Economic Development and the Role of Stock Markets

Published: 05th December 2011
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Recent years have witnessed enormous growth in developing countries stock markets. This has had costs as well as benefits for development. It has increased volatility in the economy as funds have flowed in from abroad and even more dramatically flooded out. We take a look at stock markets in developing countries and consider some proposed policies to get the most benefits from these markets. We also consider some of the limitations of depending too heavily on stock markets as an engine of growth.

Some studies have suggested that stock market development can play a highly constructive role in encouraging growth. These studies show that greater past stock market development (measured by either past capitalization or turnover in relation to GDP) predicts faster subsequent economic growth, even after other variables known to influence growth, such as the rate of investment and education, are accounted for. Even more striking, both banking and stock market development were found to have independent positive effects on growth, suggesting that each plays a somewhat different role in the economy. A correlation between stock market development and growth would be expected by many theories, including the view that finance follows industry. Therefore, industrial growth and stock market growth would occur together, but in that case, stock market growth would merely reflect the growth of the real sector. The fan that there is faster growth after greater stock market development has already been realized is suggestive of causality but is not conclusive. This is because past financial depth is correlated with future depth. Countries that had well-developed stock markets in the past usually do in the future as welt. So the correlation between growth and past depth could really be driven by a third factor, such as the protection of private property and the rule of law. However, the results suggest that stock markets do have a role to play. Moreover, we can expect that stock markets promote the more general availability of liquidity and risk diversification services, may serve to motivate entrepreneurs who may later go public, and provide incentives for managerial performance that make it easier for firms to raise capital in any form.

The question, then, is, should government do anything to develop and promote such markets, given the remaining uncertainty about the importance of their role? It makes no sense to actively develop stock markets unless certain prerequisites are met. First, one needs macro-stability; investors will not invest in equity without it. Second, policy credibility is needed. How will policymakers keep the economy stabilized, and how will they react in a financial crisis to prevent a meltdown? And third, one needs a solid domestic-firm base; there is no point to opening a stock market if there are few firms in which outside investors would wish to take an equity stake.

Given that these prerequisites are in place, it is reasonable to wonder why a country would need to promote stock markets; wouldn't these markets develop as a result of market forces? One rationale for a public policy promoting the development of stock markets could be to balance the effective tilt toward debt finance implicit in policy to date (for example, public deposit insurance, while clearly necessary, functions like an interest subsidy, which tilts the playing field away from equity markets). Although evidence of spillovers or other special benefits for the promotion of stock market development is probably not enough to make a case for public subsidies to create-and expand stock markets, in many countries policymakers may conclude that the evidence is compelling enough to eliminate bias, explicit or implicit, that has operated against stock markets in the past.

In this regard, the first type of stock market development policy could be termed barrier removal. Rather than promoting stock markets directly, let alone subsidizing their development, this strategy would remove other impediments, generating stock market development on its own. In practice, this usually entails certain forms of deregulation. One must be careful here because, many regulations were put in place not necessarily because there was government failure but because of genuine market failure in the financial sector. If some regulations responding to market failure are removed, others may have to be established in their place. However, certain regulations probably do have the effect of retarding the development and expansion of the stock market. Prime examples are capital repatriation legislation strongly limiting the amount of profit foreign investors can take out-of a country, the existence of restrictions on investing directly, restrictions on foreign broker participation, entry restrictions on investment banking and brokering that are not rational or that encourage rent seeking, and the failure to ensure that regulations are transparent and evenly applied. Changing such regulations has potential costs as well as benefits and should be entered into carefully.

There are other significant problems with relying too strongly on stock markets as a development strategy. First, stock markets lead to substantial foreign-investor influence over domestic-company operations. A large percentage of shares of listed LDC companies are usually foreign-owned. Second, stock markets can lead to short-term speculation that can dominate trading and distort the decision making of managers, often inducing a short time horizon. Third, "hot money" that flows in and out of a country to speculate in markets can produce wide currency swings and destabilize the economy.

Many questions remain regarding the role of financial intermediation in general, and stock markets in particular, in economic development. This is sure to be an active area of policy discussion in the years ahead.


HTML clipboardRashid Javed is an Asian author. He writes articles about various topics of accounting and economics such as CVP analysis and propensity to consume.

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