Although the term “developed” is widely used in the literature on stock markets, a precise definition of the term cannot be found. Does a “developed” stock market mean a large or a liquid market? Does “developed” mean a “highly performing” market? Does the rapid growth of emerging stock markets, for instance, mean that these markets are– or are about to become – developed markets?

The commonly used measures to assess stock market development are stock market size   and stock market liquidity indicators (Chen, et. al., 2017). But are they enough or sufficiently comprehensive to assess the development of stock markets? is always debatable.

Principally, it needs to be stated that growth and development are not the same thing. For a stock market to grow means that it increases in size or liquidity. To develop implies increasing or improving a   stock   market’s   ability to satisfy an economy’s   needs   as stipulated among the main functions of stock markets. Stock market development is better reflected in the quality of services provided by a stock market than in its size, liquidity or its index performance. If a stock market were flooded with money, it would be more liquid but not necessarily more “developed”. On the other hand, a well-developed market can serve the economy better with its size and liquidity than one of the same size and liquidity that is less developed. This is not to say that size and liquidity are irrelevant. Large size and greater liquidity can improve the ability of a stock market to serve the economy, but they can best be utilized for this purpose via markets which are developed. Stock markets - and this is the case with many emerging stock markets-can grow too much, but can it be argued that they are capable of developing too much? Moreover, stock market growth and development do not have to conflict - they can reinforce each other. The distinction between stock market growth and stock market development is best understood by the traditional analogous distinction between economic growth and economic development.

Despite the amount of work that has been done on the development of stock markets, there is no single criterion that can be used to measure stock market development. A stock market might be large, but not liquid, or it could be quite liquid, yet trading occurs in only a small number of stocks, which account for a considerable portion of the total market capitalization. In addition, stock markets may be large, liquid and reasonably non-concentrated but may not be linked to or may not even reflect performance in the real sector. Consequently, only one or two indicators will not be enough to capture all aspects of stock market development.

To assess the status of stock market development, Wassal (2013) among with many others proposes a set of indicators that capture the main aspects of stock markets, namely : i) stock market size; ii) stock market liquidity; iii) stock market concentration; iv) stock market linkage to real sector performance; and v) stock market performance/volatility. Using a variety of indicators could provide a more accurate depiction of stock market development as it is a complex and multi-faceted concept and no single measure or indicator can capture all aspects of stock market development.

 

i) Stock market size:

There are two main indicators of stock market size: market capitalization and the number of listed companies.

(a)  Market Capitalization

A common indicator for assessing stock market size is Market capitalization/GDP, which equals the market value of listed shares divided by the relevant GDP. This indicator has been widely used in the literature as a stable measure of stock market development for two reasons. First, it is a measure of stock market size, which is positively correlated with the ability to mobilize capital and diversify risk. Second, it is presumed to include companies’ past retained profits and future growth prospects so that a higher ratio to GDP can signify growth prospects as well as stock market development (Levine and Zervos, 1998b, Bekaert et al, 2001; Rajan and Zingales, 2003). The main shortcoming of this measure is that a high ratio solely driven by the appreciated values of only a few companies with little or no change in the amount of funds raised and no change in the breadth of the stock market may be misinterpreted as stock market development (Adelegan, 2008).

(ii)The Number of Listed Companies

The number of listed companies is used as a complementary measure of stock market size. The main advantage of this measure is that it is a proxy for the breadth of the stock market and is not subject to stock market fluctuations (Rajan and Zingales, 2003; and Karolyi, 2004). Moreover, it is not tainted by possible mis-measurement of GDP, which often happens in many developing countries.

Nevertheless, this measure suffers from two main weaknesses: first, the number of listed companies is too slow-moving to fully capture high frequency changes among listed companies.   The number of listed companies can also be affected by corporate restructuring, combining and merging. Second, this measure may allocate a low score to economies whose industrial structure is concentrated in the sense of having only a smaller number of large companies. It can be a noisy measure as concentration only partly reflects limited access to finance (Rajan and Zingales, 2003 and Karolyi, 2004). It is worth highlighting that while marginal differences in the number of listed companies are uninformative, extreme value can be useful.

 

ii) Stock market liquidity:

One of the most important aspects of stock market development is liquidity. Liquid markets offer a number of benefits: i) they render financial assets more attractive to investors, who can transact in them more easily. In addition, liquid markets allow investors to switch out of equity if they want to change the composition of their portfolio; ii) liquid markets permit financial institutions to accept larger   asset-liability   mismatches;   iii)   they   allow companies   to   have permanent   access   to   capital through equity issues; and iv) liquid markets allow a central bank to use indirect monetary instruments and generally contribute to a more stable monetary transmission mechanism (Sarr and Lybek, 2002).

With liquid markets, the initial investors do not lose access to their savings for the duration of the investment   project   for   they can easily,   quickly and cheaply sell their   stake in the company. Consequently, more liquid markets could ease investment in long-term, potentially more profitable projects, thereby improving the allocation of capital and enhancing prospects for long-term growth. Put another way, the more liquid the stock market, the larger the amount of savings that are channeled through stock markets.

While   economists   advance   many   theoretical   definitions   of   “liquidity”,   there is   no   single unambiguous, theoretically correct or universally accepted definition of liquidity (Ahn, et. al., 2015). However, analysts generally use the term to refer to the ability to easily buy and sell securities. There are   five   dimensions   of   market   liquidity,   which   are:   tightness,   immediacy,   depth,   breadth   and resiliency. Tightness refers to low transaction costs, such as the difference between buy and sell prices. Immediacy represents the speed with which orders can be executed and settled, and thus reflects among other things, the efficiency of the trading, clearing and settlement systems. Depth refers to the existence of abundant orders, either actual or easily uncovered of potential buyers and sellers, both above and below the price at which a security would be trading on the market. Breadth means that orders are both numerous and large in value with minimal impact on prices, and resiliency usually denotes the speed with which price fluctuations resulting from trades are dissipated.(Sarr and Lybek, 2002)

A comprehensive measure of liquidity would quantify all the costs associated with trading, including the time cost and the uncertainty of finding a counterpart and finalizing the transaction. Yet no single measure unequivocally measures tightness, immediacy, depth, breadth and resiliency. Due to the difficulties involved in elaborating such a measure, the most commonly used indicators of liquidity by analysts are traded value/GDP and turnover ratio (Bao, Hou, & Zhang, 2016.

 

(a)Traded Value/GDP

Traded value is a volume-based indicator. Volume-based indicators are most useful in measuring   market   breadth,   i.e.   the existence of both numerous   and large orders   in   volume with minimal transaction price impact. Traded value/GDP equals the total value of shares traded on the stock market divided by GDP. It measures the organized trading of shares as a percentage of national output and therefore should positively reflect stock market liquidity on an economy-wide basis.

 

(b) Turnover Ratio

Since traded value can be given more meaning by relating it to the value of outstanding volume of shares being considered, turnover ratio is commonly used as a second indicator of liquidity. Turnover ratio gives an indicator of the number of times the outstanding volume of shares changes hands. Turnover ratio equals the value of total shares traded divided by market capitalization.

In some sense, turnover ratio as an indicator of liquidity complements traded value/GDP. While the former captures market trading relative to the size of the economy, the latter measures trading compared with the size of the stock market. A small, liquid market will have a high turnover ratio but a small traded value/GDP ratio. A high turnover ratio is often used as an indicator of low transaction cost. However, some analysts consider turnover as a good indicator of speculative activity in a given market. As noted earlier, the turnover is derived by dividing the one-year average market capitalization by total annual traded value. A value of 100 per cent means that the two terms are equal and that, on average, each share has changed hands once during the year in question. Higher turnover ratio means that shares have frequently changed hands, which may reflect a tendency to speculation.

Finally, making use of both indicators – traded value/GDP and turnover ratio – can provide a more comprehensive picture of the liquidity of stock markets than the information provided by the use of only one of them.

 

iii) Stock market concentration:

It is possible for stock markets to be large relative to their economies, but still concentrated. That is, only a few companies dominate the given market. Consequently, market concentration may be measured by looking at the share of market capitalization accounted for by the large companies in the market. These large companies are seen by some analysts as being the leading three to five companies in the market (Maunder et al., 1991, and Raunig & Scharler, 2012). Yet, another commonly used indicator of the degree of stock market concentration is the share of market capitalization accounted for by the ten largest stocks (e.g. International Finance Corporation, S&P).

Concentration adversely affects market development as it hampers market breadth by the concentration of capitalization within a handful of large companies, limiting the range of attractive investment opportunities and thus adversely affecting liquidity in the stock market in question. In addition, having a stock market which is driven by only a few companies could weaken the link between stock prices for non-leading companies and/or their performance and growth prospects. That is to say, the prices of stocks in non-leading companies are affected by market movements of stock prices of leading companies more than their own performance and prospects. This distorts the “signaling” function of stock markets. Market concentration also might encourage speculative activities as investment alternatives are limited and diversification possibilities are limited as well.

 

iv) Stock market linkage to real sector performance:

The relationship between stock prices and real economic activity is circular. On the one hand, stock prices depend on a company’s performance and its growth prospects so that to the degree that a company’s performance improves and the rate of return increases, stock prices rise in turn. On the other hand, stock prices should reflect the present discounted value of expected future dividends or expected future growth. From this perspective, stock prices serve as a leading indicator of future changes in real economic activity (Guo, 2015). Generally, there are three main channels whereby stock prices can affect real economic activity: i) the wealth effect: under the life cycle/permanent income, higher stock prices and increased wealth in stocks lead investors to increase their consumption. This increase in consumption will be more significant in countries where the stock ownership base is large; ii) cost of capital: with stock prices increasing, the cost of new capital relative to existing capital decreases, more companies go public and raise funds for investment through public offerings. In addition, a good performance on the stock market might attract foreign capital, which would allow interest rates to go down (ceteris paribus); and iii) the confidence effect/expectation effect: a highly performing stock market might improve overall expectations, which might induce economic growth through more investment as part of a positive feedback effect. Moreover, stock prices signal faster growth of companies and as a result a possible growth of future real individuals’ income might also induce more consumption (Morck et. al, 1990, and Raunig & Scharler, 2011). Although these factors/channels are hard to quantify, it is important to accurately assess the strength of the link between stock markets and real economic activity.

 

 

v) stock market performance/volatility:

Stock prices are supposed to serve as signals for resource allocation. Yet, excessive volatility which does not reflect economic fundamentals would distort the “signaling” function of stock markets (Raunig & Scharler, 2012). Although it is theoretically difficult to identify a clear criterion for defining the degree of “excessiveness”, many analysts argue that less volatility reflects greater stock market development. However, a certain degree of stock market volatility is unavoidable, even desirable, as stock price movements indicate changing values across economic activities so resources can be better allocated.

There are significant implications surrounding stock market volatility, given that it affects incentives to save and to invest. Theoretically, all other things being equal, the more volatile the stock market, the fewer savers will save and hence the less investment there will be. Excessive stock market volatility would lead investors to demand a higher risk premium, increasing the cost of capital which in turn would impede investment and hamper economic growth. In addition, this volatility might lead to a shift of funds to less risky assets which –once again – will cause companies to pay more for access to capital. (Levine and Zervos, 1996; and Arestis et al, 2001).

Stock market volatility might result from the volatility of underlying economic fundamentals, in particular, the volatility of the real output flow whose present discount value that the stock price is supposed to reflect should matter. Raunig and Scharler (2012) argue that a higher leverage ratio may induce companies’ managers to undertake riskier projects than they otherwise would. In addition, uncertainty of macroeconomic policies may also result in stock market volatility. (e.g. volatility of exchange rates, or volatility of the inflation rate). Stock market volatility may also be caused by the arrival of new, unanticipated information that alters expected returns on stocks (Diebold & Yilmaz, 2012).

In light of the above discussion, one could define a “developed” stock market as “a market that is sufficiently large and liquid - relative to the size of its economy - possessing a non-concentrated market capitalization and demonstrating adequate linkage to the performance of the real economic sector”.

It would be possible to establish a stock market development index by elaborating a weighted average comprising market size, liquidity, volatility, linkage to real sector and market concentration. However, the weight to be assigned to each individual factor could be an issue of some contention.