Financial Integration In Belgium: A Cointegration Test

Abstract

The three main theories of exchange rate behaviour, namely, the flow-oriented theory, the stockoriented theory, and the arbitrage pricing theory posit that there is a relationship between exchange rate movements and stock returns. In light of mixed and inconclusive results in existing studies on the relation between exchange rate and stock returns, this paper reinvestigates the sensitivity of the total value of stock transactions in Belgium (as a percentage of GDP) to changes in the real effective exchange rate over the period 1980-2014. We also examine the link between stock transactions in Belgium and the United States (as percentages of GDP). Annual data on the three variables are obtained from the World Development Indicators of the World Bank Group. Due to non-stationarity in time series data, the cointegration technique is applied. The results of the Dickey Fuller-Generalized Least Squares (DF-GLS) unit root test indicate that the variables are I (1). The Johansen (1995) cointegration test provides evidence of a long-run relation between the three variables. The results of the cointegration analysis indicate a significant positive long-run relation between stock transactions in Belgium (as a percentage of GDP) and the real effective exchange rate. The results also indicate a significant positive long-run relation between stock transactions in Belgium and the United States. The long-run coefficients are significant at the 1% significance level. The short-run adjustment coefficient has the expected negative sign, which indicates adjustment toward long-run equilibrium. Diagnostic tests are performed to test for autocorrelation and normality in error distribution. The model fails to reject the null hypothesis of no autocorrelation at lag order. The model fails to reject the null hypothesis that the errors are normally distributed. The stability test is also satisfied. Dynamic forecasts indicate an increase in the total value of stock transactions in Belgium over the next ten years. Orthogonalized shocks to the real effective exchange rate and the total value of stock transactions in the United States are found to have permanent effects on the total value of stock transactions in Belgium. The important policy implications following from the empirical analysis are presented and discussed.