Country Governance and International Equity Returns

Ben R. Marshall

Massey University – School of Economics and Finance

Nhut H. Nguyen

Massey University

The Hung Nguyen

Monash University

Nuttawat Visaltanachoti

Massey University – Department of Economics and Finance

December 9, 2015


Monthly equity returns in countries with strong governance lead monthly equity returns in countries with weak governance. This predictability is robust to alternative ways of measuring country governance, and holds in and out of sample at both the individual country and group level. It is not driven by country size, liquidity, stock market development, short selling constraints, or microstructure biases. Rather, information is reflected in weak governance country equity returns with a delay due to gradual information diffusion, which predominately occurs through the cash-flow channel.

Country Governance And International Equity Returns – Introduction

Prices are more informative about future earnings in countries with stronger governance (e.g. Haw, Hu, Lee, and Wu, 2012) as investors are better placed to engage in arbitrage (e.g., Morck, Yeung, and Yu, 2000). We therefore investigate the hitherto unanswered question “do strong governance (“STRONG_GOV”) country equity returns lead weak governance (“WEAK_GOV”) country equity returns?” The evidence we present suggests the answer is a clear “yes.”

Our tests are based on the World Bank Worldwide Governance Indicators (WGI).1 As Kaufmann, Kraay, and Mastruzzi (2010) note, the WGI consist of six composite indicators of governance including Voice and Accountability, Political Stability and Absence of Violence/Terrorism, Government Effectiveness, Regulatory Quality, Rule of Law, and Control of Corruption. These data cover a broad spectrum of country governance indicators which have been shown to impact equity prices in the literature, such as minority shareholder rights, creditor rights, and judicial efficiency (e.g. Johnson, Boone, Breach, and Friedman, 2000), political instability (e.g. Berkman, Jacobsen, and Lee, 2011), corruption (e.g. Lee and Ng, 2006), media freedom (e.g. Pantzalis, Stangeland, and Turtle, 2000), and terrorism (e.g. Karolyi and Martell, 2010). We obtain WGI data for the 61 countries that are in either the Griffin, Kelly, and Nardari (2010) or Griffin, Hirschey, and Kelly (2011) samples. Each year we then assign a country to “STRONG_GOV”, “MEDIUM_GOV”, or “WEAK_GOV” based on its average ranking across the six WGI categories.2

We also conduct numerous robustness checks around the governance variables. The six individual WGI composite indicators are highly correlated with the average WGI measure, so our core results are unchanged if we use one aspect of governance. Our results also hold when we use an average governance measure derived from La Porta, Lopez-de-Silanes, Shleifer (2006) (hereafter LLS) variables, or when we substitute the LLS anti-directors right index with that from Djankov, La Porta, Lopez-de-Silanes, and Shleifer (2008), or Spamann (2010). Moreover, the results are robust to the use of “Protecting Minority Investors” World Bank data.

We show STRONG_GOV country stock returns react more quickly than WEAK_GOV country stock returns to all new information. Moreover, we find the monthly returns in STRONG_GOV countries strongly predict monthly returns in WEAK_GOV countries. A one standard deviation increase in STRONG_GOV country returns leads to an 9.1% annualized increase in WEAK_GOV country returns, while the overall monthly out-of-sample R2 is 1.5%, which compares favorably to the best predictors documented in the literature.

Approximately 77% of information from STRONG_GOV countries returns is impounded in returns contemporaneously with the remainder being reflected with a lag.4 This result is consistent with the “speed of adjustment” hypothesis of Brennan, Jegadeesh, and Swaminathan (1993) and Chordia and Swaminathan (2000). These papers recognize some stocks within the same market adjust more quickly to economy-wide information than others, so it seems plausible to expect stocks within different international markets to adjust to global economic information at different speeds. There are a number of possible explanations for this gradual information diffusion. First, global macroeconomic news may be received by investors in WEAK_GOV countries with a delay based on the theory of Hong and Stein (1999) and Hong, Torous, and Valkanov (2007). Second, domestic investors in WEAK_GOV countries may be quickly aware of the news but slower to trade on it due to uncertainty around how the news will impact companies in their portfolio.5 Third, Duffie (2010) shows capital can be slow moving on account of institutional impediments.

The predictability primarily flows through the cash-flow channel, consistent with Haw, Hu, Lee, and Wu, (2012), with the discount rate channel playing a more minor role. The predictability is not caused by different market closing times, country size, liquidity, stock market development or risk. Moreover, neither microstructure frictions nor short selling constraints explain the result. Finally, the predictability is not driven solely by U.S. returns and it persists in both good and bad times.

Equity Returns

Equity Returns

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