Chapter 2

2.0 Introduction

The literature review gives an overall idea about the importance of financial markets, most precisely, stock markets to growth throughout history. The theoretical review is divided into different parts, section 2.1 talks about the financial system and growth in general, 2.2 illustrates different studies about stock markets and growth, 2.3 gives provides different indicators of stock market development, 2.4 provides different empirical studies which were done on stock market development and growth and finally, section 2.5 gives a summary of the review.

2.1 Overview of the Financial System and its relationship with Economic Growth

The financial system acts as a mediator between those in need of finance (borrowers) and those who have excess funds (lenders). This type of transaction can be done straightforward by engaging in direct lending or indirectly via organized markets (stock markets) or financial intermediaries like banks. The financial system plays an important role in the allocation of resources in any economy since it helps in the channeling of money from the saving portion of the population to the corporate sector. It also assists in the allocation of investment funds among companies and enables the sharing of risks between firms and the household sector.

Since the past decades, there have been a variety of studies which have emphasized on the relationship between financial development and economic growth. This issue has generated much controversy among economists since there are major questions which revolve around it. First of all, whether or not there is a link between financial sector developments and economic growth? And if yes, what is the nature and direction of the causal relationship? Is it unilateral or bilateral?

Patrick (1966) highlighted the possible causal behavior of financial development and economic growth through his “supply-leading” and “demand-following” hypotheses. The supply-leading hypothesis states that the intentional establishment and development of financial markets and their related services would provoke real investment and thus, leading to economic growth while under the demand-following hypothesis, it is the growing real economy which causes increased demand for financial services which consequently leads to financial development. Following Patrick’s work on the “supply-leading” and “demand-following” hypotheses, literatures on financial development and economic growth can be divided between those who stress the likely benefits of financial markets (to savings, capital allocation, corporate control and risk management) and others who argue that the financial system is unimportant for growth.

Over the years, famous economists promoted the idea that a good financial system does promote growth, the pillars in this field are; Bagehot (1873), Bawerk (1891), Schumpeter (1911), Gerschenkon (1962), Hicks (1969), Goldsmith (1969), McKinnon and Shaw (1973), Cameron (1976) and Miller (1988). These economists provided descriptions and empirical evidence of how and when financial markets encouraged growth.

Bagehot (1873) and Hicks (1969) investigated on how financial development ignited industrialization in England by enabling capital mobilization for huge works. In the same line, Schumpeter (1911) asserted that services provided by well functioning financial intermediaries like banks can stimulate technological progress by giving financial support to those entrepreneurs with highest chances of realizing innovative products. As a result, financial development encourages growth through capital mobilization and technology. In addition to that, using the Endogenous Growth Model of Romer and Lucas (1988), a strand of the literature contended that financial intermediation as well as stock market development does promote economic development by raising the rate and improving the productivity of investment. Recent economists have also paid much attention on financial system and economic growth due to the mounting nexus between these variables. Beneivenga (1991) and Levine (1997) established that more liquid markets do create investment in the long-term and hence economic growth due to falling transaction costs. Furthermore, King and Levine (1993) concluded that “higher levels of financial development are significantly and robustly correlated with faster current and future rates of economic growth, physical capital accumulation and economic efficiency improvements” (PP.717-18). Atje and Jovanovic (1993) also concluded that financial markets stimulated more economic growth as compared to financial intermediation. Besides, Berthelemy and Varoudakis (1996) affirm that insufficient developments in the financial sector may engender a poverty trap and consequently become a severe problem to growth even for countries which have established educational attainment and macroeconomic stability as preconditions for sustained economic growth. Additionally, Goodhart (2004) pointed out that transaction and information costs can be reduced by increasing the accessibility of financial instruments and that efficient financial market can help investors protect, trade and pool risks as well as rising their investment and growth in the economy.

On the other hand, one of the main economists who revoked the importance of the financial system for economic growth by asserting that “where enterprise leads finance follows” is Joan Robinson (1952). He maintained that it is economic growth which creates the demand for various types of financial products to which the financial system responds automatically. Other economists like Nobel Prize Winner, Lucas (1988) argued that some economists “badly over-stressed” the function of financial markets in economic growth while Stern (1989) did not even mention financial development in the lists of omitted topics in his survey. Similarly, in a collection of thesis, founders of developmental economics (including Meier and Seers (1984) and Chandavarkar (1992)) neglect completely the role of finance in economic growth, since they viewed the financial system as having an insignificant position in economic development. Thus, this line of researchers gave only a minor (if not any), role to financial factors in economic growth.

There has also been a number of papers like Favara (2003), Beck and Levine (2004), Loayza and Ranciere (2006), Saci et Al (2009) among many others which have provided evidence of negative relationship between financial sector activity and economic growth in the short term and conclusively a significant and positive one in the long-run.

2.2 Overview of Stock Market Development and Economic Growth

Lately, a new opening has been created in the literature of financial development and economic growth due to the increasing focus on stock markets worldwide. As a result, there has been a shifting interest among economists to analyze the relationship between stock market development and economic growth. Kunt, Levine and Zervos (1993, 1995, 1996 and 1998) were among the firsts to have theoretical concern about this topic and till now there is still a lot of debates around it. Stock market development is seen as a multi dimensional concept which takes into consideration the expansion of markets for equities and bonds in a country or internationally over the years. According to Levine and Zervos (1996), a huge amount of literature suggested that the functioning of stock markets can affect economic growth through various channels. As such, by raising the quality of these channels through a differentiated kind of service, stock markets can compete with financial intermediaries in order to trigger investment and growth. However, till now the effect of this relationship between stock market development and economic growth still remains debatable since some models found a positive link between them while others established a negative one.

The various channels which were mentioned above as per Levine and Zervos (1996) are:

2.2.1 Liquidity

Liquidity can be defined as the ease and ability by which an asset can be converted into money at any time period without great lost. However, while converting assets into cash, there are some kind of risks of uncertainties which may arise due transaction costs and asymmetric information. To be able to hedge and share these risks among investors, financial intermediaries including stock markets have been created. Moreover, the importance of financial mediators in the promotion of liquidity become more prominent with the arrival of high- return investment which also required long-run commitment of capital. Since many investors are risk averse for such type of projects, liquid financial markets turn out to be a vital p