Any opinions, findings, conclusions or recommendations expressed in this material are those of the authors and do not necessarily reflect the views of UK Essays.
Stock markets have received a great deal of attention, both as a source of financial development and ultimately economic growth, and in the context of large swings in stock market valuation. The depth of a stock market as captured by the market capitalization is an important measure of one aspect of financial development. The role of stock markets as a part of financial markets in economic development process is emphasized by growth theories.
Stock markets have becoming more integrated in recent years. There are several factors that contributed to the linkages or interdependencies of stock market. The question of whether the stock market can predict the economy has been widely debated. Those who support the market’s predictive ability argue that the stock market is forward-looking and current prices reflect the future earnings potential or profitability of companies. Since stock prices reflect expectations about profitability and since profitability is directly linked to economic activity, fluctuations in stock prices are thought to lead the direction of the economy.
The subprime crisis that began in August 2007 in the USA has been labeled as the worst financial crisis since the Great Depression. The crisis has developed into the largest financial shock, affecting heavy damage on markets and institutions at the core of the global financial system (IMF 2008). The stock market activity is one of the principal activities in the corporate world among the chain of activities, which got affected due to the financial crisis.
Some studies have suggested that the stock market development can have highly constructive role in encouraging growth. Fama (1991) argues that the stock market is a single leading indicator of the business cycle. This is contrary to Harvey (1989), who finds that the stock market is not a predictor of economic activities. These studies have finding the causality between stock market and economic growth in Saudi Arabia.
1.1.1 Stock market
The stock market indices are one of the principal indicators of the economic activities. According to the Wikipedia, a stock market or equity market is a public market (a loose network of economic transactions, not a physical facility or discrete entity) for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately. Funds are channeled from savers to borrowers, either directly or indirectly. The direct channel is through financial markets, exchanges where securities or financial instruments are bought and sold. Financial markets provide direct finance when borrowers issue securities directly to savers.
In principal, a well functioning stock market may help the development process in an economy through the following; first growth of savings, secondly efficient allocation of investment resources and lastly better utilization of the existing resources. The stock market is supposed to encourage savings by providing household with an additional instrument which may better meet their own risk preferences and liquidity needs. If a household has a sudden increase in wealth, its current and future consumption levels will increase. One of the main components of household wealth is the value of stocks held by household. When stock prices rise, household wealth increases, and when stocks prices fall, household wealth decreases. Stocks prices affect the economy by affecting household wealth, which affects household consumption. In well developed capital market, share ownership provides individuals with a relatively liquid means of sharing risk in investment project.
Cliff Pratten claims that the activities of buying and selling stock and shares on the stock market are extremely important for the allocation of capital within economies. Although mast of the business on the stock market consists of dealing in exiting securities, the prices of these securities provide important signals. Companies whose share prices are at premium to the book value of their assets and low dividend yields have a badge of approval which enhances their chances of borrowing capital on favourable terms and of raising capital by issuing new shares. Besides that, transaction prices and quotations provide investors with an indication of the market value of their wealth which may influence their decisions about consumption expenditure. When prices are at historically high level and rising this indicates confidence among investors and may affect the confidence of businessmen and hence their investment decisions.
1.1.2 Economic growth
Economic growth is the increase of per capita gross domestic product (GDP) or other measure of aggregate income. Traditional neoclassical models of growth are a direct outgrowth of the Harrod-Domor and Solow models, which both stress the importance of savings. The Solow neoclassical growth model in particular represented the seminal contribution to the neoclassical theory of growth and later earned Solow the Noble Prize in economics. It expanded on the Harrod- Dumor formulation or Harrod-Dumor growth model by adding a second factor, labor and introducing a third independent variable, technology to the growth equation.
Traditional neoclassical growth theory, output growth results from one or more of three factors: increase in labor quantity and quality (through population growth and educational), second increase in capital (through saving and investment) and thirdly improvement in technology. The Solow neoclassical growth model, for which Robert Solow of the Massachusetts institute of Technology received the Nobel Prize, is probably the best known model of economic growth.
Growth is a main important part behind of a success of a nation. It is often measured as the rate of change in GDP. Economic growth refers only to the quantity of goods and services produced. Economic growth can be either positive or negative. Negative growth can be referred to by saying that the economy is shrinking. Negative growth is associated with economic recession and economic depression.
1.2 Saudi Arabia
SOURCES: WORLD DEVELOPMENT INDICATOR (WDI) 2009
Above graph shows market capitalization in Middle East countries on year 2009. According to WDI Saudi Arabia’s market capitalization is highest among it. Market capitalization is a proxy to stock market in this study. GDP of Saudi Arabia is stable from earliest seventies until recently. So we choose Saudi Arabia as a case of this study.
1.2.1 Background of Saudi Arabia
The Kingdom of Saudi Arabia covers most of the Arabian Peninsula. It is a large country. It size is 2186000 square kilometers. The major west coast port of Jeddah is 1500 kilometres by road from its east coast counterpart, Dammam. The state bordering Saudi Arabia, beginning from the north and proceeding in a clockwise fashion, are Jordan, Iraq, Kuwait, Bahrain, Qatar, the United Arab Emirates, Oman and Yemen.
1.2.2 Economy of Saudi Arabia
Saudi Arabia is the world largest proven oil reserves and is the world largest exporter of oil. Its oil industry is state owned, and the government maintains control over all of the kingdom’s mineral resources. The Saudi Arabial oil company, known as Saudi Aramco, is the world’s largest oil company.
The Saudi Arabia economy expanded 0.60 percent over the last year, as measured by the year-over-year change in Gross Domestic Product. Unlike the commonly used quarterly GDP growth rate the annual GDP growth rate takes into account a full year of economic activity, thus avoiding the need to make any type of seasonal adjustment. The Saudi Arabia Gross Domestic Product is worth 369 billion dollars or 0.60% of the world economy, according to the World Bank. From 1969 until 2009, Saudi Arabia’s average annual GDP Growth was 5.06 percent reaching an historical high of 27.49 percent in December of 1974.
1.2.3 Stock Market of Saudi Arabia
Saudi Arabia joint stock companies had their beginning in the mid 1930’s, when the first such company, the Arab Automobile Company was established. On 1975 there were 14 public companies. The rapid economic expansion and Saudisation of foreign banks in the 1970’s led to the establishment of a number of large corporations and joint veture banks. Major share offering were made the public during this period. The market remained informal, until the early 1980’s when the government embarked on a rapid development program.
In 1984, a Ministerial Committee consisting of Ministry of Finance and National Economy, Ministry of Commerce and Saudi Arabian Monetary Agency, SAMA was formed to regulate and develop the market. With the aim of improving the regulatory framework, share trading intermediation was restricted to commercial banks. In 1984, the Saudi Share Registration Company (SSRC) was established by the commercial banks. The company provides central registration facilities for joint stock companies and settles all equity transactions. Automated clearing and Settlement was introduced in 1989.
The Electronics Securities Information System (ESIS), developed and operated by SAMA, was introduced in 1990. Tadawul, the new securities trading, clearing and settlements was launched in October 2001. On 2003 the Capital Market Authority was established pursuant to the “Capital Market Law”. The authority represents the government apparatus which is mainly entrusted with management and organization of the Saudi Capital Market. The development of this share market is to protect the investors and fairness and a integrity of the capital market. The stock market index of the Saudi Stock Exchange, the Tadawul All-Share Index (TASI) is growing by leaps and bounds every fiscal year and the Saudi Stock Exchange is presently ranked 11th in the world in terms of market capitalization.
Chart of stock price of Saudi Arabia versus GDP of Saudi Arabia
The chart illustrates the relationship between the growth rate of GDP and stock price of Saudi Arabia. Growth rate of GDP is more volatile compare the growth rate of stock price from 1991 until 2009. All through the time period of growth rate of GDP very volatile. As for stock price, the growth rate is quite calm and it remains the same throughout the study period from 1991 to 2003. Beginning from 2004 the stock price of Saudi Arabia start to increase and sharply drop down on 2006 and it showing volatile although the time period after 2004.
1.3 Problem statement
Financial market performs an important role in the economic development process; particularly, stock market is one of the indicators in financial market. The growing importance of stock market around the world has opened a new avenue of research into the relationship between stock market and economic growth. The measurement of stock market development is important because it is the precept for predicting economic growth.
There have been numerous studies analysing the connection between stock market and economic. The economic literature as provided ample evidence that stock price has positive effect on economic growth. Guha and Mukherjee (2008) examined positive relationship between stock market development and economic growth. The same thing goes to Shahbaz, Ahmed and Ali (2008) and Paytatakti Oskooe (2010). While Shahnoushi, Ebadi, Danehsvar & Shokri (2008) and Fase & Abma(2003) find negative relationship between financial market and economic growth.
One of the debatable issues in economics was the direction of the relationship between economic growth and stock market. Blackburn (2005) advocates a possible two way causal linkage between financial markets and economic growth. However this is has typically finding the causality between stock market and economic growth in Saudi Arabia.
1.4 Research question
What is the direction between stock market and economic growth?
What is the is a relationship between development of stock market on economic growth?
The main objective of this study is to examine the impact of stock market on the economic growth in Saudi Arabia.
To determine the direction of the relationship between the stock market and economic growth.
To examine the relationship between stock market development and economic growth.
This study covers deeply into the enhance understanding of the crucial relationship and directional of the causality between the similar approach of stock market development and economic growth indicators that will be the main sources for the purpose of data collection in this study. It is clear that if causality can be establishing from stock market to economic growth then these studies have direct policy implication and improve the effectiveness of policy design and implementation in future.
This study provides knowledge to investors who are considering investing in Saudi Arabia. By knowing the relationship between the markets, it can help investors to hedge some risk. This study also can give some useful information to investment practitioners and policy makers. This study will be a contribution to the literature on the topic of stock market and economic growth.
Chapter 2: Literature review
Different studies have been carried out by financial economist on the implications of stock market development for various components of an economy. Similarly the early theories of Valeriano F. Garcia and Lin Liu (1991) suggest that as part of the financial system, the stock markets play important roles in economic growth. Thus, more recent research on the role of the stock market in an economy has argued from a different angle. Review of other studies will be done in this chapter to give various dimensions of stock market in an economy. This review will focus on various issues.
To analyze the relationship between stock market and economic growth, there results would be positive, negative or no relationship between both. To find more details, we will review other studies on the issue in relationship.
The study by Levine and Zervos (1996) is among that considered the relationship between stock market development and economic growth without considering the role of the banking sector. This study use pooled cross country time series regression for 41 countries over the period 1976 to 1993. While assessing the relationship between stock market development and economic growth, the article also includes large number of control variables such as secondary school enrolment, the number of revolution, the ratio of government consumption and expenditures, the inflation rate and black market exchange rate. By using these variables the result showing that stock market development is positively correlated with economic growth. King and Levin (1993) and Levin and Zervos (1998) have found positive relationship effect between stock market and economic growth. These studies claim that countries with better developed financial systems particularly those with large efficient banks and a large well organized and smoothly functioning stock markets tend to grow much faster.
Similarly, Shahbaz et al. (2008) find that there exist a very strong relationship between stock market development and economic growth in Pakistan. In order to find the relationship they employed two new tests , DF-GLS and Ng-Perron in their study. Eventhough both controlling variables FDI and HUMAN giving positive relationship between growth, Nowbutsing, B. M. and Odit M. P. (2009) also find positive relationship between stock market and economic growth in Maruritius. This is replicated in both long run and short run equations over the period 1989 to 2006.
Similarly, Kaufman and Jacoby (1986) found positive relationship between stock market and economic growth from 1972 to 1978. They conclude that decrease in stock market can preceded a fall in the productivity in six industrialized OECD countries. Levine et al. (2000), Demirguc-Kunt and Levine (1999) and World Bank (1989) do also focus in the relationship between growth and stock market development. According to their research they received empirical positive support by using cross country studies. These studies not only show the relationship but they also stated there is strong predictive power of finance and growth. Numerous earlier studies, such as Chen et al. (1986), Fama (1990), Abdullah and Hayworth (1993), Gallinger (1994) and Mukherjee and Naka (1995), suggest that stock returns are positively related to real economic activity.
Beside this, Stiglitz (1985) found that there is negative relationship between stock market and economic growth. He too argues that developed stock markets quickly reveal information through price changes, creating a free rider problem and reducing investor incentives to spend resources to conduct costly search. Harris (1997) shows that this relationship is at best weak. Reestimating the same model for forty-nine countries over the period 1980-91, but using current investment rather than lagged, and utilizing two-stage least squares, he demonstrates that in the case of the full sample which includes both developed and developing countries, and of the subsample of developing countries, the stock market variable does not offer much incremental explanatory power. In the subsample of developed countries, although the level of stock market activity has some explanatory power, its statistical significance is weak.
Some have argued that stock market development may hurt economic growth. The argument is that stock markets may hurt growth as saving rate may be reduced due to externalities in capital accumulation. Moreover, diffuse ownership may negatively affect corporate governance and invariably the performance of listed firms thereby impeding the growth of the stock markets stated by Bhide, (1993), Shleifer & Vishny (1986) and Stiglitz (1985). Park (1997) has claimed that the negative correlation of growth with future stock returns may be attributed to factors closely related to future growth and to countercyclical macroeconomic policy. For instance, a rise in output growth is usually considered as a sign of future inflation, which affects negatively future growth and returns. Policymakers may respond by raising interest rates and, thus, reduce future cash flows of firms. The model proposes an alternative route through which growth has an impact on future returns after a boost in output, increasing adjustment costs reduce the initial rise in real stock prices. Lucas (1988) found that there in negative relationship between stock market and economic growth. Both are independent and not correlated each other.
McQueen and Roley (1993) reporting a negative relationship between production and future returns focused only on the U.S. case. The response found here might be the outcome of an anticipated change in the monetary stance after a rise in the growth rate. This reaction operates as an anti-inflationary policy device via the discount rate by raising the cost of capital relative to expected cash flows and inducing changes in future real returns. To our knowledge, this is the first empirical documentation of this evidence across a large set of developed economies. The same thing goes to Blanchard et al. (1993) estimates negative coefficient of growth rate in the stock. The time period is from 1951 to 1997.
Levine and Zervos (1998), suggest that liquidity market is low risk market. They find that financial assets that traded in this market are less risky because it allow saver to buy and sell the stock cheaply and quickly according to their wish. Liquidity is the ability to quickly convert an asset into cash without a big effect on the price. In this trading, it applies as the ability to buy or sell a currency pair without a real effect on the price. Less risky assets and easy access to capital markets improve the allocation of capital, an important channel of economic growth. The author used cross country regression from the period 1976 to 1993. They argue 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. The same thing goes to Rousseau and Wachtel (2000). Their findings emphasize the potential gains associated with developing deep and liquid financial markets in an increasingly global economy. Both study showing that liquidity market positively related to economic growth.
By mobilizing savings to investment, distributing money to productive sectors finance play an important role in economic growth. . Finance theory suggests that stock market returns have predictive power for investment output stated in Barro (1990). Rousseau and Wachtel (2000) also said that stock market development is strongly correlated with growth rates of real GDP per capita. More importantly, they established that stock market liquidity predict the future growth rate of the economy when it enter the growth regression. This is also reliable with Fama (1981) that stock market returns have predictive power for investment output. The argument by Fisher and Merton (1984) also found that stock market liquidity predict the future growth rate of the economy when it enter the growth regression.
Another important point of stock market is volatility. Singh (1997) argues that the inherent volatility of the stock market pricing process under developing country conditions make a poor guide efficient investment allocation. So the stock market volatility could worsen macroeconomic instability and thereby not contribute to increase growth in developing countries. Similarly, Federer (1993) also stated that volatility created inefficient allocation of resources, increased interest rate and slow down the capacity and the productivity of investment. Therefore, this will reduce the growth of economic.
Although some authors suggest that stock market volatility might reduce economic growth, Schwert (1989) found that stock market volatility provides important information about future economic growth. He also stated that stock market volatility tends to increase dramatically during financial crisis such as the 1987 stock market crash, the 1997 East Asia crisis, and the 1998 Russian bond default and periods of uncertainty. Campbell et al.(2001) also argues that stock market volatility has significant predictive power for real GDP growth. These authors show that after controlling the dependent variables, the stock market volatility still has significant predictive power for GDP growth.
King and Levine (1993) found that a new stock exchange can increase economic growth by aggregating information about firm’s prospects, by investments. The author used data from period 1960 to 1989. Productivity growth may increase with exist of new stock exchange. Similarly, North (1991) also argues that the formation of a stock exchange can boost economic growth by lowering the expenses of exchanging ownership rights in firms. This is an important part of some institutional stories of economic growth. Benchivenga & Smith (1996) emphasize the positive role provided by stock exchanges on the size of new real asset investments through common stocks. Investors easily influence to invest in familiar stocks. This encourages companies to go to public when they need more finance to invest in capital goods.
On the other hand, Bencivenga and Smith (1992) state that in the long run, new stock market can increase economic growth by reducing holdings of liquid assets and increasing the growth rate of physical capital. However a new stock can be negative in short-run because this can increase the household’s wealth and raise their contemporaneous consumption enough to temporarily lower the growth rate. Devereux and Smith (1994) suggest that increased stock market integration can lead to greater risk sharing and therefore a fall in economic growth.
The relationship between stock markets and growth may also be influenced by the link between stock markets and banks. Stock markets and banks are clearly substitute sources. Arestis (2001) argue that both banks and stock markets lead to increased growth, however, that banks lead to greater efficiency gains than stock market. The study observes that stock market has negative effects in Japan, France, UK and Germany in the time period 1968 to 1998. While Atje and Jovanovic (1993) conclude that stock markets lead to greater growth effects than banks for forty countries from 1960 to 1985. They find no relationship for bank lending on economic growth but a large effect of stock markets on economic growth.
While the role of banking also brought into Levine and Zervos (1998) analysis. The results suggest that the level of banking development turns out to be significant in explaining economic growth. They also find that there is strong and significant relationship between stock market development and economic growth after controlling for initial investment in education, initial income, political stability, fiscal policy, openness trade and macroeconomic stability. Similarly Beck and Levine (2004) argue the relationship between stock market, bank and economic growth. By using panel econometric techniques over the period 1976 to 1998, they specifically find both of stock market and bank development have positive relationship with economic growth.
The fact that there exists a strong relationship between financial and economic growth does not necessarily imply a causal relationship. The evidence on causality may have strong bearing on economic policy makers whether in the form of one way directional causality, bi-directional causality or no directional causality at all. When looking at two way causal relationship between stock market and economic growth, Blackburn et. al (2005) support there is a possible to two way causal linkages between stock markets and economic growth. According to them, the existence of information irregularity and the attempt of both lenders and borrowers to resolve multiple enforcement problems through the appropriate design of financial contracts explain the emergence and evolvement of financial markets. This process explains the positive impact of economic growth on the development of financial markets.
Similarly Deb, S. G. and Mukherjee, J. (2008) also find bi directional causal relationship between market capitalization and economic growth for the Indian economic over the period 1996 to 2007. While Shahbaz, M. et. al (2008) also confirms the bi-directional causality between stock market development and economic growth in case of Pakistan in long run. But in the short run, there is only one way causality that is from stock market to economic growth over the period 1971 to 2006.
Concluding remarks for literature review
From the above, it may see that the effect of stock market and economic growth has been a controversial subject. Some studies indicated the statistically significant effect of stock market development on economic growth while other did not. Similarly, some reported positive impact of stock liquidity on economic growth. Some argue that stock market volatility has significant power on for GDP growth while some did not. Some studies found new stock exchange can increase economic growth and vice versa. Some authors also conclude that stock market lead to greater growth effect than banks while some found banks lead to greater efficiency gain than stock market. Finally in direction of causality some studies advocates one way directional linkage between stock market and economic growth and some conclude bi-directional between both stock market and economic growth. In order to validate in Saudi Arabia context, no study has been conducted by using the recent data. This study therefore tests the hypotheses concerning stock market development and economic growth in Saudi Arabia.
Chapter 3: Methodology
This section is designed to explain the methodology and the data used to achieve the objective of this study. This paper mainly focuses on two issues. First find the relationship between stock market and economic growth and the second objective is to determine the direction of the causality between stock market and economic growth. In this study we are using quarterly data over the period 1999 to 2009 in Saudi Arabia. This study covers ten years period.
3.2 Theoretical Framework
The Solow and endogenous growth models have different implications for what is, or is not, important in determining the rate of growth. Using these models as guides, economists have tried to estimate the role of various factors suspected of determining the rate of economic growth. There are basically two categories of economic growth theories those based on the traditional Solow (1956) growth model and those based on the concept of endogenous growth. This model predicts that all market-based economies will eventually reach the same constant growth rate if they have the same rate of technological progress and population growth.
In the framework of the new growth theory, unexpectedly few empirical studies of the relation between stock market and economic growth are available. Levine and Zervos (1998) who the person mentioned earlier the important study. They are among the first to ask whether stock market as a casino or a key to economic growth and examine this issue empirically finding positive and significant correlation between stock market development and long run growth. Our main contribution is to quantitatively assess the role of stock market for growth in Saudi Arabia. Using a new data set on indicators of stock market development of the Tadawul All-Share Index (TASI) over the period 1999 to 2009.
3.3 Model specification
There are two model specifications in my study. One is to find the relationship and the other one is to determine the causality between stock market and economic growth in Saudi Arabia.
The first model examines the relationship between stock market development and economic growth directly or rather than through investment behavior. The level of investment is used as a control variable.
GDP = Î²0 + Î²1MKT CAP + Î²2LD + Î²3INV + µ
GDP = Real Per Capita GDP Growth
MKT CAP = Market Capitalization
LD =liquidity total value of share traded
INV = investment
µ = error term
The second model is to determine the causality between stock market and economic growth. This model is to test the second hypothesis of whether stock market causes the economic growth or vice versa.
GDP = Î²0 + Î’1SM + µ
GDP = REAL PER CAPITA GDP GROWTH
SM = STOCK MARKET
µ = ERROR TERM
3.4 Explanation of variable
Stock market development is measured by two proxies. There is market capitalization and value traded ratio.
Market capitalization defined by the ratio of market capitalization to real GDP. Market capitalization represents the aggregate value of a company or stock. It is obtained by multiplying the number of shares outstanding by their current price per share. This is calculated by dividing the value of listed companies (market capitalization) by GDP or calculated by multiplying a company’s shares outstanding by the current market price of one share
Liquidity (value traded as a percentage of GDP)
Liquidity defined by the ratio of trading volume to real GDP. Total value traded divided by GDP gives a measure of the liquidity in the market. Market liquidity measures how easily securities can be bought and sold.
Generally, investment is the application of money for earning more
Cite This Work
To export a reference to this article please select a referencing stye below:
Related ServicesView all
DMCA / Removal Request
If you are the original writer of this essay and no longer wish to have the essay published on the UK Essays website then please.