The Effect Of Stock Market Development On Economic Growth Finance Essay

In the fiscal system, financess flow from those who have surplus financess to those who have a deficit of financess, either by direct, market based funding or by indirect, bank based finance. The former British Prime Minister William Gladstone expressed the importance of finance for the economic system as follows: “ Finance is, as it were, the tummy of the state, from which all the variety meats take their tone. ”

Ever since the pioneering parts of Goldsmith ( 1969 ) , McKinnon ( 1973 ) , and Shaw ( 1973 ) , the relationship between fiscal development and economic growing has been capable to enormous contentions in economic circles. A figure of theories have been developed with a position to explicate these relationships both at theoretical and empirical degrees. All coincide in proposing that there is a strong positive correlativity between the extent of fiscal development and economic growing. Nevertheless, economic experts still hold conflicting positions sing this positive relationship.

Some economic experts merely do non believe that finance growing relationship is of import. For case, Robert Lucas asserted in1988 that economic experts severely overstress the function of fiscal factors in economic growing. Furthermore, Joan Robertson declared in1952 that “ where endeavor leads, finance follows. ” Harmonizing to this position, economic development creates demands for peculiar types of fiscal agreements, and the fiscal system responds automatically to these demands. This line of literature besides stresses the negative impact of stock market development on the rate of investing, the clip skyline of houses, international fight and economic development. It is argued that organized and complex stock markets do non in pattern perform at all good its supposed monitoring, testing and disciplinary maps. Clearly, harmonizing to these economic experts, the fiscal system plays an inconsequential function in economic development.

However, other economic experts have long believed that fiscal markets and other establishments are of import factors in back uping economic development. A big literature, dating at least as far back as Joseph A. Schumpeter ( 1911 ) , emphasizes the positive influence of the development of a state ‘s fiscal sector on the degree and the rate of growing of its per capita income. The statement basically is that the services the fiscal sector provides-of reapportioning capital to the highest value usage without significant hazard of loss through moral jeopardy, inauspicious choice, or dealing costs are an indispensable accelerator of economic growing. Financial development can ease the transportation of productive capacity across agents and clip from the less productive users to those with greater potency. It besides enables the mobilisation of resources and reduces fragmented capital markets and traditional ego financed investments- ( Bencivenga & A ; Smith ( 1991 ) ) . Berthelemy and Varoudakis ( 1996 ) province that deficient fiscal development has sometimes created a poorness trap and may go a terrible obstruction to growing even in state that has established other conditions ( educational attainment, macroeconomic stableness, etc ) for sustained economic development. Economists like Gurley and Shaw ( 1995 ) , Goldsmith ( 1969 ) , and McKinnon ( 1973 ) , view fiscal establishments as cardinal in economic activity. Harmonizing to these writers, difference in the measure and quality of services provided by fiscal establishments partly explains why states grow at different rates.

To reason, fiscal development is the key to investing and hence to growing. In fact, Bankss and other fiscal establishments can promote thrift and apportion nest eggs more fruitfully than otherwise by offering a return on nest eggs and besides by enabling nest eggs to be used outside the sector in which they originate at lower costs and with less hazard than without a fiscal system. They perform the intermediation procedure. The fiscal system is besides peculiarly of import in reapportioning capital and therefore supplying the footing for the uninterrupted restructuring of the economic system that is needed to back up growing. Furthermore, the fiscal system provides the economic system with a payment mechanism for mundane minutess and authorities with a vehicle through which it can exercise some sort of growth-inductive influences on the economic system.

Stock MARKET DEVELOPMENT AND ECONOMIC GROWTH

The turning importance of stock markets around the universe has late opened a new avenue of research into the relationship between fiscal development and economic growing, which focuses on the effects of stock market development. Considerable argument still exists about the relationship between stock market development and economic growing.

Indeed, past literature considered fiscal mediators as the lone causative channel to economic growing, and this new stage of developmental economic sciences has achieved much in assisting us understand this undiscovered channel of causing since Bagehot ( 1873 ) . In fact, stock markets and Bankss provide services that could either be complements or replacements for each other depending on the industrialisation extent of the economic system.

Levine and Zervos ( 1996 ) argue that good developed stock markets may be able to offer different sorts of services than banking systems and may, hence, supply a different sort of drift to investing and growing than the development of the banking system. It is obvious that a healthy and dynamic stock market plays an simple function in spurring economic growing and to show this correlativity five factors, viz. liquidness, hazard variegation, information acquisition about houses, monitoring directors and exercising control and nest eggs mobilisation, have been considered.

Liquid

One manner stock markets may impact economic activity is through their liquidness. Liquidity is the easiness and velocity with which agents can change over assets into buying power at in agreement monetary values. Liquidity hazard is defined as uncertainnesss in change overing assets into a medium of exchange. Information dissymmetries and dealing costs may suppress liquidness and escalate the liquidness hazard. Financial mediators, including stock markets, enable investors to portion these hazards. The nexus between liquidness and economic development arises because some productive undertakings require a long tally committedness of capital. However, rescuers do non associate to release control of their nest eggs for long periods. Without liquid markets or other fiscal agreements that promote liquidness, hence, less investing may happen in the high return undertakings.

Levine ( 1991 ) and Bencivenga, Smith and Starr ( 1996 ) suggest that stock markets make fiscal assets traded in them less hazardous because they allow rescuers to purchase and sell rapidly and cheaply when they wish to change their portfolio. Rescuers can keep liquid assets ; equity bonds or sedimentations that they can turn to medium of exchange rapidly and easy. At the same clip, the markets transform those fiscal instruments into long-run capital investings in illiquid production procedures. With liquid stock markets, saver stockholders can sell their assets, while houses have lasting entree to the capital invested by the initial holders. Specifically, liquid stock markets cut down the downside hazard and cost of puting in undertakings that do non pay off for a long clip. Liquid stock markets, hence, are markets where it is comparatively cheap to merchandise fiscal instruments and where there is small uncertainness about the timing and colony of those trades. Less hazardous assets and easy entree to capital markets improve the allotment of capital, an of import channel for economic development. More nest eggs and investing farther enhance long-run economic growing.

Besides, capital inflows-both foreign direct investing and portfolio investment-are of import beginnings of investing financess for emerging economic systems. Portfolio flows tend to be larger to states with organized and liquid markets. Therefore, the being of liquid equity markets facilitates capital influx and the ability to finance current history shortages.

A more developed equity market may besides supply liquidness that lowers the cost of the foreign capital that is indispensable for development as pointed out within the plants of Bencivenga et Al ( 1996 ) , and Neusser and Kugler ( 1998 ) . Liquid has besides been argued to increase investor inducement to get information on houses and better corporate administration ( Kyle 1984 ) , thereby easing growing. Levine farther argued that a liquid stock market complements a strong banking system, proposing that Bankss and stock markets provide different packages of fiscal services to the economic system.

Theory is ill-defined, nevertheless about the growing effects of greater liquidness. Bencivenga and Smith ( 1991 ) show that by cut downing uncertainness, greater liquidness may cut down salvaging rates plenty so that growing slows. There are three channels through which this may take topographic point ( Demirguc-Kunt and Levine ( 1996 ) ) . The first is that greater stock market liquidness, by increasing the returns to investing, may cut down salvaging rates. The 2nd is that, given the equivocal consequence of uncertainness on nest eggs, greater stock market liquidness might in fact cut down salvaging rates since less uncertainness may diminish the demand for precautional nest eggs. The 3rd channel operates through the euphory and nearsightedness that may be encouraged by extremely liquid stock markets. Disgruntled participants find it easy to sell rapidly which can take to deterrences to exercise corporate control, therefore impacting adversely corporate administration and aching economic growing in the process- ( Jensen and Murphy ( 1990 ) ) .

Indeed, for the instance of the African subcontinent, liquidness has been a important factor in haltering stock market development ( Adjasi and Biekpe 2006 ) and accordingly idiots economic growing. Naceur and Ghazouani ( 2007 ) besides posit that the good consequence of liquidness is merely found after a threshold degree. Furthermore, Sarkar ( 2006 ) discussed that stock market development may hold no consequence on fixed capital formation due to the high dealing and information costs in least developed states.

Hazard DIVERSIFICATION

Development in the fiscal system is besides believed to ease trading, fudging and pooling of hazard in the presence of informational and dealing costs. The function of equity markets in supplying portfolio variegation, enabling single houses to prosecute in specialised production is bound to ensue in efficiency additions ( Acemoglu and Zilibotti 1997 ; Capasso 2008 ) . Indeed, in the presence of stock markets which provide for assorted vehicles for reassigning hazard through which investors can confidently put, investors have the chance of exchanging from low-risk to bad investings.

Hazard variegation through internationally incorporate stock markets is a 2nd vehicle through which stock market development may act upon economic growing. Saint Paul ( 1992 ) ; Devereux and Smith ( 1994 ) demonstrate that stock markets provide a vehicle for diversifying hazard. Atje and Jovanovic ( 1993 ) besides suggest that stock markets provide greater chance for hazard spreading and hazard pooling. The stock market ‘s ability to supply hazard variegation services can impact long run economic growing by changing resource allotment and salvaging rates. The basic intuition is straightforward. While rescuers by and large do non like hazard, high return undertakings tend to be riskier than low return undertakings. Therefore, stock markets that ease hazard variegation tend to bring on a portfolio displacement towards undertakings with higher expected returns. Intuitively, since high expected return undertakings tend to be relatively hazardous, better hazard variegation through internationally incorporate stock markets will further investing in higher return undertakings. This will in bend lead to economic growing.

Again, nevertheless, theory suggests fortunes when greater hazard sharing slows growing rate. Greater hazard sharing and more efficient capital allotment have theoretically equivocal effects on salvaging rates. Devereux and Smith ( 1994 ) and Obstfeld ( 1994 ) show that reduced hazard sharing through internationally incorporate stock markets can deject salvaging rates plenty so that, when coupled with an outwardness based or additive growing theoretical account, overall economic growing rate falls. With outwardnesss, growing could fall sufficiently so that overall public assistance falls with greater hazard variegation.

INFORMATION ACQUISITION ABOUT FIRMS

It is hard and dearly-won to measure houses, directors and market conditions as discussed by Vincent Carosso ( 1970 ) . Individual rescuers may non hold the clip, capacity or means to roll up and treat information on a broad array of endeavors, directors and economic conditions. Rescuers will be loath to put in activities about which there is small dependable information. Consequently, high information costs may maintain capital from fluxing to its highest value usage.

Information acquisition costs create inducements for fiscal mediators to emerge- ( Boyd and Prescott ( 1986 ) ) . Atje and Jovanovic ( 1993 ) suggest that a formal market for securities greatly increases the sum of information available to investors about houses and their proposed investing undertakings, thereby bettering the efficiency of fiscal intermediation.

The stock market besides improves the flow of information from direction to proprietors. In add-on, stock markets promote the acquisition and airing of information about firms- ( Grossman and Stiglitz ( 1980 ) , Kyle ( 1988 ) , and Holmstrom and Tirole ( 1994 ) ) . As stock markets become larger and more liquid, market participants may hold greater inducements to get information about houses and it will be much easier for an investor who has information to merchandise at posted monetary values. Intuitively, with larger more liquid markets, an agent who has acquired information can easy mask this private information and do money before that information becomes widely available and monetary value alterations. The ability to gain from information will excite investors to research and proctor houses. This improved information about houses should better resource allotment and spur economic growing.

Opinions differ over the importance of stock markets in bettering information acquisition. Stock markets aggregate and disseminate information through published monetary values. Even agents who do non set about the dearly-won procedure of measuring houses, directors and market conditions can detect stock monetary values that reflect information obtained by others. This public goods facet of geting information therefore disclosed may be sufficiently big that information additions from big liquid stock markets are little. Stiglitz ( 1993 ) argues that good working stock markets rapidly reveal information through monetary value alterations. This speedy public disclosure will cut down inducements for disbursement private resources to obtain information.

Monitoring MANAGERS & A ; EXERTING CORPORATE CONTROL

Besides cut downing the costs of geting information, stock market development may besides act upon corporate control. Wiliam Meckling ( 1976 ) , Diamond and Verracchia ( 1982 ) and Jensen and Murphy ( 1990 ) show that efficient stock markets help extenuate the chief agent job. For illustration, public trading of portions in stock markets that expeditiously reflect information about houses allows proprietors to associate managerial compensation to stock monetary values. Associating stock public presentation to director ‘s compensation helps aline the involvements of directors with those of proprietors.

Similarly, if coup d’etats are easier in good developed stock markets and if directors of underperforming houses are fired following a coup d’etat, so better stock markets can advance better corporate control by easing coup d’etats of ill managed houses. Scharfstein ( 1988 ) argue that coup d’etat menaces induce directors to maximise the house ‘s equity monetary value. By exercising corporate control and monitoring directors, stock markets promote efficient resource allotment that consequences in growing ( Adjasi and Biekpe 2006 ) . First, given that the stock monetary value at any clip is mirror of house public presentation, weakening corporate administration would be reflected as a autumn in portion monetary value. Management would hold a disincentive to work in their personal involvements if their compensation is tied to stock public presentation ( Jensen and Murphy 1990 ) . Therefore, the accent is on the function of equity markets in supplying proper inducements for directors to do investing determinations. Dow and Gorton ( 1997 ) argued that such investing determinations affect house value over a longer clip period than the directors ‘ employment skylines through equity-based compensation strategies. Binswanger ( 1999 ) and Yartey ( 2007 ) , nevertheless argued that the above might non be true in a state of affairs of investor nearsightedness. In other words, directors work towards maximising stockholders ‘ value with a position to increase the house ‘s portion monetary value. In instance direction fails to make so, the menace of a coup d’etat may happen.

There are dissensions, nevertheless, about the importance of stock markets in corporate control. Inside investors likely have better information about the corporation than foreigners. Therefore, if good informed proprietors are willing to sell their company, less good informed may demand a premium to buy the house due to information dissymmetry. This may cut down the efficaciousness of corporate coup d’etats as a mechanism for exercising corporate control. To the extent that good working equity markets help coup d’etats, this may let hostile coup d’etats that lead to a autumn in the efficiency of resource allocation- ( Stiglitz 1985 ) . Furthermore, liquid stock markets may cut down inducements for proprietors to supervise managers- ( Amar Bhide 1993 ) and this may hinder effectual corporate administration. By cut downing issue costs, stock market liquidness encourages more diffuse ownership with fewer inducements and greater hindrances to actively supervising managers- ( Shleifer and Vishny 1986 ) .

SAVINGS MOBILISATION

Mobilizing-pooling involves the agglomeration of capital from disparate rescuers for investing. Without entree to multiple investors, many production procedures would be constrained to economically inefficient graduated tables. Furthermore, mobilisation involves the creative activity of little denomination instruments. These instruments provide chances for families to keep diversified portfolios, invest in efficient scale houses, and to increase plus liquidness. By heightening hazard variegation, liquidness, and the size of executable houses, hence, mobilisation improves resource allocation- ( Stirr and Tufano 1995 ) .

In footings of raising capital, Greenwood and Smith ( 1996 ) show that big, liquid, and efficient stock markets can ease nest eggs mobilisation and this can deeply impact economic development. By agglomerating nest eggs, stock markets enlarge the set of executable investing undertakings. Since some worthy undertakings require big capital injections and some enjoy economic systems of graduated table, stock markets that ease resource mobilisation can hike economic efficiency and speed up long tally growing. Besides the direct consequence of better nest eggs mobilisation on capital accretion, can better resource allotment and hike technological invention, thereby encouraging economic growth- ( Adjasi and Biekpe 2006 ) .

Opinions differ over the importance of stock market for raising capital. Mayer ( 1988 ) , for illustration, argues that new equity issues account for a really little fraction of corporate investing. By executing these five maps, the being of a liberalized stock market might do a existent investing roar. A liberalized stock market may besides assist to cut down the cost of equity every bit good as doing a rush in the stock market rating ( Obsfeld 1994 ; Stulz 1997 ) . Thus stock markets are of import fiscal establishments moving as growing channels.

Alternate PERSPECTIVES: Emerging Capital MARKETS

These theories of finance considered so far, assume the being of well-developed capital markets and therefore are chiefly applicable to advanced economic systems. In relation to emerging economic systems where the capital markets are by and large developing, there is another subdivision of neoclassical literature that is relevant. This school of idea is associated with McKinnon and Shaw who argued that in many Third World states, the authorities hold the involvement rates unnaturally low and supply subsidised credits either to favored or precedence sectors. Liberalization of these repressed recognition markets will further development since raising involvement rates to their equilibrium degrees non merely leads to higher nest eggs but to more efficient usage of investing resources. They concentrated on recognition markets and did non analyze the function of stock market. Therefore, harmonizing to their theory, stock market is non of import in these developing states. However, Stiglitz and others showed that if recognition markets are liberalized, because of dissymmetry in information between the providers ( Bankss ) and users of finance ( corporations ) , the market determined involvement rates does non apportion recognition expeditiously. For case, if there is an extra demand for loans at a given involvement rate, the Bankss may ration recognition instead than raise involvement rates. Imperfect information therefore consequences in some groups being wholly excluded from the recognition market although the expected returns from their investings may be higher than those of the groups that get recognition. To cut down or to extinguish such inefficiencies, Cho ( 1986 ) argue that recognition markets need to be supplemented by a well working stock market. Consequently, being of stock market enhances the allocative efficiency of capital.

Empirical LITERATURE REVIEW

Empirical EVIDENCE OF THE ROLE OF STOCK MARKET ON ECONOMIC GROWTH

The involvement in the digest of historical informations on stock market development and its consequence on the rate of economic growing seems to be stronger than of all time. Assorted vehicles for analysis have been used in the different surveies. This subdivision contains a reappraisal of empirical surveies trying the impact of stock market development and economic growing which is besides the concern of my present work.

Atje & A ; Jovanovic ( 1993 ) , in their cross sectional survey of 40 states over the period 1979-88 shows that the comparative size of a state ‘s stock market helps to explicate subsequent growing in per capita gross domestic merchandise. They show that trading volume has a strong influence on growing after commanding for lagged investing while bank recognition does non. In other words, they found that the merchandise of investing with initial stock market activity is important and conclude that stock markets do increase the rate of return on investing, and hence, bring on economic growing.

To measure whether overall stock market development is strongly connected with economic growing, Levine and Zervos ( 1996 ) constructed a stock market development index that takes into history size, liquidness and hazard variegation. Specifically, increased stock market capitalisation, measured by either the ratio of stock market value to GDP or by the figure of listed companies, may better an economic system ‘s ability to mobilise capital and diversify hazard. Liquidity is another of import index of stock market development in that it may be reciprocally related to dealing costs, which impede the efficient operation of stock market. Liquidity may be measured by the entire value of market public presentation captured by the presence or absence of extra volatility of market returns, inordinate concentration and plus pricing efficiency.

To measure whether the index of stock market, STOCK, is strongly linked to hanker run economic growing, clip series growing arrested development is used for 41 states covering the period 1976-1993. The consequence suggests a strong positive relationship between overall stock market development and long tally economic growing. Even after commanding for the initial degree of GDP per capita, initial investing in human capital, political stableness and steps pecuniary, financial and exchange rate policy, stock market development remains positively and significantly correlated with long run economic growing.

Much of the staying bing grounds points to stock market development taking topographic point in tandem with other facets of fiscal development. Using information for 44 industrial and developing states for the period 1986-1993, Demiguc-Kunt and Levine ( 1996 ) conclude that states with good developed stock markets besides have good developed Bankss and non bank fiscal mediators, while states with weak stock markets tend to hold weak Bankss and fiscal mediators. Therefore, the being of a developed stock market leads to the development of the fiscal sector which helps to speed up economic growing.

Again in the context of stock market development and economic growing, Levine and Zervos ( 1998 ) through empirical observation investigates whether banking and stock market indexs are robustly correlated with current and future economic growing. They argue that well developed stock markets may be able to offer different sorts of fiscal services than the banking systems and may, hence, supply a different sort of drift to investing and economic growing. Using cross-country arrested developments for a figure of 47 states covering the period 1976-1993, Levine and Zervos demonstrate that assorted steps of equity market activity are positively correlated with steps of existent activity and that the association is peculiarly strong for developing states. Conditioning on a figure of variables, including indexs of banking development, they conclude that stock market supply different fiscal services from Bankss. They argue that stock markets may heighten growing through liquidness, which makes investing less hazardous, thereby enabling companies to bask lasting entree to capital through liquid equity issues.

Pioneering work from Spears ( 1991 ) , Pardy ( 1992 ) , show that stock market development is strongly correlated with growing rates of existent GDP per capita. More significantly, they found that stock market liquidness predict the future growing rate of economic system. Filer et Al. ( 1999 ) , Rousseau and Wachtel ( 2000 ) and Tuncer and Alovsat ( 2001 ) examined stock market-growth link and exhibited positive insouciant correlativity between stock market development and economic activity. Subsequent empirical work by Jayaratne and Strahan ( 1996 ) and more late Roisseau and Sylla ( 2001 ) and Seetanah ( 2008 ) besides confirmed the above. However, most of earlier surveies suffered from assorted statistical failings viz. with regard to endogeneity and causality issues together with immeasurable transverse state heterogeneousness. Subsequent research, with larger panel sets and longer clip series attempted to go to to the earlier critisms. Beck and Levine ( 2003 ) for case, investigated the impact of stock markets and Bankss on economic growing utilizing a panel information set dynamic panel ( GMM ) , those stock markets and Bankss positively influence economic growing. Chen et Al ( 2004 ) , Paudel ( 2005 ) and Love and Zicchino ( 2006 ) besides acknowledged that stock markets, due to their liquidness, enable houses to achieve much needed capital rapidly, therefore easing capital allotment, investing and growing. Bahadur and Neupane ( 2006 ) concluded that stock markets fluctuations predicted the future growing of an economic system and causality is found merely in existent variables.

Recent surveies have employed vector theoretical accounts, nevertheless most are state specific surveies including research in Ghana ( NZue 2006 ) , Pakistan ( Shahbaz, Ahmed and Ali 2008 ) and India ( Agrawalla and Tuteja 2007 ) . There exists nevertheless few surveies which could non set up any important nexus in the stock market-economic growing nexus chiefly the theoretical and empirical plants of Bencivenga and Smith ( 1991 ) ; Jappelli and Pagano ( 1994 ) ; Demirguc-Kunt and Levine ( 1996 ) ; Ram ( 1999 ) ; Adjasi and Biekpe ( 2006 ) and Ghazouani ( 2007 ) . It is notable that Rousseau and Xiao ( 2007 ) in their survey of China found that banking sector development was cardinal to the Chinese success but nevertheless could non set up any important relationship for the instance of stock market development. Among the recent few surveies concentrating entirely on developing states characteristic Christopoulos and Tsionas ( 2004 ) , Seetanah ( 2007, 2008 ) which confirmed earlier work at Luintel and Khan ( 1999 ) and that of Demetriades and Hussein ( 1996 ) . Conversely, Odedokun ( 1996 ) found assorted consequences.

In drumhead, old empirical research has suggested a connexion between stock market development and economic growing, but is far from unequivocal. Although the relationship postulated in a causal one, most empirical surveies, until recently have addressed causality sidelong, and this even more marked within a panel information analysis.