Evolution of Inter and Intra-Regional Linkages to MENA Equity Market

1. Evolution of Inter and Intra-Regional Linkages to MENA Equity Market Eric Girard and Eurico Ferreira

2. Introduction Mellon Capital:”Our global tactical and strategic asset allocation products…invest in developed country markets…and treat other less liquid markets as a block…” An important question examined in this paper is whether or not thin emerging capital markets such as MENA capital markets should be treated as a block in a global strategic or tactical portfolio. The proximity (geographic, culture, religion, etc.) of the countries may lead one to conclude that there is a close connection between their economies  hence, susceptibility to be sensitive to shocks from neighboring countries.

3. MENA Markets: some issues • Wars, political turmoil, economic instability and institutional underdevelopment have traditionally been powerful obstacles to an increased access to MENA capital markets. • Small capital markets with recent economic and financial development geared towards an increase in openness to foreign investors. • During the nineties, Egypt, Israel, Jordan, Lebanon, Morocco, Tunisia and Turkey have been progressively lifting foreign investors’ ownership, and capital and dividends repatriation restrictions. Even the traditionally closed Gulf Country Council markets have become more accessible to foreign investors through international funds and trusts.

4. MENA Capital Markets overview (2000)

5. Financials: MENA Vs. G7 and other EM countries

6. Lit. Review stuff • Abraham, Seyyed and Al-Elg (2001) study Bahrain, Kuwait and Saudi Arabia using monthly index returns from 1993 to 1998, and observe low or negative correlations between markets5 years, 3 markets, 60 data points • Omran and Gunduz (2001) use a multivariate cointegration methodology and find no long term stochastic trends between Jordan, Turkey, Egypt, Israel and Morocco from January 1996 to June 19993.5 years, 5 markets, 42 data points • Darrat, Elkhal and Hakim (2000) find long-term bivariate cointegrative relationships for Morocco-Egypt and Morocco-Jordan, but no multivariate cointegrative relationships between the three capital markets from October 1996 to August 1999 2.8 years, 5 markets, 34 data points

7. Motivation and research questions • Previous studies small samples, few markets inexistence of intra-regional long-term (stochastic) price linkages. • Remaining questions to be answered: • Any intra-regional spillovers (short-lived linkages)? • Any inter-regional spillovers between MENA capital markets and other regional blocks? • Any spillovers from the three major international financial crises that occurred during the 90s? • Evolution of short-run price linkages that reveal a globalization trend as observed with most emerging markets during the 90s?

8. Data • 11 MENA markets (Bahrain, Egypt, Israel, Jordan, Kuwait, Lebanon, Morocco, Oman, Saudi Arabia, Tunisia, and Turkey) and 5 regional indices (Asia AC, Europe, East Europe, Latin America AC, and North America) • Daily, weekly and monthly frequency Index series (MSCI, IFC, Local Datastream); Span: 1990 to 2001; also all data are in US Dollarscurrency risk set to zero. • Spillover study is done using daily data: • Capture potential short-lived interactions—I.e.capital movement are intrinsically short-term occurrencesFinancial information networks are capable of disseminating news instantaneously around the world, a shock in a national stock market can be transmitted to another market within a very short period of time. • Many of our series have less than eight years in coverageserious methodological issues with using too few data points. • Test results could be affected by infrequent trading.

9. Methodology • 2 Market Linkage issues: • Global Strategic Asset Allocation (GSAA): Long horizon Cointegration analysis • Series are I(1)?Tests of stationarity (ADF and KPSS) • Bilateral cointgration (long term bivariate conintegrative relationship) • Multilateral cointegrationLong-term common stochastic trends • Global Tactical Asset Allocation (GTAA): Short Horizon  Spillover Issue: Pooled restricted GARCH-VAR methodology on price differences-I(0). • Generalized Variance decomposition function (%endogenous and %exogenous of total variance forecast)SIZE • Generalized Impulse Response function: forecast the effect of 1 SD shock in ALL endogenous variable SIGN, TIMING • Block Exogeneity Granger CausalityPREDICTABILITY • Geweke CausalityINSTANTANEOUS SPILLOVER • Dynamic of spillovers: Pooled methodology

10. Long-term Stochastic Trend (we need to go through this one before we do the fun stuff) Bilateral Cointegration Results: Intra-regional long term linkages (4 out of 55) Bahrain-Jordan; Israel-Turkey; Morocco-Saudi Arabia; Morocco-Tunisia Inter-regional long term linkages (6 out of 55) Israel-North America; Morocco-North America; Saudi-Arabia-North America; Tunisia-North America; Kuwait-East Europe; Tunisia-Europe Multivariate cointegration analysis: No common stochastic trends; reverse cointegration tests (Hansen and Johansen, 1999) support findings Cointegration tests reveal some pairwise but no common stochastic trends to all MENA markets—i.e., no long-run co-movements

11. GARCH-VAR: This is a system, so variables are vectors • “Diagonal” VAR-GARCH (see Engle and Sheppard, 2001). By including a GARCH process for each equation of the VAR heteroskedasticity is gone—i.e., the greatest drawback of the VAR methodology. • Covariances (as in an MGARCH model) are assume to be negligible so that our (Quasi) likelihood estimator will not die on us—i.e., an MGARCH-VAR with 16 variables would require us to estimate, 16 AR equations, 16 variance equations, and 120 covariance equations.

12. Then, What? And How? • Dynamic process • VARGARCH is pooled forward • multitude of GARCH-VAR…over time. • multitude of GVDF, GIRF, GC and Geweke stuff…over time. • AmplitudeGVDF • SignGIRF • TimingGIRF • Direction • Granger Causality (Lead-lag) • Geweke Causality (contemporaneous)

13. Generalized Variance Decomposition Summary Proportion of exogenous variance coming from MENA Proportion of exogenous variance coming from Blocks

14. GIR Intra-regional Exogenous Shocks: Israel

15. GIR  Intra-regional Exogenous Shocks: Morocco

16. GIR  Intra-regional Exogenous Shocks: Jordan

17. GIR  Inter-regional Exogenous Shocks: Israel

18. GIR  Inter-regional Exogenous Shocks: Morocco

19. GIR  Inter-regional Exogenous Shocks: Jordan

20. The more integrated economies of Israel and Turkey seem to process information flows from global markets and act as conduits to other, smaller, MENA markets. Summary of shocks: GIRF

21. Causality Analysis • Granger causality(lead-lag): Consistent with GVDF, No feed back relationships • Geweke causalitycontemporaneous relationship • Most of the residuals correlation coefficients are positive  investors view other regional economies as prone to different events. • Residuals correlation are negative for four GCC market, indicating that capital tend to flow naturally from one market to another. Similar findings by Hassan (2003) who examines linkages among Bahrain, Kuwait and Oman stock markets from October 1994 and August 2001. • Increase in contemporaneous spillover from other regional blocks • Interesting case of Turkey and Israel increasing amount of contemporaneous spillovers between Israel and the five regional indices lead-lag spillover analysis fails to capture existing linkages that have become increasingly contemporaneous. The same conclusions can be drawn from Turkey and to a lesser extent for Morocco and Tunisia.

22. Conclusion Results from using the IR and VD functions illustrate a striking feature of MENA markets, namely the slow and small transmission of shocks during any period of this study. Results of our four spillover tests (Granger, GIRF, GVDF, residuals correlation, and Geweke) provide evidence that MENA markets are gradually opening to other regional and trans-continental economies, but remaining highly segmented (to the exception of Turkey and Israel) and perhaps predictable. In this case, tactical asset allocation strategies across MENA markets can be beneficial.