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The Impact of Creditor Protection on Stock Prices in the Presence of Credit Crunches

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  • Galina Hale
  • Assaf Razin
  • Hui Tong

Abstract

Data show that better creditor protection is correlated across countries with lower average stock market volatility. Moreover, countries with better creditor protection seem to have suffered lower decline in their stock market indexes during the current financial crisis. To explain this regularity, we use a Tobin q model of investment and show that stronger creditor protection increases the expected level and lowers the variance of stock prices in the presence of credit crunches. There are two main channels through which creditor protection enhances the performance of the stock market: (1) The credit-constrained stock price increases with better protection of creditors; (2) The probability of a credit crunch leading to a binding credit constraint falls with strong protection of creditors. We find strong empirical support for both predictions using data on stock market performance, amount and cost of credit, and creditor rights protection for 52 countries over the period 1980-2007. In particular, we find that crises are more frequent in countries with poor creditor protection. Using propensity score matching we also show that during crises stock market returns fall by more in countries with poor creditor protection.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 3440.

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Date of creation: 2011
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Handle: RePEc:ces:ceswps:_3440

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Keywords: liquidity crisis; creditor protection; stock volatility; credit crunch;

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References

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  1. Galina Hale & Assaf Razin & Hui Tong, 2006. "Institutional Weakness and Stock Price Volatility," NBER Working Papers 12127, National Bureau of Economic Research, Inc.
  2. Guillermo A. Calvo & Alejandro Izquierdo & Ernesto Talvi, 2006. "Phoenix Miracles in Emerging Markets: Recovering without Credit from Systemic Financial Crises," NBER Working Papers 12101, National Bureau of Economic Research, Inc.
  3. Dmitry Livdan & Horacio Sapriza & Lu Zhang, 2009. "Financially Constrained Stock Returns," Journal of Finance, American Finance Association, American Finance Association, vol. 64(4), pages 1827-1862, 08.
  4. Heckman, James J, 1978. "Dummy Endogenous Variables in a Simultaneous Equation System," Econometrica, Econometric Society, Econometric Society, vol. 46(4), pages 931-59, July.
  5. John D. Burger & Francis E. Warnock, 2006. "Local Currency Bond Markets," NBER Working Papers 12552, National Bureau of Economic Research, Inc.
  6. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 91(3), pages 401-19, June.
  7. Burger, John D. & Warnock, Francis E., 2007. "Foreign participation in local currency bond markets," Review of Financial Economics, Elsevier, Elsevier, vol. 16(3), pages 291-304.
  8. Sassan Alizadeh & Michael W. Brandt & Francis X. Diebold, 2001. "High- and Low-Frequency Exchange Rate Volatility Dynamics: Range-Based Estimation of Stochastic Volatility Models," NBER Working Papers 8162, National Bureau of Economic Research, Inc.
  9. Oliver Hart & John Moore, 1991. "A Theory of Debt Based on the Inalienability of Human Capital," STICERD - Theoretical Economics Paper Series, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE /1991/233, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  10. Arturo Galindo & Alejandro Micco, 2005. "Creditor Protection and Credit Volatility," Research Department Publications, Inter-American Development Bank, Research Department 4401, Inter-American Development Bank, Research Department.
  11. Reuven Glick & Ramon Moreno & Mark Spiegel, 2001. "Financial crises in emerging markets," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue mar.23.
  12. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, American Economic Association, vol. 79(1), pages 14-31, March.
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Cited by:
  1. World Bank, 2012. "Resilience, Equity, and Opportunity," World Bank Other Operational Studies 12648, The World Bank.

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