By: GICHIRI, Karanja MBA Class of 2021
Financial globalization—the increasing integration of national economies with global financial markets—has profound implications for emerging markets like Kenya. This article explores the impact of financial globalization on equity returns at the Nairobi Securities Exchange (NSE), a crucial barometer of Kenya’s economic and financial health. The study uses daily and monthly data spanning from 2002 to 2019 to assess how globalization affects NSE returns by analyzing the integration of the Kenyan equity market with global markets, the role of economic openness, and the influence of foreign investor participation.
Overview of the Nairobi Securities Exchange
The NSE is Kenya’s only public securities trading platform and is the largest exchange in East and Central Africa. It tracks seven indices to monitor market activity, with the NSE 20 Share Index serving as the primary proxy for overall market performance. The NSE is partially integrated with global financial markets, particularly the MSCI Frontier Markets Index and the MSCI All-World Share Index. This partial integration implies that while the NSE is linked to global markets, local factors still play a significant role in determining equity returns.
Globalization and Market Integration
The study finds that the NSE’s integration with global equity markets is evolving, with varying degrees of linkage to different markets. For instance, the NSE 20 returns showed a stronger relationship with the MSCI Frontier Markets Index compared to the MSCI World All-Countries Index. This suggests that Kenya’s financial market integration is more pronounced with frontier markets—those considered less advanced than emerging markets—than with developed markets. This integration is attributed to Kenya’s significant trade relationships with countries in frontier markets.
The time-varying attributes of integration were analyzed using monthly returns in U.S. dollars from January 2002 to December 2019. Findings suggest that the NSE’s integration with global markets changes over time, influenced by both global economic conditions and domestic policies. The Kenyan market remains sensitive to both local and global shocks, which can affect stock market performance. This partially integrated status means that the NSE can benefit from global capital flows, but it also exposes the market to risks of global financial instability, such as sudden withdrawals by foreign investors.
Economic Openness and Equity Returns
Economic openness, defined by the ratio of total trade (imports and exports) to GDP, was examined to understand its effect on the NSE 20 returns. Surprisingly, the results indicated a weak negative relationship between economic openness and the NSE 20 returns. This finding suggests that increasing global trade does not necessarily result in higher returns for Kenya’s equity market. Instead, it could reflect the complexities and vulnerabilities that come with deeper integration into global markets, such as exposure to global economic shocks.
Several studies have highlighted that, for emerging markets, local factors often play a more significant role than global factors in determining equity returns. The analysis supports this argument, indicating that while economic openness contributes to financial globalization, its impact on local stock market returns may be limited.
Foreign Investor Participation
The study also examined the impact of foreign investor participation on the NSE 20 returns. The research identified a weak positive relationship between foreign investor activity and NSE 20 returns. However, foreign investor participation was found to be statistically insignificant in predicting NSE returns when considered in isolation. When macroeconomic variables such as inflation and Treasury bill rates were included in the regression model, the addition of foreign investor participation did not significantly improve the model’s predictive power.
This outcome aligns with literature that highlights the dual effect of foreign investor activity in emerging markets. While their entry can drive up equity prices by lowering the cost of capital, sudden exits—often triggered by global financial shocks—can lead to large negative returns. The 2008 global financial crisis serves as a case in point, where foreign investors’ withdrawal from frontier markets like Kenya caused substantial price declines.
Policy Implications and Recommendations
Given the findings that the NSE is only partially integrated with global markets, the study emphasizes the need for cautious policy formulation by Kenyan regulators and policymakers. This partial integration implies a risk of market contagion from both developed and frontier markets to the NSE. Therefore, institutions like the Central Bank of Kenya should remain vigilant and ensure adequate foreign exchange reserves to mitigate potential capital flight risks.
Moreover, the study’s findings suggest that investors can achieve better portfolio diversification by investing in indices or funds tracking the MSCI World All Countries Index rather than the MSCI Frontier Index, given the different levels of integration observed. For policymakers, this research underscores the importance of maintaining economic stability and fostering investor confidence to mitigate the adverse effects of financial globalization on the domestic equity market.
Conclusion
The study concludes that while the NSE is becoming increasingly integrated with global markets, the integration is not uniform and is influenced by both global and local factors. The Kenyan equity market’s partial integration offers both opportunities and challenges. While it can attract foreign investment and reduce the cost of capital, it also exposes the market to global financial shocks. Policymakers and investors alike must navigate these complexities carefully to harness the benefits of financial globalization while mitigating its risks.
