Stock market integration, cost of equity capital, and corporate investment: Evidence from Brazil

• Published date: 01 January 2019
• Date: 01 January 2019
• DOI: http://doi.org/10.1111/eufm.12147

DOI: 10.1111/eufm.12147

ORIGINAL ARTICLE

Stock market integration, cost of equity capital,

and corporate investment: Evidence from Brazil

David Hillier

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Tiago Loncan

Department of Accounting and Finance,

University of Strathclyde, 199 Cathedral

Street, Glasgow G4 0QU, UK

Emails: tiago.rodrigues-

loncan@strath.ac.uk;

david.hillier@strath.ac.uk

Abstract

We study the effect of stock market integration on the cost of

capital and investment, using Brazil as a case study. We show that

integration, as proxied by foreign ownership, has a positive impact

on the financing side by reducing cost of capital. On the output

side, we find that integration increases corporate investment, but

only for well-governed firms. We contribute to the debate on the

prosand consof financialglobalization, particularly byproviding

evidence of imp ortant linkages b etween financial int egration and

real economic activity.

KEYWORDS

cost of capital, international asset pricing, investment, stock market

integration

JEL CLASSIFICATION

F65, F61, F36, G15, G12

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INTRODUCTION

The past 30 years have seen a gradual erosion of financial and economic barriers, and this has led to

greater integration between emerging and developed capital markets. It is generally accepted that

higher levels of foreign stock ownership drive integration. However, as noted by Bekaert, Harvey,

Kiguel, and Wang (2016), some of the benefits of financial liberalization remain uncertain, especially

with respect to integration velocity and its impact on improving the real economy.

According to neoclassical international finance theory, equity market liberalization leads to improved risk

sharing between domestic and international investors as well as lowercost of equity (Bekaert & Harvey, 2000;

Chari & Henry, 2004; Henry, 2000b). However,because of home bias and time-varying integration, emerging

The authors are grateful for comments and discussions from participants at the European Financial Management Symposium on

Finance and Real Economy, held in Xiamen University, April, 2017. We also thank an anonymous reviewer and John Doukas, the

Journal’s Editor, for insightful comments and suggestions. All errors are our own.

Eur Financ Manag. 2019;25:181–206. wileyonlinelibrary.com/journal/eufm © 2017 John Wiley & Sons, Ltd.

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stock markets can remain segmented despite liberalization events. A number of implicit barriers make

integration imperfect, such as home preferences in asset allocation,illiquidity, low institutional quality, poor

corporate governance, political risk, and market volatility (Bekaert, Harvey, Lundblad, & Siegel, 2010;

Carrieri, Chaieb, & Errunza, 2013; de Jong & de Roon, 2005; Errunza & Ta, 2015; Solnik & Zuo, 2016).

In this paper, we add a number of contributions to the financial globalization debate and empirically

examine the effects of stock market integration on the cost of equity capital and corporate investment.

First, we estimate the effects of stock market integration on stock returns for Brazilian stock portfolios.

We use foreign ownership as a proxy for the level of stock market integration, a time-varying measure

of foreign investors’presence in the domestic stock market. We extend the findings from the

integration and cost of capital literature, recently reported by Bekaert et al. (2010, 2016) and Carrieri

et al. (2013), with fresh evidence from a major emerging market.

Second, we study the role of asset characteristics, by analyzing the effect of integration on stock

portfolios sorted by size, book-to-market ratios, momentum, illiquidity, and corporate governance

quality. Although prior research has looked into some characteristics, evidence is limited to

investability, firm size, and governance (Bae & Goyal, 2010; Chari & Henry, 2004; Christoffersen,

Chung, & Errunza, 2006; Errunza & Ta, 2015; Huang, 2007; Patro & Wald, 2005). We bring forth

additional factors, such as growth opportunities, liquidity, and momentum.

Third, we investigate how integration affects corporate investment, a real economic variable. This

is particularly important because there is no consensus on the role of financial integration on capital

accumulation and economic growth. We contribute to a growing body of work by Larrain and

Stumpner (2017), Bekaert, Harvey, and Lundblad (2005, 2011), Gupta and Yuan (2009), Bonfiglioli

(2008), Chari and Henry (2008), and Aizenman, Pinto, and Radziwill (2007) and study the real

economic effects of financial globalization. Moreover, we provide a closer look at the role played by

corporate governance in the integration–investment nexus.

On the financing side, we present strong evidence that stock market integration decreases the cost

of equity capital. Foreign ownership, our measure of integration, was about 10% of stock market

capitalization at the beginning of the sample period in 2001, rises steadily and reaches levels close to

25% by the end of 2015. The increase in foreign ownership was accompanied by a marginal reduction

in expected returns, as we find a negative partial effect of lagged foreign ownership on stock returns.

We also show that the effects of integration are unevenly split. In particular, large market capitalization

firms, more liquid stocks, and strong governance firms benefited more than their peers.

On the real economy side, we estimate the effect of financial integration on corporate investment

employing vector autoregressive models. We split stocks into two portfolios, clustering firms

according to explicit corporate governance standards: Novo Mercado (a special corporate governance

listing segment) and Ex-Novo Mercado (firms with less stringent governance). Our findings suggest

positive effects of stock market integration on investment, but only for Novo Mercado firms.

The rest of our study is organized as follows. In section 2, we discuss theories of stock market integration.

Section 3 presents our dataset and section 4 describes the methodology employed in our asset pricing

analysis. In section 5, we present and discuss our findings related to integration and the financing side, and in

section 6, we analyze the effects of stock market integration on the real economic side. Section 7 concludes.

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RELATED LITERATURE

2.1

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Integration and the cost of equity capital

In fully segmented markets, foreign investors have no access to the local equity market and the

domestic CAPM (Capital Asset Pricing Model) holds. Local investors do not benefit from global

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HILLIER AND LONCAN