Determinants of Stock Market Development: A Review of the Literature

Abstract
The paper provides a comprehensive review of the theoretical and the empirical literature on the
determinants of stock market development. Based on the theoretical literature, the determinants of
stock market development can be broadly classified into two groups: macroeconomic factors and
institutional factors. The theory and the empirics predict different ways in which macroeconomic
factors affect stock market development. The real income and income growth rate foster stock market
development. The banking sector, interest rate, and private capital flows can foster or inhibit stock
market development. Inflation and exchange rates have adverse effects on stock market development.
In terms of the institutional factors, the literature indicates that different legal origins and stock
market integration can have positive or negative impact on stock market development. In addition,
factors such as legal protection of investors, corporate governance, financial liberalization and trade
openness contribute positively to the development of the stock market. Although the empirical studies
have incorporated a large set of variables in their models, the theoretical studies do not contain rich
models of stock market development. It is understandable that a theoretical model which contains a
large set of the determinants of stock market development may be difficult to solve. However, such a
model seems very appealing and will provide a unification of the existing literature.

JEL Code: E44

Keywords: Determinants; Stock Market Development; Literature Review.

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1. Introduction

The importance of the stock market cannot be overstated. By reducing the cost of mobilising
savings, the stock market may facilitate investment in the most productive technologies. The
stock market may also improve capital allocation by enabling the implementation of long-
term projects with long-term payoffs. In addition, the stock market provides market liquidity
which allows investors to trade financial assets in a less risky manner while allowing
companies to enjoy easy access to capital. The development of stock markets may improve
corporate governance by addressing the principal-problem. Stock markets generally align the
interest of managers and owners, and hence motivate the managers to strive to maximize the
value of firms. Moreover, well-developed stock markets foster international risk-sharing by
allowing world portfolios to shift from safer low-return capital to riskier high-return capital
(see Jensen and Murphy 1990; Levine 1991; Obstfeld 1994; Bencivenga et al. 1996;
Greenwood and Smith 1997).

Due to its importance, a growing number of studies have been devoted to analyse the linkages
between the stock market and various aspects of the economy. To better understand the
complexity of the stock market, its determinants must be known. To this end, various studies
have identified key macroeconomic and institutional factors that potentially drive the stock
market. Whereas the empirical studies appear to have grown over the years, the theoretical
literature is surprisingly very limited. It takes a careful examination of the theoretical models
to assemble the determinants of the stock market as established by economic theory. It is
therefore not uncommon to find several empirical studies on the determinants of stock market
development that failed to motivate these so-called determinants with economic theory.

To our knowledge, there is no study that surveys the existing theoretical and empirical studies
on the determinants of stock market development. Hence, we take this initiative to provide a
comprehensive review of the literature. Based on our review of the theoretical literature, the
determinants of stock market development can be broadly classified into two groups. These
are: (i) macroeconomic determinants, and (ii) institutional determinants. Generally speaking,
the theory and the empirics predict different ways in which macroeconomic factors affect
stock market development. The real income and its growth rate foster stock market
development. The banking sector, interest rate and private capital flows may foster or inhibit
stock market development. Inflation and exchange rates have adverse effects on stock market
development. In terms of the institutional factors, the literature indicates that different legal
origins and stock market integration may have positive or negative effects on stock market
development. In addition, factors such as legal protection of investors, corporate governance,
financial liberalization and trade openness contribute positively to the development of the
stock market.

We observe that although the empirical studies have incorporated a large set of variables in
their models, the theoretical studies do not contain rich models of the determinants of stock
market development. It is understandable that a theoretical model which contains a large set
of the determinants of stock market development may be difficult to solve. However, such a
model seems very appealing and will provide a unification of the existing literature. The next
section presents a review of the theoretical literature on the determinants of stock market
development. Section 3 reviews the empirical literature on the determinants of stock market
development as well as the summary and implications of this review. Section 4 concludes.

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2. Determinants of Stock Market Development: The Theoretical Literature

The theoretical literature on the determinants of stock market development remains very
limited. To assemble these determinants, extensive review of various models treating aspects
of the stock market and key economic and institutional variables is required. Based on our
detailed analysis of macroeconomic and financial models in the literature, the determinants of
stock market development can be broadly classified into: (i) macroeconomic factors and (ii)
institutional factors. The macroeconomic factors include but not limited to economic
development, banking sector development, inflation rate, interest rate, exchange rate, and
private capital flows. The institutional factors are the legal origin, legal protection, corporate
governance, financial market liberalisation, stock market integration, and trade openness. We
discuss the association of these factors and the stock market development in turn.

2.1. Macroeconomic Factors

2.1.1. Economic Development

The links between financial systems and the economy appears rather complex. There is
substantial literature devoted to uncovering the role of financial systems in the economy (see,
for example, McKinnon 1973; Shaw 1973; Jensen and Murphy 1990; King and Levine 1993;
Obstfeld 1994; and Bencivenga et al. 1996). However, the theoretical role of the economy in
the formation of financial systems remains comparatively less developed in the literature (see
Levine 1997).

There is a general consensus in the theoretical literature that the real income level and its
growth have positive impacts on financial market development, which encompasses the
development of stock markets. Models that link the level and growth rate of the economy to
the financial system assume that there is significant fixed cost associated with the formation
of financial intermediaries. When the economy develops, the importance of this fixed cost
reduces, allowing more people to participate in financial activities. Hence, economic
development enables more people to benefit from the financial services and products (see
Hicks 1969; North 1981; Greenwood and Jovanovic 1990). Greenwood and Smith (1997)
agree with this view by arguing that due to the significant fixed costs involved in the
formation of markets, these markets may not become active until economies have developed
to certain stages. When economies develop to those stages, financial markets can sustain
enough activities to become cost effective. This means that there are “threshold effects” in
the formation of financial markets.

In the same vein, Boyd and Smith (1998) develop a growth model where capital
accumulation is financed externally through a combination of debt and equity. Their model
demonstrates why the stock market may grow rapidly as an economy develops. Boyd and
Smith (1998) argue that as an economy develops and accumulates more capital, the relative
price of capital will fall. Since investment projects produce capital whereas state verification
consumes final goods and services, it implies that the relative monitoring costs rise as an
economy grows. As a result, investors may employ, in relative terms, more of the technology
with observable returns to economize on verification, as an economy develops. Because the
use of the technology with observable returns is generally associated with equity issues, it
holds that economic growth will be accompanied by an increase in stock market activity.

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2.1.2. Banking Sector Development

The literature on the relationship between the banking sector and the stock market is largely
inconclusive. While some authors argue that the banking sector and the stock market are
substitutes, others argue that they should be viewed as the components of the overall financial
system, and even complements each other as they develop simultaneously.

Regarding the substitutability between the banking sector and the stock market, various
studies have shown that banks perform better than stock markets in providing financial
functions – such as information acquisition about firms, corporate governance, and
intertemporal risk sharing – to the economy (see Grossman and Hart 1980; DeAngelo and
Rice 1983; Stiglitz 1985; Bhide 1993; Jensen 1993; Allen and Gale 1997, 2000; Chakraborty
and Ray 2004; Levine 2005). On acquiring information about firms, Stiglitz (1985) points out
that there is free rider problem in the market-based environment. A well-developed stock
market quickly disseminates information to the public, thus discouraging individual investors
from devoting resources toward evaluating firms. However, this problem can be mitigated by
banks which privatize the information they acquire and establish long-run relationship with
firms. This creates incentives for individual investors to research into firm and market
conditions, thereby promoting effective resource allocation and economic growth.

In terms of corporate governance, stock market-based systems fail to monitor managers

effectively for various reasons (see Levine 2005). Firstly, takeover threats may fail to become
effective corporate governance control devices because insiders have more information than
outsiders (Stiglitz 1985). Secondly, free-rider problems exist in the takeover threats. The
rapid public dissemination of costly information about firms lowers the incentive for
obtaining information for effective takeover bids, and effective corporate control (Grossman
and Hart 1980). Thirdly, existing managers often take actions to deter takeover threats, and
hence weaken market performance under effective disciplining devices (DeAngelo and Rice
1983). Fourthly, the excessively close relationship between board of directors and
management may hinder the shareholder control management through the board of directors
(Jensen 1993). Regarding the intertemporal risk sharing, greater stock market development
can adversely affect resource allocation through increase in liquidity. This is because a liquid
stock market may allow investors to sell their shares easily, so that they may have lower
incentives to exercise careful corporate governance control (Bhide 1993). In the same vein,
Allen and Gale (1997; 2000) argue that the banking sector may provide better intertemporal
risk sharing services than stock markets, thereby improving resource allocation.

However, some studies have criticized the debate on the relative importance of the bank-
based versus the market-based financial system. These studies argue that the focus should be
placed on the importance of the overall financial development on the economy (see Merton
and Bodie 1995; 2004; Levine 1997). Instead of viewing the banking sector and the stock
market as substitutes, Levine (2005) argues that the two may provide complementary growth-
enhancing financial services to the economy. Stock markets may enhance economic growth
by playing a prominent role in facilitating tailor-made risk management services and boosting
market liquidity. Moreover, the stock market may complement the banking sector
development. For example, stock markets spur competition for corporate control and provide
alternative means of financing investment; it may therefore reduce the potential harmful
effects of influential banks.

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These competing renditions connote that the existence of the banking system may foster or
hinder the development of stock markets. On the one hand, if banks and stock markets are
substitutes, a healthy competition between them will enhance their development, whereas
unhealthy competition can cause the demise of either of them. On the other, if banks
complement stock markets, both will expand rapidly and simultaneously.

2.1.3. Inflation Rate

The theoretical literature shows that higher rates of inflation are associated with less liquid
and smaller equity markets. It also shows the existence of non-linear relationship between the
rate of inflation and financial market development (see Huybens and Smith 1998; 1999; Boyd
et al. 2001; Choi et al. 1996; Azariadas and Smith 1996).

Boyd et al. (2001) point out that these theories share the common feature that there exists an
informational friction whose severity is endogenous. Given such feature, an increase in the
inflation rate reduces real rate of return on money and all other assets. In essence, this reduces
agents’ incentive to lend and increase their inventive to borrow. As a result, higher rate of
inflation reduces the availability of credit and encourages lower quality borrowers into the
credit seeking pool. The reduction in loanable funds, together with the diminished quality of
borrowers leads to an increase in credit market frictions. Furthermore, Huybens and Smith
(1999) and Choi et al. (1996) stress that credit market frictions lead to rationing of credit; the
latter becomes severe when the rate of inflation rises. As a consequence, fewer loans are
made in the financial sector, resource allocation becomes less efficient, and financial
intermediation activities reduce, which adversely influence capital formation. The reduction
in capital investment negatively affects long-run stock market performance.

The existing theoretical studies also stress that informational frictions become crucial in the
financial system only when inflation exceeds critical rates. According to Azariadas and Smith
(1996) and Choi et al. (1996), when the inflation rate is very low, credit market frictions may
not be binding, and inflation may not interfere with the flow of information, or distort
resource allocation and economic growth. However, once the inflation rate exceeds the
critical level, credit market frictions become binding, thereby causing a significant drop in
financial sector performance. In particular, these studies predict the existence of more than
one threshold levels. Once inflation exceeds the second critical level, there is endogenous
oscillation in all variables under perfect foresight dynamics, and so inflation will be highly
correlated with variability of inflation and volatility of asset return (see Boyd et al. 2001).
Furthermore, related studies argue that there exists a third inflationary threshold level (see
Huybens and Smith 1998; 1999). In their argument, once the inflation rate exceeds this third
threshold level, perfect foresight dynamics drive an economy to converge to a steady state of
underdeveloped financial system or a low level of real activity. When this happens, any
further increase in inflation rate will have no additional harmful effect on the financial
system.

2.1.4. Interest Rate

Interest rates are important in the formation of financial and stock market prices. Cooley and
Smith (1992) have shown that the level of interest rate may affect the existence of financial
markets for endogenous reasons even when the formation is costless. Such scenario occurs
when the real interest rate is lower than the economic growth rate in the absence of financial
markets. When the interest rates are too low, there will be insufficient incentives for agents to

5
specialize, leading to the extinction of potential borrowers from specialized entrepreneurs. At
the same time, low interest rates provide incentives for potential lenders to invest
independently. Such a result is an internally consistent situation with no demand for and
supply of services provided by financial markets.

Regarding the relationship between interest rates and stock prices, the theoretical literature
shows conflicting views. While some studies show a negative relationship between interest
rates and stock prices (see Gordon and Shapiro 1956; Spiro 1990; Mok 1993), others show a
positive relationship between them (see Shiller 1988; Asprem 1989; Barsky 1989). The
rationale for the negative relationship between interest rates and stock prices is that higher
interest rates reduce the value of stocks as shown by the dividend discount model (see
Gordon and Shapiro 1956), making fixed income securities more attractive to investors than
stocks. A similar argument is made by Mok (1993), who points out that an increase in the
interest rate reduces the present value of future dividend incomes, which then depresses stock
prices. Moreover, higher interest rates may reduce the propensity of investors to borrow and
invest in the stock market. It also raises the cost of doing business by increasing the cost of
capital. Conversely, a drop in interest rates result in a lower opportunity cost of borrowing. It
also stimulates investment, other economic activities, and stock prices. This argument is
supported by Spiro (1990), who indicates that people may prefer to invest in banks rather
than stock markets when there is an increase in real interest rates.

In contrast, some theoretical studies show that the relationship between interest rates and
stock prices is positive. According to Shiller (1988), changes in stock prices reflect changes
in investor expectations about the future value of certain economic variables which have a
direct impact on the pricing of equities. For example, a decrease in interest rates makes
investors to expect further decreases in interest rates. Such an expectation will have a
negative impact on stock prices because fixed-income securities will appreciate if interest
rates continue to drop. Asprem (1989) shows that a positive relationship between interest
rates and stock prices could exist in small and illiquid equity and financial markets where
credit flows have been highly regulated. Barsky (1989) demonstrates, in a general
equilibrium model, that there may be a positive relationship between interest rates and stock
prices. He shows that increased risk and reduced productivity growth will lower the risk-free
interest rate. This may cause stock prices to fall depending on agents’ degree of risk aversion
to intertemporal substitution.

2.1.5. Exchange Rate

Classical economic theory establishes a strong association between stock market performance
and exchange rate behaviour (see Dornbusch and Fisher 1980; Ross 1976; Adler and Dumas
1983; Jorion 1991). For example, Dornbusch and Fisher (1980) show that movements in the
stock market may be affected by exchange rate fluctuations. In their “flow oriented” models
of exchange rate determination, they illustrate how the transmission mechanism works from
the exchange rate to the stock market. In these models, currency movements change
international competiveness and the balance of trade position of countries. As a result, the
real output of countries will be affected, which in turn affect the current and future cash flows
of companies and their stock prices. Hence, currency appreciation (depreciation) can
adversely (positively) affect stock prices.

Gavin (1989) demonstrates that the correlation between stock prices and real exchange rates
can be negative or positive under different conditions. He models an open economy in which

6
stock prices substitutes for real interest rates in the determination of aggregate demand. By
including the stock market in this model, an anticipated fiscal expansion can lead to an
expansion in output, if the anticipation time of such fiscal expansion is short enough. This is
because the anticipated expansion leads to an increase in the current stock prices by
generating high profits in the future. In this model, if aggregate demand shocks are
unanticipated, disturbances of this kind can create negative correlation between the stock
prices and real exchange rates. Yet, if the time between announcement and implementation of
fiscal policy disturbances is long enough, a positive correlation can be generated between
stock prices and real exchange rates (see Gavin 1989).

The existing studies also show that stock prices may or may not be negatively affected by
exchange rate risks under different settings. The modern portfolio theory shows that investors
are unwilling to pay a premium for firms with active hedging policies if exchange rate risks
are diversifiable. Thus, exchange rate risks – which can be diversified away – should not
affect the cost of capital nor add value to the firm. This implies that stock prices will not be
negatively affected by exchange rate risks (see Jorion 1991). On the contrary, the arbitrage
pricing theory by Ross (1976) claims that if the economy is characterised by a small number
of factors, investors will be willing to pay a premium if these factors are well priced. In this
case, hedging policies by financial managers will affect the cost of capital if the exchange
rate is one of those factors. However, Adler and Dumas (1983) argue that when the foreign
exchange risk is priced across the stock and the foreign exchange markets, hedging may
reduce the cost of capital for the firm but the overall risk-adjusted value of the firm remains
unchanged after ex ante costs and transaction costs have been considered. As a result,
hedging policies will be welcomed by investors only if foreign exchange risk is priced in the
stock market, together with the occurrence of some type of market segmentation across the
stock market and the foreign exchange market. Under this circumstance, stock prices are
negatively affected by exchange rate risks.

2.1.6. Private Capital Flows

Private capital flows comprise of syndicated bank loans, foreign direct investment (FDI) and
portfolio investment. In particular, equity portfolio flows can take place in various forms.
They include: direct equity purchases by investors in the host stock markets, investment
through country funds, issue of rights on equities held by depository institutions and direct
foreign equity offerings (see Claessens and Rhee 1993).

There are two opposing views on the relationship between FDI and stock market
development. Some studies argue that FDI is nothing but a substitute for domestic stock
market development (see Hausmann and Fernández-Arias 2000a,b), while others argue that
FDI complements stock markets (see Claessens et al. 2001). Hausmann and Fernández-Arias
(2000a,b) observe that FDI flows more into countries which are riskier, financially
underdeveloped, and institutionally weak. FDI becomes an alternative to underdeveloped
financial markets for both debt and equity financing. In this respect, FDI correlates negatively
with stock market development. In contrast to this, Claessens et al. (2001) argue that FDI
tends to flow into countries with sound institutions and economic fundamentals, thereby
fostering their financial systems. In particular, FDI fosters the development of stock markets
through the following channels. Firstly, FDI may improve the participation of firms in capital
markets. This is because some foreign investors may want to finance their investment
projects with external capital. Other investors may want to recover their investment by selling

7
their equities in stock markets. Secondly, FDI may boost the liquidity of domestic stock
markets through the purchase and sale of existing equities by foreign investors.

Regarding foreign portfolio investment, Claessens (1993) argues that it has positive long-
term impact on capital markets. He points out that equity portfolio flows can benefit the
efficiency of domestic capital markets by leading to further liberalization and development of
domestic equity markets. It then further improves the mobilization and allocation of domestic
resources. In addition, equity portfolio flows can improve risk sharing between foreign and
domestic investors because the repayments are indexed on the performance of the firms
concerned. It also leads to the development of a capital structure that improves managerial
incentives and therefore increases the value of the firms.

2.2. Institutional Factors

There are a large number of studies that document the importance of institutions in the
development of stock markets. This section reviews how institutional factors, such as the
legal origin, legal protection on investors, corporate governance, financial market
liberalization, stock market integration, and trade openness, affect the development of stock
markets.

2.2.1. Legal Origin

The literature shows that the legal origin plays an important role in explaining stock market
development. La Porta et al. (1997) classify the legal origin as common law and civil law.
The common law adopted by countries such as the UK and the USA is made by judges and
later incorporated into the legislature, whereas the civil law adopted by countries such as
France, Germany and Sweden originated partly from scholar and legislator-made civil law
tradition. These authors contend that the legal origin can explain the systematic differences
in the legal rules protecting investors and the quality of law enforcement across countries.
Furthermore, La Porta et al. (1997, 1998) argue that the common law system is more
conducive in promoting the quality of legal institutions than the civil law system. In the same
vein, Sarkar (2010) argues that common laws improve the quality of legal institutions based
on factors such as adaptability and political factors. The adaptability consideration focuses on
the process of framing new rules. In countries where common laws are practiced, judges
interpret the laws on case-by-case basis which allows the formation of legal regulation to be
more adaptable to changing environment. In contrast, judges in countries practicing civil laws
are constrained by explicit laws and codes, leaving little discretion to them. Therefore the
civil law system may suffer from inflexibility because changes may only be initiated by fits
and starts through legislation. The political factors relate to the degree of judicial
independence provided by the two law systems. Sarkar (2010) points out that there is greater
independence provided to the judiciary under the common law system. Judges under common
law systems are less influenced by the legislature, and therefore are able to better protect
individual property rights from clutches of the state. In contrast, under the civil law system,
the legislature has greater control over legal institutions. Therefore, the judges are less able to
protect individual property rights from the encroachment by the states. In essence, the legal
origin has strong bearing on the quality of institutions, and thus the effective functioning of
markets, the stock market inclusive.

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2.2.2. Legal Protection

Legal protection of investors also plays an important role in fostering stock market
development. As suggested in the new institutional economics (see North 1991), legal rules
shape economic outcomes according to how far they support the economic activity in a
market-based economy. As has been supported by Pagano (1993a,b), the existence of
transparency and regulations may influence the efficiency of stock markets. For example, the
mandatory disclosure of reliable information about firms may increase investor confidence
and therefore participation. Regulations that increase investors’ confidence in brokers will
also encourage trading activities in the stock market. La Porta et al. (1997) argue that better
legal protection of the interests of shareholders and creditors will promote the flow of
investments and the availability of external finance to firms. These authors find that
institutional variables such as rule of law, anti-director rights, and one-share-one-vote are
crucial predictors of stock market development. Based on their previous studies, La Porta et
al. (2000) further demonstrate that legal protection of shareholders and creditors is crucial in
explaining the different models of corporate finance in different countries. Differences in
legal systems and legal enforcements are therefore important in understanding why some
firms raise more funds than others across countries. Their studies show that better investor
protection is associated with effective corporate governance, which is manifested in broader
and deeper financial markets, dispersed share ownership, and efficient resource allocation
among firms.

2.2.3. Corporate Governance

Differences in corporate governance systems will affect the development of external

financing across countries. Shleifer and Vishny (1997), for example, discuss the importance
of corporate governance in affecting the development of external financing. They show
several mechanisms through which effective corporate governance in a firm can be
maintained. The first one is reputation-building. Managers repay investors because they want
to have access to the capital market and raise funds in the future. As such, they need to build
reputations as good borrowers in order to convince investors to provide them funds in the
future. The reputation-building models of private financing have been presented in other
theoretical studies such as Diamond (1989, 1991), and Gomes (1996).

The second one is legal protection of creditors. Shleifer and Vishny (1997) argue that the
development of external financing to firms is closely related to the control rights received by
the investor in exchange. External financing is a contractual arrangement between the firm as
a legal entity and the investors, which give the investors certain rights over the assets of the
firm (see Hart 1995). The most important legal right that shareholders have is the right to
vote on important corporate matters, such as the election of board of directors, mergers,
acquisitions, and liquidations. Shleifer and Vishny (1997) show that much of the differences
in corporate governance systems across countries is reflected in the differences in the nature
of the legal obligations that managers have to the investors, and in the differences in how
courts interpret and enforce these obligations. The differences in corporate governance
systems will then affect the development of external financing across countries.

The third one is concentrated ownership, which includes large shareholders, takeovers, and
large creditors. Investors may get more effective control rights by being large if legal
protection does not give enough control rights to small investors. This is because when
control rights are concentrated in the hands of a small number of investors with relatively

9
large cash flow stake, it is less costly to exercise concerted action over the firm than when
distributed across small investors. In other words, concentration of ownership and legal
protection are complementary in an effective corporate governance system (Shleifer and
Vishny 1997), which is essential for equity market development.

2.2.4. Financial Market Liberalisation

A number of theoretical studies have documented that financial market liberalisation has a
positive impact on stock market development. According to Henry (2000a), stock market
liberalisation is a decision made by a country’s government to allow foreigners to purchase
shares in that country’s stock market. Based on the fundamental prediction of the standard
international asset pricing models, Henry (2000a) contends that stock market liberalisation
allow risk sharing between domestic and foreign investors. Therefore the cost of equity
capital of the liberalising country will be lowered, which fosters the development of stock
market.1

Henry (2000a) further points out that the prediction of the standard international asset pricing
models has two important implications. First, if stock market liberalisation lowers the cost of
equity capital, then by holding expected future cash flows constant, there should be an
increase in a country’s stock price index after liberalisation. However, Bekaert and Harvey
(1995) argue that emerging markets are not completely segmented from the rest of the world
despite foreign ownership restrictions. In this case, the equity premium will lie between the
autarky and completely integrated premium. The general consensus from the theoretical
literature indicates that the local price of risk is greater than the global price of risk (see Stulz
1999; Bekaert and Harvey 2000; Errunza and Miller 2000). Therefore, there will be a fall in
equity premium when there is liberalisation in a completely or partly segmented stock
market. Holding expected future cash flows constant, such fall in the equity premium will
lead to a permanent fall in the aggregate cost of equity capital, and therefore an increase in
aggregate equity price index. Second, the reduction in a country’s cost of equity capital will
transform some investment project which had a negative net present value before
liberalisation into positive net present value after liberalisation – implying an increase in
physical investment after stock market liberalisation. This effect should promote higher
economic growth rate and generate a broader impact on economic welfare than the financial
windfall gains to domestic shareholders (also see Henry 2000b).

Levine and Zervos (1998a) show that financial and economic policies, such as stock market
liberalisation, are important factors that drive stock market development. They find that stock
markets become larger, more liquid and more internationally integrated after restrictions on
capital and dividend flows are removed. This is because financial liberalisation policies
remove financial market distortions and make domestic financial assets more attractive.
Similarly, Mishkin (2001) points out that financial liberalisation has a positive impact on
corporate governance. He shows that financial liberalisation enhances transparency and
accountability, and reduces the problems of adverse selection and moral hazards. Such
improvement reduces the cost of borrowing in stock markets; thereby spurring the
development of stock markets.

2.2.5. Stock Market Integration

1
See also Stapleton and Subrahmanyan (1977), Errunza and Losq (1985), and Eun and Janakiramanan (1986).

10
Stock market integration can have either positive or negative impact on stock market
development. According to Bekaert and Harvey (2000), a market is defined as being
financially integrated if projects with identical risks have identical expected returns across
different markets. In the segmented market, domestic investors are restricted to investing in
local securities, while foreign investors are excluded from investing in the local market or are
allowed to invest at a relatively high cost. Obstfeld (1994) and Stulz (1999) show that when
markets are not financial integrated, an economy may experience various fundamental
distortions. First, local investors may not be able to diversify their equity portfolio because
they are only allowed to invest in local securities. Second, market segmentation causes an
inefficient allocation of productive resources. Since investors are willing to pay premiums for
diversification, new local firms that may operate inefficiently in industries will arise to
provide diversification. At the same time, current firms may also diversify away from their
core activities that make them more attractive to investors by accepting negative net present
value projects.

Bekaert and Harvey (2000) point out that financial integration can improve these
inefficiencies. When local investors are allowed to buy efficient foreign stocks, they will no
longer be interested in investing in inefficient local companies. At the same time, the
domestic producers may reallocate capital from the inefficient conglomerate divisions to the
ones that have comparative advantages. Bekaert and Harvey (2000) caution, however, that
financial market integration may also hinder the development of stock markets. They argue
that financial market integration is a necessary but not a sufficient condition to promote
financial market development. On the one hand, if legal reforms are initiated and the market
structure is satisfactory, there will be an increase in capital flows, thereby promoting financial
market development. In other words, effective capital market liberalisation may be associated
with significant new foreign capital flows. On the other, if restrictive measures are initiated or
the political and economic environment is not conducive to international investors, one
should see a decline in foreign capital flows.

2.2.6. Trade Openness

Trade openness benefits financial market development in two different ways, which is
characterised as ‘supply-side’ and ‘demand-side’ roles (see, for example, Niroomand et al.
2014). Trade openness is beneficial to financial market development through the supply side
of financial markets (see Rajan and Zingales 2003; Braun and Raddatz 2005). Trade openness
fosters financial market development by increasing the demand for financial products and
services (see Newbery and Stiglitz 1984;).

On the supply side role, Rajan and Zingales (2003) demonstrate that trade openness has a
positive impact on the development of financial markets. This is because trade openness
weakens the incentives of incumbent financial intermediaries or interest groups to slow down
financial market development in order to reduce entry and competition. As a result, trade
openness tends to induce investment and bank lending, hence foster the general development
of financial markets. Similar view is shared by Braun and Raddatz (2005), who show that
countries experience improvements in their financial systems when they liberalise their trade
sectors. This is because trade liberalisation reduces the power of groups who are most
interested in blocking financial market development.

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On the demand side role, Newbery and Stiglitz (1984) point out that trade openness increases
price elasticities and can potentially increase uncertainty and income volatility. As a result, it
could increase the demand for insurance products and therefore foster financial market
development. In the same vein, Svaleryd and Vlachos (2002) argue that trade openness
increases a country’s exposure to external shocks and foreign competition. The increase in
risks associated with trade openness therefore triggers the demand for new financial products
and services to diversify such risks.

3. Determinants of Stock Market Development: The Empirical Evidence

This section reviews the empirical literature on the determinants of stock market
development. Generally the available studies have examined the determinants of stock market
development along three lines: macroeconomic, institutional, and a mixture of these two.
Hence, we followed these broad lines.

3.1. The Macroeconomic Determinants of Stock Market Development

A number of empirical studies have examined the relationship between macroeconomic

variables and the development of stock market. This section surveys such empirical studies.
The commonly examined macroeconomic variables are, among others, economic growth,
inflation, FDI and the exchange rate.

Some studies have shown that stock market development and economic growth are positively
related. These studies are, among others, Atje and Jovanovic (1993), Levine and Zervos
(1996; 1998b), Minier (2003), Adjasi and Biekpe (2006), Masoud and Glenn Hardaker
(2012), and Sehrawat and Giri (2015). In addition to investigating the nature of the
association between stock market development and economic growth, there are other studies
focusing on the causality between them. Such studies abound in the literature and are beyond
the scope of this paper.2

There is a growing literature assessing the relationship between inflation and stock market
activities. Boyd et al. (1996), for example, examine the relationship between inflation and
financial market activities in 51 countries for the period 1970-93. They find two key results.
First, they observe that at low-to-moderate long-run inflation rates, there is a pronounced
negative correlation between inflation, the volume of trading in equity markets, and measures
of stock market liquidity. Second, the relationship between inflation and stock market
development is highly nonlinear. In particular, as inflation increases, the relationship between
inflation and the volume of stock market activities weakens and eventually vanishes once
inflation exceeds a critical level. In another study, Boyd et al. (2001) investigate empirically
the relationship between inflation and stock market development as proxied by the stock
market capitalization ratio, total value traded ratio, turnover ratio, and a measure of return
volatility. They find that inflation is negatively and significantly associated with each of these
stock market measures. Furthermore, they find that the relationship is highly nonlinear for all
these relationships except the one between inflation and stock market volatility.

In addition, some studies examine the relationship between inflation and equity returns.
These studies generally indicate that the response of equity returns to inflation depends on the
level of inflation. In relatively low inflationary environments, there is negative association
2
The interested reader may refer to studies such as Arestis and Demetriades (1997), Shan et al. (2001),
Hondroyiannis et al. (2005), Cheng (2012), Marques et al. (2013), and Phiri (2015).

12
between inflation and real equity returns. However, in high inflationary environments, the
equity returns respond more positively to changes in inflation (see Barnes et al. 1999; Boyd
et al. 1996; 2001). In contrast, other studies show that there is no association between
inflation and equity returns. For example, Kutan and Aksoy (2003) find that average equity
returns are unrelated to the level of inflation for Turkey.

Quite a number of studies have documented the nature of the association between FDI and
stock market development. Jeffus (2004), for example, examine the relationship between the
FDI and stock market in four Latin American countries. He finds that FDI and stock market
development are highly and positively correlated. His results further suggest that FDI is a
predictor of stock market growth. He argues that when firms enter into a new market, they
may seek to raise additional capital through the local stock market. This enhances the local
stock market. Similarly, Malik and Amjad (2013) investigate the impact of FDI on the stock
market development in Pakistan for the period 1985-2011, both in aggregate stock market
and sector-wise development. They find a positive and statistically significant relationship
between FDI and aggregate market capitalisation. In contrast to these studies, Rhee and
Wang (2009) find FDI to exert a negative impact on stock market liquidity in Indonesia. In
particular, they find that a 10% increase in foreign institutional ownership in the current
month is associated with around 2% increase in the bid-ask spread, 3% decrease in depth, and
4% rise in price sensitivity in the markets.

Regarding the relationship between exchange rates and the stock market, the existing
empirical studies show mixed results. For example, Ma and Kao (1990) find currency
appreciation to have a negative impact on the domestic stock market in an export-oriented
economy, while it has a positive impact on the domestic stock market in an import-oriented
economy. Phylaktis and Ravazzolo (2005) focus on the relationship between stock prices and
exchange rates in the Asia-Pacific countries. Their results show that stock prices and
exchange rates are positively related. In terms of country specific studies, the study by Wu
(2000) shows that Singapore’s currency appreciation against the U.S. dollar and Malaysian
ringgit, and its depreciation against Japanese yen and Indonesian rupiah, lead to a long-run
increase in stock prices in most of the period under his study.

Garcia and Liu (1999) investigate the macroeconomic determinants of stock market
development, which include real income, saving rate, stock market liquidity, financial
intermediary development, and macroeconomic volatility. Their results suggest that real
income level, saving rate, financial intermediary development and stock market liquidity
have positive and significant impact on stock market capitalisation whereas macroeconomic
stability does not prove significant. Using similar macroeconomic variables as suggested by
Garcia and Liu (1999), Ben Naceur et al. (2007) examine the role of stock markets in
economic growth, and the role of macroeconomic variables in stock market development for
12 countries in the Middle Eastern and North African (MENA) region. Their results show
that saving rate, stock market liquidity, and financial intermediary development have positive
impact on stock market growth, whereas macroeconomic instability has negative impact on
stock market growth. However, last year’s income has no significant impact on stock market
growth, implying that economic growth does not promote stock market development in the
12 MENA countries.

3.2. The Institutional Determinants of Stock Market Development

13
Apart from the studies that examine the impact of macroeconomic factors on stock market
development, there are also studies that examine the relationship between institutional factors
and the development of stock markets. The common institutional factors which resurface in
the empirical literature include the legal environment, privatisation, financial liberalisation,
and sovereignty credit ratings. These factors are discussed in turn.

The seminal work of La Porta et al. (1997; 1998) introduces the role of the legal environment
in the development of financial markets, stock markets inclusive. La Porta et al. (1997) study
the legal determinants of external finance using a sample of 49 countries. They compare
external finance across those countries as a function of the legal origins, the quality of legal
investor protections, and the quality of law enforcement. Their results reveal strong evidence
that the legal environment has huge impact on the size and the breadth of capital markets
across the sampled countries. Their study further shows that countries with weaker investor
protection as measured by the character of legal rules and the quality of law enforcement
have smaller and narrower equity markets. They argue that countries with civil laws
experienced the poorest investor protections, and thus the least developed capital markets,
when compare with common law countries. In another study, La Porta et al. (1998) examine
the legal rules which cover protection of corporate shareholders and creditors, the origin of
these rules, and the quality of their enforcement in 49 countries around the world. They show
that the legal tradition influences the degree of protection of creditors and shareholders, and
the efficiency of contract enforcement, thereby affecting financial market development.

Building on La Porta et al. (1998), Pistor et al. (2000) provide a comprehensive analysis of
legal change in the shareholder protection and creditor rights in 24 transition economies from
1992 to 1998 and its effect on the propensity of firms to raise external finance. They find that
not only the quality of legal frameworks but also the effectiveness of legal institutions are
important for financial market development. In particular, they point out that the
effectiveness of legal institutions has a stronger impact on external finance when compared
with the law on the books, even though there is a substantial improvement in shareholder and
creditor rights.

Buchanan and English (2007) explore the role of legal foundations in returns distribution, the
growth rate of stock market capitalisation, and the ratio of stock market capitalisation to
GDP. Using a sample of 24 emerging markets for the period of 1976-1999, they find that the
legal foundation of an emerging market does have impact on its returns distribution and the
size of its equity market. Specifically, they find that emerging markets from the French civil
law systems experience higher returns, higher average growth rates in market capitalisation
and lower average market capitalisation to GDP than those markets from the English
common law systems.

There are some studies which focus on the impact of privatisation on stock market
development. For example, Perotti and van Oijen (2001) examine whether privatisation in
emerging market economies has a significant indirect effect on domestic stock market
development through the improvement of political risk, in 31 countries during the period of
1988-1995. They argue that a continued privatisation program represents a major political
test that eventually resolves uncertainty over political commitment towards a market oriented
policy, regulation and private property rights. They find that privatisation process is
associated with improvements in perceived political risk. Furthermore, they find that changes

14
in political risk tend to have a strong effect on local stock market development in emerging
markets. They conclude that successful privatisation leads to the resolution of political risk,
which in turn becomes a vital source of the rapid development of stock markets in emerging
market economies.

Similarly, Boubakri and Hamza (2007) investigate the dynamics of privatisation, the legal
environment and stock market development. They assess the particular conditions under
which privatisation is an effective means in developing local stock markets for a sample of 61
countries for the period of 1980-2003. They find the initial legal environment to be
significant and to have contemporaneous impact on stock market development, while
privatisation is not. In addition, they investigate the inter-temporal effect of privatisation on
stock market development, in interaction with the legal environment. By employing a panel
model with random effects, their study suggests that privatisation has a two-year lagged
effect on stock market development in emerging markets, and a one-year lagged effect in
developed countries.

Other studies examine the impact of institutional factors such as financial liberalisation on
stock market development. One of such studies is Levine and Zervos (1998a), who evaluate
the effect of capital control liberalisation on the behaviour of stock market size, liquidity,
volatility and international integration in 16 emerging markets for the period 1986-1993.
They find that stock markets tend to become larger, more liquid, more volatile, and more
internationally integrated after the capital controls are removed. In the same study, they
investigate the relationship between three institutional regulatory indicators (information
disclosure, accounting standards, and investor protection) and stock market development.
Their results suggest that easy access to information about listed firms is positively associated
with stock market development. They find, in addition, that countries with sound accounting
standards and investor protection laws tend to have better developed stock markets.

Similarly, Henry (2000a) examines the effect of stock market liberalisation on a country’s
aggregate cost of equity capital. By constructing event windows of stock market liberalisation
in a sample of 12 emerging market countries, he finds that stock markets experienced
statistically significant stock price revaluation after liberalisation. Specifically, there is an
average abnormal returns of 3.3% per month in real dollar terms during an eight-month
window leading up to the implementation of a country’s initial stock market liberalisation.
Their estimates based on five-month, two-month and implementation-month-only windows
also suggest statistically significant stock price revaluation. In a closely related study, Chinn
and Ito (2006) investigate whether financial openness leads to financial development in 108
countries over the period 1980 to 2000. They find that a higher level of financial openness
fosters stock market development when a certain level of legal development has been
attained. In addition, they examine the optimal sequence of liberalisation in both goods and
financial markets. They find that trade openness is a precondition for capital account
liberalisation, while banking system development is a prerequisite for stock market
development.

Kim and Wu (2008) assess how the sovereign credit ratings history provided by independent
rating agencies impact on domestic financial sector development and international capital
inflows to 51 emerging markets from 1995-2003, within a panel data framework. They find
three important pieces of evidence. First, long-term foreign currency sovereign credit ratings
are conducive to financial intermediary development and international capital flows. Second,
long-term domestic currency ratings encourage domestic market growth but retard

15
international capital flows. Third, both short-term foreign and domestic currency
denominated ratings discourage all forms of financial market development and international
capital flows.

3.3. Macroeconomic and Institutional Determinants of Stock Market Development

To understand the multifaceted nature of stock market development, other studies have
resorted to empirical models that combine macroeconomic and institutional variables.
Majority of these studies utilise panel data techniques. For example, El-Wassal (2005)
investigates the relationship between stock market development, macroeconomic variables
(such as economic growth, foreign portfolio investment), and institutional variables (such as
financial liberalisation policies, and country risk) in 40 emerging market economies. His
empirical results suggest that economic growth, financial liberalisation policies, and foreign
portfolio investment are the important and favourable drivers of stock markets in the selected
emerging market economies. However, political risk is not significant in driving these stock
markets.

Yartey (2007) examines the macroeconomic and institutional determinants of stock market
development in 13 African countries. He finds income level, domestic savings and
investment, financial intermediary development, and stock market liquidity to have positive
impact on stock market development in Africa. Furthermore, he finds institutional quality –
which consist of corruption, law and order, bureaucratic quality, democratic accountability
and government stability – to be an important determinant in fostering stock market
development in Africa. In another study, Yartey (2010) investigates the determinants of stock
market development in 42 emerging market economies and finds three key results. First, in
addition to income level, gross domestic investment, banking sector development, and stock
market liquidity, private capital flows is an important determinant which positively affects
the development of stock market in emerging market economies. Second, he finds that the
impact of banking sector development on stock market development is non-monotonic. This
implies that the banking sector and the stock market are compliments at the early stages of
their respective development, but the two become substitutes once they developed and started
to compete as vehicles for financing investment. Finally, institutional factors such as political
risk, law and order, democratic accountability, and bureaucratic quality are favourable
determinants of stock market development because they promote the viability of external
financing.

Billmeier and Massa (2009) assess the macroeconomic and institutional determinants of stock
market development in 17 emerging markets in the Middle East and Central Asia. In addition
to traditional macroeconomic variables, they include an institutional variable and remittances
as the explanatory variables. They group the countries into hydrocarbon-rich economies and
non-hydrocarbon-rich economies, and investigate whether the effect of institutions and
remittances on stock market development differ between these two groups of countries. They
document three key results. First, both institutions and remittances have a positive and
significant impact on stock market capitalisation. Second, institutions and remittances matter,
especially in countries without sizeable hydrocarbon sector. Third, in resource-rich countries,
stock market capitalisation is mainly driven by the oil price.

16
3.4. Summary and Policy Implications

Overall, our survey provides three interesting results. First, real income level, saving rate,
gross domestic investment, private capital flows, financial intermediary development, and
foreign portfolio investment, are important determinants of stock market development
especially in the industrialised and emerging market economies. In particular, these factors
have positive impact on stock market development. Second, macroeconomic instability, as
measured by the level of inflation, can adversely affect the development of stock markets in
especially emerging market economies. Finally, institutional factors such as institutional
quality, financial liberalisation policies, political risk, law and order, and bureaucratic quality
are important drivers of stock market development within and across countries.

The literature is now supportive of the positive impact of stock market development on
economic growth as well as a reverse causality from the latter to the former. Therefore,
knowing the determinants of stock market development is an important step for policy-
making and implementation. The findings from this survey carry important policy
implications, especially for developing countries in general and emerging market economies
in particular. First, since the level of real income has positive impact on stock market
development, it holds that policies and initiatives designed to promote the expansion of real
income will simultaneously enhance stock market development and therefore should be
pursued vigorously. Second, by revealing that saving rate and domestic investment act as
stimulants of stock market development, it means that policymakers will be able to achieve
and maintain stock market growth and expansion by laying strong foundations for savings
and investment growth. Third, well-functioning financial intermediaries, rather than compete
against, complement stock markets. Therefore, policymakers should learn from this evidence
that the banking system should not be ignored in their quest to enhance the performance of
stock markets. This particular evidence could be taken from the Asian Tigers whose stock
markets advanced alongside the banking systems. Fourth, private capital flows, especially
foreign private capital flows, are vital in promoting stock market development. This means
that the nature of a country’s foreign policies will be critical in determining the size of private
capital flows. A more friendly and open country may attract foreign private capital than a less
friendly and closed one. It is imperative that if policymakers hanker to promote stock market
development through private capital flows, they should focus on making their countries
attractive and friendly to foreign investors. Fifth, macroeconomic instability, as measured by
the level of inflation, can adversely affect the development of the stock market. In order to
promote stock market development, it is important to control inflation to a level that is
favourable for stock market development. This level of inflation may differ from one country
to the other. It is therefore the responsibility of policymakers to estimate and pursue this
threshold level of inflation (i.e. the level of inflation above which inflation may be a
debilitating factor to stock market development) for their economies. Finally, institutional
factors are very fundamental to stock market development. Therefore, it is crucial that
policymakers fixate on developing quality institutions that reduce political risk, enhance law
and order, and foster efficient bureaucracy and democratic accountability, in order to promote
stock market development. Other important policy implications can be drawn from this
survey. Hence the ones presented should not be seen as exhaustive.

4. Conclusion

This paper reviewed the theoretical and the empirical literature on the determinants of stock
market development. Based on the theoretical literature, the determinants of stock market

17
development can be broadly classified into two groups: macroeconomic factors and
institutional factors. In terms of the macroeconomic factors, the theories suggest that real
income and its growth rate can foster stock market development. Banking sector, however,
can be viewed either as substitute or complement of stock market. Inflation rate is negatively
related to the stock market growth in a non-linear fashion. Interest rate can have negative or
positive relationship with the stock market development. Exchange rate movement is
negatively associated with stock market development. In particular, currency appreciation can
adversely affect stock prices. And private capital flows can have either positive or negative
impact on stock market. For the institutional factors, the theories provide more certain
direction as to how they affect the stock market development. Different legal origins have
different impacts on stock market growth. In addition, factors such as legal protection on
investors, corporate governance, financial liberalisation and trade openness contribute
positively to the growth of stock market. Stock market integration can have either positive or
negative impact on stock market development. Against this backdrop, there are a growing
number of empirical studies trying to explore the impact of these macroeconomic and
institutional factors on stock market development. The empirical literature shows that
macroeconomic variables such as real income level, saving rate, gross domestic investment,
private capital flows, financial intermediary development, and foreign portfolio investment,
are important and have positive impact on stock market development. Macroeconomic
instability, as measured by the level of inflation, can adversely affect the development of the
stock market. Finally, the empirical evidence also suggest that institutional factors such as
institutional quality, financial liberalisation policies, political risk, law and order, and
bureaucratic quality play major roles in the development of stock markets. Although the
empirical studies have incorporated a large set of variables in their models, the theoretical
studies do not contain rich models of stock market development. It is understandable that a
theoretical model which contains a large set of the determinants of stock market development
may be difficult to solve. However, such a model seems very appealing and will help unify
the existing literature.

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