Exploring what determines stock market development has become a prominent area of research in recent years. The issue has gained considerable attention in the empirical research recently, with the exception of the theoretical attempt by Calderon-Rossell (1991), in the very earliest stages. He was the first to develop a partial equilibrium model of stock market growth. To date, this model represents the most “serious” attempt to lay the foundations of a financial theory of stock market development. However, as a partial equilibrium model, it fails to take into account, for instance, the potential effects of government policies and institutional factors.

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 countrys 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.