Uncovered Equity Disparity in Asian Emerging Markets
If a country’s equity market is expected to appreciate, should we expect its currency to appreciate or depreciate?
This question matters to international equity investors, policymakers and academics. An investor holding foreign equities is exposed to exchange rate ﬂuctuations by nature. Policymakers care about this relation as valuation changes – induced by foreign exchange and equity returns – generate signiﬁcant swings in international investment positions.
Consider a US portfolio manager with money invested in Japan. When the Japanese stock market rises relative to the US, the manager is overweight with Japanese equities and, to return to a neutral position, sells Japanese stock and then sells the Japanese yen proceeds for US dollars. The sale of yen for dollars causes the yen to depreciate at the same time that the Japanese stock market is outperforming. This is called uncovered equity parity (UEP) condition.
UEP is relevant for at least two reasons. On the one hand, it asserts that foreign net equity flows drive FX returns, which have been notoriously difficult to predict using other macro-economic variables. On the other hand, from the perspective of international portfolio management, it is also important for global investors, as investments in foreign equity markets inevitably involve investing in FX.
The paper Uncovered Equity “Disparity” in Emerging Markets analyses the dynamics of foreign equity markets, FX markets, and capital flows using an unbalanced panel of daily data for eight East Asian emerging markets (EMs) from 1996 to 2013 which includes the recorded trades of all foreign investors in the six EMs, paired with daily closing prices of the Bombay Stock Exchange (BSE) Sensitive 30 Index in India, National Stock Exchange (NSE) CNX Nifty 500 index in India, Jakarta JSX Composite index in Indonesia, the Kospi and Kosdaq indices in Korea, the PSE Composite index in the Philippines, the TWSE/TAIEX index in Taiwan, and the Bangkok SET Index in Thailand. These data enable more accurate inferences on UEP in EMs than the monthly/quarterly bilateral flows used in prior studies. Moreover, unlike most of the earlier literature, which is based on single-equation modelling approaches, the reduced-form vector autoregressive (VAR) models and structural vector autoregressive (SVAR) models employed in our paper both allow controlling for reverse causality and endogeneity biases. Moreover, through these models this paper is the first to comprehensively examine the mechanisms towards UEP as both contemporaneous and lead-lag relationships.
The first theoretical mechanism towards UEP requires that, in line with the notion of portfolio rebalancing, foreign equity investors rebalance away from (toward) countries whose equity/FX markets have recently performed well (poorly). The evidence from this paper refutes this mechanism for UEP both as a contemporaneous and lead-lag relationship: i) net equity flows respond positively to both current and past local-currency equity returns, and ii) net equity flows are oblivious to past FX returns which suggests that foreign equity investors in EMs mainly use exchange rates as a vehicle. Motivated by these findings, the paper further investigates whether foreign investors in EMs predominantly pursue return-chasing strategies by formally testing whether equity flows are driven by high expected equity returns. Decomposing the current returns into the expected and unexpected components, the paper shows that there is a significantly positive relation between the expected component and current flows but a much weaker positive relation with the unexpected component, which formally endorses the return-chasing hypothesis. The second mechanism towards UEP implies that a decrease in net equity flows comes hand-in-hand with domestic currency depreciation. This paper provides favorable evidence of this mechanism.
The results hold after the analysis introduces the global equity volatility as control variable. It is also found that the uncovered equity “disparity” is time-varying and asymmetric as it magnifies in economic downturns and financial crisis.
An implication of these findings is that, with regard to foreign equity flows, policymakers should not just monitor equity or FX markets, but also the interconnections between these two markets and capital flows. A practical implication for EM equity market participants is that they may want to pay close attention to FX hedging strategies since FX movements do not offset local-currency equity returns but rather constitute an additional risk factor exposure.
Download Uncovered Equity “Disparity” in Emerging Markets at SSRN.
The paper is forthcoming in the Journal of International Money and Finance.