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ABSTRACT
The extent to which international goods and financial markets are integrated is an issue of
continuing interest for policymakers and market participants. On the one hand, a high
degree of economic and financial integration is beneficial since it can foster economic
growth, increasing risk sharing and allocating savings more efficiently, on the other hand,
however, it may also lead to high cross border economic interdependence and
transmission of shocks. Literature review indicates that, there is no unanimous definition
of financial integration. This study therefore focused on the type of financial integration
whose estimates are conducted by investigating the changes in the co movements across
countries between selected financial asset returns.
The general objective of the study was to determine the extent of financial integration in
the East African financial markets as documented by existing literature. To achieve thisobjective, literature review on financial integration in the developed markets of Europe,
the emerging markets of Asia and the African continent was conducted. Studies from
Europe and Asia indicated evidence of increased beta convergence in the financial
marketsStocks, Bonds and Treasury bills. However, empirical studies on integration of
the East African Community (EAC), focusing on the viability of a monetary union
showed partial convergence for the variables considered (Exchange rates, GDP, business
cycles, fiscal and monetary variables). The empirical studies concluded that, the three
countries tend to be affected by similar shocks and would therefore need significantadjustments to align their monetary policies and to allow a period of monetary policy
coordination to foster convergence that will improve the chances of a sustainable
currency union.
The overall conclusion of this independent study is the lack of empirical work on
financial markets integration with specific focus on the stocks and bonds markets,
indicating the lack of empirical evidence on the extent of financial integration and long-
run equilibrium of investment returns in the East African Financial markets.
Further research can therefore be conducted to examine the financial integration of equitymarkets using quantity-based measures such as market capitalization and also to
determine what constitutes significant adjustments for the EAC countries to be able to
align their monetary policies and to allow a period of monetary policy coordination to
foster convergence that will improve the chances of a sustainable currency union.
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CHAPTER ONE: INTRODUCTION
1.1 Background
Financial market development is an important component of financial sector development
and supplements the role of the banking system in economic development. In otherwords, financial markets are needed as an alternative source of financing, supplementing
commercial banks, which dominate the EAC financial sector with low competitiveness
(Gaertner, et al 2011). Specifically, capital markets assist in price discovery, liquidity
provision, reduction in transactions costs, and risk transfer. They reduce information cost
through generation and dissemination of information on firms leading to efficient markets
in which prices incorporate all available information [Yartey and Adjasi (2007), Garcia
and Liu (1999)].
A large body of research has found evidence that capital market development contributes
to economic growth, including in sub-Saharan African countries (Levine and Zervos,
1998; Adjasi and Biekpe, 2006b). Developed capital markets promote growth by
mobilizing domestic savings and investments and by efficiently allocating mobilized
resources to the domestic companies. In addition, deep and liquid local capital markets
can lessen vulnerability of an economy to external shocks, by reducing currency and
duration mismatches in raising funds. Cross-country evidence shows that financial
development can reduce income inequality by increasing the income of the poor. There
exists a certain minimum-efficient size of bond markets, because large issuance and
trading volumes are more economical (Eichengreen and Luengnaruemitchai, 2004).
Capital markets in the East African Community (EAC) face common challenges of low
capitalization and liquidity, but to different degrees due to the different levels of
development in the markets. To this effect, the respective countries have been pursuing
development of capital markets through regional integration.
Regional integration is a process in which states enter into a regional agreement in order
to enhance regional cooperation through regional institutions and rules. The objectives of
the agreement could range from economic to political, although it has generally become a
political economy initiative where commercial purposes are the means to achieve
broader socio-political and security objectives. It could be organized either on a
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supranational or an intergovernmental decision-making institutional order, or a
combination of both.
When investments of the same risk command different returns one would conclude that,
financial markets are not integrated because of restrictions like legal barriers which
prevent capital from freely flowing between countries. In other words, in an integrated
financial market, investments of the same risk always have exactly the same expected
return. For example, a country with uniform tax laws and regulation usually has an
integrated financial market because there are no circumstances where one'sreturn will be
reduced because of tax restrictions or different regulation.
The extent to which international goods and financial markets are integrated is an issue of
continuing interest for policymakers and market participants, whether firms, investors, or
financial intermediaries. On the one hand, a high degree of economic and financial
integration is beneficial since it can foster economic growth, increasing risk sharing and
allocating savings more efficiently. On the other hand, however, it may also lead to high
cross border economic interdependence and transmission of shocks.
The researcher notes that, there is no unanimous definition of integration in the literature.
In financial economics, markets are said to be integrated when only common risk factors
are priced and (partially) segmented when local risk factors also determine equilibrium
returns. Another, more general definition relates market and economic integration to a
strengthening of the financial and real linkages between economies. Typically, estimates
of the first definition of integration require sophisticated asset pricing tests (examples are
given by Bekaert and Harvey, 1995 and 1997). Estimates of the second, instead, are
usually conducted by investigating the changes in the comovements across countries
between selected financial asset returns (Dumas, Harvey and Ruiz, 2003). This study
focuses on the second type, particularly, the East African stocks and bond markets.
http://financial-dictionary.thefreedictionary.com/Investmentshttp://financial-dictionary.thefreedictionary.com/Riskhttp://financial-dictionary.thefreedictionary.com/Expected+Returnhttp://financial-dictionary.thefreedictionary.com/Expected+Returnhttp://financial-dictionary.thefreedictionary.com/Regulationhttp://financial-dictionary.thefreedictionary.com/Returnhttp://financial-dictionary.thefreedictionary.com/Returnhttp://financial-dictionary.thefreedictionary.com/Regulationhttp://financial-dictionary.thefreedictionary.com/Expected+Returnhttp://financial-dictionary.thefreedictionary.com/Expected+Returnhttp://financial-dictionary.thefreedictionary.com/Riskhttp://financial-dictionary.thefreedictionary.com/Investments -
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1.2 Research Problem
Financial markets are integrated when the law of one price holds. This means that,
investment returns and prices ofinvestments of the samerisk within different countries in
a given region converge to a common figure. Beta convergence acts as a good measure of
determining the extent of financial integration and so is the law of one price. Existing
literature in general indicates that, there is evidence of increased beta convergence in the
financial markets Stocks, Bonds and Treasury bills. Most empirical studies on
integration have focused on the developed markets of Europe (Baele et al. 2004,
Cappiello et al. 2006, Babetskii et al.2007, Abad et al. 2009, Avadanei 2010) and the
emerging markets of Asia (Hung and Cheung, 1995, DeFusco et al. 1996, Moosa and
Bhatti 1997, Bhoi and Dhal 1998, Kaminsky and Schmukler 2001, Masih and Masih
2001, Cowen et al. 2006).
However, the empirical studies on the extent of financial integration of the East African
Community (EAC) focus on business cycles and macro-economic variables - Exchange
rates (real and nominal), GDP, fiscal policy variables and monetary policy variables. For
instance, Opolot and Osoro (2009) examined the nature and extent of synchronization of
business cycles from 1981 to 2000 and concluded that, there is hope for a monetary union
in the EAC, but further policy reforms would be necessary to stabilize the national
economies and the need for the EAC countries to increase policy co-ordination in order to
achieve the desired level of synchronization of macroeconomic fluctuations. Buigut and
Valev (2005) arrived at a similar conclusion. Mkenda (2001) and Buigut (2011)
investigated the convergence of real and nominal exchange rates. The findings of the
studies showed partial convergence for the variables considered and concluded that, the
three countries tend to be affected by similar shocks and would therefore need significant
adjustments to align their monetary policies and to allow a period of monetary policy
coordination to foster convergence that will improve the chances of a sustainable
currency union.
Emerging from these studies is the knowledge gap on the degree of beta convergence of
the investment returns of stocks and bonds in the East African Community financial
markets.
http://financial-dictionary.thefreedictionary.com/Investmentshttp://financial-dictionary.thefreedictionary.com/Riskhttp://financial-dictionary.thefreedictionary.com/Riskhttp://financial-dictionary.thefreedictionary.com/Investments -
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1.3 Research Objectives
The general objective of the study is to conduct a review of existing literature to
determine the extent of financial integration in the East African financial markets. The
specific objectives generated from this general objective include;
To conduct literature review to determine the degree of integration in the EastAfrican financial markets.
To conduct literature review to determine long-run equilibrium of returns among theEast African financial markets.
To determine the knowledge gap on the degree of beta convergence of theinvestment returns of stocks and bonds in the East African Community financial
markets.
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CHAPTER TWO: THEORETICAL LITERATURE REVIEW
2.1 Introduction
Financial integration which lends its origin in the European Union, has theoretically been
covered extensively. As part of literature review, we focus our theoretical framework on
the definition, categories of financial integration, the measurement and benefits of
financial integration as well as the relevant economic theories.
2.2 Definition of Financial Integration
Existing Literature provides various alternative definitions of financial integration;
Baele et al. (2004) assume that, a market for a given set of financial instruments and/or
services is fully integrated if all potential market participants have the same relevant
characteristics as outlined below;
1. They face a single set of rules when they decide to deal with those financialinstruments and/or services.
2. They have equal access to the same set of financial instruments and/or services.3. They are treated equally when they are active in the market.
This definition of financial market integration contains three important features. First, it
is independent of the financial structures within regions. Financial structures encompass
all financial intermediaries institutions or markets and how they relate to each other
with respect to the flow of funds to and from households, governments and corporations.
Second, frictions in the process of intermediation i.e. the access to or investment of
capital either through institutions or markets can persist after financial integration is
completed. Financial integration is concerned with the symmetric or asymmetric effects
of existing frictions on different areas. Even in the presence of frictions, several areas can
be financially integrated as long as frictions affect these areas symmetrically. However, if
the frictions have asymmetric effects on the areas, the process of financial integration
cannot reach the completion point.
Third, definition of financial integration separates the two constituents of a financial
market, namely the supply of and the demand for investment opportunities. Full
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integration requires the same access to banks or trading, clearing and settlement
platforms for both investors (demand for investment opportunities) and firms (supply of
investment opportunities, e.g. listings), regardless of their region of origin. In addition,
once access has been granted, full integration requires that there is no discrimination
among comparable market participants based solely on their location of origin. When a
structure systematically discriminates against foreign investment opportunities due to
national legal restrictions, then the area is not financially integrated. An area can also be
partially financially integrated.
The definition of financial market integration is closely linked to the law of one price. The
law of one price states that if assets have identical risks and returns, then they should be
priced identically regardless of where they are transacted. In other words, if a firm issues
bonds in two countries or regions, it must pay the same interest rate to both sets of
bondholders If the law of one price does not hold, then there is room for arbitrage
opportunities. However, if the investment of capital is non-discriminatory, then any
investors will be free to exploit any arbitrage opportunities, which will then cease to exist,
thereby restoring the validity of the law of one price.
Baltzer et al. (2008) show it is easy to see that the law of one price is in fact an implication
of the above definition. If all agents face the same rules, have equal access and are treated
equally, any price difference between two identical assets will be immediately arbitraged
away. Still, there are cases where the law of one price is not directly applicable. For
instance, an asset may not be allowed to be listed on another regions exchange, which
according to our definition would constitute an obstacle to financial integration. Another
example is represented by assets such as equities or corporate bonds. These securities are
characterized by different cash flows and very heterogeneous sources of risk, and as such
their prices are not directly comparable. Therefore, alternative measures based on stocks
and flows of assets (quantity-based measures) as well as those investigating the impact of
common shocks on prices (news-based measures) may usefully complement measures
relying on price comparisons (price-based measures).
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requisite adjustment has been made for risk. If the differential in expected risk-adjusted
returns is greater than zero but less than or the same as the transaction cost, we can say
that markets are disintegrated but are nonetheless efficient.
Financial integration can also vary in strength from perfect integration to perfect
disintegration or segmentation. When expected real interest rates are not the same in the
markets in question (not perfect integration), then the markets are said to be segmented.
Segmentation is a result of lack of integration and this can happen due to high transaction
costs involved in arbitrage or market inefficiency (Guha et al., 2004).
Financial integration includes not only integration of financial markets or services but can
take other forms as well. These forms need not be interconnected nor are they advanced
forms (stages) of the integration process. Liebscher et al. (2006) show that integration can
take many forms and present various aspects:
Central Africa) or through dollarization, such as in Latin America and the
Caribbean.
ralization of the capital account.
of listing of securities on foreign stock exchanges.
2.4 Measuring Financial Integration
Various measures exist in the literature for assessing the level of financial integration.
The methods which are used most are connected with growing investment opportunities.
However, Ho (2009) says that a standard measure of financial integration is difficult to
develop. There are many types of financial transactions and some countries impose a
complex array of price and quantity controls on a broad assortment of financial
transactions. This leads to enormous hurdles in measuring cross-country differences in
the nature, intensity and effectiveness of barriers to international capital flows
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(Eichengreen, 2001). Given the variety of asset classes traded, the measurement of
financial integration is not straight forward (Kalemli-Ozcan and Manganelli, 2008).
Financial integration is often measured following the approach adopted by Baele et al.
(2004).
They consider three broad categories of financial integration measures:
Price-based measures, which capture discrepancies in prices or returns on assetscaused by the geographic origin of the assets. This category of measures is divided
into two methods of measurement: yield-based and country effects.
News-based measures, which measure the information effects from other frictions orbarriers. If the global news has relatively bigger importance than local news, the
degree of systematic risk should be identical across assets in different countries.
Quantity-based measures, which quantify the effects of friction faced by the demandfor and supply of investment opportunities.
Price-based measures measure discrepancies in prices or returns on assets caused by the
geographic origin of the assets. This constitutes a direct check of the law of one price,
which in turn must hold if financial integration is complete. If assets have sufficiently
similar characteristics, it can base these measures on direct price or yield comparisons.Otherwise it needs to take into account differences in systematic (or non-diversifiable)
risk factors and other important characteristics. The cross-sectional dispersion of interest
rate spreads or asset return differentials can be used as an indicator of how far away the
various market segments are from being fully integrated. Similarly, beta convergence, a
measure borrowed from the growth literature, is an indicator for the speed at which
markets are integrating. In addition, measuring the degree of cross-border price or yield
variation relative to the variability within individual countries may be informative with
respect to the degree of integration in different markets.
The news-based measures are designed to distinguish the information effects from other
frictions or barriers. More precisely, in a financially integrated area, portfolios should be
well diversified. Hence, one would expect news (i.e. arrival of new economic
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information) of a regional character to have little impact on prices, whereas common or
global news should be relatively more important. This presupposes that, the degree of
systematic risk is identical across assets in different countries; to the extent that it is not,
financial integration is not completed and local news may continue to influence asset
prices.
The quantity-based measures quantify the effects of frictions faced by the demand for and
supply of investment opportunities. When they are available, we will use statistics giving
information on the ease of market access, such as cross-border activities or listings. In
addition, statistics on the cross-border holdings of a number of institutional investors can
be used as a measure of the portfolio home bias. Of course, no measure can be used for
all markets, as the specifics of some market or the data available for implementing a
measure can differ across markets. However, the spirit is the same across all markets, as
they capture the extent of possible asymmetries.
Schfer (2009) presents that the classification of integration indicators can be geared to
the type of data collected or to the information revealed. With this approach, indicators
are calculated either on the basis of statistical data on actual business activities (e.g.
interest rate statistics) or by means of surveys of banks and consumers behaviour and
intentions. For example, surveys can be used, to learn about the banks international
strategies or about consumer attitudes towards foreign providers. With regard to the type
of information mined, the indicators can be either qualitative or quantitative. The latter
category, in turn, can be volume-based or price-based. Indicators can also be classified by
their contribution to the measurement of integration as specified in the three definitions
of the term given above.
Accordingly there are:
Indicators depicting the extent to which the economic objectives associated with theintegration process have been met. In other words, what progress has actually been
made on achieving
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Indicators depicting whether banks and consumers perceive the uniform internalmarket as a whole as their domestic market.
Indicators depicting the extent to which the legal prerequisites are in place for banksand consumers to take a pan-European view, i.e. how far the artificial hurdles have
been removed.
Two problems may arise with each of the three groups of indicators. Firstly, it may be
difficult to correctly measure the variables entered into the respective indicator owing to
limited data availability. Secondly, if this is not an issue, it will then be necessary to
check whether the calculated indicator permits constructive statements on the status of
retail banking market integration
2.5 Benefits of Financial Integration
Baele et al. (2004) or Economic Commission for Africa (2008) consider three widely
accepted interrelated benefits of financial integration: more opportunities for risk sharing
and risk diversification, better allocation of capital among investment opportunities and
potential for higher growth. Some studies also consider financial development as a
beneficial consequence of financial integration.
2.5.1 Risk sharing
Economic theory predicts that financial integration should have an effect on facilitating
risk sharing (Jappelli and Pagano, 2008). The integration into larger markets or even the
formation of larger markets is beneficial to both firms and financial markets and
institutions. According to Baele et al. (2004) financial integration provides additional
opportunities for firms and households to share financial risk and to smooth out
consumption inter-temporally.
Financial integration allows project owners with low initial capital to turn to an
intermediary that can mobilize savings so as to cover the initial costs. These avenues
indicate a strong link between financial institutions and economic growth (Levine, 1997).
The exploitation of economies-of-scale can allow firms, in particular those small and
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medium-sized ones that face credit constraints, to have better access to broader financial
or capital markets.
Risk-sharing opportunities make it possible to finance highly risky projects with
potentially very high returns, as the availability of risk-sharing opportunities enhances
financial markets and permits risk-averse investors to hedge against negative shocks.
Because financial markets and institutions can handle credit risk better, integration could
also remove certain forms of credit constraints faced by investors. The law of large
numbers guarantees less exposure to credit risk as the number of clients increases.
Individual risks could also be minimized by integrating into a larger market and, at the
same time, enhancing portfolio diversification.
Through the sharing of risk, financial integration leads to specialization in production
across the regions. Furthermore, financial integration promotes portfolio diversification
and the sharing of idiosyncratic risk across regions due to the availability of additional
financial instruments. It allows households to hold more diversified equity portfolios, and
in particular to diversify the portion of risk that arises from country-specific shocks.
Similarly, it allows banks to diversify their loan portfolios internationally. This
diversification should help Euro area households to buffer country-specific income
shocks, so that shocks to domestic income should not affect domestic consumption, but
be diversified away by borrowing or investing abroad (Jappelli and Pagano, 2008).
Kalemli-Ozcan et al. (2003) provide empirical evidence that sharing risk across regions
enhances specialization in production, thereby resulting in well-known benefits.
2.5.2 Improved capital allocation
It is a generally accepted view that greater financial integration should allow a better
allocation of capital (Levine, 2001). An integrated financial market removes all forms of
impediments to trading of financial assets and flow of capital, allowing for the efficient
allocation of financial resources for investments and production. In addition, investors
will be permitted to invest their funds wherever they believe these funds will be allocated
to the most productive uses. More productive investment opportunities will therefore
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become available to some or all investors and a reallocation of funds to the most
productive investment opportunities will take place (Baele et al., 2004).
Kalemli-Ozcan and Manganelli (2008) show that, by opening access to foreign markets,
financial integration will give agents a wider range of financing sources and investment
opportunities, and permits the creation of deeper and more liquid markets. This allows
more information to be pooled and processed more effectively, and capital to be allocated
in a more efficient way.
2.5.3 Economic growth
The theoretical literature proposes various mechanisms through which financial
integration may affect economic growth. In the neoclassical framework, all effects are
generated through capital flows. In the standard model, opening international capital
markets generates flows from capital-abundant towards capital-scarce countries, thereby
accelerating convergence (hence short term growth) in the poorer countries. In a more
sophisticated context, productivity may also increase since capital flows may relieve the
economy from credit constraints and thus allow agents to undertake more productive
investments (Bonfiglioli, 2008). Furthermore, in the standard neoclassical growth model,
financial integration enhances the functioning of domestic financial systems through the
intensification of competition and the importation of financial services, bringing about
positive growth effects (Levine, 2001).
An alternative view (Obstfeld, 1994a) suggests that international capital mobility may
affect productivity independently of investment, by promoting international risk
diversification, which induces more domestic risk taking in innovation activities, thereby
fostering growth. There is ample evidence in the literature that financial integration leads
to higher economic growth. Gianetti et al. (2002) demonstrate that, financial integration
facilitates access to investment opportunities and an increase in competition between
domestic and foreign financial institutions. This in turn leads to improved efficiency of
financial institutions as financial resources are released for productive activities. In
addition, financial integration leads to increased availability of intermediated investment
opportunities, and consequently higher economic growth. Authors also argue that, the
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integration process will increase competition within less developed regions and thereby
improve the efficiency of their financial systems by, for instance, reducing intermediation
costs.
2.5.4 Financial development
According to Hartmann et al. (2007) financial development can be understood as a
process of financial innovations, and institutional and organizational improvements in the
financial system. Combined, the process have the effect of reducing asymmetric
information, increasing the completeness of markets and contracting possibilities,
reducing transaction costs and increasing competition.
Jappelli and Pagano (2008) show that, the main channel through which the removal of
barriers to integration can spur domestic financial development is increased competition
with more sophisticated or lower-cost foreign intermediaries. This competitive pressure
drives down the cost of financial services for the firms and households of countries with
less developed financial systems, and thus expands local financial markets. In some
cases, the foreign entrants themselves may supply the additional financial services.
Direct penetration by foreign banks and cross-border acquisitions of intermediaries are
likely to erode local banks rents. If mergers bring banks closer to their efficient scale, the
process will also be associated with a decreasing cost of intermediation. Sharper
competition, possibly coupled with cost cutting, translates into more abundant credit
and/or lower interest rates. A second channel is through harmonization in national
regulations (accounting standards, security laws, bank supervision, corporate
governance), which the process of integration requires. To the extent that regulatory
harmonization promotes convergence to the best international standards, it will also
enhance domestic financial development and the entry of foreign financial intermediaries
in more backward countries.
The link between financial development and financial integration is of the utmost
importance, as there is strong evidence that financial development is linked with
economic growth (Baele et al., 2004).
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As described in Levine (1997), financial systems serve some basic purposes. Among
others, they (i) lower uncertainty by facilitating the trading, hedging, diversifying and
pooling of risk; (ii) allocate resources; and (iii) mobilize savings. These functions may
affect economic growth through capital and technological accumulation in an intuitive
way. However, while Levine (1997) recognizes the positive relationship between
economic growth and financial development, he is careful not to infer any causality.
Indeed, economic growth and financial development are so intertwined that it is difficult
to draw any firm conclusion with respect to causality. Nevertheless, recent research has
found evidence that financial development affects growth positively. Rousseau (2002)
finds empirical evidence that, financial development promotes investment and business
by reallocating capital. Trichet (2005) argues that financial integration fosters financial
development, which in turn creates potential for higher economic growth. Financial
integration enables the realization of economies of scale and increases the supply of
funds for investment opportunities. The actual integration process also stimulates
competition and the expansion of markets, thereby leading to further financial
development. In turn, financial development can result in a more efficient allocation of
capital as well as a reduction in the cost of capital.
2.6 Economic Integration Theories
We identified traditional economic integration or Preferential Trade Agreements (PTA)
theory that explains possible gains from trade and economic integration, or what is
commonly referred to as the static analysis of PTAs. New economic integration theory
that has evolved with changing economic conditions and trade environments, or what is
commonly referred to as the dynamic analysis of economic integration was also
discussed.
2.6.1 Traditional Economic Integration Theory
Studies discussing trade integration gains and explaining the theoretical implications of
preferential trade agreements are based on the pioneering study of Viner (1950).His
study, Viner's Traditional Customs Unions Theory was the first to identify concrete
criteria to distinguish between the possible advantages and disadvantages of economic
integration. Viner's so called "static analysis" of economic integration has divided
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possible effects of economic integration into the well known trade creation and trade
diversion effects.
Trade creation refers to the case when two or more countries enter into a trade agreement,
and trade shifts from a high-cost supplier member country to a low-cost supplier member
country in the union. Trade diversion may occur when imports are shifted from a low-
cost supplier of a non-member country of the union (third country) to a high-cost supplier
member country inside the union. This may be the case if common tariff after the union
protects the high cost supplier member country inside the union.
2.6.2 New Economic Integration Theory
Balassa (1962), and Cooper and Massell (1965) introduced dynamic effects into theanalysis of the welfare effects of economic integration, as a more efficient economic
reason or rationale behind the formation of customs unions or economic integration
schemes in general. Balassa's dynamic theory of economic integration proved that the
static analysis in terms of trade creation and trade diversion is simply not enough to fully
capture or analyze welfare gains from economic integration.
According to Allen (1963),Balassa (1962) listed the principle dynamic effects of
integration as large-scale economies, technological change, as well as the impact of
integration on market structure and competition, productivity growth, risk and
uncertainty, and investment activity. The same view is shared by Kreinin (1963).
According to Brada and Mendez (1988) integration is assumed to raise investment and
reduce risks. This can be explained by the fact that a larger market will raise the expected
return on investments and reduce uncertainty by enabling firms to lower their costs as a
result of increased economies of scale, and a bigger pool of consumers. Schiff and
Winters (1998) summarized the definition of the dynamic effects of economic integration
schemes as anything that affects the country's rate of economic growth over the medium
term.
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CHAPTER THREE: EMPIRICAL LITERATURE REVIEW
3.1 Introduction
This chapter presents a review of empirical literature on financial integration which
continues to attract considerable research effort among academicians. The discussion was
focused on empirical studies done in Asia, Africa and Europe as outlined below.
3.2 Studies in Asia
Hung and Cheung (1995) investigated the relationship between the major developed
markets of United States, United Kingdom and Japan with the emerging markets of
Malaysia, Thailand, Korea, Taiwan, Singapore and Hong Kong. Their major findings
were that, Singapore and Taiwan are co integrating with Japan while Hong Kong is cointegrating with the United States and the United Kingdom. There are no long run
equilibrium relationship between Malaysia, Thailand and Korea and the developed
markets of the United States, the United Kingdom and Japan. The relationship between
the developed and emerging markets also change over time, as shown by the differing co
movements between them in each of the sub-periods. Furthermore, an increasing
interdependence between most of the developed and emerging markets is observed after
the 1987 stock market crash. They concluded that, findings on the differential co-
movements between the developed and emerging markets can lead to further insights into
socioeconomic connections and provide useful information to both domestic and foreign
investors. Arising from this conclusion is the knowledge gap about the exact position on
the socioeconomic connections between domestic and foreign investors.
DeFusco et al. (1996) examined the long-run diversification potential of 13 emerging
capital markets. They applied the Johansen [18] and Johansen and Juselius [19] co
integration procedures to the U.S. and 13 emerging capital markets in three geographical
regions of the world using weekly data in the U.S. None of the three regions examined
possesses co integrated markets. They found that, these markets are not co integrated
between them, an indication that the correlation between returns from each market is
independent of the investment horizon return correlations. The conclusion of the study
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points out segmentation between U.S market and these emerging markets in the three
regions; an indication of the possible existence of international diversification benefits in
the short and long term across these markets. Assisted by these findings, one can carry
out a research to determine whether there is co integration among the thirteen emerging
equity markets in the Pacific Basin, Latin America and the Mediterranean regions.
Moosa and Bhatti (1997), sought to fill the gap of non-existence of empirical evidence on
the degree of integration between the goods and financial markets of Japan and six Asian
countriesby examining integration between the Japanese markets and those of six Asian
countriesHong Kong, Korea, Malaysia, the Philippines, Singapore and Taiwanover
the period 1980-1994. The study was conducted by testing uncovered interest parity
(UIP) and ex ante purchasing power parity (PPP).They found that, the results of testing
international parity conditions are affected not only by the length of the data sample or
the testing technique, but also by model specification. Their results are consistent with
and confirm the conventional wisdom that, there is a high degree of integration among
Asian goods and financial markets. The research gap emerging from this study, is
exploring of the issue of integration on the financial markets in isolation of the market for
goods and the use of conventional specifications in carrying out a similar study. One
could also consider a study on covered interest parity and compare the findings with
those on the uncovered interest parity.
Bhoi and Dhal (1998) aimed at empirically evaluating the extent of integration of Indias
financial markets in the post-liberalization period. The existing gap here was how far the
policy and institutional reforms initiatives undertaken in deregulating the financial sector,
had resulted in narrowing the inter-market divergences and achieved a reasonable degree
of market integration. Employing the co integration method, as well as causal and partial
adjustment analysis, , they found that there exists a fair degree of convergence of interest
rates among the short term markets - money, credit and gilt markets - the capital market
exhibits fairly isolated behaviour. The movement of various interest rates in uniform
directions, nevertheless shows an encouraging sign of the growing maturity of the
financial markets and their sensitivity to monetary policy. Additionally, there was a low
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conclusion drawn from this study is that, the US and the UK markets lead other
international markets both in the short and long term, despite the global financial crash of
October 1987. From this study we deduce the opportunity for further research that
captures the nature of linkages among international financial markets (not just stocks)
during the period after the 2008 global crisis. This could form some basis for a
comparative study on the October 1987 global financial crash and the 2008 global
financial crisis with the aim of establishing whether global financial crisis have an impact
on the interdependence of developed and emerging markets.
Cowen et al. (2006) in the IMF working paper conducted in Asia and pacific department
for the period 2001-2004, aimed at documenting trends and patterns in trade and financial
integration (which had been observed not long ago) at the regional level and explore
potential linkages, or the lack thereof, between the two. The study gap was the
association between finance and trade as established in previous studies. They found that,
correlation between trade and finance was positive but relatively small (compared to
OECD countries). The lack of time series data made it impossible for them to judge any
causal impact. In conclusion, they suggested that, East Asian financial and economic
integration is likely to increase over the future, as it is lower than in regions where the
barriers are lower, and the general trend is towards a reduction in barriers. The problem
in Asia in the context of this study which requires some research is the
identification/establishment of suitable regional vehicles in which to hold savings and
instruments in which they to invest.
3.3 Studies in Africa
Kenny and Moss, (1998) examined the emerging phenomenon of African stock
exchanges by evaluating the common economic criticisms of stock markets and the
political pitfalls involved in their operation. They wanted to understand whether - African
stock markets could work and their importance to the continents development. The study
methodology was the examination of debate and literature and therefore, no empirical
findings. It concludes that the positive economic effects of bourses on African economies
are far larger than any negative effects, and argues that the political costs can be
mitigated while political benefits can also be gained. Therefore, stock markets might not
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perform efficiently indeveloping countries and that it may not be feasible for all African
markets to promote stock markets given the huge costs and the poor financial structures.
Further research can be carried out to establish ways of reducing the costs and also
strengthening the financial structures to address the inefficiency problem identified in the
study above.
Mkenda (2001) investigated whether the East African Community, comprising of Kenya,
Tanzania and Uganda, constitutes an optimum currency area or not. The study employed
the Generalized Purchasing Power Parity method, and various criteria suggested by the
theory of Optimum Currency Areas. The findings of the study indicated that, while the
various indices calculated in the study based on the theory of Optimum Currency Areas
gave mixed verdicts, the Generalized Purchasing Power Parity (G-PPP) method supports
the formation of a currency union in the region. Using the G-PPP method, the study
established co integration between the real exchange rates in East Africa for the period
1981 to 1998, and even for the period 1990 to 1998. Overall the study concluded that, the
three countries tend to be affected by similar shocks. The study gap established from
these empirical findings is the determination of the cultural factors affecting/influencing
the establishment of a monetary union in East Africa.
Buigut and Valev (2005) set out to establish if the East African Community is a viable
Monetary Union and assess whether the political force driving the EAC towards a
monetary union had any economic basis .They did this by investigating the symmetric
nature of demand and supply shocks belying real GDP growth in partner states from
1980-2001as a precondition for forming an optimum currency area (OCA). The study
was meant to fill the existing gap of lack of empirical work/study on the much politically
advocated viable monetary union, using the Vector Autoregression (VAR) technique
Results from this study showed that, the speed of adjustment to shocks and the effect of
variability on real output (real GDP) appeared to be symmetric with the exception of
Uganda. In particular, Uganda experienced large shocks and adjustments were very slow
which could prove costly in a monetary union. Although the findings could not confirm a
viable monetary union at the time, they concluded that, the potential for a monetary union
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exists if there is deeper trade integration. The emphasis from this study is the importance
of a well-functioning common market. A new research gap that researchers can consider
filling, is the determinants of a well-functioning common market.
Kishor and Ssozi (2009) investigated whether the East African Community (EAC)
constitutes an optimum currency area (OCA) by estimating the degree and evolution of
business cycle synchronization between the EAC countries. They also investigated
whether the degree of business cycle synchronization has improved after signing of the
EAC treaty in 1999. The study aimed at contributed to the existing meager empirical
economic research about the viability of the EAC as a monetary union and not addressing
a specific research gap. The research methodology employed was that of unobserved
components model of structural shocks obtained from a structural VAR model and a time
varying parameter model to estimate the degree and evolution of business cycle
synchronization, respectively. Their results indicate that, the proportion of shocks that is
common across different countries is small, implying weak synchronization. However,
they also found that, the degree of synchronization has improved after signing of the
EAC treaty in 1999. The research gap established from their study is the lack of policy
measures that can enhance synchronization of business cycles to make the initiative a
success.
Opolot and Osoro (2009) aimed at investigating the feasibility of forming a monetary
union in the East African Community by examining the nature and extent of
synchronization of business cycles from 1981 to 2007, using the Christiano-Fitzgerald
(2003) version of the Band Pass filter. Further, they established the extent of co-
movement of business cycles using percentage standard deviations, autocorrelation
coefficients, cross-correlations, and contemporaneous correlations. The research gap was
similar to that of Buigut and Valev (2005) empirical feasibility of the East Africanmonetary union. Their findings suggest that, there is a general reduction in the volatility
of business fluctuations across the EAC countries and that, the extent of synchronization
seems to have improved since the late 1990s in all of the East African Countries, except
Burundi, attributing this trend to the relative macroeconomic stability that seemed to have
been obtaining in the region, then. In their study, they concluded that, although this
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general pattern suggests there is hope for a monetary union in the EAC, it calls for further
policy reforms to stabilize the national economies and the need for the EAC countries to
increase policy co-ordination in order to achieve the desired level of synchronization of
macroeconomic fluctuations. Future research can be carried out to determine sigma
convergence of the respective economies.
Opolot and Luvanda (2009) investigate the extent of macroeconomic convergence in the
East African Countries (EAC) using sigma convergence time. The findings were mixed
and incoherent, with convergence being established only for some countries and
indicators especially after 1995. With respect to nominal variables, there is evidence of
some partial convergence of monetary policy variables, while for fiscal policy variables,
there is absolutely no evidence of convergence. This study concluded that, there is need
for the EAC countries to increase policy harmonization and co-ordination so as to
establish a coherent policy environment in the region. More so, the EAC countries ought
to continue with the macroeconomic stabilization objective and integrate the
macroeconomic convergence benchmarks into the national planning and decision-making
frameworks so as to further enhance macroeconomic stability. The gap here, is a study to
establish effective monitoring and enforcement mechanisms for the EAC countries to
ensure strict observance of the macroeconomic convergence criteria and what policy
actions should be taken to ensure full convergence where partial convergence exists.
Buigut (2011) was motivated to fill the existing gap of lack of rigorous examination on
the prevailing state (by the time of the study) of monetary policy convergence for the
EAC. His study aimed at determining whether the member countries of the East African
community would form a successful monetary union based on the long-run behaviour of
nominal and real exchange rates, the monetary base and real GDP. The four variables
were each analyzed for co-movements among the five countries (Kenya, Uganda,
Tanzania, Rwanda and Burundi) using co integration technique. The findings of the study
showed partial convergence for the variables considered, suggesting there could be
substantial costs for the member countries from a fast-tracked process. The study
concluded that, the EAC countries need significant adjustments to align their monetary
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policies and to allow a period of monetary policy coordination to foster convergence that
will improve the chances of a sustainable currency union. The gap emanating from the
study is the determination of the current state of convergence of the EAC countries
policies, which remains unknown.
3.4 Studies in Europe
Baele et al. (2004) in a working paper series for the European Union bank investigated
the integration of corporate bond markets. Their aim was to determine whether
integration was progressing, stable or regressing. The research methodology was based
on cross-sectional regression analysis over the period 1998-2003, borrowing from the
exiting literature. In the analysis, the yield spread on a corporate bond, relative to a
benchmark government bond yield, was decomposed into a component common to all
and a component due to the corporate bonds coupon size, time to maturity, liquidity,
sector, and credit quality. In their findings, price-based integration measures suggest that,
the level and evolution of corporate bond yield spreads in the Euro area is to a large
extent determined by credit rating, and to a lesser extent by the common coupon,
maturity, liquidity and sector factors. The results also showed that once corrected for
pervasive riskthe country where a bond is issued has only marginal explanatory power
for the cross-section of corporate bond yield spreads . From the above findings, the study
concluded that, the corporate bond markets in the analyzed countries are reasonably
integrated with each other. But then, the researcher does not explicitly explain or state
what constitutes reasonable integration. In other words, is there a benchmark level of
integration which puts a demarcation between reasonable and unreasonable integration?
This is the research question (research gap for filling) that future research can answer.
Cappiello et al. (2006) in the working paper series of October from the European Central
Bank examined financial integration of the equity markets of the Euro area and the new
EU countries (Cyprus, Czech Republic, Estonia, Hungary, Latvia, Poland and Slovenia)
by carrying out the analysis of returns on equity market indices. The research issue for
solving in the working paper was the essence of monitoring the development of the
economic and financial links between these countries (which had exhibited interesting
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characteristics) and the Euro zone, bearing in mind that, they would eventually join the
European monetary union. They employed the factor model to analyse the variance of
market returns and regression analysis to determine the co-movement of returns over two
sample periods; pre convergence (before December 1999) and a convergence period
(after January 2000). Their results indicated the existence of closer links between the
three largest new member states, the Czech Republic, Hungary and Poland while for the
four smaller countries, Cyprus, Estonia, Latvia and Slovenia, they found a very low
degree of integration between themselves. However, Estonia and to a less extent Cyprus
show increased integration both with the Euro zone and the block of large economies.
These researchers, in support of the findings, argued that, institutional factors, the sheer
size of the economy, geographical distance and weak economic linkages with the Euro
area could be responsible for these results. The study concluded that, although all the
considered countries have experienced tremendous development in their stock markets,
their degrees of integration and speed of convergence with the Euro zone differ quite
markedly. By the foregoing, is it possible to achieve a similar objective using quantity-
based measures such as market capitalization? How about considering the period after the
global financial crisis? Would we arrive at the same findings? These are the questions
that seek for answers from future research.
Babetskii et al. (2007) focused on the empirical dimension of financial integration among
stock-exchange markets in four new European Union member states (Czech Republic,
Hungary, Poland, and Slovakia) in comparison with the Euro area. Their aim was to test
for the existence and determine the degree of the four states financial integration relative
to the euro currency union. Specifically, they were seeking to know whether there is
convergence of the above stock markets and if it really exists, how fast it was and how it
was changing over time.Being an empirical study, they applied harmonization analysis
(by means of standard and rolling correlation analysis) to outline the overall pattern of
integration, beta convergence (through the use of time series, panel, and state-space
techniques) to identify the speed of integration and sigma convergence to measure the
degree of integration.
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The findings of the study unambiguously point to the existence of beta-convergence of
the stock markets under review at the national and sectoral levels. In addition, shocks
dissipate at quite a high speed, infact less than half of a week and finally, the lack of
major impact of either EU enlargement or the announcement thereof on convergence.The
study concluded that, while evaluating the degree of stock market integration between
Euro-candidates and the Euro area, one should bear in mind that this is a relatively small
yet important segment of financial markets. The research gap in this study which future
researchers can consider filling is the extension of the objectives to a broader
examination of integration of the money, bond, and credit markets in the enlarged EU.
Abad et al. (2009) studied whether the introduction of the Euro had an impact on the
degree of integration of European government bond markets. They carried out a
comparative analysis of the degree of integration of government bond markets in two
groups of EU-15 countries: those that joined the European Monetary Union (EMU) and
those that stayed out. Using a sample spanning the period since the beginning of
Currency Union (1999) until June 2008, they applied news-based indicators on the
government bonds markets. They found that, apart from a set of world (regional)
instruments, a set of local instruments are also able to predict local bond returns. This
result suggests incomplete integration. They also found that, EMU and US government
bond markets present a low degree of integration. This finding serves as an indication
that, it is domestic rather than international risk factors that mostly drive the evolution of
government debt returns in EMU countries. Finally, the degree of integration with the US
and German bond markets clearly differs between Euro and non-Euro participating
countries; an indication that, these countries present a higher vulnerability to external risk
factors. Their study concluded that, government bond returns of EMU countries are more
influenced by Eurozone risk factors but the EMU countries are only partially integrated
with the German market since their markets are still segmented and present differences in
their market liquidity or default risk.
Avadanei (2010) studied corporate bond markets in an effort to know the economic
importance of the corporate bond market, the Euro implications regarding the growth of
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the market as well as the degree of the bond market integration. The aim of the study was
to draw out the lessons from the European monetary union by pointing out the
development of the corporate bond market. The article adopted a theoretical approach
and therefore does not employ any empirical research methodology. The discussion
points out that, the corporate bond market should operate in an efficient and liquid
manner due to its importance. On the implications of a common currency, it emerges that,
the varying benefits of corporate bond issuance is a reflection of the fact that institutional
and fiscal frameworks, as well as other historically determined characteristics that shape
financial structures, differ widely from one country to the next. Finally, the European
corporate bond markets convergence, showed an enhanced degree of financial
integration. His study concludes that, the existence of a mature and robust corporate bond
market, which works alongside a sound banking system, is an important feature of a well-
developed financial system. The existence of such a market appears to be positive for
economic development, as it allows corporations and banks to raise funds more quickly
and more flexible terms than would otherwise be possible.On the same conclusion, he
notes that the developments in Euro area corporate bond issuance can be explained by
movements in economic activity, the costs of issuance and mergers and acquisition
related activity. The latter reflects financing needs related to corporate restructuring,
which in turn may be partly related to the introduction of the single currency.
3.5Summary of Literature ReviewThis section presents (in table format) a summary of the literature review discussed above
in the same order. The summary outlines the name of the researcher (author), research
objectives, year of study, research methodology employed, the major findings of the
study and the emerging research gap(s).
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Summary of Literature Review
Author Study objectives Year of
Study
Methodology Major findings Research Gaps
1. Studies in Asia
Hung andCheung
To investigate therelationship between the
major developed markets
of United States, United
Kingdom and Japan with
the emerging markets of
Malaysia, Thailand, Korea,
Taiwan, Singapore and
Hong Kong
1995 Co integrationmethod
Singapore and Taiwan are cointegrating with Japan while
Hong Kong is co integrating
with the United States and the
United Kingdom. There are no
long run equilibrium
relationship between
Malaysia, Thailand and Korea
and the developed markets of
the United States, the United
Kingdom and Japan
Findings on thedifferential co-
movements between the
developed and emerging
markets can lead to
further insights into
socioeconomic
connections and provide
useful information to
both domestic and
foreign investors.
DeFusco et al To determine whether
there is linkage betweenthe American market and
thirteen emerging equity
markets in the Pacific
Basin, Latin America and
the Mediterranean regions
1996 Co integration
method
There is no co integration
between these markets; anindication that the correlation
between returns from each
market is independent of the
investment horizon return
correlations
The relationship among
the thirteen emergingequity markets in the
Pacific Basin, Latin
America and the
Mediterranean regions is
not addressed in the
study.
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Moosa and
Bhatti
Examined integration
between the Japanese
markets and those of six
Asian countries- Hong
Kong, Korea, Malaysia,
the Philippines, Singapore
and Taiwan-over theperiod 1980-1994.
1997 The study was
conducted by
testing uncovered
interest parity (UIP)
and ex ante
purchasing power
parity (PPP).
The results are consistent with
and confirm the conventional
wisdom that there is a high
degree of integration among
Asian goods and financial
markets.
Study does not address
the issue of integration
on the financial markets
isolation of the goods.
One could also consider
a study on covered
interest parity andcompare the findings
with those on the
uncovered interest
parity.
Bhoi and Dhal To empirically evaluate the
extent of integration of
Indias financial markets in
the post-liberalization
period.
1998 Co integration
method
There exists a fair degree of
convergence of interest rates
among the short term markets-
money, credit and gilt markets
- the capital market exhibits
fairly isolated behaviour.
Since the degree of
integration of domestic
market is dependent on
policy and institutional
setting facing such
market segments, the
ongoing financial reform
programme needs to be
accelerated to further
widen and deepen
various markets towards
achieving a higher
degree of convergence
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Kaminsky and
Schmukler
To examine the
characteristics of
international market
integration and the effects
of capital controls in theshort and long run.
2001 They applied band-
pass filter
techniques to data
from six emerging
economies duringthe 1990s.
Markets seem to be linked
more at longer horizons,
Equity prices seem to be more
connected internationally than
interest rates. They also findlittle evidence that controls
effectively segment domestic
markets from foreign markets
Medium term, bond
prices and interest rates,
were not considered in th
study
Masih and
Masih
To investigate whether
there exists dynamic causal
linkages amongst
international stock markets
2001 -Vector error-
correction modeling
- Level VAR
modeling
There exists significant
interdependencies between the
established OECD and the
emerging Asian Markets
There is need to carry ou
a similar study capturing
the period after the 2008
global crisis and compare
the findings
Cowen et al. To establish whether there
is an association between
trade and financial flows
among the East Asia
countries
2006 Correlation analysis Correlations are positive but
relatively small (compared to
OECD countries). One year
lags or leads have little effect
so it is not possible to judge
any causal impact.
Need for a study to
identify suitable regional
vehicles in which to hold
savings and instruments
in which they can invest
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2. Studies in Africa
Kenny
and
Moss
To examine the
emerging phenomenon
of African stock
exchanges by evaluating
the common economiccriticisms of stock
markets and the political
pitfalls involved in their
operation
1998 The examination of
debate and literature
A high proportion of countries in Sub-
Saharan Africa have a long history of
very low savings and deposit ratios,
and incomplete credit markets with
inefficient financial intermediation
There is a need to come up w
ways of reducing the costs an
also strengthening the financ
structures
Mkenda To investigate whether
the East African
Community, comprising
of Kenya, Tanzania, and
Uganda, constitutes an
optimum currency area
or not.
2001 Generalized
Purchasing Power
Parity method
The study established co integration
between the real exchange rates in East
Africa for the period 1981 to 1998, and
even for the period 1990 to 1998
Given that, there are differen
types of purchasing power
parity, there is a need to
consider a similar study usin
absolute and relative
purchasing power parity and
compare the findings.
Buigut
and
Valev
To establish if the East
African Community is a
viable Monetary Union
2005 Vector
Autoregression
(VAR) technique
The speed of adjustment to shocks and
the effect of variability on real output
(real GDP) appeared to be symmetric
with the exception of Uganda. In
particular, Uganda experienced large
shocks and adjustments were very slow
which could prove costly in a monetary
union.
The study only mentions abo
the speed of adjustment but
does not address how the
markets are able to adjust to
shocks
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Buigut To determine whether
the member countries
would form a successful
monetary union
2011 co integration
techniques
Partial convergence for the variables
considered, suggesting there could be
substantial costs for the member
countries from a fast-tracked process.
Further research can be
recommended to determine
what constitutes significant
adjustments for the EAC
countries to be able to align
their monetary policies and t
allow a period of monetarypolicy coordination to foster
convergence that will improv
the chances of a sustainable
currency union.
3.Studies in Europe
Baele et
al.
To investigate the
integration of corporate
bond markets
2004 Cross-sectional
regression
analysis
The corporate bond markets in the
analyzed countries are reasonably
integrated with each other
The researcher does not
explicitly explain or state wh
constitutes reasonable
integration
Cappiello
et al.
To examine financial
integration of the equity
markets of the Euro area
and the new EU
ountries (Cyprus, Czech
Republic, Estonia,
Hungary, Latvia, Poland
and Slovenia)
2006 Analysis of
variance and
regression
analysis
Increase in the degree of Existence of
closer links between the three largest
new member states, the Czech Republic,
Hungary and Poland while for the four
smaller countries, Cyprus, Estonia,
Latvia and Slovenia, they found a very
low degree of integration between
themselves
Exploring the possibility of
achieving a similar objective
using quantity- based measu
such as market capitalization
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Babetskii
et al.
To estimate financial
integration of the stock
markets of the Euro area
countries and the new
EU countries (Czech
Republic, Hungary,
Poland; Slovakia,Slovenia).
2007 Rolling
correlation
analysis
The existence of beta- convergence of
the stock markets under review at the
national and sectoral levels. In addition,
shocks dissipate at quite a high speed,
infact less than half of a week and
finally, the lack of major impact of either
EU enlargement or the announcementthereof on convergence
The extension of the objectiv
to a broader examination of
integration of the money, bo
and credit markets in the
enlarged EU.
Abad et
al.
To determine whether
the introduction of the
Euro had an impact on
the degree of integration
of European government
bond markets
2009 Comparative
analysis using
news-based
indicators
- They found that, apart from a set of
world (regional) instruments, a set of
local instruments are also able to predict
local bond returns
-EMU and US Government bond
markets present a low degree of
integration
Need for a similar study on t
European Equity markets an
compare the findings.
Avadanei To draw out the lessons
from the European
monetary union by
pointing out the
development of the
corporate bond market
2010 Theoretical
approach
-The varying benefits of corporate bond
issuance is a reflection of the fact that
institutional and fiscal frameworks, as
well as other historically determined
characteristics that shape financial
structures, differ widely from one
country to the next.
-The European corporate bond markets
convergence, showed an enhanced
degree of financial integration
The study does not tell us the
specific measures of a matur
and robust corporate bond
market. This calls for a more
rigorous study which
identifies/explains the
measures.
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3.6 Research Gap
On critically evaluating the existing literature, it has been observed that, most empirical
studies on financial integration stock markets, bond markets, money markets, credit
markets and the pension funds, have focused on the developed markets of Europe (Baele
et al. 2004, Cappiello et al. 2006, Babetskii et al.2007, Abad et al. 2009, Avadanei 2010)
and the emerging markets of Asia (Hung and Cheung, 1995, DeFusco et al. 1996, Moosa
and Bhatti 1997, Bhoi and Dhal 1998, Kaminsky and Schmukler 2001, Masih and Masih
2001, Cowen et al. 2006). The studies indicate evidence of increased beta convergence in
the financial marketsStocks, Bonds and Treasury bills.
However, the empirical studies on integration of the East African Community (EAC)
focus on the viability of a monetary union with a focus on business cycles and macro-
economic variablesExchange rate (real and nominal), GDP, fiscal policy variables and
monetary policy variables. For instance, Opolot and Osoro (2009) examined the nature
and extent of synchronization of business cycles from 1981 to 2000 and concluded that,
there is hope for a monetary union in the EAC, but further policy reforms would be
necessary to stabilize the national economies and the need for the EAC countries to
increase policy co-ordination in order to achieve the desired level of synchronization of
macroeconomic fluctuations. Buigut and Valev (2005) arrived at a similar conclusion.
They also found that, the degree of synchronization has improved after signing of the
EAC treaty in 1999. The research gap established from their study is the lack of policy
measures that can enhance synchronization of business cycles to make the initiative a
success. Mkenda (2001) and Buigut (2011) investigated the convergence of real and
nominal exchange rates. The findings of the study showed partial convergence for the
variables considered and concluded that, the three countries tend to be affected by similar
shocks and would therefore need significant adjustments to align their monetary policies
and to allow a period of monetary policy coordination to foster convergence that will
improve the chances of a sustainable currency union. The gap emanating from the study
is the determination of the current state of convergence of the EAC countries policies,
which remains unknown and also the determination of the cultural factors
affecting/influencing the establishment of a monetary union in East Africa.
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Clearly, no single study has discussed financial markets integration with specific focus on
the stocks and bonds markets.
3.7 Conclusion
As reviewed through the theoretical and empirical literature, it is evident that, academic
research on integration of the East African financial markets is lacking and therefore
objective one and two could not be achieved. This points to the existence of aknowledge
gap on the degree of beta convergence of the investment returns of stocks and bonds in
the East African Community financial markets.
3.8 Recommendations for Further Research
This study has laid a good platform for conducting further research which includes;
(i) Establishment of the findings on the differential co-movements between thedeveloped and emerging markets which can lead to further insights into
socioeconomic connections and provide useful information to both domestic and
foreign investors.
(ii) Need to research on further policy reforms to stabilize the national economies andalso determine ways of increasing policy co-ordination in order to achieve the
desired level of synchronization of macroeconomic fluctuations.
(iii) Further research can be recommended to determine what constitutes significantadjustments for the EAC countries to be able to align their monetary policies and
to allow a period of monetary policy coordination to foster convergence that will
improve the chances of a sustainable currency union.
(iv) Examining the financial integration of equity markets using quantity-basedmeasures such as market capitalization.
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