STOCK MARKET DEVELOPMENT AND ECONOMIC GROWTH: EVIDENCE FROM UNDERDEVELOPED NATION (Nepal)

Proposal Writing for:				hand, was the real growth rate in per capita GDP.
				Levine and Zervos reported a very strong positive
STOCK MARKET DEVELOPMENT AND ECONOMIC				correlation between stock market development and
GROWTH: EVIDENCE FROM UNDERDEVELOPED				economic growth. The most interesting aspect of this
NATION (Nepal)				study was the decrease in the statistical significance
				of other financial deepening variables after stock
				market development index was included in regression
By				equation. The study concluded with the proof that
Jyoti Koirala ()				stock market development is more influential than
				other financial deepening indicators on the growth of
				the economy.

A Research Proposal Submitted to:				Traditional growth theorists believed that there is no
Faculty Members				correlation between stock market development and
Business or Economics Departmen				economic growth because of the presence of level
				effect not the rate effect. Singh (1997) contended
				that stock markets are not necessary institutions for
August, 2009				achieving high levels of economic development. The
				study focused on the rapid growth of stock markets
				in the liberalization process in developing countries
				over the 1980s and 1990s and argued that financial
Chapter 1: Introduction				liberalization (making the financial system more fragile)
				is not likely to enhance long-term growth. Singh and
1.1. General Background				Weis (1999) viewed stock market as a agent that
				harm economic development due to their
Stock market development has an important role to				susceptibility to market failure, which is often
play in economic development. Shahbaz and his				manifest in the volatile nature of stock markets in
friends (2008) argue that stock market development				many developing countries. The traditional
is an important wheel for economic growth as there				assessment model of stock prices and the wealth
is a long-run relationship between stock market				effect provided hypothetical explanation for stock
development and economic growth. Stock market				prices to be proceeded as an indicator of output
development has the direct impact in corporate				(Comincioli, 1996). According to wealth effect,
finance and economic development.				however, changes in stock prices cause the variation
				in the real economy.
Gerald (2006) states that stock market development
is important because financial intermediation supports				Although empirical tests of the relationship between
the investment process by mobilizing household and				financial development and economic development are
foreign savings for investment by firms. It ensures				not consistent, the bulk of the evidence supports a
that these funds are allocated to the most				relationship between financial development and
productive use and spreading risk and providing				economic development. Demetriades and Hussein
liquidity so that firms can operate the new capacity				(1996) found the evidence of both bi-directionality
efficiently. A growing body of literature has affirmed				and reverse causality by using unit root tests,
the importance of financial system to economic				co-integration tests and vector auto-regression tests
growth.				of causality. The study concluded that financial
				development causes economic growth, economic
Financial markets, especially stock markets, have				growth causes financial system development, and in
grown considerably in developed and developing				some cases, the causality is in both directions. As
countries over the last two decades. Claessens, et al				independent variables, the study has used the ratio
(2004) states that several factors have aided in their				of bank deposit liabilities to nominal GDP and the ratio
growth, importantly improved macroeconomic				of bank claims on the private sector to nominal GDP.
fundamentals, such as more monetary stability and				The dependent variable is real GDP per capita in local
higher economic growth. General economic and				currency terms. Rajan and Zingales (1998) predicted
specific capital markets reforms, including privatization				the average annual real growth of value added in an
of state-owned enterprises, financial liberalization, and				industry in the United Stated over the period from
an improved institutional framework for investors,				1980-90. As predictor variables the study used the
have further encouraged capital markets				proportion of investments funded with external
development.				financing and the ratio of capital spending to net
				property, plant, and equipment. Industries were
Similarly Mishkin (2001) states that a well-developed				further divided into young and old companies. This
financial system promotes investment by identifying				process helped them to differentiate industries that
and financing lucrative business opportunities,				were more or less dependent on external financing.
mobilizing savings, allocating resources efficiently,				The study wanted to test if financially dependent
helping diversify risks and facilitating the exchange of				industries perform better in countries that have more
goods and services				developed financial sectors. As measures of financial
				development in each of forty-one countries. The
From the view point of Sharpe, et al (1999), stock				study used the ratio of domestic credit plus stock
market is a mechanism through which the transaction				market capitalization to GDP, the ratio of domestic
of financial assets with life span of greater than one				credit to the private sector relative to GDP, and an
year takes place. Financial assets may take different				index of accounting transparency. They study
forms ranging from the long-term government bonds				revealed that the financial development facilitates
to ordinary shares of various companies. Stock				economic development by providing cheaper funds to
market is a very important constituent of capital				growing industries.
market where the shares of various firms are traded
Trading of the shares may take place in two
different forms of stock market. When the issuing
firm sells its shares to the investors, the transaction				Table: 2.7
is said to have taken place in the primary market but				Review of Empirical Works from 1997 to 1999 AD
when already issued shares of firms are traded
among investors the transaction is said to have				Study
taken place in the secondary market.				Area
				Major Findings
Stock markets are very important because they play				Harris (1997)
a significant role in the economy by channeling				Stock markets and development
investment where it is needed and can be put to				Level of stock market activity has little explanatory
best (Liberman and Fergusson, 1998). The stock				power in the developing country sample and weak
market is working as the channel through which the				explanatory power for the developed country
public savings are channelized to industrial and				sample.
business enterprises. Mobilization of such resources				Singh (1997) and Weis (1999)
for investment is certainly a necessary condition for				Financial liberalization, stock markets and economic
economic take off, but quality of their allocation to				development.
various investment projects is an important factor				Stock market is a agent that harm economic
for growth. This is precisely what an efficient stock				development due to their susceptibility to market
market does to the economy (Berthelemy and				failure.
Varoudakis, 1996).				Raguraman and Zingales (1998)
				Financial dependence and growth.
Earlier research emphasized on the role of the				Financial developmet facilitates economic
banking sector in the economic growth of nation. In				development by providing cheaper funds to
the past decade, the world stock markets surged,				growing industries.
and emerging markets accounted for a large amount				Levine and Zervos (1998)
of this boom (Demirguc-Kunt and Levine (1996a).				Stock markets, banks and economic growth.
Recent research has begun to focus on the				Strong and statistically significant relationship between
linkages between the stock markets and economic				the stock and GDP.
development. New theoretical work shows how				Luitel and Khan (1999)
stock market development might boost long-run				A quantitative reassessment of the finance-growth
economic growth and new empirical evidence				nexus.
supports this view. Demirguc-Kunt and Levine				Financial development is very supportive to economic
(1996a), Singh (1997), and Levine and Zervos (1998)				development.
find that stock market development is playing an
important role in predicting future economic growth.				The development of endogenous growth theory in
				recent years has offered the opportunity to define
In underdeveloped like Nepal the development and				and explain the link between financial development
growth of stock markets have been widespread in				and economic growth. The study of Pagano (1993)
recent times. Despite the size and illiquid nature of				and Levine (1997) concluded that the financial
stock market, its continued existence and				development could affect the rate of economic
development could have important implications for				growth by altering productivity growth and the
economic activity. For instance, Pardy (1992) has				efficiency of capital. It also affects the accumulation
noted that even in less developed countries capital				of capital through its impact on the saving rate or by
markets are able to mobilize domestic savings and				altering the proportion of saving.
able to allocate funds more efficiently. Thus stock
markets can play a role in inducing economic growth				Benchivenga et al (1996) emphasized that there is
in less developed country like Nepal by channeling				positive role of liquidity provided by stock exchanges
investment where it needed from public. Mobilization				on the size of new real asset investments through
of such resources to various sectors certainly helps in				common stock financing. Investors are more easily
economic development and growth. Stock market				persuaded to invest in common stocks, when there
development has assumed a developmental role in				is little doubt on their marketability in stock
global economics and finance because of their impact				exchanges. Some contrary opinions do exist regarding
they have exerted in corporate finance and economic				the impact of liquidity on the volume of savings,
activity. The role of financial system is considered to				arguing that the desire for a higher level of liquidity
be the key to economic growth (Neupane, et. al.				works against propensity to save (Benchivenga and
2006).				Smith, 1991), (Japelli and Pagano 1994), such
				arguments were not well supported by empirical
Paudel (2005) states that stock markets, due to their				evidence. The second important contribution of stock
liquidity, enable firms to acquire much needed capital				exchanges to economic growth is through global risk
quickly, hence facilitating capital allocation, investment				diversification opportunities. Saint-Paul (1992),
and growth. Stock market activity is thus rapidly				Deveraux and Smith (1994) and Obstfeld (1994)
playing an important role in helping to determine the				argue quite reasonably that opportunities for risk
level of economic activities in most economies.				reduction through global diversification make high-risk
				high-return domestic and international projects viable
Tuladhar (1996) states that financial markets are				and consequently, allocate savings between
catalyst in the development of economy. The study				investment opportunities more efficiently. Whether
further added that developed economies have highly				global diversification might reduce the rate of
sophisticated financial institutions. Over the past				domestic savings (Deveraux & Smith 1994)
decade, many developing economies have established				seemed to be a weak argument, as it is not
capital markets as they moved towards more liberal				convincingly evidenced.
economic policies. These emerging markets have
shown extraordinary growth with very high volatility,				Levine and Zervos (1998) analyzed by using stock
which have attracted many investors into these				market liquidity (turnover of shares and value), size
markets.				(market capitalization), volatility (twelve month rolling
				standard deviation), integration with world markets
This study will attempt to dig out the empirical				(CAPM and APT intercept terms), and bank credit for
evidence in the context of underdeveloped nations				the private (bank credit to the private sector to
regarding the role of stock market development on				GDP) as predictors of economic growth, capital
economic growth.				accumulation, improvement in productivity, and
1.2. Statement of the Problem:				savings growth rates for forty-seven countries from
				1976-93. The study reveals a positive relationship
In the last two decades, the link between financial				between stock market and bank development and
intermediation and economic growth is a subject of				economic growth, capital accumulation, and
high interest among academics, policy makers and				productivity growth. The authors conclude that stock
economists around the world. There have been				markets provide an easy means to trade the
attempts to empirically assess the role of stock				ownership of productive assets, which facilitates
market and economic growth. The link between				resource allocation, which, in turn, facilitates capital
stock market and growth has varied in methods and				formation, which leads to faster economic growth.
results. There exists two controversies in the
predictions.				In the framework of the new growth theory,
				surprisingly few empirical studies of the relation
Adjasi and Biekpe (2005) found a significant positive				between stock market and economic growth are
impact of stock market development on economic				available. The one important study mentioned earlier
growth in countries classified as upper middle-income				is one by Levine and Zervos (1998) who are among
economies. In the same way, Chen et al (2004)				the first to ask whether stock markets are merely
elaborated that the nexus between stock returns				burgeoning casinos or a key to economic growth and
and output growth and the rate of stock returns is a				to examine this issue empirically, finding a positive and
leading indicator of output growth Arestic et al.				significant correlation between stock market
(2001) using time-series on five industrialized countries				development and long run growth. The work of
also indicate that stock markets play a role in growth.				Luintel and Khan (1999), among others, is supportive
Various studies such as Spears, (1991); Levine and				of this view.
Zervos, (1998); Atje and Jovanovic, (1993);
Comincioli, (1996); Levine and Zervos, (1998); Filer et				2.1.3 Review of Literature during 2000
al, (1999); Tuncer and Alovsat, (2001). Levine and
Zervos (1995) and, Demirguc-Kunt (1994) has				Empirical work done in the past two decades mostly
supported the view .stock markets promote				focused on the role of financial development in
economic growth..With well-functional financial sector				stimulating economic growth, without taking into
or banking sector, stock markets can give a big				account of the stock market development. Evolution
boost to economic development (Rousseau &				of stock market has impact on the operation of
Wachtel, 2000; Beck & Levine, 2003). Bahadur				banking institutions and hence, on economic
and Neupane (2006) concluded that stock markets				promotion. This means that stock market is
fluctuations predicted the future growth of an				becoming more crucial, especially in a number of
economy and causality is found in real variables.				emerging markets and their role should not be
				ignored (Khan and Senhadji, 2000).
There are also alternate views about the role stock
markets play in economic growth. Apart from the				Beck et al (2000) analyzed the relationship between
view that stock markets may be having no real				financial development and economic growth, total
effect on growth, there are theoretical constructs				factor productivity growth, physical capital
that show that stock market development may				accumulation ratesand private savings rates. The
actually hurt economic growth. For instance, Stiglitz				study reported that there is a large positive effect
(1985, 1994), Shleifer and Vishny (1986), Bencivenga				of financial intermediaries and total factor productivity
and Smith (1991) and Bhide (1993) note that stock				growth and economic growth but a lesser effect for
markets can actually harm economic growth. They				long-term economic growth and total factor
argue that due to their liquidity, stock markets may				productivity growth.
hurt growth since savings rates may reduce due to
externalities in capital accumulation. Diffuse ownership				Wurgler (2000) analyzed the relationship between
may also negatively affect corporate governance and				financial markets and capital allocation in sixty-five
invariably the performance of listed firms, thus				countries from 1963-95. The study revealed that
impeding the growth of stock markets.				countries with more developed financial markets shift
				capital to growing industries and away from declining
Despite of alternative views empirical works continue				industries. The efficiency of the financial system is
to show largely some degree of positive relationship				inversely related to government ownership in the
between stock markets and growth. These studies				economy and directly related to information
largely based on developed countries only. Only few				availability for firms and legal protections for minority
studies have been conducted in context of Nepalese				stockholders.
stock market, and those conducted studies do not
show clear conclusion regarding its impact on				Table: 2.8
economy. Yadhav (2002) finds that firms with higher				Review of Empirical Work from 2000 to 2004 AD
investment have higher saving and higher capital				Study
formation. Though his study may be significant in				Area
other cases it is of less significance here. Similarly				Major Findings
Wagle (2002) also carried out the study on trends of				Beck, Levene and Loayza (2000)
saving, investment, and capital formation in Nepal, but				Finance and sources of growth.
his study fails to provide any specific link between				There is a large positive effect of financial
saving, investment and capital formation with stock				intermediaries and total factor productivity growth.
market development. Similarly Sindhurakar (2004) has				Wurgler (2000)
carried out the study on relationship between the				Financial market and allocation of capital.
stock market and economic growth without analyzing				The efficiency of financial system is inversely related
the econometric models.				to information availability for firms and legal
				protections for minority stockholder.
The study specifically deals with the following issues:				Arestis et al. (2001)
1. What is the relationship between the Gross				Financial development and economic growth.
Domestic Product (GDP) and government				Both stock market and bank may be able to help in
investment, government expenses, foreign aid,				economic development.
savings, and foreign direct investment				Bell and Rausseau (2001)
2. Is there any relationship between the market				A case of finance lend industrialization
capitalization and Gross Domestic Product (GDP)?				Financial development in India has instrumental role for
3. What is the impact of concentration ratio on				promoting economic performance.
economic growth of a nation?
4. What is the significance of liquidity on economic				Mishkin (2001) and Caporale et al (2004)
growth? What is its impact in capital market?				Financing, savings, capital and risk.
5. Is there any co-integration between the stock				Financing productive projects mobilize domestic
development index and economic growth?				savings, allocate capital and diversify the risk, facilitate
6. Is there any Granger causality between the stock				exchange of goods and services.
development and economic growth?
7. Is the Levine and Zerovos model valid in
underdeveloped nation like Nepal?				Tuncer and Alovsat (2001) examined stock
8. Can the small group of investors manipulate a				market-growth nexus and exhibited positive casual
Nepalese capital market easily?				correlation between stock market development and
9. How can the government able to develop the				economic activities. Chen et al (2004) elaborated that
stock market in coming days?				the nexus between stock returns and output growth
				and the rate of stock returns is a leading indicator of
One group of study argues that stock market does				output growth.
not help in economic development of a nation while				The study of Phylaktis and Ravazzolo (2001)
the other group argues that it helps in economic				measured financial linkages by analyzing the
development. However, empirical investigations of the				covariance of excess returns on national stock
link between financial development in general and				markets of emerging economies. A major advantage
stock markets and growth in particular have been				of this framework is that by examining the
relatively limited. Various empirical researches have				co-movement of future returns aggregated over a
suggested a possible connection between stock				long horizon instead of the co-movement of one
market development and economic growth, but are				period expected returns one can detect small but
far from definitive.				persistent movements in expected returns and more
				accurately measure the degree of financial integration
1.3. Objective of the Study				than one period stock return regression models.

The main objective of this study is to examine the				The study of (Arestis, Demetriades and Luintel, 2001)
impact of stock market development in the				found that in countries like Germany, stock market
economic development and growth of the nation in				volatility has a significant and negative impact on
context to Nepal. The specific objectives of the				growth. Another point worthy of note is that studies
study are as follows.				based on a cross-country framework in general have
				omitted China due to lack of data. Needless to say
1. To conduct the empirical analysis of stock market				that given the increasing role of China in the world
by investigating the link between stock markets and				economy, understanding China is important in its own
economic growth.				right. The study used a vector autoregressive model
				to study the relationship between stock market
2. To further analyze the link based on set of				development measures and economic growth for
different variables of economic indicators and stock				developed economies, controlling for the banking
market indicators.				sector development. The study finds that the stock
				market and economic growth both may be able to
3. To examine the importance of liquidity for the				promote growth, with the impact of the banking
economic growth.				system being stronger. With well-functional financial
				sector or banking sector, stock markets can give a
4. To analyze the impact of firm concentration ratio				big boost to economic development (Rousseau and
on economic growth.				Wachtel, 2000; Beck and Levine, 2003).

5. To examine the validity of model of Levine and				Mishkin (2001) and Caporale et al (2004) provided the
Zervo’s study on stock market in developing				evidence that an organized and managed stock
nation like Nepal.				market stimulate investment opportunities by
				recognizing and financing productive projects that
6. To determine and analyze the co-integration and				lead to economic activity, mobilize domestic savings,
causality between the stock market development				allocate capital proficiency, help to diversify risks, and
index and economic growth.				facilitate exchange of goods and services.
				Undoubtedly, stock markets are expected to
				increase economic growth by increasing the liquidity
				of financial assets, make global and domestic risk
Chapter: 2 Review of Literature				diversification possible, promote wiser investment
				decisions, and influence corporate governance, that is,
2.1 Review of Empirical Works				solving institutional problems by increasing
				shareholders’ interest value (Vector, 2005).
This section concerns with review of important
empirical works, concerning stock market				Bell and Rousseau (2001) evaluated the relationship
development and economic growth starting from				between individual macroeconomic indicators and
1873 to 2008. Some important studies and their				measures of financial development in India and
finding are presented in tabular form in chorological				revealed that the financial sector has been
order. The review of literature is undertaken in three				instrumental in promoting economic performance.
sections. The first section focuses on the review of				Nourzad (2002) analyzed the effect of financial
empirical works carried out before 1990s with their				development on productive efficiency using eight
major findings. Similarly, the second section deals with				measures of financial development for countries at
the review of studies carried out during 1990s and				different stages of economic development. The
finally third section deal with the review of studies				study analyzed three sets of panels of data: annual
during 2000.				data for twenty-nine countries from 1966-90, annual
				data for eighteen countries from 1970-90, and five
2.1.1 Review of Empirical Works before 1990s				year average data for twenty-eight countries from
				1970-90. The author finds that productive efficiency
During nineteenth and twentieth century, Bagehot				is greater in countries that have more developed
(1873) and Schumpeter (1912) had focused on the				financial sectors.
constructive assistance of financial sector to
economic growth. In the study the direction of				Table: 2.9
causality between the higher growth in financial				Review of Empirical Works from 2005 to 2007 AD
sector and country’s economic growth rate was
not clear (Robinson, 1952 and Locus, 1988). In the				Study
wake of a large body of empirical evidence,				Area
considerable studies have made on modeling and				Major Findings
understanding the strong positive linkages between				Shrestha (2005)
real and financial development. Much of this research				Stock Market and Economic Development.
has followed the “functional” approach in the				Gross Domestic Product influence stock market.
analysis of such linkages.				Vinhas de Souza (2005)

				Financial liberalization and business cycles: The
				experience of the new EU member states.
Table: 2.1				Capital market reform programs, government
Review of Empirical Works from 1873 to 1986				approved new laws are regulatory framework for
				capital market flourish.
Study				Siliver and Duong (2006)
Area				Role of stock market for real economic activity:
Major Findings				evidence for Europe.
Bagehot (1873)				Stock market has certain predictive content for real
A description of money market with currency				economic growth.
monopoly.				Yartey and Adjasi (2007)
Constructive assistance of financial sector to
economic growth.				Stock market development in Sub-Saharan Africa:
Schumpeter (1912)				Critical issues and challenges
The theory of economic development.				African stock market facing challenge of integration
Technological innovation is the force underlying				and need better technical and institutional
long-run economic growth.				development to address the problem of low liquidity.
Robinson (1952)
				Efficient stock markets provided guidelines to keep
The Generalization of the General Theory, in The				appropriate monetary policy through the issuance and
Rate of Interest and Other Essays.				repurchase of government securities in the liquid
				market, which is an important step towards financial
There is a two-way causal relationship between				liberalization. Similarly, well-organized and active stock
financial development and economic performance.				markets could modify the pattern of demand for
Goldsmith (1969)				money, and would help create liquidity that eventually
Association between levels of financial development				enhances economic growth (Caporale et al, 2004).
with economic growth.				Similarly, Siliverstovs and Duong (2006) revealed that
A significant association between the level of financial				the accounting for expectations has represented by
development and economic growth.				the economic sentiment indicator in which stock
				market has certain predictive content for the real
The “finance-led growth” hypothesis				economic activity.
postulates the “supply-leading” relationship
between financial and economic developments. It is				Paudel (2005) acknowledged that stock markets, due
argued that the existence of financial sector and				to their liquidity, enable firms to attain much needed
financial intermediations in channeling the limited				capital quickly, hence facilitating capital allocation,
resources from surplus units to deficit units would				investment and growth. Adjasi and Biekpe (2005)
provide efficient allocation resources by leading the				found a significant positive impact of stock market
other economic sectors in their growth process.				development on economic growth in countries
Indeed, a number of studies argued that the				classified as upper middle-income economies. Bahadur
development of financial sector has significantly				and Neupane (2006) concluded that stock markets
promoted economic development (Schumpeter,				fluctuations helps in the prediction of the future
1912). The study argued that the technological				growth of an economy.
innovation is the force underlying long-run economic
growth.
				2.1.4 Concluding Remarks
Robinson (1952), on the other hand, concluded that
the economic growth creates a demand for various				From the above, it may be seen that the effect of
types of financial services to which the financial				capital markets on economic growth has been a
system responds. Goldsmith (1969) reported a				controversial subject. Some studies indicated the
significant association between the level of financial				statistically significant effect of stock market
development (defined as financial intermediary assets				development on economic growth while others did
divided by GDP) and economic growth. The study				not. Similarly, some reported positive impact of stock
however recognized that there is no possibility of				liquidity on economic growth while some did not. In
establishing the confidence for the direction of the				order to validate one view or the other in Nepalese
causal mechanisms.				context, no study has been so far conducted by
				using the recent data by considering Deminigue-Kunt
The earlier studies on international stock market				and Levene’s stock market development index.
linkages focused on the identification of short-term				This study therefore tests the above hypothesis
benefits of international portfolio diversification. The				concerning stock market development and economic
study of Levy and Sarnat (1970) and Solnik (1974),				growth in undeveloped country, Nepal.
examined the short-term correlations of returns
across national markets and pointed out the
existence of substantial markets have high possibilities
to diversify the risk internationally.				Chapter 3: Research Methodology

McKinnon (1973) provided the evidences that				3.1 Research Design
liberalization of financial markets allows financial
deepening which reflects an increasing use of financial				For the analysis of relationship between the stock
intermediation by savers and investors and the				market development and economic growth
monetization of the economy, which allows efficient				descriptive, co-relational and time series research
flow of resources among people, and institutions				design will be employed. For the purpose of
over time. This encourages savings and reduces				conceptualization and description, the descriptive
constraint on capital accumulation and improves in				research design is going to be used. For the analysis
allocating efficiency of investment by transferring				purpose the study covers the time period of ten
capital from less productive to more productive				years. This study will be made on a macro level so it
sectors.				consists of all the sectors including commercial banks,
				manufacturing and processing organization, hotel
Another group of studies concentrated on examining				sectors, trading, insurance, finance companies and,
financial links among stock markets by using either				development banks and so on.
bivariate or multivariate co-integration methodology.
Taylor and Tonks (1989) were the first to apply				3.2 Nature and Sources of Data
bivariate co-integration on the UK and U.S. markets to
test the importance of the abolition of foreign				This study will base on both primary and secondary
exchange controls in 1979. Furthermore, the empirical				data. Most of the data related to economic growth
evidence was not conclusive, while a strong empirical				and stock market development will be collected from
causal relationship among the banking system, stock				annual report and official reports of concerned
market development and economic performance was				organization. The required information will be
hardly established. Financial development is considered				supplemented by Ministry of Finance, Department
as a means to economic growth through various				of Industries, Commerce and Supplies, economic
channels. An important role of financial intermediaries				survey published by Nepal Government, quarterly
is to provide liquidity to individual investors (Diamond				economic bulletin published by Nepal Rastra Bank
and Dybvig 1983). Similarly study of Stiglitz and				(NRB), National Planning Commission and Security
Weiss, (1981); and Cho, (1986) concluded that the				Board of Nepal (SEBON), World Bank Report will be
returns does not increase as the interest rate to				considered.
borrowers rises.
				A field survey based on questionnaire and interview
				will also be conducted to collect opinions of different
				respondents in three groups. The respondents
				selected for the survey will be stock investors,
				general student and public who have not invested in
Table: 2.2				shares to obtain the information in respect of
Review of Empirical Works from 1881 to 1986				economic performance and stock market
				development.
Study
Area				3.3 Selection of Enterprises
Major Findings
Shiller (1981)				The study is related to aggregate values so
				aggregate values of economy that is determinants of
Do stock prices move too much to Be Justified by				macroeconomic indicators and aggregate value of
Subsequent Changes in Dividends?				market activities that is determinants of stock
Price movements cannot be simply justified by				market developments are going to be selected.
changes in fundamentals.
Stiglitz and Weiss (1981)				3.4 Methods of Analysis
Credit rationing in markets with imperfect information
Due to stagnant bank returns, increase in interest				Analysis is the systematic and careful examination of
rate does not increase its return.				available facts so that certain conclusions can be
Diamond and Dybvig (1983)				drawn from it. The major part of the study is based
A simple example, Federal Reserve Bank of				on the testing of association of stock market and
Richmond.				economic growth.
An important role of intermediaries is to provide
liquidity to individual investors.				3.4.1 Econometric Model
Lucas (1988)
				This study is heavily based on Levine and
On the mechanics of economic development.				Zervos’s study on stock market development
Not clear findings about the causality between				and long run growth. However, their study is based
financial sector and economic growth.				on cross-country regression, but this study considers
Taylor and Tonks (1989)				time series analysis and single equation regression
				applied to the collected data.
The internationalization of stock markets and the
abolition of U.K. exchange control				Study will determine the casual relation between
There is multivariate co-integration on UK and US				stock market development and economic growth
market.				then determine how they evolve over time and
Romer (1986)				finally seek the relationship between the stock
Increasing returns and long run growth				market development and its economic performance.
				Levine and Zervos (1996) suggested the following
Increase in productivity will cause economic growth.				equation to evaluate whether there is any relationship
Cho (1986)				between the stock market development and long run
Inefficiencies from financial liberalization in the absence				economic growth.
of well-functioning equity markets.
Returns do not increase as interest rate rises.				GDPt = aXt + bSTOCKt + µt
				� (1)
At the theoretical level, the study of stock markets
and growth gave new impetus with analyses of the				Where GDP Growtht is the Gross Domestic Product
design of optimal financial contracts under				growth rate and Xt is a set of control variables that
asymmetric information in dynamic general equilibrium				is associated with GDP. These variables include
models. The study of Bernanke and Gertler, 1989				government expenditure (EXPN), Public Investment
concluded that the evolution of the financial system				(INV), public development aid (AID), foreign direct
led to financial contract which emerged to solve the				investment (FDI). In the same way STOCKt
problems of moral hazard. The study concluded that				represents stock market development index. It
when the firms are in need of external finance face a				includes market capitalization ratio (Mcap), liquidity
cost minimization problem, which they must solve by				ratio (Liquidt) and concentration ratio (Conct). A and
issuing different forms of financial contracts under				B are unknown parameters to be estimated and Mt
different circumstances.				is an error term. We can consider the following
				equations in details.
2.1.2 Review of Empirical Works during 1990s
				GDPt = a1 Xt + b1 Mcapt + b2 Liquidt + b3 Conct +
Stock exchanges are expected to increase the				µt
amount of savings channeled to corporate sector.				� (2)
Some evidence can be found in the work of
Greenwood and Jovanovich (1990). Furthermore, the				Government expenditure is selected as control
study concluded that the stock markets play an				variables because in underdeveloped country,
important role in allocation of capital to corporate				government plays key role in economic growth for
sector that in turn stimulates real economic activity.				driving the different productive activities. Thus it can
Many countries are facing financial constraints				impact positively as well as negatively on economic
particularly developing countries, where bank loans				growth. Public investment is selected as a control
are restricted to some favorable groups of				variable because if the public investment policy is
companies and personage investors. This limitation				directed correctly (for instance towards
can also reflect constraints in credit markets				infrastructures development), it can impact
(Mirakhor and Villanueva, 1990).				significantly on economic growth, since public
				investment can target health, education, etc., which all
Table: 2.3				contribute to increase total factor productivity. Public
Review of empirical work from 1990 to 1991				development aid is selected because in developing
				countries savings is inadequate so development aid is
Study				an ‘oxygen pipe’ for nation’s
Area				development. Foreign direct investment is taken
Major Findings				because it measures the private investment as
Mirakhor and Villanueva (1990)				domestic investment is very low as compared to it
Market integration and investment barriers in				so it is ignored here.
emerging equity markets.
There are high constraints in credit markets.				The Liquidity ratio variable represents the turnover
Greenwood and Jovanovich (1990)				ratio measured as the value of total shares traded
				divided by market capitalization (high turnover then
Financial development, growth, and the distribution of				high liquidity). Liquidity allows investors to easily buy
income.				and sell securities. As Levine and Zervos (1996) put it,
Financial markets and financial institutions can affect				stock markets may affect economic activity through
capital accumulation.				their liquidity since investors are reluctant to relinquish
Vishny (1990)				control of their saving for long periods. Market
				capitalization ratio, which equals the value of listed
The stock market and investment.				shares divided by GDP, is taken as the indicator for
Stock market on an aggregate level does not predict				stock market development. This ratio measures the
the future investment.				stock market size, ability to mobilize the capital and
Levine (1991)				helps to diversity the risk. Concentration ratio is the
				four firm concentration ratios, which is measured by
Stock markets, growth, and tax policy.				dividing market capitalization of four largest stocks by
Strong positive relationship between stock market				total market capitalization. If few companies
liquidity, productivity improvements and capital				dominate the market, they can manipulate the price
accumulations.				formation process. Thus a high concentration ratio is
Bencivenga and Smith (1991)				not desirable. Countries with highly concentrated
				markets have markets that are underdeveloped. So
Financial intermediation and endogenous growth.				market concentration is hypothesized to be
Financial agents can affect savings decisions by				negatively correlated with market size and market
reducing liquidity costs.				liquidity.

The ability of financial intermediaries to offer				3.4.2 Correlation Analysis
profitable investments enhances savers’
confidence and attracts additional savings. The				Correlation analysis is necessary in order to find out
efficient operation of financial intermediaries leads to				whether the selected variables in time series have
output growth and generates additional demand for				any relation or not. If there is no correlation there
deposits and financial services (Greenwood and				would be no causality so this test is necessary.
Jovanovic, 1990). Financial institutions can affect
agents’ savings decisions by reducing liquidity				A mathematical formula for measuring the correlation
costs and offering greater opportunities for				developed by Pearson is as follows.
diversifying risks (Bencivenga and Smith, 1991).
Portfolio diversification, through the stock market,				(3)
may have an additional growth effect by encouraging
specialization of production (Saint-Paul, 1992).				Where r is a correlation coefficient, Xt and Yt are
				two variables whose correlation is to be calculated.
In addition, some studies concluded that stock				Correlation is a measure of the relation between two
markets could improve corporate governance by				or more variables. The measurement scales range
alleviating the principal-agent problem between the				from -1.00 to +1.00. The value of -1.00 represents a
owners and managers (Jensen and Murphy, 1990). By				perfect negative correlation, while a value of +1.00
contrast, other studies pointed out that stock				represents a perfect positive correlation. A value of
market development could have negative effects by				0.00 or close to zero represents a lack of correlation.
facilitating hostile counter-productive takeovers
(Vishny, 1990). Moreover, some argue that takeover				3.4.3 Time Series Analysis of the Data
threats could hassle managers that discourage
long-term investment, and therefore lead to				For the data analysis purpose the following time
inefficient allocation of resources (Singh and Weiss,				series analysis is made. They are as follows.
1998). Furthermore, some assert that stock markets,
by providing profit incentives, are more effective				3.4.3.1 Unit Root Tests:
than banks in information acquisition and dissemination
and therefore could enhance quality of investment				According to Nelson and Plosser (1982), Chowdhury
and thus stimulate growth (Holmstrom and Tirole,				(1994) there exists unit roots in most macroeconomic
1994). On the contrary, some others believe that				time series. While dealings with time series, it is
banks are superior to stock markets in that they				necessary to analyze whether the series are
could monitor firms’ investment and				stationary or not. Since regression of non-stationary
management at a lower cost. They contend that in				series on other non-stationary series leads to what is
reality, due to dispersed stock ownership, individual				known is spurious regression causing inconsistency of
investors are relatively small and they neither have				parameter estimate (Engle and Yoo, 1987). The
the ability nor the incentives to acquire the costly yet				hypothesis behind is that random shocks in economy
necessary information for achieving efficient resource				have long lasting effects (Engle & Granger,
allocation (Bhide, 1993; Singh, 1993).				1987). The most popular of these tests are the
				Augmented Dickey-Fuller (ADF) test and the
Contrary to traditional view, there are evidences that				Phillips-Perron (PP) tests. ADF test will be considered
support the hypothesis that there exist long-run				for this study because ADF tests use a parametric
correlation between stock market development and				autoregressive structure to capture serial correlation.
economic growth. But in literature the testing of this
hypothesis is rare for developing countries. However,				3.4.3.2 Co-integration Test
Pardy (1992) in his seminal work has argued that in
less developed countries capital markets are able to				The finding that many macro time series may contain
mobilize domestic savings and allocate funds more				a unit root has spurred the development of the
efficiently. Spears (1991) reported that in the early				theory of non-stationary time series analysis. Engle
stages of development, financial intermediation				and Granger (1987) pointed out that a linear
induced economic growth. Demirguc-Kunt (1994) has				combination of two or more non-stationary series
supported the view that stock markets promote				may be stationary. If such a stationary linear
economic growth.				combination exists, the non-stationary time series are
				said to be co-integrated. The stationary linear
A number of subsequent studies adopted the growth				combination is called the co-integrating equation and
regression framework in which the average growth				may be interpreted as a long-run equilibrium
rate in per capita output across countries is				relationship among the variables. The purpose of the
regressed on a set of variables controlling for initial				co-integration test is to determine whether a group
conditions and country characteristics as well as				of non-stationary series is co-integrated or not.
measures of financial market development (King and				Eviews5 statistical software implements VAR-based
Levine, 1993a). The study further analyzes the				co-integration tests using the methodology developed
relationship between financial development and real				in Johansen (1991, 1995a).
GDP per capita growth, the rate of physical capital
accumulation, and increases in efficiency over the				There are two different methods for testing for
period from 1960-89. The study measured the				co-integration, Engle & Granger (1987) and
financial development by using the financial depth				Johansen (1988). Jung and Seldon (1995) state that
ratio (ratio of liquid liabilities to GDP), the level of				the Johansen co-integration test is more valid as
banking, the ratio of credit issued to non-financial				there is no need of prior knowledge of the
private firms to total credit and the ratio of credit				co-integration vectors, in cases when they are
issued to private firms to GDP. The study revealed				unknown. As this study does not have the
that higher levels of financial development are				co-integration vectors it is better to use the
positively associated with faster rates of economic				Johansen (1988) test. The Johansen methodology
growth and that the level of financial development is				utilizes Vector Auto Regression (VAR) to test the
a good indicator of future growth prospects.				co-integration. The Johansen (1988) method of
				testing for the existence of co-integrating
Robert Barro (1990) reported that in the case of US,				relationships has become standard in the
stock market variables and stock returns, can largely				econometrics literature because of its superiority
explain the subsequent aggregate investments. On				over other alternatives.
the contrary, Morck et al (1990) suggested that in
the US, the stock market on an aggregate level is				3.4.3.3 Granger Causality between Economic Growth
not much of a predictor of future investment.				and Stock Market Development
Meanwhile, a study by Galeotti and Schiantarelli
(1994), based on quarterly aggregate data from the				Measuring the correlation (similarities in strength and
non-financial corporate sector in the US, revealed that				direction between two graphs) between variables
investment decisions are significantly affected by				such as GDP and STOCK would according to Granger
stock price fluctuations, regardless whether the				(1969) not be enough to construct a complete
variation is due to fads or due to changes in				understanding about the relationship between two
fundamentals. On the other hand, firm- level studies				time series. The reason is that some correlations may
typically showed that there is a very limited effect of				be spurious and not useful, as there might be a third
the stock market on investment (Abel and Blanchard,				variable that cannot be accounted for. For example
1986; Morck, Shleifer, and Vishny, 1990; Blanchard,				there is a correlation between teacher’s salaries
Rhee, and Summers, 1993).				in the UK and the consumption of alcohol in the UK.
				Another example is that ice cream sales are
Table: 2.4				correlated to shark attacks on swimmers (Lethen,
Review of Empirical Works from 1992 to 1993				1996). In both examples it would be highly unlikely
				that one causes the other but that there exists
Study				other hidden variables affecting both. There is a
Area				correlation but no causal connection.
Major Findings
Saint-Paul (1992)				By using the Granger causality approach with the
Financial markets and economic development.				question if variable X (in a time series), causes
Stock markets have additional growth effect.				variable Y (in another time series), a researcher
Pardy (1992)				wants to see how the value of the existing Y can be
Institutional reform in emerging securities markets.				explained by past values of Y. And then by adding
				lagged values of X add to explanation of the
In less develops countries the capial maket are able				relationship (Eviews 5.0 statistical software)
to mobilize domestic savings.
King and Levene (1993)				This does in practice imply that if you find a variable
Finance and growth				that is Granger causing another variable in a certain
Rate of physical capital accumulation has increased in				direction or both, manipulation of one would affect
efficiency over the period from 1960 to 1989.				the other. To reduce spurious results the process
Atje, and Jovanovic, (1993)				of finding Granger causality also involves finding out
Stock market and development				other relations between the time series and such
Significant correlation between the stock markets				relations include looking at correlation and
and economic growth.				co-integration (Sahlin and Sjogren, 2008). So this
Pagano (1993)				study is not only looking at the correlation,
				co-integration and causality but also looking at a
Financial market and growth.				further developed relationship between the time
Financial growth can affect the rate of economic				series. This is combined to produce an answer to if
growth by altering productivity growth and the				there is a relationship between the variables. Hence,
efficiency of capital.				in this study the word relationship stated by statistical
Bhide (1993)				software is used as a generic term for the combined
The hidden cost of stock market liquidity.				correlation, co-integration and causality time series.
Highly liquid market may reduce the shareholders				For the calculation purpose the following equations
incentives to monitor managers.				have to be estimated.

Atje and Jovanovic (1993) concluded that there is a				3.4.4.4 Other Statistical Tools Considered
large effect of stock markets on economic growth
but no relationship for bank lending on economic				For our data presentation and analysis other statistical
growth. Alternatively, Harris (1997) argued that the				tools will be. They are mean, median, standard
Atje and Jovanovic results are not supported by				deviation, maximum and minimum, T-test, F-test and
empirical results. Harris analyzed data for forty-nine				Standard Error of Estimate (SEE).
countries over the period from 1980-91 for the
growth in GDP per unit of effective labor, investment
as a percent of GDP, the growth of total employed
labor and the total value of shares traded on the				Chapter 4: Concluding the research proposal
stock market as a percent of GDP. The study
reported that the level of stock market activity has				There are many studies that have examined the
little explanatory power in the sample of developing				relationship between growth and stock markets using
countries and weak explanatory power for the				either cross country or panel methods. However their
sample of developed countries. The study of Stiglitz				empirical approach typically suffers from serious
(1994) provided the evidence that when the stock				econometric weakness. Traditional growth theorists
prices is determined by publicly available information				believed that there is no correlation between stock
then it help investors make better investment				market development and economic growth. Singh
decisions. Better investment decisions by investors				(1997) argues that stock markets are not necessary
means better allocation of funds among corporations				institutions for achieving high levels of economic
and, as a result, a higher rate of economic growth. In				development. Some recent studies have stated that
efficient capital markets prices already reflect all				stock markets play an important role in allocation of
available information, and this reduces the need for				capital to corporate sector that in turn stimulate real
expensive and painstaking efforts to obtain additional				economic activity. Studies of Caporale (2004), Vector
information.				(2005), Mishkin (2001) and few other studies too
Table: 2.5				state that an organized and managed stock market
Review of Empirical Work for 1995 AD				stimulates economic activities. Most of these studies
				have reported positive effects of stock on economic
Study				growth. One group of study argues that stock
Area				markets do not help in economic development of a
Major Findings				nation while the other group argues that it help in
Bencivenga, Smith,and Starr (1995)				economic development.
Transactions costs, technological choice and
endogenous growth.				With this contrast view, this study attempts to find
Theoretical predications on strong connections				possible connection between stock market
between stock market liquidity and fast growth.				development and economic growth with reference to
Bencivenga et al. (1995)				Nepal. The variables selected for the study are Gross
Transactions costs, technological choice and				Domestic Product (GDP), Government Investment
endogenous growth				(INV), Government Expenditure (EXPN), Foreign Aid
Enhanced stock market liquidity reduces the				(AID), Foreign Direct Investment (FDI), Market
disincentives for investing in long duration and higher				Capitalization Ratio (MCAP), Concentration Ratio
return projects since investors can easily sell their				(CONC) and Liquidity (LIQDT).
stake in the project.
Longin and Solnik (1995)
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STOCK MARKET DEVELOPMENT AND ECONOMIC GROWTH: EVIDENCE FROM UNDERDEVELOPED NATION (Nepal)

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