Granger Causality of the relationship between financial liberalization and stock market efficiency



Abstract

This paper examines the relationship between financial liberalization and stock market efficiency in a panel of 28 emerging markets 1996-2010. Different from previous studies by investigating Granger causality relationship using Pooled Mean Group (PMG), Mean Group (MG) and Dynamic Fixed Effect (DFE) to find out the direction of the effect in the relationship between financial liberalization and stock market efficiency. Subsequently, our work makes a fresh contribution to the literature to focus on informational efficiency of stock markets rather than financial development. We find evidence of financial liberalization Granger causing stock market efficiency which is consistent with liberalization-dependent hypothesis. It suggests that liberalization is the factor influences stock market efficiency and not the other way round. Furthermore, in panel Granger causality running from financial liberalization to efficiency, the short-run effect is not significant, whereas, in the long-run financial liberalization does lead to more informational efficiency. Therefore, the J-curve hypothesis is supported in a way that liberalization has deteriorating effect in the short-run and improving impact in the long-run.

Introduction

Low savings and high population in the developing countries had certainly faced problems in managing raising the capital for the development projects just before 1998. A continuous debt crisis in the developing countries and a simultaneous financial crisis in industrialized countries have certainly affected the flow of private and public capital to developing countries (Kanu, 2011). The era of late 1980's was found to be of financial improvements in developing countries as they began to liberalize their financial markets to a great extent.

This critical change was propelled by their undertaking to advertise financial developments utilizing business sector and certainly motivate investors. In spite of increasing interest and cooperation of developing emerging markets in liberalization, very few things are known about the efficacy of these fledging markets. A large number of economists are under serious thoughts that these markets and business sectors are capable for esteeming speculation chances powerfully and flawlessly. Particularly with a high number of recent financial crises, economists are under serious debates about the positive and negative effects of this financial liberalization and market efficiency in the developing countries.

The economic development theory says that, stock markets particularly in private markets provide greater efficiency in the allocation of financial resources. The effects of liberalization were mixed in both the developing and developed countries according to the previous empirical evidences and the claim of Mehrez and Kaufmann (2000) was that opening the financial markets for the purpose of foreign capital certainly leads to financial crisis. The claim further enhances the reason for such significant financial crisis was such a rapid change in the liberalization of the financial system. Good institutions usually make sure that the developed nations should also enjoy the benefits of financial stock market efficiency. For this purpose, quality of institution was considered as much more important than the level of financial liberalization. Carrieri, Chaieb et al. (2013) raised an important point that improvement in the field of institutions ...