Investor Protections and Economic Growth

A close look at equity prices around the world reveals how much they have been affected by the current financial crunch as well as by credit and market risks. Fluctuations in growth and exchange rate expectations have only enhanced their influence. Financial integration has scaled up the correlation between advanced, emerging, and (to a measurable extent) developing economies’ equity markets over the last dozen weeks, so that equity prices have been moving more closely together. However, financial integration has not been accompanied by a harmonization of investor protections and corporate governance principles.

As the policy response to the economic crisis moves from short-term solutions – corporate bailouts and economic stimulus – to longer-terms fixes like financial market regulatory reform, it becomes increasingly important that policy-makers move beyond finger-pointing. Countries with stronger investor protections tend to grow faster than those with poor protections. A recent paper, using objective measures of investor protections in 170 countries, establishes that the level of investor protection matters for cross-country differences in GDP growth. An improvement in investor protection leads to better risk sharing, which implies a larger demand for capital. This “demand” effect indicates a positive association between investor protection and growth.

Furthermore, the level of investor protection matters more for poor countries than it does for rich countries in terms of promoting growth. This finding is quite plausible given that poorer countries are more in need of external finance to stimulate growth, and one of the prerequisites for drawing on external finance is to make both local and foreign investors confident that their invested capital is sufficiently protected. As a result, all else being equal, poor countries that have established stronger protection of investors are likely to be more prosperous as international capital markets revive.