Testing the Flow-Oriented vs. Portfolio Balance Hypotheses: Beyond Trade Channel Evidence of Balance Sheet Effects Dominance in Asia-Pacific OECD Equity and FX Markets

Abstract

This study explores the dynamic, multi-horizon linkages between stock market prices and exchange rates across Asia-Pacific OECD countries to test the competing validity of the Flow-Oriented and Portfolio Balance hypotheses. Employing a wide-ranging econometric framework that integrates the Panel CS-ARDL model with Breitung-Candelon frequency-domain causality, Time-Varying Parameter Panel VAR (TVP-P-VAR), and asymmetric panel ARDL techniques, the research captures long-run equilibria, regime-dependent shifts, and structural asymmetries. The empirical findings decisively invalidate the traditional flow-oriented trade competitiveness perspective, revealing instead that currency depreciation and interest rate hikes inflict severe contractionary damage on equity valuations through a dominant Balance Sheet effect. As a result, asset market channels and sentiment-driven capital flows in Asia-Pacific countries with financial integration operate as stronger forces than traditional goods market mechanisms. On the contrary, the results strongly validate the stock-oriented Portfolio Balance model, demonstrating that bullish market sentiment and equity market expansions drive rapid, high-frequency currency appreciation via portfolio capital inflows. Asymmetric and time-varying estimations reveal that regional financial markets react significantly more aggressively to negative macro-financial shocks during stress regimes than to positive stimuli during economic expansions. These economies differ significantly in exchange rate arrangements, export dependence, capital market sophistication, institutional quality, and openness to international investment. The study contributed to the financial market literature by establishing that asset market channels and sentiment-driven capital flows have superseded traditional goods market mechanisms in financially integrated economies. Central banks should be positioned to understand both the limits of interest rate defenses and the need to handle asymmetric volatility. The findings of the research have broad implications that require policymakers, central banks and financial regulators to develop and execute policies which will achieve sustainable financial market growth. These insights urge policymakers to abandon static linear assumptions and adopt dynamic, macro-financial risk management frameworks to safeguard regional financial stability.