The impact of central bank independence on the cost of capital: a cross-country analysis

The theory of central bank independence is clear, but there is limited evidence to support the benefits. In this study, we investigate whether central bank independence impacts the cost of capital. We perform a cross-country panel data analysis of 23 developed and 17 emerging countries in this study and find international variations in the cost of capital associated with varying degrees of central bank independence. Specifically, we find that central bank independence reduces the country’s equity risk premium. Further analysis shows that central bank independence has pronounced effects in reducing the cost of capital in emerging countries. Our study suggests that greater central bank independence results in lower levels of cost of capital. This study findings are consistent with alternative cost of capital measures, and also robust to a quasi-natural experiment using a difference-in- -differences, placebo test, hierarchical cluster, and the Newey-West standard error. Overall, the results of this study suggest that a country’s government attracts foreign investors by strengthening central bank independence.