1. Introduction

The 2008 global financial crisis revealed how the drying up of stock market liquidity can act as a precursor to broader economic downturns. This experience renewed academic interest in the role of market liquidity as a leading indicator of business cycles and economic activity (^{Apergis et al., 2023}; ^{Chikwira & Mohammed, 2023}; ^{Im et. al., 2024}; ^{Næs et al., 2011}). ^{Florackis et al. (2014)} have demonstrated that sharp declines in liquidity not only restrict the availability of long-term financing but also affect investor sentiment, leading to reductions in investment and consumption.

From a theoretical standpoint, liquid stock markets play a central role in economic development. They improve capital allocation, reduce the cost of funding, and enhance the informational content of asset prices (^Levine,1991; ^{Amihud, 2002}). A liquid secondary market enables investors to adjust their portfolios with minimal transaction costs, thereby lowering the risk premium required to hold risky assets and supporting productive investment. Moreover, current asset prices in liquid markets tend to reflect investor expectations about future macroeconomic conditions, reinforcing the consumption-smoothing channel (^{Næs et al., 2011}).

When financial systems face liquidity constraints, their vulnerability increases (^{Elliott et al., 2025}; ^{Huang et al., 2024}; and ^{Kim et al, 2024}). A decline in equity prices may lead to reduced investment and can amplify economic recessions (^{Florackis et al., 2014}). Moreover, liquidity should also convey information about future macroeconomic conditions. The “flight to quality” phenomenon, often observed before economic downturns, illustrates how investors, anticipating instability, reallocate capital away from equities toward safer assets. This behavior underscores the prospective nature of stock markets as forward-looking mechanisms that reflect investor expectations markets (^{Switzer & Picard, 2016}).

Since 2010, the BRICS-Brazil, Russia, India, China, and South Africa-have emerged as major players in the global economy. Figure 1 illustrates the significant expansion of their stock markets, particularly in China and South Africa, where market capitalization as a share of GDP exceeds 100% in the latter (see Figure 1) (^{Pant, 2013}). However, unlike developed markets, BRICS countries differ in their institutional quality, financial structures, and susceptibility to external shocks. These features let us raise an important question: Does stock market liquidity serve as a reliable predictor of economic growth and recession risk in BRICS countries?

Source: Prepared by the authors with data from ^{Federal Reserve Bank of St. Louis (n.d.)}.

Figure 1 Stock Market Capitalization to GDP for the BRICS Countries 

Using quarterly data from the ^{Federal Reserve Bank of St. Louis (n.d.)} for the period 2010 to 2017, we examine whether stock market liquidity is a significant predictor of both economic growth and the likelihood of recession in BRICS countries. We estimate a dynamic panel data model to assess the short-run impact of liquidity on GDP growth. Following ^{Estrella and Mishkin (1998)}, we also employ a probit model to evaluate the ability of liquidity indicators to anticipate recessions. To capture multiple dimensions of market liquidity, we rely on three standard proxies: the Amihud illiquidity measure (IRLM), trading volume, and the relative bid/ask spread (RS). Our findings suggest that lower levels of liquidity are significantly associated with weaker economic growth and a higher probability of recession, even after controlling for key macroeconomic variables, including money supply growth, interest rate spreads, and market volatility.

By focusing on emerging economies where the proportion of stock market capitalization to Gross Domestic Product (GDP) is substantial (averaging more than 50%), this study contributes to the growing literature on the predictive power of stock market liquidity. It provides policymakers with insights relevant to designing macroprudential frameworks in developing countries. The rest of the paper is structured as follows. Section 2 provides a brief literature review. Section 3 describes the methodology and data used to analyze the impact of stock market liquidity on economic growth, and Section 4 shows and discusses our results. Our concluding remarks appear in the last section.

2. Literature Review

The relationship between stock market liquidity and real economic activity has garnered growing attention, particularly in the aftermath of financial crises that have highlighted the role of financial markets in amplifying or transmitting shocks to the broader economy (^{Mattana & Panetti, 2014}; ^{Chu & Chu, 2020}). Several theoretical frameworks suggest that stock market liquidity can affect growth through multiple channels. A liquid market reduces the cost of capital and improves resource allocation, enabling firms to undertake long-term investments that foster productivity and economic expansion (^{Levine, 1991}; ^{Amihud, 2002}).

In addition to the investment channel, liquidity influences the economy through expectations embedded in asset prices. As noted by ^{Næs et al. (2011)}, changes in stock market liquidity can precede shifts in macroeconomic conditions, as investors adjust their portfolios in anticipation of downturns. This phenomenon is often reflected in a “flight to quality” phenomenon, where capital moves away from equities and into safer assets during periods of uncertainty (^{Bao Dinh & Tran, 2024}). Overall, stock market liquidity serves as a signaling mechanism for the future state of the economy, influencing both consumption and investment decisions.

3. Data and Methodology

4. Results

Table 1 presents descriptive statistics for the liquidity proxies, as well as the GDP growth and control variables used in the analysis (see Table 1). Table 2, in turn, presents the correlation matrix among these variables (see Table 2). The results indicate that the GDP growth rate is negatively correlated with all other variables, most notably with the stock market volatility (-0.59) and the relative spread (RS) (-0.41). The results also suggest that higher volatility and wider spreads are associated with slower economic growth. The IRLM also shows a negative correlation with GDP growth (-0.30), implying that lower market liquidity is associated with slower economic growth.

Volatility exhibits a strong positive correlation with the IRLM (0.74) and the RS (0.82), thus indicating that periods of high illiquidity are typically accompanied by increased stock market volatility. Additionally, the IRLM and the RS are positively correlated (r = 0.58), although the correlation is not perfect. This suggests that both proxies capture different aspects of market liquidity.

Table 3 presents the results of the dynamic panel estimations, highlighting the role of stock market liquidity, measured through the IRLM, as a significant leading indicator of economic activity. The coefficient associated with the first lag of the IRLM is consistently negative and statistically significant across all model specifications, suggesting that decreases in market liquidity are associated with immediate declines in GDP growth. In other words, periods of reduced market liquidity tend to precede short-term economic slowdowns (see Table 3).

Interestingly, the second lag of the IRLM shows a positive and statistically significant effect on GDP growth, indicating a partial rebound in economic activity following the initial shock. This dynamic pattern suggests that liquidity shocks have a short-term contractionary effect, so their impact may be temporary, allowing for a delayed adjustment in investment or consumption behavior. Such short-term reversals may reflect the market’s ability to correct after initial overreactions, especially in environments where macroeconomic fundamentals remain relatively stable.

Our findings are consistent with the notion that liquidity shocks impair the financing of productive investments, raise the cost of capital, and contribute to macroeconomic fragility. The results align with the evidence reported by ^{Næs et al. (2011)} for developed markets, where liquidity was shown to anticipate cyclical turning points. Similarly, ^{Florackis et al. (2014)} found that stock market illiquidity negatively predicts GDP growth in the United Kingdom, especially during periods of low economic activity.

What distinguishes the present analysis is its focus on BRICS economies, where financial markets are less mature and potentially more sensitive to liquidity disruptions. The strong and immediate effect of liquidity observed here suggests that it may carry even greater information value in emerging markets, where alternative sources of financing are more limited.

Table 4 presents the results of the dynamic panel model estimations using the RS as an alternative proxy for market liquidity. Similar to the IRML, the results indicate a significant negative relationship between stock market liquidity and economic growth. However, notable differences emerge in terms of magnitude (see Table 4).

The first lag of the Relative Bid/Ask Spread (RS_t-1) shows a negative and statistically significant coefficient in three out of the four model specifications (columns 1, 2, and 4), with estimated values ranging from 0.46 to 0.52. This suggests that an increase in RS (higher transaction costs) is associated with a reduction in GDP growth in the following quarter. In contrast, the second and third lags of the RS variable are not statistically significant in any specification, implying that the impact of the RS on economic growth is short-lived and does not persist dynamically, unlike the pattern observed with the IRLM.

Market volatility (Vol) remains negative and statistically significant in model (3), reinforcing the evidence that higher market volatility tends to coincide with lower economic growth. Meanwhile, the control variables, term spread (Y spread) and money supply growth (ΔM2), do not show significant effects in any of the models, suggesting that RS carries an informational signal about GDP growth. Finally, the R² of the most comprehensive model (column 4) reaches 0.49, which is slightly lower than the explanatory power observed with the IRLM-based model (0.5866 in Table 3) (see Table 3). This suggests a modest loss of explanatory power when using the RS as the primary proxy for liquidity.

Our results are consistent with studies that highlight the role of the RS as an indicator of transaction costs and market friction, as shown by ^{Jun et al. (2003)}, and more recently by ^{Apergis et al. (2015)}, who validate the use of the RS as an effective measure of liquidity in emerging markets.

The significance of the first lag of the RS supports the argument by ^{Næs et al. (2011)}, who contend that liquidity reflects investor confidence and can anticipate changes in real economic activity. However, unlike the IRLM, no compensatory effect is observed in the later lags, suggesting that the RS may better capture the contemporaneous impact of transaction costs, but not necessarily the full temporal dynamics of the market. Likewise, the fact that RS exhibits a more immediate but non-persistent effect is consistent with the findings of ^{Galariotis and Giouvris (2015)}, who demonstrate that different liquidity proxies provide varying degrees of predictive power over the business cycle.

Figure 2 illustrates the behavior of the liquidity proxies during periods of economic recession in Brazil, Russia, India, China, and South Africa (see Figure 2). We can observe that during a recession, there is a decrease in liquidity in the stock market. Figure 3 provides additional information on the behavior of the liquidity proxies and the interest rate dynamics in Brazil, Russia, India, China, and South Africa (see Figure 3). It can be observed that during recession periods, there is a significant increase in the interest rates, with the most prominent peaks occurring during economic downturns.

Source: Prepared by the authors.

Figure 2 Liquidity Proxies and Recession Periods - IRLM 

Source: Prepared by the authors.

Figure 3 Liquidity Indexes and Recession Periods - RS 

Table 5 presents the results of the probit model, which estimates the probability of an economic recession in the BRICS countries (see Table 5). The dependent variable in the model is a binary indicator of recession. In contrast, the independent variables include two proxies for market liquidity: the Relative Bid/Ask Spread (RS) and the IRLM, along with standard control variables, the sovereign bond yield spread (Y spread), growth in the money supply (ΔM2), and financial market volatility (Vol) (See Table 5).

The results reveal that liquidity, as proxied by both the IRLM and the RS, significantly increases the probability of a recession. In Model (1), the RS coefficient is positive and statistically significant at the 10% level, indicating that wider bid/ask spreads, implying greater transaction costs and lower liquidity, are associated with a higher likelihood of economic contraction. In Model (2), the IRLM displays a stronger and more robust effect, significant at the 5% level, reinforcing its role as a leading indicator of macroeconomic fragility. This confirms that lower market liquidity systematically precedes downturns in economic activity across the BRICS economies.

Among the control variables, the yield spread is negative and highly significant in Model (1), consistent with the traditional interpretation that a flatter or inverted yield curve signals recession risks. However, this effect disappears in Model (2), likely due to the stronger explanatory power of the IRLM. Notably, market volatility becomes positive and significant in Model (2), suggesting that heightened volatility amplifies the adverse impact of liquidity on recession.

In terms of model performance, the IRLM-based specification shows superior fit (lower AIC and BIC values), underscoring the informational value of liquidity shocks in predicting macroeconomic downturns. These findings are consistent with previous studies, such as ^{Florackis et al. (2014)} and ^{Næs et al. (2011)}, which found that stock market liquidity serves as a reliable early indicator of real economic activity, particularly during periods of heightened volatility. Overall, the evidence suggests that liquidity conditions in stock markets, particularly in emerging economies with more limited financing alternatives, may serve as effective predictors of recessions, complementing traditional indicators such as the term spread.

5. Conclusion

The relationship between stock market liquidity and economic growth is a crucial area of study, particularly in emerging markets where financial systems play a central role in supporting economic development. As shown by the sub-prime financial crisis, the drying up of liquidity in stock markets often serves as a precursor to broader economic downturns, highlighting the vital role liquidity plays in economic stability (^{Næs et al., 2011}).

Our findings underscore this connection, as we observe that BRICS countries with more liquid stock markets tend to exhibit greater resilience against external shocks and more sound economic growth. Without sufficient liquidity, markets become less transparent, and price signals become distorted, resulting in inefficiencies in resource allocation.

Furthermore, a lack of liquidity exposes markets to higher volatility and instability. In times of heightened volatility or external shocks, illiquid markets are more vulnerable to abrupt price swings, which can exacerbate the severity of downturns (^{Muzaffar & Malik, 2024}). Nevertheless, liquid markets possess a natural buffer, allowing for a smoother adjustment to adverse events. In this regard, liquidity serves as a stabilizing force, ensuring that markets can absorb shocks more effectively and maintain a degree of resilience in the face of external pressures.

Given the short-term impact of liquidity on economic growth, future research may explore whether or not behavioral biases exacerbate the impact of liquidity on economic growth. Those biases may include investors’ overconfidence, regret, or even market sentiment. In summary, fostering and maintaining stock market liquidity in countries where market capitalization constitutes a high proportion of the GDP is essential not only for the smooth functioning of daily trading but also for ensuring long-term economic stability and growth. Policymakers and market participants must prioritize mechanisms to foster stock market capitalization and enhance liquidity to safeguard against market disruptions and ensure sustainable development.