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Domestic Financial Market Integration

The process of globalization refers to the opening up of domestic markets and institutions to the free cross-border flow of capital and financial services by removing barriers such as capital controls and withholding taxes.

The Indian economy had witnessed the globalization process since the 1980s through partially liberalizing the licensing system and developing the markets globally. However, huge fiscal deficits of the government led the economy to the verge of bankruptcy in terms of its payments and a balance of payment crisis. In the early 1990s, the economy underwent the process of full liberalization with financial integration as one of the major objectives. In order to overcome the deadlocks in the system, it was essential to open up the financial sector to international competitiveness for effective as well as the efficient working of the same. From a broader perspective, there could be vertical as well as horizontal financial integration. Under vertical integration, linkages take place between domestic and international markets while horizontal integration occurs within the domestic markets. One of the benefits of unification of financial markets is an investor can acquire a greater risk-adjusted return on their projects/investments by diversifying their portfolio of assets. Moreover, greater access to global markets has broadened the aspects of borrowing and lending choices available to any economy. Apart from the benefits of integration, there are costs which include macroeconomic instability, the volatility of international flows, inefficient allocation of capital flows, etc.

Globally, the financial market integration which is growing across the boundaries has been due to technological advances, deregulation and globalization and it has assumed greater significance due to the following reasons:

  1. A medium to reflect price signals
  2. To encourage domestic investment and savings
  3. To enhance the efficiency of institutions and resource allocation
  4. To promote advanced technology and market discipline

India experienced a large inflow of foreign direct investment after the removal of barriers on the global flows

The market integration in the Indian economy can be divided into a different phase where the first phase can be traced back to 1990s and second phase was the period from 2000 onwards. The adoption of convertibility in the current account and a system of exchange in 1994 and 1993 respectively accelerated the links between money markets and foreign exchange markets. The second phase witnessed broader stability in the markets. A visible integration was observed between the money and foreign exchange markets through near convergent financial prices. According to the RBI annual report of 2007, a higher degree of correlation in interest rates was reflected in the money market for the period 2000-06 as compared with 1993-2000.

Financial Market

A financial market is a place where the exchange of goods and services between sellers and buyers takes place, also the determination of prices is done by the supply and demand factors. It can be located physically or be virtually available on a network like an internet. Here, people are engaged in selling a good or service to the ones who are willing to purchase it. This buying and selling constitute the components of demand and supply. Steady market demand will ensure that a decline in prices in the market occurs due to increased market supply and vice versa. Similarly, a steady market supply will ensure that a rise in the market prices takes place due to an increase in demand. The availability of materials, consumer preference and perceptions and external socio-political events play a major role in affecting financial markets. The three markets upon which our analysis is based have been discussed below:

financial market integration - stock trading on mobile and laptop

Foreign Exchange Market

There have been various shifts in the exchange rate regime with respect to the Indian economy. Initially, there was a system of par value in which the Indian rupee was fixed against gold and after the collapse of the Bretton Woods System in 1971, the value of the rupee was pegged against the pound sterling. In order to avoid the instability caused by pegging to a single currency, the respective value was pegged against a basket of currencies. Until the 1990s, the market was highly regulated in the form of restrictions on international transactions. A unified system of exchange rate developed in the year 1993 and the rupee became convertible on the transactions related to current account in 1994. The composition of the transactions occurring on the balance of payments drastically altered with major emphasis on the capital account. Many instruments, derivative markets, have been introduced to hedge the risk in foreign currency markets.

Money Market

Short-term borrowing and lending with the maturity of funds ranging from an overnight basis to one year are included in the money market. The money market instruments are considered to be a liquid and close substitute for money. This market helps in transmitting the monetary policy changes to the real sectors of the economy. Due to the dearth of instruments in pre-1980’s period, a large segment of the money markets was comprised of call money market. There are various segments in the money market which includes market repo, notice/term money, call money and CBLO. Major developments in the money market were traced in the year 1991 and 1998 with considerable focus on the establishment of new instruments, relaxation of ceilings in interest rates, promotion of wider participation.

Capital Market

Capital markets in India can be categorized into two types: Primary Markets in which new shares and bonds are issued and Secondary Markets where existing securities and bonds are traded. In the early 1990s, capital markets in India witnessed structural reforms in the form of removal of restrictions on capital flows across countries. This has facilitated a greater degree of integration in financial markets and so increased volatility across markets. According to the report of RBI on Currency and Finance in 2007, there exists a strong co-movement of interest rates between government securities and other segments of the market. The factors that affected the turnover of government securities include SLR holding of banks, the private sector's demand for credit and stance of monetary policy.

An indicative measure of rising integration with international markets can be seen with the growing significance of FII's within domestic fronts. The integration of equity markets and also liberalization of the same can be analysed through the evolution of derivative markets and also rising flows of FDI in the Indian economy.

The financial market integration can be seen as the co-movement that takes place between similar kinds of assets or balancing the return for similar assets. This financial market integration can be viewed as domestically and internationally. According to a study conducted by Anderson et al. (2005), it was found that in financial markets of developed and emerging countries, integration in markets leads to a higher degree of correlation between asset prices particularly equity prices and high-yield bond prices.

According to studies like-Feldstein and Horoika (1980), Feldstein (1983) and Haque (1990), it was discovered that a correlation among savings and national investment is a method to gauge integration of market corroborated by the theory that “the perfect mobility of capital breaks the link between national savings and investment if a country can borrow sufficient funds from outside to make up for a shortfall in savings”. It was found that portfolio preference and structural rigidities was responsible for deadlocks in long term capital flows internationally and due to this any increase in savings are reflected in the form of additions in investment domestically. “They argued that in an internationally integrated market, it is the short-term flow of capital that eliminates short-term interest rate differentials”. Afterwards, their finding was criticized by Taylor (1994) and gave a conclusion that favoured capital mobility on an international basis.

Moosa et al. (1997) took financial markets and goods market to measure the degree of integration between the two. They examined the period of 1980-1994 for Japan and six other countries with the help of purchasing power parity and interest rate parity(uncovered). The results reflected a significant correlation between the two markets.

GĂ©rard et al. (2003), examined return on stock indices which were denominated in dollars on a monthly basis for both developed and emerging markets (Japan, Hong Kong, the U.S., Malaysia, Korea and Thailand). With the use of “Inter Temporal Capital Asset Pricing Model (ICAPM)”, it was found that for the period of 1985-1998, there was little segmentation of markets.

While using the same methodology, Quyyam et al. (2005) examined the integration in financial markets for five countries namely, India, Sri Lanka, Nepal, India and Bangladesh. The results indicated that there was no perfect integration between the world economy and the above-listed countries.

Lane et al. (2006) considered capital flows(gross in nature) as the measure of market integration. With respect to this study, the results were calculated in terms of share in external assets and liabilities for a particular country. The study concluded that there was an asymmetry in the composition of assets and liabilities for India and China. The country’s liabilities that yielded higher returns included debt, FDI and portfolio equities where FDI formed a major component in China whereas in India investment in a portfolio constituted a primary component.


In 21st century integration of financial market has become a certain consequence of financial architecture. In order to harness the benefits of external financing and diverse sources of borrowing and lending activities, India liberalized its boundaries to the global financial system. In addition, the financial crisis in the U.S. had stimulated negative spillover effects on the degree of market integration. There is a strong and wide acceptance of the impact of well-integrated markets on the growth of the real economy but the effects of this integration are questioned. An integrated system is appreciated because of the ease of efficient allocation of resources but the increased volatility of international flows may lead to a situation of external crisis. Although the Indian economy has witnessed inefficiency in its market system, capital markets are viewed as another source in order to reduce or mitigate risk.

India as a developing country has become more dependent upon the financial and banking sector to bridge the gap between demands for and supply of monetary needs. The main reason for enhanced linkages among exchange rate, interest rate and asset prices is the rising accessibility to alternative sources of capital. Due to structural and regulatory factors, every country’s financial system differs from another. One of the objectives of global integration is to cater to the problem of containing the financial stability of a domestic country.

In the period of the pre-global financial crisis, the trading volume of bond & equity grew significantly and it shows the upward trend in the capital market. The inferences from J-J co-integration test suggest that integration in the financial market is seen in all variables undertaken for the study in financial markets of India – forex markets, short term money markets and capital markets – debt and equity. It was ascertained from the study that for the pre-global crisis, a relationship of call money rate with the forex markets and bond market in government securities is found in the long run at 1% significance level. While for the post-global crisis, a relationship of call money rate with the forex markets and equity market is observed in the long run at the same significance level.

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