The phenomenon of global stock market contagion

A Srikanth

Men, it has been well said think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.

Charles Mackay

THE WORLD markets catch cold when the US market sneezes. The recent reaction of the world markets to the steep fall in Nasdaq is a case in point. The 357-point (9.70 per cent) drop in Nasdaq on April 14 resulted in the Bombay Stock Exchange Sensex losing 291 points on April 17.

The impact is not limited to the Indian market. Most South-East Asian markets too felt the shock-waves of the Nasdaq crash. On April 17, when the market reopened after the weekend, Japan's Nikkei lost 1,426 points (6.98 per cent), Hong Kong's Hang Seng index 1,380 points (8.54 per cent) and Singapore's STI index 190 points (8.68 per cent). The European markets too reacted adversely to the Nasdaq fall.

In the same way, the recovery on Nasdaq on April 17 and 18 reversed the trends in most South-East Asian and European markets (except India) the next day. In India, the impact of the Nasdaq crash seems far from over as the Sensex lost a further 135 points on Tuesday and 79.66 points on Wednesday. A similar contagion effect was observed when the Dow Jones index crashed in October 1997.

The phenomenon of global stock market contagion is now too familiar and serious to ignore and has become an integral part of the stock market activity. International spread of a financial crisis is no new phenomenon and dates back to the Mississippi and the South Sea bubbles. The collapse of the Mississippi scheme in the Netherlands during 1719-1720 led to the quick demise of the South Sea Company in England within one year in 1720.

The impact of the October 1987 crash was even more widespread. The 21.50 per cent fall in the Dow resulted in a 44 per cent decline in Australia, 22.20 per cent in Canada, 21.70 per cent in the UK, 18.60 per cent in France and 17.70 per cent in Germany. This is despite the fact that the indicators of economic conditions varied widely among the countries. Surprisingly, the impact was very little in the Italian and the Japanese markets.

However, the contagion effect has become more pronounced in recent years because of the rapid global economic integration. It may also be observed that the phenomenon of global stock market contagion always comes for debate only when a major crisis hits the US market.

In this context, it is interesting to look at the nature of the long-term relationship between the US and markets around the world. Empirical analysis abroad has shown that the average correlation between the US and other foreign markets (the UK, France, Germany, Switzerland, Japan and East-Asian markets) between 1958 to 1995 was around 0.40. It is possible that the correlation would have gone up over the last five years. Yet, it is not high enough to say that the global markets are fully inter-connected.

Other works of research have shown that while the stock markets of Hong Kong, India, Korea and Malaysia share a long-term relationship with the US market, that of Indonesia, the Philippines and Singapore are linked to the bourses of Japan. But the extent of this correlation is weak enough for each market to remain independent and have a mind of its own.

International correlations for stock fluctuate wildly over time. It has also been found that correlations increase in periods of high volatility and at times of market crashes. That is, international markets move together more closely during periods of big declines than they do at other times. They all fall together but do not rise in unison. Analysis of the relation between the Nasdaq and the Dow Jones indices and the Sensex seems to confirm this.

The relationship between the markets was studied since January 1999 till date. The period is relevant in the sense that both Infosys Technologies (March 1999) and Satyam Infoway (October 1999) got listed on Nasdaq. Though the extent of correlation between Nasdaq and the Sensex rose subsequent to the listing of these stocks, the movement between the indices have been quite close during March-April 1999. Again since August 1999, the correlation between the two indices has been quite high (see graph).

Apart from accounting for the listing of Infosys Technologies and Satyam Infoway, the period of high correlation also coincided with periods of high volatility both the in the US and the Indian markets (see Business Line, April 9, 2000 for a story about increase in volatility). A similar analysis of the Infosys Technologies stock both at Nasdaq and in the Indian market conforms the above trend.

The Infosys Technologies stock was not only as volatile as the Sensex, its correlation with the US stock was also found to be high during these periods of high volatility. However, the correlation between the US and the Indian stock of Infosys Technologies was not as strong as between the Nasdaq index and the Sensex. This means that in times of high volatility, the Sensex was reacting more to the Nasdaq movement as a whole than that of the Infosys Technologies stock alone.

One implication of this result is that it could undermine the logic behind international portfolio diversification. If the benefits of diversification are not available when it is needed most, there would seem to be little point in diversification, in the first place.

It is equally interesting to know the driving force behind the financial contagion. To some extent the integration of the global economies has a role to play. Arbitrage activity in commodity and security markets along with the dynamics of the currency market are important forces behind international propagation of crisis.

Cross-border investments and withdrawals was an important cause for the burst of the Mississippi Bubble. Expansion of production outside Europe during the First World War that proved excessive at 1925 prices; financial complications of reparations and war debt; badly set exchange rates, recycling of German reparations by American private lending to German corporations, reduction of interest rates in New York to assist Britain stabilise its pound-sterling were some of the international causes for the 1929 Crash.

The attitudes of the foreign mutual funds and the FIIs also matter. Since 1980, the net inflows of FDI and portfolio investments to developing economies have been on the rise. While the developing economies are issuing more international debt than before, a growing pool of institutionally-managed funds is investing abroad. These linkages come into play especially during times of crisis. As the FIIs and the foreign mutual funds rebalance their portfolios across countries at such times, it results in international financial contagion. This was partly responsible for the Asian crisis.

More than anything else, psychological factors seem to be playing an increasingly important role. Surveys conducted after market crashes abroad have shown that investors react to big price drops more than any other news. The sheer force of the impact of a big price drop creates panic among investors. Moreover nearly 67 per cent of the individual investors and 64 per cent of the institutional investors in the survey agreed that it was investors psychology which has been driving market declines.

In panic situations, lack of information encourages herd behaviour among investors. Disposal of stock by one investor is assumed to be based on news that is not yet known, so that investors interpret this action as a signal to sell their holdings. Lack of information also encourages investors to take poor performance in one market as a signal that bad news is imminent in other markets too. The fact that the poor performance and the consequent fall of the net stocks in the US was interpreted as bad news for the entire Indian technology sector is a case in point.