European Integration and European Stock Markets 1

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1 European Integration and European Stock Markets 1 Lumír Kulhánek and Daniel Uherek Silesian University, School of Business Administration, Karviná, Czech Republic kulhanek@opf.slu.cz and OFO Investments Ltd., London, U.K. uherek@ofo.nu Introduction At present, we are witnesses of the integration process of the national financial markets towards the worldwide, global financial market. Investors tend not to make a distinction between national and foreign financial instruments; banks operate in the worldwide area. For these reasons, the motives for international investing are examined along with advantages and disadvantages regarding the strategy of international investing on the stock markets. With reference to this fact, it is necessary to pay attention in Europe partly to the impact of the introduction of the single Euro currency, partly to the development of the stock markets in transition economies integrating into the European Union. 2 There are a great number of reasons for this research. Among the main ones can be ranked the fact that globalization tendencies lead to the integration of the closed economies into the international capital flows, capital markets have arisen in the transforming economies and the extension of activities of the private investors have taken place. The increase in demand for cross-border investment stocks within the euro area brings about considerable changes in the market structures, both on exchange-traded markets and in brokerage industry. 3 These changes occur not only in the euro area market structures, but rather on a pan-european level. In this paper, first, we will take notice of the development of the stock markets in the three transition economies in the Czech Republic, Hungary and Poland. Subsequently, a comparison will be made with the development of the stock markets in the selected countries 1 The paper is published with the support of the Grant Agency of the Czech Republic Project No. 42/2/148 Comparing Financial Markets Development in the Czech Republic and EU-Countries. 2 The term emerging markets is not used in this contribution, but which is often applied in similar contexts. 3 Compare similar conclusions, to which ECB analyses came (ECB, 21, p. 37). 1

2 of the European Union (France, Germany, Great Britain, Greece, the Netherlands, Portugal, Spain), where only Great Britain is not part of the euro area. Both main quantitative characteristics of the development of stock markets will be analyzed (monthly returns and risk), as well as the correlation of returns among particular countries. The subject of the analysis will not be globalization and integration factors of financial markets. We proceed rather from the assumption that the globalization of financial markets is caused by a great number of factors, to which belong: the deregulation of financial markets, the development of technologies and institutionalization. The deregulation of financial markets comprises partly the deregulation of the market liberalization of the fundamental market structure (elimination of the fixed brokerages in intermediary trades, deregulation measures making financial markets accessible to foreign investors), partly the institutional deregulation (elimination of the elimination of restrictions for financial activities of domestic and foreign financial institutions). The development of information and telecommunication technologies affects not only the rate of executing instructions but also it facilitates a quick spread of information, the reduction of costs for obtaining information and it leads to a permanent valuation, intellectualization and balancing of the price discrepancies. Institutionalization is manifested firstly in the decisive role of institutional investors on the current financial markets and in portfolio internationalization of institutional investors. 1. Data The analysis of the development of the national stock markets and their international comparison are made by applying monthly Morgan Stanley Capital International (MSCI) stock indexes. 4 These indexes have been available for the Czech Republic and Hungary since December 1994, for Poland since December 1992, for Portugal and Greece since December As to other countries, which are included in the analysis Spain, Germany, France, the Netherlands and Great Britain and for the MSCI Index Europe, data has been accessible in the long time series already since the year Owning to these facts, the period of December 1994 to July 23 is examined, and for monthly returns the period of January 1995 to July See 2

3 For more detailed analysis, this period December 1994/January 1995 to July 23 is divided into two subperiods the first one from December 1994/January 1995 to December 1998, and the second one from January 1999 to July 23. MSCI stock indexes are published both in the domestic currency, and in the US dollar and since the year 1998 also in the Euro. Analyses have been carried out on the basis of indexes in the local currencies, since the primary objective was to depict the development of the national stock markets and not the aspects of the international portfolio diversification. In some cases, the results of the analyses in the local currencies are completed and compared with the results assessed according to the development of stock indexes in the US dollar (Kulhánek 22a, 22b). 2. The development of stock markets in the years The development of particular stock markets in the examined countries and the development of the MSCI index Europe in the years are showed in Figure 1. As it is apparent from the Figure 1, the increasing trend of stock markets (with a decrease in the year 1998) was replaced in transition economies and in the selected EU countries from the beginning of the year 2 by a plunge continuing up to the first quarter of the year 23. Figure 1: Development of selected stock market indexes (1994:12-23:7) :1 96:1 97:1 98:1 99:1 :1 1:1 2:1 3:1 95:1 96:1 97:1 98:1 99:1 :1 1:1 2:1 3:1 CZ HU PL PT GR EUROPE DE ES FR GB NL EUROPE Yet, in transition economies we can notice the stoppage of the decrease or a mild recovery of the stock market as early as in the last quarter of the year 21, the development 3

4 in particular transition countries is different though. Greece showed the most dynamic growth in the observed period, the fall of the stock index was initiated earlier as compared with other countries though, and similarly it was very dynamic as the previous growth. The development in Portugal after the dive in the year 1998 can be characterized rather as stagnation along with the following decrease from the year 2. The development in Spain, Germany, France, the Netherlands and Great Britain is obvious from the right part of Figure 1. The detailed examination of the development of stock indexes in the period of 1994: :1 is represented in Figure 2, from which a relative synchronous development of the most developed European stock markets is evident (see the right part of Figure 2). Figure 2: Development of selected stock market indexes (1994: :1) :1 95:7 96:1 96:7 97:1 97:7 98:1 98:7 99:1 95:1 95:7 96:1 96:7 97:1 97:7 98:1 98:7 99:1 CZ HU PL PT GR EUROPE DE ES FR GB NL EUROPE The highest increase in the monthly index in that period 1994: :1 was registered in Hungary (January 1996: 51,69 %) and Greece (March 1998: 43,19 %), the highest decrease in Hungary too (August 1998: -36,44 %) and further in Poland (also August 1998: -29,43 %). The Czech Republic recorded in this period the highest growth of 8,71 % in August 1997 and the highest decrease of -23,69 % (August 1998), Portugal with the highest growth of 16,8 % (January 1997) and the highest fall of -14,41 % (August 1998 like in all examined countries). 5 As it is apparent from the Figure 2, starting in October 1998 the stock markets began to turn up; starting in March 2 the equity markets in the transition countries 5 The highest increase in the monthly index for France, Germany, Great Britain, the Netherlands and Spain was registered in Germany (15,62 ˇ) and Spain (15,4 %), %), the highest decrease in Spain (-22,41 %) and Germany (-17,21 %). 4

5 and some of EU-countries began to turn down. Figure 3 represents the development of stock markets in the second subperiod of the examined period in the period of from 1:1999 to 7:23. A characteristic feature for this period is first stagnation and subsequently the slump of stock indexes practically in all examined countries. Starting in September 21 the equity markets in the transition countries began to turn up. Starting 22, the stock markets development in transition countries is different. Figure 3: Development of selected stock market indexes (1999:1-23:7) :1 99:7 :1 :7 1:1 1:7 2:1 2:7 3:1 3:7 99:1 99:7 :1 :7 1:1 1:7 2:1 2:7 3:1 3:7 CZ HU PL PT GR EUROPE DE ES FR GB NL EUROPE The highest increase in the monthly index in that period 1999:1-23:7 was registered in Czech Republic (May 1999: 25,4 %, December 2: 22,93 %) and Poland (January 1999: 22,67 %), the highest decrease in Czech Republic too (August 1998: -2,56 %) and further in September 22 in Germany (-24,93 %) and Portugal (-19,97 %). 3. Monthly returns and risk Main characteristics of the monthly returns of the national stock markets mean and standard deviation of returns and also other characteristics - for the entire period of 1:1995-7:23 are depicted in Table 1. The data confirm general assertions that stock markets in transition countries not only may offer higher returns, but also the risks associated with returns are frequently higher than in the established markets as well. In cases of some 5

6 countries it can be noticed with Kulhánek and Uherek (23) that a higher risk does not have to be accompanied by higher returns. Table 1: Selected characteristics of monthly returns (1995:1-23:7) CZ HU PL PT GR DE ES FR GB NL EUR Mean,64 2,32 1,7,51 1,2,61 1,22,77,37,63,62 Median,84 1,83 -,3,33,2,6 1,38 1,12,52 1,41 1,43 Max. 25,4 51,69 41,26 16,8 43,19 19,67 15,4 12,99 8,86 14,1 11,16 Min. -23,69-36,44-29,43-19,97-2,48-24,93-22,41-15,98-11,99-18,44-14,31 Std. Dev. 8,24 11,34 1,71 6,37 9,68 7,27 6,78 6,7 4,18 6,5 5,5 Skewness,6,588,778 -,66,926 -,488 -,467 -,331 -,614 -,749 -,633 Kurtosis 3,838 6,987 5,282 3,619 5,767 4,171 3,925 2,97 3,456 3,786 3,472 Jarque-B. 3,1 74,18 32,74 1,72 47,56 9,98 7,42 1,91 7,37 12,28 7,83 Probab.,227,,,423,,7,25,384,25,2,2 Sum 65,7 238,8 11,3 52,9 15,4 63,2 125,4 79,5 38,2 64,8 63,7 Sum S. D Observ CZ Czech Republic, HU Hungary, PL Poland, PT Portugal, GR Greece, DE Germany, ES Spain, FR France, GB Great Britain, NL the Netherlands, EUR MSCI Index Europe. Source: Own calculation according to the MSCI data. The volatility of the monthly returns is in transition countries generally high. The highest average monthly return was registered in transition economies by the stock market in Hungary 6 (2,32 %), in the EU countries in Spain (1,22 %). In the Czech Republic it amounted to,64 % and it was comparable with the average monthly return of the MSCI Europe index (,62 %). The Portuguese stock market recorded in this period slightly lower average monthly return (,51 %). The detailed examinations of the development of monthly returns for two groups of countries in subperiods of 1:1995-1:1999 and 1:1999-7:23 are represented in Figures 4 and 5. Stock markets are for a comparison divided into two groups. The development of monthly returns in Czech Republic, Hungary, Poland, Portugal and Greece is obvious from the left part of Figures, the development in Germany, France, Spain, the Netherlands and Great Britain is obvious from the left part of Figures. The development of MSCI Index Europe return is not included. 6 The stock market in Hungary earned the highest monthly return (in local currency) over the whole period, but with comparatively high standard deviation. 6

7 Figure 4: Monthly returns (1995:1 1999:1) :1 95:7 96:1 96:7 97:1 97:7 98:1 98:7 99:1-4 95:1 95:7 96:1 96:7 97:1 97:7 98:1 98:7 99:1 CZ HU PL PT GR DE ES FR GB NL Figure 5: Monthly returns (1999:1 23:7) :1 99:7 :1 :7 1:1 1:7 2:1 2:7 3:1 3:7 99:1 99:7 :1 :7 1:1 1:7 2:1 2:7 3:1 3:7 CZ HU PL PT GR DE ES FR GB NL The monitoring of monthly returns and risk (measured by standard deviation) and their international comparison proves in principle the fundamental relation between returns and risk. As it is obvious from Figure 6, the highest monthly average return, which the Hungarian stock market achieved, was connected with the highest standard deviation. Similar relatively high average monthly returns of the Polish or Greek stock markets were related to the high risk (or standard deviation). Then again, the stock market in Great Britain showed the lowest average monthly return and the lowest standard deviation. 7

8 Relatively low average monthly return of the Czech stock market was connected with the relatively high standard deviation (the fourth highest standard deviation from the examined stock markets). What is characteristic for the stock markets of transition economies is the fact that they are connected with a higher risk. This higher risk does not guarantee higher return though. Figure 6: Monthly Return and Risk (1995:1-23:7) 12, 1, 8, 6, 4, 2,,,,25,5,75 1, 1,25 1,5 1,75 2, 2,25 PT GR CZ HU PL FR DE NL ES GB US EURO WRLD 4. Trends of monthly returns The comparison of trends of the development of monthly returns of particular countries brings remarkable results too. For the purposes of this comparison, the trends of the development of monthly returns were obtained by filtering the values of monthly returns by means of the Hodrick-Prescott filter. 7 See for example, monthly returns and Hodrick-Prescott trend of monthly returns for stock markets in the Czech Republic and Portugal in the years , which are showed in Figure 7. In majority of examined stock markets, from the year 1995 to the year 1997 the increasing trend of monthly returns was registered, which was then replaced by the decreasing 7 At this point, we dispense with the discussion pertaining to the technique of the Hodrick-Prescott filter, its advantages, disadvantages and application suitability. 8

9 trend. In two transition countries (Hungary and Poland) the decreased trend started sooner (in Poland 11:1995, in Hungary 11:1996). Conversely, in the Czech Republic, the trend of monthly returns stabilized in 1997 and it began to increase from the half of the year 21 (see Figure 8). As a result of this development, the Czech stock market is different from the development of trends of monthly returns in the examined both transition countries and EU countries. Figure 7: Returns and trends of returns at Czech and Portuguese stock markets CZ HP-trend PT HP-trend Figure CZ HU PL PT GR DE ES FR GB NL 9

10 This development reflects also changes of characteristics of returns of stock markets in examined period. For the purposes of valuating changes in the development of stock markets, the entire examined period of 1995:1 23:7 (i.e. 13 observations) was divided into two subperiods 1995:1-1998:12 and 1999:1-23:7. Characteristics of monthly returns of these two subperiods are depicted in Tables 2 and 3. Mean Table 2: Changes of characteristics of stock market returns CZ HU PL PT GR DE ES FR GB NL EUR ,15 4,54 1,56 2,13 2,82 1,81 2,8 1,78 1,36 2,4 1, ,33,38,65 -,9 -,55 -,43 -,16 -,11 -,49 -,6 -,38 Median ,8 4,45,5 1,88,98 2,55 3,19 2,24,95 2,9 2, ,44 -,51 -,3-1,28-1,18-1,18,41,37 -,4,28 -,17 Maximum ,71 51,69 41,26 16,8 43,19 15,62 15,4 12,99 8,86 14,1 8, ,4 15,98 22,68 13,16 17,85 19,67 14,34 12,76 8,84 12,69 11,16 Minimum ,69-36,44-29,43-14,41-2,48-17,21-22,41-12,29-9,59-13,9-13, ,56-19,44-19,16-19,97-19,76-24,93-16,83-15,98-11,99-18,44-14,31 Std. Deviation ,7 13,88 12,2 6,56 1,49 5,72 6,82 5,65 3,47 5,29 4, ,14 8,2 9,31 5,89 8,72 8,3 6,5 6,33 4,57 6,45 5,39 Observations CZ Czech Republic, HU Hungary, PL Poland, PT Portugal, GR Greece, DE Germany, ES Spain, FR France, GB Great Britain, NL the Netherlands, EUR MSCI Index Europe. Source: Own calculation according to the MSCI data. Data in the Table 2 represent the decrease in stock indexes from the year 2 and confirm a different character of the development in these periods. Whereas in the periods of all observed stock markets, with the exception of the Czech Republic, registered a positive monthly average return, in the periods of only three observed transition economies recorded a positive monthly average return, and at the same time all stock markets of the observed EU countries recorded negative monthly average return. The highest decrease in returns was registered by the stock markets in Hungary, Greece and Portugal. 1

11 5. Stock markets linkages Since the sixties, when Grubel (1968) expanded the framework of a modern portfolio analysis to the international stock markets, the advantages of the international diversification have been analyzed in detail. The results of a number of empirical studies in this area indicate analogously at the same time as Solnik (1974) that the benefits from the international diversified portfolios arise from a relatively low interconnection of the individual national stock markets, which is assessed according to the correlation coefficients of proceeds rate among those national stock markets. A question arises legally in connection to the aim of the paper too, what degree of interdependence stock markets in the EU-countries and the EUaccessing countries show. Due to the changeable character of the development of stock markets, the valuation of mutual relations between the developments of the particular national stock markets was conducted in two steps. First, the correlation coefficients of monthly returns for the entire observed period were identified (see Table 3). Subsequently, the correlation coefficients were identified as five-year running averages (6 observations) beginning from 1995:1-1999:12 to 1998:8-23:7 (see Figures 9 and 1). Table 3: Correlation coefficients of the monthly returns (1995:1 23:7) CZ HU PL PT GR DE ES FR GB NL EUR CZ 1,545,456,266,275,29,283,265,178,18,274 HU,545 1,64,625,45,513,519,53,449,445,55 PL,456,64 1,456,316,438,4,429,394,366,453 PT,266,625,456 1,467,667,728,716,57,635,723 GR,275,45,316,467 1,494,514,5,444,415,513 DE,29,513,438,667,494 1,765,88,736,868,923 ES,283,519,4,728,514,765 1,81,744,753,858 FR,265,53,429,716,5,88,81 1,777,866,943 GB,178,449,394,57,444,736,744,777 1,815,895 NL,18,445,366,635,415,868,753,866,815 1,93 EUR,274,55,453,723,513,923,858,943,895,93 1 CZ Czech Republic, HU Hungary, PL Poland, PT Portugal, GR Greece, DE Germany, ES Spain, FR France, GB Great Britain, NL the Netherlands, EUR MSCI Index Europe. Source: Own calculations. As it is noticeable from Table 3, very high correlation coefficients are (traditionally 8 ) showed by the returns of stock markets in France, Germany and the Netherlands. In the case 8 See Kulhánek (22a), among others. 11

12 of France and Germany the value of the correlation coefficient (,88) is the highest at the same time out of the entire stock market sample analyzed in this treatise. The correlation coefficients are also very high for the Netherlands and Germany (,868) and the Netherlands and France (,866). Correlation coefficients of these three countries with Spain and Great Britain are lower, but also relatively very high. Monthly returns of the Portuguese stock market are mostly correlated with Spanish stock market (,728) and with French market (,716). Greece and examined transition economies show considerably lower correlation coefficients. The Czech stock market is mostly correlated with the Hungarian stock market (correlation coefficient,545) and Polish stock market (,456). Correlation coefficients of the Czech stock market with the stock markets in EU-countries are very low. In the case of Czech Republic and Germany is the value,29 the highest value. The Polish stock market shows the highest correlation coefficient with the Hungarian market (,64) in a comparison with the countries assessed. As it apparent from the left part of Figure 9, changes of five-year moving averages of correlation coefficients against MSCI Index Europe are obvious in the course of time. The most correlated returns of stock markets against the MSCI Index Europe are in France, Germany, the Netherlands, but also in Great Britain and Spain. Figure 9: Five-year moving averages of correlation coefficients against Europe Index :1 :7 1:1 1:7 2:1 2:7 3:1 3:7 :1 :7 1:1 1:7 2:1 2:7 3:1 3:7 CZ HU PL PT GR DE ES FR GB NL CZ HU PL PT GR DE FR ES GB NL The Czech market showed first a decrease of correlation coefficients till the 21:1, then it was followed by the increase up to 22:6, and subsequently the correlation 12

13 coefficient began to stagnate. The Portuguese market shows a stable correlation coefficient till 22:8, even though on the lower level than France, Germany and the Netherlands. Development trends of correlation coefficients are obvious from the right part of Figure 9. The Hungarian, partly the Polish markets show principally a rising correlation against the Czech stock market (see the left part of Figure 1). Five-years moving averages of correlation coefficients for the Czech stock market against the stock markets in the EU countries are still very low, even though in the periods from 2:1 to 22:6 an increase was marked from,25 to,395 against Germany and from,196 to,358 against MSCI Index Europe. The development of five-years moving correlation coefficients for the Portuguese stock market against the examined stock markets is depicted in the right part of Figure 1. Figure 1: Correlation coefficients against Czech and Portuguese stock markets :1 :7 1:1 1:7 2:1 2:7 3:1 3:7 :1 :7 1:1 1:7 2:1 2:7 3:1 3:7 CZ_HU CZ_PL CZ_PT CZ_GR CZ_DE CZ_ES CZ_FR CZ_GB CZ_NL CZ_EUROPE PT_CZ PT_HU PT_PL PT_GR PT_DE PT_ES PT_FR PT_GB PT_NL PT_EUROPE Conclusion The effects of globalization are far reaching. Expanding the global market system influences not only the evolution of financial systems, but also development on financial markets both in transition and EU countries. The integration of the European stock markets has increased in the course of the nineties. The comparison of returns and risks on stock markets in three Central European transition countries (Czech Republic, Hungary and Poland) has confirmed characteristics in 13

14 the period observed which are typical for the emerging markets. Stock markets in transition countries have become increasingly interconnected. The monthly return correlation coefficients are generally positive but low. From a point of view of the international portfolio investment a low correlation between stock markets returns in the Central European transition countries and in the EU countries can contribute to the decrease in portfolio risk and be applied to the portfolio diversification. References 1. European Central Bank (21), The Euro Equity Markets. Frankfurt, ECB. ISBN Grubel, H. G. (1968), Internationally Diversified Portfolios. American Economic Review, Vol. 58, 1968, pp Ibanez, D. M. and Molyneux, P. (22), Integration of European Banking and Financial Markets. Technology and Finance Working Papers from United Nations University No papers/eifc1-14.pdf. ISSN Kulhánek, L. (22a), Comparison of Capital Markets Returns in the Czech Republic and in the EMU. In Finance. 5 th Anniversary Financial Conference. Veliko Tarnovo, Abagar, pp ISBN Kulhánek, L. (22b), Integration of the European Capital Markets and the Corporate Finance Management. In Restructuring and Development Processes of Enterprises and their Value Creation. Borowiecki, R. and Jaki, A. (eds). Warsaw, TNOIK, pp ISBN Kulhánek, L. and Uherek, D. (23), Globalization, Financial System and Equity Market Linkages in Transition Countries. In Globalization and Entrepreneurship: Fears, Challenges and Opportunities. Pula, Faculty of Economics and Tourism University of Rijeka. 7. Morgan Stanley Capital International (1998), Methodology and Index Policy. New York, MSCI, March ( 8. Solnik, B. (1974), Why not Diversify Internationally Rather than Domestically? Financial Analyst Journal, Vol. 3, 1974, July-August, pp