Effects of the Stock Market on Economic Development

Effects of the Stock Market on Economic DevelopmentOver the last few decades world line of products trades argon riseing tremendously and the rip merc mittises spoticularly in developing countries represent a large sh be of this boom. Investors be venturing into the world s newest markets and some atomic number 18 seeing crowing returns but are developing countries themselves reaping any benefits from their computer memory markets? The evidence indicates that they are.Over the past 10 years, the total value of ancestrys listed in all of the world s pipeline markets rose from $4.7 trillion to $15.2 trillion, while the Share of total world capitalisation represented by the emerging markets jumped from less than 4 percent to almost 13 percent. Trading in the emerging markets besides surged the value of shares traded climbed from less than 3 percent of the world total in 1985 to 17 percent in 1995.The emerging markets shoot attracted the interest of international giveor s while raising a number of critical apparent movements for policy makers in developing countries Do stock markets posit overall scotch knowledge and, if so, how? What is the alliance, surrounded by stock markets and banks in fostering scotch gain? And, how back developing countries benefit from stock market branch?Impact on incr tranquilizeDo stock markets ingrain overall stinting evolution?Although some analysts view stock markets in developing countries as casinos that have little positive impact on frugal evolution, recent evidence suggests that stock markets can give a big boost to stinting culture.Stock markets whitethorn affect economic bodily process by means of the creation of stillity. Many profit adapted enthronizations require a semipermanent commitment of capital, but investors are often reluctant to relinquish control of their savings for abundant periods. Liquid equity markets make investment less risk of exposurey and more than attractive because they concede savers to acquire asset equity and to sell it quickly and cheaply if they need access to their savings or want to commute their portfolios.At the same time, companies esteem permanent access to capital raised through with(predicate) equity issues. By facilitating longer-term, more profitable investments, liquid markets remediate the allocation of capital and enhance prospects for long-run economic change stateth. Further, by making investment less risky and more profitable, stock market liquidity can also lead to more investment. chuck succinctly, investors will come if they can leave.There are alternative views active the effect of liquidity on long-term economic recrudesceth, however. near analysts argue that really liquid markets encourage investor myopia. Because they make it easy for dissatisfied investors to sell quickly, liquid markets may weaken investors commitment and edit investors incentives to exert corpo pasture control by over- seeing managers and monitoring firm performance and potential. According to this view, enhanced stock market liquidity may actually hurt economic growth.The data-based evidence, however, powerfully supports the belief that greater stock market liquidity boosts or at least precedes economic growth. To see how, consider deuce-ace measures of market liquidity three powers of how easy it is to buy and sell equities.One commonly used measure is the total value of shares traded on a country s stock exchanges as a share of GDP. This ratio does not directly measure the cost of buying and selling securities at posted prices. Yet, aver- aged over a long time, the value of equity proceedings as a share of national output is likely to vary with the ease of trading. In other(a) words, if it is very expensive or risky to trade, there will not be much trading. This ratio is used to rank 38 countries by the liquidity of their stock markets in four different free radicals. The nine countries with th e most illiquid markets are in the first group the nine countries with the most liquid markets that is, with the largest value-traded-to-GDP ratios are in the fourth group the second and third groups, apiece of which contains 10 countries, fall mingled with the two extremes of liquidity. As Chart 1 show, countries that had sexual intercoursely liquid stock markets in 1976 tended to grow much fast-breaking over the next 18 years than countries with illiquid markets.The second measure of liquidity is the value of traded shares as a percentage of totals market capitalization (the value of stocks listed on the exchange). This turnover ratio measures trading relative to the size of the stock market. Chart 2 indicates that greater turnover predicted faster growth. The more liquid their markets in 1976, the faster countries grew between 1976 and 1993.The third measure is the value-traded-ratio divided by stock price volatility. Markets that are liquid should be able to handle atrociou s trading without large price swings. As Chart 3 shows, countries whose stock markets were more liquid in 1976 countries with higher trading-to-volatility ratios grew faster over the next 18 years than countries with less liquid markets. As demonstrated in the series of paper on which this article is based (see back- ground note), the buckram link between stock market liquidity and economic growth continues to hold when dogmatic for other Economic, social, political, and policy factors that may affect economic growth, and when using instrumental multivariate estimation procedures, various periods, and different country samples. The basic conclusion that emerges from this statistical go bad is that stock market development explains future economic growth.What is important is that other measures of stock market development do not tell the same story. For example, stock market size as measured by dividing market capitalization by GDP is not a good predictor of economic growth (Ch art 4), while greater stock price volatility does not of necessity predict poor economic performance (Chart 5). Empirically, it is not the size or volatility of the stock market that matters for growth but the ease with which shares can be traded.Countries may be able to garner big growth dividends by enhancing the liquidity of their stock markets. For example, regression analyses suggest that if Mexico s value-traded-to- GDP ratio in 1976 had been the same as the average for all 38 countries in our sample (0.06 instead of Mexico s actual ratio of 0.01), the annual income of the average Mexican would be 8 percent higher today. This type of forecast does not explain how to enhance liquidity, but it does give an indication of the potentially large economic costs of policy, regulatory, and legal impediments to stock market development.Is there really a link between stock market liquidity and economic growth, or is stock market liquidity just highly fit with some non monetary factor t hat is the true cause of economic growth?Multiple regression procedures suggest that stock market liquidity helps forecast economic growth even after accounting for a variety of non pecuniary factors that Influence economic growth. After controlling for inflation, fiscal policy, political stability, education, the efficiency of the legal dodge, exchange rate policy, and openness to international trade, stock market liquidity is still a reliable indicator of future long- term growth.Stock markets versus banksIs there and independent link between stock market development and growth, or is stock market liquidity correlated with banking development and is the latter the pecuniary factor that really spurs economic growth?Although countries with well- authentic banks as measured by total bank loans to tete-a-tete enter- prises as a share of GDP tend to grow faster than countries with underhighly-developed banks (Chart 6) the effects of banks on growth can be separated from those of st ock markets.To evaluate the relationship between stock markets, banks, and growth, our 38 sample countries were divided into four groups. conclave 1 had greater-than-median stock market liquidity (as measured by the value- traded-to-GDP ratio) in 1976 and greater- greater-than-median banking development. Group 2 had liquid stock markets in 1976 but less-than-median banking development. Group 3 had less-than-median stock market liquidity in 1976 but well-developed banks. Group 4 had illiquid stock markets in 1976 and less-than-median banking development.Countries with both liquid stock markets and well-developed banks grew much faster than countries with both illiquid markets and underdeveloped banks. Furthermore, greater stock market liquidity is associated with faster future growth no matter what the direct of banking development. Similarly, greater Banking development implies faster growth no matter what the level of stock market liquidity. Thus, it is not a question of stock ma rket development versus banking develop- mint each, on its own, is a strong predictor of future economic growth.Why might stock markets and banks both, independently of each other, boost economic growth?Although the empirical evidence is consistent with the view that stock markets and banks promote economic growth independently of each other, the reasons are not fully understood. One statement is that stock markets and banks let different types of fiscal services. Stock markets offer opportunities primarily for trading risk and boosting liquidity in contrast, banks counseling on substantiateing long-term relationships with firms because they hear to acquire information about projects and managers and enhance corporate control. (There is, of course, some overlap. Like stock markets, banks help savers diversify risk and provide liquid deposits. Like banks, stock markets may stimulate the acquisition of information about firms, because investors want to make a profit by identifyi ng under- valued stocks to invest in stock markets may also help improve corporate governance by simplifying takeovers, providing an incentive to improve managerial competency.)Is greater stock market liquidity associated with more or go against investment?Both Chart 7 shows that countries that had more liquid stock markets in 1976 enjoyed both faster place of capital accumulation and greater productivity gains over the next 18 years However, although liquid equity markets imply more investment, new equity sales is not the only source of finance for this increased investment? Most corporate capital creation is financed by retained earnings and bank loans. Although this phenomenon is not wholly understood, greater stock market liquidity in developing countries is linked to a rise in the amount of capital raised through bonds and bank loans, so that corporate debt-equity ratios rise with market liquidity. Stock markets tend to complement not replace bank lending and bond issues.Eco nomist believes otherwise regarding the grandness of financial organization and its impact on economic growth.Walter Bagehot (1873) and John Hicks (1969) viewed purpose of financial governance as a critical factor for the militarization of capital. Joseph Schumpeter (1912) explains that a well developed financial system stimulates funding for entrepreneurs According to his view, Economic development fabricates demand for financial arrangements, and the financial system automatically counters these demands. excessively this, some economists just do not believe the share of finance development is crucial to economic growth. Among those (Robert Lucas, 1988) reasoned that economists poorly over-stress the role of financial development for economic growth.A growing body of work would push even most skeptics toward the belief that the development of financial markets and institutions is a critical and inextricable part of the growth process and away from the view that the financial s ystem is an inconsequential side show, responding passively to economic growth and industrialization. There is even evidence that the level of financial development is a good predictor of future rates of economic growth, capital accumulation, and technological change.This research paper is based on an brisk papers by (Garcia and liu 1999) and (Julia Losseva, 2006). The main objective of this paper is to find the relationship between stock market development and the economic growth in developed economies. However there is an effort made to address the role of liquidity in the development of stock market which hasn t been given much of the attention.Some researchers argue that there is no influence of stock market development on economic growth. Recent evidence confirmed that Stock markets may affect economic development by providing liquidity to the market. Usually a profitable investment require long term commitment of the capital however Investors are apprehensive in holding up th ere capital for long time. Liquid equity market makes facilitates investment and offer quicker ways to alter portfolios so it s vital to both the investor and stock market development.(King and Levine, 1933) provide mechanism to enhance the economic activity they highlighted that financial system is better able to evaluate and finance the profitable prospective investor. The study explicate that financial institution provide the mechanism of evaluation and monitoring less costly and more competently, than the individual investors. Additionally the financial system provides better mobilization of capital and financing to the investors. hence promotes the growth by productivity improvements. Besides this financial system also assist in risk diversification for investor in relation to uncertain innovative improvements despite of the fact that financial system distortion moment in a reduction over the rate of economic growth. It is stressed that the more developed financial system in cluding banks and stock markets enhances the productivity and stimulate economic growth. Government policy on financial systems may have crucial influence on long dethaw growth.(Levine and zervos, 1998) proposed that a well functioning stock market and banks enhance long run economic growth.In light of these conflicting views, this paper uses existing theory to invent an analytical frame work of the finance-growth nexus and then assesses the quantitative importance of the financial system in economic growth.In light of these conflicting views, this paper uses existing theory to organize an analytical frame-work of the finance-growth nexus and then assesses the quantitative importance of the financial system in economic growth. Although conclusions must be stated hesitantly and with ample qualifications, the prevalence of theoretical reasoning and empirical evidence suggests a positive, first-order relationship between financial development and economic growth.Broad problem area Is there a Causal relationship between stock market development and economic growth? Literature SurveyFinancial development and economic growth the role of stock marketsEconomists Hold startlingly different opinions regarding the importance of the financial system for economic growth. Walter Bagehot (1873) and John Hicks (1969) argue that it figure outed a critical role in facilitating the mobilization of capital.Joseph Schumpeter (1912) contends that well functioning banks spur technological innovation by identifying and funding those entrepreneurs with the best chances of success.In contrast, Joan Robinson (1952, p. 86) declares that, economic development hits demands for particular types of financial arrangements, and the financial system responds automatically to these demands.The relationship between financial development indicators and economic growth has received a considerable attention in recent empirical literature. Many authors have concluded that the development of the f inancial system has a positive effect on the rate of economic growth.And the volume and efficiency of investment Fry, (1997), McKinnon (1973) Shaw 1973, and others such as Kapur (1976), Matheson (1980) and fry (1989) and (1997) have presented the theoretical backward of the relationship . Financial intermediation has positive effect on economic growth.McKinnon, 1973 and Shaw, 1973 emphasis the role of financial liberalization to increase saving and investment they argued that financial deepening improve not only productivity but also capital and saving. Therefore it improves prospects for investments and growth. Second by reducing the information and transaction cost the financial intermediaries.The main policy implication of the McKinnon/ Shaw frame work is that government restriction on the financial sector such as interest rate ceilings, high reserve requirements and directed credit policies distort the process of financial development and reduce economic growth. Greenwood and Jo vanovic (1990) and king and Levine (1993) argue that the government intervention in the banking system reduces the growth rate of the economy because of the high transaction cost.Gurley and Shaw 1955, 1960, 1967 centred their theme on the importance of financial intermediation to direct saving to investment. Further to their research Atje and Jovanovich 1993, link stock market development as a positive sign for economic growth and efficiency. Similarly Levine and zervos 1998 and Singh 1997 proposed stock market development as a positive function to the long term growth.(Gold smith 1969) emphasized that the well unified financial system facilitates the growth economy and explained the overall positive impact of financial structure on economic growth. Pagano, 1993 identify that there is an increased risk sharing benefits in larger stock markets through market externalities while Levine and bencivenga smith and Starr, 1996 show that the stock market may affect economic activity throug h the creation of the liquidity similarly Devereux and Smith, 1994 and obstfeld 1994 shows that the risk diversification through internationally integrated stock markets is another vehicle through which the stock markets can effect economic growth.In the early researches carried out by (Greenwood and jovanovic s, 1990) emphasized the argument that well functioning financial markets lowers the transaction cost which help in directing the capital to most favourable project in terms of returns therefore promotes growth.Both (McKinnon/ Shaw and Gurley and Shaw 1955, 1960, 1967) stress the role of financial intermediaries on economic growth and they concluded that the easy transfer of funds gears the high social return for economic growth.(King and Levine, 1933) provided empirical evidence by observing financial intermediaries and their role in economic growth by using a cross country data of 80 different countries establish a direct relationship between a well developed stock market, ba nking system promotes economic growth.(King and Levine, 1933) provide mechanism to enhance the economic activity they highlighted that financial system is better able to evaluate and finance the profitable prospective investor. The study explicate that financial institution provide the mechanism of evaluation and monitoring less costly and more efficiently, than the individual investors. Additionally the financial system provides better mobilization of capital and financing to the investors. Therefore promotes the growth by productivity improvements. Besides this financial system also assist in risk diversification for investor in relation to uncertain innovative improvements despite of the fact that financial system distortion way out in a reduction over the rate of economic growth. It is stressed that the more developed financial system including banks and stock markets enhances the productivity and stimulate economic growth. Government policy on financial systems may have crucia l influence on long run growth.(Levine and zervos, 1998) proposed that a well functioning stock market and banks enhance long run economic growth.Joseph Schumpeter s view financial intermediaries are crucial for innovation and economic development and the same argument was concluded in the empirical work by Goldsmith, 1969 McKinnon, 1973) However some economist like Lucas, 1988 believe that financial development is not important for economic growth and describe the relationship of financial development and economic growth as over stressed.King and Levine strongly hold the view that there is strong relationship between among financial development and real per capita GDP growth and the rate of capital Allocation. They also determined the financial development is robustly correlated with future rates of economic growth.As a result King and Levine supported the idea which was proposed by Schumpeter 80 years back. In another article (Levine, 1933) develop an endogenous model to clarify t he relationship between growth finance and entrepreneurship. The study the role entrepreneurs in initiating economic activity there are two views of Schumpeter the first one which states that innovation are the motivation to seek temporarily monopoly profit.The second view which less popular is financial intermediary play a vital role in economic growth because of the fact that these financial intermediaries provide fund to the entrepreneur for their innovative activity and facilitate development of new product in the market.Previously the economist such as (Schumpeter, 1911) and (Walter Bagehot, 1873) emphasize the role of banking system in economic growth. Beside this historical emphasize on banking system there are few researches on the relationship between stock market and long run growth.Therefore (Levine and zervos, 1998) focused on stock market by using 47 countries data from (1976 -1993). The study empirically investigates whether banking and stock market indicators are stro ngly correlated with the current and future rate of economic growth, capital accumulation and productivity growth.Te evidences are consistent with the views that service provided by financial institution and markets are noteworthy for long run growth as argued by (King Levine, 1933) finally the study summarizes that financial environment plays crucial role in the economic growth process.In recent papers by (Rajan and Zingales, 1998) contribute to the finance and growth literature by examining whether industrial sector requiring external finance, in countries with well developed financial markets grow faster compared to those less developed financial market. The results are consistent with the theory that financial markets and institution reduce the cost of external finance.For firms and promote industrial growth a emphasized this would imply that an intentness in need of external finance such as pharmaceutical grow relatively faster than tobacco industry requires little external fi nance in countries with well developed financial system Rajan and Zingales ,1998.Similarly Demirguc-kunt and Maksimovic, 1966 found consistent results with Rajan and Zingales, 1998 that firms in countries with well functioning banking system and equity markets grow faster than it was predicted to sum up the study suggest that financial development may cause the rise of new firms and can improve the growth indirectly and also finding provide evidence that financial market imperfection have an important role in on investment and growth.Moreover, some economists just do not believe that the finance-growth relationship is important. Robert Lucas (1988, p. 6) asserts that economists badly over-stress the role of financial factors in economic growth, while development economists frequently get their skepticism about the role of the financial system by ignoring it (Anand Chandavarkar 1992).The link between liquidity and economic development arises because some high-return projects require a long haul commitment of capital, but savers do not like to relinquish control of their savings for long periods. Thus, if the financial system does not augment the liquidity of long-term investments, less investment is likely to occur in the high-return projects. Indeed, Sir John Hicks (1969, pp. 143-45) argues that the capital market improvements that mitigated liquidity risk were primary causes of the industrial revolution in England.The critical new is capital market liquidity. With liquid capital markets, savers can hold assets-like equity, bonds, or demand deposits-that they can sell quickly and easily if they seek access to their savings. Simultaneously, capital markets transform these liquid financial instruments into long-term capital investments in illiquid production processes.With liquid capital markets, savers can hold assets-like equity, bonds, or demand deposits-that they can sell quickly and easily if they seek access to their savings. Simultaneously, capital marke ts transform these liquid financial instruments into long-term capital investments in illiquid production processes.Informational asymmetries and transaction costs may inhibit liquidity and intensify liquidity risk. These frictions create incentives for the emergence of financial markets and institutions that augment liquidity. Liquid capital markets, therefore, are markets where it is relatively trashy to trade financial instruments and where there is little uncertainty about the measure and settlement of those trades. Before delving into formal models of liquidity and economic activity, some intuition and chronicle may help motivate the discussion.Demirguc kunt and Levine 1996 identifies the relationship between stock market development and financial intermediary development. They find that better developed stock markets also have better developed financial intermediaries. Levine and Zervos 1998 proposes that liquidity of the stock market is significantly correlated with curren t and future rates of economic growth. They also notice that stock market liquidity and banking development significantly predict future areas of growth.Demirguc kunt and Levine, 1996 investigated the relationship between stock market development and financial intermediary development they also found that those countries having well developed stock markets have better developed financial intermediaries. Therefore they concluded that stock market development goes hand in hand with financial intermediary development.The financial development and its impact on new firms creation are investigated by (Beck, Demirguc-kunt and Levine, 2001) and the impact of economic development and financial structure on industry growth are examined by using country industry panel based on work by Rajan and Zingales, 1998 it is questions that whether industries that heavily depend on external finance grow faster in market or bank based financial system.Whether the level of financial development is a matt er for economic development , beck Demirguc kunt and Levine, 2001 found that the banks non banks financial intermediaries and stock market are larger more active and more efficient in richer countries. These characteristics of financial system develops as countries become wealthier also the result indicates that while countries become wealthier stock markets become more active and efficient relative to the banks the more important finding of the article is that externally dependent industries grow relatively faster in countries with better developed financial systems which is consistent with the financial services view predicting that industries that dependent on external finance grow faster in economies with a higher level of financial development grow relatively faster in countries with better developed financial systems, which is consistent with the financial services view predicting that the industries that dependent on external finance grow faster in economies with a higher lev el of financial development.Further to their research by using 44 industrial and developing countries they investigated that institutionally developed market with strong information disclosure laws, international accounting standards and unrestricted capital flows are larger more liquid markets with less volatility and are internationally integrated with smaller markets.(Levine and Renelt, 1992 Arestis and Demetriades, 1997 Luintel and khan 1999) regarded the presence of endogeneity which weakens the estimated effect of stock market indicators (Harris, 1997) as in case of cross country regression to establish the relationship between stock market development and economic growth.Thus our results may be indirectly valuable for less developed economies in way that may help policy decision relating to the adoption of specific types of financial system.Informational asymmetries and transaction costs may inhibit liquidity and intensify liquidity risk. These frictions create incentives for the emergence of financial markets and institutions that augment liquidity. Liquid capital markets, therefore, are markets where it is relatively inexpensive to trade financial instruments and where there is little uncertainty about the timing and settlement of those trades.The ability to acquire and process information may have important growth implications. Because many firms and entrepreneurs will solicit capital, financial intermediaries, and markets that are better at selecting the most promising firms and managers will induce a more efficient allocation of capital and faster growth (Jeremy Greenwood and Boyan Jovanovic 1990). Bagehot (1873, p. 53) expressed this view over 120 years ago.Acquiring Information about Investments and Allocating Resources It is difficult and costly to evaluate firms, managers, and market conditions as discussed by Vincent Carosso (1970). Individual savers may not have the time, capacity, or means to collect and process information on a wide array o f enter-prises, managers, and economic conditions.Information acquisition costs create incentives for financial intermediaries to emerge (Diamond 1984 and John Boyd and Edward Prescott 1986). Assume, for example, that there is a fixed cost to acquiring information about a product-ion technology. Without intermediaries, each investor must pay the fixed cost. In response to this information cost structure, however, groups of individuals may form (or join or use) financial intermediaries to economize on the costs of acquiring and processing information about investments.Information costs, however, may also motivate the emergence of money. Because it is costly to evaluate the attributes of goods, barter exchange is very costly. Thus, an easily recognizable medium of exchange may arise to facilitate exchange (King and Charles Plosser 1986 and Williamson and Randall Wright 1994).The financial systems ability to provide risk diversification services can affect long-run economic growth by a ltering resource allocation and the saving rates. The basic intuition is straightforward. While savers generally do not like risk, high-return projects tend to be riskier than low-re-turn projects. Thus, financial markets that ease risk diversification tend to induce a portfolio shift toward projects with higher expected returns (Gilles Saint-Paul 1992 Michael Devereux and Gregor Smith 1994 and Maurice Obstfeld 1994).Furthermore, a growing literature shows that differences in how well financial systems reduce information and transaction costs influence saving rates, investment decisions, technological innovation, and long-run growth rates.If we will consider the discussion exist on the relationship between the financial system and economic growth financial markets development is always considered as pivotal element for growth of economy through the diverse contribution of stock markets and banks.Stiglitz (1985) argues that, because stock markets quickly reveal information through po sted prices, there will be few incentives for spending private resources to acquire information that is almost immediately publicly available.The absence of financial arrangements that enha