Financial Integration, Economic Instability and Trade Structure in Emerging Markets

Financial Integration, Economic Instability
And Trade Structure In Emerging Markets†

Anthony Chambet and Rajna Gibson∗
University of Zurich
This version: December 13, 2006
Abstract
In this study, we estimate the level of financial integration using a mul-

tivariate GARCH(1,1)-M return generating model allowing for partial market
integration as well as for the pricing of systematic emerging market risk.We
find that emerging markets still remain to a large extent segmented and that
financial integration has decreased during the financial crises of the 1990s. We
next investigate the relationship between a country’s trade concentration and its
level of financial integration.We find that countries with an undiversified trade
structure have more integrated financial markets. Finally, our results suggest
that countries less open to trade are more segmented.
JEL classification: F15, F36, G11, G15.
Keywords: Emerging markets, economic instability, stock market integration,
international trade.
† We would like to thank Eliza Hammel, Vihang Errunza and Hans Genberg for their insightful
comments, Francesca Carrieri for her discussion of the paper at the EFA 2005 Meetings in Moscow,
as well as Carsten Murawski for computational assistance and J.P. Morgan for providing access
to their data. Financial support by the National Center of Competence in Research ”Financial
Valuation and Risk Management” (NCCR FINRISK) is gratefully acknowledged. NCCR FINRISK
is a research program by the Swiss National Science Foundation.
∗ Please send all correspondence to: Rajna Gibson, Institut für schweizerisches Bankwesen, Uni-
versität Zürich, Plattenstrasse 14, 8032 Zürich, Switzerland, tel: (00441) 634-29-69, fax: (00441)
634-49-03, e-mail: rgibson@isb.unizh.ch
1
1 Introduction
Emerging stock markets have been the subject of a large body of research in the
literature on international asset pricing. In this paper, we analyse two main issues
regarding the development of emerging stock markets’ financial integration levels over
the last decade. The first objective is to estimate the level of financial integration
of these stock markets, by developing and testing a three factor asset pricing model,
in the spirit of Chen et al. (1986). The asset pricing model assumes that emerging
stock markets excess returns are driven by a world stock market factor, a domestic
stock market factor and a systematic emerging stock market factor. It allows us to
investigate whether the level of stock market integration of a sample of 25 emerging
market countries has been affected by the various financial crises of the 90’s. The
main characteristic of this model is that it analyzes stock market integration and its
time-series behavior while simultaneously accounting for the pricing of “systematic
emerging market risk” by foreign investors. Indeed, we conjecture that by investing

even in a diversified portfolio of those countries’ stocks, an investor will not be able
to completely abstract from the economic instability prevailing in emerging markets.
Hence, we introduce in our asset pricing model, a new factor, defined as the systematic
emerging market risk proxy and account for the fact that investors may require higher
expected excess returns to bear the economic instability inherent to a diversified
portfolio of emerging markets’ stocks. Our proxy for systematic emerging market
risk is the difference between the yield of the J.P. Morgan EMBI global index and
the ten-year US Treasury bond yield.
The empirical results are obtained by studying a sample of 25 emerging stock
markets countries over the period January, 1st 1995 to June 30th, 2004. To our
knowledge, there is in the literature only one other study by DeJong and DeRoon
(2005) that covers such an extensive range of emerging markets. The results suggest
that these countries still remain, to a large extent, segmented and that the level of
integration,especially in Asian countries, has decreased following the various financial
crises of the late 1990s. More recently, the level of stock market integration of several
2
countries has been trending upwards but has also become more volatile. Moreover,
the systematic emerging market risk exposure is significant for all countries in the
sample and commands a time-varying risk premium.
Our second objective is to analyze the relationship between the level of finan-
cial integration in emerging markets and the real determinants of these countries’
economies, especially as far as their trade policy is concerned. Our contribution to
this stream of literature is twofold. First, we examine the relationship between the
level of financial integration and a country’s trade openness by relying on a refined
decomposition of the variable trade openness into its “natural”- or geographical - and
its “residual” openness along the lines of Wei (2000).We find that countries natural
and residual trade openness are significantly and positively related to their level of
financial integration. These results provide support to the international finance liter-
ature, in the spirit of Aizenmann (2003) and Aizenmann and Noy (2004) that views
trade openness and financial integration as complements rather than substitutes.
Second, we study the relationship between a country’s degree of financial integration
and its trade structure. More precisely, to our knowledge, there has not yet been any
attempt within the macro-finance literature, to explore the relationship between the
degree of a country’s trade concentration and its level of financial integration. We
conjecture that countries can use financial integration as a “natural hedge” against
their lack of trade diversification. This substitution effect is motivated by the lower
costs and the higher flexibility associated with the development of international finan-
cial trade. The empirical results obtained with our sample of countries over the last
decade corroborate our null hypothesis: we obtain a significantly positive relationship
between the level of financial integration and the imports -or exportsconcentration
variable used in our regressions to measure the lack of trade diversification prevailing
in a given country. This result is robust to the introduction of other control variables
in our regressions. Thus, our results are consistent with the fact that countries more
open to trade are also more integrated but have to be qualified with respect to the
more or less diversified structure of these countries’ trade policy. An open conceptual
issue is to determine whether the “natural hedge” hypothesis tested in this study is
3
the deliberate or involuntary consequence of these countries’ financial liberalization
efforts undertaken during the last decade.
The structure of the paper is the following: In Section 2, we briefly review the
concepts of emerging markets integration and liberalization in light of the relevant

literature and describe the data used in the empirical study. In Section 3, we present
the empirical three factor asset pricing model that captures the joint impact of stock
markets’ segmentation and of systematic emerging market risk on emerging market
stocks’ excess returns. The results associated with the empirical test of the model are
presented in Section 4 both in the cases where the unitary risk premia and the level
of financial integration are assumed to be constant and time-varying. In Section 5,
we examine the impact of a country’s trade policy structure on its level of financial
integration focusing in particular on how the latter independent variable is related
to the degree of a country’s trade diversification. Section 6 concludes by highlighting
the main results obtained as well as possible extensions of the study .
2 Emerging Market Finance
2.1 Emerging markets’ integration and liberalization
Financial markets participants label a nation an emerging market if it is characterized

by a recently instituted, or recently revitalized, set of domestic financial markets.
The IFC defines an emerging market as a country that meets one of two criteria:
first, it is located in a low- or middle-income economic region and second, its in-
vestable market capitalization is low relative to its most recent GDP figures. Nations
terminate their emerging markets status once their income per capita exceeds the
upper-income threshold for three consecutive years, and once their investable market
capitalization/GDP ratio is near the average ratio for “developed markets” for three
consecutive years. Nations that retain or introduce investment restrictions remain
categorized as emerging, reflecting the IFC’s opinion that “pervasive investment re-
strictions on portfolio investment should not exist in developed markets” see IFC
(1999). In 1996, the IFC introduced a new category, frontier markets. This grouping
4
includes nations that have equity exchanges, but on which trading activity is very
thin. When liquidity in these portfolio markets increases, frontier nations graduate
to the IFC’s set of emerging market nations. Nations, as classified by the IFC, are
listed in Table 1.
[Insert Table 1 about here]
In 1985, Mexico’s equity market capitalization was 0.7% of its GDP and the
market was only accessible by foreigners through the Mexico Fund that traded on
the New York Stock Exchange. In 2000, equity market capitalization had risen to
21.8% of GDP and U.S. investors alone were holding through a variety of channels
about 25% of the market, see Thomas and Warnock (2002). This dramatic increase in
capital flows to Mexico could not have happened if it had not embarked on a financial
liberalization process, relaxing restrictions on foreign ownership of assets, and taking
other measures to develop its capital markets, in conjunction with macroeconomic
and trade reforms.
Mexico is far from being an isolated case. Other Asian, European and South
American countries have experienced similar developments that raise a number of in-
triguing questions. In a pioneering contribution, Errunza (1974) and later on Bekaert
and Harvey (2003) question, on one hand, what are, from the perspective of investors
in developed markets, the diversification benefits of investing in these newly avail-
able emerging markets, and on the other hand, what are, from the perspective of
developing countries, the effects of increased foreign capital on the development of
domestic financial markets and, ultimately, on these countries’ economic growth.
These authors argue that financial integration is central to both questions1 . In fi-
nance, markets are considered integrated when assets of identical risk command the
same expected return irrespective of their domicile. Since equity markets liberaliza-
tion give foreign investors the opportunity to invest in domestic equity securities and
domestic investors the right to transact in foreign equity securities, it should facili-
tate emerging markets integration within the global capital market through improved
1 Errunza (2001) also discusses the contribution of financial market liberalization to economic
growth.
5
international risk sharing, and thus increase investment, see Bekaert et al. (2003).
The diversification benefits of investing in emerging markets are nevertheless
limited by the high level of economic instability that characterizes emerging coun-
tries taken as a whole. Indeed, regional economic instability and financial contagion
threats contribute directly to foreign investors’ pricing of risk when they buy stocks
in those countries. Thus, even when holding a diversified portfolio of emerging mar-
kets’ stocks, we conjecture that an investor will still be subject to a certain degree
of “systematic emerging market risk” which essentially captures these countries’ un-
avoidable exposure to regional economic instability. One of our objectives will be to
quantify the economic significance of the systematic emerging market risk premium
associated with holding emerging market financial assets.
2.2 Characterizing emerging markets’ risk
We proxy systematic emerging markets’ risk with the yield spread defined as the dif-
ference between the yield on the J.P. Morgan’s Emerging Bond Index Global (EMBI
Global) and the yield on ten-year U.S. Treasury bonds. This spread represents a
market assessment of the systematic emerging market exposure for a diversified in-
vestor.
The EMBI Global, which covers 27 emerging market countries2 , is one of the most
comprehensive emerging markets’ debt benchmark. Included in the EMBI Global are
U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market
debt instruments issued by sovereign and quasi-sovereign entities. The EMBI Global
defines emerging market countries with a combination of World Bank-defined per
capita income brackets and each country’s debt-restructuring history.

The importance of the EMBI spread as a market instrument can be explained
by the fact that many financial variables in emerging markets fluctuate in parallel
with it, most importantly exchange rates. Domestic interest rates of all maturities
are also affected by fluctuations in the EMBI spread. In the case of short-term rates,
2 Algeria, Argentina, Brazil, Bulgaria, Chile, China, Colombia, Côte d’Ivoire, Croatia, Ecuador,
Greece, Hungary, Korea, Lebanon, Malaysia, Mexico, Morocco, Nigeria, Panama, Peru, Philippines,
Poland, Russia, South Africa, Thailand, Turkey, Venezuela.
6
there is an indirect mechanism via the exchange rate: when deciding on the level of
the short-term rates, central banks look at inflation expectations, which are affected
by exchange rate fluctuations. But an increase in the EMBI spread can also affect
inflation expectations directly if, for example, it is accompanied by concerns about

the possibility of future monetization of part of the public debt. Domestic rates at
longer maturities are affected by the EMBI spreads in two ways: indirectly, through
short-term rates, because fluctuations in these rates affect the term structure, and
directly because the price of financial instruments of longer maturities reflect not only
interest rate risk and term premia, but also default risk, see Chang and Sundaresan
(2000), which is closely related to economic instability.
The domestic component of the EMBI is thus a good market instrument to proxy
economic instability in a given emerging country. Assuming that this country-specific
risk cannot be fully diversified away, the EMBI Global, as an emerging markets index,
provides investors with an estimation of their risk exposure to the economic insta-
bility of emerging markets as a whole3 . This aggregate representation is particularly
relevant since the waves of financial crises that have plagued emerging economies
over the last decade have highlighted the fact that, despite being only partially inte-
grated, emerging markets are very much interdependent and not immune to contagion
effects4 . In their study, Carrieri et al. (2005b) also document that emerging market
specific risk is statistically significant and priced separately from emerging market
currency risk. We will examine if, within the framework of our model where we use
the EMBI yield spread as a proxy for systematic emerging market risk, the latter was
significantly priced, and thus reflected the fact that foreign investors care about the
economic instability of these countries.
3 Note that the yield spread on the EMBI Global index is used as a benchmark by Carrieri et al.
(2005b) to test the quality of other variables proxying for emerging markets’ specific risk.
4 Following the Tequila and Asian crises of respectively 1994 and 1997, an abundant literature
has addressed the issue of contagion in financial markets. Recent surveys of the literature include
Calvo and Mendoza (2000), Corsetti et al. (2003), and Forbes and Rigobon (2002).
7
2.3 Description of the data
The data used in this study was obtained from Datastream International, J.P. Mor-
gan, and Morgan Stanley Capital International (MSCI). We collected weekly data
from January 1st, 1995 to June 30th, 2004 for 25 countries, which, on one hand, have
been labelled emerging countries by the IFC and, on the other hand, are included in
J.P. Morgan’s EMBI Global5 . The period covered, if relatively short, includes all the
episodes of financial crises of the last decade, from the Tequila crisis to the 2001–2002
Argentinian turmoil.
The geographic distribution of our sample of countries is presented in Table 2.
We classify the sample into five regional country groupings: Africa, which includes
Egypt, Morocco, and South Africa; the Eastern Asia region, which includes China,
Indonesia, Korea, Malaysia, Philippines, Taiwan and Thailand; Eastern Europe’s
countries, which are comprised of the Czech Republic, Hungary, Poland and Russia;
the middle East and central Asia region which includes India, Israel, Pakistan and
Turkey; and the South American sample, which consist of the largest economies in
the region, Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. This
sampling spans the entire geographical range of emerging markets; nevertheless re-
gional weights differ from one group to the other. In this way, countries located in
Eastern Asia and South America account for 60% of the sample. To our knowledge,
there is, in the international asset pricing literature, only one other study by DeJong
and DeRoon (2005) that covers such an extensive range of emerging markets.
Emerging stock markets are proxied by the MSCI country total equity market
indices, which are value-weighted indices constructed consistently across countries
and are representative of each country’s equity market. Similarly, the world stock
market is proxied with the MSCI world index. In this study, we consider the case
of an American investor investing in emerging markets. Therefore, returns on all
5 Given the number of parameters to estimate in a multivariate model with time-varying risk
premia, we chose to work with weekly data. Note that potential issues due to lack of liquidity are
partially avoided since we use stock market indices and not individual stocks.
8
the MSCI stock indices are expressed in US dollars. Besides the long term interest
rate is proxied by the ten-year Treasury bond’s yield and the short term rate by the
one-month “risk-free” Treasury bill’s yield. Finally, the systematic emerging markets
risk is proxied by the spread defined as the difference between the yield on the J.P.
Morgan EMBI Global and the ten-year Treasury bond’s yield. Descriptive statistics
about the dataset are provided in Table 3. All returns and yields are expressed on
a continuously compounded basis. The behavior of emerging market excess returns
is similar to that reported in the literature see, for instance, Bekaert and Harvey
(2003), Carrieri et al. (2005a). On average, emerging market stock excess returns are
large in absolute terms and display high volatility. The stock excess returns exhibit
high level of kurtosis, the skewness is positive for more than 60% of the countries in
the sample and the hypothesis of normally distributed excess returns is rejected by
a Jarque-Bera test at the one-percent significance level in all instances.
3 The Pricing Of Systematic Emerging Markets Risk
In A Partial Integration Model
3.1 The Model
We propose to estimate a empirical multi-factor asset pricing model of partial market

integration. The model is inspired by the pioneering theoretical international asset
pricing models introduced by Errunza and Losq (1985) and by Stulz (1981). The
originality of our approach consists in accounting simultaneously for partial stock
market integration and for systematic emerging markets’ risk. In our model, the
expected excess return equation is thus determined by three risk factors identified
as the domestic stock market factor, the world stock market factor and finally a
systematic “emerging market” factor. The latter is assumed to be independent from
the hypothesis of market segmentation. Indeed, by its very nature, the exposure to
this risk is not restricted to the stock market but pertains to the whole economy.
9
It would thus be priced in the same way in a fully segmented stock market where
foreign direct investment (FDI) is the sole channel of investment accessible to foreign
investors as in a perfectly integrated market where all investment barriers have been
lifted.
We are thus interested in testing whether the following equation characterizing
emerging stock market expected excess returns is satisfied:
Et−1 [rj,t ] = (1 − αj,t )λj,t vart−1 (rj,t ) + αj,t λW,t covt−1 (rj,t , rW,t ) + λS,t covt−1 (rj,t , St ),
(1)
where rj,t denotes the jth emerging stock market excess return, vart−1 (rj,t ) is the
instantaneous domestic stock market variance, covt−1 (rj,t , rW,t ) is the instantaneous
jth stock market covariance with the excess world stock market returns and covt−1 (rj,t , St )
is the instantaneous jth stock market covariance with the EMBIG spread proxying
systematic emerging markets’ risk. αj,t , which is constrained to lie in the interval
[0, 1], is the coefficient of stock market integration, λj,t , λW,t and λS,t denote re-
spectively the unitary market prices of domestic, world stock market risks and of
systematic emerging markets’ risk. These parameters are all assumed to be time-
varying, consistently with the large amount of evidence in the empirical literature,
see Harvey (1991), Bekaert and Harvey (1995), De Santis and Gerard (1997).
Observe, for instance, that in a fully integrated stock market (i.e., α = 1) with (in-
dependent) systematic emerging markets’ risk, conditional expected excess domestic
stock market returns would be characterized by the following reduced form version
of Equation (1):
Et−1 [rj,t ] = λW,t covt−1 (rj,t , rW,t ) + λS,t covt−1 (rj,t , St ), (2)
since only world stock market risk and systematic emerging markets’ risk are then
faced by the investor. On the contrary, and under the assumption that systematic
emerging markets risk is independent from the hypothesis of market segmentation,
the following empirical relationship would apply in a fully segmented stock market
10
(i.e., α = 0):
Et−1 [rj,t ] = λj,t vart−1 (rj,t ) + λS,t covt−1 (rj,t , St ), (3)
since, in this case, only domestic stock market risk and systematic emerging markets’
risk would be priced by investors.
It is worthwhile mentioning that the empirical model in Equation (1) could be

reformulated along the lines of the econometric model of asset returns proposed by
Moskowitz and M.Grinblatt (1999) in order to show that industry momentum drives
a large part of individual stocks’ momentum and later extended by Carrieri et al.
(2004) to account for imperfect industry integration6
In a sense our model also resembles the dynamic formulation of Carrieri et al.
(2005a). Indeed, we also use a two-step estimation procedure initially introduced by
Bekaert and Harvey (1995) to identify the time - varying global and domestic risk
premia. However, our model accounts for a third source of risk, defined as system-
atic emerging markets’ risk, and thus includes an emerging markets’ systematic risk
premium, denoted by λS,t covt−1 (rj,t , St ) in Equation (1). Our specification for the
excess stock market returns differs also from the one used in the regime-switching lit-
erature originated with Bekaert and Harvey (1995). In their study, the so-called level
of financial integration is actually the econometrician’s assessment of the likelihood
that the market is integrated in each period. In effect, Bekaert and Harvey (1995)
estimate the conditional probability that the market is fully integrated whereas, as-
suming that emerging markets are only partially integrated, we assess the evolution
of their level of stock market integration through time. Our model is also quite close
to the one developed by Bekaert and Harvey (1997) except that we introduce an
additional risk factor, namely systematic emerging market risk, and that we will use
a different econometric specification - than the factor ARCH model - to characterize
the variance-covariance matrix dynamics.
6 We would like to thank a referee for pointing this alternative derivation of our empirical model.
11
3.2 Econometric specification and estimation
In order to perform an empirical test of the conditional specification of the excess

stock market returns as characterized in Equation (1), we use a two step estimation
procedure. It is based on a multivariate GARCH(1,1)-M specification to characterize
the joint stochastic process governing the emerging stock market portfolio excess
returns, the world stock market excess returns and the sovereign spread dynamics
and on univariate regressions in the second stage to estimate the unitary market
price of domestic stock market risk and the level of stock market integration that are
specific to each country.
By first regressing each series against a constant and a trend and then applying
an ARCH-LM test to the residuals, we find that the presence of ARCH effects is
strongly supported for each of the time-series under study (the results are presented
in Table 4). ARCH and GARCH models are due to Engle (1982) and Bollerslev (1986)
respectively. GARCH models provide a wide variety of specifications that capture
important features of the time-varying variance-covariance matrix. The GARCH-M
model, introduced by Engle et al. (1987), allows one to model the excess market
return as a function of its conditional variance and of its conditional covariances with
the state variables.
The empirical equation for the excess domestic market return here denoted by
rj,t is based on the market model defined in Equation (1) if both global and domestic
stock market risks as well as systematic emerging markets’ risks are priced with
time-varying unitary risk premia weighted by their level of stock market integration
2
rj,t = (1 − αj,t )λj,t σj,t + αj,t γW, t λj,W,t + λS,t σj,S,t + εj,t , j = 1, . . . , 25. (4)
The market model characterized in Equation 1 is assumed to hold for every finan-
cial asset, including the world stock market. Thus, the system of pricing restrictions
consisting in the return equations for the twenty five countries in our sample and
12
the world stock market has to be simultaneously satisfied at each moment of time.
The world stock market being fully integrated, αt is always equal to 1 in its return
equation. Besides, due to its large diversification and to the small percentage of
world market capitalization represented by emerging stock markets, we assume that

the excess return on the world stock market is not affected by St , the EMBIG yield
spread. The excess return equation for the world stock market can thus be specified
as follows:
2
rW,t = λW,t σW,t + εW,t , (5)
which is similar to the specification widely used in the empirical asset pricing litera-
ture, see, for instance, Carrieri et al. (2005a).
As far as systematic emerging markets’ risk is concerned, we use as a proxy the
EMBIG yield spread defined as the difference between the EMBI Global and the ten-
year Treasury bonds yields. This spread, which can be interpreted as the excess return
on the EMBI Global, represents the premium that needs to be paid to compensate for
the aggregate systematic risk caused by economic instability in emerging markets. We
rely on the theoretical literature on credit risk models to determine the econometric
specification for this yield spread. Longstaff and Schwartz (1995) as well as Duffee
(1999) have both shown that credit spreads follow a mean-reverting process. We
thus conjecture that the emerging markets’ yield spread can be characterized by the
following dynamics:
St = ηS,1 + ηS,2 St−1 + εS,t . (6)
Given the size of our sample of countries (25 countries) and the large number of
parameters that need to be estimated in a model with time-varying risk premia (13
parameters per country, that is a total of 325 parameters while relying on 493 weekly
return observations), we decided to estimate the system of equations consisting in
the return equations for the twenty five emerging markets under study (Equation 4),
the return equation for the world stock market (Equation 5), and the equations char-
acterizing the dynamics of the emerging markets yield spread (Equation 6) and the
variance-covariance matrix in two steps with quasi-maximum likelihood (QML). Two-
13
step procedures have become increasingly common in the empirical finance literature
to deal with large systems of non-linear equations. For instance, Bekaert and Harvey
(1995), in their study of time-varying world integration, first estimate separately a
price of world stock market risk which they then impose in the return equation of
each country in their sample.
In the first step, we use the property that since the market model characterized in
Equation (1) is assumed to hold for every emerging stock market, it must also hold
for a portfolio built with these domestic stock markets. In particular, if we build
a value-weighted emerging markets’ portfolio with the MSCI stock indices of each
country in the sample, denoted EMSI, its excess returns will satisfy the following
characterization
2
rEMSI,t = (1 − αEMSI,t )λEMSI,t σEMSI,t + αEMSI,t λW,t σEMSI,W,t
+λS,t σEMSI,S,t + εEMSI,t .
In the first step of our estimation procedure we thus estimate the following reduced
trivariate version of the multivariate Garch (1,1)-in-mean model:
2
rEMSI,t = (1 − αEMSI,t )λEMSI,t σEMSI,t + αEMSI,t λW,t σEMSI,W,t ,
+λS,t σEMSI,S,t + εEMSI,t ,

2
rW,t = λW,t σW + εW,t ,
St = ηS,1 + ηS,2 St−1 + εS,t ,
Ht = Ω + B ′ Ht−1 B + A′ εt−1 ε′t−1 A,
where the first equation is the return equation for the value-weighted emerging mar-
kets’ equity portfolio.
In order to model the time-varying variance-covariance matrix in the first step of
our estimation procedure described above, we use the BEKK specification proposed
by Engle and Kroner (1995). The BEKK model is characterized by the following
14
equation
Ht = Ω + B ′ Ht−1 B + A′ εt−1 ε′t−1 A, (7)
where Ω, A and B are 3 × 3 matrices, with Ω symmetric and positive definite. This
specification assumes that the conditional covariance matrix is determined by the
vector of past returns and spread shocks. Because the second and third terms on the
right-hand side of Equation (7) are expressed in quadratic forms, the positive defi-
niteness of the conditional covariance matrix of asset returns is guaranteed, provided
that Ω is positive definite.
We perform a quasi-maximum likelihood estimation. This estimation technique
looks for values of the parameter vector θ that maximize the log-likelihood function
T
X
L= lt (θ). (8)
t=1
Under the assumptions that the innovations εEMSI,t , εW,t and εS,t are conditionally
trivariate normal, we can write the conditional log-likelihood function lt (θ), ignoring
the constant term, as follows
1 1
lt (θ) = − ln(det(Ht )) − ε′t Ht−1 εt . (9)
2 2
The methodology is named quasi-maximum due to the fact that the parameters
obtained result from the maximization of a misspecified conditional density function.
We know, for example, that stock returns display fat tails which are inconsistent with
the normal distribution assumption. It is therefore important to correct the standard

errors in order to obtain consistent results. In this study, we follow the approach of
Bollerslev and Wooldridge (1992) to correct for departures from normality.
The first step estimation of the trivariate model allows us to obtain estimates of
λW , the price of world stock market risk, of λS , the emerging markets’ systematic
risk premium, as well as of the coefficients determining the process followed by the
emerging markets’ yield spread (η1 ,η2 ).
In the second step, we run separate univariate regressions of Equation (4) for each
15
of the twenty five emerging stock markets in the sample, imposing the estimated
values obtained for λW and λS from the estimated trivariate model. The second
stage regression, for each country, allows us to obtain estimates of both the local (or
domestic) market price of risk, λj , and of the level of stock market integration αj .
The trade-off associated with this two-step procedure is that it guarantees fea-
sibility but has the drawback of increasing estimation errors. Indeed, it includes
estimation errors from the estimates obtained in the first step in the second pass
univariate regressions. We do not correct for these estimation errors but we will keep
them in mind when discussing the significance of our empirical results.
4 Financial integration and the pricing of system-
atic emerging markets’ risk
The main objective of this section is to examine how the degree of financial integra-
tion of sample of countries has been affected by the various financial crises of the
90’s.We therefore estimate the general model with a time-varying level of integration
and time-varying risk premia7 In this model, the price of global (λW,t ), local (λj,t ),
and emerging markets (λS,t ) risks are characterized as functions of a set of global
information variables widely used in previous research (see in particular Dumas and
Solnik (1995), De Santis and Gerard (1997) and De Santis and Gerard (1998)). More
specifically,

λj,t = exp θ1 + θ2 rW,t−1 ,

λW,t = exp φ1 + φ2 ∆T Billst , (10)
λS,t = ϕ1 + ϕ2 ∆T ermt ,
7 We also estimated a version of the model with constant unitary risk premia. The main results
from this estimation, available from the authors upon request, can be summarized as follows. First,
both local and world market risks are positively and significantly priced for all the countries in the
sample. Second, the levels of integration obtained are low and vary between 13.27 % for Marocco
and 55.43 % for Mexico. Finally, we find that the emerging market risk premium is significant and
represents on average 20.25% of each equity market expected excess return.
16
where rW,t−1 denotes the lagged world market return in excess of the risk free rate,
∆T Billst denotes the change in the US short term rate and ∆T ermt the change in the
US term structure spread. The choice of these instrumental variables is motivated
by our expectations regarding the risk premia’s time-varying property. We have

chosen U.S instrumental variables to model the time variation of the three unitary
risk premia due to the lack of available macro-economic or financial domestic data
at weekly frequencies for our entire sample of emerging markets’ countries. The
choice of the specific single instrumental variable retained to model each time-varying
risk premium is based on their respective ability to capture business cycle effects
demonstrated in previous studies on the one hand and on parsimony considerations
on the other hand.
In general, the choice of specific instrumental variables is motivated by the fact
that their evolution should capture business cycle effects on agents’ risk aversion
and thus on their required market prices of risk. Thus, we would expect the world
stock market premium (expressed in U.S. dollars) to be negatively correlated with
changes in the U.S. Treasury bills’ yields. Due to the lack of available data for
some emerging market countries, the unitary market prices of emerging market and
domestic stock market unitary premia are related to two US instrumental variables
that, one can argue, have world-wide business cycle effects. The exponentiation used
in the specification of λj,t and λW,t imposes one of the necessary conditions of the
asset pricing theory namely that the unitary price of stock market risk be positive.
A linear specification was retained for λS,t , the emerging markets’ risk premium,
in order to estimate the model without making any assumption on the sign of the
emerging markets’ total risk premium. Similar assumptions underlie much of the
latent variables literature, see, for instance, Hansen and Hodrick (1983), Gibbons
and Ferson (1985), and have been since imposed by Dumas (1994) and Dumas and
Solnik (1995).
We model the level of integration, αj,t , as a logistic function of the lagged domestic
excess stock market returns, rj,t−1 , which is here treated as a proxy of each domestic
market’s cost of capital. We follow Stulz (1999), who gives empirical and theoretical
17
evidence supporting the fact that the cost of capital of a given country decreases when
financial markets become more integrated. Bekaert and Harvey (2000) use aggregate
dividend yield changes to estimate changes in a country’s cost of capital. Although
the dividend yield series is less noisy than the excess stock market returns series and
would thus have offered a better proxy of the cost of capital, the former data series
was not available for all the countries represented in our sample.
We thus expect the level of integration to be negatively correlated with the lagged
domestic excess stock market returns. The logistic function ensures that αj,t belongs
to the interval [0, 1]8 . We thus conjecture the following time-varying specification for
the level of integration of each emerging market country:

exp δ1 + δ2 rj,t−1
αj,t = . (11)
1 + exp δ1 + δ2 rj,t−1
This expression draws a parallel between our approach and the existing literature on
stock market integration based on regime-switching models. Indeed, our measure of
the level of financial integration is specified similarly to the time-varying transition
probabilities from one level of integration to the one next period adopted by Bekaert
and Harvey (1995). Their regime-switching model is a dynamic extension of the
standard Hamilton (1989, 1990) static model developed by Diebold et al. (1996).
The estimated results displayed in tables 5 and 6 suggest first that the hypothesis
of a time-varying level of integration is accepted for all the emerging countries in

the sample. In particular, we find that, consistently with our conjecture, the level of
integration is negatively related to lagged domestic stock market returns. Besides, the
hypothesis of time-varying risk premia cannot be rejected for our sample countries.
This result is in contrast with the one obtained by Carrieri et al. (2005a) who, with
a limited sample of eight emerging markets, find that the global stock market risk is
only priced for some countries over the period 1977 to 2000.

8 Although it is likely that global information variables are also important in determining each
country’s level of integration, we only allow the global variables to influence these levels indirectly,
i.e., through their correlation with our local information variable, the lagged domestic excess stock
market returns, in order to keep the model parsimonious.
18
We observe that each country’s domestic stock market returns covariances with
the world stock market returns as well as with the emerging markets yield spread
are positive9 and that the model thus generates a positive premium for systematic
emerging markets’ risk. Regarding the dynamics of the time-varying risk premia,
we notice that the world stock market risk premium is indeed negatively linked to
changes in the US Treasury bills’ yields. We further observe that the local stock
market risk premium is positively related to lagged world stock market returns. An
increase (respectively a decrease) in world stock market returns can be interpreted
as an increase (respectively a decrease) in the risk premium demanded by risk-averse
agents to invest in the world stock market. Thus, we would expect this change in
preferences to positively affect the local stock market risk premium. Finally, the
emerging markets risk premium depends positively on the changes in the US term
structure spread, which can be viewed as proxying the different phases of the business
cycle.
Figure 1 displays the evolution of monthly averages of the level of integration for
a sub-sample of countries. The displayed countries belong essentially to Asia and to
South America since those countries have the largest representation in our sample
and the stronger emphasis is however on Asian countries given that these countries
were at the core of the financial crises of the nineties. We observe, in every country
displayed, a general collapse in the level of integration during financial crises: the
graphs in Figure 1 show declines in the level of integration during both the Tequila
crisis (Fall 1994 to Spring 1995) and the Asian crises (1997–1998). This collapse is
however much more exacerbated for the Asian countries but had however noticeable
effects in Eastern European countries such as the Czech Republic or in Latin America
(for instance, in Argentina and in Peru). The drop in the level of integration was
in most countries rapidly followed by an upward trend toward the pre-crisis levels of
integration. This pattern tends to suggest that emerging markets are more segmented
in times of financial turmoil and more integrated in times of financial stability, which
9 Figures displaying the evolution of the time-varying covariances are available upon request.
19
is consistent with the idea that investors pay more attention to domestic risk during
crisis periods. We also notice that many emerging markets’ levels of integration have
remained highly volatile after the major breakdown associated with the Asian crisis
(see in particular Thailand or Indonesia). These results, however, do not allow us to

draw any conclusion on the existence of a long-term trend in emerging markets’ levels
of integration. Indeed, world integration is a long term process and our sample covers
less than a decade. From this perspective, the evolution of the levels of integration
displayed in Figure 1 aims at describing an episode of financial disruption from which
most emerging markets have recovered quite quickly based on our results.
[Insert Figure 1 about here]
Finally, we test the robustness of the hypothesis that both the level of market
integration and the risk premia are time-varying. For this purpose, we decide to test
not only the general model where all the coefficients are time-varying but also four
nested models where the level of integration and the three risk premia are successively
assumed to be the only time-varying coefficient (the three other coefficients are thus
assumed each time to be constant). Using a Wald test, we test the null hypothesis
that the above mentioned parameters are constant. The Chi-square statistics with
associated p-values reported in Table 7 show that the null hypotheses that the level
of market integration and the risk premia are constant, individually or as a whole,
are rejected for all countries in the sample.
5 Explaining emerging markets’ levels of stock mar-
ket integration
5.1 Financial markets and the real economy
So far, we have studied emerging stock markets exclusively from an investment per-
spective, as if they were completely separated from the real side of these economies.
20
In general, the development of financial markets is framed in a broader perspective,
as a direct result of economic growth and of the development of international trade
in goods and services.
The links between financial markets and growth have already been extensively
addressed in the economic literature, see Bekaert et al. (2003) for a recent survey.
For instance King and Levine (1993), Levine and Zervos (1998) and Beck and Levine
(2001) study the contributions of stock market development to economic growth while
Bekaert and Harvey (2000) and Bekaert et al. (2003) consider the impact of financial
liberalization on growth. To the extent that financial liberalization and stock market
development promote financial integration, the latter connection to economic growth
has thus already been clearly identified.
Similarly, income per capita may also influence the propensity to engage in in-
ternational financial asset trade. An increase in income per capita may indeed raise
international financial asset trade if we assume that a higher income per capita is
associated with lower risk aversion. If participation in foreign stock markets involves
fixed costs such as learning costs, this may provide another reason why international
cross-holdings might rise with income. Moreover, the size of the domestic finan-
cial sector, which depends directly on the level of economic development, plausibly
facilitates financial integration in several ways. For instance, domestic financial in-
termediaries that also distribute international assets offer a local channel by which
investors can gain foreign exposure. Exposure to domestic financial markets may also
increase the desire for international diversification. On the liability side, an extensive
financial infrastructure is attractive to foreign investors. The strength or effectiveness
of domestic financial regulation may also be important: foreign investors will stay
away from markets that do not protect their interests.
The links connecting international trade to the openness of financial markets have
and still are subject to debate. Initially, trade models like the Heckser-Ohlin model
suggested that international commodity trade is a substitute for trade in capital. Con-
trarily, Aizenmann (2003) and Aizenmann and Noy (2004) invoke a positive feedback
between goods trade and financial openness, treating them as complementary rather
21
than substitutes. Openness in goods markets may also increases the willingness to
conduct cross-border financial transactions, reducing financial home bias. Taking the
case of Ireland, Honohan and Lane (2000) show that the bilateral pattern of goods
and services trade explains the bilateral pattern of portfolio equity investment very
well. In the same vein, Obstfeld and Rogoff (2001) propose an interesting and simple
theoretical model in which financial asset trade is the mirror image of goods trade.
In their model there is a close connection between the gains to international finan-
cial diversification and the extent of goods trade. Finally, Dumas and Uppal (2001)
model suggests that financial market integration is a meaningful goal to be pursued
even in the presence of imperfect mobility in goods trade.
If other papers in the international finance literature have assessed the evolu-
tion of market integration through time, Carrieri et al. (2005a) are the first to try
to explain systematically the determinants of emerging markets’ levels of financial
integration. They estimate a pooled cross-sectional regression of pre-estimated fi-
nancial integration indices for eight emerging markets on a group of proxy variables
capturing the extent of economic and financial development that includes the size
of the trade sector to the GDP. The authors find that trade openness is positively
and significantly related to financial integration only in the regressions with no fixed
effects. In our view, additional empirical evidence on the relationship between trade
openness and financial integration is still necessary to sharpen our understanding of
the validity of the above quoted theoretical explanations regarding their interaction.
In this last section, we intend to contribute to the empirical literature character-
izing the relationship between the level of financial integration and the structure of
emerging markets’ trade in goods and services. Our main goals are twofold. First, fol-
lowing Frankel and Romer (1999) and Wei (2000), we propose to use a decomposition
of a country’s trade openness into its “natural” and “residual” trade factors. This
decomposition will allow us to investigate the relation between financial integration
and trade openness more thoroughly than in the existing literature. In particular,
we are interested in verifying the economic intuition that countries less open to trade
should be more segmented. Second, we empirically document the relationship be-
22
tween financial integration and the degree of a country’s international trade partner
diversification. To our knowledge, there has not yet been any theoretical or empir-
ical study that has systematically analysed this issue. We conjecture that financial
integration is positively related to trade partner concentration. Economically, we

will thus investigate if countries that are less diversified with respect to their trade
partners tend to be more financially integrated. The conjectured relationship can
be motivated by the following arguments: first, the development of international
trade has historically followed a bilateral path and precedes the creation of financial
markets. The latter have benefited from technological innovation that made it less
costly to adopt multilateral trading systems up-front. Second, the stickiness of the
goods and trade structure in place is less easy to reform, and thus, countries may
be inclined to use financial integration in order to substitute for the low levels of
diversification in their trade policy. An economic interpretation of this statistical
relationship could be that financial integration provides developing countries with a
“natural hedge” against their international trade partner concentration. The above
arguments invoked in order to motivate this “natural hedge” hypothesis deserve fur-
ther theoretical grounding, a subject that we however leave for future research.
5.2 Measuring emerging markets’ trade openness
We start by characterizing the level of trade openness of the countries in our sample
according to their geographic and demographic attributes. A more refined decom-
position of trade openness should allow us to investigate the relationship between
financial integration and trade openness more thoroughly than in the existing liter-
ature and to shed additional light on their degree of complementarity for emerging
markets.
We construct for the period 1995–2003 a panel data set for the twenty four coun-
tries in our sample using yearly data obtained from the International Monetary Fund’s
International Financial Statistics (IFS) Direction of Trade Statistics10 . We then es-
10 For the remaining part of the study, Taiwan has been excluded from our sample due to a lack
of published macroeconomic data given its peculiar political situation.
23
timate the following equation:

Xi,t + Ii,t
log = β0,i + β1 Remotenessi + β2 log P opulationi,t
GDPi,t
CoastLengthi
+β3 LandlockDummyi + β4 (12)
Areai
+β5 IslandDummyi + εi,t ,
where the dependent variable is the conventional measure of a country’s openness,

exports (X) plus imports (I) expressed as a percentage of GDP. Equation (12) is very
similar to the popular “gravity equation” used in the international trade literature
to explain countries’ bilateral trade11 , with the difference that in our interpretation,
the countries’ total trade is substituted to bilateral trade quantities. The gravity
model of international trade has a remarkably documented history of success as an
empirical tool in international trade economics. The elasticities of trade with respect
to variables such as the trading partner’s distance and size are documented as being
economically large and statistically significant (see Rose (1999)) in an equation that
explains a reasonable proportion of the cross-country variation in trade. Wei (2000)
is to our knowledge the single reference that extends the gravity model to ”multi-
lateral trade” by recognizing that the determinants of bilateral trade may also be
conjectured to apply with respect to a country’s aggregate trade.
We also allow for a country-specific intercept in order to take into account each
country’s unobservable factors12 . Accordingly, we conduct fixed-effect least squares
estimation. We further think that the fixed effects estimation approach that treats
each country’s openness level as a fixed, yet unknown parameter to be estimated, is
more appropriate to model heterogeneity among countries than the random effects
estimation approach that treats it as drawn from an unknown population and thus as
a random variable. Following Wei (2000), we define the fitted value of this regression
as the measure of an emerging country “natural openness” and label the residual,
11 Recent applications of the gravity equation include Anderson and van Wincoop (2003) and
Frankel and Romer (1999). Krugman (1979) and Helpman and Krugman (1985) provide the theo-
retical foundation of the gravity equation.
12 The price level as measured by the price index of each country while observable nevertheless
only represents one such source of economic heterogeneity.
24
which potentially includes the effects of trade policies, as “residual openness”.
This distinction allows us to recognize the fact that one country’s ability to trade,
which can be measured by the size of its total trade relative to GDP, depends both
on its inherited geographic location and size factors ( i.e. ”natural” variables) as well
as upon a set of ”residual” variables capturing the impact of a country’s political and
economic choices on its foreign trade policy. It is obviously much more difficult to
identify and specify this latter set of variables. Since the residual term in equation
(12) accounts for the factors that are left ”unexplained” by our set of ”natural”
variables, it also measures the explanatory power of omitted variables that would
otherwise contribute to explain a country’s level of trade openness. We can therefore
label this residual term as ”residual openness” and consider that it captures, among
other factors, the impact of a country’s economic and political choices on its level of
trade openness. Thus, our decomposition allows us to understand and to discriminate
between the ”natural” and the ”residual” or man - made choices shaping a country’s
trade openness.
The variable Remoteness captures how distant an emerging country is from its
trading partners. Emerging country i’s remoteness is empirically constructed as a
weighted average of its distance to all other countries in the world where the weights
are determined as each country’s share of total trade in the world’s total trade13 .
For other geographic characteristics, we construct two dummy variables, Landlock, if
the emerging country is landlocked, and Island, if the country is an island. We also
consider the ratio of the length of an emerging country’s sea coast to its land area,
labelled as CoastLength/Area. Finally, we proxy the “size” of an emerging country
by its population.
Table 8 reports a succession of five regressions that attempt to explain trade
openness (exports plus imports divided by GDP). In column 1, only Remoteness is
included. We observe that its coefficient is both negative and significant, which is
13 For this measure, the “world” consists of 184 countries. The distance measure for a par-
ticular pair of countries is the “greater circle distance” as commonly used in the interna-
tional trade literature. We obtain the following formula defining remoteness: Remotenessi =
X +Ij
P184j log(Distancei,j ).
P
X +I
k=1 k k
j6=i
25
consistent with the hypothesis that countries that are more distant from the world

markets are less open. Adding log P opulation in column 2 yields similar results:
large countries, i.e., countries with large domestic markets, are less open. Besides,
the introduction of this new variable adds to the overall explanatory power of the
regression.
In columns 3 to 5, we successively introduce our three other geographic variables,
the Landlock dummy, the ratio of coastal length to land area, and the Island dummy.
The Landlock dummy’s coefficient is negative and significant which corresponds to
the intuition that landlocked countries trade less. The positive signs associated with
the other two coefficients are consistent with the fact that a country with a longer
coast is more open and that an island economy is also more open to foreign trade.We
however observe that the coastal length variable remains statistically insignificant.
With an overall explanatory power rising to 0.56 once all the variables have been
included in the regression, our set of variables is quite successful in explaining emerg-
ing countries’ trade openness14 . Nevertheless, the non-negligible size of the residuals
contained in these regressions suggests that emerging markets’ trade policies, the level
of their economic development or of their endowments in natural resources may also
play a significant role in characterizing their trade openness. Besides, we observe that
geographic and demographic factors tend to offset each other. For instance, coun-
tries like China and India have large coastal length to land area ratios but also large
domestic markets. Similarly, landlocked countries such as the Czech Republic and
Hungary compensate their geographic constraints compared to more open countries
like Argentina and South Africa by being less remote from major Western markets.
14 We also performed the same regressions with non-fixed effects and obtained very similar results.
Essentially, the adjusted R2 for the non-fixed effects regressions corresponding to model 1 to 5 in
Table 8 now range from 0.22 to 0.54 and all the variables except Coast Length divided by Land
Area and the Island dummy are significant and bear the same sign as in Table 8. These results are
available from the authors upon request.
26
5.3 Financial integration and trade partner concentration
Our objective in this sub-section is to characterize the relationship between the level
of financial integration and the structure of international trade over time and across
emerging market countries. For that purpose, we construct a panel data set for the 24
emerging countries in our sample and treat yearly averages of αi 15 , the time-varying
coefficient of financial integration estimated in Section 4 for each country i, over the
1995–2003 period as our dependent variables. The basic panel specification is
αi,t = δi + λ1 ∗ ExportsConcentrationi,t + λ2 ∗ ImportsConcentrationi,t

X
+ λ3 ∗ N aturalOpennessi,t + λ4 ∗ ResidualOpennessi,t + βk Zk,i,t + εi,t ,
where we relate the average yearly level of financial integration of each country
to a set of country- and time-varying determinants: four trade related variables—
i.e., ExportsConcentrationi,t , ImportsConcentrationi,t , N aturalOpennessi,t, and

ResidualOpennessi,t—as well as a set of control variables labelled Zk,i,t . The two
openness variables are respectively the fitted value of the regression defined in Equa-
tion (12) and its residual. The variables ExportsConcentration and ImportsConcentration
measure the level of trade concentration of a given country. They allow us to relate
a country’s goods trade diversification level to that country’s α and thus to test the
null hypothesis that financial integration provides emerging markets with a natural
hedge against their lack of trade partner diversification, i.e. that countries which are
less diversified with respect to their trade partner policy tend to be more financially
integrated16 . Exports(Imports)Concentrationi is defined as the share of country i’s
total exports (imports) realized with its first four exports (imports) partners. Data
on emerging markets’ trade concentration levels for the year 2002 are reported in
15 We use yearly averages of the financial integration coefficients since the right - hand side variables
in the subsequent regression are macro-economic variables which are only observable at an annual
frequency.
16 The positive correlation observed between trade openness and financial market integration may
simply reflect the consequence of both factors having increased over time. It is therefore very
interesting to observe similar coefficients for the natural and residual openness parameters since
the variables used to measure natural openness ( with the exception of a country’s population) are
time invariant. This suggests that there is more to the link between trade openness and financial
integration than just the evolution of two independent time series with similar trends through time.
27
Table 9. On average a country’s first four trade partners represent 51% of its exports
and 46% of its imports. The high level of trade concentration observed for Mexico,
which is explained by NAFTA, is in sharp contrast to Russia’s very low level of trade
concentration. We find that the favorite trade partners include almost exclusively
the USA, other OECD members and neighbor countries17 .
The first control variable to be included in the list of regressors is the level of GDP
per capita, to allow for a systematic relation between financial integration and the
level of economic development. We also consider an indicator of domestic financial
development, since it is potentially an important factor in driving financial integra-
tion: the ratio of stock market capitalization to GDP18 These two variables have been
previously used in both the financial integration literature, see, for instance, Carrieri
et al. (2005a), Bekaert and Harvey (1995), and the financial development literature,
see, for example, Rajan and Zingales (2003). Finally, we use a country-specific inter-
cept to allow for country-specific trends in the level of financial integration. Accord-
ingly, we conduct fixed-effect least squares estimation with White-corrected standard

errors, so that covariances are robust to general heteroskedasticity.
Table 10 shows the regressions’ results for a range of specifications. In column 1,
only ExportsConcentration and ImportsConcentration are included as explanatory
variables. The coefficients associated with these independent variables in the regres-
sion are both positive and significant thus suggesting that countries with a higher
level of trade partner concentration should have more integrated financial markets.
The null hypothesis that countries policymakers tend to use financial integration -
by adopting financial liberalization policies - as a natural hedge against goods and
services’ trade partner concentration is thus supported by the data. Besides, the
inclusion of other regressors does not affect either the sign or the significance of the
two trade concentration variables’ coefficients. As mentioned in the beginning of this
17 We observe low levels of correlation -all around 0.15- between the Concentration and Openness
variables. A country’s physico-geographic characteristics do not seem to influence the structure of

its trade flows.
18 The data was obtained from the International Monetary Fund’s IFS.
28
section, we view the more recent history of financial trade as well as the lower costs
required to extend it to multilateral partners as possible reasons that motivate the
natural hedge hypothesis. In column 2 and 3, we successively add our two openness
variables and observe a positive and significant coefficient for both of them. This re-
sult is consistent with the complementarity hypothesis advocated by Aizenmann and
Noy (2004) according to which countries less open to trade are also less integrated19
The overall explanatory power of the regression is substantially improved with the
addition of these two variables. Several reasons might explain the differences between
the lack of significance in the fixed regressions for the trade openness variable associ-
ated with Carrieri et al. (2005a)’s results when compared to ours. First, our sample
of emerging countries is much more extensive than theirs. Second, the length of our
sample periods do not match and third our measures of stock market integration are
not identical. Finally, we use a finer measure of trade openness that might capture
more precisely its effects on financial integration.
In column 4 and 5, we introduce the two control variables, GDP per capita and
the ratio of stock market capitalization to GDP. Their coefficients are positive and
significant: a larger domestic stock market and a higher level of economic devel-
opment tend to increase the level of a country’s financial integration. Conversely,
countries with a shallow domestic stock market and a low income per capita should
be more segmented. These results are consistent with the levels of integrations such
as Morocco, Egypt and Pakistan.20 . The overall explanatory power of the panel
specification rises to 0.63 once all these variables are included; suggesting that the
set of variables performs reasonably well in “explaining” the level of emerging mar-
kets’ financial integration. We also observe that the introduction of other regressors
does not affect either the sign or the significance of ExportsConcentration’s and
ImportsConcentration’s coefficients. Finally, we run Wald tests of the null hypoth-
19 The positive correlation observed between trade openness and financial integration may reflect
the consequence of both variables having increased over time. It is therefore interesting to observe
similar coefficients for both the natural and the residual openness variables since the factors used to
measure natural openness - with the exception of a country’s population -are time invariant. This
suggests that there is indeed more to the link between financial integration and trade openness than
just the evolution of two independent time series with similar trends through time.
20 These results are also consistent with the ones obtained in the existing literature, in particular
by Carrieri et al. (2005a).
29
esis that λ1 and λ2 , the coefficients for trade concentration, are equal to zero. The
tests generate F-statistics equal respectively to 114.50 and 107.31 with associated
p-values equal to zero.
These empirical results shed new light on the questions left open in Section 2.
First, financial liberalization alone is not sufficient to foster complete financial inte-
gration among emerging markets because the “real” (or “production”) side of these
economies also contributes to this process. Second, countries that are more open
to foreign trade are also financially more integrated. However, the latter statement
needs to be qualified based on a country’s goods trade partner concentration level.
Indeed, the main new result stemming from this empirical study on the determinants
of financial integration is to show that the latter provides emerging countries with a
“natural hedge” against insufficient trade partner diversification and thus contributes
directly to their globalization21. From a theoretical perspective, we are left with sev-
eral open questions: first, what are the main economic policy drivers of the natural
hedge hypothesis and secondly is the natural hedge hypothesis a temporary or a
structural characteristic of emerging markets’ economic policies?
6 Conclusion
In this paper, we first study the behavior of emerging markets’ excess stock returns in
a multi-factor model that takes into account potential market segmentation as well
as emerging markets’ systematic risk. For that purpose, we propose and estimate
a multivariate GARCH(1,1)-in-mean excess stock returns’ generating model which
allows for the pricing of time-varying domestic and world stock market risks as well
as for the pricing of a time-varying non-diversifiable emerging market risk reflecting

these countries’ level of economic instability. Our second contribution is to study
21 A natural extension of this study would have been to examine the link between each emerg-
ing country level of product concentration and its level of financial integration. Lack of available
statistical data on product market concentration however precluded us from studying this a priori
interesting relationhip empirically.
30
the impact of the trade structure of emerging economies on the evolution of the
time-varying levels of financial integration generated by our empirical model.
Our empirical results lead to the following conclusions. First, we find that emerg-
ing stock markets remained partially segmented during the nineties. Our model gen-
erates levels of stock market integration that typically range between 13% (Morocco)
and 55% (Mexico) for the twenty five countries under study over the period extending
from January 1st, 1995 to June 30th, 2004. Second, we find that non-diversifiable
emerging market risk is significantly priced. This reflects investors’ concerns about
emerging countries’ level of economic instability. This emerging markets’ risk pre-
mium is non-negligible, representing on average 20.25% of the total risk premium
demanded by investors to hold emerging markets’ stocks. Third, the level of integra-
tion as well as the unitary risk premia are found to be time-varying over the sample
period, which is consistent with previous results in the empirical finance literature,
see, for instance, Bekaert and Harvey (1995). Fourth, we find that during the fi-
nancial crises of the nineties, the levels of financial integration in emerging markets
dropped sharply, well beyond Asian countries, but recovered quickly afterwards.
In the second part of the study, we investigate whether the structure of emerging
economies trade policies influences the observed evolution of their levels of financial
integration. After having decomposed a measure of countries’ trade openness into
its natural and residual components, we observe that these two trade openness vari-
ables positively contribute to stock market integration. These empirical results shed
new light on the relationship between trade openness and financial integration by
suggesting that these two development factors are complementary rather than sub-
stitutes. However, we go one step further in characterizing emerging markets’ trade
policies and show that the structure of international trade matters too: countries
that are less diversified with respect to their foreign trade partners policy have more
integrated stock markets. In other words, we find evidence of a substitution effect
between trade partner concentration and stock market integration. We explain this
relationship based on the historical bilateral development of goods trade and by the
fact that it is less costly—given technological progress in securities trading mecha-
31
nisms, in particular—for countries to engage in the multilateral trading of financial
securities.
These results could be extended in several ways. It would be interesting to ex-
amine whether the relationship between the structure of foreign trade partner and
financial integration also extends to developed stock markets. Furthermore, exchange
rate uncertainty could also be introduced in the model given the extreme sensitivity
of international trade to currency fluctuations. Finally, the positive relationship be-
tween trade partner concentration and financial integration documented in our study
deserves further conceptual grounding as far as its causes and policy implications are
concerned.
32
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35
Developed Emerging Frontier
Australia Argentina Nigeria Bangladesh
Austria Brazil Pakistan Botswana
Belgium Chile Peru Bulgaria
Canada China Philippines Cote d’Ivoire
Denmark Colombia Poland Croatia
Finland Czech Republic Portugal∗ Ecuador
France Egypt Russia Estonia
Germany Greece Saudi Arabia Ghana
Ireland Hungary Slovakia Jamaica
Italy India South Africa Kenya
Japan Indonesia Sri Lanka Latvia
Netherlands Israel Taiwan Lithuania
New Zealand Jordan Thailand Mauritius
Norway Korea Turkey Romania
Spain Malaysia Venezuela Slovenia
Sweden Mexico Zimbabwe Trinidad and Tobago
Switzerland Morocco Tunisia
United Kingdom Ukraine
Table 1: IFC country classification. Source: International Finance Corporation

(1999). ∗ : through 1998.
36
Africa East. Asia East. Europe Mid. East/Cent. Asia South America
Egypt China Czech Rep. India Argentina
Morocco Indonesia Hungary Israel Brazil
Sth. Africa Korea Poland Pakistan Chile
Malaysia Russia Turkey Colombia
Philippines Mexico
Taiwan Peru
Thailand Venezuela
Table 2: Geographic distribution of the countries in the sample.
37
Panel A
Mean Standard Dev. Skewness Kurtosis Jarque-Bera

Argentina 1.29 · 10−4 0.0548 0.27 7.54 408.94
Brazil 7.50 · 10−4 0.0545 -0.33 4.49 52.38
Chile −8.09 · 10−4 0.0316 -0.16 4.89 71.97
China −17.67 · 10−4 0.0526 0.17 5.38 113.30
Colombia −8.90 · 10−4 0.0387 0.07 5.72 145.84
Czech Rep. 7.89 · 10−4 0.0370 0.03 4.07 22.44
Egypt 2.05 · 10−4 0.0348 0.48 5.90 183.49
Hungary 29.12 · 10−4 0.0472 -0.19 6.97 312.13
India 0.90 · 10−4 0.0387 -0.02 4.21 28.68
Indonesia 1.66 · 10−4 0.0826 0.89 14.52 2656.98
Israel 11.17 · 10−4 0.0382 0.10 5.43 117.09
Korea 8.70 · 10−4 0.0638 -0.03 9.31 778.50
Malaysia −5.94 · 10−4 0.0538 0.55 18.37 4640.54
Mexico 11.62 · 10−4 0.0459 0.08 4.85 67.82
Morocco 4.93 · 10−4 0.0206 0.27 4.96 81.09
Pakistan −9.40 · 10−4 0.0489 -0.02 4.59 49.87
Peru 10.60 · 10−4 0.0361 0.59 8.07 529.91
Philippines −34.65 · 10−4 0.0450 -0.11 6.91 299.71
Poland 7.57 · 10−4 0.0487 0.10 4.44 41.43
Russia 60.38 · 10−4 0.0864 0.50 7.18 361.89
Sth. Africa −2.94 · 10−4 0.0353 -0.32 5.19 102.20
Taiwan −8.72 · 10−4 0.0428 0.51 5.46 138.64
Thailand −15.03 · 10−4 0.0633 0.60 5.91 194.65
Turkey 40.46 · 10−4 0.0819 0.18 10.40 1074.84
Venezuela 13.14 · 10−4 0.0631 -0.87 15.49 3108.45
World 3.88 · 10−4 0.0210 -0.17 4.74 61.86
Panel B
Mean Standard Dev. Skewness Kurtosis Jarque-Bera

TBills 9.01 · 10−5 3.60 · 10−4 -0.92 2.27 75.66
TBonds 11.14 · 10−4 1.92 · 10−4 -0.24 2.47 9.91
EMBI Global 21.38 · 10−4 264 · 10−4 -0.70 13.71 2270.32
Table 3: Descriptive statistics for emerging stock markets’ excess returns

(panel A) and interest rate variables (panel B). All figures are weekly val-
ues. The sample covers the period January, 1st 1995 to June, 30th 2004. EMBI
Global refers to the spread between the return on the EMBI Global index and the
corresponding long-term government bond yield.
38
LM Statistic LM Statistic LM Statistic LM Statistic
Argentina 28.63 Hungary 6.57 Morocco 6.36 Taiwan 7.04
(0.00) (0.00) (0.00) (0.00)
Brazil 6.30 India 6.66 Pakistan 19.59 Thailand 28.74
(0.00) (0.00) (0.00) (0.00)
Chile 11.45 Indonesia 47.16 Peru 24.85 Turkey 21.80
(0.00) (0.00) (0.00) (0.00)
China 6.18 Israel 6.91 Philippines 7.84 Venezuela 7.46
(0.00) (0.00) (0.00) (0.00)
Colombia 12.96 Korea 25.61 Poland 8.36 World 8.29
(0.00) (0.00) (0.00) (0.00)
Czech Rep. 8.84 Malaysia 32.06 Russia 13.50 Spread EMBIG 30.55
(0.00) (0.00) (0.00) (0.00)
Egypt 19.75 Mexico 6.77 Sth. Africa 8.61
(0.00) (0.00) (0.00)
Table 4: ARCH-LM tests. This is a Lagrange multiplier (LM) test for autoregressive conditional heteroskedasticity in the residuals
(ARCH). p-values for rejection of the null hypothesis of absence of ARCH effects are provided in parentheses.
39
φ1 φ2 ϕ1 ϕ2 ηS,1 ηS,2
2.58 −4.19 · 106 7150.4 2.48 · 109 7.23 · 10−3 0.4215
(4.18) (−5.37) (8.35) (6.48) (51.7) (38.5)
Table 5: World market price of risk, emerging markets risk premium and
parameters characterizing the EMBIG spread in the trivariate GARCH-
M partial integration model with time-varying risk premia and level of
integration. t-statistics are provided in parentheses
40
δ1 δ2 θ1 θ2 LL δ1 δ2 θ1 θ2 LL
Argentina 0.8228 −448.09 1.18 142.09 37799.35 Mexico 0.3539 −41.67 1.68 80.60 39667.95
(3.61) (−7.95) (8.37) (4.01) (4.72) (−8.91) (6.12) (4.87)
Brazil 0.4967 −166.72 1.12 129.58 36329.36 Morocco 0.4164 −728.29 1.69 118.82 37307.82
(4.26) (−7.10) (6.90) (6.14) (3.11) (−8.42) (5.78) (6.31)
Chile 0.7859 −359.96 2.63 26.52 36718.22 Pakistan 0.8362 −738.56 2.34 67.94 36916.02
(3.92) (−8.39) (6.53) (4.82) (3.49) (−9.15) (7.01) (5.73)
China 0.5984 −308.31 2.10 67.58 38494.26 Peru 0.5520 −398.01 2.25 62.55 38671.78
(4.08) (−12.22) (7.19) (8.35) (3.85) (−8.06) (4.16) (6.04)
Colombia 0.5258 −610.88 1.09 160.63 38229.90 Philippines 0.5385 −334.77 2.24 60.05 36584.89
(5.73) (−6.72) (4.28) (5.17) (5.17) (−7.20) (7.52) (5.24)
Czech Rep. 0.7413 −324.26 1.44 112.05 38103.38 Poland 0.3914 −256.50 1.04 148.67 36293.51
(5.34) (−9.40) (5.42) (8.20) (4.90) (−7.85) (6.83) (6.41)
Egypt 0.3204 −648.79 2.16 83.33 39372.31 Russia 0.7783 −489.79 1.94 88.12 39589.47
(4.19) (−6.25) (8.04) (7.32) (4.04) (−7.35) (7.30) (4.91)
41
Hungary 0.5231 −256.95 1.86 79.43 36544.15 Sth. Africa 0.7186 −180.86 1.70 42.5 37410.16
(4.84) (−11.36) (5.81) (4.27) (3.61) (−5.82) (5.15) (8.12)
India 0.6013 −521.77 1.47 128.31 37730.35 Taiwan 0.4381 −199.78 2.32 43.02 36237.22
(4.65) (−10.53) (4.98) (6.48) (3.96) (−13.17) (7.09) (5.81)
Indonesia 0.3347 −398.19 1.14 149.90 38909.32 Thailand 0.6140 −295.17 1.94 76.78 36801.79
(3.36) (−12.88) (7.45) (4.69) (3.28) (−11.74) (4.82) (7.14)
Israel 0.5808 −162.08 2.77 40.57 39492.54 Turkey 0.4706 −517.08 1.27 144.82 36484.68
(5.70) (−6.51) (9.54) (6.65) (5.13) (−10.67) (5.26) (4.75)
Korea 0.3189 −134.42 1.54 100.58 37267.34 Venezuela 0.5431 −579.71 2.90 22.60 37470.39
(3.56) (−7.94) (4.50) (5.15) (5.25) (−8.53) (4.69) (8.03)
Malaysia 0.5601 −284.72 1.43 115.41 38581.87
(4.32) (−14.73) (6.79) (9.32)
Table 6: Domestic market price of risk and stock market integration level in the GARCH-M partial integration model
with time-varying risk premia and level of integration. t-statistics are provided in parentheses.
General α λj λW λS General α λj λW λS
Argentina 68.86 15.89 13.32 15.59 12.94 Mexico 69.57 14.71 11.16 17.40 11.91
(0.0000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Brazil 68.57 12.11 10.79 10.61 12.55 Morocco 68.45 15.12 9.49 14.08 10.60
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Chile 60.41 14.09 15.67 10.72 11.64 Pakistan 62.74 11.87 9.75 11.46 11.28
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
China 61.11 11.80 9.09 11.10 12.98 Peru 63.59 11.25 10.82 11.25 11.88
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Colombia 64.02 14.69 16.30 11.76 11.30 Philippines 64.25 13.91 13.10 13.59 11.89
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Czech Rep. 62.41 12.98 17.48 17.40 12.86 Poland 64.71 14.28 14.70 11.92 13.05
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Egypt 66.40 13.66 17.90 11.78 13.12 Russia 69.06 15.17 11.28 11.01 13.69
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
42
Hungary 68.64 14.62 10.16 10.34 10.32 Sth. Africa 68.20 14.65 10.93 17.82 12.38
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
India 65.92 11.48 9.03 16.78 12.10 Taiwan 64.83 13.29 13.53 12.11 13.06
(0.0000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Indonesia 65.05 12.89 9.85 15.69 11.29 Thailand 64.10 12.85 10.43 10.34 13.32
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Israel 66.81 15.03 15.37 14.53 13.80 Turkey 65.74 13.02 11.04 9.48 11.35
(0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Korea 60.53 14.40 10.94 15.42 12.83 Venezuela 60.39 12.26 13.50 11.42 13.61
(0.000) (0.0000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000) (0.000)
Malaysia 63.98 13.84 16.78 10.82 13.75
(0.000) (0.000) (0.000) (0.000) (0.000)
Table 7: Likelihood ratio tests of time-varying versus constant coefficients. The results displayed are Chi-square statistics with
associated p-value.
Dependent Variable: Log Openness
1 2 3 4 5
Remoteness −0.364 −0.338 −0.369 −0.356 −0.319
(−2.48) (−2.52) (−2.44) (−2.15) (−2.28)
Log Population −0.117 −0.120 −0.114 −0.125

(−2.59) (−2.65) (−2.18) (−2.40)
Landlock dummy −0.201 −0.239 −0.214

(−2.69) (−2.31) (−2.17)
Coast length divided by land area 0.593 0.376

(1.47) (1.35)
Island dummy 0.898

(1.84)
Adjusted R2 0.29 0.49 0.53 0.53 0.56
Table 8: Explaining openness. The dependent variable is Log Openness. Fixed

effect panel estimation using averaged yearly data from the 24 emerging countries
in our sample for the period 1995–2003. White corrected t-statistics are reported in
parentheses. See text for the definition of variables.
43
Exports Imports USA Other OECD Neighbor Countries
Argentina 0.505 0.545 X X X
Brazil 0.395 0.465 X X X
Chile 0.413 0.489 X X X
China 0.592 0.498 X X X
Colombia 0.610 0.505 X X X
Czech Rep. 0.557 0.486 X X
Egypt 0.448 0.362 X X
Hungary 0.541 0.447 X X
India 0.363 0.222 X X X
Indonesia 0.509 0.435 X X X
Israel 0.553 0.414 X X
Korea 0.508 0.512 X X X
Malaysia 0.543 0.540 X X X
Mexico 0.916 0.724 X X X
Morocco 0.534 0.458 X
Pakistan 0.450 0.362 X X
Peru 0.531 0.484 X X X
Philippines 0.555 0.553 X X X
Poland 0.490 0.477 X X
Russia 0.274 0.367 X X X
Sth. Africa 0.437 0.399 X X
Thailand 0.476 0.458 X X X
Turkey 0.407 0.352 X X
Venezuela 0.607 0.509 X X X
Table 9: Emerging markets trade concentration. In the first two columns are
reported the proportions of exports and imports represented by a country’s first four
trade partners. The next three columns identify whether the United States, other
OECD countries and neighbor countries belong to this privileged group of trade
partners.
44
Dependent Variable: αi
1 2 3 4 5
Exports concentration 0.585 0.538 0.581 0.515 0.554
(2.17) (2.35) (2.42) (2.10) (2.15)
Imports concentration 0.640 0.685 0.610 0.642 0.652

(2.11) (2.09) (2.05) (2.12) (2.06)
Natural Openness 0.396 0.459 0.344 0.425

(2.27) (2.16) (2.30) (2.41)
Residual Openness 0.330 0.368 0.466

(2.24) (2.26) (2.20)
Log GDP per capita 0.527 0.562

(2.14) (2.08)
Stock market capitalization/GDP 0.676

(2.12)
Adjusted R2 0.19 0.38 0.46 0.59 0.63
Table 10: Explaining emerging equity markets integration. The dependent

variable is α, the level of integration reached by emerging stock markets. Fixed
effect panel estimation using averaged yearly data from the 24 emerging countries
in our sample for the period 1995–2003. White corrected t-statistics are reported in
parentheses. See text for the definition of variables.
45
.5 .500 .52
.495 .48
.4
.490
.44
.3
.485
.40
.480
.2
.36
.475
.1
.470 .32
.0 .465 .28
95 96 97 98 99 00 01 02 03 95 96 97 98 99 00 01 02 03 95 96 97 98 99 00 01 02 03
Argentina Brazil Czech Republic
.5 .50 .50
.45
.48
.4
.40
46
.46
.3 .35
.44 .30
.2 .25
.42
.20
.1
.40
.15
.0 .38 .10
95 96 97 98 99 00 01 02 03 95 96 97 98 99 00 01 02 03 95 96 97 98 99 00 01 02 03
Indonesia Korea Malaysia
.64 .5 .50
.45
.60 .4
.40
.56 .3
.35
.30
.52 .2
.25
.48 .1
.20
.44 .0 .15
95 96 97 98 99 00 01 02 03 95 96 97 98 99 00 01 02 03 95 96 97 98 99 00 01 02 03
Mexico Peru T hailand
Figure 1: Time-varying level of integration (monthly averages) for the period 1995-2002.

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Financial Integration, Economic Instability

And Trade Structure In Emerging Markets†

This version: December 13, 2006

In this study, we estimate the level of financial integration using a mul-

emerging market risk” by foreign investors. Indeed, we conjecture that by investing

concepts of emerging markets integration and liberalization in light of the relevant

2 Emerging Market Finance

2.1 Emerging markets’ integration and liberalization

Financial markets participants label a nation an emerging market if it is characterized

[Insert Table 1 about here]

2.2 Characterizing emerging markets’ risk

capita income brackets and each country’s debt-restructuring history.

inflation expectations directly if, for example, it is accompanied by concerns about

[Insert Table 2 about here]

[Insert Table 3 about here]

3 The Pricing Of Systematic Emerging Markets Risk

In A Partial Integration Model

3.1 The Model

We propose to estimate a empirical multi-factor asset pricing model of partial market

It is worthwhile mentioning that the empirical model in Equation (1) could be

In order to perform an empirical test of the conditional specification of the excess

[Insert Table 4 about here]

world market capitalization represented by emerging stock markets, we assume that

+λS,t σEMSI,S,t + εEMSI,t .

+λS,t σEMSI,S,t + εEMSI,t ,

St = ηS,1 + ηS,2 St−1 + εS,t ,

Ht = Ω + B ′ Ht−1 B + A′ εt−1 ε′t−1 A,

the normal distribution assumption. It is therefore important to correct the standard

4 Financial integration and the pricing of system-

atic emerging markets’ risk

by our expectations regarding the risk premia’s time-varying property. We have

of a time-varying level of integration is accepted for all the emerging countries in

[Insert Table 5 about here]

(see in particular Thailand or Indonesia). These results, however, do not allow us to

[Insert Figure 1 about here]

[Insert Table 7 about here]

5 Explaining emerging markets’ levels of stock mar-

5.1 Financial markets and the real economy

integration is positively related to trade partner concentration. Economically, we

5.2 Measuring emerging markets’ trade openness

of published macroeconomic data given its peculiar political situation.

where the dependent variable is the conventional measure of a country’s openness,

only represents one such source of economic heterogeneity.

[Insert Table 8 about here]

αi,t = δi + λ1 ∗ ExportsConcentrationi,t + λ2 ∗ ImportsConcentrationi,t

i.e., ExportsConcentrationi,t , ImportsConcentrationi,t , N aturalOpennessi,t, and

[Insert Table 9 about here]

ingly, we conduct fixed-effect least squares estimation with White-corrected standard

variables. A country’s physico-geographic characteristics do not seem to influence the structure of

by Carrieri et al. (2005a).

structural characteristic of emerging markets’ economic policies?

[Insert Table 10 about here]

as for the pricing of a time-varying non-diversifiable emerging market risk reflecting

Forbes, K., Rigobon, R., 2002. No Contagion, Only Interdependence: Measuring

Table 1: IFC country classification. Source: International Finance Corporation

Table 2: Geographic distribution of the countries in the sample.

Mean Standard Dev. Skewness Kurtosis Jarque-Bera

Mean Standard Dev. Skewness Kurtosis Jarque-Bera

Table 3: Descriptive statistics for emerging stock markets’ excess returns

Log Population −0.117 −0.120 −0.114 −0.125

Landlock dummy −0.201 −0.239 −0.214

Coast length divided by land area 0.593 0.376