Political Risk, Financial Crisis, and Market Volatility

Abstract

This paper examines the impact of political uncertainty on the recent financial crises in emerging markets. By examining political election cycles, we find that eight out of nine of the recent financial crises happened during periods of political election and transition. Using a combination of probit and switching regression analysis, we find that there is a significant relationship between political election and financial crisis after controlling for differences in economic and financial conditions. We observe increased market volatility during political election and transition periods. Moreover, we have some evidence that political risk is more important in explaining financial crisis than market contagion. Our results suggest that political uncertainty could be a major contributing factor to financial crisis. Thus, politics does matter in emerging markets. Since the odds of financial crisis tend to be much larger during the political election periods, institutional investors should take that into account when making emerging market investment during those time periods.