The rule of law is a very important, widely used and praised concept in the studies of democracies. The traditional view is that the improvement of rule of law yields economic development. But how much does the erosion of rule of law affect the economic development of a country? While there is an assumption that a continuous decrease in the quality of institutions results in negative economic effects, the literature offers little empirical evidence of this trend. Moreover, it is unclear whether investors care about the recession of rule of law in general or only about certain aspects of rule of law that may remain relatively unchanged even under an authoritarian regime.

This thesis delves into these questions using mixed methods, and explores first, the effect of the erosion of rule of law on foreign portfolio investment inflows in Hungary and second, stock market reactions to events associated with the erosion of rule of law in Hungary. For the former, the analysis uses panel data to estimate the impact of the erosion of the rule of law by comparing the changes in quarterly foreign portfolio investment flows in Hungary between 2004 and 2016 to the contemporaneous changes in three control countries through difference in differences estimations. For the latter, the analysis begins by reviewing five foreign language newspapers to identify events that reportedly led to the erosion of rule of law in Hungary. From there, the analysis calculates cumulative abnormal returns for all securities listed on the Budapest Stock Exchange on these dates.

The findings provide important insights on a country in transition, showing mixed economic effects of the erosion of rule of law and the departure from democracy. More specifically, the research suggests that, as long as certain property rights and the enforcement of contracts are guaranteed, the market may turn a blind eye if other aspects of rule of law are systematically violated and/or cease to exist. In the long term, this may result in indirect financial support to and, therefore, conservation of emerging illiberal democracies.