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What is the interaction between financial development and democratisation in developing countries? This research examines whether institutional improvement (i.e. democratisation) stimulates financial development. Improved institutional quality is associated with increases in financial development – at least in the short run – especially for lower-income countries, ethnically divided countries and French legal origin countries. Democratic transitions are typically preceded by low financial development, but followed by a short-run boost in financial development and greater volatility of financial development.

Much work has been done to explore the relationship between institutional improvement, especially political liberalisation, and economic growth. The existing research in this field does not unanimously establish the consequences of political reform for economic development. Instead, it is made up of one line of research supporting positive consequences, another line stressing negative consequences and some maintaining ambiguous views. How do democratic processes improve institutional quality and influence financial development, especially in countries with low GDP per capita, high ethnic and religious divisions, or specific legal origins?

In comparison with autocracies, democracies better facilitate property rights protection and contract enforcement, encouraging investment. Democracy is one of the significant forces that lead governments to undertake reforms to enhance financial development. However, there has been little research that directly studies the impact on financial development of democratic process for institutional improvement.

The findings underline the influence of institutional reform over the supply side of finance. There is a strong and robust relationship between institutional quality and economic performance, and there are further grounds for institutional reform. These findings have implications for:

• Financial openness: Institutional improvement could serve as one channel in which trade openness could boost financial development and growth.
• Economic and political reform: There are positive feedback effects and interaction effects between economic and political liberalisation. Institutional reform under an open economic environment could exert an additional boost to investment and economic growth, and thus to financial development.