Leading indicators, institutions, and growth: An application to emerging markets in the Middle East

Using a set of three emerging markets in the Middle East, I test the hypothesis that financial variables contain incremental information useful in predicting macroeconomic recessions. Financial variables are used as leading macroeconomic indicators in a business cycles framework. The model's forecasting power is tested using various measures of goodness of fit. Stock market price indexes are found to have a strong predictive power within a 1–4 quarter horizon in all three countries, and indeed have the strongest predictive power for recessions three to four quarters ahead. The results imply that financial variables can constitute a fast and reliable method to check future economic trends in emerging markets.; Next, I investigate the impact of institutions on the effectiveness of financial variables as leading macroeconomic indicators. Specifically, I attempt to answer the following questions: Does accounting for institutional breaks, financial market deregulation and political credibility increase our ability to forecast future real economic activity? Do these factors affect the influence of financial variables on future economic activity? A sample of six emerging markets is used in the attempt to answer these questions. Financial indicators are used to predict the growth rate of output, using an autoregressive model. The forecasting power of the model is measured, using out-of-sample projections. In five of the six cases, the institutional and political credibility indicators consistently add to the overall explanatory power, and in four of these cases, they add significantly to the overall forecasting power.; Last, I investigate the determinants of differences in the development of financial markets, both within the Middle East region and across other regions of the world. A simple econometric model is applied, using a financial panel data set. The analyses identify the factors that are most important for the success of financial development in emerging markets. Those factors include privatization, private ownership of banks or changes in the rules of these financial markets are the keys to their development, and whether something more political such as the degree of political credibility may affect the effectiveness of various reforms.