Do Foreign Investors Insulate Firms from Local Shocks? Evidence from the Response of Investable Firms to Monetary Policy

There is an intense debate over whether the openness of emerging financial markets arising from liberalization has led to a loss of monetary control by local authorities. This paper is the first to examine such a claim. The evidence indicates that while emerging markets are influenced by foreign monetary policy, local authorities have not lost monetary control. Using a broad index, we find that local monetary policy has a significant effect on 20 of 28 emerging markets. On average, a one standard deviation positive shock to local policy interest rates leads to a 1.74 percent per month decline in returns. Accounting for foreign monetary policy does not diminish this impact, even where foreign monetary policy has a significant effect. Further evidence indicates that the impact of local monetary policy on emerging markets is not due entirely to the impact on non-investable stocks, as local monetary policy has a similar significant effect on the returns of investable and noninvestable stocks. Moreover, foreign monetary policy does not dominate or diminish the effect of local monetary policy on investable or non-investable stocks, even though it has a significant effect on both investable and non-investable stocks. Finally, we find that during currency crises local monetary policy generally has no effect on emerging stock markets. These findings are robust to controlling for possible endogeneity of local monetary policy changes, changes in exchange rate regimes, and to alternative measures of monetary policy and modeling approaches. Financial Market Openness and Monetary Control There is an intense debate over whether the openness of emerging financial markets arising from liberalization has led to a loss of local monetary control. For instance, in a 1998 speech, John Williamson, then Chief Economist for the South Asia region at the World Bank noted that: “We need to re-examine the merits of financial liberalization in the light of [the concern that it] lead[s] to a loss of monetary control, and it might nurture financial crises. ” “. in recent months the global economic crisis has led to a widespread questioning of the benefits of a liberalized financial system. ” “Critics . contended that financial liberalization would have two negative effects: it might lead to a loss of monetary control, and it might nurture financial crises” (Williamson(1998)). Nearly a decade after the 1997 Asian crisis, the World Bank-International Monetary Fund (2005; p.318) further fueled this debate when they stated that, “. macroeconomic risks . may be triggered by financial liberalization (e.g., loss of monetary control.following liberalization.). ” As if taking sides in this debate, Nobel laureates Paul Krugman (1998) and Joseph Stiglitz (1999) advocated strongly for restricting liberalization on the grounds that it would limit the devastating effects of the sudden stoppage of capital inflows and the acceleration of capital outflows associated with currency crises, which local monetary authorities are not adequately equipped to deal with. Liberalization does not raise such concerns among all. In his 1998 speech John Williamson (1998) downplayed the loss of monetary control in liberalized economies, noting, “The one that is not in practice a problem is the loss of monetary control; on the contrary, the indirect methods of monetary control that go with financial liberalization appear to be more effective than direct credit controls. ” However, so potentially detrimental is financial market openness to local monetary control that even in the United States, where, relative to the emerging markets, there are adequate institutional mechanisms to counterbalance its effect, the Chairman of the U.S. Federal Reserve was recently prompted to comment: “A narrower question . is whether the increased openness of the U.S. economy has in some way affected the ability of the Federal Reserve to . foster price stability and maximum sustainable employment. On this issue, some analysts have argued that globalization hinders monetary policy--