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Connection Between Economic Growth And Stock Market Advancement Finance Essay

Macroeconomic indicators comprise a range of variables which include rates of inflation and interest, exchange rate, foreign direct investment, money supply, investment expenditure, consumption expenditure and output. Output is also known as gross domestic product (GDP), which is the worth of the combine production of goods and services in a country during a year. The aggregate value consist of various sectors and sub-sectors in an economy that varies country to country.

Transformation in fundamentals of economy and variation in expectations about future outlook are sensitive for movement of stock market indices. Domestic economic rudiments perform seminal role in the functioning of stock market. Stock market provides a platform for trade of securities such as buying and selling of stock. It brings together enterprises that wish to raise capital through the issue of new stock and individuals and organizations seeking to invest savings or surplus funds. Stock market arranges to match the diverse interests with various needs of investors in terms of risk, return, capital gain etc. It is essential that the stock market is efficient, so that the buyers and sellers may able to get realistic prices for holding shares. For rapid industrial growth and economic development sound capital market is an essential prerequisite. Karachi Stock Exchange, the premier stock market of Pakistan, has made substantial progress both in terms of area of its operations and growth of listed companies since its establishment.

The global growth of stock markets and the emerging market boom have attracted the attention of academics, practitioners and policy makers. There has been considerable debate by investigator on the causal association between stock market progression and economic development with studies establishing uni-directional and bi-directional i.e. causality running from stock market development to economic growth and from both directions. Levine and Zervos (1996) outlined that functioning of equity markets affects liquidity, risk diversification, acquisition of information about firms, corporate control and savings mobilization. By altering the quality of these services, the functioning of stock markets can alter the rate of economic growth. Demirgüç-Kunt and Maksimovic (1996) explained that stock markets serve important functions even in those economies in which a well-developed banking sector already exists, the reason being that equity and debt financing are not commonly prefect substitutes. Equity financing has a key role in the management of the conflicts of interest that may arise between different stakeholders in the firm. Levine (1997) stated the ability of stock market to exercise corporate governance for example public trading of shares in the equity markets which productively reveal information about company’s owners to tie managerial reparation to shares value, thus, connecting stock accomplishment to manager compensation facilitates bring into line the concentration of administrator with those of owners. Arestis et al. (2001) demonstrated that at the aggregate amount increased stock market capitalization could be together with a boost in the level of bank business, if not a rise in fresh lending, as financial intermediaries probably offer complementary services to issuers of fresh equity in shape of underwriting. Capasso (2006) stated that the Dynamic of capital markets reliant on the degree of economic performance as well as growth of equity market itself. Particularly, when economies have small and immature equity markets, capital accretion leads to a rise in the share in the economy of bank and debt financing. As economies expand and capital markets further progress, additional development of capital markets result in enhancement of equity financing in the economy. Yartey and Adjasi (2007) augmented the ability of efficient stock markets to reduce the cost of information. It is suppose to do so through the creation and dissemination of company specific information that efficient stock prices reflect. Equity markets are categorized efficient when prices assimilate all available information. Decreasing the costs of acquiring information is attributed to assist and make better the acquisition of information regarding the investment opportunities and therefore exert positive influence on allocation of resources.

1.2 Problem Statement:

The study endeavors to investigate the connection between economic growth and stock market advancement in case of developing economy such as Pakistan. The conceptual and theoretical framework of this study is set up on the ground of uni-directional causality running from economy to stock market.

1.3 Hypothesis:

Economic development increases stock market capitalization.

1.4 Outline of the Study:

The thesis is structured as follows: Chapter 2 provides literature review, Chapter 3 presents research method, Chapter 4 explains results and finally Chapter 5 reports discussions, conclusion, implications, recommendations and future research.

CHAPTER 2: LITERATURE REVIEW

The increasing significance of capital markets throughout the world has recently unlocked a new opportunity of research into the relationship between financial improvement and economic growth, which concentrated on the consequence of stock market development. Researchers attempted to exemplify whether, how and to what extent the stock market development such as stock market capitalization, liquidity, volatility, size, risk diversification, information dissemination and global integration can contribute in the process of economic growth. The summaries of some of these studies are presented below:

2.1 Saving Mobilization:

The role of stock markets, banks and financial intermediaries also characterized as a source of domestic and international saving mobilization that significantly contributes in the process of economic growth.

Levine and Zervos (1996) stipulated that large, liquid and efficient stock markets supposed to ease saving mobilization. By agglomerating savings, stock markets broaden the set of worthy investment projects. Levine (1997) revealed that mobilizing includes the generation of small denomination instruments. These instruments offer opportunities for individuals to retain branch out portfolios, spend in efficient scale organizations, and enhance asset liquidity. Caporale, Howells and Soliman (2003) suggested that stock market is expected to boost savings by providing individuals with an additional instrument which inspiration may greater in meeting individuals risk preferences and liquidity requirements. In a well-developed stock market, stock ownership promotes households with a comparatively liquid means of sharing risk in investment projects. Azarmi et al. (2005) suggested that the stock market contributes to economic development through (a) being an initial source and a facilitator of equity finance (b) being an efficient mechanism for spreading ownership widely in the population and mobilizing the savings of population (c) being a highly efficient mechanism for allocating capital to productive use (d) facilitating a link between the capital markets of a particular country and the markets of the industrial world. Yartey and Adjasi (2007) described that stock market also propose an opportunity for growing companies to raise capital at lower cost, besides this, companies are less dependent on bank financing in countries where stock markets are well-developed, which ultimately minimize the risk of a credit crunch. Therefore equity market can have profound impact in accelerating economic growth through encouraging savings amongst households and providing avenues for corporate financing. Mun et al. (2008) suggested that well-developed capital market may provide liquidity that reduces the cost of the foreign capital necessary for development, thereby, economy with increased development of stock market tends to produce more domestic savings. Shahbaz, Ahmed and Ali (2008) stated that an organized and managed capital market attract investment opportunities by recognizing and funding productive projects that spurs to economic activity, mobilize domestic savings, contribute to diversify risks, allocate capital proficiency and facilitate exchange of goods and services.

2.2 Agency Theory:

Eisenhardt (1989) stated that agency theory deals with two issues that can happen in agency affairs. The first is the agency trouble that takes place when (a) the requirements or aims of the principal and agent differ and (b) it is complex or costly for the principle to confirm what the agent is really doing. Jensen and Murphy (1990) explained the difference of interest between the corporation’s chief executive and shareholders of a publicly owned corporation is remarkable example of principal-agent problem. Managerial actions and investment opportunities are not perfectly observable by shareholders, even shareholders are not aware what actions the CEO can take or which of these actions may appreciate shareholder wealth. In these conditions, agency theory envisages to plan compensation policy that provide the manger inducements to select and implement measures that boost shareholders wealth, it implies that efficient stock market help to mitigate the principal-agent problem through tying manager compensation to stock performance. Stiglitz (1985) demonstrated role of stock market in exerting corporate control and takeover threats (a) if an acquiring firm disburse lots of resources gaining information, the consequence of this activities examined by other souk members when the acquiring firm tendering for shares. This influences others to bid for shares, which drives increase in stock prices. Therefore the firms that employed resources obtaining information must pay a higher price than it might have to disburse in case “free-riding” firms unable to examine its bid (b) existence of public good nature to takeovers that may reduce the inducement for takeovers. In case the conquest turns out well, and the stock prices rises then those original shareholders who retained the stocks get a substantial returns with no directing resources. Hence, value escalating takeovers perhaps not succeed as the acquiring firm require to pay a high price, which may reduce incentives for researching firms in hope of takeover (c) modern managers often can take strategic actions to discourage takeovers and maintain firm’s positions. Scharfstein (1988) explained that shareholders unable to determine whether firm value is low for the reason the manager shirked or simply because the firm’s environment was undesirable. If value of the firm is low due to the manager shirked, the likelihood of a takeover is high; shareholders offer holding shares at a low price because shareholders perceive the value of the firm to be low, while the raider knows that the value of the firm is high if it runs properly. On the other hand, if firm value is low simply given that the environment is unfavorable, the probability of takeover is low, shareholders still tender shares at a low price, but the raider does not value the firm as highly. Thus, the takeover mechanism produces a means of penalizing the manager precisely when firm value is low because the manager shirked and not because the environment was unfavorable. Caporale et al. (2003) suggested that financial markets can also influence economic growth through the information channel for example stock market function as a monitor of managerial performance because the stock price incorporates performance information that cannot be extracted from a firm’s current or future data. A poorly performing management may become the target of a take-over. Thus, the information that is reflected in a firm’s share price is important for structuring managerial incentives to build up a firm’s productivity, and hence economic growth in aggregate. Capasso (2006) stated that continues monitoring and control on firms’ management create the most effective incentives for managers to decide feasible investment projects that boost enterprises’ market value and thereby encourage the average return on capital and investment. The difference of interests of firm’s management with equity holders and owners, and as a result, manager’s decisions might be standout against enterprises’ profitability and interest. This kind of conflict of interests establishes a typical agency problem that possibly be settled through credible threats and incentive-compatible contracts.

2.3 Life Cycle Theory:

Life cycle theory is developed by Ando and Modigliani (1963). According to life cycle theory individuals expected lifetime wealth provides basis to make consumption decision. Fraction of wealth of individuals perhaps occupy in the shape of shares linking price changes to changes in consumption expenditure. Hence, increases in stock prices escalate the estimated assets that in turn inflate the consumption outlay, stating the direction of causality to consumption expenditure from stock prices. Alternatively, an augment in consumption outlay probably result in a boost in the earnings of corporate sectors, which consequently produce increase in stock prices, implying causality from consumption expenditures to stock prices.

Husain and Mahmood (2001) stated that relationship between stock market and economy can be seen in generally in two ways (a) the association deems the capital market as the foremost reflector of the economic movement in the country (b) the relationship emphasizes that the equity market expected to have an effect on aggregate demand, mainly by ways of aggregate utilization and investment. In other terms, it can be concluded that the relationship between stock market and economy is based is based on association of stock prices with consumption expenditures, investment spending and economic activity. Here, economic activity is generally measured by gross domestic product or Index of Industrial production. The link between stock prices and consumption is based on life cycle theory.

Husain (2006) stated that stock market is expected to play an imperative function in the country by mobilizing domestic resources and employ fund to productive investments. In order to perform this role the significant relationship between stock market and economy must be exist. In this regard, the causal analysis between stock market variables e.g. stock prices, market capitalization etc. and variables, for instance, reflecting real sector of the economy like real investment spending, real GDP and real consumption expenditures, perhaps provide useful insights regarding the role of stock market in an economy.

2.4 Stock Market Volatility:

Arestis et al. (2001) argued that price volatility is an important characteristic of stock market, as it perhaps reduce the ability of stock markets to boost efficient allocation of investment. Although a certain level of price volatility in the stock market is absolutely enviable because it display the consequence of emergence of new information in an efficient capital market, but presence of excessive volatility is anticipated to result in an uneconomical distribution of resources, increasing pressures on interest rates in prospect of greater uncertainty, obstructing both the level and the efficiency of investment and, thereby, decreasing growth. Capasso (2006) explained that stock market development is not reflected by volatility of stock return. However, increased level of volatility can significantly influence the return on investment and growth by affecting the average portfolio risk. There are variety of channels through which high volatility can exert adverse effect on investment and growth (a) it may trigger immense financial system instability as whole (b) it can reduce the delivery of financial funds and increase the cost of approach to capital by dissuading savings from risk averse households (c) since the capital markets facilitate to direct resources towards the greater yielding investment through price intimation, highly volatile stock prices spur inefficient allocation of resources because prices do not perfectly reflect return on investments. These statements indicate that high volatility should adversely affect growth and capital accumulation. Shahbaz et al. (2008) stated that the volatility of stock market may reduce the ability of the public to supervise on a company’s investment efficiency. Further, the public may increase investment returns by speculating in the stock market thereby the stock market development may be unfavorable to the economic growth.

2.5 Liquidity:

Diamond and Dybvig (1983) offered an important model of liquidity, a portion of savers get stuns subsequent to selecting between two investments, a non-liquid with high-return and a liquid with little-yield project. Those getting shocks require to take savings back prior to the non-liquid project turn out. This threat generates incentives for investing in the liquid with low-yield scheme. The model presume that it is expensive to confirm whether other participants has faced a shock or not, so it is impractical to compose appropriate inducement state-contingent indemnity agreement. Levine (1991) investors who meet with liquidity problems trade holding stocks of illiquid production technology to other at profits. Participants exists in the markets simply buy and sells the shares at stocks exchanges without delving into the process whether other members meet with shocks or not. Therefore, with liquid equity markets, stock-holders being facilitated to readily trade owned shares. On the other end organizations enjoy continues access to funds devoted by original shareholders. This role of equity market, facilitating trade, reduces risk of liquidity. Thus fall in transaction costs by facilitation of stock market, added investment take place in the non-liquid, high-yield projects and if illiquid projects benefit from adequately enormous externalities, then superior equity souk effects rapid steady state development. Bencivenga, Smith and Starr (1991) proposed that equity markets enable financial assets traded in market not as much of risky for the reason that equity market permits savers to purchase and sell rapidly and inexpensively when participants desire to change owned portfolios, while companies enjoy hassle free access to capital through equity issues. Assets with lower risk and easy access to stock markets improve the distribution of resources, an essential source of economic growth. In addition to these, savings and investments could also provide an opportunity for enhancing long-term economic growth. Demirgüç-Kunt and Levine (1996) suggested that liquidity is an important attribute of stock market development because theoretically liquid markets ameliorate the allocation of resources and strengthen prospects of long-term economic growth. Term liquidity commonly utilizes to impart the capacity to simply trade all securities. Since liquidity permits investors to modify owned portfolios rapidly and inexpensively, it makes investment less risky and facilitates longer-term, more profitable investment. A comprehensive measure of liquidity might quantify the entire costs connected with trading, comprising time costs and ambiguity of locating a counterpart and reconciling the trade. Maysami, Howe and Hamzah (2004) explained money with following two perspectives first is a rise in money escalation displays a sign of availability of excess liquidity that may use for buying securities and hence result in higher stock prices. On contrary, a boost in money supply expected to effect inflation, rise in discount rate that ultimately reduces stock prices. Shahbaz et al. (2008) described that efficient stock markets act as guidelines to provide a mean of maintaining a suitable monetary policy by way of the issuance and buy-back of government securities in the liquid market that is an essential measure of financial liberalization. Likewise, regimented and efficient capital markets may alter the pattern of demand for money and expected to produce liquidity that ultimately encourages economic development.

CHAPTER 3: RESEARCH METHOD

3.1 Variables:

The objective of this study is to analyze that the economic development increases stock market capitalization in Pakistan. For this, following variables have utilized:

3.1.1 Real gross domestic product – independent:

Economic growth is represented by the log of real gross domestic product at constant factor cost of 1999-2000. GDP is the worth of the aggregate production of goods and services in a country during the period of a year. This aggregate value consist of various sectors and sub-sectors in an economy that varies country to country.

3.1.2 Stock market capitalization – dependent:

Stock market development is represented by log of stock market capitalization, which shows the ability of stock market development to mobilize capital, provide liquidity and diversify risk. Stock market capitalization is the total market value of ordinary shares comprising the general index.

3.1.3 Dummy Variable:

During 2001-2003 Pakistan’s economy was affected by Afghan war along with 9/11 consequences that adversely influenced investors’ confidence. Therefore a dummy variable has incorporated to identify stock market behavior during and after 2001-2003.

3.2 Method of Data Collection:

Researcher has personally visited the library of State Bank of Pakistan and collected data for the variables stock market capitalization and real gross domestic product at constant factor cost of 1999-2000 from State Bank of Pakistan Monthly Statistical Bulletin various issues.

3.3 Sample Size:

9 years data have employed from the period of July 1999 to June 2008 of Pakistan economy.

3.4 Research Models:

Model-1: MC = α + β (GDP) +

Whereas,

MC = market capitalization as the measure of stock market development

α = the intercept of the equation

β (GDP) = the change coefficient of real gross domestic product at constant

factor cost of 1999-2000

= The error term

Model-2: lnMC = α + β (lnGDP) + β (D) +

Whereas,

lnMC = log of market capitalization as the measure of stock market

development

α = the intercept of the equation

β (lnGDP) = the change coefficient of log of real gross domestic product at

constant factor cost of 1999-2000

β (D) = the change coefficient of dummy variable

= The error term

3.5 Statistical Technique:

Researcher has carried-out empirical investigation by applying log-linear regression through SPSS. Log-linear regression is a statistical technique that utilizes to test the effect of an independent variable on a dependent variable.

CHAPTER 4: RESULTS

4.1 Findings and Interpretation of the Results:

Table-1: Model-1 Summary

Model

R

Durbin-Watson

F

Sig.

1

0.982

0.965

0.851

191.771

0.000

Table-1 provides the model summary. The regression model is best fit as indicated by significant F-value, while value of R-square represents the total variation in the model. Since time series data have used in our analysis therefore Durbin-Watson has applied to test autocorrelation issue, as its value is 0.851 that indicates existence of positive serial correlation issue therefore this model is not acceptable.

Table-2: Model-1: Result Summary

Model-1

Un-standardized

Coefficients

Standardized Coefficients

t

Sig.

Β

Std. Error

Beta

Constant

-7087055.397

635493.942

-11.152

0.000

GDP

1.874

0.135

0.982

13.848

0.000

The results are summarized in Table-2. The results reflected that all the variables are statistically significant. The beta of independent variable real GDP exhibits positive value that means there is a significant positive affiliation between economic expansion and stock market advancement in Pakistan, but it is necessary to address the autocorrelation issue as evident by value of Durbin-Watson before accepting the hypothesis. The equation of regression model-1 can be written as below:

MC = -7087055.397 + 1.874 (GDP) +

Table-3: Model-2: Summary

Model

R

Durbin-Watson

F

Sig.

2

0.997

0.993

2.368

456.440

0.000

Table-3 provides the model summary. The regression model is best fit as indicated by significant F-value, while value of R-square represents the total variation in the model. Since time series data have used in our analysis therefore Durbin-Watson has applied to test autocorrelation issue, as its value is 2.368 that means there is no serial correlation issue.

Table-4: Model-2: Result Summary

Model-2

Un-standardized

Coefficients

Standardized Coefficients

t

Sig.

Β

Std. Error

Beta

Constant

-71.918

4.108

-17.507

0.000

lnGDP

5.601

0.267

0.889

21.2005

0.000

Dummy

-0.317

0.084

-0.159

-3.758

0.009

The results are summarized in Table-4. The results reflected that all the variables are statistically significant. Data in this thesis has employed from July 1999 to June 2008, whereas during 2001-2003 Pakistan’s economy was affected by Afghan war along with 9/11 consequences that adversely influenced investors confidence and thus stock market capitalization continued to decline from 2001 to 2003, therefore a dummy variable has incorporated to identify the stock market behavior during and after 2001-2003. Further it is observed that GDP and stock market capitalization both variables grow exponentially thereby log-linear model has used by transforming both variables into log. The slope coefficient, β, of log-linear model measures the elasticity that a percent change in GDP induces 5.601% in stock market capitalization; this is also referred as theory of constant elasticity. The equation of log-linear regression model-2 can be written as below:

lnMC = -71.918 + 5.601 (lnGDP) + (-0.317) (D) +

In light of above analysis it has confirmed that there is a positive affiliation between economic expansion and stock market advancement in Pakistan. The study has also found support for the hypothesis that economic development increases stock market capitalization. Hence the hypothesis is accepted.

4.2 Hypothesis Assessment Summary:

Table-5: Hypothesis Assessment Summary

Hypothesis

Economic development increases stock market capitalization

Relationship

Positive with causality running from economy to stock market

Variables

GDP at constant factor cost of 1999-2000 – Independent

Stock market capitalization – Dependent

Dummy variable

Sample Size

9 years data from July 1999 – June 2008

Research Model

Log-liner regression model

β value

lnGDP

5.601

Dummy

-0.317

t-statistics

Constant

-17.507

Significant

0.000

lnGDP

21.2005

Significant

0.000

Dummy

-3.758

Significant

0.009

Result

Hypothesis is accepted

CHAPTER 5: DISCUSSIONS, CONCLUSION, IMPLICATIONS, RECOMMENDATIONS AND FUTURE RESEARCH

5.1 Discussions and Conclusion:

This thesis has examined the affiliation between economic expansion and stock market advancement in Pakistan by utilizing annual data from July 1999 to June 2008. The researcher has applied log of real GDP at constant factor cost of 1999-2000 as independent variable and log of stock market capitalization as dependent variable and employed regression models for empirical investigation.

The results confirmed that there is a positive affiliation between economic expansion and stock market advancement in Pakistan. The study has also found support for the hypothesis that economic development increases stock market capitalization. The results are paradoxical with the studies of researchers who reported the causality of relationship running from stock market improvement to economic growth. Levine and Zervos (1996) in the cross-country study concluded that development of stock market is positively and robustly contributed to long-run economic growth. Arestis et al. (2001) examined the impact of stock market growth on economic expansion for five developed countries and reported that role of stock market development in economic growth is weak in Germany, UK and France, on the other hand stock market development is positively related to economic growth in USA and Japan. Azarmi et al. (2005) evaluated the empirical connection between stock market advancement and economic progression for India and suggested that stock market significantly and positively link with economic growth in pre-liberalization period and remained negative during post-liberalization period. Mun et al. (2008) investigated the relationship between stock market and economic activity in Malaysia and found that stock market causes economic activity by means fluctuation in stock prices induces changes in GDP.

5.2 Implications and Recommendations:

The thesis implies that movements in KSE indices are sensitive to changes in the rate of economic growth because variations in stock prices are influence by changes in economic activities. Economic growth play vital role in attracting investors confidence and thus facilitates investors’ participation in stock trading because investors believe that economic development acts as barometer of stock market performance.

5.3 Future Research:

It is suggested that link between economic expansion and stock market advancement can be further explored by examining the effects of financial liberalization, policies, interest rates, exchange rates and real estate prices. As these are seem to be promising avenue for further research.

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