# **1.** **<u>Introduction</u>**

Has the world become more financially integrated in the last decades? Are the patterns of financial globalization the same in developed, emerging, and frontier markets? Have they changed after the global financial crisis? More importantly, is financial globalization a stabilizing or a destabilizing force? To answer these important questions, we construct a new measure of financial globalization, the Financial Globalization Index (FGI). We compute it for a large sample of countries over the last quarter century, and study how it correlates with stock market volatility.

Of course, we are not the first to propose a measure of financial integration.<sup>1</sup> Our FGI is an asset price correlation measure that builds upon Pukthuanthong and Roll (2009). The main difference between our measure and Pukthuanthong and Roll’s is that, following Forbes and Rigobon (2002), we recognize that changes in the correlation between different countries’ stock markets partly reflect changes in global volatility and we correct for it.

The main finding of our analysis of financial globalization is that, for the “average” country, it increased by 0.6 percentage points per year over the 1992-2016 period. Had we not controlled for changes in volatility, the figure would have been much larger, 1.3 percentage points. For the subsamples of developed, emerging, and frontier countries, the corrected figures are 0.5, 0.9, and 0.4 percentage points, respectively, compared with the uncorrected figures of 1.6, 1.5, and 0.6. The correction also alters our reading of the patterns of globalization during periods of financial turbulence and hence of the effects of the global financial crisis. Finally, when we compare the levels of financial globalization of developed, emerging, and frontier markets, we find that nowadays the average FGI of emerging and frontier markets is still a fraction (0.61 and 0.15) of that of the average developed market.

Our analysis relates to a growing body of literature on international asset correlation. With respect to developed economies, using country-industry and country-style equity portfolios, Bekaert et al. (2009) do not find evidence of an increase in the correlation of countries’ stock market returns, with the notable exception of Europe. This makes them conclude that it is difficult to support the argument that global trends have led to permanent changes in the correlation of international assets. Pukthuanthong and Roll (2009), instead, find evidence of a financial integration trend in developed markets for the 1989-2009 period. Looking at pre-2011 data, Volosovych (2011) also points to a positive long-run trend in the co-movement of industrialized countries’ bond returns.

With respect to emerging markets, looking at bilateral correlations of countries’ stock indices for the period 1988-1999, Saunders and Walter (2002) conclude that they have become so integrated with developed economies’ that they no longer represent a separate asset class. This, however, may well reflect episodes of financial turbulence over that period. Bekaert and Harvey (2014) look at the difference between the rates of returns at the industry level, and argue that the distinction between asset classes is still valid, though the correlation between developed and emerging markets has increased. Levy-Yeyati and Williams (2012) show that while emerging markets’ business cycles have partially decoupled from advanced economies’, financial integration has strengthened, leading to a

> 1 We refer the reader to Quinn et al. (2011) for a comprehensive survey of different measures of financial openness and integration, some of which we use in section 5.

2