Stock Exchanges in Developing Countries

BIBLIOGRAPHY

Stock exchanges play an important role in developing countries. One of the major challenges that developing countries face is capital formation. In economic terms, capital consists of equipment and machinery used to make consumer goods. The capital structure of developed nations consists of many different types of capital goods organized in factories and industries. Developed countries have capital goods arranged in stages of production. For example, iron ore is first mined, then it is refined, then it is made into steel. Steel is then shaped and assembled into final products, like cars and buildings. Workers use capital equipment at each stage to produce final goods for consumers.

Capital goods derive from financial investment. In order to develop a modern capital structure, someone must invest in buying capital goods. Stock exchanges provide a source of funding for capital investment. When a corporation forms or expands, it needs money to invest in capital (as well as labor and other supplies). The executives of the corporation can raise money for capital by selling new shares of stock in a stock exchange. Each share of stock entitles its owner to part of a corporation’s future profits. Sales of new shares in stock exchanges serve two purposes. Stock exchanges enable individuals to invest their own money for private gain. Stock exchanges also enable businesses to raise money to buy capital equipment. This is important for many developing countries that lack advanced capital equipment. The alternative to development through private investment is government funding for investment projects. Government-funded investment projects can be financed either by a nation’s own government or through direct foreign aid.

Stock trading also determines who runs corporations. If a corporation is run well, its stockholders will earn a high dividend or capital gains on the price of their stock. If corporate management runs a corporation badly, the price of the corporation’s stock will fall. When a corporation’s stock price falls dramatically, it is easy for new investors to buy up shares of the stock and replace the management. This is how stock exchanges get rid of incompetent corporate executives. Stock exchanges thus help developing countries to avoid waste from incompetent corporate management.

Stock exchanges played an important role in the development of industrial western Europe and North America. The London Stock Exchange emerged in the eighteenth century. Initially, brokers traded stocks in coffeehouses and private clubs. The stock market in Amsterdam emerged in the seventeenth century. The financial system of Belgium dates to at least the fourteenth century, but the Brussels Stock Exchange opened in 1801. Initially, these stock exchanges were informal and simple. With the passage of time, these early stock exchanges developed into sophisticated institutions with formal rules. Eventually, stock exchanges in major cities began to direct capital investment throughout the West and in parts of Asia. For example, Belgium developed rapidly during the nineteenth century. Statistical studies indicate that the economic development of Belgium was driven by the development of Belgian financial markets, including the Brussels Stock Exchange. Financial development in Belgium began with the country’s independence in 1830, and was accelerated by the liberalization of the Belgian stock market in 1867. This pattern was paralleled in many nations. Statistical studies show that well-developed stock exchanges have enhanced long-run economic growth, increased capital investment, and raised productivity throughout the industrialized world.

Since the 1970s many developing nations have begun to form more advanced financial markets. One study (Agarwal 2001) of nine African nations indicates that stock exchange development has led to increased economic growth. Another study (Mohtadi and Agarwal 2007) of twenty-one developing nations shows that the development of stock exchanges increases private investment and economic growth. This study indicates that stock exchanges contribute to economic development by stabilizing productivity and liquidity shocks.

As stock exchanges develop, the issue of financial regulation arises. Some evidence supports the case for liberalization of stock exchanges. Peter Henry (2003) finds that deregulating stock exchanges reduces capital costs and increases investment and per worker productivity. Liberalized stock exchanges can also facilitate the adoption of new technologies in developing nations. Some distortions in the international financial system led investors to hold too much debt and too little equity (Henry 2006). The liberalization of stock exchanges has caused a shift from debt to equity holding during the 1990s. This shift from debt to equity caused a short run increase in economic growth. Henry (2000) also finds that liberalizing stock exchanges can reduce the cost of equity capital by allowing risk-sharing between foreign and domestic investors.

Some scholars point to examples of stock market crashes as evidence of need for regulation. The 1929 crash on Wall Street is well known, but there are more recent examples of stock exchange panics to examine. The Kuwaiti stock market crash of 1982 is often cited as an example of how stock markets need regulation. The Kuwaiti crash left investors with over $90 billion of debt and put serious strain on the Kuwaiti banking system. The Kuwaiti example indicates that stock exchanges can malfunction badly. It should be noted that the Kuwaiti crash represents only a single incident of stock exchange failure. While the Kuwaiti crash supports the case for stock exchange regulation, this incident does not prove the case for regulation.

Investment in stock exchanges typically leads to financial inequality as some investors earn fortunes, but stock exchange activity also promotes economic development and rising living standards for all. The inequality that arises from stock exchange activity may be an unavoidable part of economic progress. Stock exchanges appear to contribute to economic development in developing nations significantly. Regulation of emerging stock exchanges might yield some benefits, but there is a strong case for opening stock exchanges up to free competition and foreign investment.

SEE ALSO Bubbles; Developing Countries; Development Economics; Equity Markets; Finance; Investment; Speculation; Stock Exchanges

BIBLIOGRAPHY

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D. W. MacKenzie