Summary :

Considerable efforts have been recently devoted in the MENA region to improve foreign portfolio investment in the region’s stock markets. Financial liberalization policies have thus included among others plans to revitalize the various stock markets in order to encourage international participation in listed companies, increasing thus the inflow of capital and lowering subsequently the cost of capital in the domestic MENA financial markets. Moreover, and despite their small market capitalization, during the past ten years, MENA countries’ equity markets have exhibited performance characteristics parallel to other emerging markets in similar stages of development. Record market capitalization growth rates can be noted in Morocco and Jordan, and to a lesser extent in Egypt and Tunisia over the 1998-2011 period. This is due to massive privatization plans introduced in those countries, to the extensive sale of government assets to private firms, and to the considerable efforts devoted recently in enhancing the depth and liquidity of the four stock markets. Nonetheless private capital and portfolio flows to the region have remained relatively limited, and MENA financial systems remain relatively opaque in comparison to other emerging markets. Intra-regional and international portfolio investments have been made mainly in those MENA economies that have implemented policies conducive to strengthening the operational framework of the domestic financial market.With the above in mind, this study sheds new light on the impact of international financial integration on the cost of capital in the MENA emerging countries during financial and non-financial crises episodes. Compared to other emerging market economies and as noted above, MENA’s attractiveness to international investors has been quite modest before the financial crisis, even in the better performing countries of Morocco, Tunisia, Jordan and Egypt. Those MENA countries have recently liberalised more than others investment regulation, removed ownership restrictions as well as trade and capital flows barriers.Moreover, this study adds to the exiting finance literature by providing new insight on the micro-economic implications of international financial integration on the firm’s cost of capital in the MENA stock markets of Egypt, Jordan, Morocco and Tunisia. For this purpose we develop annual proxies for the firm-level cost of equity in a panel of the four emerging markets. We then compute annual financial integration indicators capturing long run linkages, the dynamics of country exposure to international shocks (differentiating between fundamental and shift contagion), and ownership structure. Finally, we analyse the impact of international integration on the microeconomic cost of capital using a set of dynamic panel models with appropriate control variables and robustness checks. Our results provide new information on the impact of international financial integration on the real sector. In the process, we will also be able to monitor integration levels and to compare the cost of capital among the four MENA countries.Our dataset is taken from the Thomson Reuters database and covers four MENA countries: Tunisia (47 firms), Egypt (200 firms), Morocco (68 firms) and Jordan (220 firms). For each listed firm, we retrieve the daily close price, the value of the market index as well as firm level information on a yearly basis: total number of shares outstanding, financial structure (shareholders equity to total assets), annual turnover (annual traded volume divided by the number of outstanding shares) and total ownership from foreign institutional investors.For each company included in the sample, we estimate the cost of equity through the International Capital Asset Pricing Model (ICAPM). Under this approach, the cost of equity depends on a risk free rate and on a term equal to the global market risk premium (the price of risk) multiplied by the stock’s beta (the amount of risk). The model is computed on a rolling annual basis where observed betas represent the stock’s exposure to systematic risk in each specific time-period.For each financial market, we compute rolling annual correlation coefficients as a first proxy for financial shock exposure. We use a time-varying risk-decomposition model in order to monitor country exposure to international shocks on equity markets. We begin with a standard asset pricing model. We measure a market’s exposure to global spillovers by running a set of VAR models for each year and each market. We measure exposure to joint endogenous shocks occurring during the global crisis by implementing Baur and Fry’s (2009) methodology. This method captures system-wide contagion based on a panel data modelling of market linkages. Pooled indices are regressed on the global market index over the entire sample period. Joint abnormal linkages are detected by observing the size of the fixed time effect test statistics. The fixed time effect is included for the crisis period only (from 2007 until the end of the sample in 2011). Finally, we adopt a panel structural VAR modelling approach in order to model the impact of an increase in financial integration on the international cost of equity for MENA firms, controlling for turnover, numbers of shares and financial structure. Our empirical results show that:(1)  In each MENA individual country in our sample, an increase in financial shock exposure leads to an increase in the cost of equity. In the case of all four MENA countries included in our sample, the coefficients associated with pairwise correlation, VAR inverted p-values and systematic risk exposure levels are all positive and significant.(2)  These results are confirmed by the impulse response function analysis showing the response of the cost of equity ICAPM to a one standard deviation in one of the shock vulnerability variables, for each model estimated on a country basis.(3)  For each country in our sample, our results highlight that an increase in shock exposure leads to a temporary increase in the cost of equity. Overall, these results suggest that financial integration leads to a higher cost of equity in turmoil periods. This mechanism operates through portfolio adjustment: under financial integration, systematic risk exposure shifts from a domestic CAPM where systematic risk is measured by the variance of the local index, to an International CAPM where investors determine expected returns by monitoring firm exposure to international shocks on the global market index. Given that international betas of emerging market firms are generally lower, this mechanism leads to a lower risk premium. However, if the gains from diversification are offset by a large increase in the variance of the international market or cancelled by a sudden increase in co-movements, this causality becomes positive. In other words, the adoption of international pricing models by emerging market investors can lead to a higher cost of equity for listed firms in periods of externally induced financial stress.(4)   From a policy perspective, these results suggest that while financial integration carries long run benefits, it goes along with destabilization costs in times of international crises periods. In addition, our results show that destabilization is not confined to the macroeconomic level but also affects the microeconomic cost of capital. This may partly explain the observed drop in aggregate investment in the region in the aftermath of the global crisis (given that the cost of capital negatively affects the net present value of investment projects).(5)  The policy challenge is therefore to protect emerging economies from hot capital flows and global liquidity shocks, while reaping the benefits of integration. Given the already low levels of financial integration observed in the region, financial repression and capital controls would not help improve resilience to international shocks. Rather, we argue that improving the transparency of financial information would help protect these economies from sudden psychological shifts among domestic and international investors.The policy implications of the study are as follows:(1)  The development of MENA’s financial sector should be a top priority on the reform agenda. Stock and bond markets are sometime virtually absent and firms cannot raise capital domestically or internationally.(2)  Increased financial integration within the MENA region would lower the vulnerability of those markets to international shocks and is expected to bring considerable benefits to MENA’s investors by rendering capital more mobile across borders and by lowering the cost of capital. As a result, a more liquid capital market would offer lower borrowing costs for MENA’s corporate sector wishing to raise funds locally and would lower its exposure to the short term speculative capital inflows.(3)  Increased financial liberalization within the MENA region is also expected to enhance regional intermediation of financial resources through close integration of financial markets and increased access of MENA’s investors to regional financial markets to finance investment. In addition, MENA’s investors will have access to a variety of risks adjusted rates of return to enhance the efficiency of portfolio allocation and diversification, which will foster the efficiency of MENA’s financial markets. Increased liberalization within the MENA region is expected to attract important portfolio investments to the region for diversification purposes.(4)  The enhancement of MENA’s local capital markets, especially stock markets is also another way to dampen the effects of the global financial crises, and will help reduce the exposure of private corporations to currency mismatches due to foreign borrowings. Those corporations will be able to raise funds locally and reduce their exposure to external financial shocks. They will also reduce any currency mismatch (exchange rate risk) in their balance sheets, and dampen the implications of any sudden outflows of capital emanating from the current crisis or from other financial shocks.(5)  One way to protect from the mechanisms highlighted in this study would be to implement stricter informational disclosure regulation (accounting norms, auditing requirements), in order to prevent waves of irrational mimetic herding among uninformed investors. Previous studies have shown that imperfect information results in mimetic trading. This induces significant increases in the correlation between the domestic and international market indices during crisis periods, ultimately leading to an increase in the cost of equity. Such transparency reforms should be made in the context of increased south?south trade and financial integration, which would help consolidate the markets and minimize contagion vulnerability. Recent examples of such policies in emerging countries include the integration of bond markets in South East Asia, or the ongoing prudential reforms in South Korea, Malaysia and Indonesia. International financial integration should remain a long run policy objective. However, the associated risks should be fully acknowledged and tackled via domestic reforms and international cooperation.(6) In order to improve financial market integration MENA policy makers need to analyse how the firm-level cost of equity would react in periods of international or regional financial crisis. This would provide a better understanding of the benefits and costs of equity market integration.