Globalization and Investment Opportunities: a Cointegration Study of Arab, U.S. and Emerging Stock Markets 1

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1 Globalization and Investment Opportunities: a Cointegration Study of Arab, U.S. and Emerging Stock Markets 1 Said M. Elfakhani Associate Dean and Professor of Finance Suliman S. Olayan School of Business American University of Beirut Mahmoud Arayssi Lecturer, Suliman S. Olayan School of Business American University of Beirut Hanin A. Smahta MBA Graduate American University of Beirut Second Draft Please forward all correspondence to Professor Said Elfakhani, Suliman S. Olayan School of Business, American University of Beirut, School of Business, Bliss Street, P.O.Box , Beirut, Lebanon, Tel: (+961-1) , SE01@AUB.EDU.LB 1 This study builds on the MBA project work of one of the authors, Hanin Smahta, and the supervisory work of the first two authors. The authors acknowledge the financial support of the American University of Beirut Research Board (URB) for funding data collection. All errors are the authors. 1

2 Globalization and Investment Opportunities: a Cointegration Study of Arab, U.S. and Emerging Stock Markets Abstract There is a debate in the investment circles on whether international diversification is still possible despite growing globalization and the consequent integration between various stock markets all over the world. This study explores whether Arab markets can offer international investors unique risk and return characteristics to diversify international and regional portfolios. A test of co-integration (measuring long-run relationship) is conducted among Arab stock markets, US and emerging markets general indices for a 65-month period ( ). Our results show that Jordan and Kuwait, Jordan and Tunisia, Kuwait and Tunisia, and Kuwait and Saudi Arabia are co-integrated among each other, while the others are not. On the other hand, only Jordan, Kuwait and Morocco are co-integrated with the US general market index. The emerging markets did not co-integrate with any other country index. Periods of boom and recession, before and after March 2000, have different effects on the co-integration results of this paper. Evidence suggests that some Arab markets that cointegrated with the US might offer a probable substitute for people who invest in the US markets, whereas the markets that did not co-integrate with the US might still offer good diversification opportunities. 2

3 I. Introduction Investors face a wide choice of diverse investment opportunities in many different countries, and many factors to consider before making an investment decision. One such factor is the extent of markets integration and the value of diversification across countries. Financial theory suggests that investors should invest internationally because of the larger potential for risk reduction stemming from the lower correlation existing between assets of different countries. Globalization has probably increased the correlations between countries brought by increased economic integration among economies of the world, thus greatly changing the investment world. The spread of information is much faster today, which makes access to other markets easier, especially with the introduction of free-trade areas, custom unions, joint markets and regional economic unions. Therefore, one question that arises is whether diversification is still yielding its desired benefits despite the increasing correlation brought by globalization, and whether there are countries or regions in the world that still offer good diverse opportunities. We try to shed some light on this issue using eleven Arab stock markets as a testing field against the US and emerging market indices. The major contributions of this paper include (1) the use of an innovative technique namely co-integration analysis, (2) the use of Beveridge and Nelson (1981) decomposition of the index into its permanent and cyclical component as a more precise method avoiding misleading conclusions, and (3) providing for the first time a comprehensive reference about Arab stock markets. The latter feature is valuable since there are few resources that provide accurate historical information about the markets of the Arab Region. Using the Augmented Dickey Fuller (ADF) test and Johansen s Multivariate 3

4 Approach (JMA), the main result of this paper is the co-integration found between the following pairs of countries: Jordan and Tunisia, Jordan and Kuwait, Jordan and USA, Kuwait and Tunisia, Kuwait and Saudi Arabia, Kuwait and USA, Morocco and USA. Hence, we can conclude that new opportunities to diversify and lower investment risks can be provided by incorporating some Arab markets in the investor s portfolio. The next section presents a general overview of globalization, financial integration and discusses how Arab stock markets are trying to face the trend of globalization, with special focus on their strengths and weaknesses. Section III presents a literature review on previous studies that are relevant to this project. Section IV describes the data used, its sources, and grouping in addition to the methodology applied for correction of infrequent trading and for co-integration testing. Section V presents the empirical results relating to the co-integration analysis. Finally, Section VI provides the overall conclusions and recommendations. II. Globalization and Investment in the Arab World Some researchers suggest that globalization pushes investors to make more diverse and more rational decisions concerning their investment portfolios, while others argue that globalization has been a great threat to the benefits of diversification. Some researchers believe that the increased correlation among different countries has diminished the benefits that could be realized from diversification. The October 1987 crash of US financial markets led to the gloom and doom in many financial markets around the world. Other financial disasters, such as the recent recession in the Japanese market, and the financial crisis in the emerging markets in mid 1998, indicate certain difficulties for financial institutions investing globally. On the other hand, advocates of globalization cite how the collapse of Argentina in the mid 90s and the possibility of contagion to other Latin American Markets 4

5 coincided with booming Asian markets, particularly the soaring Korean stock market index. The Malaysia, Thailand, and China indices have all been moving higher as well ( Azzam 1997). They also argue that the globalization of financial markets has increased the inflows to some countries, created new opportunities to enhance investments, shared new technologies, raised production levels, created new jobs, accelerated growth, and helped reduce the volatility of international portfolios, provided only that the underlying investments are imperfectly correlated. According to Rouwenhorst (2002), an equally-weighted internationally diversified portfolio of both core and emerging markets experienced only 35% of the volatility of individual markets, a risk reduction of 65%. According to Azzam (1997), prior to 1970, the securities traded in the US stock and bond markets comprised of 65% of all securities available in world capital markets. More recently, US security markets represent a smaller proportion of the total world capital market, and it is likely that this trend will continue. Thus, investors have a propensity to seek opportunities across the world and sectors. Unfortunately, Arab markets have not benefited much from the surge in capital flows toward the emerging markets in the past 2, though things picked up recently. According to international standards, Arab Stock Markets are still considered new. Four of them 3 just started operating over the last two decades. Others, like Egypt and Morocco, have been in existence for much longer but, until recently, their level of activity was insignificant. Table 1 presents a summary data on eleven Arab stock markets. For each sampled country, the date for starting market activities, whether foreigners can trade domestic stocks, and the level of modernization in the trading system are shown. 2 The Arab region attracted less than 2% of these flows in Namely, Bahrain, Jordan, Oman, and Saudi Arabia. 5

6 Country Starting Date Foreign for First Participation Domestic Stock Market Saudi Arabia 1935 Access open to GCC citizens, but limited foreign access Bahrain 1957 BSE (1987) Non-GCC citizens and expatriates can own shares on BSE Oman MSM (1988) Foreigners can own 65% of the company shares (sometimes 100%) Kuwait 1950s KSE (1983) Table 1. A Summary Data on Eleven Arab Stock Markets Level of Modernization Other Comments State-of-the-Art System: - Supervised by Saudi Arabian Monetary Agency (SAMA) since 1985 Electronic Securities - The government introduced new laws to encourage foreign investment Information Systems (ESIS) - Large market (over 33% of GDP) Electronic trading system - GCC stocks may be listed on BSE - Government is encouraging new joint-stock companies Limited foreign access Fully computerized stocktrading system Egypt ASE and CSE Limited foreign access Electronic stock-trading (1890) system Jordan AFM (1976) Up to 50% Electronic stock-trading system Lebanon BSE (Mid 30s) Open Electronic stock-trading system (Super CAC French system) Morocco CSE () Open Electronic stock-trading system Tunisia TSE (1989) Up to 49% Electronic stock-trading system UAE ASE (1998) Open Electronic stock-trading system Qatar DSE (1995) Restricted Electronic stock-trading system Traditional - In 1996, cross-listing agreements were signed with the Bahraini and Kuwaiti stock exchanges - Small market - First major crisis in Second major crisis is the collapse of Souk El Manakh ((1982) - Third crisis: closing for 28 months starting with Iraqi invasion in August Small market - Cross-listing agreements with Egypt and Lebanon - Largest number of listed stocks - Many economic reforms - Liquid - Sensitive to by the Israeli-Arab conflict - Stopped from 1983 till 1996 due to civil war - Small - Privatization of CSE in Active - Illiquid and overpriced securities (Azzam 1997) - Fast growing market - Growing market 6

7 Arab countries have taken action in recent years to develop their financial securities market. However, the issuance of securities instead of bank loans as a principle-financing vehicle has become more urgent in recent years. The change in attitude is caused by the drive for privatization that is gaining momentum in a number of Arab countries. Most Arab countries have realized the importance of developing their own securities market, primarily to channel their domestic savings and to bolster foreign investors confidence in their economic and financial viability. Arab markets have tried to curtail capital flight by providing competitive financial instruments and attracting foreign portfolio capital. Arab countries have recognized the benefits to be reaped from globalization of financial markets and their enhanced integration. They are unwilling to forgo these benefits and are keen to be inline with international standards. Bahrain, Egypt, and Oman have adopted the recommendations of the group of thirty and the International Organization for the Standardization in order to standardize procedures and improve the overall quality of clearing and settlement (ESCWA 1999). Besides, some of the main constraining factors, especially in the GCC countries, have been high volatility in market prices, undesirable practices and structural inadequacies. This has frequently led to severe attrition of investor confidence plus occasionally hampering sustained growth in the markets. Different aspects of the nature of supply and demand, such as the quality and price of company issues and excessive speculation for short-term capital gain, create grounds for some concern. Securities finance represents a further challenge for carefully coordinated development strategies. By emerging market standards, Arab Stock markets are still small, accounting for 6.5 % of the total market capitalization of the 38 emerging markets in Asia, Latin 7

8 America, Africa and eastern Europe and around 0.6% of the world s total stock market capitalization of around $30 b. in 2001(Daily Star 2002). Total capitalization of the 12 Arab stock markets stood at $175 b. at the end of 2001, with the Saudi stock market, the largest in the region, accounting for around 40% of the total or $70 b. By comparison, total capitalization of one company, Citigroup, was $160 b. in The region s stock market suffers a lack in depth and liquidity, and therefore is not able to absorb even a small percentage of Arab funds invested overseas. Overall, the supply of corporate securities, including shares, papers and bonds, in the Arab markets, remains generally limited, relative to the GDP of the economies. Arab stock markets are hindered by the domination of family owned businesses, the control of the public sector over a wide range of economic activities, and finally, by the small number of quoted companies and the limited shares available for trading, which has led to thin and non-liquid financial markets. Traditionally, investing in the Middle East has been speculative in nature and not based on sector-based studies and fundamental analysis. This is partly due to the fact that accurate and timely information on fundamental economic performance as well as information on local companies and stock markets is limited in most Arab countries. The lack of information is due in part to a profound desire for privacy which is a characteristic trait of this region. Foreign direct investments (FDI) into the Arab world during 2001 accounted for only $5.9 b., which is 2.9 % of developing world s investment flows. In addition, most Arab countries have been suffering from bureaucratic controls, underdeveloped capital markets, and weak legal structure. Insufficient transparency and insider trading are other vulnerabilities of Arab stock markets. We still have companies listed on the region s stock exchanges that do not issue quarterly 8

9 financial figures 4, and some of them do not release audited annual results in a timely manner. Several Arab countries have weaknesses in regulation and supervision of financial systems, and in the enforcement of laws against insider trading. An improperly regulated stock market becomes a speculative paradise. In fact, the majority of Arab countries have been suffering from successive budget and current account deficits, and swelling public debts for the past 15 years. The combined current account deficit of the Arab countries stood at $17.8 b. in 1995 and is growing. Whereas GCC countries 5 have had low levels of outstanding external debt, their internal debt has been on the rise, and annual debt service bills, among other things, have dampened their ability to control rising budgetary expenses. Another important factor that adversely affects the stock markets of the Arab countries is the turmoil and long periods of political instability witnessed by the Arab world. That s why we find this region dominated by political issues, national pride, territorial struggle, and military build up. In general, sporadic progress has been made in establishing, developing and reforming financial markets in the Arab region in recent years, including moving away from government controls, and directing economic activities toward growth. Some Arab countries made substantially greater progress, with varying reforms to further the developments of their financial markets. In fact, investors are very sensitive to political uncertainty. Countries in turmoil have little interest in establishing stock markets. Even if a market exists, trading activity and stock prices may decline or blackout altogether. On the international front, Arab countries have started making tentative steps to tap the international capital markets with great success. Many sovereign and corporate 4 Starting in 2003, in an effort to increase the level of disclosure of listed companies, the Doha Stock Market not only required them to publish annual audited results but also quarterly results. 5 GCC countries consist of Saudi Arabia, Kuwait, UAE, Oman, Bahrain, and Qatar. 9

10 debt and equity issues of Lebanon, Egypt, Morocco, Jordan, Oman, and Tunisia proved that the appetite for the MENA region is very strong. The latest statistics showed that the net private capital flows to the MENA region in 1997 increased 120% reaching more than $14 b. This occurred despite a significant drop in capital inflows to emerging markets in 1997 reaching $200 b., down from $295 b. in Standard & Poor s raised Qatar s long-term foreign-currency sovereign credit and senior unsecured debt ratings to A+ making Qatar high in the investment grade ratings, which allow it access to more potential investors than speculative grade ratings of BB+ or below. Syria is looking to open its first stock exchange as part of an economic reform package aimed at forming a balanced association agreement with the European Union including the free movement of goods and capital, and financial, economic and political cooperation; it is also considering joining the World Trade Organization (WTO). In what follows, a summary of the major capital markets developments in Arab countries in 2003 is presented. Equity markets have surged in almost all ESCWA countries 7 with an average increase in 2003 of 85% over the 2002 level (Refer to table 2.1 below). Two factors contributed to this trend: first, the shift of investors focus from international markets, which have been in decline since 2000, to the regional market; second, low interest rates on deposits. Capital that has been repatriated from overseas, rose in the past two years adding to the stock of excess liquidity in the region. Latest data from the Bank of International Settlement show that Saudi and other Gulf citizens have been moving part of their funds out of the international banking centers. Starting mid-2001, Arab investors have been diversifying their international portfolios in response to falling interest rates, tumbling equity markets and threats facing the 6 Inter-Arab Investment Guarantee Corporation ESCWA countries are : Jordan, Palestine, Syria, Iraq, Egypt, Lebanon, Yemen, UAE, Qatar, Bahrain, Oman, Kuwait and Saudi Arabia. 10

11 security of their investments abroad. For example, total deposits at Saudi banks rose by 7.5% from $85.3 b. at the end of 2002 to $91.7 b. by August Regional integration necessitates developed capital markets and the idea of a common regional stock exchange may prove necessary at some point in the near future. The rise in the stock markets together with the solid upturn in real estate prices boosted the wealth effect of consumers and reflected positively on domestic demand and internal liquidity. On the other hand, continuing fiscal deficits and rising imports of goods and services in GCC countries combined with workers remittances transferred out of the Gulf region, have led to a fall in saving and investment in that region. This higher capitalization indicates that restructuring and privatization efforts are well under way in the region. For example, the privatization of utilities has taken precedence in some GCC countries, like Oman, Qatar and UAE. They depend on their respective private sectors and foreign investors to finance and operate utility projects, while Saudi Arabia is in the process of privatizing telecommunications. 8 New incentives have been used in GCC countries to attract foreign investment, i.e., liberalized regulations and laws that govern foreign capital inflows. For example, in Saudi Arabia, a new capital market law gives way to a greater role for the private sector in the future investment growth and aims at improving the investment environment which in turn develops the largest capital market in the Arab region for local as well as foreign investors. This new law is intended to enhance transparency and accountability, increase competition in the brokerage services sector and attract foreign investment. 9 At present, only Saudi banks can offer brokerage services, and only individuals from Gulf Arab states can trade directly on the Saudi market. The new law 8 Fasano, U. and Z. Iqbal, GCC countries: from oil dependence to diversification, IMF, Washington, Saudi Arabia approves long-awaited stock exchange law, MEES 46:25, 23 June

12 will license non-bank financial intermediaries to authorize the offering of securities to the public. Kuwait enacted a new law, which allows 100% foreign ownership of firms and grants them a 10-year grace period of tax payments. The law is seen as an invitation by the Kuwaiti government to foreign investors after the Iraq war. However, major tax reforms have to be carried out before a change of foreign investment occurs. 10 In an effort to attract foreign investment to Egypt, a new labor law authorizes companies to hire workers with more flexible conditions, allowing termination of employment for poor performance but stipulates appropriate compensation to be paid in this event. The market capitalization for Lebanon and Egypt were small relative to their national income. The ratio of market capitalization to the total ESCWA GDP was close to 65% for 2003, which is considerably less than emerging markets. The total trading turnover has more than doubled reaching 52.6b. traded shares this year compared to levels recorded in 2002 (see table 2.1). The Arab Monetary Fund published a website showing the activity of the fourteen participating Arab stock market including nine ESCWA member countries. Their data shows a 114.4% increase in the number of traded shares during the second quarter of 2003 compared to the first quarter of The value of traded shares increased to $63b. in The aggregate share price index for the ESCWA region increased from 11,934 points in 2002 to 18,746 points in 2003, up by 57% in 2003 (see table 2.2). The Lebanese bourse was the only ESCWA stock exchange that posted losses in the first ten months of Kuwait grants foreign investors 10 years tax exemption, MEES 46:47, 24 November Al Shall market report: performance of the Arab stock markets Q2 2003, August

13 Table 2.1 Major Arab capital markets indicators Countries Mkt Capitalization ($mn) Value of Shares Traded ($mn) Jordan 5, , Palestine n/a n/a n/a n/a n/a n/a n/a n/a Lebanon 2, , Egypt 24, , UAE n/a n/a n/a 363 Bahrain 6, , Saudi Arabia Oman n/a n/a Qatar Kuwait 18, , Morocco 15, , , , n/a 1, , n/a Tunisia 2, , , , , , , GCC Table 2.2 Major Arab capital markets indicators Countries No. Shares Traded (millions) Price Index No. Cos Listed Jordan Palestine n/a n/a n/a n/a n/a n/a n/a Lebanon Egypt UAE Bahrain Saudi Arab Oman n/a n/a Qatar Kuwait Morocco n/a n/a n/a Tunisia GCC Total Sources: Central banks, ministries of finance, stock exchanges and Arab Monetary Fund websites, ESCWA surveys of Economic and Social Developments in the ESCWA Region, 2001 and Note: Numbers for several years for Palestine and for 2003 Morocco were not available; this fact understates the total for all values in the Table 2. 13

14 III. Literature Review Many researchers have investigated the short and long-term interrelationships among worldwide financial markets. The primary focus of empirical work has been the G-7 and some industrialized countries. In brief, results show that markets of Japan, US, UK, and Germany drive the fluctuations in the markets of Taiwan, South Korea, Singapore, and Hong (Masih and Masih, 1997); markets of Hong Kong, Singapore, Korea and Taiwan are not co-integrated among themselves but are co-integrated with the G-7 countries (Kwan et al., 1995); the North American markets have been able to predict the European and Pacific Rim s stock-market movements, whereas the Pacific Rim s markets can explain only about 3% of the North American return variability (Cheung et al., 1997); and that global events such as October 1987 crash and the Gulf War impacted many countries, and that country specific volatility such in Mexico are reflected in domestic and regional indices (Aggarwal et al., 1999). On another front, it was observed in Business Week (2000) that the correlation between the S&P and the Morgan Stanley Capital-International-Europe-Asia-and-Far East (EAFA) has increased from 25% in 1995 to 78% in This increase is explained by three possible reasons: the increase in mergers and acquisitions between USA and the Europe Asia and Far East countries, the technological advances that are shortening the distances and making it easier for investors to trace their investments anywhere over the globe, and the growing importance of high tech companies that are characterized by their global reach. Ratanapakorn and Sharma (2002) use the co-integration analysis and Granger causality test and the innovative analysis to analyze the short-run and long-run relationships among stock indices of the US, Europe, Latin America, and Eastern Europe-Middle East for the pre-asian crisis and for the crisis period. Although no long- 14

15 run relationship existed among these indices during the pre-asian crisis period, the crisis market an indirect influence of Asian markets on US markets through European markets. A paper by Butler and Joaquin (2002), however, illustrates that foreign stocks are no longer providing much of the benefits of diversification because they are moving in harmony with the US stocks. Yet, Popper and Coy (2002) and Kistner (1999) assured that the benefits from diversification could still be reaped but it is essential for the investors to continuously rebalance the asset allocation of their portfolio. On the side of Arab Stock Markets, Al-Rimawi (2001) addresses the specific juridical impact of Shari a (Islamic law) on capital markets, and surveys the securities and company laws in Jordan, Kuwait, and Oman. Another paper by Martin (1996) finds that developments in the financial markets indicate a growing trend towards global portfolio investment and a real investment value of the Arab Markets. In their test of market efficiency hypothesis (EMH) and the random walk hypothesis (RWH) using three emerging Gulf markets (Kuwait, Saudi Arabia, and Bahrain), Abraham, Seyyed, and Al Sakran (2002) correct their data for the infrequent trading problem, and thin trading problem that characterize these markets (using a modified version of Stoll and Whaley method suggested by Jokivuolle, 1995), and the confounded effect of the non-synchronous trading (applying the Beveridge and Nelson, 1981, decomposition to observed index level). Their results show that price changes are independent for all three markets. RWH could not be rejected in the Saudi Arabian and Bahraini markets. The Kuwaiti market, however, fails to follow the RWH even after the correction. With regard to methodology, earlier studies employed causality and correlation analysis to assess the relationship between the markets concerned, and suggest that 15

16 regressions based on trending time series data can be spurious. This problem of bogus regressions was further pursued by Granger and Newbold (1974) and Granger (1981), which led to the development of the concept of co-integration. Using this technique, Ratanapakron and Sharma (2002) find no long-run relationship exists among the US, Europe, Asia, Latin America and Eastern Europe- Middle East indices during the pre-asian crisis period. Copeland and Rensselaer (2000) report the lack of capital mobility for Chile and Uruguay among Latin America countries. The lack of relationship suggests opportunities for international diversification in these markets. Hence, this paper expands this type of analysis to the often neglected Arab stock markets. We use Jokivuolle(1995) and Abraham et al s (2002) methodology to adjust for infrequent trading, which is believed to be a common problem of Arab Stock Markets (Abraham et al, 2002). Then, following Ratanapakron and Sharma (2002), this paper tests the order of integration in each series of stock market indices using Dickey Fuller, ADF, Phillip and Perron unit root tests. After that, the Johansen test statistic is used to check the co-integration between major Arab Stock Markets, US Stock Market, and Emerging Stock Markets. IV. Data Description and Methodology This paper assesses the extent of co-movement among the Arab stock markets as well as with the US and the Emerging stock markets. Besides, the impact of globalization on the relation between these stock markets is illustrated. A. Data Sources The testing sample includes the returns of the U.S market, of the emerging markets and those of the Arab markets. The data of the U.S and the emerging markets 16

17 were taken from MSCI (Morgan Stanley Capital International) website which offers end-of day closing prices and yearly returns of its indices. This site is highly reliable 12 ; In fact, according to a survey conducted by Pension & Investments, over 90% of international equity assets in the U.S are benchmarked to the MSCI indices. Finding a reliable source for indices of the Arab stock markets was more challenging. These indices were collected using the Middle East Economic Digest (MEED) issues from the end of April 1997 to the end of September, It must be noted here that Morocco, which used to provide the CFG as its stock market index, started at the end of January 2002 using the MASI index instead. B. Data Description and Grouping 1. Benchmark Markets Index MSCI covers 27 emerging market country indices. MSCI classifies a country as an emerging one after evaluating factors such as gross domestic product per capita, local government regulations, perceived investment risk, foreign ownership limits and capital controls, or the general perception by the investment community when determining an emerging classification of a market. We have chosen two benchmark market indexes. The USA General Stock Market index and the Emerging Markets Free index (EMF). The EMF index contains the following twenty six emerging markets: Argentina, Brazil, Chile, China, Columbia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Jordan, Korea, Malaysia, Mexico, Morocco, Pakistan, Peru, Philippines, Poland, Russia, South Africa, Taiwan, 12 MSCI uses a consistent and transparent index construction and maintenance methodology ensuring accurate representation of each country s underlying industry group distribution and market capitalization. Its country index is constructed in the following way: every listed security in the market is identified, and the data on its price, outstanding shares, significant owners, free float and daily trading volumes are collected. The securities are then organized by industry group, and stocks are selected, targeting 60% coverage of market capitalization. MSCI publishes a family of equity and fixed income indices, in US dollars and local currencies that include developed and emerging markets. 17

18 Thailand, Turkey, and Venezuela. Both indexes are available from MSCI Morgan Stanley website. 2. Arab Stock Market Indices The stock market indices of the GCC countries: Saudi Arabia, Kuwait, UAE, Oman, Bahrain, and Qatar were used. In addition, the indices of the stock markets that provided data for our period of study were picked. These countries were: Lebanon, Egypt, Morocco, Jordan, and Tunisia. The final sample consisted of 845 observations. C. Methodology A major difficulty in interpreting the results from tests on thinly traded markets is the confounding effect of infrequent trading on the observed index. To separate the effects of infrequent trading, this paper applies a correction to the observed index by using the decomposition of the index by Beveridge and Nelson (1981) into its permanent and cyclical components. Let us denote by in period t and by 0 X t 0 X ) t the log of the observed index the log of the true unobserved index in the same period; be calculated based on Jokivuolle(1995) proposition that the permanent component of the log of the observed index equals the log of the true unobserved index. The permanent component 0 X ) t an infinite order MA process and can be written as : R t ) X 0 t T 0 = + X t Lim T j= t 1 ) 0 Rt ( j) ( T t) µ 0 X ) t will of the Beveridge and Nelson decomposition is (equation 1) ) where 0 ( j) is the optimal forecast of the return R 0 t+j made in time t and as shown by Beveridge and Nelson(1981) and 0 X ) t follows a random walk with a drift equal to the slope of the ARIMA process µ. 13 Following the notation in Jokivuolle(1995), if we let 13 For further information on the proof, please refer to Jokivuolle, Journal of Financial and Qualitative 18

19 0 = 0 t ) y t R µ be the adjusted forecast of the return, the permanent component can be re- ) T written as = + t 0 0 ) 0 X t X t Lim yt ( j) (equation 2) T j= 1 The decomposition procedure involves calculating the stock index return then identifying the underlying process for each of the observed log relatives using correlograms and partial correlograms. 14 After deciding the underlying process for the calculated returns, the estimated coefficients are plugged into the permanent component formula to come up with the corrected indices. The monthly returns are calculated according to the following formula: R t = Ln S 0 t Ln S 0 t-1, where R t stands for the observed index returns at time t, Ln S 0 t is the natural log of the observed (and corrected as in equation 2 above) index at time t, and Ln S 0 t-1 is the natural log of the observed index at time t-1. Critical differences between correlation and co-integration exist. Co-integration focuses on long run relationships between variables as well as the influence of one variable on the other, whereas correlation merely depicts a positive or negative association between two variables in the short run. The process of examining the cointegration between indices consists of the following steps: first, detecting nonstationarity was performed testing for unit roots (ADF) on the log of the calculated corrected index; second, the JMA co-integration test was executed using the approach developed by Johansen (1994). Distinguishing between stationary 15 and non-stationary 16 series is essential Analysis 30(3), September The testing software used here is Easy regression International (Easy Reg), which does a set of econometric tests. The software was developed by Bierens (1997) and can be downloaded for free from the Web. Easy Reg was used to find the parameters and the drift of the moving average process. 15 A stationary time series is a series that tends to return to its mean value and fluctuate around it within more or less a constant range, and thus is said to have a finite variance. 19

20 before conducting any co-integration tests. Not going through this process of distinguishing between stationary and non-stationary data can lead to serious problems of spurious regression whereby the results suggest that there are statistically significant long-run relation ships between the variables in the regression model when in fact all that is being obtained is evidence of contemporaneous correlations rather than meaningful causal relations. It should also be noted that co-integration results between non-stationary variables are valid only if these variables are integrated of the same order. Thus, testing the order of integration of the variables is a prerequisite of testing for co-integration. If a series has to be differenced d times before it becomes stationary 17, it is said to be integrated of order (d). Thus, stationary variables are said to be integrated of order (0) or I(0) variables 18 and they do not co-integrate with non-stationary variables. The ADF 19 test was used to test the stationarity of the data. This test is considered to be more accurate than simple Dickey Fuller test because it contains lagged terms to account for the fact that the underlying data generating process may be more complicated than a simple first-order autoregressive process (AR (1)). The lag length proposed by Akike Information Criterion (AIC), commonly used in studies applying the unit root tests, will be employed in this paper. Unit root tests often suffer from poor size and power properties. Thus it is necessary to conduct a number of simulations to make the result more accurate because the ADF test applied 16 A non-stationary series has a different mean at different points in time and its variance increases with the sample size or with time (here the concept of mean is not really applicable). 17 Usually one differencing is sufficient, and at most two. 18 Order of integration needs to be tested for each variable in the model to establish how many times the variable needs to be differenced before it results in a stationary series. This is done by testing for the unit roots found in the variable and its consequent differences until stationarity is attained. 19 The ADF chosen from the Easy Reg is that of the unit root with drift hypothesis. The test, recommended by Easy Reg, consists of testing the null hypothesis of non-stationarity against the alternative hypothesis of trend stationarity conducted at the 5% and 10% significance levels. Note that in practice the test tends to have low power and a failure to reject the null hypothesis does not automatically mean that the series is non-stationary. 20

21 to time series of modest sample size, like the one used in this paper, may suffer from distortion, requiring the p-value of the test to be simulated on the basis of the Gaussian AR(q) model. Next, we try to present the economic interpretation of co-integration. Consider two time series y t and x t, which are both of the same order of integration, i.e. they are both I(d). In general, any linear combination of the two series will also be of the same order I(d). For example, the residuals obtained from regressing y t on x t are I(d). 20 If y t and x t are linked to form an equilibrium relationship spanning the long-run, then even though the series themselves may contain stochastic trends, they will nevertheless move closely together in the long run and the difference between them will be stable. Therefore, the concept of co-integration represents the existence of a long-run equilibrium to which an economic system converges over time. Here, the residual can be defined as the disequilibrium error. In the short-run, the divergence between the series will vary with a boundary if the model is correctly specified. 21 Conventional regression analysis is only suitable if both time series variables are found to be stationary of the same order. However, for time series that are found to be non-stationary regular statistical tests lead to spurious regressions, but co-integration tests depict long-run relationships. Since co-integration tests can only be conducted among non-stationary variables of the same order of co-integration, two variables were considered not co-integrated when one was non-stationary and the other was. This approach consists of testing the null hypothesis of no co-integration(r=0), against the alternative hypothesis of co-integration (r=1). 20 If there exists a vector β, such that the disturbance term from the regression (u t = y t βx t ) is of a lower order of integration, that is I(d-b) where b>0, then Engle and Granger (1987) define y t and x t as cointegrated of order I(d,b). Thus, if y t and x t were both I(1), and u t ~ I(0), then the two series would be cointegrated of order CI(1,1). 21 The difference will be stationary, even though the series are non-stationary. 21

22 V. Empirical Results The data set consists of 65 months returns for 13 indices starting at the end of May 1997 and finishing at the end of September The ADF and the JMA tests conducted on the monthly returns of 11 Arab Stock market index, the USA General Stock Market Index and the EMF stock market index. The auto regressive order of all the countries is found to be zero. The drift, µ, is zero for all the countries except for Qatar it is equal to The mean is 1 for Jordan, Kuwait, and Qatar, and 2 for the rest of the countries. The ADF test of non-stationarity against trend stationarity in accordance with the necessary number of simulations was performed. A rejection of the null hypothesis implies that after the necessary number of simulations, the variable being tested was stationary, and therefore does not co-integrate with other variables. On the other hand, failing to reject the null hypothesis means that after the necessary simulations, the variable is non-stationary. Next, the first difference and the second difference of variables that had non-stationary returns were tested in order to determine their order of integration. Table 3 summarizes the results of the ADF tests conducted on the variables and on the first difference of non-stationary variables studied in this paper 22. Table 3 shows that Egypt, Oman, Lebanon and EMF had stationary variables, while Jordan, Kuwait, Morocco, Tunisia, Saudi Arabia and the USA were integrated of the first degree since their first differences were found stationary. After taking the first and second differencing, we find that Bahrain, Qatar and UAE had non-stationary first differences, and thus are integrated of order higher than one. Thus, it could be concluded that these three markets do not co-integrate with the other markets and they 22 ADF tests and the co-integration tests were performed on the returns of the indices without the correction for the infrequent trading. Results are available from the authors upon request. 22

23 Table 3. Order of Integration of the Sampled Markets Indices Regional or market Variable Properties First difference properties indices Optimal P P-Values Optimal P P-Values Order of Integration Jordan 4 Egypt 4 Kuwait 3 Bahrain 13 Oman 7 Qatar 11 Morocco 4 Tunisia 5 Lebanon 5 UAE 6 SA 2 EMF 14 USA * (Accept Ho) ** (Reject Ho) * (Accept Ho) * (Accept Ho) ** (Reject Ho) * (Accept Ho) * (Accept Ho) * (Accept Ho) ** (Reject Ho) * (Accept Ho) * (Accept Ho) * (Reject Ho) * (Accept Ho) 3 0.1* (Reject Ho) I(1) Inapplicable Inapplicable I(0) ** (Reject Ho) * (Accept Ho) I(1) Inapplicable Inapplicable I(0) * (Accept Ho) * (Reject Ho) ** (Reject Ho) undetermined yet undetermined yet I(1) I(1) Inapplicable Inapplicable I(0) * (Accept Ho) * (Reject Ho) undetermined yet I(1) Inapplicable Inapplicable I(0) ** (Reject Ho) I(1) * * Significance level 5% * Significance level 10% Configuration of the order of integration using ADF tests on the eleven Arab Stock markets and the two benchmark markets (the USA General Stock Market Index and the Emerging Market Free index, EMF, introduced by Morgan Stanley Capital International, MSCI). P-value represents the statistical significance of the optimal lag length P. The sampling period is 65 months extending from April 1997 till September will be dropped from subsequent analysis. Next, the JMA test was used to study the co-integration between the 13 markets 23

24 at hand. The AR model estimated for the purpose of conducting the test is that which contains intercept and time trends with the order of the model being chosen based on the Schwarz information criteria. Table 4 summarizes the co-integration relations between the U.S and the Arab stock markets (Panel A), and among Arab markets (Panel B). The US index returns, found non-stationary, co-integrates with Kuwait, Jordan and Morocco (but with low statistical significance, at 10%). The index, however, does not co-integrate with Egypt, Oman, and Lebanon (because of stationary returns). With regard to the co-integration of Bahrain, Qatar, UAE with the US, it was not possible to test this relationship because the unit root tests conducted revealed no conclusive results on their respective orders of cointegration. The remaining countries showed no results of co-integration with the US after the Johansen s test was conducted. The EMF index turned out to be stationary I(0) after conducting the ADF on the variable itself. Therefore, it could be concluded that there is no co-integration between the Emerging markets index and any of the Arab markets indices despite the fact that the Emerging markets index includes two Arab countries (Jordan, and Egypt). This finding may be due to the fact that Arab markets constitute only 6% of the emerging markets, and this constitutes less than 1% of the G7 markets. It could also be due to the weak economic fundamentals and corporate earnings, which create a negative impression for investors in addition to lack of liquidity, inadequate transparency, absence of commercial courts to settle business disputes and investment irregularities such as insider trading as well as poor reporting standards by public companies. Further, the Arab stock market performance has been disappointing during the last decade except for some stock markets that are struggling to improve their situation. No cointegration is found either between the US and Emerging markets. 24

25 Table 4. Co-integration between Arab stock markets (integrated of order1) and the US and Emerging Market Indices, and Among Arab Markets Panel A: Arab Stock Markets Test Statistic Cointegration with USA Jordan 16.8 Cointegrating* Kuwait 17.0 Cointegrating* Morocco 16.8 Cointegrating* Egypt, Oman, and Lebanon Nm No conintegration because of stationary returns Bahrain, Qatar, and UAE Nm Cointegration is not possible because of inconclusive unit root tests Saudi Arabia and Tunisia Nm No cointegration Panel B: Arab Stock Markets Test Statistic Cointegration Properties Jordan & Kuwait 16.9 cointegrating* Jordan & Morocco 9.6 no cointegration Jordan & Tunisia 24.1 cointegrating** Jordan & Saudi Arabia 10.1 no cointegration Kuwait & Morocco 12.8 no cointegration Kuwait & Tunisia 24.4 cointegrating** Kuwait & Saudi Arabia 19 cointegrating* Morocco & Tunisia 9.3 no cointegration Morocco & Saudi Arabia 7.3 no cointegration Tunisia & Saudi Arabia 14.3 no cointegration * cointegrating at 10%, critical value= 16.9 (+ or -) 0.3. ** cointegrating at 5%, critical value = 19.2 Tests of cointegration using the JMA method. Panel A shows the results of cointegration tests conducted between the eleven Arab Stock markets and each of the two benchmark markets (the USA General Stock Market Index and the Emerging Market Free index, EMF, introduced by Morgan Stanley Capital International, MSCI), and Panel B shows cointegration results among Arab markets. JMA statistics are presented along with cointegration properties (i.e., cointegrated or not cointegrated). Asterisks represent the level of statistical significance. The sampling period is 65 months extending from April 1997 till September A closer look at the cointegration relationship found between Morocco, Jordan, and Kuwait with US markets, this result is not very surprising especially that these three markets are among the most developed markets of the region and have had impressive market capitalization growth (see Jordan Times, 2003). This growth is due 25

26 to various reasons, one of which is the fact that Kuwait, Morocco, and Jordan have joined the World Trade Organization in 1995 for the first two countries and in 2000 for Jordan. Further analysis of Jordan shows that it is hosting the most successful privatization program in the region supported by the U.S. Agency for International Development, generating revenues so far of nearly 12 percent of gross domestic product (GDP), creating more than 6,000 jobs, and providing benefits to consumers in the form of declining telecommunications rates, shorter waits for telephone lines, and, in the transportation sector, higher numbers of available buses leading to higher levels of rider-ship, and drastic improvement in education and human development (see The World Bank has already invested over US $2 b. in the social and economic development of the country and in improving the international infrastructure of the country as well as its public sector expenditures management, and intends to invest another US $300 to US $400 m. in Jordan over the next three years. Also, the International Finance Corporation (IFC) is very much involved in nurturing the private sector. With regard to Morocco, it signed a bilateral accord on commerce and investments in 1995, which resulted in a steadfast growth in Moroccan-US economic ties. In 1999, a donation agreement between Morocco and USA has also served to increase US foreign direct investments share in Morocco in terms of technology transfer and trade exchanges between the two countries. These economic and commercial ties were reinforced during the April 2002 talks between the American and Moroccan officials. The Moroccan-American ties were expanded in 2001 to include the other two Maghreban countries, Algeria and Tunisia. This partnership is said to target breaking the European monopoly in the Maghreb zone. The initiative revolves around 26