Oct. 20, 2011
UI study shows elections increase market, economic volatility
Elections are great for democracies, but a new study by a University of Iowa researcher finds they may not be so good for business.
A new study co-authored by Artem Durnev, assistant professor of finance in the Tippie College of Business, finds that countries with national elections have more volatile economies because businesses don't like political uncertainty. The study also found economic volatility increases during political campaigns.
Autocracies, however, demonstrate no such volatility, as they have less political risk and so investors are more easily able to make business decisions in those countries.
The study measured volatility as the returns on stocks for companies based in each country, or companies based elsewhere that do significant business in a country. Durnev and his co-researchers looked at 50 countries, both developed and developing, and observed stock market volatility during the six months leading up to an election and for the year after the election.
The study found that in general, more mature democracies saw increased market volatility in the six months prior to an election. The markets in autocracies did not exhibit that volatility.
This doesn't mean that autocracies face no market uncertainty, he says. People in dictatorships often have a habit of mounting revolutions, destabilizing the economy by throwing out the dictator, and increasing market volatility. The death of a dictator while still in office also causes increased market volatility because investors are unsure how the country's citizens will react and new leadership will govern.
But the volatility in democracies was more frequent and clearly tied to the election, he says. The study did not quantify each country's market volatility because that level depended on factors unique to each country and each election. For instance, Durnev expects Russian markets to experience little volatility in the run-up to next year's presidential elections there because it's all but a foregone conclusion that Vladimir Putin will win re-election to a second tenure in office.
"It won't be a surprise if he receives 75 percent of the vote, so businesses already know what to expect in the Russian economy in the coming years and can plan for it," he says.
However, Egypt's already destabilized economy will likely become even more so because nobody knows who will win the coming elections. It could be a moderate party friendly to business and the West, he says, or it could be a party that will try to create an Islamic theocracy. The country's military rulers may also renege on their promise to hold elections and keep power themselves.
"This is a risky time to be making business deals in Egypt," he says.
But the study found that markets don't necessarily settle down in the year after an election. Sometimes, Durnev says the election brings political stability that leads to economic stability. But sometimes, the election only creates more instability, increasing political risk and doing nothing to smooth a country's economy.
The study found that export-oriented industries, industries dependent on contract enforcement, and labor-intensive industries exhibit higher volatility when political risks are higher. Labor-intensive industries also display higher volatility when governments from the political left lead a country or when labor laws are stricter.
Autocratic regimes, on the other hand, reduce volatility, especially in industries that are more dependent on trade or contract enforcement.
Durnev says the study sheds light on what's happening in the U.S. economy right now. Political uncertainty is high and so businesses respond by putting off expansions, investments, and new hires, slowing the economic recovery. He expects businesses to continue sitting on their cash until after the next election, when they have a clearer idea of who our new leaders will be. But even then, he says they may hold back because the polarized nature of American politics will create an ongoing uncertainty no matter who wins.
He says a companion study he is working on confirms that businesses hold back on financial investment in a country when political risk is high.
Durnev's study, "Precarious Politics and Return Volatility," was co-authored by Maria Boutchkova of the University of Leicester, Hitesh Doshi of the University of Houston, and Alexander Molchanov of Massey University. It was published in the current issue of the Review of Financial Studies.
STORY SOURCE: University of Iowa News Service, 300 Plaza Centre One, Iowa City, Iowa 52242-2500