Dynamic Stock Market Integration Driven by the European Monetary Union: An Empirical Analysis

Abstract

This paper investigates the impacts of the introduction of the euro on the pattern of stock market linkages and the dynamic process of stock market integration over the period from 1989-2003. On a regional level, we examine integration among stock market indices of European Union (EU) countries with the European Monetary Union (EMU) while on a global level, integration of the EMU vis-a-vis Japan and the US are analyzed. We assess stock market integration within the context of a bivariate exponential generalized autoregressive conditional heteroscedasticity (EGARCH) framework with time varying conditional correlations. First, we discuss that European stock market integration has undergone a clear regime shift. Second, we find a striking number of significant return and volatility spillovers within the EMU and for the entire EMU region with the US and Japan and that these linkages have strengthened with currency unification. Third, we show that the introduction of the euro has indeed caused this stock market integration. Finally, our seemingly unrelated regression estimations (SURE) find that stock market integration is a persistent and seasonal process as its main determinants are the existing levels of integration and stock market development and there are signs of a positive January effect. While the introduction of the monetary union has in general been a significant driving force behind this regional and global phenomenon, the effectiveness of the different economic convergence criteria associated with the EMU in driving this process differs across member states. On a global level, the commitment to price stability has significantly strengthened stock market integration between the EMU and the US whilst convergence in industrial production has increased ties between the EMU and Japan.