This study uses daily closing prices for five stock market indices. They are Shanghai Stock Exchange A-Share Index (SH) for Mainland China,14 New York Stock Exchange Composite Index (US) for the US, Financial Times Stock Exchange All-Share Index (UK) for the UK, Tokyo Stock Price Index (JP) for Japan, and Hang Seng Index (HK) for Hong Kong. These stock market indices are chosen because each represents the largest possible proportion of its respective market, whether in terms of capitalisation or turnover. The stock markets of the US, UK, Japan and Hong Kong as a whole are thought as a good representation of the world’s developed markets.15 Unlike some prior studies (for example, Arshanapalli and Doukas, 1993) which use Dow Jones Industrial Average and Nikkei 225, we choose NYSE Composite Index and TOPIX to represent the stock markets of the US and Japan respectively, so that all five stock indices in this study are capitalisation-weighted. Since it is generally agreed that cointegration tests pertain to the long-run and only impart economic significance when examined over sufficiently long time horizons, our data is taken over the period Jan 1st 1993 – March 31st 2010 from Datastream, covering almost the entire history of the Shanghai Stock Exchange.
A technical problem we encounter is the existence of nonsynchronous holidays among the stock markets being considered. If one market is closed due to national holidays, bank holidays or other special occasions, the data for other markets are eliminated to avoid nonsynchronous holiday bias. The holiday-adjusted sample contains 3845 observations. All data are presented in natural logarithms.
14 We choose Shanghai Stock Exchange to represent the Mainland China’s stock market since the other
stock exchange – Shenzhen Stock Exchange is relatively small and its price movement is almost perfectly correlated with that of Shanghai Stock Exchange. Substituting Shanghai Index with Shenzhen Index for cointegration analysis yields almost identical results.
15
Under the taxonomy of Morgan Stanley Capital International, Hong Kong is categorised as a developed market.
Daily data is chosen since lower frequency data may fail to capture the additional information content embedded in the data series. However, it has been argued that frequency of data (i.e. daily, weekly, and monthly) likely has only limited effects on the cointegration analysis, as Hakkio and Rush (1991) have shown that, given a fixed sample period, cointegration test would yield identical results regardless of the number of observations. However, they did not demonstrate the validity of this argument in a multivariate setup.
When working with stock prices denominated in several currencies, we encounter a practical question of whether these prices should be converted into a common currency. There are those that make the conversion such as Taylor and Tonks (1989), Kasa (1992), DeFusco et al. (1996), Masih and Masih (1999), there are others who use stock prices in local currencies, for example, Chung and Liu (1994) and Ghosh et al. (1999), as well as those conduct their analyses in both settings, for example, Hassan and Naka (1996) and Manning (2002). According to Fratzscher (2002), the underlying assumption of using prices in local currencies is that investors are able to hedge at least some of their foreign exchange exposure. Using prices denominated in a common currency would assume that investors are not able to hedge any of their exposure. This may also introduce a bias in that a high degree of integration may simply be due to a similarity in exchange rate changes rather than direct stock market integration.
Tsutsui and Hirayama (2004) suggest that if the dominant cause of the stock price comovements were real shocks common to many countries, exchange rates would not play a leading role in stock price linkage; if active portfolio adjustments by international investors are the chief cause of the linkage, exchange rates must be a contributing factor in stock market interdependence, since investors compute stock returns in their local currency. For example, Hassan and Naka (1996) conduct cointegration tests both in local currency and in common currency (the US dollar) and find that cointegration is detected only in the case of local currency. This might be an indication
that portfolio adjustments are not an important factor in stock price comovements. Following Hassan and Naka (1996), Manning (2002) and others, we conduct our analysis in both local currencies and common currency. In the common currency case, we assume the viewpoint of the US investors and thus convert all index prices into US dollar. The nominal stock index prices in local and common currencies (rebased to 100) are plotted in Figure 3.1 and 3.2.
Figure 3.1 Stock Index Prices (Local Currencies)
0 200 400 600 800 94 96 98 00 02 04 06 08 SH 0 100 200 300 400 500 94 96 98 00 02 04 06 08 US 80 120 160 200 240 280 94 96 98 00 02 04 06 08 UK 40 60 80 100 120 140 94 96 98 00 02 04 06 08 JP 0 100 200 300 400 500 600 94 96 98 00 02 04 06 08 HK
Figure 3.2 Stock Index Prices (Common Currency)
The visual inspection of the stock index prices given in Figure 3.1 and 3.2 reveals that the all five index prices plummeted during the 2007-2009 global financial crisis. The dot-com boom and burst in 2000 was evident in US, UK, HK and JP, but less apparent in SH. The prices of JP and HK also dipped temporarily as the result of 1997 Asian financial crisis whereas SH was largely immune from this dramatic event. The conversion into common currency has subtle changes on the trends of index prices. While experiencing at least one downturn over the sample period, index prices of US, UK, HK and SH have either doubled or tripled over this time horizon. The only exception was
0 100 200 300 400 500 600 700 94 96 98 00 02 04 06 08 SH 0 100 200 300 400 500 94 96 98 00 02 04 06 08 US 50 100 150 200 250 300 350 94 96 98 00 02 04 06 08 UK 60 80 100 120 140 160 180 94 96 98 00 02 04 06 08 JP 0 100 200 300 400 500 600 94 96 98 00 02 04 06 08 HK
JP, whose price remains a standstill over the 17-year period. The sluggish performance of the Japanese stock market mirrors the ‘Lost Decades’ of its economy.