4.3.1 Banks
The important role that banks can play in facilitating economic growth has long been known. Both Walter Bagehot in the nineteenth century, and Joseph Schumpeter at the start of the twentieth have stressed the importance of banks in channelling surplus finance to productive investments, and this is clearly a fundamentally important function in any successful economy.
In his seminal paper14 on the foundations of economic growth, the eco- nomic historian Alexander Gerschenkron argued that, particularly at an early stage of development, countries could not rely on arm’s-length capital
markets to provide the long-term investment finance needed to kick-start growth. For this, large banks were an essential prerequisite.
More recently, Boyd and Prescott (1986) have developed models where banks lower the aggregate cost of obtaining and processing information below what would occur via capital markets alone, where each investor must acquire information individually.
The role of banks in reducing the asymmetric information problems inher- ent in financial transactions has already been discussed in this chapter, but as research into information theory has developed, this vital role has come to be seen as increasingly important.
As highlighted in previous chapters, King and Levine (1993) show empiric- ally how these combined effects lead to a more efficient allocation of resources and therefore to higher economic growth. Levine and Zervos (1998) also test the proposition that banking development is positively associated with growth empirically, and find robust evidence that this is indeed the case.
4.3.2 Stock markets
Levine and Zervos (op. cit.) also test empirically for the relationship between growth and stock market development, and find that, as with banks, stock market development is also positively associated with economic growth. Why should this be, however?
A key function of stock markets is to provide liquidity. Thus investors can buy or sell shares whenever they choose to do so. For Levine (1991) and Bencivenga et al. (1995), this positively affects growth, as liquid markets enable longer-term investments to occur more easily than would otherwise be the case. The rationale for this is that investors will only be prepared to commit funds to long-term projects if there is sufficient liquidity, so that they know they can withdraw this funding at any point.15
For Hicks (1969) this attribute of stock markets was a key factor in the start of the industrial revolution in Britain in the eighteenth century. For Hicks, the necessary technological innovations had been made some time before the start of the industrial revolution, and it was only with the devel- opment of deep and liquid stock markets that sustainable long-term financ- ing became available and the industrial revolution began.
Another explanation for the link between stock market development and growth is that a large, integrated stock market enables investors to diversify their portfolios fully.16 As a result, they are prepared to invest in higher risk assets than would be the case if their portfolio were not balanced with other less risky, and uncorrelated assets. This enables more risky projects to be undertaken than would otherwise be the case, leading to higher growth on average over the longer term.
However, other theoretical work on the role of stock markets has suggested that stock market development may be negative for growth. The liquidity that stock markets introduce into the financial system may also have the effect of
reducing incentives for investors to monitor corporate behaviour, as they know they can withdraw their funds at any point. For Shleifer and Vishny (1986) this can adversely affect corporate governance, leading to a less effi- cient allocation of resources and therefore lower growth. Another perspective in this respect is that the development of stock markets may adversely affect savings rates, as savers may prefer to seek higher investment returns on the stock market.
From an empirical perspective, the evidence on this theoretical debate cur- rently suggests that (a) stock markets are positively associated with economic growth, capital accumulation and productivity growth, and (b) stock market development does not adversely affect savings rates (Levine and Zervos, 1998).
However, it is also the case that stock market development may only become a positive impetus to higher growth after a certain level of economic development has been achieved. In particular, many of the positive features described above – such as the ability of investors to fully diversify their port- folios through the stock market – are dependent on there being a sufficiently developed and diverse industrial structure to the underlying economy. In less developed countries this may not be so, suggesting that overly focusing on establishing the structures of a stock market in poorer countries may be the wrong priority.
Box 4.2 considers these issues in this regard with respect to the experience of stock market development in sub-Saharan Africa in the 1990s.
Box 4.2 Stock market development in sub-Saharan Africa
The oldest stock market in sub-Saharan Africa was established in South Africa in 1887. For more than half a century that was it, until Zimba- bwe established an exchange in 1946. The next to follow suit was Kenya in 1954, followed by Nigeria (1961) and Côte d’Ivoire (1976). There was then a hiatus in the process of developing stock exchanges, until a wave of exchanges were established in the late 1980s and early 1990s as shown in the table below.
Stock markets in sub-Saharan Africa
Country Companies Market capitalisation (US$mn)
Turnover (US$mn)
1990 1996
South Africa (1887) 626 137,540 241,571 27,202
Zimbabwe (1946) 64 2,395 2,635 255
Kenya (1954) 56 453 1,846 67
Nigeria (1961) 183 1,372 3,560 72
Côte d’Ivoire (1976) 31 549 914 19
Botswana (1989) 12 na 326 31
In this chapter we have considered the theoretical and empirical argu- ments in favour of stock exchanges as an important component of financial sector development – as well as more general economic devel- opment. It was arguments of this form no doubt that were put to policy-makers in the latest group of countries in sub-Saharan Africa to establish exchanges.
As can be seen from the table above, with the exception of South Africa, stock markets in the region remain very small indeed, both in absolute terms as well as relative to the size of their economies – for example, market capitalisation in Nigeria in 1996 was 8% of GDP, compared to more than 100% in other developing regions. Also, with the exception of South Africa again, the exchanges tend to be concen- trated in a narrow range of sectors that are most important to the countries concerned. Furthermore, excluding South Africa, turnover is very low relative to that seen in other regions: in 1995 none of these markets had a turnover greater than 10% of market cap (compared with more than 200% in Turkey and more than 100% in China at the same time) and eight of the twelve most illiquid stock markets in the world were in sub-Saharan Africa.
This small size, high concentration and low liquidity has – unsurpris- ingly – produced high levels of volatility, with national exchanges gain- ing or losing more than 100% of their value in any one year not being uncommon.
However, as the table above shows, there was considerable growth in some newly founded exchanges in the years immediately after their launch and – given their small size – this growth has continued since the mid-1990s.
Sub-Saharan African exchanges remain characterised by the factors described above, however: in 2007 the top performing exchange was Zimbabwe’s Mining Index, which rose 160% on the back of booming global commodity prices. This highlights the fragile nature of the exchanges – massive ups or downs driven by international factors which may not have any relationship with the real economies in question.
Market turmoil – including suspension of trading – in early 2008 as the impact of the US subprime crisis is felt highlights this point well.
As long as the exchanges remain small, concentrated and illiquid this will continue to be the case. There has been considerable debate about
Ghana (1989) 21 na 1,492 17
Namibia (1992) 12 na 472 38
Swaziland (1990) 6 17 1,642 8
Mauritius (1989) 40 268 1,676 78
Malawi (1996) na na na na
Zambia (1994) 5 na 229 3
Source: Kenny and Moss, 1998.
the creation of regional exchanges in sub-Saharan Africa to overcome the problems described above, and create a situation where the benefits identified with stock market development can materialise. For the posi- tives to outweigh the negatives, this would seem a very promising option.
4.3.3 Bond markets
Although numerous studies purport to investigate the role of capital markets in spurring economic growth, in reality the overwhelming bulk of this work has focused on stock rather than bond markets. In part this is understand- able, since the importance of bond markets in most developing countries is very low, as illustrated in the table below for some Asian economies in 1996.
Despite this relative lack of academic interest in the subject, policy-makers have increasingly stressed the importance of developing broad and deep local bond markets in developing countries. This has been particularly notable in recent years in Asia, where the perception has developed that the lack of such markets made the region vulnerable to the financial crises of 1997 and 1998.
Why do equity markets seem to develop more readily than bond markets, though? In many ways this is related to the nature of the two instruments.
An equity share affords the investor a proportional stake in the future of the company, where the ‘upside’ is essentially unlimited. In contrast, the return on a bond is limited to the interest, while the downside is that the principal may not be paid – there may be a default. If there are concerns about the
Table 4.8 Banks, stock markets and corporate bond markets in emerging Asia Country Domestic credit by
banking sector
Stock market capitalisation
Domestic corporate debt securities
Amount (% GDP)
Change (% GDP)
Total (%GDP)
Equity raised (%
GCF *)
Outstanding (% GDP)
Net issues (% GCF)
Hong Kong 162.4 70.8 244.8 na 0.6 0.0
Indonesia 55.4 31.9 34.8 8.0 na na
Korea 65.7 29.5 33.5 4.0 17.4 10.9
Malaysia 93.1 43.9 269.2 14.0 23.3 18.9
Philippines 49.0 68.5 84.8 8.0 0.0 0.0
Singapore 97.3 36.1 161.6 na 2.7 18.9
Taiwan 142.2 35.8 84.7 na na na
Thailand 100.0 31.3 65.8 6.0 3.9 1.*
Average 95.64 43.48 122.4 8.0 8.0 5.3
Source: Herring and Chatusripitak, 2000.
* = Gross fixed capital formation.
possibility of default, it will be difficult to develop a local bond market, par- ticularly where the legal framework establishing and enforcing a bondholder’s rights in the event of a default are not clearly set out.
Given all this, issuers of bonds may not credibly be able to offer a high enough rate of interest to compensate investors for the perceived risks. In contrast, while equity investors also hold significant downside risks, their incentives and those of the company’s management are usually more aligned – both tend to profit from a rise in the share price. Consequently, a well- developed stock market may result in investors being happy to purchase shares in a company, when they would not be prepared to hold the same company’s corporate bonds. The incentives facing the issuers and holders of bonds are clearly not well aligned (Herring and Chatusripitak, 2000).
Despite these problems, there are clear advantages in developing a local corporate bond market, not least of which is the fact that important informa- tion is contained in the market-determined interest rates attached to corpor- ate bonds. This has important implications for the efficiency and structure of the other aspects of the financial system, and will be covered in more detail in Chapter 5.
To summarise, while there is little academic evidence to link bond market development to economic growth, and corporate bond markets are extremely limited in most developing countries, the development of a deep and broad corporate bond market is an important component of a country’s financial sector development, particularly at later stages of development.
Having considered structural issues in financial sector development, and the linkages between the components of the financial sector and growth, the next section focuses on the crucial role played by governments in the domestic financial system.