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Over the last few decades world stock markets are growing enormously and the stock markets particularly in developing countries represent a large share of this boom. Investors are venturing into the world s newest markets and some are seeing handsome returns but are developing countries themselves reaping any benefits from their stock markets? The evidence indicates that they are.

Over the past 10 years, the total value of stocks listed in all of the world s stock markets rose from $4.7 trillion to $15.2 trillion, while the Share of total world capitalization represented by the emerging markets jumped from less than 4 percent to almost 13 percent. Trading in the emerging markets also surged: the value of shares traded climbed from less than 3 percent of the world total in 1985 to 17 percent in 1995.

The emerging markets have attracted the interest of international investors while raising a number of critical questions for policy makers in developing countries: Do stock markets affect overall economic development and, if so, how? What is the relationship, between stock markets and banks in fostering economic growth? And, how can developing countries benefit from stock market growth?

Impact on development:

Do stock markets affect overall economic development?

Although some analysts view stock markets in developing countries as  casinos that have little positive impact on economic growth, recent evidence suggests that stock markets can give a big boost to economic development.

Stock markets may affect economic activity through the creation of liquidity. Many profitable investments require a long-term commitment of capital, but investors are often reluctant to relinquish control of their savings for long periods. Liquid equity markets make investment less risky and more attractive because they allow savers to acquire asset equity and to sell it quickly and cheaply if they need access to their savings or want to alter their portfolios.

At the same time, companies enjoy permanent access to capital raised through equity issues. By facilitating longer-term, more profitable investments, liquid markets improve the allocation of capital and enhance prospects for long-term economic growth. Further, by making investment less risky and more profitable, stock market liquidity can also lead to more investment. Put succinctly, investors will come if they can leave.

There are alternative views about the effect of liquidity on long-term economic growth, however. Some analysts argue that very liquid markets encourage investor myopia. Because they make it easy for dissatisfied investors to sell quickly, liquid markets may weaken investors commitment and reduce investors incentives to exert corporate control by over- seeing managers and monitoring firm performance and potential. According to this view, enhanced stock market liquidity may actually hurt economic growth.

The empirical evidence, however, strongly supports the belief that greater stock market liquidity boosts or at least precedes economic growth. To see how, consider three measures of market liquidity three indicators of how easy it is to buy and sell equities.

One commonly used measure is the total value of shares traded on a country s stock exchanges as a share of GDP. This ratio does not directly measure the costs of buying and selling securities at posted prices. Yet, aver- aged over a long time, the value of equity transactions as a share of national output is likely to vary with the ease of trading. In other words, if it is very costly or risky to trade, there will not be much trading. This ratio is used to rank 38 countries by the liquidity of their stock markets in four different groups. The nine countries with the most illiquid markets are in the first group; the nine countries with the most liquid markets that is, with the largest value-traded-to-GDP ratios are in the fourth group; the second and third groups, each of which contains 10 countries, fall between the two extremes of liquidity. As Chart 1 show, countries that had relatively liquid stock markets in 1976 tended to grow much faster over the next 18 years than countries with illiquid markets.

The second measure of liquidity is the value of traded shares as a percentage of totals market capitalization (the value of stocks listed on the exchange). This turnover ratio measures trading relative to the size of the stock market. Chart 2 indicates that greater turnover predicted faster growth. The more liquid their markets in 1976, the faster countries grew between 1976 and 1993.

The third measure is the value-traded-ratio divided by stock price volatility. Markets that are liquid should be able to handle heavy trading without large price swings. As Chart 3 shows, countries whose stock markets were more liquid in 1976 countries with higher trading-to-volatility ratios grew faster over the next 18 years than countries with less liquid markets. As demonstrated in the series of papers on which this article is based (see back- ground note), the strong link between stock market liquidity and economic growth continues to hold when controlling for other Economic, social, political, and policy factors that may affect economic growth, and when using instrumental variable estimation procedures, various periods, and different country samples. The basic conclusion that emerges from this statistical work is that stock market development explains future economic growth.

What is important is that other measures of stock market development do not tell the same story. For example, stock market size as measured by dividing market capitalization by GDP is not a good predictor of economic growth (Chart 4), while greater stock price volatility does not necessarily predict poor economic performance (Chart 5). Empirically, it is not the size or volatility of the stock market that matters for growth but the ease with which shares can be traded.

Countries may be able to garner big growth dividends by enhancing the liquidity of their stock markets. For example, regression analyses suggest that if Mexico s value-traded-to- GDP ratio in 1976 had been the same as the average for all 38 countries in our sample (0.06 instead of Mexico s actual ratio of 0.01), the annual income of the average Mexican would be 8 percent higher today. This type of forecast does not explain how to enhance liquidity, but it does give an indication of the potentially large economic costs of policy, regulatory, and legal impediments to stock market development.

Is there really a link between stock market liquidity and economic growth, or is stock market liquidity just highly correlated with some nonfinancial factor that is the true cause of economic growth?

Multiple regression procedures suggest that stock market liquidity helps forecast economic growth even after accounting for a variety of nonfinancial factors that Influence economic growth. After controlling for inflation, fiscal policy, political stability, education, the efficiency of the legal system, exchange rate policy, and openness to international trade, stock market liquidity is still a reliable indicator of future long- term growth.

Stock markets versus banks:

Is there and independent link between stock market development and growth, or is stock market liquidity correlated with banking development and is the latter the financial factor that really spurs economic growth?

Although countries with well-developed banks as measured by total bank loans to private enter- prises as a share of GDP tend to grow faster than countries with underdeveloped banks (Chart 6); the effects of banks on growth can be separated from those of stock markets.

To evaluate the relationship between stock markets, banks, and growth, our 38 sample countries were divided into four groups. Group 1 had greater-than-median stock market liquidity (as measured by the value- traded-to-GDP ratio) in 1976 and greater- greater-than-median banking development. Group 2 had liquid stock markets in 1976 but less-than-median banking development. Group 3 had less-than-median stock market liquidity in 1976 but well-developed banks. Group 4 had illiquid stock markets in 1976 and less-than-median banking development.

Countries with both liquid stock markets and well-developed banks grew much faster than countries with both illiquid markets and underdeveloped banks. Furthermore, greater stock market liquidity is associated with faster future growth no matter what the level of banking development. Similarly, greater Banking development implies faster growth no matter what the level of stock market liquidity. Thus, it is not a question of stock market development versus banking develop- mint each, on its own, is a strong predictor of future economic growth.

Why might stock markets and banks both, independently of each other, boost economic growth?

Although the empirical evidence is consistent with the view that stock markets and banks promote economic growth independently of each other, the reasons are not fully understood. One argument is that stock markets and banks provide different types of financial services. Stock markets offer opportunities primarily for trading risk and boosting liquidity; in contrast, banks focus on establishing long-term relationships with firms because they seek to acquire information about projects and managers and enhance corporate control. (There is, of course, some overlap. Like stock markets, banks help savers diversify risk and provide liquid deposits. Like banks, stock markets may stimulate the acquisition of information about firms, because investors want to make a profit by identifying under- valued stocks to invest in; stock markets may also help improve corporate governance by simplifying takeovers, providing an incentive to improve managerial competency.)

Is greater stock market liquidity associated with more or better investment?

Both Chart 7 shows that countries that had more liquid stock markets in 1976 enjoyed both faster rates of capital accumulation and greater productivity gains over the next 18 years However, although liquid equity markets imply more investment, new equity sales is not the only source of finance for this increased investment? Most corporate capital creation is financed by retained earnings and bank loans. Although this phenomenon is not wholly understood, greater stock market liquidity in developing countries is linked to a rise in the amount of capital raised through bonds and bank loans, so that corporate debt-equity ratios rise with market liquidity. Stock markets tend to complement not replace bank lending and bond issues.

Economist believes differently regarding the importance of financial system and its impact on economic growth.

Walter Bagehot (1873) and John Hicks (1969) viewed role of financial system as a critical factor for the mobilization of capital. Joseph Schumpeter (1912) explains that a well developed financial system stimulates funding for entrepreneurs; According to his view, Economic development fabricates demand for financial arrangements, and the financial system automatically counters these demands.

Besides this, some economists just do not believe the role of finance development is crucial to economic growth. Among those (Robert Lucas, 1988) reasoned that economists poorly over-stress the role of financial development for economic growth.

A growing body of work would push even most skeptics toward the belief that the development of financial markets and institutions is a critical and inextricable part of the growth process and away from the view that the financial system is an inconsequential side show, responding passively to economic growth and industrialization. There is even evidence that the level of financial development is a good predictor of future rates of economic growth, capital accumulation, and technological change.

This research paper is based on an existing papers by (Garcia and liu; 1999) and (Julia Losseva, 2006). The main objective of this paper is to find the relationship between stock market development and the economic growth in developed economies. However there is an effort made to address the role of liquidity in the development of stock market which hasn t been given much of the attention.

Some researchers argue that there is no influence of stock market development on economic growth. Recent evidence confirmed that Stock markets may affect economic development by providing liquidity to the market. Usually a profitable investment require long term commitment of the capital however Investors are apprehensive in holding up there capital for long time. Liquid equity market makes facilitates investment and offer quicker ways to alter portfolios so it s vital to both the investor and stock market development.

(King and Levine, 1933) provide mechanism to enhance the economic activity they highlighted that financial system is better able to evaluate and finance the profitable prospective investor. The study explicate that financial institution provide the mechanism of evaluation and monitoring less costly and more efficiently, than the individual investors. Additionally the financial system provides better mobilization of capital and financing to the investors. Therefore promotes the growth by productivity improvements. Besides this financial system also assist in risk diversification for investor in relation to uncertain innovative improvements despite of the fact that financial system distortion result in a reduction over the rate of economic growth. It is stressed that the more developed financial system including banks and stock markets enhances the productivity and stimulate economic growth. Government policy on financial systems may have crucial influence on long run growth.

(Levine and zervos, 1998) proposed that a well functioning stock market and banks enhance long run economic growth.

In light of these conflicting views, this paper uses existing theory to organize an analytical frame work of the finance-growth nexus and then assesses the quantitative importance of the financial system in economic growth.

In light of these conflicting views, this paper uses existing theory to organize an analytical frame-work of the finance-growth nexus and then assesses the quantitative importance of the financial system in economic growth. Although conclusions must be stated hesitantly and with ample qualifications, the preponderance of theoretical reasoning and empirical evidence suggests a positive, first-order relationship between financial development and economic growth.

Broad problem area  Is there a Causal relationship between stock market development and economic growth?

Literature Survey:

Financial development and economic growth: the role of stock markets:

Economists Hold startlingly different opinions regarding the importance of the financial system for economic growth. Walter Bagehot (1873) and John Hicks (1969) argue that it played a critical role in facilitating the mobilization of capital.

Joseph Schumpeter (1912) contends that well functioning banks spur technological innovation by identifying and funding those entrepreneurs with the best chances of success.

In contrast, Joan Robinson (1952, p. 86) declares that, economic development creates demands for particular types of financial arrangements, and the financial system responds automatically to these demands.

The relationship between financial development indicators and economic growth has received a considerable attention in recent empirical literature. Many authors have concluded that the development of the financial system has a positive effect on the rate of economic growth.

And the volume and efficiency of investment Fry, (1997), McKinnon (1973) Shaw 1973, and others such as Kapur (1976), Matheson (1980) and fry (1989) and (1997) have presented the theoretical backward of the relationship . Financial intermediation has positive effect on economic growth.

McKinnon, 1973 and Shaw, 1973; emphasis the role of financial liberalization to increase saving and investment they argued that financial deepening improve not only productivity but also capital and saving. Therefore it improves prospects for investments and growth. Second by reducing the information and transaction cost the financial intermediaries.

The main policy implication of the McKinnon/ Shaw frame work is that government restriction on the financial sector such as interest rate ceilings, high reserve requirements and directed credit policies distort the process of financial development and reduce economic growth. Greenwood and Jovanovic (1990) and king and Levine (1993) argue that the government intervention in the banking system reduces the growth rate of the economy because of the high transaction cost.

Gurley and Shaw 1955, 1960, 1967; centred their theme on the importance of financial intermediation to direct saving to investment. Further to their research Atje and Jovanovich; 1993, link stock market development as a positive sign for economic growth and efficiency. Similarly Levine and zervos; 1998 and Singh; 1997 proposed stock market development as a positive function to the long term growth.

(Gold smith; 1969) emphasized that the well structured financial system facilitates the growth economy and explained the overall positive impact of financial structure on economic growth. Pagano, 1993; identify that there is an increased risk sharing benefits in larger stock markets through market externalities while Levine and bencivenga smith and Starr, 1996; show that the stock market may affect economic activity through the creation of the liquidity similarly Devereux and Smith, 1994; and obstfeld 1994 shows that the risk diversification through internationally integrated stock markets is another vehicle through which the stock markets can effect economic growth.

In the early researches carried out by (Greenwood and jovanovic s, 1990) emphasized the argument that well functioning financial markets lowers the transaction cost which help in directing the capital to most favourable project in terms of returns therefore promotes growth.

Both (McKinnon/ Shaw and Gurley and Shaw 1955, 1960, 1967) stress the role of financial intermediaries on economic growth and they concluded that the easy transfer of funds gears the high social return for economic growth.

(King and Levine, 1933) provided empirical evidence by observing financial intermediaries and their role in economic growth by using a cross country data of 80 different countries establish a direct relationship between a well developed stock market, banking system promotes economic growth.

(King and Levine, 1933) provide mechanism to enhance the economic activity they highlighted that financial system is better able to evaluate and finance the profitable prospective investor. The study explicate that financial institution provide the mechanism of evaluation and monitoring less costly and more efficiently, than the individual investors. Additionally the financial system provides better mobilization of capital and financing to the investors. Therefore promotes the growth by productivity improvements. Besides this financial system also assist in risk diversification for investor in relation to uncertain innovative improvements despite of the fact that financial system distortion result in a reduction over the rate of economic growth. It is stressed that the more developed financial system including banks and stock markets enhances the productivity and stimulate economic growth. Government policy on financial systems may have crucial influence on long run growth.

(Levine and zervos, 1998) proposed that a well functioning stock market and banks enhance long run economic growth.

Joseph Schumpeter s view financial intermediaries are crucial for innovation and economic development and the same argument was concluded in the empirical work by Goldsmith, 1969; McKinnon, 1973); However some economist like Lucas, 1988 believe that financial development is not important for economic growth and describe the relationship of financial development and economic growth as over stressed.

King and Levine strongly hold the view that there is strong relationship between among financial development and real per capita GDP growth and the rate of capital Allocation. They also determined the financial development is robustly correlated with future rates of economic growth.

As a result King and Levine supported the idea which was proposed by Schumpeter 80 years back. In another article (Levine, 1933) develop an endogenous model to clarify the relationship between growth finance and entrepreneurship. The study the role entrepreneurs in initiating economic activity there are two views of Schumpeter; the first one which states that innovation are the motivation to seek temporarily monopoly profit.

The second view which less popular is financial intermediary play a vital role in economic growth because of the fact that these financial intermediaries provide fund to the entrepreneur for their innovative activity and facilitate development of new product in the market.

Previously the economist such as (Schumpeter, 1911) and (Walter Bagehot, 1873) emphasize the role of banking system in economic growth. Beside this historical emphasize on banking system there are few researches on the relationship between stock market and long run growth.

Therefore (Levine and zervos, 1998) focused on stock market by using 47 countries data from (1976 -1993). The study empirically investigates whether banking and stock market indicators are strongly correlated with the current and future rate of economic growth, capital accumulation and productivity growth.

Te evidences are consistent with the views that service provided by financial institution and markets are noteworthy for long run growth as argued by (King Levine, 1933) finally the study summarizes that financial environment plays crucial role in the economic growth process.

In recent papers by (Rajan and Zingales, 1998) contribute to the finance and growth literature by examining whether industrial sector requiring external finance, in countries with well developed financial markets grow faster compared to those less developed financial market. The results are consistent with the theory that financial markets and institution reduce the cost of external finance.

For firms and promote industrial growth a emphasized this would imply that an industry in need of external finance such as pharmaceutical grow relatively faster than tobacco industry requires little external finance in countries with well developed financial system Rajan and Zingales ,1998.

Similarly Demirguc-kunt and Maksimovic, 1966 found consistent results with Rajan and Zingales, 1998 that firms in countries with well functioning banking system and equity markets grow faster than it was predicted to sum up the study suggest that financial development may cause the rise of new firms and can improve the growth indirectly and also finding provide evidence that financial market imperfection have an important role in on investment and growth.

Moreover, some economists just do not believe that the finance-growth relationship is important. Robert Lucas (1988, p. 6) asserts that economists "badly over-stress" the role of financial factors in economic growth, while development economists frequently express their skepticism about the role of the financial system by ignoring it (Anand Chandavarkar 1992).

The link between liquidity and economic development arises because some high-return projects require a long-run commitment of capital, but savers do not like to relinquish control of their savings for long periods. Thus, if the financial system does not augment the liquidity of long-term investments, less investment is likely to occur in the high-return projects. Indeed, Sir John Hicks (1969, pp. 143-45) argues that the capital market improvements that mitigated liquidity risk were primary causes of the industrial revolution in England.

The critical new is capital market liquidity. With liquid capital markets, savers can hold assets-like equity, bonds, or demand deposits-that they can sell quickly and easily if they seek access to their savings. Simultaneously, capital markets transform these liquid financial instruments into long-term capital investments in illiquid production processes.

With liquid capital markets, savers can hold assets-like equity, bonds, or demand deposits-that they can sell quickly and easily if they seek access to their savings. Simultaneously, capital markets transform these liquid financial instruments into long-term capital investments in illiquid production processes.

Informational asymmetries and transaction costs may inhibit liquidity and intensify liquidity risk. These frictions create incentives for the emergence of financial markets and institutions that augment liquidity. Liquid capital markets, therefore, are markets where it is relatively inexpensive to trade financial instruments and where there is little uncertainty about the timing and settlement of those trades. Before delving into formal models of liquidity and economic activity, some intuition and history may help motivate the discussion.

Demirguc kunt and Levine; 1996 identifies the relationship between stock market development and financial intermediary development. They find that better developed stock markets also have better developed financial intermediaries. Levine and Zervos; 1998; proposes that liquidity of the stock market is significantly correlated with current and future rates of economic growth. They also discovered that stock market liquidity and banking development significantly predict future areas of growth.

Demirguc kunt and Levine, 1996; investigated the relationship between stock market development and financial intermediary development they also found that those countries having well developed stock markets have better developed financial intermediaries. Therefore they concluded that stock market development goes hand in hand with financial intermediary development.

The financial development and its impact on new firms creation are investigated by (Beck, Demirguc-kunt and Levine, 2001) and the impact of economic development and financial structure on industry growth are examined by using country industry panel based on work by Rajan and Zingales, 1998 it is questions that whether industries that heavily depend on external finance grow faster in market or bank based financial system.

Whether the level of financial development is a matter for economic development , beck Demirguc kunt and Levine, 2001 found that the banks non banks financial intermediaries and stock market are larger more active and more efficient in richer countries. These characteristics of financial system develops as countries become wealthier also the result indicates that while countries become wealthier stock markets become more active and efficient relative to the banks the more important finding of the article is that externally dependent industries grow relatively faster in countries with better developed financial systems which is consistent with the financial services view predicting that industries that dependent on external finance grow faster in economies with a higher level of financial development grow relatively faster in countries with better developed financial systems, which is consistent with the financial services view predicting that the industries that dependent on external finance grow faster in economies with a higher level of financial development.

Further to their research by using 44 industrial and developing countries they investigated that institutionally developed market with strong information disclosure laws, international accounting standards and unrestricted capital flows are larger more liquid markets with less volatility and are internationally integrated with smaller markets.

(Levine and Renelt, 1992; Arestis and Demetriades, 1997; Luintel and khan 1999) regarded the presence of endogeneity which weakens the estimated effect of stock market indicators (Harris, 1997) as in case of cross country regression to establish the relationship between stock market development and economic growth.

Thus our results may be indirectly valuable for less developed economies in way that may help policy decision relating to the adoption of specific types of financial system.

Informational asymmetries and transaction costs may inhibit liquidity and intensify liquidity risk. These frictions create incentives for the emergence of financial markets and institutions that augment liquidity. Liquid capital markets, therefore, are markets where it is relatively inexpensive to trade financial instruments and where there is little uncertainty about the timing and settlement of those trades.

The ability to acquire and process information may have important growth implications. Because many firms and entrepreneurs will solicit capital, financial intermediaries, and markets that are better at selecting the most promising firms and managers will induce a more efficient allocation of capital and faster growth (Jeremy Greenwood and Boyan Jovanovic 1990). Bagehot (1873, p. 53) expressed this view over 120 years ago.

Acquiring Information about Investments and Allocating Resources It is difficult and costly to evaluate firms, managers, and market conditions as discussed by Vincent Carosso (1970). Individual savers may not have the time, capacity, or means to collect and process information on a wide array of enter-prises, managers, and economic conditions.

Information acquisition costs create incentives for financial intermediaries to emerge (Diamond 1984; and John Boyd and Edward Prescott 1986). Assume, for example, that there is a fixed cost to acquiring information about a product-ion technology. Without intermediaries, each investor must pay the fixed cost. In response to this information cost structure, however, groups of individuals may form (or join or use) financial intermediaries to economize on the costs of acquiring and processing information about investments.

Information costs, however, may also motivate the emergence of money. Because it is costly to evaluate the attributes of goods, barter exchange is very costly. Thus, an easily recognizable medium of exchange may arise to facilitate exchange (King and Charles Plosser 1986; and Williamson and Randall Wright 1994).

The financial system's ability to provide risk diversification services can affect long-run economic growth by altering resource allocation and the saving rates. The basic intuition is straightforward. While savers generally do not like risk, high-return projects tend to be riskier than low-re-turn projects. Thus, financial markets that ease risk diversification tend to induce a portfolio shift toward projects with higher expected returns (Gilles Saint-Paul 1992; Michael Devereux and Gregor Smith 1994; and Maurice Obstfeld 1994).

Furthermore, a growing literature shows that differences in how well financial systems reduce information and transaction costs influence saving rates, investment decisions, technological innovation, and long-run growth rates.

If we will consider the discussion exist on the relationship between the financial system and economic growth; financial markets development is always considered as pivotal element for growth of economy through the diverse contribution of stock markets and banks.

Stiglitz (1985) argues that, because stock markets quickly reveal information through posted prices, there will be few incentives for spending private resources to acquire information that is almost immediately publicly available.

The absence of financial arrangements that enhance corporate control may impede the mobilization of savings from disparate agents and thereby keep capital from flowing to profitable investments (Stiglitz and Andrew Weiss 1981, 1983). Because this vast literature has been carefully reviewed (Gertler 1988; and Andrei Shleifer and Robert Vishny, forthcoming), this subsection notes a few ways in which financial contracts, markets, and institutions improve monitoring and corporate control, and reviews how these financial arrangements for monitoring influence capital accumulation, resource allocation, and long-run growth.

On the other hand Levine at al. 200 focus on the connection between financial intermediaries and the economic growth and the research question is that whether better functioning financial intermediaries account for a causal effect on the economic growth if so what determines the level of financial development, hence results might help the policy maker to adopt new incentives to develop specific financial sector in order to promote economic growth Levine et al. 2000 believe that financial development is an important indicator of future economic growth and it might be leading predictor rather than underlying cause of economic growth.

Economists have recently modelled the emergence of financial markets in response to liquidity risk and examined how these financial markets affect economic growth.

Theory, however, suggests that enhanced liquidity has an ambiguous affect on saving rates and economic growth in most models, greater liquidity.

  1. Increases investment returns<./li>
  2. Lowers uncertainty.

Higher returns ambiguously affect saving rates due to well-known income and substitution effects. Further, lower uncertainty ambiguously affects savings rates (David Levhari and T. N. Srinivasan 1969). Thus, saving rates may rise or fall as liquidity rises.

Indeed, in a model with physical capital externalities, saving rates could fall enough, so that growth actually decelerates with greater liquidity (Tullio Jap-pelli and Marco Pagano 1994). Besides reducing liquidity risk, financial systems may also mitigate the risks associated with individual projects, firms, industries, regions, countries, etc. Banks, mutual funds, and securities markets all provide vehicles for trading, pooling, and diversifying risk.

Causality between financial development and economic growth:

               It is now well recognised that financial development is critical for economic growth. Recent literature on growth deals with the causal relationship along three lines

  1. Financial Deeping stimulates economic growth:
  2. Some analyst suggests that the financial development has a causal influence on economic growth. The financial sector increases saving and allocates them to more productive investments.

  3. Economic growth promotes the development of the financial sector :
  4. Some of the analyst thought financial development appears as a consequence of the overall economic development Continual economic expansion requires more financial services and new instruments. The financial system adapts itself to the financing needs of itself to the financing needs of the real sector and fits in the autonomous development.

  5. A circular relationship that financial development and the economic growth simultaneously affect each other:
  6. Reciprocal relationship; economic growth makes the development of the financial intermediation system profitable and the establishment of an efficient financial system permits faster economic growth.

Specifically, countries with larger banks and more active stock markets grow faster over subsequent decades even after controlling for many other factors underlying economic growth.

Industries and firms that rely heavily on external financing grow disproportionately faster in countries with well developed banks and securities markets than in countries with poorly developed financial systems. Moreover, ample country studies suggest that differences in financial development have, in some countries over extensive periods, critically influenced economic development. Economic activity and technological innovation undoubtedly affect the structure and quality of financial systems. Innovations in telecommunications and computing have undeniably affected the financial services industry. Moreover, "third factors," such as a country's legal system and political institutions certainly drive both financial and economic development at critical junctures during the growth process.

Nevertheless, the weight of evidence suggests that financial systems are a fundamental feature of the process of economic development and that a satisfactory understanding of the factors underlying economic growth requires a greater understanding of the evolution and structure of financial systems.

In arising to ameliorate transaction and information costs, financial systems serve one primary function: they facilitate the allocation of resources, across space and time, in an uncertain environment (Merton and Bodie 1995, p. 12).

Based on previous literature we will investigate below mentioned variables as determinants of stack market development. Financial Intermediary Development, Regulatory framework, Income growth, Savings and investment, financial development, Inflation, Market capitalization, stock Market liquidity, GDP, Gross fixed investment.

Real income has been found to be highly correlated with stock market development. Typically the higher the saving the higher the amount of capital flows towards stock market. The speed at which investor buy or sell the securities is pivotal to the development of stock market hence the liquidity of the market is (miller, 1991) hence without liquid stock market less investment may occur.

A growing body of work would push even most skeptics toward the financial factors in economic growth, while development economists frequently express their skepticism about the role of the financial system by ignoring it (Anand Chandavarkar 1992).

Put differently, in a Kenneth Arrow (1964)-Gerard Debreu (1959) state-contingent claim framework with no information or transaction costs, there is no need for a financial system that expends resources researching projects, scrutinizing managers, or designing arrangements to ease risk management and facilitate transactions. Thus, any theory of the role of the financial system in economic growth (implicitly or explicitly) adds specific frictions to the Arrow- Debreu model.

Financial markets and institutions may arise to ameliorate the problems created by information and transactions frictions. Different types and combinations of information and transaction costs motivate distinct financial contracts, markets, and institutions.

In arising to ameliorate transaction and information costs, financial systems serve one primary function: they facilitate the allocation of resources, across space and time, in an uncertain environment (Merton and Bodie 1995, p. 12).

Thus, economic growth provides the means for the formation of growth-promoting financial intermediaries, while the formation of financial intermediaries accelerates growth by enhancing the al-location of capital. In this way, financial and economic development is jointly determined (Greenwood and Jovanovic 1990).

Evidence on the relationship between financial structure and the functioning of the financial system, however, is more inconclusive.

The Level of Financial Development and Growth: Cross-Country Studies consider first the relationship between economic growth and aggregate measures of how well the financial sys-tem functions. The seminal work in this area is by Goldsmith (1969). He uses the value of financial intermediary assets divided by GNP to gauge financial development under the assumption that the size of the financial system is positively correlated with the provision and quality of financial services. Using data on 35 countries from 1860 to 1963 (when avail-able) Goldsmith (1969, p. 48) finds:

Goldsmith's work, however, has several weaknesses: (a) the investigation involves limited observations on only 35 countries; (b) it does not systematically control for other factors influencing economic growth (Levine and David Renelt 1992); (c) it does not examine whether financial development is associated with productivity growth and capital accumulation; (d) the size of financial intermediaries may not accurately measure the functioning of the financial system; and (e) the close association between the size of the financial system and economic growth does not identify the direction of causality.20.

Recently, researchers have taken steps to address some of these weaknesses. For example, King and Levine (1993a, 1993b, 1993c) study 80 countries over the period 1960-1989, systematically control for other factors affecting long-run growth, examine the capital accumulation and productivity growth channels, construct additional measures of the level of financial development, and analyze whether the level of financial development predicts long-run economic growth, capital accumulation, and productivity growth. (Also, see Alan Gelb 1989; Gertler and Andrew Rose 1994; Nouriel Roubini and Xavier Sala-i- Martin 1992; Easterly 1993; and the overview by Pagano 1993.).

They use four measures of "the level of financial development" to more precisely measure the functioning of the financial system than Goldsmith's size measure. Table 1 summarizes the values of these measures relative to real per capita GDP (RGDP) in 1985.

The second measure of financial development, BANK, measures the degree to which the central bank versus commercial banks is allocating cr.

The role of stock and credit market in the economic development has been an important subject of economic analysis. The main question is whether the stock or the credit market either follows or precedes economic development (Dritsaki and Dritsaki Bargiota, 2006).

The subject under preview was initially studied by Schumpeter (1912), who considers that the development of the financial sector of a country affects not only the level but also the rate of growth.

Other important studies are those of Lewis (1955) and Jung (1986). Lewis (1955), confirmed the existence of a bilateral relationship between the financial development and the real growth while Jung (1986) found a unilateral relationship from financial development to economic growth for the LDCs (Less Development Countries) and the reverse causal direction is valid for the DCs (Developed Countries).

According to Levine and Zervos (1993), the stock market development is strongly correlated to the growth rates of real GDP per capita, while they found that the stock market liquidity and banking development may well predict the future growth rate of the economy.

Other important studies that used the Granger causality tests are those by Luintel and Kahn (1999), Kar and Pantecost (2000), Shan and Morris (2002), and Dritsaki and Dritsaki - Bargiota (2006).

To be more specific, Luintel and Kahn (1999), found a bi  directional causality between the financial development and economic growth through the empirical investigation of the long  run relationship in ten sample countries. Furthermore, Kar and Pantecost (2000) that used data from Turkey found that economic growth leads financial development. The most significant finding though, is that the direction of causality between financial development and economic growth is related to the choice of measurement for financial development, at least in the case of Turkey.

Shan and Morris (2002), found results that contradict those of Kar and Pentecost (2000). With the employment of Granger causality tests found that there is no causal relationship between financial development and economic growth in the most countries out of the 19 OECD countries.

Finally, Dritsaki and Dritsaki - Bargiota (2006), found a bilateral causal relationship between the banking sector development and economic growth, a unidirectional relationship between economic growth and stock market development in the case of Greece..

The present paper has as an objective to investigate the causal relationship between the stock market, the credit market and their role in the economic development. This study involves a transition economy, to be more specific Bulgaria and presents a great importance due to the special way that the particular markets function in such an economy. Another interesting feature is the entrance of Bulgaria in the EU as well as the adaption of euro as a national currency of the economy.

What also must be mentioned is the openness of the economy and the inflow of the foreign capitals to the domestic economy, while at the same time the inflation may well be a factor that affects the link between banks, stock markets and economic growth; To be more specific Boyd et al. (2000), have shown that for countries with low  to moderate inflation, the inflation rates (as Bulgaria is the last few years) there is a strongly negative relationship between the banking and stock market development with inflation. Additionally, higher long  run inflations may lead to slower economic growth. For the reasons mentioned above the inflation should be tested as exogenous variable. Furthermore, the Granger causality test may confirm or not, the existence of a unilateral or bilateral relationship among the economic growth, the development in the banking sector and the development in the stock market.

Thus, the present paper studies the validity of the theories that suggest that the financial development plays an important role in the process of the economic growth.

Financial development and economic growth: the role of stock markets:

The role taken by stock market and the ever increasing dependence of economic growth on financial growth provides new opening to research in to the relationship between financial development and economic growth, which focuses the effect of stock market development.

Numerous studies have been carried out to reveal the relationship of stock market development and its role in economic growth by using the economic indicators to explain the part of the variation of growth development rates across countries. (Atje and Jovanovic 1993; Levine and zervos 1998) provided a cross country growth analysis using regression analysis to measure the effect of the economic indicators on banking system since these results are obtained by using cross country regression analysis which doesn t provides a precise view the relationship of stock markets and growth.

Further to their analysis there is a wide spread critique concerning the robustness of the econometric results which have been raised because of using cross country growth regressions. So these results must be viewed with some caution.

There is considerable econometric advantage if we deploy time series analysis instead of cross country regression analysis in examining the role of stock markets in the relationship between financial development and growth; this will better enable us to address of issue of causality and there are less likely that the research will suffer from other limitation of cross country growth regressions. Times series method also provides useful insight in identifying the relationship across countries and clarifies important details that are hidden in averaged out results.

The paper utilizes the time series analysis to examine the relationship between economic growth and stock market development while controlling the effect of commercial banking and stock market volatility.

Time series analysis has its own limitation; e.g. we need to obtain long time series of stock market development indicators which narrows down the focus of empirical analysis to five developed economies namely Germany, United States, Japan United Kingdom and France.

While the absence of less developed economies form our sample means that no direct inferences can be made about the contribution of stock markets at early stages of economic development our finding never the less have implication for the debate on bank based versus capital market based financial system which has been already been discussed by the following researchers (Rajan and Zingales 1995, 1996) and (Horace, okazaki 1994); (Edwards and Fischer, 1994); (Corbett and jenkinson; 1994).

Thus our results may be indirectly valuable for less developed economies in way that may help policy decision relating to the adoption of specific types of financial system.

The paper is structured as follow.

In section 1 we provide the role of stock markets and banks in the process of economic growth in section 2 we provide our data and econometric methodology in section three we present finding and discussions and their implications and debate on financial system. And the last section 4 will provide the summary and some concluding remarks.

STOCK MARKETS AND BANKS AND ECONOMIC GROWTH:

Positive effect of stock markets:

Recent studies suggest that stock markets may contribute to long run growth. Stock market encourage specialization as well as acquisition and dissemination of information (diamond, 1984; greenwood and Jovanovic 1990; Williamson 1986) and may reduce the cost or saving thereby facilitating investments. (Greenwood smith, 1997) well developed stock markets may enhance corporate control by mitigating the principal agent problem through aligning the interest of managers and owners.

Tips for policymakers:

Given the important role well-functioning stock markets seem to play in economic growth, what can countries do to promote them? Fully answering this question is well beyond the scope of any single article. Legal, regulatory, accounting, tax, and supervisory systems influence stock market liquidity. The efficiency of trading systems determines the ease and confidence with which investors can buy and sell their shares. And the macroeconomic and political environments affect market liquidity.

Consider the impact of one particular policy lever: liberalizing controls on international capital flows. Liberalization may involve easing restrictions on capital inflows or reducing impediments to repatriating dividends or cap- ital. In either case, reducing barriers to cross- border capital flows can affect the functioning of emerging stock markets: first, by enhancing the integration of emerging markets into world capital markets, thereby bringing the prices of domestic securities into line with those elsewhere; and, second, by forcing.

However As shown in Chart 5, volatility does not have any measurable effect on long-term growth. Thus, if policymakers have the patience to weather some short-run volatility, lib- realization offers expanded opportunities for long-run economic growth.

Does every country need an active stock market of its own?

Unfortunately, there is not much evidence available to answer this question. In principle, all countries do not need domestic stock markets. They do, however, need easy access to liquid stock markets where residents and domestic firms can buy, sell, and issue securities. It is the ability to trade and issue securities easily that facilitates long-term growth, not the physical location of the market. In other words, there is little reason to believe that California would grow faster if the New York Stock Exchange were moved to Los Angeles.

When should policymakers really push stock market development? This is even more uncertain. The available information suggests that policy maker Domestic firms seeking foreign investment to upgrade their information disclosure policies and accounting systems. Moreover, the entry of more foreign investors into emerging markets may lead to pressure to upgrade trading systems and modify legal systems to support more trading and the introduction of a greater variety of financial instruments.

Through all of these channels, the removal of barriers to foreign investment can improve the operation of domestic capital markets. This is consistent with recent evidence. As shown in the table, stock market liquidity raised significantly in 12 out of 14 countries those lib- realized controls on international capital flows. Chile, for example, liberalized restrictions on the repatriation of dividends by foreign investors in January 1988. None of the 14 countries experienced a statistically significant drop in liquidity following liberalization. In conjunction with the earlier findings that market liquidity boosts economic growth, these results suggest that liberalizing international capital flow restrictions can accelerate economic growth by enhancing stock market liquidity.

The table also indicates, however, that stock market volatility rose in 7 out of 11 countries following liberalization. Volatility did not fall significantly in any of the 11 countries following liberalization. Thus, while easing international capital flow restrictions may increase liquidity, it may also increase volatility. This should not be of much concern in the long run should remove impediments tax, legal,and regulatory barriers to stock market development. But there is not strong evidence to support interventionist policies like tax incentives that artificially boost stock market size and activity.

While much work remains to be done, a growing body of evidence suggests that stock markets are not merely casinos where players come to place bets. Stock markets provide ser- vices to the nonfinancial economy that are crucial for long-term economic development. The ability to trade securities easily may facilitate investment, promote the efficient allocation of capital, and stimulate long-term economic growth. Furthermore, the evidence suggests that stock market liquidity encourages or at least strongly forecasts corporate investment, even though much of this investment is financed through retained earnings, bank loans, and bonds, rather than equity issues. Policymakers should consider reducing impediments to stock market development. Easing restrictions on international capital flows would be a good place to start.

Own contribution and proposed methodology:

I will use econometric analysis to find out what is the key to stock market development. We will follow the work of Garcia and Liu (1999). I will perform a panel regression on the pooled dataset constituting the United Kingdom, France, Italy and Spain. Unlike other research I am going to cover past 18 years in my panel set of data (1990-2008).

I will test the following determinate of stock market development (market capitalization), economic growth, turnover ratio, GFI, FDI, and Inflation government debt risk, privatization risk, banking index and financial intermediary development.

The main sources of my data are EBRD, and UNCTAD statistical tables And S&P. The data will cover the listed and major sock holding companies.

Description of the model:

This paper will undergo cross sectional analysis over a period of 1990 to 2008. We will not use simple regression analysis because of the possibility of omitting important variables. As a result we will use panel data with a large number of observations to increases the degrees of freedom and by decreasing the correlation between explanatory variables which in turn gives a better statistical result. Therefore we will run a regression by using the following equation.

YSMD = a + ²i xt + U

 a &  ² are constants and  X is a variable. Following is the general assumption of OSL. The term  a is specific for an individual country and varies across different countries. We will further refine our regression equation as we proceed with the project.

The focus will be to compare the differences of emerging markets of South Asia with west Asia. To make our research more conclusive we will put a strong emphasize on liquidity of stock market which can give better prospects for the stock market development and the overall economic growth.

We will get the data from UNCTAD united nation conference on trade and development.Afterwards the determinant identifies and discussed in the literature review will undergo panel regression and we will see the correlation between different variables. This will follow the implication of the research.

TEST OF CO INTEGRATION CO INTEGRATION TEST:

This study uses Granger causality test proposed by Granger; 1969 for testing the causality between stock market growth and economic growth.

The hypotheses of interest are,

  1. Stock market (Granger) development cause economic growth.
  2. Stock market development doesn t (Granger) cause economic growth.
  3. Stock market growth doesn t causes (Granger) Economic growth and vice versa (i.e. there is no bilateral causation)

The study of this relationship has been achieved with the implementation of co integration test. The co integration test was preceded by a stationarity test (ADF test). In particular, a multivariate autoregressive VAR model will be used while other independent variables, GDP, stock market capitalization will be used as exogenous variables. Furthermore, Granger causality tests were applied in order the causal relationship between SMD development, economic growth (IPI) and stock market development (capitalization index) to be examined.

We will conduct also the Granger causality test: Granger s test is used when the variable is stationary or co integrated.

Regression: xt=c+±xt-1+²yt-1+ut.

Test H0: ²=0 (Time Series Econometrics, J. Hamilton, P.G. 302).

The process of cointegration should be followed by the estimation of a VAR model in which a vector error correction mechanism should be included. This process is necessary given the fact that the variables under preview in logarithmic form are cointegrated.

Unit Root Test:

In order to apply the cointegration technique as mentioned above, we examine the stationarity of the time series studied. A pre-condition for the implementation of a multi - VAR cointegration technique is the unit root test.

The unit root test for our data will be Augmented Dickey Fuller (ADF) test (1979). The ADF (1979) test has been widely used for testing the existence of a unit root in the time series studied. This test is based on the following auxiliary regression of the general form;

Where;

This test aims at testing the null hypothesis that ³2 = 0 which is tantamount for a single unit root in the data generating process for pt. In order to determine the ADF form the significance of the constant was examined as well as the significance of the coefficient of the trend. Following these steps we ended up to the final form of the regression that includes no constant and no time trend.

Cointegration with the Johansen technique:

The cointegration analysis will be based on Johansen s multivariate cointegration methodology. Additionally, the estimation of the cointegration vectors will be applied with the treatment of the Johansen s maximum likelihood approach. According to Johansen (1988) any p  dimensional vector autoregression can be written in the following  error correction representation.

Where;

Xt: p  dimensional vector of I (1) processes,

¼: a constant

µt: a p  dimensional vector with zero mean (  is the variance  covariance matrix)

The   matrix has a rank that is limited in the (o, r) and can be decomposed into:

Where;

±, ²: p x r matrices

r: distinct cointegrating vectors.

The procedure of Johansen provides the maximum likelihood estimates of ±, ², while   and the two likelihood ratio test statistics determine the order of the cointegration space. The trace and the maximum eigenvalue statistics are used to determine the rank of   and to reach a conclusion on the number of cointegrating equations, r, in our multivariate VAR system. The economic time series studied are I(1), while when only one relationship in the long run exists their combination is I(0).

VAR Model with an Error Correction Mechanism:

The error correction model may well be derived by the long run cointegration vector having the following form;

Where;

": denotes the first differences of the variables.

: are the estimated residuals from the cointegrated regression

´: is the short run parameter that takes values in the (0,1)

ut: is a white noise.

What must be underlined in the process of estimation of a VAR model is the criterion used for the correct specification of the model. In particular, the researcher should predetermine the deterministic components as well as the number of lags used in the model. In this study the Schwartz  Bayesian criterion (1978), was used which according to Mills and Prasad (1992) outperforms other criteria.

Bibliography:

  • Atje, Raymond, and Boyan Jovanovic. 1993.  Stock Markets and Development, European Economic Review 37 (2/3), pp. 632-40.
  • Losseva, Julia; 2006. The determinants of stock market development in central European and eastern countries
  • Andriesz, Asteriou, Pilbeam. The linkage between financial liberalization and economic development, empirical evidence from Poland
  • valeriano f. Garcia and lin liu Journal of applied economics, vol. Ii, no. 1 (may 1999), 29-59 macroeconomic determinants of stock market development
  • Bencivenga, Valerie R., Bruce D. Smith, and Ross M. Starr. 1996.  Equity Markets, Transactions Costs, and Capital Accumulation: An Illustration The World Bank Economic Review 10 (2).
  • Demirguc-Kunt, Asli, and Ross Levine 1996a.  Stock Markets, Corporate Finance and Economic Growth: An Overview, The World Bank Economic Review 10 (2), pp. 223-239.
  • Demirguc-Kunt, Asli, and Ross Levine. 1996b.  Stock Market Development and Financial Intermediaries: Stylized Facts, The World Bank Economic Review 10 (2), pp. 291-321.
  • Garcia, Valeriano F. 1986.  A Critical Inquiry into Argentine Economic History 1946- 1970 Garland Publishing Co. New York.
  • Goldsmith, Raymond W. 1969. Financial Structure and Development, New Haven, CN: Yale University Press.
  • Gurley, John, and Edward Shaw. 1955.  Financial Aspects of Economic Development, American Economic Review, pp. 515-38.
  • Gurley, John, and Edward Shaw. 1960. Money in a Theory of Finance, Washington, DC: Brookings Institutions.
  • Gurley, John, and Edward Shaw. 1967.  Financial Structure and Economic Development, Economic Development and Cultural Change 34 (2), pp. 333-46.
  • King, Robert G., and Ross Levine. 1993a.  Finance and Growth: Schumpeter Might Be Right, Quarterly Journal of Economics 108, No. 3, pp. 717-38.
  • King, Robert G., and Ross Levine. 1993b.  Finance, Entrepreneurship and Growth: Theory and Evidence, Journal of Monetary Economics 32, pp. 513-42.
  • Levine, Ross. 1997.  Financial Development and Economic Growth: Views and Agenda, Journal of Economic Literature 35 (2), pp. 688-726.
  • Levine, Ross and Sara Zervos. 1996.  Stock Market Development and Long- Run Growth The World Bank Economic Review, Vol. 10, No.2.
  • Levine, Ross and Sara Zervos. 1998.  Stock markets, Banks, and Economic Growth The World Bank Policy Research Working Paper No. 1690, December 1996.
  • Levine, Ross, and Sara Zervos. 1998.  Stock Markets, Banks, and Economic Growth, American Economic Review 88 (2), pp. 537-58.
  • Liu, Lin, 1998.  Financial Development and Economic Growth: A Literature Review, Mimeograph. The World Bank, Washington, DC.
  • McKinnon, Ronald I. 1973. Money and Capital in Economic Development, Washington, DC: The Brooking Institution.
  • Market and Economic Development: An empirical evidence for transition economies; The case of Bulgaria (Theodoros1, Eleni, Sofios; 2000)

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