Working Paper: NBER ID: w15141
Authors: Galina Hale; Assaf Razin; Hui Tong
Abstract: Data show that better creditor protection is correlated across countries with lower average stock market volatility. Moreover, countries with better creditor protection seem to have suffered lower decline in their stock market indexes during the current financial crisis. To explain this regularity, we use a Tobin q model of investment and show that stronger creditor protection increases the expected level and lowers the variance of stock prices in the presence of credit crunches. There are two main channels through which creditor protection enhances the performance of the stock market: (1) The credit-constrained stock price increases with better protection of creditors; (2) The probability of a credit crunch leading to a binding credit constraint falls with strong protection of creditors. These mechanisms are consistent with the patterns observed in the cross-country data. We find that except for OECD countries with low creditor protection, stock market return is negative in the crisis years and positive in non-crisis years.
Keywords: creditor protection; stock prices; credit crunches; financial crisis
JEL Codes: F4; G0
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Stronger creditor protection (G33) | Lower average volatility of stock prices (G17) |
| Stronger creditor protection (G33) | Higher expected stock prices (G19) |
| Stronger creditor protection (G33) | Decrease in probability of credit crunches (E51) |
| Decrease in probability of credit crunches (E51) | Increase in expected stock prices (G17) |
| Credit crunches (E51) | Binding credit constraints (E51) |
| Countries with better creditor protection (F34) | Less severe declines in stock market indexes during financial crisis (G01) |
| Stock market returns are negative during crisis years (G01) | Stock market returns are positive in non-crisis years (G17) |