Boosted by freer flows of global capital and technological advancements, cross-border linkages between stock markets around the world have been strengthening in recent years. In particular, the growing use of electronic trading – which increases the speed of international financial transactions – and the deregulation of equity markets is accelerating this trend.

This phenomenon can be seen in the case of China, where the partial opening of the country’s stock markets to foreign investors and the gradual shift toward market-determined exchange rates has led to Chinese equity markets being increasingly integrated into the global financial system. The impact of this integration was seen in August 2015, when Asian bourses fell sharply following the plunge in Chinese stock prices after a change in the renminbi exchange rate regime was announced. More recently, in January 2016, the suspension of trading in Chinese stocks triggered a widespread correction in global equity markets. This shows that, as countries become more financially integrated, there is a corresponding rise in the cross-border transmission of equity market shocks.

Furthermore, a study by Professor Chow Hwee Kwan from Singapore Management University’s (SMU) School of Economics found that, following the global financial crisis, such “volatility spillovers” are not temporary shocks that occur as a result of contagion, but rather persisted after the crisis. Her research also showed that the susceptibility of individual Asian bourses to volatility transmitted from other markets is linked to its degree of openness, and that equity markets in the region are becoming more important emitters of financial shocks since the global financial crisis.

In particular, Prof Chow’s study provides evidence that compared to the pre-crisis period, stock markets in Asia have become more susceptible to spillovers from China and less so to spillovers from Japan after the crisis. Prior to the crisis, volatility in the Asian equity markets appears to be more affected by the gyrations in the Japanese market compared to the Chinese market. However, the level of influence on Asian stock markets from the Chinese market has risen to that of Japan. Meanwhile, spillovers from the United States remain higher than those from China and from Japan in both the pre- and post-crisis periods.

The study used “spillover indexes” that obtain an overall picture of shock transmissions in Asian stock markets. It focused on the benchmark indices of 10 Asian economies: China, Hong Kong, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand. The S&P500 and FTSE100 indexes were also included to reflect the region’s integration with global markets. The computed “spillover indexes” provide measures of inward and outward transfers of shocks for each individual equity market, giving us a pattern of cross-border volatility transmissions. A comparison of shock transmissions before and after the global financial crisis is then carried out.

Mitigating the risk of openness

While deeper financial integration brings about significant economic benefits – such as portfolio diversification for investors and risk sharing across countries – it also exposes domestic financial markets to international financial transactions, resulting in higher risks of financial instability. Indeed, recurring financial and currency crises in the past few decades has raised the question of whether developing countries should continue to promote financial openness, says Prof Chow.

In Asia, the level of openness varies widely across different groups of economies. Unsurprisingly, as global financial centres, Japan, Hong Kong, and Singapore are fully integrated with global markets, while at the other end of the spectrum, China is making efforts to gradually open its markets. Initiatives to strengthen financial cooperation and integration are also ongoing in the region. For instance, ASEAN countries are working to integrate their capital markets, including efforts to facilitate cross-listing of securities and cross-border settlement.

Prof Chow noted that Singapore’s financial sector has thrived on its openness and, as such, imposing measures such as capital controls to mitigate the impact of financial shocks is not feasible. “The susceptibility to financial shocks and increase in volatility transmission are key challenges which our financial market regulators have to face. Should there be a sudden and large scale outflow of capital, having currency swap lines will help ease liquidity crunches,” she says.

Over the longer term, she believes that financial stability can be achieved by adopting policies that build resilience and boost confidence in Singapore, such as by maintaining a high level of official reserves and employing policies that mitigate systemic risk in the financial sector. In view of her research, Prof Chow said that firms and individuals will need to take into account the greater volatility in the stock markets when crafting their investment strategies. “Market participants may have to take a longer term view of their investments. Various derivative products that offer protection against market volatility will also become more useful.”

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