Democracy and Stock Return

Democracy and Stock Market Returns
Xun Lei1
Xi’an Jiaotong-Liverpool University
International Business School Suzhou
Department of Finance
111 Ren'ai Road
Suzhou, Jiangsu, 215123, China
Phone: (0086) 1396 0720613
E-mail: xun.lei@xjtlu.edu.cn
Tomasz Piotr Wisniewski

The Open University
Faculty of Business and Law
Division of Accounting and Finance
Walton Hall
Milton Keynes, MK7 6AA, UK
Phone: (0044) 1908 655020
E-mail: tomasz.wisniewski@open.ac.uk
1 Corresponding author
Electronic copy available at: https://ssrn.com/abstract=3198561

Democracy and Stock Market Returns
Abstract
This paper examines the relationship between the level of democratization and
stock index returns in a sample of 74 countries. Compared with democracies,
autocratic states are characterized by lower returns despite exhibiting higher
return volatility. Even though this higher volatility can be mostly attributed to
diversifiable country-specific risk, the Capital Asset Pricing Model is unable to
explain the return differential. Instead, it is the level of investor protection that
can fully account for the phenomenon described here. Autocratic leaders are
reluctant to promulgate regulation shielding investors and the resultant risk of
expropriation depresses the returns realized by outsiders.
Keywords: Stock Returns, Political Regimes, Democracy, Autocracy, Investor

Protection
JEL Codes: G12, P16

I. Introduction
Do political institutions matter for the stock markets? Do the laws and regulations of so-
called true ‘democracies’ and democratic institutions have any effect on stock valuations?
Although these questions are of fundamental importance, they remain largely unexplored.
Generally, it is believed that democratic institutions are associated with better investor
protection, although the academic literature is relatively silent on this topic. If such belief could
be upheld empirically, it would provide a valid rationale for why stock markets domiciled in
democratic countries tend to thrive over time. On the other hand, one could argue that equity
investments in more autocratic states also carry a certain appeal. Stock prices in autocracies
may be less likely to move in tandem with global trends, which would present portfolio
investors with a range of attractive diversification opportunities.
For all of the reasons mentioned above, one may wonder whether democratic systems would
be preferred from the perspective of stock market investors. However, only anecdotal evidence
on this topic is available and more empirical inquiry into this matter is needed. Although degree
of democracy has been used as a political risk component by some authors (see, for instance,
Diamonte et al., 1996; Erb et al., 1996; Perotti and Van Oijen, 2001), to the best of our
knowledge there are virtually no studies examining how the evolution of democracy affects
fluctuations of stock prices. One exception is the work of Lehkonen and Heimonen (2015) who
use a sample of emerging markets spanning from 2000 to 2012 in order to show the existence
of a positive association between levels of democratization and returns. Whether this finding
is statistically significant, however, was largely dependent on their model specification. Ours
is a larger dataset in that it also includes developed markets and focuses on a longer timeframe.
Our sample comprises annual return data for 74 stock markets and covers the period between
1975 and 2015. The results reported here confirm the existence of a positive relationship
between democracy levels and stock returns. Using this expanded data set, however, enabled

us to reach more compelling conclusions regarding statistical significance. In fact, the return-
democracy nexus is sufficiently robust to support the design of a profitable trading strategy
based on the democracy index alone.
We also contribute to the literature by carefully examining different aspects of investment risk
across the democratic spectrum. In doing so, we not only analyze volatility risk but also
decompose it into two components. One of them arises from the covariation with the world
stock market index, while the other is diversifiable in a global portfolio and pertains to country-
specific developments. The covariation risk appears to be marginally higher for markets located
in democratic states, whereas the latter type of risk is elevated in autocracies. Inasmuch as these
results are illuminating, these risk profiles are unable to fully account for the returns gap
observed between democratic and autocratic regimes.
Confronted with this failure of the Capital Asset Pricing Model, we put forward an alternative
explanation that is fully consistent with the empirical regularities observed here. We document
that investors who commit their capital to authoritarian countries do not enjoy the same level
of legal protection that is typically encountered in mature democracies. By evidencing this, we
attempt to fill the lacunae in our knowledge on investor protection patterns. While Li (2009)
examined the issue of how foreign direct investment expropriation varies with democracy level
and political constraints, we scrutinize the situation from the vantage point of stock market
investors. We show that the extent to which investors are legally protected is predictive of
future returns and explains the higher rewards during periods of democratic government rule.
The remainder of the paper is structured as follows. The next section reviews the body of
literature studying whether the democratization process and democratic institutions affect
financial markets and economic prosperity. Subsequently, we proceed to discuss our data
sources and basic summary statistics. Section IV contains the main body of our empirical
analysis and reports estimates of regressions linking stock index returns to the level of

democracy. Section V reflects on whether the relationship we uncovered is driven by risk
considerations, or by the strength of investor protection. A battery of robustness checks is
subsequently presented in Section VI. The paper ends with a set of conclusions and
recommendations for investors.
II. Theorizing on Democracy, Economy and Stock Markets
With the practice of democratization beginning in the early 19th century, political scientists
and economists have gradually defined the exact meaning of democracy. Schumpeter (1942)
characterizes democracy as a political system in which people can elect their national rulers in
regular competitive elections. Dahl (1982) believes that democracy is a representative
government system that runs under legal rules, in which most citizens can participate in politics
and can be effectively represented in political decision-making. Democracy, as understood by
Tavares and Wacziarg (2001), adds many poor voices to the voice of the rich few, changing
the composition of citizenry that influences the shaping of policy. Finally, Rivera-Batiz (2002)
portrays democracy as a system embracing a wide range of characteristics, such as checks and
balances mechanisms of administrative power, constitutional process and protection, free and
uncensored media, clear and effective legislature and judiciary, limited terms of office, as well
as transparency, openness, and democratic participation. Contemporary definitions of
democracy invariably incorporate elements of universal suffrage, guaranteed political rights
and freedoms, and a government policy-making process that is both inclusive and subject to
supervision. It is important to note that underpinning political systems, be they autocratic or
democratic, are a set of institutions defined by North (1981) as the sum of a country’s formal
and informal rules and the implementation characteristics of these rules.
Although we know little about how political regimes affect financial markets, voluminous
literature has been produced in the field of economics, political science, and public policy on
the link between political systems and economic growth. Since stock markets and the broader

economy are, at least to some degree, intertwined we present a short synopsis of this
scholarship here. Broadly speaking, researchers have failed to reach a consensus on whether
political democratization can speed up economic growth (for a literature review see Sirowy
and Inkeles (1990)). Some empirical studies discovered the existence of a positive relationship
(see, for instance, Clague et al., 1996; Kurzman et al., 2002; Acemoglu et al., 2019), which
was attributed to the fact that democratic regimes have lower barriers to entry for enterprises
(Cuberes and Jerzmanowski, 2009) and better protection of property rights, which in turn
fosters investments (Friedman, 1962; Pastor and Sung, 1995). Electoral arrangements under
democratic institutions can also result in more capable leaders being elected (Lohmann, 1999;
Comeau, 2003). One could also argue that an authoritarian regime hinders economic growth
due to internal factionalism, corruption, rent-seeking, ethnic conflict, and other contradictions
(Quinn and Woolley, 2001). These views, however, are not universally shared, with some
scholars claiming that it is democracy that hampers economic growth (see, for instance,
Landau, 1986; Tavares and Wacziarg, 2001; Wood, 2007). Acemoglu et al. (2008) robustly
estimated the relationship between income and democracy in 136 countries over the past 500
years, but their results show no significant causal relationship between them. They argue that
an increased income will not necessarily promote democracy and democracy is not a necessary
condition for income. Doucouliagos and Ulubaşoğlu (2008) produced a detailed comparative
study of 84 empirical papers examining the relationship between democracy and growth by
using meta-analysis and concluded that half of the empirical studies did not find a direct
significant relationship between democracy and economic growth.
There is also a great deal of theoretical and empirical exploration that focused on the
relationship between political regimes and foreign direct investment (FDI) flows. Here again,
consensus proves to be elusive. For example, Olson (1993), Henisz (2000) and Jensen (2003,
2006) state that through improving the protection of property rights and reducing the political

risk of cross-border investment, political liberalization makes host countries more attractive to
foreign capital. Putman (1998) and Oneal (1994) hold the opposite view; they believe that
democratization has a negative impact on FDI, because corporations that cooperate with
authoritarian regimes can gain certain privileges and democratization leads to the loss of these
privileges. With the theoretical disputes in the discussion unresolved, empirical studies are also
plagued by conflicting results. In a study of U.S. manufacturing investment inflows, Rodrik
(1996) found that democracy is positively related to FDI - a finding that was later confirmed
by Jensen (2003) in a sample of 144 countries. At the other end of the spectrum, Resnick’s
(2001) results suggest that democratic transition is inversely related to FDI inflows. Busse
(2004) argued that FDI inflows in the 1970s and 1980s were mainly concentrated in
dictatorship countries whereas, from the 1990s, democratic countries attracted more industrial
capital inflows. The work of Asiedu and Lien (2011) adds further nuance to the analysis by
highlighting the fact that the impact of democracy on promoting FDI is largely dependent on
whether the country is an exporter of oil and minerals.
With regard to our article, the focus is on the rewards reaped by stock market investors in
countries characterized by different shades of democracy. The only previous paper that has
considered this issue directly is Lehkonen and Heimonen (2015), who report that stock market
performance is boosted by the presence of democratic processes and institutions. We are not
only able to confirm this finding in a larger sample of countries, but also demonstrate a much
stronger degree of statistical significance. In addition, we analyze whether the return
differential is attributable to various types of risks. As the Capital Asset Pricing Model (Sharpe,
1964; Lintner, 1965 and Mossin, 1966) reminds us, investors should be compensated only for
taking on non-diversifiable risk. From the perspective of a global investor, much of the country-
specific risk will diffuse in an internationally held portfolio and the premium should be only
earnable for the covariation of the local stock market index with the global market portfolio.

We dissect the national volatility risk into country-specific and global components and consider
them in the context of democratization.
Another element of the puzzle, which should not be overlooked, is the propensity of the state
to expropriate investors. Engagement in outright expropriation of firm assets, over-regulation,
confiscatory taxation, and solicitation of bribes could seriously undermine the chances of re-
election for politicians wielding power in democratic nations. Autocrats, on the other hand, are
largely immune from such considerations and, consequently, their incentives to expropriate are
stronger.
When rulers of states try to enrich themselves at the expense of shareholders, a number of
inimical outcomes typically follow. These outcomes are clearly outlined in the “twin agency
problem” proposed by Stulz (2005). First, corporate managers will become motivated to
engage in earnings manipulation and diversion. Earnings that have been either concealed,
misappropriated, or stolen by corporate insiders become inaccessible to the grabbing hands of
the state. Such toxic constellation become known as the “twin agency problem”, because
outside investors are subjected to predation from both corporate insiders and political leaders.
Second, the quality of disclosure suffers due to the fact that profitable firms reporting their
financial results faithfully are at a higher risk of being expropriated by the state. The optimal
reaction would be to reduce the level of transparency and governance which, in turn,
exacerbates the detrimental effect that state expropriation has on shareholder value (Durnev
and Fauver, 2011). Similarly, politicians will be opposed to promulgating and enforcing more
robust disclosure rules, as application of these rules will shed more light on their predacious
ways (Bushman et al., 2004). Third, corporate ownership in countries with state expropriation
will be more concentrated. Controlling shareholders assume the functions of managers and, in
doing so, they are able to appropriate private benefits for themselves instead of surrendering

them to an agent-manager. Stulz (2005) documents that dispersed ownership is inefficient in
the presence of predatory state and managerial diversion of profits.
This last observation is the focal point of a theoretical model derived by Giannetti and Koskinen
(2010) who explicitly recognize the fact that, in weak investor protection countries, investors
have additional incentives to becoming controlling shareholders. Control gives them access to
both private and security benefits arising from ownership. Consequently, affluent investors
demand more stocks and are prepared to pay more for them compared to minority investors
form whom the private benefits of control are inaccessible. The demand from controlling
shareholders drives the stock prices to high levels and, in equilibrium, the expected returns to
outside investors are diminished.
Our empirical evidence seems to cohere with the logic of arguments outlined above. We report
that autocrats, unrestrained by democratic processes and motivated by their desire to arrogate
private wealth, are unlikely to enact strong investor protection laws. We also demonstrate that
the level of investor protection is predictive of future returns and that investor protection alone
is capable of explaining the returns gap between autocratic and democratic states.
III. Data
Variables measuring stock index returns and the degree of democracy are of utmost importance
to our investigation. With regards to the former, we calculate continuously compounded dollar-
denominated returns that are inclusive of dividend payments. These returns are based on market
capitalization weighted country-level Morgan Stanley Capital International (MSCI) indexes,
which are among the most respected and widely used benchmarks in the global financial
industry. Due to the short stock market history in some countries, the dataset in this study is an
unbalanced panel.

Our data on MSCI indices has been sourced from Thomson Reuters DataStream and covers 74
countries over the period from 1975 to 2015. Of all the markets, MSCI classed 22 as developed
(e.g., United States, United Kingdom), 23 as emerging (e.g., Brazil, China), 19 as frontier
(Bahrain, Pakistan), and 10 as standalone (e.g., Ghana, Trinidad and Tobago). A complete list
of countries and their classification is presented in Appendix A. Collectively, our sample
markets represent almost all the investable opportunity sets in the world.
Our primary democracy measure is sourced from Polity IV Project database. This source first
derives a democracy indicator measured on an eleven-point scale ranging from 0 to 10. Its
design involves gauging the ability of citizens to express their political preferences, the extent
to which civil liberties are guaranteed, and the existence of constraints on the power of
executive. Similarly, an autocracy variable, measured on eleven-point scale is constructed by
focusing on competitiveness and regulation of political participation, procedures for executive
recruitment, and the constraints imposed upon them. In the final step, a POLITY variable is
derived by deducting the autocracy score from the democracy score. We modify this POLITY
variable to reduce its skewness by firstly adding 11 to every observation in order to ensure that
all observations are positive and then applying a natural logarithm transformation. In the
regressions that follow, the resultant variable is labelled DEMOCRACY.
In our “Further Results and Robustness Checks” section, we also consider an alternative
democracy measure obtained from Freedom House - an organization that publishes annual
reports on the democracy and human rights situation in 192 countries and 14 disputed religions
in the world.2 More specifically, we use the political rights variable, which is measured on an
ordinal seven-point scale. The definition of political rights from Freedom House is that people
can freely participate in the political process by having the right to select a particular candidate
2 For more details, please refer to the Freedom House website: https://freedomhouse.org/.
10

in a legitimate election, to participate in political parties or organizations, and to elect a
representative who has a decisive influence on public policy-making and who is responsible
for the electorate. Since political rights in this database are measured on an inverted scale, our
variable which is taken to represent the natural log of the original Freedom House indicator is
called LACK_OF_POLITICAL_RIGHTS. Predictably, this variable is strongly and negatively
correlated with DEMOCRACY ( = -0.7248, p-value = 0.0000).
To control for the impact of economic environment on stock returns, macroeconomic indicators
were incorporated in the regressions that follow. The macroeconomic data was collected
primarily from the World Bank’s World Development Indicators (WDI) database. The first
macroeconomic indicator included is labeled GDP_GROWTH and measures the annual
percentage growth rate of the gross domestic product at market prices based on constant local
currency. A significant number of studies have tested the association between financial market
performance and economic growth (see, for example, Honohan, 2004; Demetriades and
Andrianova, 2004). The second variable denoted as INFLATION reflects the annual percentage
change in the consumer price index (CPI). Hyperinflation signals mismanagement of monetary
policy and could be a good proxy for general macroeconomic policy instability. Rising prices
have also been shown to negatively impact financial sector performance in some studies (Boyd
et al., 2001). An interest rate variable is also introduced to capture the variation in the risk-free
component of discount rates, and it is expressed in real terms. This is warranted given that
nominal interest rate would be highly collinear with inflation. We also control for the economic
development of a country by incorporating data on the natural logarithm of GDP per capita.
Financial openness (de jure/de facto) is measured by the lack of restrictions on cross-border
financial flows, as quantified by the Chinn-Ito Index3. The variable corresponding to this index
has been labelled in this paper as KAOPEN. Lastly, and perhaps most importantly, our return
3 For more details, please refer to http://web.pdx.edu/~ito/Chinn-Ito_website.htm.
11

regressions examine how the movements of the local markets covary with the global trends.
This is done by using return on the MSCI World index as an explanatory variable. MSCI World
index captures the market value of large and medium capitalization stocks across 23 developed
markets.
Several variables have also been considered in order to assess the impact of the political and
institutional environment. The source of political and institutional data is the Database of
Political Institutions (DPI) (Cruz, et al., 2015). This database is mainly used to measure a
country's political system and election rules. It contains information regarding the electoral
system, identification of the ruling party’s affiliation and ideology, the legislative system, and
the checks and balances mechanisms, among others. Researchers at the World Bank
Development Research Group compiled the database for the first time in 2001 (Beck et al.,
2001). The current 2015 version is hosted by the Inter-American Development Bank (IDB) and
has expanded its coverage to about 180 countries observed over 40 years (1975-2015).
A number of variables sourced from the DPI dataset are employed in our empirical
investigation. Since differing political ideologies of the government might exert influence on
the stock market movements (see, for instance, Hensel and Ziemba, 1995; Santa-Clara and
Valkanov, 2003; Cahan et al., 2005), we quantify this effect by constructing RIGHT_WING
and LEFT_WING dummy variables representing the ruling party’s orientation with respect to
economic policy. A centrist orientation serves here as a benchmark. The variable RELIGION is
a binary indicator taking a value of one if the ruling party has an ideology rooted in religion
(Christian, Catholic, Islamic, Hindu, Buddhist and Jewish) and zero otherwise. In view of the
fact that several researchers have noted differential market behavior around national elections
(see, for instance, Gartner and Wellershoff, 1995; Wong and McAleer, 2009), a dummy
recording whether an executive election took place in a particular country-year is included
(ELECTION_EXE). Similarly, the ELECTION_LEG indicator takes a value of unity whenever
12

legislative elections occur. A summary of all the aforementioned variables can be found in
Table I.
[Insert Table I about here]
Table II presents descriptive statistics and allows us to gain more intuition about the properties
of the underlying data. In addition to reporting a conventional mean, the table also shows an
“adjusted mean” which first calculates the average for each country and then computes a mean
of these averages. Such an approach allows a decrease in the dominance of developed
economies with long time series. The average dollar-denominated total return on the MSCI
country indexes is 7.38% per annum, which is reasonably close to the average MSCI World
return of 8.55%. This result prevails despite the fact that the first average is taken over 74
markets, while the other considers only 23. Examination of the antilogged means for
DEMOCRACY and LACK_OF_POLITICAL_RIGHTS reveals that the political systems in most
of our sample countries were relatively democratic. As can also be seen from Table II, the
average growth rate of GDP is 3.31% per year, while the mean of 15.58% for annual inflation
was influenced by several hyperinflationary episodes. After accounting for inflation, the
average real interest rate stands at 5.68%. The level of economic affluence varied markedly.
By applying an exponential transformation to the LNGDPPC statistics, we can see that the 75th
percentile of the distribution was 5.49 times higher than the 25th percentile. With regard to
political factors, leftist and rightist administrations spent about 30.17% and 33.18% of the time
in power, respectively, with the rest falling under the reign of centrist governments. The mean
of the variable measuring government religious inclinations has a very low average value
(0.1204), implying that most governments do not associate themselves with any particular
religion. Finally, legislative elections appear to be more frequent than executive ones.
[Insert Table II about here]
13

Table III reports unconditional correlation coefficients among the core variables used in the
empirical investigation. The stock index returns correlate positively with DEMOCRACY ( =
0.0666, p-value = 0.0058) and negatively with LACK_OF_POLITICAL_RIGHTS ( = -0.0650,
p-value = 0.0071). This is a preliminary indication of a positive relationship between the level
of democratization and stock price movements. It can also be seen that economic prosperity, as
measured by the GDP growth, coincides with increasing value of equity. Furthermore, the
national markets tend to move in tandem with the MSCI world stock market index. The
remaining explanatory variables do not appear to be strongly associated with stock returns.
Generally speaking, the correlations between explanatory variables are not high, suggesting
that our regressions are unlikely to suffer from multicollinearity problems. Indeed, we find that
the variance inflation factors for our regressors in all of the considered model specifications
are lower than 10, attesting to the fact that multicollinearity is not present.
[Insert Table III about here]
IV. Empirical analysis
4.1 Modelling Stock Returns
A battery of specification tests has informed the design of the econometric models used to
explicate the variation in returns. Tests consistently indicate that country fixed effects in return
regressions are jointly insignificant and that their inclusion can only lead to less efficient
estimation. The Baltagi and Li (1990) version of the Lagrange Multiplier (LM) test (Breusch
and Pagan, 1980), which has been specifically developed for unbalanced panels, suggests that
the use of cross-sectional random effects is not advisable and that the random effect estimator
degenerates to the pooled estimator. Year fixed effects, on the other hand, prove to be
indispensable. The rationale behind this statistical finding it is that stock markets movements
tend to co-vary across nations and year dummies allow the global trend component to be
14

captured. Their inclusion in the model therefore helps to isolate the country-specific variation
in stock returns. We note in passing that the Hausman (1978) specification test suggests that
period random effects are not suitable in this context because residuals from the random effect
model are correlated with the regressors.
Specifications (1) and (2) in Table III present estimation results for models with time fixed
effects. As the reader will notice, these specifications do not incorporate World_Return as a
regressor. As both year dummies and World_Return do not change in the cross-sectional
dimension, their joint inclusion inevitably leads to a problem of perfect multicollinearity. To
overcome this predicament, time fixed effects are removed from specification (3) and return
on the MSCI World index is employed instead. This is equivalent to capturing the global trends
in an alternative way. A further complication arises, however, as the panel cross-section
heteroskedasticity likelihood-ratio tests strongly reject the null hypothesis that residuals are
homoskedastic. This could be a direct consequence of variation in investment risk profiles or
differing macroeconomic data quality across countries. To remedy this problem, we employ a
feasible GLS estimation with cross-section weights. This estimation method is also adopted in
specification (5) where the DEMOCRACY variable enters at a lag. Furthermore, column (4)
presents estimations of dynamic panels using the system generalized method of moments
(GMM) technique introduced by Arellano and Bond (1991) and further developed by Arellano
and Bover (1995) and Blundell and Bond (1998). This class of models is capable of providing
consistent results, even in cases in which different sources of endogeneity are present (Wintoki
et al., 2012; Ullah et al., 2018).
[Insert Table IV about here]
The most striking observation arising from Table IV is the consistent evidence of a positive and
statistically significant relationship between stock returns and democracy level. It is worth
noting that this relationship remains stable in all specifications regardless of the econometric
15

approach adopted. While the importance of this regressor in undeniable from a statistical point
of view, one should also consider the economic significance of the estimates. For example, the
slope of 0.0706 on the DEMOCRACY variable in column (3) suggests that for a one percentage
point increase in the transformed POLITY IV index, the stock return of the MSCI index is
expected to go up ceteris paribus by 0.0706 percentage points. In other words, moving from
perfect democracy to a perfect autocracy (a fall of 100% in our DEMOCRACY measure)
depresses stock index returns by 7.06% per annum, all other things being equal. We will explore
the possible rationalizations underlying this returns gap in Section V of the paper. Strikingly,
column (5) suggests that democracy level has predictive power for stock market fluctuations,
which entails a number of important ramifications. Firstly, it raises questions about market
efficiency, an issue we explore in the next sub-section. Secondly, it suggests that the
relationship goes beyond a simple association and can possibly be construed as causality in the
Granger (1969) sense.
The regression results regarding the impactful control variables also merit further discussion.
Firstly, GDP growth rates show a consistent and significant positive relationship with stock
returns in all of the regressions. For example, the estimates reported in column (3) reveal that
whenever GDP growth increases by one percentage point, the stock return goes up by 0.6432
percentage points. This conclusion is in line with theoretical expectations and is also supported
by many previous studies (see, for instance, Asprem, 1989; Flannery and Protopapadakis, 2002;
Humpe and Macmillan, 2009).
When pondering inflation, one could expect a positive relationship with returns, as companies
own real assets that can act as inflationary hedges. On the other hand, when inflation reaches a
certain level, the government and central bank will tend to tighten fiscal and monetary policies,
affecting expectations regarding future corporate profitability and interest rates. Unsurprisingly,
scholarly literature has not reached a consensus on this issue. For example, Fama’s (1981)
16

proxy hypothesis suggests a negative link between stock returns and inflation, but this link
should not be considered a direct causal relationship, as it exerts itself through other
macroeconomic factors. Therefore, in order to obtain a more nuanced understanding of the
effects of inflation, we introduce nonlinearities into the regression equation by incorporating
both the untransformed and the squared inflation rate. While the signs of coefficients on
INFLATION and INFLATION2 terms are consistent across different specifications, their
statistical significance is not. This may reflect the fact that the impact of inflation on stock
prices is relatively complex (Flannery and Protopapadakis, 2002).
Although Santa-Clara and Valkanov (2003) show that US stock returns tended to be higher
under Democratic presidencies in the US, one wonders whether this result should be
generalized into the global context. Even if the returns under leftist executives appear to be
somewhat higher, the statistical significance of this finding could be questioned. An earlier
study by Bohl and Gottschalk (2006), which also aggregated cross-country evidence, casts
additional doubts on the importance of the left-wing premium in an international context.
A rule of government that follows a religious ideology seems to be conducive to generating a
bull market. Although this finding has not been hitherto reported in the literature, a number of
studies have made the point that religious practices can impact on the behavior of investors and
companies alike. Ariel (1990) shows that prior to holidays such as Good Friday or Christmas
mean returns are significantly higher, while Bialkowski et al. (2012) and Al-Khazali (2014)
establish that stock markets in predominantly Islamic countries tend to be more buoyant during
the period of Ramadan. Furthermore, the analysis performed by Callen and Fang (2015) sheds
light on the fact that firms headquartered in counties with higher level of religiosity are less
prone to stock price crash risk and, relatedly, are also characterized by lower variances of equity
returns (Hilary and Hui, 2009).
17

The variable that holds the strongest explanatory power for local stock market fluctuations is
the WORLD_RETURN, which attests to the importance of common shocks simultaneously
reverberating across all countries.
4.2. Trading Strategy
The last column in Table IV indicates that democratization of a country can be predictive of
future stock returns. We operationalize this insight practically, by designing an implementable
trading strategy. More specifically, we execute a portfolio approach using our DEMOCRACY
indicator. To that end, we produce annual rankings of countries based on their democracy level.
At each year end we select countries that record a DEMOCRACY value higher or equal to the
90th percentile of that year’s distribution and construct an equally weighted portfolio invested
in indexes of these countries. This “High Democracy Portfolio” is kept throughout the duration
of the subsequent year and is rebalanced anew at the year end. In a similar vein, we construct
a “Low Democracy Portfolio” by focusing on nations that have DEMOCRACY values lower or
equal to the 10th percentile of the distribution.
We assume an investment of one US dollar into each of the portfolios initially and plot the
evolution of portfolio values in Figure I. At the end of the sample period, the capital invested
in a “High Democracy Portfolio” grew to $4.93, representing an annualized dollar-
denominated continuously compounded return of 9.83%. At the other extreme, the “Low
Democracy Portfolio” earned an annual return of only 5.29%, bringing the terminal investment
value to $3.11. The gap in returns of 4.54% is both economically and statistically significant
(p-value = 0.0956). In absence of any transaction costs or other market frictions, a return
equivalent to the gap could be earned by embarking on a long-short strategy. Considering that
portfolio rebalancing is done annually, our profit estimate is likely to surpass any reasonable
transaction costs, especially in cases in which index futures contracts are used to carry out the
18

trading. Traders need to bear in mind that while such long-short strategy may be zero-cost, it
is certainly not zero-risk, as the standard deviation of the returns gap amounts to 16.85% per
annum. Taken together, these results illustrate the practical implications of our research and
confirm some degree of return predictability.
[Insert Figure I about here]
V. Possible Rationalizations
5.1. Can the findings be attributed to risk differential?
We undertake further exploration to uncover the underlying rationale behind the link between
returns and democracy. Perhaps the difference in stock returns across political regimes might
be easily explained by the level of prevailing risk. However, as postulated by the Capital Asset
Pricing Model (CAPM), only non-diversifiable risk should carry compensation to investors. A
version of this model with non-stochastic risk-free rate can be written down as:
𝐸(𝑅̃ 𝐹 ̃𝑀
𝑖,𝑡+1 ) = (1 − 𝛽𝑖 )𝑅 + 𝛽𝑖 𝐸(𝑅𝑡+1 ) [1]
where 𝐸(𝑅̃
𝑖,𝑡+1 ) is the expected return on the national stock market index, 𝛽𝑖 is the global beta
̃
of the domestic market i, 𝑅 𝐹 is a risk-free rate, while 𝐸(𝑅 𝑀
𝑡+1 ) is the expected return on the
world stock market index. The tilde () placed above a term indicates a random variable. A
regression analogue of equation [1] can be expressed as follows:
𝑅̃ ̃𝑀
𝑖,𝑡 = 𝛼𝑖 + 𝛽𝑖 𝑅𝑡 + 𝜀̃
𝑖,𝑡 [2]
where 𝛼𝑖 is the intercept for country i and 𝜀̃

𝑖,𝑡 is the error term that captures country-specific
developments unrelated to movements of the global stock market index. The global index in
our case is proxied by MSCI World. Given that 𝑐𝑜𝑣(𝑅̃

𝑀
𝑡 , 𝜀̃
𝑖,𝑡 ) = 0, the following result for the
total variance can be obtained:
19

𝑣𝑎𝑟(𝑅̃ 2 ̃𝑀
𝑖,𝑡 ) = 𝛽𝑖 𝑣𝑎𝑟(𝑅𝑡 ) + 𝑣𝑎𝑟(𝜀̃
𝑖,𝑡 ) [3]
Equation [3] implies that total variance of national index returns can be decomposed into a part
related to co-variation with the global stock market index and a part that arises from country-
specific risk. In our inquiry, we undertake the task of such variance decomposition. More
specifically, in each country-year we run a regression equivalent to equation [2] using monthly
data. The estimates are then inserted into equation [3] in order to dissect the total variance.
Subsequently, the estimate of total variance and its two components are multiplied by 12 to
annualize them and a square root transformation is applied to derive the TOTAL_VOLATILITY,
COUNTRY_SPECIFIC_VOLATILITY, and GLOBAL_SYSTEMATIC_VOLATILITY variables.
In our sample, DEMOCRACY is negatively correlated with TOTAL_VOLATILITY ( = -0.0591,
p-value = 0.0145) and COUNTRY_SPECIFIC_VOLATILITY ( = -0.1436, p-value = 0.0000),
while the correlation with GLOBAL_SYSTEMATIC_VOLATILITY is positive ( = 0.0918, p-
value = 0.0001). To probe this issue further, we estimate a number of regression models
considering the determinants of each volatility type. Since financial series exhibit a
phenomenon of volatility clustering (Engle, 1982; Bollerslev, 1986), dynamic panel data
models are used, where lagged volatility acts as a regressor. The system GMM approach is
utilized for the purposes of estimation and the findings are reported in Table V.
[Insert Table V about here]
Different variants of regressions are considered in Table V. The evidence seems to largely
corroborate the claim that stock markets located in autocratic countries exhibit higher country-
specific volatility of returns. Although the risk arising from co-variation with global trends is
lower, the statistical significance of this finding is questionable. On balance, the total volatility
of returns appears somewhat elevated in absence of democratic institutions. Taken together,
the results unveil divergent risk characteristics across the democratic continuum. The issue of
20

whether the disparities in risk profiles can account for the return differential between autocratic
and democratic regimes will be revisited and pondered in greater depth in section 5.3.
5.2. Investor protection
Autocrats may have incentives to confiscate assets, repudiate their debts, and renege on
inconvenient contracts, given that in the short term such actions produce an immediate windfall
far surpassing any potential tax revenues that may have been forgone (Olson, 1993). Mature
democracies, on the other hand, constrain their leaders through a system of checks and
balances, limiting predatory behavior by the state. An independent judiciary, that is the
cornerstone of a well-functioning democracy, safeguards enforcement of contracts and protects
the rights of individuals and investors. These considerations are mirrored in the findings of Li
(2009) who shows that autocracies are more likely to expropriate foreign direct investments.
The lack of political constraints on autocrats seems, to a large extent, account for this result. In
a game-theoretic setting, Guriev and Sonin (2009) further demonstrate that, in oligarchic
economies, autocrats cannot credibly commit to both property right protection and no
expropriation. These extant findings lead us to believe that autarchic leaders may be reluctant
to introduce legal frameworks that shelter capital holders from the vagaries of the state.
To formally test this conjecture, we download data on the strength of investor protection index
from the World Economic Forum Global Competitiveness Index data set maintained by the
World Bank. Higher values of the index represent more robust protection of investors’ rights.
Our preliminary analysis shows this investor protection measure is positively correlated with
DEMOCRACY ( = 0.1969, p-value = 0.0000). While this preliminary finding may be
instructive, more rigorous panel data modeling techniques need to be employed to control for
possible confounding factors.
21

Our tests indicate that both country and time effects are jointly significant in the investor
protection models. The importance of country effects coheres with the findings of previous
research showing that time invariant characteristics, such as legal origin, affect protection of
corporate shareholders (La Porta et al., 1998). Guided by the aforementioned specification test,
we estimate two-way fixed effect models, which are displayed in Table VI. The most striking
finding that arises from our estimations is that democracy fosters investor protection.
Autocrats, on the other hand, appear disinclined to formalize their commitment to private
property. Since they are the ultimate source of power within society and the impartiality of
courts under their rule can be questioned, the temptation to coercively exploit investors is ever-
present. Given that this is the case, an amalgamation of the “twin agency problem” (Stulz,
2005) and the theoretical model of Giannetti and Koskinen (2010) could successfully explicate
the positive relationship between returns and democracy levels reported in this paper.
[Insert Table VI about here]
5.3. Which of the rationalizations is most credible?
An important question that arises at this stage is which of the mechanisms considered above
can fully account for the democracy-autocracy return differential. A variable can be classified
as a valid underlying mechanism for the observed phenomenon only if the following three
conditions are met. Firstly, the variable should be related to the level of democratization. In
effect, this has already been demonstrated to a certain degree for the different volatility types
and investor protection. Secondly, the mechanism variable should be able to predict returns.
Thirdly, once the variable is controlled for in our return regressions, the explanatory power of
the DEMOCRACY measure should diminish, causing it to lose its statistical significance. To
verify whether the last two conditions hold, we estimate a set of models of the following form:
22

𝑅𝐸𝑇𝑈𝑅𝑁𝑖,𝑡 = 𝛼 + 𝛾1 𝐷𝐸𝑀𝑂𝐶𝑅𝐴𝐶𝑌𝑖,𝑡 + 𝛾2 𝑉𝐴𝑅𝐼𝐴𝐵𝐿𝐸_𝑀𝐸𝐶𝐻𝐴𝑁𝐼𝑆𝑀𝑖,𝑡−1 +
∑𝑘𝑛=1 𝛾𝑛+2 𝐶𝑂𝑁𝑇𝑅𝑂𝐿𝑛𝑖,𝑡 + 𝑖,𝑡 [4]
The second and third requirement of our testing protocol necessitates that DEMOCRACY
becomes insignificant, while the VARIABLE_MECHANISM exhibits robust predictive power.
The four variables scrutinized in the previous two sections are taken individually to act as
VARIABLE_MECHANISM. We examine regressions that include a full set of control variables
(labelled as CONTROL in equation [4]) and report our findings in Table VII.
[Insert Table VII about here]
Interestingly, Table VII unveils a clear failure of the CAPM model, as we cannot reject the null
hypothesis that the level of systematic risk is unrelated to returns. In fact, none of the examined
volatility variables is significant or able to markedly diminish the explanatory power of the
democracy level, which rules them out as credible justifications for the democracy-autocracy
returns gap. The only rationalization that stands up to rigorous scrutiny relates to the level of
investor protection. As has been established earlier, democracies are more inclined to limit
state expropriation by protecting investors’ rights. According to the model of Giannetti and
Koskinen (2010), this raises expected stock returns to outsiders, a fact that is corroborated by
our empirical results. Furthermore, once we account for the degree to which investors are
legally shielded, the level of democratization loses its meaningfulness as a determinant of
returns. In other words, the investor protection story is the only one that meets all three criteria
of our verification procedure and can thus be viewed as a credible justification for the results
presented in this paper.
VI. Robustness Checks and Further Results
To check the robustness of our findings we perform a myriad of additional tests. Firstly, it also
needs to be stated that democracy is a complex political and social concept, which may be
23

difficult to quantify with a great degree of precision. Criticisms of commonly used democracy
measures have emerged (see, for instance, Munck and Verkuilen, 2002) and none of the specific
measurements can be considered perfect. Therefore, in order to make our study more
comprehensive and robust, we introduce an alternative variable capturing the absence of
democracy. It is the LACK_OF_POLITICAL_RIGHTS index described previously in our data
section, which has been sourced from the Freedom House. We replicate our return model
estimations replacing the variable sourced from the Polity IV database with the Freedom House
counterpart. Results tabulated in column (1) of Table VIII reveal a strong negative association
between the rewards reaped by outside investors and the repression of political freedom, which
supports the validity of the conclusions reached in our paper.
[Insert Table VIII about here]
Secondly, our sample includes several economies that have experienced episodes of significant
inflationary pressures. High nominal interest rate associated with an inflationary environment
could affect the expected and realized gross stock market returns. Although our baseline
specification controlled for the rate of inflation and real interest rate, we probe into this issue
further by selecting excess returns as our dependent variable. At the same time, we drop
INFLATION, INFLATION2, and REAL_INTEREST_RATE from the list of explanatory factors.
The results are shown in column (2) of Table VIII and are almost identical to those displayed
in column (3) of Table IV.
Thirdly, when dealing with the return regressions, we introduce a nonparametric covariance
matrix estimator, proposed by Discoll and Kraay (1998). This method further controls for the
effects of cross-sectional dependence on the basis of the Newey and West (1987) serial
correlation robust estimator.4 The advantage of obtaining robust standard errors derived from
4 Arellano (2003, 19) provides a more detailed discussion of this estimation method.
24

this approach is that the variance-covariance matrix estimators do not depend on the number
of cross-sectional units. Specifically, Discoll and Kraay (1998) average the moments of all the
cross-sectional units in the same time period, so that the heteroskedasticity and serial
correlation robust Newey and West (1987) variance estimator based on time series can be
applied to panel data. Hoechle (2007) extends this approach and makes it applicable to
unbalanced panels. The results based on this methodology are shown in column (3) of Table
VIII and reveal that the influence of the DEMOCRACY variable remains significant at the 1%
level.
Furthermore, to verify whether the relationship is stable over time, we split our data period into
two subperiods. Year 2003 constitutes the partition point, which splits the sample into two
roughly equal subsamples (582 vs 543 country-years). We estimate models in both subperiods
and report our findings in columns (4) and (5) of Table VIII. Reassuringly, the relationship
between democracy level and stock returns appears to be statistically significant in both
subperiods, substantiating the permanence of the phenomenon being described.
In light of our empirical results, it may be instructive to further explore the risk-return trade-
off conditional on the level of democratization. To this end, we split all sample countries into
three groups based on the Polity IV score. These groupings are defined as autocracies (-10 to -
6), anocracies (-5 to +5), and democracies (+6 to +10). Sharpe ratios are calculated for each of
our country-years and an average is subsequently taken within each group. Figure II depicts
our findings and shows that the average Sharpe ratio tends to increase with democracy level.
The differences between the three groups are statistically significant (F-statistic = 3.15. p-value
= 0.0422).
[Insert Figure II about here]
25

We also analyze whether interactions of political control variables with democracy levels can
explicate the behavior of stock markets. Our analysis employs five political indicators for a
left-wing and a right-wing party in power, a government following a religious ideology, as well
as dummies capturing the occurrence of executive and legislative elections. Of all the
interactions considered, only the term DEMOCRACY×LEFT_WING proved to be statistically
significant and exerted a positive impact on returns (see Table IX). One interpretation that
could be offered for this finding is that leftist autocrats, prompted by their ideological
inclinations, are more likely to expropriate investors’ wealth through nationalization.
Introduction of a democratic process, with all of its checks and balances, puts breaks on these
radical left-leaning impulses. And, as the theories outlined in the paper assert, a reduction in
investor expropriation increases stock returns.
[Insert Table IX about here]
We further introduce an interaction term between INFLATION and DEMOCRACY into
regression (6) of Table IX. This term bears a positive coefficient and is statistically significant.
The implication is that, in an inflationary environment, stock markets in democratic countries
perform ceteris paribus better than those in autocracies. One possible rationalization could be
that autocratic leaders may seek to finance their unmanageable fiscal deficits both through the
issuance of paper money and the nationalization of investors’ assets. In such circumstances,
the heightened risk of expropriation and elevated inflation rates coincide, profoundly
undermining the efficacy of using corporate property as an inflationary hedge.
Column (7) in Table IX considers interaction between LNGDPPC and democracy levels.
According to the estimates, high level of GDP per capita attenuates the negative influence of
autarchy on stock market returns. In some very rich but undemocratic countries (such as those
in the oil-rich Middle East), the increase in national wealth may have inflated overall stock
market pricing. Furthermore, autocratic leaders in affluent nations may not need to resort to
26

arrogation of investors’ wealth. Other, less objectionable, sources of finding may be at their
disposal.
Last but not least, we reflect on whether the democracy indicator is an exogenous variable, or
whether the capital market performance can affect the process of democratization. We use an
instrumental variable strategy and, inspired by Neumayer (2008), use abolition of death penalty
as an instrument for DEMOCRACY. The underidentification, weak identification, and
overidentification tests show that the instrumental variable is valid. Based on this
instrumentation exercise, Durbin-Wu-Hausman test and a C statistic (Hayashi, 2000) were
calculated. No clear evidence for the existence of endogeneity emerged, indicating that our
estimates are consistent. A complete description of the endogeneity testing process is provided
in Appendix B.
VII. Conclusions
This paper examines whether there is a link between democratic rule and stock returns in an
international sample of 74 countries spanning over four decades. One could argue that better
political institutions create investor friendly environments with secured property rights and
lower risks of expropriation by the government. Consequently, one might expect a positive
association between the level of democratization and stock returns on a priori grounds. Using
a range of methodological approaches, we present strong empirical evidence in favor of this
association. We document that dollar-denominated stock returns tend to be appreciably higher
in democratic states. However, attempts to explain away the association by observed return
volatility or insights offered by the CAPM prove futile. Instead, one factor that was able to
expound this constellation of results is the strength of investor protection. We document that
autocrats, who have historically shown a greater tendency to expropriate, are reluctant to
protect the rights of capital holders. This appears to be mirrored in the distribution of returns.
27

These findings have important implications for international stock investors. Since stock
investments in more autocratic countries offer lower rewards and are laden with expropriation
risk, investors may want to underweight these countries in their portfolios. This reasoning could
be taken one step forward and a long-short strategy could be operationalized. We propose a
lucrative strategy which combines investments in highly democratic countries with a short
position in the stock indices of autocratic states. Such a strategy is easily implementable, as
data on democratization around the globe is available freely. Needless to say, the notion that
performance of a portfolio could be improved by monitoring such publicly available data runs
contrary to the efficient market hypothesis (Fama, 1970).
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33

Figure I
Values of High and Low Democracy Portfolios
Note: This figure depicts the value of portfolios being annually reinvested in countries with low and high
democracy scores. The initial value of investment in 1975 was assumed to be one US dollar.
34

Figure II
Average Sharpe Ratio for countries with different Polity IV scores
Note: The sample of country-years was split into three groups based on the DEMOCRACY score. The
average value of the Sharpe ratio within each group is depicted in the figure above.
35

Table I
Variable definitions
Variable Definition Source
Annual continuously compounded dollar-denominated returns on the MSCI country stock Thomson Reuters Datastream
RETURN
market index inclusive of the dividends
Combined polity score obtained by deducting autocracy score from democracy score. Polity IV
Both types of scores are reported in Polity IV dataset and are measured on an eleven-point
DEMOCRACY
scale. The composite value was rescaled by adding 11 to obtain positive numbers across
all observations and a natural logarithm transformation was subsequently applied.
Natural logarithm of the political rights indicator representing democracy level (inverted Freedom House
LACK_OF_POLITICAL_RIGHTS
scale)
GDP_GROWTH Annual GDP growth rate World Development Indicators
INFLATION Percentage change in the CPI World Development Indicators
LNGPDPC Natural logarithm of the GDP per capita expressed in current US dollars World Development Indicators
REAL_INTEREST_RATE Real interest rate World Development Indicators
The Chinn-Ito index (KAOPEN) measuring a country's degree of capital account Chinn-Ito dataset hosted on the
openness. The index was initially introduced in Chinn and Ito (2006). KAOPEN is based Portland State University website
KAOPEN on the binary dummy variables that codify the tabulation of restrictions on cross-border
financial transactions reported in the IMF's Annual Report on Exchange Arrangements
and Exchange Restrictions (AREAER).
Annual continuously compounded dollar-denominated return on the MSCI World stock Thomson Reuters Datastream
WORLD_RETURN
market index. The return incorporates dividend payments.
LEFT_WING A dummy variable indicating that a left-wing party is in power Database of Political Institutions
RIGHT_WING A dummy variable indicating that a right-wing party is in power Database of Political Institutions
A dummy variable taking the value of one whether a government follows a religious Database of Political Institutions
RELIGION
ideology and zero otherwise
ELECTION_EXE A dummy indicating whether an executive election took place in a specific country-year Database of Political Institutions
ELECTION_LEG A dummy indicating whether a legislative election took place in a specific country-year Database of Political Institutions
36

Table II
Summary statistics
Variable Mean Adjusted Mean Std. Dev. 25thPercentile Median 75thPercentile
RETURN 0.0738 0.0518 0.3504 -0.1132 0.1024 0.2822
DEMOCRACY 2.7950 2.6557 0.5485 2.8904 3.0445 3.0445
LACK_OF_POLITICAL_RIGHTS 0.5409 0.7241 0.6775 0.0000 0.0000 1.0986
GDP_GROWTH 0.0331 0.0349 0.0368 0.0149 0.0322 0.0520
INFLATION 0.1558 0.1455 1.4462 0.0180 0.0352 0.0713
LNGPDPC 9.2269 9.0335 1.2056 8.4415 9.4036 10.1442
REAL_INTEREST_RATE 0.0568 0.0586 0.0767 0.0235 0.0475 0.0751
KAOPEN 1.0090 0.8666 1.4119 -0.1540 1.3035 2.3220
WORLD_RETURN 0.0855 0.0808 0.1794 -0.0032 0.1310 0.2081
LEFT_WING 0.3017 0.2610 0.4591 0.0000 0.0000 1.0000
RIGHT_WING 0.3318 0.2886 0.4710 0.0000 0.0000 1.0000
RELIGION 0.1204 0.1138 0.3256 0.0000 0.0000 0.0000
ELECTION_EXE 0.0782 0.0896 0.2685 0.0000 0.0000 0.0000
ELECTION_LEG 0.2658 0.2554 0.4419 0.0000 0.0000 1.0000
Note: This table presents summary statistics for the variables used in this study. Exact definitions of variables can be found in Table I. The sample considered spans the period from 1975 to 2015
and includes 74 countries. To arrive at the “Adjusted Mean” we first calculate the average of a given variable for each country and then take the mean of these averages.
37

Table III
Matrix of correlations
POLITICAL_RIGHTS
REAL_INTEREST_
WORLD_RETURN
ELECTION_LEG
ELECTION_EXE
GDP_GROWTH
DEMOCRACY
RIGHT_WING
LEFT_WING
INFLATION
LACK_OF_
LNGDPPC
RELIGION
KAOPEN
RETURN
RATE
RETURN 1.0000
DEMOCRACY 0.0666 1.0000

(0.0058)
LACK_OF_POLITICAL_RIGHTS -0.0659 -0.7248 1.0000
(0.0071) (0.0000)
GDP_GROWTH 0.0876 -0.2913 0.3197 1.0000
(0.0003) (0.0000) (0.0000)
INFLATION 0.0171 0.0144 0.0108 -0.0740 1.0000
(0.4859) (0.5567) (0.6581) (0.0025)
LNGPDPC -0.0334 0.1661 -0.5585 -0.2344 -0.0888 1.0000
(0.1715) (0.0000) (0.0000) (0.0000) (0.0003)
REAL_INTEREST_RATE 0.0026 0.0226 0.0611 -0.1044 -0.0506 -0.1235 1.0000
(0.9277) (0.4342) (0.0346) (0.0003) (0.0858) (0.0000)
KAOPEN -0.0086 0.1277 -0.4138 -0.1527 -0.1516 0.6594 -0.0825 1.0000
(0.7283) (0.0000) (0.0000) (0.0000) (0.0000) (0.0000) (0.0047)
WORLD_RETURN 0.6078 0.0361 -0.0471 -0.0234 -0.0200 -0.0286 0.0632 -0.0183 1.0000
(0.0000) (0.1330) (0.0501) (0.3311) (0.4130) (0.2703) (0.0288) (0.4548)
LEFT_WING 0.0134 0.1297 -0.1990 -0.0266 -0.0457 0.0113 0.0697 -0.0561 0.0053 1.0000
(0.5808) (0.0000) (0.0000) (0.2704) (0.0617) (0.6434) (0.0162) (0.0219) (0.8250)
RIGHT_WING 0.0249 0.2392 -0.2452 -0.0883 0.0644 0.1659 -0.0239 0.1668 0.0361 -0.4639 1.0000
(0.3045) (0.0000) (0.0000) (0.0002) (0.0085) (0.0000) (0.4100) (0.0000) (0.1343) (0.0000)
RELIGION 0.0271 -0.0081 -0.0397 -0.0301 -0.0267 0.0264 -0.0110 0.0070 0.0238 -0.2075 0.2087 1.0000
(0.2634) (0.7381) (0.0992) (0.2122) (0.2761) (0.2774) (0.7051) (0.7757) (0.3228) (0.0000) (0.0000)
ELECTION_EXE -0.0065 0.0684 -0.0141 0.0007 0.0826 -0.0402 0.0933 -0.0676 -0.0193 -0.0318 0.0236 -0.0880 1.0000
(0.7901) (0.0045) (0.5584) (0.9713) (0.0007) (0.0986) (0.0013) (0.0058) (0.4234) (0.1862) (0.3267) (0.0003)
ELECTION_LEG 0.0092 0.0850 -0.0705 -0.0298 0.0167 0.0375 0.0057 0.0312 0.0012 -0.0075 0.0433 0.0067 0.2544 1.0000
(0.7058) (0.0004) (0.0034) (0.2176) (0.4962) (0.1235) (0.8451) (0.2029) (0.9598) (0.7550) (0.0724) (0.7821) (0.0000)
Note: This table reports Pearson correlation coefficients between the variables. The p-value for the null hypothesis that a specific correlation coefficient is equal to zero is reported in parentheses.
38

Table IV
Regressions linking MSCI indexes returns to democracy level and control variables
Model Time effects Pooled feasible GLS System GMM Pooled feasible GLS
Independent Variable (1) (2) (3) (4) (5)
** *** *** **
0.0265 0.0666 0.0706 0.0685
DEMOCRACY
(0.0125) (0.0190) (0.0157) (0.0313)
0.0548***
LAGGED DEMOCRACY
(0.0201)
1.1585*** 0.6432*** 1.3077 *** 0.7313***
GDP_GROWTH
(0.3030) (0.2235) (0.4764) (0.2489)
-0.5811* -0.5990** -0.9172** -0.4226
INFLATION
(0.3354) (0.2642) (0.4679) (0.2921)
1.4556** 0.6252 1.7776** 0.3468
INFLATION2
(0.7115) (0.8814) (0.8476) (1.0321)
-0.0062 -0.0191*** -0.0180 -0.0134
LNGDPPC
(0.0073) (0.0068) (0.0133) (0.0083)
-0.0732 -0.1905* -0.2916** -0.1560*
REAL_INTEREST_RATE
(0.0932) (0.0976) (0.1349) (0.0897)
0.0035 0.0045 0.0034 0.0069
KAOPEN
(0.0059) (0.0050) (0.0086) (0.0051)
0.0349** 0.0124 0.0535** 0.0136
LEFT_WING
(0.0171) (0.0123) (0.0239) (0.0137)
-0.0083 -0.0093 0.0162 -0.0098
RIGHT_WING
(0.0170) (0.0137) (0.0268) (0.0149)
0.0380* 0.0279** 0.0270 0.0295**
RELIGION
(0.0212) (0.0124) (0.0241) (0.0124)
0.0213 0.0178 0.0292 0.0152
ELECTION_EXE
(0.0262) (0.0187) (0.0253) (0.0186)
-0.0166 -0.0122 -0.0140 -0.0116
ELECTION_LEG
(0.0152) (0.0109) (0.0159) (0.0115)
39

1.0791*** 1.0927*** 1.0808***
WORLD_RETURN
(0.0445) (0.0580) (0.0447)
-0.0592
RETURN LAG1
(0.0407)
-0.0786***
RETURN LAG2
(0.0272)
-0.0007 -0.0859 -0.0250 -0.0527 -0.0470
Constant
(0.0358) (0.0997) (0.0698) (0.1631) (0.0814)
No of Observations 1711 1125 1125 1052 1090
No of Countries 74 62 62 62 62
R-squared 0.4817 0.5054 0.5514 0.5502
F-statistic 37.8386 21.0637 105.0410 101.2454
Prob(F-statistic) 0.0000 0.0000 0.0000 0.0000
AR(2) test -0.2411
Prob>z 0.8095
Hansen test 45.8829
Prob>chi2 0.9981
Note: The regressions reported in this table link stock market index returns to our democracy variable (or lagged democracy) and controls. Exact variable definitions can be found in Table I. The
first two specifications report results for a model with time fixed effects. Specifications (3) and (5), have no fixed effects and are estimated using feasible GLS with cross-section weights. For
these models, R-squared and F-test are reported as weighted statistics. The F-statistic is for the null hypothesis that all of the explanatory variables are jointly unable to explain the underlying
process. Specification (4) is based on system GMM estimation outlined in Blundell and Bond (1998). In these models WORLD_RETURN is assumed to be an endogenous variable and the standard
errors reported are robust with respect to cross-sectional dependence and heteroscedasticity. The AR(2) test is for the null hypothesis that the errors in the first difference regression exhibit no
second order serial correction, while the Hansen’s test verifies the validity of overidentifying restrictions in the GMM estimation. Parameter standard errors, which in the static models allow for
the serial correlation and heteroskedasticity of the error terms, are reported in parentheses. *, **, *** denote statistical significance at 10%, 5% and 1%, respectively.
40

Table V
Determinants of risk levels
Dependent Variable TOTAL_VOLATILITY COUNTRY_SPECIFIC_VOLATILITY GLOBAL_SYSTEMATIC_VOLATILITY
Independent Variable (1) (2) (3) (4) (5) (6)
* ** **
-0.0054 -0.0088 -0.0119 -0.0175 0.0118 0.0040
DEMOCRACY
(0.0081) (0.0107) (0.0070) (0.0077) (0.0054) (0.0113)
-0.7311*** -0.4752*** -0.4679***
GDP_GROWTH
(0.1967) (0.1469) (0.1559)
0.5331*** 0.3818** 0.4775*
INFLATION
(0.2181) (0.1511) (0.2408)
-0.7909** -0.2173 -0.8503*
INFLATION2
(0.3900) (0.2268) (0.4394)
0.0107* -0.0213*** 0.0067
LNGDPPC
(0.0064) (0.0059) (0.0041)
0.0102 0.0133 0.1313*
REAL_INTEREST_RATE
(0.0720) (0.0558) (0.0664)
-0.0037 -0.0069 -0.0001
KAOPEN
(0.0054) (0.0051) (0.0032)
-0.0061 -0.0094 -0.0019
LEFT_WING
(0.0114) (0.0092) (0.0124)
-0.0095 -0.0037 -0.0147
RIGHT_WING
(0.0118) (0.0097) (0.0103)
-0.0159 -0.0154 -0.0090
RELIGION
(0.0184) (0.0105) (0.0160)
0.0177 0.0163 0.0012
ELECTION_EXE
(0.0175) (0.0121) (0.0181)
-0.0035 -0.0011 -0.0025
ELECTION_LEG
(0.0077) (0.0055) (0.0078)
-0.2108*** -0.0658*** -0.2127***
WORLD_RETURN
(0.0206) (0.0195) (0.0207)
41

0.4136*** 0.3695***
LAGGED TOTAL_VOLATILITY
(0.0379) (0.0483)
0.5165*** 0.2334***
LAGGED COUNTRY_SPECIFIC_VOLATILITY
(0.0430) (0.0497)
0.2962*** 0.3767***
LAGGED GLOBAL_SYSTEMATIC_VOLATILITY
(0.0370) (0.0585)
0.1598*** 0.2950*** 0.1206*** 0.3965*** 0.0692*** 0.0301***
Constant
(0.0251) (0.0773) (0.0204) (0.0735) (0.0162) (0.0574)
No of Observations 1637 1089 1637 1089 1637 1089
No of Countries 73 62 73 62 73 62
AR(2) test -1.0912 -1.2794 0.4490 -1.3319 -1.4259 -0.0857
Prob>z 0.2752 0.2008 0.6535 0.1829 0.1539 0.9317
Hansen test 71.1217 52.2646 69.6202 52.3470 71.8056 54.5437
Prob>chi2 0.6672 0.9890 0.7125 0.9887 0.6459 0.9800
Note: The regressions reported in this table consider different types of volatility as a function of the democracy variable and controls. The dependent variable in specifications (1) to (2) is the annualized
total volatility of national index returns. This total volatility is then dissected into two components, namely COUNTRY_SPECIFIC_VOLATILITY and GLOBAL_SYSTEMATIC_VOLATILITY. These
components are modelled individually in columns (3) to (6). Specifications (1), (3) and (5) include no controls except for the autoregressive term, while specifications (2), (4), and (6) incorporate a full
set of explanatory variables. All of the regressions are dynamic panels estimated using the system GMM method by Blundell and Bond (1998). In these models WORLD_RETURN is assumed to be an
endogenous variable and standard errors robust to cross-sectional dependence and heteroscedasticity are reported in parentheses. The AR(2) test is for the null hypothesis that the errors in the first
difference regression exhibit no second order serial correction, while the Hansen’s test verifies the validity of overidentifying restrictions in the GMM estimation. *, **, *** denote statistical significance
at 10%, 5% and 1%, respectively.
42

Table VI
Strength of investor protection and democracy level
Independent Variable (1) (2)
***
0.8371 0.4015***
DEMOCRACY
(0.3185) (0.0987)
0.2098
GDP_GROWTH
(0.7029)
-3.0653*
INFLATION
(1.5842)
9.0554***
INFLATION2
(3.3638)
0.3224
LNGDPPC
(0.3295)
-0.0589
REAL_INTEREST_RATE
(0.2485)
-0.1175
KAOPEN
(0.1210)
-0.1115
LEFT_WING
(0.1346)
-0.0174
RIGHT_WING
(0.1158)
0.2048
RELIGION
(0.2466)
0.1189
ELECTION_EXE
(0.1123)
-0.0501
ELECTION_LEG
(0.0480)
3.6410*** 2.1801
Constant
(0.8540) (3.1925)
No of Observations 638 408
No of Countries 74 50
R-squared 0.9126 0.9466
F-statistic 70.6896 86.8895
Prob(F-statistic) 0.0000 0.0000
Note: Investor protection index from the World Economic Forum Global Competitiveness Index dataset
acts as a dependent variable in the models reported above. Exact variable definitions can be found in
Table I. The estimation method used here is the two-way fixed effect panel. Specification (1) includes
no controls, while specification (2) incorporates all controls. The F-statistic is for the null hypothesis
that all of the explanatory variables are jointly unable to explain the underlying process. Parameter
standard errors robust to heteroskedasticity and serial correlation are given in parentheses. *, **, ***
denote statistical significance at 10%, 5% and 1%, respectively.
43

Table VII
Return regressions exploring the rationalizations for the democracy-autocracy returns gap
Independent Variable (1) (2) (3) (4)
*** *** ***
0.0583 0.0584 0.0570 0.0023
DEMOCRACY
(0.0201) (0.0201) (0.0200) (0.0168)
0.0782
LAGGED TOTAL_VOLATILITY
(0.0593)
0.0963
LAGGED COUNTRY_SPECIFIC_VOLATILITY
(0.0697)
0.0494
LAGGED GLOBAL_SYSTEMATIC_VOLATILITY
(0.0625)
0.0113**
LAGGED INVESTOR_PROTECTION
(0.0053)
0.7897*** 0.7548*** 0.7697*** -0.3451
GDP_GROWTH
(0.2519) (0.2491) (0.2539) (0.2098)
-0.4117 -0.4335 -0.4022 -0.4550
INFLATION
(0.2997) (0.3002) (0.2960) (0.3880)
0.1613 0.1957 0.2385 -2.5390*
INFLATION2
(1.0770) (1.0946) (1.0479) (1.5087)
-0.0115 -0.0103 -0.0134 -0.0180
LNGDPPC
(0.0083) (0.0085) (0.0082) (0.0119)
-0.1661* -0.1753* -0.1561* -0.3870***
REAL_INTEREST_RATE
(0.0899) (0.0934) (0.0882) (0.1069)
0.0080 0.0079 0.0073 0.0062
KAOPEN
(0.0051) (0.0052) (0.0051) (0.0081)
0.0137 0.0149 0.0127 0.0590***
LEFT_WING
(0.0138) (0.0139) (0.0137) (0.0192)
-0.0095 -0.0089 -0.0100 0.0247
RIGHT_WING
(0.0151) (0.0152) (0.0150) (0.0214)
0.0319** 0.0302** 0.0312** 0.0524***
RELIGION
(0.0130) (0.0125) (0.0130) (0.0180)
0.0158 0.0178 0.0148 0.1162***
ELECTION_EXE
(0.0190) (0.0193) (0.0187) (0.0207)
-0.0118 -0.0118 -0.0121 -0.0555***
ELECTION_LEG
(0.0116) (0.0116) (0.0116) (0.0178)
1.0789*** 1.0833*** 1.0775*** 1.1720***
WORLD_RETURN
(0.0441) (0.0447) (0.0445) (0.0360)
-0.0960 -0.1038 -0.0627 0.0506
Constant
(0.0885) (0.0881) (0.0820) (0.1098)
No of Observations 1089 1089 1089 359
No of Countries 62 62 62 50
R-squared 0.5493 0.5500 0.5493 0.7973
F-statistic 93.4796 93.7799 93.4864 96.6503
Prob(F-statistic) 0.0000 0.0000 0.0000 0.0000
Note: The regressions reported in this table link stock market index returns to our democracy variable, a lagged variable suspected to drive
the democracy-autocracy return differential and controls. Exact variable definitions can be found in Table I. The regressions are estimated
using feasible GLS with cross-section weights and the R-squared and F-test are reported as weighted statistics. The F-statistic is for the null
hypothesis that all of the explanatory variables are jointly unable to explain the underlying process. Parameter standard errors, which in the
static models allow for the serial correlation and heteroskedasticity of the error terms, are reported in parentheses. *, **, *** denote statistical
significance at 10%, 5% and 1%, respectively.
44

Table VIII
Determinants of returns: Robustness checks
Model with an Model with MSCI
Discoll and Kraay Models estimated in
alternative democracy excess returns as
(1998) estimation different subperiods
variable dependent variable
Estimation Period
1975-2015 1975-2015 1975-2015 1975-2003 2004-2015
Independent Variable (1) (2) (3) (4) (5)
*** *** **
0.0698 0.0762 0.0974 0.0551***
DEMOCRACY (0.0231) (0.0410) (0.0161)
（0.0159)
-0.0681***
LACK_OF_POLITICAL_RIGHTS
(0.0145)
0.6251*** 0.6343*** 1.2604*** 0.5687 0.7743***
GDP_GROWTH
(0.2257) (0.2214) (0.3380) (0.3706) (0.1947)
-0.6771** -0.8278** -0.3102 -0.4956
INFLATION
(0.2568) (0.3768) (0.3123) (0.3633)
0.8603 1.6537*** 0.5665 -2.6662
INFLATION2
(0.8569) (0.5233) (0.8362) (1.6982)
-0.0333*** 0.0212*** -0.0184 -0.0231* -0.0275***
LNGDPPC
(0.0083) (0.0082) (0.0153) (0.0133) (0.0084)
-0.1705 -0.1209 -0.1135 -0.2954**
REAL_INTEREST_RATE
(0.1024) (0.1397) (0.1005) (0.1202)
0.0046 0.0157* 0.0096 0.0089 0.0074
KAOPEN (0.0081) (0.0089) (0.0065) (0.0075)
（0.0048)
0.0010 0.0053 0.0412** -0.0068 0.0359**
LEFT_WING
(0.0131) (0.0137) (0.0202) (0.0222) (0.0156)
-0.0150 -0.0169 -0.0008 -0.0099 0.0011
RIGHT_WING
(0.0139) (0.0162) (0.0191) (0.0237) (0.0163)
0.0241** 0.0242 0.0367** 0.0159 0.0409***
RELIGION
(0.0110) (0.0171) (0.0174) (0.0194) (0.0138)
45

0.0186 -0.0114 0.0195 0.0042 0.0534***
ELECTION_EXE
(0.0180) (0.0179) (0.0274) (0.0273) (0.0159)
-0.0095 -0.0085 -0.0062 -0.0018 -0.0383***
ELECTION_LEG
(0.0109) (0.0107) (0.0172) (0.0162) (0.0122)
1.0737*** 1.0945*** 1.1312*** 0.9300*** 1.2252***
WORLD_RETURN
(0.0441) (0.0485) (0.1321) (0.0521) (0.0453)
0.3460*** -0.5246*** -0.0933 -0.0639 0.0888
Constant
(0.0835) (0.0793) (0.1849) (0.1134) (0.0920)
No of Observations 1125 1125 1125 582 543
No. of Countries 62 62 62 47 57
R-squared 0.5522 0.5258 0.4015 0.4624 0.7268
F-statistic 105.4025 123.5323 50.5800 37.5877 108.2691
Prob(F-statistic) 0.0000 0.0000 0.0000 0.0000 0.0000
Note: Colum (1) displays regression in which MSCI returns are a function of LACK_OF_POLITICAL_RIGHTS variable and controls. Column (2) shows regression with MSCI excess returns as the
dependent variable. Column (3) estimates the baseline return regression using the Discoll and Kraay (1998) method. Columns (3) and (4) present results for the models fitted in different subperiods.
Exact variable definitions can be found in Table I. The estimation method employed here is feasible GLS with cross-section weights. Parameter standard errors allowing for heteroskedasticity and serial
correlation of the error terms are reported in parentheses. The F-statistic is for the null hypothesis that all of the explanatory variables are jointly unable to explain the underlying process. *, **, *** denote
statistical significance at 10%, 5% and 1%, respectively.
46

Table IX
Return models including interactive terms
Independent Variable (1) (2) (3) (4) (5) (6) (7)
*** *** *** *** *** **
0.0558 0.0704 0.0732 0.0703 0.0654 0.0465 0.2062***
DEMOCRACY
(0.0186) (0.0158) (0.0172) (0.0157) (0.0149) (0.0192) (0.0752)
0.0456**
DEMOCRACY×LEFT_WING
(0.0197)
0.0785
DEMOCRACY×RIGHT_WING
(0.0884)
-0.0185
DEMOCRACY×RELIGION
(0.0235)
0.1148
DEMOCRACY×ELECTION_EXE
(0.1114)
0.0352
DEMOCRACY×ELECTION_LEG
(0.0294)
0.5186**
DEMOCRACY×INFLATION
(0.2396)
-0.0147*
DEMOCRACY×LNGDPPC
(0.0082)
0.6510*** 0.6568*** 0.6517*** 0.6454*** 0.6356*** 0.6469*** 0.6270***
GDP_GROWTH
(0.2175) (0.2243) (0.2267) (0.2242) (0.2253) (0.2201) (0.2213)
-0.6569** -0.5970** -0.6152** -0.5894** -0.5799** -2.0910*** -0.6984***
INFLATION
(0.2607) (0.2615) (0.2699) (0.2652) (0.2702) (0.7299) (0.2686)
0.7192 0.6567 0.6557 0.6084 0.5697 0.9736 0.8159
INFLATION2
(0.8678) (0.8819) (0.8841) (0.8834) (0.9078) (0.8010) (0.8589)
-0.0215*** -0.0196*** -0.0199*** -0.0191*** -0.0187*** -0.0201*** 0.0183
LNGDPPC
(0.0071) (0.0069) (0.0074) (0.0069) (0.0068) (0.0072) (0.0207)
-0.2180** -0.1847* -0.1925* -0.1862* -0.1991** -0.2261** -0.2172**
REAL_INTEREST_RATE
(0.0997) (0.1002) (0.0976) (0.0984) (0.1002) (0.1009) (0.0988)
KAOPEN 0.0032 0.0044 0.0048 0.0044 0.0043 0.0058 0.0049
47

(0.0049) (0.0050) (0.0051) (0.0050) (0.0050) (0.0051) (0.0051)
-0.1147** 0.0127 0.0130 0.0118 0.0111 0.0162 0.0189
LEFT_WING
(0.0511) (0.0123) (0.0124) (0.0123) (0.0123) (0.0120) (0.0129)
-0.0012 -0.2457 -0.0083 -0.0094 -0.0109 -0.0063 -0.0038
RIGHT_WING
(0.0151) (0.2677) (0.0140) (0.0137) (0.0140) (0.0138) (0.0143)
0.0283** 0.0272** 0.0820 0.0278** 0.0294** 0.0296** 0.0259**
RELIGION
(0.0126) (0.0121) (0.0685) (0.0124) (0.0127) (0.0125) (0.0127)
0.0184 0.0272 0.0179 -0.3261 0.0168 0.0177 0.0183
ELECTION_EXE
(0.0184) (0.0121) (0.0187) (0.3355) (0.0185) (0.0180) (0.0183)
-0.0130 -0.0123 -0.0128 -0.0120 -0.1150 -0.0120 -0.0134
ELECTION_LEG
(0.0110) (0.0109) (0.0111) (0.0109) (0.0872) (0.0107) (0.0109)
1.0778*** 1.0791*** 1.0785*** 1.0791*** 1.0799*** 1.0745*** 1.0773***
WORLD_RETURN
(0.0441) (0.0445) (0.0444) (0.0443) (0.0442) (0.0443) (0.0440)
0.0418 -0.0201 -0.0242 -0.0240 -0.0126 -0.0517 -0.3637*
Constant
(0.0838) (0.0708) (0.0697) (0.0703) (0.0641) (0.0819) (0.1868)
No of Observations 1125 1125 1125 1125 1125 1125 1125
No of Countries 62 62 62 62 62 62 62
R-squared 0.5503 0.5515 0.5514 0.5515 0.5529 0.5575 0.5510
F-statistic 97.0175 97.4951 97.4396 97.4756 98.2093 99.9022 97.3099
Prob(F-statistic) 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000
Note: This table reports estimates of models in which MSCI returns is dependent on democracy level, interaction terms and a full set of controls. Exact variable definitions can be found in Table I. The
estimation method employed here is feasible GLS with cross-section weights. Parameter standard errors allowing for the heteroscedasticity and serial correlation of the error terms are reported in
parentheses. The F-statistic is for the null hypothesis that all of the explanatory variables are jointly unable to explain the underlying process. *, **, *** denote statistical significance at 10%, 5% and 1%,
respectively.
48

Appendix A
The table below lists the sample countries together with the length of the MSCI stock index return series used in our analysis.
Table A1
List of countries in the sample
Developed Markets Emerging Markets Frontier Markets Standalone Markets
Australia (1975-2015) Brazil (1988-2015) Bahrain (2006-2015) Argentina (1988-2015)
Austria (1975-2015) Chile (1988-2015) Bangladesh (2010-2015) Bosnia Herzegovina (2011-2015)
Belgium (1975-2015) China (1993-2015) Croatia (2003-2015) Botswana (2009-2015)
Finland (1975-2015) Colombia (1993-2015) Estonia (2003-2015) Bulgaria (2006-2015)
Canada (1975-2015) Czech Republic (1995-2015) Jordan (1988-2015) Ghana (2009-2015)
Denmark (1975-2015) Greece (1988-2015) Kazakhstan (2006-2015) Jamaica (2009-2015)
France (1975-2015) Hungry (1995-2015) Kenya (2004-2015) Lebanon (2005-2015)
Germany5 (1975-2015) India (1993-2015) Lithuania (2009-2015) Russia (1995-2015)
Ireland (1988-2015) Indonesia (1989-2015) Mauritius (2003-2015) Trinidad & Tobago (2009-2015)
Israel (1993-2015) Korea (1988-2015) Morocco (1995-2015) Ukraine (2007-2015)
Italy (1975-2015) Kuwait (2006-2015) Nigeria (2003-2015)
Japan (1975-2015) Malaysia (1988-2015) Oman (2006-2015)
Netherlands (1975-2015) Mexico (1988-2015) Pakistan (1993-2015)
New Zealand (1988-2015) Peru (1993-2015) Romania (2006-2015)
Norway (1975-2015) Philippines (1988-2015) Serbia (2009-2015)
Portugal (1988-2015) Poland (1994-2015) Slovenia (2003-2015)
5 The data before 1990 cames from West Germany.
49

Singapore (1975-2015) Qatar (2005-2015) Sri Lanka (1993-2015)
Spain (1975-2015) Saudi Arabia (2006-2015) Tunisia (2005-2015)
Sweden (1975-2015) South Africa (1993-2015) Vietnam (2007-2015)
Switzerland (1975-2015) Taiwan (1988-2015)
United Kingdom (1975-2015) Thailand (1988-2015)
United States (1975-2015) Turkey (1990-2015)
United Arab Emirates (2006-2015)
50

Appendix B
Possible endogeneity?
Is the democracy indicator an exogenous variable, or can capital market performance affect the
process of democratization? Based on the economic literature, Lipset (1959) argues that
democracy must be based on economic development, because the middle class is the backbone
of democracy, and only when the middle class has grown and consolidated can the community
counter dictatorships. This is the so-called the Lipset hypothesis, supported by studies such as
Huber et al. (1993) and Putnam et al. (1994). Barro (1999) provides further empirical evidence
to document that economic growth begets democracy, and that the democratic system is
impossible to sustain without adequate economic support. On the other hand, new institutional
economists such as Acemoglu et al. (2003; 2005; 2008) and Rodrik (2003) disagree with this
viewpoint. They believe the reason why some studies have found that economic growth
promotes development of democracy is related to model bias issues like omitted variables.
They argue that there is no absolute two-way causal relationship between economic growth
and democracy. In addition to the potential reverse causality discussed above, there are the
usual omitted variable concerns. For example, bad policy decisions of nondemocratic rulers
may induce both a fall in economic growth and demands for democratization. Similarly,
political unrest paving the way for democracy might also disrupt financial market.
From an econometric viewpoint, one way to address potential endogeneity issues is to use the
instrumental variables (IV) strategy to estimate the model, which can (at least partially)
mitigate the reverse causality and omitted variable problems. The prerequisite for instrumental
variable estimation is to find valid instruments that meet several criteria. First, they should only
work through the possible endogenous independent variables to influence the dependent
variable. Second, the instruments must be exogenous and have significant effects on the
endogenous explanatory variables (Wooldridge, 2002). If the instrumental variable is valid and
51

the key explanatory variable is endogenous, then a two-stage least squares estimation (2SLS)
should be used, as the simple OLS would be inconsistent (Wooldridge, 2002). On the other
hand, if the instrumental variable is valid but the key explanatory variable is exogenous, then
the result of non-instrumental analysis should be accepted.
Before implementing the endogeneity tests, we need to find suitable instrumental variables for
the democracy indicator and employ the relevant statistical techniques to verify the validity of
these instruments. Our approach to selecting an instrumental variable for DEMOCRACY is
inspired by Neumayer (2008) who argues that in democratic societies the death penalty tends
to be perceived as a violation of human rights and the process of democratization renders its
abolition more likely. This result is in accordance with the previous findings of Neapolitan
(2001) and Greenberg and West (2003). Consequently, the abrogation of capital punishment
could be an attractive source of exogenous variation in democracy, which we exploit in our
testing.
More specifically, we define a dummy variable ABO∈{0,1} to measure whether a country has
abolished the death penalty or not. The data for this variable is taken from Amnesty
International. According to the extant literature, this variable should be correlated with the level
of democratization. At the same time, it is unlikely to be correlated with national stock market
returns, as countries experiencing stock market upswings may be retentionists. We consider a
country abolitionist during a given year if it abolishes the death penalty for all crimes, or for
ordinary crimes only, or de facto abolishes the death penalty 6 (ABO = 1), and regard it as
retentionist otherwise (ABO = 0). It is worth noting that the ABO dummy is highly correlated
with DEMOCRACY ( = 0.4279, p-value = 0.0000) but very weakly correlated with stock
market returns ( = 0.0101, p-value = 0.6776).
6The criterion of de facto abolitionist employed by Amnesty International is that a country has ‘not executed anyone during
the past 10 years’ and is believed to ‘have a policy or established practice of not carrying out executions’.
52

In the next step, we verify the effectiveness of the ABO instrumental variable by performing a
series of tests. First, a LM version of the Anderson (1951) canonical correlations test is
performed to check whether there is an underidentification issue. Underidentification test
checks whether the included instrumental variable is relevant. The null hypothesis is that the
instrumental variable is underidentified and the corresponding test statistic follows chi-squared
distribution under the null. In our data, the Anderson LM statistic is 162.91 (p-value = 0.0000),
which shows that the underidentification problem is not present. Furthermore, we apply the
heteroskedastic-robust Kleibergen-Paap (2006) rk LM test which dispenses with the i.i.d.
assumption. The value of the corresponding statistic is 113.83 (p-values = 0.0000), which
reinforces the results of the Anderson (1951) test.
Although relevant, the instruments may still be weak, which would lead to poor estimation.
The Cragg-Donald (1993) Wald F-test can be utilized to examine this issue and Stock and Yogo
(2005) provide the relevant critical values for this test. The Cragg-Donald F-statistic is 188.12,
which is higher than any of the Stock-Yogo critical values (5.53 – 16.38). Consequently, we
could reject the null hypothesis of weak instruments by accepting that the true size is no more
than 10%. We also implemented heteroskedastic-robust Kleibergen-Paap (2006) rk Wald F-test
and the corresponding statistic of 133.50 was higher than the 10% Stock-Yogo critical value,
which lends credence to our earlier conclusion.
Another issue to contend with when using instrumental variables is the possibility of
overidentification. The inclusion of lags of ABO as instruments allows us to perform a Hansen-
type overidentification test. It verifies whether instrumental variables are correlated with the
endogenous variables, but uncorrelated with the error terms (Hayashi, 2000). The null
hypothesis here is that all the instrumental variables are exogenous. The Sargan statistic turns
out to be 1.86 (p-value = 0.1732), implying that we cannot reject the null hypothesis. If we are
concerned about the presence of heteroskedasticity and autocorrelation, the Hansen's J-statistic
53

could be used as an alternative to the Sargan statistic (Hayashi, 2000). The Hansen's J-statistic
is 0.65 (p-value = 0.4188), which corroborates the finding that the instruments are valid, and
no misspecification is present. Based on all of the abovementioned tests, we can consider the
instrumental variable ABO to be effective.
We seek the answer the question of whether we need to use the instrumental variables strategy
by resorting to endogeneity testing. This pursuit starts with employing the most common
method, namely the Durbin-Wu-Hausman test (Durbin, 1954; Wu, 1974; Hausman, 1978). We
re-estimate the main specification by using pooled OLS and 2SLS and used the Hausman
method to test whether the estimated coefficients of the two equations were systematically
different. When we consider the heteroscedastic robust standard errors, the Wu-Hausman F-
test statistic is 0.06 (p-value = 0.8070) and the Durbin-Wu-Hausman chi-squared test statistic
is 0.06 (p-value = 0.8058). Moreover, we implemented another endogeneity test based on a C
statistic (also known as a “GMM distance” or “difference-in-Sargan” statistic). It is defined the
difference of two Sargan-Hansen statistics: one for the equation with the smaller set (subset)
of instruments, where the suspect regressor(s) are treated as endogenous, and one for the
equation with the larger set of instruments, where the suspect regressor(s) are treated as
exogenous (Hayashi, 2000). Under the null hypothesis both the smaller set of instruments and
the larger set of instruments are valid. In other words, the specified endogenous regressor(s)
can actually be treated as exogenous. In context of our sample, the chi-squared statistic7 equals
to 0.06 (p-value = 0.8058), which parallels the conclusions obtained from the Hausman test8.
Consequently, we fail to reject the null hypothesis that the Polity IV variable DEMOCRACY is
exogenous (Davidson and MacKinnon, 1993, Wooldridge, 2000). In short, there is no clear
7The test statistic is distributed as chi-squared with degrees of freedom equal to the number of regressors tested.
8Under conditional homoskedasticity, this endogeneity test statistic is numerically equal to a Hausman test statistic (Haysshi,
2000).
54

evidence for the presence of endogeneity and the instrumental variables strategy does not need
to be used.
We note in passing that the conclusions of the study would remain unchanged even if we
decided to proceed with the instrumentation. Table A2 reports the 2SLS regression results with
abolitionist dummy and other explanatory variables acting as instruments for DEMOCRACY.
The instrumented democracy indicator still appears to be a significant explanatory factor in the
return regressions.
[Insert Table A2 about here]
55

Table A2
IV (2SLS) estimation
Independent Variable First-stage regression for IV (2SLS) estimation for
DEMOCRACY RETURN_GROSS
0.4099***
ABO
(0.0355)
0.0861**
DEMOCRACY
(0.0437)
-3.5155*** 1.3041***
GDP_GROWTH
(0.6742) (0.3698)
1.0266* -0.8349**
INFLATION
(0.6099) (0.3840)
-2.3816** 1.6701**
INFLATION2
(1.2976) (0.7420)
-0.0107 -0.0186
LNGDPPC
(0.0243) (0.3295)
-0.3577 -0.1195
REAL_INTEREST_RATE
(0.2552) (0.1306)
-0.0026 0.0096
KAOPEN
(0.0132) (0.0090)
0.1942*** 0.0383
LEFT_WING
(0.0381) (0.0243)
0.3399*** -0.0044
RIGHT_WING
(0.0366) (0.0264)
0.0037 0.0362
RELIGION
(0.0414) (0.0226)
0.1197*** 0.0178
ELECTION_EXE
(0.0352) (0.0312)
0.0525* -0.0065
ELECTION_LEG
(0.0292) (0.0187)
0.0625 1.1311***
WORLD_RETURN
(0.0716) (0.0484)
2.5522*** -0.1184
Constant
(0.2285) (0.1621)
No of Observations 1125 1125
No of Countries 62 62
R-squared 0.3332 0.4013
F-statistic 29.97
Wald chi-squared 625.88
Prob(F-statistic) 0.0000 0.0000
Note: The data of abolition of the death penalty (ABO) is taken from Amnesty International. Exact
variable definitions can be found in Table I. The results reported are based on IV (2SLS) estimation.
Parameter standard errors robust to heteroskedasticity and serial correlation are given in parentheses. *,
**, *** denote statistical significance at 10%, 5% and 1%, respectively.
56

Democracy and Stock Return

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Democracy and Stock Return

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Democracy and Stock Market Returns

Tomasz Piotr Wisniewski

Electronic copy available at: https://ssrn.com/abstract=3198561

Keywords: Stock Returns, Political Regimes, Democracy, Autocracy, Investor

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investors with a range of attractive diversification opportunities.

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based on the democracy index alone.

observed between democratic and autocratic regimes.

of legal protection that is typically encountered in mature democracies. By evidencing this, we

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considerations, or by the strength of investor protection. A battery of robustness checks is

recommendations for investors.

II. Theorizing on Democracy, Economy and Stock Markets

regular competitive elections. Dahl (1982) believes that democracy is a representative

and can be effectively represented in political decision-making. Democracy, as understood by

as transparency, openness, and democratic participation. Contemporary definitions of

democracy invariably incorporate elements of universal suffrage, guaranteed political rights

supervision. It is important to note that underpinning political systems, be they autocratic or

and informal rules and the implementation characteristics of these rules.

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significant relationship between democracy and economic growth.

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plagued by conflicting results. In a study of U.S. manufacturing investment inflows, Rodrik

whether the country is an exporter of oil and minerals.

stronger degree of statistical significance. In addition, we analyze whether the return

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them in the context of democratization.

to expropriate investors. Engagement in outright expropriation of firm assets, over-regulation,

misappropriated, or stolen by corporate insiders become inaccessible to the grabbing hands of

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the presence of predatory state and managerial diversion of profits.

outside investors are diminished.

capitalization weighted country-level Morgan Stanley Capital International (MSCI) indexes,

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of countries and their classification is presented in Appendix A. Collectively, our sample

executive. Similarly, an autocracy variable, measured on eleven-point scale is constructed by

focusing on competitiveness and regulation of political participation, procedures for executive

regressions that follow, the resultant variable is labelled DEMOCRACY.

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called LACK_OF_POLITICAL_RIGHTS. Predictably, this variable is strongly and negatively

correlated with DEMOCRACY ( = -0.7248, p-value = 0.0000).

macroeconomic indicator included is labeled GDP_GROWTH and measures the annual

3 For more details, please refer to http://web.pdx.edu/~ito/Chinn-Ito_website.htm.

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recording whether an executive election took place in a particular country-year is included

(ELECTION_EXE). Similarly, the ELECTION_LEG indicator takes a value of unity whenever

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[Insert Table I about here]

of these averages. Such an approach allows a decrease in the dominance of developed

DEMOCRACY and LACK_OF_POLITICAL_RIGHTS reveals that the political systems in most

[Insert Table II about here]

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0.0666, p-value = 0.0058) and negatively with LACK_OF_POLITICAL_RIGHTS ( = -0.0650,

[Insert Table III about here]

IV. Empirical analysis

4.1 Modelling Stock Returns

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model are correlated with the regressors.

dimension, their joint inclusion inevitably leads to a problem of perfect multicollinearity. To

in an alternative way. A further complication arises, however, as the panel cross-section

homoskedastic. This could be a direct consequence of variation in investment risk profiles or