Financial Development and Financial Liberalisation

Financial Liberalisation

The liberalisation of equity markets reduces the barriers in cash flows, enhances the liquidity of these markets, increases the number of investors and decreases the cost of capital (Bekaert and Harvey, 2000). In integrated equity markets, a lower cost of capital is a result of better possibilities for international investors to eliminate country-specific risks. Henry (2000) argues that if stock market liberalisation reduces the cost of equity capital, then the country’s equity price index increases when the market learns that a stock market liberalisation is going to occur. The risk free rate and equity premium decrease as a result of the increase of net capital inflows and risk sharing resulting from the liberalisation process. Liberalisation can increase market liquidity, which means that domestic investors may allow a larger proportion of savings to be invested in long-term projects that would be profitable as their net present value becomes positive.

 Financial Development

 As a result of liberalisation, the financial linkages may vary between countries of developed and less developed financial systems. One can argue that financial development and correlation of stock returns move in opposite directions. The financially developed systems are closely linked because of fewer restrictions imposed on capital flows, thus promoting portfolio diversification. While poorly developed financial systems are restrictive to capital mobility, resulting in less effective capital inflows and outflows (Dellas and Hess, 2000).

An extensive literature in this area focuses on examining equity price linkages. Although, many studies have examined long-run relationships and short-run dynamic causal linkages in emerging and developed markets, of which they show a considerable increase in equity market integration.

Contagion and Spill Over

 In this literature, the term Contagion is defined as:  "Correlation over and above what one would expect from economic fundamentals" (Bekaert et al., 2005). Contagion increases with volatility; the prediction is that after a large idiosyncratic shock, the correlation coefficient between two markets should increase.