A Decomposition of Global Linkages in Financial Markets Over Time

This paper tests if real and financial linkages between countries can explain why movements in the world's largest markets often have such large effects on other financial markets, and how these cross-market linkages have changed over time. It estimates a factor model in which a country's market returns are determined by global, sectoral, and cross- country factors (returns in large financial markets) and by country-specific effects. Then it uses a new data set on bilateral linkages between the world's five largest economies and approximately 40 other markets to decompose the cross-country factor loadings into direct trade flows, competition in third markets, bank lending, and foreign direct investment. In the latter half of the 1990s, bilateral trade flows are large and significant determinants of how shocks are transmitted from large economies to other stock and bond markets. Bilateral foreign investment is usually insignif- icant. Therefore, despite the recent growth in global financial flows, direct trade still appears to be the most important determinant of how move- ments in the world's largest markets affect financial markets around the globe. n the first half of 2002, the United States was buffeted by a series of negative shocks—from disappointing eco- nomic growth, to terrorist threats and uncertainty about a potential war with Iraq, to continued fallout from a series of financial scandals that raised broader concerns about corpo- rate governance. As a result, the U.S. stock market fell by approximately 17% over the first 6 months of the year. 1 Many other markets around the world declined in harmony; over the same 6-month period, Finland's stock market fell by 30%, Ireland's by 14%, Mexico's by 11%, and Hong Kong's by 6%. Other stock markets, however, performed relatively well and appeared to be insulated from the flow of negative news emanating from the United States. For ex- ample, over the same period Iceland's stock market experi- enced positive returns of 26%, South Africa's of 21%, South Korea's of 12%, and Colombia's of 11%. Shocks to the world's largest economies and their financial markets often spread to some markets, whereas markets in other countries are relatively insulated. This paper examines if real and financial linkages be- tween countries can explain why the world's largest finan- cial markets often appear to have such large, yet diverse, effects on other financial markets, and how these cross- market linkages have changed over time. More specifically, the paper attempts to answer four questions. First, how important are cross-country linkages with large financial markets, as compared to global and sectoral factors, in explaining financial market returns in countries around the world? Second, how important are bilateral trade flows, trade competition in third markets, bank lending, and in- vestment exposure in explaining these cross-country link- ages? Third, how has the relative importance of these various global linkages changed over time? Finally, how does the relative importance of these global linkages differ across stock markets and bond markets? In order to answer these questions, this paper begins by developing a factor model of market returns in different countries. It assumes that a country's market returns are a function of cross-country factors (returns in other large financial markets), global factors (world stock market re- turns, global interest rates, oil prices, gold prices, and commodity prices), sectoral factors (stock returns for 14 sectoral indices), and country-specific effects. After estimat- ing the importance of these factors for different countries and regions, the paper then focuses on the estimated cross- country linkages between the five largest economies (France, Germany, Japan, the U.K. and U.S.) and approxi- mately 40 developed countries and emerging markets around the world. It decomposes these cross-country link- ages into four specific bilateral linkages: two real linkages (direct trade flows and competition in third markets) and two financial linkages (bank lending and foreign direct investment). After measuring the importance of each of these factors and bilateral linkages in stock markets between 1986 and 2000, the paper than examines how their relative importance has changed over time and differs in bond markets.