Modeling The Financial Crisis From 1997 To 1999: A Spatial Econometric Perspective

The economic integration of international stock markets has become especially relevant over the last decade. Two explaining factors can be highlighted for this globalization process: (i) the substantial development of technology, which allows traders to transmit information more quickly from one financial market to another, and (ii) the increased flow of capital between countries as a consequence of less restrictive controls on asset market transactions. Such integration tends to produce a long-run equilibrium relationship, which ties price movements in national stock indices and could significantly reduce benefits from international portfolio diversification. Information on time variation paths for international market linkages is relevant not only to portfolio managers, but also to international economic and financial policy makers. The nature of the correlations between national stock returns is a key element in the portfolio theory of Markowitz, which currently continues to be widely used in asset allocation and portfolio management. Thus, more attention has recently been given to gaining a better understanding of the international transmission of stock prices shocks and volatilities. Although the U.S. economy continues to behave as the leader market that influence other markets, lower transaction costs seem to be encouraged by irrational prices and speculative bubbles in financial markets, as seen in the recent Asian crisis. Indeed, the international correlation of stock prices may also be the outcome of volatility contagion. That is, a substantial decrease in one national stock index may be quickly transmitted to other national stock exchange, consequently increasing volatility.This paper deals with the volatility contagion issue between international trading areas from the Asian crisis, it focuses on the dynamic linkages among national stock returns and the transmission of volatility during the period 1997-1999. The purpose is to re-explain the causes of the recent East Asian financial crisis based on the empirical estimating of a Sharpe-Lintner-Black's capital asset pricing model(CAPM) from a spatial econometric perspective. In most applications of cross-country analyses, an implicit assumption is that the error terms from different countries are independent (E[ε ε'] = σ~2 I). However, in such a cross-sectional context in which the observational units are spatially organized, this assumption may be overly restrictive. In particular,the possibility exists for spatial spillovers across country boundaries leading to forms of spatial dependence that would violate these assumptions. To date this issue remains unsolved and, consequently, it is unclear to what extent empirical evidence derived from such cross-country analyses is robust to ignored spatial effects and processes. Besides, an interest in economic spillover effects in other spaces has recently become common even in the mainstream economics. By recognizing such forms of spillover as cases of spatial dependence, this study develops a spatial econometrics model of CAPM to measure the spatial externalities of financial crisis.China was not hit much in the 1997-1999 financial crises due to its financial isolation from the world's money markets. But according to the WTO agreements signed by the Chinese state government, at the end of year 2006, China opened its domestic money markets to foreign financial agents. This exposes China to potential international financial crisis. As such, a full understanding of the dynamic linkages among national stock returns and the transmission of volatility is extremely vital to Chinese financial institutes.