Asian Review of Financial Research Vol.28 No.1 pp.71-108
Stock Market Liquidity as a Predictor of the Real Economy
Key Words : Stock Market Liquidity,Business Cycle,Macroeconomy,Predictability,Causality
The world economy has experienced several historical events in which liquidity dry-ups were accompanied by real economic recessions, including the Asian crisis in the late 1990s and the global financial crisis in the late 2000s. Since then, financial market liquidity has been extensively studied and several recent empirical studies have documented evidence of time variation in liquidity and its relation to the macroeconomy (Fujimoto, 2004; Lu and Glascock, 2010; Næs, Skjeltorp, and Ødegaard, 2011). While there is a consensus about the close link between financial market liquidity and the real economy, previous studies provide conflicting views on the lead-lag relation, or causality between them. In this study, we use Korean stock market data to provide new empirical evidence that financial market liquidity has leading information on the real economy. To this end, we examine the time-series relation between stock market liquidity and the real economy using the daily data of stocks listed on the Korean Stock Exchange and quarterly macroeconomic variables over the 1987 to 2013 period. Specifically, we construct two aggregate liquidity measures at a quarterly frequency following Amihud (2002, Illiquidity and stock returns: cross-section and time-series effects, Journal of Financial Markets 5, 31-56) and Pastor and Stambaugh (2003, Liquidity risk and expected stock returns, Journal of Political Economy 111, 642-685), and we also use real GDP, real consumption, real investment and unemployment rate as proxies for the state of the real economy. Our empirical findings are as follows. First, we find that stock market liquidity varies before a change in real economy, and that liquidity has significantforecasting power for future real economic growth. The estimation results of our predictive models indicate that improved stock market liquidity predicts real economic growth, whereas deteriorating stock market liquidity predicts a slowdown in the real economy. The predictability of stock market liquidity is highly significant even after controlling for various financial market variables known to be important predictors of the real economy, such as monetary liquidity, interest rate, dividend yield, market excess returns and market volatility. This implies that stock market liquidity contains leading information not contained in other asset price predictors for future economic conditions. Second, from Granger causality tests, we find evidence that stock market liquidity causes changes in the real economy, whereas the real economic variables do not have significant forecasting power for future stock market liquidity. This result provides new evidence for conflicting views about the lead-lag relation between liquidity and the macroeconomy in the literature, and further highlights the critical role of stock market liquidity as a predictor of the real economy. Third, we analyze the effects of firm characteristics on the predictability of liquidity, and find that the liquidity of stocks with low market capitalization and low payout ratio contains more significant information about future economic conditions than that of large and high-payout-ratio firms. Given that small and low -payout-ratio stocks are more likely to be affected by a recessionary shock in the real economy than large and high-payout ratio stocks, investors may trade those stocks according to the prediction of future economic conditions, resulting in the market liquidity of those stocks being highly informative. The result implies that the predictability of stock market liquidity comes from investors' trading activities based on rational expectations of future economic states. Finally, our results are robust for choice of liquidity measures and real economic indicators, and the out- of-sample predictability is also statistically significant. We also document that stock market liquidity can significantly forecast up to two-year-ahead economic conditions. Moreover, the predictability of liquidity is not much affected when the specific periods of the Asian crisis and the global financial crisis are excluded from the sample. Overall, our findings are consistent with flight-to-quality, the phenomenon wherein investors suddenly shift their portfolios from risky assets to safe ones during economic downturns, creating a negative shock in the liquidity of risky assets. This implies that stock market liquidity contains valuable information about future economic states not contained in other asset price variables, and highlights the role of liquidity in financial markets as a predictor of the real economy. Our study contributes to the literature on the time variation of liquidity in emerging markets by taking a closer look at the Korean economy. Although numerous studies have examined the effects of financial market liquidity on asset pricing and the macroeconomy, most of them have focused on major developed markets, including the U.S. stock market. Given that several emerging economies including Korea have suffered from a lack of liquidity during financial crises, they are suitable for investigating the relation between liquidity and economic states. In particular, empirical research on liquidity in the Korean stock market has been mainly confined to market microstructure issues. Our findings provide a new direction for future research on financial market liquidity in Korea.