Equity Markets and Economic Development: What Do We Know

The remainder of the paper is structured as follows. The first section investigates the welfare
implication of domestic equity market development. Allocation efficiency appears to be the
main transmission mechanism, and informational transparency is crucial. The second section
focuses on the international integration of equity markets, and investigates its consequences
based on an asset pricing definition. It appears that equity market integration lowers the cost
of capital, increases financial vulnerability and has a mixed impact on capital flows. Finally,
the third section brings together our conclusions.

1. Equity market development

1.1 Equity markets and allocative efficiency: the causality mechanism

Initial models of ‘financial repression’ suggested that increased interest rates led to higher
financial savings and greater capital allocation (McKinnon, 1973). However, these models
were criticized for overlooking the possibility that endogenous constraints in the credit market
constitute obstacles to the allocative efficiency of investment (Stiglitz&Weiss, 1981).
Economists therefore considered equity market development to be a potential a solution to
inefficiencies associated with weak credit markets in the presence of information
asymmetries. For illustration, Cho’s (1986) seminal model supposes that banks and equity
investors have the same level of information on firms. The information asymmetries
hypothesis implies that individual borrowers can be sorted according to their expected
productivities, but that their degrees of riskiness are unknown. Since banks cannot identify the
individual risk characteristics of firms, they aggregate borrowers into groups, and base their
decisions according to the expected variance in the distribution of riskiness for each group of
borrowers. The banking sector expected return is thus a function of a fixed interest rate r*
and the default risk. The model supposes that a group of firms j are innovative and highly
productive while group of firms i have established customer relations with banks. Therefore,

<<   2   3   4   5   6   7   8   >>

More intriguing information