Exchange rate flexibility and financial integration: The case of France 1977-2014

Abstract

From 1977 until 2014, the real effective exchange rate in France declined. Over the same period, the total value of stocks traded in proportion to the nation’s GDP increased. The data is consistent with economic theory - currency depreciation was followed by an increase in the total value of stock transactions (in proportion to GDP). The results of most regression analyses have shown that the relationship between currency depreciation and stock transactions are not always consistent with economic theory. The effect of currency depreciation on stock transactions can be either positive or negative due to various reasons, one of which is the omission of an important variable. Phylaktis and Ravazzolo (2005) showed that the lack of a significant relationship between exchange rate movements and stock transactions could be due to excluding the influence of the world capital markets. This paper builds on Phylaktis and Ravazzolo (2005) and tests the hypothesis that currency depreciation increases the total value of stock transactions in France. Annual data is obtained from the World Development Indicators of the World Bank. The total value of stocks traded is expressed as a percentage of GDP. The real effective exchange rate index is the nominal effective exchange rate divided either by a price deflator or by an index of costs. A trivariate VECM is estimated for the period 1977-2014. The paper investigates the short-run and long-run relationships between the real effective exchange rate and the total value of stocks traded in France. The effect of the U.S. stock market, representing the world capital markets, is also examined. The Dickey-Fuller Generalized Least Squares unit root test indicates that the variables are I(1). The Johansen cointegration test indicates a long-run relationship between the variables. Since AIC selected a model with 4 lags and the maximum rank of the cointegrating matrix is found to be 1, the VECM is estimated with 4 lags and 1 rank specification. The short-run results indicate that the adjustment coefficient is statistically insignificant; thus the estimated results are plausible in the short-run but not in the long-run. The short-run results indicate a significantly negative relationship between the real effective exchange rate and the total value of stock transactions in France; thus there is a close association between the stock market and the foreign exchange market in France. The short-run relationship between stock transactions in the U.S. and France is also found to be significantly negative.