transmission of economic shocks and how they are likely to change going forward.

Separately, this paper explores whether closer integration at the firm-level helps explain the recent rise in comovement across national stock markets. In this regard, it augments standard factor models used in empirical finance, which explore the relative importance of global and country-specific factors in explaining the cross-section of global equity returns, with factors that capture the degree to which companies are integrated into the world economy, derived from companies' balance sheets. This will address the question of how much of the recent increase in comovement across stock markets is related to greater economic integration as opposed to transitory factors such as contagion.

The Changing Degree of Comovements in Emerging Economy Stock Returns
Randall Morck (Business School, University of Alberta, Canada), Fan Yang, and Bernard Yeung

This paper explores how the degree of co-movement of individual stocks in emerging economies has changed over time, and relates these changes to changes in emerging economies' institutional environments and in the strength of their linkages to the global economy. For example, individual stock returns in emerging economies that develop stronger links with the world economy, or that develop sounder financial, legal and economic institutions, exhibit less co-movement than previously. One interpretation of this finding is that sounder institutions allow investors to better distinguish the investment opportunities available to individual firms, and to trust that the fruits of those investments will accrue to shareholders. To the extent that stock prices guide microeconomic capital allocation decisions in emerging economies, asynchronous stock prices can be seen as evidence of more economically efficient capital allocation. The importance of economic and financial linkages to the global economy in reducing co-movement suggests that integration into the global economy may substitute, at least partially, for weak domestic institutions.

Understanding The Evolution of World Business Cycles
M. Ayhan Kose, Christopher Otrok (Department of Economics; University of Virginia), and Charles H. Whiteman (Department of Economics; University of Iowa)

Abstract: There is an often repeated view in both academic and policy circles that the nature of world business cycles has changed over time due to `globalization', which is often associated with developing trade links and more integrated financial markets. This paper studies whether, and if so, how world business cycles have changed over time. We employ a Bayesian dynamic latent factor model to estimate common components in the main macroeconomic aggregates (output, consumption, and investment) in the G7 countries. Using the model we estimate both world and country specific factors; these factors are then used to quantify the relative importance of the world and country components in explaining comovement in each observable aggregate. We use the dynamic factor framework to understand the evolution of these dynamic relationships over different time periods. In particular we study whether or not the changing relationships previously documented are due to short samples and static analyses that are concealing stable but persistent dynamic cross-country relationships. We examine the properties of world and national business cycles under four sample periods [The Gold Standard period (1870-1913), the Interwar period (1920-1939), the Bretton Woods period (1950-1972), and the period of Flexible Exchange Rates (1973-2001)] by estimating factor models for each sample. Using Bayes factors we provide evidence on whether the dynamic relationships between variables have changed over time or if each sub-period is a different realization from the same fundamental process. We also study how different types of global and country specific shocks have affected the nature of world business cycles over time. In particular, we consider the roles played by world and country specific monetary policy, fiscal policy, productivity, terms-of-trade, and oil price shocks. We estimate dynamic factor models to determine world and country specific components using the data of these shocks. We then project measures of the shocks on endogenous variables to compute a variance decomposition of world and national business cycles into the world and national components of the shocks. We examine whether the changes in world and country specific business cycles are due to the changes in the common components versus national components of these shocks.

Long-Term Global Market Correlations
K. Geert Rouwenhorst

In this paper we examine the correlation structure of the major world equity markets over 150 years. We find that correlations vary considerably through time and are highest during periods of economic and financial integration such as the late 19th and 20th centuries. Our analysis suggests that the diversification benefits to global investing are not constant, and that they are currently low compared to the rest of capital market history. We decompose the diversification benefits into two parts: a component that is due to variation in the average correlation across markets, and a component that is due to the variation in the investment opportunity set. There are periods, like the last two decades, in which the opportunity set expands dramatically, and the benefits to diversification are driven primarily by the existence of marginal markets. For other periods, such as the two decades following World War II, risk reduction is due to low correlations among the major national markets. From this, we infer that periods of globalization have both benefits and drawbacks for international investors. They expand the opportunity set, but diversification relies increasingly on investment in emerging markets.

Synchronization and Structural Convergence
Jean Imbs

This paper proposes to quantify the importance of sectoral specialization patterns in explaining the international synchronization of aggregate activity. It purports to do so using the information contained in the cross-section of bilateral correlations, borrowing from the recent literature on the contagion of financial crises. The purely cross-sectional approach is useful as a first pass on the data, as preliminary results underline both the statistical and economic importance of an index capturing the similarity of sectoral production patterns. Following the literature on contagion, this paper proposes to further investigate the properties of the cross-section of bilateral output correlations over well-chosen sub-periods. The question this attempts to address is the following: can one ascribe some of the rising business cycles synchronization, documented for instance between European countries, to structural convergence, defined as an increase in the degree of similarity in production patterns? And, through judicious sub-sampling (in both the time and the cross-sectional dimensions), can one disentangle this effect from the impact of trade intensity, or that of synchronized macroeconomic policies? The former question can for instance be addressed focusing on episodes of structural change unaccompanied by trade liberalization. The latter question can be answered by focusing on within-country disaggregated data, e.g. state-level data in the U.S., where the possible effects of monetary convergence are (obviously) accounted for.

Organizing Committee

Ashoka Mody (IMF) amody@imf.org (202) 623-9617
Robin Brooks(IMF) RBrooks2@imf.org (202) 623-6236
Kristin Forbes(FRB) Kristin.Forbes@do.treas.gov (202) 622-0070

For further information please contact: Margaret Dapaah (202) 623-8071