Understanding Crime, Political Uncertainty and Stock ...

Understanding Crime, Political Uncertainty and Stock Market Returns

Understanding Crime, Political Uncertainty and Stock Market Returns A case study of the Colombian stock market Juan Carlos Franco Laverde, Maria Estela Varua and Arlene Garces-Ozanne

Introduction By the end of the twentieth century, the world had unfortunately seen a global proliferation of crime, terrorism and corruption, and studies on the relationship between this ‘unholy trinity’ and the economic performance of countries have become regular topics in the economic literature. Kutan and Perez (2002), for example, investigate the effects of organised crime on the two former local stock markets in Colombia: Medellin and Bogotá. They find that political risk, kidnapping and election uncertainty are important determinants of returns and volatility on the two Colombian stock markets. Likewise, Suarez and Pshisva (2006) present evidence suggesting that firm-related kidnappings reduce investment because managers operate under the duress of fear. Managers are not only intimidated by the probability of expropriation, but also by threats to their personal safety. Their research finds that firms tend to invest less when kidnappings directly target the firm, but that other forms of crime, such as homicides, guerrilla attacks and general kidnappings, have no significant effect on a firm’s investment. Juan Carlos Franco Laverde is a PhD student at the University of Western Sydney. Maria Estela Varua is a Lecturer in Economics and Finance at the University of Western Sydney. Arlene Garces-Ozanne is a Lecturer in Economics at the Department of Economics, University of Otago.

WORLD ECONOMICS • Vol. 10 • No. 2 • April–June 2009

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J.C.F. Laverde, M.E. Varua and A. Garces-Ozanne

Terrorism is another field that has been studied in relation to economic activity. Becker and Murphy (2001) argue that economic performance should not be much affected, because terrorist attacks typically destroy only a small fraction of the overall stock of capital in a country. By contrast, Abadie and Gardeazabal (2005) show how terrorism, which represents a small fraction of the overall economic risk in a country, may actually have substantial impacts on the allocation of productive capital, specifically foreign investment, across countries. They find that the higher the level of terrorist risks, the lower the levels of net foreign direct investment (FDI) will be. Specifically, one standard deviation change in terrorist risk on the net FDI position induces a fall in the net FDI position of about 5% of gross domestic product. Specific studies on terrorism and its influence on stock prices are more limited. Most of the studies focus only on a single or few events, such as the 11 September 2001 attacks, as considered by Hon et al. (2004). Similarly, Chen and Siems (2004) study the impact of six major events (e.g. 1941 Pearl Harbor attack, 1990 Iraqi attack on Kuwait) on national market index returns, while Berrebi and Klor (2005) focus only on attacks on Israeli companies during the period 1998 to 2000. In Abadie and Gardeazabal (2005), 75 attacks between the years 1995 and 2002 on publicly traded firms are documented in the course of analysing the impact of terrorism on the performance of the firm. They find, using cross-sectional data on 98 to 110 countries, that the impact of terrorist attacks differs according to the country in which the incident occurred. They argue, for instance, that attacks occurring in countries that are democratic and affluent result in larger negative share price adjustments. Interestingly, they find that human capital losses, such as kidnappings of company executives, are associated with larger negative stock price reactions than physical losses, such as bombings of facilities or buildings. This paper contributes to the existing literature on crime and economic performance by examining whether organised crime activities and political uncertainty affect stock market returns and volatility in Colombia, a country whose recorded murder and kidnapping rates ranked among the highest in the world in 1998–2000 (Becker 2007). One standard deviation change in terrorist risk is approximately equal to the difference in terrorist risk between Italy (less risky) and the United States (more risky), based on the Global Terrorism Index (Abadie & Gardeazabal 2005).

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The rest of the paper is organised as follows. The next section presents a brief overview of recent sociopolitical events in Colombia. The section after that explains the data set, provides an overview of the methods used, and presents and explains our empirical results. The paper finishes with some conclusions, and suggests some policy implications from the findings.

The Colombian setting Colombia, officially known as the Republic of Colombia since 1883, has a very rich cultural heritage, inherited from the interaction of various people of different races and nationalities – Spanish colonists, African slaves, and immigrants from Europe and the Middle East – with the original indigenous people. It is the world’s second biggest exporter of coffee and cut flowers, and has produced many world-famous personalities, such as Gabriel Garcia Marquez (1982 Nobel Laureate in Literature), Fernando Botero (sculptor and painter), and even Juan Pablo Montoya (Formula One champion). However, for many, Colombia is more often associated with crime and violence, most of which is drug related: kidnappings, armed robberies, murders and assassinations. Despite serious efforts on the part of the government – including, for instance, the serious man-hunt that ended in the killing of the country’s most infamous and powerful drug trader, Pablo Escobar – to combat drug-trafficking, organised crime, violent guerrilla war and paramilitary activities, these criminal activities have not stopped and continue to add to the country’s political and economic uncertainty. In 2002, the people of Colombia elected Alvaro Uribe Velez as president, hoping that his government would challenge the organised crime groups, namely the main leftist guerrilla group, known as Fuerzas Armadas Revolucionarias de Colombia (FARC) or the Colombian Revolutionary Army, and the right-wing paramilitary group. The latter was formed as a reaction to guerrilla attacks and kidnapping. True to his campaign promises, President Uribe took a decidedly more aggressive stance against the country’s guerrilla groups and has imposed numerous taxes to help fund the country’s military. In 2006, Alvaro Uribe Velez was re-elected for another four years. The re-election of Uribe was a result of two major government programmes he had initiated in his first term of office. These two major


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programmes were those of national security and economic growth. The country continues to grow under Uribe’s leadership due to austere government budgets, focused efforts to reduce public debt levels, an exportorientated growth strategy, an improved security situation in the country and high commodity prices. However, ongoing economic tasks facing the president include the need to reform the pension system, reduce high unemployment and achieve congressional passage of a fiscal transfer reform. International and domestic financial analysts also note with concern the growing central government deficit, which hovers at 5% of GDP. Nonetheless, the government’s economic policy and democratic security strategy have created a growing sense of confidence in the economy, particularly within the business sector.

Data and modelling results Sources and definition of data Our quantitative analysis examines the degree to which the performance of the Colombian stock market is influenced by the performance of global stocks, political uncertainty, crime and day-of-the-week effects. The study uses five years of daily stock market returns data from July 2001, the date the current Colombian Securities Exchange was created, up to October 2006. It is important to note that, before July 2001, the Colombian stock market was composed of three exchanges, namely Bogotá, Medellin and Cali. The three markets were merged in order to boost low trading volumes, increase capital-market transparency as well as to facilitate integration with other exchanges around the world. Maya and Torres (2004) illustrate how the unification of the three stock markets led to a structural change from July 2001 onwards, which has resulted in an increase in the level of efficiency of the Colombian stock market. The study period also includes two presidential elections, one in 2002 and the other in 2006. IGBCRt represents the returns of the Colombian stock market whereas S&P500t–1 approximates the stock market returns in the United States, IGBC stands for Indice General de la Bolsa de Colombia (General Index of Colombian Stock). The S&P500 is one of the most common indices, owned and maintained by Standard & Poor’s, and is made up of stocks of 500 companies (mostly American) that are representative of various industries in the US.

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lagged one period, which is used as a proxy to capture the impact of global stock market development on the domestic market. Dummy variables are used to capture political uncertainty in the country during election periods and day-of-the-week effect. The dummy variable Poluncer takes the value of one, eight working days prior to the presidential election and eight working days after the election. The dummy variables Dummy-Tue and Dummy-Fri are used to capture the effects of days when stock market activity is low (Tuesdays) and when stock market activity is high (Fridays), respectively. Data for crime rate and extortion are taken from the Fondelibertad (the National Fund for the Defence of Individual Freedom). CRt–1 represents the crime rate in Colombia, calculated as the sum of daily registered general events plus daily registered extortion events. The difference between general events and extortion events is that extortion involves a ransom component, an example of which is kidnapping. Table 1 reports descriptive statistics for IGBCRt , S&P500t–1 and CRt–1. As can be seen from the table, the average return for IGBCR is relatively higher than that of S&P500 during the sample period. This could in part be explained by the fact that the IT downturn and the terrorist attacks on 11 September 2001, which undoubtedly negatively affected many industries in the US, occurred during the sample period. It is also interesting to note that the standard deviation of the Colombian stock market is not much different to that of the world market, indicating that the relative riskiness of the local market is not much different to that of the world market. Following the common practice in literature for modelling asset returns (see, for example, Bollerslev and Wooldridge 1992; Melvin and Tan 1996), Table 1: Descriptive statistics Variable

Mean

Standard deviation

Minimum

Maximum

Number of observations

Stock market returns (IGBCRt) S&P500 from previous day (S&P500t–1) Crime rate from previous day (CRt–1)

0.0018 0.0001 0.0199

0.0159 0.0106 0.9516

–0.1107 –0.0505 –0.0445

0.1469 0.0557 3.4500

1202 1202 1202

Fondelibertad stands for Fondo Nacional para la Defensa de la Libertad Personal, in Spanish – an institution created as part of the national institutional infrastructure against extortion and kidnapping in Colombia.


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a generalised autoregressive conditional heteroskedasticity (GARCH) model that shows how local market returns are influenced by world market returns, political uncertainty and the crime rate, was specified and estimated. In general, the goal of the GARCH model is to provide a volatility measure (like a standard deviation) that can be used in financial decisions concerning, for instance, risk. The chosen statistical method determines the influence of a particular variable on the Colombian stock market when the other effects are controlled for. This allows the impact of a particular variable to be isolated. Another advantage of the GARCH model is that it allows for volatility to be estimated based on historical data. Empirical results and discussion Table 2 summarises the main findings and shows that the previous business day’s activity of the US stock market (S&P500t–1) had a positive and statistically significant effect on the Colombian stock market return. However, we find that a 10% increase in the S&P500 will increase the return on the Colombian Stock market (IGBCRt) by a mere 0.7%. As for the crime rate, the results show that it is a significant variable with a negative coefficient. This suggests that, on average, a 1% increase in the crime rate will reduce the IGBC return by 0.006% only. This result is consistent with the study conducted by Kutan and Perez (2002). Likewise, political uncertainty is found to have a significant negative impact on the Colombian stock market return. The result implies that stock market returns decrease as the election day approaches. Furthermore it also suggests that it takes around eight days after the election for consumer and business confidence to return. The Tuesday dummy (Dummy-Tue) shows a significant negative effect on the index. This result can partly be explained by the fact that investors typically wait for the outcome of the S&P500t–1 (external market) before making decisions. That is, early in the week (like Tuesday), there is still some uncertainty as to how the external market will behave, hence domestic (Colombian) investors wait a few days before acting on the market. By contrast, the Friday dummy (Dummy-Fri) shows a significant and positive effect on the index. This is because, towards the end of the

The specific GARCH equations estimated are available from the authors upon request.

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Table 2: The influence of variables on Colombian stock market returns Variable

Influence of Colombian stocks (all else being equal)

S&P500 from previous day (S&P500t–1) A 10% increase in S&P500 from previous day increases the value of Colombian stocks by 0.7%. Crime rate from previous day (CR–1) A 10% increase in the crime rate reduces the value of Colombian stocks by 0.006%. Political uncertainty (Poluncer) The value of Colombian stocks decreases by 0.004% in the leadup to an election. Tuesday effect (Dummy-Tue)

The value of Colombian stocks decreases by 0.002% on Tuesdays.

Friday effect (Dummy-Fri)

The value of Colombian stocks increases by 0.002% on Fridays.

week (by Friday), investors are more certain about external stock market behaviour and are therefore more confident acting in the domestic stock market, hence there is more stock market activity later in the week.

Conclusions The results show that political uncertainty and crime rates are important determinants of stock market returns in Colombia. Political uncertainty diminishes market activity, indicating that the uncertainty associated with presidential elections brings about a decline in trading volume. Quick restoration of political stability may contribute to economic growth in the long term as evidence indicates that financial market development is a key factor in achieving stable long-term economic growth (Demirguc-Kunt & Levine 1996). Likewise, the findings indicate that stock market activity in Colombia partly depends on the crime rate. The results suggest that policymakers need to establish convincing evidence of reconciliation with guerrilla and paramilitary groups in order to lessen the incidence of violent crime and, consequently, negative effects on stock market returns.

Several ‘day’ dummies were also tested in the model, however these other dummy variables were insignificant and show no pattern at all, hence were not included in the final analysis.


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References Abadie, A. & Gardeazabal, J. (2005) Terrorism and the world economy. Department of Foundations of Economic Analysis II, Working Paper 2005-19, Bilbao, Spain: University of the Basque Country. Becker, G. (2007) Crime and economic development. Retrieved from www.beckerposner-blog.com/archives/2007/05/crime_and_econo.html. Accessed 5 March 2008. Becker, G. & Murphy, K. (2001) Prosperity will rise out of the ashes. Wall Street Journal, 29 October, p. 2001. Berrebi, C. & Klor, E. (2005) The impact of terrorism across industries: an empirical study. CEPR discussion paper 5360, Centre for Economic Policy Research. Bollerslev, T. & Wooldridge, M. (1992) Quasi-maximum likelihood estimation and influence in dynamic models with time varying covariances. Econometric Reviews, 53, 2, pp. 143–172. Chen, A. & Siems, T. (2004) The effects of terrorism in global capital market. European Journal of Political Economy, 20, 2, pp. 349–366. Demirguc-Kunt, A. & Levine, R. (1996) Stock markets, corporate finance, and economic growth: an overview. World Bank Economic Review, 10, 2, pp. 223–239. Hon, M., Strauss, J. & Yong, S.K. (2004) Contagion in financial markets after September 11: myth or reality? Journal of Financial Research, 27, 1, pp. 95–114. Kutan, A.M. & Perez, S.M. (2002) Does organized crime affect stock market development? Evidence from Colombia. Working Paper 4/02, Cass Business School, London. Maya, C. & Torres, G. (2004) The unification of the Colombian stock market: a step towards efficiency. Empirical evidence. Latin American Business Review, 5, 4, pp. 69– 98. Melvin, M. & Tan, K.H. (1996) Foreign exchange market bid-ask spreads and the market prices of social unrest. Oxford Economic Papers, 48, 2, pp. 329–341. Suarez, G. & Pshisva, R. (2006) Captive markets: the impact of kidnappings on corporate investment in Colombia. Finance and Economic Discussion Series. Washington, DC: Federal Reserve Board.

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