Stock Market and Economic Growth in Eastern Europe

Maria A. Prats and Beatriz Sandoval

Maria A. Prats, University of Murcia, Murcia, Spain, mprats@um.es

Beatriz Sandoval, University of Murcia, Murcia, Spain, beatriz.sandoval@um.es

Abstract

A developed financial system is essential in a market economy. This paper studies the

importance of the development of financial markets in general, and the stock market in

particular, from the review of existing literature in the area of the relationship between financial

development and economic growth, and especially, the link between the stock market and

economic growth. Through an empirical analysis for six countries in Eastern Europe (Bulgaria,

Slovakia, Hungary, Poland, Czech Republic and Romania) it is tried to show the link between

the stock market development and economic growth in these countries from 1995 to 2012 in

order to explain the transition processes, from communist to market economies, which began

with the fall of the Berlin Wall in 1989.

The results show evidence of Granger causality between economic growth variables and

financial market variables.

1. Introduction

Since the 20th century, especially the last decades, there has been a great interest

in studying the relation between the financial system and the economic growth. There are

numerous debates about the reasons of this relation and the role that the financial

development has in the different financial institutions in the economic growth of a

country. In particular, there has been a special interest in determining the role that the
stock market has in this context, giving way to the implementation of an important

theoretical and empirical framework in which the link between the stock market and the

economic growth of a country or group of countries is analyzed.

In the same way, the economic growth has a lot of consideration for the

institutions and the economic politics, since the concept of economic growth and the

prosperity and wellbeing of a country are associated. In general, the growth rate of gross

domestic product (GDP) is used as an economic growth indicator, while there is a broad

debate on consideration of whether this is the best indicator of a country's well-being

could be consideration of other non-material aspects, as indicated by Stiglitz, Sen and

Fitoussi (2009). Despite this enriching and unfinished debate, economic growth continues

to have a great importance for the prosperity of economy. For example, Salai-Martin

(2006), states that there has been a greater poverty reduction precisely in those regions

with a higher growth.

Therefore, the objective of this paper is to review theoretical relationship between

financial development and economic growth, and particularly, of the link between the

stock market and economic growth, as well as an empirical study for six countries of

Eastern Europe from 1995 until 2012, to try to get the link between the development of

the stock market and economic growth in these countries.

This work will be structured as follows. Section 2 reviews the literature on the

link between financial system and development, and more specifically, between

economic growth and stock market. Section 3, discusses the characteristics and results of

an empirical model, which attempts to demonstrate causality between variables of

 development of stock market and economic growth in six countries of Eastern Europe.

Finally, set out the conclusions.

2. Theoretical framework

2.1 Literature review: financial system and economic growth

Gehringer (2013) defines the financial development such as improving the quality

of financial transactions.

Levine (2004) extends this definition and points out that there is development

finance when the intermediaries, markets and financial instruments improve (although

3 not necessarily deleted) information and transaction costs and, therefore, do better

their corresponding work in terms of the performance of the functions of the financial

markets.

However, indicators are needed to measure the financial development. The choice

is a complex task, because there is not a single indicator. Some authors, such as Law

and Singh (2013), only use indicators relating to banking activity, such as the volume

of credit to the private sector or size of the liabilities. Other authors, like GoldSmith

(1969), emphasize the role of financial intermediaries, using the value of the

intermediated assets. King and Levine (1993), for example, use both types of

indicators.

Levine (1997) carried out a theoretical approach since the emergence of the

financial markets to economic growth. Firstly, he says that the costs of acquiring

information and transactions created incentives for the emergence of financial

markets and institutions. The degree of financial development affects the markets and
institutions so that they can fulfil their functions correctly. Levine also indicates that

the functions of the financial markets may affect economic growth through two

channels: capital accumulation and technological innovation. It can be seen the

process in the form of schema in Figure 1.

Figure 1. Theoretical approach financial markets and economic growth

Market Frictions

- Cost of information

- Transaction costs

Financial Markets and

Intermediaries

Financial development

Functions

- Facilitate the Exchange, coverage

and risk diversification

- Allocate resources

- Control the managers and

corporate control

- Mobilize savings

- Facilitate the exchange of goods

and services

Channel growth

- Capital accumulation
 - Technological innovation

ECONOMIC GROWTH

Adapted from Levine (1997)

Joseph Schumpeter was the first author to highlight the role of financial

intermediation1. Schumpeter (1911) notes that the services provided by financial

intermediaries are essential for economic innovation, productive investment and

economic growth.

The link between financial system and economic growth has been studied and

analyzed empirically from the 20th century. Goldsmith (1969) was one of the first

authors to demonstrate empirically the involvement between financial development

and economic growth2. Goldsmith (1969) in a study for 35 countries between 1860

and 1963, uses the value of the assets intermediated as a percentage of GDP, as a

proxy of financial development, under the assumption that the size of the financial

sector is positively correlated with the provision and quality of its services. Goldsmith

concludes that there is a parallel between economic growth and financial periods of

several decades in development.

King and Levine (1993) examined data from 80 countries to study the relationship

between financial development and long-term economic growth. These authors

studied, for the period 1960-1989, the relationship between financial development

and the growth rate of GDP per capita, the rate of capital accumulation and the rate of

improvement of economic efficiency. Used to measure the level of financial

development: the size of the financial intermediaries, i.e. the financial depth (the ratio

of liquid liabilities of financial intermediaries and GDP); the importance of banks in

relation to the Central Bank (i.e., the allocation of total domestic credit by the Central

Bank and banks); the distribution of assets in the financial system, measured as the

credit granted to private non-financial companies divided between the total credit

(excluding the credit banks); and the credit granted to private non-financial

companies divided between GDP. King and Levine found that higher levels of

financial development are positively associated with higher rates of economic growth,

of accumulation of physical capital and efficiency improvements. In addition, they

also conclude that financial development is a good predictor of long-term growth in

the next 10-30 years.

In addition to the relationship between financial development and economic

growth, also has been investigated on what features of the financial system are more

conducive to induce economic growth. There is much debate over whether the

banking financial systems (bank-based) stimulate more economic growth than the

market-based financial systems (market-based) and vice versa. Traditionally,

Continental Europe is bank-based, United Kingdom and United States are market-

based.

Authors who are inclined to a financial system bank-based, highlight the

deficiencies that have capital markets to fulfil functions that have in the financial

system, and as indicated in Levine (2004). For example, Stiglitz (1985) points out the

inadequacies of the capital markets and indicates that banks can take large positions

in a company with a controlled risk.

 For authors who are in favour of a financial system market-based, Levine (2004),

argue that in banks-based systems, these can have a great influence on the companies

and the influence can manifest itself to them in a negative way. Rajan (1992)

indicates that the banks can monitor companies and control their investment

decisions, and this can distort incentives from the company.

On the other hand, there are authors who argue that the two aspects of the

financial system, bank-based and market-based, are complementary, and both

contribute to economic growth. For example, Levine and Zervos (1998) conclude that

development of banks and the liquidity of the stock market (both) are good predictors

of economic growth, capital accumulation and productivity growth.

It should be noted that the regulation and the legal system, are essential for the

proper functioning of the financial system. La Porta, Lopez de Silanes, Shleifer and

Vishny (1997) analyze the legal system from 49 countries and found that there is

great evidence that the legal system has effects on the size and breadth of the capital

markets.

These authors emphasize that countries with a protection of investors poorer (as

measured by the legal nature of the standards and the quality of the law enforcement),

have small capital markets. The influence of the industrial sector in the financial

system has also been studied. Carlin and Meyer (2003) using a sample of 27

industries in 14 countries of the OECD in the period 1970-1995, found a strong

relationship between the structure of financial systems, the characteristics of the

industries and the growth and investment industries. Rajan and Zingales (1998)

conclude that the development ex ante of financial markets, facilitates growth ex post
 sectors dependent on external funding, so that financial markets and institutions

reduce the external cost of financing companies. Some authors also show that

financial development without limit is not positive.

For example, Law and Singh (2013) show that there is a threshold in the

relationship finance-growth, which, up to a limit, the financial development is

positive for economic growth, but once this limit is exceeded, the financial

development is not translated into economic growth. But it should be noted that only

authors use banking development indicators as measures of financial development

and no indicator of the development of the stock market, for example.

3. Empirical frame

3.1 The model and the countries

Bulgaria, Hungary, Poland, Czech Republic, Romania and Slovakia are the

countries under study. All these countries have a common characteristic, they were

socialist economies for several decades of the 20th century and formed the so-called

Eastern bloc. According to Firtescu (2012), post-communist economies have had to

confront a transition to become market economies. Therefore, it is interesting to consider

whether the development of their financial systems, and especially their stock markets,

has had impact on the economic growth of these countries. For this purpose, it will

analyze an econometric model with economic and financial variables, which intends to

examine the relationship between all the variables, and if there is Granger causality

especially, financial variables to economic variables, and also economic variables to

financial variables and between financial variables. The economic variables used are
gross domestic product (GDP) and foreign direct investment. The financial variables used

are market capitalization, stock total traded value, and the turnover ratio. These last three,

measure the development of the stock market.

Specifically, a vector Autoregressive model (VAR) with the aim of studying of

Granger causality between the variables is estimated. The specification and monitoring of

the model is based on Ake and Dehuan (2010), and Ake and Ognaligui (2010).

3.2 The data

The data sets of variables have been obtained from the World Bank database. The

data are annual, and range from 1995 to 2012, in order to collect these countries

transition to economies of market, initiated with the fall of the Berlin wall in 1989.

According to the World Bank, stock total traded value (current US $) is the value of

shares traded. Turnover ratio is the value of domestic shares traded divided by their

market capitalization. The value is annualized by multiplying the monthly average by

125. This ratio shows if the market size corresponds to the value of the negotiations.

The data series for all countries are in Appendix.

3.3 Methodology

It will specify and estimate a vector Autoregressive model (VAR). On the

application to financial and economic variables, the VAR model would follows, where

the variables are endogenous and explained by the lags:

𝐸𝐺𝑡 = 𝐸𝐺𝑡−𝑖 + 𝑗 𝑆𝑀𝑡−𝑗 + 𝑢1𝑡 (1)

𝑆𝑀𝑡 = 𝑆𝑀𝑡−𝑖 + 𝑗 𝐸𝐺𝑡−𝑗 + 𝑢2𝑡 (2)

 Where EG is economic growth and consists of variables that indicate economic

growth: Gross domestic product (GDP) and Foreign direct investment (FDI). SM is stock

market and consists of variables that denote development of the stock market:

Market capitalization (MC), Stock total traded value (TTV) and Turnover ratio

(TR).

There is a frequent change to transform the data into quartile data, by quadratic

interpolation, so that the added data is the same as the sum of the un-added data. Firstly,

the existence of unit roots and the stationarity of the series of the different countries are

studied. After a first graph analysis, we can sense that the series have a unit root (as they

are highly persistent), as well as that some variables have an exponential attitude and

abrupt changes. There are logarithmic corrections in GDP in all countries, foreign direct

investment in Hungary and Romania, market capitalization in Slovakia and Romania,

stock total traded value in Slovakia, Hungary, Poland and Czech Republic, and turnover

ratio in Hungary and Czech Republic.

The existence of the unit roots and the order of integration of all of the variables

are checked via the Ng-Perron test (2001), where the authors suggest using the MZα and

Mzt statistics. Also, to evaluate the robustness of the results, the KPSS test is

implemented: Kwiatkowski, Phillips, Schmidt and Schin (2001), in which the stationarity

of the series is studied. The results point out that the series have unit roots and it is

assumed that they are. The next step is to analyze the existence of cointegration, using the

Johansen test (1991).

Next, after observing the presence of cointegration between the variables, the

Granger causality is studied, by the VAR with the vector error correction, with the
variables in differences. The estimated coefficients of VAR are not relevant for the object

of this study, the remarkable is to analyze the link between the variables. Granger (1968)

indicates that if a variable Y contains information in past terms that helps in the

prediction X, and that information isn´t contained in any other series used, then Y

Granger-causes X. This is a concept that is based on the predictability, on the capacity of

a variable to help to predict another.

3.4 Results

The results of the countries that we object to the study are detailed in appendix 4.

It is able to see that in all countries, except for Czech Republic, at least one financial

variable Granger-causes an economic variable, whether it is GDP or a direct foreign

inversion. In Bulgaria, the market capitalization and the stock traded value Granger-

cause the direct foreign inversion. In Slovakia, the stock traded value Grangercauses

the GDP. In Hungary, the market capitalization helps to predict the GDP and the

direct foreign inversion; the stock traded value and the turnover ratio (with a

significant level of 10%) Granger-cause the direct foreign inversion. In Poland, the

market capitalization Granger-causes the GDP. In Romania, the stock traded value

helps to predict the GDP, as well as the turnover ratio Granger-causes the GDP and

the direct foreign inversion (with a significant level of 10%).

Granger causality also exists in the inverse, economic variables Granger-cause

financial variables. In Bulgaria, the GDP and the direct foreign inversion help to

predict the market capitalization and the total stock traded value. In Slovakia, the

GDP and the direct foreign inversion help to predict the market capitalization. In

Hungary, the direct foreign inversion Granger-causes the market capitalization, and
 the GDP Grangercauses the turnover ratio (with a significant level of 10%). In

Poland, the GDP helps to predict the market capitalization (with a significant level of

10%). In Czech Republic, the direct foreign inversion Granger-causes the market

capitalization, the total stock traded value and the turnover ratio. And finally, in

Romania, the GDP and the direct foreign inversion Granger-cause the total stock

traded value and the turnover ratio.

Therefore, it is interesting to state the influence that the variables that indicate

stock market growth between them, Granger causality between liquidity and size. The

turnover ratio isn’t taken into account because it is made up approximately by the

other two indicators. In Bulgaria the total stock traded value Granger-causes the

market capitalization and vice versa. In Slovakia, Hungary and Romania, the total

stock traded value Granger- causes the market capitalization only in this way.

Consequently, for this selection of countries from Eastern Europe, there is

evidence that the Granger causality between the variable that indicate economic

growth and those that note stock market growth and so then, the existence of a link

between the stock market and the economic growth, like the connection between

stock market growth variables have, in size as well as liquidity.

4. Conclusions

With this paper it was intended the theoretical and empirical analysis of the

relation between the stock market and the financial system. Firstly, in the theoretical

term, it can be stated the importance of the financial system in a developed economy. The

literature was reviewed about how the financial system and the financial development
affect the economic growth. There are a considerable number of authors that maintain

that a very important relation between financial variables and economic growth exists.

Secondly, in the empirical term, it was tried to demonstrate the connection

between the stock market growth variables and the economic growth in various countries.

A selection of 6 countries from Eastern Europe were used: Bulgaria, Slovakia, Hungary,

Poland, Czech Republic and Romania, from 1995 until 2012. As variables that explain

the development of the stock market the market capitalization, the total stock traded and

the turnover ratio were used. As variable characteristics of the economic growth, the

GDP in current prices and the direct foreign inversion were used. The Granger causality

was used to study these variables and has proven evidence of existing links between the

stock market growth variables and the economic growth variables. In particular, the

relation of the cause between the financial variables and the economic variables is higher

in Bulgaria, Hungary and Romania.

The relation between financial variables and the economic growth of a country or

group of countries has been analyzed more profoundly in the last decades of the 20 th

Century. There is still a long way to go in the investigation of financial variables that can

influence in the economic growth of a country, such as financial and bank crisis or

idiosyncratic aspects of the regulation and legal system.