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A_Historical_Perspective_on_the_Role_of_Stock_Markets_in_Economic_Development

A_Historical_Perspective_on_the_Role_of_Stock_Markets_in_Economic_Development

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A_Historical_Perspective_on_the_Role_of_Stock_Markets_in_Economic_Development
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SPECIAL ARTICLE
SEPTEMBER 8, 2012 vol xlvii no 36
EPW
 
Economic & Political
Weekly
58
A Historical Perspective on the Role of Stock Markets in Economic Development
 Vineet Kohli
 A longer version of this paper was presented at a conference organisedby the Centre for Economic Studies and Planning, Jawaharlal NehruUniversity, on 7 March 2011. I am grateful to C P Chandrasekhar,J Mohan Rao and R Ramakumar for comments and discussions on anearlier draft of this paper. Needless to say, all errors and omissions are mine. Vineet Kohli (
 vineetjnu@gmail.com
) is at the Tata Institute of SocialSciences, Mumbai.
Providing a critical appraisal of the new mainstreamliterature, which argues that successful late developerslike Germany and Japan had strong stock markets intheir early phase of development, this paper tries to trackthe size of stock markets over the 20th century usingdata provided by Raymond Goldsmith. It also presentshistorical case studies of Germany and Japan, whichshow that government intervention in the financialsector was rife in the early years and proved critical inshaping the size and role of stock markets in theireconomies. Besides, these case studies do not show thatequity funding flourishes when governments adopt ahands-off approach towards the financial system.
D
eveloping strong and liquid stock markets is an impor-tant pillar of the financial sector reforms currently being pursued in a number of developing countries.For a time, it was believed that such reforms were not histori-cally grounded because the successful late developers used thebanking system (with extensive government intervention) forfinancing development. In recent years, however, mainstreameconomists have developed alternative historical accounts of finance in developed countries. These reveal that late develop-ers like Germany and Japan, till now considered as models of successful bank-based development, possessed strong stock markets in their early phase of development. Rajan andZingales (2003a, b; henceforth
RZ
) claim that stock markets inJapan, Germany and some other European countries weremore developed in 1913 than in 1980. Similarly, Hoshi andKashyap (2001) argue that pre-second world war Japan hadstrong stock markets and it was only the exigencies of wartimefinance that shaped the Japanese economy into a bank-basedsystem. Fohlin (2007) has argued that on factors such as thecost of trading, stock markets in Germany were very welldeveloped by the end of the 19th century. The sum and substanceof these studies, therefore, is that strong stock markets werean important ingredient of development in the past and thecurrent turn towards greater liberalisation of stock markets is,historically speaking, not unique.The purpose of this paper is to evaluate this literature. Itdoes so by looking at the work of 
RZ
. It also examines the sizeof stock markets in various countries from 1875 onwards usingthe data provided by Goldsmith (1985). The use of Goldsmith’sdata fails to confirm
RZ
’s central proposition that bank-basedeconomies witnessed a sharp decline of stock market indica-tors over the 20th century. Second, the paper presents histori-cal case studies of Germany and Japan. These show that evenif early stock markets in these countries were exceptionally large, they were not qualitatively important for the purpose of providing liquidity and risk sharing. Neither do these casestudies show that equity funding flourishes best when govern-ments adopt a hands-off approach towards the financial sys-tem and follow liberal policies towards capital flows. Instead,government (and central bank) intervention in the financialsector during the early development of both Japan and Ger-many proved critical in shaping the size and role of stock mar-kets within their respective economies. Three questions thendetain our attention. What was the size of the early stock mar-kets? What role did they play? What policies shaped them?
 
SPECIAL ARTICLE
Economic & Political
Weekly
 
EPW
SEPTEMBER 8, 2012 vol xlvii no 36
59
1 Early 20th Century as a Golden Age of Stock Markets:ACritical Appraisal of Rajan and Zingales
RZ
examine various indicators of stock market developmentsuch as the market capitalisation ratio, equity issues as a per-centage of capital formation and the number of listed compa-nies and conclude that most economies, especially those incontinental Europe and Japan, had more developed stock mar-kets in 1913 than in 1980. France, Germany and Japan, amongothers, argue
RZ
, had much larger stock markets than the
US
atthe beginning of 20th century but that their relative positionsdeteriorated as the century drew towards a close. Their dataset reveals that the market capitalisation ratio in France fellfrom 0.78 in 1913 to 0.09 by 1980. Over the same period, it fellfrom 0.44 to 0.09 in Germany and 0.49 to 0.33 in Japan. Onthe other hand, the fall in market capitalisation ratio, from1.09 to 0.81, was less pronounced in the
UK
, whereas the
US
  witnessed an increase from 0.39 in 1913 to 0.46 by 1980. More-over, in 1913, no distinction could be made between marketand bank-based financial systems, which according to
RZ
, is apost-second world war phenomenon. They conclude on a vic-torious note, “Recent studies highlight the distinction betweencontinental Europe and Anglo-American countries, but theearly data do not confirm this”.To explain what they have termed “the great reversal” of stock markets over the 20th century,
RZ
propose an interestgroup theory of financial development. According to them, inthe absence of strong property rights and public disclosure,lenders are not willing to spread credit beyond the close circleof borrowers with whom they enjoy close ties. The underdevel-opment of financial markets, therefore, becomes a source of market power, which the incumbents seek to protect by block-ing efforts to develop a strong financial system based on ruleof law and transparency. The opposition of incumbents tostronger property rights and greater transparency, argue
RZ
,can be muted by the economy’s openness to trade and capitalflows.
1
For example, “discipline” imposed by capital flows may erode a government’s ability to direct finance to incumbentfirms through fiscal and monetary policy tools. In the circum-stances, well-established industrial firms would like to attractfinance from foreign investors who may require stronger pro-tection under the law as a condition for their investments.
RZ
 further argue that over the course of the 20th century, stock markets have waxed and waned in accordance with the move-ment in trade and capital flows. The high stock market indica-tors of 1913 were an outcome of openness to trade and capitalflows that was characteristic of the gold standard era. How-ever, from the 1930s, financial markets entered a long periodof decline as liberal policies towards trade and capital flowsfell victim, first, to the Great Depression and, subsequently, tothe Bretton Woods regime.On a purely logical plane, the interest group theory of finan-cial development proposed by 
RZ
is unconvincing. The powerto create legal infrastructure for a market-based system thatmandates greater information disclosure and respect forinvestor rights ultimately rests with the government. Thegovernment also decides on the degree of openness of theeconomy to trade and capital flows through its trade, indus-trial and financial policies. If the government is weak in itsdealings with existing incumbents, it may not be able to writeor enforce market-friendly laws. If it is weak, surely the incum-bents can also block any attempt on its part to liberalise tradeand capital flows. Also, even if liberalisation strengthens prop-erty rights and improves disclosure, it is not clear that they should suffer a reversal when liberalisation is withdrawn.The second roadblock to
RZ
’s interest group theory of finan-cial development is posed by the contrary movements in open-ness and investor-friendly laws and institutions over the courseof the 20th century. The
US
had no federal laws to protectshareholders till 1933. Such protection as was available toshareholders at the state level was progressively weakenedfrom about 1885 as states competed with each other to maketheir territories attractive to companies.
2
Proper disclosurerequirements were imposed on security issuers only after afederal law of 1933.
RZ
acknowledge the improvements inshareholder protection brought about by the federal regulationof 1933, but maintain that the
US
was an outlier to the generaltrend of the deterioration of market-friendly institutions in thepost-Great Depression period. However, the
UK
seems to havefollowed a more or less similar path of improvements in corpo-rate disclosure and investor protection in the post-Great De-pression era (Cheffins 2003). Till the 1940s, directors’ dutiestowards shareholders were not enunciated in the law. Neither were companies required to provide information on currentearnings till the company Act of 1948 made the public disclo-sure of an annual profit and loss statement mandatory (ibid). All in all, the movement towards greater investor protectionand disclosure requirements becomes noticeable from the1930s in the
US
and the 1940s in the
UK
, that is, much after theliberal capital and trade flow regime of the gold standard wasdestroyed by the Great Depression.
2 Movements in the Size of Stock Markets between 1875and 1978: Estimates Based on Goldsmith’s Data
Sylla (2006), in a review of 
RZ
’s 2003 book,
Saving Capitalism from Capitalists
, suggests that the size of 
US
stock markets in1913 has probably been underestimated by them due to thenon-inclusion of figures related to curb and over-the-counterexchanges. This distorts their analysis by making othercountries look more market-based than the
US
in 1913. It alsoexaggerates the relative decline of stock markets outside the
US
after 1913. Sylla’s suggestion is to use the figures providedby Goldsmith (1985), which, he believes, are more dependable.In the following, we go by Sylla’s advice and examine themovement of stock markets in different countries usingGoldsmith’s estimates.Table 1 (p 60) gives the market capitalisation to gross nationalproduct (
GNP
) ratio for 11 countries for which information isavailable in Goldsmith (1985) from 1875 onwards. Goldsmith’sdata also reveals a sharp decline in the average market capi-talisation ratio in 1978 from its 1913 levels. While a decline inthe market capitalisation ratio is undeniable, the other half of 
RZ
’s claim, that the decline was more pronounced in what are
 
SPECIAL ARTICLE
SEPTEMBER 8, 2012 vol xlvii no 36
EPW
 
Economic & Political
Weekly
60
today perceived as bank-based economies, does not survivethe scrutiny of Goldsmith’s data. Spearman’s rank correlationcoefficient between market capitalisation ratios in 1913 and1978 is positive and statistically significant. The value of therank correlation coefficient is very high at 0.782 and thep-value is 0.0134. In other words, the ranking of differentcountries did not change much between these two dates. Thedecline was much sharper in the
UK
and the
US
than, say, inGermany, France or Italy, where stock market capitalisationshows remarkable stability between the two dates.The market capitalisation ratio may fluctuate with nochange in a stock market’s ability to perform its fundamentalfunction of funding long-lived assets. If, for example, with thesame amount of long-lived assets, an economy is able to pro-duce more
GDP
, there would be a fall in the market capitalisa-tion ratio without any decline in the stock market’s ability toprovide funding. A better indicator of stock market size would,therefore, be market capitalisation relative to the size of long-lived assets. Table 2 provides information on the market valueof corporate shares as a ratio of structures and equipment(taken as a proxy of long-lived assets) at different dates in thesample countries for which information could be obtainedfrom Goldsmith’s dataset since 1875.Table 2 also fails to confirm
RZ
’s hypothesis. The decline inthe size of stock markets between 1913 and 1978 was morepronounced in the
UK
and the
US
than France and Germany.If we delete the
UK
and the
US
from our sample of countriesin Table 2, the mean value for the remaining countries ishigher in 1965 than in 1913 and at the same level in 1973 as in1913. Only in 1978 do we find a sharp decline in the size of stock markets in this sub-sample. The “great reversal” hypo-thesis is contingent on the selection of particular benchmark dates and is not a general phenomenon that holds across datecomparisons. All in all, Goldsmith’s data shows that theobserved decline in market capitalisation to
GNP
ratio be-tween the pre-war and post-war dates is not an outcome of the decline in stock markets’ ability to fund long-lived assets.Rather the decline is probably an outcome of the fall inlong-lived assets (as proxied by structures and equipments)relative to
GNP
.Finally, let us look at the size of the financial sector relativeto the real sector of the economy. Table 3 lists the share of financial assets in national assets (defined as the sum of finan-cial assets, tangible assets and monetary metals) usingGoldsmith’s data. The results are startling. The extent of financial deepening increased between 1913 and 1978. Themean value of the ratio of financial to national assetsincreased from 0.40 in 1913 to 0.45 in 1978. Table 3 showsthat financial deepening increased till 1929, after which itlevelled off in subsequent years. The claim that the shift tocapital controls harmed financial sectors is hard to maintain. Also, in the 50 years or so after 1929, there were some incred-ible examples of financial deepening. There was Italy, wherethe ratio of financial to national assets increased by 25%between 1929 and 1978, and India, where the increase overthe period was an incredible 80%.
3 A Case for Broadening the Scope of Enquiry
Strong stock market indicators do not necessarily imply thatstock markets are qualitatively important for risk diversifica-tion and liquidity provision. For example, if a large number of shares are issued to a few investors, who then obtain liquidity by pledging their shares with the banking system (as in theJapanese case), stock markets will appear large but that does
Table 1: Ratio of Market Capitalisation to GNP
1875 1895 1913 1929 1939 1950 1965 1973 1978
Belgium 0.64 0.58 0.87 0.69 0.34 0.32 0.24 0.18 0.18Denmark 0.64 0.74 0.88 1.26 0.66 0.39 0.33 0.29 0.28France 0.39 0.66 0.23 0.25 1.08 0.58 0.39Germany 0.16 0.23 0.45 0.35 0.21 0.18 0.48 0.38 0.38Great Britain 0.58 1.56 1.21 1.54 1.82 1.10 0.83 0.64 0.76India 0.02 0.03 0.05 0.09 0.14 0.12 0.14 0.13 0.12Italy 0.07 0.11 0.06 0.27 0.25 0.19 0.57 0.27 0.10Japan 0.04 0.32 0.41 0.76 1.18 0.24 0.46 0.28 0.39Norway 0.14 0.27 0.40 0.47 0.28 0.11 0.33 0.22 0.21Switzerland 0.80 0.82 1.23 1.37 1.49 1.26 1.16 0.69 1.02US 0.54 1.02 0.95 1.94 1.05 0.58 1.25 0.79 0.78Mean 0.36 0.57 0.65 0.81 0.74 0.43 0.62 0.40 0.42Median 0.39 0.45 0.66 0.69 0.50 0.25 0.48 0.29 0.38
Source: Author’s calculations based on Goldsmith (1985).
Table 2: Ratio of Market Capitalisation to Value of Structures and Equipment
1875 1895 1913 1929 1939 1950 1965 1973 1978
Belgium 0.13 0.11 0.19 0.17 0.08 0.10 0.07 0.07 0.05Denmark 0.59 0.45 0.47 0.62 0.28 0.14 0.14 0.14 0.09France 0.21 0.40 0.13 0.22 1.18 0.63 0.36Germany 0.07 0.13 0.14 0.09 0.08 0.08 0.35 0.15 0.15Great Britain 0.33 1.23 0.90 1.23 1.57 0.86 0.58 0.36 0.26India 0.01 0.02 0.04 0.05 0.08 0.09 0.06 0.06 0.04Italy 0.06 0.08 0.04 0.16 0.13 0.11 0.39 0.23 0.07Japan 0.03 0.26 0.33 0.56 0.83 0.37 0.47 0.29 0.28Norway 0.08 0.15 0.18 0.23 0.14 0.05 0.04 0.03 0.02Switzerland 0.20 0.30 0.36 0.44 0.35 0.29 0.35 0.45 0.27US 0.49 0.54 0.74 1.36 0.73 0.51 0.81 0.48 0.41Mean 0.20 0.33 0.35 0.46 0.43 0.26 0.40 0.26 0.18Median 0.13 0.20 0.33 0.23 0.21 0.14 0.35 0.23 0.15
For Denmark, India and Switzerland, structures include both residential and non-residential structures. For Belgium, market capitalisation has been divided by reproducibletangible assets due to lack of availability of data.Source: Author’s calculations based on Goldsmith (1985).
Table 3: Ratio of Financial Assets to National Assets
1875 1895 1913 1929 1939 1950 1965 1973 1978
Belgium 0.28 0.30 0.39 0.38 0.39 0.41 0.39 0.43 0.40Denmark 0.49 0.56 0.58 0.59 0.54 0.51 0.49 0.53 0.50France 0.34 0.00 0.47 0.44 0.00 0.35 0.55 0.44 0.41Germany 0.24 0.37 0.40 0.27 0.36 0.29 0.44 0.43 0.43Great Britain 0.38 0.51 0.47 0.60 0.63 0.64 0.60 0.56 0.53India 0.12 0.11 0.13 0.16 0.19 0.22 0.29 0.31 0.29Italy 0.28 0.30 0.31 0.40 0.42 0.29 0.45 0.52 0.50Japan 0.23 0.25 0.38 0.54 0.58 0.35 0.45 0.48 0.50Norway 0.26 0.35 0.41 0.50 0.42 0.44 0.44 0.46 0.46Switzerland 0.43 0.48 0.48 0.55 0.54 0.48 0.50 0.46 0.48US 0.37 0.40 0.43 0.54 0.51 0.50 0.54 0.50 0.47Mean 0.31 0.33 0.40 0.45 0.42 0.41 0.47 0.47 0.45Median 0.28 0.35 0.41 0.50 0.42 0.41 0.45 0.46 0.47
Source: Author’s calculations based on Goldsmith (1985).

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