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

• Study the information structure changes between
  the equity markets in the US and four East Asian
  economies during the Asian crisis and
• 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