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
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