0. Introduction
Countries embarking on financial reforms usually bear two objectives in mind: (a) to raise the
level of saving and investment; and (b) to improve the allocation of investment resources
consistent with certain economic and social objectives. Endogenous growth models have
suggested that financial development leads to an increased savings mobilization and a better
allocation of capital (Greenwood & Jovanovic, 1990; Bencivenga & Smith, 1991). In this
view, financial liberalization is expected to raise the growth rate and improve living standards
in developing countries (ADB, 1994). This mechanism has been confirmed by empirical
studies which suggested a long-run relationship between financial liberalization, financial
development and long-run growth (King & Levine, 1993; Levine & Zervos, 1998).
However, these focused mainly on financial intermediation and the banking sector1. By
contrast, the theoretical and empirical literature on the implications of equity market
development is scant. A number of economists have even suggested that the process has no
impact on real activity (Stiglitz, 1989; Mayer, 1990). Sceptics argue that volatile equity
markets constitute “costly irrelevances which (developing countries) can ill afford” (Singh,
1999; Singh & Weiss, 1998). Another view is that development contributes to maximizing the
allocation efficiency of investment by providing a specific bundle of financial services (Atje
& Jovanovic, 1993). Equity markets and banking sector development may exert an
independent but positive impact on economic growth (Levine & Zervos, 1998). Recent
empirical work has indeed suggested that equity market liberalizations are associated with
higher real growth, in the range of one percent per annum (Bekaert, Harvey & Lundblad,
2001). Acknowledging the controversial nature of equity market development for economic
growth in developing countries, the objective of this paper is to review the main theoretical
causality mechanisms.
1 Bank loans constitute the primary source of outside funding for the corporate sector around the world. For
instance, in the U.S., banks provided about 62 percent of total outside finance for non-financial firms on average
for the 1970-1998 periods, while stock issues accounted for only two percent (Hubbard, 2000)