Trade Liberalization and the Behavior of Emerging Stock Market Prices

Abstract

The subject of this paper is to examine the effect of trade liberalization on the behavior of real emerging stock market prices. The paper first explores the theoretical link between trade liberalization and real stock price behavior by developing an open economy asset pricing model with production. Using this model we develop three regimes of trade liberalization: (I) no liberalization, where there is a fixed quota on the level of imported inputs; (ii) partial liberalization, where the home country's government allows the level of imports to grow up to a threshold; (iii) full liberalization where the quantity constraint on the imported intermediate inputs is removed. The predictions of the model are that real equity returns show negative serial correlation in the first regime, positive autocorrelation in the second regime and zero serial correlation or no predictability in the third regime. In the paper, we then test to determine if the stock price behavior predictions from the theory are confirmed by actual real stock price data from 25 emerging market countries. Employing return autocorrelation and variance ratio tests we find that there is a distinct change in the serial correlation property of the returns as these countries have liberalized the trade sector. Emerging market real stock prices tend to obey the random walk property after these countries liberalized, while real returns show significant positive autocorrelation during the period when these countries were relatively closed.