Equity Markets and Economic Development: What Do We Know

lira crisis of February 2001, and the Argentine peso crisis of December 2001-January 2002.
For instance, Bekaert, Harvey and Ng. (2003) highlighted that correlation increased
significantly during the Asian crisis, so that even countries whose economic fundamentals
(deficits, inflation, and unemployment rate) were not degraded were affected by contagious
waves of bear markets. Theory and evidence hence suggest that increased financial
vulnerability is an unavoidable cost of market integration.

2.1.3 Portfolio rebalancing and capital flows

Standard portfolio theory states that the inclusion of weakly correlated assets into a domestic
portfolio reduces risk and maximize long run yields (Markowitz, 1952,1959). Concurrently,
the additional benefits of international diversification have been highlighted by Grubel (1968)
and Solnik (1974). In theory, these benefits are attributed to smaller correlation between
international assets, as compared to assets belonging to the same market. According to Roll
(1992) this differential can be explained by differences in cross-national industrial structures.
Intuitively, the benefits of international diversification thus depend on the degree of market
integration/segmentation. In an international context where many emerging countries
dismantled restrictions and controls on capital flows and at the same time relaxed regulations
on the operation of domestic financial markets and moved away from regimes of ‘financial
repression’, the consequence has been the increased globalization of investments seeking
higher rates of return and the opportunity to diversify portfolio risk.

Financial liberalization and deregulation policies have eased the implementation of
diversification strategies by allowing international capital movements, leading to an increase
in global portfolio investment flows. However, integration brings along an increase in
international cross-market correlations, which hinders the benefits of international
diversification. The relationship between integration, correlation and diversification is

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