17852 ] DEC ]7 --t ;- -iatch findings Stock markets, corporate finance, and economic growth Emerging stock markets are booming, raising important questions for policymakers in developing countries During the past decade the capitalization of their savings for long periods. Liquid stock emerging markets increased twentyfold, to markets ease this tension. In liquid markets about $2 trillion. In 1994 trading on these savers hold an asset-equity that they can sell GROWTH OF markets accounted for about 17 percent of quickly and cheaply. At the same time firms the $9.6 trillion of shares traded on the have permanent access to the capital raised world's stock markets, up from a mere 3 per- through equity issues. By making long-run MARKETS cent of the much smaller $1.6 trillion in investments more attractive, liquid stock 1985. This rapid growth in emerging stock markets may boost investment in longer-run, market activity raises critical questions for more profitable activities, enhancing the OPPORTUNITIES developing country policymakers. What prospects for long-term economic growth. effect do stock markets have on economic On the negative side, stock markets are growth? How does stock market development sometimes seen as "casinos" that have little FOR DEVELOPING affect firms' financing decisions? And if stock positive impact and perhaps even a negative markets are good for growth, what policies impact on long-term growth. According to can governments adopt to foster their devel- this view, by enabling investors to sell quick- opment? This note summarizes answers to ly, liquid markets may reduce investors' these questions drawn from a recent research incentives to oversee managers and monitor project in the Finance and Private Sector firms' performance and prospects, so that Development Division of the Policy Research they fail to exert corporate control. And liq- Department. uid markets may induce a short-term per- spective among investors that encourages firms to take actions-selling off assets, for Do stock markets example-that raise their profits temporarily promote growth? at the expense of long-term growth. Which view is correct? The evidence Theory is ambiguous about whether stock strongly supports the view that access to a liq- markets help or hurt economic growth. On uid stock market increases long-term eco- the positive side, a liquid stock market may nomic growth. In a set of thirty-eight coun- make it easier for firms to raise capital for tries divided into four groups according to investment. Many profitable activities require the initial liquidity of their stock markets, the a long-run commitment of capital. Yet nine countries with very liquid markets in investors are reluctant to relinquish control of 1976 grew much faster over the next eighteen FROM THE DEVELOPMENT ECONOMICS VICE PRESIDENCY OF THE WORLD BANK NO. 14 JULY 1996 years, on average, than the countries with illiq- GDP) revealed that countries that began with uid or very illiquid markets (figure 1). This com- liquid stock markets and well-developed banks parison is based on a commonly used measure of grew much faster than countries with illiquid liquidity, the total value of equity traded as a stock markets and poorly developed banks (fig- share of gross domestic product (GDP). Of ure 2). Moreover, stock market liquidity and course, this ratio does not directly measure the banking development are independently strong costs of buying and selling securities at posted predictors of future economic growth: greater prices. Yet averaged over a long period, the value stock market liquidity implies faster growth, no of equity transactions as a share of national out- matter the level of banking development, and put probably varies with the ease of trading. Put greater banking development implies faster differently, if trading is very costly and risky, growth, no matter the level of market liquidity. there will be little trading. Other market liquid- How do liquid stock markets boost growth? ity indicators give similar results. The evidence suggests that liquid markets boost But liquidity is just one measure of stock both the quantity and the quality of investment. market development, and other measures show Compared with countries that began in 1976 no strong relationship with growth. For exam- with illiquid markets, countries that started with pie, the size of the stock market relative to the more liquid stock markets had more invest- economy (market capitalization divided by ment-and therefore faster rates of capital accu- GDP) is a poor predictor of future economic mulation-and better-quality investment-and Liquid stock growth. And contrary to what pundits some- thus more rapid productivity gains. markets boost both times suggest, greater stock price volatility does not forecast poor economic performance. Of the the quantity and various measures of stock market development, How do stock markets influence quality of only market liquidity-the opportunity to easi- firms' financing decisions? investment ly buy and sell equity in the economy's corpora- tions-is closely associated with future growth. How do liquid stock markets affect firms' Moreover, regression analysis suggests that stock financing decisions? In particular, how might market liquidity helps forecast economic growth firms that gain access to a liquid market alter even after accounting for such nonfinancial fac- their mix of debt and equity? To answer this tors as inflation, initial income, political stabili- question, the study first analyzed how firms that ty, investment in education, the black market lack access to a liquid stock market could be exchange premium, and the efficiency of the expected to behave. It identified three ways that legal system. lack of access to a liquid market might affect A well-developed banking sector is also a pre- firms' behavior: diction of economic growth. Dividing the coun- * First, entrepreneurs would have limited oppor- tries into four groups based on stock market liq- tunities for diversifying risk. As a result they uidity and bank development (as measured by bank loans to private enterprises as a share of Figure 2 Growth was fastest in economies beginning with liquid markets and Figure I Economies with very liquid markets well-developed banks grew fastest Per capita growth (percent), 1976-93 4 Very iliquid 3 Illiquid 2 Liquid Very liquid 0 1 2 3 0 Per capita growth (percent), 1 976-93 Illiquid Liquid Source: IFC. Source: Levine and Zervos. tnigflt opt for investment strategies that reduce The evidence suggests that the effect of stock their risk at the expense of long-term growth, for market development on firms' debt-equity ratios example, by investing less or choosing less capital- depends on the initial level of stock market devel- intensive production technologies. opment. The study examined firms' debt-equity * Second, firms would have trouble striking the ratios in thirty industrial and developing coun- appropriate balance between debt and equity. tries, ranked on the basis of the development of Firms with high levels of debt that are close to their stock markets (defined to include size and bankruptcy face incentives to act opportunisti- liquidity measures) and divided into three groups cally. As a result they may enter into overly risky of ten. The first ten countries had the least devel- projects, harming their creditors. Because of oped stock markets. The second group had stock this, a highly leveraged firm often has trouble markets twice as developed as the first group's. obtaining more credit. Firms with access to a And the third group had stock markets almost well-functioning stock market can avoid this four times as developed as the first group's. problem by issuing equity, mitigating debt-asso- Debt-equity ratios are 10 percent higher for ciated incentive problems and making it possi- the second group of countries than for the first ble for them to borrow more. (figure 3). But the debt-equity ratios for the * Third, investors and creditors would have third group of countries-those with the most much less information about firms. Well-func- developed stock markets-are 25 percent lower tioning stock markets aggregate information than for the first group. This suggests that as about the prospects of firms whose shares are countries with an initially low level of stock traded and make it available to investors and market development increase the size and liq- creditors. This strengthens investors' and credi- uidity of their markets, debt-equity ratios rise. tors' corporate control, spurring managerial Firms not only issue new equity, they also bor- Firms are likely to competency. But lacking the information made row in amounts even larger than the value of be smaller and to available by a liquid stock market, investors are that equity. But as stock markets continue to likely to invest less and to invest less wisely, and develop, the debt-equity ratio declines, with growmoreslowlyin they tend to exert less corporate control, giving firms relying more on equity and less on debt. the absence of a managers fewer incentives to perform well. (These results hold even when other determi- well-functioning Taken together, these three problems mean nants of firm financing decisions are controlled stock market that firms lacking access to a well-functioning for, such as firm characteristics, tax variables, stock market are likely to be smaller and to and macroeconomic factors.) grow more slowly than would otherwise be the This pattern suggests that at early stages of case. But theory is ambiguous about how such market development, improvements in informa- firms would alter their debt-equity ratios if they tion, monitoring, and corporate control may be suddenly gained access to a well-functioning sufficient to induce creditors to lend more. At market. this stage, debt and equity finance are comple- * Increased options for diversifying risk tend to mentary. The market's role of aggregating infor- make expansion more attractive. But theory mation is especially important for large firms does not tell us whether firms will rely more on debt or on equity to finance this expansion. Figure 3 As stock markets develop, firms . Even if we assume that the firm issues addi- first rely more on debt, then more on equity tional equity, the effect on the debt-equity ratio Debt-equityratio is uncertain. A firm might substitute outside 2.5 equity for debt, reducing its debt-equity ratio. 2.0 Or it might substitute outside equity for inside .5 equity, leaving the debt-equity ratio unchanged. o I * Finally, by aiding the flow of information, o05 better-functioning stock markets lower the cost o of raising capital. But since these lower costs Less More appl to ebt s wel asto euity it s unlear developed developed apply to debt as well as to equity, it iS unclear developed Stock market development (size and liquidity)idety) which firms would rely on more. Source: Demirguc-Kunt and Maksimovic 1996. because their stocks are traded more often and flows supports this view. In twelve of the ceounr. are followed by many analysts. tries stock market liquidity rose significantly Do banks and stock markets complement after liberalization, and none of the fourteen one another? In many developing countries with experienced a statistically significant fall in liq- emerging stock markets, bankers worry that the uidity. Interestingly, stock market volatility rose stock markets will reduce the volume of their significantly in seven of the cases, and did not business. The study's results suggest that these fall significantly in any of them. These findings concerns are misplaced. As the functioning of a are consistent with the view that liberalizing developing stock market improves, firms initial- capital flows offers expanded opportunities for ly take on a higher debt-equity ratio, so banks long-run economic growth through greater mar- have more business, not less. The results also ket liquidity, provided that policymakers are suggest that in countries with developing finan- prepared to weather increased market volatility. Countries that cial systems, stock markets and banks play dif- Besides liberalizing capital movements, are lower barriers to ferent yet complementary roles. there other measures that countries can take to Thus policies to develop stock markets need foster stock market development? Theory and not undermine existing banking systems, and evidence suggest that policymakers should can expect better stock markets and banking can develop simulta- remove impediments to market development, domestic capital neously. Indeed, even at higher levels of stock mar- such as tax, legal, and regulatory barriers. They markets ket development, higher economic growth means should also set and enforce standards for that banks can increase the volume of their busi- accounting and disclosure. But they should stop ness even as their share of total finance dedines. short of more interventionist measures, such as tax incentives for firms that go public. While these policies may artificially boost the size of What policies foster stock market stock markets, there is no evidence that they development? increase liquidity-or economic development. Not evety countty needs to have its own stock Theory suggests several reasons why reducing market to reap the benefits associated with a liquid barriers to cross-border capital flows might market. What matters is that residents and firms increase market liquidity and enhance the func- have easy access to a liquid market where they can tioning of emerging stock markets. Domestic trade and issue securities. It is the ability to trade firms seeking foreign investment often have to and issue securities easily that aids long-run improve their accounting systems and the quali- growth, not the physical location of the market. ty of the information they disdose to investors. -As/i Demirgiu(-Kunt and Ross Levine As more foreigners enter the market, there may also be increased pressure to upgrade the trading apparatus and legal system to support more trad- Further reading ing and the trading of additional financial instru- Demirgiu,-Kunt, Aslh, and Ross Levine. 1996. "Stock Markets, ments. Increased integration with world capital Corporate Finance, and Economic Growth: An Overview." markets also tends to squeeze out distortions in The World Bank Economic Review 10(2): 223-40. the prices of domestic securities. Through all Demirgiiu-Kunt, Ashl, and Ross Levine. 1996. "Stock Market these channels, lowering international invest- Development and Financial Intermediaries: Stylized ment barriers would be expected to improve the Facts." The World Bank Economic Review 10(2): 291-322. operation of domestic capital markets. Demirgu,-Kunt, Aslh, and Vojislav Maksimovic. 1996. The evidence from a sample of fourteen "Stock Market Development and Financing Choices of countries that liberalized international capital Firms." The World Bank Economic Review 10(2): 341-70. This DECnote was prepared by Ash Demirgdi-Kunt and Ross Levine in the Policy Research Department of the World Bank based on a research project on Stock Market Development and Financial Intermediary Growth (RPO 678-37). DECnotes transmit key research find- ings to Bank Group managers and staff. They are drawn from the work of individual Bank researchers and do not necessarily represent the views of the World Bank and its member countries-and therefore should not be attributed to the World Bank or its affiliates. DECnotes are produced by the Research Advisory Staff. We welcome your questions and comments; please e-mail them to the authors or to Evelyn Alfaro, RAD. Prepared for World Bank staff