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The literature review gives an overall idea about the importance of financial markets, most precisely, stock markets to growth throughout history. The theoretical review is divided into different parts, section 2.1 talks about the financial system and growth in general, 2.2 illustrates different studies about stock markets and growth, 2.3 gives provides different indicators of stock market development, 2.4 provides different empirical studies which were done on stock market development and growth and finally, section 2.5 gives a summary of the review.
2.1 Overview of the Financial System and its relationship with Economic Growth
The financial system acts as a mediator between those in need of finance (borrowers) and those who have excess funds (lenders). This type of transaction can be done straightforward by engaging in direct lending or indirectly via organized markets (stock markets) or financial intermediaries like banks. The financial system plays an important role in the allocation of resources in any economy since it helps in the channeling of money from the saving portion of the population to the corporate sector. It also assists in the allocation of investment funds among companies and enables the sharing of risks between firms and the household sector.
Since the past decades, there have been a variety of studies which have emphasized on the relationship between financial development and economic growth. This issue has generated much controversy among economists since there are major questions which revolve around it. First of all, whether or not there is a link between financial sector developments and economic growth? And if yes, what is the nature and direction of the causal relationship? Is it unilateral or bilateral?
Patrick (1966) highlighted the possible causal behavior of financial development and economic growth through his “supply-leading” and “demand-following” hypotheses. The supply-leading hypothesis states that the intentional establishment and development of financial markets and their related services would provoke real investment and thus, leading to economic growth while under the demand-following hypothesis, it is the growing real economy which causes increased demand for financial services which consequently leads to financial development. Following Patrick’s work on the “supply-leading” and “demand-following” hypotheses, literatures on financial development and economic growth can be divided between those who stress the likely benefits of financial markets (to savings, capital allocation, corporate control and risk management) and others who argue that the financial system is unimportant for growth.
Over the years, famous economists promoted the idea that a good financial system does promote growth, the pillars in this field are; Bagehot (1873), Bawerk (1891), Schumpeter (1911), Gerschenkon (1962), Hicks (1969), Goldsmith (1969), McKinnon and Shaw (1973), Cameron (1976) and Miller (1988). These economists provided descriptions and empirical evidence of how and when financial markets encouraged growth.
Bagehot (1873) and Hicks (1969) investigated on how financial development ignited industrialization in England by enabling capital mobilization for huge works. In the same line, Schumpeter (1911) asserted that services provided by well functioning financial intermediaries like banks can stimulate technological progress by giving financial support to those entrepreneurs with highest chances of realizing innovative products. As a result, financial development encourages growth through capital mobilization and technology. In addition to that, using the Endogenous Growth Model of Romer and Lucas (1988), a strand of the literature contended that financial intermediation as well as stock market development does promote economic development by raising the rate and improving the productivity of investment. Recent economists have also paid much attention on financial system and economic growth due to the mounting nexus between these variables. Beneivenga (1991) and Levine (1997) established that more liquid markets do create investment in the long-term and hence economic growth due to falling transaction costs. Furthermore, King and Levine (1993) concluded that “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” (PP.717-18). Atje and Jovanovic (1993) also concluded that financial markets stimulated more economic growth as compared to financial intermediation. Besides, Berthelemy and Varoudakis (1996) affirm that insufficient developments in the financial sector may engender a poverty trap and consequently become a severe problem to growth even for countries which have established educational attainment and macroeconomic stability as preconditions for sustained economic growth. Additionally, Goodhart (2004) pointed out that transaction and information costs can be reduced by increasing the accessibility of financial instruments and that efficient financial market can help investors protect, trade and pool risks as well as rising their investment and growth in the economy.
On the other hand, one of the main economists who revoked the importance of the financial system for economic growth by asserting that “where enterprise leads finance follows” is Joan Robinson (1952). He maintained that it is economic growth which creates the demand for various types of financial products to which the financial system responds automatically. Other economists like Nobel Prize Winner, Lucas (1988) argued that some economists “badly over-stressed” the function of financial markets in economic growth while Stern (1989) did not even mention financial development in the lists of omitted topics in his survey. Similarly, in a collection of thesis, founders of developmental economics (including Meier and Seers (1984) and Chandavarkar (1992)) neglect completely the role of finance in economic growth, since they viewed the financial system as having an insignificant position in economic development. Thus, this line of researchers gave only a minor (if not any), role to financial factors in economic growth.
There has also been a number of papers like Favara (2003), Beck and Levine (2004), Loayza and Ranciere (2006), Saci et Al (2009) among many others which have provided evidence of negative relationship between financial sector activity and economic growth in the short term and conclusively a significant and positive one in the long-run.
2.2 Overview of Stock Market Development and Economic Growth
Lately, a new opening has been created in the literature of financial development and economic growth due to the increasing focus on stock markets worldwide. As a result, there has been a shifting interest among economists to analyze the relationship between stock market development and economic growth. Kunt, Levine and Zervos (1993, 1995, 1996 and 1998) were among the firsts to have theoretical concern about this topic and till now there is still a lot of debates around it. Stock market development is seen as a multi dimensional concept which takes into consideration the expansion of markets for equities and bonds in a country or internationally over the years. According to Levine and Zervos (1996), a huge amount of literature suggested that the functioning of stock markets can affect economic growth through various channels. As such, by raising the quality of these channels through a differentiated kind of service, stock markets can compete with financial intermediaries in order to trigger investment and growth. However, till now the effect of this relationship between stock market development and economic growth still remains debatable since some models found a positive link between them while others established a negative one.
The various channels which were mentioned above as per Levine and Zervos (1996) are:
Liquidity can be defined as the ease and ability by which an asset can be converted into money at any time period without great lost. However, while converting assets into cash, there are some kind of risks of uncertainties which may arise due transaction costs and asymmetric information. To be able to hedge and share these risks among investors, financial intermediaries including stock markets have been created. Moreover, the importance of financial mediators in the promotion of liquidity become more prominent with the arrival of high- return investment which also required long-run commitment of capital. Since many investors are risk averse for such type of projects, liquid financial markets turn out to be a vital pawn in providing finance for these long-term transactions which normally stimulate investment and economic growth in a country.
Owing to the significance of liquidity for stock markets, many authors who studied stock market developments could not detour it in their analysis. Kyle (1984) and Holmstrom and Tirole (1993) supported the argument that liquid stock markets can increase the motivation for stakeholders to get more corporate information and thus, improve corporate governance and the economy as a whole.
Bencivenga (1991) explored the relationship between liquid markets and economic growth and deducted that more liquid markets can propel long term investment and economic growth by lowering transaction costs. Adding up to this study, Levine (1991) and Bencivenga, Smith and Starr (1996) suggested that liquidity plays an essential role in economic growth. Liquid financial markets not only bring savers who have liquid assets and firms which are permanently in need of fund together but they also help savers reduce the downside risks and cost of investing in long unprofitable projects. This is so because via a stock market, investors can buy and sell their financial assets quickly and cheaply as soon as they are in need of liquidity. Hence, liquid equity markets permit savers to buy bonds, equity or deposits which can be liquidated whenever they want while simultaneously, enabling firms to get permanent access to capital raised by issuing these financial assets. Thus, according to Levine and Zervos (1996) “more liquid stock markets ease investment in long-run through potentially more profitable projects, thereby improving the allocation of capital and enhancing prospects for long-run growth.” Furthermore, Levine and Zervos (1993) uncovered the strong correlation between stock market development and growth rate of real GDP (per capita) and real physical capital (per capita). From this analysis, they noticed that both liquidity in stock markets and banking developments predict the future growth rate. King and Levine (1993) showed that the stage of financial intermediation in a country can be an excellent indicator of long-run economic growth, capital accumulation and output. Additionally, they found that enhanced liquidity in stock markets can lead to accelerating productivity growth. This is so because investors can now diversify their risk due to the availability of different types of shares from which a portfolio of high return investment can be created. In the recent literature, Paudel (2005) stated that liquidity in stock markets allowed firms to obtain capital quickly, consequently smoothing capital allocation, investment and growth.
Unfortunately, the role of liquid stock markets in promoting economic growth has been put into question. Bencivenga and Smith (1991) inquired about this issue and concluded that growth can be slowed down due to reduced savings caused by greater liquidity which, in turn, came from reduced uncertainty. Dermirguc-Kunt and Levine (1996) added to this theory by identifying 3 ways through which liquidity may deter growth. First of all, referring to the income and substitution effects, it can be affirmed that greater liquidity in stock markets created by increasing returns to investment, may reduce the rates of saving. Secondly, as a result of a reduction in investment uncertainty, greater stock market liquidity may impact negatively on saving rates due to the unclear effects which uncertainty has on savings. This accordingly can create a fall in the demand for precautionary savings. Finally, liquidity in equity markets might encourage investor shortsightedness and euphoria which can adversely affect corporate governance and economic growth.
Risk diversification is the second channel through which stock market may affect economic growth. It is commonly associated with the dealing, pooling and hedging of risk in the presence of informational and transaction costs in internationally integrated stock markets. Saint Paul (1992), Devereux and Smith (1994) and Obstfeld (1994) reasonably argued that opportunities to manage risks by diversifying globally make high-risk, high return transactions (local and foreign) more feasible. Thus, savings are allocated more efficiently between investment opportunities. Atje and Jovanovic (1993) also found that stock markets provide better chances for the pooling and spreading of risks. Therefore, the capacity for the stock market to offer services in relation to risk diversification can have an effect on economic growth in the long term due to the way resources and savings are allocated. Since high-return projects are riskier than lower return ones and that investors are assumed to be risk averse to these types of investments, equity markets will tend to ease risk diversification through internationally integrated stock markets which are more inclined to these kinds of assets. Conclusively, this will accelerate the process of economic growth (Obstfeld (1994)).
Conversely, there are some theorists like Devereux and Smith (1994) and Obstfeld (1994) who showed that greater risk allocation can slow growth owing to its uncertain effect on savings. As per their findings, reduced risk sharing via international equity markets can discourage savings, economic growth and economic welfare as a whole.
Acquisition of Information about firms
Referring to Carosso (1970), getting corporate information about firms, managers or other financial conditions can be quite laborious. Individual savers and other stakeholders who generally need this type of information for investment purposes may not have adequate time, resources or capacity to gather and process these data themselves and they would be rather reluctant to invest in such projects which do not provide trustworthy information. Thus, the emergence of equity markets help to lower down the high costs of information acquirement since information about listed firms are readily available to those people who are have particular interest in them (Diamond (1984) and Boyd and Prescott (1986)).
Additionally, Atje and Jovanovic (1993) pointed out that a stock market can positively influence the availability of firms’ information which will sequentially improve the efficiency of the financial intermediation. The equity market also smoothen the flow of information from management to owners for traded companies. Grossman and Stiglitz (1980), Kyle (1984) and Holmstrom and Tirole (1994) do argue that stock markets not only assist in the acquisition of information but in its distribution too. As stock markets grow and become more liquid, marketers will have more motivation to get firm-level information and so it will be much easier for them to trade at prices at place. Larger liquid markets can also lead to the risk of arbitrage, whereby, arbitrageurs will try to beat the market and benefit from price discrepancies by accessing private information and make money before the information becomes publicly available and price changes. Yet, Fama (early 1960s), affirmed that equity markets are “informationally efficient” and thus, it is quite impossible to earn supernormal profits as historical, public and insider information are already included in the share price. Plus the ability to earn abnormal profits from information will encourage investors to research and supervise firms. So, as Stiglitz (1994) rightly said, efficient capital markets lessen the costly and painstaking efforts of obtaining additional data. As a consequence, information efficiency will stimulate the allocation of resources and economic growth. Besides, Peres (2010) indicated that stock markets do provide the necessary resources to share private information in an “incentive-compatible” way and that stock prices do help in capital allocation by combining detached information and by identifying the most meriting investment opportunities.
Economists like Stiglitz (1985), who are against the idea that the stock markets are important to enhance the acquisition of information, advocate that price changes is the most prominent mean that well-established equity markets use to disclose information. However, revealing information quickly to the public may create a free rider problem and discourage stakeholders to spend in private resources to acquire costly information. Thus, this may have “l’effet contraire” on resource allocation and growth.
Stock market development may have an influence on the corporate control of firms as well. Meckling (1976), Diamond and Verrecchia (1982) and Jensen and Murphy (1990) are among the first researchers to talk about the efficiency of stock markets to alleviate the principle-agent problem. The trading of shares on stock markets allows owners to fasten managerial reward to stock prices via the efficient flow of information. Thus, aligning stock performance to manager’s rewards helps to bond the interests of both owners and managers. Furthermore, in well-developed equity markets, it is easier for larger firms to takeover smaller non-performing ones, therefore, as per Laffont and Tirole (1988) and Scharfstein (1988) threats of being taken over by larger firms induce managers to take full advantage of the firm’s equity price. Consequently, by controlling corporations and supervising managers, better stock markets can facilitate the takeover of poorly managed firms and finally mitigate the principal-agent problems. As a result, this leads to better resource allocation and growth of the economy.
Opponents of that idea do argue that due to asymmetric information, those investors willing to buy smaller firms may be reluctant to do so unless provided with a premium since they generally have less information about the firms than do current owners (Myers and Majluf (1984)). Subsequently, the take-over threat mechanism will not have the required effect in exerting corporate control as it should have had otherwise. Thus, according to Stiglitz (1985), corporate control cannot be widely supported by stock markets as hostile takeovers may lead to inefficient allocation of resources. By subordinating exit costs, liquidity in equity markets encourages more disperse ownership and greater barriers to supervise managers properly (Shleifer and Vishny (1986)). Shleifer and Summers (1988) found that facilitating takeovers in developed stock markets can induce welfare-reducing transformation in both ownership and administration. Bhide (1993) attested that liquid stock markets can also impact adversely on motivation of owners to supervise of firms and hence hampers the effectiveness of corporate governance.
Lastly, it is expected that stock exchanges will increase the amount of savings directed to the financial sector. Evidence can be found in the works of Greenwood and Smith (1996) which demonstrated that large, liquid and well-developed equity markets can help in mobilizing savings through the creation of small valuable instruments which gives households the chance hold diversified portfolios of assets. Thus, with respect to Stirr and Tufano (1995), mobilization of savings may improve liquidity, risk diversification and the size of firms which will consequently lead to better resource allocation, enhance technological progress and stimulate economic growth. Moreover, agglomerating savings through the stock markets can help raised the amount of viable investment plans. Stock markets also facilitate resource mobilization from projects that benefit from economies of scale to those that need huge capital injections, as a result, boosting economic efficiency and long-run growth.
Nevertheless, disagreements over the importance of stock markets in mobilizing and raising capital do exist. Mayer (1988) protested that only a small amount of corporate investment is accountable to the issuing of new shares.
2.3 Measuring Stock Market Development using various indicators
Throughout the ages, there have been various indicators which were used as measurement for developments in the stock market. Referring to the multifaceted measure of Dermiguc-Kunt and Levine (1996), there are six main pointers of stock market development. These are: (a) the size of the stock market, (b) market liquidity, (c) volatility in equity market, (d) level of concentration in the market, (e) risk diversification and international integration and (f) regulatory and institutional indicators. Despite the wide variety of indicators that exist, no single one is adequate in itself to give a general estimation of the overall stock market. Therefore, it is important to construct stock market indexes based from these indicators in spite of the serious problems that the weighting and counting of qualitative data can bring.
2.3.1 Stock Market Size
The size of the stock market is normally measured using the market capitalization ratio which is equivalent to the value of listed shares divided by the Gross Domestic Product (GDP). This calculation is made because there is a direct positive correlation between market size and capital mobilization and risk diversification.
To be able to measure liquidity properly, it is important to take into account all the costs associated to trading mainly time costs, uncertainty of finding a counterpart and settlement costs. To be able to do this, two measures have been designed accordingly. The first one take into account the total value of shares traded on stock market over GDP and is currently known as the total value traded ratio. This ratio computes the trading of shares as a proportion to national output and thus reflects the impact of liquidity on the economy as a whole. The other measure is termed as the Turnover ratio which evaluates the value of traded shares above market capitalization. Lower transaction costs are often reflected through higher turnover. When doing the analysis for stock market development index, both measures will be included because of the relative importance of liquidity in facilitating long-term capital investments and information acquisition which will in turn influence growth.
Volatility can be defined as the relative rate at which the price of shares fluctuates. It can be calculated by taking the yearly standard deviation of daily price variations. If price of shares oscillates heavily over short time periods, then it is said that the stock price is highly volatile. However, if there are only a little or no fluctuations in the price, then it is said to have low volatility. Even though, high volatility does not mean more or less stock market development, less volatility is generally considered as revealing greater developments in stock markets.
2.3.4 Market Concentration
Concentration in stock markets usually refers to the degree to which a relatively small number of companies dominate the market by holding a larger percentage of the total market capitalization. High concentration is generally not advisable as it has an adverse effect on liquidity. The level of concentration is measured by analyzing the proportion of market capitalization administered by the largest firms.
2.3.5 Risk Diversification to integrate internationally
Relating to the past literatures, it is normally assumed that risk diversification by investing in a broad array of international portfolios can help investment decision and encourage growth. Nevertheless, there are certain barriers which can prevent capital flows throughout the world; this can be in the form of information asymmetry, taxes, regulatory restrictions and other trade barriers. To be able to measure the stock market integration, Korajczyk and Viallet (1990) made use of a multi-factor International Asset Pricing Model (IAPM) which entails that the estimated return on each asset is related in a linear way to a combination of standard portfolios. When analyzing the assets pricing model locally, the benchmark of portfolios include only domestically traded securities whiles the international one includes all securities. If the model is good, then all the systematic expected returns on asset above the risk-free interest rate should be explained by the combination of portfolios. One disadvantage of this measure lies in the fact that as a country becomes more integrated on international backgrounds, the benchmark of portfolios shift from domestic stocks to international ones. Thus, the domestic mispricing risk will rise even more as the stock market becomes more efficient and integrated internationally.
2.3.6 Regulatory and Institutional Indicators
The functioning of stock markets may be affected by the regulatory and institutional measures that the government and other international bodies may take. The law stipulating the obligatory disclosure of corporate information about firms and other financial intermediaries may be a good stimulus for investor participation in stock markets. Regulations that inspire investors’ confidence in brokers and other financial intermediaries may encourage investment and trading in stock markets. Other macro prudential and corporate governance regulators at country level are also important to promote international investment and protect against global malpractices. To be able to evaluate the regulatory and institutional features of capital markets, seven indicators were constructed by the International Finance Corporation (IFC). These indicators are: (a) the market publish price-earnings information, (b) accounting standards, (c) the quality of investor protection laws, (d) analyzing the securities and exchange commission of a country, (e) restrictions on dividend repatriation by foreign investors, (f) capital repatriation by foreign investors and (g) domestic investments by foreigners.
Due to the fact that Mauritius has a relatively small stock exchange market and that there are restrictions upon the availability of firm-level information, I will consider only the indexes for Market size and liquidity in my dissertation. This will be done by the construction of a stock market index which will take into account these indicators.
Empirical Review of Past Literatures
The growing concern of stock market development and economic growth, lead the floor to an extensive range of researches which analyses this relationship in different ways. Some authors analysed the causal relationship between stock market development and growth in one single country while others made cross-country analysis. Moreover, there are particular studies which even took the effect of interest rates on equity market and growth into consideration. Due to the multitude of working papers about this topic, I have considered only those empirical literatures which are more or less relevant to my work and to the Mauritian perspective. So, in the first part of this section, I will elaborate mainly on the past studies which linked stock market development and growth across countries, and then, I will analyze a country-based study. In the third part, I will deal mainly with papers relating to the causal relationship that exists between market development and growth and the last portion will relate merely to researches in the Mauritian context. An overall conclusion about the relevancy of these studies, the possible effect of this relationship and the model I am intending to use will sum up the review.
Atje and Jovanovic (1993) made a cross-country analysis of thirty-nine countries for eight years from 1980 to 1988. Their study showed that the relative size of a country’s stock market can help to explain growth in the Gross domestic product per capita. After controlling for lagged investment, they also found that the volume of trade could have a positive impact on growth while bank credits did not have any effect. Conclusively, the stock markets did promote return on investment which could significantly entail economic growth.
Levine and Zervos (1996) have attempted to analyze the link between stock market development and long run economic growth, using pooled cross-country for forty-one countries for the period 1976 to 1993. They constructed the following time-series growth regression model with the real per capita growth rate as the dependent variable:
Growth = αX + β (STOCK) + u
Where X is the rate of control variables, α is the vector coefficient on the X variables, STOCK is the index for stock market development which took into account indicators of market size, liquidity and risk diversification, β is the coefficient of STOCK and finally u is the stochastic error. The main of aim of this regression was to evaluate the effect of “independent partial correlation” on equity market development and growth. Thus, the variables denoted by X were included into the equation to control growth associated factors. After analyzing the data through various tests, it could be concluded that developments in stock markets was positively correlated with economic growth. Moreover, some influential variables did indicate a strong link between the component of stock market development and long run growth.
In the same line of research, Demirguc-Kunt and Levine (1996) considered the data for forty-four developed and emerging economies for the years 1986 to 1993. They deducted that countries which have healthy stock markets tend to have better financial intermediaries while countries with fragile equity markets have weak banks and other intermediaries. So, developed stock markets could lead to financial sector expansion which, in turn, could induce economic growth.
There are also some studies which are made on country-based analysis like that of Osinubi (2002) who examined whether stock market promoted growth in Nigeria for the period 1980 to 2000 using ordinary least squares (OLS) regression. Osinubi made use of an extended production function approach as per Levine and Zervos (1996) to determine growth in an economy. Referring to this approach, other determinant of economic activities like the stock market development index (which include market size, liquidity and market concentration), trade openness, debt overhang, state of political stability, public investment and country/policy dummies were incorporated in the model. Accordingly, a unit root test was performed and the results from this times series analysis did confirmed the positive relationship between economic growth and the measures of stock market development used. With a 99% R-squared test and a 98% adjusted R-squared, the outcome suggested that growth in Nigeria was adequately explained by the model. Nevertheless, the relationship was statistically insignificant meaning that the effect of developments in stock market on growth is weak. This was mainly attributable to the lack of volatility in the ratio of the Nigerian stock market contribution to gross fixed capital formation between 1971 and 1980 and also due to the structural rigidities prevailing in the economy. Subsequently, to be able to benefit from the positive relationship, it is essential that all sectors in the economy collaborate together in Nigeria.
Many researchers have also analysed the causal relationship between stock market development and economic growth. Shahbaz, Ahmed and Ali (2008) did analyse this relationship with reference to a
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