Stock Market Development and Economic Growth

Stock Market Development and Economic Growth: Evidence from Developing Countries Hamid Mohtadi and Sumit Agarwal ∗ Abstract This study examines the relationship between stock market development and economic growth for 21 emerging markets over 21 years, using a dynamic panel method. Results suggest a positive relationship between several indicators of the stock market performance and economic growth both directly, as well as indirectly by boosting private investment behavior. Thus they lend support both to the financial intermediation literature as well as to the traditional growth literature. ∗ Authors are, Associate Professor, University of Wisconsin-Milwaukee and Senior Quantitative Analyst, Fleet Financial, Providence, RI. For correspondence contact the first author, at Department of Economics, University of Wisconsin-Milwaukee, Milwaukee, WI 53201, email: mohtadi@uwm.edu

1 Stock Market Development and Economic Growth: Evidence from Developing Countries 1. Introduction As the global equity markets have experienced their most explosive growth over the past decade, emerging equity markets have experienced an even more rapid growth, taking on an increasingly larger share of this global boom. For example, while overall capitalization rose from $4.7 trillion to $15.2 trillion globally, the share of emerging markets jumped from less than 4 to 13 percent in this period. Trading activity in these markets surged equally fast: the value of shares traded in emerging markets climbed from less than 3 percent of the $1.6 trillion world total in 1985 to 17 percent of the $9.6 trillion shares traded in all world’s exchanges in 1994. Both the global boom and the involvement of the emerging markets in it, has attracted the interest of academics and policy makers. As a result, a plethora of studies now focus on how to measure the benefits of globally diversified portfolios, while a large number of countries expound regulatory reforms to foster capital market development and attract foreign portfolio flows. Yet, there exists very little hard empirical evidence on the importance of stock markets development to long–run economic growth and almost none exists regarding the developing countries. The one exception is a study by Levine and Zervos (1998) who find a positive and significant correlation between stock market development and long run growth. However, their study relies on a cross-sectional approach with well known empirical limitations including the inability to sort country-specific effects. The present 2 paper addresses this shortcoming by using a rich and disaggregated panel data and by adopting a dynamic panel approach. Theoretically, the traditional growth literature was not suited to explore the relationship between financial intermediation and economic growth because it focused on steady-state level of capital stock per worker or productivity, but not on the rate of growth (which was attributed to exogenous technical progress). The recent revival of interest in the link between financial development and growth stems from the insights of endogenous growth models, in which growth is self-sustaining and influenced by initial conditions. In this framework, the stock market is shown to not only have level effects, but also rate effects (e.g, Levine, 1991). However, a debate now exist within this framework. On one side is the view that stock markets promote long-run growth. For example, Greenwood and Smith (1996)...

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