Does deterioration in rule of law per se create or destroy value?

Abstract

We investigate the link between the rule of law and equity returns in post-transitional economies over the period January 2010–December 2020 by using panel data regressions. By applying several rule-of-law proxies for national legal frameworks and justice system quality as proxies for the rule-of-law principle, the data sets from the capital markets of Poland, Latvia, Lithuania, and Estonia showed that country-level judicial system quality is an important driver of company market performance, and that post-transitional countries with lower rule-of-law measures exhibit higher returns on equity than those with better measures. Our results support the idea that since poor governance and country instability increase agency and transaction costs, in addition to decreasing growth prospects and profitable projects available to companies, the risk premium demanded by investors increases, leading to higher equity returns.