East Asian Equity Markets, Financial Crisis, and the Japanese Currency

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East Asian Equity Markets, Financial Crisis, and
the Japanese Currency

• Stephen Yan-leung Cheung
• Professor of Finance (Chair)
• Department of Economics and Finance
• City University of Hong Kong
• July 24, 2002

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Agenda

• Motivations
• Objectives
• Data
• Methodology and Results
• Conclusions

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Motivations

• Yen/ US volatility
• Yen/ US was very volatile during the last decade
• From 80 Yen/US to 147 Yen/US
• Yens depreciation reduce Asias trade deficit
  with Japan from an annual deficit of 59 billion
  in 1995-97 to 19 billion in 2001

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Yen/USD movement during 1990-2002

• Source DataStream

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Motivations

• Interest rate differential
• Low interest rate in Japan and Yens depreciation
  
• Yen carry trade looked lucrative

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Interest rates in Asian countries
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Motivations

• Trade deficit
• Yens depreciation has positive effect on Japans
  economy, e.g. reduced Asias trade deficit with
  Japan from an annual deficit of 59 billion in
  1995-97 to 19 billion in 2001. (duplicated, pls
  refer point (a)!!!)
• Had tremendous pressure on Korean and Taiwanese
  exports
• On 15 June 1998, Yen hit 14 Yen/US
• Finance Minister of China expressed that pressure
  for a devaluation of the Yuan was growing
• There was a fear of another round of competitive
  devaluation.
• Japan used to be a growth engine, fear on Asian
  economies.

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Asian stock indices and Dollar/Yen exchange rate
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Motivations

• Asian emerging markets, good investment
  opportunities before Asian Crisis (Levy and
  Sarnat, 1970 Solnik, 1974)
• US market, the leading market (Cha and Cheung,
  1998 Cheung and Ng, 1996)
• The Change in information transmission mechanism
  after crisis (Cha and Cheung, 1998 Tuluca and
  Zwick, 2001)

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Objectives

1. Study the information structure changes between
   the equity markets in the US and four East Asian
   economies during the Asian crisis and
2. Examine the impacts of Japanese currency
   movements on these four East Asian economies

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Data

• Daily logarithmic returns
• Hong Kong
• Korea
• Singapore
• Taiwan
• US
• Sample period
• Pre-crisis period January 1995 June 1997
• Crisis period July 1997 June 2000
• Post-crisis period July 2000 July 2001

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Methodology and results

• Stationarity
• Dickey-Fuller test
• - all stock indices are I(1) processes
• Johansen cointegration test on the indices of the
  US and four Asian economies
• Pre-crisis period pairwise cointegrated
• Crisis and post-crisis period no cointegration
• Action include an error correction term for the
  pre-crisis period only

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Table 1. Unit Root Test Results
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Interaction pattern

• Causality test
• decide the lead-lag relationship between 2 stock
  indices
• Hypothesis 1
• The US leads the East Asian Economies?
• Xt C ? j1,,k ?jXt-j ? j1,,n
  ?jYt-j ?t
• where
• Xt Return on one of East Asian market indexes
  at time t, as measured by first log differences
• Yt the return on the US stock index
• Causality using joint significance of ?j's to
  test whether the lagged values of Yt provide
  additional explanatory power for Xt after
  controlling for Xt's own history.

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Interaction pattern

• Hypothesis 2
• The East Asian Economies lead the US?
• Yt C ? j1,,k ?jYt-j ? j0,,n ?jXt-j
  ? j1,,m ?jSt-j ?t
• Note Second summation index j starts from 0
  instead of 1, because
• the US and East Asian markets operate in
  different time zones
• GARCH effects
• the error term and lagged dependent variables are
  not independent
• Action
• maximum likelihood procedure
• construct the likelihood ratio statistic to test
  the hypothesis that ?js are zero

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Interaction pattern

• Results
• The US leads the East Asian Economies?
• Pre-crisis period only leads Hong Kong and
  Singapore
• Crisis and Post-crisis period all
• Error correction term is significant in all cases
• these East Asian markets do respond to deviations
  from the cointegrating relationships
• The East Asian Economies leads the US?
• Pre-crisis period all except Taiwan
• Crisis period all
• Post-crisis period NO
• Error correction term is NOT significant

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Table 2. Causality Test Results
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Effects of the Japanese Currency

• Methodology
• Augment with an exchange rate term
• Xt C ? j1,,k ?jXt-j ? j1,,n ?jYt-j
  ? j1,,m ?jSt-j ?t
• Yt C ? j1,,k ?jYt-j ? j0,,n ?jXt-j
  ? j1,,m ?jSt-j ?t
• where
• St-j daily dollar-yen exchange rate in
  first log differences

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Effects of the Japanese Currency

• Results
• The Japanese currency affects 4 Asian economies?
• No material effects on the significance of ?j's
  and the error correction term
• Pre-crisis period Hong Kong only
• Crisis period all
• Post-crisis period NO
• Entire period some
• yield spurious inferences about market
  interactions
• provide erroneous information for making
  investment and portfolio management decisions

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Effects of the Japanese Currency

• Robustness of the Yen effect
• Transform the equity return data from local
  currency units to returns in the US dollar
• Similar result is generated
• Japanese currency as a proxy of economic
  condition?
• Include the return on the Japanese Nikkei 225
  index
• to test if its presence would render the yen
  variable insignificant
• Result NO

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Table 3. The Japanese Currency Effect
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Conclusions

• Confirms the dominant role of the US market in
  the East Asian equity markets
• Information structure during the crisis period is
  different from the non-crisis periods.
• The Japanese currency is found to affect these
  equity markets during the crisis period, but
  disappears in the post-crisis sample.

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Conclusions

• Implications of the changing causal relationship
  
• Academia
• warrant a detailed study on information flow and
  propagation mechanisms under different market
  conditions
• Investment community
• different investment strategies should be pursued
  under different market conditions
• the use of long sample data may yield obscure and
  even erroneous information on market interactions.

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Thank You