77120 THE WORLD BANK ECONOMIC REVIEW, VOL. 10, NO. 2: 323-339 Stock Market Development and Long-Run Growth Ross Levine and Sara Zervos Is the financial system important for economic growth? One line of research argues that it is not; another line stresses the importance of the financial system in mobiliz- ing savings, allocating capital, exerting corporate control, and easing risk manage- ment. Moreover, some theories provide a conceptual basis for the belief that larger, more efficient stock markets boost economic growth. This article examines whether there is a strong empirical association between stock market development and long- run economic growth. Cross-country growth regressions suggest that the predeter- mined component of stock market development is positively and robustly associated with long-run economic growth. To assess whether stock markets are merely burgeoning casinos where more and more players are coming to place bets, or whether stock markets are impor- tantly linked to economic growth, this article reviews a diffuse theoretical litera- ture and presents new empirical evidence. In terms of theory, a growing litera- ture argues that stock markets provide services that boost economic growth. Greenwood and Smith (forthcoming) show that large stock markets can lower the cost of mobilizing savings and thereby facilitate investment in the most pro- ductive technologies. Bencivenga, Smith, and Starr (1996) and Levine (1991) argue that stock market liquidity—the ability to trade equity easily—is impor- tant for growth. Although many profitable investments require a long-run com- mitment of capital, savers do not like to relinquish control of their savings for long periods. Liquid equity markets ease this tension by providing an asset to savers that they can quickly and inexpensively sell. Simultaneously, firms have permanent access to capital raised through equity issues. Moreover, Kyle (1984) and Holmstrom and Tirole (1993) argue that liquid stock markets can increase incentives for investors to get information about firms and improve corporate governance. Finally, Obstfeld (1994) shows that international risk sharing through internationally integrated stock markets improves resource allocation and can accelerate the rate of economic growth. Ross Levine is with the Policy Research Department at the World Bank, and Sara Zervos is with the Finance Department at Brunei University. This article was originally prepared for the World Bank conference on Stock Markets, Corporate Finance, and Economic Growth, held in Washington, D.C., February 16-17, 1995. The authors acknowledge helpful advice from Mark Baird, John Boyd, Gerard Caprio, Ash Demirguc-Kunt, William Easterly, Michael Gavin, Robert Korajczyk, Lant Pritchett, Sergio Rebelo, William Schwert, Bruce Smith, AJan Stockman, David Zervos, and two anonymous referees. © 1996 The International Bank for Reconstruction and Development / THE WORLD BANK 323 324 THE WORLD BANK ECONOMIC REVIEW, VOL 10, NO. 2 Theoretical disagreement exists, however, about the importance of stock markets for economic growth. Mayer (1988) argues that even large stock mar- kets are unimportant sources of corporate finance. Stiglitz (1985, 1994) says that stock market liquidity will not enhance incentives for acquiring informa- tion about firms or exerting corporate governance. Moreover, Devereux and Smith (1994) emphasize that greater risk sharing through internationally inte- grated stock markets can actually reduce saving rates and slow economic growth. Finally, the analyses of Shleifer and Summers (1988) and Morck, Shleifer, and Vishny (1990a, 1990b) suggest that stock market development can hurt eco- nomic growth by easing counterproductive corporate takeovers. We use cross-country regressions to examine the association between stock market development and economic growth. To conduct this investigation, we need measures of stock market development. Theory does not provide a unique concept or measure of stock market development, but it does suggest that stock market size, liquidity, and integration with world capital markets may affect economic growth. Consequently, we use a conglomerate index of overall stock market development constructed by Demirguc.-Kunt and Levine (1996).1 More specifically, we use pooled cross-country, time-series regressions to evalu- ate the relationship between stock market development and economic growth. Using data on forty-one countries over the period from 1976 to 1993, we split the sample period, so that each country has two observations (data permitting) with data averaged over each subperiod. In the tradition of recent work (Barro 1991), we regress the growth rate of gross domestic product (GDP) per capita on a variety of variables designed to control for initial conditions, political stabil- ity, investment in human capital, and macroeconomic conditions. We then in- clude the conglomerate index of stock market development. Thus, we evaluate whether there is a relationship between economic growth and stock market de- velopment that is independent of other variables associated with economic growth. Our article builds on Atje and Jovanovic's (1993) study of stock market trad- ing and economic growth in two ways. First, we use indexes of stock market development that combine information on stock market size, trading, and inte- gration. Second, we control for initial conditions and other factors that may affect economic growth in light of the evidence that many cross-country regres- sion results are fragile to changes in the conditioning information set (Levine and Renelt 1992). Thus, we gauge the robustness of the relationship between overall stock market development and economic growth to changes in the con- ditioning information set. We find a strong correlation between overall stock market development and long-run economic growth. After controlling for the initial level of GDP per capita, initial investment in human capital, political insta- bility, and measures of monetary, fiscal, and exchange rate policy, stock market development remains positively and significantly correlated with long-run eco- 1. When we ran the regressions using the other aggregate indexes in Demirgii?-Kunt and Levine (1996), the results were similar to those presented in table 1. Levine and Zervos 325 nomic growth. The results are consistent with theories that imply a positive relationship between stock market development and long-run economic growth. The results are inconsistent with theories that predict no correlation or a nega- tive association between stock market development and economic performance. Cross-country growth regressions suffer from measurement, statistical, and conceptual problems. In terms of measurement problems, country officials some- times define, collect, and measure variables inconsistently across countries. Fur- ther, people with detailed country knowledge frequently find discrepancies be- tween published data and what they know happened. In terms of statistical problems, regression analysis assumes that the observations are drawn from the same population; yet vastly different countries appear in cross-country regres- sions. Many countries may be sufficiently different to warrant separate analy- ses. Conceptually, we should interpret the coefficients from cross-country re- gressions cautiously. When averaging over long periods, many changes are occurring simultaneously: countries change policies, economies experience busi- ness cycles, and governments rise and fall. Thus, aggregation may blur impor- tant events and differences across countries. Analysts should extend this research by examining the time-series relationship between stock market development and economic growth. Also, cross-country regressions do not resolve issues of causality. Consequently, we should not view the coefficients as elasticities that predict the magnitude of the change in growth following a particular policy reform. Instead, the coefficient estimates and the associated ^-statistics should be used to evaluate the strength of the partial correlation between stock market development and economic growth. These measurement, statistical, and conceptual problems, however, should not detract from the benefits that can accrue from cross-country comparisons. Elucidating cross-country empirical regularities between stock market develop- ment and economic growth will influence beliefs about this relationship and shape future theoretical and empirical research. Put differently, beliefs about stock markets and growth not supported by cross-country comparisons will be viewed more skeptically than those views confirmed by cross-country regres- sions. Section I reviews the theoretical literature on the functioning of stock mar- kets and economic growth. Section II turns to the data and constructs a con- glomerate measure of stock market development. Section III evaluates the strength of the empirical link between stock market development and long-run economic growth. Section IV summarizes the findings. I. THEORETICAL FRAMEWORK Is the financial system important for economic growth? One line of research argues that the financial system is unimportant for economic growth; another line stresses the importance of the financial system in mobilizing savings, allo- cating capital, exerting corporate control, and easing risk management. Fur- 326 THE WORLD BANK ECONOMIC REVIEW, VOL. 10, NO. 2 thermore, some theories provide a conceptual basis for believing that larger, more efficient stock markets boost economic growth. In a recent survey of development economics, Stern (1989) does not mention the role of the financial system in economic growth. At the end of his review, Stern lists various issues that he did not have sufficient space to cover. Finance is not even included in the list of omitted topics. Similarly, a recent collection of essays by the pioneers of development economics, including three Nobel prize- winners, does not describe the role of the financial system in economic growth (Meier and Seers 1984). Clearly, according to these economists, the financial system plays an inconsequential role in economic development. Furthermore, 1995 Nobel prizewinner Robert Lucas argues that economists frequently exag- gerate the role of financial factors in economic development (Lucas 1988). Such a view is not limited to the recent past; Robinson (1952) argues that the finan- cial system does not spur economic growth; financial development simply re- sponds to developments in the real sector. Thus, many influential economists give a very minor role, if any, to the financial system in economic growth.2 In contrast, a prominent line of research stresses the role of the financial system in economic growth. Bagehot (1962), Schumpeter (1932), Cameron and others (1967), Goldsmith (1969), and McKinnon (1973) provide conceptual descriptions of how, and empirical examples of when, the financial system af- fects economic growth. Building on these seminal contributions, Gelb (1989), Ghani (1992), King and Levine (1993a, 1993b), and De Gregorio and Guidotti (1995) show that measures of banking development are strongly correlated with economic growth in a broad cross-section of countries. According to this vein of research, a well-functioning financial system is critical for sustained economic growth. Besides evaluating the general importance of the financial system, this article provides empirical evidence regarding the growing debate concerning the spe- cific role of stock markets in economic growth. A burgeoning theoretical litera- ture suggests that the functioning of equity markets affects liquidity, risk diver- sification, acquisition of information about firms, corporate control, and savings mobilization. By altering the quality of these services, the functioning of stock markets can alter the rate of economic growth. Debate exists, however, over the sign of this effect. Specifically, some models suggest that stock market develop- ment has a negative effect on growth, while other models predict a positive relationship between stock market development and economic growth. Stock markets may affect economic activity through their liquidity. Many high-return projects require a long-run commitment of capital. Investors, how- ever, are generally reluctant to relinquish control of their savings for long peri- ods. Therefore, without liquid markets or other financial arrangements that pro- mote liquidity, less investment may occur in the high-return projects. Levine (1991) and Bencivenga, Smith, and Starr (1996) show that stock markets may 2. Many of these references are from Chandavarkar's (1992) insightful discussion of financial and economic development. Levine and Zervos 327 arise to provide liquidity: savers have liquid assets—such as equities—while firms have permanent use of the capital raised by issuing equities. Liquid stock mar- kets reduce the downside risk and costs of investing in projects that do not pay off for a long time. With a liquid equity market, the initial investors do not lose access to their savings for the duration of the investment project because they can quickly, cheaply, and confidently sell their stake in the company. Thus, more liquid stock markets ease investment in long-run, potentially more profit- able projects, thereby improving the allocation of capital and enhancing pros- pects for long-term growth. Theory is unclear, however, about the effects of greater liquidity on growth. Bencivenga and Smith (1991) show that by reduc- ing uncertainty, greater liquidity may reduce saving rates enough to slow growth. Risk diversification through internationally integrated stock markets is an- other vehicle by which stock market development may influence economic growth. Saint-Paul (1992), Devereux and Smith (1994), and Obstfeld (1994) demonstrate that stock markets provide a vehicle for diversifying risk. These models also show that greater risk diversification can influence growth by shift- ing investment into higher-return projects. Intuitively, because projects with high expected returns also tend to be comparatively risky, better risk diversification through internationally integrated stock markets will foster investment in projects with higher returns. Again, however, theory suggests circumstances in which greater risk sharing slows growth. Devereux and Smith (1994) and Obstfeld (1994) show that reduced risk through internationally integrated stock markets can depress saving rates, slow growth, and reduce economic welfare. Stock markets may also promote the acquisition of information about firms (Grossman and Stiglitz 1980; Kyle 1984; Holmstrom and Tirole 1993). In larger and more liquid markets it will be easier for an investor who has gotten infor- mation to trade at posted prices. The investor will thus be able to make money before the information becomes widely available and prices change. The ability to profit from information will stimulate investors to research and monitor firms. Better information about firms will improve resource allocation and spur eco- nomic growth. Opinions differ, however, on the importance of stock markets in stimulating the acquisition of information. Stiglitz (1985, 1994), for example, argues that well-functioning stock markets quickly reveal information through price changes. Quick public revelation will reduce—not enhance—incentives for expending private resources to obtain information. Thus, theoretical debate still exists on the importance of stock markets in enhancing information. Stock market development may also influence corporate control. Diamond and Verrecchia (1982) and Jensen and Murphy (1990) show that efficient stock markets help mitigate the principal-agent problem. Efficient stock markets make it easier to tie manager compensation to stock performance. A closer link helps to align the interests of managers and owners. Furthermore, Laffont and Tirole (1988) and Scharfstein (1988) argue that takeover threats induce managers to maximize a firm's equity price. Thus, well-functioning stock markets that ease corporate takeovers can mitigate the principal-agent problem and promote effi- 328 THE WORLD BANK ECONOMIC REVIEW, VOL. 10, NO. 2 cient resource allocation and growth. Opinion differs on this issue, too. Stiglitz (1985) argues that outsiders will be reluctant to take over firms because outsid- ers generally have worse information about firms than do owners. Thus, the takeover threat will not be a useful mechanism for exerting corporate control; stock market development, therefore, will not improve corporate control sig- nificantly (Stiglitz 1985). Moreover, Shleifer and Vishny (1986) and Bhide (1993) argue that greater stock market development encourages more diffuse owner- ship and this diffusion of ownership impedes effective corporate governance. Finally, Shleifer and Summers (1988) note that by simplifying takeovers, stock market development can stimulate welfare-reducing changes in ownership and management. In terms of raising capital, Greenwood and Smith (forthcoming) show that large, liquid, and efficient stock markets can ease savings mobilization. By agglomerating savings, stock markets enlarge the set of feasible investment projects. Since some worthy projects require large capital injections and some enjoy economies of scale, stock markets that ease resource mobilization can boost economic efficiency and accelerate long-run growth. Disagreement exists, however, on the importance of stock markets for raising capital. Mayer (1988), for example, argues that new eq- uity issues account for a very small fraction of corporate investment. II. MEASURES OF STOCK MARKET DEVELOPMENT Each theoretical model in the literature focuses on one characteristic of the functioning of stock markets, such as size, liquidity, or integration. Consequently, one research strategy is to evaluate empirically, characteristic by characteristic, the predictions from each individual theoretical model. Although useful, this strategy is model-specific and focuses narrowly on individual characteristics. We take a different approach here, as do Demirgiic,-Kunt and Levine (1996) and Demirgiic,-Kunt and Maksimovic (1996). We use a multifaceted measure of over- all stock market development that combines the different individual character- istics of the functioning of stock markets. Thus, we provide an empirical assess- ment of whether overall stock market development is strongly connected with long-run economic growth. Individual Stock Market Development Indicators We use individual indicators of size, liquidity, and risk diversification. We measure the size of the stock market using the ratio of market capitalization divided by GDP. Market capitalization equals the total value of all listed shares. The assumption underlying the use of this variable as an indicator of stock mar- ket development is that the size of the stock market is positively correlated with the ability to mobilize capital and diversify risk. We measure the liquidity of the stock market in two ways. First, we compute the ratio of total value of trades on the major stock exchanges to GDP. This ratio measures the value of equity transactions relative to the size of the economy. Levine and Zervos 329 This liquidity measure complements the measure of stock market size because markets may be large but inactive. Second, we compute the ratio of the total value of trades on the major stock exchanges divided by market capitalization. This ratio, frequently called the turnover ratio, measures the value of equity transactions relative to the size of the equity market. The turnover ratio also complements the measure of stock market size as well as the total value of equity transactions divided by GDP, because markets may be small (compared with the whole economy) but liquid. The liquidity indicators do not directly measure the ease with which agents can buy and sell securities at posted prices. They do, however, measure the degree of trading, compared with the size of both the economy and the market. Since liquidity may significantly influence growth by easing investment in large, long-term projects and by promoting the acquisition of information about firms and managers, we include these two li- quidity measures in our stock market development index. Theory suggests that the ability to diversify risk—by investing in an interna- tionally diversified portfolio of stocks—can influence investment decisions and long-run growth rates (Devereux and Smith 1994; Obstfeld 1994). Barriers to international capital flows—such as taxes, regulatory restrictions, information asymmetries, and sovereign risk—may impede the ability of investors to diver- sify risk internationally. Thus, international capital flow barriers will impede risk diversification, reduce capital market integration, and keep arbitrageurs from equalizing the price of risk internationally. To measure the ability of agents to diversify risk internationally, we use Korajczyk's (1996) estimate of the de- gree of international integration of national stock markets. Korajczyk (1996) uses a multifactor International Arbitrage Pricing Model (IAPM) to measure stock market integration. The IAPM implies that the ex- pected excess return on each asset is linearly related to a linear combination of benchmark portfolios. For the benchmark portfolios, P, Korajczyk (1996) estimates the common factors based on an international portfolio of equities using the asymptotic principal components procedures of Connor and Korajczyk (1986). Given m assets and T periods, consider the following regression: (1) Rfj = a, + biP, + e,,,, i = l , 2 , . . . , m; *=1,2,...,T where Ri