A TEST OF REVERSE CAUSATION IN CAPITAL MARKET DEVELOPMENT AND ECONOMIC GROWTH IN NIGERIA

ABSTRACT

This study sought to examine the impact of Nigeria’s economic growth on the Nigerian capital market by investigating the impact of economic growth on the Nigerian Stock Exchange market capitalization ratio; impact of economic growth on the Nigerian Stock Exchange turnover ratio; impact of economic growth on the Nigerian Stock Exchange value traded ratio; impact of economic growth on new issues in the Nigerian Stock Exchange; impact of economic growth on the number of listings in the Nigerian Stock Exchange and causal relationship between economic growth and capital market growth indicators in Nigeria. The ex-post facto research design was used and time series data for the 15-year period, 1996-2010, were collated from the Central Bank of Nigeria Statistical Bulletins, the Securities and Exchange Commission Statistical Bulletin and the Nigerian Stock Exchange Factbooks. The two-stage least squares (2SLS) regression model was used to estimate the impact of economic growth on conglomerate indices of the Nigerian Stock Exchange for hypotheses one to five while the Granger causality f-statistics was used to test  hypothesis  six.  Values  of  Stock  Market  Capitalization  Ratio  (SMCR),  Stock  Market Turnover Ratio (SMTR), Stock Market Value Traded Ratio (SMVTR), Stock Market New Issues Ratio (SMNIR) and Stock Market Number of Listings (NSM) were used as proxies for capital market development and adopted as the dependent variables, while the independent variable was the Gross Domestic Product Growth Rate (GDPGR), used as proxy for economic growth. Six hypotheses were considered and descriptive statistics on both the dependent and independent variables were computed. The study found, among others, that economic growth has a positive and non-significant impact on the market capitalization ratio of the Nigerian Stock Exchange (coefficient of SMCR=0.42, t-value = 1.19).  Economic growth has a positive and significant impact on the Nigerian stock market turnover ratio (coefficient of SMTR= 0.17, t-value = 29.21). Economic growth has a positive and non-significant impact on the Nigerian stock market value traded ratio (coefficient of SMVTR= 0.00, t-value = 1.66). Economic growth has a positive and non-significant impact on the new issues ratio of the Nigerian stock exchange (coefficient of NIR = 0.00, t-value = 0.03). Economic growth has a negative and non-significant impact on the number of listings in the Nigerian stock market (coefficient of NSM = -0.00, t-value = -0.70). Economic growth and all capital market growth indicators employed do not Granger-cause each other. However, the various capital market growth indicators used Granger-cause each other, and, thus, bi-directional, except for the unidirectional causality running from the Nigerian stock market turnover ratio to the value traded ratio. The study, therefore, recommends, amongst others, that government provides the enabling environment for the economy to thrive in order for the Nigerian capital market to achieve the desired world-class status and compete favourably in international  capital  markets,  the  strengthening  of  legislative  and  regulatory  framework governing the capital market in Nigeria to conform to the legislative and regulatory standards of advanced capital markets. These will increase the confidence of local and foreign investors to patronize  the  market  and  save  through  the  mechanism  which  the  market  provides.  The channeling of these savings into productive investments will further engender the country’s economic growth and development.

CHAPTER ONE

INTRODUCTION

1.1      Background of the Study

According  to  Al-Faki  (2006),  the  capital  market  is  a  “network  of  specialized  financial institutions, series of mechanisms, processes and infrastructure that, in various ways, facilitate the bringing together of suppliers and users of medium- to long- term capital for investment in socio-economic developmental projects”. The capital market is divided into the primary and the secondary market. The primary market, or the new issues market, provides the avenue through which government and corporate bodies raise fresh funds through the issuance of securities that are subscribed to by the general public or a selected group of investors. The secondary market provides an avenue for the sale and purchase of existing securities.

A large pool of theoretical evidence exists locally and internationally showing that capital market growth boosts economic growth. Carlin and Mayer (2003) show that the capital market impacts economic growth, though not as strongly as the banking sector. Greenwood and Smith (1997) show that large stock markets can decrease the cost of mobilizing savings, thus facilitating investment in most productive technologies. Levine (1991) and Bencivenga, et al (1996) argue that stock market liquidity, which is the ability to trade equity easily and cheaply, is crucial for growth. Many profitable investments require a long-run commitment of capital but savers are reluctant to relinquish control of their savings for long periods. Liquid equity markets address this challenge by providing assets which savers can sell quickly and cheaply. Simultaneously, firms have permanent access to capital raised through equity issues. Kyle (1984) and Holmstrom and Tirole (1993) argue that liquid stock markets can increase incentives for investors to get information about firms and improve corporate governance while Obstfeld (1994) shows that international risk-sharing, through internationally integrated stock markets, improves resource allocation and can accelerate the rate of economic growth.

These arguments on the importance of stock market development in the growth process are supported by various empirical studies, such as Levine and Zervos (1993, 1996, and 1998); Atje and Jovanovic (1993), and Demirguc-Kunt (1994). Filer, et al (1999) find that an active equity

market  is an important engine of economic growth in developing countries. Rousseau and Wachtel (2002) and Beck and Levine (2002), show that stock market development is strongly correlated with growth rates of real GDP per capita, and that stock market liquidity and banking development both predict the future growth rate of the economy when they both enter the growth regression.

Stock exchanges exist for the purpose of trading ownership rights in firms, and are expected to accelerate economic growth by increasing liquidity of financial assets,  making global risk- diversification easier for investors, promoting wiser investment decisions by savings-surplus units based on available information, compelling corporate managers to work harder in shareholders’ interests, and channeling more savings to corporations (Greenwood and Jovanovic,

1990 and King and Levine, 1993). In accord with Levine (1991), Bencivenga, et al (1996) emphasise the positive role of liquidity provided by stock exchanges on the size of new real asset investments through common stock financing. Investors are more easily persuaded to invest in common stocks when there is little or no doubt on their marketability in stock exchanges. This, in turn, motivates corporations to go public when they need more finance to invest in capital goods.

Stock prices determined in exchanges, and other publicly available information, help investors make  better  investment  decisions.  Better  investment  decisions  by  investors  mean  better allocation of funds among corporations and, as a result, a higher rate of economic growth. In efficient capital markets, prices already reflect all available information, and this reduces the need for expensive and painstaking efforts to obtain additional information (see, Stiglitz, 1994).

On a broader scope on the debate on whether financial development engenders economic growth or   whether   financial   development   is   consequential  upon   increased   economic   activity, Schumpeter (1912) opined that technological innovation is the force underlying long-run economic growth, and that the cause of innovation is the financial sector’s ability to extend credit to the “entrepreneur” (Filer, et al, 1999) while Robinson (1952) claims that it is the growth of the economy that  causes  increased  demand  for  financial  services which,  in  turn,  leads  to  the development of financial markets.

According  to  Rosseau  and  Wachtel  (2002),  mature  financial  systems  can  cause  high  and sustained rates of economic growth, provided there are no real impediments to growth. Carlin and Mayer (2003) also find a positive link between financial system development and economic growth in developed countries. Greenwood and Smith (1996) show that stock markets lower the cost of mobilizing savings, thereby facilitating investments in the most productive technologies. Levine and Zervos (1998) find a positive and  significant correlation between stock market development and long-run growth. Bencivenga, et al (1996) and Levine (1991) argue that stock market liquidity plays a key role  in economic growth, stressing that profitable investments require long-run commitment of capital but  savers prefer not to relinquish control of their savings for long periods, and liquid equity markets ease this tension by providing assets to savers that are easily liquidated at any time.

Kyle (1984) argues that an investor can profit by researching a firm and obtain vital information before it becomes widely available and prices change. Thus, investors will be more likely to research and  monitor  firms.  To  the  extent  that  larger,  more  liquid  stock  markets  increase incentives to research firms, the improved information will improve resource allocation and accelerate economic growth. The role of stock markets in improving informational asymmetries has been questioned by Stiglitz (1985), who argues that stock markets reveal information through price changes rapidly, creating a free-rider problem that reduces investors’ incentives to conduct costly search.

Levine and Zervos (1998) examine, empirically, the issue of whether stock markets are merely burgeoning casinos, as asserted by Keynes (1936), or a key to economic growth, and find a positive and significant correlation between stock market development and long-run growth. Sarkar (2007), however, criticised their use of cross-sectional approach because it limits the potential robustness of their findings with respect to country-specific effects and time-related effects. Akinlo (2008) adds that they did not address the issue of causality, etc.

Akinlo (2008) investigates the causal relationship between stock market development and economic growth in Nigeria during the period, 1980-2006. The study shows that gross domestic product (GDP) and stock market development are co-integrated, and that there is only one uni- directional Granger causality running from GDP to market capitalization. Nwaogwugwu (2008),

however, reveals a strong bi-directional causation between economic growth and stock market development, defined in terms of market capitalization and volume of transactions, in Nigeria from 1989-2007. Ujunwa and Salami (2010) find that stock market size and turnover ratios are positive in explaining economic growth while stock market liquidity coefficient was negative in explaining long-run growth in Nigeria between 1986 and 2006.

Most of the research works on capital market development and economic growth have been based on the ‘supply-leading’ hypothesis and few on the ‘demand-following’ hypothesis, as postulated by Patrick (1966). The supply-leading hypothesis claims a causal relationship from financial development to economic growth such that the intentional creation and development of financial institutions and markets would increase the supply of financial services, which would lead to economic growth (King and Levine, 1993a, b; Levine and Zervos, 1998; and Demirguc- Kunt and Maksimovic, 1996).

Little literature are available on the demand-following hypothesis which claims that it is the growth of the economy that causes increased demand for financial services which, in turn, leads to the development of financial markets (see, Robinson, 1952 and Lucas, 1988).

This study seeks to fill this knowledge gap, that is, to explore the impact of capital market development on Nigeria’s economic growth from the demand-following argument that it is the growth of the Nigerian economy that has promoted the development of the capital market, hence a test of reverse causation.

1.2      Statement of the Problem

Alile (1998) describes the capital market as the major vehicle (or mechanism) for mobilizing long-term funds for investment purposes. The Nigerian economy has generally been growing over time, just as the Nigerian capital market. The challenge, which this work is intended to undertake, is to determine the influence of the nation’s economic growth on the development of the capital market, which was established in 1961 to provide and sustain the capital requirements of the Nigerian economy, in the growth matrix.

A nation’s growth, economically, is expected to promote an efficient and effective financial sector that pools domestic savings and mobilises capital for productive purposes. Hence, an economy that is not growing can hinder stock market development, and engender such problems

as:

1.  Low capitalization, which limits the savings function of the stock market; and

2.  Illiquidity of the stock market to promote investment

The capital market connects the financial sector with the real sector of the economy and, in the process, facilitates real sector growth and economic development. The fundamental channels through which the capital market is connected to economic growth can be outlined as follows: the  capital  market  increases  the  proportion  of  long-term  savings  (pensions,  etc)  that  are channeled to long-term investments; the capital market enables contractual savings industry (pension and provident funds, insurance companies, medical aid schemes, collective investment schemes) to mobilise long-term savings from individuals/households and channel them into long-term investments. It fulfills the transfer function of current purchasing power from surplus sectors to deficit sectors, in exchange for reimbursing a greater purchasing power in the future. In this way, the capital market enables corporations raise funds to finance their investments in real assets.

The implication will be an increase in productivity within the economy leading to more employment, increase in aggregate consumption and, ultimately, growth and development. It also helps in diffusing stresses on the banking system by matching long-term investments with long-term capital. It  encourages broader ownership of productive assets by small savers. It enables them to benefit from economic growth and wealth distribution, and provides avenues for investment opportunities that encourage a thrift culture critical in increasing domestic savings and investment ratios that are essential for rapid industrialization. When the economy is not developed, however, its size may not support the growth and development of the stock market.

According to Ezeoha, et al (2009), the liquidity role of the stock market stands out clearly as the most significant, among its numerous functions. Citing Levine (1991, 1997), they concur that without a liquid stock market, many profitable long-term investments would not be undertaken because savers may be reluctant to tie up their investments for long periods of time. The stock

market mainly provides liquidity by enabling firms to raise funds through the sale of securities cheaply, easily and speedily. Through this catalyst role, the stock market is also able to influence investment and economic growth in general.

Filer, et al (1999) argue that an active stock market is crucial in reallocating capital in developing countries such that, in the absence of such markets, growth in low and middle income countries would be substantially lower than it could have been if such active stock exchanges were present. Mohtadi and Agarwal (2004) argue that large stock markets lower the cost of mobilizing savings and also facilitate investments in the most productive technologies. Arestis, et al (2001), Applegarth (2004) and Osei (2005) insist that it is the development of the stock market that spurs growth in the economy but Yartey (2008) and Akinlo (2008) disagree, arguing that the level of economic activities in a country constitute the key drivers of stock market development in that country.

These contentions, and the need to clarify them, prompted Gugliemo, et al (2004) to assert that the nexus of stock market development and economic growth is not universally clear and, hence, it becomes crucial to investigate this as it reveals the extent of efficiency in capital allocation of an economy and Nurudeen (2009), who, though, finds that stock market development increases economic growth in Nigeria, to posit a resort to empirical investigations to resolve the issue but none of the empirical examinations has been able to resolve the controversy which, according to Ezeoha, et al (2009), boils down to the paradox of the egg and the hen, which is older?

Previous studies on the link between capital market development and economic growth focused on Patrick’s (1966) supply-leading hypothesis but our study seeks to find out if the reverse is the case, that is, if it is the growth in Nigeria’s economy that has influenced the development of the nation’s capital market, in line with Patrick’s (1966) demand-following hypothesis.

A capital market, according to Nigeria’s Securities and Exchange Commission (SEC), is a financial market which trades in medium- to long-term financial instruments (stocks and bonds) with maturity in excess of one year. It is a network of participants, instruments and facilities which functions basically to facilitate, efficiently, the flow of savings into long-term investments for  socio-economic  development  (Udora,  2004).  It  is  the  major  engine  of  growth  and

development for any economy, and it accommodates certain institutions for the creation, custodianship, distribution and  exchange  of  financial  assets  and  management  of  long-term liabilities (Osaze, 2001).

On the other hand, economic growth is an increase in an economy’s ability to produce real goods and services (Baye and Jansen, 1995). It is about the enhancement of an economy’s productive capacity  by  employing  available  resources  to  reduce  risks,  remove  impediments  which, otherwise, could lower costs and hinder investment (Sanusi, 2011). It is related to a quantitative sustained increase in a country’s per capita output or income accompanied by expansion in its labour force, consumption, capital and volume of trade (Jhingan, 2007).

1.3      Objectives of the Study

The main objective of this study is to determine the impact of economic growth on capital market development while, specifically, this study sets out to achieve the following objectives:

1.  To examine the impact of economic growth on the Nigerian Stock Exchange market capitalization ratio;

2.  To examine the impact of economic growth on the Nigerian Stock Exchange turnover ratio;

3.  To examine the impact of economic growth on the Nigerian Stock Exchange value traded ratio;

4.  To examine the impact of economic growth on the new issues traded ratio in the Nigerian

Stock Exchange;

5.  To examine the impact of economic growth on the number of listings in the Nigerian

Stock Exchange;

6.  To  examine  the  causal  relationship  between  economic  growth  and  capital  market development indicators in Nigeria.

1.4      Research Questions

As a follow-up to the above objectives, the research questions for this study are:

1.  To  what  extent  does economic growth have  positive  and  significant  impact  on the

Nigerian Stock Exchange market capitalization ratio?

2.  To  what  extent  does economic growth have  positive  and  significant  impact  on the

Nigerian Stock Exchange turnover ratio?

3.  To  what  extent  does economic growth have  positive  and  significant  impact  on the

Nigerian Stock Exchange value traded ratio?

4.  To what extent does economic growth have positive and significant impact on the new issues in the Nigerian Stock Exchange?

5.  To  what  extent  does economic growth have  positive  and  significant  impact  on the number of listings in the Nigerian Stock Exchange? and

6.  To what extent is there a causal relationship between economic growth and the Nigerian

Stock Exchange market development indicators?

1.5      Research Hypotheses

To  empirically examine  the  questions raised above, the  following are  the  study’s research hypotheses:

1.         Economic  growth  does  not   have  a   positive   and  significant   impact   on   market capitalization ratio in the Nigeria Stock Exchange;

2.        Economic growth does not have a positive and significant impact on turnover ratio in the

Nigerian Stock Exchange;

3.         Economic growth does not have a positive and significant impact on value traded ratio in the Nigerian Stock Exchange;

4.         Economic growth does not have a positive and significant impact on the new issues ratio in the Nigerian Stock Exchange;

5.:            Economic growth does not have a positive and significant impact on the number of listings in the Nigerian Stock Exchange; and

6.        There  is  no  causal  relationship  between  economic  growth  and  the  Nigerian  Stock

Exchange market growth indicators.

1.6      Scope of the Study

This study set out to test the reverse causation in capital market development and economic growth, specifically as it applies to Nigeria, and covered a 15-year period, 1996-2010. It utilized annual data on real economic growth and the relevant capital market development indicators, namely, stock market capitalization, value of shares traded in the market, total new issues and the number of securities listed on the exchange, as reported and published by the regulators – the Central Bank of Nigeria’s Statistical Bulletin, the Securities and Exchange Commission’s Statistical Bulletin and the Nigerian Stock Exchange’s Factbook.

The study period was immediately preceded, in 1995, by the  implementation of numerous financial and economic reforms by the federal government, beginning with the federal government’s abrogation of the Exchange Control Act of 1962 and the Nigerian Enterprises Promotion Decree (NEPD) of 1989 which removed previous restrictions on foreign participation in the economy; the promulgation of the Foreign Exchange (Monitoring and Miscellaneous Provisions) Decree No.16 (now Act) of 1995 and the Nigerian Investment Promotion Commission (NIPC) Decree No.17 (now Act) of 1995 in their stead, thereby facilitating unrestricted foreign participation in portfolio and direct investments in the economy; the deregulation of interest rates; and the enactment of the Technical Committee on Privatization and Commercialization (TCPC) Decree of 1995 (now Bureau of Public Enterprises (BPE) Act) which heralded the second phase of the privatization and commercialization programme, among others, which were all expected to influence and grow the economy. This study seeks to examine the impact of such growth on the Nigerian capital market.

1.7      Significance of the Study

The following groups will benefit immensely from this research work:

1.  Financial Experts

This study is intended to ascertain the true position, in Nigeria, of the effect of economic growth on capital market development. Financial experts will benefit from the expository nature of this study which will create the much required awareness among them to enable them analyse and advise government  and  other  stakeholders on  polices that  will promote the  growth of the economy and impact positively on the capital market for the benefit of Nigerians.

2.  Government/Policy Makers

In recognition of the increasing importance of the financial sector in the Nigerian economy, the Nigerian capital market has undergone several changes. Such reforms are streamlined for higher efficiency and better competitiveness with other stock markets. The findings of this research exercise will benefit government and policy-makers in formulating polices that will enhance the growth of the economy and also promote the development of the country’s capital market.

3.  Academic Purpose

Most of the researches done in this area of finance have been on ‘the supply-led hypothesis’ that capital market development enhances economic growth. Not much work   has   been   done   on economic growth promoting capital market development. This study adopts this latter approach, and will contribute to literature by its findings, following the demand-following hypothesis. It is also expected to trigger further studies with a view  to resolving this issue.

1.8      Limitations of the Study This study acknowledges that other factors, beside economic growth, may impact the development  of the  capital  market  but  we  set  out  to  examine,  specifically,  the  impact  of economic growth only, so we do not introduce control variables to investigate the influence of such other factors. Another limitation of this study is  in the use of secondary data, which transfers errors or mistakes in the reporting of data that would affect the validity of the results.

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