Stock market: An economic agency

The idea that financial development promotes economic growth dates back to the works of Bagehot (1873) and Schumpeter (1912). Following their early arguments, the pioneering research of McKinnon (1973) and Shaw (1973) paved the way for modeling the role of financial development in economic growth. More recently, extensive empirical research has supported the hypothesis that well-functioning financial systems augment economic growth (e.g., Levine & Zervos, 1996, 1998a; Rodrik, 2008; Rodrik & Subramanian, 2009; Rousseau and Wachtel, 2000, 2011). Demirgüç-Kunt et al. (2011) suggested that the relationship between financial development and economic growth is more complex than first perceived and the relationship between the two differs across income levels of countries.

Hailemariam and Guotaithe (2014) revealed the existence of statistically significant relationship between stock market development and economic growth both directly, as well as indirectly by boosting investment behavior. The results also indicate robustly that stock market development is an important wheel for economic growth. The study was empirically based on the data for 17 emerging market and 10 developed market economies during the period from 2000 - 2011 using the generalized method of momentum (GMM) for dynamic panel data. To control for the country specific effect, the model was further estimated for the developed and emerging member economies. The model developed was:

Where

αi :- captures any country specific effects such as initial endowments .

gt :- captures any common period specific effects such as general technical progress.

eit:- is an independent disturbance and the subscripts I and t represent country and time period, respectively

GDP - Annual growth rate.

CAP - the value of listed shares divided by GDP.

STV -total value of shares traded on the stock market divided by GDP.

STR - the value of total shares traded divided by market capitalization.

M2 - Average annual growth rate in money.

FDI - The amount of foreign direct investment and portfolio inflows and outflows divided by GDP.

 

Financial development as a concept is multifaceted with no clear measurement or definition. Inference via individual proxies may result in an incomplete understanding of the relationship between financial development and economic growth, since sole proxies are unlikely to capture the true capacity of financial development. To address this issue, Cave, Chaudhuri & Kumbhakar (2019) employed a multiple indicators multiple causes (MIMIC) model to create a more complete measure of financial development. In doing this, they treated banking sector and stock market developments as two latent indicators of financial development and use the MIMIC model to predict them which are used as their proxies. Using data from 101 countries over the period 1990–2014, they found a robust negative relationship between banking sector development and economic growth, whereas the effect of stock market development on economic growth is positive up to a threshold after which the effect becomes negative.

Fig.1(a) Banking sector and stock market depth indicator. Note: For banking sector depth, financial system deposits as a ratio of GDP; whereas for stock market, market capitalization is being used as the depth indicator (Cave, Chaudhuri & Kumbhakar, 2019)

Fig.1(b) Banking sector efficiency indicator. ii. Stock market efficiency indicator. Note: For banking sector efficiency, net interest margin; whereas for stock market, turnover ratio is being used as the efficiency indicator (Cave, Chaudhuri & Kumbhakar, 2019)

In light of the fact that empirical research supports the premise that stock markets promote economic growth, over the past decade research has shifted to the question of the determinants of stock market development. Understanding both the dynamics and the determinants of the development of stock markets is not only crucial to understanding the relationship between finance and economic growth, but also has important policy implications as it sheds light on areas that need government action to make the economic and institutional environment conducive to stock market development.