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Increased financial integration among stock markets in the world leads international investors to look for new investment opportunities in order to reduce the potential risks of each investment. When stock market indices of different countries do not follow the same trend, then the international investors can find good opportunities to diversify their portfolio investments among these countries. International investors are generally interested in emerging stock markets but the interdependence among these markets and developed markets may affect the scope for diversification possibilities.
There is a large body of financial literature which studies the existence of interlinkages among international capital markets since such linkages have serious implications for portfolio diversification as well as macroeconomic policies of the countries concerned. Investors who buy shares in foreign as well as domestic companies seek to reduce market risk and reap rewards through global diversification. Such diversification pays so long as various national markets are not perfectly correlated. International capital market relationships also have important implications for macroeconomic policies that influence trade and fiscal balances of countries and the financial policies of different agents within the capital importing economy.
National stock markets have emerged as the major channel for financial integration of emerging market economies amid globalization, deregulation and advances in information technology. Among the factors contributing to growing financial integration is a rapid increase in the cross-border mobility of private capital inflows due to investors seeking portfolio diversification and better yields, a growing reliance of nations on the savings of other nations, and a shift in the leverage preference of companies from debt to equity finance. It is generally perceived that stock markets integration can be associated with several benefits, including development of markets and institutions and effective price discovery, leading to higher savings, investment and economic progress. At the same time, linkages among stock markets can pose various risks, such as the contagion and associated disruption of economic activities that were evident during the crisis in Asia in the late 1990s.
One outcome of the efforts of the Indian government at liberalizing the country’s capital market has been the increased integration of the Indian stock market with international markets, through various channels like foreign portfolio investments (FII investments) in Indian stock markets and the ADR/GDR route, whereby Indian shares are listed and traded on the US and other international stock exchanges. In a country like India, where the stock market is undergoing significant transformation with liberalization measures, the analysis of the nature of integration with other developed and regional emerging markets would not only give an idea of the possible gains to be reaped out of portfolio diversification from the Indian market, but may also provide some indication of the vulnerability of the country’s stock market in case of a regional financial crisis and consequent reversal of capital flows from the region.
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