«VOLUM E 1 1, N UM B E R 1 I S SN 2 1 6 8 - 0 6 1 2 F L ASH DR I V E I S SN 1 9 4 1 - 9 5 8 9 ON L I N E T h e In s t it ut e f o r Bu s i n e s s an ...»
GCBF ♦ Vol. 11 ♦ No. 1 ♦ 2016 ♦ ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 212 Global Conference on Business and Finance Proceedings ♦ Volume 11 ♦ Number 1 Although most of these empirical studies focus on the banking sector, stock markets which are probably the most widely used capital market institution also play an important role in economic growth. Atje and Jovanovic (1989) by comparing the impact of the level of stock market development and bank development on subsequent economic growth, they concluded that a large effect of stock market development as measured by the value traded divided by GDP on subsequent development (Bekaert and Harvey, 1997).
Caporale, Howells and Soliman (2004) in their research also suggest that stock markets can give a big boost to economic development. Causality between domestic credit and economic growth was found in Greece, Korea and Philippines through the use of trivariate tests (Caporale, Howells and Soliman, 2004). A positive correlation between stock market development and economic growth was also confirmed by Bekaert and Harvey (1997) by conducting research on eighteen countries during the 1986-92 periods (Bekaert and Harvey, 1997).
Stock Markets and Economic Growth
Although a number of economists suggest that the stock markets have little relevance to real economic activity (Stiglitz, 1989), other empirical research also shows a positive correlation between stock markets development and economic growth (Bekaert and Harvey, 1997). Stock markets lead to economic growth through: the diversification of portfolios, militating against moral hazard, managing change of ownership, contributing to innovation and ensuring liquidity in the system.
Diversification of Portfolios: An efficiently managed capital market allows investors to have an unlimited means to diversify their portfolios. With an efficiently managed capital market corporations can raise equity capital and venture into equity stakes because of the ability of capital markets to reduce the risk involved.
Investment in firms becomes more attractive with the creation of stock markets due to the ability of individuals to diversify firm related risks. With a poorly functioning capital market, corporations may choose lower value- low risk projects to inefficiently diversify so as to attract investment capital.
Although such projects may not even be within the realm of the corporations’ special expertise, they serve the purpose of diversifying because of the inability of capital markets to provide the means for investors to efficiently diversify. Thus stock markets may play an important role in economic growth (Bekaert and Harvey, 1997).
Militating Against Moral Hazards: The stock market plays an understated but important role in militating against the moral hazard problem especially from a corporate finance perspective. Generally, moral hazard refers to the tendency of a party (an individual or institution) to take risks or act less carefully than otherwise, leaving another party to hold some responsibility for the consequences of those actions (IADI, 2013). Moral hazard in corporate finance often arises because managers gain from decisions affecting firm value only to the extent of the shares they hold. With managers’ compensations linked to the extent of shares they hold in a firm, a manager has an incentive to take actions that maximizes his compensation in ways which might have little or nothing to do with maximizing the firm’s value. In such instances, moral hazard can be reduced through debt holding. Debt holding decreases incentives for imprudent actions basically in two ways: increasing the fraction of equity ownership held by managers, and increasing the probability of bankruptcy after imprudent actions (Bekaert and Harvey, 1997).
Managing Change of Ownership: Stock markets apart from providing performance measures to be used in employment contracts also disciplines managers indirectly through change of ownership. In instances where managers are performing poorly, stock prices decline below the potential value of assets. Such firms are then takeover targets for investors who will increase the value of the shares by replacing the existing managers. Consequently, managers are enticed to refrain from productivity- decreasing actions due to the threat of takeovers (Bekaert and Harvey, 1997).
GCBF ♦ Vol. 11 ♦ No. 1 ♦ 2016 ♦ ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 213 Global Conference on Business and Finance Proceedings ♦ Volume 11 ♦ Number 1 Contribution to Innovation: An efficient stock market contributes to economic growth by having a positive effect on entrepreneurs. Entrepreneurs do not only consider the profits generated from a new venture but also takes into consideration the possibility of a lump-sum gain through selling the venture to the public.
Inefficient stock markets means public offering is less feasible as a result of high transaction costs or the uncertainty of getting a fair price in the stock market. Consequently this reduces the incentive to enter new venture and hence reduce the overall long- term productivity of an economy. An efficient stock market reduces the transaction costs of trading the ownership of physical assets and as a result open the way for the emergence of an optimal ownership structure (Bekaert and Harvey, 1997).
Role of Capital Market in Enhancing Economic Performance
The development of capital markets has brought about two main economic benefits namely: improving the allocation of capital and helping to distribute risk more efficiently (Dudley and Hubbard, 2004). Since the prices of corporate debt and equity respond quickly to changes in demand and supply, changes in the outlook for an industry are embodied in current assets. The signal created by such a price change either encourages of discourages capital inflows into the industry. Businesses with high returns are able to attract additional capital quickly and easily. Investors cut the flow of new capital to industries with low returns.
The ability of companies to raise funds in the capital markets speeds the dissemination of new technologies throughout the economy. Moreover, by increasing the returns available from pursing new ideas, technologies or ways of doing business, the capital markets promote entrepreneurial and other risk taking activities (Dudley and Hubbard, 2004).
Empirical evidence from countries where capital markets are developed especially the United States and the United Kingdom supports the conclusion that capital markets ensure capital flows to its best uses and that riskier activities with higher payoffs are funded. This evidence is manifested through higher returns to capital, persistent large inflows of capital, stability of banking system and high rate of private equity investment and public equity offerings (Dudley and Hubbard, 2004). In terms of return to capital the returns to capital have been persistently much higher in the United Kingdom (UK) and the United States (US) than in the European Union and Japan with the gap in returns been particularly wide recently. In 2003 the return on capital in the US and UK was 11.1% and 12.6% respectively as compared to 11.0% and 6.5% for the European Union and Japan respectively. With UK and US investors earning higher returns, it strongly implies that capital market based economy results in more efficient allocation of capital (Dudley and Hubbard, 2004).
Through facilitating improved allocation of capital and risk sharing, capital markets contribute to superior economic performances. In countries where capital markets have become more developed, their economic performance has also improved correspondingly empirical evidence of this can be found in the UK and the US where their capital markets are developed. Moreover, the gap in the relative performance of countries with developed capital markets such as the US and UK compared to that of Europe and Japan has widened over time as capital markets have become dominant in the US and the UK (Dudley and Hubbard, 2004).
Evidence of this superior economic performance can be found in five major aspects namely: greater employment opportunities, higher productivity, higher real wage growth, greater macroeconomic stability and greater homeownership. The improvements in these respects contribute significantly towards the reduction of poverty levels.
Greater Employment Opportunities: Unemployment and underemployment are major causes of poverty.
Poor people can generally improve their well being through the use of labour. Hence the creation of productive employment opportunities is vital for achieving poverty reduction and sustainable economic and social development. Providing decent jobs that both secure income and empowerment for the poor especially women and younger people is vital. The creation of employment plays a key role in poverty reduction (UN, DESA 2011). There are many aspects of the nexus between employment and poverty. The GCBF ♦ Vol. 11 ♦ No. 1 ♦ 2016 ♦ ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 214 Global Conference on Business and Finance Proceedings ♦ Volume 11 ♦ Number 1 poor can escape poverty if there is: an increase in wage employment, an increase in self-employment and an increase in real wage. Poverty declines if the aggregate of all these effects is favourable for the poor (Khan, 2007). Given the importance of employment for poverty reduction, job-creation should occupy a central place in a country’s poverty reduction strategy.
Strong capital markets have been shown to drive trade and economic ties between emerging economies. It also contributes more to growth in trade and economic interdependence between emerging markets. This is documented by Beine and Candelon (2007) for stock markets. Deepening capital markets contribute significantly to the emergence of influential regional economic blocs in the developing world which goes a long way to create jobs and thus help to reduce poverty (ACCA 2012). Job creation is strongest among small and mid-cap companies (“Emerging Growth Companies”) which are or could be listed on stock exchanges. Emerging Growth Companies have a large proportion of the European Union (EU) economy and have a disproportionately vital share of job creation. A study by the ESSEC Business School and GE capital covering, Germany and France and the UK for the period of 2007 to 2010 depicted that, while these companies made up a small proportion of total companies they contribute about one third of private sector revenue and employ about a third of each country’s workforce. The listing of such companies on the stock exchange therefore helps to contribute to job creation (EU IPO Report, 2015). A report by Oliver Wyman (2014) estimates that successful Small and Medium Scale Enterprises (SME) capital markets can generate up to 0.1-0.2% uplift to overall GDP each year, and create hundreds of thousands of new jobs globally (Oliver Wyman 2014).
Empirical evidence from the UK and the US where capital markets are developed shows that employment growth in these countries has generally been substantially higher than in the European Union and Japan.
Moreover, the UK and the US have been able to operate at significantly lower unemployment rates as compared to the European Union due to superior productivity growth performance. Higher productivity growth lowers the non-accelerating inflation rate of unemployment (NAIRU) thus labour utilization is much higher in the US than Europe. For example, the overall employment rate in Europe among potential workers was just 81 percent of the US in the year 2003 (Dudley and Hubbard, 2004).
Higher Productivity: A research conducted by CSLS (2003) suggests that the relationship between productivity growth and poverty reduction especially in developing countries appears even stronger than that of between economic growth and poverty reduction. For the past decade the growth of labour productivity in the UK and the US where capital markets are developed has increased and the gap in performance relative to Europe and Japan has widened. Capital markets play a vital role in ensuring higher productivity through two main ways. Firstly, capital markets help to improve the allocation of capital and as a result contribute to raising the average return on capital. Secondly, capital markets facilitate the allocation of risk and help provide a mechanism by which start-up companies could raise capital (Dudley and Hubbard, 2004).
Higher Real Wage: Owing to the higher productivity growth workers are able to earn higher real wages.
Evidence from the United States (US) and the United Kingdom (UK) where capital markets are relatively developed over the fourteen year period (from 1990 to 2004) using the real wage growth on a five year moving average basis depicts that real wage growth has improved over time. This growth has persistently tended to be higher in the UK and the US than in France, Germany or Japan (Dudley and Hubbard, 2004).
Higher real wages earned by workers enables workers to spend more on education and skill formation of their children, hence raising the productive capacity of the future workforce. The process would in effect complete the virtuous circle of economic growth resulting in poverty reduction through growth of employment with rising productivity.(Islam 2004).