# **3.3 Robustness Tests**

The results presented in this section show that stock markets in Latin American are below what can be expected, given the region’s economic and institutional fundamentals and policies. Given the relevance of these results, we subjected them to a number of robustness tests by including several additional control variables suggested by the literature on capital market development.

First, we controlled for macroeconomic volatility, as the empirical evidence suggests that the depth of domestic financial systems is inversely related to volatility (see, for example, IADB, 1995). To the extent that macroeconomic volatility might have been higher in Latin America than in other regions and was not fully captured by the control variables included in the regressions, this could explain the negative sign and statistical significance of the Latin American dummy.<sup>30</sup> To address this issue, we reestimated the regressions including measures of inflation and interest rate volatility at different time horizons.<sup>31</sup> We find that these variables tend to have a negative (although usually not statistically significant) relation with stock market development, but their inclusion does not affect the sign and significance of the Latin American dummy. Also, the size of the coefficients on this dummy is mostly unaffected by the inclusion of these controls.

Second, the lower level of stock market development in Latin American countries may be due to a worse institutional environment in these countries, which was not adequately captured by the control variables used in the regressions. To address this issue, we included a number of additional measures of the quality of the institutional framework. In particular, we controlled for indicators of corruption, bureaucratic quality, law and order, political risk, government stability, and investment profile developed by International Country Risk Guide; an index of the quality of accounting standards constructed by Bushman, Piotroski, and Smith (2004); and different proxies for the functioning of the judicial system, including the time it takes to resolve disputes (Djankov et al., 2003), and an index of the overall efficiency of the judicial system, as reported by Business International Corporation. We also controlled for a country’s legal tradition, as this has been found to be associated with the protection of shareholder rights (La Porta et al., 1997, 1998), the efficiency of the judicial system (Djankov et al., 2003), and the protection of property rights (Beck, Demirguc-Kunt, and Levine, 2003). While many of these variables are statistically significant and have the sign suggested by the literature, the Latin American dummy remains statistically significant and negative and the size of its coefficients is mostly unchanged.

Finally, we controlled for the level of savings in each country. A higher savings level means that more local resources are available to be invested in the domestic financial

> 30 Note that the regressions include two indicators of macroeconomic soundness, the annual inflation rate and the government deficit over GDP.

> 31 We controlled for the volatility of inflation and real interest rates over the previous three, five, and ten years. Also, as Boyd, Levine, and Smith (2001) highlight the nonlinear relation between inflation and financial sector performance, we explored nonlinear effects of inflation on stock market development. Although the results suggest that nonlinear effects might be important, they do not affect the basic conclusions reported above.

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