Understanding Market Inefficiency in the East Asian Region during Times of Crisis.

• Author: Morales, Lucia
• Position: Asian Financial Crisis and Global Financial Crisis - Report

1. Introduction

   Since the 1990s, the East Asian region has been exposed to two major episodes of financial turmoil that stirred uncertainty, namely the 1997-98 Asian Financial Crisis (AFC), and the 2007-09 Global Financial Crisis (GFC). High levels of volatility in financial markets are a source of major concern among market participants (investors, regulators, governments and market analysts) due to the magnitude of the damage and the socio-economic hardship that they can cause. Increasing levels of market uncertainty have a negative impact on investors' levels of confidence; they undermine the efficient allocation of resources and ultimately cause significant delays in terms of investment decisions. At the time of crisis, the circulation of liquidity deteriorates in a significant manner, placing major restrictions on economic activities and disrupting regional and international financial systems. Noteworthy delays are caused by the need of introducing changes on already designed investment portfolios with the aim of incorporating appropriate assessments on market uncertainty and increasing levels of risk to counteract negative effects on the overall investment portfolio. When volatility levels are identified to be highly persistent and exhibit clustering behaviour, past volatility can be used to construct forecasts on future volatility, a behaviour in clear contradiction with the basic principles of efficient markets, in which forecasting abilities are not considered to be plausible. In addition, periods of relative tranquillity, when stock markets are considered to be stable, can be followed by intervals of high instability due to regional or global events, leading to a change of dynamics of market interlinkages.

   Even after decades of empirical investigation, little is known about differences in the degree of efficiency across markets. Equally little is known about the underlying factors that contribute to greater stock market efficiency in the context of significant market uncertainty associated with severe periods of market disruption. This is an issue explored in this study by looking at the inefficiencies of individual markets during two major crisis events in the Asian region and by analysing whether the dynamics of individual markets have been significantly affected.

   The literature indicates that the highest levels of inefficiency are registered during times of crisis, a state of affairs that might be justified by heavy government intervention seeking to control the behaviour of markets. These actions could end up introducing predictable patterns in market dynamics, and as a result they could undermine their efficiency in the context of the Efficient Market Hypothesis. In the finance literature, an efficient market is one in which stock prices fully reflect all available information, thereby leading to the efficient allocation of scarce capital resources (Samuelson 1965; Fama 1965, 1970, 1991). Hence, market inefficiency could seriously limit the ability of the stock market to allocate funds to the most productive sectors of the economy, potentially hampering long-term growth. Consequently, a financial system that is efficient lays the economic foundations for public policy intervention in the economy and its stock markets, but at the same time it raises concerns regarding the limits of this intervention and on how resource allocation can turn up being affected by governments' own interests in terms of capital provisions. Market interventions could lead to the enhancement of market inefficiencies, an argument that is supported by studies finding significant inefficiency levels during periods of crisis (Cajueiro and Tabak 2004, 2005a, 2005b; Lim 2008). Therefore, a study examining market efficiency during periods of crisis is needed in the Asian context, as it will help gain further understanding of market dynamics and how they are affected by financial uncertainty. Moreover, the study seeks to identify if Asian markets are exhibiting different dynamics as their economies mature and become more integrated.

   Cognizant of the relevance of understanding how global and regional events affect financial markets, the study proposes a comparative analysis of stock market performance and efficiency during times of extraordinary uncertainty such as those associated with crises periods. The goal is to examine the volatility behaviour of major stock markets in the East Asian region (namely Japan, Hong Kong, Malaysia, Singapore, South Korea, and China), and their behaviour during the Asian and Global Financial Crises. The chosen markets were selected on the basis of market capitalization (value of all shares traded on the selected stock exchange); consequently, this study can be seen as representative for the entire East Asian region. The main objective of the study is to understand how market efficiency levels might have varied during the occurrence of the two major crises, and also to confirm if market inefficiencies are a common finding in the case of the two shocks.

   A Unit Root framework combined with Variance Ratio tests (VR), cointegration modelling (Johansen and Engle & Granger tests) and volatility analysis (GARCH) is used to identify volatility persistence patterns in the region. This study focuses on the detection of significant changes in both market returns variance and market long-run relationships and provides some initial results and insights on market interlinkages and volatility behaviour in the region during times of sustained uncertainty. Overall, the paper contributes to the current discussion on the issue of how market inefficiency can be explained by existing theories that do not take into account imperfect (or manipulated) information and its pernicious effects on both the financial markets and the macro-economy.

   The paper is structured as follows. The second section discusses whether the behaviour of markets can be understood in line with the theoretical frameworks popularized by Samuelson (1965) and Fama (1965, 1970). Arguments in line with the psychological and sociological factors influencing investors' behaviour (Shiller 1982) are also alluded to in this section. The subsequent section explains the methodology used and connections made with research studies that have been supported by the chosen tests. The fourth section proposes a comparative analysis of the two crisis periods to gain a better understanding of market dynamics, and the fifth section deals with policy implications. The final section concludes.

2. A General Review of the Efficient Market Hypothesis

   In the economy described by the classical economists of the late eighteenth and early nineteenth centuries (Smith 1776), markets behave spontaneously under the impulse of price changes (the famous "invisible hand") that lead to adjustments between supply and demand and to equilibrium. Perfect information is an implicit important assumption in this idealized economy. It is upon these premises that Fama (1965, 1970) developed the efficient market hypothesis applicable to the case of financial markets. According to this hypothesis, a market is said to be efficient if, for any assets in that market, the price of that asset can be written as Pt = EtPt, where Pt is the present value of future prices, and where Et corresponds to the mathematical expectation conditional on all information available at time (t), with n well informed and profit maximizing market participants that are risk neutral. The above definition suggests that in an efficient market, all available information at time (t) is fully reflected in an asset price; no algebraic interpretation of one asset price as a function of another can therefore be performed, and no unexploited opportunities for (abnormal) profits exist.

   Consequently, from a technical viewpoint and following the argument outlined by Granger (1986) if, in a given market, two or more asset prices show a stable common relationship in the long run (i.e., if two or more asset prices are cointegrated), the market will not be "efficient" (Richards 1995). The establishment of a cointegration relationship is equivalent to the existence of an error correction term (ECM). In this case, the price of one asset does not only depend on its own past prices but also on the history of the prices of different assets. The ECM implies that, in the case of a deviation of one asset price from the induced long-run relationship, unused profit opportunities would automatically arise. If market participants were aware of the existence of a stable long-run relationship between prices, they would be able to exploit them and be in a position to make excess profits (Copeland 1991), therefore contradicting the efficient market hypothesis (EMH). In short, the existence of cointegration between assets contradicts the weak form of the market efficiency argument because of its forecastability. A market is not efficient if cointegration between pairs is found, since cointegration means the predictability of at least one of the variables and this contradicts the notion of the market behaving in a random fashion. Existing research in the field (Alam, Hasan and Kadapakkam 1999; Phylaktis and Ravazzolo 2005; Chen, Firth and Meng 2002; Narayan, Smyth and Nandha 2004) has been supported by the use of Vector Autoregression, Cointegration and Error Correction Methodology (ECM) to examine markets' behaviour with the aim of understanding if they follow a random walk. These studies have been laying the ground for the selected research methodology to support the present study. If markets are found to follow an autoregressive process (i.e., there is no random walk), the weak form of the market efficiency argument is then rejected.

   Many tests on the EMH have been performed leading to a plethora of diverse results with mild support for the hypothesis particularly up to the 1990s (see Lim and Brooks 2011). In the case of Asian countries, the...