ECONOMIC FREEDOM AND STOCK MARKET INTERDEPENDENCE : EVIDENCE FROM THE AUSTRALASIAN REGION 1

This study investigates the impact of economic freedom on the stock market interdependence between Australia and ten Asian countries (China, Hong Kong, India, Indonesia, Japan, Malaysia, Philippines, Singapore, South Korea and Thailand). The empirical analysis is carried out using panel data regression. The results show that freedom relating to doing business, government spending policies, and foreign direct investmentsignificantly impacts stock market interdependence between Australian and the selected Asian countries. These results have important implications for policymakers as well as investors within the Australasian region. JEL classification: C32, C33, G01, G15, O16, KeywordsEconomic freedom, stock market interdependence, AGDCC GARCH I. BACKGROUND OF THE STUDY The objective of this study is to examine the impact of economic freedom, foreign direct investment (FDI), stock market development and trade openness on the stock market correlations of Australia and ten Asian countries (China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia, the Philippines, Singapore and Thailand). For this purpose, the study constructs panel data using annual data on economic freedom from 1996 to 2013. To measure the stock market time-varying relationship between Australia and Asian markets, the study uses an asymmetric generalized dynamic conditional correlation (AGDCC) GARCH model. The time-varying correlations between these stock markets are measured using weekly data from 1996 to 2013 and extracted end-of-year correlations to match with certain determinants of stock market linkages (economic freedom). Further, the annual data on FDI inflows, stock market capitalization and trade openness are also collected for the same period. To analyse the impact of economic freedom, FDI, stock market development and trade openness on the stock market correlations of Australia and Asian markets, the study uses panel regression models. The increasing financial liberalization of equity markets over the last three decades has attracted great interest among academics, policy makers and practitioners. This has been mainly to explore the impact of these reforms on both financial markets and the development of the economy. Researchers have shown great interest in these markets as the liberalization of equity markets has provided an opportunity, for the first time, for foreign investors to invest in domestic equity markets, and for domestic investors to invest directly into foreign markets (Bekaert and Harvey, 2003). Further, these reforms have significantly helped investors to reduce the risks to their portfolios by providing an opportunity to diversify their investments into other developing markets. This is due to the fact that the stock markets of developing countries are not fully integrated with the developed markets (Darrat et al., 2000). On the other hand, the stock markets of developed countries are highly integrated. This means that changes in these market returns are highly correlated. The explanation for this is that a large proportion of returns volatility in a developed country is the result of the changes in returns of other developed markets (Bekaert and Harvey, 2002). The liberalization of financial markets in nations has created enormous investment opportunities for global investors. This liberalization also leads to a better allocation of limited resources among the potential investments. Darrat et al. (2000) argue that if there are no restrictions on capital flows across national boundaries and no transaction costs, then it can be expected that two assets with similar risk profiles should be priced the same, regardless of origin. High transaction costs and the presence of numerous restrictions on capital flows can lead to inefficient allocation of scare resources, and can cause markets to become segmented. For this reason, researchers are keen to understand the level of stock market integration and the factors that drive this interdependence over time. A number of studies have identified the factors that drive stock market interdependence. Some of the studies indicate that a significant bilateral trade linkage between countries can have considerable influence on their stock market relationship (e.g. Chen and Zhang, 1997; Pretorius, 2002; Forbes and Chinn, 2004; Chambet and Gibson, 2008; Tavares, 2009). Other studies document that the macro fundamentals and market related variables have a substantial impact on stock market interdependence over time (e.g., Bracker et al., 1999; Pretorius, 2002; Johanson and Soene, 2003; Jithendranathan, 2005). However, the previous studies have not explored the impact of economic freedom indicators on stock market correlations. Particularly, this study examines Economic Freedom And Stock Market Interdependence: Evidence From The Australasian Region Proceedings of Academics World 17 International Conference, Tokyo, Japan, 15 January 2016, ISBN: 978-93-82702-12-2 31 several indicators that represent economic freedom; these include business freedom, financial freedom, fiscal freedom, freedom from corruption, government spending, investment freedom, monetary freedom, property rights and trade freedom. The factors relating toeconomic freedom play an important role in determining foreign capital inflows into countries. Therefore, these factors have a substantial role in explaining the degree of stock market correlations over time, and have important policy and practical implications. Policy makers are more interested in knowing the factors that drive foreign capital inflows and outflows. This understanding will assist them to formulate appropriate policies to stabilize their financial systems and to act against capital flight. Similarly, an understanding of the factors that drive stock market correlations is particularly useful to portfolio investors who wish to diversify their investments into foreign markets in order to gain higher risk-adjusted returns. The empirical studies of Yang et al. (2003), Campbell and Hamao (1992), Eun and Shim (1989) and Taylor and Tonks (1989) suggest that the potential benefits from international portfolio diversification are reduced due to the high degree of comovements among the stock markets. At the same time, some other studies (Pukthuanthong and Roll, 2009 and Brooks and Del Negro, 2004) document that since the late 1990s, international stock markets have become progressively more interdependent. A study by Kearney and Lucey (2004) also suggests that if the correlations among different stock markets increase, then the portfolio diversification benefits significantly decrease. Similarly, the earlier portfolio diversification studies of Grubel (1968) and Levy and Sarnat (1970) indicate that the motivation for investors to diversify their investments into international stock markets arises from low correlations between the domestic and foreign asset returns. Bekaert and Harvey (1995), Harvey (1995), Korajczyk (1996) and Chambet and Gibson (2008) empirically provided evidence in support of the view that the emerging and developed stock markets are less interdependent, and may offer considerable diversification benefits for the international investors. This suggests that it is important for portfolio managers to understand how the comovements of stock markets vary across time. Early attempts to model capital control were made by Black (1974) and Stulz (1981) who represented barriers to international portfolio investment as proportional taxes on foreign asset holdings. Black (1974) assumed that the tax rate is positively associated with long positions and negatively associated with short positions. On the other hand, Stulz (1981) assumed that a positive tax applies equally to all the positions. Other authors, such as Eun and Janakiramanan (1986), Errunza and Losq (1989) and Hietala (1989), argue that investment barriers include prohibitions on particular crossownerships of assets. In the early 1990s, several studies (Divecha et al., 1992; Speidell and Sappenfield, 1992; Wilcox, 1992; Harvey, 1993) explored the return properties and potential diversification opportunities for global investors to invest in emerging markets. However, Bekaert (1995) argues that the restrictions on foreign investment may hamper the benefits that are expected from portfolio diversification. Further, this author argues that – provided the barriers to foreign capital are avoided – the capital moving from industrial countries to emerging economies has several positive impacts, including reductions in domestic capital costs and increases in economic welfare through the mobilization of efficient resources. Further, Bekaert (1995) identifies three important barriers to investment. The first barrier comprises the ‘legal barriers’ arising from differences in the legal status of foreign and domestic investors; for example, ownership restrictions and taxes. The second category of barriers are ‘indirect barriers’, such as differences in available information to domestic and foreign investors, accounting standards and investor protection. The third set of barriers deal with risk, and include liquidity risk, political risk, economic policy risk, macroeconomic instability and currency risk. Numerous studies point out that both foreign direct investment (FDI) and portfolio investment into other countries are determined by several factors in the host countries. Therefore, this study aims to understand the extent to which the quality of economic freedom indicators play a pivotal role in explaining stock market correlations in the Australasian region. Particularly, this study aims to investigate the impact of economic freedom indicators on stock market linkages from the perspective of Australian and Asian markets. This study uses four sets of economic freedom indicators such as, rule of law (property rights and freedom from corruption), limited government (fiscal freedom and government spending), regulato