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What Explains Comovement in Stock Market Returns during the 2007–08 Crisis?

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The 2007–08 financial crisis was one of historic dimensions—few would dispute that it was one of the broadest, deepest, and most complex crises since the Great Depression. Initially, however, the crisis seemed to be of rather limited scope, and many thought countries would be able to “decouple” from events in the United States. But after Lehman Brothers collapsed in September 2008, the crisis spread rapidly across institutions, markets, and borders. There were massive failures of financial institutions and a staggering collapse in asset values in developed and developing countries alike. Nonetheless, the reactions of stock markets varied widely around the globe, with some countries showing greater comovement with the US market than others (figure 1).

Together with Tatiana Didier, we empirically investigate the factors that determine comovement between stock market returns in the United States and those in 83 other countries in a recent paper. In particular, we evaluate the extent to which comovement with US stock market returns during this recent turbulent period was driven by real linkages, was driven by financial linkages, or was the consequence of “demonstration effects” (see Goldstein 1998 and Masson 1998), in which investors became aware of vulnerabilities present in the US context and reassessed the risks in other countries, reevaluating the value of their stockholdings.

Real linkages refer to trade effects, of which there are two main kinds: a competitiveness effect, when changes in relative prices affect a country’s ability to compete abroad; and an income effect, when the crisis reduces income and consequently demand for imports. Financial linkages reflect primarily linkages in the financial account (or capital flows) among countries that are connected to the international financial system. Such linkages can be direct or indirect. Direct financial linkages arise as a result of direct financial exposures between the crisis-hit country (in this case the United States) and others. Indirect financial linkages involve actions of international investors (“common creditors”) that lead to comovement across the various countries where they hold assets, because of margin calls, changes in risk aversion, or herding (due to asymmetric information).

Finally, comovement in market returns might not be related to any sort of linkages across markets, but might happen as a result of a new interpretation of existing information, which stimulates learning and awareness (that is, “demonstration effects”). In particular, after investors see a certain economy collapse (for example, the United States in 2007–08), they might reassess the risks of investments in countries with similar economic vulnerabilities, such as low levels of bank capital, high bank exposure to the real estate sector, or high corporate leverage.

To capture potential trade linkages, we examine the effect of variables such as exports to the United States relative to GDP, total exports to GDP, trade openness (defined as exports plus imports to GDP), and export composition measures (such as the share of fuel or of agricultural exports in total exports). To examine the role of financial linkages, we include measures of bilateral financial linkages, such as foreign holding of US equity and US holding of foreign equity, as well as broader measures of financial integration, such as financial account openness, capital inflows to GDP, stock market size, and liquidity. Finally, to account for the possibility of demonstration effects from the US crisis that raise investors’ awareness of potential risks in other markets, we control for measures of banking, corporate, macroeconomic, and sectoral vulnerabilities.

Our estimations reveal some interesting patterns relating to the comovement of stock markets with the US market during the recent crisis. First, financial linkages are the dominant factor explaining this comovement. We find evidence of financial linkages at work both in the period before and in the period after the collapse of Lehman Brothers. In particular, markets with high ratios of equity holdings by US investors exhibited greater comovement. Countries with high levels of portfolio inflows, more liquid, and more developed stock markets were also more correlated with the US market. For example, Figure 2 plots the relationship of our measure of comovement (estimated in a regression of local stock returns on US stock returns) and stock market liquidity. It shows that more liquid markets exhibited greater comovement with US stock markets.

Second, to the extent that there were “demonstration effects” from the US crisis that led to greater comovement of financial markets around the world with the US market, these manifested themselves primarily during the first stage of the crisis, before the collapse of Lehman, and when vulnerabilities and risks in the US financial system became evident. During this early period we find that in countries with more vulnerable banking and corporate sectors, stock markets were more significantly correlated with the US market. We do not find evidence of these effects during the period after the collapse of Lehman, suggesting that the reassessment of risks in other markets took place as soon as they surfaced in the United States.

Third, despite the large contraction in trade flows during the crisis period, we find no support for significant effects of real (or trade) linkages in explaining the comovement of stock markets across countries with the US market.

Further reading:

Didier, Tatiana, Inessa Love, and Maria Soledad Martinez Peria. Forthcoming. “What Explains Comovement in Stock Market Returns during the 2007–2008 Crisis?” International Journal of Finance and Economics. (Access the Working Paper version.)

Goldstein, Morris. 1998. The Asian Financial Crisis: Causes, Cures, and Systemic Implications. Policy Analyses in International Economics 55. Washington, DC: Institute for International Economics.

Masson, Paul R. 1998. “Contagion: Monsoonal Effects, Spillovers, and Jumps between Multiple Equilibria.” IMF Working Paper 98/142, International Monetary Fund, Washington, DC.

Figure 1. Comovement with US stock market, July 2007–April 2009
Figure shows the coefficient from regressing each country’s stock market monthly returns against US monthly returns over the period July 2007–April 2009. (Click image for a larger version.)


Figure 2: Impact of stock market liquidity on the comovement between local and US stock market returns
Figure shows comovement between local and US stock returns (estimated coefficients) and the stock market turnover ratio across countries. (Click image for a larger version.)



Maria Soledad Martinez Peria

Assistant Director, Research Department, IMF

Inessa Love

Former Senior Economist

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