Literature Review On Stocks And Economic Growth Finance Essay
2.1 Theoretical Review
In principle, a stock market is expected to encourage economic growth. They provide a boost to domestic savings and increasing the quantity and the quality of investment. Stock markets may affect economic activity through the creation of liquidity. Bencivenga et al (1996) and Levine (1991) argue that stock market liquidity (the ability to trade equity easily) is crucial for growth. 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. They allow savers to acquire an asset (equity) and to sell it rapidly at a competitive price, 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 enhance the allocation of capital and increase prospects for long-term economic growth. Further, by making investment less risky and more profitable, stock market liquidity can also lead to more investment.
The stock market is expected to encourage savings by providing individuals with an additional financial instrument that may better meet their risk preferences and liquidity needs. Better savings mobilization may increase the savings rate (Levine and Zervos, 1998). Stock markets establish a market place where investors feel comfortable to relinquish control of their savings. Because securities are in small denominations, a larger fraction of the population can participate in the stock market.
In a well-developed stock market, share ownership provides individuals with a relatively liquid means of sharing risk when investing in promising projects. Stock markets help investors to cope with liquidity risk by allowing those who are hit by a liquidity shock to sell their shares to other investors who do not suffer from a liquidity shock. The result is that capital is not prematurely removed from firms to meet short-term liquidity needs.
Stock markets also provide an avenue for growing companies to raise capital at lower cost (Dailami and Aktin, 1990). In addition, companies in countries with developed stock markets are less dependent on bank financing, which can reduce the risk of a credit crunch. Stock markets therefore are able to positively influence economic growth through encouraging savings amongst individuals and providing avenues for firm financing. Stock markets play a key role in allocating capital to the corporate sector, which will have a real effect on the economy on aggregate. Debt finance is likely to be unavailable in many countries, particularly in developing countries, where bank loans may be limited to a selected group of companies and individual investors.
Efficient stock markets may also reduce the costs of information (King and Levine, 1993). They may do so through the generation and dissemination of firm specific information that efficient stock prices reveal. Stock markets are efficient if prices incorporate all available information. Reducing the costs of acquiring information is expected to facilitate and improve the acquisition of information about investment opportunities and thereby improves resource allocation. Stock prices determined in exchanges and other publicly available information may help investor make better investment decisions and thereby ensure better allocation of funds among corporations and result in a higher rate of economic growth.
Stock market liquidity is expected to reduce the downside risk and costs of investing in projects that do not pay off for a long time. With a liquid market, the initial investors do not lose access to their savings for the duration of the investment project because they can easily, quickly, and cheaply, sell their stake in the company (Bencivenga and Smith, 1991). Thus, more liquid stock markets could ease investment in long term, potentially more profitable projects, thereby improving the allocation of capital and enhancing prospects for long-term growth.
Countries with both liquid stock markets and well-developed banks grew faster than countries with both illiquid markets and underdeveloped banks. More interestingly, greater stock market liquidity implies faster growth no matter what the level of banking development. Similarly, greater banking development implies faster growth regardless of the level of stock market liquidity (Rousseau and Wachtel, 2000). Thus, it is not stock markets versus banks; it is stock markets and banks.
Clearly, stock markets offer something to the economy that banks do not. As suggested above, stock markets may play a prominent role in expanding opportunities for trading risk and boosting liquidity. In contrast, banks may focus more on establishing long-term relationships with firms, so that they can acquire information about managers and firm prospects (Beck and Levine, 2003). To grow, economies need both liquidity and information about firms. Thus, if stock markets provide the liquidity and banks the information, then banks and stock markets would be independently associated with growth.
A well-functioning equity market enables entrepreneurs to make long-term, more productive investments in physical capital because they have access to longer-term sources of funds (Bencivenga and Smith, 1992). More productive capital implies higher returns for investors; thus, lenders as well as equity investors more confidently advance funds to these entrepreneurs. Information that flows from trading of companies’ shares also boosts lenders’ understanding of and confidence in the prospects of these firms. Greater stock market liquidity in emerging market economies thus is associated with an increase in the amount of funds raised through bond offerings and bank loans. Indeed, most capital accumulation is financed through bond offerings and bank loans. As a result, corporate debt-equity ratios actually rise with greater stock market liquidity. Stock market development in emerging market economies tends to complement rather than replace bank lending.
The role of equity markets in enhancing portfolio diversification allows individual firms to engage in specialized production. Stock markets allow investors to hold a small share in a large number of firms. By representing ownership of large-value, indivisible physical assets by easily tradable and divisible financial assets, and making trade in them more liquid, they promote the efficient allocation of capital. They give lenders the opportunity to diversify their investments.
Equity markets are able to generate information about the innovative activity of entrepreneurs (King and Levine, 1993) or the aggregate state of technology. Incentive to acquire information on firms and improve corporate governance facilitates growth. Liquid markets encourage the acquisition of information about firms because investors want to make a profit by identifying undervalued stocks and exploiting this information.
International risk sharing through internationally integrated stock markets improves resource allocation and accelerates growth (Obstfeld, 1994). Risk diversification through internationally integrated stock markets considerably affects economic growth. The financial system improves the productivity of capital is by inducing individuals to invest in riskier but more productive technologies by providing risk-sharing opportunities.The model reveals that greater international integrated stock market induces shifts from safe, low return investments to riskier, high return project investments, thereby accelerating long run growth.
Moreover, well-developed stock markets may enhance corporate control mitigating principal/agent problems by aligning the interests of managers and owners, in which case managers strive to maximize firm value thereby promoting economic growth. The presence of stock markets would mitigate the principal agent problem, thus promoting efficient resource allocation and growth. Corporate governance refer to the extent that shareholders and creditors effectively monitor firms and induce managers to maximize firm value, this will improve the efficiency with which firms allocate resources and make savers more willing to finance production and innovation (Holmstrom and Tirole, 1993). Stock market provide proper incentives for managers to make investment decisions that affect firm value over a longer time period than the managers’ employment horizons through equity-based compensation schemes.
Diverse equity ownership creates a constituency for political stability, which, in turn, promotes growth (Perotti and van Oijen, 2001). Lowering barriers to cross-border capital flows affects the functioning of emerging stock markets. Fewer impediments for foreign investors will enhance market integration with world capital markets and therefore affect the pricing of domestic securities. Domestic firms, in seeking foreign investment, will often have to upgrade the information disclosed to investors. As more foreign investors enter the market, pressure will be applied to upgrade trading systems and modify legal frameworks to support a greater variety of financial instruments.
The role of stock markets in improving informational asymmetries has been questioned by Stiglitz (1985) who argues that stock markets reveal information through price changes rapidly, creating a free-rider problem that reduces investor incentives to conduct costly search. The contribution of liquidity itself to long-term growth has been questioned. Demirguc-Kunt and Levine (1996) point out that increased liquidity may deter growth via three channels. Firstly, a stock market may lower saving rates through income and substitution effects. Secondly, by lowering the doubt associated with investments, greater stock market liquidity may reduce saving rates as a result of ambiguous effects of doubt on savings. Thirdly, stock market liquidity supports investor myopia, impacting negatively on corporate governance and affecting economic growth.
Also, Levine and Zervos’s use of a cross-sectional approach limits the potential robustness of their findings with respects to country specific effects and time related effects. Bencivenga and Smith (1992) state that a new stock market also can increase economic growth by reducing holdings of liquid assets and increasing the growth rate of physical capital, at least in the long run. In the short run, however, the equilibrium response of the capital stock to a new stock exchange can be negative because the opening of an exchange can increase households‟ wealth and raise their contemporaneous consumption enough to temporarily lower the growth rate of capital.
2.2 Empirical Review
Levine and Zervos (1993); Atje and Jovanovic (1993); Levine and Zervos (1998); Rousseau and Wachtel (2000) and Beck and Levine (2003) show that stock market development is strongly correlated with growth rates of real GDP per capita. More importantly, they found that stock market liquidity and banking development both predict the future growth rate of the economy when they both enter the growth regression. They concluded that stock markets provide different services from those provided by banks.
From the point of view of Greenwood and Jovanovic (1990), a new stock exchange can increase economic growth by aggregating information about firms‟ prospects, thereby directing capital to investment with returns. These effects of a stock market opening result in a measured increase in productivity. Stock exchanges exist for the purpose of trading ownership rights in firms, and a new stock exchange may increase productivity growth. Investors choose whether to invest directly in their own project or through a financial intermediary in exchange for a fee. Thanks to its superior information and its ability to eliminate project-specific risks, it offers a higher return and a lower risk on capital, thereby promoting growth.
The developments in stock market do influence the level of economic growth of countries. Atje and Jovanovic (1993) found a substantial effect on stock market development and growth rate of economic activity. According to their study, the rate of return on investment will be higher in a financially developed economy. The financial system insures investors against idiosyncratic risk, and, since more productive investments tend to be riskier, induces investors to shift their portfolio towards higher return investment. Moreover, financially developed system creates more information about investment projects, and can therefore guide investors’ funds to better use. Both effects raise the rate of return of economy-wide investment. In their empirical testing for a sample of 37 countries comprising of both developing and developed countries, they found a large effect of stock markets on subsequent development. They found it surprising that more countries are not developing their stock markets as quickly as they can as a means of spreading up their economic development.
King and Levine (1993) study on seventy seven countries made up of developed and developing economies used cross-country growth regression. The study was conducted over the period 1960 to 1989 .The aim of the research was to find out whether higher levels of financial development are significantly and robustly correlated with faster current and future rates of economic growth, physical capital accumulation and economic efficiency improvements. They systematically control for other factors affecting growth. They examine three growth indicators namely real per capita GDP growth, growth in capital stock per person, total productivity growth. King and Levine note a strong positive relationship between each of the financial development indicators and the three growth indicators. The result showed that finance not only follows growth; finance seems important to lead economic growth. This further buttressed the assertion that financial services stimulate economic growth.
Obstfeld (1994) show that international risk sharing via internationally integrated stock markets can accelerate the rate of growth by improving resource allocation. Stock markets are used as a device to enable investors to transfer their risks. They can invest confidently; they have the possibility to switch from high-risk to low risk investments. Moreover, Kyle (1984) and Holmstrom and Tirole (1993) argue that liquid stock markets can increase incentives for investors to get information about firms and improve corporate governance, thereby facilitating growth. Kyle (1984) argues that, an investor can profit by researching a firm, before the information becomes widely available and prices change. More liquid stock markets increase incentives to research firms, the improved information will improve resource allocation and accelerate economic growth. As markets become larger and more liquid, agents may have greater incentives to expend resources in researching firms because it is easier to profit from this information by trading in big and liquid markets
Empirical evidence by Levine and Zervos (1996), utilizing pooled cross-county regressions and data for 49 countries during the period 1976 to 1993, demonstrates that various measures of equity market activity are positively correlated with measures of real activity and that the association is particularly strong for developing countries. Levine and Zervos (1996) used a combination of information on stock market size, liquidity and international integration to show that these measures are robustly correlated with current and future rates of economic growth. They also show that stock market effects are additional to those of banking-system development. Levine (1996) strengthens the argument and suggests that stock markets may enhance growth through liquidity, which makes investment less risky, thereby enabling companies to enjoy permanent access to capital through liquid equity issues. They find a positive link between financial development and economic growth. This argument leads to the conclusion that “financial factors are an integral part of the growth process."
Some years later, Levine and Zervos (1998) conduct a similar analysis for 47 countries from 1976 to 1993. They empirically investigates whether banking and stock market indicators are both robustly correlated with current and future rates of economic growth. They simultaneously examine two components of the financial system: banks and equity markets. They measure stock market development along various dimensions: size, liquidity and volatility. More precisely their measures are aggregate stock market capitalization to GDP and the number of listed firms (size), domestic turnover and value traded (liquidity, and the standard deviation of monthly stock returns (volatility). The results suggest a strong and statistically significant relationship between initial stock market development and subsequent economic growth. Including stock market liquidity, stock market capitalization and bank intermediation jointly as regressors, yields a separate and significant influence on the rate of economic growth for each of them. They conclude that stock market liquidity as measured by value of stock market trading is positively and significantly correlated with contemporary and future growth rates, capital accumulation and productivity growth. Banking development and stock market liquidity are both robust predictions of real per capita Gross Domestic Product growth.
Rousseau and Wachtel (2000) make an important contribution to the literature by using panel techniques with annual data to assess the relationship between stock markets, banks, and growth. Rousseau and Wachtel (2000) conduct their study over the period 1980-1995 for 47 economies. The study extends the Levine and Zervos study of stock markets, banks, and growth to a panel context. They use M3/GDP to measure bank development and the Levine and Zervos (1998) measures of stock market size and activity, which they deflate by the price index of the national stock exchange to eliminate price changes from their measure of how well the stock market functions. They study the impact of bank and equity markets on economic growth. Rousseau and Wachtel report that greater financial sector development leads to increased economic activity.
Adjasi and Biekpe (2006) examined the effect of stock market development on economic growth in 14 African countries. The study revealed a positive relationship between stock market development and economic growth and indicated that stock market developments played a significant role in growth only for moderately capitalized markets. Greenwood and Smith (1996) show that stock markets lower the cost of mobilizing savings, facilitating investments into the most productive technologies. They enable savings mobilisation. More efficiently mobilised savings cause capital accumulation, which firms tap to finance large projects via equity issues. This, undoubtedly, spurs economic growth.
Nowbutsing and Odit (2009) investigate the impact of stock market development on growth in Mauritius. They conducted a time series regression over the period 1989 -2006/7. Two measures of stock market development namely SIZE and Liquidity were adopted. They used market capitalization as a % of GDP and total value of share traded as a % of GDP at constant price as proxies for Size and Liquidity respectively. They used a two step procedure of Engle and Granger. The positive relationship between stock market development and economic growth is replicated in both the long run and short run equations. They concluded that stock market development positively affect economic growth in Mauritius both in the short run and long run.
Seetanah, Sawkut, Sannasee and Seetanah (2010) examined simultaneously banking sector development, stock market development, and economic growth in a unified framework. They used panel VAR procedures to study 27 developing countries over a period of 15 years (1991- 2007). The model was based on the principles of some earlier studies (e.g. King and Levine, 1993; Levine and Zervos, 1998 and Seetanah, 2008). They measure stock market development with an index, which is based from stock market capitalisation, total value of share traded and a ratio between these two indicators. They found that stock market development is an important ingredient of growth, but with a relative lower magnitude as compared to the other determinants of growth, particularly with banking development. Also they noticed that stock market development and banking development are complement to each other.
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