• Background of the Study

According to Al-Faki (2006), the capital market is a “network of specialized financial institutions, series of mechanisms, processes and infrastructure that, in various ways, facilitate the bringing together of suppliers and users of medium- to long- term capital for investment in socio-economic developmental projects”. The capital market is divided into the primary and the secondary market. The primary market, or the new issues market, provides the avenue through which government and corporate bodies raise fresh funds through the issuance of securities that are subscribed to by the general public or a selected group of investors. The secondary market provides an avenue for the sale and purchase of existing securities.

A large pool of theoretical evidence exists locally and internationally showing that capital market growth boosts economic growth. Carlin and Mayer (2003) show that the capital market impacts economic growth, though not as strongly as the banking sector. Greenwood and Smith (1997) show that large stock markets can decrease the cost of mobilizing savings, thus facilitating investment in most productive technologies. Levine (1991) and Bencivenga, et al (1996) argue that stock market liquidity, which is the ability to trade equity easily and cheaply, is crucial for growth. Many profitable investments require a long-run commitment of capital but savers are reluctant to relinquish control of their savings for long periods. Liquid equity markets address this challenge by providing assets which savers can sell quickly and cheaply. Simultaneously, firms have permanent access to capital raised through equity issues. Kyle (1984) and Holmstrom and Tirole (1993) argue that liquid stock markets can increase incentives for investors to get information about firms and improve corporate governance while Obstfeld (1994) shows that international risk-sharing, through internationally integrated stock markets, improves resource allocation and can accelerate the rate of economic growth.

These arguments on the importance of stock market development in the growth process are supported by various empirical studies, such as Levine and Zervos (1993, 1996, and 1998); Atje and Jovanovic (1993), and Demirguc-Kunt (1994). Filer, et al (1999) find that an active equity market is an important engine of economic growth in developing countries. Rousseau and Wachtel (2002) and Beck and Levine (2002), show that stock market development is strongly correlated with growth rates of real GDP per capita, and that stock market liquidity and banking development both predict the future growth rate of the economy when they both enter the growth regression.

Stock exchanges exist for the purpose of trading ownership rights in firms, and are expected to accelerate economic growth by increasing liquidity of financial assets, making global risk-diversification easier for investors, promoting wiser investment decisions by savings-surplus units based on available information, compelling corporate managers to work harder in shareholders’ interests, and channeling more savings to corporations (Greenwood and Jovanovic, 1990 and King and Levine, 1993). In accord with Levine (1991), Bencivenga, et al (1996) emphasise the positive role of liquidity provided by stock exchanges on the size of new real asset investments through common stock financing. Investors are more easily persuaded to invest in common stocks when there is little or no doubt on their marketability in stock exchanges. This, in turn, motivates corporations to go public when they need more finance to invest in capital goods.

Stock prices determined in exchanges, and other publicly available information, help investors make better investment decisions. Better investment decisions by investors mean better allocation of funds among corporations and, as a result, a higher rate of economic growth. In efficient capital markets, prices already reflect all available information, and this reduces the need for expensive and painstaking efforts to obtain additional information (see, Stiglitz, 1994).

On a broader scope on the debate on whether financial development engenders economic growth or whether financial development is consequential upon increased economic activity, Schumpeter (1912) opined that technological innovation is the force underlying long-run economic growth, and that the cause of innovation is the financial sector’s ability to extend credit to the “entrepreneur” (Filer, et al, 1999) while Robinson (1952) claims that it is the growth of the economy that causes increased demand for financial services which, in turn, leads to the development of financial markets.

According to Rosseau and Wachtel (2002), mature financial systems can cause high and sustained rates of economic growth, provided there are no real impediments to growth. Carlin and Mayer (2003) also find a positive link between financial system development and economic growth in developed countries. Greenwood and Smith (1996) show that stock markets lower the cost of mobilizing savings, thereby facilitating investments in the most productive technologies. Levine and Zervos (1998) find a positive and significant correlation between stock market development and long-run growth. Bencivenga, et al (1996) and Levine (1991) argue that stock market liquidity plays a key role in economic growth, stressing that profitable investments require long-run commitment of capital but savers prefer not to relinquish control of their savings for long periods, and liquid equity markets ease this tension by providing assets to savers that are easily liquidated at any time.


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