How does your stockmarket grow?

LEGIONS of highly paid stockbrokers in London and New York pore over them. International fund managers bet billions of dollars on them. And investment bankers have made a fortune by organising the flotation of companies on them. But emerging stockmarkets still stir up a mixture of pride and fear among policymakers in poor countries. On the one hand, they see a blossoming bourse as proof that they are serious about pro-market reform; on the other, they worry that such markets might in some cases do more economic harm than good.
     The recent gyrations of Wall Street are a timely reminder that stockmarkets are, by their nature, unpredictable beasts--and nowhere more so than in emerging markets, as investors who got their fingers burnt in the Mexican crisis that began in December 1994 can testify. Last week, Poland, Hungary and Brazil were among the markets that fell furthest in Wall Street's wake. Others, such as those of India and Turkey, have also been jittery lately.
     In spite of this, says the International Finance Corporation (IFC), part of the World Bank, over 19,000 companies were listed on the stockmarkets of developing economies at the end of 1995, more than twice as many as a decade ago. Their share of world stockmarket capitalisation has also grown fast (see chart). But are poor economies benefiting from this?
     At first sight, the answer seems obvious. By improving the efficiency with which money is channelled from savers to investors, stockmarkets should bring nothing but economic benefits. Companies have a new source of finance; savers have new investment opportunities.
     But there are dangers, too. The biggest worry, which many governments have voiced incessantly since the Mexican crisis, is that opening up a domestic stockmarket to foreigners increases the risk that share prices will become more volatile, with footloose cash disappearing at the first sign of bad economic news. Such volatility, they fear, will deter local companies from making long-term investments. Big inflows and outflows of capital will also complicate the management of their exchange rates. Proponents of stockmarket liberalisation counter that the potential gains of foreign equity capital make such risks well worth running.
     Who is right? Surprisingly, there have been few serious attempts to measure the economic impact of stockmarkets in the developing world. In a series of recent papers* Ross Levine, an economist at the World Bank, and Sara Zervos of BZW, a British investment bank, have tried to fill the gap. They look closely at 49 countries (both rich and poor) between 1976 and 1993, and try to measure their stockmarkets' contribution to growth.
     To assess the stage of development that a market has reached, the economists use eight different indicators. One of the obvious measures gauges a market's size by looking at its capitalisation ratio, or the total value of shares as a percentage of GDP. But this alone fails to account for many other important features of stockmarkets. That is why Mr Levine and Ms Zervos also construct several measures of market liquidity, such as turnover ratios (which measure the total value of all trades divided by a country's market capitalisation). They also look at stockmarket volatility and the openness of countries' capital markets.

Big, but not necessarily beautiful
The two economists then examine how closely these different indicators are correlated with economic growth. The strongest link is with liquidity: after adjusting for differences in other factors that can influence growth, such as education levels, inflation rates and openness to trade, they conclude that those countries with the most liquid stockmarkets tend to grow fastest. For example, they estimate that had Mexico's stockmarket been as liquid as Malaysia's in 1976, its economy would have enjoyed 0.4% a year faster growth per person until 1993.
     On the other hand, after accounting for liquidity and other factors, countries with large stockmarkets appear no more likely than those with small ones to grow quickly. Nor does there seem to be a strong link between stockmarket volatility and economic growth.
     Why might liquidity matter so much? The most likely answer is that investors are leery of illiquid markets. Many profitable investments require a long-term commitment of capital; but savers might not want to tie up their savings for such long periods of time. Liquid equity markets allow savers to sell their shares easily if they want to, while allowing firms access to long-term capital through equity issues. Indeed, the study finds that those countries with the most liquid stockmarkets in 1976 both accumulated more capital and enjoyed higher productivity growth over the next 18 years.
     The two economists also reckon that liquid stockmarkets encourage banks to lend, giving investment a further boost. This is because in poor countries a successful bourse can dramatically improve the information that is available about companies, which ought to give creditors confidence. That may be one reason why the ratio of bank loans to GDP tends to rise as stockmarkets become more liquid.
     All of these conclusions should be treated with care. Correlation does not prove causation. Fast-growing countries may simply be more likely to develop liquid stockmarkets. But the economists do make allowances for this, lending more credence to their findings.
     Given that stockmarket liquidity is a useful catalyst, how can policymakers improve it? One obvious way is to open markets to foreign investors, the very thing that many emerging-market governments fear most. For them, the authors have good news. Not only does liberalising capital controls appear to boost liquidity, but the resulting increase in short-term volatility does not appear to hamper growth. That is something for poor countries to remember as their markets bob around in Wall Street's wake.