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II. STOCK MARKET AND ECONOMIC GROWTH: THEORETICAL AND ANALYTICAL ISSUES

Written by: International Monetary Fund

Article Overview: In principle, the stock market is expected to accelerate economic growth by providing a boost to domestic savings and increasing the quantity and the quality of investment (Singh, 1997).

II. STOCK MARKET AND ECONOMIC GROWTH: THEORETICAL AND ANALYTICAL ISSUES

In principle, the stock market is expected to accelerate economic growth by providing a boost
to domestic savings and increasing the quantity and the quality of investment (Singh, 1997).
The stock market is expected to encourage savings by providing individuals with an
additional financial instrument that may better meet their risk preferences and liquidity
needs. Better savings mobilization may increase the savings rate (Levine and Zervos, 1998).
Stock markets also provide an avenue for growing companies to raise capital at lower cost. In
addition, companies in countries with developed stock markets are less dependent on bank
financing, which can reduce the risk of a credit crunch. Stock markets therefore are able to
positively influence economic growth through encouraging savings amongst individuals and
providing avenues for firm financing.
The stock market is supposed to ensure through the takeover mechanism that past
investments are also most efficiently used. Theoretically, the threat of takeover is expected to
provide management with an incentive to maximize firm value. The presumption is that, if
management does not maximize firm value, another economic agent may take control of the
firm, replace management and reap the gains from the more efficient firm. Thus, a free
market in corporate control, by providing financial discipline, is expected to provide the best
guarantee of efficiency in the use of assets. Similarly, the ability to effect changes in the
management of listed companies is expected to ensure that managerial resources are used
efficiently (Kumar, 1984).
Efficient stock markets may also reduce the costs of information. They may do so through
the generation and dissemination of firm specific information that efficient stock prices
reveal. Stock markets are efficient if prices incorporate all available information. Reducing
the costs of acquiring information is expected to facilitate and improve the acquisition of
information about investment opportunities and thereby improves resource allocation. Stock
prices determined in exchanges and other publicly available information may help investor
make better investment decisions and thereby ensure better allocation of funds among
corporations and as a result a higher rate of economic growth.
Stock market liquidity is expected to reduce the downside risk and costs of investing in
projects that do not pay off for a long time. With a liquid market, the initial investors do not
lose access to their savings for the duration of the investment project because they can easily,
quickly, and cheaply, sell their stake in the company (Bencivenga and Smith, 1991). Thus,
more liquid stock markets could ease investment in long term, potentially more profitable
projects, thereby improving the allocation of capital and enhancing prospects for long-term
growth. It is important to point out, however, that, theory is ambiguous about the exact
impacts of greater stock market liquidity on economic growth. By reducing the need for
precautionary savings, increased stock market liquidity may have an adverse effect on the
rate of economic growth.
Critics of the stock market argue that, stock market prices do not accurately reflect the
underlying fundamentals when speculative bubbles emerge in the market (Binswanger,
1999). In such situations, prices on the stock market are not simply determined by
discounting the expected future cash flows, which according to the efficient market
hypothesis should reflect all currently available information about fundamentals. Under this
condition, the stock market develops its own speculative growth dynamics, which may be
guided by irrational behavior. This irrationality is expected to adversely affect the real sector
of the economy as it is in danger of becoming the by-product of a casino.
Critics further argue that stock market liquidity may negatively influence corporate
governance because very liquid stock market may encourage investor myopia. Since
investors can easily sell their shares, more liquid stock markets may weaken investors’
commitment and incentive to exert corporate control. In other words, instant stock market
liquidity may discourage investors from having long-term commitment with firms whose
shares they own and therefore create potential corporate governance problem with serious
ramifications for economic growth (Bhide, 1994).
Critics also point out that the actual operation of the pricing and takeover mechanism in well
functioning stock markets lead to short term and lower rates of long term investment. It also
generates perverse incentives, rewarding managers for their success in financial engineering
rather than creating new wealth through organic growth (Singh, 1997). This is because prices
react very quickly to a variety of information influencing expectations on financial markets.
Therefore, prices on the stock market tend to be highly volatile and enable profits within
short periods. Moreover, because the stock market undervalues long-term investment,
managers are not encouraged to undertake long-term investments since their activities are judged by the performance of a company’s financial assets, which may harm long run
prospects of companies (Binswanger, 1999). In addition, empirical evidence shows that the
takeover mechanism does not perform a disciplinary function and that competitive selection
in the market for corporate control takes place much more on the basis of size rather than
performance (Singh, 1971). Therefore, a large inefficient firm has a higher chance of survival
than a small relatively efficient firm.
These problems are further magnified in developing countries especially sub-Saharan African
economies with their weaker regulatory institutions and greater macroeconomic volatility.
The higher degree of price volatility on stock markets in developing countries reduces the
efficiency of the price signals in allocating investment resources. These serious limitations of
the stock market have led many analysts to question the importance of the system in
promoting economic growth in African countries.

IMF Working Paper
African Department
Stock Market Development in Sub-Saharan Africa: Critical Issues and Challenges
Prepared by Charles Amo Yartey and Charles Komla Adjasi
August 2007

Related Articles
  VI. A. Macroeconomic Stability: WHAT DETERMINES STOCK MARKET DEVELOPMENT IN AFRICA?
  Introduction: Stock Market Development in Sub-Saharan Africa
  VI. B. Banking Sector Development: WHAT DETERMINES STOCK MARKET DEVELOPMENT IN AFRICA?
  V. STOCK MARKETS AND ECONOMIC GROWTH: THE MACRO CHANNEL
  VIII. SUMMARY AND CONCLUSION: Stock Market Development in Sub-Saharan Africa

Article Tags: acquisition, avenues, bank financing, credit crunch, dissemination, economic growth, efficiency, financial discipline, financial instrument, liquidity, managerial resources, mobilization, presumption, principle, risk preferences, stock market, stock markets, stock prices, takeover, zervos



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