How does Stock Market Liquidity Forecast Economic Growth?

Abstract

This paper examines the relationship between stock market liquidity and the real economy in Korea during the period 1995:2–2011:4. We find that stock market liquidity is positively and significantly correlated with future economic growth. Specifically, we find that the Amihud (2002) illiquidity measure is a good predictor of the next quarter’s real GDP growth. We also find that the illiquidity of small, young, non-dividend-paying, and distressed firms, which are more likely to be informationally opaque and difficult to arbitrage, is more informative when predicting future economic downturns. From the perspective of the flight to quality, the implication is that investors shift their portfolios toward safe assets when they expect the economy to be in trouble.

Keywords: Korean stock market, Economic development, Firm characteristics