Relationship Between Stock Markets and Economic Development - Essay Example

THE RELATIONSHIP BETWEEN STOCK MARKETS AND ECONOMIC DEVELOPMENT By ------------------------------------------------------------------------------------------- THE RELATIONSHIP BETWEEN STOCK MARKETS AND ECONOMIC DEVELOPMENT Introduction ­ Stock markets and economic growth have been known to have a special mutually complementary relationship. As has been evidenced in many developing countries during past few decades, the growth of stock market has been propelled by economic liberalisation which has in turn contributed to economic development of a country by further attracting huge investments. However, this paper evaluates validity of the statement as to whether and how stock markets can actually contribute to economic growth of a country, and that this can be achieved up to what extent. Empirical studies do suggest that a well developed stock market can considerably support economic growth in the long run through faster capital accumulation, improved resources allocation and exploiting the prevalence of positive sentiment across the country. (Ahmed, Ali & Shahbaz, 2008) Aim This paper aims to bring about direct relationship between a well-developed stock market and its contribution to economic development of a country. Background In 19th and 20th centuries, academicians such as Bagehot (1873) and Schumpeter (1911) had focused on contribution of financial sector to economy. The main function of money or capital in the initial years was to trade in credit for the purpose of financing development before the Great Depression. Gurley and Shaw (1955) were the first to study the relationship between financial markets and real activity. However, the direct relationship was not very clear until recently. Recent literature has paid much attention to banking reforms which directly affected both the stock markets and economic growth relationships. Levine (1997) suggested that liquid market spread can lead to stable and long term investments leading to economic growth through reduced transaction expenditure. While the conventional economists always believed that there was no direct relation between stock market growth and economic growth because of presence of level effect and not the rate effect. Many of them in fact believed that stock markets actually harm the economic growth due to its volatile nature, market flexibility due to unstructured and unexplainable sentiments and generally no justification for sudden surge or fall in stock indexes leading to perceived gains and losses of millions of dollars in a fraction of a day. However, there has been considerable growth of stock market share in economic direction of a country. During late 90s over a period of a decade, the total value of world’s stock markets rose from $4.7 trillion to $15.2 trillion while capitalisation share jumped fro 4% to 13%. (Levine 1998). The figures have since seen exponential growth in the past decade too, with world economy growing steadily between 6 to 10% in developing countries, and around 5% in developed world. These emerging markets have attracted international investors leading policymakers to always wonder as to how the stock markets can affect overall economic development, about their relationship and how can developing countries derive maximum benefit from these markets? (Levine 1998) Literature Review It has been generally accepted that well organised stock markets attract investments by promoting productive projects leading to economic activity within the market. It stimulates domestic savings, allocates capital proficiency, diversifies risks and facilitates exchange of goods and services. (Mishkin and Caporale et al as mentioned in Ali et al, 2008) One of the major advantages of developing economies was better developed financial system. Thus investors could be provided with adequate funding for their projects. Financial markets also contributed to economic development through better physical capital accumulation. During late 60s and early 70s, researchers found significant correlation between stock markets and per capita income too. (Ali et al, 2008) Furthermore, stock markets also played an important role in allocation of capital to corporate sector that in turn could stimulate economic activity considerably. Paudel (2005) acknowledged that due to their fast liquidity, stock markets enable firms to attain much needed capital quickly, and hence facilitate capital allocation, investment and growth which cannot be achieved by traditional banking sector. (Ali et al, 2008) Arestis et al. (2001) brought out that banking sector provided long term contribution to economy than stock markets. However, recently the emphasis has increasingly shifted to stock market indicators. Stock market development has been the subject of intensive theoretical and empirical studies. In principle, a well-developed stock market should encourage savings and thereby allocate adequate capital to productive investments, which leads to an increase in the rate of economic growth. However, theory also offers different prophecies regarding role of stock markets in economic growth. Literature on financial liberalisation has suggested abolished caps on interest rates and market competition for banks as more credible and effective means to achieve economic growth. As per certain fundamental valuation models, stock prices variations are outcome of future economic expectations. Therefore, perceived changes in future economy can lead to inaccurate variations in the stock markets. However, according to wealth effect, variation in stock prices cause changes in the real economy too. In a model of 10 developing countries, Demetriades and Hussain (1996) find very little indication of stock market as a principal segment in the process of economic development of a country. (Bahadur & Neupane, 2006) Economic Liberalisation While much debate has gone in towards effects of stock markets on economy, let us also look as to how economic liberalisation affects the stock markets. As is evident from the figure here, economic liberalisation does make tremendous difference on stock markets too, whereby in most cases they have developed in size and definitely not gone down in size. Since in any equation, the effect can be expected to affect both sides equally, the converse is also true and that the development of stock markets can also be expected to favourably affect the country’s economic development. Financial Markets and Economic Growth It has now been established that liberalisation of financial markets bring about efficient allocation of capital. However, when financial market is composed of banks alone and not stock markets, the market will not achieve efficient allocation of capital resources primarily because of shortcomings of debt finance in presence of asymmetric information. The most important limitation being that the banks finance only safe and well-established borrower in contrast with stock markets which can finance risk prone, but productive and innovative developments. High risk directly leads to higher profits and better economy in the long run. This also facilitates risk being diversified among capital raisers and mutual convergence of capital raisers’ and investors’ interests. This stimulates investment patterns and reduces cost of capital thus contributing to long-term economic growth of a country. Development of stock markets is therefore imperative to achieve full benefits of market liberalisation. (Caporale, Howells and Soliman, 2004) Granger causality test assessed empirical evidence of long run integration and causality of macroeconomic variables and stock market indicators. In econometric sense, it displayed significant role of financial markets, and particularly stock markets in economic development of a country and vice versa. In a study using Granger causality techniques to examine the link between financial markets and growth, Rousseau and Wachtel (2000) analyzed 47 economies. The report conclusively established that greater financial sector development directly leads to increased economic activity. (Bahadur & Neupane, 2006) Impact on Mutual Growth Prospects Stock markets stimulate economic movement through the creation of liquidity. While most profitable investments demand long term commitment of capital, investors are generally reluctant to surrender control of their savings for longer periods. It doesn’t suit their requirements of quick profits and easy liquidity. These markets reduce investment risks considerably and also make it lucrative by allowing investors to acquire assets and sell them quickly when they need cash or want to rework their portfolio. At the same time, the companies enjoy permanent access to this capital raised through equity issues. Thus, liquid markets improve the distribution pattern of capital and enhance chances of long-term economic growth too. Further, by making investments even less risky and more profitable through professionals managing the stock options in the form of good mutual funds, stock market liquidity can also lead to better investment patterns. (Levine 1998) Monetary growth prospective also highlights an important step in financial liberalisation that a well-developed stock market provides for exercise of fiscal policy through issue and repurchase of government securities in a liquid market. They alter pattern and demand for money while stock markets create liquidity thereby both mutually helping economic growth of country. Rousseau and Wachtel (2000) and Beck and Levine (2003) brought out that growth of stock markets directly resulted in growth of per capita income. Both the liquidity aspect and banking sector development forecast future growth pattern for a country’s economy when they enter growth regression. (Caporale, Howells and Soliman, 2004) Further, since today’s stock value echoes expected future dividend, stock market indexes might be useful to forecast future economic activity. An increase in stock market indexes potentially signals the market’s expectations of higher corporate dividends and profits and in turn, higher economic growth for the country. Conversely, any economic growth can also be expected to positively stimulate the financial sectors, and particularly stock markets in the long run. (Bahadur & Neupane, 2006) Further, as per one study, GDP growth has been found to be directly linked to liquid stock markets. The study is based on markets in 38 countries, both industrial and developing ones. Some developing countries with better financial markets have liquid stock markets thereby enabling better allocation of capital. The tables show that countries with very liquid stock markets in 1976 tended to grow very rapidly as compared with countries with very illiquid markets. (Levine 1998) Further, countries can also be expected to increase their growth rates considerably by increasing their liquidity, which allowed much more leverage to regulatory bodies than other financial sectors like banks which have restricted manoeuvrability and flexibility in short term. After scheming 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, 1998) Policy Making Tips While it is evident that stock markets make tremendous impact on economic development of a country, we need to delve briefly into aspects, which in turn could benefit stock markets, thereby positively stimulating a country’s economy. There are clearly laid down legal, regulatory, accounting, tax and supervisory systems which directly influence prospects of stock market liquidity in the long run. Efficiency of a good trading system also gives rise to faith and convenience with which an investor can purchase or liquidate his stocks as per his requirements. At the same time, a country’s macro economical, political and security situation determines the state of market economy, its future trend and in-flow of investments into the country. Removal of undesirable and politically created barriers for foreign investors also has considerable bearing on the market environment and confidence of investors. Policymakers should think about reducing hurdles in stock market development. A consistency in policies by successive governments brings back an investor again and again to the market for his own growth, and in turn, market growth. Easing limitations on foreign investment could be an excellent way to start the process. While the guidelines for policy makers is itself a subject worth researching into, it can be stated that consistent economic liberalisation with benevolent monitoring of emerging system can alone bring about the necessary development of a mature and rational stock market system, and its positive outcome in terms of economic development of a country. Conclusion Since its advent a few decades ago, stock markets have assumed gigantic proportions in world economies today. While growth in banking sector provided a firm footing to move forward safely, risk handling characteristics of stock markets have made them unbelievably progressive, arguably turning around prospects of many economies during past few decades. Other countries with smaller stock markets have been taking lessons seriously to make a dynamic turn around. Stock markets have assumed a crucial developmental role in global economics during past century. Its enormous capability to finance developmental projects has made success stories worth emulating for many countries. Without support from stock markets, many developed and developing economies of the world could never have reached the magnitude and scale they boast of today. Most theories of skeptics regarding contribution of stock markets to a country’s economy have been proved incorrect through scientific testing. Stock markets have a tremendous impact on growth of a country’s economic prospects. Various empirical tests have shown that a mutually beneficial equilibrium exists between stock markets and the economy of a country, one grows and in turn the other grows as well. These fluctuations have also helped to gauge the potential of and future economic direction, which may not always be accurate, but is definitely a reliable data to start with. Bibliography Levine Ross. 1998. Stock Markets: A Spur to Economic Growth. Retrieved on 18 Apr 08 from http://www-old.itcilo.org/actrav/actrav-english/telearn /global/ilo/equity/fdstock.htm. Ahmed Nadeem, Ali Liaquat, & Shahbaz Muhammad. 2008. Stock Market Development and Economic Growth. Retrieved on 18 Apr 08 from http://www.eurojournals.com/irjfe %2014%20shahbaz.pdf. Guglielmo Maria Caporale, Peter G. A Howells, And Alaa M. Soliman. Journal Of Economic Development 33 Volume 29, Number 1, June 2004. Stock Market Development And Economic Growth: The Causal Linkage. Retrieved on 17 Apr 08 from http://165.194.73.110/newjed/full-text/29-1/02_J665_.PDF. Surya Bahadur G.C, Suman Neupane. The Journal of Nepalese Business Studies Vol. III No. 1 Dec. 2006. Stock Market and Economic Development: a Causality Test. Retrieved on 17 Apr 08 from http://www.nepjol.info/index.php/JNBS/article/viewFile/481/468 Salvatore Capasso. 2003. Stock Market Development and Economic Growth: A matter of informational problems. 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