Global Growth Opportunities and Market Integration

We propose an exogenous measure of a country’s growth opportunities by interacting the country’s local industry mix with global price to earnings (PE) ratios. First, we find that these exogenous growth opportunities strongly predict future changes in real GDP and investment in a large panel of countries. This relation is strongest in countries that have liberalized their capital accounts, equity markets, and banking systems. Second, we re-examine the link between financial development, external finance dependence, investor protection, capital allocation, and growth. We find that financial development, external finance dependence, and investor protection measures are much less important in aligning growth opportunities with growth than is capital market openness. Third, we formulate new tests of market integration and segmentation. Under integration, the difference between a country’s local PE ratio and its global counterpart should not predict relative growth, but the difference between its exogenous global PE ratio and the world market PE ratio should predict relative growth. In a perfectly integrated world economy, capital should be invested where it expects to earn the highest risk-adjusted return. Much of the research on real variables and quantities is strongly at odds with the notion of global integration. For example, in their classic study of 16 developed countries, Feldstein and Horioka (1980) found that domestic saving rates explain over 90% of the variation in investment rates. Because the Feldstein and Horioka sample ends in 1974, it does not reflect the considerable progress towards globalization in the 1970s and 1980s. However, Obstfeld and Rogoff (2000) continue to find a high correlation between domestic investment and ∗Bekaert is at Columbia University and NBER; Harvey is at Duke University and NBER; Lundblad is at Indiana University; Siegel is at the University of Washington. We appreciate the helpful comments of José Campa, Rajesh Chakrabarti, Will Goetzmann, John Graham, Anna Pavlova, Anna Scherbina, Andy Siegel, Jeff Wurgler, and seminar participants at the 2004 EFA meetings in Maastricht, the October 2004 Financial Market Integration lecture series at the ECB in Frankfurt, the 10th Annual Global Investment Conference in Whistler, the 11th Assurant/Georgia Tech Conference on International Finance, the 2005 WFA meetings in Portland, the 2005 Globalization and Financial Services JBF/World Bank Conference, the China International Conference in Finance, the Sixth CIFRA International Conference on Financial Development and Governance in Moscow, the Emerging Markets: Present Issues and Future Challenges Conference at the Universidad de Navarra (Oct. 2005), the University of North Carolina, the 2005 Pacific Northwest Finance Conference, Harvard University, the World Bank, and the University of Wisconsin. We are especially grateful for the comments of the referee and the Editor, Rob Stambaugh.