Economic policy uncertainty of China and investment opportunities: a tale of ASEAN stock markets.
| Autor | Thaker, Hassanudin Mohd Thas |
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Introduction
Among the myriad factors influencing investment opportunities, economic policy ranks high in importance in both normal and abnormal economic climates. Nearly every major economic event has considerable direct or indirect implications for stock market movements. Chiefs among the economic events are those tied to economic policy driven by actions taken by the central bank which formulates monetary policy, decides on the short-term interest rate and manages the money supply. The changes in these institutions' policies have a well-known spillover effect on financial markets, which are usually quick to adapt to the changing states of the economy as well as sentiment signals by policy authorities. Baker et al. (2013) premise that economic policymakers may aggravate the volatility of monetary, fiscal, or regulatory policy and this volatility is termed economic policy uncertainty (EPU). The agency cost between the policymakers and investors arises due to the stringent bureaucratic process which becomes one of the constraints that leave investors uncertain about the current economic policies and their involvement in the economy.
From the perspective of capital market theory, the main objective is to allocate efficiently scarce resources among competing for investment alternatives. This allocation decision depends primarily on the operational and informational efficiency of the market (Levine and Zervos, 1998; and Caporale et al., 2004). Furthermore, when information asymmetry abounds in a market, it leads to an increase in the risk of the stock market; subsequently leading to higher transaction costs which later can engender adverse selection. The implication of such a higher transaction costs is the dissuasion of investors from participating in the price discovery process, which, in turn, impedes market efficiency. As a result, intelligent investors are likely to perceive such situations as inopportune or too risky to invest or trade. The same holds in the context of immediate change in economic policy or fickle political environments. For instance, when federal banks or central banks freeze the quantity of money supply, liquidity shrinks, perturbing investor confidence. The impact would bein the form of higher borrowing costs and diminished investment activity by investors because there are pessimistic about investment performance (Brunnermeier and Pederson, 2009). This may lead to the withdrawal of investment activity by investors due to the prevailing uncertainty in the market.
Given the significant rise of China in economic and financial importance around the world and its hegemony in the South-East Asian region, the effects of Chinese EPU on the ASEAN stock market movement are merited. We expound on this rationale further in several steps. Firstly, it is noticeable that China's economic activity is considered one of the fastest growing in the world. Trade-wise, most economies in the world have a relationship with China, no matter how unilateral in nature. This attracts significant attention from investors and academia. Thus, further exploration of if China changes its economic policy, what will happen to its counterparts in terms of investment and stock market movement would be an interesting field to study. Secondly, we choose EPU of China because of the strong economic integration with other ASEAN countries. For example, in 2018, the volume of transactions in the monetary unit between China and ASEAN countries recorded a total of $587.87 billion, which is 14% higher compared to 2017. Furthermore, the continuous investment by China in ASEAN countries totaled about $205.71 billion. Aside from the apparent contingency of Chinese policy decisions spilling over to financial markets, investors are to remain ever vigilant of the fact that China is still a country that is transitioning from a centrally planned economic system to a market-based system. Compounded by the political necessities of the Chinese Communist Party to perpetuate the status quo, the Chinese authorities often need to improvise in enacting economic policies and have been known to take unorthodox decisions. Thus, this combination of potentially volatile and heterodox policy imperatives of the Chinese authorities, makes China's EPU an interesting phenomenon worthy of study. Unfortunately, empirical focus on this matter is relatively scarce until this date.
In this study, we specifically investigate the relationship between the level of EPU in China vis-a-vis five ASEAN countries; Malaysia, Singapore, the Philippines, Thailand and Indonesia. Our objective is to understand the spillover of policy uncertainty into the above five markets when there is a change in the EPU of China. This work builds upon the previous work ofLiet al (2019), where the authors look at the consequence of China's EPU on G7 countries' market volatility. The authors concluded that the EPU of China has a significant relationship with the market volatility of G7 countries. The same hypothesis has been tested with similar results by Liu and Zhang (2015), Duan et al (2018) and Ma et al (2018). However, the EPU-Market nexus has received very little attention from emerging markets, particularly in the ASEAN region.
We claim three novelty contributions in this paper. Firstly, this study is expected to enrich the existing literature in the field of EPU and stock market activity. Given the limited literature available in the context of ASEAN, as most of the literature is western flavored where the focus is more toward EPU of the US and spillovers effects toward other countries, we believe, the findings from this study are expected to enrich existing literature available in this area of research. To the best knowledge of the authors, this study is expected to be the first-ever study looking at this area of research by analyzing the EPU of China with emerging ASEAN markets. Most of the existing literature neglected the investment side when there is a change in EPU of China; instead, they focus on the impacts on the market and the economy in general. We fill this gap by using the concept of investment opportunities (covering different time horizons) available to investors when the EPU of China changes. Secondly, the outcomes of this study hope to help in designing better policies for monitoring, promoting and stabilizing ASEAN stock markets globally whenever EPU of China. Finally, the use of multi-resolution analysis in the timefrequency domain via Wavelets yields the results previously undocumented in the literature.
The remainder of this paper is organized as follows. Section 2 explores the literature available in the context of the research area. Section 3 describes the methodological part and Section 4 presents the findings and explains the results. Finally, we offer concluding remarks.
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Literature review
2.1 Theoretical foundation
The efficient market hypothesis (EMH) consists of three main forms: (1) weak-form efficiency, (2) semi-strong form efficiency and (3) strong-form efficiency (Malkiel and Fama, 1970). According to weak-form efficiency, historical information does not play an important role in influencing the stock price and does not have an association with future prices. Thus, any supplementary information is incapable of predicting future stock prices under weakform efficiency. This form of efficiency clashes with the EPU of China since most of the information available or taken into consideration in calculating the EPU are historical and current. The next category is called semi-strong form efficiency, where this efficiency highlights that all new publicly available information is reflected in the share prices. If this is the case, using the EPU of China to search for good investment may not be good enough to decide on investment as the EPU can occur anytime and is unpredictable. Lastly, under strong-form efficiency, both private and publicly available information is reflected in the stock prices. In informationally efficient markets, the EPU of China no longer assumes the role as important information intermediary since every single piece of information relevant to investors is already incorporated in the stock price. Given this phenomenon, the question of whether the EPU of China contains valuable information relevant to the market remains ambiguous and deserves a closer look.
2.2 Prior literature
Since the global economy is interconnected, a negative or positive shock on the economy can be transmitted to other countries directly or indirectly through the channels of financial market connections (Forbes and Chin, 2004). Indeed, its effect can be strong and significant when the diffusion originates from one of the world's leading economies (Sum, 2012). Several intensive pieces of research have been carried out to examine the effect of EPU and stock market return or volatility (Boako and Alagidede, 2018; Beirne et al., 2010). Some studies have focused on how EPU within the country affects the country'sstock markets while others have focused on the effect of EPU in one country on the stock market returns.
Becker and Peters (1998) found that the news and information originating from the US were responsible for the existence of spillovers between the US and UK stock markets. It was later confirmed by Ehrmann and Fratzscher in 2005, who argued that news releases would have an impact on markets; however, the impact of spillovers was strong especially in the US because of economic integration then followed by the Eurozone. Besides, Sum (2012) examined the implications of US EPU on their stock market return, and they found that stock market excess returns have responded negatively to the increased changes in EPU. Another study conducted on the European stock market by Sum (2012) analyzed the impact of EPU in Europe on other Eurozone countries' stock market returns and the results showed that there was a negative impact of EPU on all Eurozone...
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