Conclusions

This paper showed that capital controls and crises do affect the integration of capital markets using data from firms from emerging economies that simultaneously trade their stocks in domestic and international stock markets.

First, the paper showed that the cross-market premium accurately reflected the effective impact of controls on cross-border capital movement on international arbitrage. More specifically, controls, if effective, affect the size and sign of the difference in prices between the underlying stocks and their DRs in New York. By raising the costs of shifting funds across borders, regulations on capital movement prevent investors from engaging in arbitrage-related activities. Controls on inflows depress the price of the underlying stocks in domestic markets, as investors need to pay a tax to purchase relatively undervalued assets, as opposed to buying the DRs. Conversely, controls on capital outflows increase the price of the underlying stocks, as investors are restricted from transferring the proceeds from the sale of those assets abroad.

These controls on cross-country capital movement have been frequently used to prevent crises and inhibit capital outflows once crises occur. While these controls have been criticized many times for being easy to evade, this paper showed that even when they did not fully preclude cross-border flows, they appear to work as intended and segment markets effectively—where effectiveness is understood as the success in producing the desired market segmentation. Whether or not this segmentation is beneficial to the economy is an altogether different question that exceeds the scope of this paper.

Second, as expected, the paper showed that crises were reflected in capital markets. When crises erupt, the cross-market premium becomes volatile, reflecting the shocks that markets receive and the difficulties in performing instantaneous arbitrage. Contrary to periods of capital controls however, arbitrage is still possible during crises, as is evident from the fact that the cross-market premium oscillates around zero. Nevertheless, the decrease in the average premium during crises, including the fact that the underlying stock tends to trade at a slight discount, suggests that the risks of holding the underlying stock compared to the DR increases.

Ultimately, the paper illustrated that cross-market premium could be used as a tool to measure capital market integration, particularly during periods of capital controls and crises. For example, to the extent that there is market segmentation, this measure reflects the intensity of the segmentation and the force of capital flows. As the case of the Republic of Korea proves, the premium diminished when controls on capital outflows became less restricted. Moreover, when investors were pushing to get out of Argentina at the beginning of the 2001 crisis, the cross-market premium sharply increased, and as markets calmed down, the premium subsided. Nevertheless, even when markets are not segmented, this measure can show the shocks markets suffer, as reflected in the crisis periods. In the end, this measure might become a useful tool for policymakers to monitor market sentiment in economies with assets traded both domestically and abroad.

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