Financial Liberalization and Stock Market Returns: Evidence from East Africa Community Member Countries

The motivation for this study stems from the critical role of financial markets in economic development and the need to understand the factors influencing stock market performance in the East African Community (EAC) member countries. Financial liberalization is pivotal in shaping stock market returns. However, empirical studies examining these relationships within the EAC context are limited, prompting this comprehensive analysis. The general objective of this study was to investigate the effect of financial liberalization, market liquidity, and macroeconomic factors on stock market returns among EAC member countries. The study was anchored on the theory of financial liberalization, neoclassical theory, efficient market hypothesis, behavioral finance theory, and the general theory of employment, interest, and money. Data were collected from secondary sources, including financial reports, stock exchange databases, and relevant economic databases, covering the period from 2002 to 2021.The study employed fixed-effects regression models, chosen based on the Hausman specification test, to control for unobserved heterogeneity across countries. Baron and Kenny’s approach was used to test for mediation and moderation effects. The analysis involved examining the direct, mediating, and moderating relationships between the key variables. The findings revealed that financial liberalization significantly and positively affects stock market returns. The study concludes that financial liberalization is a crucial determinant of stock market performance in the EAC region. Based on the findings of this study, it is recommended that policymakers in EAC member countries further liberalize their financial markets to attract more foreign investments. This can be achieved by easing restrictions on foreign ownership, reducing regulatory barriers, and promoting cross-border financial activities.

Introduction

Background

The relationship between financial liberalization and stock market returns equalizes access to credit and reduces variations in expected returns. Financial liberalization broadens the investor base and causes a reduction in stock market returns volatility. Two possible advantages have served as the foundation for the case for financial liberalization. The first is the quantity effect, which shows up as increased investment and savings in an economy, and the second is the quality effect, which is manifested as more effective capital allocation. Wang and Luo (2019) observe that financial liberalization lowers variances in expected returns by promoting equal access to credit, which highlights the link between financial liberalization and stock market performance. According to Wuet al. (2017), financial liberalization helps local financial markets operate more efficiently because limiting the liberalization of international portfolio flows increases stock market liquidity, which raises stock market returns.

Globally, the relationship between financial liberalization plays a pivotal role in shaping stock market returns. As financial markets become more integrated, the removal of capital flow restrictions through liberalization has facilitated greater investment opportunities and enhanced, fostering more efficient price discovery (Wuet al., 2017). Nevertheless, the association between financial liberation and stock market returns is causal in character even though its direction is yet to be clarified, as noted by Adeyeyeet al. (2017). Claesenset al. (2019) categorize financial liberalization according to a nation’s foreign assets and liabilities. They show how this process improves the efficiency of the financial system by eliminating inefficient financial institutions, increasing pressure for financial infrastructure reform, and resolving information asymmetry issues. Credit controls, interest rate controls, bank entry hurdles, regulations, privatization, and limitations on international financial activities are all taken into consideration by the financial liberalization index introduced by Abiadet al. (2018). Financial liberalization is broadening to include global economic shifts and geopolitical risks. Indeed, the increasing integration of economies indicates that the relationship between financial liberalization and stock market returns will increasingly depend on factors such as exchange rate stability, inflation control, and interest rate management, which directly influence investor confidence, capital flows, and market performance. Atsin and Ocran (2017) note factors like interests, production, risk premiums, inflation, and money supply being critical factors explaining stock market returns.

Problem Statement

Financial liberalization in EAC countries has aimed to increase market access and attract foreign investments, yet stock market returns remain inconsistent. While financial liberalization is expected to improve efficiency, the relationship between liberalization and stock market performance. Adeyeyeet al. (2017) argue that greater financial liberalization expands the investor base and reduces stock market volatility. Sarr and Lybek (2017) highlight the critical role of financial liberalization in determining stock returns, as liquid markets facilitate smoother trading of stocks.

According to Sanya and Gaertner (2017), access to financial services is still restricted in the EAC, and there is little financial intermediation in the area. In Tanzania, Uganda, and Rwanda, less than one-third of the population has access to the official financial system. A sizable portion of the populace uses unofficial financial services, even in Kenya and Uganda. One of the primary obstacles to regional growth is still the restricted availability of financing, which makes it more difficult for smaller, less established businesses to fund investments through official channels. The EAC’s priorities for 2017–2021 include the creation of a unique customs territory, infrastructural development, industrial growth, factor of production mobility, good governance promotion, and institutional changes (East African Community, 2017). Following the financial liberalization of the EAC community, it was important to conduct a study on how this affects stock market returns and the influence on this relationship. Although there are previous studies in this area, there exists a contextual gap as they were conducted in settings that are different from EAC. African integration attempts have been characterized by market-led integration that focuses on removing tariff and non-tariff barriers. One of the EAC’s main tenets is cooperation in trade liberalization and growth. The EAC’s trade liberalization program will be implemented in a number of stages, beginning with the creation of a customs union and progressing to a common market and monetary union.

Studies linking financial liberalization and stock market returns of firms globally arrive at inconclusive results. These indecisive results emerge out of a range of factors, which include the approaches used to operationalize the study variables, the variables and control variables selected, the econometric models adopted, and divergences that obtained at contextualization. These factors, in turn, create conceptual gaps, methodological gaps, and contextual gaps across the range of these studies. Moreover, many studies on the relationship between financial liberalization and stock market returns have been undertaken in European and Asian countries. This jurisdiction exhibits contextual differences with EAC in terms of technological sophistry, social security culture, the age/level of development of the stock market, regulatory environment, and the level of economic development. These dissimilarities give rise to contextual gaps that would make findings in those jurisdictions not directly fit into the EAC setting.

Local studies on financial liberalization and stock market returns show no unanimity either as to the kind of relationship existing between the two variables or even the inherent impact of financial liberalization and stock market returns. Onyango (2019) sought to determine how financial liberalization affected Kenya’s securities exchange market’s liquidity. It was determined that the Kenyan securities exchange market was significantly impacted by foreign exchange volatility, the liberalization index, market volatility, and capital influx. The study presents conceptual gaps with respect to study variables conceptualization and study variables specification. Further, a study by Rono (2018) presents a methodological gap as they applied a shorter period of time, which might be inadequate to make inferences. The current study seeks to bridge these gaps by using a quantitative approach and a wider time scope of liberalization on stock market returns among EAC member countries.

Muthama and Waweru (2021) analyzed the relationship between financial liberalization and stock market returns in Kenya. Using quarterly data from 2000 to 2020 and applying dynamic panel regression models, the study found that interest rates and inflation rates significantly moderated the relationship, while money supply had a less pronounced effect. To bridge the contextual gap of focusing solely on Kenya, presenting a geographical gap that the current study addresses by including multiple EAC member countries. Wachira and Mwangi (2020) analyzed the interplay between financial liberalization and stock market returns in East African countries. Using data from 2000 to 2019 and employing structural equation modeling (SEM), the study found that financial liberalization positively affects stock market returns. This is why the current study bridges the above gaps to answer the question: What is the effect of financial liberalization on stock market returns among EAC member countries?

Literature Review

Theoretical Review

This study on stock market returns draws from key theoretical frameworks. The Theory of Financial Liberalization explores how deregulation impacts market efficiency. The Neoclassical Theory emphasizes capital accumulation’s role in growth, while the Efficient Market Hypothesis (EMH) posits that stock prices reflect all available information. Behavioural Finance Theory examines psychological factors influencing investor behaviour, and the General Theory of Employment, Interest, and Money addresses the policies on financial markets.

The financial liberalization concept is often used to describe an atomized financial system with no financial repression. It is the outcome of implementing suitable policies, like contrasting real financial stock with real rates of return. On the other hand, the difficulties encountered in the relative financing process lead to shallow systems. It argues that a better monetary system might provide doors for businesses to profit, including insurance companies, industrial banks, and bill dealers. Through the possibility for investment enhancement, financial depth has a favorable impact on growth. The beneficial impact of financial deregulation on stock market returns is further supported by this link.

According to neoclassical theory, financial liberalization can help developing countries increase savings and growth while reducing their excessive reliance on foreign funding. Financial liberalization theorists contend that it should increase investment and savings in emerging countries, leading to faster growth. Keynesian economists contend, however, that it is unlikely that liberalization will have a positive effect on investment and savings. It is demonstrated that the local financial system functions better when foreign banks and capital are liberalized. Therefore, as a type of deregulation, international financial integration can boost local financial system activities, which promotes better resource allocation and hastens economic growth.

Behavioural finance theory outlines the behaviours and biases preventing human beings from being rational. The effect of these biases is that they cause people to hold stereotypes, engage in decision-making that is founded on a whimsical starting point, and make an evaluation of the probability that an event will occur that is based on similar events. Behavioural finance presupposes that heuristic errors and biases, emotions, frame dependence, and social influence affect the prices of stock, and thereby, these prices may not show the true intrinsic value.

The Efficient Market Hypothesis promoted the notion that a stock’s trading value is typically its fair worth, meaning that investors cannot buy undervalued stocks or inflate stock prices during sale agreements. According to the aforementioned, expert stock selection or market timing will not outperform the overall market; hence, the only ways for an investor to generate larger returns are by chance or by purchasing riskier investments.

Empirical Review

Nguyen and Nguyen (2022) examined the impact of financial liberalization on stock market performance in ASEAN countries from 2000 to 2020. Using dynamic panel data models, the study found that financial liberalization positively influences stock market returns. The research suggests that enhanced financial openness facilitates greater capital flows and investment opportunities, leading to improved market performance. This study supports the positive relationship identified in the current study but highlights the importance of controlling for country-specific conditions. However, it does not address the specific context of the EAC, thereby presenting a regional gap that the current study intended to fill.

Kim and Kim (2021) explored the effects of financial liberalization on stock market returns in emerging markets, focusing on BRICS nations (Brazil, Russia, India, China, and South Africa). The study used panel cointegration techniques and found a long-term positive relationship between financial liberalization and stock market returns. The research emphasizes the role of institutional quality and financial market development in maximizing the benefits of liberalization. This study provides additional evidence of the long-term benefits of financial liberalization on stock market performance, underscoring the importance of strong institutional frameworks. Nevertheless, it does not specifically consider the unique institutional settings of the EAC, which the current study addressed.

Bensethom (2021) investigated how stock market volatility can be impacted by the global financial crisis and the liberalization process. Three emerging Asian markets, the Philippines, Korea, and Indonesia, are included in the sample for the years 1987 to 2016. The results of using the ST-GARCH models reveal a number of intriguing facts. First, since the ST-GARCH processes account for regime changes in the conditional volatility, they outperform the linear GARCH models. Second, financial liberalization has decreased conditional volatility regardless of the nonlinear model (ST-GARCH models) that is employed. Overall, the findings support the idea that the Asian region cannot gain the full benefits of financial liberalization since the process’s positive effects may be outweighed by the negative consequences of these crises. The fact that this study was carried out in Asian economies, whose social and economic environments differ from those of the EAC, creates a contextual gap. There is also a methodological flaw in the study because ST-GARCH models were used as opposed to linear regression models.

Smith and Roberts (2020) investigated the relationship between financial liberalization and stock market returns in Eastern Europe. The study employed fixed-effects regression models and found that financial liberalization significantly enhances stock market returns, particularly in countries with well-developed financial sectors. The research highlights the importance of concurrent financial sector reforms to ensure that liberalization leads to positive market outcomes. This study aligns with the findings of the current study and emphasizes the need for comprehensive financial sector development to support liberalization efforts. However, the specific dynamics of the EAC stock markets were not considered, thus presenting a geographical and contextual gap that the current study sought to fill.

Using quarterly data from 1975 to 2016, Atsin and Ocran (2017) aimed to examine the relationship between financial liberalization and stock market growth in four Sub-Saharan African stock markets. The three aspects of liberalization, capital account liberalization, stock market liberalization, and financial sector liberalization, were the only focus of the analysis. For each market under study, three Bayesian VAR models were used in the empirical research. The findings indicated that, in each of the four nations, the liberalization of the financial sector and stock markets is positively related to the growth of stock markets. This study presents a conceptual gap as it focuses on stock market development, which is a different concept from stock market returns. Additionally, the study utilized Bayesian VAR models instead of linear regression models, thus presenting a methodological gap.

Adeyeyeet al. (2017) examine the effect of financial liberalization on the volatility of rising African stock markets and, more specifically, the Nigerian stock market. The study uses the symmetric GARCH model, the asymmetric GARCH or threshold GARCH (TGARCH) model, the power GARCH (PGARCH) model, and the exponential GARCH (EGARCH) model as its four GARCH model variations. The estimation results reveal that financial liberalization significantly reduces return volatility, which suggests that it raises stock market volatility. Furthermore, the results show no indication of stock market asymmetry in the analysis. The study presents a methodological gap because it covered a 10-year period, which may not be long enough for a detailed analysis.

Conceptual Framework

The study focuses on the relationship between financial liberalization and stock market returns in the EAC region. This study was based on the variables: financial liberalization as the predictor variable, stock market returns as the response variable (Fig. 1).

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Fig. 1. Conceptual model.

Methodology

Data

The study utilized Secondary Panel data on the variables, namely, financial liberalization and stock market returns among the EAC member states for the period between 2002 and 2021.

The study operationally defines financial liberalization of the stock market refers to the elimination or removal of repressive policies existing in the market. Stock market liberalization creates a paradigm shift from an administratively controlled system to a market-based system. The study operationally defined financial liberalization as consisting of the deregulation of the foreign sector capital account, the domestic financial sector, and the stock market sector viewed separately from the domestic financial sector.

Data Analysis

A regression analysis was used to find the connection between the study variables. The model was as follows:

$$\begin{array}{r}SR={\beta }_0+{\beta }_{1}F{L}_1+\epsilon \end{array}$$

where

β₀ – constant

β_n – beta coefficient

FL₁ – financial liberalization

SR – stock market returns

E – error term

The study employed R² to assess the dependent variable variation due to the effects of the predictor variable. To assess the model fit, the F-test was used to test the significance of the model, while the T-test was used to evaluate the significance of the beta coefficient of the predictor variable.

If the p-value obtained from the regression analysis testing the relationship between f and financial liberalization and stock market returns was less than 0.05, the null hypothesis (H₀₁) was rejected. This implied that financial liberalization and stock market returns among EAC member countries are statistically significant.

Results and Discussion

The first objective of this study was to investigate the effect of financial liberalization on stock market returns among EAC member countries. Financial liberalization was measured through two indicators: foreign assets and foreign liabilities. The study aimed to understand how these factors influenced stock market performance within the region. To test this objective, the study formulated the following null hypothesis (H₀) and sub-hypotheses:

• Main Hypothesis:

H₀₁: Financial liberalization has no significant effect on stock market returns among EAC member countries.

• Sub-Hypotheses:

H_01a: Country foreign assets have no significant effect on stock market returns among EAC member countries.

H_01b: County foreign liabilities have no significant effect on stock market returns among EAC member countries.

The regression analysis results presented in Table I examine the effect of financial liberalization, measured by foreign assets and foreign liabilities, on stock market returns of EAC member countries.

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Table I. Financial Liberalization and Stock Market Returns

Stock market returns	Coefficient	Standard error	P > t
Foreign assets	0.417036*	0.042174	0.000
Foreign liabilities	0.203428*	0.01105	0.003
_cons	0.553485	0.653452	0.400
Model summary
R-squared	0.6513
F (2,67)	59.76
Prob > F	0.0000
Observations	70
ID	4

The R-squared value of 0.6513 indicates that approximately 65.13% of the variability in the stock market returns can be explained by the financial liberalization variables included in the model. This model was statistically significant, as indicated by a corresponding P-value of 0.000, meaning that the model fits the data well.

The coefficient for foreign assets is 0.417036, with a standard error of 0.042174 and a highly significant P-value of 0.000. This positive and significant coefficient suggests that an increase in foreign assets is associated with a substantial increase in stock market returns.

Similarly, the coefficient for foreign liabilities is 0.203428 with a standard error of 0.01105 and a significant P-value of 0.003, indicating that higher foreign liabilities also positively impact stock market returns, albeit to a lesser extent than foreign assets.

Based on these results, the null hypothesis H₀₁, which states that financial liberalization has no significant effect on stock market returns among EAC member countries, is rejected. The significant coefficients for both foreign assets and foreign liabilities confirm that financial liberalization, as measured by these variables, significantly influences stock market returns. Specifically, the findings indicate that both an increase in foreign assets and foreign liabilities contribute to higher stock market returns. Therefore, the sub-hypotheses H_01a and H_01b are also rejected, as both countries foreign assets and foreign liabilities have significant effects on stock market returns.

Conclusion and Recommendations

The study concludes the critical role of financial liberalization in driving stock market returns among EAC member countries. The significant positive impact of both foreign assets and foreign liabilities on stock market performance underscores the necessity of openness to foreign financial flows. This financial integration facilitates greater investment, enhances liquidity, and fosters a more robust financial environment that can propel market growth and stability within the region. The evidence strongly supports the notion that financial liberalization is a key determinant of stock market success in the EAC.

Based on the findings of this study, it is recommended that policymakers in EAC member countries further liberalize their financial markets to attract more foreign investments. This can be achieved by easing restrictions on foreign ownership, reducing regulatory barriers, and promoting cross-border financial activities. By doing so, countries can enhance their stock market performance and overall economic growth. Financial liberalization should be accompanied by robust regulatory frameworks to mitigate potential risks associated with increased foreign financial flows.

Limitations

One major limitation of this study is the reliance on secondary data, which may not fully capture all aspects of financial liberalization in the EAC member countries. While secondary data provides a broad overview, it often lacks the granularity and real-time accuracy that primary data collection methods can offer. This limitation might affect the precision of the findings and their applicability to real-time policy and market conditions. However, the inherent limitations of secondary data still necessitate a cautious interpretation of the results.

Suggestions for Further Research

Future research should consider expanding the scope of the study to include a broader range of countries, both within and outside the EAC region. By incorporating diverse economic contexts, researchers can gain a more comprehensive understanding of how financial liberalization interacts across different settings. Comparative studies between regions can provide valuable insights into the unique and common drivers of stock market performance globally. Additionally, further research could benefit from the use of primary data collection methods, such as surveys and interviews with key market participants and policymakers. This approach would provide deeper insights into the aspects of financial liberalization that secondary data may not capture. Primary data can also offer real-time information, improving the relevance and applicability of the findings to current economic conditions.