Financial literacy as a determinant of market participation: New evidence from China using IV-GMM

Abstract

We analyze the relationship between financial literacy (FL) and market participation among Chinese households. Our ordinary least square (OLS) regression results show that advanced FL is statistically positively related to market participation. Because of endogeneity concerns between FL and market participation, researchers have challenged OLS results for their bias and inconsistency. We consider the instrumental variable estimator using the generalized method of moments (IV-GMM) that aims to remedy endogeneity issue. We perform the Hansen J test of over-identification restrictions to ensure that the excluded instruments are appropriately independent of the error process. The IV-GMM estimates show that individuals with a higher advanced FL score are more likely to invest in stock markets. Specifically, with an additional one point of the advanced FL score, the probability of market participation will increase by about 12% points. We also perform robustness tests using different model specifications and different FL measures. Results are consistent with the main finding that advanced FL is positively related to market participation. Based on the results of the IV-GMM, we conclude that individuals with a higher level of advanced FL are more likely to participate in stock markets.