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TABLE OF CONTENTS DECLARATION ............................................................................Error! Bookmark not defined. LIST OF ABBREVIATIONS ......................................................................................................... iv ABSTRACT..................................................................................................................................... v CHAPTER ONE: INTRODUCTION .........................................................................................

1 1.1 Background ................................................................................................................................ 1 1.2 Research Problem ...................................................................................................................... 3 1.3 Research Objectives ................................................................................................................... 4 CHAPTER TWO: THEORETICAL LITERATURE REVIEW .............................................. 5 2.1 Introduction ................................................................................................................................ 5 2.2 Definition of Financial Integration ............................................................................................ 5 2.3 Types of Financial Integration ................................................................................................... 7 2.4 Measuring Financial Integration ................................................................................................ 8 2.5 Benefits of Financial Integration ............................................................................................. 11 2.5.1 Risk sharing .................................................................................................................... 11 2.5.2 Improved capital allocation ............................................................................................ 12 2.5.3 Economic growth ........................................................................................................... 13 2.5.4 Financial development ................................................................................................... 14 2.6 Economic Integration Theories ................................................................................................ 15 2.6.1 Traditional Economic Integration Theory ...................................................................... 15 2.6.2 New Economic Integration Theory ................................................................................ 16 CHAPTER THREE: EMPIRICAL LITERATURE REVIEW .............................................. 17 3.1 Introduction .............................................................................................................................. 17 3.2 Studies in Asia ......................................................................................................................... 17 3.3 Studies in Africa ...................................................................................................................... 20 3.4 Studies in Europe ..................................................................................................................... 24 3.5 Summary of Literature Review ................................................................................................ 27 3.6 Research Gap ........................................................................................................................... 35 3.7 Conclusion ...............................................................................Error! Bookmark not defined. 3.8 Recommendations for Further Research .................................................................................. 36 REFERENCES .............................................................................................................................. 37

LIST OF ABBREVIATIONS

E. U EAC EMU GDP -

European Union East African Community European Monetary Union Gross Domestic Product Generalized Purchasing Power Parity International Monetary Fund Optimum currency area Organisation for Economic Co-operation and Development Ex ante purchasing power parity Preferential Trade Agreements United Kingdom United States Uncovered interest parity Vector Autoregression

G-PPP IMF OCA OECD PPP -

PTAs U.K U.S UIP -

VAR -

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ABSTRACT The extent to which international goods and financial markets are integrated is an issue of continuing interest for policymakers and market participants. On the one hand, a high degree of economic and financial integration is beneficial since it can foster economic growth, increasing risk sharing and allocating savings more efficiently, on the other hand, however, it may also lead to high cross border economic interdependence and transmission of shocks. Literature review indicates that, there is no unanimous definition of financial integration. This study therefore focused on the type of financial integration whose estimates are conducted by investigating the changes in the co movements across countries between selected financial asset returns. The general objective of the study was to determine the extent of financial integration in the East African financial markets as documented by existing literature. To achieve this objective, literature review on financial integration in the developed markets of Europe, the emerging markets of Asia and the African continent was conducted. Studies from Europe and Asia indicated evidence of increased beta convergence in the financial markets Stocks, Bonds and Treasury bills. However, empirical studies on integration of the East African Community (EAC), focusing on the viability of a monetary union showed partial convergence for the variables considered (Exchange rates, GDP, business cycles, fiscal and monetary variables). The empirical studies concluded that, the three countries tend to be affected by similar shocks and would therefore need significant adjustments to align their monetary policies and to allow a period of monetary policy coordination to foster convergence that will improve the chances of a sustainable currency union. The overall conclusion of this independent study is the lack of empirical work on financial markets integration with specific focus on the stocks and bonds markets, indicating the lack of empirical evidence on the extent of financial integration and longrun equilibrium of investment returns in the East African Financial markets. Further research can therefore be conducted to examine the financial integration of equity markets using quantity-based measures such as market capitalization and also to determine what constitutes significant adjustments for the EAC countries to be able to align their monetary policies and to allow a period of monetary policy coordination to foster convergence that will improve the chances of a sustainable currency union.

CHAPTER ONE: INTRODUCTION 1.1 Background Financial market development is an important component of financial sector development and supplements the role of the banking system in economic development. In other words, financial markets are needed as an alternative source of financing, supplementing commercial banks, which dominate the EAC financial sector with low competitiveness (Gaertner, et al 2011). Specifically, capital markets assist in price discovery, liquidity provision, reduction in transactions costs, and risk transfer. They reduce information cost through generation and dissemination of information on firms leading to efficient markets in which prices incorporate all available information [Yartey and Adjasi (2007), Garcia and Liu (1999)]. A large body of research has found evidence that capital market development contributes to economic growth, including in sub-Saharan African countries (Levine and Zervos, 1998; Adjasi and Biekpe, 2006b). Developed capital markets promote growth by mobilizing domestic savings and investments and by efficiently allocating mobilized resources to the domestic companies. In addition, deep and liquid local capital markets can lessen vulnerability of an economy to external shocks, by reducing currency and duration mismatches in raising funds. Cross-country evidence shows that financial development can reduce income inequality by increasing the income of the poor. There exists a certain minimum-efficient size of bond markets, because large issuance and trading volumes are more economical (Eichengreen and Luengnaruemitchai, 2004). Capital markets in the East African Community (EAC) face common challenges of low capitalization and liquidity, but to different degrees due to the different levels of development in the markets. To this effect, the respective countries have been pursuing development of capital markets through regional integration. Regional integration is a process in which states enter into a regional agreement in order to enhance regional cooperation through regional institutions and rules. The objectives of the agreement could range from economic to political, although it has generally become a political economy initiative where commercial purposes are the means to achieve

broader socio-political and security objectives. It could be organized either on a


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supranational or an intergovernmental decision-making institutional order, or a combination of both. When investments of the same risk command different returns one would conclude that, financial markets are not integrated because of restrictions like legal barriers which prevent capital from freely flowing between countries. In other words, in an integrated financial market, investments of the same risk always have exactly the same expected return. For example, a country with uniform tax laws and regulation usually has an integrated financial market because there are no circumstances where one's return will be reduced because of tax restrictions or different regulation. The extent to which international goods and financial markets are integrated is an issue of continuing interest for policymakers and market participants, whether firms, investors, or financial intermediaries. On the one hand, a high degree of economic and financial integration is beneficial since it can foster economic growth, increasing risk sharing and allocating savings more efficiently. On the other hand, however, it may also lead to high cross border economic interdependence and transmission of shocks. The researcher notes that, there is no unanimous definition of integration in the literature. In financial economics, markets are said to be integrated when only common risk factors are priced and (partially) segmented when local risk factors also determine equilibrium returns. Another, more general definition relates market and economic integration to a strengthening of the financial and real linkages between economies. Typically, estimates of the first definition of integration require sophisticated asset pricing tests (examples are given by Bekaert and Harvey, 1995 and 1997). Estimates of the second, instead, are usually conducted by investigating the changes in the comovements across countries between selected financial asset returns (Dumas, Harvey and Ruiz, 2003). This study focuses on the second type, particularly, the East African stocks and bond markets.

1.2 Research Problem Financial markets are integrated when the law of one price holds. This means that, investment returns and prices of investments of the same risk within different countries in a given region converge to a common figure. Beta convergence acts as a good measure of determining the extent of financial integration and so is the law of one price. Existing literature in general indicates that, there is evidence of increased beta convergence in the financial markets Stocks, Bonds and Treasury bills. Most empirical studies on integration have focused on the developed markets of Europe (Baele et al. 2004, Cappiello et al. 2006, Babetskii et al.2007, Abad et al. 2009, Avadanei 2010) and the emerging markets of Asia (Hung and Cheung, 1995, DeFusco et al. 1996, Moosa and Bhatti 1997, Bhoi and Dhal 1998, Kaminsky and Schmukler 2001, Masih and Masih 2001, Cowen et al. 2006). However, the empirical studies on the extent of financial integration of the East African Community (EAC) focus on business cycles and macro-economic variables - Exchange rates (real and nominal), GDP, fiscal policy variables and monetary policy variables. For instance, Opolot and Osoro (2009) examined the nature and extent of synchronization of business cycles from 1981 to 2000 and concluded that, there is hope for a monetary union in the EAC, but further policy reforms would be necessary to stabilize the national economies and the need for the EAC countries to increase policy co-ordination in order to achieve the desired level of synchronization of macroeconomic fluctuations. Buigut and Valev (2005) arrived at a similar conclusion. Mkenda (2001) and Buigut (2011) investigated the convergence of real and nominal exchange rates. The findings of the studies showed partial convergence for the variables considered and concluded that, the three countries tend to be affected by similar shocks and would therefore need significant adjustments to align their monetary policies and to allow a period of monetary policy coordination to foster convergence that will improve the chances of a sustainable currency union. Emerging from these studies is the knowledge gap on the degree of beta convergence of the investment returns of stocks and bonds in the East African Community financial markets.
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1.3 Research Objectives The general objective of the study is to conduct a review of existing literature to determine the extent of financial integration in the East African financial markets. The specific objectives generated from this general objective include; To conduct literature review to determine the degree of integration in the East African financial markets.

To conduct literature review to determine long-run equilibrium of returns among the East African financial markets.

To determine the knowledge gap on the degree of beta convergence of the investment returns of stocks and bonds in the East African Community financial markets.

CHAPTER TWO: THEORETICAL LITERATURE REVIEW 2.1 Introduction Financial integration which lends its origin in the European Union, has theoretically been covered extensively. As part of literature review, we focus our theoretical framework on the definition, categories of financial integration, the measurement and benefits of financial integration as well as the relevant economic theories. 2.2 Definition of Financial Integration Existing Literature provides various alternative definitions of financial integration; Baele et al. (2004) assume that, a market for a given set of financial instruments and/or services is fully integrated if all potential market participants have the same relevant characteristics as outlined below; 1. They face a single set of rules when they decide to deal with those financial instruments and/or services. 2. They have equal access to the same set of financial instruments and/or services. 3. They are treated equally when they are active in the market. This definition of financial market integration contains three important features. First, it is independent of the financial structures within regions. Financial structures encompass all financial intermediaries institutions or markets and how they relate to each other with respect to the flow of funds to and from households, governments and corporations. Second, frictions in the process of intermediation i.e. the access to or investment of capital either through institutions or markets can persist after financial integration is completed. Financial integration is concerned with the symmetric or asymmetric effects of existing frictions on different areas. Even in the presence of frictions, several areas can be financially integrated as long as frictions affect these areas symmetrically. However, if the frictions have asymmetric effects on the areas, the process of financial integration cannot reach the completion point. Third, definition of financial integration separates the two constituents of a financial market, namely the supply of and the demand for investment opportunities. Full
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integration requires the same access to banks or trading, clearing and settlement platforms for both investors (demand for investment opportunities) and firms (supply of investment opportunities, e.g. listings), regardless of their region of origin. In addition, once access has been granted, full integration requires that there is no discrimination among comparable market participants based solely on their location of origin. When a structure systematically discriminates against foreign investment opportunities due to national legal restrictions, then the area is not financially integrated. An area can also be partially financially integrated.

The definition of financial market integration is closely linked to the law of one price. The law of one price states that if assets have identical risks and returns, then they should be priced identically regardless of where they are transacted. In other words, if a firm issues bonds in two countries or regions, it must pay the same interest rate to both sets of bondholders If the law of one price does not hold, then there is room for arbitrage opportunities. However, if the investment of capital is non-discriminatory, then any investors will be free to exploit any arbitrage opportunities, which will then cease to exist, thereby restoring the validity of the law of one price.

Baltzer et al. (2008) show it is easy to see that the law of one price is in fact an implication of the above definition. If all agents face the same rules, have equal access and are treated equally, any price difference between two identical assets will be immediately arbitraged away. Still, there are cases where the law of one price is not directly applicable. For instance, an asset may not be allowed to be listed on another regions exchange, which according to our definition would constitute an obstacle to financial integration. Another example is represented by assets such as equities or corporate bonds. These securities are characterized by different cash flows and very heterogeneous sources of risk, and as such their prices are not directly comparable. Therefore, alternative measures based on stocks and flows of assets (quantity-based measures) as well as those investigating the impact of common shocks on prices (news-based measures) may usefully complement measures relying on price comparisons (price-based measures).

Brouwer (2005) argues that financial market integration is the process through which financial markets in an economy become more closely integrated with those in other economies or with those in the rest of the world. This implies an increase in capital flows and a tendency for prices and returns on traded financial assets in different countries to equalize. Economic Commission for Africa (2008) confirms that, this requires the elimination of some or all restrictions on foreign financial institutions from some (or all) countries. Ideally, financial institutions would be able to operate or offer cross-border financial services, as well as establish links between banking, equity and other types of financial markets. Financial integration could also arise even in the absence of explicit agreements. Such forms of integration could include entry of foreign banks into domestic markets, foreign participation in insurance markets and pension funds, securities trading abroad and direct borrowing by domestic firms in international markets.

Ho (2009) shows that financial market integration could proceed with enforcement of a formal international treaty. This refers to two distinct elements. One is the provision for concerted or cooperative policy responses to financial disturbances. The other is the elimination of restrictions on cross-border financial operations by member economies including harmonization of regulations of financial systems. Both elements are necessary to achieve full unification of regional financial markets, and taxes and regulations between member economies. 2.3 Types of Financial Integration Literature, for example, Oxelheim (1990) or Guha et al. (2004), distinguishes between total, direct and indirect financial integration. Total financial integration thus embraces direct and indirect integration. Total (perfect) integration means that expected real interest rates are the same on the markets concerned. Where total financial integration is not perfect, the reason may be imperfect direct and/or indirect financial integration. Direct financial integration, which is also called capital market integration, is expressed in deviations from the law of one price for financial securities. Under perfect direct financial integration this law obtains, and an investor can expect, the same return on investments from different markets (and for borrower the same loan costs), after the
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requisite adjustment has been made for risk. If the differential in expected risk-adjusted returns is greater than zero but less than or the same as the transaction cost, we can say that markets are disintegrated but are nonetheless efficient.

Financial integration can also vary in strength from perfect integration to perfect disintegration or segmentation. When expected real interest rates are not the same in the markets in question (not perfect integration), then the markets are said to be segmented. Segmentation is a result of lack of integration and this can happen due to high transaction costs involved in arbitrage or market inefficiency (Guha et al., 2004).

Financial integration includes not only integration of financial markets or services but can take other forms as well. These forms need not be interconnected nor are they advanced forms (stages) of the integration process. Liebscher et al. (2006) show that integration can take many forms and present various aspects: Central Africa) or through dollarization, such as in Latin America and the Caribbean. of listing of securities on foreign stock exchanges. 2.4 Measuring Financial Integration Various measures exist in the literature for assessing the level of financial integration. The methods which are used most are connected with growing investment opportunities. However, Ho (2009) says that a standard measure of financial integration is difficult to develop. There are many types of financial transactions and some countries impose a complex array of price and quantity controls on a broad assortment of financial transactions. This leads to enormous hurdles in measuring cross-country differences in the nature, intensity and effectiveness of barriers to international capital flows
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ralization of the capital account.

(Eichengreen, 2001). Given the variety of asset classes traded, the measurement of financial integration is not straight forward (Kalemli-Ozcan and Manganelli, 2008). Financial integration is often measured following the approach adopted by Baele et al. (2004).

They consider three broad categories of financial integration measures: Price-based measures, which capture discrepancies in prices or returns on assets caused by the geographic origin of the assets. This category of measures is divided into two methods of measurement: yield-based and country effects. News-based measures, which measure the information effects from other frictions or barriers. If the global news has relatively bigger importance than local news, the degree of systematic risk should be identical across assets in different countries. Quantity-based measures, which quantify the effects of friction faced by the demand for and supply of investment opportunities.

Price-based measures measure discrepancies in prices or returns on assets caused by the geographic origin of the assets. This constitutes a direct check of the law of one price, which in turn must hold if financial integration is complete. If assets have sufficiently similar characteristics, it can base these measures on direct price or yield comparisons. Otherwise it needs to take into account differences in systematic (or non-diversifiable) risk factors and other important characteristics. The cross-sectional dispersion of interest rate spreads or asset return differentials can be used as an indicator of how far away the various market segments are from being fully integrated. Similarly, beta convergence, a measure borrowed from the growth literature, is an indicator for the speed at which markets are integrating. In addition, measuring the degree of cross-border price or yield variation relative to the variability within individual countries may be informative with respect to the degree of integration in different markets.

The news-based measures are designed to distinguish the information effects from other frictions or barriers. More precisely, in a financially integrated area, portfolios should be well diversified. Hence, one would expect news (i.e. arrival of new economic
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information) of a regional character to have little impact on prices, whereas common or global news should be relatively more important. This presupposes that, the degree of systematic risk is identical across assets in different countries; to the extent that it is not, financial integration is not completed and local news may continue to influence asset prices.

The quantity-based measures quantify the effects of frictions faced by the demand for and supply of investment opportunities. When they are available, we will use statistics giving information on the ease of market access, such as cross-border activities or listings. In addition, statistics on the cross-border holdings of a number of institutional investors can be used as a measure of the portfolio home bias. Of course, no measure can be used for all markets, as the specifics of some market or the data available for implementing a measure can differ across markets. However, the spirit is the same across all markets, as they capture the extent of possible asymmetries.

Schfer (2009) presents that the classification of integration indicators can be geared to the type of data collected or to the information revealed. With this approach, indicators are calculated either on the basis of statistical data on actual business activities (e.g. interest rate statistics) or by means of surveys of banks and consumers behaviour and intentions. For example, surveys can be used, to learn about the banks international strategies or about consumer attitudes towards foreign providers. With regard to the type of information mined, the indicators can be either qualitative or quantitative. The latter category, in turn, can be volume-based or price-based. Indicators can also be classified by their contribution to the measurement of integration as specified in the three definitions of the term given above.

Accordingly there are: Indicators depicting the extent to which the economic objectives associated with the integration process have been met. In other words, what progress has actually been made on achieving

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Indicators depicting whether banks and consumers perceive the uniform internal market as a whole as their domestic market. Indicators depicting the extent to which the legal prerequisites are in place for banks and consumers to take a pan-European view, i.e. how far the artificial hurdles have been removed.

Two problems may arise with each of the three groups of indicators. Firstly, it may be difficult to correctly measure the variables entered into the respective indicator owing to limited data availability. Secondly, if this is not an issue, it will then be necessary to check whether the calculated indicator permits constructive statements on the status of retail banking market integration 2.5 Benefits of Financial Integration Baele et al. (2004) or Economic Commission for Africa (2008) consider three widely accepted interrelated benefits of financial integration: more opportunities for risk sharing and risk diversification, better allocation of capital among investment opportunities and potential for higher growth. Some studies also consider financial development as a beneficial consequence of financial integration. 2.5.1 Risk sharing Economic theory predicts that financial integration should have an effect on facilitating risk sharing (Jappelli and Pagano, 2008). The integration into larger markets or even the formation of larger markets is beneficial to both firms and financial markets and institutions. According to Baele et al. (2004) financial integration provides additional opportunities for firms and households to share financial risk and to smooth out consumption inter-temporally.

Financial integration allows project owners with low initial capital to turn to an intermediary that can mobilize savings so as to cover the initial costs. These avenues indicate a strong link between financial institutions and economic growth (Levine, 1997). The exploitation of economies-of-scale can allow firms, in particular those small and
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medium-sized ones that face credit constraints, to have better access to broader financial or capital markets.

Risk-sharing opportunities make it possible to finance highly risky projects with potentially very high returns, as the availability of risk-sharing opportunities enhances financial markets and permits risk-averse investors to hedge against negative shocks. Because financial markets and institutions can handle credit risk better, integration could also remove certain forms of credit constraints faced by investors. The law of large numbers guarantees less exposure to credit risk as the number of clients increases. Individual risks could also be minimized by integrating into a larger market and, at the same time, enhancing portfolio diversification.

Through the sharing of risk, financial integration leads to specialization in production across the regions. Furthermore, financial integration promotes portfolio diversification and the sharing of idiosyncratic risk across regions due to the availability of additional financial instruments. It allows households to hold more diversified equity portfolios, and in particular to diversify the portion of risk that arises from country-specific shocks. Similarly, it allows banks to diversify their loan portfolios internationally. This diversification should help Euro area households to buffer country-specific income shocks, so that shocks to domestic income should not affect domestic consumption, but be diversified away by borrowing or investing abroad (Jappelli and Pagano, 2008). Kalemli-Ozcan et al. (2003) provide empirical evidence that sharing risk across regions enhances specialization in production, thereby resulting in well-known benefits. 2.5.2 Improved capital allocation It is a generally accepted view that greater financial integration should allow a better allocation of capital (Levine, 2001). An integrated financial market removes all forms of impediments to trading of financial assets and flow of capital, allowing for the efficient allocation of financial resources for investments and production. In addition, investors will be permitted to invest their funds wherever they believe these funds will be allocated to the most productive uses. More productive investment opportunities will therefore

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become available to some or all investors and a reallocation of funds to the most productive investment opportunities will take place (Baele et al., 2004). Kalemli-Ozcan and Manganelli (2008) show that, by opening access to foreign markets, financial integration will give agents a wider range of financing sources and investment opportunities, and permits the creation of deeper and more liquid markets. This allows more information to be pooled and processed more effectively, and capital to be allocated in a more efficient way. 2.5.3 Economic growth The theoretical literature proposes various mechanisms through which financial integration may affect economic growth. In the neoclassical framework, all effects are generated through capital flows. In the standard model, opening international capital markets generates flows from capital-abundant towards capital-scarce countries, thereby accelerating convergence (hence short term growth) in the poorer countries. In a more sophisticated context, productivity may also increase since capital flows may relieve the economy from credit constraints and thus allow agents to undertake more productive investments (Bonfiglioli, 2008). Furthermore, in the standard neoclassical growth model, financial integration enhances the functioning of domestic financial systems through the intensification of competition and the importation of financial services, bringing about positive growth effects (Levine, 2001). An alternative view (Obstfeld, 1994a) suggests that international capital mobility may affect productivity independently of investment, by promoting international risk diversification, which induces more domestic risk taking in innovation activities, thereby fostering growth. There is ample evidence in the literature that financial integration leads to higher economic growth. Gianetti et al. (2002) demonstrate that, financial integration facilitates access to investment opportunities and an increase in competition between domestic and foreign financial institutions. This in turn leads to improved efficiency of financial institutions as financial resources are released for productive activities. In addition, financial integration leads to increased availability of intermediated investment opportunities, and consequently higher economic growth. Authors also argue that, the
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integration process will increase competition within less developed regions and thereby improve the efficiency of their financial systems by, for instance, reducing intermediation costs. 2.5.4 Financial development According to Hartmann et al. (2007) financial development can be understood as a process of financial innovations, and institutional and organizational improvements in the financial system. Combined, the process have the effect of reducing asymmetric information, increasing the completeness of markets and contracting possibilities, reducing transaction costs and increasing competition. Jappelli and Pagano (2008) show that, the main channel through which the removal of barriers to integration can spur domestic financial development is increased competition with more sophisticated or lower-cost foreign intermediaries. This competitive pressure drives down the cost of financial services for the firms and households of countries with less developed financial systems, and thus expands local financial markets. In some cases, the foreign entrants themselves may supply the additional financial services. Direct penetration by foreign banks and cross-border acquisitions of intermediaries are likely to erode local banks rents. If mergers bring banks closer to their efficient scale, the process will also be associated with a decreasing cost of intermediation. Sharper competition, possibly coupled with cost cutting, translates into more abundant credit and/or lower interest rates. A second channel is through harmonization in national regulations (accounting standards, security laws, bank supervision, corporate

governance), which the process of integration requires. To the extent that regulatory harmonization promotes convergence to the best international standards, it will also enhance domestic financial development and the entry of foreign financial intermediaries in more backward countries. The link between financial development and financial integration is of the utmost importance, as there is strong evidence that financial development is linked with economic growth (Baele et al., 2004).

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As described in Levine (1997), financial systems serve some basic purposes. Among others, they (i) lower uncertainty by facilitating the trading, hedging, diversifying and pooling of risk; (ii) allocate resources; and (iii) mobilize savings. These functions may affect economic growth through capital and technological accumulation in an intuitive way. However, while Levine (1997) recognizes the positive relationship between economic growth and financial development, he is careful not to infer any causality. Indeed, economic growth and financial development are so intertwined that it is difficult to draw any firm conclusion with respect to causality. Nevertheless, recent research has found evidence that financial development affects growth positively. Rousseau (2002) finds empirical evidence that, financial development promotes investment and business by reallocating capital. Trichet (2005) argues that financial integration fosters financial development, which in turn creates potential for higher economic growth. Financial integration enables the realization of economies of scale and increases the supply of funds for investment opportunities. The actual integration process also stimulates competition and the expansion of markets, thereby leading to further financial development. In turn, financial development can result in a more efficient allocation of capital as well as a reduction in the cost of capital. 2.6 Economic Integration Theories We identified traditional economic integration or Preferential Trade Agreements (PTA) theory that explains possible gains from trade and economic integration, or what is commonly referred to as the static analysis of PTAs. New economic integration theory that has evolved with changing economic conditions and trade environments, or what is commonly referred to as the dynamic analysis of economic integration was also discussed. 2.6.1 Traditional Economic Integration Theory Studies discussing trade integration gains and explaining the theoretical implications of preferential trade agreements are based on the pioneering study of Viner (1950).His study, Viner's Traditional Customs Unions Theory was the first to identify concrete criteria to distinguish between the possible advantages and disadvantages of economic integration. Viner's so called "static analysis" of economic integration has divided
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possible effects of economic integration into the well known trade creation and trade diversion effects. Trade creation refers to the case when two or more countries enter into a trade agreement, and trade shifts from a high-cost supplier member country to a low-cost supplier member country in the union. Trade diversion may occur when imports are shifted from a lowcost supplier of a non-member country of the union (third country) to a high-cost supplier member country inside the union. This may be the case if common tariff after the union protects the high cost supplier member country inside the union. 2.6.2 New Economic Integration Theory Balassa (1962), and Cooper and Massell (1965) introduced dynamic effects into the analysis of the welfare effects of economic integration, as a more efficient economic reason or rationale behind the formation of customs unions or economic integration schemes in general. Balassa's dynamic theory of economic integration proved that the static analysis in terms of trade creation and trade diversion is simply not enough to fully capture or analyze welfare gains from economic integration. According to Allen (1963),Balassa (1962) listed the principle dynamic effects of integration as large-scale economies, technological change, as well as the impact of integration on market structure and competition, productivity growth, risk and uncertainty, and investment activity. The same view is shared by Kreinin (1963). According to Brada and Mendez (1988) integration is assumed to raise investment and reduce risks. This can be explained by the fact that a larger market will raise the expected return on investments and reduce uncertainty by enabling firms to lower their costs as a result of increased economies of scale, and a bigger pool of consumers. Schiff and Winters (1998) summarized the definition of the dynamic effects of economic integration schemes as anything that affects the country's rate of economic growth over the medium term.

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CHAPTER THREE: EMPIRICAL LITERATURE REVIEW

3.1 Introduction This chapter presents a review of empirical literature on financial integration which continues to attract considerable research effort among academicians. The discussion was focused on empirical studies done in Asia, Africa and Europe as outlined below. 3.2 Studies in Asia Hung and Cheung (1995) investigated the relationship between the major developed markets of United States, United Kingdom and Japan with the emerging markets of Malaysia, Thailand, Korea, Taiwan, Singapore and Hong Kong. Their major findings were that, Singapore and Taiwan are co integrating with Japan while Hong Kong is co integrating with the United States and the United Kingdom. There are no long run equilibrium relationship between Malaysia, Thailand and Korea and the developed markets of the United States, the United Kingdom and Japan. The relationship between the developed and emerging markets also change over time, as shown by the differing co movements between them in each of the sub-periods. Furthermore, an increasing interdependence between most of the developed and emerging markets is observed after the 1987 stock market crash. They concluded that, findings on the differential comovements between the developed and emerging markets can lead to further insights into socioeconomic connections and provide useful information to both domestic and foreign investors. Arising from this conclusion is the knowledge gap about the exact position on the socioeconomic connections between domestic and foreign investors.

DeFusco et al. (1996) examined the long-run diversification potential of 13 emerging capital markets. They applied the Johansen [18] and Johansen and Juselius [19] co integration procedures to the U.S. and 13 emerging capital markets in three geographical regions of the world using weekly data in the U.S. None of the three regions examined possesses co integrated markets. They found that, these markets are not co integrated between them, an indication that the correlation between returns from each market is independent of the investment horizon return correlations. The conclusion of the study

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points out segmentation between U.S market and these emerging markets in the three regions; an indication of the possible existence of international diversification benefits in the short and long term across these markets. Assisted by these findings, one can carry out a research to determine whether there is co integration among the thirteen emerging equity markets in the Pacific Basin, Latin America and the Mediterranean regions.

Moosa and Bhatti (1997), sought to fill the gap of non-existence of empirical evidence on the degree of integration between the goods and financial markets of Japan and six Asian countries by examining integration between the Japanese markets and those of six Asian countriesHong Kong, Korea, Malaysia, the Philippines, Singapore and Taiwanover the period 1980-1994. The study was conducted by testing uncovered interest parity (UIP) and ex ante purchasing power parity (PPP).They found that, the results of testing international parity conditions are affected not only by the length of the data sample or the testing technique, but also by model specification. Their results are consistent with and confirm the conventional wisdom that, there is a high degree of integration among Asian goods and financial markets. The research gap emerging from this study, is exploring of the issue of integration on the financial markets in isolation of the market for goods and the use of conventional specifications in carrying out a similar study. One could also consider a study on covered interest parity and compare the findings with those on the uncovered interest parity. Bhoi and Dhal (1998) aimed at empirically evaluating the extent of integration of Indias financial markets in the post-liberalization period. The existing gap here was how far the policy and institutional reforms initiatives undertaken in deregulating the financial sector, had resulted in narrowing the inter-market divergences and achieved a reasonable degree of market integration. Employing the co integration method, as well as causal and partial adjustment analysis, , they found that there exists a fair degree of convergence of interest rates among the short term markets - money, credit and gilt markets - the capital market exhibits fairly isolated behaviour. The movement of various interest rates in uniform directions, nevertheless shows an encouraging sign of the growing maturity of the financial markets and their sensitivity to monetary policy. Additionally, there was a low

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degree of price convergence in Indian financial market due to the prevailing stage (then) of development of financial market and the sensitivity of individual markets to tax regime, institutional setting in the form of restriction to entry, and notably, investors preference for non-price features of certain financial products. They concluded that, since the degree of integration of domestic market is dependent on policy and institutional setting facing such market segments, the ongoing financial reform programme needs to be accelerated to further widen and deepen various markets towards achieving a higher degree of convergence. The opening for further research emanating from this study is therefore to explore on the ways to accelerate the ongoing financial reform programme and deepen various markets towards achieving a higher degree of convergence.

Kaminsky and Schmukler (2001) sought to answer the research question on whether capital controls matter in determining the link between domestic and foreign stock market prices and interest rates. The study was conducted at the World Bank. The objective of the study was to examine the characteristics of international market integration and the effects of capital controls in the short and long run. They applied band-pass filter techniques to data from six emerging economies during the 1990s. The major findings were that, while markets seem to be linked more at longer horizons, equity prices seem to be more connected internationally than interest rates. They concluded that, the effects of controls on outflows do not seem to differ from those of controls on inflows. We note that, the analysis was limited to the experience of the 1990s in a handful of countries. Therefore, there is need to examine more exhaustively the many channels through which financial markets might be connected and also encompass a variety of stages of financial development in the data analysis. Masih and Masih (2001) set out to investigate the dynamic causal linkages amongst nine international stock markets in the US, UK and Australia. The study employed the following research methodologies: (i) vector error-correction modeling and (ii) level VAR modeling with possibly integrated and co integrated processes, advocated by: (i) Toda and Phillips (Econometrica, 61 (1993) 1367) and (ii) Toda and Yamamoto (J. Econometrics, 66 (1995) 225), respectively. They found that, there exists significant interdependencies between the established OECD and the emerging Asian Markets. The
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conclusion drawn from this study is that, the US and the UK markets lead other international markets both in the short and long term, despite the global financial crash of October 1987. From this study we deduce the opportunity for further research that captures the nature of linkages among international financial markets (not just stocks) during the period after the 2008 global crisis. This could form some basis for a comparative study on the October 1987 global financial crash and the 2008 global financial crisis with the aim of establishing whether global financial crisis have an impact on the interdependence of developed and emerging markets. Cowen et al. (2006) in the IMF working paper conducted in Asia and pacific department for the period 2001-2004, aimed at documenting trends and patterns in trade and financial integration (which had been observed not long ago) at the regional level and explore potential linkages, or the lack thereof, between the two. The study gap was the association between finance and trade as established in previous studies. They found that, correlation between trade and finance was positive but relatively small (compared to OECD countries). The lack of time series data made it impossible for them to judge any causal impact. In conclusion, they suggested that, East Asian financial and economic integration is likely to increase over the future, as it is lower than in regions where the barriers are lower, and the general trend is towards a reduction in barriers. The problem in Asia in the context of this study which requires some research is the identification/establishment of suitable regional vehicles in which to hold savings and instruments in which they to invest. 3.3 Studies in Africa Kenny and Moss, (1998) examined the emerging phenomenon of African stock exchanges by evaluating the common economic criticisms of stock markets and the political pitfalls involved in their operation. They wanted to understand whether - African stock markets could work and their importance to the continents develop ment. The study methodology was the examination of debate and literature and therefore, no empirical findings. It concludes that the positive economic effects of bourses on African economies are far larger than any negative effects, and argues that the political costs can be mitigated while political benefits can also be gained. Therefore, stock markets might not
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perform efficiently in developing countries and that it may not be feasible for all African markets to promote stock markets given the huge costs and the poor financial structures. Further research can be carried out to establish ways of reducing the costs and also strengthening the financial structures to address the inefficiency problem identified in the study above.

Mkenda (2001) investigated whether the East African Community, comprising of Kenya, Tanzania and Uganda, constitutes an optimum currency area or not. The study employed the Generalized Purchasing Power Parity method, and various criteria suggested by the theory of Optimum Currency Areas. The findings of the study indicated that, while the various indices calculated in the study based on the theory of Optimum Currency Areas gave mixed verdicts, the Generalized Purchasing Power Parity (G-PPP) method supports the formation of a currency union in the region. Using the G-PPP method, the study established co integration between the real exchange rates in East Africa for the period 1981 to 1998, and even for the period 1990 to 1998. Overall the study concluded that, the three countries tend to be affected by similar shocks. The study gap established from these empirical findings is the determination of the cultural factors affecting/influencing the establishment of a monetary union in East Africa.

Buigut and Valev (2005) set out to establish if the East African Community is a viable Monetary Union and assess whether the political force driving the EAC towards a monetary union had any economic basis .They did this by investigating the symmetric nature of demand and supply shocks belying real GDP growth in partner states from 1980-2001 as a precondition for forming an optimum currency area (OCA). The study was meant to fill the existing gap of lack of empirical work/study on the much politically advocated viable monetary union, using the Vector Autoregression (VAR) technique Results from this study showed that, the speed of adjustment to shocks and the effect of variability on real output (real GDP) appeared to be symmetric with the exception of Uganda. In particular, Uganda experienced large shocks and adjustments were very slow which could prove costly in a monetary union. Although the findings could not confirm a viable monetary union at the time, they concluded that, the potential for a monetary union
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exists if there is deeper trade integration. The emphasis from this study is the importance of a well-functioning common market. A new research gap that researchers can consider filling, is the determinants of a well-functioning common market. Kishor and Ssozi (2009) investigated whether the East African Community (EAC) constitutes an optimum currency area (OCA) by estimating the degree and evolution of business cycle synchronization between the EAC countries. They also investigated whether the degree of business cycle synchronization has improved after signing of the EAC treaty in 1999. The study aimed at contributed to the existing meager empirical economic research about the viability of the EAC as a monetary union and not addressing a specific research gap. The research methodology employed was that of unobserved components model of structural shocks obtained from a structural VAR model and a time varying parameter model to estimate the degree and evolution of business cycle synchronization, respectively. Their results indicate that, the proportion of shocks that is common across different countries is small, implying weak synchronization. However, they also found that, the degree of synchronization has improved after signing of the EAC treaty in 1999. The research gap established from their study is the lack of policy measures that can enhance synchronization of business cycles to make the initiative a success.

Opolot and Osoro (2009) aimed at investigating the feasibility of forming a monetary union in the East African Community by examining the nature and extent of synchronization of business cycles from 1981 to 2007, using the Christiano-Fitzgerald (2003) version of the Band Pass filter. Further, they established the extent of comovement of business cycles using percentage standard deviations, autocorrelation coefficients, cross-correlations, and contemporaneous correlations. The research gap was similar to that of Buigut and Valev (2005) empirical feasibility of the East African monetary union. Their findings suggest that, there is a general reduction in the volatility of business fluctuations across the EAC countries and that, the extent of synchronization seems to have improved since the late 1990s in all of the East African Countries, except Burundi, attributing this trend to the relative macroeconomic stability that seemed to have been obtaining in the region, then. In their study, they concluded that, although this
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general pattern suggests there is hope for a monetary union in the EAC, it calls for further policy reforms to stabilize the national economies and the need for the EAC countries to increase policy co-ordination in order to achieve the desired level of synchronization of macroeconomic fluctuations. Future research can be carried out to determine sigma convergence of the respective economies.

Opolot and Luvanda (2009) investigate the extent of macroeconomic convergence in the East African Countries (EAC) using sigma convergence time. The findings were mixed and incoherent, with convergence being established only for some countries and indicators especially after 1995. With respect to nominal variables, there is evidence of some partial convergence of monetary policy variables, while for fiscal policy variables, there is absolutely no evidence of convergence. This study concluded that, there is need for the EAC countries to increase policy harmonization and co-ordination so as to establish a coherent policy environment in the region. More so, the EAC countries ought to continue with the macroeconomic stabilization objective and integrate the macroeconomic convergence benchmarks into the national planning and decision-making frameworks so as to further enhance macroeconomic stability. The gap here, is a study to establish effective monitoring and enforcement mechanisms for the EAC countries to ensure strict observance of the macroeconomic convergence criteria and what policy actions should be taken to ensure full convergence where partial convergence exists.

Buigut (2011) was motivated to fill the existing gap of lack of rigorous examination on the prevailing state (by the time of the study) of monetary policy convergence for the EAC. His study aimed at determining whether the member countries of the East African community would form a successful monetary union based on the long-run behaviour of nominal and real exchange rates, the monetary base and real GDP. The four variables were each analyzed for co-movements among the five countries (Kenya, Uganda, Tanzania, Rwanda and Burundi) using co integration technique. The findings of the study showed partial convergence for the variables considered, suggesting there could be substantial costs for the member countries from a fast-tracked process. The study concluded that, the EAC countries need significant adjustments to align their monetary
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policies and to allow a period of monetary policy coordination to foster convergence that will improve the chances of a sustainable currency union. The gap emanating from the study is the determination of the current state of convergence of the EAC countries policies, which remains unknown. 3.4 Studies in Europe Baele et al. (2004) in a working paper series for the European Union bank investigated the integration of corporate bond markets. Their aim was to determine whether integration was progressing, stable or regressing. The research methodology was based on cross-sectional regression analysis over the period 1998-2003, borrowing from the exiting literature. In the analysis, the yield spread on a corporate bond, relative to a benchmark government bond yield, was decomposed into a component common to all and a component due to the corporate bonds coupon size, time to maturity, liquidity, sector, and credit quality. In their findings, price-based integration measures suggest that, the level and evolution of corporate bond yield spreads in the Euro area is to a large extent determined by credit rating, and to a lesser extent by the common coupon, maturity, liquidity and sector factors. The results also showed that once corrected for pervasive risk the country where a bond is issued has only marginal explanatory power for the cross-section of corporate bond yield spreads. From the above findings, the study concluded that, the corporate bond markets in the analyzed countries are reasonably integrated with each other. But then, the researcher does not explicitly explain or state what constitutes reasonable integration. In other words, is there a benchmark level of integration which puts a demarcation between reasonable and unreasonable integration? This is the research question (research gap for filling) that future research can answer.

Cappiello et al. (2006) in the working paper series of October from the European Central Bank examined financial integration of the equity markets of the Euro area and the new EU countries (Cyprus, Czech Republic, Estonia, Hungary, Latvia, Poland and Slovenia) by carrying out the analysis of returns on equity market indices. The research issue for solving in the working paper was the essence of monitoring the development of the economic and financial links between these countries (which had exhibited interesting
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characteristics) and the Euro zone, bearing in mind that, they would eventually join the European monetary union. They employed the factor model to analyse the variance of market returns and regression analysis to determine the co-movement of returns over two sample periods; pre convergence (before December 1999) and a convergence period (after January 2000). Their results indicated the existence of closer links between the three largest new member states, the Czech Republic, Hungary and Poland while for the four smaller countries, Cyprus, Estonia, Latvia and Slovenia, they found a very low degree of integration between themselves. However, Estonia and to a less extent Cyprus show increased integration both with the Euro zone and the block of large economies. These researchers, in support of the findings, argued that, institutional factors, the sheer size of the economy, geographical distance and weak economic linkages with the Euro area could be responsible for these results. The study concluded that, although all the considered countries have experienced tremendous development in their stock markets, their degrees of integration and speed of convergence with the Euro zone differ quite markedly. By the foregoing, is it possible to achieve a similar objective using quantitybased measures such as market capitalization? How about considering the period after the global financial crisis? Would we arrive at the same findings? These are the questions that seek for answers from future research.

Babetskii et al. (2007) focused on the empirical dimension of financial integration among stock-exchange markets in four new European Union member states (Czech Republic, Hungary, Poland, and Slovakia) in comparison with the Euro area. Their aim was to test for the existence and determine the degree of the four states financial integration relative to the euro currency union. Specifically, they were seeking to know whether there is convergence of the above stock markets and if it really exists, how fast it was and how it was changing over time. Being an empirical study, they applied harmonization analysis (by means of standard and rolling correlation analysis) to outline the overall pattern of integration, beta convergence (through the use of time series, panel, and state-space techniques) to identify the speed of integration and sigma convergence to measure the degree of integration.

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The findings of the study unambiguously point to the existence of beta-convergence of the stock markets under review at the national and sectoral levels. In addition, shocks dissipate at quite a high speed, infact less than half of a week and finally, the lack of major impact of either EU enlargement or the announcement thereof on convergence. The study concluded that, while evaluating the degree of stock market integration between Euro-candidates and the Euro area, one should bear in mind that this is a relatively small yet important segment of financial markets. The research gap in this study which future researchers can consider filling is the extension of the objectives to a broader examination of integration of the money, bond, and credit markets in the enlarged EU.

Abad et al. (2009) studied whether the introduction of the Euro had an impact on the degree of integration of European government bond markets. They carried out a comparative analysis of the degree of integration of government bond markets in two groups of EU-15 countries: those that joined the European Monetary Union (EMU) and those that stayed out. Using a sample spanning the period since the beginning of Currency Union (1999) until June 2008, they applied news-based indicators on the government bonds markets. They found that, apart from a set of world (regional) instruments, a set of local instruments are also able to predict local bond returns. This result suggests incomplete integration. They also found that, EMU and US government bond markets present a low degree of integration. This finding serves as an indication that, it is domestic rather than international risk factors that mostly drive the evolution of government debt returns in EMU countries. Finally, the degree of integration with the US and German bond markets clearly differs between Euro and non-Euro participating countries; an indication that, these countries present a higher vulnerability to external risk factors. Their study concluded that, government bond returns of EMU countries are more influenced by Eurozone risk factors but the EMU countries are only partially integrated with the German market since their markets are still segmented and present differences in their market liquidity or default risk.

Avadanei (2010) studied corporate bond markets in an effort to know the economic importance of the corporate bond market, the Euro implications regarding the growth of
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the market as well as the degree of the bond market integration. The aim of the study was to draw out the lessons from the European monetary union by pointing out the development of the corporate bond market. The article adopted a theoretical approach and therefore does not employ any empirical research methodology. The discussion points out that, the corporate bond market should operate in an efficient and liquid manner due to its importance. On the implications of a common currency, it emerges that, the varying benefits of corporate bond issuance is a reflection of the fact that institutional and fiscal frameworks, as well as other historically determined characteristics that shape financial structures, differ widely from one country to the next. Finally, the European corporate bond markets convergence, showed an enhanced degree of financial integration. His study concludes that, the existence of a mature and robust corporate bond market, which works alongside a sound banking system, is an important feature of a welldeveloped financial system. The existence of such a market appears to be positive for economic development, as it allows corporations and banks to raise funds more quickly and more flexible terms than would otherwise be possible. On the same conclusion, he notes that the developments in Euro area corporate bond issuance can be explained by movements in economic activity, the costs of issuance and mergers and acquisition related activity. The latter reflects financing needs related to corporate restructuring, which in turn may be partly related to the introduction of the single currency. 3.5 Summary of Literature Review This section presents (in table format) a summary of the literature review discussed above in the same order. The summary outlines the name of the researcher (author), research objectives, year of study, research methodology employed, the major findings of the study and the emerging research gap(s).

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Summary of Literature Review Author Study objectives Year of Study Methodology Major findings Research Gaps

1. Studies in Asia Hung and Cheung To investigate the relationship between the major developed markets of United States, United Kingdom and Japan with the emerging markets of Malaysia, Thailand, Korea, Taiwan, Singapore and Hong Kong 1995 Co integration method Singapore and Taiwan are co integrating with Japan while Hong Kong is co integrating with the United States and the United Kingdom. There are no long run equilibrium relationship between Malaysia, Thailand and Korea and the developed markets of the United States, the United Kingdom and Japan There is no co integration between these markets; an indication that the correlation between returns from each market is independent of the investment horizon return correlations Findings on the differential comovements between the developed and emerging markets can lead to further insights into socioeconomic connections and provide useful information to both domestic and foreign investors. The relationship among the thirteen emerging equity markets in the Pacific Basin, Latin America and the Mediterranean regions is not addressed in the study.

DeFusco et al

To determine whether there is linkage between the American market and thirteen emerging equity markets in the Pacific Basin, Latin America and the Mediterranean regions

1996

Co integration method

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Moosa and Bhatti

Examined integration between the Japanese markets and those of six Asian countries- Hong Kong, Korea, Malaysia, the Philippines, Singapore and Taiwan-over the period 1980-1994.

1997

The study was conducted by testing uncovered interest parity (UIP) and ex ante purchasing power parity (PPP).

The results are consistent with and confirm the conventional wisdom that there is a high degree of integration among Asian goods and financial markets.

Study does not address the issue of integration on the financial markets isolation of the goods. One could also consider a study on covered interest parity and compare the findings with those on the uncovered interest parity. Since the degree of integration of domestic market is dependent on policy and institutional setting facing such market segments, the ongoing financial reform programme needs to be accelerated to further widen and deepen various markets towards achieving a higher degree of convergence

Bhoi and Dhal

To empirically evaluate the 1998 extent of integration of Indias financial markets in the post-liberalization period.

Co integration method

There exists a fair degree of convergence of interest rates among the short term marketsmoney, credit and gilt markets - the capital market exhibits fairly isolated behaviour.

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Kaminsky and Schmukler

To examine the characteristics of international market integration and the effects of capital controls in the short and long run.

2001

They applied bandpass filter techniques to data from six emerging economies during the 1990s.

Markets seem to be linked more at longer horizons, Equity prices seem to be more connected internationally than interest rates. They also find little evidence that controls effectively segment domestic markets from foreign markets There exists significant interdependencies between the established OECD and the emerging Asian Markets

Medium term, bond prices and interest rates, were not considered in the study

Masih and Masih

To investigate whether 2001 there exists dynamic causal linkages amongst international stock markets

-Vector errorcorrection modeling - Level VAR modeling Correlation analysis

There is need to carry out a similar study capturing the period after the 2008 global crisis and compare the findings Need for a study to identify suitable regional vehicles in which to hold savings and instruments in which they can invest

Cowen et al.

To establish whether there is an association between trade and financial flows among the East Asia countries

2006

Correlations are positive but relatively small (compared to OECD countries). One year lags or leads have little effect so it is not possible to judge any causal impact.

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2. Studies in Africa Kenny and Moss To examine the emerging phenomenon of African stock exchanges by evaluating the common economic criticisms of stock markets and the political pitfalls involved in their operation To investigate whether the East African Community, comprising of Kenya, Tanzania, and Uganda, constitutes an optimum currency area or not. To establish if the East African Community is a viable Monetary Union 1998 The examination of debate and literature A high proportion of countries in SubSaharan Africa have a long history of very low savings and deposit ratios, and incomplete credit markets with inefficient financial intermediation There is a need to come up with ways of reducing the costs and also strengthening the financial structures

Mkenda

2001 Generalized Purchasing Power Parity method

The study established co integration between the real exchange rates in East Africa for the period 1981 to 1998, and even for the period 1990 to 1998

Given that, there are different types of purchasing power parity, there is a need to consider a similar study using absolute and relative purchasing power parity and compare the findings. The study only mentions about the speed of adjustment but does not address how the markets are able to adjust to shocks

Buigut and Valev

2005 Vector Autoregression (VAR) technique

The speed of adjustment to shocks and the effect of variability on real output (real GDP) appeared to be symmetric with the exception of Uganda. In particular, Uganda experienced large shocks and adjustments were very slow which could prove costly in a monetary union.

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Kishor and Ssozi

To investigate whether the East African Community (EAC) constitutes an optimum currency area

2009 Structural VAR model

The proportion of shocks that common across, different countries small, implying weak synchronization. Additionally, the degree of synchronization has improved after signing of the EAC treaty in 1999 There is a general reduction in the volatility of business fluctuations across the EAC countries. Further, the extent of synchronization seems to have improved since the late 1990s in all of the East African Countries, except Burundi

Future research will seek to investigate policy measures that can enhance synchronization of business cycles to make the initiative a success

Opolot and Osoro

To investigate the 2009 The Christianofeasibility of forming a Fitzgerald (2003) monetary union in the full sample East African Community asymmetric version of the Band Pass filter

Need to research on further policy reforms to stabilize the national economies and also determine ways of increasing policy co-ordination in order to achieve the desired level of synchronization of macroeconomic fluctuations. Further research on the need for the EAC countries to design effective monitoring and enforcement mechanisms to ensure strict observance of the macroeconomic convergence criteria is necessary .

Opolot and Luvanda

To investigate the extent of macroeconomic convergence in the East African Countries (EAC)

2009 Sina convergence hypothesis, time series analysis and panel unit root tests

The findings were mixed and incoherent, with convergence being established only for some countries and indicators especially after 1995. With respect to nominal variables, there was evidence of some partial convergence of monetary policy variables, while for fiscal policy variables; they found absolutely no evidence of

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Buigut

To determine whether the member countries would form a successful monetary union

2011 co integration techniques

Partial convergence for the variables considered, suggesting there could be substantial costs for the member countries from a fast-tracked process.

Further research can be recommended to determine what constitutes significant adjustments for the EAC countries to be able to align their monetary policies and to allow a period of monetary policy coordination to foster convergence that will improve the chances of a sustainable currency union.

3.Studies in Europe Baele et al. To investigate the integration of corporate bond markets 2004 Cross-sectional regression analysis The corporate bond markets in the analyzed countries are reasonably integrated with each other The researcher does not explicitly explain or state what constitutes reasonable integration Exploring the possibility of achieving a similar objective using quantity- based measures such as market capitalization

Cappiello To examine financial et al. integration of the equity markets of the Euro area and the new EU ountries (Cyprus, Czech Republic, Estonia, Hungary, Latvia, Poland and Slovenia)

2006 Analysis of variance and regression analysis

Increase in the degree of Existence of closer links between the three largest new member states, the Czech Republic, Hungary and Poland while for the four smaller countries, Cyprus, Estonia, Latvia and Slovenia, they found a very low degree of integration between themselves

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Babetskii et al.

To estimate financial integration of the stock markets of the Euro area countries and the new EU countries (Czech Republic, Hungary, Poland; Slovakia, Slovenia).

2007 Rolling correlation analysis

The existence of beta- convergence of the stock markets under review at the national and sectoral levels. In addition, shocks dissipate at quite a high speed, infact less than half of a week and finally, the lack of major impact of either EU enlargement or the announcement thereof on convergence - They found that, apart from a set of world (regional) instruments, a set of local instruments are also able to predict local bond returns -EMU and US Government bond markets present a low degree of integration -The varying benefits of corporate bond issuance is a reflection of the fact that institutional and fiscal frameworks, as well as other historically determined characteristics that shape financial structures, differ widely from one country to the next. -The European corporate bond markets convergence, showed an enhanced degree of financial integration

The extension of the objectives to a broader examination of integration of the money, bond, and credit markets in the enlarged EU.

Abad et al.

To determine whether 2009 Comparative the introduction of the analysis using Euro had an impact on news-based the degree of integration indicators of European government bond markets 2010 Theoretical approach

Need for a similar study on the European Equity markets and compare the findings.

Avadanei To draw out the lessons from the European monetary union by pointing out the development of the corporate bond market

The study does not tell us the specific measures of a mature and robust corporate bond market. This calls for a more rigorous study which identifies/explains the measures.

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3.6 Research Gap On critically evaluating the existing literature, it has been observed that, most empirical studies on financial integration stock markets, bond markets, money markets, credit markets and the pension funds, have focused on the developed markets of Europe (Baele et al. 2004, Cappiello et al. 2006, Babetskii et al.2007, Abad et al. 2009, Avadanei 2010) and the emerging markets of Asia (Hung and Cheung, 1995, DeFusco et al. 1996, Moosa and Bhatti 1997, Bhoi and Dhal 1998, Kaminsky and Schmukler 2001, Masih and Masih 2001, Cowen et al. 2006). The studies indicate evidence of increased beta convergence in the financial markets Stocks, Bonds and Treasury bills.

However, the empirical studies on integration of the East African Community (EAC) focus on the viability of a monetary union with a focus on business cycles and macroeconomic variables Exchange rate (real and nominal), GDP, fiscal policy variables and monetary policy variables. For instance, Opolot and Osoro (2009) examined the nature and extent of synchronization of business cycles from 1981 to 2000 and concluded that, there is hope for a monetary union in the EAC, but further policy reforms would be necessary to stabilize the national economies and the need for the EAC countries to increase policy co-ordination in order to achieve the desired level of synchronization of macroeconomic fluctuations. Buigut and Valev (2005) arrived at a similar conclusion. They also found that, the degree of synchronization has improved after signing of the EAC treaty in 1999. The research gap established from their study is the lack of policy measures that can enhance synchronization of business cycles to make the initiative a success. Mkenda (2001) and Buigut (2011) investigated the convergence of real and nominal exchange rates. The findings of the study showed partial convergence for the variables considered and concluded that, the three countries tend to be affected by similar shocks and would therefore need significant adjustments to align their monetary policies and to allow a period of monetary policy coordination to foster convergence that will improve the chances of a sustainable currency union. The gap emanating from the study is the determination of the current state of convergence of the EAC countries policies, which remains unknown and also the determination of the cultural factors affecting/influencing the establishment of a monetary union in East Africa.
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Clearly, no single study has discussed financial markets integration with specific focus on the stocks and bonds markets. 3.7 Conclusion As reviewed through the theoretical and empirical literature, it is evident that, academic research on integration of the East African financial markets is lacking and therefore objective one and two could not be achieved. This points to the existence of a knowledge gap on the degree of beta convergence of the investment returns of stocks and bonds in the East African Community financial markets. 3.8 Recommendations for Further Research This study has laid a good platform for conducting further research which includes; (i) Establishment of the findings on the differential co-movements between the developed and emerging markets which can lead to further insights into socioeconomic connections and provide useful information to both domestic and foreign investors. (ii) Need to research on further policy reforms to stabilize the national economies and also determine ways of increasing policy co-ordination in order to achieve the desired level of synchronization of macroeconomic fluctuations. (iii) Further research can be recommended to determine what constitutes significant adjustments for the EAC countries to be able to align their monetary policies and to allow a period of monetary policy coordination to foster convergence that will improve the chances of a sustainable currency union. (iv) Examining the financial integration of equity markets using quantity-based measures such as market capitalization.

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