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RESEARCH PRODUCT

Democracy, political risks and stock market performance

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We study whether the emerging stock markets’ performance is affected by direct and indirect effects of democracy level and political risk. We argue that the relationship between democracy level and the political risk is parabolic instead of a simple linear relation i.e. there exists a limit in democracy after which the political risk begins to decline and this is reflected in stock prices. Using panel data for 38 emerging markets at yearly frequency and controlling for several domestic and international factors, we find a fairly robust evidence that during the period 2000-2010, this relationship is true and after some threshold, the more democratic countries produce higher returns. Similar relation is also found for several political risk components, namely: conflicts and tensions; military in politics, religious tensions and internal conflicts. No consistent evidence of the direct effects of democracy, political risk or its subcomponents on share prices is found. We also test whether the polynomial relationship between democracy and political risk can help to explain stock market crisis, but find no significant results.