The Impact of Stock Markets on Economic Growth - Essay Example

Stock Market and Economic Growth Introduction It is a matter of fact that during the last decades the total value of stocks which were listed in the stock markets of the whole world has significantly increased to $15, 2 trillion. The share of total capitalization represented by developing and developed markets rose to almost 13% from 4%. It is necessary to note that trading is also constantly increasing in developing and emerging markets such as Taiwan, Korea, India, Mexico, etc. The value of traded shares was reported to rise from 3% to 17% during last years. It is suggested by theoretical economists and financiers that stock markets are able nowadays to promote long-run economic growth. Stock markets are told to stimulate specialization, distribution and receiving relevant information. Therefore stock markets can reduce significantly the costs of mobilizing savings and assist attracting foreign investors. It is known that stock markets in highly developed countries such as Germany may intensify and encourage corporate control by means of facilitating the problem “principal-agent”. The problem may be solved through consolidating the interests of managers and demands of owners and as the result the managers would strive to achieve goals and to maximize the value of the firm. (Levine 1999) Nowadays the developing and emerging markets are attracting rapt interest of foreign investors throughout the world. They raised number of problematic questions needed to be discussed. Investors tried to find out whether stock markets affect economic growth of the country or don’t. The most important question asked is how developing countries are able to benefit from the growth of stock market. Stock markets: impact on economic growth Although some critics analyze that stock markets have little positive effect on the country’s economic growth, many other analysts and evidence stress that stock markets are necessary for economic growth and they are able to provide the developing countries (Taiwan, Malaysia) with a big boost to economic growth and further development. (Levine 1997) It is known that stock markets are connected with the economic growth through the creation of liquidity. It means that really profitable investments demand just long-turn capital commitment, but investors don’t want to relinquish their capital for such long time without any control. Actually liquid stock markets make their investments more secure and in such way more attractive. Stock markets allow investors to acquire equity (an asset) and then to sell it rather quickly and without any problems if investors want to get access to their investments or they want to change their portfolios. Levine admits that “at the same time, companies enjoy permanent access to capital raised through equity issues”. (Levine 1997) Liquid stock markets facilitate long-term investments and make them more profitable. Therefore it is apparent that stock markets are necessary and important for economic growth, because they improve capital allocation and in such a way they enhance prospects for long-term economic development. Stock markets as it was mentioned above make investments more secure and attractive. What is more important is that stock markets can create more investment opportunities. In other words investors will be attracted, because they will be provided with possibility to leave if they want. (Levine 1999) In fact there are more ideas how stock markets affect and assist long-term economic growth of the country. There is a suggestion that stock markets stimulate investor’s short sight, because they allow unsatisfied investors to sell quickly their assets. As the result of this suggestion stock markets may significantly weaken commitments of investors and to reduce their incentives to perform control by examining managerial work and checking performance of the firm’s potential. According to such suggestion increased liquidity of stock market may considerably stop the economic growth. Nevertheless there is the evidence that the greater the liquidity of stock market is the greater is the economic growth. These two elements are told to be directly proportional. To understand how this system works it s necessary to consider three main measures of stock market liquidity. (Levine 1999) The first measure is the total value of shares which are traded on the stock exchange of the country as GDP (gross domestic product) share. But this ratio doesn’t affect significantly the costs of selling and/or buying securities at asked prices. The value of equity transactions was averaged for a long time, but nowadays it is varying, because the trade is easier than earlier. The value of equity transitions is the share of country’s output and development. It means that if the trade is risky and expensive, nobody will trade much. It is mentioned that this ration is used “to rank 38 countries by the liquidity of their stock markets in four different groups”. (Levine 1999) It is analyzed that countries with relatively liquid stock markets (the USA, Germany, Japan, and the United Kingdom) in 1976 turned out to develop faster over the next decades than the countries whose markets were illiquid during the mentioned period. The second point is the value of shares traded as “a percentage of total market capitalization (the value of stocks listed on the exchange)”. (Levine 1999) This ratio is used to measure trading relative to the stock market’s size (small, medium or large). It is apparent that greater ratio is the evidence of faster economic growth. The third ratio is the value-traded-ratio which is divided by volatility of stock price. It means that liquid markets have to be able to deal with heavy trade without significant changes in prices. Countries with higher trading ratio (the USA, Germany, Japan) grew faster than countries with less liquid markets (Mexico). It is demonstrated that there is a strong link between stock market liquidity and economic development of the country and this connection continues to hold if to control economic, social and political factors which may influence economic development of the country and/or if to use “instrumental variable estimation procedures, various periods, and different country samples”. (Stiglitz 1989) In other words economic growth is explained by development of stock market. Nevertheless there are some negative points concerning the link between economic growth and stock market development. For example the size of stock market (market capitalization divided by GDP) is not good forecaster of economic development whereas greater volatility of stock price doesn’t mean poor economic growth. The most important element of economic growth is the ease to trade shares. It is admitted that countries are able to get big profits and dividends if they enhance liquidity of stock market. For example, if the value-traded-to-GDP ratio of Mexico is average (0.06 instead 0.01 during 1976), the country’s annual income will be 8% higher in several years. It is claimed that stock market liquidity is useful for predicting economic development even if all non-financial factors affecting economic growth are accounted. Ross Levine mentions that “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”. (Levine 1999) Stock markets and economic growth: the channels of transmission: It is necessary to define main channels how stock markets influence economic growth of the country. Actually well-functioning stock market is useful and necessary for economic development through following issues: 1. growth of investments and savings 2. effective and efficient resources allocation 3. better distribution and utilization of existing resources (Singh 1993) Two market mechanisms are responsible for these central tasks. The first mechanism is the pricing process and the second is the take-over mechanism. Stock markets are considered to encourage savings and investments by means of providing investors and shareholders with additional opportunities which can satisfy their preferences. It is necessary to note that in developed markets such as Japan and Germany shareholders are provided with “with a relatively liquid means of sharing risk in investment projects” (Singh 1993) Although not all developed stock markets cope with this task. For example the net contribution of stock markets to the financial needs in the United Kingdom was rather negative during the period of 1970-1985. The reason is take-over. In other developed countries new issues were positive, but their amount was too small – 1% in the United States of America, 3% in Germany and 5% in Japan. (Singh 1993) Conclusion Although stock markets are able to contribute long-term economic growth of the country, they are only a small fraction of banking system. Stock markets have made important contributions to economic growth in Germany, Japan and France. Stock markets’ contribution in the mentioned countries was from about one-seventh to one-fourth. Stock markets are important for economic growth of the USA and the United States, but their financial influence was rather weak there. Nevertheless stock markets are able to promote long-term economic growth according to some analysts. (Artesis 2001) It is necessary to admit that volatility of stock markets had negative influence in France and Japan. Stock market volatility didn’t affect greatly the United Kingdom. Concerning Germany the volatility was stated to be insignificant. Volatility of any kind influences economic growth of the country. To sum up it is necessary to say that there are lots of opinions concerning necessity of stock markets for economic growth of the country. (Artesis 2001) Works cited Arestis, Philip. “Financial Development and Economic Growth: the Role of Stock Markets”. Journal of Money, Credit & Banking, 33, 1 (2001): 16-21. Levine, Ross. “Financial Development and Economic growth: Views and Agenda”. Journal of Economic Literature, 35, 2 (1997): 688-726. Levine, Ross. “Stock Markets: a Spur to Economic Growth”. Finance & Development (1999). [available at http://www.itcilo.it/english/actrav/telearn/global/ilo/equity] Singh, Ajit. “The Stock Market and Economic Development: Should Developing Countries Encourage Stock Markets?” Unctad Review, 4 (1993). Stiglitz, Jozeph. “Financial Markets and Development”. Oxford Review of Economic Policy, 5, 4 (1989): 55-68. Read More