The Impact of Stock Market Illiquidity on Real UK GDP Growth

We empirically test the hypothesis that stock market illiquidity affects real UK GDP growth using data over the period 1989q1-2012q2. We conduct our empirical exercise within a standard linear model as well as a non-linear model, which allows for regime switching behavior in terms of a liquid versus an illiquid regime and over the phases of the business cycle. Our findings strongly support a statistically significant negative impact of stock market illiquidity over and above the usual macroeconomic controls on UK GDP growth; the impact becomes stronger during periods of highly illiquid market conditions and weak economic growth. Our out-of-sample forecasting analysis provides evidence in favor of a regime-switching model of illiquid versus liquid market conditions in predicting UK growth better than any other model; further, this very model is the only one to outperform the GDP growth forecasts published in the Bank of England’s Inflation Report.