Can Investor Sentiment Be a Channel of Contagion During the 1997 Asian Crisis? Evidence from Closed-End Country Funds

Abstract

This paper tests whether changes in investor sentiment can be a channel of contagion during the 1997 Asian crisis using data from US based closed-end country funds (CECFs) and the corresponding net asset values (NAVs). Specifically, I examine whether there are any incremental conditional mean and asymmetric volatility spillovers between domestic NAV and overseas CECF markets during the crisis after controlling for the shocks from economic fundamentals. The empirical results based on the tests of international CAPM in the absence purchasing power parity with multivariate GARCH-in-mean approach show that before the crisis local NAV investor sentiment is more important than US market sentiment in determining CECF returns, while US market sentiment is more important than CECF investor sentiment in determining NAV returns. During the crisis, the intensity of mean spillover from NAV to CECF has decreased, but it has increased significantly for the mean spillover from CECF to NAV, suggesting that the changes in foreign investor sentiment in particular the sentiment from US CECF investors played the major role in determining local NAV returns and therefore can be the potential cause of the 1997 Asian crisis. After the crisis, both the mean spillovers from NAV to CECF and from CECF to NAV have shifted back to their pre-crisis levels, but the mean spillovers from both US and foreign exchange markets have become more important for CECFs. Finally, there is a unidirectional relationship of asymmetric volatility shocks between CECF and its NAV where the direction of the shocks runs from NAV to CECF, and this relationship strengthens during the crisis. This finding implies that the trading behavior of local NAV investors is the major source of asymmetric volatility shocks to the corresponding CECF traded in the US, and the impact of these shocks increases significantly during the crisis.