AN ECONOMETRIC ANALYSIS ON THE RELATIONSHIP BETWEEN BILATERAL TRADE LINKS AND GRANGER CAUSALITY: THE CASE OF AUSTRALIA AND KEY BILATERAL TRADE PARTNERS

Abstract

The incidence of global and regional financial crisis has caused analysts to re-examine existing economic policies and tools. There is a growing need for adaptive policies and tools that help economists to anticipate or recognize the early signs of a crisis and the potential for contagion of financial crisis from other countries. An issue of concern is how trade and financial links could prove detrimental to a country’s economic development –linkages seem to facilitate the transmission of crisis across borders. The negative impact of a crisis is often reflected in market indexes. This study explores the relationship between bilateral trade links and financial contagion in financial markets with particular emphasis on Australia. Monthly data from July 1997 to June 2013 was obtained from Yahoo Finance for the composite stock market indexes of Australia and six bilateral trade partners; China, United States, Korea, Japan, Singapore and United Kingdom. Using Eviews7 software, this study explored the relationship between stock indexes for the seven countries via co-integration and pairwise Granger Causality (GC) tests. Findings show that returns in the Australia are co-integrated with returns of the other six countries. Since GC tests are affected by the variation in lag-length, this study explained how it overcame shortcomings of commonly used lag selection criteria. Results indicate that, out of the six countries, only past values of returns on the Chinese stock index can be used to predict current values of the Australian stock index. Thus, Australian policy makers should consider the impact of the Chinese stock market on the Australian stock market. However, bilateral trade links are not the only factor responsible for the occurrence of financial contagion and more research is needed to understand the complex nature of how and why financial crisis spread as and in the manner they do.