Relationship Between Stock Exchange and Growth

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Correlation Between Stock Exchange and Economic Growth Abstract This paper examines the correlation between capital market and economic growth in Pakistan using a regression function. Using annual data from 1999 to 2009, examining the relationship of the variables used in the analysis. The results show that the capital market development is positively correlated with economic growth, with feed-back effect, but the strongest link is from economic growth to capital market, suggesting that capital market follows economic growth, economic growth determining financial institutions to change and develop.

Key words: correlation; economic growth; capital market Introduction The Pakistani stock market comprises of three exchanges, namely Karachi stock exchange, Lahore stock exchange and Islamabad stock exchange. For the purpose of this study we will focus exclusively on Karachi stock exchange (KSE), which is the main exchange of the country. A stock exchange is a place to regulate and perform the activities of stock (equity) market. It is considered as a “barometer” of the economy, because of its immediate and visible reaction on the news and transactions of economic importance.

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Capital market and monetary policy are closely interrelated as they are determined jointly by the supply of money, interest rates and liquidity position. One cannot ignore the monetary side effects in survey of capital market behaviour and forecasting. The linkage between the macro economic targets and financial and material growth in the different sectors of stock exchange is indispensable for a balanced economic growth.

Harmonization between the rules and regulations developed by the Securities and Exchange Commission of Pakistan (SECP), the State Bank of Pakistan (SBP) and the Central Board of Revenue (CBR) are also required to determine the balanced strategies regarding the reinvestment of corporate profits (retained earnings) for modernization and expansion, dividend payments, treatment of the sick units and placing of the companies on default counters at the stock exchanges. (Government of Pakistan) Capital markets are key elements of a modern, market-based economic system s they serve as the channel for flow of long term financial resources from the savers of capital to the borrowers of capital. Efficient capital markets are hence essential for economic growth and prosperity. The Karachi stock market showed lackluster performance as its index decreased by 25. 7 percent in terms of local currency owing to deterioration in domestic macroeconomic conditions and political upheaval and slumped to 36. 5 percent in terms of USD compared to 23. 5 percent rise in the same period last year. Government of Pakistan, 2008) The Pakistan financial system displays all the classic characteristics of an emerging market: market capitalisation amounts to only 5. 5% of GNP; less than 0. 3% of the population are shareholders, resources mobilised through the capital market are insignificant compared to that through the banking system, and equities account for about 4% of the assets of the financial system. The pricing of both equity and debenture capital is administratively set by the Government. Khambata & Khambata, 2005) Prime Minister Syed Yosuf Raza Gilani said the stock market plays a vital role in the national economy and the stock exchange is a primary indicator for the micro economic stability. He said the stock exchange has shown an impressive performance that has provided ample investment opportunity for the local as well as international investors. (Sana News, 2009) Fiscal year 2007-08 proved to be a tough year for the domestic stock exchange. Many factors played key role in eroding the investors’ confidence.

These factors include: (i) political instability, (ii) adverse law and order situation, (iii) deteriorating security environment in tribal areas, (iv)downgrading of Pakistan’s rating by S&P and Moody’s, (v) suspension of Pakistan from the Commonwealth, and (vi) continued tightening of monetary policy to stabilize inflation and curb aggregate demand. Moreover, SBP intervention to make rupee stable in the inter-bank and of open markets also conferred hope of alleviating local economy.

Finally, the clouds of lingering fears were dispersed and the index re-energized on the back of announcement of two-year further recommencement in Capital Gain Tax exemption. Federal budget created an overall ‘neutral-to-positive’ impact (especially for fertilizer, oil and auto sectors) on the stock market. (Government of Pakistan, 2008) In the context, an analysis of the relationship between capital markets (Stock exchange) and economic growth could explain why stock exchange has impact on the economy, and could find solutions in order to stimulate the process of conomic growth through capital market using public policy instruments. Related to this issue, even there are many studies regarding developed countries. My paper examines the correlation between capital market and economic growth for economy of Pakistan case, considering data for the period 1999-2009, using regression model. This paper is structured as follows. In Section 2, I define the measures for capital markets and economic growth, relatively to the mainstream of financial literature. Section 3 presents the database and methodology that we used.

Section 4 presents the main empirical results and Section 5 contains the concluding remarks. Literature Review In the recent financial literature on endogenous growth, the relationship between capital markets development and economic growth has received much attention (see King and Levine, 1993; Levine, 1997; Rajan and Zingales, 1998; Filler, Hanousek, and Campos, 1999; Arestis, Demetriades, and Luintel, 2001; Calderon and Liu, 2002, Carlin and Mayer, 2003). In this context, King and Levine (1993) state that the level of financial intermediation is a good predictor for economic growth rate, capital accumulation and productivity.

Minier (2003) analyzed the influence of the stock market dimension on economic development by regression tree techniques; he found evidence that the positive influence of stock market development on economic growth held only for developed stock markets in terms of turnover, in the case of underdeveloped stock markets the influence is negative. Garretsen, Lensink and Sterken (2004) found out a causal relationship between economic growth and financial markets development: a 1% improvement of economic growth determines a 0. 4% rise of market capitalization/GDP ratio.

Beck, Lundberg and Majnoni (2006), also, found a positive correlation between capital market development (measured by a dummy variable computed to reflect if the market capitalization exceeds 13,5% of GDP) and economic growth. Bose (2005) offers a theoretical financial model that explains the positive correlation between stock market development and economic growth; the model is based on the hypothesis that for levels of GDP per capita higher than a certain threshold the information costs become lower than bankruptcy costs, determining the development of capital markets.

Hence, it is explained why stock markets appeared late after banks. Hondroyiannis, Lolos and Papapetrou (2005) studied the case of Greece (1986-1999); they found out that the relationship between economic growth and capital market development is bi-directional. Bolbol, Fatheldin, and Omran (2005) analyzed the effect of financial markets (measured by the ratio of market capitalization on GDP and the turnover ratio) on total factor productivity and growth (the per capita GDP growth rate) in Egypt (1974-2002); they demonstrated that capital market development had a positive influence on factor productivity and growth.

Nieuwerburgh, Buelens and Cuyvers (2006) analysed the long-run relationship between stock market development (measured by market capitalization and number of listed shares) and economic growth (measured as a logarithmic difference of GDP per capita) in Belgium. There are several discussions about the relationship between the development of the financial system and the economic growth. The literature focuses on the financial system’s components, the capital market that influences economic growth.

Graff (1999) stated that there are four possibilities concerning the causal relationship between financial development and economic growth: (1) Financial development and economic growth are not causally related. (2) Financial development follows economic growth. (3) Financial development is a cause of economic growth. (4) Financial development is an impediment to economic growth. The economic growth is a complex process that is influenced by more factors, other than the capital market development. Moreover, capital market development is the results of many influence factors.

There are several interdependencies between these factors, which makes it difficult to establish and isolate the causal relation between the economic growth and the capital market development. There are several empirical studies that analyze the correlation between the economic growth and the financial development. Calderon and Liu (2002), studying the direction of this causality, conclude that, as a general trend, the financial development generates economic growth, the causal relation being stronger in the emergent countries and being explained by two channels: the fast capital accumulation and the growth of productivity.

Rajan and Zingales (1998) emphasize that the financial development is a prediction element for the economic growth, because the capital market reflects the present value of the future growth opportunities. Data and Methodology I analyze the link between capital market and the economic growth in Pakistan on annually data from 1999 to 2009, meaning 10 observations. In Table 1 I present the variable used to characterize the Pakistan capital market and economic growth. I tried to develop the hypothesis to find out the relationship between capital market and the economic growth. Table 1 Variables| |

Capital market variable| Karachi Stock Exchange Index| Economic growth variable| Gross Domestic Product Rate| Ho: There is no association between Gross Domestic Product and KSE-100 index H1: There is association between Gross Domestic Product and KSE-100 index The hypotheses have been tested by using Statistical Package for the Social Sciences (SPSS). Empirical Result Model Summary| Model| R| R Square| Adjusted R Square| Std. Error of the Estimate| 1| . 861a| . 741| . 708| 4. 05066E5| a. Predictors: (Constant), KSE| | From the results given in the above table R=0. 861 shows a perfectly positive correlation between GDP and KSE-100 index.

But it shows a weak positive relation. R2=0. 741indicates that 74. 1% change in the GDP is explained by KSE-100 index where as 25. 9% change is due to other variables. Conclusion The purpose of the paper is to examine the causal relationship between capital market (KSE-100 index) and economic growth (GDP). I use annual data from 1999 to 2009. The regressions suggest that the capital market (KSE-100 index) is positively correlated with economic growth (GDP). The findings suggest that the stock market in Pakistan is developed to play its role in influencing the real sector of the economy. Bibliography

Abid Hameed, H. A. (2006). Stock Market Volatility and Weak-form Efficiency. The Pakistan Development Review . Abid Hameed, H. A. (Winter 2006). Stock Market Volatility and Weak-form Efficiency:. The Pakistan Development Review . Government of Pakistan. (2008, July 18). Update on Pakistan’s Economy. Investors Relations Desk . Khambata, F. , & Khambata, D. (2005, June 14). Emerging capital markets: A case study of equity markets in Pakistan. Asia Pasific Journal of Management , 67-89. Sana News. (2009, 08 01). Retrieved from Sana News Web site: http://www. sananews. com. pk King, R. G. and Levine, R.

Finance and Growth: Schumpeter Might Be Right, The Quarterly Journal of Economics, MIT Press, vol. 108 (3), 1993, pp. 717-737 Levine, R. Financial Development and Economic Growth: Views and Agenda, Journal of Economic Literature, 35, 1997, pp. 688-726 Rajan, R. and Zingales, L. Financial Dependence and Growth, The American Economic Review, 88, 1998, pp. 559-586 Filer R. , Hanousek, J. and Campos, N. Do Stock Markets Promote Economic Growth? , CERGE-EI Working Papers wp151, The Center for Economic Research and Graduate Education – Economic Institute, Prague, 1999, www. cerge-ei. cz/pdf/wp/Wp151. df accessed 19 July 2007 Arestis, P. , Demetriades, P. and Luintel, K. Financial Development and Economic Growth: The Role of Stock Markets, Journal of Money, Credit and Banking, 33, 2001, pp. 16-41 Calderon, C. and Liu, L. The Direction of Causality between Financial Development and Economic Growth, Central Bank of Chile. Working Paper, 2002, http://www. bcentral. cl/estudios/documentos-trabajo/pdf/dtbc184. pdf, accessed 19 July 2007 Carlin, W. and Mayer, C. Finance, Investment, and Growth, Journal of Financial Economics, 69, 2003, pp. 191-226 Garretsen, H. , Lensink, R. and Sterken, E.

Growth, financial development, societal norms and legal institutions, Journal of International Financial Markets, Institutions and Money, 14, 2004, pp. 165-183 Beck, T. , Lundberg, M. and Majnoni, G. Financial intermediary development and growth volatility: do intermediaries dampen or magnify shocks? , Journal of International Money and Finance, 25, 2006, pp. 1146-1167 Bose, N. Endogenous Growth and the Emergence of Equity Finance, Journal of Development Economics, 77, 2005, pp. 173– 188 Hondroyiannis, G. , Lolos, S. and Papapetrou, E. Financial market and economic growth in Greece, 1986-1999, Journal of International Financial

Markets, Institutions and Money, 15, 2005, pp. 173-188 Bolbol, A. , Fatheldin, A. , and Omran, M. Financial development, structure, and economic growth: the case of Egypt, 1974-2002, Research in International Business and Finance, 19, 2005, pp. 171-194 Nieuwerburgh, S. , Buelens, F. and Cuyvers, L. Stock market development and economic growth in Belgium, Explorations in Economic History, 43, 2006, pp. 13–38 Graff, M. A. Financial Development and Economic Growth – A New Empirical Analysis, Dresden Discussion Papers in Economics No. 5, 1999, http://papers. ssrn. com/sol3/papers. cfm? abstract_id=258928, accessed 19 July 2007.

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