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Stock Markets:

A Spur to Economic Growth


ROSS LEVINE

between stock markets and banks in fostering sell quickly, liquid markets may weaken
World stock markets are boom- economic growth? And, how can developing investors’ commitment and reduce investors’
countries benefit from stock market growth? incentives to exert corporate control by over-
ing and stock markets in devel- seeing managers and monitoring firm perfor-
oping countries account for a Impact on development mance and potential. According to this view,
Do stock markets affect overall economic enhanced stock market liquidity may actually
disproportionately large share development? Although some analysts view hurt economic growth.
of this boom. Investors are ven- stock markets in developing countries as The empirical evidence, however, strongly
“casinos” that have little positive impact on supports the belief that greater stock market
turing into the world’s newest economic growth, recent evidence suggests liquidity boosts—or at least precedes—eco-
markets and some are seeing that stock markets can give a big boost to eco- nomic growth. To see how, consider three
nomic development. measures of market liquidity—three indica-
handsome returns. But are
Stock markets may affect economic activity tors of how easy it is to buy and sell equities.
developing countries themselves through the creation of liquidity. Many prof- One commonly used measure is the total
reaping any benefits from their itable investments require a long-term com- value of shares traded on a country’s stock
mitment of capital, but investors are often exchanges as a share of GDP. This ratio does
stock markets? The evidence reluctant to relinquish control of their savings not directly measure the costs of buying and
indicates that they are. for long periods. Liquid equity markets make selling securities at posted prices. Yet, aver-
investment less risky—and more attrac- aged over a long time, the value of equity
tive—because they allow savers to acquire an transactions as a share of national output is
asset—equity—and to sell it quickly and likely to vary with the ease of trading. In other

O
VER THE past 10 years, the total cheaply if they need access to their savings or words, if it is very costly or risky to trade,
value of stocks listed in all of the want to alter their portfolios. At the same there will not be much trading. This ratio is
world’s stock markets rose from $4.7 time, companies enjoy permanent access to used to rank 38 countries by the liquidity of
trillion to $15.2 trillion, while the capital raised through equity issues. By facili- their stock markets in four different groups.
share of total world capitalization represented tating longer-term, more profitable invest- The nine countries with the most illiquid mar-
by the emerging markets jumped from less ments, liquid markets improve the allocation kets are in the first group; the nine countries
than 4 percent to almost 13 percent. Trading of capital and enhance prospects for long-term with the most liquid markets—that is, with
in the emerging markets also surged: the economic growth. Further, by making invest- the largest value-traded-to-GDP ratios—are in
value of shares traded climbed from less ment less risky and more profitable, stock the fourth group; the second and third groups,
than 3 percent of the world total in 1985 to market liquidity can also lead to more invest- each of which contains 10 countries, fall
17 percent in 1995. ment. Put succinctly, investors will come if between the two extremes of liquidity. As
The emerging markets have attracted the they can leave. Chart 1 shows, countries that had relatively
interest of international investors while rais- There are alternative views about the effect liquid stock markets in 1976 tended to grow
ing a number of critical questions for policy- of liquidity on long-term economic growth, much faster over the next 18 years than coun-
makers in developing countries: Do stock however. Some analysts argue that very liquid tries with illiquid markets.
markets affect overall economic development markets encourage investor myopia. Because The second measure of liquidity is the
and, if so, how? What is the relationship they make it easy for dissatisfied investors to value of traded shares as a percentage of total

Ross Levine,
a US national, is a Senior Economist in the Finance and Private Sector Development Division of the World Bank’s Policy Research Department.

Finance & Development / March 1996 7


GDP grows faster in economies with liquid stock markets
Chart 1 Chart 2
Initial value-traded ratio (1976) and subsequent growth (1976–93) Initial turnover (1976) and subsequent economic growth (1976–93)

Very illiquid Austria, Colombia, Denmark, Finland, Chile, Denmark, Greece, Jordan,
Very illiquid
Indonesia, Nigeria, Norway, Portugal, Luxembourg, Nigeria, Norway, Portugal,
Venezuela Venezuela
Argentina, Belgium, Greece, Jordan, Austria, Belgium, Colombia, Finland,
Illiquid Luxembourg, Mexico, Spain, Sweden, Illiquid Indonesia, Malaysia, Mexico, Spain,
Thailand, Zimbabwe Sweden, Zimbabwe
Australia, Brazil, Canada, France,
Liquid Brazil, Chile, France, Germany, India, Italy, Liquid Germany, Netherlands, Singapore,
Korea, Malaysia, Netherlands, Philippines Thailand, United Kingdom, United States

Australia, Canada, Hong Kong, Israel, Argentina, Hong Kong, India, Israel, Italy,
Very liquid Japan, Singapore,Taiwan Province of Very liquid Japan, Korea, Philippines, Taiwan Province
China, United Kingdom, United States of China

0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 0 0.5 1.0 1.5 2.0 2.5 3.0 3.5
Annual per capita GDP growth (percent) Annual per capita GDP growth (percent)
Source: International Finance Corporation. Source: International Finance Corporation.
Note: Initial liquidity is measured as the ratio, in 1976, of the value of shares traded to GDP. Note: Initial turnover is measured as the ratio, in 1976, of the value of shares traded to
market capitalization.

Chart 3
Initial trading-to-volatility ratio (1976) and
subsequent economic growth (1976–93)
Very
illiquid Argentina, Colombia, Denmark, Greece,
Norway, Spain, Sweden, Venezuela
Our study, which is based on a total of 38
Illiquid Austria, Belgium, Brazil, Finland, Italy, countries, includes both industrial and
Mexico, Sweden
developing countries. This is because some
Canada, Chile, France, Germany, India, developing countries have more liquid stock
Liquid
Jordan, Philippines exchanges than countries with higher per
Australia, Israel, Japan, Korea, capita GDP.
Very liquid Netherlands, Thailand, United Kingdom,
United States

0 0.5 1.0 1.5 2.0 2.5 3.0 3.5


Annual per capita GDP growth (percent)

Source: International Finance Corporation.


Note: Initial trading-to-volatility ratio is the ratio, in 1976, of the value of shares traded to volatility, which is
measured as a 12-month rolling standard deviation estimate based on market returns. Data are available
for only 30 countries in the study.

market capitalization (the value of stocks nomic, social, political, and policy factors that stock markets. For example, regression analy-
listed on the exchange). This turnover ratio may affect economic growth, and when using ses suggest that if Mexico’s value-traded-to-
measures trading relative to the size of the instrumental variable estimation procedures, GDP ratio in 1976 had been the same as
stock market. Chart 2 indicates that greater various periods, and different country sam- the average for all 38 countries in our sample
turnover predicted faster growth. The more ples. The basic conclusion that emerges from (0.06 instead of Mexico’s actual ratio of 0.01),
liquid their markets in 1976, the faster coun- this statistical work is that stock market devel- the annual income of the average Mexican
tries grew between 1976 and 1993. opment explains future economic growth. would be 8 percent higher today. This type of
The third measure is the value-traded-ratio What is important is that other measures of forecast does not explain how to enhance liq-
divided by stock price volatility. Markets that stock market development do not tell the same uidity, but it does give an indication of the
are liquid should be able to handle heavy trad- story. For example, stock market size—as potentially large economic costs of policy, reg-
ing without large price swings. As Chart 3 measured by dividing market capitalization ulatory, and legal impediments to stock mar-
shows, countries whose stock markets were by GDP—is not a good predictor of economic ket development.
more liquid in 1976—countries with higher growth (Chart 4), while greater stock price Is there really a link between stock market
trading-to-volatility ratios—grew faster over volatility does not necessarily predict poor liquidity and economic growth, or is stock mar-
the next 18 years than countries with less liq- economic performance (Chart 5). Empirically, ket liquidity just highly correlated with some
uid markets. As demonstrated in the series of it is not the size or volatility of the stock mar- nonfinancial factor that is the true cause of eco-
papers on which this article is based (see back- ket that matters for growth but the ease with nomic growth? Multiple regression procedures
ground note), the strong link between stock which shares can be traded. suggest that stock market liquidity helps
market liquidity and economic growth contin- Countries may be able to garner big growth forecast economic growth even after account-
ues to hold when controlling for other eco- dividends by enhancing the liquidity of their ing for a variety of nonfinancial factors that

8 Finance & Development / March 1996


Size and volatility of stock markets are less important in forecasting GDP growth
Chart 4 Chart 5
Initial market size (1976) and Initial volatility (1976) and
subsequent economic growth (1976–93) subsequent economic growth (1976–93)

Very large Canada, Chile, Hong Kong, Japan, Very volatile Argentina, Brazil, Chile,
Jordan, Luxembourg, Singapore, Korea, Mexico, Philippines,
United Kingdom, United States Thailand, Zimbabwe
Australia, Belgium, Brazil, Greece, Israel, Greece, Israel, Italy, Jordan,
Large Malaysia, Netherlands, Spain, Taiwan Volatile Norway, Spain, United
Province of China, Zimbabwe Kingdom, Venezuela
Colombia, Denmark, Finland, France, Australia, Belgium, Canada,
Small Germany, Korea, Mexico, Norway, Stable Colombia, Denmark, France,
Philippines, Venezuela Pakistan, Sweden

Argentina, Austria, India, Indonesia, Italy, Austria, Finland, Germany,


Very small Nigeria, Portugal, Sweden, Thailand Very stable India, Japan, Netherlands,
New Zealand, United States

0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 0 0.5 1.0 1.5 2.0 2.5
Annual per capita GDP growth (percent) Annual per capita GDP growth (percent)
Source: International Finance Corporation. Source: International Finance Corporation.
Note: Initial market size is measured as the ratio, in 1976, of market capitalization to GDP. Note: Initial volatility is measured as a 12-month rolling standard deviation estimate
based on market returns in 1976. Data are available for only 32 countries in the study.

Banks also spur growth Chart 7


Chart 6 Initial liquidity (1976) predicts high rates
Initial banking development (1976) and of subsequent capital accumulation and
subsequent economic growth (1976–93) productivity growth (1976–90)

Very developed Austria, Finland, Germany, Hong Productivity


Kong, Japan, Portugal, Singapore, Very illiquid growth
Spain, Taiwan Province of China
Capital
Canada, France, Israel, Italy, Jordan, growth
Developed Korea, Netherlands, Norway,
Illiquid
Sweden, United States
Australia, Belgium,Denmark, Greece,
Less developed Malaysia, Philippines, Thailand,
United Kingdom, Venezuela Liquid

Under- Argentina, Brazil, Chile, Colombia,


developed India, Indonesia, Mexico, Nigeria, Very liquid
Zimbabwe

0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 0 1 2 3 4 5


Annual per capita GDP growth (percent) Annual growth of capital per person and productivity (percent)

Source: International Monetary Fund. Sources: International Monetary Fund and International
Finance Corporation.
Note: Initial banking development is measured as a percentage of GDP in 1976 represented by bank
loans to enterprises. Data are available for 37 countries in the study. Note: Initial liquidity is measured as the ratio, in 1976, of value
of shares traded to GDP. (See chart 1 for countries.)

influence economic growth. After controlling To evaluate the relationship between stock banking development implies faster growth
for inflation, fiscal policy, political stability, markets, banks, and growth, our 38 sample no matter what the level of stock market
education, the efficiency of the legal system, countries were divided into four groups. liquidity. Thus, it is not a question of stock
exchange rate policy, and openness to in- Group 1 had greater-than-median stock mar- market development versus banking develop-
ternational trade, stock market liquidity ket liquidity (as measured by the value- ment—each, on its own, is a strong predictor
is still a reliable indicator of future long- traded-to-GDP ratio) in 1976 and greater- of future economic growth.
term growth. greater-than-median banking development. Why might stock markets and banks both,
Group 2 had liquid stock markets in 1976 independently of each other, boost economic
Stock markets versus banks but less-than-median banking development. growth? Although the empirical evidence is
Is there an independent link between stock Group 3 had less-than-median stock market consistent with the view that stock markets
market development and growth, or is stock liquidity in 1976 but well-developed banks. and banks promote economic growth indepen-
market liquidity correlated with banking devel- Group 4 had illiquid stock markets in 1976 dently of each other, the reasons are not fully
opment—and is the latter the financial factor and less-than-median banking development. understood. One argument is that stock mar-
that really spurs economic growth? Although Countries with both liquid stock markets kets and banks provide different types of
countries with well-developed banks—as and well-developed banks grew much faster financial services. Stock markets offer oppor-
measured by total bank loans to private enter- than countries with both illiquid markets and tunities primarily for trading risk and boost-
prises as a share of GDP—tend to grow faster underdeveloped banks. Furthermore, greater ing liquidity; in contrast, banks focus on
than countries with underdeveloped banks stock market liquidity is associated with establishing long-term relationships with
(Chart 6), the effects of banks on growth can faster future growth no matter what the level firms because they seek to acquire informa-
be separated from those of stock markets. of banking development. Similarly, greater tion about projects and managers and enhance

Finance & Development / March 1996 9


corporate control. (There is, of course, however. As shown in Chart 5, volatil-
some overlap. Like stock markets, Stock markets after liberalization ity does not have any measurable
banks help savers diversify risk and effect on long-term growth. Thus, if
provide liquid deposits. Like banks, Year of policymakers have the patience to
liberalization Size Liquidity Volatility
stock markets may stimulate the weather some short-run volatility, lib-
acquisition of information about Argentina 1989
eralization offers expanded opportuni-
firms, because investors want to ties for long-run economic growth.
Brazil 1983
make a profit by identifying under- Does every country need an ac-
Chile 1988
valued stocks to invest in; stock mar- tive stock market of its own?
Colombia 1989–91
kets may also help improve corporate Unfortunately, there is not much evi-
governance by simplifying takeovers, India 1990–92 dence available to answer this ques-
providing an incentive to improve Jordan 1987 tion. In principle, all countries do not
managerial competency.) Korea 1981–92 need domestic stock markets. They
Is greater stock market liquidity Malaysia 1986 n.a. do, however, need easy access to liq-
associated with more or better invest- Pakistan 1990 uid stock markets where residents and
ment? Both. Chart 7 shows that coun- Philippines 1988 domestic firms can buy, sell, and issue
tries that had more liquid stock Portugal 1988 n.a. securities. It is the ability to trade and
markets in 1976 enjoyed both faster Thailand 1988
issue securities easily that facilitates
rates of capital accumulation and long-term growth, not the physical
Turkey 1990 n.a.
greater productivity gains over the location of the market. In other words,
Venezuela 1988
next 18 years. there is little reason to believe that
However, although liquid equity Source: Ross Levine and Sara Zervos, 1995, “Capital Control California would grow faster if the
markets imply more investment, new Liberalization and Stock Market Development,” unpublished (World New York Stock Exchange were
Bank).
equity sales are not the only source of Note: Arrows indicate increases; dashes indicate no significant
moved to Los Angeles.
finance for this increased investment. change; n.a. indicates data were not available. When should policymakers really
Most corporate capital creation is push stock market development? This
financed by retained earnings and is even more uncertain. The available
bank loans. Although this phe- information suggests that policymak-
nomenon is not wholly understood, greater domestic firms seeking foreign investment to ers should remove impediments—tax, legal,
stock market liquidity in developing countries upgrade their information disclosure policies and regulatory barriers—to stock market
is linked to a rise in the amount of capital and accounting systems. Moreover, the entry development. But there is not strong evidence
raised through bonds and bank loans, so of more foreign investors into emerging mar- to support interventionist policies—like tax
that corporate debt-equity ratios rise with kets may lead to pressure to upgrade trading incentives—that artificially boost stock mar-
market liquidity. Stock markets tend to com- systems and modify legal systems to support ket size and activity.
plement—not replace—bank lending and more trading and the introduction of a greater While much work remains to be done, a
bond issues. variety of financial instruments. growing body of evidence suggests that stock
Through all of these channels, the removal markets are not merely casinos where players
Tips for policymakers of barriers to foreign investment can improve come to place bets. Stock markets provide ser-
Given the important role well-functioning the operation of domestic capital markets. vices to the nonfinancial economy that are cru-
stock markets seem to play in economic This is consistent with recent evidence. As cial for long-term economic development. The
growth, what can countries do to promote shown in the table, stock market liquidity rose ability to trade securities easily may facilitate
them? Fully answering this question is well significantly in 12 out of 14 countries that lib- investment, promote the efficient allocation of
beyond the scope of any single article. Legal, eralized controls on international capital capital, and stimulate long-term economic
regulatory, accounting, tax, and supervisory flows. Chile, for example, liberalized restric- growth. Furthermore, the evidence suggests
systems influence stock market liquidity. The tions on the repatriation of dividends by for- that stock market liquidity encourages—or at
efficiency of trading systems determines the eign investors in January 1988. None of the least strongly forecasts—corporate invest-
ease and confidence with which investors can 14 countries experienced a statistically sig- ment, even though much of this investment is
buy and sell their shares. And the macroeco- nificant drop in liquidity following liberaliza- financed through retained earnings, bank
nomic and political environments affect mar- tion. In conjunction with the earlier findings loans, and bonds, rather than equity issues.
ket liquidity. that market liquidity boosts economic growth, Policymakers should consider reducing
Consider the impact of one particular policy these results suggest that liberalizing inter- impediments to stock market development.
lever: liberalizing controls on international national capital flow restrictions can acceler- Easing restrictions on international capital
capital flows. Liberalization may involve eas- ate economic growth by enhancing stock mar- flows would be a good place to start. F&D
ing restrictions on capital inflows or reducing ket liquidity.
impediments to repatriating dividends or cap- The table also indicates, however, that stock
ital. In either case, reducing barriers to cross- market volatility rose in 7 out of 11 countries
border capital flows can affect the functioning following liberalization. Volatility did not fall
of emerging stock markets: first, by enhancing significantly in any of the 11 countries follow- This article is based on 12 papers presented at a
the integration of emerging markets into ing liberalization. Thus, while easing interna- World Bank conference, “Stock Markets, Corporate
world capital markets, thereby bringing the tional capital flow restrictions may increase Finance, and Economic Growth,” organized by Asli
prices of domestic securities into line with liquidity, it may also increase volatility. This Demirgüç-Kunt and Ross Levine. These papers are
those elsewhere; and, second, by forcing should not be of much concern in the long run, available from the author on request.

10 Finance & Development / March 1996