DOBRI AN ON RECENT TRENDS

IN CAPITAL MARKETS

CAPITAL MARKETS AND ECONOMIC GROWTH

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 Zea-
land: while New Zealand has a strong sovereign rating, high levels
of private sector borrowing have produced a large net foreign in-
debtedness position; finance companies and building societies ha-
ve a small but growing share of deposit-taking and lending mar-
kets (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 twen-
ty years can be characterized as a shift from a relatively high level

90
of regulation to a light-handed approach that is now swinging back
toward some more formal control. The experience has been vari-
able across markets (some are highly developed and efficient, ot-
hers 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 (finan-
ced primarily by substantial overseas debt), a large rise in unem-
ployment 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 be-
came more efficient (i.e. for banks costs and margins fell; the qua-
lity of bank balance-sheets improved; borrowing, lending and the
range of financial instruments available grew; service and con-
sumer choice improved). Kousis and McCulloch examine whether
regulation that is more conducive to competitive and efficient fi-
nancial system has a significant positive impact on sectoral output
and productivity growth in a sample of 25 OECD countries, in-
cluding 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 mar-
kets; New Zealand’s approach to banking regulation is based on

91
disclosure and market discipline, and employs limited prudential
requirements; the absence of a depositor-protection mandate, a-
long 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 secu-
rities regulation and the restructuring of the New Zealand Stock
Exchange (NZX) have strengthened the securities regulatory fra-
mework. Kousis and McCulloch set out the structure and function
of New Zealand financial markets, describe the experience of re-
forms to date, and the priorities for ongoing reform, and summa-
rize independent assessments of New Zealand’s capital markets
that have been carried out recently. “Managed funds and superan-
nuation schemes are significant vehicles for personal saving. The
number of superannuation schemes has steadily declined over ti-
me. This is partly a result of private sector employer sponsored
schemes consolidating from standalone to multi-employer arran-
gements. However, the number of scheme members has also de-
clined, 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 arrange-
ments is expected to continue.”2
Agarwal’s study supports the Levine and Zervos’s argu-
ment that well-developed stock markets may be able to offer a
different kind of financial services than the banking system, and

92
provide an extra impetus to economic activity (the two main pa-
rameters of capital market development namely, size and liqui-
dity are found statistically significant to explain the economic ac-
tivity); 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 fi-
nancial 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 ef-
fects. “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 exa-
mine a broad array of stock market development indicators. Spe-
cifically, we examine different measures of stock market size, mar-
ket 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 capita-
lization has increased over time (but liquidity on the stock ex-

93
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 re-
stricts capital flows and repatriation of capital and dividends; in
order to estimate the contribution of various components of fi-
nancial 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 ge-
nerally suffered from the classical defects of bank-dominated eco-
nomies, 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 de-
veloping 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-

94
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 fo-
reign direct investment (FDI) flows arise endogenously when mo-
nitoring is nonverifiable and financial frictions exist (the mecha-
nism generating MNC activity is not the risk of technological ex-
propriation 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 fl-
ows and multinational ownership of assets abroad arise endoge-
nously to align the incentives of the inventors of technology and
the entrepreneurs in host economies; countries with better inves-
tor protections tend to enforce laws that limit the ability of mana-
gers 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 misbe-
haves. It is reasonable to assume that the inventor has a compa-
rative advantage in monitoring the behavior of the foreign entre-
preneur 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 si-
tuated 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
95
 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 institu-
tional development, additional controls for other institutional cha-
racteristics are also employed; the predictions on the use of licen-
sing as opposed to foreign investment and the financing and own-
ership of foreign affiliates are considered first by pooling cross-
sections 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 insti-
tutional 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 ma-
ximizing 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 pro-
nounced effects for affiliates in countries with weaker capital mar-
kets.”6
Antràs et al. reason that in order to convince external fun-
ders to supply capital, entrepreneurs need to give financial claims
on the project to parent firms to ensure that they provide moni-
toring when monitoring is unverifiable; an optimal contract calls
for the developer of the technology to own equity in the project

96
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 restric-
tions.”7

REFERENCES

1. Kousis, A. • McCulloch, B., “Capital Market Development New Zea-

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

97