Ebook Taking Stock Seriously: Equity Market Performance, Government Policy, and Financial Globalization
How do government policies and institutions affect equity market performance across countries? This question is gaining urgency as stock markets become broader and deeper in the developed and developing worlds. In 2004, global stock market capitalization stood at $37.2 trillion, compared to global GDP of $41.3 trillion. While this was slightly less than global commercial bank assets ($57.3 trillion), it markedly exceeds the total size of outstanding public debt securities, which stood at $23.1 trillion. The bulk of total stock market capitalization represents developed-country equity markets, but less developed country (LDC) markets—which accounted for 14 percent of total capitalization in 2004—are quickly gaining ground. Some emerging market countries, such as Malaysia, Singapore, and South Africa, have total stock market capitalizations that exceed their respective GDPs. Equity markets provide a useful mechanism for governments to raise capital through the sale of state-owned enterprises, and thereby lessen their reliance on sovereign debt. Moreover, equity markets enhance corporate efficiency, spur innovation, and provide a valuable source of capital for long-term economic development (Lavelle 2004). In short, it is clear that equities constitute an increasingly important capital market in the world economy. However, we currently know very little about how government policy choices and political institutions influence equity investors’ decisions.
The growth of global financial markets since the early 1990s has attracted attention from both scholars and pundits. A large literature in political science, public policy, and economics considers the ways in which the increased openness of trade and financial markets might affect national economic outcomes and government policy making. While some scholars take a more restrained view, others argue that economic globalization generates a “golden straight jacket” for governments. At the extreme, global markets become masters of governments, eviscerating the authority of national states. Along these lines, Susan Strange maintains that, “where states were once the masters of markets, now it is the markets which, on many crucial issues, are the masters over the governments of states.” In the realm of capital markets, investors’ capacity for exit, and the political voice it confers, is central to such accounts. While capital market openness provides governments with greater access to capital, it also subjects them to external (market) discipline (Obstfeld and Taylor 2004). Governments must sell their policies not only to domestic voters, but also to international investors. Because investors can respond swiftly and severely to actual or expected policy outcomes, governments must consider financial market participants’ preferences when selecting policies. This logic suggests that, as financial openness increases, governments’ capacity to spend and tax, and the more general ability to pursue divergent policies, should diminish markedly.
Yet much of the work on the impact of economic globalization generally, and financial globalization specifically, ignores the fact that nations are integrated differently into the global economy. Some have high levels of trade openness, but lower levels of capital market openness (Garrett 2000). High trade openness may present governments with one set of pressures, while high capital market openness may expose them to a different – and perhaps contradictory – set of demands (see Rodrik 1997). Likewise, nations are integrated into the global financial system in different ways, relying on different types of capital flows and asset markets (e.g., equities, bonds, bank loans, direct investment). For example, in 2004 the ratio of sovereign bond investment to equity investment was 0.19 for South Africa, 0.47 for Malaysia, and 1.93 for Hungary. Different types of investors will have different preferences and concerns regarding asset allocation and public policies. For instance, investors in equities may react negatively to certain policy outcomes, while investors in sovereign bonds may perceive these outcomes positively. Alternatively, political institutions such as democracy and veto points may affect some types of assets significantly, but have little impact on others. Our analyses of the impact of financial openness on government policies must acknowledge this variety among global capitalists.
Along these lines, Maxfield (1997) provides one of the few explicit treatments of the diversity of investors in global capital markets. In her study of central bank independence in the developing world, she considers how different types of asset holders (FDI, equity, bank loans, and sovereign bonds) would respond to changes in monetary institutions, given the liquidity of their assets and the ways in which government policies affect their returns. As Maxfield’s study illustrates, government policies can affect assets differently. For instance, bondholders may dislike expansionary fiscal policies, while direct investors and equity market participants will appreciate the effects of such policies on aggregate demand and on human capital formation (Santiso 2003).
Moreover, assessing the existence and extent of heterogeneity in global capital markets provides insight into the ways in which governments and their citizens are affected by financial globalization. If a country relies heavily on foreign direct investment (FDI) rather than on sovereign lending or bank financing, it may face few pressures to reduce public spending (see Jensen 2006). On the other hand, if a government relies heavily on the bond market to finance its expenditures, but has a relatively low level of stock market capitalization, it may face greater pressures for fiscal and monetary tightening (Mosley 2003). Finally, if a country relies on various types of financial inflows, as most do, then we might imagine that asset holders will have diverse preferences over public policy.
Our first contribution is to explain the linkages between equity market outcomes and national government policies, which have been largely neglected in the literature on financial globalization. Our second advance is to consider how investors’ concerns might vary across financial assets, with an empirical focus on equity and sovereign bond markets. By analyzing equity and sovereign bond markets, we can compare the impact of government policymaking on the holders of investments with similar degrees of liquidity but different payoff and risk structures.
While political economists recently have explored the linkages between policies and institutions, on the one hand, and financial markets, on the other, this work has largely overlooked the possible influence of equity market investors. For instance, scholars have investigated the political correlates of interest rate premiums in government bond markets (Mosley 2003, Saiegh 2005, Wibbels 2006); the impact of political events and institutions on foreign exchange markets (Bernhard and Leblang 2002, Freeman et al 2000, Moore and Mukherjee 2006) and on currency crises (Leblang 2002, Leblang and Bernhard 2000, Leblang and Satyanath 2006); and the political correlates of foreign direct investment flows (e.g., Jensen 2006, Li 2006, Li and Resnick 2006).
The few extant analyses of stock markets and politics tend to focus on one or two countries, or on sectoral variation within a particular market, rather than on the determinants of national-level market outcomes in a broader cross country context. For instance, Leblang and Mukherjee (2005) consider the impact of government partisanship and elections on stock market outcomes in the United States and Great Britain (also see Herron 2000, Roberts 1990). In a broader study, McGillivray (2003) considers the impact of partisan changes and electoral institutions on stock market outcomes in fourteen advanced democracies. Her analyses, however, focus largely on sectoral level variation, arguing that shifts in political constellations change investors’ expectations regarding which industries will benefit from industrial and trade policies. Indeed, McGillivray is less interested in equity market outcomes per se than in using such outcomes (stock price dispersion, specifically) as a proxy for the expectations of economic actors regarding political decisions (also see Jensen and Schmith 2005). Similarly, Bernhard and Leblang (2006) consider the impact of politics and political uncertainty on daily market behavior in several advanced democracies. Unlike most analyses, theirs considers outcomes in multiple asset markets, including currencies, equities, and government bonds. Bernhard and Leblang’s aim, however, is exploring the consequences of discrete political events—such as elections and cabinet formations—on capital markets, rather than on explaining the broader impact of public policy and institutions on capital market outcomes.
In the next section, we discuss the politics of equity market performance, focusing in particular on the effects of government policies and institutions on market valuations. We then evaluate statistically the correlates of aggregate price-to-earnings ratios for a sample of 31 countries during the 1985-2004 period. Among the findings is that government fiscal balance is not associated with market valuations—a result that runs counter to the conventional notion of financial markets as a constraint on government profligacy. We also find that capital account openness, economic growth, and the relative size and depth of the stock market are positively associated with equity market valuations. Then, as an empirical assessment of the potential variation across asset types, we shift our focus to the sovereign bond market. We analyze the influence of these same factors—plus other relevant policies and control variables—on borrowing costs for the subset of the sample in which we have available data. Among the significant findings is that expansionary fiscal policy is a hindrance to sovereign borrowing, in contrast to its neutral effects on equity markets. In addition, institutional characteristics such as the level of democracy and the number of veto players have no appreciable association with bond market outcomes. We conclude by placing our findings in the context of the broader debate on the influence of globalization on public policy choices.
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