Does the Stock Market in India Move with Asia?

A Multivariate Cointegration–Vector Autoregression

Approach
Paramita Mukherjee and Suchismita Bose

Abstract: This paper examines if the Indian stock market moves with other markets in
Asia and the United States in an era of capital market reforms and the sustained interest of
foreign investors in that market. By using techniques of cointegration, vector autoregression,
vector error-correction models, and Granger causality, we find that, though there is definite
information leadership from the U.S. market to all Asian markets, the U.S. indexes do not
uniquely influence the integration of Asian markets, while Japan is found to play a unique
role in the integration of Asian markets. The U.S. market is seen not only to influence, but
also to be influenced by information from most of the major Asian markets. The Indian stock
return in recent times is definitely led by major stock index returns in the United States,
Japan, as well as other Asian markets, such as Hong Kong, South Korea, and Singapore.
More important, returns on the Indian market are also seen to exert considerable influence
on stock returns in major Asian markets.
Key words: cointegration, comovement, Indian equity market, integration of Asian
markets.

Questions about cross-border capital flows and financial market integration have long at-
tracted the sustained attention of both researchers and policymakers, as such linkages have
serious implications for international portfolio diversification as well as the macroeco-
nomic policies of concerned countries. An outcome of free international capital mobility
and growing financial integration is the comovement of stock prices of various national
markets (Bekaert et al. 1998)1. Stock price comovements mostly emerge endogenously
through liberalization of capital controls, improvements in communication technology,
and innovation of financial products. The linkages among stock markets can be analyzed
to determine if there are any common forces driving the long-run movement of stock
indexes or returns, or if each individual stock index or return is driven solely by its own
fundamentals. When a group of markets are said to share a single common stochastic
trend, it implies that they are perfectly correlated over long horizons, and that gains to
international diversification from these markets will diminish or disappear over the long
term. Such markets are also prone to greater risks of financial contagion.
Investment through foreign institutional investors (FIIs) is key to integrating global
markets, as such flows of funds depend on the FIIs’ perception about the domestic market.
Available alternatives at different points of time and the consequent allocation of funds

Paramita Mukherjee (oparmita@hotmail.com) is a faculty member at the Institute of Chartered

Financial Analysts of India (ICFAI) Business School, Kolkata, India. Suchismita Bose is an
economist at the Monetary Research Project, ICRA Limited, Mumbai, India. The authors thank
Dipankor Coondoo and Mihir Rakshit for valuable suggestions and the conference participants of
Jadavpur University, Kolkata, and the Indian Institute of Capital Markets, Mumbai, for comments.
The usual disclaimers apply.

Emerging Markets Finance & Trade / September–October 2008, Vol. 44, No. 5, pp. 5–22.
Copyright © 2008 M.E. Sharpe, Inc. All rights reserved.
1540-496X/2008 $9.50 + 0.00.
DOI 10.2753/REE1540-496X440501
6  Emerging Markets Finance & Trade

lead to a degree of synthesis between markets. Recently, Asian capital markets have
attracted a substantial proportion of international capital flows to emerging markets, as
gains from portfolio diversification to the region were significant.2 India also has taken
measures to open up its capital market. Economic policy reforms encouraging external
capital flows have been on track from the 1990s to the present. Since 1999, there have
been significant structural reforms in the Indian financial markets as well, which have
enhanced the investability of Indian securities globally.
The degree of a country’s openness or capital controls3 is likely to affect the degree
of integration of its financial market with global markets. India has liberalized its capital
market gradually while strengthening its financial-sector infrastructure. Among various
measures, the Economic Freedom of the World (EFW) index of economic freedom (see
Table 1) ranked India 66th of 127 countries in 2003, compared to 75th of 123 countries in
the mid-1990s. In terms of capital market restrictions, India’s EFW subindex for citizens’
access to foreign capital markets, foreign access to domestic capital markets, and foreign
ownership restrictions improved significantly between 1995 and 2003, from 4.7 to 8.6 on
a scale of 10. This score is next only to the score of Hong Kong and Singapore in Asia.4
The Standard & Poor’s (S&P) and International Finance Corporation (IFC) indices for
emerging stock markets also confirm a improving position for India. The performance
of India’s S&P/IFC index5 has been better than that of most other Asian countries in the
last two years, probably explaining the sustained growth in foreign investor interest in
India.
International mutual funds are one of the main channels for capital flows to emerging
economies, and because U.S. mutual funds are known to hold more than 50 percent of
the world’s mutual fund assets,6 we examine their investment patterns in emerging Asian
and Indian markets. Net flows to international equity funds and its subset, emerging
market funds, were very high in 2003 (Table 2) and the first quarter of 2004 and have
declined somewhat thereafter. Net flows to Asia-Pacific funds were particularly large
from 2003 to the first quarter of 2004. Also, as of mid-2005, in terms of the average of
the past three-year returns, the holdings of a dozen top-performing U.S.-based funds
that invest particularly in Asia (excluding Japan) suggest that a dedicated country fund
for India, having 100 percent Indian stocks, is by far the top-performer, yielding more
than a 50 percent return.7 This consistently good performance may indicate why foreign
investment in India has grown in recent times. Thus, both indicators of openness as well
as the pattern of U.S. mutual fund holdings in Asia attest to the fact that the liberaliza-
tion process has had a significant effect on portfolio capital flows to the Indian market in
which international investors have shown sustained interest in the recent past.
In India, FII flows to and from the country in recent times are observed to be very
closely associated with the state of the domestic stock market (Mukherjee et al. 2002)
and there is evidence of a positive correlation between the volatility of FII flows and that
of Indian stock market returns (Coondoo and Mukherjee 2004a; 2004b). The number of
FIIs registering in India, as well as the amount of their net investments, have increased
manifold of late,8 and policy measures are consistently being introduced to ensure the
sustainability of flows in the future (Bose and Coondoo 2004). Moreover, the correlation
between Indian and global stock markets has substantially increased with the growing
activities of foreign portfolio investors and linkages with foreign markets through ADR/
GDR issues and other channels. From the mid-1990s to end-1996, the correlation of the
Indian stock price index with those of the United States and Singapore were 0.59 and 0.78,
respectively. On the other hand, after the Asian crisis between 1999 and mid-2003, the
Table 1. Some indicators of the degree of capital market accessibility and stock market performance
Subindex for access Subindex for
of citizens to restrictions in
foreign capital foreign capital
markets/foreign market exchange/
access to domestic index of Percentage of
EFW index for capital markets/ capital controls S&P/IFCG stocks Percentage
international capital foreign ownership among 13 included in change in
market controls* restrictions (GCR) IMF categories S&P/IFCI index S&P/IFCI index

2000 2004 2003 2004

Country 1995 2003 1995 2003 1995 2003 (percent) (percent) (percent) (percent)

China 4.9 4.0 4.8 7.2 5.0 0.8 28 32 77.7 –2.1

Hong Kong 9.7 9.2 9.4 10.0 10.0 8.5
India 2.3 4.3 4.7 8.6 0.0 0.0 66 82 76.5 20.1
Indonesia 3.8 4.2 7.5 6.8 0.0 1.5 73 46 69.7 39.3
Japan 7.7 8.0 7.4 7.6 8.0 8.5
Malaysia 6.2 4.6 7.3 8.4 5.0 0.8 91 87 25.5 12.7
Philippines 6.6 3.6 8.2 6.4 5.0 0.8 64 44 41.4 25.0
Singapore 9.3 8.1 8.7 10.0 10.0 6.2
South Korea 4.8 4.6 4.7 7.6 5.0 1.5
Taiwan 5.7 8.6 6.4 8.6 5.0 — 100 90 33.3 25.7
Thailand 4.6 3.8 7.3 6.0 2.0 1.5 99 100 — —
United States 8.4 8.3 8.8 9.6 8.0 6.9 84 72 147.2 –6.1

Sources: Index of Economic Freedom; Economic Freedom of the World: 2004 Annual Report, Fraser Institute.
Notes: Scores are out of 10. *Out of 123 countries in 1995 and 127 countries in 2003.
September–October 2008  7
Table 2. United States mutual fund flows (in millions of U.S. dollars)
2004Q2 2004Q1 2003 2002 2001 2000 1999

To
8  Emerging Markets Finance & Trade

  Global equity funds 1,609.2 2,574.7 –1,995.4 –5,152.1 –3,005.5 12,626.7 4,673.2
  International equity funds 5,268.1 14,256.4 14,650.8 4,240 –4,488.2 13,322.4 2,998.5
  Emerging markets equity funds –914.1 3,112 4,672.7 –330.7 –1,662.7 –349.9 23.5
  Japanese equity funds 1,314.6 1,541.4 1,863.3 –82 –269.8 –830.6 731
  Latin American equity funds –53 –39.7 185.7 32.7 –146.7 –94.6 –120.9
  Asia Pacific (ex-Japan) funds –423.4 1,068.2 1,510.8 –43 –496.2 –1,207.9 151.7

Sources: IMF’s Global Financial Stability Report (GFSR), September 2004.

Notes: Net flows of U.S.-based mutual funds. Emerging and regional sectors are all subsets of international equity.
 September–October 2008  9

same correlations reached highs of 0.69 and 0.88.9 With this backdrop, there is a need to
look at the resultant stock market integration with developed markets and other regional
markets that are alternative investment destinations for such FII flows.
This paper examines the linkages among the Indian stock market in recent years, the
major stock markets in Asia, and the U.S. stock markets. The study is important in the
context of the Indian market, which is now a major destination of FII investment. From
the perspective of the Indian market, the study of its degree of integration with other
markets has implications for possible portfolio diversification by foreign investors, espe-
cially as foreign investors are believed to be the new drivers of the market. However, the
significance of this study also lies in its departure from similar studies on Asian markets
by including the Indian stock market, left out so far as it was considered to be more or
less insulated from other regional markets.

Review of Literature
In the literature, the integration of global equity markets or stock price comovement
has been studied extensively, particularly since the stock market crash of October 1987.
Though most of the studies initially had been conducted for developed markets, such
as those of the United States, Europe, and Japan, recent post-Asian crises literature has
started to focus on emerging Asian markets. These studies have consistently indicated
strong linkages among world equity markets, particularly between those with close eco-
nomic ties or geographic proximity.
Among the contributions to the literature, Wheatley (1988), using data on the United
States and seventeen other countries for the period 1960–1985, supports the notion of
equity market integration. Eun and Shim (1989) find considerable interaction between
stock market indexes, with one-way causality running from the United States to foreign
markets, including Hong Kong and Japan. In a more recent work, Yang et al. (2003),
using data from 1970 to 2001, observed no long-run relationship between the United
States and other large international markets, such as Japan, the United Kingdom, and
Germany, but they had evidence of increasing integration of the U.S. market with smaller
ones. Maneschiold (2006) has observed a low degree of integration between the Baltic
and international capital markets, such as the United States, Japan, Germany, the United
Kingdom, and France. However, concerning the Asia-Pacific markets, the U.S. market has
been observed to have a significant leading influence, particularly after the stock market
crash of 1987 and the Gulf War of 1991 (see, e.g., Arshanapalli et al. 1995; Ghosh et
al. 1999; Jeon and Von Furstenberg 1990; Siklos and Ng 2001). Other studies indicate
that equity indexes for Hong Kong, Indonesia, Japan, Korea, Malaysia, Philippines,
Singapore, Taiwan, and Thailand were jointly cointegrated throughout the 1990s with
and without U.S. influence (Manning 2002). Considering the lead–lag relation between
markets, though there is evidence of Japanese information leadership in the Asian region,
the U.S. market influence is found to be even stronger (Kim 2005).
Kasa (1992) was the first to apply the multivariate cointegration method proposed by
Johansen and Juselius (1990) to five well-established financial markets to examine the
existence of a single common stochastic trend as a driver of the cointegrated system.
Phylaktis and Ravazzolo (2002) apply the same approach to examine the potential inter-
relations among the trending behaviors of the stock price indexes of a group of Pacific
basin countries, Japan, and the United States from 1980 to 1998. The results show that,
10  Emerging Markets Finance & Trade

though U.S. and Japanese markets definitely play some role in Asian stock price comove-
ment, with Japan being more significant than the United States, neither Japan nor the
United States had any unique influence on the Pacific Rim stock markets. For the open
economies, though the linkages increased in the late 1990s, there is still room for long-term
gains for international investors in most of the Pacific basin countries, as these markets
are not perfectly integrated. For semi-open economies, long-term diversification benefits
from exposure to these markets might be limited in view of stronger integration between
them; however, short-run benefits exist due to substantial transitory fluctuations.
Evidence also varies regarding the effect of the Asian financial crisis on the integration
of the Asian markets and the changing role of the U.S. and Japanese markets. Ghosh et
al. (1999) suggest that, postcrisis, whereas some markets are cointegrated with the United
States, others are cointegrated with Japan, and still others are not cointegrated with either.
Using the data for pre- and postcrisis periods for the most and least affected countries in
Asia, Yang and Lim (2002) find a substantial increase in the degree of interdependence
after the 1997 crisis. Fan (2003) confirms that the Asian financial crises have a statistically
significant effect on the relations among Asia-Pacific stock markets. Choudhry and Lin
(2004) have found significant long-run relations between the Far East markets before and
during/after the crisis, along with an indication of the dominance of the Japanese market
compared to the U.S. market in the region. Choudhry (2004) investigates the transmission
of returns and volatility between politically unfriendly country pairs, such as Israel and
Jordan, India and Pakistan, and Greece and Turkey, with the United States as friendly to
all of them; that study finds evidence of mean and volatility spillover from the United
States to these smaller countries, but not much in the other direction. With such mixed
results, the literature tends to conclude that financial markets in the Asia-Pacific region
have been neither well integrated nor completely segmented in the recent past.
A few studies also examine the linkages between the Indian stock market with some of
the Asian markets and the United States. Brooks and Catao (2000), in a study involving
twenty-one developed and nineteen emerging countries, including India, find evidence
of stock market integration from March 1986 through August 2000, operating through
the channel of the information technology (IT) industry. In a recent study for 1999–2000
through 2000–2001, Hansda and Ray (2002) observe a unidirectional causality from
the United States (Nasdaq) to the Bombay Stock Exchange (BSE) and National Stock
Exchange (NSE). The relation as well as direction of causation holds for the technology
segment of the New York Stock Exchange and BSE/NSE. Nath and Patel (2003) exam-
ine the movements of stock markets in India (NSE), the United States (Nasdaq), Japan,
Hong Kong, Singapore, and Taiwan from July 1990 to May 2003 and find no long-term
equilibrium relations. But they find some amount of causality from global markets to
the Indian market. Using weekly data from 1991 to 2003, Wong et al. (2005) find that
the Indian stock market is integrated with mature markets (the United States, United
Kingdom, and Japan) and sensitive to the dynamics in these markets in the long run. In
the short run, both the United States and Japan Granger cause the Indian stock market,
but not vice versa.
Notably, the literature on the Indian market covers studies on its linkage with the de-
veloped market, using the NSE in most cases. Nath and Patel (2003) use the BSE but do
not divide the sample period as pre- and post-Asian crisis. Our paper tries to contribute
to the growing literature by focusing on the linkage of the Indian stock market (BSE)
with the Asian stock markets as well as the U.S. market10 during the postcrisis period.
We employ correlation, cointegration, vector error-correction modeling (VECM) tech-
 September–October 2008  11

niques, and Granger causality tests to examine the long-run and short-run association
among stock prices.

Data and Methodology

We investigate the level of market integration and lead–lag relationships of the Indian
market with two developed markets, namely the United States and Japan, perceived to
be driving Asian stock prices and five other Asia-Pacific markets, namely Hong Kong,
Korea, Malaysia, Singapore, and Taiwan. The stock indexes used for the study are the
most important benchmark index for each country (Table 3, panel a).
The Indian BSE Sensitive Index (SENSEX), regarded to be the pulse of the Indian
stock market, is a free float market capitalization–based index estimated from a basket
of thirty constituent stocks representing a sample of large, liquid, and representative
companies from a wide range of sectors. For the United States, we take both the Dow
Jones Industrial Average (DJIA), which measures the entire U.S. market, and the S&P
500 index, which focuses on the large cap segment of the market. We take the Nik-
kei stock average for Japan, Hang Seng Index (HSI) for the Hong Kong stock market,
Bursa Malaysia (KLSE) Composite Index (CI) for Malaysia, Korea Composite Stock
Price Index (KOSPI) for Korea, Straits Times Index (STI) compiled by the Straits Times
Newspaper for Singapore, and Taiwan Stock Exchange Capitalization Weighted Stock
Index (TWI) for Taiwan.
The daily data set used here spans a period of six and a half years, from January 1,
1999, to June 30, 2005, for days on which all of the relevant markets were open for trad-
ing. We convert the series of daily closing values of stock indexes in local currencies to
U.S. dollar terms, as typically any global investor comparing among alternatives would
value his diversified portfolio in U.S. dollar terms.11 Although high-frequency data are
relevant in studying any financial time series–related phenomena, the day-to-day fluc-
tuations of stock prices are known to be significant and may unduly affect the results on
the degree of interlinkages. Thus, we construct a second data set by smoothing the daily
series through a seven-day moving average filter; for each of the markets, the series is
calculated as the seven-day moving average of returns from the day t – 7 to t – 1. We use
this second data set to augment some of our results. We term the original data series as
the daily series and the filtered series as the MA7 series for future reference.
A degree of integration between different markets and the Indian market, during
various phases of ups and downs, is quite apparent from Figure 1, which depicts the
movements of different market indexes during the sample period. The summary statis-
tics for the nine stock index return series (Table 3, panel a) also show that these markets
have insignificant differences in their mean returns. During the sample period, the stock
market in India outperforms other markets, followed by South Korea. The U.S. S&P
and Japanese indexes perform the worst, with negative returns reflecting the downturn
in these economies in the recent past. Korea, Taiwan, and India are the most volatile
markets in this period; the U.S. stock market has the lowest volatility. The distributions
of returns in all markets are characterized by higher peaks and fatter tails relative to a
normal distribution. The Jarque–Bera test for joint normal kurtosis and skewness rejects
the normality hypothesis. It is well documented in the literature that stock returns are
leptokurtic or heavy tailed, implying more extreme returns and crashes than normally
expected. Returns from all concerned indexes, except the Japanese Nikkei and U.S. S&P
500, are found to be negatively skewed over the sample period.
Table 3. Country indexes and returns
Panel a: Countrywise indexes and summary statistics of daily returns from January 1, 1999, to June 30, 2005

India US_DJIA US_S&P Japan Hong Kong Malaysia South Korea Singapore Taiwan

Mean (percent) 0.049 0.007 –0.002 –0.008 0.022 0.027 0.040 0.026 0.002
Median (percent) 0.102 0.000 0.000 0.024 0.000 0.000 0.084 0.004 0.000
Maximum (percent) 9.271 6.155 5.573 7.091 5.434 5.851 8.409 7.605 6.792
Minimum (percent) –11.655 –7.396 –6.005 –7.417 –9.285 –6.342 –12.601 –9.095 –10.461
Standard deviation 0.016 0.012 0.012 0.015 0.014 0.011 0.022 0.013 0.018
Skewness –0.378 –0.028 0.112 0.013 –0.242 –0.119 –0.344 –0.232 –0.051
Kurtosis 7.427 6.114 4.906 4.544 6.125 8.219 5.497 7.079 5.223
Jarque-Bera 1,411.21 678.55 257.68 166.85 699.64 1,909.62 469.50 1,178.82 346.37
12  Emerging Markets Finance & Trade

Probability 0 0 0 0 0 0 0 0 0

Panel b: Cross-correlation matrix for the daily stock returns across countries from January 1, 1999, to June 30, 2005

India US_DJIA US_S&P Japan Hong Kong Malaysia South Korea Singapore Taiwan

India 1 0.06 0.04 0.08 0.27 0.12 0.24 0.24 0.21

US_DJIA 1 0.91 0.25 0.11 0.01 0.08 0.13 0.07
US_S&P 1 0.29 0.11 0.00 0.09 0.14 0.08
Japan 1 0.10 0.01 0.09 0.12 0.07
Hong Kong 1 0.29 0.51 0.57 0.31
Malaysia 1 0.21 0.31 0.16
South Korea 1 0.48 0.38
Singapore 1 0.30
Taiwan 1
US_DJIA-Lag1 0.11 1 0.91 0.02 0.38 0.21 0.31 0.31 0.24
US_S&P-Lag1 0.14 0.91 1 0.04 0.41 0.22 0.34 0.32 0.24
 September–October 2008  13

Figure 1. Movements of stock indexes (January 1, 1999, to June 30, 2005)

Note: Figures are drawn after stabilizing the individual country stock prices in US$ terms to a com-
mon base at January 1, 1999.

The cross-correlation matrix of Indian, other Asian, and U.S. stock returns for our
sample period gives a preliminary idea about the degree of association among the differ-
ent markets (Table 3, panel b). The returns in the Japanese market are observed to have
the highest short-term linkages with contemporaneous U.S. returns, but the short-term
association with other Asian market returns is much weaker. Stock returns in Hong Kong,
Singapore, and South Korea show very close linkages and have the highest correlation
with the previous day’s U.S. market returns. The Taiwanese market returns are also quite
closely associated with returns in Hong Kong, Korea, Singapore, and India, but not with
U.S. and Japanese returns. Returns in the Indian market are highly correlated with stock
index returns in Hong Kong, Singapore, and Korea, and have the lowest correlation with
returns from the Nikkei index and lagged (contemporaneous) returns from the DJIA and
S&P 500.
To examine the stationarity property of market prices, we employ both the augmented
Dickey–Fuller (ADF) and Phillips–Perron (PP) unit-root tests.12 We then employ the
14  Emerging Markets Finance & Trade

Johansen and Juselius (1990) procedure to test for the presence of multiple cointegrating
relations indicating the existence of common trends. We report only the results from the
trace test for cointegration and for the case in which the data-generating process has a
linear trend and allows a constant term to be confined to the cointegrating relations, though
the result is robust to some alternative specification of the deterministic variables. The
critical values used in the cointegration test are based on Osterwald-Lenum (1992).
Next, we estimate a Vector Error Correction Model (VECM), as described in Engle
and Granger (1987). The error-correction model (ECM) model in this study for India
expresses changes in the Indian market returns in terms of the lagged changes of the
other market returns and an error-correction term (ECT), derived from the long-run
cointegrating relation between the markets using the Johansen procedure. If the Indian
market and the other markets are cointegrated, part of the current changes in the Indian
market return should reflect the adjustment that the Indian market attempts to achieve to
align with trends in other markets. We report the results for one- to seven-day lags for the
models after checking for the robustness of results with higher-order lag specifications.13
The lag specification seems to conform with finance theory and investors’ intuition that
the stock market is very volatile.
To complete our analysis, we also test for the short-term causal or informational linkages
between different pairs of markets using the standard pairwise Granger causality test, which
helps to elucidate the lead–lag relations between pairs of markets. If there is no long-run
equilibrium relation between the pairs of stock returns, then the VECM-based causality
test reduces to the standard Granger causality test. The null hypotheses of the Granger
(non)causality being tested are that the joint significance of all coefficients is zero if each
stock return does not Granger cause another; hence, the test is the standard F-test.

Evidence of Comovement and Causality

First, we test for multivariate cointegration among all of the indexes.14 When the group
of markets is considered together with the DJIA as the representative of the U.S. market,
we find evidence of a single cointegrating equation among all of the markets considered
(all markets-DJIA) with our daily series (Table 4, panel a), though the markets are not
found to be cointegrated considering the S&P 500 to represent the U.S. market.15 However,
when only all Asian markets (all Asia) are considered, there is again strong evidence of a
single cointegrating equation for these market indexes. The MA7 series results (Table 4,
panel b) show evidence of four cointegrating equations when all markets are considered,
with the DJIA representing the U.S. market (all Markets-DJIA) and three cointegrating
equations when the U.S. S&P 500 index is considered (all Markets-S&P).16 For all Asian
markets (all Asia), there is again evidence of three cointegrating equations. The above
results indicate that the U.S. market may not play a unique role in integrating the Asian
markets, as the markets are found to be cointegrated even without considering any of the
U.S. indexes. On the other hand, contrary to some earlier results, we find that Japan may
have a role in integrating Asian markets in more recent times. We conclude this because
the Asian markets are not seen to be cointegrated when the Japanese index is excluded
from the analysis (all Asia ex Japan) with the daily series. The MA7 series also shows
evidence of weaker cointegration when the Japanese index is excluded, with the number
of cointegrating equations dropping from three to two for the all-Asia group.
The analysis with the MA7 series yields an interesting result concerning India, as
the Indian market is seen to play a role in integrating Asian markets as the number of
 September–October 2008  15

Table 4. Results of multivariate cointegration

Panel a: Results of tests for multivariate cointegration between markets (daily series)

Lags interval: 1 to 7

Hypothesized
number Likelihood
Market groups of CE(s) ratio Conclusion

All markets (DJIA) None 165.44* 1 CE

At most 1 118.66
All markets (S&P500) None 152.64 No cointegration
All Asia None 126.94* 1 CE
At most 1 81.81
All Asia except India None 108.17** 1 CE
At most 1 62.79
All Asia except Japan None 89.597 No cointegration

Panel b: Results of tests for multivariate cointegration between markets (MA7-series)

Lags interval: 1 to 1

All markets (DJIA) None 249.40** 4 CE(s)

At most 1 171.99**
At most 2 125.49**
At most 3 88.66*
At most 4 54.25
All markets (S&P500) None 239.73** 3 CE(s)
At most 1 165.32**
At most 2 118.03*
At most 3 80.77
All Asia None 211.83** 3 CE(s)
At most 1 138.24**
At most 2 91.48*
At most 3 55.62
All Asia except India None 165.79** 2 CE(s)
At most 1 94.78*
At most 2 55.95
All Asia except Japan None 169.76** 2 CE(s)
At most 1 98.57**
At most 2 52.18
All Asia except Japan and India None 128.11** 1 CE
At most 1 57.63

Notes: Assumption: Linear deterministic trend in the data. * (**) Rejection of hypothesis of no cointe-
gration at the 5 percent (1 percent) level of significance.

cointegrating equations excluding the Indian index falls from three to two, an effect quite
similar to the case of exclusion of the Japanese index. Further, excluding both India and
Japan shows evidence of a single cointegrating equation among the remaining five Asian
markets. The results of the cointegration analyses also imply that, though the Asian markets
are integrated with the U.S. market and with themselves, the number of common trends
driving these markets is quite high. This is in line with the findings of Choudhry and Lin
16  Emerging Markets Finance & Trade

(2004) that the Asian markets are only partially integrated. Six common trends emerge
from the daily series when the seven Asian markets are considered, and four common
trends are found with the MA7 series. The smoothened MA7 series also brings out that
the number of common trends increases, indicating weaker cointegration, when the Indian
and Japanese markets are excluded from the group. This implies that the Japanese and
Indian markets are significant in the integration of these Asian markets.
Next, we report the results of the vector autoregression (VAR)-VECM model based
on the daily series, considering the first to second lags and the sixth to seventh lags of
the explanatory variables and the DJIA as the representative of the U.S. market. We find
that the ECT, which captures the adjustment toward long-run equilibrium, is statistically
significant for India (Table 5), indicating the existence of a long-run relation between India
and the other Asian and U.S. markets.17 Examining the individual t-statistics of the index
returns for India’s ECM shows that contemporaneous changes in the Indian market are
explained by changes in the Nikkei and DJIA returns of the previous day. Indian returns
with a six-day lag also turn out to be highly significant in explaining contemporaneous
Indian returns.18 The returns in HSI returns with a two-day lag, Nikkei returns with a
six-day lag, and KOSPI and TWI returns with a seven-day lag also partially influence the
changes in Indian returns. Considering the ECMs for the other markets, one finds that
Indian returns, in turn, with a day’s lag, partially explain returns on TWI and U.S. DJIA.
Indian returns with one-day and six-day lags influence KOSPI returns, and with a two-
day lag influence Nikkei returns. Japanese Nikkei returns with a one-day lag influence
all other markets, whereas the lagged U.S. DJIA returns influence returns in all other
Asian markets except Japan. Asian market (lagged) returns that partially explain U.S.
DJIA returns are Nikkei, KOSPI, HSI, STI, and BSE returns.
The results of the Granger causality test involving the daily series (Table 6) show19
that U.S. market returns influence all markets; only the DJIA returns do not strongly
influence the Japanese market. Bidirectional causality is found between the U.S. returns
and the more developed Asian markets, such as Japan, South Korea, and Singapore. The
Japanese market return leads all Asian market returns without exception. All market
indexes except those of Malaysia and Taiwan influence the Indian BSE index return,
whereas Indian returns influence TWI returns. Bidirectional causality is found between
the Indian and the Japanese and Korean stock returns.

Conclusions
This study examines the existence of comovements of the Indian stock price index with
other Asian and U.S. stock markets after the late-1990s Asian crises. We analyze the
series of daily stock price (return) data for seven Asian markets and the United States,
made comparable in U.S. dollar terms, for the period from January 1999 to June 2005.
The period of study is marked by several capital market reforms and flush of flows by
FIIs, who continually move funds across global markets, leading to the possibility of
increased integration of the Indian market with others. India has not been included in
previous studies on Asian markets.
We find that, though there is definite information leadership from the U.S. market to
all Asian markets, the U.S. indexes do not exert any unique influence in the cointegra-
tion of Asian markets. This supports the findings of Phylaktis and Ravazzolo (2002) and
Choudhry and Lin (2004). Evidence suggests that the U.S. market is also influenced
by information from most major Asian markets, such as Japan, Korea, Hong Kong,
Table 5. Vector error correction model for stock returns
ΔINDIA ΔHK ΔJAPAN ΔMALAY ΔSK ΔSNGP ΔTAI ΔUS_DJIA

CointEq1 –0.0006** 0.000 0.000 –0.001** 0.000 –0.001* 0.000 0.0006*

ΔINDt–1 0.030 –0.009 –0.027 0.021 0.056** 0.025 0.087* 0.031**
ΔINDt–2 –0.004 0.002 0.048** –0.026 0.012 0.001 0.029 0.022
ΔINDt–6 –0.072* –0.026 –0.017 0.005 –0.067** –0.016 0.018 0.000
ΔHKt–2 0.063** –0.018 0.041 –0.020 0.064 0.040 0.077** 0.002
ΔHKt–6 0.015 –0.010 0.049 0.017 0.048 0.053** 0.036 0.038
ΔHKt–7 0.039 0.013 0.096* –0.013 0.020 –0.005 –0.050 0.084*
ΔJapant–1 0.154* 0.313* –0.029 0.098* 0.481* 0.237* 0.237* 0.077*
ΔJapant–6 0.045** –0.009 –0.014 –0.018 0.027 –0.016 –0.012 0.010
ΔJapant–7 0.025 0.046** 0.044 –0.015 0.051 –0.004 0.005 0.003
ΔMalayt–1 0.024 –0.029 0.007 0.147* –0.017 0.002 0.100* 0.007
ΔMalayt–2 –0.058 –0.039 0.001 0.025 –0.083** 0.003 –0.002 0.014
ΔSKt–1 0.027 0.016 –0.043** 0.000 –0.058** –0.008 0.018 0.009
ΔSKt–2 –0.021 –0.022 –0.032 –0.019 –0.054** –0.015 –0.005 –0.043*
ΔSKt–6 –0.027 –0.037** 0.007 0.005 –0.029 –0.031** 0.000 0.002
ΔSKt–7 –0.042** –0.010 –0.0497* –0.016 –0.022 –0.003 –0.012 –0.020
ΔSngpt–1 0.009 0.035 –0.014 0.004 0.122* –0.018 0.049 –0.061**
ΔSngpt–2 0.036 0.061** –0.003 –0.006 0.086** –0.003 –0.010 0.011
ΔSngpt–6 0.018 0.048 –0.117* 0.013 0.054 –0.027 –0.009 –0.009
ΔSngpt–7 –0.009 0.024 0.012 –0.019 0.100** 0.064** 0.107* –0.007
ΔTAIt–1 –0.036 –0.041** 0.003 0.023 –0.023 –0.035** –0.062* 0.016
ΔTAIt–2 0.006 0.004 –0.011 0.068* –0.001 0.000 0.008 0.012
ΔTAIt–6 –0.012 –0.017 –0.006 0.013 0.015 0.012 –0.053** –0.030**
ΔTAIt–7 0.066* –0.021 0.033 0.027** –0.020 –0.010 0.002 –0.0398**
ΔUS_DJIAt–1 0.091* 0.360* 0.029 0.152* 0.424* 0.264* 0.269* –0.040
ΔUS_DJIAt–2 0.047 0.059** 0.042 –0.047** 0.028 0.035 –0.014 –0.005
ΔUS_DJIAt–6 –0.018 –0.007 –0.001 0.027 0.039 0.041 0.074** –0.010
ΔUS_DJIAt–7 0.027 0.006 –0.008 –0.053** –0.094** 0.002 –0.023 0.013
C 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
Adj. R 2 0.04 0.25 0.01 0.10 0.21 0.17 0.12 0.02

Notes: Only those regressors that are significant in at least one regression are reported. * (**) Significant at 1 percent (5 percent).
September–October 2008  17
Table 6. Results for Granger causality between pairs of stock returns
F-statistic Causes

United United
States States South
Caused by India (DJIA) (S&P) Japan Malaysia Hong Kong Korea Singapore Taiwan
18  Emerging Markets Finance & Trade

India 1.27 0.26 2.41* 2.19 0.27 5.14* 1.86 15.30*

United States (DJIA) 11.66* 1.23 38.01 139.55* 88.57* 85.69* 51.21*
United States (S&P) 17.32* 4.26* 43.54* 169.42* 105.93* 93.17* 55.3*
Japan 24.42* 8.05* 7.53* 29.85* 165.32* 145.21* 101.24* 61.56*
Malaysia 1.28 0.15 0.04 0.04 1.24 0.52 0.13 7.32*
Hong Kong 4.23* 0.31 0.54 0.95 0.38 5.41* 1.44 18.84*
South Korea 4.35* 2.82** 6.01* 0.96 0.75 3.54* 0.23 10.61*
Singapore 4.47* 1.25 2.74** 0.03 1.13 4.96* 11.82* 16.59*
Taiwan 0.45 0.39 0.45 0.01 7.24* 0.14 0.54 0.43

* 5 percent level of significance; ** 10 percent level of significance. Reported results are at two lags.
 September–October 2008  19

Singapore, and India, in recent times with increased market integration. However, though
contemporaneous correlations with the Japanese and other Asian market returns are not
very high, contrary to the findings of some studies (e.g., Phylaktis and Ravazzolo 2002),
we find that Japanese market information significantly influences almost all Asian and
U.S. indexes and considers data up to mid-2005. Japan is found to play a unique role in
integrating Asian markets.
As far as India is concerned, we find that from the post-Asian crisis up to mid-2005,
the Indian stock market certainly did not function in relative isolation from the rest of
Asia and the United States. Recent stock returns in India definitely have been led by
major stock index returns in the United States, Japan, and other Asian markets, such as
Hong Kong, South Korea, and Singapore. The interesting part of the findings suggests
that returns on the Indian market are also observed to exert considerable influence on
stock returns in major Asian markets, such as Japan and South Korea, along with Taiwan
and Malaysia to some extent. There is also some evidence that India plays a certain role
in integrating these markets.
The observation that there are linkages between the Indian market and other Asian
and developed markets is in line with the findings in the existing literature. That Indian
returns also affect others, however, is quite contrary to the findings in the literature.
Wong et al. (2005) find no such causality from India, at least in the short run. Regard-
ing the policy implications of our study, the findings suggest that the nature of Indian
market comovement or integration with emerging Asian markets—that is, neither fully
integrated nor completely segmented—does not yet warrant any immediate concern
regarding possible contagion in case of any financial crisis in the region. The degree
of integration also indicates that there is still much scope for reaping risk minimization
and return maximization benefits of portfolio diversification, at least in the short term,
by investing in emerging Asian markets, as integration of these markets is not of a very
high order. This leaves sufficient room for switching between mature markets, such as
that of the United States, and different Asian markets, including India.

Notes
1. Using data on twenty emerging markets, including India, it is shown that the stock market
returns are more highly correlated with world market returns after the introduction of liberalization
measures in the financial sector.
2. 37.5 percent of net private capital flows to all emerging markets and developing countries
were directed toward Asian economies during 2003, whereas in 2004, emerging Asian economies
received 66.2 percent of total net private capital flows; net private portfolio flows to the region were
also the highest among regions in the world, at $25.8 billion (IMF 2005).
3. See, e.g., Bird and Rajan (2000), who note that restraints on capital movements can be di-
vided into controls on capital account transactions per se (capital controls) and controls on foreign
currency transactions (exchange controls). Capital controls can cover foreign direct investment
(FDI), portfolio investment, borrowing and lending by residents and nonresidents, transactions
using deposit accounts, and other miscellaneous transactions. Exchange controls regulate the
rights of residents to use (remit or receive) foreign currencies and hold offshore or onshore foreign
currency deposits. Such capital controls may affect the functioning of the economy differently,
depending on their nature.
4. According to IMF classifications contained in the Annual Report on Exchange Arrange-
ments and Exchange Restrictions, a country is classified as either liberalized (value of unity) or not
(value of zero) in terms of liberalization of the capital account, current account, and requirements
to surrender export proceeds. According to this classification, India has yet to remove any of the
restrictions and has a score of zero, though India’s overall EFW subindex for international capital
20  Emerging Markets Finance & Trade

mobility is now above that of China, Indonesia, Philippines, and Thailand, and compares well with
countries with more open economies such as South Korea and Malaysia.
5. The S&P/IFC Global (S&P/IFCG) indices for countries represent their entire market,
whereas S&P/IFC Investable (S&P/IFCI) indices are designed to represent that portion of the
market available to foreign investors in each country. India’s degree of openness is now much
higher than that of China, Indonesia, or Philippines (Table 1, column 4). This share has gone up
to 82 percent by end-2004, from 66 percent in early 2000, indicating further opening up of the
stock market in India.
6. Investment Company Institute (2004). About 50 percent of the assets of U.S. mutual funds
are in equity. U.S. mutual funds are also known to invest the highest proportion (9 percent of as-
sets) in foreign equity compared to other major industrialized countries.
7. Further, in terms of percentage of asset holdings by country, of the top twelve funds in
this category of Asian funds, Hong Kong ranks first, followed by South Korea and India. These
observations are based on data taken from Morningstar.
8. The number of registered FIIs in India stands at 823 at the end of 2005 compared to 18
registered FIIs in 1993. FII annual inflows to the Indian equity market have grown from a meager
trickle of $828 million in 1993 to highs of $6.5, $8.5, and $10.7 billion in 2003, 2004, and 2005.
9. According to the BSE (2001), the correlation has been more pronounced in the case of heavily
technology-weighted indices. During the period 1992–2000, emerging market daily correlations
with the Nasdaq were in the range of 20 to 50 percent; these correlations surged to 60 to 80 percent
during 1999 and 2000. The major contributors to this trend were the Asian indices because Asia as
a region became increasingly dependent on technology exports to developed countries.
10. This is because the linkage is supposed to be through the FIIs for whom Asian markets
are an equally attractive destination as India in the region. We have included the United States
because several studies have shown that it is still the index that leads emerging market indices
such as that of India.
11. Converting individual indices to U.S. dollar terms is not new in the literature (see, e.g.,
Wong et al. [2005]).
12. Both the ADF and PP tests fail to reject the null hypothesis of the existence of a unit root
in (log) levels of stock price indexes at the 5 percent level of significance, and hence, all of the
market indexes are nonstationary. In contrast, unit-root tests reject the same null hypothesis in the
first-differenced form of the series, which indicates that all of the series in the first-differenced
form (stock returns series) are stationary. Therefore, each stock market index is integrated of order
one, or I(1), and we may proceed to test for cointegration among these series.
13. The selection of the order of lags in the Johansen test and, subsequently, the VECM is
important, as the choice of the lag can have an important effect on the outcome of these tests
(Enders 1995). To select the maximum lag length deemed reasonable, as the cointegration test
requires, the Akaike information criterion (AIC) and Schwarz–Bayesian criterion (SBC) are used
to optimize the goodness of fit and the statistical significance of coefficients of lagged variables
is considered.
14. However, we checked for bivariate cointegration between the Indian BSE Sensex and each
of the other country’s indexes. The results for daily-series indicate very clearly that the Indian stock
market is not individually integrated with any of the Asian markets or the U.S. market. However,
considering the smoothened MA7-series, there is evidence of bivariate cointegration between the
Indian and the Japanese, Singaporean, and Malaysian indexes, as well as the Taiwanese TWI. Thus,
the possibility of near-perfect association in the long term between the Indian and the above Asian
markets is not entirely ruled out.
15. The difference between the results concerning the DJIA and S&P500 might be attributable
to the fact that the former index consists of 30 blue chip stocks, whereas the latter is composed of
500 stocks, the interaction among which might be blurring the movement of the index with other
market indices, at least to some extent.
16. The results of the daily series and the MA7-series are very different from one another. This
may be because the day-to-day variation contained in the daily series has large random components,
whereas those variations are filtered through moving average smoothing in the MA7-series. Hence,
findings from the MA7-series cannot be ignored.
17. The ECT is also significant in the ECM for the United States, Malaysia, and Singapore.
18. This could be due to a day-of-the-week effect.
 September–October 2008  21

19. The reported results consider two-day lags; the results were found to be robust considering
up to seven days’ lag.

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