The Importance of Stock Markets in Economic Growth
The tremendous economic growth witnessed in developing countries over the last decade can, partly, be attributed to entrenchment and strengthening of the free market policies. Such policies include those designed to encourage local and international firms to list in the respective countries’ stock bourses. The importance of well-established financial systems, such as the stock market, as a precondition for economic growth cannot be gainsaid. According to Smith and Starr (1996), the stock markets makes financial assets traded in them less risky and enable companies to access capital through equity issues; thus improving capital allocation in the economy which in turn spur economic growth.
Financial Systems and Industrialization
John Hicks (1969) also argues that growth in financial systems played a critical role in Europe’s industrialization, particularly, in mobilizing capital for immense work. Similarly, Joseph Schumpeter (1912) posits that well-functioning financial systems spur technological innovation by identifying and providing capital for those enterprises which have higher chances of successful implementation. More recently, research has revealed a positive relationship between financial development and economic growth (Levine, 1998). In addition to the realization that development of financial markets is inextricable from part of economic growth, there is evidence that the level of financial development is a good predictor of future economic growth, capital accumulation and technical change (Levine 1998).
Developing Countries and Stock Market Development
A review by the Levine et al (1999) revealed that the world stock markets were booming and those in developing countries constituted a disproportionately larger amount of that boom. With these in mind, developing countries can thus align their economic growth policies with policies geared towards attracting local and foreign companies to list in their stock exchange markets. Many countries have reformed their laws and regulations which removed capital controls and other barriers to attract foreign capital portfolio flows into their countries; which provides an avenue for developing countries to enhance economic growth using the capital injected into the economy. It is also postulated that growth in stock markets goes hand-in-hand with growth in other financial aspects such as banks, brokerage firms, investment companies, and pension funds, which are equally essential for the economic growth of a country (Levine et al, 1999). Gurley and Shaw (1955) argued that a well-developed stock market can foster economic growth in the long run by availing capital and improving the efficiency of trade.
Corporate Governance and Stock Market Value
Following the efficient markets theory, the value of stocks in a stock market is determined by information about the stock in question (Shiller 2003). This argument sounds plausible given that nowadays customers have a myriad of channels of information and are more responsive to information about products they purchase. It, therefore, follows that corporate governance is critical for companies that are listed in the stock exchange to ensure that they send the right signal to the market, which in turn translates to an increase in their stock prices in the stock exchange. Atje and Jovanovic (1993) established a relationship between economic growth and the stock market value of traded divided by GDP, aided by liquidity, diversification, corporate governance, and acquisition of information. Although stock markets ensure a proper environment for obtaining more financial resources, sometimes it is considered an agent of failure due to its susceptibility to market failure (Carp 2012). Nonetheless, research has shown that a positive correlation exists between growth in stock markets and economic growth in developing countries such as Pakistan, Egypt, and South Africa (Shabaz et al., 2008; Enisan and Olufisayo, 2008).
The Role of Behavioral Finance
The assumption of rationality of agents, which has hitherto shaped opinions regarding financial markets, has come to question with critics asserting that agents are not always fully rational in their undertakings (Barberies and Thaler, 2003). This notion is captured in the theory of behavioral finance where some agents operating in the stock market act in a manner inconsistent with the subjective expected utility theory and make irrational decisions. However, opponents of this theory posit that even if some agents in the economy are less than fully rational, rational agents will prevent them from influencing security prices through arbitrage. Research has, however, shown that in an economy where rational and irrational traders interact, irrationality can have a substantial and lifelong impact on stock prices (Barberies and Thaler, 2003).
Conclusion
In conclusion, the growth of the stock market is inextricably related to the economic growth of a country, and therefore policies aimed at growing the stock market should be pursued.
Works cited
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Barberis, Nicholas, and Richard Thaler. "A survey of behavioral finance." Handbook of the Economics of Finance 1 (2003): 1053-1128.
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Carp, Lenuţa. "Can stock market development boost economic growth? Empirical evidence from emerging markets in Central and Eastern Europe." Procedia Economics and Finance 3 (2012): 438-444.
Enisan, Akinlo A., and Akinlo O. Olufisayo. "Stock market development and economic growth: Evidence from seven sub-Sahara African countries." Journal of economics and business61.2 (2009): 162-171.
Gurley, John G., and Edward S. Shaw. "Financial aspects of economic development." The American Economic Review45.4 (1955): 515-538.
Levine, Ross, and Sara Zervos. Stock markets, banks, and economic growth. The World Bank, 1999.
Levine, Ross. "The legal environment, banks, and long-run economic growth." Journal of money, credit and banking(1998): 596-613.
Schumpeter, Joseph A. "The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle (1912/1934)." Google Scholar (1961).
Shahbaz, Muhammad, Nadeem Ahmed, and Liaquat Ali. "Stock market development and economic growth: ARDL causality in Pakistan." International Research Journal of Finance and Economics 14.1 (2008): 182-195.
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