Does Policy Instability Matter for International Equity Markets?

• Published date: 01 March 2020
• Date: 01 March 2020
• DOI: http://doi.org/10.1111/irfi.12222
• Author: Huiping Zhang,Swee‐Sum Lam,Weina Zhang

Does Policy Instability Matter for

International Equity Markets?

SWEE-SUM LAM

†

,HUIPING ZHANG

‡

AND WEINA ZHANG

†

†

NUS Business School, Department of Finance, National University of Singapore,

Singapore and

‡

Division of Business & IT, James Cook University Singapore, Singapore

ABSTRACT

We test whether policy risk is systematically priced in equity returns across

49 countries from 1995 to 2013. We construct two global policy risk factors

based on the ratings from international country risk guide. They capture the

policy risk from government instability (GOVLMH) and the quality of bureau-

cracy (BURLMH). Both factors are significantly and positively related to equity

returns and the BURLMH factor carries a monthly risk premium of 65 basis

points. A countrywith weaker economic and institutional conditions has more

risk exposure to the BURLMH factor whereas a country with high democracy

has more risk exposure to the GOVLMH factor. Overall, our study reveals the

importanceand complexity of policy risk in international equitymarkets.

JEL Codes: G15; G18

Accepted: 27 June 2018

I. INTRODUCTION

Policy instability refers to a nonzero probability that existing policies may be

changed. Since policies set the rules of the game for economic agents such as

firms and investors to make investment decisions, high policy instability can

delay decision-making and affect the economy adversely. For example, Ali

(2001) documents that the volatility of economic policies is negatively corre-

lated with gross domestic product (GDP) growth rate by using a sample of

119 countries from 1970 to 1995. In a similar spirit, Taylor (2010) and Hoshi

(2011) suggest that high policy uncertainty in relation to the resolution of large

bankrupt financial institutions has worsened or prolonged the recent financial

crisis. In this study, we validate the empirical link between policy instability

and financial assets such as equities in an international setting.

On the theoretical front, Pástor and Veronesi (2013) are among the first to

show that the change of government policy commands an equity risk premium

in theory. This prediction implies that across different policy regimes, equity

investors demand compensation as the change of existing policy can affect

firm’s profitability. However, their theoretical prediction is not immediately

applicable to the international financial environment because investors can

© 2018 International Review of Finance Ltd. 2018

International Review of Finance, 20:1, 2020: pp. 155–196

DOI: 10.1111/irfi.12222

nowadays invest outside their own countries easily. As a result, they can reduce

the exposure to one country’s policy instability by investing in other countries

with less policy instability. It is an empirical question whether investors can

diversify away the policy instability across different countries. Our study pro-

vides a direct answer to this question.

We propose two new factors of global policy risk in an international setting

and find their explanatory power for equity returns. Specifically, we select two

country ratings from International Country Risk Guide (ICRG) that are related to

policy instability. The first rating is the “government stability”rating which mea-

sures a government’s ability to stay in office and its ability to carry out its

declared program.

1

If the government were unstable, policies would likely be

unstable too.

2

A low rating represents high policy instability and a high rating

represents low instability. The second rating is the “bureaucracy quality”rating

that captures the institutional strength and expertise of the bureaucracy to

maintain the consistency and stability in policies.

3

Countries without strong

bureaucracy can be chaotic in managing policy changes. Hence, the two ratings

reflect the stability of the existing policies in a country evaluated by ICRG.

After sorting all countries according to the scale of the two ratings on a

monthly basis, we construct two low-minus-high (LMH) zero-investment

country-level portfolios to form two policy risk factors arising from government

stability and bureaucratic quality, respectively, for our entire sample of 49 coun-

tries. The two portfolios are rebalanced every month based on the changing

monthly ratings. We name them GOVLMH and BURLMH factors hereafter. The

return difference between the countries with low ratings (LOW) and high rat-

ings (HIGH) represents two types of equity returns compensating for the two

sources of aggregate policy risk in the world—government changes and incom-

petent bureaucracy, respectively. Moreover, these measures also allow for time-

varying return compensation for policy risk as suggested by Pástor and Veronesi

(2013). Here, we extend their theory to international markets.

Our first result shows that our newly proposed policy risk factors are signifi-

cantly and positively related to the equity returns of 49 countries at the 1% level.

Given that the average monthly return of BURLMH is 0.4% per month and the

average beta loading on BURLMH is 0.34, the return reward for the BURLMH risk

factor is about 0.14% per month, which is about one-third of that for the market

risk factor. The return reward for the GOVLMH is smaller at 0.04% per month

given that the risk premium is 0.4% and the beta loading on GOVLMH is 0.087.

1 The definition is taken from the office link of ICRG at www.prsgroup.com/ICRG_

Methodology.aspx.

2 For example, Julio and Yook (2016) use the timing of national elections to proxy for policy

uncertainty in an international setting and document that foreign direct investment flows

are dampened by the instability.

3 The original definition is being modified from the source at www.prsgroup.com/ICRG_

Methodology.aspx. We remove the condition “when government changes.”We think that

this condition is not applicable to all countries in our sample as some countries have never

experienced a change of ruling party for many decades, such as China and Singapore.

© 2018 International Review of Finance Ltd. 2018156

International Review of Finance

We also find that significant variation exists in the return exposures to the

two factors across countries. In a politically stable country such as China (with

negative exposure to the GOVLMH factor), the exposure to the BURLMH factor

is significantly positive. When a country has high bureaucratic quality such as

France, Italy, Portugal, Spain, and Sweden (with negative exposure to the

BURLMH factor), its exposure to the GOVLMH factor is significantly positive.

While some countries have significantly positive exposures to both factors

(e.g., Argentina, Chile, Hungary, Korea, Pakistan, and Sri Lanka), none of the

49 countries in our sample has significant negative exposures to both factors.

The latter result implies that there exists no good hedging country for interna-

tional investors to reduce their exposure to multidimensional policy risk in the

global context. These results also suggest that it is necessary and important to

consider different sources of policy risk.

To validate the significance of cross-country variations in the return expo-

sures to policy risk, we divide 49 countries into different subgroups based on

their economic and institutional conditions. We find that in developed coun-

tries, the equity returns are more affected by the GOVLMH factor rather than

the BURLMH factor. In developing countries, however, the results are the oppo-

site. Similar contrasting results are also found in highly democratically account-

able countries in contrast to those low ones. High democratic accountability

signifies a political system in which the government is highly accountable to

the public and vice versa. These results suggest that in a developed or a highly

democratically accountable country, the investors perceive the major source of

policy instability to accrue from government instability (GOVLMH) since the

bureaucracy would have matured with sophistication and quality. On the other

hand, in a developing country or a low democratically accountable country,

apart from a government that is expected to be unstable, investors demand

additional compensation if the bureaucracy were also incompetent in reducing

policy shocks.

Moreover, we find that global policy risk has become an important missing

systematic risk factor. We conduct Fama–Macbeth regressions and find that the

BURLMH factor carries a significant risk premium of 65 basis points (bps) per

month. Subsample analysis also shows that the BURLMH factor carries a

monthly risk premium of 58 bps in countries with low democratic accountabil-

ity but not in highly democratically accountable countries. There is also evi-

dence that suggests the BURLMH factor has not yet been efficiently priced by

the global equity markets.

In the first robustness test, we confirm that our two global policy risk factors

are better measures than several existing policy or political risk measures from

Baker et al. (2016) and Berkman et al. (2011).

In the second robustness test, we compute correlation coefficients between

the “bureaucracy quality”rating, “government stability”rating as well as other

22 country variables that represent the economic and institutional rationale.

We find both ratings are not highly correlated with any of the economic, social,

or financial factors with correlation coefficients below 0.5. We also constructed

© 2018 International Review of Finance Ltd. 2018 157

Does Policy Instability Matter?