Stock Market Development and Economic Growth in
Changing Institutional Environment:
A Case Study of China
University of Groningen
Faculty of Management and Organization
Supervisor : Niels Hermes Student : Shuo Chen
E-mail : chenshuo920@hotmail.com Student Number : 1624857
Abstract
This thesis empirically analyses the impacts of a changing institutional environment on the link between Chinese stock market development and the economic growth from January 1999 to December 2007. A number of important regulations and their impacts are reviewed and analysed, in order to find out whether the development of institutional framework can make the stock market more contributive to economy, this thesis investigates the relation between the stock market development and economic growth before and after the some important regulatory changes. The main finding is that, during the period from 1999 to 2007, Chinese stock market development is negatively related to economic growth. Regulatory changes could neither make the stock market more contributive to economic growth nor strengthen the linkage between them.
Table of Content
• Introduction ...4
• Section I: Chinese stock market and the changing institutional environment...7
• Section II: Theories: A Literature review ...18
• Section III: Methodology and Data Collection...31
• Section IV: Results...42
• Section V: Findings and Discussion...66
• Section VI: Conclusion...69
• Acknowledgement...70
• References...71
Introduction
The relation between stock market developments and economic growth is a popular issue in academic world, vast literatures and arguments have been presented to explain the influences of the functions of stock market on economic growth. Some researchers believe that stock market development can contribute to the economic growth in three general aspects. Firstly, well functioning stock market with sufficient liquidity can facilitate the growth of productivity by enhancing investment and
helping resource allocation. Secondly, it can, for example, reduce the agency cost thus promotes corporate governance, which will improve efficiency of organization and productivity of the companies. Thirdly, the growth of stock market can not only increase the income of individuals, but also enhance the consumers’ confidence of future economy, which leads to the increase of consumption demand. Since consumption is the purpose of all productions (Smith, 1776), the increase of
consumption demand will stimulate the promotion of productivity. But disagreements argue that stock markets maybe not as contributive as expected. Some studies
indicated that the growth of stock market didn't have much effect on the consumer spending. Some studies argue that even when the stock market is perfectly efficient, the effects of stock market on resource allocation are limited, since the investment decision of investors can not directly affect the usage of resources in the listed companies. The impact of stock market on corporate governance is doubted by researchers since empirical evidence shows that stock market can not efficiently reduce agency-cost. Although the theoretical disagreements still exist, most empirical analyses indicate that the stock market is, more or less, related to the economic
growth. Some evidences also suggest that the link between stock market and economic growth is weaker in the developing economies than in developed economies, which imply that the relations between stock market development and economic growth may vary under different contexts. (Harris (1997), Filer, Hanousek and Compos (2000), et al)
countries may be strengthened by reforming the institutions and regulations of the stock market (Dailami and Atkin,1990, Henry, 2000 et al). Researchers believe that stock market liberalization can not only increase the liquidity of the market, but also lower the cost of equity capital, which will strengthen the role of stock market in facilitating investment. Some researchers show that regulations concerning
information transparency can not only enhance the confidence of investors, but also improve the price formation of the stock market. Policies concerning turnover tax are also considered very important in the sense of the effects on the volume of trades in the stock market. Since it can directly influence the transaction cost of investors, a proper arrangement of turnover tax may improve the liquidity of stock markets. Although literatures indicate that the institutional reform on stock market may
strengthen the link between stock market development and economic growth, this idea has never been empirically proved.
As a complement of existing literatures, this thesis will empirically analyse the relation between stock market development and economic growth in a developing country under the context of a changing institutional environment to provide evidence of the influences of stock market regulatory changes on the link between stock market and economic growth. In order to analyse the impacts of stock market regulatory changes, this study will access a stock market which is operating in a changing institutional environment, and respectively investigate the relations between stock market development and economic growth before and after the publication of certain policies. This thesis selects Chinese stock market as the case to study because, within the period from 1999 to 2007, a number of policies had been published to improve the functions of the stock market, and Chinese stock market is believed to be more
contributive to economic growth after the regulatory changes. The situation in China provides a context to analyse the impacts of regulatory changes on the relation between stock market development and economic growth.
more contributive to the economic growth, or at least the link between them should be stronger. In order to study the impacts of stock market regulatory changes on the relation between stock market development and economic growth, this thesis raise the research question did Chinese stock market development contribute to the economic growth in the changing institutional environment? If Chinese stock market
contributed to economic growth, stock market development must be positively related with the economic growth, and stock market development can be considered as one of the reasons of economic growth. The changing institutional environment is a factor which may influence the relation between stock market development and economic growth in China. Therefore this research question can be answered by exploring the following sub-questions. 1st Was Chinese stock market development positive related with economic growth? 2nd Did Chinese stock market development cause its economic growth? 3rd What was the impacts of the regulatory changes on the relation between
stock market development and economic growth? To answer the first sub-question,
this thesis will apply a regression test to investigate the correlation between stock market development and economic growth. To answer the second sub-question, causality test will be applied to find out whether the stock market development is the causation of economic growth in China. To answer the third sub-question, the regression and causality test will be applied respectively before and after the regulatory changes.
Section I: Chinese stock market and the changing institutional environment This section is to discuss the impacts of the institutional changes in Chinese stock market. In order to make it clear for all readers, the development of the framework of Chinese financial system will be introduced first. Information concerning the
development of Chinese financial system is collected from the official web site of the central bank of China and the study of Chinese financial system presented by Allen, Qian.J and Qian.M (2005). Information about Chinese stock market regulations are collected from the officially web site of China Securities Regulatory Commission.
One of the main functions of financial system is to facilitate the allocation of resource, across space and time (Merton and Bodie, 1995). From 1949 to 1978, under the
context of central plan economy, the function of the Chinese financial system was centralized in one single bank, People’s Bank of China (PBOC), which was owned by the Ministry of Finance of the central government of China. It served as not only a central bank but also a commercial bank which controlled more than 90% of the total financial assets of the country. After The Third Plenary Session of the 11th CPC1 Central Committee, the government established the open of economy and the
marketization as a long term goal of the economic reform. Since then, the structure of the financial system started to change step by step.
-Banking Sector
In the banking sector, the first stage of the change was between 1978 and 1984. In 1978, PBOC departed from the Ministry of Finance, and became an independent entity as the central bank of China to manage the monetary policy. Its commercial transactions were taken over by four state-own commercial banks, Bank of China (BOC), People’s Construction Bank of China (PCBC), Industrial and Commercial Bank of China (ICBC) and Agriculture Bank of China (ABC). Though they are independent entities, the four state-owned banks could not operate like the regular commercial banks, because they had to support financing the state-owned enterprises or projects, which used to be a function of PBOC. In mid-1980s, under the
supervision of ABC, the Rural Credit Cooperatives was set up to serve in the rural area in China. Meanwhile, some non-banking financial institutions emerged, for
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example, trust companies. The second stage of the development of banking sector started in 1992, followed the theme of deregulation and privatization of economy, private commercial banks and FDI in banking sectors began to emerge in coastal areas in China. In 1994, three policy banks were founded under the supervision of PBOC, to support financing some of the state-owned enterprises and projects in order to release the burden of the four state-owned banks, and enable them to operate as regular commercial banks. In mid 1990s, some medium sized commercial banks listed their shares in the stock exchanges. After China joint WTO, three of the four most important state-owned commercial banks issued stocks in the stock exchange in Shanghai, Shenzhen and Hong Kong. Until December 2007, there are seventeen financial institutions which operate as commercial banks, ten of which had listed their shares in stock market. Three policy banks operate as investment departments of the central government. More than 100 foreign banks setup offices or branches in China.
-Insurance Sector
Insurance sector is also an important component of the financial system, but Chinese insurance sector did not revival until 1980s. Before 1982, there was only one
insurance company in China. However the whole industry had experienced great development since 1990s. Until now there are nine domestic insurance companies, branches of nine foreign insurance companies, and four joint venture insurance companies operating in China. In the beginning of 1990s, Insurance Regulation Commission (CIRC) and PBOC believed that since the institutional framework of stock market was immature, therefore insurance sector and banking sector were restricted to invest in the stock market, in order to control the risks of insurance and banking sectors.
-Stock Market Institutions
which were the major contributors of the economic growth. By assigning the top managers of the (SOEs), Chinese government effectively controls the operation of the SOEs, which also enabled the government to control the development of the country’s economy. Although the government allowed companies to issue equities in the stock exchange, they worried that the stock market may damage its control of the economy, by diffusing its ownership in SOEs. In order to maintain the control of SOEs, the government compelled the listed companies to split their shares into non-tradable shares and tradable shares when they initial public offer (IPO) the shares in primary market. More than half of total shares are non-tradable shares, which must be held by state-owned entities, and are not allowed to be traded in the secondary market. The price non-tradable shares were fixed when they were issued. The rest of the shares are tradable shares, which will go into the secondary market and be traded publicly. Since it is difficult for the holders of tradable shares to gather enough votes against the decisions which are made by the holder of non-tradable shares, public investors could hardly influence the decision of corporate governance, therefore government could maintain the control of SOEs. A number of studies were presented to criticize this regulation. Since the majority part of shares is non-tradable, take-overs in Chinese stock market were restricted. Because the stock price in the stock exchange only shows the prices of tradable-shares, it brings difficulties for the valuation of the list companies (Zhang, 2004 and Wu, 2006). Since the market of tradable shares is relatively smaller in size, the share prices will be more volatile when there is
excessive speculation in the stock market (Li, 2005). In order to prevent the price of tradable shares from being over-volatile, in December 1996, CSRC permitted the two stock exchanges in Shanghai and Shenzhen to set thresholds on daily price movement. As a result, stock prices will neither rise more than 10% nor fall lower than -10% compare with the previous trading day.
-Stock Market Regulatory Changes from 1999 to 2007
supports, the following policies and regulations are considered more efficient in improving the operation of the market.
In October 1999, the CIRC permitted the insurance sector to have a few proportion of investment in the stock market indirectly. According to this policy, insurance
companies were allowed to use no more than 5% of their total assets to invest in stock market or other equity portfolio through mutual funds or other legal financial
institutions. August 2000, 8 insurance companies got the permission from CIRC to increase their investment in the stock market to 10% of their total assets, and two months later, CIRC further loosened the limitation to 15%. In February 2005, CSRC and CIRC permitted the insurance companies to use no more than 20% of their total assts directly investing in stock market. Yang (2006) believes that investment in the stock market can effectively diversify the portfolios of insurance companies. The entree of capitals from insurance companies may contribute to the market liquidity by increasing the total value of trade in the stock market. Liu and Bo (2000) suggest that that the entree of the capitals of insurance companies could reduce the market
volatility, since the insurance companies are risk-adverse investors and they intend to make more long term investments.
CSRC had noticed the disadvantages of the split-share structure of stock market before 1999, and it attempted to “release” some of the non-tradable shares of SOEs in June 2001. But this programme was called-off in June 2002 by the central government, because there were disagreements in pricing the non-tradable shares. Most of the holders of non-tradable shares want to sell their shares in the price of tradable shares, because the prices of tradable shares were higher than non-tradable shares. However the public investors argued that the risk of non-tradable shares is much lower than the risk of tradable shares, since the price of non-tradable shares are fixed. It is not fair for the holders of tradable shares if the non-tradable shares are sold at the price of
tradable shares, since the holders of tradable shares bear more risks than the holders of non-tradable shares do. The pricing problem was not solved until the publication of the pricing method of non-tradable shares of SOEs in December 2003. According to this “method”, the valuation of the non-tradable-shares in SOEs will be based on the profitability of the companies. In 2004, the government of China published Some
government document, aimed at increasing the liquidity of the stock market,
improving the corporate governance of listed companies and the efficiency of Chinese stock market, was the first official document that showed the attitude of the
government towards this issue, and it authorised and permitted CSRC to restart its programme of capital structural reform on Chinese stock market. In April 2005, one year after the publication of the “nine-chapters’ comment”, CSRC activated its programme to “release” the non-tradable shares company by company. A report presented by the research department of Shenzhen Stock exchange (2006) shows that the reform of the split-share structure will improve the stock price formation, since the reform asks for the re-valuation of listed companies. Wu (2006) believes that the diminishing non-tradable shares revives the function of merger and acquisition of the stock market, and partially returns the rights of corporate governance to public investors.
Since the audit system and accounting system in China was underdeveloped, financial information of listed companies can not be effectively disclosed, the activities of listed companies can not be sufficiently monitored and supervised. In August 2001, the revelation of the first and one of the biggest frauds (Yinguangxia 000557)2 got the regulator’s attention to the importance of information disclosure. In December 2001, CSRC published a regulation which aimed at introducing the foreign accounting and auditing firms into Chinese stock market to provide the annual external audit reports of listed companies and the audit report before the IPO of companies. In May 2002, CSRC activated a programme to re-examine the quality of the information which was published in the financial reports of list companies. In this programme, the external auditors were all hired by CSRC, and their audit reports were only available for CSRC. CSRC believed that by hiring the external audits by itself, it can prevent the audits and the listed companies from getting “too close”, thus to obtain more accurate information. In order to monitor the insider-trades, in December 2002, CSRC
published a policy to compel the listed companies to disclose and update the information of the dominant shareholders. In March 2003, CSRC enhanced the
punishment of under-performing companies. According to the new policy, if the listed
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company has been operating at a loss for continuous 3 yeas, the trading of its stock will be suspended. If the company still suffers from loss in the fourth year, it will be banned to list its shares in the stock exchange. In September 2003, the CSRC published a regulation to raise the listing requirement of the stock market. The new policy stated that if the companies intend to issue stocks in the exchange, they need to reach a stricter requirement of profitability and information disclosure. At the end of 2003 and the beginning of 2004, another two policies which aim at improving information transparency were published. In December 2003, CSRC increase the requirement for external audit firms to get the certificate to provide services on the IPO of companies. One month later, the publication of the new policy authorised the qualified external audit more power to access the financial information of list
companies. According to the CSRC, regulations which enhance the information disclosure of Chinese stock market can improve price formation of the market and protect the interest of public investors. Impacts of these policies were significant. In a press conference in 2002, CSRC showed that 166 listed companies whose financial reports could not reach the new requirement of information exposure were punished or sued. In another press conference in June 2003, Shang (president of CSRC) believed that information transparency of Chinese stock market had been effectively promoted, and CSRC would continue working on how to improve the market efficiency and protect the interest of all investors.
The Qualified Foreign Institutional Investors (QFII) is a regulatory regime of stepwise liberalization of Chinese stock market. The activation of QFII in May 2003 shows that China began to allow for foreign investors to make investment in Chinese stock market. According to CSRC and State Administration of Foreign Exchange (SAFE), qualified foreign institutional investors are allowed to purchase a certain amount of RMB3 and invest in domestic stock market. From May 2003 to December 2007, there are 49 institutional investors who had received the qualification to invest in Chinese stock market, and the total amount of initial investment is 9.95 billion USD.
Within the period from 1999 to 2007, for three times, CSRC used the policies to directly influence the transaction costs of public investors. In April 2002, CSRC setup
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a limitation of transaction fee that was charged by brokers. According to this
regulation, brokers were not allowed to charge more than 3‰ of each order. January 2005, CSRC cut the stamp tax (turnover tax) from 3‰ to 1‰, which significantly reduces the transaction cost for all investors. However, at the end of May 2007, CSRC sharply raised the stamp tax back to 3‰. According to CSRC, by cutting down the transaction fee and the stamp tax, it reduced the transaction cost of the investors thus to maintain the market liquidity effectively, by increasing the stamp tax, it effectively controlled the excessive speculation in the stock market.
According to the discussion above, from 1999 to 2007, regulations of Chinese stock market mostly referred to six dimensions.
- Facilitating the cross-sector capital flow. - Reforming the split-share structure. - Improving the information transparency - Raising the requirement for issuing shares - Stock market liberalization.
- Transaction cost adjustment.
Figure.1 Capitalization (100 million RMB) 0 50000 100000 150000 200000 250000 300000 350000 99 00 01 02 03 04 05 06 07 Capitalization
(Source: official website of CSRC http://www.csrc.gov.cn/)
Figure.2 Total Value of Trade (100 million RMB)
0 10000 20000 30000 40000 50000 60000 99 00 01 02 03 04 05 06 07 Total Value of Trade
(Source: official website of CSRC http://www.csrc.gov.cn/)
Figure.3 Shanghai Composite Index
1000 2000 3000 4000 5000 6000 99 00 01 02 03 04 05 06 07 Shanghai Composite Index
Table.1 Summary of the Regulatory Changes
Time Brief Content Volume
of Trades
Price
Index Capitalization Dimension
Jul 1999 Law of Securities of P.R China - - Legislation framework.
Oct 1999 Permission of insurance sector to
indirectly invest in stock market + + +
Facilitating the cross-sector capital flow
Aug 2000
Permission of insurance sector to increase the investment in stock market
to 10% of its total assets
+ + + Facilitating the cross-sector
capital flow
Oct 2000
Permission of insurance sector to increase the investment in stock market
to 15% of its total assets
+ + + Facilitating the cross-sector
capital flow
June 2001 Sell-offs of the state-hold shares of
SMEs - - -
Reform of the split-share structure
Dec 2001
Introducing of foreign auditing and accounting firms into Chinese stock
market.
- - Improving the information
transparency
Apr 2002 Setting up the limitation of transaction
fee to 3‰ + + + Transaction cost adjustment
May 2002 Re-examination of financial information of listed companies
Improving the information transparency Jun 2002 Pausing of the sell-offs of the state-hold
shares of SMEs + + +
Reforming the split-share structure
Dec 2002 Compulsory disclosure of information about dominant shareholders
Improving the information transparency Mar 2003 Method of punishment of
under-performing listed companies
Raising the requirement for issuing shares
May 2003 The activation of QFII Stock market liberalization
Sep 2003 Raising of listing requirement of stock
exchanges + +
Dec 2003 Pricing method of non-tradable shares + + Reforming the split-share structure
Dec 2003 Raising of the requirement on the
qualification of audit firms + +
Improving the information transparency
Jan 2004
Qualified audit firms gain more power to access the financial information of
listed companies
+ + + Improving the information
transparency
Jan 2004 Some Comments to the Development
and Reform of Capital Market + + +
Reforming the split-share structure
Jan 2005 Cutting of stamp tax to 1‰ + + + Transaction cost adjustment
Feb 2005
Permission of insurance sector to directly invest in stock market, and increase the investment to 20% of its
total assets
+ + + Facilitating the cross-sector
capital flow
Apr 2005 Launch of the capital structural reform
programme + + +
Reforming the split-share structure
May 2007 Increase of stamp tax to 3‰ - - Transaction cost adjustment
In the discussion above, all regulatory changes have influences on Chinese stock market, but literatures show that some regulations may affect the development of stock market more than others do. Some studies indicate that the regulations which facilitate stock market liberalization and improve the price formation can significantly contribute to the increase of size and liquidity of stock market. Dailami and Atkin (1990, p26) believed that under lax listing requirements, the performance information of listed companies cannot be fully disclosed, which associates with improper
valuation of listed companies. Without an open and fair price formation, investors will not be confident to trade in the market, thus the liquidity of stock market will be difficult to be maintained, which threatens the future growth of the market. The authors believe that stock market regulations which enhance the information
transparency of the stock market and raise listing requirements can improve the price formation of the stock market. Henry (2000) and Jain-Chandra (2002) address the positive impacts of market liberalization. The author shows that in the international asset pricing models (IAPMs), cost of equity capital will be reduced if the country allows foreign investors to purchase shares in domestic stock market, since the risks will be shared by domestic and foreign agents. With a lower cost of equity capital companies can issue equities cheaper, hence the capitalization of stock market in developing countries will be improved. Stiglitz (1989), Hu and Shi (2000) show that policy which adjusts turnover tax directly affects the transaction cost of investors. Stock market needs turnover tax in order to control the excessive speculation, and reduce the price volatility. And stock market also needs the rate of turnover tax to be low in order to maintain the volume of transaction of the stock market. The
implication is that the turnover tax should be not too high in order to maintain the liquidity, and not to low to reduce excessive speculation. Since the regulations and policies which are mentioned above significantly influence the liquidity, size and price formation of the stock market, they are considered crucial in the development of the stock market in developing countries.
it is difficult to separately analyse the impact of one single regulation on the stock market, which implies that it is difficult to split up the whole period only based on one single regulation or policy. However, Table.1 shows that most important regulations on Chinese stock market, which directly related to stock market liberalization, information transparency and listing requirements, were published in the middle of and later the period between 1999 and 2007. Regulations concerning improving the information transparency were published between December 2001 and January 2004. The stock market liberalization regime, QFII, did not come into force until May 2003. Regulations which aim at raising the requirements for issuing shares were published in May and September 2003. The turnover tax was adjusted twice in January 2005 and May 2007. Since the reform of split-share structure asks for re-valuation of listed companies, it can also improve the price formation of shares. Although CSRC had attempted to start the reform the in 2001, the pricing method of non-tradable shares was not published until May 2003, which implies that before 2003 the reform did not contribute to price formation since there was no official pricing method. The
discussion above indicates that most of the crucial regulations of Chinese stock market were published after December 2002. And the most important regulations concerning stock market liberalization and price formation are all published in 2003. Therefore Chinese stock market is expected to be better functioning after mid-2003 than it does before. Therefore the period (from 1999 to 2007) will be broken down in June 2003. Then we have Period.1 (January 1999 – June 2003) and Period.2 (July 2003 – December 2007). The link between stock market development and economic growth should be stronger in Period.2 than it does in period.1.
Section II: Theory: a literature review
Theory of this thesis refers to the literatures on two issues. The first one is whether the functions of stock market contribute to economic growth. The second one is how the regulatory changes affect the functions of stock market.
- Stock Market Development and Economic Growth
The roles of financial system and stock market in the economies have been argued by vast literatures. Hicks (1969) shows that well functioning financial system will boost the industrialization by facilitating the mobilization of capitals. Schumpeter (1912) shows that the banking sector can stimulate the innovation of technologies by
or with better implementation of new production processes. However, Lucas (1988) believe that financial system does not directly participate in production, but only provides services which may promote the productivity of firms, therefore existing literatures might over-stress the role of financial system in the economy.
Studies concerning the relation between stock market development and economic growth provide arguments on three issues. The first issue is whether a stock market can contribute to economic growth by enhancing investments and promoting resource allocation. Bencivenga, Smith, Starr (1994, 1995) show that stock market with low transaction cost and sufficient liquidity can facilitate long term investments. Since investors or savers are unlikely to give up the access to their savings or investments for long period while some profitable projects need large amounts of capital resource for a long term, it is difficult for firms to finance their long term projects. In a stock market with low transaction cost and sufficient liquidity, firms can have capital of permanent use by issuing equities in the market, while investors can have more liquid assets which allow them to buy or sell quickly and cheaply, hence, long term
investments are facilitated by stock market. King and Levine (1993) believe that security markets can promote the resource allocation and spur the technology innovations. Efficient security market can evaluate and monitor the perspective entrepreneurs who have innovative projects and reveal the rewards (profits) of those projects. With the information which is disclose by the security market, investors can choose the most promising ones to invest. Thus the best performance firms will have enough capital resource to carry on their technological innovation projects. Hence, resource allocation is promoted and technology innovations are boosted. However, DeLong (1991) and Ferderer (1993) argue that the excessive speculation in a stock market may increase the price volatility which makes investors feel uncertain. Since the uncertainty will harm the confidence of investors, investments will be hindered. Dow and Gorton (1997) argue that although investors can choose the best performing companies with profitable projects to invest based on the information which is
market is efficient (stock price content all known information and reflect the collective attitude of all investors about the future prospects of the firm), capital resource may not be used effectively, hence the effectiveness of stock market on resource allocation is limited.
The second issue is whether a well functioning stock market can improve the
corporate governance of listed companies, which can improve the productivity of the companies. One of the most important issues of corporate governance is how to reduce the agency cost. Jensen, Meckling (1976) and Barney, Dwayne (1994) show that agency cost exists because of different interests between shareholders and managers due to the separation of ownership and control, however the managerial ownership, for example stock options, can be used to align the interest of shareholders and executives to reduce agency cost. Jensen (1986) show that if there are too much free cash flow in the firm, the usage of this resources may be inefficient, because the interests of mangers and investors are different. And this problem is called agency cost of free cash flow. One solution to this problem is to reduce the free cash flow in the firm by generating debt. The author shows that debts can be generated in leverage buyout (borrow money to take-over target firms). Takeovers are facilitated by well functioning stock markets, because a well functioning stock market reduces the cost of information acquiring and the cost of transactions, it can help to reduce the agency cost of free cash flow and improve the efficiency of the usage of resources in firms. Some literatures show that liquid stock market can better monitor the performance of the listed companies. Kyle (1985) shows that in stock trading, informed traders and insiders give orders based on their private information while noise traders(traders without private information) give orders randomly, then market makers will quote a price which can combine the order of informed traders and noise traders. So the price which is quote by market makers contains the private information about the
performance of the firms, which is attached in the order of informed traders.
Holmstrom and Tirole (1993) show that it will be easier for informed traders to make money with their private information when there are more noise traders. By assuming that the number of noise traders will increase when the market liquidity increases, the authors believe that informed traders will spend more time to monitor the
performance of firms in more liquid stock markets, thus more performance
for structuring managerial contract to align the incentive of managers with the performance of the firm, therefore in a more liquid stock market, performance of listed companies will be better monitored, which helps to design more efficient managerial contracts. However some literatures indicate disagreements. Bhide (1991) argues that a liquid and efficient stock market enables investors to sell their shares quickly and cheaply, which facilitate the diffusion of ownership. Because the diffused shareholders face a problem of collective actions, also because performance of
managers can not be effectively evaluated without active inside shareholders, thus the corporate control will be influenced. Jensen and Murphy (1990) argue that although the stock ownership can align the managerial incentive with the interests of
shareholders, most managers hold only a small fraction of their firms’ stock, thus the managers compensation is not very sensitive to the performance of firms. This conclusion implies that the existing stock ownership compensations could not
successfully link the income of CEO with the performance of firms, thus agency cost can not be effectively reduced.
The final issue is that whether the growth of stock market can contribute to the growth of economies by increasing consumer consumptions. Poterba (2000) believed that the rising stock price would not only increase the investors’ income, but also enhance their confidence of the future economy. Because of the wealth effect4, the households who gain disposable income from the stock exchange tends to increase their
consumptions. Since the consumption is the purpose of productions, (Smith, 1776) effective demand of consumption may stimulate the increase of investment and the improvement of productivity. (Keynes, 1936) However, Starr (1998) argued that most households will not change their spending behaviour in response to the stock market growth, because they are uncertain about their future income and they will also worry about the possible decline of the stock market in the next year. Therefore the effect of the stock market in promoting consumption demand is doubted.
Discussions above indicate that stock market can contribute to economic growth because it has following functions. First of all, well functioning stock market
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facilitates investments by reducing the cost for issuing and transferring equity and providing more liquid assets to investors. Secondly, it can provide performance information which can be used to monitor the performance of firms and to guide the allocation of resources. Finally, stock market growth may increase consumer
consumptions. Although some studies show that there maybe difficulties for stock markets to have much influence on economic growth, most researchers still believe that the well functioning stock market have positive effects on long term investments, resource allocation and corporate governance. Some studies show that by reforming the stock market institutions, the functions of stock market in enhancing long term investments, improving resource allocation and promoting corporate governance can be strengthened.
- Institutional reform and the functions of stock market
Literatures show that stock market regulatory changes, which were mentioned in preceding section, will significantly affect the functions of the stock market.
Bekaert, Harvey, Lundblad (2000, 2005) and Henry (2000) show that stock market liberalization can reduce the cost of equity capitals because the risks will be shared by domestic and foreign agents. The reduction in a country's cost of equity capital will transform some investment projects which had a negative net present value (NPV) before liberalization into positive NPV after liberalization, which will encourage more investments. Bekaert, Harvey and Christian also show that capital market
liberalization will reduce the financial constrains of emerging markets, because the foreign investors may insist on better corporate governance. Although foreign
speculators may increase volatility of emerging capital markets after the liberalization, they can contribute to the increase of market liquidity, which spurs the growth of the market. Therefore the stock market liberalization can not only strengthen the function of stock market in facilitating investments, but also improving the corporate
governance and increasing market liquidity.
and Xu (2003) suggest improving information transparency by raising the requirement for certification of audit firms and disclosure requirements of listing companies. Since the audit system and accounting system are underdeveloped in developing countries, listed companies may increase their profit in books by account manipulations. Raising the requirement for the certification of audit firms, for example, raising the
requirements of educational level for professionals in auditing firms, can improve ability of auditing firms to discover the cheating behaviour of listed companies. Raising the disclosure requirements for listed companies, may increase the
performance information content in financial reports of firms. For example, requiring the listed companies to publish in formation about dominant shareholders can indicate the transaction of inside shareholders, and the behaviour of insiders may imply some performance information of the firm which can not be extracted from the current profit data. Since the listed companies are forced to publish more information by regulations, the cost for investors to acquire information will be reduced. In China, the stock price formation is also related to the issue of slit-share structure. By reforming the capital structure, more and more non-tradable shares will be sold and become tradable. Since the reform asks for the re-valuation of listed companies in order to pricing the non-tradable shares, more information will flow into the share prices (Wu, 2006). With more performance information, investors will be more confident to trade, thus liquidity will increase. And stock market can better allocate the capital resource and improve corporate governance with the performance information.
Policy concerning the adjustment of turnover tax can also improve the function of stock market in facilitating investments (Hu and Shi (2000), Stiglitz (1989), et al). The discussions of the relation between stock market development and economic growth show that more liquid stock markets with low transaction cost can facilitate long term investments5. The reduction of the turn tax can reduce the transaction cost of investors, which will increase the volume of trades in the stock market. In this point of view, low transaction tax can spur long term investments. However, if the transaction tax is too low, speculations behaviour will increase. Although speculators can improve the information content in stock price, excessive speculation can increase the price volatility of stock markets, which may hinder investments. Therefore, in
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order to curb excessive speculations, the turnover tax can not be too low. The implication is that turnover tax should be low enough to maintain a low transaction cost, but high enough to reduce price volatility. Although the literatures did not indicate what rate is “proper” for the development of stock market, most researchers agree that policy concerning turnover tax is very important for the stock markets in both developed countries and developing countries, in the sense of maintaining liquidity and reducing price volatility.
Discussions above indicate that the impacts of regulatory changes can reduce the cost for issuing and transferring equity, increase market liquidity, enhance information transparency and control the excessive speculations. When these regulatory changes come into force, the role of emerging stock market in promoting productivity, which spurs economic growth, will be strengthened, thus the link between stock market development and economic growth is expected to be stronger.
- Empirical Evidence
Theories concerning the relation between stock market development and economic growth are supported by many empirical evidences. Various econometric tools were applied in the empirical analyses. Atje and Jovanovic (1993), Levine and
say that the stock market contributes to the economic growth. In order to provide clearer evidences on the relation between stock market development and economic growth in individual countries, Arestis and Demetriades (1997) propose applying time series analysis with cointegration test. In their study, tests are applied to investigate the relation between financial development and economic growth in Germany, US and South Korea, with the measures of stock market capitalization, stock market volatility, M2 and domestic bank credit. The results suggest that the relations between financial development and economic growth are different in these countries. In
Germany, development of banking sector is positive related to long term growth, while the relationship between stock market development and economic growth is weak. In USA, the relation between financial development and economic growth is insignificant. In South Korea, financial development especially the development of banking sector is positively related to economic growth. The Findings of cointegration test not only indicate a clear result of individual country, but also shed lights on the causal relation. Engle and Granger (1987) believe that the cointegration test can prove the existence of causal relation between the two series. However, cointegration test cannot indicate which direction the causality is. In order to find out whether the stock market development is the causation of economic growth, or not, researchers apply causality tests. Tuncer and Alovast (1998) applied the Sims causality test, but the finding does not suggest any conclusive results, stock markets in only a few
developed countries will cause economic growth and no causality is found between stock market development and economic growth in developing countries. Filer, Hanousek and Campos (2000) apply a Granger causality test to analyse the causal relation between stock market and economic growth, the findings show that stock market development does not cause economic growth. Maria, Howell and
In China, Zhu, Wen and Lu (2000), analyzed the macroeconomic statistic data and historical data of stock market from 1994 to 2000. With the stepwise regression and backward regression, the authors show that the size of the stock market is the only significant variable which is positively related to economic growth. Li (2005)
investigated the long-run and short-run linkages between the stock market growth and long-run growth, with the quarterly data of Shanghai Composite Index and the
macroeconomic statistics during the period from January 1992 to June 2005. The result of causality test shows that stock market growth did not cause the economic growth. Zhu and Yan (2006) empirically investigated the relationship between Chinese stock market development and economic growth with the cointegration test. The result suggested that the liquidity and volatility of Chinese stock market had stronger influence on economic growth than the size does. Empirical studies on Chinese stock market suffer from two problems. The first one is about the measure of stock market liquidity. When measuring the stock market liquidity, some Chinese scholars use the ratio of value of trades divided by the value of tradable shares as the turnover rate. However, the calculation of this turnover rate is different from the calculation of turnover rate which is in the studies done by Levine and Zervos(1996), Rousseau and Wachtel (1999), et al (value of trades divided by market capitalization) . Since the market capitalization equals to the sum of the total value of tradable shares and the total value of non-tradable shares, the value of market capitalization is larger than value of tradable shares. One may notice that the way of calculating the turnover rate, which is used by Chinese scholars, has neglected the non-tradable shares, which hinder the increase of market liquidity. Therefore if one use the ratio of the value of
trades divided by market capitalization to calculate the turnover rate in Chinese stock
market, the ratio will be smaller than the turnover rate in existing Chinese studies. Since the factor of non-tradable shares, which have significant influence on liquidity, is neglected, the turnover ratio in the studies on Chinese stock market can not
perfectly measure the liquidity. Another problem in the empirical studies on Chinese stock market refers to data collections. Since some of the data is unavailable, time series analysis concerning Chinese stock market face a problem of insufficient
Although there is no empirical analysis concerning the impacts of the stock market institutional reforms on the relation between stock market development and economic growth, there are some studies which shed lights on the relation between financial liberalization and economic growth. Bekaert, Harvey and Lundblad (2005) apply a cross-country regression to analyse the relation between equity market liberalization and economic growth. The researchers measure the liberalization with an indicator variable. The variable will take the value of one when it is possible for foreign investors to own the equity in the market and zero otherwise. Their findings indicate that equity market liberalization is positively correlated with economic growth. Ben Naceur, Ghazouani and Omran (2007) analyse the relation between equity market liberalization and economic growth in MENA (Middle East and North Africa) region following the method which is used by Bekaert, et al (2005), their findings indicate that financial liberalization is positively related to economic growth, which implies that it is possible to improve the functions of financial system, which will contribute to economic growth, in developing countries by financial institutional reforms.
Table.2
Time Authors Methodology Measures of Stock Market Conclusion
1993 Atje and Jovanovic
Cross-sectional regression with the annual data from 1980-1988 in 39 countries and OLS estimates
Size: Capitalization/GDP Liquidity: Value of trades/GDP
Positively correlated
1996 Levine, Ross and Zervos, Sara
Cross countries regression with the annual data from 1976-1993 in 41 countries
Size: Capitalization/GDP Liquidity: Value of trades/GDP
Value of trades/Capitalization
International Integration: IAPM pricing error
Positively correlated
1997 Arestis, Philip; and Demetriades, Panicos
Cointegration test with the data of Germany, USA and South Korea
Size: Capitalization/GDP
Volatility: Sixteen quarter moving standard deviation
Not significant
1997 Harris, Richard D. F
Cross-sectional regression with the annual data from 1980-1991 in 49 countries and 2SLS estimates. (Samples are separate in to 2 groups developed/less-developed countries)
Liquidity: Value of trades/GDP Positively correlated in
developed countries. Insignificant in less-developed countries. 1998 Gursoy, Cudi Tuncer and Muslumov, Alovsat
Sim causality test with annual data of 20 countries from 1981-1994
Size: Capitalization/GDP Liquidity: Value of trades/GDP
Value of trades/Capitalization No conclusive results. Slightly positively correlated in developing countries 1999 Rousseau, P.L., and P. Wachtel
Vector autoregression of stock market with annual data from 1980-1995 of 47 countries
Size: Capitalization/GDP Liquidity: Value of trades/GDP
Value of trades/Capitalization
Positively correlated
2000 Spyros I. Spyrou Vector autoregression of stock market development and economic growth with the annual data from 1977-1997 in 5 emerging market
Size: Logarithm of market capitalisation Volatility: 12-month rolling standard deviation
of the differences of stock indexes
2000 Randall K. Filer Jan Hanousek and Nauro F. Campos
Granger causality test with the annual data of 70 countries from 1985 to 1997.
Liquidity: Value of trades/Capitalization Size: change in the number of domestic
shares listed
Stock market development did not cause economic growth, but it did cause the appreciation of currency. 2000 Chengzzhong
Zhu, Jiandong Wen and Shichun Lu
Stepwise regression and backward regression with quarter data from 1994 to 2000
Size: Capitalization/GDP
Value of tradable shares/Capitalization
Liquidity: Value of trades/GDP
Value of trades/Tradable shares
Positively correlated Stock market size is the only significant variable.
2002 Andong Zhu, Michael Ash, and Robert Pollin
Replication of Levine and Zervos, Alternative method of outlier control
Size: Capitalization/GDP Liquidity: Value of trades/GDP
Value of trades/Capitalization
International Integration: IAPM pricing
Stock Market liquidity insignificant with economic growth,
2004 Guglielmo Maria, Peter G. A Howell and Alaa M Soliman
Causality test with alternative VAR test which was suggested by (Toda and Yamamoto 1995) with quarter data from 1977-1998 in
7developing countris
Size: Capitalization/GDP Liquidity: Value of trades/GDP
Stock market development cause economic growth 2005 Ben Naceur, Samy and Ghazouani, Samir
GMM (generalized method of moments) estimates of 10 countries in MENA(middle-east and north Africa) region
Size: Capitalization/GDP Liquidity: Value of trades/GDP
Value of trades/Capitalization Negatively correlated 2005 Bekaert, Geert., Harvey, Campbell R. and Lundblad, Christian
Cross-section Regression on the relation between financial liberalization and economic growth with the annul data in 95 countries.
Official Equity Market Liberalization (the political event of financial liberalization)
2005 Li, Zhigang Granger causality test of the relation between Chinese stock market growth (Shanghai
Composite Index) and economic growth with
the quarter data with quarter data from 1992 to 2005
Stock market price: Logarithm of Shanghai
composite index
Stock market would not lead to economic growth.
2006 Zhu, Mengnan and Yan, Jiajia
Cointegration test with the monthly data from 1999 to 2006
Size: Value of tradable shares /GDP Liquidity: Value of trades/GDP
Volatility: 12-month rolling standard deviation
of the differences of stock indexes
liquidity and volatility of Chinese stock market had stronger influence on economic growth than capitalization does 2007 Ben Naceur, Samy., Ghazouani, Samir and Omran, Mohammed.
Cross-section Regression on the relation between financial liberalization and economic growth with the annul data in 10 countries in MENA(middle-east and north Africa) region
Official Equity Market Liberalization (the political event of financial liberalization)
Positively correlated
Section III: Methodology and Data Collection
In order to explore the research question, three issues needs to be studied, first of all, whether the relation between stock market development and economic growth is positive or negative? Secondly, which one is the causation, stock market development or economic growth? Thirdly, can the regulatory changes strengthen the link between stock market development and economic growth? The main research question will be given a positive answer only if the relation between stock market development and economic growth is positive, stock market development is the causation of economic growth and the link between stock market development and economic growth is stronger in period.2 than it is in period.1. The discussion above indicates that we are not only going to look at the sign of the effects of the stock market development, but also compare the size of the effects between period.1 and period.2. Therefore, this thesis will analyse the correlation and causality between stock market development and economic growth. Granger and Newbold (1974) show that linear regression tests in time series analysis may generate results of spurious correlation, which means that results only indicate the mathematical relationship between variables in a certain time period, yet, it can not verify the causal connection or long term equilibrium between them. Therefore it is necessary to find out whether there is a causal connection or long term equilibrium before we conduct the regression test and the causality test. Engal and Granger (1987) suggest using cointegration test to verify the existence of causal connection between variables. Therefore the analysis in this thesis will be consisted of three stages. In the first stage, this thesis will try to prove that there is a causal
connection between stock market development and economic growth with a
cointegration test. Second, by applying regression tests, whether the relation between stock market development and economic growth is positive or negative will be found out. Finally, this thesis will look at the direction of the causality with Granger
the econometric tools, the stock market development and economic growth need to be measure.
• Measures of stock market development
Based on the discussion about the relation between stock market development and economic growth, the measures of stock market development in this thesis will be planned as follows.
-size
One of the main functions of stock market is facilitating investments, thus, the most direct way to indicate the development of stock market is by measuring how much investments are facilitated by the stock market. To indicate the amount of investments in the stock market, I propose to measure the size (market capitalization) of the stock market. In this thesis, the ratio of the market capitalization divided by GDP (CAP) will be used as a variable to indicate the size of the stock market. The selection of this measure consists with the measures of size in the empirical studies presented by Atje and Jovanovic (1993), Levein and Zervos (1996), Arestis; and Demetriades (1997), Rousseau and Wachtel (1999)…et al.
-liquidity
In previous section, this thesis discussed the theoretical link between the functions of stock market and the economic growth. Among all the literatures that were mentioned, the studies of Bencivenga, Smith, Starr (1994) imply that the reason for why the stock market can facilitate the long-term investment is because the stock market can provide an asset which is sufficiently liquid, and allows the investors to encash it quickly and cheaply. The study of Holmstrom and Tirole (1993) show that in a more liquid stock market, informed traders will spend more time to monitor the activities of the firm, since the prices of the order which is given by informed traders content the private information of the performance of the firm, stock price will content more information in more liquid stock market. According to these two theories, liquidity not only reflects the ability of a stock market in facilitating long-term investment, but also the ability of the stock price in disclosing information. In this thesis, the Ratio of total
value of trades divided by GDP (LIQ1) will be used to indicate how active the stock
Capitalization (LIQ2), which indicates how active the investors are in the stock
market. The selection of this measure consists with the the empirical studies presented by Levein and Zervos (1996), Gursoy and Muslumov (1998), Rousseau and Wachtel (1999) and Filer, Hanousek and Campos (2000) …et al
-Price Volatility
In previous section, the studies of DeLong (1989, 1991) and Ferderer (1993) suggest that the excessive price volatility will give confusing price information and hinder the investment. Therefore high volatility is expected to have negative impacts on market efficiency and investment enhancing. In this thesis, the standard deviation of monthly
moving average of the monthly return rate of Shanghai Composite Index (VOL) will
be used to reflect the price volatility in the stock market. The selection of this measure consists with the measure of size in the empirical studies of Spyrou (2000) and Zhu and Yan (2006). The calculation of the Variable will take two stages. In the first stage, I will calculate the rate of monthly return of Shanghai Composite Index (r) by
calculating the differences of natural logarithm of monthly price index
1 ln ln − − = t t t P P r
In the second stage, I will calculate the VOL by calculating the standard deviation of the 12 months moving average return rate:
11 / ) ( 12 1 2
∑
= − − = m m t t r MA VOLMA is the moving average of the return rate of twelve continuous months. • Measure of economic growth
To Measure the economic growth, month-on-month growth rate of Gross domestic
product (GROW) will be used. The gross domestic product (GDP) of a country
shows the total market of all final goods and services in a country, and it also reflects the size of the economy.
• Other factors
Since the economic growth is influenced by various factors, stock market
saving rate tends to have more investment, and maintain the economic growth. As a development of Harrod-Domar model, Solow and Swan (1956) propose exogenous growth model by adding the factor of productivity of labour in the model. Another contribution is that Solow and Swan introduces the concept of steady state into the growth model. Because of the diminishing marginal return to the increase of labour and capital, economies will tend to steady state in the long run. In order to overcome the steady state, development of new technology will be crucial. Although the Solow and Swam mention that the development of technology is the determination of long run growth, the factors in the model can not explain the development of technology. As a criticism of exogenous growth model, Romer (1986) argues that the
determination of growth should be within the growth model. He introduces human capital which refers to the level of education and training and the innovation process into his endogenous growth model to explain the increase of productivity. Feder(1982) suggest that the marginal factor productivities in export origin industries are higher than the factor productivities in non-export origin industries, because export origin industries are operating in a more competitive environment, and competition induces innovativeness, adaptability and efficient management of firms‘ resources. Therefore the expansion of export business will also contribute to the economic growth. Barro (1990) show that public services which are provided by the government can be considered as an input of private production, therefore he suggest that government expenditure should also be taken into account to as a complement of endogenous growth model to help explain the long-run growth. Cottani, Cavallo and Khan (1990) show that the instability and misalignment of real exchange rate will affect the foreign investments and the international trades of a country, therefore real economic
performance will be influenced. Keynes (1936) show that effective demand of consumption may stimulate the increase of investment and the improvement of
- Secondary school enrolment
- government consumption expenditures - Inflation
- International trade - Saving deposit
- Foreign exchange rate
Considered the selection of the measures in existing literatures, this thesis will include the Month-on-Month growth rate of households’ savings deposit (SAVE) to indicate the influence of the growth of saving deposit on the economic growth in China, the
Ratio of net exports divided by GDP (TRA) to measure the influence of the expanding
export business on the economic growth, the Ratio of government consumption
expenditures divided by GDP (GOV) to measure the influence of the government on
the economic activities. Consumer price index (CPI) will be used to measure the movement of consumer prices. Secondary school enrolment shows the level of the education in a country, which is related to the technological innovation of industries. However, since there is no monthly data for this measure, the school enrolment rate has to be neglected in this thesis. Since the exchange rate of Chinese currency (RMB) is directly controlled by the State Administration of Foreign Exchange of China, and the trades of the currency are restricted by the government, the exchange rate of RMB is not a market rate. Therefore the measure of the exchange rate will also be neglected.
• Data
-.06 -.04 -.02 .00 .02 .04 .06 .08 99 00 01 02 03 04 05 06 07 Monthly growth of GDP
measures are clear except the monthly growth of GDP. In Graph 1.1, we can see that the monthly GDP still shows strong seasonal pattern, in graph 1.2, we can see that the monthly growth of GDP is not clear.
Graph 1.1 Monthly GDP Graph 1.2 Monthly growth of GDP
2000 3000 4000 5000 6000 99 00 01 02 03 04 05 06 07 Monthly GDP
In order to obtain a clear trend of the measures of economic, the Hodrick-Prescott filter (H-P filter) is applied to further smooth the monthly growth of GDP. This mathematical tool was first developed by Hodrick and Prescott in 1980, and it is used in macroeconomics, especially in real business cycle theory, to obtain a smoothed representation of a time series. In the framework of Hodrick-Prescott filter6, the parameter Lambda (λ ) is a positive number which is used to adjust the sensitivity of the filter, the larger λ is, the smoother the solution trend will be. In a study of business cycle, Backus and Kehoe (1992) suggest an adjustment of the value by 14,400 for monthly data. In the study about how to adjust the H-P filter for the frequency of observation, Ravn and Uhlig suggest settingλ =129,600. Without knowing which value of λ is optimal, both settings of λ will be taken into account. Following the method suggested by Backus and Kehoe, we apply the filter to the monthly growth of GDP and setλ =14,400, the return is named GROW1, and shown in graph 2.1.
6
The frame work of Hodrick-Prescott filter, a given time series yt is the sum of a growth component
t
g and a cyclical component ct: yt = gt +ct for t=1,…… ,T. Hodrick and Prescott (1997) suggest a
way to isolate ct from yt by following minimization problem
-.08 -.04 .00 .04 .08 -.08 -.04 .00 .04 .08 99 00 01 02 03 04 05 06 07 GROW Trend Cycle Hodrick-Prescott Filter (lambda=14400)
-.08 -.04 .00 .04 .08 -.08 -.04 .00 .04 .08 99 00 01 02 03 04 05 06 07 GROW Trend Cycle Hodrick-Prescott Filter (lambda=129600)
.0105 .0110 .0115 .0120 .0125 .0130 .0135 .0140 99 00 01 02 03 04 05 06 07 GROW2 Graph 2.1 Lambda = 14,400
Following the method suggested by Ravn and Uhlig, we apply the filter to the monthly growth of GDP and setλ =129,600, the return is named GROW2, and shown in graph 2.2:
Graph 2.2 Lambda = 129,600
GROW1 and GROW2 will both be used as the variables of economic growth to analyse the relation between stock market development and economic growth. Tests will be applied respectively on GROW1 and GROW 2, once the results were
confirmed to be consistent with each other, they will be accepted as final results.
Table.3 shows the descriptive statistic of all variables.
Table 3 Descriptive Statistic of Variables
GROW1 GROW2 SAVE TRA VOL LIQ2 LIQ1 GOV CPI CAP
• Existence of Causality: cointegration
- Cointegration Test
In existing literatures (Arestis and Demetriades(1997), Demirbas(1999), Zhu and Yan(2006), et al), cointegration test was used to verify the existence of causal relation(s) between time series. The framework of the cointegration test contents the concept of stationarity and non-stationarity of a time series. If the means and
variances of time series are constant, the series is called stationary, otherwise it is called non-stationary. The basic idea of the cointegration is first introduced by Granger (1981). According to Granger, most time series variables in economics and finance are non-stationary, yet a linear combination of them can be stationary. If the linear combination of two variables is stationary, there should be a long term
equilibrium relation between them, and this two series are cointegrated. Hall and Henry (1989) show that if two series are cointegrated, they will move closely together in the long run, therefore difference between them is considered constant. Engle and Granger (1987) show that if the two series are cointegrated with each other, there must be a unidirectional or bi-directional Granger Causality between these two series. Therefore, testing the existence of causal connection between two time series can be transfer into testing whether the combination of the two series is stationary. In this thesis, Johanson Cointegration test (Johansen maximum likelihood approach)7 will be applied to test cointegrating relations between stock market development and
economic growth. The mathematic process will be conducted by the commercial package Eviews 5.1.
Since there is an assumption for cointegration that if the two non-stationary series are cointegrated with each other, each of the series should be able to be brought back to stationarity by the same times of linear transformation of differencing (the same order of difference). In order to verify the assumption of cointegration, it is necessary to conduct a pre-test to find out whether the non-stationary series (origin series) can be transformed into stationary series after the same order of differences. (Hendry and Juselius (2000))
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