Stock Market Linkages: Evidence From the US, China and India During the Subprime Crisis

Timisoara Journal of Economics and Business | ISSN: 2286-0991 | www.tjeb.ro
Year 2015 | Volume 8 | Issue 1 | Pages: 137–162
STOCK MARKET LINKAGES: EVIDENCE
FROM THE US, CHINA AND INDIA DURING THE SUBPRIME CRISIS
Amanjot SINGH 1
Parneet KAUR 2
DOI: 10.1515/tjeb-2015-0012
The Subprime crisis spillovered the returns and volatility from
the US stock market to the other integrated economies. The
present study attempts to analyze the stock market linkages
between the US, India and China, especially during the US
subprime Crisis. The technique of Tri-Variate Vector
Autoregression and the Spillover Index has been employed so
as to analyze the relations during the time period 2007 to
2009. To estimate the time varying risk parameters, the
technique of Threshold Generalized Autoregressive
Conditional Heteroskedastic [TGARCH (1,1)] model has been
used. A uni-directional causality has been observed from the
US market to the Indian and Chinese market, whereas
another unidirectional causality has also been spotted
running from the Chinese market to the Indian market in the
context of stock market returns during the crisis period. A uni-
directional volatility spillover from the US to the Indian market
and from the Indian to the Chinese market has been found to
be significant. As per the volatility Spillover Index, the cross
market impact on the volatility reduces over a time period
2007-2009, due to the increased impact of the past volatility
and the presence of 'leverage effect'. The falling returns
added to the volatility in the respective markets. The efficient
tests of causality inspired by Hill (2007) reported an indirect
impact of the US market volatility on the Chinese market via
Indian. The portfolio managers should discount this
information well ahead of time to maintain the portfolio
values by taking positions in futures and options market.
Keywords:
 Financial Crisis; Spillover; Variance Decomposition; Vector Autoregression Model;
Volatility.
JEL Classification:
 G01, G15, F00, F36.
1 Research Scholar, Punjabi University, India.
2 Assistant Professor, Punjabi University, India.
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OPEN
DOI: 10.1515/tjeb-2015-0012
Singh, A. & Kaur, P. (2015).
Stock Market Linkages: Evidence From the US, China and India During the Subprime Crisis
Timisoara Journal of Economics and Business | ISSN: 2286-0991 | www.tjeb.ro
Year 2015 | Volume 8 | Issue 1 | Pages: 137 – 162138
1. Introduction
The bursting of the housing sector bubble triggered the subprime crisis in the US, which was not
limited only to the banking sector, but also had an impact on the overall financial sector in the
US. Moreover, being the dominant economy and increased integration in the context of trade
and financial channels with the other different countries, the crisis started in the US gets
transferred to the other countries as well, (Angkinand et al., 2009). Even emerging markets like
the BRIC nations felt the heat of the crisis due to their increasing exposure to the developed as
well as other nations (Beirne et al., 2009). The globalization and the increased integration of the
financial system have made the world economies into 'one single market' under which the
macroeconomic challenges in one country have an impact on the other countries as well,
making way for the stock markets in the recipient economies to witness an uneasy phase. When
there are fundamental challenges like twin deficit crisis, lower GDP growth rate, unemployment,
lower consumer confidence, lesser productivity etc., then that do affect the other integrated
economies with which the source country is having the trade and financial relations. However,
most of the times it has been observed that the herding behavior of the investors put the stock
markets in a tizzy phase especially in developing nations (Laih & Liau, 2013). So, both the
fundamental changes and behavioral finance (investment) catalyse as the spillover agents.
Furthermore, the inter linkages among the markets gets strengthened during a crisis period, as
studied by Yang et al. (2003) while studying the Asian financial crisis. The fund managers/
investors should discount the linkages among the markets concerned as this would have an
impact on the portfolio diversification strategies especially during an adverse event.
How the linkages among the US, Indian and Chinese stock markets pan out during the subprime
crisis? And does the lagged returns in the US had an impact on the stock markets of the China
and India? Or the other way around. Similarly, does the volatility in the US market had an impact
on the volatility in the Indian and Chinese markets?. The present study attempts to model the
stock market linkages i.e. the first moment (returns) as well as the second moment (volatility)
between the US, India and China during the Subprime crisis and answers the questions that has
been raised, by employing Vector Autoregression (VAR) Model. To estimate the conditional
variance, Threshold Generalized Autoregressive Conditional Hetroskedastic Model [TGARCH
(1,1)] model has been used. The period considered for the purpose of study ranges from 2007
to 2009. A case of two promising emerging markets (India and China) and one developed
market (United States; eventually the source of Global Financial Crisis) has been taken.
Moreover, there are differences in the timings of stock markets of the countries concerned: a
VAR model with lags as endogenous variables would solve this problem in accounting for
spillovers. There are numerous studies that have tried to capture the stock market linkages
between the US, Indian and Chinese markets during the subprime crisis (see for details like;
Nikkinen et al., 2013; Bianconi et al., 2013; and many more.). But most of the studies have
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OPEN
DOI: 10.1515/tjeb-2015-0012
Singh, A. & Kaur, P. (2015).
Stock Market Linkages: Evidence From the US, China and India During the Subprime Crisis
Timisoara Journal of Economics and Business | ISSN: 2286-0991 | www.tjeb.ro
Year 2015 | Volume 8 | Issue 1 | Pages: 137 – 162139
taken a very long period ranging from six to eight years to capture the linkages. However, the
present study has tried to account for the linkages during the period 2007-2009, when the
major events took place in the US market in relation to the subprime crisis embodying Lehman
Brother Crisis, etc. As per the Business Cycle Dating Committee of the National Bureau of
Economic Research (2010), the recovery from the US crisis started from June 2009 so the
period up till December 2009 has been considered thereby taking the time period comprising of
a trough. Apart from the stock market linkages, the study also made an attempt to capture the
return and volatility spillovers in an index among the countries concerned; inspired by the
methodology adopted by Diebold and Yilmaz (2009).
The Global Competitiveness Report 2013-2014 published by World Economic Forum has
recently placed China ahead of the other BRICS nations. China and India are slowly opening up
their financial market and other markets as well for the foreign players. Gupta and Wang (2009)
highlighted the estimates of the other researchers where they are projecting a manifold
increase in the India-China trade numbers compared to the US-China trade relations during the
year 2020. With the increasing trade relations with the other countries and increasing capital
flows from the Chinese economy, Rajwade (2014) in his article titled "China's Global Economic
Power", reported that the day is not that far when we will be having the Yuan as the future
reserve currency being decided by the monetary authorities. The steps taken in the form of
incorporating a BRIC bank are further paving the way for this achievement.
Both the China and India are among the strongest emerging markets having a wide base of
middle income strata of the society, thereby providing a protection to the demand side of the
products and services. The trade relations between the China and India are increasing over a
period of time. The increasing trade and financial linkages among the China and India have
made the stock markets in these respective nations interlinked with each other, as reported by
the results. These linkages further have an impact on the portfolio diversification benefits under
which the correlation between the asset classes should be lower in order to enjoy the
diversification benefits (Click & Plummer, 2005). Our motive is to study the linkages among the
US, Chinese and Indian stock markets and especially during the subprime crisis. The behavior of
the US, Chinese and Indian stock markets during the financial crisis is a lesson to be
comprehended by the International investors in their efforts to hedge against downside risks in
future. The study would provide an insight to the portfolio diversification strategies to be
followed by the managers during a turbulent period.
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OPEN
DOI: 10.1515/tjeb-2015-0012
Singh, A. & Kaur, P. (2015).
Stock Market Linkages: Evidence From the US, China and India During the Subprime Crisis
Timisoara Journal of Economics and Business | ISSN: 2286-0991 | www.tjeb.ro
Year 2015 | Volume 8 | Issue 1 | Pages: 137 – 162140
Figure 1. Market Capitalisation % of GDP
Source: World Bank Data
Figure 1 highlights the market capitalization as a percentage of GDP over a period of time. In the
US, the market capitalization has been very high during the period 1999-2000 whereas in India
and China it has been high during the period 2007-2008. A very high value (generally above 100)
indicates over-valuation of a market. The high market capitalization in China and India during
2007-2008 spotlights the buoyancy in the stock markets before the financial crisis. After this
period, a significant decline in the market capitalization as a percentage of GDP can be observed
due to the emergence of the crisis during that time period. The decrease in the market
capitalization signifies a sharp decline in the stock market due to the emergence of the Subprime
crisis. Although most of the countries witnessed this type of a downward rally in their stock
markets yet how the markets pan out in terms of the linkages with each other is a question that
needs to be answered. The results obtained after employing the VAR model along with the
efficiency tests, spotlight the existence of unidirectional spillovers among the countries
undertaken during the crisis period. The subprime crisis started in the US acted as a spillover
agent in the context of stock market returns and volatility; from the US market to the Indian and
Chinese markets.
Our paper contributes to the existing literature in three ways. Firstly, we tried to model the
return and volatility linkages among the US, China and India during the actual subprime crisis
period 2007-2009, considering a trough phase as well instead of taking a longer period of time.
Secondly, we have captured the cross market spillovers in the context of stock market returns
and volatility in the form of an index creation. Thirdly, we have employed the VAR model for both
50
70
90
110
130
150
170
190
China Market capitalization of listed companies (% of GDP)
India Market capitalization of listed companies (% of GDP)
United States Market capitalization of listed companies (% of GDP)
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OPEN
DOI: 10.1515/tjeb-2015-0012
Singh, A. & Kaur, P. (2015).
Stock Market Linkages: Evidence From the US, China and India During the Subprime Crisis
Timisoara Journal of Economics and Business | ISSN: 2286-0991 | www.tjeb.ro
Year 2015 | Volume 8 | Issue 1 | Pages: 137 – 162141
the stock market returns and volatility along with Efficient tests proposed by Hill (2007). The
results obtained from the TGARCH model have been further modelled into the VAR framework.
The rest of the paper has been divided into five sections. Section 2 relates to the review of the
literature, sections 3 and 4 comprise the Research Methodology part and the Empirical findings
and Interpretation part, respectively. Section 5 concludes the paper.
2. Literature review
Over a period of time, many researchers have tried to capture the linkages among the stock
markets. The studies are not limited to the stock markets alone, yet the other areas like
commodity markets, currency markets and the debt markets have also been taken up by
the researchers in order to account for the linkages among them. A rich literature is
available on the stock market linkages in this context.
Hamao et al. (1990) examined return spillovers and volatility spillovers in the three major
stock markets (New York, Tokyo, and London) by using univariate GARCH models and
reported significant volatility and return spillovers among the concerned countries.
Friedman and Shachmurove (1997) examined the European Community stock markets by
employing a Vector Autoregression (VAR) model. The results showed that the smaller
markets, such as Belgium, Denmark and Italy do not have an impact on other markets. The
impulse responses reported that Britain is a leading market that have an impact on the
France, Netherlands, and Germany. Tabak and lima (2002) examined the causal
relationships among the stock markets of Latin America and the United States. The results
highlighted that there is some short-run relationship between these stock markets. The
Granger causality test detected causality between the Brazilian stock market and other
Latin American stock markets. In order to study the dynamic linkages between crude oil
price shocks and stock market returns in 22 emerging economies Maghyereh (2004) used
Vector Autoregression (VAR) analysis as well. The results supported the evidence that oil
shocks have no significant impact on stock index returns in emerging economies.
Click and Plummer (2005) reported that the stock markets of Indonesia, Malaysia,
Philippines, Singapore, and Thailand are cointegrated and possess a long run relationship
after the Asian financial crisis. The authors also performed certain exclusion tests to see
that whether all the variables are present in the long run relation or not. The results showed
that all the variables contribute in a significant way in the long run.
While studying the linkages between the two stock exchanges in mainland China, Hong
Kong and in the U.S. by employing M-GARCH approach, Li (2007) came out with the finding
that the Chinese mainland stock markets have a linkage with the Hong Kong market but
have no direct interaction with the U.S. stock market. Valadkhani and Chancharat (2008)
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OPEN
DOI: 10.1515/tjeb-2015-0012
Singh, A. & Kaur, P. (2015).
Stock Market Linkages: Evidence From the US, China and India During the Subprime Crisis
Timisoara Journal of Economics and Business | ISSN: 2286-0991 | www.tjeb.ro
Year 2015 | Volume 8 | Issue 1 | Pages: 137 – 162142
investigated cointegration and causality relations between the stock market price indices of
Thailand and its major trading partners (Australia, Hong Kong, Indonesia, Japan, Korea,
Malaysia, the Philippines, Singapore, Taiwan, the UK and the US). The results of Granger
causality reported unidirectional causalities running from the Hong Kong, the Philippines
and the UK to Thailand. The authors also found bidirectional Granger causality, between
Thailand and three of its neighboring countries (Malaysia, Singapore and Taiwan). Abas
(2009) examined the linkages of the two leading emerging markets, i.e. Chinese and Indian
market with other developed markets by employing Granger causality and cointegration
tests using an error correction model. The author came out with the finding that the Chinese
and Indian markets are correlated with all four developed markets undertaken for the
purpose of study, United States, United Kingdom, Japan and Hong Kong.
Ismail and Rahman (2009) analyzed the relationship between the US and four Asian
emerging stock markets, namely Hong Kong, India, South Korea and Malaysia by employing
linear Vector Autoregressive (VAR) model and nonlinear Markov Switching Vector
Autoregressive (MS-VAR) model. The results reported that Hong Kong (HSI) and Indian (BSE)
markets are significantly affected by the previous one month return of the Korean (KOSPI)
market, whereas Malaysia market significantly gets affected by the previous one month
return of Hong Kong (HSI) and Korean (KOSPI) markets. Moon and Yu (2010) found an
evidence of significant volatility spillover from the US market to the Chinese in the post
break period (December 2005) by employing symmetric and asymmetric GARCH-M models.
The results are in contrast with Li (2007) because of the time period undertaken for the
purpose of study. By making use of various statistical measures Gupta (2011) studied the
Co-movement and the direction among the emerging countries, especially the BRIC
countries during the condition of financial turmoil. The author finds out that the Indian,
Russian and Chinese markets Granger cause Brazilian market. Jeyanthi (2012) examined
both the long - run as well as short - run relationships between the stock prices of the BRIC
countries by employing Granger Causality test. The Granger causality test reveals that there
is bidirectional Granger causality that exists between India and Brazil, India and China for a
full sample period and the pre crisis period. Gangadhar and Yoonus (2012) examined the
financial integration between the US and the Indian stock market by using Vector
Autoregression as well as Cointegration technique. The results found no Co-integration
between the two indices, but the Indian returns gets significantly affected by the US returns,
whereas Reddy and Wadhwa (2012) explored the financial integration of the BRIC emerging
markets and the US market by employing Granger causality test. The results indicate that
there is a unidirectional relationship between the US and other stock markets of the BRIC
nations. Padhi and Lagesh (2012) employed DCC GARCH model to capture the co-
movement in volatility in the India, Asian and US market and came out with the finding that
bilateral shocks and volatility spillover exists in the India/Malaysia, India/Taiwan and
India/Indonesia markets. Singh and Sharma (2012) studied the inter-linkages between the
stock markets of Brazil, Russia, India, and China by using the Granger causality model,
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