Macroeconomic determinants of emerging stock markets

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Business Economics - Finance

Macroeconomic determinants of emerging stock

markets

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Inhoud

Macroeconomic determinants of emerging stock markets ... 1

1. Objective ... 3 2. Literature ... 4 3. Market capitalization ... 6 4. Market characteristics ... 8 4.1 Africa ... 8 4.2 Asia ... 9 4.3 South America ... 11 4.4 Eastern Europe ... 12 4.5 Chapter summary ... 13 5. Explanatory variables ... 14

5.1 Lagged market capitalization ... 14

5.2 Institutional and macroeconomic factors ... 17

5.3 Real income ... 14

5.4 Savings and investments ... 14

5.5 Financial intermediary development ... 15

5.6 Bank sector ... 15

5.7 Stock market liquidity ... 16

5.8 Political factors ... 17 6. Descriptive statistics ... 18 6.1 General ... 18 6.2 Africa ... 19 6.3 Asia ... 20 6.4 Eastern Europe ... 20 6.5 South America ... 20 7. Methodology ... 21 8. Results ... 24

9. Summary and conclusion ... 30

References ... 32

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1. Objective

Ever since the first important contributions by Gurley and Shaw (1967), McKinnon (1973) and Shaw (1973), the relationship of stock market development and economic growth has been one of the most important points of discussion in economics. Numerous studies have focused on the different features of this relationship at the empirical and theoretical sides. McKinnon (1973) and Shaw (1973) find that developed countries with efficient financial systems can grow by well-organized allocation of capital. The researchers find that developed and especially developing countries are subject to restrictions in the financial sectors. Repressive policies lead to less competitive financial intermediary sectors through low savings and investment rates in comparison to more efficient markets. In less competitive financial markets, financial intermediaries do not function at full capacity and may therefore obstruct the development of the entire economic system.

The general view of economists is that the stock market influences the economic growth through its additional possibilities of capital allocation, but there is another that an increasing number of researchers support. A number of economists study the effects of macroeconomic determinants on the stock market. Studies by Shabazz et al. (2013) continuously research the effects of these determinants. Yartey (2007 & 2008) and Kemboi & Tarut (2012) have studied identical effects of macroeconomic determinants on stock market growth.

The objective of this study is to find the influence of macroeconomic factors on stock markets in emerging countries in Asia, South America, Eastern Europe and Africa. Market capitalization is used as a determinant for market development, because Yartey (2008), Garcia and Liu (1999), and Kemboi and Tarut (2012) find market capitalization is the best determinant to account for stock market growth. Garcia and Liu also find (1999) that market capitalization is far less arbitrary than other macroeconomic determinants. The main goal of this paper is to determine stock market development using stock market capitalization as an indicator for stock market development. The main focus is on the performance of major emerging markets in South America in relation to the performance in East Asia and Eastern Europe. We conduct panel analysis on pooled data from selected countries from 1992 to 2012. These countries include Argentina, Brazil, Chile, Colombia, Kenya,

4 South Africa, Morocco, Nigeria, Egypt, Indonesia, South Korea, Malaysia, Thailand, India, China, Estonia, Bulgaria, Hungary, Romania, Poland, the Czech Republic and Russia. These countries are selected since they are major emerging economies from South America, Asia and Africa. The eastern European countries are relatively small emerging markets.

Although there is not one obvious definition of what an emerging stock market is, emerging stock markets are selected from several market indexes and large financial researchers such as, IFC’s “Emerging Market Factbook” of 1997. Although IFC made the listing, the data came from Morgan & Stanley Capital International (MSCI) list. This list is widely used as a benchmark for international equity markets. Other sources that select emerging markets are the International Monetary Fund (IMF) index, Financial Times Stock Exchange (FTSE) emerging markets index and BBVA analysts emerging market index. The combination of these indices allow for the selection of a broad spectrum of countries on several continents. The first chapter will entail the theory of how macroeconomic factors influence stock markets. In the next chapter several theories behind stock market development for emerging stock markets is explained. The following chapter discusses the characteristics of emerging stock markets. Thereafter, the effects of macroeconomic variables on stock market growth are explained.

2. Literature

The relationship between stock market development and economic growth has long been an important research subject. The causal relationship between financial development and economic growth is argued in roughly three separate claims: The first stating that financial deepening promotes economic growth. The second, arguing that economic growth stimulates stock market development and a third, stating that there is a reciprocal relationship. Gurley and Shaw (1967) find that as economies develop, self-financed capital provide possibility for bank-intermediated debt finance. Later, when the equity market is formed, the additional capital markets are used as additional instrument for raising external funds. That illustrates structures of financing options change with a country’s development. As a country’s economy develops from poor to a richer economy, the importance of commercial

5 banking and non-financial institutions grow, while the role of the central bank diminishes. Poor countries tend to allocate a larger share of debt to their private sectors when measured as a percentage of the total GDP. In contrast, rich countries have an overall larger financial system and stock value traded is higher as a ratio of a country’s GDP. Gurley and Shaw (1967) find that as the economy of a country grows, the financial intermediaries and equity markets develop and prosper.

Since the 1980s there has been pressure on emerging markets to open financial markets and institutions. This integration of financial markets has drawn large interest for research. Studies by Vannasche (2004) and Guiso et al. (2004) state the positive impact of financial integration. It promotes greater financial development of through improved functioning of financial markets. It provides companies access to many credit and security markets. The most important findings are that financial integration results in decreased cost of capital, higher economic growth and more private investments. One side states that private investments have a more positive impact on emerging market growth, while the other states that credit markets have a more positive effect. This contradiction can be explained by studies focusing on one effect and omitting others.

The general view of economists is that a stable financial system is crucial to economic growth. As part of the financial system, stock markets have an important role in economic growth. This raises the question what determines stock market development. Stock market development is not a one-dimensional concept. Usually it is measured by stock market size, liquidity, volatility, concentration, and integration with world capital markets and regulation, and supervision in the market. Garcia and Liu (1999) used market capitalization as a measure for stock market development in their study, because it is less arbitrary than other individual measures and indexes of stock market development.

According to Pilinkus (2010) the stock market is a concurrent part of economies as it distributes financial resources to different economic entities. This reciprocal relationship between development of stock and changes in a country’s economy was observed many years ago. As a country’s economy progresses, the stock market becomes more dynamic. A stock market also illustrates the type of state the economy of a country is in. When stock prices rise, economic growth is

6 probable and on the contrary, when stock prices fall an economic downturn is expected.

Another theory, according to Yartey (2008), states that the stock markets of emerging economies are largely dependent on macroeconomic factors, while political risk, law and bureaucracy are highly influential as well. These same factors have also been found as the key drivers of emerging stock market development in a study by Andrianaivo and Yartey (2009). The study by Garcia and Liu (1999) also found macroeconomic factors influential for stock market development. They identified income level, domestic investment and the financial intermediary sector as the most important factors driving stock market development, while macroeconomic volatility is not significant. Despite of these findings in several studies there is no consensus on which macroeconomic factors determine stock market development.

There are numerous studies that state that there is a relationship between macroeconomic factors and stock markets. Studies using multifactor models frequently incorporate macroeconomic factors. These studies are mainly aimed at the developed markets. In contrast, the aim of this study is to estimate stock market development of emerging markets. There is not a lot of theoretical and empirical evidence on what determines stock market development, but a limited number of studies have shown a positive relationship between stock market development and economic growth.

3. Market capitalization

In the 1990s the world market capitalization tripled. Emerging markets grew from 4% to 13% of the total world market capitalization. According to Kuntz and Levine (1996) market capitalization could be estimated using stock market liquidity, volatility, institutional development, the relationship between financial intermediaries and stock markets, economic growth and financing choices of firms. Important in this research is the assumption of political, as well as, financial stability.

Economic literature found that there is a causal relationship between financial development and economic growth. Some investments require large long-term investments, which many investors are adverse to. Equity markets provide liquidity to investors, which lead to more potential investments (Levine, 1996), as costs are

7 lowered. A study by Filer, Hanousek and Campos (1999) focuses on the relationship between stock market returns and economic growth. It found a causal relationship between macroeconomic development and the equity markets, especially in less developed countries. Perotti and Van Oijen (1999) state that an active equity market is important in economic growth, as diverse ownership of equity creates a good foundation for political stability, which promotes economic growth. Most of these studies provide evidence that stock returns fluctuate with changes in macroeconomic variables. Aggregate equity prices are expected to have a causal relationship with macroeconomic variables. That relationship suggests that the value of equity shares is dependent on the value of dividends, which are derived from company earnings. Since these earnings are influenced by real economic activities, there should be a causal connection between economic variables and equity prices. According to LeRoy and Porter (1981), macroeconomic variables influence real economic activities. It affects discount rate and cash flows of firms, which determine the intrinsic value of equity in discounted cash flow models.

Other studies confirmed this relationship between macroeconomic variables and equity prices. Flannery and Protopapadakis (2002) stated that economic variables are essential for determining returns of equity, since changes in these variables affect cash flows and the risk-adjusted discount rate of firms. Researchers also find that returns on shares reflect the underlying real economic activity. That suggests that there is a relationship concerning macroeconomic activity and equity returns observable (Patro et al, 2002), especially in developed markets. Other researchers, Pearce and Roley (1985) find that unexpected fluctuations in monetary policy have a significant influence on equity prices. Similar discoveries are made by several other researchers regarding the link between volatility of stock prices and macroeconomic variables. Kracaw (1984) found comparable results in other equity markets. Cheung and Ng (1998) find that stock markets are generally integrated with a country’s aggregate real economic activity such as consumption and money supply. While there has been extensive research done on the relationship between macroeconomic variables and equity returns, very limited research is done regarding the macroeconomic influence on emerging stock markets. Yartey (2008) finds that this determinant is the best measurement for stock market development, as it is less

8 arbitrary than other indicators, when estimating stock market development. Garcia and Liu (1999) form similar conclusion regarding the effects of macroeconomic determinants on stock market development. Yartey’s reasoning (2008) for using market capitalization as indicator for stock market development, is that market size is positively correlated with allocation of capital and risk diversification of an economy. According to Fama and French the market size also positively correlates to stock returns, as the Fama-French model accounts for value and small cap stocks outperforming the stock market (Fama & French, 1992).

4. Market characteristics

4.1 Africa

It is difficult to form a general statement regarding the equity markets in Africa, considering the continent consists of a large number of developing countries at different stages in their financial development. In contrast, the total African market is fairly small compared to other regions, as the equity markets are not as developed and stable as the other regions such as Asia and South America. In general, the financial markets in Africa have undergone drastic changes over the last decades. At first it was largely dependent on relatively large banking sectors, but after the late 1990s capital markets have played an essential role in financing. Secondly, credit to the private sector as a percentage of the GDP is higher than before the new millennium. Despite the swift growth of the banking systems in Africa, the debt ratio is the lowest in the world. The average bank credit invested in the private sector is approximately fifteen percent of the GDP, while in developed economies this is more than a hundred percent.

In comparison to similar emerging markets, African banks now play a small role in the financial system. Banking penetration is fairly low, at eighteen percent in sub- Saharan Africa. In other developing countries this ratio is on average forty-four percent (EIB, 2013). Furthermore banking access is nearly none in rural areas, because of the lack of financial intermediaries.

9 For a more complete image of the financial markets the money market is studied. According to Yartey (2008) the M1 to M2 ratio in Africa was the highest in the world. That means that cash is the most used financial instrument. Consequently, financial intermediation is hindered by the high usage of cash, the absence of credit assessment information and bad protection of property rights.

Though the stock markets are still relatively small compared to other emerging markets, the number of stock markets in Africa has grown rapidly since 1989. The total market capitalization increased more than a hundred percent from 1995 to 2005 (Yartey, 2008). These stock markets are dominated by large firms that also represent a large portion of the total market capitalization. This is caused by the small number of companies that comprise the stock market. South Africa, Egypt and Nigeria are the exception to the previous statement. The South African stock exchange dominates the region regarding the market capitalization and the exchanges in Egypt and Nigeria have grown since the early 2000s. Along with the Egyptian markets, the South African markets account for more than half of the listed companies in the entire continent.

Institutional investors and governments are rarely active in the secondary markets of the African continent and therefore lack the experience and resources for effectively influencing use of stock exchanges. The African stock markets are relatively illiquid, caused by a low number of transactions and there are enormous gaps between buyers and sellers. Normally shares are traded in low volumes. Those shares traded represent the majority of market capitalization (Yartey & Adjasi, 2007). Turnover ratios are relatively low compared to the national GDP. This is one of the foundations of low liquidity in local stock markets. The low liquidity implies a complexity in supporting local stock market trading systems, market analysis and brokers because volumes traded are low.

4.2 Asia

According to Solow’s neo-classical growth model, economic growth is dependent on the distribution of labor, capital and technological growth (Solow and Swan, 1956). This also implies that financial institutions have a large influence on economic growth, since this sector is responsible for the allocation of a significant portion of

10 savings to investment projects. According well-known economists, Asian countries owe their growth to cheap labor, high capital, and high technological growth. This was confirmed by a study from Kim and Lau (1994). They find that relative to other regions labor and capital was cheaper to find and due to technological innovation Asia could develop more rapidly than other region since the 1960s. Since the Asian crisis in 1997-1998, debt markets are transformed to enhance the scale and increase liquidity of these markets. Policies changed with introduction of several benchmark bonds. This enhanced the markets infrastructure and provided more opportunities for foreign investors (Shimada and Yang, 2010). The Asian Development Bank has issued its goal of stabilizing the financial sector by the improvement of the regional markets infrastructure. Since then the banks in particular became far less susceptible to external changes, such as financial crises in other regions of the world.

Another important consequence following the Asian crisis, was the development of local currency bond markets as an alternative source of funding to bank loans (ADB, 2014). Since then the Asian Bond Markets Initiative was setup. Its aim was to globalize the Asian bond markets, while also creating more liquid markets. This enabled more efficient allocation of savings to investments. Since the launch of the Asian Bond Markets Initiative in 2002, the emerging East Asian bond markets have grown to $6.7 trillion at the end 2013 (ADB, 2014)

After the financial crisis the Asian the ADB found that the financial markets in Asia were scattered. These markets were not integrated. It led to problems channeling funds from net savings countries to net borrowing countries. Financial integration increases emerging markets to greater volatility in returns. Governmental financial policy may also lead to such volatilities by adjusting policies in such a way that a country may be more vulnerable to outside changes.

Most of the investigated financial markets in Asia were very small in the 1990s. Market capitalization and turnover ratios were very low compared to developed markets. The same can be said for the South African and South American markets. Over the years, market capitalization grew gradually. The smaller Asian markets on average show a low stock market turnover ratio and market capitalization. Low turnover ratios implicate a low value of shares traded compared to the value of all shares traded. The aggregate CPI for the Asian region is relatively

11 high at around ten percent before 1992. From the 1970s until the 1990s the aggregate inflation was even higher except for 1985 and 1986, before Black Monday in 1987, when the global financial markets crashed (WorldBank, 2014). The larger markets such as China and South Korea have shown high stock market growth, high turnover ratio and high market capitalization. This is also shown in the results, shown in the Appendix. According to popular research these are consequences of relatively stable macroeconomic policies.

A number of listed companies in Asia are state-owned. These companies fail to meet the performance levels of the private sector. This leads to lower aggregate performance levels and thus a lower market capitalization. Most Asian countries have agreed to the privatization of numerous companies since the 1990s in accordance to the ADB’s plans.

4.3 South America

Commonly the South American economy is largely dependent on its export of natural resources. More recently the continent has undergone a more rapid economic growth. According to World Bank data (2013), large, more integrated economies, such as Brazil underwent a significant change in 2009. These financial markets are more correlated with western economies and under the continuous influence of the financial crisis, the economic growth declined.

The banking sector in South America has played an important role in economic growth of the region. Through financial integration, there are numerous foreign investors. The number of foreign investors is also a product of financial liberalization. Although banking sectors were dominant, financial credit to the private sector as a percentage of the GDP was relatively low, at well below fifty percent in the 1990s (IADB, 2004). This originates from the continuous advantage banking sectors have in information processing and diversification of risk, both of which are essential in financial intermediation. In contrast the securities markets often lack infrastructure to provide and alternative.

Since strong financial institutions stimulate the development of financial markets to provide an alternative method of finance. Great economic and stock market development took place. After a steep drop in 2010, the South American

12 financial markets have started to recover. Unfortunately, the political situation in South America remains uncertain. The black market in the Argentinian peso disrupts the country entirely as most people go to the underground markets to get more value for their money. The peso therefore is overvalued on the official market, while on the black market it continues to devaluate. Because of their currency controls, continuous debt restructuring and declining reserves, it becomes more difficult to climb out of the crisis. The Argentinian government defaulted on some of their debt as of September of 2014 and the central banks’ reserves continue to fall. Venezuela faces some similar problems. Currency controls can cause for overvaluation of a currency relative to foreign currency. Currency controls are not uncommon in South America, as Argentina, Brazil and Venezuela also have some form of currency controls in effect.

4.4 Eastern Europe

Economic and political uncertainty influenced macroeconomic policy in Eastern Europe during the 1990s. In the first half of the 1990s some countries inflation were still in recovery after the end of the Cold War. The inflation in Bulgaria and Russia was more than a thousand percent during the middle of the 1990s (World Bank, 2014).

After economic restructuring, reallocation of labor and capital, these countries have undergone significant changes. The prospect of EU membership also had a positive effect on the economic development. Capital inflows rose and political risk declined. Still, privatization was a large issue in these countries. Some countries relied heavily on foreign investors to proceed with this policy, while others lured investors through investments funds.

An important issue for the Eastern European countries was the relationship between exchange rates, stock market development and economic growth. Fluctuations of currencies can influence import and export. High foreign direct investments also influence local currency. While high FDI may cause a reduction in labor costs, it can also force changes in currency exchange rates.

Equity markets did not play an important role in the economic development of these Eastern European countries (Islami & Welfens, 2013). While interdependency with

13 other European regions remains feeble, it has also caused a significant improvement in capital markets. Membership of the European Monetary Union (EMU) and the introduction to the Euro decreased financial uncertainty and currency risk substantially.

The economic growth of Eastern European countries is relatively low. From 1992 to 2012 the annual GDP per capita increases circa three percent, while this seems low, during the early 1990s, the average GDP per capita in Eastern European countries was declining. From 1992 to 1996 GDP per capita growth in Bulgaria, Estonia, Poland, Romania, Hungary, the Czech Republic and Russia was a tenth of a percent on average. Savings and investments increased gradually to an average of respectively approximately 22 and 24 percent of the GDP annually. Stock markets grew deliberately, but remain relatively small. The value traded and market capitalization as a percentage of the GDP are respectively approximately 10 and 21 percent. Turnover ratio are low, while the market are quite liquid compared South American and African markets. During the uncertain first half of the 1990s, the inflation was on such a high level that only South America has a higher annual average inflation.

4.5 Chapter summary

Asia has the highest GDP growth per capita on average with more than 9 percent growth annually. On average the GDP of other emerging regions grow approximately two to three percent annually. Savings and investments in Asia remain relatively high compared to Eastern European, South American and African countries. The Asian stock market seems more developed according to the high turnover ratio, which is comparable to developed regions such as USA and Japan. The market capitalization however is comparable to the average market capitalization of the largest African equity markets. Asia shows relatively low inflation compared to South America, Eastern Europe and Africa.

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5. Explanatory variables

5.1 Lagged market capitalization

There are several ways to explain stock market growth. The main focus of this study is on the relationship between economic growth and the market capitalization. Market capitalization is a good explanatory variable for equity market development. Previous studies found that several individual variables are highly correlated with stock market development, but market capitalization was found paramount. Yartey (2008), and Garcia & Liu (1992) use market capitalization as indicator for stock market development, because that market size is positively correlated with allocation of capital and risk diversification on an economy.

5.2 Real income

Previous studies find that the volume of a country’s financial intermediaries is the foundation of a large stock market. A high volume of financial intermediation lowers transaction costs for companies and investors. This makes it cheaper for those companies to find capital. Therefore more efficient financial market provides greater opportunities for financial development. Great financial development also provides a growth incentive to the financial markets.

Real income is found to be highly associated with size of a stock market. As a country’s income increases it is more likely for the stock market to grow. In this study GDP in US dollars is used to measure income level and growth rate. Similar to Garcia and Liu’s study (1999), this study uses GDP per capita in US dollars as an indicator for income level and to circumvent any causal difficulties lagged values in are used.

5.3 Savings and investments

Savings and investments are also an important factor in explaining stock market growth. Financial markets provide financial intermediaries means to transfer savings to investments. Larger savings lead to a higher amount of funds allocated to the stock markets. The financial theorem also states that saving and investments have a positive impact on the income level of a country. Garcia and Liu’s (1999) find that

15 savings might not be highly correlated with income level; moreover they find that in Latin America, it was actually negatively correlated with income level.

5.4 Financial intermediary development

The financial intermediary development is another variable used in the regression. A few of these financial intermediary sectors are the banking sector and stock markets. These markets can either be complements or substitutes. Economic theory suggests, such as Modigliani Miller (1958), that in stringent market efficiency the value of companies are not dependent of a firm source of financing. In reality however, with imperfect information allocation, the sources of financing are significant for firms. There may be a negative relationship between interest rates and stock market development in the short run. On the contrary, in long term investors diversify their assets and allocate funds to both banks and stock markets. Similar to Boyd and Smith (1996), Berlin (2012) finds that banking and stock markets are complements rather than substitutes. This suggests that according to Berlin (2012) the banking sector and stock markets are positively correlated. Demirguc-Kunt and Levine (1996) also find that the level of stock market development is positively correlated with financial intermediary development. In contrast, according to research by Bijlsma and Zwart (2013) during the recent financial crisis investors tend to substitute bank-based for market-based financing. The assumption that countries may have a negative relationship between banking and financial equity market is backed by Garcia (1986). Bijlsma and Zwart (2013) also find that the volume of loans has diminished in all regions of the world during the recent financial crisis. A prime example of this is the United States. The issuance of listed shares has increased and domestic credit to the private sector has decreased in more developed countries.

5.5 Bank sector

To measure the influence of financial intermediaries on stock market development, several variables are used. Domestic credit to the private sector as a percentage of the GDP and the liquid liabilities are used to find a correlation between financial intermediary development and stock market development. Domestic credit to the private sector relative to the GDP measures the role of the banking sector in term of long-term financing provided to private firms. Liquid liabilities are currency held

16 outside the banking system in addition to demand and interest-bearing liabilities of all financial intermediaries. M3 divided by GDP provides an indication of the bank sector size relative to the size of an economy. These variables provide means to estimate the financial sectors’ influence on stock market development. In general, economists find that domestic credit and the bank sector size should have a positive effect on market growth.

5.6 Stock market liquidity

One of the last variables to consider in the determining stock market development is stock market liquidity. Keynes (1930) considers an asset liquid if it is realizable at short notice without a loss. In other terms: Liquidity is the degree to which a security can be bought or sold. This is usually characterized by high volume of trading activity without large price effects. It is also largely deemed as one the most important purposes that the stock market provides. High return investments require a long-term capital. These projects are subject to high default and liquidity risk. Investors are generally hesitant to take on these risks. Without liquid stock markets less high-return project are invested in. Liquid stock markets provide means for investors to diversify their portfolios quickly, while also providing opportunities for less risky and more profitable investments (Levine, 1991). These provisions provide more opportunities for investors to channel their savings through stock markets and could lead to higher market capitalization.

Market size is one of the variables used to measure stock market liquidity as it accounts for the size of a stock market. The turnover ratio is the total value of shares traded divided by the market capitalization. This ratio measures the total value of traded equity divided by the size of the market. This way the level of liquidity is measured. To compare the liquidity of the equity markets, the turnover ratio is divided by a country’s GDP. Secondly, total value of stock traded is divided by a country’s GDP. Both variables measure the degree of access that investors have to the equity markets. These variables measure the degree of trading compared to size of the GDP and the stock market size. The hypothesis is that there is a positive relationship between stock market liquidity and stock market size.

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5.7 Political factors

Political stability is important in estimating the stock market development. This stability is the state of peace that countries experience, influenced by government policies and activities. According to Alesina et al. (1992), political stability influences macroeconomic factors. That is why this study focuses on how macroeconomic factors influence stock market development in emerging markets. Moreover, macroeconomic stability is very important to estimate financial growth. The expectation is that high macroeconomic volatility leads to fewer investments in stock markets. That is a cause of fewer incentives for investor, which leads to fewer investments. History shows that a highly volatile economy can be susceptible to less transparent stock markets. In such an economy, stock prices are subject to high standard deviations. It is less transparent whether stock prices changes are short or long term.

5.8 Institutional and macroeconomic factors

Institutional and macroeconomic factors are the main drivers in stock market development. Pagano (1993) finds that regulatory and institutional variables influence stock market development. Other macroeconomic influences are used to explain stock market development. The macroeconomic approach is not limited by the lack of institutional information. The extent of research of macroeconomic influence on stock market development is limited and the amount of research regarding this subject is mostly fixated on just one country at a time. This study however, looks at multiple regions. The Generalized Method of Moments estimation is used to determine whether macroeconomic variables and political stability are significantly important in stock market development. In previous research political stability by Yartey (2008) is found significant in determining stock market development.

Institutional factors reflect directly in macroeconomic factors. Especially legal institutions are highly correlated with stock market liquidity. Demirguc-Kunt and Levine (1996) find that countries with great regulatory and institutions are much more likely to have liquid stock markets. The size of financial intermediaries as a share of a country’s GDP rises as an economy develops. They also find that financial

18 liberalization positively affected stock market development through improvement of liquidity, size and stability of the capital markets in developing countries such as Pakistan, Turkey and Venezuela (Demirguc-Kunt and Levine, 1996). Another study by Odeniran and Udeaja (2010) also find that financial liberalization aids stock market development in Nigeria. Unlike other studies, this research finds financial deepening does not influence economic growth. However, bank sector development does yield a positive impact on economic growth in Nigeria.

6. Descriptive statistics per region

6.1 General statistical review

Stock prices and profitability of firms are subject to severe changes, when there are unexpected deviations in economic policies. The expectation is that changes in monetary policy, fiscal policy and exchange rates lead to volatile market capitalization and stock market prices. Volatile macroeconomic factors have negative effects on market capitalization. To measure the effect of macroeconomic stability the annual changes in inflation are taken into the regression model. Additionally, the effects of inflation changes are taken into consideration. High inflation rates may suggest instability, however when inflation rates remain relatively unchanged it may not indicate any instability. However, high volatile inflation rates may indicate higher macroeconomic volatility. This study takes into account the volatility instead of the annual inflation. The difference between of the annual inflation rates are measured so that the volatility is measured. The descriptive statistics in the Appendix show the volatility of the inflation per region. Inflation is relatively low in Asia, while it is very high in the South American market.

Foreign investments play an important part in stock market development. According to Claessens et al. (2001) FDI’s are positively correlated with stock market capitalization and stock value traded. FDI’s are complementary to stock market development. They also find that macroeconomic stable countries tend to have better financial growth. Furthermore, due to globalization, it is easier to invest in multiple equity markets simultaneously. In Asia and South America, FDI has grown as a share of capital flows. In the 1970s bank lending provided for seventy percent of

19 capital flows, whereas in the 1990s this was only around twenty percent. To determine the influence of FDI as a percentage of the GDP, the variable is added to the regression. The annual change of FDI in Africa is shown in appendix 5.

Most of these macro-economic determinants are strongly correlated. That could cause a multicollinearity problem, which can produce unreliable estimations. To ensure avoidance of a multicollinearity problem, market capitalization and stock value traded are formulated as a percentage of a country’s GDP, and turnover ratio as a percentage of the market capitalization. Additionally, all political output is a ratio between zero and one. The closer to one, the more stable the political factors.

Appendix 5 through appendix 8 show the first differences used to estimate the effects of macroeconomic variables on stock market development.

6.2 Africa

The appendix shows that income levels per capita keep rising annually in Africa. Additionally, investments decline almost on a bi-annual basis, while savings followed that same trend.

Market capitalization on aggregate declines more than fifty-five percent in Africa in 2008, while the stock market value traded declined at a lesser rate. That means that on aggregate the size decline more than the value stock traded.

Bank sector development continues to rise in the African region except for the decline of more than sixteen percent in the beginning of the 1990s, which strokes with the hypothesis and the literature that bank sector development in Africa gained importance during the 1990s, as the credit to the private sector rose annually during that period in Africa.

As expected,

M3, which is money in circulation, is relatively high compared to the levels in Eastern Europe and South America. The African region is highly dependent on its bank sector for corporate finance, but bank penetration amongst individuals was relatively low. This would suggest the amount money in circulation should be relatively high.

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6.3 Asia

The data of the Asian markets show that income levels per capita rise annually. Appendix 6 also shows investments also decline on a bi-annual basis, similar to the trend in African markets. Savings however does not follow that same trend.

Market capitalization shows a decline at the end of the 1990s. This was expected, since there was a financial crisis during that same period. In 2008 market capitalization decline enormously, with more than sixty percent. The Asian stock market on aggregate seems to recover rapidly, as it shows signs of growth in stock value traded and market capitalization in the following year, but thereafter the market decline again. The region also shows higher volatility in stock market turnover. M3 is comparable to the African region. Money in circulation is relatively high compared to the levels in Eastern Europe and South America.

6.4 Eastern Europe

The appendix clearly shows that income levels per capita keep rising annually in Eastern Europe. Additionally, investments increase almost annually, while savings follow that same trend.

Market capitalization increases on aggregate during the studied period. In contrast, at the beginning of the financial crisis in 2008, it declines more than thirty-three percent in Eastern Europe, while the stock market value traded declined at a lower rate. That means that on aggregate the size decline more than the value of the stock traded. Money in circulation is relatively low as well compared to the levels in other emerging region such as Asia and Africa.

6.5 South America

The appendix clearly shows that income levels per capita keep rising annually in South America. Investments decline almost on a bi-annual basis, while savings followed that same trend.

Market capitalization on aggregate declines more than thirty-six percent at the beginning of the financial crisis in 2008, while the stock market value traded shows a small decline. Stock turnover actually increases (shown in appendix 8), which means stock is relatively liquid compared to previous years, while the original data shows that stock market turnover is low compared to the Asian markets.

21 Inflation in South America is highly volatile, as shown in appendix 8. South American governments have capital controls in effect to closely monitor that inflation volatility. Money in circulation is relatively low compared to the levels in other emerging region such as Asia and Africa.

7. Methodology

This study aims to explain the development of emerging stock markets using macroeconomic and political factors. In a previous study, Yartey (2008) focuses on the effects of macroeconomic and institutional determinants on stock market development. There is little research regarding the development of stock markets in emerging countries, but Calderon-Rossell (1991) designed a partial equilibrium model of stock market development. This model is the most complete foundation for financial theory of stock market development.

The aim of this research is to find which macroeconomic determinants influence stock markets using an adjusted version of the Calderon-Rossell model (1991). Yartey (2007) finds that an increase in growth of the financial intermediary sector, effect stock market development with 0.6 percent. More recent studies find that GDP growth, domestic investments and financial intermediary development are vital to stock market development.

The model used in this study resembles a dynamic panel structure since our model has at least one lagged dependent variable. All of the data is shown per region in the appendix. The correlation for most variables is characterized as endogenous. Most variables are created simultaneously to- or have a reciprocal relationship with- the dependent variable. To estimate the stock market growth of an economy, the Generalized Method of Moment estimator is used. The market capitalization (Y) is estimated with the lagged market capitalization rate Yt-i, GDP per capita in US dollars, credit to private sector as percentage of the GDP and its square, stock market value traded as a percentage of the GDP, private capital flows as percentage of GDP, foreign direct investment, macroeconomic stability (measured by inflation) and domestic savings. Macroeconomic variables are labelled in the model as M and political factors are accounted for by P. The General Method of Moments (GMM)

22 model is: Y =α +δY + βM +ωP+ε. Datastream and World Bank are used for the data used in the estimation.

Since all of the explanatory variables are closely correlated with the dependent variable, that can lead to inconsistent estimations with Least Squares (LS). The regression estimation contains several lagged variables and exogenous variables. These variables correlate with the error terms and since the model contains endogenous variables as well as lagged endogenous variables, LS and Fixed Effects do not produce consistent estimates. The assumption for using the GMM estimator is that there is no serial correlation in the first differences of the error term. This is a necessary for the GMM estimator to be consistent. Presence of second order serial correlation or more reduces the instrumental variables validation. Arellano and Bond (1991) propose valid specification tests after the estimations of a dynamic model from panel data with the GMM. The researchers suggest tests for the GMM estimator exploit all linear moment restrictions that result from independence of errors, lagged dependent variables and variables that have influenced by the model as well as other dependent variables.The GMM model considers the effects of investments, lagged market growth, income level, credit, value traded, inflation and political stability on market growth for the regions Africa, South America, Eastern Europe and Asia.

The initial assumption for a GMM-estimation is that there are a set of moment conditions that the parameters of interest satisfy. These conditions can be general, and often a particular model has more specified moment conditions than parameters to be estimated. In general the set of moments are equal or greater than the parameters. E(m(y,b) = 0. In this estimation the first differences are used to satisfy the orthogonality condition. Another assumption for the estimation is that there is no second order autocorrelation in the error term, because the consistency of the GMM should satisfy this condition. If there is autocorrelation of higher than the first order it is a sign of misspecification.

Previous studies, such as a study by Yartey (2008), show the modified Calderon-Rossell model is the best way to determine the macroeconomic determinants that influence the stock market development. However given the data structure, a dynamic estimator is necessary for the specification. The relationships of

23 the variables are endogenous. This stems from the fact that most variables are developed simultaneous with the dependent variable and the variables may have a reciprocal relationship with the dependent variable. There might also be unobserved effects. If these are discarded, this may cause for inconsistent estimations. The original estimation could cause problems, since the regressors may correlate with the error term. That is why Arellano and Bond (1991) developed a more complete dynamic estimator. This estimator best exploits the moment restrictions produced by the dynamic panel model. The estimator is an instrumental variable estimator, which uses the lagged variables of all endogenous and exogenous variables as instruments. This dynamic GMM estimator is: θ =𝑋𝑋′ 𝑍𝑍𝑍𝑍 𝑍𝑍′𝑦𝑦_{𝑋𝑋′ 𝑍𝑍𝑍𝑍 𝑍𝑍′ 𝑋𝑋}. Here θ is the vector of both the endogenous and exogenous regressors, X and y are the vectors of the first differences of all the explanatory variables. Z is the vector of instruments and W is a vector used to weight the instruments.

Arellano and Bond (1991) suggested two estimators—a one step and the two step estimator. The one step estimator is established when the weight matrix is the average covariance matrix of Z. This weight is: 1 1

𝑁𝑁∑𝑍𝑍′𝐻𝐻𝑍𝑍

. The two step GMM estimator

is most ideal. The optimal choice for the two step estimator is given as: _𝑁𝑁1∑𝑍𝑍′_𝑣𝑣2 _𝑍𝑍. Where v are the residuals derived from the initial consistent estimate of θ. The one and two step estimators are asymptotically equal to each other if the error terms are orbicular. There is a tendency for the two step estimator to underestimate the standard errors of estimates and provide a false assumption of precision under some circumstances. In general, studies estimate with the two step estimator, while hypothesis tests are based on the one step estimator’s statistics. A similar method is used during this study.

24

8. Results

The aim of the estimation for stock market growth is to explain stock market growth by macroeconomic determinants. All p-values are compared to α=0.05. The stock market growth=market capt-1+log(gdp per capitat)+ investmentst + value tradedt + inflationt + credit to private sectort+credit2t+εt.

Table 1

Table 2 Arellano-Bond test

On aggregate the market capitalization of the previous year has a small negative effect on the current year’s market growth. In contrast, the first model in table 1 finds that credit to the private sector has a positive effect on the market growth. When the bank sector grows with one percent, the stock market grows with 0.303509 percent.The effect decreases with a higher amount of credit provided to the private sector. When a bank sector is highly developed and provides a relatively large amount of credit, then there may be a decline in credit provided to the private sector. This effect is expected, since stock markets and bank sectors are substitutes for sources financing and in more developed markets debt is often substituted for equity.

An increase of one percent in the lagged market capitalization rate decreases stock market development with 0.109269. The value traded on a stock market increases with one percent, while the stock market grows with 0.775478. Domestic investments as a percentage of a country’s GDP have a negative effect on stock market development. An increase in investments of one percent causes the stock

Dependent variable Market_cap

Variable Coefficient Std. Error t-statistic Prob.

MARKET_CAP(-1) -0.109269 0.042441 -2.574.600 0.0107 LOG_GDP_PER_CAPITA 0.047125 0.030380 1.551.176 0.1223 INVESTMENTS -0.793041 0.153020 -5.182.586 0.0000 CREDIT_PRIVATE_SECTOR 0.220264 0.123054 1.789.975 0.0748 VALUE_TRADED 0.775478 0.027225 2.848.370 0.0000 CREDIT2 -0.183315 0.047721 -3.841.410 0.0002 CPI 0.100248 0.122987 0.815109 0.4159

Dependent variable Market_cap

Variable Coefficient Std. Error Prob.

25 market to contract by 0.793041 percent. Income levels per capita have a positive effect on stock market growth of 0.047125 percent, when it increases by one percent. The effects of the income levels are not significant. An increase of inflation has a positive effect of 0.100248 percent on market growth, but that effect is not significant and thus negligible.

The objective for the second model, in table 3, is to find the effects of real interest on stock market development. The effects of real interest on stock market development is found by the following model stock market development=market capt-1+log(gdp per capitat)+ investmentst + value tradedt + real interestt + credit to private sectort+credit2t+εt

Table 3

The model finds that real interest has a significantly negative effect on stock market growth. Investments have a negative effect on stock market development as well. Credit provided to the private sector, value traded and income level have a positive effect on stock market development. All these determinants affect stock market development significantly. As the bank sector develops, the positive effect decreases. Also, similar to the previous model, the lagged market capitalization rate has a negative influence on stock market growth.

The subsequent model investigates the effect of domestic savings, as shown in table 4. Domestic investments are substituted for gross domestic savings. The savings is incorporated in the model as a ratio of a country’s GDP.

Dependent variable Market_cap

Variable Coefficient Std. Error t-statistic Prob.

MARKET_CAP(-1) -0.143395 0.036358 -3.943.993 0.0001 LOG_GDP_PER_CAPITA 0.026111 0.020284 1.287.263 0.1994 INVESTMENTS -0.586865 0.146709 -4.000.190 0.0001 CREDIT_PRIVATE_SECTOR 0.415752 0.109545 3.795.251 0.0002 VALUE_TRADED 0.774399 0.019602 3.950.589 0.0000 CREDIT2 -0.241993 0.042017 -5.759.416 0.0000 REAL_INTEREST -0.378275 0.111010 -3.407.561 0.0008

26

Table 4

The model finds some changes in significance levels amongst the macroeconomic determinants. Savings have a positive and significant effect on stock market development. The same effects are found for value of stock traded, bank sector development and income levels. The models still finds real interest and the lagged market capitalization ratio to have a negative effect on stock market growth. The value of stocks traded on the market has a significant positive influence on stock market development, while the income levels have an insignificant effect on stock market development. Bank sector development has a significant influence on the market development.

In the next model the impact of FDI is considered. For the estimation FDI are the foreign direct investments as a ratio of a country’s GDP. FDI supplants the gross domestic savings of the previous model. The output results are shown in table 5.

Table 5

The model finds a positive influence of FDI on stock market development. The model finds no major statistical changes in the effects of macro-economic determinants on stock market development.

Dependent variable Market_cap

Variable Coefficient Std. Error t-statistic Prob.

MARKET_CAP(-1) -0.192598 0.014175 -1.358.711 0.0000 LOG_GDP_PER_CAPITA 0.016186 0.025276 0.640382 0.5226 SAVINGS 0.735646 0.065373 1.125.311 0.0000 CREDIT_PRIVATE_SECTOR 0.307794 0.063926 4.814.832 0.0000 VALUE_TRADED 0.789353 0.010347 7.629.046 0.0000 CREDIT2 -0.195901 0.031642 -6.191.236 0.0000 REAL_INTEREST -0.449875 0.033084 -1.359.803 0.0000

Dependent variable Market_cap

Variable Coefficient Std. Error t-statistic Prob.

MARKET_CAP(-1) -0.200408 0.017020 -1.177.463 0.0000 LOG_GDP_PER_CAPITA 0.049338 0.041510 1.188.579 0.2359 FDI 1.197.413 0.208525 5.742.293 0.0000 CREDIT_PRIVATE_SECTOR 0.310325 0.106788 2.905.980 0.0040 VALUE_TRADED 0.766571 0.014105 5.434.781 0.0000 CREDIT2 -0.192484 0.051426 -3.742.921 0.0002 REAL_INTEREST -0.477617 0.089164 -5.356.618 0.0000

27 The effects of capital flows are investigated in the next model. The results are shown in table 6. Capital flows consists of FDI and portfolio investments. The model finds capital flows to have a positive effect on stock market development. Other determinants such as value of stock traded and bank sector development have a significant influence on stock market development. This is in line with results from previous estimations shown in table 1 through 5.

Table 6

Previous studies discovered political factors important in determining stock market development. All political outcomes are ratio’s between zero and one. The following model investigates the influence of political factors on stock market development in the target regions is investigated. The output of the political stability effect is shown in table 7. The effects of political stability on stock market development is found by the following model stock market development=market capt-1+log(gdp per capitat)+ investmentst + value tradedt + real interestt + credit to private sectort+credit2t+political stability + εt. The change in outcome results from a reduced sample of observation, which influences the estimation negatively and causes the explanatory variable to be insignificant.

Table 7

Dependent variable Market_cap

Variable Coefficient Std. Error t-statistic Prob.

MARKET_CAP(-1) -0.262174 0.040000 -6.554.422 0.0000 LOG_GDP_PER_CAPITA 0.150305 0.062389 2.409.163 0.0169 CAPITAL_FLOWS 1.321.721 0.456165 2.897.465 0.0042 CREDIT_PRIVATE_SECTOR 0.356906 0.104968 3.400.148 0.0008 VALUE_TRADED 0.797156 0.043618 1.827.602 0.0000 CREDIT2 -0.207579 0.056539 -3.671.432 0.0003 REAL_INTEREST -0.497168 0.128995 -3.854.155 0.0002

Dependent variable Market_cap

Variable Coefficient Std. Error t-statistic Prob.

MARKET_CAP(-1) -0.069004 0.069032 -0.999592 0.3190 LOG_GDP_PER_CAPITA 0.322968 0.263279 1.226.717 0.2217 INVESTMENTS -0.928055 1.441.543 -0.643793 0.5206 CREDIT_PRIVATE_SECTOR -1.064.572 2.786.100 -0.382101 0.7029 VALUE_TRADED 0.594175 0.744466 0.798122 0.4259 CREDIT2 0.536348 1.266.231 0.423578 0.6724 CPI 0.856771 0.894763 0.957539 0.3397 POLITICAL_STABILITY 0.208966 0.632464 0.330401 0.7415

28 The model finds changes in the effects of macroeconomic factors. Of the determinants, only the lagged market capitalization and value traded influences stock market development positively. The effects of both determinants are not significant. Inflation also affects the model negatively and that influence is not significant. Political stability however, does not affect the model significantly.

As political stability does not provide insight into how certain aspects of the institutional policies -which lead to political stability- affect stock market development. Next, the effects of specific political institutions on stock market development in emerging countries are studied. The model finds that law has no significant influence on stock market development.

The next model investigates the impact of democratic accountability on stock market development. Democratic accountability is the method in which stakeholders provide feedback to incentivize officials in charge of setting public policies. In contrast with law, democratic accountability impacts stock market development significantly and positively. Unfortunately, only value traded and democratic accountability significantly affect stock market development. The results are shown in table 8.

Table 8

In table 9 the effects of the law on stock market development are shown. The rule of law captures perceptions of the extent to which agents have confidence and abide by the rules of society (World Bank, 2013). World Bank uses some indicators to determine the rule of law levels, such as absence of corruption, government powers constraint, open government security, civil justice and criminal justice. The

implementation of rule of law into the model changes the effects of the

Dependent variable Market_cap

Variable Coefficient Std. Error t-statistic Prob.

MARKET_CAP(-1) -0.056744 0.047650 -1.190.854 0.2354 LOG_GDP_PER_CAPITA 0.063038 0.167630 0.376057 0.7074 INVESTMENTS -0.208205 0.894396 -0.232788 0.8162 CREDIT_PRIVATE_SECTOR 0.726980 1.588.798 0.457566 0.6479 VALUE_TRADED 0.609437 0.234959 2.593.799 0.0103 CREDIT2 -0.292980 0.777088 -0.377023 0.7066 CPI -0.046336 0.724060 -0.063995 0.9491 DEMOCRATIC_ACCOUNTABILIT 1.061.076 0.130673 8.120.072 0.0000

29 macroeconomic determinants as a whole. Although the lagged market capitalization still affects stock market development negatively, other variables such as

investments, bank sector development and value traded are shown to be insignificant in the estimation. Only income levels and inflation influence stock market growth significantly.

The results also show that the rule of law on aggregate has no significant effects on the stock markets of the investigated countries in Africa, Asia, Eastern Europe and South America.

Table 9

In the last estimation, the influence of corruption is examined. As projected in table 10, corruption has an insignificant effect on stock market development. The expectation was that corruption would have a negative effect. While the model finds similar results to the hypothesis, the effect of this corruption is not significant in determining stock market development.

Table 10

Dependent variable Market_cap

Variable Coefficient Std. Error t-statistic Prob.

MARKET_CAP(-1) -0.133716 0.065233 -2.049.809 0.0419 LOG_GDP_PER_CAPITA 0.363059 0.134110 2.707.163 0.0075 INVESTMENTS -0.380824 1.284.801 -0.296407 0.7673 CREDIT_PRIVATE_SECTOR 1.292.292 3.908.502 0.330636 0.7413 VALUE_TRADED 0.600005 0.526006 1.140.682 0.2556 CREDIT2 -0.568015 1.820.441 -0.312020 0.7554 CPI 1.662.586 0.678166 2.451.591 0.0153 LAW -3.195.224 5.362.838 -0.595808 0.5521

Dependent variable Market_cap

Variable Coefficient Std. Error t-statistic Prob.

MARKET_CAP(-1) 0.066628 0.066057 1.008.638 0.3147 LOG_GDP_PER_CAPITA -0.147409 0.170413 -0.865013 0.3884 INVESTMENTS 0.736904 0.580127 1.270.246 0.2059 CREDIT_PRIVATE_SECTOR 0.921285 1.889.118 0.487680 0.6265 VALUE_TRADED 0.776715 0.095933 8.096.470 0.0000 CREDIT2 -0.199764 0.847793 -0.235629 0.8140 CPI -2.121.044 0.603936 -3.512.033 0.0006 CORRUPTION -0.245789 0.129607 -1.896.413 0.0598

30

9. Summary and conclusion

The Generalized Method of Moments investigated the effects of macroeconomic determinants of 22 countries from Africa, Asia, Eastern Europe and South America. The empirical study finds that the stock market liquidity, private capital flows and the bank sector development have a positive effect in determining stock market development. Contrary to previous research, this study finds domestic investments and lagged market capitalization to have a negative effect on stock market development in emerging markets. The GMM estimation finds that the bank sector tends to develop with the stock market in the early stages of growth. This is similar to findings by Demirguc-Kunt & Levine (1996). These findings mean that bank sector is a possible complement to the stock market. The positive effects of bank sector development diminish with greater size of the bank sector. The model also finds that democratic accountability is an important determinant of stock market development in emerging markets. These results confirm outcomes from previous studies by Yartey (2008) and Garcia & Liu (1999). Also similar to previous research, the financial intermediary development has a positive impact on stock market growth. The research also shows that economic growth is vital in stock market development. This can have large consequences for governmental policies in emerging countries. Policy makers can implement procedures that promote the banking sector, which in the early stages of growth is a complementary instead of a substitute for the stock market. The prime difference compared to previous research, is that the base model shown in table 1, finds that income levels do not impact stock market development in emerging markets significantly. This changes when the statistical significance level α=0.10. Then the income levels per capita do affect stock market development significantly. Domestic investments tend to have a negative effect on stock markets of emerging countries.

The improvement of stock market liquidity in emerging markets is another way to promote stock market development. The value of stock traded in emerging stock markets has a positive effect on stock market growth.

In aggregate, the GMM estimation finds political stability insignificant in stock market development in emerging markets. While previous studies show that established institutions reduce political risk, this study finds that most institutional

31 quality in emerging market are insignificant to their stock market development. Only democratic accountability has a significant effect on stock market development, which suggests that a system where decision makers are held responsible for their policies, promotes stock market growth in emerging markets. The results also suggest that the other institutional quality in emerging markets do not affect stock market development significantly. This contradicts previous research results found by Yartey (2008) and Garcia & Liu (1999). To find the cause of these contradictions, further research is required. Additional data is necessary to find the cause of the problems arising with the addition of political stability factors and a broader spectrum of countries is necessary to find a definitive cause for the contradictory results of lagged market capitalization and investments.

32

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