Study of economic development of Pakistan through stock market

TABLE OF CONTENTS

Abstract

Acknowledgement

Chapter I: INTRODUCTION
1.1 Background of the Study
1.2 Role of the Securities Market in Economic Development
1.3 Stock Markets and Economic Growth
1.4 Purpose of the Study
1.5 Stock Markets in Pakistan
1.6 Karachi Stock Exchange (KSE)
1.7 KSE: Performance
1.8 KSE Indices

Chapter II: REVIEW OF THE LITERATURE
2.1 Stock Market Development and Long Run Growth
2.2 Risk Diversification – International Integration
2.3 Financial Factors in Economic Growth: The Theoretical Nexus
2.4 Cross-Country Econometric Evidence
2.5 Time-Series Econometric Evidence
2.6 Current Economic Situation of Pakistan
2.7 Key Projections
2.8 Summary of Pakistan’s Macroeconomic Performance

Chapter III: RESEARCH METHODOLOGY
3.1 Data and Methodology
3.2 Data Sources
3.3 Descriptive Statistics
3.4 Correlation Coefficient
3.5 Augmented Dickey Fuller (ADF)
3.6 Co-Integration Analysis
3.7 Dummy Variable

Chapter IV: DATA ANALYSIS
4.1 Descriptive Statistics for Growth in Stock Prices and Macro Variables
4.2 The Correlation Coefficient of Stock Prices and Macro Variable
4.3 Efficiency of the Stock Market in Post Liberalization Period
4.4 Causal Relations between Stock Prices and the Variables
4.5 The Long-Run Relations of Stock Prices with Real Variables
4.6 The Direction of Causality between Two Variables
4.7 Shifts in Stock Prices and Real Variables

Chapter V: SUMMARY, CONCLUSION AND RECOMMENDATIONS
5.1 Summary & Conclusion
5.2 Recommendations
5.3 Suggested Areas of Further Research

REFERENCES

Appendix I: SOURCE DATA

Appendix II: ABBREVIATIONS

ABSTRACT

The purpose of the research is to examine the causal relationship between stock prices and the variables representing the real sector of the economy like read GDP, and real investment spending, in Pakistan. Researcher has used annual data from December 1980 to June 2007, to examine the stochastic properties of the variables, and has taken care of the expected shift in the series due to the start of the liberalization program in the early 1990s. State Bank General Price Index (SBGPI) with base 1980-81 is used for stock prices whereas for real variables GDP, and investment, at constant prices of 1980-81 were used.

The descriptive statistics indicate a much higher expansion in stock prices relative to real variables. However, the stock prices also experienced much higher volatility during the sample period whereas the real variables seem to be stable. The correlation analysis shows low correlations between stock prices and real variables. However, there is evidence of significant increase in these correlations in the post reform period suggesting that these reforms resulted in significant improvement in the behavior of stock market and its linkages to the economy.

In the formal investigation, the co-integration regressions indicate the presence of a long run relationship between stock prices and real variables. Regarding the cause and effect relationship the error correction model suggest a unidirectional causality from the real variables to stock prices implying that in Pakistan fluctuations in real sector cause changes in stock prices. The analysis does not verify the evidence of improvement in the linkages of stock market to the economy, which is indicated by the correlation analysis. These results have not changed by the incorporation of the expected shift in the variables resulting from the liberalization measures.

The findings suggest that the stock market in Pakistan is still not that developed to play its due role in influencing the real sector of the economy. It can be implied, however, that the government can use the real sector to influence the stock market. An important implication of the findings is that the stock market in Pakistan cannot be characterized as the leading indicator of the economic activity. The study clearly indicates that it lags economic activity. It seems that the phenomenal growth in stock market variables like market capitalization, trading volume, the market index, etc. do not seem to influence the economy of Pakistan.

ACKNOWLEDGEMENT

I am highly grateful to my advisor Dr. Fazal Hussain without his help and guidance; it was not possible to accomplish and completed the thesis. I am fortunate that my advisor guided me with full devotion and dedication during the thesis writing.

I am also grateful to my friend Mr. Vishnu Parmar (Ph. D. student of SZABIST) and Mr. Nawaz Khan (MS student of SZABIST) that they have supported my to lot during my research work. I also thankful to my colleagues, Mr. Sajjad Ahmed, Mr. Muhammad Irfan and Mr. Zahid Khan that they have helped me in whenever they have been asked. I also thankful to my wife that she has supported me during my research.

These people coordinated and arranged the appointments with the concerned personnel. Without their help the target of achieving the required objective would have become very difficult.

Rizwan Raheem Ahmed

CHAPTER ONE
INTRODUCTION

1.1 BACKGROUND OF THE STUDY:

The stock market plays an important role in the economy by mobilizing domestic resources and channeling them to productive investment. This implies that it must have significant relationship with the economy. The relationship can be seen, in general, in two ways. The first relationship views the stock market as the leading indicator of the economic activity in the country whereas the second focuses on the possible impact the stock market may have on aggregate demand particularly through aggregate consumption and investment. In other words, whether changes in stock market cause fluctuations in macroeconomic variables, like Consumption Expenditures, Investment Spending, Gross Domestic Product (GDP), Index of Industrial Production (IIP), etc., or are caused by these variable is an interesting issue to be examined. The former case implies that stock market leads economic activity whereas the latter suggests that it lags economic activity.

The knowledge of the relationship between stock prices and macro variables is now becoming more important in the case of developing countries in view of the various economic reforms taking place there. Starting in the beginning of the 1990s there have been a number of measures taken for economic liberalization, privatization, relaxation of foreign exchange controls, and in particular the opening of the stock markets to international investors. These measures resulted in significant improvements in the size and depth of stock markets in developing nations and they are beginning to play their due role. (Husain & Mahmood, 2001)

The issue whether stock market leads or lags economic activity is now becoming very crucial in Pakistan, as the stock market has gained much attraction in the last few years. The market has been, in general, among the best performing markets. The indicators like market capitalization, trading volume, the market index has shown phenomenal growth. These developments are often claimed by the authorities to be an indication of economic progress of the country. It would be useful to examine whether these developments has influenced the economy, particularly the real sector. Moreover, the relationship between stock prices and the real sector variables is also important in view of the various economic reforms started in early 1990s. The measures taken for economic liberalization, privatization, relaxation of foreign exchange controls, and in particular the opening of the stock markets to international investors are supposed to have great impacts on the economy including the real sector. (Husain, 2006)

1.2 ROLE OF THE SECURITIES MARKET IN ECONOMIC DEVELOPMENT:

The deepening and level of sophistication of modern financial markets is arguably a recent phenomenon. However, stock markets have long played an important role in economic life. Most academicians and policy makers in developing countries hold the view that securities market development is a key element of financial deepening as this market provides a variety of financial assets to the economy to facilitate resource mobilization for investment. Arguments against the benefits of securities market development are hardly heard. Securities market development is often regarded as an important barometer of financial deepening in developing countries where financial sectors are represented mainly by the banking industry. The importance of securities market development to financial development and deepening is sometimes emphasized to the extent that it is regarded as a necessary condition for complete financial liberalization. Despite the general perception that securities market development is an evolutionary process correlated with the level of per capita income, the question as to why one country with lower per capita income may have a much more advanced securities market than a higher income country has not been answered satisfactory yet.

Hicks (1969) argue that in the nineteenth century, for the first time in history, many private investment projects were so large that they could no longer be financed by individuals or from retained profits. The technological inventions of the industrial revolution, such as steam engine, had been made before, but their implementation had to wait for well-developed financial markets. The industrial society required an adapted financial system where publicly traded companies could get long-term financing.

Linking historical evidence to the role of the stock exchange for economic growth requires a theoretical framework. We draw on the functional approach of Levine (1991). Financial markets allow for more efficient financing of private and public investment projects. By representing ownership of large-value, indivisible physical assets by easily tradable and divisible financial assets, and making trade in them more liquid, they promote the efficient allocation of capital. They give lenders the opportunity to diversify their investments. In these roles, financial markets increase the quality and quantity of intermediated funds. Using descriptive historical evidence, we describe how the Karachi' stock exchange fulfilled these roles. Agtmael and Errunza (1982) summarize and provide a wide range of arguments for the positive role of the securities market in economic development. The securities market could:

1. Raise funds for investments through issuance of new securities.
2. Improve efficiency and solvency of the financial system by increased competition in the system and improved financial structure.
3. Facilitate mobilization of financial savings by providing an incentive to save and invest and compete with other financial assets.
4. Improve allocative efficiency of investment by reducing the distortion of planned allocation of resources, which is often plagued with political favoritism, special privileges of the public sector over the private initiative, preference for large projects over small businesses, credit rationing and distorted interest rates.
5. Enhance solvency of the corporate sector by strengthening the financial structure of corporations.
6. Asset decentralization of ownership by promoting the spread of ownership participation by the general public.
7. Expand access for new and emerging companies to venture capital.
8. Improve accounting and auditing procedures and standards through disclosure of regular, adequate and reliable information, checked by independent auditors.

Gill, David and Peter Tropper (1988) argue that major benefits of a strong, healthy market in economic development come in, among others, five main ways. First, it contributes to the stability of a country’s financial system and economy to the extent that it reduces the vulnerability of companies to floating and high real interest rates through permanent equity financing. Secondly, it helps promote growth and employment by providing finance for small businesses both directly through a country’s larger formal markets, and indirectly by making venture-capital operations more feasible in the more advanced developing countries. Thirdly, it eventually promotes democratic ownership of industry by distributing the ownership of securities more widely among the public. Fourthly, it can make access to international capital markets easier to the extent that the market develops into an efficient and liquid securities exchange. Lastly, a formal and well regulated market increases economic efficiency by establishing fair prices for securities and by minimizing the costs of buying and selling them.

1.3 STOCK MARKETS AND ECONOMIC GROWTH:

For more than a decade stock markets have boomed in just about every country. From 1984 to 1994 the capitalization of world stock exchanges grew fivefold to a combined $18 trillion. Most of this money is still invested in industrial nations, but the dramatic growth has been in the emerging countries. Foreign investors have increased their annual net investment in emerging markets from $13 billion in 1990 to $61 billion in 1993.

"Push" and "pull" are behind the sharp increase in the interest of private equity investors in the developing world. The push is for better profits and more diversification. Even with adjustments for risk, returns are generally higher in the developing markets. At the same time the investment community has increasingly recognized that developing country exchanges have a low, even negative correlation with the stock markets in industrial nations. Negatively correlated stock markets move in opposite directions: when one is heading up, the other is going down. Investing in the developing world is a means to reduce overall portfolio risk. Recent Bank research confirms that cross-country portfolio diversification is more important than diversifying across sectors. The "pull" for international private equity is the beneficial impact of wide-ranging structural reforms, legislative as well as economic, in many developing countries. As governments have liberalized or eliminated capital restrictions, improved the flow of financial information, and strengthened investor protection, they have earned the attention of the investment community. Put simply, investors have seen a chance to make more money and been given assurances that they will be able to take their profits home.

Last year the rush to invest in the developing world slowed considerably. Private capital flows to some Latin American countries dropped, culminating in the year-end Mexican crisis---a crisis brought about in part by an overdependence on foreign capital. The Mexican difficulties and a reviving U.S. equity market are causing an even greater slowing of private investment abroad in 1995. Portfolio flows almost certainly will stagnate for a time. But the "push" factors remain. Despite increased integration, the international market will remain imperfect for many years. Economic turbulence, investor conservatism, and variances in national growth rates will all contribute to differences in returns and market conditions. Bigger profits and better diversification cannot fail to entice investors. One measure of the amount of funds that could be shifted to developing country stock markets is the still minuscule investment in such markets by institutional investors in the industrial countries. U.S. pension funds generally are more adventurous than their counterparts elsewhere in the industrial world. Yet the typical U.S. fund holds no more than 1 to 2 percent of its portfolio in equity securities from emerging countries. Studies indicate that a fund could raise its expected annualized return by 2 percentage points with no increase in risk if it increased its holdings of emerging market stocks to 20 percent of its portfolio. An increase of that size won’t come quickly. But fund managers will gradually increase their market position in developing countries, trickling vast sums of capital into the developing world.

The money will not be divided up equally. Investors will discriminate carefully between markets. So far, Asian and Latin American countries have absorbed most of the equity flow. Africa, the Middle East, and other areas remain largely ignored. The emerging markets of Asia have attracted almost all the private equity investment from Japan and half the equity dollars invested in developing countries by the United States in 1993. Within regions there also are big differences. Hong Kong attracted more U.S. equity investment than other Asian emerging countries combined. In Latin America most of the funds have gone to Argentina, Brazil, and Mexico. As the events in Mexico show, investors do not always make the best choice, but they do choose countries that have a sound institutional and regulatory framework for the capital market. And they avoid the rest. No emerging countries can afford to be overlooked. Almost by definition, all require outside capital to sustain economic growth. But many are at their borrowing limit---liabilities can grow only as fast as export earnings. And all are in danger of being the indirect victims of the increasing political pressure on the aid budgets of industrial nations. Encouraging international private equity investors is a sound alternative to more debt and increasingly uncertain help. Most important, encouraging and sustaining a vital stock exchange does more for a national economy than simply bring in new capital. A developed stock market is as important to national economic growth as banks. While the importance of the financial sector has long been recognized, the contribution of the stock exchange has been less obvious. Each provides a different bundle of crucial services, but both stimulate the accumulation of capital and contribute to improvements in productivity (Errunza & Losq, 1987).

Credit markets are not, as is sometimes contended, a close substitute for equity markets. Banks and stock markets have complementary and shifting roles in a developing economy. Both sectors help fund the development of private enterprise, exchanging roles back and forth as the economy and its enterprises mature. Simple debt financing with instruments that are rarely traded comes first. Equity financing of larger firms comes next as the economy attains a critical level of real development. As growth continues, both large and small firms start to swap short- and long-term debt for equity investments. Finally, as the financial markets begin functioning with increased efficiency; equity funding becomes available for a range of ventures. At that point the larger firms begin to take on more debt, in part because they now have acceptable debt-equity ratios and in part because the stock market aggregates the information needed by lenders and investors alike. The importance of a healthy and vibrant national stock market is underlined by a recent study showing that a developed banking system and a robust stock exchange not only promote economic growth, but also predict it. Capitalization, liquidity, or turnover can measure a country’s stock market. Each measure appears to reveal something about where a national economy is headed (Fama, Eugene, 1965).

Researchers have found a robust correlation between stock market indicators in 1976 and economic growth averaged over 1976-93. This correlation does not appear to be simply the result of stock market traders and investors' anticipating growth. Indicators of liquidity, for example, are closely associated with growth prediction, but these liquidity indicators are a measure of trading volume, not simply prices. The conclusion: stock market development does not merely follow economic development, but provides the means to predict future rates of growth in capital, productivity, and per capita GDP. If nothing else, the potentially large economic benefits of a vital stock market highlight the cost of government efforts to impede market development by policy or law. Conversely, a national program that encourages both markets and banks to thrive can have dramatic effects. One hypothetical example tests the effect of a one standard deviation increase in a measure of banking development combined with the same deviation in a measure of stock market development. The result is an increase in real per capita growth of 1.6 percent a year over the following 18 years; a 33 percent accumulated increase in GDP over the period (Fama, Eugene, 1991).

A large inflow of private equity money is not without drawbacks. As Mexico and other Latin American nations recently observed, private capital flows can be volatile. If the international investment community spots weak exports, an overvalued currency, a rise in consumption relative to savings, or an over reliance on short-term capital inflows, money will go out faster than it came in. A government that seeks to attract international equity capital is, knowingly or not, committing itself to sounder, more agile economic management. Equity dollars and export earnings end up on the same side of the account, but neither is a substitute for the other. The mix of policies needed to sustain inflows of private capital varies from country to country. But there is no substitute for fiscal restraint; an emphasis on exports over consumption, and sound regulation of the banking system and the capital markets (Fama, Eugene, 1991).

1.4 PURPOSE OF THE STUDY:

Several studies have already been done on Karachi Stock Exchange for last ten years (Husain & Mahmood, 2001) & (Husain, 2006). Few of these were studied the impact of Economic conditions on the Karachi Stock Exchange and some of these shows the relationship of booming Karachi stock and its positive, negative or no impact on economic development of Pakistan. Few researches were conducted on the behavior of the market and some were conducted in comparisons of other stock markets.

The purpose of the research is to examine the causal relationship between stock prices and the variables representing the real sector of the economy like real GDP and investment spending in Pakistan. The recent phenomenon has to study the issues regarding the efficiency, seasonality, volatility and other characteristics of the stock market as well as the role of the stock market in the economic development of Pakistan. In this study, all the above said key issues will be discussed in a quantitative perspective and the results of the study determine the role of the stock market in the economic development of Pakistan and the behavior and other characteristics of the market.

The undertaken study also find out the true picture of government claims in which the government constantly emphasizes the higher index of the stock market is really an indicator of economic development of the country for several years. Undertaken study not only evaluates the efficiency, seasonality and volatility of the market but also establish the relationship between the high index of Karachi stock exchange and the economic development of Pakistan. The study examine, is there really any positive correlation between the Karachi Stock exchange and the economic development of Pakistan or it is only the myth?

Government regularly claims the high stock market is due to the economic stability in the country and local and foreign investments come into the Karachi stock market and other sectors. Consequently, the high stock exchange leads towards the economic development of the country. This is not only the government claim but it is also the well-accepted fact throughout the World. Many theories also suggested the same notion, which has been discussed in next chapter of literature review. But the undertaken study has to examine the realities of these theories in the context of Pakistan.

1.5 STOCK MARKETS IN PAKISTAN:

There are three Stock markets in Pakistan:

1. Karachi Stock Exchange; formed in 1947
2. Lahore Stock Exchange; formed in 1971
3. Islamabad Stock Exchange; formed in 1989

Out of all the three Exchanges, the Karachi Stock Exchange is the premiere Stock Exchange of the country, with more than 700 listed companies. It was established soon after the creation of Pakistan.

1.6 KARACHI STOCK EXCHANGE (KSE):

The Karachi Stock Exchange (KSE) was established on 18th September 1947. It was later converted and registered as a Company Limited by Guarantee on 10th March 1949. Initially, 90 members were enrolled, however, only half a dozen of them were active as brokers. Similarly only 5 companies were listed with a paid up capital of Rs.37 million.

Karachi Stock Exchange is the biggest and most liquid exchange and has been declared as the "Best Performing Stock Market of The World For the year 2002". As at March 15, 2007, 754 companies were listed with the market capitalization of Rs. 3,200.182 billion (US $ 52.00) having listed capital of Rs. 495.968 billion (US $ 8.27 billion). The KSE 100 Index closed at 11,310 on March 15, 2007.

KSE has been well into the 3rd year of being one of the Best Performing Markets of the world as declared by the international magazine "Business Week". Similarly the US newspaper, USA Today, termed Karachi Stock Exchange as one of the best performing bourses in the world. Foreign buying interest had been very active on the KSE in 2006 and has continued in 2007 so far. According to estimates from the State Bank of Pakistan, foreign investment in capital markets total about US$ 523 Million. According to a research analyst in Pakistan, around 20pc of the total free float in KSE-30 index is held by foreign participants.

KSE has seen some fluctuations since the start of 2007. One reason could be that it is the election year in Pakistan, and stocks are expected to remain dull. KSE has set an all time high of 12,400 points, before settling around the 11,000 mark. Result season in June and better payout expectations can drive the market to record level high again. (Karachi Stock Exchange, 2007)

1.7 KSE: PERFORMANCE:

In million except companies, index and bonds data:

TABLE – 1

Five Years Progress

Abbildung in dieser Leseprobe nicht enthalten

(Karachi Stock Exchange, 2007)

TABLE – 2

Decade-Wise Progress

Abbildung in dieser Leseprobe nicht enthalten

(Karachi Stock Exchange, 2004)

1.8 KSE INDICES:

KSE began with a 50 shares index. As the market grew, a representative index was needed. On November, 1, 1991 the KSE-100 was introduced with a base of 1,000 points. By 2001, it had grown to 1,770 points. By 2005, due to a period of robust growth the index had skyrocketed to 9,989 points. It reached a peak of 11,485 points in March 2006. As at March 2007 it is currently trading at 11,310 points (March. 15, 2007). The KSE-100 approach remains to this date the most generally accepted measure of the Exchange. The KSE-100 is a capital weighted index and consists of 100 companies representing about 86 percent of market capitalization of the Exchange. At the end of 2006, KSE-30 index was introduced, which was Pakistan first free float index comprising of 30 most floated stocks in KSE. KSE-30 index was trading at 14,199 points (March 15, 2007).

Karachi Stock Exchange 100 Index (KSE-100 Index) is a benchmark used to compare prices over a period of time, companies with the highest market capitalization are selected. However, to ensure full market representation, the company with the highest market capitalization from each sector is also included. This approach has disadvantages to go along with its advantages. The index was launched in late 1991 with a base of 1,000 points. By 2001, it had grown to 1,770 points. By 2005, it had skyrocketed to 9,989 points. It reached a peak of 12,285 in February 2007. (Karachi Stock Exchange, 2007)

CHAPTER TWO
REVIEW OF THE LITERATURE

2.1 STOCK MARKET DEVELOPMENTS AND LONG-RUN GROWTH:

The theoretical basis to examine the link between stock prices and the real variables are well established in economic literature, e.g., in Baumol (1965), Bosworth (1975). The relationship between stock prices and real consumption expenditures, for instance, is based on the life cycle theory, developed by Ando and Modigliani (1963), which state that individuals base their consumption decision on their expected lifetime wealth. Part of their wealth may be held in the form of stocks linking stock price changes to changes in consumption expenditure. Similarly, the relationship between stock prices and investment spending is based on the q theory of James Tabin (1969), where q is the ratio of total market value of firms to the replacement cost of their existing capital stock at current prices. Finally, the relationship between stock prices and GDP, a measure of economic activity, indicates whether the stock market leads or lags economic activity.

The empirical evidence, particularly in the South Asian region, regarding the direction of causality between stock prices and the real variables is not conclusive. For example, a unidirectional causality from stock prices to consumption expenditures is observed by Nishat and Saghir (1991) in Pakistan and Ahmed (1999) in Bangladesh whereas Mookerjee (1988) observes the opposite case in India. Similarly, Mookerjee (1988) and Ahmed (1999) report a unidirectional causality from stock prices to investment spending for India and Bangladesh respectively whereas the opposite case is reported by Nishat and Saghir (1991) for Pakistan. Regarding causal relation between stock prices and economic activity Mookerjee (1988) finds evidence that GDP leads stock prices in India whereas Nishat and Saghir (1991) find the opposite evidence in Pakistan. On the other hand, Ahmed (1999) finds the evidence that Index of Industrial Production (IIP) leads stock prices in Bangladesh. In another study for Pakistan, Hussain and Mahmood (2001), covering the data from 1959/60 to 1998/99 report a unidirectional causality from the macro economic variables, GDP, consumption, investments, to stock prices implying that the stock market lags economic activity and thus cannot be characterized as the leading indicator of the economy in Pakistan.

Levine and Zervos (1993), states that the World stock markets are booming. Developing country stock markets compose a disproportionately large amount of this growth. Over the past 10 years, world stock market capitalization rose from $4.7 trillion to $15.2 trillion, and emerging market capitalization jumped from less than 4 percent to almost 13 percent of total world capitalization. Similarly, over this decade, the trading of shares on emerging stock exchanges rose from less than 3 percent to 17 percent of the total value of transactions on the world's stock exchanges.

Further, Korajczyk (1996) shows that emerging markets have become more integrated with world capital markets during the past seven years. The blossoming of emerging stock markets has attracted the attention of international investors. Portfolio equity flows to emerging markets jumped from $150 million in 1984 to over $39 billion in 1995. Yet, there exists very little empirical evidence on the relationship between stock market development and long-run economic growth. To assess whether stock markets are merely burgeoning casinos where more and more players are coming to place bets or whether stock markets are importantly linked to economic growth, this paper reviews a diffuse theoretical literature and presents new empirical evidence. In terms of theory, a growing literature argues that stock markets provide services that boost economic growth.

Greenwood and Smith (1996) show that large stock markets can lower the cost of mobilizing savings and thereby facilitate investment in the most productive technologies. Bencivenga, Smith, and Starr (1996) and Levine (1991) argue that stock market liquidity -- the ability to trade equity easily is important for growth. Specifically, although many profitable investments require a long-run commitment of capital, savers do not like to relinquish control of their savings for long periods. Liquid equity markets ease this tension by providing an asset to savers that they can quickly and inexpensively sell. Simultaneously, firms have permanent access to capital raised through equity issues.

Moreover, Kyle (1984) and Holmstrom and Tirole (1993) argue that liquid stock markets can increase incentives to get information about firms and improve corporate governance. Finally, Obstfeld (1994) shows that international risk sharing through internationally integrated stock markets improves resource allocation and can accelerate the rate of economic growth. Theoretical disagreement exists, however, about the importance of stock markets for economic growth. Meyer (1988) argues that even large stock markets are unimportant sources of corporate finance. Stiglitz (1985, 1993) says that stock market liquidity will not enhance incentives for acquiring information about firms or exerting corporate governance.

Devereux and Smith (1994) emphasize that greater risk sharing through internationally integrated stock markets can actually reduce saving rates and slow economic growth. Finally, Shleifer and Summers' (1988) and Morck, Shleifer, and Vishny's (1990) analyses that stock market development can hurt economic growth by easing counterproductive corporate takeovers. Considering the conflicting theoretical perspectives on the importance of well-functioning stock markets for economic growth, this paper uses cross-country regressions to examine the association between stock market development and economic growth. To conduct this investigation, we need measures of stock market development. Theory, however, does not provide a unique concept or measure of stock market development. Theory suggests that stock market size, liquidity, and integration with World capital markets may affect economic growth.

Consequently, this uses a conglomerate index of overall stock market development constructed by Demirguc-Kunt and Levine (1996). This index combines information on stock market size, liquidity, and international integration to produce an overall measure of stock market development. More specifically, they use pooled cross-country, time-series regressions to evaluate the relationship between stock market development and economic growth. Using data on 41 countries over the period 1976-1993, they split the sample period, so that each country has two observations (data permitting) with data averaged over each sub-period. In the tradition of recent work, they regress the growth rate of Gross Domestic Product (GDP) per capita on a variety of variables designed to control for initial conditions, political stability, investment in human capital, and macroeconomic conditions. They then include the conglomerate index of stock market development. Thus, they evaluate whether there is a relationship between economic growth and stock market development that is independent of other variables associated with economic growth.

This builds on Atje and Jovanovic's (1993) study of stock market trading and economic growth in two ways. They use conglomerate indexes of stock market development that combine information on stock market size, trading, and integration. Second, they control for initial conditions and other factors that may affect economic growth in light of evidence that many cross-country regression results are fragile to changes in the conditioning information set. Thus, they gauge the robustness of the relationship between overall stock market development and economic growth to changes in the conditioning information set. We find a strong correlation between overall stock market development and long-run economic growth.

After controlling for the initial level of GDP per capita, initial investment in human capital, political stability, and measures monetary, fiscal, and exchange rate policy, stock market development remains positively and significantly correlated with long-run economic growth. The results are consistent with theories that imply a positive relationship between stock market development and long-run economic growth. The results are inconsistent with theories that predict no correlation or a negative association between stock market development and economic performance. Cross-country growth regressions suffer from measurement, statistical, and conceptual problems. In terms of measurement problems, country officials sometimes define, collect, and measure variables inconsistently across countries. Further, people with detailed country knowledge frequently find discrepancies between published data and what they know happened. In terms of statistical problems, regression analysis assumes that the observations are drawn from the same population. Yet, vastly different countries appear in cross-country regressions. Many countries may be sufficiently different such that they warrant separate analyses. Conceptually, they should interpret the coefficients from cross-country regressions cautiously. When averaging over long periods, many changes are occurring simultaneously: countries change policies; economies experience business cycles; and governments rise and fall. Thus, aggregation may blur important events and differences across countries. Eventually, analysts should extend this research by examining the time-series relationship between stock market development and economic growth. Also, cross-country regressions do not resolve issues of causality. Consequently, they should not view the coefficients, as elasticity that predict by how much growth will change following a particular policy change. Rather, the coefficient estimates and the associated t-statistics evaluate the strength of the partial correlation between stock market development and economic growth. These measurements, statistical, and conceptual problems, however, should not blur the benefits that can accrue from cross-country comparisons. Elucidating cross-country empirical regularities between stock market development and economic growth will influence beliefs about this relationship and shape future theoretical and empirical research. Put differently, beliefs about stock markets and growth that cross-country comparisons do not support will be viewed more skeptically than those views confirmed by cross-country regressions.

Considerable debate exists on the question: Is the financial system important for economic growth? One line of research stresses the importance of the financial system in mobilizing savings, allocating capital, exerting corporate control, and easing risk management. A second branch of the literature argues that the financial system is unimportant for economic growth. Consider first the view that finance is unimportant. In a recent survey of development economics, Nicholas Stern (1989) does not mention the role of the financial system in economic growth.

Furthermore, at the end of Professor Stern's review, he lists various issues that he did not have sufficient space to cover. Finance is not even included in the list of omitted topics. Similarly, a recent collection of essays by the 'pioneers of development economics,' including three Nobel Laureates, does not describe the role of the financial system in economic growth. Clearly, according to these economists, the financial system plays an inconsequential role in economic development. Furthermore, the most recent Nobel Prize winner, Robert Lucas (1988), argues that economists frequently exaggerate the role of financial factors in economic development.

Moreover, Joan Robinson (1952) argues that the financial system does not spur economic growth; financial development simply responds to developments in the real sector. Thus, many influential economists give a very minor, if any, role to the financial system in economic growth.' In contrast, a prominent line of research stresses the role of the financial system in economic growth. Bagehot (1873), Schumpeter (1912), Cameron, et.al. (1967), Goldsmith (1969), and McKinnon (1973) provide conceptual descriptions of how and empirical examples of when the financial system affects economic growth. Building on these seminal contributions, Gelb (1989), Ghani (1992), King and Levine (1993), and De Gregorio and Giudotti (1995) show that measures of banking development are strongly correlated with economic growth in a broad cross-section of countries.

According to this vein of research, a well-functioning financial system is critical for sustained economic growth. Thus, considerable debate exists on the importance of the many of these references are from Chandavarkar's (1992) insightful discussion of financial and economic development, relationship between the financial system and economic growth. This study contributes to the historical debate on the role of the financial system by examining the empirical link between stock market development and economic growth. Besides evaluating the general importance of the financial system, this paper provides empirical evidence regarding the growing debate concerning the specific role of stock markets in economic growth. A burgeoning theoretical literature suggests that the functioning of equity markets affects the following:

(a) Liquidity,
(b) Risk diversification,
(c) Information acquisition about firms,
(d) Corporate control, and
(e) Savings mobilization.

By altering the quality of these services, the functioning of stock markets can alter the rate of economic growth. Debate exists, however, over the sign of this effect. Specifically, some models suggest that stock market development slows growth, while other models predict a positive relationship between stock market development and economic growth. One way stock markets may affect economic activity is through their liquidity. Many high-return projects require a long-run commitment of capital. Investors, however, are generally reluctant to relinquish control of their savings for long-periods. Without liquid markets or other financial arrangements that promote liquidity, therefore, less investment may occur in the high return projects.

As shown by Levine (1991) and Bencivenga, Smith, Starr (1996), stock markets may arise to provide liquidity: savers have liquid assets - like equities - while firms have permanent use of the capital raised by issuing equities. Specifically, liquid stock markets reduce the downside risk and costs of investing in projects that do not pay off for a long time: with a liquid equity market, the initial investors do not lose access to their savings for the duration of the investment project because they can quickly, cheaply, and confidently sell their stake in the company. Thus, more liquid stock markets ease investment in long-run, potentially more profitable projects, thereby improving the allocation of capital and enhancing prospects for long-term growth. Theory is unclear, however about the growth effects of greater liquidity. Bencivenga and Smith (1991) show that by reducing uncertainty, greater liquidity may reduce saving rates enough so that growth slows. Risk diversification through internationally integrated stock markets is a second vehicle through which stock market development may influence economic growth.

Saint-Paul (1992), Devereux and Smith (1994), and Obstfeld (1994) demonstrate that stock markets provide a vehicle for diversifying risk. These models also show that greater risk diversification can influence growth by shifting investment into higher-return projects. Intuitively, since high expected-return projects also tend to be comparatively risky, better risk diversification through internationally integrated stock markets will foster investment in higher return projects. Again, however, theory suggests circumstances when greater risk sharing slows growth. Devereux and Smith (1994) and Obstfeld (1994) show that reduced risk through internationally integrated stock markets can depress saving rates, slow growth, and reduce economic welfare.

Stock markets may also promote the acquisition of information about firms [Grossman and Stiglitz (1980) and Holmstrom and Tirole (1993)]. Specifically, in larger, more liquid markets, it will be easier for an investor who has gotten information to trade at posted prices. This will enable the investor to make money before the information becomes widely available and prices change. The ability to profit from information will stimulate investors to research and monitor firms. Better information about firms will improve resource allocation and spur economic growth. Opinions differ, however, over the importance of stock markets in stimulating information acquisition. Stiglitz (1985) and Stiglitz (1993), for example, argue that well functioning stock markets quickly reveal information through price changes. This quick public revelation will reduce - not enhance - incentives for expending private resources to obtain information. Thus, theoretical debate still exists on the importance of stock markets in enhancing information.

Stock market development may also influence corporate control. Diamond and Verracchia (1982) and Jensen (1978) show that efficient stock markets help mitigate the principal-agent problem. Efficient stock markets make it easier to tie manager compensation to stock performance. This helps align the interests of managers and owners. Furthermore, Laffont and Tirole (1988) and Scharfstein (1988) argue that takeover threats induce managers to maximize the firm's equity price. Thus, well-functioning stock markets that ease corporate takeovers can mitigate the principal-agent problem and promote efficient resource allocation and growth. Opinion differs on this issue too. Stiglitz (1985) argues that outsiders will be reluctant to takeover firms because outsiders generally have worse information about firms than existing owners. Thus, the takeover threat will not be a useful mechanism for exerting corporate control; stock market development, therefore, will not importantly improve corporate control.

Moreover, Shleifer and Vishny (1986), and Bhide (1993) argue that greater stock market development encourages more diffuse ownership and this diffusion of ownership impedes effective corporate governance. Finally, Shleifer and Summers (1988) note that by simplifying takeovers, stock market development can stimulate welfare-reducing changes in ownership and management. In terms of raising capital, Greenwood and Smith (1996) show that large, liquid, and efficient stock markets can ease savings mobilization. By agglomerating savings, stock markets enlarge the set of feasible investment projects. Since some worthy projects require large capital injections and some enjoy economies of scale, stock markets that ease resource mobilization can boost economic efficiency and accelerate long-run growth.

Disagreement exists, however, over the importance of stock markets for raising capital. Mayer (1988), for example, argues that new equity issues account for a very small fraction of corporate investment. Thus, snore theories provide a conceptual basis for believing that larger, more liquid, more efficient stock markets boost economic growth. Other theoretical models, however, have a more pessimistic opinion about the importance of stock markets. Given these dissenting views, this paper examines the empirical relationship between stock market development and growth.

Demirguc-Kunt and Levine (1996) and Demirguc-Kunt and Maksimovic (1996), they take a different approach. We use a multifaceted measure of overall stock market development that combines the different individual characteristics of the functioning of stock market: Thus, we provide an empirical assessment of whether overall stock market development is strongly connected with long-run economic growth. Specifically, we use an aggregate index of overall stock market development constructed by Demirguc-Kunt and Levine (1996). This index combines information on stock market size, liquidity, and integration with world capital markets. Since Demirguc-Kunt and Levine (1996) analyze and discuss the individual indicators and aggregate index at length, here they only briefly define the individual indicators and the construction of the overall indexes.

2.2 RISK DIVERSIFICATION – INTERNATIONAL INTEGRATION:

Theory suggests that the ability to diversify risk by investing in an internationally diversified portfolio of stocks can influence investment decisions and long-run growth rates [Devereux and Smith (1994) and Obstfeld (1994)]. Barriers to international capital flows such as taxes, regulatory restrictions, information asymmetries, sovereign risk, etc. -- may impede the ability of investors to diversify risk internationally. Thus, international capital flow barriers will impede risk diversification, reduce capital market integration, and keep arbitragers from equalizing the price of risk internationally. To measure the ability of agents to diversify risk internationally, we use Korajczyk's (1996) estimate of the degree of international integration of national stock markets.

The results suggest a strong positive relationship between stock market development and long-run economic growth. The instrumental variable results show that the predetermined component of stock market development as extracted by the first-stage regressions is strongly, positively correlated with economic growth. Moreover, the results hold after checking for outliers and reproving individual countries. As discussed in the introduction, measurement, statistical, and conceptual problems plague cross-country growth regressions. Nonetheless, the results suggest a comparatively strong link between the functioning of stock markets and economic growth.

This research empirically evaluated the relationship between stock market development and long-run growth. The data suggest that stock market development is positively associated with economic growth. Moreover, the instrumental variables procedures indicate a strong connection between the predetermined component of stock market development and long-run economic growth. While these cross-country growth regressions imply a strong link between stock market development and economic growth, the results should be viewed as suggestive partial correlations that stimulate additional research rather than as conclusive findings.

Much work remains to better understand the relationship between stock market development and economic growth. Specifically, careful case studies might better identify the causal interactions between stock market development and economic growth. Similarly, this paper examined the cross-sectional relationship between stock market development and growth. Future research could also exploit the time-series properties of the relationship. Finally, this paper says nothing about policy. While stock market development is strongly correlated with long-run economic growth, future research needs to identify the policies that will ease sound securities market development.

2.3 FINANCIAL FACTORS IN ECONOMIC GROWTH: THE THEORETICAL NEXUS

Why it is that financial development can spur economic growth? In a frictionless Arrow-Debreu World there is no room for financial intermediation. Explaining the role played by stock markets or banks requires building in frictions such as informational or transaction costs into the theory. Different frictions motivate different types of financial contracts, markets and institutions. The functional approach of Levine (1991) provides a useful framework to think about the role of financial intermediaries. They perform five interrelated functions. Each of these financial functions can increase growth through two channels: capital accumulation and technological innovation. We briefly review the functions and illustrate them for the case of Belgium in the remainder of the paper. First, financial intermediaries facilitate pooling and trading of risk. Without financial markets, investors facing liquidity shocks are forced to withdraw funds invested in long-term investment projects.

Early withdrawal reduces economic growth. Stock markets can improve upon the situation by giving lenders immediate access to their funds while simultaneously offering borrowers a long-term supply of capital. At the aggregate level, the liquidity risk that individual investors face is perfectly diversified. Investors also want to diversify productivity risk associated with individual investment projects. Without financial markets they would have to buy entire pieces of capital. Stock markets allow investors to hold a small share in a large number of firms. By facilitating diversification, financial intermediaries allow the economy to invest relatively more in the risky productive technology.

Second, financial intermediaries improve on the allocation of funds over investment projects by acquiring information ex-ante. Information asymmetries generate a need for prospective research: firms with productive investment projects but no funding have an informational advantage about the quality of their investment. It is difficult and costly for individual investors to screen projects and their managers. Information acquisition costs create incentives for intermediaries to arise: The economy avoids duplication of the screening cost. The investors elect amongst themselves an intermediary who devotes his labor endowment to prospective research for good investment opportunities. Stock markets also play this role. But because information is incorporated in the posted price, the incentives for stock market participants to acquire information may be weaker. However, as stock markets become more liquid and larger it may become easier for investors to disguise their information and this creates an incentive to collect more information. The net result of these two forces is an empirical matter.

Third, ex-post monitoring of management and exertion of corporate control also induces the need for financial intermediaries. This is the focus of the costly state verification literature. The monitor need not be monitored when his asset holdings are perfectly diversified. Stock markets promote better corporate control. Equity capital introduces a new possibility of aligning interests between the management and the ownership of the firm. Carlos and Nicholas (1990) argue that partial compensation in company stocks mitigated the severe principal-agent problems plaguing the Hudson Bay Company. The relationship is non-monotonic. As the number of shareholders with voting rights increases, the diffuse ownership makes corporate control more difficult.

Fourth, financial markets mobilize savings in an efficient way. Stock markets establish a market place where investors feel comfortable to relinquish control of their savings. Because securities are in small denominations, a larger fraction of the population can participate in the stock market.

Fifth, financial markets increase specialization. Increased specialization requires lower trans-action costs. Townsend (1979) argues that the formation of capital markets take place endogenously once the economy reaches a threshold per capita income. By reducing financial transaction costs, these capital markets stimulate specialization in the economy and hence growth. In equilibrium there will be efficiently provided financial services. One feature sets equity markets apart from other financial intermediaries. Equity funding is a fundamentally different contractual agreement from bank credit and corporate debt in that it makes repayment contingent upon performance. This stimulates economic activity both at the intensive (increase in scale) and extensive margin (new firms) by being less binding in bad times.

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