Australian Journal of Basic and Applied Sciences, 7(7): 268-280, 2013
ISSN 1991-8178
A Wavelet-based Approach to Testing Shari’ah-compliant Stock Market Contagion:
Evidence from the ASEAN Countries
1
Buerhan Saiti, Ph.D, 2Ginanjar Dewandaru, 3Dr Mansur Masih,
1
Senior Lecturer, Universiti Kuala Lumpur
2
Candidate in Islamic Finance, INCEIF, Malaysia
3
Finance and Econometrics, INCEIF, B-8-13A, Putra Villa, Taman Melati, 53100, Kuala Lumpur,
Malaysia
Abstract: Recently there has been a heightened global concern over ‘contagion’ in the conventional
financial markets. Our study is motivated by the desire to test empirically whether this contagion is
reflected in the fast growing Islamic financial markets as well. This study is the first attempt at testing
whether there has been any contagion among the Shari’ah-compliant stock markets during the most
recent international financial crisis: the US subprime crisis of 2008, with the application of a technique
known as ‘wavelet approach’ which has been very recently imported to finance from engineering
science. We analyse the daily data covering the period from June 2006 to August 2009 for the stock
market indices of the original ASEAN countries plus Australia and USA such as, NYSE COMPOSITE
(US), MSCI Islamic (Australia), MSCI Islamic (Singapore), FTSE Bursa EMAS Shari’ah (Malaysia),
Jakarta SE Islamic (Indonesia), MSCI Islamic (Thailand) and MSCI Islamic (Philippines). Our
findings based on the time-scale decomposition property of wavelet analysis tend to indicate that in all
cases of selective Shari’ah-compliant stock markets the changes in the wavelet correlation coefficients
are insignificant at all time scales during the US subprime crisis. The changes observed in wavelet
correlation coefficients are insignificant due to overlapping of confidence intervals implying that there
is no clear evidence of contagion at all time scales. These findings are plausible and intuitive and have
implications for the Shari’ah-compliant stock markets in terms of asset allocation strategy of risk
managers and for policymakers’ optimal policy response to a crisis.
Key words: Wavelet decomposition, Contagion, Interdependence, Wavelet Correlation, Shari’ah-
Compliant Stocks
INTRODUCTION
The cross-market transmission of financial crisis has been a major interest over the last decade. The
financial systems have witnessed numerous financial and currency crises, where most of them with regional or
even global consequences, such as the 1987 Wall Street crash, the 1992 ERM collapse, the 1994 Mexican pesos
crisis, the 1997 “Asian Flu”, the 1998 “Russian Cold”, the 1999 Brazilian devaluation, the 2000 Internet bubble
burst, and the default crisis in Argentina of July 2001. Recently, the US subprime crisis 2008 that considerably
hit the markets all over the world has raised a critical question on the capacity of the global financial system to
maintain its financial stability in such a meaningful way.
Some previous studies tend to argue that financial crises are characterized by financial contagion (e.g., Kyle
and Xiong, 2001; Kodres and Pritsker, 2002). This issue therefore has become extensively discussed in
theoretical and empirical studies in order to measure financial spillovers andto discover channels of transmission
of shocks across borders. King and Wadhwani (1990) have mentioned that economic fundamentals on each
country have not provided a clear explanation as regards the shock transmissions, suggesting that a stock market
reacted to stock price changes across border beyond what economic fundamentals suggest. In another study,
Forbes and Rigobon (2002) also define contagion as an excessive transmission of shocks from the origin of
crash to others beyond any idiosyncratic disturbances and fundamental linkages.
The main aim of our study is to evaluate the Islamic financial industry which has experienced a relatively
high growth in the global financial system. Over the last couple of decades, the Islamic financial sector has
developed and gained stronger position, expanding from a banking-based industry into wider areas covering
financial market-based instruments and practices. In terms of characteristics, Islamic assets have been strictly
restricted to the boundary of Shari’ah rules, which in turn has resulted in distinguished features among other
assets in the market. It is theoretically expected therefore that Shari’ah-compliant assets would have a different
behavior compared to the conventional counterparts.
The current trend for Islamic equity to move towards the global markets has encouraged a number of
studies to address the performance of Islamic equity markets and funds. In the context of the recent subprime
crisis, it appears to be important to evaluate the vulnerability of Islamic stocks. Our study therefore attempts to
Corresponding Author: Dr Mansur Masih, Professor of Finance and Econometrics, INCEIF, B-8-13A, Putra Villa, Taman
Melati, 53100, Kuala Lumpur, Malaysia
E-mail: borhanseti@gmail.com Phone: +60-123904640
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, Aust. J. Basic & Appl. Sci., 7(7): 268-280, 2013
identify whether there is any financial contagion that occurred among the Shari’ah-compliant stock markets at
this crisis period. Such a question is important because of the nature of Shari’ah rules, in particular the limit of
interest-based leverage is likely to lead to a lower systemic risk during economic expansion and recession. In
addition, Chapra (2008) and Chapra, Ebrahim, Mirakhor, and Siddiqi (2008) also mention that there are four
basic conditions in Islamic finance that may prevent the two main causes of recent crisis, which are excessive
leverage and the formation of speculative bubbles in credit markets. Also, if we define the contagion to
represent financial panics within the market during turbulence, the element of excessive speculation that is
likely to weaken the link between financial and real markets has been strongly disallowed by the principle of
Islamic teachings (Tag el-Din and Hasan, 2007).
A large number of studies have discussed the proper definition of financial contagion. Our study has
followed the application of wavelet decomposition by Gallegati (2010) to detect the contagion as the excessive
transmission of shocks above what should be expected by the fundamentals which are reflected in long horizon
(high timescale). The paper is organized as follows. Section 2 reviews the basic condition of Islamic finance
while Section 3presents some literature reviews associated with the issue of financial contagion. Section 4
introduces wavelet decomposition analysis and the notions of wavelet variance, covariance, and correlation. In
Section 5, we will first describe the data used in this study and then present the results of the wavelet-based test
for contagion. Finally, Section 6 provides some interpretations while we conclude with section 7.
2. Islamic Investment Criteria:
Shari’ah is a Divine Law which governs the practical aspect of a Muslim's daily life. In commerce, it can
determine business style and indicate a desire to comply with 'halal' and ethical investing. Shari’ah-compliant
investing is growing rapidly as an alternative investment class for all investors, both Muslim and non-Muslim,
for its foundation in ethical business practices, social responsibility and fiscal conservatism. While Islamic
investors may be mandated to invest only in a Shari’ah-compliant manner, other investors do so for the benefits
they derive, including greater stability of returns, transparency and diversification.
In Islamic finance, any market is subject to Shari’ah constraint where the market is free from prohibited
activities and elements such as riba (usury), maisir (gambling), gharar (ambiguity), and other prohibited
activities like gambling, alcohol, and so on. To describe the Islamic principle in detail, riba technically is
defined as the “premium” which should be paid by the borrower to the lender together with the principal amount
as a condition in the contract of the loan or for an extension in the duration of loan” (Iqbal and Mirakhor, 2007).
More specifically, both the premium and the principal are guaranteed regardless of the investment performance.
Islamic stock indexes must not include firms that pay or receive interest of any form. However, the percentage
of today’s listed firms that are fully in compliance with the Shari’ah is in small number. Some degree of
tolerance therefore is required.
The modern Shari’ah scholars have provided general rules for Shari’ah-compliant investors to evaluate or
screen whether a particular company is halal (lawful) or haram (unlawful) for investment (Wilson, 2004; Derigs
and Marzban, 2008).There are two types of stock screening approaches such as qualitative and quantitative
screens. The first one is qualitative screen, the screening process that focuses on the activity of a company that is
used as the main principle in Islamic investment criteria. For a company that does not comply with Shari’ah
principles, for example, a company involves in production of alcohol for drinking, gambling, and riba-based
financial institutions, then, investment in this type of company is prohibited. The second one is quantitative
screen, where Islamic scholars have applied a principle of tolerance associated with filtering criteria, namely:
(1) Debt/equity ratio. If a company’s debt financing is more than 33 percent of its capital, then it is
impermissible for investment.
(2) Interest-related income. If interest-related income of a company is more than 10 percent of its total
income, then it is not permissible for investment. This income, however, should not come from its main business
activities but from placing its surplus funds in investments that could yield interest income (Abdul Rahman et
al,. 2010).
(3) Monetary assets. This parameter refers to the composition of account receivables and liquid assets
(cash at banks and marketable securities) compared to total assets. Various minimums have been set for the ratio
of non-liquid assets (assets that are not in the form of money) necessary to make an investment permissible.
Some set this minimum at 51 percent while a few cite 33 percent as an acceptable ratio of non-liquid assets to
total assets.
On the other hand, the literal meaning of the gharar is fraud or al-khida. It is interpreted as inadequate
market information or uncertainty about exchange objects when there is no practical obstacle to obtain full
information about the objects of exchange for the contracting parties. Some gharar can be tolerated with the
reason that it is sometimes difficult to completely eliminate uncertainty from exchange contracts. Al-Zuhaili
(1984) mentions that gharar is tolerable if its benefits outweigh its damages. However, if gharar is deliberately
embodied in the contract, then it becomes unlawful, as stated by the classical jurist cases of selling birds in the
sky or fish in the sea (Al-Dharir, 1967; Saati, 2003). This has involved uncertainty about the outcome of the
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