Economic policy uncertainty and stock market liquidity: Evidence from G7 countries

• Published date: 01 June 2021
• Author: Saumya Ranjan Dash,Debasish Maitra,Byomakesh Debata,Jitendra Mahakud
• Date: 01 June 2021
• DOI: http://doi.org/10.1111/irfi.12277

LETTERS SECTION

Economic policy uncertainty and stock market

liquidity: Evidence from G7 countries

Saumya Ranjan Dash

1

| Debasish Maitra

2

| Byomakesh Debata

3

|

Jitendra Mahakud

3

1

Department of Accounting and Finance,

Indian Institute of Management Indore (IIM

Indore), Indore, Madhya Pradesh, India

2

Finance and Accounting Area, Indian

Institute of Management Indore (IIM Indore),

Indore, Madhya Pradesh, India

3

Department of Humanities and Social

Sciences, Indian Institute of Technology

Kharagpur (IIT Kharagpur), Kharagpur, West

Bengal, India

Correspondence

Debasish Maitra, Finance and Accounting

Area, Indian Institute of Management Indore

(IIM Indore), Indore, Madhya Pradesh 453556,

India.

Email: debasishm@iimidr.ac.in

Abstract

In the aftermath of the 2007–2008 global financial crisis,

there were heightened concerns among the market partici-

pants and policymakers on the potential adverse effects of

economic policies on stock marketliquidity. This paper exam-

ines the causality and co-movement between economic pol-

icy uncertainties and stock market liquidity using monthly

data from G7 countries. Our empirical analysis considers

wavelet coherence and wavelet phase angle tests. Linear and

nonlinear causality test results suggest that a causal relation-

ship exists between economic policy uncertainty and stock

market liquidity. Moreover, stock market illiquidity varies

with the uncertainty but in the same direction while liquidity

co-moves in the opposite direction. In times of economic tur-

moil or crises, the relationship between policy uncertainty

and illiquidity becomes stronger, and illiquidity leads eco-

nomic policy uncertainty. Overall, our findings indicate that

the leading indicator property of (il)liquidity is useful for pro-

viding economic information and thereby to manage market

conditions and investor expectations.

KEYWORDS

economic policy uncertainty, liquidity, stock market, time-

frequency

JEL CLASSIFICATION

C32; C51; E44; E60; Q43; Q48

Received: 10 September 2018 Revised: 7 March 2019 Accepted: 17 June 2019

DOI: 10.1111/irfi.12277

© 2019 International Review of Finance Ltd. 2019

International Review of Finance. 2021;21:611–626. wileyonlinelibrary.com/journal/irfi 611

1|INTRODUCTION

Since economicpolicies set the rules of the game for economic agents such as firmsand investors to make investment

decisions, high policy instability or uncertainty can delay decision-making and affect the economy adversely (Bloom,

2009; Brogaard & Detzel, 2015; Lam, Zhang, & Zhang, 2017). Changes in government policy or government actions

that change the economic environment affect price reactions in financial markets (Pastor & Veronesi, 2012). In the

aftermath of the 2008–2009 global financial crisis (GFC), there were heightened concerns among the market partici-

pants and policymakers on the potential adverse effects of economic policies on stock market liquidity. In the recent

financial crisis,it was evident that the stock market liquidity drying up as a precursor to the crisis in the real economy

(Allen & Carletti,2010; Liang & Wei, 2012; Naes, Skjeltorp,& degaard, 2011). The fact that sudden dry-upof market

liquidity has important economic consequences (Chen, Chou, & Yen, 2016; Erdogan, Bennett & Ozyildirim 2014; Levine,

1991; Levine & Zervos, 1998) adding financial channels to macroeconomic modeling received increasing consideration in

recent years (Borio, 2014; Ellington, 2018; Rosengren, 2010; Switzer & Picard, 2016). However, the existing literature

that has analyzed the link between economic policy uncertainty (EPU hereafter) and aggregate stock market liquidity is

relatively scant. In this study, we examine the time series relationship between EPU index

1

(Baker et al., 2016) and aggre-

gate stock market liquidity of G7 countries. In particular, we ask: whether there are causality and co-movement between

EPU and aggregate stock market liquidity? If so, which of these two leads the other, and under what circumstances?

The rationale for examining the relationship between EPU and market liquidity is threefold. First, the macroeco-

nomic expectations hypothesis suggests that stock markets are forward-looking in nature and hence, liquidity mea-

sures should reveal the properties of economic information (Naes et al., 2011; Switzer & Picard, 2016). Uncertainty

about the future government policies has real implications for economic agents' trading behavior (Bernanke, 1983;

Bloom, 2009) due to its effect on funding constraint (Brunnermeier & Pedersen, 2009). During times of economic

weakness, economic policy regulations can affect funding liquidity and consequently, may exert a positive or nega-

tive effect on market liquidity. Therefore, market participant's trading behavior would be directly related to expecta-

tions about uncertainty about future economic policies. Given the forward-looking nature of stock market liquidity,

it is reasonable to argue that uncertainty about the future economic policies will have direct implications for the trad-

ing behavior of economic agents and hence, for stock market liquidity. EPU can also reduce corporate investments

by triggering precautionary delays due to investment irreversibility (Gulen and Ion, 2015). Second, the debates over

the implication of forward-looking nature of stock market liquidity for predicting economic growth are unsettled in

the related literature.

2

Naes et al. (2011) suggest that stock market liquidity contains useful information for estimat-

ing the current and future state of the economy. However, Switzer and Picard (2016) argue that whether stock mar-

ket aggregate liquidity can be exploited to predict the future state of the economy remains an open question. Third,

the liquidity shock hypothesis suggests that liquidity may influence the macroeconomic policy through the invest-

ment channel (Levine, 1991). An extant body of related literature suggests that liquid stock market enhances the

long-term productivity, and subsequently, economic growth by easing the external financing constraints, lowering

cost of capital, and returns on firm's investment (Acharya & Pedersen, 2005; Erdogan, Bennett & Ozyildirim 2012;

Levine & Zervos, 1998). On the other hand, stock market illiquidity both increases the probability of pushing the

economy into recession, and the economy remains in recession (Chen et al., 2016). Stock market illiquidity can exac-

erbate a financial crisis by intensifying the effect of flight-to-safety (shift of capital from riskier investments to safer

ones) and flights-to-quality (the decrease in the relative demand for risky assets) (Longstaff, 2004; Ellington, 2018).

In an economic environment where investors seek to shift their portfolios from high- to low-risk assets can widen

the risk premia, and create severe disruptions in credit and funding liquidity. Therefore, sudden illiquidity shock can

be an essential cause for the economic policy-related uncertainty instead of a mere response to it.

Our empirical approach allows us to test the linear and nonlinear causal relationship between EPU, and stock

market illiquidity and liquidity [(il)liquidity, hereafter]. Motivated by the pioneering work of Ramsey (1999, 2002),

Gencay, Selcuk, and Withcher (2001a), Gencay, Selcuk, & Withcher, 2001b, Gencay, Selcuk, & Whitcher, 2002, Gen-

cay, Selcuk, & Withcher, 2005), and Aguiar-Conraria and Soares (2011a, 2011b), we examine the co-movement

612 DASH ET AL.