Testing the Contagion between Conventional and Shari’Ah-Compliant Stock Indices: Evidence from Wavelet Analysis

Abstract

Recently there has been a heightened global concern over ‘contagion’ in the conventional financial markets. Our study is motivated by the desire to test empirically whether this contagion is reflected in both the conventional and Islamic financial markets in both Islamic and non-Islamic countries. This study is the first attempt at testing whether there has been any contagion among the Shari’ah-compliant stock markets during the most recent international financial crisis such as, the US subprime crisis of 2007-2009 with the application of a technique known as ‘wavelet approach’ which has been very recently imported to finance from engineering sciences. We analyze the daily data covering the period from June 2005 to December 2011 for the 18 MSCI conventional and Islamic stock market indexes of the Islamic (Malaysia, Indonesia, Turkey, GCC) and non-Islamic countries (Japan, China, Korea, Taiwan and Hong Kong). Our study is focused on investigating the following empirical questions: (i) Do the conventional and Shari’ah-compliant stock markets move together with the US stock market in the long run? (ii) If there is a comovement, is there any evidence of a lead-lag relationship in the short- and long-run and how has the lead-lag relationship evolved over time? (iii) If they move together, are the co-movements normal (interdependent) or excessive (contagious) (iv) If there does exist a contagion, do Shari’ah-compliant stock markets help in getting diversification benefits as far as the US-based investor is concerned? Our findings based on a few recently developed techniques tend to suggest (i) both MSCI conventional and Islamic stock markets moved together with the USA MSCI stock market in the long run as evidenced in the cointegration tests (ii) An application of the wavelet-cross-correlation analysis used to determine the lead/lag relationship between two time series on a scale-by-scale basis, tends to indicate that the asymmetry of cross-correlation function of both conventional and Shari’ah-compliant MSCI stock indexes with USA conventional MSCI index becomes more pronounced as the scale increases. The wavelet cross-correlations tend to, more or less, broadly suggest that regardless of the period considered, the USA market is the leader at different time scales. (iii) The key results of this research were that there were no contagion effects among all MSCI conventional markets during the first wave of crisis – the outbreak of U.S. mortgage bubble; However, we failed to test contagion effects for MSCI Islamic stock indexes due to the lack of data; Secondly, during the second wave of crisis - collapse of Lehman Brothers, generally, the MSCI conventional stock indexes of Far East countries display contagion effects while the rest of MSCI stock indexes which include Islamic indexes do not show any contagion effects. iv) Finally, an application of the recently-developed Dynamic Multivariate GARCH approach indicates that as far as the US-based investors are concerned, both conventional and Islamic MSCI indexes of Japan, GCC ex-Saudi, Indonesia, Malaysia and Taiwan provide better diversification benefits compared to Korea, Hong Kong, China and Turkey with strong policy implications for the international investors for their portfolio diversification as a hedge against the unforeseen risks.