The Role of the Stock Market in Economic Development

by Herb Kirchhoff

Stock markets attract investors around the world. They operate in fully developed societies such as in North America and Western Europe, and in developing countries in Africa, Asia, the Middle East and other world regions. Stock markets are a financial engine, not a casino for investors. They can give a major boost to developing economies if they allow easy trading of shares.

Why They Work

Stock markets provide an economic boost through creation of liquidity. Stock markets allow investors to put their savings to work earning returns. But unlike with loans, stocks give investors an ownership interest in the company. And unlike with a loan, stocks can be sold quickly if investors need to take out their money so they can use it for other purposes. For companies, the stock market allows them to raise capital quickly through stock issues. Unlike with loans, capital raised through the stock market doesn’t have to be paid back by some set date.

Liquid Markets

Countries with liquid stock markets tend to have more economic growth than countries where it is very costly and risky to trade. There are four signs that a very liquid stock market exists. In liquid markets: investors can easily buy and sell shares at prevailing market prices in whatever quantity they desire; the value of shares traded is a substantial percentage of the nation’s gross domestic product; a substantial portion of total market capitalization is traded every quarter; and the market can handle bouts of heavy trading without wild price swings.

Stocks and Banks

Banks also promote economic growth but their stimulating effect operates independently from the stock market. One explanation for this is that banks and stock exchanges serve different financial needs. Stock markets offer substantial risk but also the possibility of great reward, without any significant investor involvement in the company. Stock investors tend to focus on the short term. Banks develop long-term relationships with firms, involve themselves in company affairs, and tend to favor larger businesses. However, as companies expand, they reach a point where they need more capital than they can raise through stock sales, so they turn to debt financing through bank loans and bond issues. This need strengthens the banks. Countries that have both strong banks and liquid stock markets tend to have the greatest economic growth rates.

Financial Policy

Developing countries that want a faster pace of economic growth should consider policy changes that will speed development of stock markets and encourage equity investment by domestic and foreign investors. The best way to do this is to remove tax, legal and regulatory barriers that inhibit equity investments. Countries don’t need to go further and adopt interventionist policies such as tax incentives to encourage stock investment. By removing barriers to the free flow of capital, countries can let market forces work naturally to boost their economic growth and prosperity.

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