Emerging Market Liberalization and Monetary Control Bill B. Francis Rensselaer Polytechnic Institute Delroy M. Hunter University of South Florida Patrick

Emerging Market Liberalization and Monetary

Control

Bill B. FrancisRensselaer Polytechnic Institute

Delroy M. HunterUniversity of South Florida

Patrick J. KellyNew Economic School

Benefits of Financial Market Liberalization

By opening to foreign investment emerging markets can benefit from:•Greater access to capital [Henry (2000), Mitton (2006)]

•At a lower cost [Chari and Henry (2004), Bekaert and Harvey (2000), de Jong and de Run (2005)]

•Spurs economic growth [Bekaert, at al (2001, 2009), Quinn and Toyoda (2008)]

Patrick J. Kelly Emerging Market Liberalization and Monetary Control

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trilema

Costs of Liberalization

“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--for example, by reducing the ability of the Federal Reserve to affect U.S. interest rates and asset prices …”

(Bernanke (2007)).

“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... ”

(Williamson (1998)).

Patrick J. Kelly 3/27Emerging Market Liberalization and Monetary Control

Costs of Liberalization

But with access to foreign capital, firms may become

•less sensitive to local monetary policy – Reducing the ability of monetary policy

authorities to influence macroeconomic targets

•and more sensitive to foreign policy– Foreign policy may not be the best policy for

the local economy


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Central Question

• To what extent are monetary policy authorities in emerging markets able to influence their economies following financial market liberalization?

• Reasons to think retaining control might be a challenge– The “Impossible Trinity” (Obstfeld, Shambaugh,

Taylor, 2005)• Integration• Exchange rate stability• Monetary control


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Calvo et al. (2002, 2003)

Received Knowledge: Impact of Monetary Policy

• Monetary policy shocks affect U.S. stock returns• One of several channels through which monetary policy

impacts the real economy– the cost of capital– Default risk (changing collateral value)– Investor Consumption and risk of default (Mishkin, 1995)

• They reflect anticipated changes in the economy– Bernanke and Binder (1992), Bernanke and Kuttner (2005), many

more

• Developed market stock prices are affected by U.S. monetary policy (Conover, Jensen and Johnson, 1999, Wongswan, 2005)

• U.S. Monetary shocks impact emerging market stock prices (Hausman and Wongswan, 2011 and Ehrmann and Fatzscher, 2009)


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Central Question

• To what extent are monetary policy authorities in emerging markets able to influence their economies following liberalization?– We study the stock price response to monetary

policy shocks

• Many emerging markets have segments of their market that have not fully opened to foreign investment

• Does keeping a fraction their firms closed to foreign investment help preserve the ability of local monetary policy authorities to affect the local economy?


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Importance

• For policy makers– Identifies where policy is effective and in what

segment of the market monetary policy is effective.– Countries (frontier markets) considering opening

their markets to foreign investment

• Investors– Identifies a factor affecting returns

– Indicator of market integration• Identifies markets which may provide greater/lessor

diversification benefits for international portfolio managers


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Gap in literature

1. Effect of local monetary policy on emerging stock markets

2. Effect of local and U.S. monetary policy on stocks open to foreign investment and closed

• Does keeping a fraction firms closed to foreign investment help preserve the ability of monetary policy authorities to affect the local economy?


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Findings:

1. Are local markets influenced by local monetary policy above and beyond the influence of foreign monetary policy post liberalization?

• In 18 of 25 markets one standard deviation increase in local policy rates an average 2.07% decline in the local market.

• Confirming prior literature, U.S. monetary policy influences 11 of 25.

2. Are firms open to foreign investment investment influenced by local (and foreign) monetary policy?

• Yes, in 16 of 23 markets local policy affects investable stock compared to 10 of 23 for non-investable.

• consistent with an “efficiency” effect– Cross country results consistent: more developed and more

internationally integrated markets are more sensitive to local policy.


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Data and Methodology

Patrick J. Kelly Emerging Market Liberalization and Monetary

Control

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The Data


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• S&P’s Emerging Markets Database (EMDB) through 2006

– Global Index – returns to all stocks in a given market

– Investible Index – returns to stocks open to foreign ownership

– Bae, Chan and Ng (2004) find that 25% to 35% of the smallest size quintile is in the non-investable category.

– Non-Investible index following Boyer, Kumagai, and Yuan (2006)

• Liberalization Dates– Bekaert, Harvey, and Lumsdaine (2002)

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11

ItGt

ItItGtGtNt MVMV

RMVRMVr

Summary Stats


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Start

Date Obs Mean Std Obs Mean Std Obs Mean Std

Argentina Oct-93 147 0.8 10.9 147 0.8 10.9 147 1.6 15.6

Brazil Nov-94 134 1 9.1 134 1 9.3 134 1.4 9

Chile Sep-94 135 0.4 5.7 135 0.3 5.8 135 0.5 5.1

Colombia Apr-91 94 0.9 10 94 1.1 10.1 94 -0.4 12.4

Mexico Jul-89 198 0.9 7.6 198 1 7.9 198 0.9 10.3

Peru Feb-93 155 1.2 7.6 155 1.1 7.9 155 1.6 8.5

Venezuela Feb-96 81 -0.4 12.3 69 -0.5 13 69 -0.1 16.5

Israel Jan-97 108 1.1 6.4 108 1.1 6.4 108 2.1 11.4

Jordan Feb-96 119 1.6 5.5 69 0.2 3.6 69 0.3 3.6

S. Africa Feb-97 107 1 6.9 107 1 6.9 55 0.6 14.2

India Jan-93 125 -0.3 7.9 125 -0.3 8.1 125 -0.2 7.9

Korea Mar-92 166 0.4 10.1 166 0.5 10.2 166 0 9.8

Malaysia Feb-89 203 0.2 8.4 203 0.3 8.6 203 0.4 8.1

Pakistan Jul-97 102 1.3 11.7 52 -1 14.5 52 0 11.4

Philippines Aug-91 173 0 8 173 -0.1 8.9 173 0 7.6

Taiwan Mar-91 178 0.1 9 178 0.2 9 178 0 9

Thailand Feb-91 179 0 11.2 179 0 11 179 0 11.5

Czech Jan-94 144 0.2 8 144 0.3 9.3 119 -0.7 8.8

Greece Feb-88 157 1 10.5 146 1.3 11.3 129 2.4 12.3

Hungary Jan-93 156 0.9 9.9 156 1.1 10.7 156 0.4 7.7

Poland Jan-93 156 1.3 13.2 156 1.3 13.2 119 1.4 10.1

Portugal Sep-86 146 1 10.5 118 0.5 6.6 118 0.5 6.6

Russia Feb-00 71 1.7 10.5 71 1.3 11.1 71 2.6 11.3

Slovakia Jan-96 106 0 7.7 56 -1.6 7.8 56 -1 7.7

Turkey Oct-89 195 0.3 15.8 195 0.3 15.8 125 -8.5 64.3

Europe

Aggregate Local Market Investable Non-investable

Central and South America

Middle East and Africa

Asia

Longest

Shortest

Data: Monetary Policy Proxies

• Interest rates chosen based on Calvo and Reinthart (2002) survey of policy targets

• Loayza and Shmidt-Hebble (2002) and Kamin, Turner and Van’t dack (1998) note that with liberalization short term interest rates become the primary tool of monetary policy– Even if not the only tool, market-based interest rates will

reflect these changes [Obstfeld et al. (2005)]1. the interbank interest rates, 2. discount rate

3. Treasury bill rate4. money market rate5. 10-year government bond rate

• All from Datastream– (changes Winsorized at 5th and 95the percentile)

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Methodology: Measuring Monetary Policy Shocks

Best Practices•Structural Vector Auto Regression (SVAR) [Christiano Eichenbaum, and Evans (1999), Kim and Roubini (2000)]

– Model expectation of monetary policy changes as function of:

• Log Oil prices (oil) x 100• Log first difference Fed Funds Rate (FF)• Log first difference Industrial Production (IP) x 100

– Where IP unavailable we use manufacturing. In Argentina and Venezuela crude petroleum production.

• Inflation (inf) (Log first difference in CPI)• Log first difference of annualize Local Monetary Policy rate

(LMP)• Log first difference of Exchange rate (FX) in US/local x 100• Real market return (Ret): Log first difference of index deflated

by local inflation– Oil, output and CPI are seasonally adjusted


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Structural Vector Auto Regression (SVAR)

• Model the evolution of each of the 7 measures in a 7 equation system (restrictions Kim

and Roubini (2000) and Bjornland and Leitemo (2009)):


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Oil is allowed to affect all monetary policy expectations, even for the US following Bernenke and Mihov (1998) Romer2 (2004) and Kim and Roubini (2000)

Many emerging markets actively manage their exchange rates

LMP

Patrick Kelly

Why do we use epsilon for what are our changes and nu for our residuals?The Notation is confusing.

Question 1

1. Are markets influenced by local monetary policy above and beyond the influence of foreign monetary policy post liberalization?

Here I report only the first period • Impulse response of returns to local and

foreign monetary policy– In paper also the standard deviation of the

structural shocks


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Example Impluse Reponse

• Russia

Response of Returns to Response of Returns to

Local Monetary policy U.S. Monetary policy


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a one standard deviation shock to local monetary policy results in a 3% decline in stock prices Tech detail

s

Local authorities meaningfully influence local markets


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CountryLocal Monetary Policy Proxy

Local Monetary Policy

U.S. Monetary Policy Country

Local Monetary Policy Proxy


U.S. Monetary Policy

Argentina IB -3.079♠ 0.189 Israel TB -2.296♠ 0.793

Brazil IB -2.000♠ -1.107♠ Jordan DR -0.068 -0.351

Chile IB -1.628♠ -1.076♠ South Africa GB -2.324♠ -1.262♠

Colombia DR 0.19 -1.859♠

Mexico IB -0.713♠ -0.945 Czech IB 0.712 -0.685

Peru DR 0.118 -0.285 Greece TB -2.641♠ -0.246

Venezuela MM -2.308♠ -1.949♠ Hungary TB -1.165♠ -1.674♠

Poland MM -2.708♠ -1.342♠

India DR -0.458 -1.011♠ Portugal DR -0.505 2.442♠

Korea MM -1.142♠ 0.493 Russia IB -2.999♠ 0.549

Malaysia TB -1.944♠ -0.355 Slovakia IB -1.193♠ -2.056♠

Pakistan MM -1.753♠ 1.118 Turkey MM -4.803♠ -1.489♠

Philippines IB -1.214♠ -0.673

Taiwan IB -0.676 0.324

Thailand IB -1.290♠ -1.908♠


Response of Returns toResponse of Returns to


Asia

Europe

Whole market sensitive to local policy: 18/25 markets (average -2.07%)U.S. Policy: 11/25 markets (average -1.32%)

robustness

Decomposing Whole Market Returns

• Are firms open to foreign investment investment influenced by local (and foreign) monetary policy?

• Are firms closed to foreign investment influenced by foreign (and local) monetary policy?

• Is the sensitivity of the market return to local policy a driven by non-investable stock?

• Same SVARs only with investable and non-investable indices– Too few observations to jointly estimate


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Non-Investable Response to Monetary Policy Shocks


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Country Coefficient Coefficient Country Coefficient Coefficient

Argentina -2.229♠ 0.802 Israel -3.635♠ -0.272

Brazil -1.844♠ -1.199♠ Jordan 0.146 -0.147

Chile -0.378 0.374

Colombia 0.252 -1.757♠ Czech -0.239 -1.159♠

Mexico -0.305 -0.315 Greece -3.238♠ -1.810♠

Peru 0.461 -0.308 Hungary -1.716♠ 0.325

Poland -1.219♠ -1.609♠

India -0.648 -0.135 Portugal -0.76 -0.069

Korea -1.530♠ 0.195 Russia -2.095♠ 0.936

Malaysia -1.817♠ -0.649 Turkey -1.557 -0.933

Philippines -0.945 -0.905♠

Taiwan -0.662 0.258

Thailand -1.370♠ -2.011♠

Response of Returns to





Europe


Asia





10/21 sensitive to local policy7/21 sensitive to U.S. policy

Investable Response to Monetary Policy Shocks


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Country Coefficient Coefficient Country Coefficient Coefficient

Argentina -3.090♠ 0.163 Israel -2.293♠ 0.766

Brazil -2.326♠ -1.613♠ Jordan 0.118 -0.370

Chile -1.645♠ -1.074♠ South Africa -2.296♠ -1.261♠

Colombia 0.063 -1.822♠

Mexico -1.730♠ -0.21 Czech 0.738 -0.644

Peru -0.012 -0.236 Greece -2.779♠ -0.127

Venezuela -0.591 -1.571 Hungary -1.224♠ -1.630♠

Poland -2.695♠ -1.335♠

India -0.471 -0.136 Portugal -0.869♠ -0.571

Korea -1.070♠ 0.466 Russia -3.354♠ 0.743

Malaysia -1.957♠ -0.311 Turkey -4.729♠ -1.397

Philippines -1.584♠ -0.566

Taiwan -0.654 0.353

Thailand -1.229♠ -1.772♠


Asia


Europe









16/23 sensitive to local policy7/23 sensitive to U.S. policy

Differences between Non- Investables and Investables

• Are investable stock more responsive to local monetary policy shocks?– In sufficient power to model both series in an

SVAR

• We difference the two series and model:– Non-Investable minus investable– Positive means Investable as a stronger effect– Negative means Non-Investable has a stronger

effect


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Response of Returns to Local

Monetary Policy

Response of Returns

to U.S. Monetary

Policy

Response of Returns to Local

Monetary Policy

Response of Returns

to U.S. Monetary

Policy

Country Coefficient Coefficient Country Coefficient CoefficientCentral and South America Middle East and AfricaArgentina -0.846 0.134 Israel -0.846 0.134Brazil 0.804 0.030 Jordan 0.804 0.030Chile 1.218♠ 0.401 EuropeColombia -0.674 -0.339 Czech 0.142 1.000Mexico 1.142♠ 0.150 Greece -0.029 -1.940♠Peru 0.269 0.106 Hungary 1.024♠ 0.956♠Asia Poland 0.887 -0.896India -0.129 0.035 Portugal 0.603♠ 0.868♠Korea -0.433♠ -0.552♠ Russia 1.755♠ 0.484Malaysia 0.065 -0.217 Turkey -1.429 0.324Philippines 0.443 -0.311Taiwan 0.032 -0.068Thailand -0.145 -0.211

Non-Investable Minus Investable


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In 5 markets Investable stock more sensitive to local monetary policy shocks

Summing up Investable and Non-investable results

• Local policy affects both– Investable – Non-investable

• Local policy has a more pronounced effect on investable stock– Efficiency effect? Consistent with Reese and Weisbach

(2002) – firms enter foreign markets to raise more local capital.

• Shows that the sensitivity to U.S. Monetary policy is not solely driven by the investable component.– Contribution over Hausman and Wongswan (2006),

Ehrmann and Fratzscher (2006)


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Cross Country Explanations


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Global Stock Returns Response to Local monetary shocks U.S. monetary shocks

N 22 22 22 22 22 22Constant -5.83 -5.64 -5.51 1.38 0.54 1.56

(-2.75) (-2.54) (-2.94) (0.65) (0.26) (0.66)Market Capitalization to GDP -0.01 -0.01 0.00 -0.01 0.00 0.00

(-1.87) (-2.30) (-0.55) (-1.35) (-0.45) (-0.48)Capital Control Intensity 0.03 0.03 0.03 -0.01 -0.01 -0.01

(2.69) (2.42) (3.44) (-1.42) (-0.98) (-0.92)Net In-Flows in Billions 0.74 0.81 0.60 -0.49 -0.81 -0.57

(1.85) (2.14) (1.63) (-1.06) (-2.88) (-1.10)Exchange Rate Regime -0.05 -0.04 0.02 -0.22 -0.24 -0.19

(-0.46) (-0.42) (-0.20) (-3.42) (-3.56) (-2.72)Political Risk 0.09 0.09 0.03 0.04 0.03 0.01

(1.82) (2.16) (1.02) (1.10) (0.75) (0.37)Central Bank Political Autonomy 2.58 2.68 1.45 1.00

(-1.56) (-1.72) (-1.31) (-0.89)Central Bank Economic Autonomy 0.38 1.12 -1.78 -1.36

(0.30) (0.87) (-1.23) (-0.91)

Adj R2 0.096 0.154 0.0215 0.017 0.010 0.028

Somewhat greater in more developed markets

Weaker in more segmented markets

Weaker when more foreign capital in-flows

Conclusion

• Local monetary policy is a factor that affects the entire market in 18 of 25 markets: 2.07% decline for a 1 standard deviation shock– Not driven by non-investable stock

• When different – investable are more sensitive

– US policy does not dominate local policy

• It appears there are externalities to liberalization that – Stocks become more sensitive to local policy, but– Causes non-investable stock to respond to

foreign policy as if they too were investable in a few (7) markets


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Documents

Emerging Market Liberalization and Monetary Control Bill B. Francis Rensselaer Polytechnic Institute Delroy M. Hunter University of South Florida Patrick