Capital Market Development, Corporate Financing Pattern and

Economic Growth in India

R.N.Agarwal

Institute of Economic Growth

University Enclave, Delhi - 110007

1
 Capital Market Development, Corporate Financing Pattern and
Economic Growth in India

Abstract

Literature suggests that there might exist some correlationship between the financial
sector and capital market development, and the growth of real GDP. There have been
several studies on this subject but the results are inconclusive. Hence, the objective of the
present study is to contribute to the existing debate by analysing the Indian data
beginning with the 1980s. The study supports the Levine and Zervos’s argument that
well-developed stock markets may be able to offer a different kind of financial services
than the banking system and therefore provide an extra impetus to economic activity.
Also, the two main parameters of capital market development namely, size and liquidity
are found statistically significant to explain the economic activity. Correlation analysis
reveals that the banking sector and capital market development indicators are
complementary and not a substitute for each other. The present study has also inferred
that the right variable to be a proxy for the expansion of economic activity is the totality
of funds mobilised by the corporate sector from alternative sources and not merely the
credit offered by commercial banks as has been assumed in earlier studies.

JEL Classification: F36, F41

2
 Capital Market Development, Corporate Financing Pattern, and
Economic Growth in India

1. Introduction
The equity markets in developing countries until the mid-1980s generally suffered from
the classical defects of bank-dominated economies, that is, shortage of equity capital,
lack of liquidity, absence of foreign institutional investors, and lack of investor’s
confidence in the stock market. Since 1986, the capital markets of the developing
countries started developing with financial liberalisation and the easing of legislative and
administrative barriers and the adoption of tougher regulations to boost investor’s
confidence. With the beginning of financial liberalisation in the developing countries, the
flow of private foreign capital from the developed to the developing countries has
increased significantly and such inflows of foreign capital have been mainly in the form
of foreign direct investment and portfolio investment (World Bank 1996, Agarwal 1997).
The latter type of inflows have mainly been through their stock markets. Data reveal that
the world stock market capitalisation has risen from $4.7 trillion in 1980 to $27.5 trillion
in 1998 and the emerging market capitalisation has jumped from less than 4 percent to 7
percent of total world market capitalisation over the same period (Emerging Stock
Markets Factbook, IFC 1999) 1. Trading on the world stock markets has also surged over
time. Trading in emerging stock markets has climbed from less than 3 percent of the $1.6
trillion world total in 1985 to around 8.7 percent of the $ 22.8 trillion shares traded on all
the world stock markets in 1998. In the history of international finance, the year 1992-93
may be seen as a watershed year in which emerging markets came into their own as
capital raising mechanisms and became firmly established as a distinct asset class for the
world’s investment community. With financial liberalisation, many of the East-Asian
capital markets like Singapore, Hong Kong and Bangkok have developed over time to the
extent that they are presently regarded as international financial centers of Asia.

1
The term emerging market implies a stock market that is in transition, increasing in size, activity, or level
of sophistication. IFC classifies a stock market as emerging if if it meets at least one of two general
criterion: 1. It is located in a low or middle income economy as defined by the world bank (per capita GDP
less than $ 9656 ) for the last three consecutive years and 2. Its investable market capitalisation is low
relative to its GDP.

3
 These economies have also exhibited a record growth rate of around 10 percent for a
decade 1986-96.
In contrast to changes in the financial sector policies in South-East asia, the
decade of 1980s saw comparatively little change in the financial sector policies in India.
From the mid-1960s to the early 1990s, the Indian financial system was considered as an
instrument of public finance. A complex web of regulations regarding the interest rates,
end use of credits, and the nature and objectives of financial institutions dominated the
financial system. Though the capital market started showing signs of good performance
since the mid-1980s with the partial liberalisation of the industrial sector, introduction of
a long-term fiscal policy, and the emergence of the debenture market as an alternative
source of finance for the large corporate sector, the capital market in India suffered from
many serious weaknesses until 1992 (Agarwal 1996). Reforms in the capital market have
been introduced since 1992-93. Reflecting developments in the capital markets along
with economic reforms in other sectors of the Indian economy, the stock market boomed
in the mid-1990s. These developments have altered the financing behaviour of the
corporate sector changing their dependence from the bank-dominated loans to capital
market-based equity capital. Coincidently, since the beginning of financial liberalisation
in 1992-93, India has made a remarkable turnaround with the real GDP growth rising
from 0.8 percent in 1991-92 to 5.1 percent in 1992-93 and then rising smoothly to 7.1
percent in 1995-96. The growth rate of real GDP, though declined for two years during
1996-98, has picked up again in the last two years. From the discussion it appears as if
the financial sector and capital market development have their respective role in
economic growth.
The decisive role of the banking system in mobilising and allocating the resources
for capital formation and economic growth has been well established by many empirical
studies (Levine 1997). These studies use alternative measures of financial development
such as the ratio of bank deposits to GDP or M3 to GDP and the ratio of bank’s credit to
the commercial sector to total credit or GDP. Recently, the emphasis has shifted to the
use of both the credit market and stock market development indicators in explaining the
economic growth (Levine and Zervos 1996; Singh 1997). This is attributed to the fact
that the stock markets have come to play an important role in providing an alternative

4
source of long-term finance to financially strong and better-managed companies at a
cheaper price and to diversify risk. The number of companies listed on the stock markets,
their market capitalisation and the total value of shares traded on developing country’s
stock markets have risen significantly during 1990s (Singh 1997; Demirguc-Kunt and
Levine 1996). However, the issue of the relationship between capital markets and credit
markets (banks and other financial institutions) and their relative role in influencing
economic growth is not conclusively resolved in policy-related research. Levine and
Zervos (1996) argue that well-developed stock markets may be able to offer financial
services of a different kind than by the banking system and may therefore provide a
different kind of impetus to investment and growth than provided by the development of
the banking system. They further demonstrate that after controlling for initial conditions
and various economic and political factors, the measures of banking and stock market
development indicators are robustly correlated with current and future rates of economic
growth and economic efficiency improvements through increased liquidity and lower
risk. On the contrary, Singh (1997) argues that pressures may emanate from transactions
induced by the euphoria created by financial liberalisation. An undesirable implication of
these type of pressures is that economies may be forced to bear a greater degree of risk
with financial liberalisation than without it. This may exert an upward pressure on
interest rates and reduce the total volume of real sector investment and growth. Thus, the
role of stock market to economic growth is debatable. To examine this relationship for
the Indian economy, there have been several studies in the recent past (Nagraj 1996;
Singh 1997,1998; Nagaishi 1999). But there is still no clearcut answer to the above
question. This is a debatable issue.

Hence, the objective of the present study is to contribute to the existing debate by
analysing the Indian data since the 1980s. Specifically, the paper investigates the
relationships between stock markets and financial intermediaries. Are they
complementary or a substitute for one another? It also studies the ties between stock
market development and financing behaviour of the private corporate sector. Finally, the
paper analyses the relationship between stock market development and economic growth.

5
 The rest of the paper is organised as follows: Section 2 explains the financing
pattern of the Indian corporate sector. A theoretical framework and a review of literature
on the subject is presented in Section 3. Research methodology and the model is
explained in Section 4. Empirical results are presented in Section 5. Conclusions of the
study are presented in the concluding section.

2. Capital Market Growth and Financing Pattern of Indian Corporate Sector.

The Indian financial system is characterised by a large network of commercial banks,
financial institutions, stock exchanges, and a wide range of financial instruments.
Commercial banks and cooperative banks generally cater to the working capital needs of
the corporate sector. Since 1992-93, commercial banks have diversified into several new
areas of business like merchant banking, mutual funds, leasing, venture capital, and other
financial services. Commercial and cooperative banks hold around two-thirds of total
assets of the Indian banks and other financial institutions taken together. Medium and
long-term finance is largely provided by development financial institutions (DFIs),
investment institutions like LIC and GIC, and mutual funds, and state-level financial
institutions. In addition there are around 12,500 non-banking financial companies in the
private sector which cater to the financing needs of the corporate sector. Stock exchanges
also serve as an important and cheaper source of funds for the corporate sector. The
securities market constitute a critical component of Indian financial markets. Presently,
there are twenty two stock exchanges in the country. The Mumbai (Bombay) Stock
Exchange (BSE), is the country’s oldest exchange with a formal trading activity since
1875. The National stock exchange has been established as a model stock exchange in
1994 for introducing scripless and screen-based trading. Stock markets have two
components, namely, Primary and Secondary stock markets. A company can mobilise
resources from the stock market by the issue of new shares / debentures in the primary
market or by trading in the secondary market. Over the years, significant growth has
taken place in the financing pattern of the corporate sector.

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 According to an estimate by the RBI (RBI 1997), about Rs.155 billion were raised
by the corporate sector in 1996-97 from the new issues floated in the primary capital
market as compared to Rs. 2 billion raised in 1980-81. The share of the private corporate
sector in this collection was Rs. 105 billion. However, the new issue segment of the
primary capital market remained subdued in the next two years. During the last few years,
the private placement market has emerged as a major route for the raising of resources by
the corporate firms. During 1998-99, banks, financial institutions and the public and
private sector companies mobilised Rs.49,664 crore (84.1 percent of total resource
mobilisation from the primary market) through this route.
With the liberalisation of the financial sector since 1992, funds are also raised by
Indian companies through global depository receipts (GDRs), off-shore funds and other
means. During the period 1991-92 to 1996-97 funds collected by such means have
amounted to US$ 6.2 billion. Besides, the net cumulative investment made by the foreign
institutional investors (FIIs) in the Indian stock markets during 1993 (January) to 1997
(March) has amounted to US$ 7.1 billion (RBI, Report on Currency and Finance 1998-
99). Data on the mobilisation of resources by the corporate sector from external sources
of funds is presented in Table 1 below.

Table 1:Resource Mobilisation by the Corporate Sector

(Rs.in 10million or crore)

Commercial Other Dev. Primary Net Foreign

Banks Financial Capital Mkt. portfolio
Institutions New issues investments
plus Private @
placement
1980-81 5630 1848 200 -
1985-86 11850 4940 1745 -
1990-91 20065 12810 4312 0
1995-96 55166 38966 16117 13380
1996-97 33209 42905 10400+5100 13850
1997-98 52212 53967 3138+30100 8946
1998-99 57054 56090 5587+49664 -232
Source : RBI Annual Report, Handbook of Statistics on Indian Economy, RBI 1999.
Note : @ includes Euro equity issues and others, and net portfolio investment by FIIs.

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 These figures show a rising trend indicating substantial resource mobilisation by
the corporate sector in India from the capital market and development financial
institutions (DFIs). Lending by the commercial banks to the commercial sector reached a
climax in 1995-96 and came down in the next year. It has picked up again in the next two
years. However, long-term funding by the DFIs continued to grow. These results confirm
the earlier findings (Singh 1997) that developing country corporations depend heavily on
external sources of funds, with a significant share coming from the capital market.

3. Theoretical Framework and Review of Literature.

McKinnon (1973) and Shaw (1973) have examined the relationship between financial
development and economic growth without giving much analytical perspective to capital
market development. In an equity market, an asset can be sold/purchased at any moment
during the working hours of the stock market. Thus, equity markets make investment less
risky and more attractive. Such investments help in the capital formation and growth of
firms. Cho (1986) introduced the role of the stock market to the McKinnon-Shaw
framework by applying the theory of credit rationing which was proposed by Stiglitz and
Weiss (1981). According to this theory banks inherently suffer from the problem of
imperfect information in the credit market and cannot achieve efficient capital allocation.
On the other hand, equity finance is free from adverse selection and moral hazard effects.
Thus, substantial development of an equity market is a necessary condition for complete
financial liberalisation. Levine (1991) and Bencivenga, Smith and Starr (1996) confirm
that stock markets can boost economic activity through the creation of liquidity. Risk
diversification, through internationally integrated stock markets, is another vehicle
through which stock markets can raise resources and affect growth (Obstfeld 1995). By
facilitating longer-term, more profitable investments, liquid markets generally improve
the allocation of capital and enhance prospects for long-term economic growth. However,
there are alternative views about the effect of liquidity on growth. Increased liquidity can
also deter growth. By increasing returns to investment, greater stock market liquidity may
reduce the savings rate through income and substitution effects. Also, greater stock
market liquidity may adversely affect corporate governance and hence economic growth.

8
 Demirguc-Kunt and Levine (1996) examine the interaction between stock market
and financial intermediaries development and find that across countries, the level of stock
market development is positively correlated with the development of financial
intermediaries. Demirguc-Kunt and Maksimovic (1996) also investigate empirically the
effect of stock market development on the financing choice of firms and find that firms in
countries with an underdeveloped stock market first increase their debt-equity ratios as
their stock markets develop and that the debt and equity finance are complementary. The
first comprehensive study on the relationship between stock market development and
economic growth was made by the World Bank Research Group, namely, R.Levine and
others.2 They investigate the compatibility of stock market development with financial
intermediaries and economic growth. Their general conclusion is that stock market
development is positively correlated with the development of financial intermediaries and
long-term economic growth. Levine (1997) argues that stock markets provide a different
bundle of financial functions from those provided by financial intermediaries. Hence, to
understand the relationship between financial structure and economic growth, we need
theories of simultaneous emergence of stock markets and banks. In the Indian context,
Shah and Thomas (1997) can be considered as representative of a view supporting the
role of stock market development for economic growth. According to them the stock
market in India is more efficient than the banking system on account of the enabling
government policies and that stock market development has a key role to play in the
reforms of the banking system by generating competition for funds mobilisation and
allocation. Hence, an efficient capital market would contribute to long-term growth.
RBI data on the flow of funds in the private corporate sector during the period
1981-82 to 1996-97 is presented in table 2. Data show that there there is growing reliance
of the private corporate sector on external financing. It is further revealed by a sample of
ICICI-assisted companies that the rise in external sources of funds to the corporate sector
is shared by debentures and long-term borrowings (mainly from financial institutions) in
the 1980s and mainly by capital markets in the late 1980s and 1990s. Thus, the role of
banks in external financing has declined while that of development financial institutions

2
Boyd and Smith 1995, Demirguc-Kunt and Levine 1996, Demirguc-Kunt and Maksimovic 1996 and
Levine and Zervos 1996.

9
( including their assistance by way of underwriting and direct subscription of shares and
debt securities) and capital markets has increased since late 1980s.

Table 2 : Funding Pattern of the Indian Private Corporate Sector

(Percent of GDP)
Year Internal Funds Gross Domestic Investment
1981-86 1.72 4.50
1986-91 2.28 4.38
1991-97 3.65 7.46
Source : CSO, National accounts statistics, Various Issues.

Table 3: Sources and Uses of Funds for ICICI Assisted Companies

(Average Share in Total in percentage )

1970-80 1980-88 1988-96

No. of Companies 417 417 615
Retained Earnings 40.5 36.0 31.4
Depreciation 27.6 21.0 14.8
Paid-up-capital 8.9 4.2 4.5
Share premium 0.4 1.4 11.6
Debentures 1.3 10.1 7.3
Long-term 6.7 12.6 12.7
Borrowings
Source: Finances of ICICI Assisted Companies, ICICI, 1997

Data in table1 also shows that since1992, there has been enhanced competition in
the financial system for the external sources of funds as a result of the opening up of the
market for new entrants from within and outside the country. The capital market assumed
more importance in this period. However, Singh (1997,1998) and Nagraj (1996) have not
supported the above findings of Singh and Thomas. They have concluded that there is
little evidence of an increase in aggregate gross domestic savings or an increase in the
proportion of financial savings as a result of the growth of stock market activity. Makoto
Nagaishi (1999) has also examined the role of stock market development in the
economic growth for India. He has concluded that the Indian stock market from the
1980s onwards has not played a prominent role in domestic savings mobilisation and that
bank credit to the commercial sector, as an indicator of economic growth, has no positive
correlationship with indicators of stock market development.

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4. Research Methodology

The analysis is based on two sets of data. The first set consists of 60 observations on
monthly data for the Indian economy for the period April 1994 to March 1999 and the
second set has annual data for the period 1980-81 to 1998-99. The data has been collected
mainly from the Handbook of Statistics on Indian Economy and the Report on Currency
and Finance, published annually by the Reserve Bank of India, and Emerging Stock
Markets Fact book published annually by the International Financial Corporation, USA.
To evaluate the impact of financial sector reforms and financial globalisation on
economic growth, two dummy variables have been generated as under:

D1 = 0 for the period 1980-81 to 1984-85

= 1 later on
D2 = 0 for the period 1980-81 to 1991-92
= 1 later on

Dependent variable : Monthly index of industrial production is considered for analysing

the monthly data where as an index of gross domestic product (GDP) at constant price is
used for the analysis of annual data.

Independent variables include the development indicators of the monetary sector and
capital market (as explained in section 5) and the dummy variables D1 and D2.

To start with, financial ratios and a correlation matrix based on the financial
sector and capital market development indicators have been computed. Finally,
regression analysis has been used to assess the relative contribution of the financial sector
and capital market developments to economic growth. Results based on the annual data
only are presented below.

5. Empirical Results

Indicators of Financial Sector Development

Extending the work by King and Levine (1993), we have used four measures of financial
system development. The four measures are : (1) M3/GDP; (2) M3 / M1; (3) the ratio of
domestic credit to the private corporate sector (BCCS) to total bank credit (TBC) by the
commercial banks, and (4) aggregate of funds mobilised by the corporate sector (AFCS)
as a percentage of GDP 3. Data reveal that liquidity in the financial system, as measured
by the ratio M3/GDP, has increased from a value of 0.556 in 1990-91 to 0.669 in 1997-
98. Similarly, the ratio of M3/M1 has increased over time indicating an increase in

3
Broad money (M3) comprises the sum of quasi money and narrow money. Quasi money is often a more
direct measure of pure saving balances. However, since a clear divison cannot be made, broad money is
used.

11
savings deposits relative to transaction balances. The share of credits to the private sector
in the total credit by commercial banks does not show an upward trend. However, the
ratio of total funds mobilised by the corporate sector to GDP show a rising trend.
Table 4 : Indicators of Financial Sector Development
Year M3/GDP M3 / M1 BCCS/ BCCS/ AFCS/
TBC GDP GDP
1990-91 0.556 2.86 0.551 0.359 0.396
1993-94 0.588 2.86 0.540 0.324 0.405
1994-95 0.608 2.74 0.568 0.299 0.425
1995-96 0.595 2.79 0.572 0.342 0.413
1996-97 0.605 2.89 0.566 0.327 0.396
1997-98 0.669 3.06 0.567 0.353 0.418
Source : Report on Currency and Finance, Govt. of India, 1998-99
Note : M1 denotes currency with the public plus demand deposit with the banking sector, plus other
deposits with RBI ; M2 denotes M1 plus term liability portion of saving deposits, plus CD issued by banks,
plus term deposits with a maturity upto one year; M3 represents M2 plus term deposits with a maturity of
more than one year, plus borrowings from non-depository financial corporations by the banking system

Indicators of Capital Market Development

Stock market development like the economic development is a complex and multi-
faceted concept and no single measure will capture all aspects of stock market
development. Thus, we examine a broad array of stock market development indicators.
Specifically, we examine different measures of stock market size, market liquidity, and
regulatory and institutional development.

Stock Market Size

The market capitalisation ratio is generally taken as a measure of stock market size. (This
is measured as a ratio of market value of stocks which are listed on a stock market to
GDP). Alternatively, size is measured by the number of listed companies on a stock
market.
Liquidity

The term ‘ liquidity ‘ refers to the ability of the market to buy or sell securities. Two
measures are generally used to measure liquidity. They are turnover (total value traded)
in the stock market as a ratio of: (i) GDP; and (ii) stock market capitalisation. The second
measure is also called turnover ratio. High turnover ratio is associated with low

12
transaction cost. It also denotes the degree of activity on a stock market. Thus, a small but
active stock market has a small size but a high turnover ratio.

Indicators of stock market development for one of the oldest and premier stock
exchanges in India, namely, the Bombay Stock Exchange are presented in Table 5.

Table 5 : Indicators of Capital Market Development ( in % )

Financial MCAP/ Turnover / Turnover NO. of

Year GDP GDP ratio Listed Cos.
1981 9.64 5.2 59.5 1031
1988 8.6 4.4 59.2 2240
1991 36.2 9.6 57.0 2556
1992 39.0 8.3 37.0 2781
1993 50.3 8.4 27.5 3263
1994 51.3 9.0 24.0 4413
1995 45.4 4.1 10.5 5398
1996 50.2 7.4 17.0 5999
1997 52.6 --- 42.0 5843
Source: World Development Indicators, World Bank, 1998; Emerging Stock Markets: Factbook, 1999;
Bombay Stock Exchange -Official Directory.

Data reveal that stock market size, as measured by the number of listed
companies and market capitalisation has increased over time. But liquidity on the stock
exchange, as measured by the turnover ratio has not increased. A comparative analysis of
the development in the stock markets of some selected Asian economies for the period
1985 to 1996 is presented below in Table 6.

Table 6 - Stock Market Development in Asia : 1985-96

Country MCAP as % MCAP as % Turnover Turnover Foreign share

of GDP of GDP Ratio Ratio in Indian
All-India All-India (in %) (in %) StockMarket
turnover(%)
Financial 1985 1996 1985 1996 1995
Year
India 9.9 66.2 34.5 21.7 25
Indonesia 0.1 41.2 2.6 35.3 75
S.Korea 7.8 28.9 56.4 127.7 81
Malaysia 52.0 323.6 14.4 56.5 50
Philippines 2.2 97.5 16.6 31.6 50
Thailand 4.8 53.1 30.6 44.4 26
All emerging 7.2 40.5 38.8 51.4
Economies
Sources: 1. Emerging Stock Markets Factbook , International Finance Corporation,1997; 2. Indian
Securities Market : A Review; National Sock Exchange of India, 1999; 3. .Bombay Stock Exchange,
Official Directory.

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From the table it can be inferred that the Indian stock market is comparatively less active
in terms of turnover ratio and foreign share in the turnover.

Regulatory and Institutional Indicators of Financial Development

Regulatory and institutional factors may also influence the development of banking and
stock markets. For example, mandatory disclosure of reliable information about firms and
financial intermediaries may enhance investor participation in the money and capital
markets. Similarly, regulations that instill investor confidence in brokers and other capital
market intermediaries should encourage investment in the stock market. To assess the
regulatory and institutional features of emerging stock markets, the International Finance
Corporation (IFC) has specified seven major indicators such as : availability of published
information on price-earning ratios, investor protection laws, accounting standards,
existence of a securities and exchange commission, restrictions on dividend repatriation
and capital repatriation by foreign investors, and domestic investments by foreigners. As
per the latest information, India has a regulatory authority for the stock market, called
SEBI. It has accounting standards of international accepted quality, but restricts capital
flows and repatriation of capital and dividends. SEBI has specified rules for the regularly
publishing of price-earning ratios and the provision of protection to investors.

Correlation Analysis
To assess the linkages between banking sector development and capital market
development and their influence on economic growth, a correlation matrix has been
computed using (1) monthly data and (2) annual data. Results are summarised below.
• The development indicators for the banking sector and the capital market have a
highly positive correlation coefficient implying that they have developed together.
• The credit to the commercial sector by the commercial banks has not been growing
at a speed comparable with the growth of trade and size on the capital market.
However, the magnitude of all funds mobilised by the commercial sector through
the commercial banks, development financial institutions, foreign capital flows and
the new issues has a positive association with the capital market developments.

14
 This indicates that the commercial sector has been substituting commercial bank’s
credit to them by alternative sources of funds.
• The index of industrial production or gross domestic product has a highly positive
correlation coefficient with the indicators of development of the capital market as
well as the banking sector (when the variable AFCS/GDP is considered instead of
BCCS/GDP or CCS/BCT)
• Exactly similar results are obtained when monthly data or the annual data is used.

Correlation Matrix (Based on Annual Data)

IIP M3/M1 M3/ BCCS/ BCCS/ AFCS/ MCAP/ TR/
GDP BCT GDP GDP GDP GDP
IIP 1.0
M3/M1 0.85 1.0
M3/ 0.91 0.85 1.0
GDP
BCCS/ -0.59 -0.66 -0.70 1.0
BCT
BCCS/ -0.16 0.31 0.27 -0.26 1.0
GDP
AFCS/ 0.56 0.60 0.81 -0.58 0.57 1.0
GDP
MCAP/ 0.80 0.55 0.81 -0.67 -0.10 0.58 1.0
GDP
TR/ 0.91 0.87 0.84 -0.61 0.15 0.46 0.64 1.0
GDP

Regression Analysis
In order to estimate the contribution of various components of financial sector and the
capital market development on economic growth, ordinary least square method of
regression analysis has been applied using the (1) monthly as well as (2) annual data.
While working with the monthly data, as the GDP series is not available, monthly index

15
of industrial production has been used as a proxy for economic activity. Similarly, the
ratio M3/M1 has been used instead of M3/GDP as an indicator of money market
development. As an indicator of the capital market development, the ratio of turnover to
market capitalisation has been used instead of MCAP/GDP or TR/GDP. Results are
found similar using monthly or annual data. Results based on the annual data are
presented below.
IIP = -54.85 + 317.47 M3/GDP + 666.07 TR/GDP + 1.09 MCAP/GDP
(1.55) (3.91) (2.09)
R(BAR SQR) =0.90 D.W. =1.92

GDP = 7.32+0.028 MCAP/GDP+ 33.74 TR/GDP + 3.37 D2

(1.12) (4.80) ( 3.60)
R(BAR SQR) = 0.89 D.W. = 1.84

GDP = 5.79 + 0.075 MCAP/GDP + 43.89 TR/GDP –0.15 D1

(2.46) (4.15) (0.09)
R (BAR SQR) =0.78

GDP = -8.73 + 21.58 M3/GDP + 4.20 D2

(2.29) (3.57)
R (BAR SQR ) = 0.77

Regression results confirm our earlier findings that financial sector and capital
market developments are complementary to each other. Both have re-enforced each other
and moved together. Further, the level of economic activity in the Indian economy as
measured by the index of industrial production or by an index of GDP, has been found as
boosted by the development in both the segments of the financial sector. Dummy variable
D1 is not found significant but the government policies of economic reforms since 1992-
93 ( as represented by dummy variable D2 ) is found to encourage economic activity
significantly. The flow of bank’s credit or the total funds mobilised by the commercial
sector has not been found significant to encourage economic growth.

16
6. Conclusions
Our study supports the Devine and Zervos’s argument that well-developed stock markets
may be able to offer financial services of different kind than those of the banking system
and therefore provide an extra impetus to economic activity. Also, both the parameters of
capital market development such as the size and liquidity are found to be statistically
significant to explain economic activity. Correlation analysis reveals that the banking
sector and capital market development indicators are complementary and not a substitute
for each other. Thus, our study also supports the views of Levine (1991) and Bencivenga,
Smith and Starr (1996) that stock markets can boost economic activity through the
creation of new companies and liquidity. The present study has also inferred that the right
variable to be a proxy for the expansion of economic activity is the totality of funds
mobilised by the corporate sector from alternative sources and not merely the credit by
the commercial banks as has been assumed in earlier studies ( Nagraj 1996, Singh 1997
and Nagaishi 1999). Development financial institutions and capital markets also play an
important role in funds mobilisation.

17
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------------------(1997), “ Inflow of Foreign Portfolio Investment in Developing Countries:
A study of Determinants and Macroeconomic Impact”, The Indian Economic Review,
Vol.32, No.2, PP. 217-229.
Bencivenga, Smith and Starr (1996),” Liquidity of Secondary Capital Markets: Allocative
Efficiency and the Maturity Composition of the Capital Stock,” Economic Theory 7(1),
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