Generally, the existing literature outlines two sets of factors affecting the development of stock markets: “macroeconomic factors” and “institutional factors”. Macroeconomic factors include economic development level, inflation and capital flows, etc., while institutional factors include variables that reflect the state of regulatory and supervisory institutions, such as legal frameworks and the protection of property rights, etc. It is worth mentioning that these two sets of variables are interrelated. For instance, the evolution of the institutional environment is directly reflected in macroeconomic conditions and, by the same token, a favorable macroeconomic environment facilitates the development of institutions. Consequently, the mentioned division in the literature is, in the view of many, provisional, and does not imply alternative views on the determinants of stock market development (Adarov and Tchaidze, 2011).
Macroeconomic factors
On the “macroeconomic factors” side
of the
question, the
literature
on stock market development has found that the more
developed a country is, the more
deeply entrenched will be
its
stock market (Rajan and Zingales, 2003; La Porta et al., 2006). Several studies find that financial openness and liberalization increase stock market activity (Levine and Zervos,
1998b; Henry, 2000; and Edison and
Warnock, 2003). Garcia and
Liu
(1999) investigated the macroeconomic determinants of stock market development in a sample of Latin American and Asian countries. Their findings show
that GDP growth, domestic investment and
financial intermediary sector development are determinative
in stock market development. Domowitz
and
Steil (1999) highlight the direct impact of a reduction
in trading cost on turnover and
the
much more important indirect effects of a reduction in trading cost on the cost of equity.
Henry (2000) finds a strong relationship between the growth rate of investment and changes in
stock market valuation measured by returns on the stock market, the turnover ratio, and the traded value as a share of GDP. On
the
other hand, McCauley and Remolona (2000) and Shah and Thomas
(2001) find that the size of the economy is an important factor in the development of liquid and well- functioning
securities markets. Mishkin
(2001) and Ahn, et. al. (2015) argue that financial liberalization promotes
transparency and accountability, which reduces adverse
selection and moral hazard. It thus tends to reduce the cost of borrowing in stock markets, which eventually increases their liquidity and size
A large pool
of studies has investigated the
impact of
inflation on capital
markets.
An
important finding of these studies has been that high levels of inflation are associated with less liquid and smaller financial markets as financial intermediaries tend to lend less and allocate
less efficiently. Boyd et al. (2001) find negative effects of inflation on private credit and equity markets. Interestingly, they argue that the relationship between financial development and inflation could be nonlinear, with a particular threshold level after which
the
financial sector experiences an abrupt drop in performance.
Claessens et al. (2001) find that privatization programs and foreign direct investment contribute to
stock market development. Further, Perotti and Oijen (2001) argue that privatization has an indirect positive impact on stock market development through political risk reduction. Naceur et al. (2007)
show that macroeconomic
factors such as income, saving rate, and financial intermediary development
are important determinants of stock market development for a panel of countries in the MENA
(Middle East and North Africa) region.
In
a sample of 40 emerging markets over the
period 1980-2000, El-Wassal (2005) examined the relationship between
stock market growth
and
economic growth, financial liberalization and
foreign portfolio.
The
findings
show that economic growth, financial liberalization and foreign portfolio
investments were the leading factors in the expansion of stock markets.
Yartey and Adjasi, (2007) found that financial intermediary
sector development tended to
increase
stock market development in Sub-Sharan Africa, controlling for macroeconomic stability, economic development and the quality of legal and political institutions. In addition, Yartey (2008) has demonstrated that stock market development has a nonlinear relationship with
banking sector
development. That is, stock market development is initially
supported by banking
sector development through trade intermediation. Yet, as stock markets develop, they begin to compete with financial institutions in
financing investment. In
a later study, Andrianaivo
and Yartey (2009) examined
the
impact of a range of macroeconomic factors on both banking
sector and stock market development. Their findings show
that stock market liquidity, domestic savings banking sector development and
political stability are the main determinants of stock market development.
Overall, the
range
of economic factors underlying stock market development can be
roughly aggregated to
the
level of economic development, the size of the economy in question, the level of
financial openness, the inflation rate, privatization, domestic saving, banking sector development and
economic growth.
Institutional factors
As for the “institutional factors” side of the question, the empirical literature
shows that
countries with
better institutional framework
tend
to have more developed stock markets. North and
Weingast (1989)
show that
improved
checks
and balances,
credible commitments and upgraded
property rights in England during the seventeenth century led to the development of stable capital
markets. Allen
et. al. (2012) show that regulatory and institutional factors could influence the efficient
functioning of stock markets. That is, compulsory disclosure of reliable information and financial data on listed companies
may
increase
investor
participation,
while regulations
that enhance investor confidence in brokers could enhance investment and trading in stock markets.
Erb et al. (1996b)
and Acharya et.al. (2017) show that expected returns and the
magnitude of political risk are
positively related. They find that both in developing and developed countries, the lower the level of political risk, the lower
the
required returns.
The
results suggest
that political risk plays
an
important role in
investment decisions and decreases the cost of equity, and consequently may have important
implications for stock market development.
La Porta et al. (1998, 2006)
argue that the origin of a country’s legal system affects the level
of
financial development. A common law basis is more conducive to the development of capital
markets than a civil law basis, as the flexibility of the common law legal system allows for protection
of
small investors. Moreover, they find that countries with a lower quality legal regime
and
poorer law enforcement exhibit smaller and narrower capital markets and that the listed companies on their stock
markets are characterized by more concentrated ownership. Perotti and Van Oijen (2001), Galindo and Micco (2004) and Djankov et al. (2005) argue
that strengthening property rights, credit
protection and investor protection through company
laws and commercial
codes, as well as disclosure
of companies’ activities and proper accounting rules and practices are key determinants of the development of corporate securities markets.
More
recent empirical research emphasizes as
well the
important
role of
access
to international markets in
fostering
the
development of local
financial markets. Capital account
liberalization broadens the investor base, enhances efficiency by weeding out inefficient institutions
and creates pressure to reform (Claessens et al, 2001).
Impavido et al. (2003)
argue that the development and particularly
the liquidity of financial markets depend also on the
existence of a diversified class of institutional investors. Mutual funds, pension funds and insurance companies act as a stable source of demand for
equity and debt securities. They foster competitiveness and efficiency in primary markets and create
an incentive for the establishment of a robust regulatory
and
supervisory
framework. In this regard,, Catalan et al.(2000) examine the determinants of stock market development for OECD (Organisation
for Economic Co-operation and Development) countries and
for some emerging economies. Their findings suggest that, setting aside the issues of macro-stability and legal rights, contractual savings institutions positively affect stock market development.
Yartey and Adjasi (2007)
shows
that political
risk and institutional quality are strongly associated with growth in stock market capitalization. The
results suggest that the establishment of quality institutions can be an important factor in the development of stock markets. Other institutional
factors
as well,
such as law and
order,
democratic
accountability and
bureaucratic quality are
important determinants of stock market development.
Chami et al. (2009) argue that financial markets will develop if borrowers and lenders are willing and able to enter into contracts,
and liquidity providers find conditions conducive to trading created financial instruments.
They also emphasize
the importance
of regulatory structure
in supporting
this process by
removing obstacles that render potential borrowers, lenders and liquidity providers unwilling or unable to play their roles and by creating an appropriate incentive for each agent to fulfill their end of the bargain.
The key insight of the
strand of research that emphasizes the
role of institutional framework in the
development of stock markets identifies the following factors: political stability, quality of legal
institutions (particularly with
respect to investor protection), law enforcement, disclosure of reliable
information and a diversified investor base.
It is worth highlighting that while the literature has examined a variety of macroeconomic and
institutional factors, the marginal impact of each individual factor is difficult to isolate as they are, of necessity, interrelated, and the
causality relationship between them and stock market development is a complex process to unravel.
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