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CAPITAL MARKET INTEGRATION:
PALESTINE AND ISRAELI EXPERIENCE

Tulus Suryanto & Abdul Razak Abdul Hadi1

Abstract. Capital Market Integration: Palestine and Israeli Experience. This 
study is driven by the motivation to examine the existence of probable equilibrium 
and dynamic relations between Palestine Stock Exchange (PEX) and Tel Aviv 
Stock Exchange (TASE). Within the framework of international trade theories, 
this study uses Engle-Granger Co-integration procedure  as an estimation model 
employing monthly time series data during the observed period from January 
1998 till February 2012. It was discovered that there is a significant equilibrium 
relationship between PEX and TASE, but no empirical evidence was found on 
the presence of dynamic relations between the two stock markets using Granger 
Causality tests.  Meanwhile, analysis of dynamic interactions over post-sample 
period by Impulse-Response Functions and Variance Decomposition indicate that 
movements in TASE Index do influence the performance of PEX.

Keywords: capital market integration, granger causality test, PEX, TASE

Abstrak. Integrasi Pasar Modal: Pengalaman di Palestina dan Israel. Kajian 
ini didorong motivasi untuk menguji kemungkinan terjadinya keseimbangan dan 
hubungan dinamis antara bursa efek Palestina (PEX) dan bursa efek Tel Aviv 
(TASE). Dengan menggunakan kerangka teori perdagangan internasional, kajian 
ini menggunakan prosedur ko-integrasi Engle-Granger sebagai model estimasi 
atas data bulanan yang diobservasi mulai dari Januari 2008 sampai dengan 
Pebruari 2012. Hal yang ditemukan ialah terdapat hubungan keseimbangan 
yang signifikan antara PEX dan TASE, akan tetapi tidak ditemukan suatu bukti 
empiris atas hubungan dinamis antar dua bursa efek ini dengan uji kausalitas 
Granger. Sedangkan, analisis interaksi dinamis atas periode sampel yang ada 
dengan fungsi respon impuls dan dekomposisi variansi mengindikasikan bahwa 
pergerakan dari indek TASE berpengaruh terhadap kinerja PEX.

Kata Kunci: integrasi pasar modal, uji kausalitas granger, PEX, TASE

First draft: February, 3rd 2015, Revision: Macrh, 5th 2015, Accepted: March, 30th  2015
1 IAIN Raden Intan Lampung. Jl. Letkol Endro Suratmin, Sukarame, Lampung -35131-
University of Kuala Lumpur. Jl. Sultan Islamil, Kuala Lumpur 
Email : tulus_suryan70@yahoo.co.id; abdrazak@unikl.edu.my



Al-Iqtishad: Vol. VII No. 2, Juli 2015 198

Introduction

Today, the Palestinian population is geographically divided and made up 
into four groups: 6 million Palestinians live outside Palestine, 3million in West 
Bank, nearly 1.7 million in Gaza and 1.5 million in Israel itself. Free movement 
of commodities and trade relations are lacking among the four groups.  Transfer of 
funds is restricted by the Israeli rules, and there is neither an airport nor a seaport 
in the state of Palestine. Today, the economy of Gaza heavily depends on Egypt 
especially after the Israeli siege in 2006. Since 1945, the international trade activities 
in Palestine has been reduced and controlled by Israel and only 29% of Palestinian 
imports come from Egypt and Jordan.  Meanwhile, 95% of Palestine exports go to 
Israel and some 3% find their ways to Egypt and Jordan.  And the remaining 2% 
goes to the rest of the world (Ministry of National Economy, 2005). Some informal 
sources stated that about $1.5 billion value of trade between Gaza and Egypt in 
2011 was done mainly through the underground tunnels. 

Because of the limited investment opportunities in Palestine, most of the 
savings in the country are invested in foreign markets, especially in Egypt and Jordan.  
A recent study reveals that 75% of the six billion worth of deposits in the banks in 
Palestine are invested overseas and just 25% are invested domestically (El-Eqtesadia, 
2012).  The high percentages of the savings are invested in neighboring countries, 
particularly in their stock markets. Common culture, history, language, religion and 
kinship facilitate personal interactions among the people.  This demographic aspect 
reinforces the trade relations, tourism, labor mobility and investment flows.  

It is a general belief that many equity investors prefer to invest in other 
countries rather than in their neighboring countries in order to enjoy an effective 
diversification effect.  Yet this notion is opposed by Arshanapalli and Doukas (1993),  
Sheng and Tu (2000) and  Izquierdo and Lafuente (2004).  They postulate that the 
recent financial turmoil around the world was attributed to the mutual dependency 
of world financial markets.  There are times when the effectiveness of cross-border 
diversification is advocated by fund managers.  For this reason, regional portfolio 
investment among neighboring countries is still a credible strategy in maximizing 
portfolio returns.  This study examines the capital markets integration involving 
Palestinian and Israeli stock markets with special attention given to the trend in 
portfolio investment. 

This study was mainly meant to examine the directional relationship between 
PEX and TASE, and to determine the relative strength of the relationship between 
the two stock exchanges.  This is inspired by the well-known phenomena that 
economic cooperation among neighboring countries could help sustain strong 
economic growth in the long run. This study attempts to provide useful insights to 



Tulus Suryanto & Abdul Razak Abdul Hadi:  Capital Market Integration  199

both local and foreign investors on the prospects of the two exchanges.  This study 
deploys econometric time series analysis, Engle-Granger Co integration approach 
(1987), as an estimation model on the observed stock exchanges.  Hadi, Yahya 
and Shaari (2009) employed the same approach in examining market integration 
involving fossil fuel markets.  The following are the research questions that the study 
attempts to answer: first, is the performance of PEX affected by the movement in 
TASE index over time? Second, is there a causality effect that exists between PEX 
and TASE? Third, is there a theoretical support for TASE to be the leading indicator 
between the two stock exchanges?

Literature Review

Tel Aviv Stock Exchange (TASE) was founded in 1953 and owned by 
a consortium of 15 banks and 12 investment houses. At present, there are 622 
companies listed in the exchange whose market capitalization valued at USD 216 
billion.  In 1993, TASE made a history by registering the third largest number of 
Initial Public Offerings (IPOs) of all the world stock exchanges.  Headed by Esther 
Levanon, TASE was fully converted into computerized trading platform in 1999.  
Since 2007, there have been a number of international agreements formalized 
between TASE and other leading exchange around the world.  Those are London 
Stock Exchange, NASDAQ and Canadian Stock Exchange to name a few.  There are 
two main market indexes normally used as barometer to measure the performance 
of TASE.  The two are TA-25 Index and TA-100 Index.  The former is regarded as 
TASE’s flagship index listing the top 25 largest companies by market capitalization 
(Barak, 2012).

The Egyptian stock market has strong influence over the establishment of 
Palestine stock exchange in late 1990s.  Established in the late 1880s, the Egyptian 
exchange comprised of both Alexandria and Cairo stock exchanges.  During the 
period from1888-1958, the stock exchange had been growing rapidly and at one 
point was ranked the fifth largest in the world (in terms of market capitalization) 
until the Egyptian government put some restrictions on its trading activities in 
1959 (Mohie and Sourial, 2000).  Like any other financial markets around the 
world, Egyptian stock exchange has gone through some reforms which led to the 
consolidation of both Alexandria and Cairo stock exchanges.  In 2009, Egyptian 
Capital Market Authority was replaced by Egyptian Financial Supervisory Authority 
which assumes the functions as both regulatory and governing body.  With better 
market mechanism, the Egyptian stock market had made its peak in 2009, registering 
transaction value of 91.2 billion Egyptian dollars (Hassan, 2009).   In terms of 
informational efficiency, the Egyptian stock market is found to be in weak form 



Al-Iqtishad: Vol. VII No. 2, Juli 2015 200

(Hassan, Seyed and Mark, 2004).  Another study by Daniel in 2005 on African 
stock markets also reveals consistent result.

PEX started its first trading session on 18 February 1997. In early February 
2010, it was converted into a public shareholder company in conformity with 
good governance and transparency rules. According to the Arab and international 
classification of financial markets, the Palestinian exchange has attained advanced 
status in 2009.  On 5 Nov 2012, a total of forty- eight companies were listed on 
the Palestinian exchange, with a market value of $2.7 billion which was the highest 
compared to previous years. Palestinian listed companies operate in five major sectors 
- banking and financial services, insurance, investment, industry, and services. The 
PEX is an emerging capital market as most studies have indicated (Daraghma, 2010; 
Abu- Rub and Abu- Sharba, 2010).These studies describe the relationship between 
availability of information and its relationship with the share prices.  Some indicate 
that PEX is efficient in weak form. The study of Zoa`rob (2005) and Abu Sharbeh 
(2009) report that the lack of informational efficiency could be the reason for the 
volatility in the PEX.

Studies of the historical movement of the stock prices in the last 10 years 
show that unjustified fluctuations of stock prices are characterized by sharp 
movement in the indices’ value that occurred during the period from 2005 through 
2006 (Abdelkarim, 2007).  From 2007 until today, high market volatility has been 
observed (Abu- Rub and Abu- Sharba, 2010). Market efficiency and poor governance 
are still issues of concern to both policy makers and investors. It is widely perceived 
that this phenomenon has been negatively affecting the fair pricing of stocks and 
consequently impair investors’ confidence in the PEX as a whole.

Abdelkarim, Shahin, and  Arqawi (2009), comment on the issue of stock 
market efficiency indicating that relevance and timeliness of financial and non-
financial information are important for both pricing and market confidence , also it 
supports the investors in taking their decisions and judgments about the securities 
values; because of that and the desire to reach an efficient securities market , the 
regulators are increasingly concerned about the level of disclosure and availability 
of financial and non-financial information. Al-Quds Index (QI) is a market value 
weighted index and it was made up of 12 listed companies from different sectors in 
the Palestine exchange.   This market index provides investors with a general idea 
about the direction and performance of the market. It is computed by dividing the 
total market value of all listed companies in the market for the current period over 
the total market value of companies included in the index for the previous period. 
This index has been used in PEX since the trading session in July 1997 where the 
closing prices in that session were used as a reference point in calculation.



Tulus Suryanto & Abdul Razak Abdul Hadi:  Capital Market Integration  201

Methods
Vector Auto-Regressive Modeling (VAR) and Granger-Causality test are the 

main research tools in probing the equilibrium and short-run relations between 
the two stock exchanges - PEX and TASE. The co-movements of these two market 
indexes over time are presented.  PEX is proxies by Al-Quds Index, while Tel Aviv 
Stock Exchange is represented by TA-100Index.  The TA-100 Index is made up of 
100 largest firms listed in TASE.  The method used by Lance and James (2006) 
was applied to explore theoretical relations between the two market indexes. The 
stationary tests were first applied to the time series variables (via Augmented Dickey-
Fuller Tests), then Engle-Granger Co integration modeling was used, and finally, 
Granger causality test (within sample) was employed for determining the existence 
of short-run relation between the tested variables.  

Monthly observations were registered for the two market indexes, during the 
period from January 1998 till February 2012 involving 169 data points.  Engle-
Granger Co integration test (1992) was applied to explore the statistical relation 
between the PEX and TASE. This statistical test was developed by Granger and 
Weiss (1981) and later re-formed by Granger (1986), Granger and Weiss (1983) 
and Engle and Granger (1987).  Due to its dynamic functions, this statistical 
technique was met with wide acceptability among researchers who employed it in 
testing the validity of various theories and models. In fact co integration is essentially 
an econometric technique for testing the correlation between non-stationary time 
series variables. Two time series variables are considered to be co integrated when 
a linear combination of them is stationary, even though each one of them is non-
stationary on its own. 

First (or higher) differentiated data are necessary in tackling the problem of 
non-stationary among data series. But, one should be aware of the fact that using 
this differencing technique may result in a loss of precious data points on long-run 
characteristics of the time-series data. In fact when there is an equilibrium relationship 
between such variables, as Engle and Granger (1987) argue, the disequilibrium 
error should fluctuate about zero or equivalently the error terms should be stationary. 
Hence, unit root test is important to apply in determining the stationary of time 
series data. Any presence of unit root indicates a spurious regression relationship. 
This study uses the Augmented Dickey Fuller test in dealing with the unit root 
problem which is formulated as follows:

∆Yt = λ0 + λ1T + λ2Yt-1 + Σλi∆Yt-i + εt where i = 1, 2, 3…k   (1)
The hypotheses to be tested are:
H0: λ2 = 0 (the data is not stationary, it contains unit root)
H1: λ2< 0 (data is stationary, it does not contain unit root)



Al-Iqtishad: Vol. VII No. 2, Juli 2015 202

Once the tested data series appear stationary at first difference (or higher), 
they are considered co integrated.  Then, the Vector Error Correction Model 
(VECM) technique can be applied. This Model is a restricted Vector Autoregressive 
(VAR) technique. It is a unique technique that restricts the long run behavior of 
endogenous variables to converge to its co integrating relationship.  In addition to 
that, it also allows for short run adjustments among the tested variables. 

In investigating directional relationship between PEX and TASE, the study 
assumes only one causal direction: TASE affects PEX.   Generally, a new stock 
exchange like PEX is always under the influence of a long established exchange like 
TASE. The case is even stronger when they are located so close to one another.  The 
model adopted by this study is expressed as follows:

 PEXt = β0 + β1TASEt+ εt    (2)
where:        
PEX = Palestine Stock Exchange (proxied by Al-Quds Index)
TASE = Tel Aviv Stock Exchange Index
 εt    = Error Terms

Discussion

In investigating the causal-effect relationship between PEX and TASE, 
statistical tests in time-series econometric modeling are applied involving Augmented 
Dickey-Fuller Unit Root Test (ADF) and Bi-variate Co integration Tests (ECM).  
Hypothesis testing is performed to determine the significance level of the unit root 
test.  The result shows the P-values that indicate the level of significance.   From 
the result, it is conclusive that both PEX and TASE are non-stationary at all lags, 
while the P-values from the result show that the first-differenced PEX and TASE 
data series are consistently stationary at all lags.  The study also finds that both PEX 
and TASE are integrated at first difference.  Hence, the preliminary requirements in 
Enger-Granger Co integration procedure have now been fulfilled.

Having the preliminary requirements met, the study performs long-run 
regression on the PEX and TASE data series (based on the model specification).  The 
data shows the results of the regression analysis and rejection of the null hypothesis.  
This implies the presence of a statistically significant positive relationship between 
PEX and TASE.  Meanwhile, the data provide the descriptive statistics and the 
correlation matrix of the two market indexes.  It is evident that there exists a moderate 
degree of correlation between PEX and TASE.  In order for OLS estimation to be 
statistically valid, Engle-Granger (1987) suggests that the long-run residuals derived 
from the long-run regression (r) must be stationary.  At this point, two important 



Tulus Suryanto & Abdul Razak Abdul Hadi:  Capital Market Integration  203

implications are highlighted: first, as the long-run residuals are proven stationary, 
the PEX and TASE are considered co integrated; second, having PEX and TASE co-
integrated, the Vector Error Correction Model (VECM) can now be deployed for 
further analysis.

Table 1.  Error Correction Model at Lag 2

Dependent Variable : dPEX
Variables Parameter Standard Error t-Value P-Value
Intercept 2.1819 7.4844 0.29 0.7710
LdPEX 0.1808 0.0779 2.32 0.0215
L2dPEX -0.1458 0.0791 -1.84 0.0674

Lr -0.1738 0.0486 -3.57 0.0005*
LdTASE 0.0194 0.1802 0.11 0.9143
L2dTASE -0.0680 0.1798 -0.38 0.7057

Note: 1. dpex is first difference in PEX, ldpex is lag 1 of first difference in PEX
          2. lr is lag 1 residual and ldTASE is lag 1 of first difference in TASE

By employing Bi-variate Error Correction technique, the coefficients of 
PEX and TASE variables in the model can now be estimated.  The long term and 
short term responses involving the two tested variables are examined.  It was found 
through Akaike results (AIC) that the optimum lag-length for the tested model 
lies at lag 2 (VECM technique prefers lower AIC value).  The relevant results are 
summarized in Table 1.

The lr is a lag 1 residual derived from VECM (2).  This is the key component 
in VECM that supports long-term or equilibrium relationship between the two 
stock exchanges. A statistically significant equilibrium relation is observed by lr’s 
p-value in Table 1.  Given lr’s parameter value of 0.1748, this figure implies that 
there is approximately 17.48% speed of adjustment towards equilibrium made by 
PEX in the system. This adjustment is considered relatively fast and implies presence 
of market integration between the PEX and TASE.  Theoretically, higher speed of 
adjustment is preferred because a statistically reliable endogenous variable should 
reflect high speed in its equilibrium adjustment.

A statistically significant positive relationship between the two exchange 
markets is applied by the positive parameter value of TASE (+0.5095). This means 
that the two exchange markets are positively correlated. The existence of long-term 
significant relationship between the two exchanges could support the presence of 
a short-term relation between them.  From the F-value, the alternative hypothesis 
is rejected suggesting non existence of a short-term relationship between the two 
neighboring stock exchanges. In ensuring that the OLS assumptions are put in 
check, diagnostic tests are carried out on the tested model. 



Al-Iqtishad: Vol. VII No. 2, Juli 2015 204

To examine constant variance of the error terms, LM ARCH test is applied. 
The test results are supports rejection of H0 at all levels. This clearly indicates 
that the residuals from the estimated model are homoscedastic or operating at 
constant variance. A normality test on error terms distribution should be applied 
before making any statistical inference.  The test statistics explored by the study 
for normality depend on the distribution function involving Kolmogorov-Smirnov, 
Cramer-von Mises, and Anderson-Darling statistics. The results showing that the 
error terms from ECM (2) are not normally distributed for all four test statistics 
(see p-value).  These findings do not detract from the whole picture, considering 
the study’s preliminary nature. To ensure that all residuals are independent of one 
another, autocorrelation test is applied to examine any existence of serial correlation 
among the short-term residuals. Durbin-Watson test results support the absence of 
autocorrelation among the residuals

CUSUM analysis (or cumulative sum of residual test) is an important tool 
in econometric modeling. It is employed to tackle diagnostic problems related to 
parameter instability.  From Figure 1 representing CUSUM analysis, existence of 
parameter (short-run and long-run parameters) stability is confirmed, the short-run 
residuals lying within the lower and upper boundaries. As a whole, the predictive 
model developed from this study can be considered credible since no major diagnostic 
shortcoming were met in the tested model. 

Figure1. CUSUM Test (on Short-run Residuals of the Model) 

 

c 

-40 

-30 

-20 

-10 

0 

10 

20 

30 

40 

time 
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 

 

The results from diagnostic tests are free from major drawbacks and support 
the adoption of the suggested estimation model in the study.  Interestingly, the 
empirical results are also consistent with earlier studies. In a nutshell, the evidence 
presented here confirms the intuition that performances of regional stock markets 
are mutually dependent. It is strongly recommended that future research should 



Tulus Suryanto & Abdul Razak Abdul Hadi:  Capital Market Integration  205

incorporate other regional markets such as Iraq and Syria. The study urges both 
Palestinian and Israeli governments to review their respective foreign policy and 
emphasize on beefing up bilateral trades among themselves.  The fact that business 
globalization is inevitable, devising an effective and dynamic policy is of utmost 
importance in maintaining regional economic prosperity.

It is quite reasonable to argue the importance of an economic indicator such 
as stock market index in explaining the direction of an economic growth.  Having 
understood the equilibrium relationship between PEX and TASE, policymakers 
should devise an effective approach in rejuvenating economic activities in the 
two countries.  Similarly, stock traders and value investors should use this piece 
of information to come out with a trading strategy that can protect value of their 
investment portfolio. CUSUM analysis in depicted in Chart 1 also suggests the 
stability of both short-run and long-run parameters in the estimated model over the 
study period.

Conclusion

Despite the long hostility between Palestine and Israel, there is one thing that 
they share in common.  The empirical findings from this study have proved that 
both PEX and TASE are co-integrated. Nevertheless, there is an absence of short-
term dynamic between the two markets indexes as revealed by Granger Causality 
test.  Analysis of dynamic interactions over the post-sample period indicated that 
PEX is the most endogenous of all. Analysis of variance decomposition reveals 78% 
variations in PEX is explained by itself as compared to 92% in TASE.   From the 
analysis of impulse-response function, PEX is seen more responsive towards a given 
shock in TASE. These findings are very much in line with our model specification 
that performance of PEX is dependent upon the movements in TASE.  

It is now evident that the neighboring countries like Egypt, Jordan and Israel 
play important roles in supporting the growth of Palestinian economy.  TASE does 
influence the Palestinian economy through its capital market mechanism.  The 
results obtained from this study clearly show the mutual benefits derived from 
international trade and portfolio investment involving the two neighboring countries.  
In particular, economic prosperity in Israel will undoubtedly help boost Palestinian 
economy as the two countries share national borders, resources and relatively same 
market structure.  Hence, regional economic and political cooperation has to be 
improved between the two countries, which in turn help sustain long term economic 
growth. 



Al-Iqtishad: Vol. VII No. 2, Juli 2015 206

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