The Relation between Investor Protection and Equity Markets Development in Emerging Economies: A Study of the Bullish Period between 2003 and 2007

Abstract

Financial intermediation plays a key role in the economic organization of nations as financial agents are capable of relaxing the underlying market imperfections and frictions that make exchanges extremely costly to a level that they would simply not be performed in their absence. A long lasting debate in the literature has opposed the advocates of bank-centred systems to the advocates of market-centred systems. In the late 1990s, a series of papers by La Porta. Lopez-de-Silanes, Shleifer Vishny (henceforth LLSV), accompanied by studies from Levine (1997, 1999b), Barth, Caprio and Levine (2000) and others, have suggested and demonstrated with empirical evidence that establishing a legal environment that credibly protects the rights of investors is much more important than considerations regarding bank-based or market-based systems. LLSV (1997, 2008) have also demonstrated that the origins of the legal system influence investor protection and the development of stock markets, showing that English origin countries are the most financially developed and French Origin countries are the worst. Djankov et al. (2008) has developed an anti-self-dealing index for 72 countries to classify them according to their level of investor protection. These series of papers by various authors have changed the focus of the debate, redirecting it to the relation between corporate governance, investor protection and the development of financial markets. To understand how investor protection influences financial development is quite important given that this is the most obvious potential channel of influence of investor protection on growth. The present work intends to analyze how different levels of investor protection measured by the anti-self-dealing index (Djankov et al.) and also how legal origins have affected the stock market development in emerging and developed economies in the period between 2003 and 2007. Given their institutional framework (generally weaker than developed economies) and the fact that they compose a more diversified range of countries with various levels of development, emerging markets constitute an interesting group to study the impact of different levels of investor protection as this element can be the cause of particularly relevant discrepancies. Results confirm that investors protection have an effect on the depth of financial markets and show that the relation has worked differently in emerging economies in comparison to developed countries in the period studied. There is indication that the level of investor protection is even more important in emerging markets, although significant differences are only felt between very high and very low protection economies, whereas in developed markets higher protection stock markets have performed worse in the period. In terms of legal origin, a surprising finding was that in the period between 2003 and 2007 ‘French origin’ economies have performed better than ‘English origin’, although the indicators of financial depth still show that ‘English origin’ countries have more developed stock markets.