1. East Asian Equity Markets, Financial Crisis, and the Japanese Currency Stephen Yan-leung Cheung Professor of Finance (Chair) Department of Economics and Finance City University of Hong Kong July 24, 2002

2. East Asian Equity Markets, Financial Crisis and the Japanese Currency 2 Agenda 1. Motivations 2. Objectives 3. Data 4. Methodology and Results 5. Conclusions

3. East Asian Equity Markets, Financial Crisis and the Japanese Currency 3 Motivations a. Yen/ US volatility Yen/ US was very volatile during the last decade From 80 Yen/US to 147 Yen/US Yen’s depreciation reduce Asia’s trade deficit with Japan from an annual deficit of $59 billion in 1995-97 to $ 19 billion in 2001

4. East Asian Equity Markets, Financial Crisis and the Japanese Currency 4 Yen/USD movement during 1990-2002 Source: DataStream

5. East Asian Equity Markets, Financial Crisis and the Japanese Currency 5 Motivations b. Interest rate differential Low interest rate in Japan and Yen’s depreciation Yen carry trade looked lucrative

6. East Asian Equity Markets, Financial Crisis and the Japanese Currency 6 Interest rates in Asian countries

7. East Asian Equity Markets, Financial Crisis and the Japanese Currency 7 Motivations c. Trade deficit Yen’s depreciation has positive effect on Japan’s economy, e.g. reduced Asia’s trade deficit with Japan from an annual deficit of $59 billion in 1995-97 to $19 billion in 2001. (duplicated, pls refer point (a)!!!) Had tremendous pressure on Korean and Taiwanese exports On 15 June 1998, Yen hit 14 Yen/US Finance Minister of China expressed that pressure for a devaluation of the Yuan was growing There was a fear of another round of competitive devaluation. Japan used to be a growth engine, fear on Asian economies.

8. East Asian Equity Markets, Financial Crisis and the Japanese Currency 8 Asian stock indices and Dollar/Yen exchange rate

9. East Asian Equity Markets, Financial Crisis and the Japanese Currency 9 Motivations  Asian emerging markets, good investment opportunities before Asian Crisis (Levy and Sarnat, 1970; Solnik, 1974)  US market, the leading market (Cha and Cheung, 1998; Cheung and Ng, 1996)  The Change in information transmission mechanism after crisis (Cha and Cheung, 1998; Tuluca and Zwick, 2001)

10. East Asian Equity Markets, Financial Crisis and the Japanese Currency 10 Objectives 1. Study the information structure changes between the equity markets in the US and four East Asian economies during the Asian crisis; and 2. Examine the impacts of Japanese currency movements on these four East Asian economies

11. East Asian Equity Markets, Financial Crisis and the Japanese Currency 11 Data Daily logarithmic returns:  Hong Kong  Korea  Singapore  Taiwan  US Sample period:  Pre-crisis period: January 1995 – June 1997  Crisis period: July 1997 – June 2000  Post-crisis period: July 2000 – July 2001

12. East Asian Equity Markets, Financial Crisis and the Japanese Currency 12 Methodology and results Stationarity 1. Dickey-Fuller test: - all stock indices are I(1) processes 2. Johansen cointegration test on the indices of the US and four Asian economies : - Pre-crisis period: pairwise cointegrated - Crisis and post-crisis period: no cointegration - Action: include an error correction term for the pre- crisis period only

13. East Asian Equity Markets, Financial Crisis and the Japanese Currency 13 Table 1.Unit Root Test Results

14. East Asian Equity Markets, Financial Crisis and the Japanese Currency 14 Interaction pattern Causality test: - decide the lead-lag relationship between 2 stock indices Hypothesis 1: The US leads the East Asian Economies? X t = C +  j=1, …,k  j X t-j +  j=1, …,n  j Y t-j +  t where X t = Return on one of East Asian market indexes at time t, as measured by first log differences Y t = the return on the US stock index - Causality: using joint significance of  j 's to test whether the lagged values of Y t provide additional explanatory power for X t after controlling for X t 's own history.

15. East Asian Equity Markets, Financial Crisis and the Japanese Currency 15 Interaction pattern Hypothesis 2: The East Asian Economies lead the US? Y t = C +  j=1,…,k  j Y t-j +  j=0,…,n  j X t-j +  j=1,…,m  j S t-j +  t Note: Second summation index j starts from 0 instead of 1, because the US and East Asian markets operate in different time zones GARCH effects: - the error term and lagged dependent variables are not independent - Action: - maximum likelihood procedure - construct the likelihood ratio statistic to test the hypothesis that  j s are zero

16. East Asian Equity Markets, Financial Crisis and the Japanese Currency 16 Interaction pattern Results:  The US leads the East Asian Economies? - Pre-crisis period: only leads Hong Kong and Singapore - Crisis and Post-crisis period: all - Error correction term is significant in all cases - these East Asian markets do respond to deviations from the cointegrating relationships  The East Asian Economies leads the US? - Pre-crisis period: all except Taiwan - Crisis period: all - Post-crisis period: NO - Error correction term is NOT significant

17. East Asian Equity Markets, Financial Crisis and the Japanese Currency 17 Table 2.Causality Test Results

18. East Asian Equity Markets, Financial Crisis and the Japanese Currency 18 Effects of the Japanese Currency Methodology: - Augment with an exchange rate term X t = C +  j=1,…,k  j X t-j +  j=1,…,n  j Y t-j +  j=1,…,m  j S t-j +  t Y t = C +  j=1,…,k  j Y t-j +  j=0,…,n  j X t-j +  j=1,…,m  j S t-j +  t where S t-j = daily dollar-yen exchange rate in first log differences

19. East Asian Equity Markets, Financial Crisis and the Japanese Currency 19 Effects of the Japanese Currency Results: The Japanese currency affects 4 Asian economies? - No material effects on the significance of  j 's and the error correction term - Pre-crisis period: Hong Kong only - Crisis period: all - Post-crisis period: NO - Entire period: some - yield spurious inferences about market interactions - provide erroneous information for making investment and portfolio management decisions

20. East Asian Equity Markets, Financial Crisis and the Japanese Currency 20 Effects of the Japanese Currency Robustness of the Yen effect:  Transform the equity return data from local currency units to returns in the US dollar  Similar result is generated Japanese currency as a proxy of economic condition?  Include the return on the Japanese Nikkei 225 index - to test if its presence would render the yen variable insignificant - Result: NO

21. East Asian Equity Markets, Financial Crisis and the Japanese Currency 21 Table 3.The Japanese Currency Effect

22. East Asian Equity Markets, Financial Crisis and the Japanese Currency 22 Conclusions  Confirms the dominant role of the US market in the East Asian equity markets  Information structure during the crisis period is different from the non-crisis periods.  The Japanese currency is found to affect these equity markets during the crisis period, but disappears in the post-crisis sample.

23. East Asian Equity Markets, Financial Crisis and the Japanese Currency 23 Conclusions Implications of the changing causal relationship :  Academia: - warrant a detailed study on information flow and propagation mechanisms under different market conditions  Investment community: - different investment strategies should be pursued under different market conditions - the use of long sample data may yield obscure and even erroneous information on market interactions.

24. Thank You