STOCK MARKET LIBERALIZATION
AND EQUITY RETURNS
Evidence from European Listed Companies
By
Kirsten Kirchner
Harma Weinans
University of Groningen
Faculty of Economics & Management and Organization
MSc International Business & Management
August 2007
Kirsten Kirchner Harma Weinans
Kolderveen 34 Nieuwstraat 6A
7948 NJ Nijeveen 7814 PX Emmen
(+31) 6 - 50 60 25 48 (+31) 6 - 27 26 63 10 k.v.kirchner@student.rug.nl p.h.a.weinans@student.rug.nl
STOCK MARKET LIBERALIZATION
AND EQUITY RETURNS
Evidence from European Listed Companies
By
Kirsten Kirchner
Harma Weinans
University of Groningen
Faculty of Economics & Management and Organization
MSc International Business & Management
August 2007
Kirsten Kirchner Harma Weinans Kolderveen 34 Nieuwstraat 6A 7948 NJ Nijeveen 7814 PX Emmen (+31) 6 - 50 60 25 48 (+31) 6 - 27 26 63 10 k.v.kirchner@student.rug.nl p.h.a.weinans@student.rug.nl
STOCK MARKET LIBERALIZATION
AND EQUITY RETURNS
Evidence from European Listed Companies
ABSTRACT
This study investigates the extent to which stock market liberalization explains the equity return behavior of listed companies in 26 European countries, using several newly developed liberalization measures. Results indicate that for both Eastern and Western Europe an aggregate liberalization index based on stock market size and efficiency best explains the variance in equity returns of firms across Europe. In addition, the introduction of the Euro causes the explanatory power of our stock market liberalization index to increase for Eurozone countries, while declining for Norway, Switzerland and the United Kingdom.
Key Words: Stock Market Liberalization, Equity Returns, Europe Degree Program: MSc International Business & Management
Supervisor: Dr. H. Gönenç
-
The beginning of knowledge is the discovery of
something we do not understand. -
PREFACE
Because of their wish to extend practical knowledge in business studies with academic education, two years ago two Bachelor graduates both enrolled in the Master of Science program in International Business and Management at the University of Groningen. Little did they know then, that this decision would result in a new friendship and unite them in writing their master thesis.
We are those two students, now presenting to you our final piece of work. Not being specialized in finance has meant that this topic posed a challenge to us. A challenge we took up, as researching this field would maximize our knowledge base and simultaneously demonstrate our perseverance and ambitions.
Our interest in the field of finance was aroused once more by Dr. C. L. M. Hermes, our Advanced International Financial Management teacher, who let us get acquainted with the financial systems around the world. Now, with this thesis we are taking the next step. Our work is extending existing literature by performing a continent-wide analysis of the impact stock market liberalization has on a firm’s equity return. Using newly developed measures for stock market liberalization, we are able to show the importance of a country’s liberalization process to European business practice in that it (partially) explains stock return behavior. Thus, a word of thanks is in order to those without whom this thesis would not have been such a success. First and foremost, we would like to show our gratitude to our thesis supervisor Dr. H. Gönenç for his valuable feedback and advice. His commitment, time and efforts helped shape our thoughts and improve our work. Secondly, we thank our co-assessor Drs. H. C. Stek for reviewing and assessing our thesis. Finally, we give thanks to our families and friends for their love and support during this phase of our lives.
We hope you will enjoy reading our work and remember: although with this thesis our master International Business and Management has come to an end, our stories have not!
Groningen, August 2007.
TABLE OF CONTENTS ABSTRACT ... 2 PREFACE ... 4 TABLE OF CONTENTS ... 5 1. INTRODUCTION... 7 1.1. Problem Statement ... 7 1.1.1 Research objective.... 8 1.1.2 Research question.... 9
1.2 Organization of the Paper... 9
2. LITERATURE REVIEW... 10
2.1. Stock Market Liberalization... 10
2.2. Measuring Stock Market Liberalization... 12
2.2.1 Stock market openness.... 12
2.2.2 Stock market development.... 13
2.2.3 Other stock market liberalization indicators.... 14
2.3 Liberalization and Stock Returns ... 15
2.4 Stock Market Liberalization in Europe ... 16
3. METHODOLOGY... 18
3.1 Research Sample and Timeframe... 18
3.1.1 Research sample.... 18
3.1.2 Research timeframe.... 18
3.2 Research Methods and Justification... 19
3.2.1 Dating liberalization.... 19
3.2.2 Stock market liberalization measures.... 20
3.2.3 Relationship among stock market liberalization indicators.... 21
3.2.4 Degree of stock market liberalization.... 22
3.3 Liberalization and Stock Return data. ... 23
3.4 Analyses ... 24
3.5 Limitations ... 25
4. RESEARCH FINDINGS AND DISCUSSION ... 27
4.1 Eastern Europe ... 27
4.1.1. Eastern European stock market liberalization.... 27
4.1.2 Eastern European stock market liberalization and equity returns.... 32
4.2 Western Europe ... 36
4.2.1 Western European stock market liberalization.... 36
4.2.2 Western European stock market liberalization and equity returns.... 39
5. CONCLUSION ... 44
REFERENCES... 46
APPENDIX A: SAMPLE COUNTRIES... 55
APPENDIX B: STOCK MARKET SIZE INDICATOR... 56
APPENDIX C: STOCK MARKET ACTIVITY INDICATOR ... 58
APPENDIX D: STOCK MARKET EFFICIENCY INDICATOR ... 60
APPENDIX E: STOCK MARKET OPENNESS INDICATOR ... 62
APPENDIX F: RANKING STOCK MARKET LIBERALIZATION INDICATORS ... 64
APPENDIX G: CORRELATION STOCK MARKET LIBERALIZATION INDICATORS. 65 APPENDIX H: STOCK MARKET LIBERALIZATION INDEX 1... 67
APPENDIX I: STOCK MARKET LIBERALIZATION INDEX 2 ... 68
APPENDIX J: STOCK MARKET LIBERALIZATION INDEX 3... 69
APPENDIX K: STOCK MARKET LIBERALIZATION INDEX 4... 70
APPENDIX L: STOCK MARKET LIBERALIZATION INDEX 5 ... 71
APPENDIX M: STOCK MARKET LIBERALIZATION INDEX 6... 72
APPENDIX N: OVERVIEW STOCK MARKET LIBERALIZATION INDICES ... 74
1. INTRODUCTION
Chapter one provides an introduction to the research problem, as well as a description of the objective and the main research question of the study. Concluding the introduction, the organization of this thesis is set out briefly.
1.1. Problem Statement
Stock markets worldwide are booming. Between 1986 and 1996, the total value of stocks traded across the globe increased from $6 trillion to $20 trillion, with the proportion of stock market capitalization made up of emerging equity markets nearly tripling. Not surprisingly, this global development of stock markets and the rapid emergence of markets in developing countries have attracted the attention of both academics and practitioners. Most studies however, concentrate on investigating the benefits of international portfolio diversification and on the impact of stock market development on long-term economic growth, while little empirical evidence is available on the impact of stock market liberalization on equity returns. As a consequence, opinions on stock market development and liberalization are abundant, while facts are fairly scarce. That is, not much is known on whether and to what extent stock market development and liberalization is responsible for the variance in the equity returns of firms.
This paper intends to balance this ratio of facts to opinions in favor of empirical research. Only half a century ago, markets around the world were still characterized by many barriers to the free flow of capital. In addition, equity markets were less developed and inadequately regulated, causing high capital costs for most companies. Over the past few decades however, many countries have increasingly abolished financial and economic barriers and the majority of developed, as well as developing nations have now opened up their stock markets to foreign investment. Stock market liberalization is therefore a sequence of policy reforms attempting to remove the barriers to the international trade of equities (Nilsson, 2002).
equity market liberalization helps firms to obtain capital at lower costs (Henry, 200b). Moreover, as investors perceive less risk after liberalization, the cost of capital would fall (Stulz, 1999). Additionally, investors would be enabled to diversify risk internationally, although increasingly integrated markets could further diminish the appropriateness thereof (Harvey, 1995; Harvey & Dahlquist, 2001).
Recently Europe has seen a period of economic and monetary integration resulting from increased financial liberalization, eventually leading up to the introduction of the Euro in 1999, as well as to the EU accession of 12 Central and Eastern European countries during 2005 and 2007. Additionally, many European capital markets have been strengthening and deepening over the past two decades. This, combined with the fact that few comparative studies exist on Europe as a whole, makes Europe an interesting region to study. What’s more, linking a country’s degree of stock market liberalization to the equity returns of listed companies would be of practical importance to investors who are active in the region. Demonstrating the relationship between the stock market liberalization process in Europe and the equity returns of European listed companies, would thus enable thorough analysis of these markets for asset allocation and stock selection.
1.1.1 Research objective.
1.1.2 Research question.
Corresponding with the objectives of this study, the main question to be answered by means of the research is formulated as follows:
To what extent does stock market liberalization account for the equity return behavior of listed companies all across Europe?
1.2 Organization of the Paper
2. LITERATURE REVIEW
The second chapter of this thesis is concerned with providing the theoretical underpinning of the research. First of all, this part presents an explanation of stock market liberalization and its consequences. Furthermore, this chapter also thoroughly discusses the way stock market liberalization can be measured, as well as the relationship between stock market liberalization and equity returns. Chapter two is concluded by looking into stock market liberalization and major events, such as the introduction of the Euro.
2.1. Stock Market Liberalization
Historically, capital flows worldwide have been restricted by many barriers - e.g. capital controls. To stimulate the development of national markets however, many countries have now implemented important reforms through their financial markets, as these mechanisms enable a country to expand economically by allocating capital efficiently. Over the past twenty years many developed, as well as developing countries have launched several important capital market reforms, including stock market liberalization. Whereas the liberalization of capital markets is concerned more generally with the abolishment of a country’s capital in- and outflow restrictions, stock market liberalization in specific permits foreign investors to acquire shares on the national stock market of the liberalizing country (Henry, 2000a; de la Torre, Gozzi & Schmukler, 2007).
2007). According to prior literature stock market liberalization is effective if national stock markets are integrating within the world market (e.g. Bekaert, Harvey & Lundblad, 2003; de la Torre, Gozzi & Schmukler, 2007). Therefore, the effects of liberalization on the possibility of (international) risk sharing and the cost of equity capital are closely related to the process of integration.
Frequently, segmented stock markets - like emerging markets - are characterized by high levels of risk, high returns and a low correlation with the world market. As a reaction to the process of liberalization, segmented stock markets are changing into integrated ones. Therefore, many studies conclude that opening up these stock markets through the process of liberalization will enable investors to benefit from the possibility to diversify their portfolios (e.g. Harvey, 1995). Stock markets are defined to be integrated when assets of equivalent risk initiate identical returns, irrespective of the market in which they are traded. In other words, markets are integrated if the law of one price holds. Moreover, diversification is defined as the ability to invest in foreign portfolios, decreasing the exposure of risk between national and foreign investors through the risk sharing process. The principal thought behind diversifying portfolio risk is the elimination of country-specific risks. However, as a consequence of the market integration process - demanding identical returns - diversification benefits might decrease significantly as stock returns will decline (Bekaert & Harvey, 2003). Assuming investors are on average risk averse, they will frequently accept this decline in their portfolio returns if risk is reduced.
In line with the prediction of Asset Pricing Models, many authors demonstrate empirically that an effective stock market liberalization process - and thus increased integration - will decrease a country’s cost of equity capital (e.g. Bekaert & Harvey, 2000; Henry, 2000b; de la Torre, Gozzi & Schmukler, 2007). More specifically, this fall is caused by two main events. Firstly, as liberalization opens up the national capital market, the net inflow of capital will ameliorate. Consequently, this will result in a decreasing risk-free rate of return. Secondly, the possibility of international portfolio diversification will lower the equity premium (Levine & Zervos, 1996; Stulz, 1999, Bekaert & Harvey, 2003). Similarly, Henry (2000a) argues that liberalization will not necessarily decrease the cost of equity capital, yet it is reasonable to assume that it will change due to the process of liberalization.
2.2. Measuring Stock Market Liberalization
In light of financial theory, prior research forwards a variety of indicators directly reflecting stock market liberalization. Individually, these indicators might not be able to reveal a distinct relationship between equity return and stock market liberalization. However, investigating several complementing indicators together as a proxy of stock market liberalization, will improve the understanding of this complex phenomenon.
2.2.1 Stock market openness.
As one might expect, countries do not equally benefit from stock market liberalization, since this process differs in magnitude, timing and speed across countries. Whereas emerging markets began to open up their national stock markets from the late 1980s onwards, the majority of stock markets in developed economies were already liberalized by the early 70s. Partly resulting from the establishment of the European Monetary Union, all mature Western European stock markets were open to foreign investors by the early 1990s.
As a result of these early stock market openings in developed countries, the majority of prior research examining stock market liberalization is focused on emerging economies. However, it is assumed that not only emerging markets benefit from liberalization, as long developed markets might gain from increased international capital flows as well. Liberalization will boost the capital inflow from previously restricted markets into more developed ones - e.g. the European Union (Stulz, 1999; Kim & Singal, 2000a; Kaminsky & Schmukler, 2003).
Regulatory reforms accurately reflect the openness of a country’s stock market to foreign investors. In their studies Kaminsky & Schmukler (2003) and Vinhas de Souza (2004) determine a country’s level of stock market openness by the usage of information on acquisition and repatriation possibilities concerning capital, dividends and interest for foreign investors. Countries are categorized by these authors from closed to partially open to open. Open stock markets will consequently benefit a country’s economy more by facilitating capital flows and international risk-sharing.
2.2.2 Stock market development.
Global portfolio investments rapidly increased throughout the 1990s, particularly in emerging markets. Along with this boost in international capital flows, the structure of stock markets has transformed as well. Although this acceleration in stock market development might suggest a process driven by market forces, growth in emerging stock markets was predominantly encouraged by national governments through the elimination of investment barriers – e.g. through liberalization (Levine, 1997; Singh & Weisse, 1998).
Many authors have demonstrated that a well-developed stock market is highly beneficial to a country (e.g. Levine, 1997; Levine & Zervos, 1998). Following Bekaert & Harvey (2003) this current study argues that stock market liberalization can be (partially) determined from a country’s stock market development process, meaning that more developed equity markets indicate a higher level of stock market liberalization. Stock market size, efficiency and activity are frequently used by prior literature as development indicators closely related to stock market liberalization (a.o. Demirgüç-Kunt & Levine, 1995; Levine & Zervos, 1998; Errunza, 2001).
Secondly, market liquidity is mirrored by the efficiency of a country’s stock market and indicated by the Turnover Ratio (Levine & Zervos, 1998). Stock markets are defined to be liquid when investors are able to buy and sell assets quickly – e.g. when it is possible to allocate capital at low costs among different assets or portfolios. More specifically, this means that stock markets are both active and efficient.
2.2.3 Other stock market liberalization indicators.
As Market Capitalization to GDP, Total Value Traded to GDP and Turnover Ratio are proven to complement each other (e.g. Demirgüç-Kunt & Levine, 1995; Levine & Zervos, 1998), these indicators are the predominant combination used by prior literature to indicate a country’s level of stock market liberalization. Alternatively, many other indicators of stock market liberalization are presented throughout the extensive amount of literature concerning stock market liberalization. To demonstrate the variety of measures used to investigate liberalization and its possible effects on stock markets, several of these frequently used indicators will be shortly presented.
Although frequently used in literature as a proxy for stock market liberalization, Volatility is not a determinant of stock market development itself. Rather, it can be argued that volatility will affect stock returns through portfolio risk (Capasso, 2006). Although in general less volatility is assumed to reflect a higher degree of stock market development, several authors, including Bekaert & Harvey (2003), state that the relationship between liberalization and volatility is not sufficiently proven by financial theory. Furthermore, prior literature sometimes also measures stock market size as the Number of Listed Firms, in addition to Market Capitalization to GDP (a.o. Demirgüç-Kunt & Levine, 1995). However, only extreme deviations in these values have explanatory power.
up the IFC Global index for each country (Bekaert, 1995; Edison & Warnock, 2003). This ratio thus reflects the extent to which stocks are available to foreign investors.
Other stock market liberalization indicators found in academic literature focus on the time when stock market restrictions are lifted or on the internationalization of equity markets. Henry (2000b) and Bekaert & Harvey (2005) for instance thoroughly investigate the key economic events affecting financial liberalization, on the basis of which they determine an Official Liberalization Date for each country. Additionally, Bekaert, Harvey & Lundblad (2001a) forward a First Sign indicator of stock market liberalization, meaning that they denote the year associated with the earliest event, either the official liberalization date, the first ADR announcement or the first country fund launch. Finally, the degree of internationalization with regards to a country’s stock market is also often mentioned as a proxy for stock market liberalization. Indicators used include the Percentage of Cross-Listed Firms and a Ratio of Value Traded Abroad to Value Traded Domestically (Claessens, Lee & Zechner, 2003).
2.3 Liberalization and Stock Returns
Since countries began to open up their national stock markets to foreign investors, a broad stream of literature emerged, examining the effects of liberalization on stock returns. Not surprisingly, most of the recent studies focus on emerging markets. The problem however, is that these studies attempt to draw conclusions from restricted data sets. That is to say, usually the investigated periods are short and returns are argued to be non-normal. Despite such a challenging environment, Bekaert & Harvey (2003) argue that empirical research will still result in sound (empirical) findings.
the reaction of abnormal returns during the post-liberalization period is not consistent throughout the empirical findings. According to Bekaert & Harvey (2000) the specification of the research model will affect the study’s outcome. In other words, the abnormal returns are expected to change after liberalization. However the direction of this change - increase or decrease - is model dependent.
Shortly introduced in the first paragraph of this chapter, conflicting views on the advantages of liberalization exist. Generally, it can be concluded that financial literature advocates the benefits of stock market liberalization. That is, many studies demonstrate that the opening of national stock markets will enhance risk-sharing possibilities, thus causing a country’s cost of capital to fall. Moreover, financial literature shows that capital inflows are boosted in the post-liberalization period, resulting from the increase in international portfolio investments. Besides, amongst others Bekaert, Harvey & Lundblad (2001a) state that economic growth is positively affected by market liberalization. Recent crises literature on the other hand heavily criticizes the proposed benefits of liberalization. It is broadly advocated throughout this type of literature that market liberalization is the driving force behind many financial crises world wide (Batra, 2004). Interestingly, many authors therefore argue that emerging markets should limit the free flow of capital in order to prevent financial crashes (a.o. Rodrik, 2000). However, the main reason for the ongoing debate between both streams of research might be caused by the lack of a uniform research method.
2.4 Stock Market Liberalization in Europe
The stock markets within most of the European countries have only developed recently. Over these years, European stock market integration has occurred through economic and monetary convergence, or more specifically through capital market liberalization - decreasing the barriers to intra-European investments - and the launch of the common currency (Yang, Min & Li, 2003; Hardouvelis, Malliaropulos & Priestley, 2004).
the effect of stock market integration in Western Europe. It is concluded by these authors that the introduction of the Euro resulted in the elimination of currency risk and in less investment barriers, contributing to a more integrated capital market within the Eurozone.
3. METHODOLOGY
The next part of this report describes the methodology applied during the study. In addition, the selected indicators or proxies are discussed and justification for their usage is provided on the basis of prior (academic) literature. Moreover, this section presents the research sample and data sources. Finally, the limitations to which this study is subject are defined.
3.1 Research Sample and Timeframe
The first part of this chapter designates this study’s extensive research sample, as well as the different research timeframes used for Eastern and Western Europe respectively.
3.1.1 Research sample.
This study focuses on determining and analyzing the possible relationship between stock market liberalization and equity returns across Europe. The countries under investigation include fifteen Western European countries and eleven Eastern European countries. An overview of these countries is provided by appendix A. From these countries’ most important national stock indices, mainly large (multinational) listed companies are selected for the sample, as they generally provide a good representation of their respective economies. For a firm to be included in the sample, it must be listed on the national stock market during the entire research timeframe. However, if a large number of companies within a single country fit the selection criteria, the sample is reduced to a maximum of forty companies, using the random sample technique provided by statistical software program SPSS.
3.1.2 Research timeframe.
introduction of the Euro. Although prior research has predominantly investigated the effect of the Euro on stock returns while concentrating on the introduction of this currency in 1999, Billio & Pelizzon (2003) argue that investors will already anticipate on the future introduction of the Euro during 1998. Therefore, they propose that a possible introduction effect of the Euro will already start to occur prior to the official introduction. To capture this possible effect of anticipation, like Billio & Pelizzon (2003), we will also use 1998 as a starting point for the post-Euro research time-frame (e.g. period 2). Furthermore, although the Financial Structure database provides all necessary liberalization data for Eastern Europe from 1996 to 2005, the timeframe for this region is shortened due to the lack of sufficient stock return data up to 1999 in Thomson Financial’s DataStream. Therefore, the research timeframe for the Eastern European area will start in 2000 and end in 2005.
3.2 Research Methods and Justification
The second paragraph of this chapter describes, as well as justifies the proxies taken to determine whether or not stock market liberalization accounts for the behavior of stock returns. After a thorough explanation of the liberalization indicators, this paragraph presents the method to determine the relationship among the different indicators. Finally, this part contains the methodology in order to assess the degree of liberalization per country.
3.2.1 Dating liberalization.
3.2.2 Stock market liberalization measures.
As became clear from the previous chapter, we argue that stock market liberalization is related to the degree of stock market openness, as well as to the stock market development process experienced by a country. Our research therefore uses indicators which are defined by prior literature to be consistent with stock market liberalization. That is, on the basis of existing literature this study uses stock market openness, size, activity and efficiency to indicate stock market liberalization.
Stock Market Size
In line with prior literature, this research uses Market Capitalization to Gross Domestic Product (GDP) as a proxy for stock market size (Demirgüç-Kunt, & Levine, 1995, Errunza, 2001). Market Capitalization/GDP is measured by dividing the value of all listed shares on a country’s stock market by GDP. The reasoning behind this indicator is that economic theory assumes that the size of a market will be positively related to capital mobility and international risk sharing. In other words, a relatively large stock market means that capital is able to move freely in and out of a country. Moreover, this free movement of capital will enable portfolio investors to share risk internationally. To determine a country’s stock market size within the Western- and Eastern European region, this study works with yearly Market Capitalization/GDP data.
Stock Market Activity & Efficiency
Following Demirgüç-Kunt, & Levine (1995), Levine & Zervos (1998) and Jun, Marathe & Shawky (2003), we apply Total Value Trade to GDP, as well as Turnover Ratio as proxies for stock market activity and efficiency respectively - or in other words liquidity. Total Value Traded/GDP is calculated by dividing the total value of shares traded by GDP. Turnover ratio on the other hand is measured by dividing the total value of shares traded by Market Capitalization. As was also argued in the previous chapter, Total Value Traded/GDP, Turnover Ratio and Market Capitalization all complement each other.
Stock Market Openness
or an open stock market. Table 1 below presents the stock market openness criteria used for the yearly classification of the sample countries under investigation.
TABLE 1
Stock Market Openness Criteria
Criteria Closed (0) Partially Open (1) Open (2)
Acquisition by Foreign Investors
Foreign investors are not allowed to hold
domestic equity
Foreign investors may hold up to 49% of every firm’s outstanding shares. Restrictions on participation may be present in certain sectors. There may
be indirect ways to invest in the stock market
Domestic equity may be held by foreign investors without restrictions ↓ And/Or Or Or And ↓ Repatriation of Capital, Dividends and Interest Capital, dividends and interest may be repatriated, however not before five years
of the initial investment
Capital, dividends and interest may be repatriated, however usually not before two and not
after five years of the initial investment
Capital, dividends and interest may be repatriated freely
Sources: Kaminsky & Schmukler (2003) and Vinhas de Souza (2004)
3.2.3 Relationship among stock market liberalization indicators.
Considering the argument of Demirgüç-Kunt & Levine (1995) that stock market liberalization indicators will complement each other, it is necessary to investigate the interrelationship among our four indicators. In order to determine the relationship among the four liberalization indicators, their mutual correlation must be established. Correlation among these indicators is generated using SPSS and represented in appendix G. From the top, the tables show the correlation coefficient given in bold, followed by its P-value and the number of observation included. Following Demirgüç-Kunt & Levine (1995), the present study also assumes that although many liberalization indicators are positively correlated, they will still capture different features of stock market liberalization when their correlation coefficients are below 0.600.
correlation coefficients below 0.600, we therefore conclude that these measures complement each other. However, activity only seems to contribute to the understanding of stock market liberalization in combination with the openness indicator. On the contrary, within Western Europe only stock market size and efficiency do not seem to explain the same aspects of liberalization. Moreover, the openness indicator for Western Europe is constant and therefore has no explanatory value.
3.2.4 Degree of stock market liberalization.
The previous two sections together determine the level of stock market liberalization across the European countries per indicator. However, before it is possible to theorize or conclude on the probable impact of stock market liberalization, it is also essential to define the overall stock market liberalization level across the European continent. In order to do so, information from the four single indicators has to be accumulated by constructing aggregate indices. A method to compute these aggregate indices is presented in a study conducted by Demirgüç-Kunt & Levine (1995) and will also be used during this current research.
The various stock market liberalization indices are composed by using the information on correlation among the indicators presented in the sub paragraph above. As can be concluded from that section, correlated indicators might still be able to complement each other, as long as the correlation is below 0.600. That is, although correlation exists, the indicators are still able to explain different parts of the overall degree of stock market liberalization. Not all indicators are however moving separately. This means that indicators with a correlation above 0.600 are not able to explain a different aspect of liberalization, when investigated in combination with other indicators. More specifically, the various aggregated indices of stock market liberalization will only accumulate the information of all indicators which are able to complement each other in determining the overall degree of liberalization.
this, a two-step procedure is followed. First of all, for every country the means-removed values are calculated for each indicator included in the index. That is, the means-removed value for variable X and country i is formulated as follows;
(1) X(i) = [X(i) - mean(X)] / [ABS(mean(X))]
Where; X(i) is the means-removed value for indicator X in country (i), “mean (X)” is defined as the timeframe average of the value of variable X across all countries and ABS is the absolute value of the variable.
After calculating the means-removed values for every indicator represented within each specific index, a simple average of these indicators is computed to finally generate an index of the overall stock market liberalization level. The average stock market liberalization values per country together form the regional indices. However, these conglomerated average values can either be positive or negative. To illustrate, if country X shows a positive index value for the year 2000, this means that country X has on average a higher stock market liberalization value, compared to the other sample countries in the region during that same year. Negative index values on the other hand indicate that a certain country has on average a lower score on stock market liberalization.
3.3 Liberalization and Stock Return data.
The data concerning the stock market liberalization indicators used during this study are collected from various sources. All necessary data for Market Capitalization/GDP, Total Value Traded/GDP as well as the Turnover Ratio are withdrawn from the Financial Structure database developed by Beck, Demirgüç-Kunt & Levine (2000). An updated version of this database is provided online by the World Bank. Moreover, Bekaert & Harvey (2005), Bekaert, Harvey & Lundblad (2001a), Dvořák, & Podpiera (2005) and several national sources provide the essential data for the openness indicator.
stock return data for Western European companies are collected for the period 1990-2005 and for Eastern Europe the data are collected for the period 2000-2005. These fundamental stock market data are all collected from Thomson Financial’s DataStream, a database containing data for all major stock markets worldwide. Moreover, DataStream covers the widest set of return data for both developed, as well as developing countries.
3.4 Analyses
In order to demonstrate whether stock market liberalization is able to explain the behavior of equity returns throughout Europe, it is first of all necessary to account for the differences between the (relatively) developed Western part and the emerging Eastern part of this continent. Therefore, this study will examine both regions on an individual basis using two different types of empirical analyses to test the effect of European stock market liberalization.
Eastern Europe
Table G1 in appendix G contains the information on the mutual correlation for Eastern Europe. As is shown by this table, size, efficiency and openness as well as activity and openness are characterized by significant correlation coefficients below 0.600. This means that these individual indicators are able to complement each other in explaining the overall level of liberalization throughout the Eastern European area. Combining the complementing indicators, five different conglomerate liberalization indices are computed for Eastern Europe. Together, these indices capture the overall degree of liberalization within this region. The first index contains the aggregated information on Market Capitalization/GDP and Turnover Ratio. Likewise, index two combines the first index with the openness indicator, accumulating information on Market Capitalization/GDP, Turnover Ratio and the Degree of Openness. Furthermore, information on the Degree of Openness is also individually aggregated with Market Capitalization/GDP (index 3), Total Value Traded/GDP (index 4) and Turnover Ratio (index 5).
research sample. Thus, the five indices generated for Eastern Europe will be regressed against the yearly return data of all sample companies.
Western Europe
The correlation coefficients of Western Europe are provided throughout tables G2-4. Whereas table G2 presents the mutual correlation between the four indicators over the entire timeframe, tables G3 and G4 show the coefficients for the periods 1990-1997 (period 1) and 1998-2005 (period 2) respectively. In contrast to Eastern Europe, it can be concluded from these three tables that only Size and Efficiency appear to complement each other in explaining the overall degree of liberalization throughout Western Europe. As a consequence, this means that only one index can be computed. This sixth aggregate index contains the information on Market Capitalization/GDP and the Turnover Ratio for Western Europe.
As became clear in chapter two, many authors argue that stock market liberalization in Western Europe will be influenced by the introduction of the common currency (Hardouvelis, Malliaropulos & Priestley, 2004; Yang, Min & Li, 2003). Hence, this study will investigate the link between equity returns and stock market liberalization over two different periods in time. In this way we are able to grasp the possible effect of introducing the common currency. More specifically, to determine if liberalization indicators will increasingly explain equity returns after the introduction of the Euro, the two different periods 1990-1997 and 1998-2005 are compared. Like for Eastern Europe, the relationship between equity returns and stock market liberalization will be tested by regressing index 6 on the yearly company return data. However, the difference here is that the regression will be carried out twice over two different timeframes - before and after the introduction of the Euro.
3.5 Limitations
sufficient data on stock returns prior to 2000. What’s more, the research findings are generated from only a small number of listed companies in each of the European sample nations. Also, the sample companies are among the largest firms in each country. The study should therefore not be considered representative of all listed firms in Europe, as the link between stock market liberalization and large companies’ equity returns might not be similar to that of smaller companies.
4. RESEARCH FINDINGS AND DISCUSSION
Chapter four contains this study’s research findings on Eastern and Western Europe respectively, regarding each country’s stock market liberalization process and the impact thereof on the equity returns of listed companies. These results are reviewed thoroughly and possible explanatory factors are considered, often in light of prior (academic) literature.
4.1 Eastern Europe
The first paragraph of this chapter discusses all the major research findings on Eastern Europe and offers possible explanations for the observed outcomes. In addition, special attention is paid to the extent to which stock market liberalization accounts for the variance in stock returns of listed companies across Eastern Europe, using five different liberalization indices.
4.1.1. Eastern European stock market liberalization.
In order to theorize or conclude on the impact stock market liberalization has on the equity returns of Eastern European listed companies, first the level of liberalization in each country is investigated. Results on the stock market liberalization indicators selected for Eastern Europe are discussed below. In addition, this information on stock market liberalization is aggregated by examining and comparing several newly developed stock market liberalization indices, specifically fitted to match the Eastern European environment.
Individual Stock Market Liberalization Indicators
The equity markets of Eastern Europe are not new. Stock exchanges in Poland and the Czech Republic for instance were established as early as the 19th century. However, all stock markets in the region closed under the communist regimes. Since the collapse of these regimes around fifteen years ago, the Eastern European countries have been in transition from planned economies towards market oriented economic systems. Stock exchanges in the region have since been (re-)created, often in light of listing mass-privatized companies, and most are still in an early stage of development.
B), Russia shows the highest capitalization relative to its GDP, at 0.345. Very likely, this result mirrors the fact that Russia is the largest economy among the sample countries. In contrast, Bulgaria has the smallest equity market relative to GDP, at 0.017; again reflecting the economic environment of the country. Interestingly however, all Eastern European countries, except for Latvia, Romania and Slovenia, show a decrease in stock market size around 2001-2002. Not surprisingly though, these years are characterized by a global economic recession, several economic crises and the terrorist attacks of September 11th, and will therefore to a large extent explain the downfall in size of the Eastern European stock markets. On the other hand, since 2004 a consistent increase in stock market size is observed throughout the Eastern European sample, which might be related to the worldwide economic recovery of recent years, as well as to the increasing integration of markets in Europe.
As the stock exchanges in the Eastern European countries are still relatively new, they show low liquidity in terms of stock market activity and efficiency (see also Appendix C and D). A possible explanation may be provided in that the listed companies here only have a short history and that the domestic institutional investor base is still fairly underdeveloped (Claessens, Dasgupta & Glen, 1998). Nevertheless, the total value traded on the stock exchanges of Turkey, Hungary, Russia and the Czech Republic is still relatively high, indicating active trading in these markets. Bulgaria, Romania and Latvia however, exhibit both low stock market activity and a low capitalization, which suggests that only a small part of stocks in these countries is actually traded. Additionally, international listing may divert trade away from the local Eastern European stock exchanges, thus causing less local activity (Claessens, Lee & Zechner, 2003).
increasingly attractive for investment due to the pan-European integration of recent years (Schröder, 2000b).
Finally, the opening of Eastern European stock markets to foreign investment can be termed a gradual process, as restrictions on foreign transactions were mostly phased out slowly. Not surprisingly then, determining the exact moment when markets switched from a closed to a partially open or an open equity market is very difficult. Nevertheless, information on policy changes regarding foreign investment is provided by several authors and national sources, on the basis of which our openness index was constructed. As shown in table E1 (Appendix E), the sample majority is by now open to foreign investment, while all other countries are partially liberalized in that respect. Explaining this development is the integration into the European Union, which commands the liberalization of capital markets, and the more general pan-European integration, for which openness towards other European markets is a requirement for success. Especially Turkey, the Baltic States and the Czech Republic are very advanced in opening up their capital markets to foreign investors, whereas Russia and Slovenia have even re-imposed regulations after the Russian crisis of 1998 and therefore remain partially open.
Overview Stock Market Liberalization Indicators
Looking at the yearly development of the stock market liberalization indicators in Eastern Europe (Appendix, B, C, D and E), we can conclude that these equity markets are influenced by economic and political events, occurring not only in Europe, but globally. A good example thereof is the consistent decrease across all stock market development indicators (size, activity and efficiency) and all sample countries around 2001-2002, reflecting the global economic recession and decreased investor confidence. Additionally, this study finds that that the Eastern European stock markets are still relatively underdeveloped. Possible explanations include the facts that these markets are still fairly new and that investors may have refrained from trading in these capital markets, because of liquidity, corporate governance or political risks.
2000-2005, only the Austrian stock market is smaller in size than the markets of Eastern Europe, ranking just below the Czech Republic in terms of market capitalization to GDP. Secondly, Turkey’s stock market activity more closely resembles that of Western European countries, with seven of these nations trading less actively than does Turkey. The other Eastern European equity markets in contrast, are trading up to forty-five times less actively than Turkey. In addition, Lithuania and Romania represent the most illiquid stock markets, while in Turkey and the Czech Republic it was far easier to buy and sell securities. Furthermore, as mentioned earlier, Slovenia and Russia remain relatively closed to foreign portfolio investment, whereas Turkey and Estonia have been fully open to foreign investment since the beginning of the timeframe. Finally, as can be seen in table F1 (Appendix F), adding up all values leads to the conclusion that Turkey and the Czech Republic have the most liberalized equity markets, whilst Bulgaria and Romania remain less advanced with regards to their stock market liberalization.
TABLE 2
Stock Market Liberalization Indicators – Eastern Europe
Size Activity Efficiency Openness
1. Russia 0.345 1. Turkey 0.546 1. Turkey 1.706 1. Latvia 2 2. Estonia 0.330 2. Hungary 0.148 2. Czech
Republic
0.635 1. Turkey 2 3. Turkey 0.323 3. Russia 0.146 3. Hungary 0.613 2. Estonia 1.833 4. Hungary 0.232 4. Czech Republic 0.142 4. Russia 0.413 3. Czech Republic 1.667 5. Czech Republic
0.207 5. Estonia 0.076 5. Poland 0.312 4. Lithuania 1.5 6. Slovenia 0.193 6. Poland 0.060 6. Estonia 0.214 5. Hungary 1.333 7. Poland 0.186 7. Slovenia 0.032 7. Bulgaria 0.204 6. Bulgaria 1 8. Lithuania 0.163 8. Lithuania 0.018 8. Latvia 0.199 6. Poland 1 9. Latvia 0.089 9. Bulgaria 0.017 9. Slovenia 0.185 6. Romania 1 10. Romania 0.084 10. Latvia 0.015 10. Romania 0.154 6. Russia 1 11. Bulgaria 0.073 11. Romania 0.012 11. Lithuania 0.118 6. Slovenia 1
Sample Average
0.202 0.110 0.432 1.394
Overview Stock Market Liberalization Indices
As incorporating information on stock market size, activity, efficiency and openness provides a better image of stock market liberalization than the data offered by any single indicator, this study uses several newly developed aggregate indices of stock market liberalization. Based on the correlations among the individual indicators for Eastern Europe (see also Appendix G), several points must therefore be made. First, stock market size is significantly and positively related to activity, efficiency and openness. This means that Eastern European countries with large stock markets often also trade more actively and more efficiently and are more open to foreign investment. Second, the two measures of stock market liquidity in Eastern Europe (activity and efficiency) are significantly positively correlated, exhibiting a coefficient of 0.927. Therefore, we can conclude that these measures are moving one for one, meaning that these two indicators do not provide complementary information. Finally, although all four indicators are significantly and positively correlated, the majority of these measures do capture different aspects of the stock market liberalization process in Eastern Europe, since the correlation coefficients are virtually all below 0.600. Therefore, on the basis of the correlations found between the four indicators, five indices of Eastern European stock market liberalization are selected for analysis: size + efficiency (index 1), size + efficiency + openness (index 2), size + openness (index 3), activity + openness (index 4) and efficiency + openness (index 5).
TABLE 3
Stock Market Liberalization Indices – Eastern Europe
Index 1 Index 2 Index 3 Index 4 Index 5
1.
Turkey 1.824 1. Turkey 1.365 1. Turkey 0.557 1. Turkey 2.252 1. Turkey 1.716 2. Russia 0.326 2. Czech Republic 0.214 2. Estonia 0.475 2. Czech Republic 0.192 2. Czech Republic 0.304 3. Hungary 0.286 3. Hungary 0.170 3. Russia 0.185 3. Hungary 0.118 3. Hungary 0.170 4. Czech Republic 0.232 4. Estonia 0.142 4. Czech Republic 0.105 4. Russia 0.051 4. Latvia -0.044 5. Estonia 0.060 5. Russia 0.126 5. Hungary 0.056 5. Estonia -0.025 5. Estonia -0.108 6. Poland -0.187 6. Poland -0.217 6. Latvia -0.057 6. Latvia -0.203 6. Russia -0.150 7.
Slovenia 0.299 - 7. Latvia 0.217 - 7. Lithuania 0.086 - 7. Poland 0.378 - 7. Poland 0.282 -8. Lithuania -0.475 8. Slovenia -0.291 8. Slovenia -0.161 8. Lithuania -0.390 8. Lithuania -0.334 9. Latvia -0.550 9. Lithuania -0.297 9. Poland -0.183 9. Slovenia -0.471 9. Bulgaria -0.403 10. Bulgaria -0.594 10. Bulgaria -0.488 10. Romania -0.440 10. Bulgaria -0.565 10. Slovenia -0.413 11. Romania -0.626 11. Romania -0.509 11. Bulgaria -0.467 11. Romania -0.585 11. Romania -0.461
Source: authors’ own calculations
4.1.2 Eastern European stock market liberalization and equity returns.
TABLE 4
Equity Return versus Stock Market Liberalization
Country Index 1 Index 2 Index 3 Index 4 Index 5 Country Average
Bulgaria R² 68.4% 69.1% 86.4% 70.9% - 59.0% Sig. .074 .055 .026 .060 - .054 10 N 8 3 6 6 - 4.6 Czech Republic R² 81.3% 71.6% 73.8% 70.2% 72.7% 73.9% Sig. .021 .040 .033 .043 .038 .035 29 N 19 17 2 15 18 14.2 Estonia R² 60.6% 70.0% 55.5% 69.4% 55.1% 62.1% Sig. .068 .041 .089 .040 .091 .066 8 N 1 2 1 1 1 1.2 Hungary R² 82.6% - 54.7% - 60.6% 39.6% Sig. .017 - .093 - .067 .059 31 N 8 - 1 - 5 2.8 Latvia R² 69.4% 66.6% 62.9% 70.2% 69.2% 67.7% Sig. .046 .056 .063 .043 .049 .051 8 N 4 4 2 4 3 3.4 Lithuania R² 60.4% 66.3% 64.2% 59.9% - 50.2% Sig. .071 .052 .059 .072 - .064 21 N 5 10 10 2 - 5.4 Poland R² 70.7% 81.0% 71.9% 70.6% 80.3% 74.9% Sig. .042 .018 .039 .045 .019 .033 30 N 6 5 9 5 5 6 Romania R² 78.1% 54.9% 59.8% 59.9% 70.2% 64.6% Sig. .028 .062 .072 .074 .045 .056 38 N 32 3 9 2 4 10 Russia R² 57.9% - 62.9% 53.7% - 34.9% Sig. .080 - .062 .098 - .080 28 N 2 - 3 2 - 1.4 Slovenia R² 98.7% 78.7% - 69.9% 74.9% 64.4% Sig. .001 .036 - .045 .032 .029 15 N 1 2 - 11 14 5.6 Turkey R² 81.2% 79.6% 62.1% 73.2% 68.5% 72.9% Sig. .019 .022 .064 .036 .048 .038 36 N 27 27 10 23 15 20.4 Index Average R² 73.6% 60.0% 59.5% 60.7% 50.1% 60.6% Sig. .042 .042 .060 .056 .039 .049 N 10.3 6.6 4.8 6.4 5.9 6.8
Source: authors’ own calculations
these five aggregate indices lies between .04 and .06, meaning the explanatory powers of these indices are highly significant. While keeping in mind the small number of observations on which these results are based, we find that stock market size and efficiency together best explain the equity return behavior in the Czech Republic (R² = 81.3%), Hungary (R² = 82.6%), Romania (R² = 78.1%), Slovenia (R² = 98.7%) and Turkey (R² = 81.2%). The other countries are explained to a higher degree by one of the other four indices of stock market liberalization. Subsequently, possible explanations for this difference in the results will be reviewed per country.
The empirical analyses of the equity return behavior in Bulgaria shows that Index 3, aggregating information on stock market size and openness, explains 18% more of the variance in Bulgarian equity returns than the first index does. As an answer to these differing results, we find that the irrationality or perceived risk of investors may account for our outcome (Mateus, 2004). Because Bulgaria still copes with a weak judiciary, organized crime and corruption among the public authorities, foreign investors may refrain from investing in this country based on these political and corporate governance concerns. Supporting our theory, empirical analyses of Central and Eastern European markets indicate that these markets are and have been vulnerable to shifts in foreign investors’ views of emerging markets, as they are important participants of the CEE stock markets (Schröder, 2000b; Claessens, Lee & Zechner, 2003).
Looking at this study’s results on Lithuania, we find that stock market size combined with efficiency and openness best accounts for local equity return behavior, explaining 66.3% of the variance. Although no common trend for Lithuania is found, there exists a large body of literature suggesting this country’s differing results are caused by country specific factors (Schröder, 2000b; Claessens, Lee & Zechner, 2003; Mateus, 2004) such as low financial integration, which is directly related to our openness indicator. In addition, of the Baltic States, Lithuania had the greatest trade link with Russia. Since the Russian crisis in 1998 however, the country has increasingly been oriented toward Western Europe, while abolishing more and more restrictions on foreign investment.
Furthermore, considering Russia this study finds that Index 3 has more explanatory power than does Index 1, although the difference is only five percent. Several points must be made on this difference in stock market liberalization indices, explaining Russian equity return behavior. First, compared to most other Eastern European samples, the Russian sample is highly concentrated. This means that only a few companies, especially Gazprom, dominate the sample. This observation is important in that foreign investors usually prefer large firms and therefore stock market liberalization will have a different influence on large firms than on companies of smaller size. Supporting this theory is research carried out by Christoffersen, Chung & Errunza (2004), who indeed find significantly different impacts of stock market liberalization based on firm size. Second, in the Russian sample the oil and gas industry plays a crucial role, accounting for over 90% of total market capitalization. Russia’s dissimilar industrial mix might therefore also explain its different outcome, as random shocks could affect industries differently, making industry effects increasingly important in explaining equity returns (Mateus, 2004; Campa & Fernandes, 2006).
theory, Patro & Wald (2005) advocate the importance of firm characteristics, such as size, in explaining the change in returns of emerging market companies.
4.2 Western Europe
This section will first of all describe the main empirical findings concerning stock market liberalization across Western Europe. Next, the empirical research findings on the relationship with equity returns will be compared to prior (academic) literature, as well as related to financial theory in general.
4.2.1 Western European stock market liberalization.
In order to provide a better understanding of the overall degree of liberalization within Western European countries, the main findings on stock market liberalization will first of all be investigated at the level of individual indicators. Thereafter, the aggregated index, computed for Western Europe, is examined thoroughly.
Individual Stock Market Liberalization Indicators
As is demonstrated by the three tables B2, C2 and D2, all liberalization indicators show to some extent a declining ratio around 1992. This decline might be explained by the crash of the European Exchange Rate Mechanism (ERM) in 1992, which was the first major crisis during the 1990s. An exception to this is the United Kingdom, of which none of the indicators seem to be affected by this crisis. However, the downfall of the ERM was predominantly caused by the withdrawal of the British Pound which was plagued by severe hedge fund speculations. Therefore, it is possible that this phenomenon explains why the 1992 crisis does not have any effect on the UK market. Interestingly, the collapse of the ERM is not the only crisis noticed during the research timeframe of Western Europe. Like in Eastern Europe, every single country experiences a decline in nearly all indicators between 2001 and 2003, as a result of the global economic recession. In general however, size seems to be the most affected indicator during this crisis.
increase in their liquidity during that same period. The average decline of Austria is arguably caused by the introduction of the Euro, followed by the worldwide stock market downturn. By closely investigating the yearly ratios, it is clear that Austria experiences a downfall in its liquidity measure between 1999 and 2002. Finally, Appendix E demonstrates by means of table E2 that all Western European countries are already fully open to foreign investment at the beginning of the sample timeframe. Therefore, Openness is not an explanatory factor in determining the impact of Western European stock market liberalization on equity returns.
Overview Stock Market Liberalization Indicators
TABLE 5
Stock Market Liberalization Indicators – Western Europe
Size Activity Efficiency Openness
1. Switzerland 1.761 1. Switzerland 1.453 1. Spain 1.213 1. Austria 2 2. United
Kingdom
1.302 2. Netherlands 0.899 2. Germany 1.071 1. Belgium 2 3. Netherlands 0.971 3. United
Kingdom
0.864 3. Netherlands 0.821 1. Denmark 2 4. Finland 0.878 4. Spain 0.763 4. Switzerland 0.782 1. Finland 2 5. Sweden 0.850 5. Sweden 0.721 5. Sweden 0.750 1. France 2 6. Belgium 0.633 6. Finland 0.651 6. Italy 0.746 1. Germany 2 7. France 0.569 7. France 0.402 7. Norway 0.722 1. Greece 2 8. Spain 0.507 8. Germany 0.384 8. United
Kingdom
0.645 1. Italy 2 9. Greece 0.464 9. Italy 0.295 9. France 0.642 1. Netherlands 2 10. Denmark 0.453 10. Denmark 0.288 10. Finland 0.611 1. Norway 2 11. Germany 0.367 11. Greece 0.282 11. Denmark 0.590 1. Portugal 2 12. Norway 0.333 12. Norway 0.264 12. Portugal 0.484 1. Spain 2 13. Italy 0.327 13. Portugal 0.174 13. Greece 0.471 1. Sweden 2 14. Portugal 0.308 14. Belgium 0.129 14. Austria 0.461 1. Switzerland 2 15. Austria 0.155 15. Austria 0.067 15. Belgium 0.192 1. United
Kingdom 2
Sample Average
0.659 0.509 0.680 2
Source: authors’ own calculations
Overview Stock Market Liberalization Index
In order to rank the Western European sample countries according to their degree of overall stock market liberalization, an aggregated index was computed. For the Western European sample only size and efficiency explain the overall degree of liberalization. Therefore, one single index – index 6, aggregating information on Market Capitalization/GDP and Turnover Ratio, is used (see also Appendix M). A comparison of the results of this index for period one and two is provided by means of table 6 below. In addition, in table N2 (Appendix N), the Western European countries are ranked according to their overall degree of liberalization. In accordance with the individual indicator rankings, Switzerland, the United Kingdom and the Netherlands are the three most liberalized countries. In addition, Austria is found to be the least liberalized country overall.
TABLE 6
Stock Market Liberalization Index – Western Europe Period 1 & 2 Index 6 Period 1 Index 6 Period 2
1. Switzerland 1.056 1. Switzerland 0.824 2. United Kingdom 0.810 2. Spain 0.499 3. Germany 0.397 3. Netherlands 0.354 4. Netherlands 0.327 4. United Kingdom 0.351 5. Sweden 0.160 5. Finland 0.248 6. Spain -0.080 6. Sweden 0.236 7. France -0.099 7. Germany -0.093 8. Denmark -0.139 8. France -0.095 9. Norway -0.148 9. Italy -0.127 10. Austria -0.220 10. Greece -0.230 11. Italy -0.324 11. Norway -0.238 12. Finland -0.349 12. Denmark -0.253 13. Belgium -0.378 13. Belgium -0.326 14. Portugal -0.442 14. Portugal -0.372 15. Greece -0.478 15. Austria -0.699
Source: authors’ own calculations
4.2.2 Western European stock market liberalization and equity returns.
introduction of the common currency results in a slight increase in liberalization. Thus, equity return behavior should be explained more by the liberalization indicators after the introduction of the Euro. However, empirical findings generated by this present study are rather ambiguous. In fact, this research finds that equity returns in several countries are not increasingly explained by liberalization in the second period. The research findings are given in table 7, after which possible explanations will be given, while distinguishing between Eurozone and Non-Eurozone countries.
TABLE 7
Equity Return versus Stock Market Liberalization
Country Index 6 – Period 1 Index 6 – Period 2 Index 6 – Whole Period Country Average Portugal R² 48.5% 67.2% 34.6% 50.1% Sig. .058 .021 .027 .035 19 N 4 10 4 6 Spain R² 66.6% 53.7% 47.0% 55.8% Sig. .022 .047 .013 .027 40 N 24 14 31 23 Sweden R² 55.4% - 19.4% 24.9% Sig. .037 - .088 .063 37 N 19 - 5 8 Switzerland R² 64.0% 42.4% 25.2% 43.9% Sig. .007 .080 .051 .046 38 N 3 1 18 7.3 United Kingdom R² 75.1% 55.7% 57.3% 62.7% Sig. .044 .063 .010 .039 38 N 27 21 29 25.7 Period Average R² 53.1% 47.7% 34.8% 45.2% Sig. .044 .047 .039 .044 N 10.1 7.3 13.1 10.2
Source: authors’ own calculations
Eurozone Countries
Several causes might explain the differences in explanatory power of the liberalization indicators for the Eurozone countries. First of all, if a certain industry is heavily represented within some countries, national stock markets will diverge from markets in other countries. This is particularly true when the overrepresented industry experiences industry specific shocks (Campa & Fernandes, 2006). Investigating the composition of the Finnish stock market reveals that the IT sector is overrepresented in this country. Thus, Finnish equity returns might be more affected by industry factors instead of country factors like stock market liberalization.
Furthermore, it is argued that small stock markets with a low level of liquidity are less correlated to other markets (Yang, Min & Li, 2003). That is, less correlated markets do not move similar to other stock markets in the Eurozone. As was mentioned in the previous paragraph, Austria has a very small stock market compared to other Western European countries. Additionally, it seems that Austria’s liquidity is also extremely low and even decreasing in the second period. This low level of similarity between Austria and the other stock markets in the Eurozone possibly means that this country is more segmented.
Finally, by examining the composition of Spain’s stock market, the average size of the listed companies is found to be larger on average, compared to other Eurozone markets. It has been proven by Christoffersen, Chung & Errunza (2004), that the stock market liberalization effect on large firms is significantly different from that on smaller companies. Therefore, it can be argued that the relatively large size of Spanish listed firms has affected the explanatory power of the liberalization indicators.
Non-Eurozone Countries
research conducted by Nilsson (2002). This study concludes that the Norwegian stock market became more integrated with the world market (rather than the European market) after the opening of the stock market to foreign investors. Furthermore, before the introduction of the Euro, Switzerland and Germany were both integrated with Western European markets as well, since they were frequently used as a monetary reference. However, after the introduction of the Euro, Germany became the leading stock market in the Eurozone. As a result, Switzerland lost international weight regarding the European stock exchanges and became more integrated with the world market. Moreover, according to Fraser & Oyefeso (2005) the stock market of the United Kingdom is not determined by a general trend. However, these authors also demonstrate that the stock market of the United Kingdom became more integrated with the world market during the second period of this study’s research timeframe. Hence, it can therefore be argued that the findings in the second sample period for these three Western European countries are explained more by worldwide shocks.
