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Relevant relationship between stock market and economic growth

Discuss about the Economic Freedom Environment and Economic Growth.

Economic growth is strongly believed to be steered on by stock market development. Productivity and greater positive economic growth is realized through physical capital accumulation and steady prices of shares in stock market. Economic growth is as well believed to be enhanced by stock markets development and banks; this is according to (Neusser & Kuglar, 1998). Despite the presence of a number of theories concerning the impact of the stock market and financial institutions on economic growth, there is insufficient information provided on the empirical relationship between the two factors. The effects of stock markets on economic growth are still obscure on both high and low income countries.

The places of trade of share for the public companies are referred to as stock markets. The buyer and the seller agree on the price at which the shares will be sold and bought upon their agreements. Regulatory authorities control the stock market exchange. The only shares which are sold or bought must be the ones listed for the transactions in the stock markets exchange. These activities tend to show the importance of the financial institutions through stock markets, idle savings are mobilized for flow and circulation in the market for productivity and growth of the economy. On the other hand, after the idle saving have been made into useful and productive capital, the process as well result to the surge of the financial institutions.

In the recent past, developing countries have been experiencing stock market growth and development. Sub-Saharan Africa have shown a sharp shoot up of the stock market since 1989 when the number used only to be five, but currently the number have increased to almost thirty. The rising numbers of stock market development in these regions have been associated with the growth of economy in those regions since the stock market has got variety of roles to play. The health of stock market should be maintained in order to reap fully out of it. As a result of stock market development, the rates of growth of savings will be increased this will in turn have some positive effect on the growth on the economy. Additionally, the available resources are ensured that they are fully made use of appropriately towards developing and growing the economy through the stock market development. Small companies are nurtured for development by the stock market development through creating good investment opportunities for those companies. The government for the countries that adopt and make good use of stock markets finds it easy to raise capital for development of their projects which helps in efficient allocation of investment resources.

Theoretical literature

The relationship and the link between the growth of economy and how the stock market development results to the growth is still an open research field for which most of the economists have been trying to work on without much success. Some empirical studies carried out (Beck et al, 2014) and Korajezyk (1996) came up with a correlation that was trying to link the stock market and growth of the economy. This was also observed to be working well in India when they applied industrial production (IP) only to experience the changes due to the shift in the data frequency. According to (Beck et al, 2014), they used the dynamic framework for Chinese provinces in assessing the roles in the transitional economy.

Stock price movements are often a reflection of what occurs in the economy and they are therefore a source of consumer confidence. Consumer confidence is affected by the stock market. The spending behavior of people is affected and sometimes discouraged by falling share prices and this has an impact on the GDP since reduced aggregate demand may lead to anoveral decline of the GDP.  The GDP can be boosted when new projects have emerged, companies are allowed to make borrowings at cheaper rates which allows for the expansion of their operations due to activities carried out in the stock markets. Shares price fluctuations can be discouraging factor in the growth of the economy through the fall of their prices together with other factors as it negatively affects the GDP. The price market as well tries to outshine the rest of other factors that lead to the growth of economy (Binswanger, 2004). For instance, when there is high intensity of recession prices of the shares in the stock market may rise and in the process, the investors work hard towards recovery in the future (Stock & Watson, 2001). This confidence built in the investors and other shareholders may have positive effect on the growth of the economy from the stock markets. The case has been documented both in high income countries and the low income countries.

Additionally, firms’ ability to invest in the economy can be hampered by the falling of the share prices in the stock market. Firms get affected by this since they will not be able to release their shares into the market because the prices are lower, and this may affect their borrowing ability and sourcing of more money towards their management of activities (Gwartney et al, 1999). This will therefore hinder the amount of cash that is channeled into the economy thus affecting the growth of the economy. However, the continuous falling of the share prices in the stock market makes it difficult for the firms which depend on the shares to cope up in the industry which will ultimately affect the economy either directly or indirectly (Stock & Watson, 2001). These are some of the facts among which when considered, may lead someone to perceive that indeed there is a close relationship between stock market and the growth of the economy. Though the type of relationship that exist cannot be relied on in most of the case in measuring the extent or rate at which economy has grown.

Other investments become more attractive when the stock market prices fall. In reference to this, bond market becomes an alternative to mesmerize firms in the market as people will be tending to shift from stock market into the government bonds. In the cases where uncertainties are experienced, investments offer better returns (Binswanger, 2001). The government bonds may be one of the major factors that lead to the fall of the stock market prices. The shift might be reducing some of the sources of business investments and ones this is done, it will have effect on the job opportunities thus resulting to retarded growth of the economy.  These discussed factors show direct link between stock market and growth of economy across the countries in the globe.

People living in various countries, stock market does lead to drop of wealth for those people who have shares. Their financial outlook have been affected when the fall prove significant. The fall in the wealth of these people will as well lead to the drop in the economic development since it affects their spending rates as consumers (Greenwood & Jovanovic, 1999). Mostly they tend to reduce their spending rates which have effect of reducing the amount of money pumped into the economy for its development (Beck et al, 2014). Although the shareholders tend to be prepared to lose money and they also tend to keep their spending patterns independent of the share prices.

The prices of stocks in the market also play important role in the economy in different channels. Higher distribution of prices of shares result to extra stimulation for households and the firms that own them either directly or indirectly through positive wealth effect and pension funds. Moreover, the state of economy has been in some instances measured though stock market where the confidence channels is the way through which the prices affect real economy (Claessens & Perotti, 2007). Uncertainty that may arise in the foreseen economic situation can be reduced by the stock price increase through boosting the confidence of households and firms. Higher prices of stocks benefit investment since cost of equity capital is lower (Neusser & Kugler,1998). Growth of the economy can be enhanced more cheaply by firms with stock exchange through giving out new shares. Tobin’s Q ratio is increased through high stock prices. This ratio encourages investment of the firms in capital and the stock market as well has effect on profits channeled to the firms. Internal finance in the economy are sourced from the profits obtained as a result of higher stock prices which are in turn invested towards growing the economy of the country. These internal finances are important for they help when the external finances are not available which ensures the steady flow of finances in the economy since there is alternative source of finance (Jeanneney & Kpodar, 2011).

Determining the relationship that exists between the stock market and the growth of economy has been tried to explain by several empirical literature. Despite all the efforts and intensive research carried out, no convincing conclusion has been attained so far by the literatures. In response to that, some developed literatures come up and conclude in the favor of positive relationship between stock prices and the economic growth. In contrary to that conclusion made by other literatures, others argue that the relationship that could be thought to be existing between them has broken down. Non-fundamental factors can result to the rise of the stock prices beyond their intrinsic values.

The empirical relationship between stock prices and output can be determined from carrying out the log-linear asset pricing framework (Campbell, 1998). In his empirical work, he regressed log-price dividend ratio against output growth. His proposed results were found significant in statistically insignificant in countries like Germany, Japan, France, the UK and the US. He raised the claim of negligible difference between the predictive content and the output. Various conclusions are made better still by the researchers over the same. According to Binswanger (2004), he ran OLS method and used industrial production growth rates on the dependent variable part while on the same he used lagged real stock returns on the side of explanatory variables for G7 countries dataset. In response to the test he conducted, all the G7 countries showed statistical significance between the variables that were tested but the case was not with France and Italy which are also among the G7 countries.

As well, focusing regression was used by (Stock & Watson, 2001), in their test they used real GDP and lagged explanatory variables which theoretically, they proved being relevant predictors for most of the industrialized economies in the G7 countries. In their results, they found infinitesimal marginal predictive content for the output at different quarter’s horizon. The prices of stock market have been volatile for used as predictors across countries in the globe. This empirical literature did not also come up with a clear and distinct relationship  that exist between the stock markets and the growth of the economy in all the countries among the high level income countries and the low level income countries.

According to Schwert (1989), the relationship between the economic activities and the stock prices can be determined through the examination of the volatility of both the economic activity and the volatility of stock prices. In his research, he came up with evidence that the health of the economy was greatly affecting the volatility of the stock market. He employed the model that made use of the monthly data which showed the increase of the average volatility by a significance of about 189 percent in the recession times. Despite all the above discussed empirical literature and the tests carried out on the relationship that could exist between the stock market and the growth of economy, the whole matter still remains inconclusive.

Data that were used in this study were secondary data that were collected for the market research database for stock market i.e. DataStream. All the aspects were followed for the organization and the entire process of data preparation. Quantitative data were obtained for analysis and comparative approach was incorporated in the data collection from the various data archive for the stock markets. Data that was collected covered the low income level countries to help in the investigation of the effects of the stock market on economic development. The sample of data was obtained from 30 low income group countries and 30 middle and high income group countries. This will help in comparing the effect of stock market in both groups of countries in order to come up with the conclusion about whether or not there is an effect imposed in the economic growth.

In order to consider the stock market development, monthly shares data was collected in various markets since 1970 to 2010 from the selected low income group countries and selected middle/high income group countries i.e. Shanghai stock exchange market. These data were taken to represent the whole list of any type of stock markets. High frequency of stock market is observed through stock market capitalization and the growth of the economy is determined by the GDP whose frequency of observation is low i.e. quarterly. Changing the frequency at which the stock market is observed and making it to lower capitalization frequency, biasness will arise and some errors will be detected as this will be as a result of lost information. For farther realization of the effect of stock market in the economic growth, since we have realized that it is affected by the frequency of the observation of the GDP, more observable frequent variable is considered for growth of the economy. According to (Gwatney et al, 1999), they suggested that this was the activity widely practiced in the analysis of the economy. The alternative proxy observed in place of the GDP due to its frequency of observation is index of industrial production. Being that shanghai is in china, this therefore gives an opportunity for China’s IP to be collected. The period of collection of IP is matched with that of the stock market data and therefore used to determine the economic growth as intended by the study.

As noted by (Gwatney et al, 1999), the breaks within the time at which data is generated tends to be stationary, type 2 error is more likely to be committed by the Dickey-Fuller test (ADF) test in reference to the trend stationary process compared with another of the non-stationary that goes per random walk. Structural breaks will lead to a huge drop of ADF test; this makes the breaks to be ignored while the unit roots are being tested. Using ADF test is accompanied with a problem of deriving the critical value by using the null hypothesis without considering the structural breaks that may in turn distort the being of unit roots. The use of ADF unit root methodology increases the chances of type 1 error which can be mistaken in the time series data when structural breaks are available in the stationary series. In order to reveal the extent to which stock market result to economic growth, surveys will be carried on the trends of economic growth treating stock market as independent variable. Cross sectional study will be found essential in this study as it will help in determining the relationship between economic growth of the low income groups and high income group countries. Collection of data was guided through the use of questionnaires in support of collecting relevant data that will be used in drawing appropriate and suitable conclusion as per the research questions. Economics resources database and other data sources will be deemed important in the study for as much as the collected data are appropriate. Simple random sampling method was also employed in order to provide for fair and equal chances for the collection of data from various databases.

The trend line on the graph shows that there is positive correlation between the tested variables and that the variables are correlated. The direction of trend line is towards the right up from the left. The strength of the correlation is weak but it exists and therefore we can say that stock market has effect on the growth of economic development.

Correlations

fdi_gdp

wdi_gdppcgr

Spearman's rho

fdi_gdp

Correlation Coefficient

1.000

.281**

Sig. (2-tailed)

.

.000

N

186

185

wdi_gdppcgr

Correlation Coefficient

.281**

1.000

Sig. (2-tailed)

.000

.

N

185

193

**. Correlation is significant at the 0.01 level (2-tailed).

Considering the Pearson’s correlation coefficient which in this case from the table it is marked by 0.281 for both variables above and below, being that this value is not too close to zero and it is a positive value, we can therefore conclude that the two variables showing the economic growth of the low income countries are positively correlated but the relationship is weak since the value is not 1 or too close to 1.

From the statistical results observed in the table and scatter plot, it is crystal clear and it can therefore be concluded that indeed, the stock markets have effect on the economic development or it leads to the growth of the economic development. This is as a result that from the correlation test, the result turns positive though not strong and also the significance test shows that there is statistical significance between the tested variables since the significance value i.e. 0.000 is less than 0.05.

Conclusion

Even though from the theoretical and the empirical analysis of the impact of stock market to the growth of economy is not brought out clearly, also, though there is a feeling that when the stock market grows, it leads to simultaneous growth of the economy. Economists are still in doubt of the real impact caused by the stock market to the growth of economy. But from the statistical testing conducted using the two tested variables in this study show that there is correlation between the stock market and growth of the economy. This has further has been confirmed with the fact that Pearson’s coefficient correlation is positive and the statistical significance too ascertains that by driving us into concluding that there is statistically significance between the stock market and economic growth.

Reference

Beck, R., Georgiadis, G., & Straub, R. (2014). The finance and growth nexus revisited. Economics Letters, 124(3), 382-385.

Binswanger, M. (2004) “Stock Returns and Real Activity in the G7 Countries: Did the   Relationship Change in the Early 1980s,” The Quarterly Review of Economics and            Finance, Vol. 44(2): 237-252.

Campbell, J. Y. (1998) “Asset Prices, Consumption, and the Business Cycle,” NBER Working Paper: No.6485.

Claessens, S., & Perotti, E. (2007). Finance and inequality: Channels and evidence. Journal of Comparative Economics, 35(4), 748-773.

Gwartney, J. D., Lawson, R. A., & Holcombe, R. G. (1999). Economic freedom and the environment for economic growth. Journal of Institutional and Theoretical Economics      (JITE)/Zeitschrift für die gesamte Staatswissenschaft, 643-663.

Greenwood, J., & Jovanovic, B. (1999). The IT revolution and the stock market (No. w6931). National bureau of economic research.

Greenwood, J., & Jovanovic, B. (1990). Financial development, growth, and the distribution of income. Journal of political Economy, 98(5, Part 1), 1076-1107.

Jeanneney, S. G., & Kpodar, K. (2011). Financial development and poverty reduction: Can there be a benefit without a cost?. The Journal of development studies, 47(1), 143-163.

Neusser, K., & Kugler, M. (1998). Manufacturing growth and financial development: evidence from OECD countries. Review of economics and statistics, 80(4), 638-646.

Schwert, G. (1989) “Why Does Stock Market Volatility Change over Time?” The Journal of Finance, Vol. 44(5): 1115-1153.

Stock, J. and WATSON, M. (2001) “Forecasting Output and Inflation: The Role of Asset Prices,” NBER Working Paper: No. 8180.

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