The Impact Of Economic Freedom

Published Date: 02 Nov 2017

This study has conducted a comprehensive literature survey on the impact of economic freedom and financial development on the stock market performance, while reviewing on a broader theoretical and empirical literature on the relationship between stock market performance, economic freedom and financial development. Understanding of these relationships from the standpoint of historical and present perspective will assist in developing this empirical analysis for the case of Malaysia, Singapore and China.

Economic Freedom

Economic theory indicates that economic freedom affects incentives, productive effort, and the effectiveness of resource use. Since the time of Adam Smith, if not before, economists and economic historians have argued that the freedom to choose and supply resources, competition in business, trade with others, and secure property rights are central ingredients for economic progress (North and Thomas 1973).

Previous research has focused on the relationship between economic freedom and the size of a country’s equity market, as measured by total market capitalization as a percentage of gross domestic products. Li (2002) shows that developed countries with greater economic freedom and stronger shareholder protections have larger total equity market capitalizations as a percentage of GDP. In particular, the size of their equity markets is negatively correlated to the size of government, as measured by government consumption as a percentage of GDP. For developing countries, Li finds that openness to trade is conducive to the growth of the equity market.

Other research has shown that the observed size of a county’s equity market is associated with institutions similar to those measured by the Fraser Institute’s economic freedom of the world (EFW) index. La Porta et. al. (1997) show that the legal environment affects the size and extent of a country’s capital markets where, the market size is measured by total market capitalization as a percentage of gross national product, and extent is measured by the number of listed companies and initial public offerings per capita.

Another study by Heckelman and Stroup (2000), Cole (2003) concluded that economic freedom is a significant factor in economic growth, regardless of the basic theoretical framework. The concept of globalization is very close to the concept of economic freedom in general, many studies find that globalization increases economic growth. However, deepness of economic freedom can have a negative impact, especially for developing economies.

De Haan, Sturm, and Zandberg (2009) examine the effects of crises on economic freedom in a case study for Norway and Sweden and by cross country regressions. They find that economic freedom is hardly affected in Norway and Sweden and goes up over time if it was affected. Their regressions suggest that economic freedom falls right after a crisis but then increases.

A recent study by Richard J. Cebula and Franklin G. Mixon (2012) investigates the impacts on economic growth of reduced fiscal freedom from both the taxing and spending sides. They employed two stage least squares using a 4-year panel data for OECD nations. The findings showed that reduced fiscal freedom leads to a reduced rate of economic growth; it is also found that reduced freedom from excessive government size also leads to a reduced rate of economic growth.

Various studies like Hartarska and Nadobiyak (2007), Crabb (2008), Enowbi-Bati.io and Kupukile (2009) have shown that there is evidence that more economic freedom is associated with improvements in credit allocation at the micro level and to better sovereign credit ratings. This study was also supported by Roychoudliury and Lawson (2010).

Financial Development

Previous studies on developed economies (Robinson, 1952; Kuznets, 1955; Friedman and Schwartz, 1963) provided evidence in support of economic growth lead to financial sector development. An empirical study by Goldsmith’s (1969) study provides evidence that there is a positive connection between financial development and economic growth. On the contrary, Ram (1999) study did not find any relationship between financial development and economic growth in his analysis of cross country data.

One of the standard proxies in the literature is a form of monetary depth measure, this could be the ratio of narrow or broad money to GDP. According to the study of King and Levine (1963), they found that, a deeper, broader, and better functioning of the financial system can stimulate higher economic growth. They pointed out that different definitions of monetary aggregates can represent different roles of financial intermediation. Some studies have used the ratio of M1 to GDP. A high ratio of M1 to GDP indicates a high level of liquidity in the economy, and thus a high degree of monetization. However, as DeGregorio and Guidotti (1995) indicate, a high level of monetization may actually indicate a low level of financial development. On the contrary, a low level of monetization may actually indicate an economy where there are many alternative assets that can serve as stores of value.

Huang (2005) examined the main factors of financial development. A comparison of a number of countries is made to justify the different roles of various factors of financial development. To capture the depth of the financial system the liquid liabilities, banks overhead costs, net interest margins, are included. For the impact of stock market on financial development three main variables are included, i.e. stock market capitalization; total values traded, and turnover ratio. The data is averaged over the period of 1990-2001. Four indexes are made by using the method of principal component analysis. These indices are FD bank, FD stock, FD efficiency, and FD size. Two techniques Bayesian model averaging model (BMA) and general to specific methods are used to gauge the robustness of a selection of determinants of financial development. The findings suggested that the level of financial development is basically determined by the quality of its institutions, government policies, geographic conditions, its income level, and finally its cultural characteristics. He found that the financial depth is associated with a stable political system and less political constraints on the executive. He also suggested that political liberalization has significant positive effect on financial development. Another important finding is that institutional quality has positive effect on the level of financial development and cultural factors such as religion or ethnic diversity indirectly and through the quality of institutions have effect on financial development.

In sub-Saharan African countries, Ndebbio (2004) examine the relationship between financial development and economic growth using Ordinary Least Squares regression. The author measures the degree of financial depth by the degree of financial intermediation and the degree of growth rate in per capita real money balances. Broad money supply (M2) was used as numerator in both measures. The results indicate that lack of growth of output is caused by shallow finance or due to the insufficiency of financial assets that properly enhance financial deepening. The author recommends that the economies involved in his studies should strive hard to accelerate the growth of money balances and should improve financial development/intermediation.

Zhang et al. (2007) study the financial deepening – productivity relationship in China over the period 1987 through 2001. Relying on provincial panel data, they examine if regional productivity growth is accounted for by the deepening process of financial development. Towards this end, an appropriate measurement of financial depth is constructed and then included as a determinant of productivity growth. The study concludes that significant and positive nexus exists between financial deepening and productivity growth.

A recent study by Jin Zhang, Lanfang Wang and Susheng Wang (2012) stated that financial development is positively associated with economic growth in China. However, their result runs contrary to the existing conclusion that a state-ruled banking sector hinders economic growth because of the distorting nature of the government. The study used data from 286 cities over the period 2001 to 2006. It employed both traditional cross-sectional regressions and system GMM estimators.

Gobbi and Zizza (2007) investigate the relationship between underground activities and financial deepening in Italian credit market. Using panel data on Italian regional credit markets, they find a strong negative impact of the share of irregular employment on outstanding credit to the private sector. According to estimates, a shift of 1 per cent of the employees from regular activities to irregular ones corresponds to a decline of about 2 percentage points in the volume of business lending and of 0.3 percentage points in outstanding credit to households, both expressed as ratios to GDP. Conversely, the feedback effects from financial deepening to the size of the informal sector are weak and statistically not significant.

Various studies like Levine (1997), Kemal et al., (2007) have shown that financial development sometimes may be harmful to growth. Although financial institutions facilitate risk amelioration and the efficient allocation of resources, it may dampen growth by lowering risk as well as return (Kemal et al., 2007). The theories examine the volatility spillover between the stock market and the foreign exchange market. The results from the volatility modelling show that the behaviour of both the stock exchange and the foreign exchange markets are interlinked. The returns of one market are affected by the volatility of other market.

P.J. Dawson (2008) contends that there exists a bi-directional causality, from finance and economic development, and from economic development to finance. Therefore, a country with a well developed financial system can promote high economic expansion through technological changes, products and services innovation. This would in turn create a high demand for the financial institutions, and as the financial institutions effectively respond to this demand, these changes will stimulate higher economic achievement. Both financial and economic developments are therefore positively interdependent and their relationship could lead to bi-directional causality according to M.S. A. Majid (2007).

Financial Liberalization

The liberalization of the capital account is captured by the regulations on offshore borrowing by financial institutions and by non-financial corporations, on multiple exchange rate markets and on capital outflow controls. In a fully liberalized capital account regime, banks and corporations are allowed to borrow abroad freely.

The main components of financial liberalisation are removal of credit controls, deregulation of interest rates, banking system independence, free entry into the banking sector, and privatisation of the banking sector. Liberalizing financial markets allows the market to determine the allocation of credit, so that the real rate of interest adjusts to its equilibrium level, low-yielding projects are not funded, and the efficiency of investment is enhanced (Arestis 2005).

In addition, Shehzad and De Haan (2008) find that financial liberalization reduces the probability of a banking crisis and, therefore, promotes economic growth. In addition, Baier et al. (2012) pointed out that countries with relatively low levels of regulation (more economic freedom) are less likely to experience a financial crisis in the near future than countries with more regulation. Townsend and Ueda (2010) find that Thai welfare increased about 15 percent due to financial liberalization.

In a fully liberalized stock market, foreign investors are allowed to hold domestic equity without restrictions and capital, dividends and interest can be repatriated freely within two years of the initial investment. In the study of Baltagi (2009), he used six different aspects of liberalization, comprising of credit controls, interest rate controls, entry barriers, regulations and privatization and international transactions. The financial openness is proxied by financial liberalization and conducive to the development of liquid stock markets but not for the stock market size. According to Kaminsky and Schmukler (2003), full financial liberalization occurs when at least two out of three sectors are fully liberalized and the third one is partially liberalized. A country is called as partially liberalized when at least two sectors are partially liberalized.

Trade Openness

From the panel study of Baltagi et al. (2009), he used the ration of total trade to GDP as the determinants of trade openness. He concluded that the trade and financial openness do not promote liquid stock markets but banking sector development. The effect of trade openness on financial development is more significant than financial openness. Herger et al (2007), Baltagi et al. (2009) and Voghouei et al (2010) concluded that opening up the trade and capital at low levels of trade and financial openness, have positive effect on financial development.

In the panel study of Grima and Shortland (2008), they used the geographical pre-disposition to trade as the main determinant. They found that development in banking sector is more in countries which are naturally open to trade, while there may be negative effects on the stock market. In addition, countries with more openness to trade and with faster economic growth gave faster banking sector development.

Voghouei et al (2010) used the sum of gross stocks of foreign assets and liabilities to GDP (%) as the determinant of financial openness in his panel study. He concluded that financial openness is significant explanatory variables for financial development. However, it appears with an unexpected negative sign for the banking sector.

Chinn and Ito (2005) noted that removal of capital controls would allow domestic and foreign investors to engage in portfolio diversification. The cost of capital would thereby be reduced, making it increasingly available for borrowers. Moreover, financial openness weeds out inefficient financial institutions, which usually increases efficiency of the financial system (Stulz 1999; Stiglitz 2000; Claessens et al. 2001).

Stock Market

The stock market can be vibrant especially with regard to any prospects for potentially positive returns, but generally stock prices and the stock market in general are very volatile. However, it would be wrong to attribute the causes to stock market movements to just the macroeconomic forces, because the financial markets are undisputedly known to be very prone to "noisy" and irrational behaviour. The prices of stocks may also move up and down due to other factors such as investors’ perception about the prospects of an individual company or the industry in which it operates. The movement in the price of stocks is also directly affected by the mechanisms of demand and supply in the market. According to the study of Harris Dellas and Martin K.Hess (2005), they examined stock returns in a cross section of emerging and mature markets over 1980 to 1999. They concluded that the level of financial development is an important determinant of the performance of stock returns even after accounting for other aspects of economic development. They further pointed out that a deeper and higher quality banking system decreases the volatility of stock returns.

R. Levine and S. Zervos (1996) argue in their work that well-developed stock markets may be able to offer different kinds of financial services than banking systems and may, therefore, provide a different kind of impetus to investment and growth than the development of other sectors of the financial system such as the banking system. Specifically, they pointed out that an increase in the stock market capitalization, as measured either by the ratio of the stock market value to GDP or by the number of listed companies, may improve an economy's ability to mobilize capital and diversify risks.

R. Levine and S. Zervos (1998), M. Khan and A. Senhadji (2000) emphasized that the establishment of stock market has played a significant role in the development of banking institutions, particularly in emerging market economies. Accordingly, the authors believe that the development of the financial sector (stock market in particular) contributes meaningfully to economic growth.

Peter Rousseau and Paul Wachtel (2000) using Granger causality techniques examined the link between financial markets and growth, analyzed 47 economies and reported that greater financial sector development leads to increased economic activity. In addition, H.M. Ibrahim (1999) found that macroeconomic forces have systematic influences on the prices of stocks through their influences on expected future cash flows. Macroeconomic fluctuations are influential on stock prices through their effect on future cash flows and the rate at which they are discounted.

Mun et al. (2008) tested the causal relationship between stock market and economic activity in Malaysia for the period of 1977 to 2006. Their study used annual data on real GDP and Kuala Lumpur Composite index (KLCI), results from Granger causality test indicated that causality runs from stock market to economic activity and not the other way around.

Arestis et al. (2001) used a time-series approach to investigate the relationship between the stock market, the banking system and economic growth based on developed-country data. They found that the contribution of the banking system is greater than that of the stock market. The role of the stock market in economic growth may be exaggerated in these cross-country studies.

D. Hongbin (2007) in his study concluded that there exists a two-way causality between China’s stock market development and economic growth, that is, economic growth can not only promote the development of the stock market, but also the stock market development similarly pushes economic growth. He cited that, although the impact of stock market is more limited in the short-term, it tends to be significant in the long-term. The study proposed that since the stock market plays the function of national economy ‘barometer’ it needed to be further strengthened.

A. Demirguc-Kunt and R. Levine (1996); R. Levine and S. Zervos (1996) investigated: (1) the consistency of stock market development with economic growth, and (2) the harmonious nature of stock market development with financial intermediaries Their main findings and outcomes were as follows: (i) they carried out cross-country growth regressions that suggested that the predetermined component of stock market development was positively and robustly associated with long-run growth. (ii) From the cross-country analysis, they found out that the level of stock market development is positively correlated with the development of financial intermediaries and consequently economic growth. (iii) While stock market development induces the substitution of equity finance for debt finance in developed countries, it facilitates more debt finance in least developed countries.

A. Vazakidis (2009) carried out a study on stock market development and economic growth in France with an attempt to investigate the causal relationship between stock market development and economic growth for the period 1965-2007, using a VAR framework. The results of the study confirmed that economic growth causes stock market development in France, and consequently therefore economic growth has a positive effect on stock market.

Corbett and Jenkinson (1994),Fry (1997), and Mayer (1988), among others, showed evidence that the relation between the stock market and economic growth is very weak or even unfavorable. Levine and Zervos (1998) showed that stock market liquidity and banking development together have a positive impact on the economy, but they also found that the behaviour of the stock market is not robustly linked with growth.

R. Levine and S. Zervos (1998), examined the nature of links between stock markets, banks and income growth, on a cross-country study consisting of 47 countries and the results showed that the size of both stock markets and banks were correlated with the future economic growth. The study identified and stated that the problems with endogeneity of the variables were perhaps even more severe with stock market variables: where the market capitalization represents the present value of future earnings, and so there is most likely a positive correlation between market capitalization and expected economic performance.

Dailami and Aktin (1990) find that a well developed stock market can enhance savings and provide investment capital at lower costs by offering financial instruments to savers to diversify their portfolios. In doing so, these markets efficiently allocate capital resources to productive investments, which would eventually promote economic growth. The causal nexus between stock market development and economic growth was examined by Vazakidis and Adamopoulos (2009) for France for the period of 1965 to 2007.

Deb and Mukherjee (2008) tested the causal nexus between stock market development and economic growth for Indian economy for the period of 1996 to 2007 by using quarterly data on real GDP, real market capitalization ratio and stock market volatility. Their study finds strong causal flow from the stock market development to economic growth and also evidenced that there is a bi-directional relationship between market capitalization and economic growth.

Others

According to the study of Grima and Shortland (2008), they found that countries with the fastest financial development are considerably more democratic and stable than the median. They highlighted that any major regime transition has negative effect on financial development.

Inflation is believed to have negative implications for financial development (Huybens and Smith 1999). An increase in the rate of inflation reduces the real return on money and assets. This reduction worsens existing credit market frictions, which results in the release of less credit. The financial sector makes fewer loans, there is increased inefficiency in resource allocation, and a diminishing of intermediary activities;

As can be seen from this review for the earlier literature, various studies have been conducted all over the world examining the impact of economic freedom and financial development on stock market performance and most of these studies document the importance of economic freedom and financial sector on economic development. Various measures of financial development are also employed to gauge the importance of financial development on economic growth and some of the studies tried to evaluate the direction of the relationship between financial development and economic freedom and stock market performance.