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

Published date01 January 2019
Date01 January 2019
DOI: 10.1111/eufm.12147
Stock market integration, cost of equity capital,
and corporate investment: Evidence from Brazil
David Hillier
Tiago Loncan
Department of Accounting and Finance,
University of Strathclyde, 199 Cathedral
Street, Glasgow G4 0QU, UK
Emails: tiago.rodrigues-;
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.
cost of capital, international asset pricing, investment, stock market
F65, F61, F36, G15, G12
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
Journals Editor, for insightful comments and suggestions. All errors are our own.
Eur Financ Manag. 2019;25:181206. © 2017 John Wiley & Sons, Ltd.
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 investorspresence 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 integrationinvestment 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.
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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