Democracy and Financial Development

Abstract

The main objective of this study is to investigate a U-shaped relationship between democracy and financial development. At the initial levels of democracy, the financial development may potentially decline as the institutions are less strong. However, institutions are strengthened by democratic regimes and consequently the financial development enhances at the higher degree of democracy. For the empirical purposes, a panel dataset consisting of 146 countries spanning from 1990 to 2018 is collected. Employing time and country fixed effects, the findings substantially support Huang (2010) implying a U-shaped relationship between democracy and financial development. The results suggest that the financial development reduces at the initial levels of democracy but once democracy attains a certain threshold the financial development significantly enhances. As the data sample consists of both OECD and non-OECD countries, it becomes pertinent to decompose the data and then reconfirm the empirical analysis. The results still suggest a U-shaped correlation between democracy and financial development for both the OECD and non-OECD countries.