Stock Market Developmentand Economic Growth in Developing countries:
Evidence from Panel VAR framework
Boopen Seetanah, V Sannassee, M Lamport
aUniversity of Mauritius,Reduit,Mauritius
* Corresponding author. Tel.:+230 4541041;
E-mail address: (Boopen Seetanah)
Introduction
‘World stock markets are booming and stock markets in developing countries account for a disproportionately large share of this boom. Investors are venturing into the world’s newest markets and some are seeing handsome returns. But are developing countries themselves reaping any benefits from their stock markets?’ (Levine 1996)
Economists have traditionally concentrated on the role of financial development to the economic growth of countries Overall there exists an overwhelming consensus that well-functioning financial intermediaries have played a significant role in economic growth (King and Levine, 1993 (a, b); Levine and Zervos, 1998; Levine et al, 2000 (a, b); Wachtel, 2003, Seetanah 2008 among others). More recently, the emphasis has been increasingly shifted to stock market indicators and the effect of stock markets on economic development[1] and the latter has been the subject of recent theoretical interest (see Demirguc-Kunt and Levine, 1996, Levine and Zervos,1993, 1995, 1998 among others). Although some analysts viewstock markets in developing countries as “casinos” that have little positive impact oneconomic growth, recent evidence suggests that stock markets may give a big boost to economic development.In fact, the focus on stock markets as an engine of economic growth is a new opening in financial literature. Going further, its benefits had been largely ignored in the past, but now there is consensus concerning the positive effects brought about by stock markets (see Pagano 1993, Levine and Zervos, 1998).
In principle a well-developed stock market should theoretically increase saving (by enhancing the set of financial instruments available to savers to diversify their portfolios) and efficiently allocate capital to productive investments, which leads to an increase in the rate of economic growth. In doing so they provide an important source of investment capital at relatively low cost (Dailami and Aktin, 1990; Greenwood and Smith, 1992).A more developed equity market also provides liquidity that lowers the cost of the foreign capital that is essential for development. As such the presence of stock markets would mitigate the principal agent problem and reduce assymetryinformation, thus promoting efficient resource allocation and growth (Adjasi and Biekpe 2006).Perotti and van Oijen (1999) stress on the fact that diverse equity ownership creates a constituency for political stability, which, in turn, promotes growth. However it has also been argued that stock markets may be counter productive, for instance more liquid stock markets may put companies at risk of counter-productive takeovers or even with the high level of integration and with the development of technological progress, if left uncontrolled, a stock market can lead to economic collapse. Moreover, the effect of uncertainty on savings rate and economic growth as markets become more liquid is ambiguous. (Bencivenga and Smith 1991).
Empirical evidence shows the existence of a strong positive correlation between stock market development and economic growth (Atje and Jovanovich, 1993, Demirgüç-Kunt and Levine, 1996a, b, Korajczyk, 1996, Levine and Zervos, 1996, 1998). However there exists some authors who could not established any significant link between stock market development and growth as well, for instance Bencivenga and Smith (1991), Naceur and Ghazouani (2007) and Adjasi and Biekpe (2006) for developing countries cases.
In fact, previous empirical research has suggested a connection between stock market development and economic growth, but is far from definitive. Although the relationship postulated is a causal one, most empirical studies have addressed causality, dynamics and endogeneity obliquely, if at all. Moreover the existing literature tend to focus overwhelmingly on developed countries sample and moreover have failed (Levine and Zervos (1993), Atje and Jovanovic (1993), Levine and Zervos (1998)) to decouple the relative contribution of banking and stock market development on economic growth in a single framework.
Our work is believed to depart from and contribute to the existing literature in various ways. In the first instance it focuses on a panel set of developing countries and moreover simultaneously examines banking sector development, stock market development, and economic growth in a unified framework. It deals with issues of unmeasured cross country heterogeneity,causality, dynamics and endogeneity, elements relatively ignored in the literature of growth modelling, by innovatively employing rigorous panel VAR proceduresto examine the complex linkages between stock market development, bank development and economic growth. Such a framework will enable us not only to detect any bi causal relationships but also the presence of indirect effects banking and stock market development on growth. The complementarity and subsitutabilty element of bank and stock market development will eventually be assessed. The data set comprises of 27 developing countries studies over a period of 15 years (1991-2007).
The rest of the paper is as follows: Section II reviews existing literature on the link between financial development and economic growth; Section III describes the methodology applied in this research as well as sources of data; section IV deals with the empirical analysis and section V concludes the study.
II Literature review
Financial Development and Economic Growth
The theoretical underpinnings of the relationship between financial depth and growth can be traced back to the work of Schumpeter (1912) and, more recently to McKinnon (1973) and King and Levine (1993). These authors claimed that financial development may lead to growth in that a well-developed financial system performs several critical functions to enhance the efficiency of intermediation namely by reducing information, transaction, and monitoring costs. Creane, Goyal, Mushfiq, and Sab (2003) argued that a modern and efficient financial system mobilizes savings, promotes investment by identifying and funding good business opportunities, monitors the performance of managers, enables the trading, hedging, and diversification of risk, and facilitates the exchange of goods and services. These functions ultimately result in a more efficient allocation of resources, a more rapid accumulation of human and physical capital, and in faster technological progress, which in turn feed economic growth. Tsuru (2000) also explained the finance-growth link by arguing that financial development can promote economic growth via its positive impact on capital productivity or the efficiency of financial systems in converting financial resources into real investment. However, its effect on the saving rate is ambiguous and could affect the growth rate negatively. ‘In net terms, the impact on welfare is likely to be positive, since increased efficiency of investment in the long term can offset any reduction in the propensity to save’ Tsuru (2000).
The relationship between financial development and economic growth was in fact extensively analysed more than two decades ago by Goldsmith (1969), McKinnon (1973), Shaw (1973) and others. They found strong and positive correlations between the degree of financial market development and the rate of economic growth. More comprehensive empirical research was undertaken by King and Levine (1993) who confirmed a very strong relationship between each of their four financial development indicators. Subsequent empirical work by Jayaratne and Strahan (1996), Levine and Zervos (1998) and more recently Roisseau and Sylla (2001) and Seetanah (2008) also confirmed the above.At the micro-economic, Demirguc-Kunt and Maksimovic (1998) and Rajan and Zingales (1998) reported that financial institutions have been crucial for firm and industrial expansion. However it is worth mentioning that there have been also some studies which could not confirm the beneficial economic effect of financial development, for instance Jappelli and Pagano (1994) and Ram (1999) among others.It should be pointed out that is only recently that scholars have been incorporating the issue of causality and endogeneity in the debate. Among the very few studies is that of Levine et al (2000,a,b) who used dynamic panel estimators to overcome the issue of dynamic in the system. Their results were seen to reconcile with the fact that financial development is a good predictor of economic growth. Similar results were obtained by Beck, Levine and Loayza (1999), Xu (2000). Among the recent few studies focusing exclusively on developing countries feature Christopoulos and Tsionas (2004), Seetanah (2007, 2008) which confirmed earlier work of Luintel and Khan (1999) and that of Demetriades and Hussein (1996). Odedokun (1996) however found mixed results.
Stock Market Development and Economic Growth
Literature on the topic of economic growth has taken a new stance, given the significance of the effect of stock markets on economic growth. Indeed, past literature considered financial intermediaries as the only causative channel to economic growth, and this new phase of developmental economics has achieved much in helping us understand this unexplored channel of causation since Bagehot (1873). In fact, stock markets and banks provide services that could either be complements or substitutes for each other depending on the industrialisation extent of the economy. Several possible avenues whereby stock market development have been advanced and discussed among them are the following.
Stock markets provide an alternative channel for savings mobilisation and better resource allocation (N’Zué 2006). They enable savings mobilisation for financing “immense works” (Bagehot 1906, Hicks (1969), Greenwood and Smith 1996). More efficiently mobilised savings cause capital accumulation, which firms tap to finance large projects via equity issues. This, undoubtedly, spurs economic growth (Levine and Zervos 1998a, 1998b; Adjasi and Biekpe 2006). Focusing on liquidity, Bencivenga, et. al. (1996) and Levine (1991) argue that stock market liquidity plays a key role in economic growth. Without a liquid stock market, many profitable long-term investments would not be undertaken because savers would be reluctant to tie up their investments for long periods of time. In contrast, a liquid equity market allows savers to sell their shares easily, thereby permitting firms to raise equity capital on favorable terms. By facilitating longer-term, more profitable investments, a liquid market improves the allocation of capital and enhances prospects for long-term economic growth. A more developed equity market may also provide liquidity that lowers the cost of the foreign capital that is essential for development. Bencivenga et. al. (1996), and Neusser and Kugler (1998)).Liquidity has also been argued to increase investor incentive to acquire information on firms and improve corporate governance (Kyle, 1984; Holmstrom and Tirole, 1993), thereby facilitating growth. Levine further argued thata liquid stock marketcomplements a strong banking system, suggestingthat banks and stock markets provide differentbundles of financial services to the economy. However Demirguc-Kunt and Levine (1996) point out that increased liquidity can deter growth through at least three channels[2].
Indeed, for the case of the African subcontinent, liquidity has been a significant factor in hamper stock market development (Adjasi and Biekpe 2006) and consequently retards economic growth. Naceur and Ghazouani (2007) also posits that the beneficial effect of liquidity is only found after a threshold level. Sarkar (2006) also discussed that stock market development may have no effect on fixed capital formation due to the high transaction and information costs in least developed countries.
A second link of stock market development on the economy is based on the premise that the presence of stock markets would mitigate the principal agent problem, thus promoting efficient resource allocation and growth (Adjasi and Biekpe 2006). Firstly, given that the stock price at any time is mirror of firm performance, weakening corporate governance would be reflected as a fall in share price. Management would have a disincentive to work in their personal interests if their compensation is tied to stock performance (Jensen and Murphy 1990). Thus the emphasis is on the role of equity markets in providing proper incentives for managers to make investment decisions.Dow and Gorton (1997) argued that such investment decisions affect firm value over a longer time period than the managers’ employment horizons through equity-based compensation schemes.Binswanger (1999)and Yartey 2007, Bhide (1999) however argued that the above might not be true in a situation of investor myopia.
The role of equity markets in providing portfolio diversification, enabling individual firms to engage in specialized production is bound to resultin efficiency gains ( Acemoglu and Zilibotti,1997, Capasso 2008). Indeed, in the presence of stock markets which provide for various vehicles for transferring risk through which investors can confidently invest. What follows from this is that investors now have the opportunity of switching from low-risk to high risk investments. Obstfeld (1994) shows that international risk-sharing through internationally integrated stock markets improves resource allocation and can accelerate growth.
Indeed, stock markets have more information than do financial intermediaries and usually translate in more efficient allocation and better growth (Caporale et al 2004, Adjasi and Biekpe 2006, Atje and Jovanovic 1993). King and Levine (1993b) also stressed on the ability of equity markets to generate information about the innovative activity of entrepreneurs or the aggregate state of technology. Perotti and van Oijen (1999) also argued that that diverse equity ownership creates a constituency for political stability, which, in turn, promotes growth.
Empirical review
Pioneering work from Spears (1991), Pardy (1992) Atje and Jovanovic (1993), show that stock market development is strongly correlated with growth rates of real GDP per capita. More importantly, they found that stock market liquidity predict the future growth rate of economy.Levine and Zervos (1998), Filer et al. (1999), Rousseau and Wachtel (2000) and Tuncer and Alovsat (2001) examined stock market-growth nexus and exhibited positive casual correlation between stock market development and economic activity.Nevertheless, most of earlier studies suffered from various statistical weaknesses namely with respect to endogeneity and causality issues together withunmeasured cross country heterogeneity. Subsequent research, with larger panel sets and longer time series and attempted to attend to the earlier criticisms. Beck, and Levine (2003) for instance investigated the impact of stock markets and banks on economic growth using a panel data set dynamic panels (GMM), that stock markets and banks positively influence economic growth. Chen et al (2004) ,Paudel (2005) and Love and Zicchino (2006) also acknowledged that stock markets, due to their liquidity, enable firms to attainmuch needed capital quickly, hence facilitating capital allocation, investment and growth.Alam and Hasan (2003) for the case of the USalso found a significant positive impact of stock market development on economic growth. Bahadur and Neupane (2006) concluded thatstock markets fluctuations predicted the future growth of an economy and causality is found only inreal variables.
More recent studies have employed vector models but has been restricted to country case studies mainly and among them featuresEnisa and Olufisayo (2009), N’Zué (2006) for the case of Ghana, Shahbaz, Ahmed and Ali (2008) for Pakistan and Agrawalla and Tuteja (2007) for the Indian case.
There exists however few studies which could not establish any significant link in the stock market-economic growth nexus (refer to theoretical and empirical works of Bencivenga and Smith 1991; Demirguc-Kunt and Levine, 1996; Adjasi and Biekpe 2006; Ghazouani, 2007 and Sarkar 2006 among others). It is noteworthy that Rousseau and Xiao (2007) for the case of Chinaalthough found that banking sector development was central to the Chinese success, however could not establish any significant relationship for the case of stock market development.
In summary, previous empirical research has suggested a connection between stock market development and economic growth, but is far from definitive. Although the relationship postulated is a causal one, most empirical studies, until lately have addressed causality obliquely, and this even more pronounced in the case of panel data analysis. Moreover very few of them have adopted a unified economic mode where both banking and stock development are simultaneously considered in a framework that allows for dynamics, feedbacks and endogeneity issues. To resolve them this paper uses VAR procedures in panel analysis to examine the linkage between stock market development, bank development and economic growth.
III Methodology and Data Analysis
The model that has been used in this study is based on the principles of some earlier studies (e.g. King and Levine, 1993; Levine and Zervos, 1998; Levine et al., 2000, Wachtel, 1998, 2001, Christopoulos and Tsionas, 2004 and Seetanah, 2008). The model takes the following functional form[3]:
(1)