Interdependence structure of Indian financial markets: an empirical investigation

Abstract

The financial sector reforms in India have ushered in wide ranging changes in the financial markets in India. Beginning in the mid-nineties, many of the barriers that had hitherto restricted the flow of funds across the different financial markets have been removed. The markets thus affected are those for call money, government bonds, foreign exchange, and stocks. The investor base in each of the markets has also been expanded considerably. A key objective of the financial sector reform process in India has been to increase the extent of interdependence between the different financial markets in India. An empirical investigation into the degree of interdependence between these markets is therefore now meaningful and appropriate. Past research elsewhere has extensively studied the interdependence across the stock markets, the money markets, and the foreign exchange markets of different countries. But there are relatively fewer studies that investigate the interrelationships across the different financial markets within a country, especially so in a developing country like India. The stock market in India has been thrown open to foreign portfolio investment since the onset of the liberalization process in 1992. It has been widely expected that foreign portfolio investment will increase the extent of interdependence between the Indian and foreign stock markets, especially with a major market like that of the USA. This issue has not been given enough attention. Past research elsewhere has documented evidence regarding the returns and volatility transmission mechanisms between the stock markets of different countries. There have been no attempts at studying the returns and volatility transmission mechanisms between the Indian stock markets and foreign stock markets, especially the US stock market. This study attempts to fill in all these gaps. The specific questions addressed by this study are: 1. Are there significant interdependence relationships between the money market, the government bond market, the foreign exchange market, and the stock market in India, at the returns level? If yes, determine the most significant interdependence relationship for each market under consideration. 2. What kinds of lead-lag relationships exist between these markets? 3. Are there any volatility spillovers between these markets? The results in the Indian context are benchmarked with similar analysis conducted on the financial markets in the US. 4. Has the extent of returns interdependence between the Indian and US stock markets increased since the onset of the capital market liberalization in India and are there any volatility spillovers between the Indian and US stock markets? 5. What has been the impact of the policy measures of the Reserve Bank of India on the inter-dependence structure between the financial markets in India? The results indicate that there are substantial phase differences between the financial markets in India as compared with the US financial markets. Even at the volatility level, the interlinkages are greater in the US than in India. The study provides evidence regarding the increased degree of interdependence of the Indian stock market with the US stock market, since the onset of the capital market liberalization in 1992. The results show that there are unidirectional volatility spillovers from the US stock market to the stock market in India. The study shows that by increasing the access of market players to multiple markets, it is possible to increase the degree of interdependence between these markets. This study has implications for the monetary policy actions of the Reserve Bank of India. It points out that the low degree of interdependence between the financial markets in India is not conducive to efficient monetary policy transmission and resource allocation mechanisms. The stud- y highlights cross - market volatility linkages that have implications for investment and regulatory policies. To decide on the volatility margins to be imposed on a particular market, regulatory authorities need to consider the volatility spillovers from the other markets. Investors should factor in these cross-market volatility linkages while formulating their risk management policies.