DORIN DOBRI AN Associate Professor, Spiru Haret University ABSTRACT. Kousis and McCulloch put it that a strong, well-functioning capital market is essential to the economic prospects of New Zealand. Agarwal’s 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 provide an extra impetus to economic activity. Antràs et al. remark that with verifiable monitoring equity shares are not an optimal mechanism for transferring utility from the entrepreneur to the inventor.

Kousis and McCulloch put it that a strong, well-functioning capital market is essential to the economic prospects of New Zealand: while New Zealand has a strong sovereign rating, high levels of private sector borrowing have produced a large net foreign indebtedness position; finance companies and building societies have a small but growing share of deposit-taking and lending markets (the larger finance companies are subsidiaries of banks, or of firms in the retail and distribution sectors); securities issued by managed funds (e.g. unit trusts) are traded on financial markets (in some cases, the fund manager operates a secondary market or acts as a broker). “The New Zealand experience over the past twenty years can be characterized as a shift from a relatively high level

of regulation to a light-handed approach that is now swinging back toward some more formal control. The experience has been variable across markets (some are highly developed and efficient, others are relatively undeveloped and shallow). In the decade before 1984 the New Zealand economy was burdened with the slowest average rates of real economic growth in the OECD region, serious and persistent balance of payments current account deficits (financed primarily by substantial overseas debt), a large rise in unemployment and a relatively high (albeit variable) rate of inflation (Reserve Bank of New Zealand, 1986). Further, New Zealand was experiencing an extended freeze on wages, dividends, rents, prices, interest rates and the exchange rate.”1 Kousis and McCulloch claim that most of New Zealand’s reforms delivered on their objectives and the financial system became more efficient (i.e. for banks costs and margins fell; the quality of bank balance-sheets improved; borrowing, lending and the range of financial instruments available grew; service and consumer choice improved). Kousis and McCulloch examine whether regulation that is more conducive to competitive and efficient financial system has a significant positive impact on sectoral output and productivity growth in a sample of 25 OECD countries, including New Zealand. According to the International Monetary Fund, New Zealand has a profitable and well functioning financial system, operating in a framework of well developed financial markets; New Zealand’s approach to banking regulation is based on


disclosure and market discipline, and employs limited prudential requirements; the absence of a depositor-protection mandate, along with the foreign ownership of all systematically important banks, would pose unique challenges to the Reserve Bank of New Zealand if a financial crisis were to occur; recent reforms in securities regulation and the restructuring of the New Zealand Stock Exchange (NZX) have strengthened the securities regulatory framework. Kousis and McCulloch set out the structure and function of New Zealand financial markets, describe the experience of reforms to date, and the priorities for ongoing reform, and summarize independent assessments of New Zealand’s capital markets that have been carried out recently. “Managed funds and superannuation schemes are significant vehicles for personal saving. The number of superannuation schemes has steadily declined over time. This is partly a result of private sector employer sponsored schemes consolidating from standalone to multi-employer arrangements. However, the number of scheme members has also declined, from 23% of the 1990 labour force being an active member of an occupational scheme, down to 14% in 2003. This trend is expected to reverse with the introduction of KiwiSaver in July 2007, although the consolidation into multi-employer arrangements is expected to continue.”2 Agarwal’s 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


provide an extra impetus to economic activity (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. Agarwal remarks that the Indian financial system is characterized by a large network of commercial banks, financial institutions, stock exchanges, and a wide range of financial instruments; by facilitating longer-term, more profitable investments, liquid markets generally improve the allocation of capital and enhance prospects for long-term economic growth; by increasing returns to investment, greater stock market liquidity may reduce the savings rate through income and substitution effects. “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 developments. 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. The market capitalization 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.”3 Agarwal observes that data reveal that stock market size as measured by the number of listed companies and market capitalization has increased over time (but liquidity on the stock ex93

change as measured by the turnover ratio has not increased); 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; 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 monthly as well as annual data; regression results confirm Agarwal’s earlier findings that financial sector and capital market developments are complementary to each other (both have re-enforced each other and moved together); the right variable to be a proxy for the expansion of economic activity is the totality of funds mobilized by the corporate sector from alternative sources and not merely the credit by the commercial banks. “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 liberalization and the easing of legislative and administrative barriers and the adoption of tougher regulations to boost investor’s confidence. With the beginning of financial liberalization in the developing countries, the flow of private foreign capital from the developed to the developing countries has increased significantly and such in-


flows of foreign capital have been mainly in the form of foreign direct investment and portfolio investment.”4 Antràs et al. demonstrate that when firms want to exploit technologies abroad, multinational firm (MNC) activity and foreign direct investment (FDI) flows arise endogenously when monitoring is nonverifiable and financial frictions exist (the mechanism generating MNC activity is not the risk of technological expropriation by local partners but the demands of external funders who require MNC participation to ensure value maximization by local entrepreneurs); when monitoring is nonverifiable, capital flows and multinational ownership of assets abroad arise endogenously to align the incentives of the inventors of technology and the entrepreneurs in host economies; countries with better investor protections tend to enforce laws that limit the ability of managers to divert funds from the firm or to enjoy private benefits or perquisites. “We introduce a monitoring technology that reduces the private benefit of the foreign entrepreneur when he misbehaves. It is reasonable to assume that the inventor has a comparative advantage in monitoring the behavior of the foreign entrepreneur because the inventor is particularly well informed about how to manage the production of output using its technology. Intuitively, the developer of a technology is particularly well situated to determine if project failure is associated with managerial actions or bad luck. We capture this in a stark way by assuming that no other agent in the economy can productively monitor the foreign entrepreneur.”5

Antràs et al. remark that with verifiable monitoring equity shares are not an optimal mechanism for transferring utility from the entrepreneur to the inventor; since credit market development may be correlated with other measures of economic and institutional development, additional controls for other institutional characteristics are also employed; the predictions on the use of licensing as opposed to foreign investment and the financing and ownership of foreign affiliates are considered first by pooling crosssections from the benchmark years; the predictions of the model relate to credit market development, but the measure of creditor rights may be correlated with more general variation in the institutional environment. “The model suggests that the response to ownership liberalizations should be larger in host countries with weak investor protections. The intuition for this prediction is that in countries with weak investor protections, ownership restrictions are more likely to bind because ownership is most critical for maximizing the value of the enterprise in these settings. As such, the relaxation of an ownership constraint should have muted effects for affiliates in countries with deep capital markets and more pronounced effects for affiliates in countries with weaker capital markets.”6 Antràs et al. reason that in order to convince external funders to supply capital, entrepreneurs need to give financial claims on the project to parent firms to ensure that they provide monitoring when monitoring is unverifiable; an optimal contract calls for the developer of the technology to own equity in the project

and may call for the parent firm to provide funds for investment; when investor protections are not perfectly secure, monitoring by third agents is helpful in reducing the extent to which managers are able to divert funds or enjoy private benefits. “Investigating the effect on scale requires an alternative setup as controlling for the many unobservable characteristics that might determine firm size is problematic. Fortunately, the model provides a stark prediction with respect to scale that can be tested by analyzing within-affiliate and within-country responses to the easing of ownership restrictions.”7
REFERENCES 1. Kousis, A. • McCulloch, B., “Capital Market Development Sector Reform, April 2007, p. 4. 2. Ibid., p. 2. 3. Agarwal, R.N., “Capital Market Development, Corporate Financing Pattern and Economic Growth in India”, IEG paper, University Enclave, Delhi, 2001, p. 12. 4. Ibid., p. 3. 5. Antràs, P. et al., “Multinational Firms, FDI Flows and Imperfect Capital Markets”, RWP, January 2007, p. 7. 6. Ibid., pp. 27 28. 7. Ibid., p. 22. New Zea-

land Case Study”, paper at the APEC Policy Dialogue Workshop on Financial