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

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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.

TABLE OF CONTENTS

Title Page . . . . . . . i

Approval Page . . . . . . . . ii

Certification Page . . . . . . . iii

Dedication iv

Acknowledgements . . . . . . . v

Abstract . . . . . . . vi

Graph/List of Tables . . . . . . . . x

List of Appendices .. . . . . . . x

CHAPTER ONE INTRODUCTION

1.1 Background of the Study. . . . . . . 1

1.2 Statement of the Problem . . . . . 4

1.3 Objectives of the Study. . . . . . . 7

1.4 Research Questions. . . . . . . . 7

1.5 Research Hypotheses. . . . . . . 8

1.6 Scope of the Study. . . . . . . 8

1.7 Significance of the Study. . . . . . 9

1.8 Limitations of the Study . . . . . 10 References. . . . . . . . . 11

CHAPTER TWO REVIEW OF RELATED LITERATURE

2.1 Theoretical Review . . . . . 15

2.1.1 Capital Market Development and Economic Growth.. 15

2.1.2 Capital Market Performance and Economic Growth. 21

2.1.3 Financial Development and Deepening . . 22

2.1.4 Financial Development and Economic Growth. . . 23

2.1.5 Finance and Growth Paradigm. . . . . 26

2.1.6 Theoretical Basis for Capital Market Development and Economic Growth. . 29

2.1.7 Financial Liberalization and Economic Growth. . . 32

2.1.8 Financial Liberalisation, Savings and Investment. . . 36

2.1.9 Financial Liberalisation and Economic Instability. . 39

2.1.10 Foreign Investments and Capital Market Development in Nigeria 44

2.1.11 Overview of the Nigerian Capital Market. . 46

2.2 Empirical Review . . . . . 52

2.2.1 Capital Market Development and Economic Growth . 52

2.2.2 Capital Market Performance and Economic Growth . 54

2.2.3 Foreign Investments, Capital Market Development and Economic Growth . 55

References. . . . . . . . . 57

CHAPTER THREE RESEARCH METHODOLOGY

3.1 Research Design. . . . . . . . 71

3.2 Nature and Sources of Data. . . . . . 71

3.3 Model Specification. . . . . . . 71

3.4 Model Justification. . . . . . . . 73

3.5 Explanatory Variables. . . . . 73

3.5.1 Gross Domestic Product Growth Rate. . . . 73

3.5.2 Stock Market Capitalization Ratio. . . . 73

3.5.3 Stock Market Turnover Ratio. . . . 74

3.5.4 Stock Market Value Traded Ratio. . . . . 74

3.5.5 New Issues Ratio . . . . . 74

3.5.6 Stock Market Number of Listings. . . . . 75

3.6 Techniques of Analysis. . . . . 75

References. . . . . . . . 77

CHAPTER FOUR PRESENTATION AND ANALYSIS OF DATA

4.1 Introduction. . . . . . . . 79

4.2 Presentation of Data. . . . . . . 79

4.3 Test of Hypotheses. . . . . . . . 87

4.3.1 Test of Hypothesis One. . . . . . . 87

4.3.2 Test of Hypothesis Two. . . . . . 89

4.3.3 Test of Hypothesis Three. . . . . . 91

4.3.4 Test of Hypothesis Four. . . . . . 93

4.3.5 Test of Hypothesis Five. . . . . . . 95

4.3.6 Test of Hypothesis Six . . . . . 97

4.4 Comparison of the Findings with the Objectives of the Study .. 102

4.4.1 Research Objective One . . . . . 102

4.4.2 Research Objective Two . . . . . . 102

4.4.3 Research Objective Three . . . . 102

4.4.4 Research Objective Four . . . . . . 103

4.4.5 Research Objective Five . . . . . . 104

4.4.6 Research Objective Six . . . . . 104

References . . 105

CHAPTER FIVE : SUMMARY OF FINDINGS, CONCLUSION AND RECOMMENDATIONS

5.1 Summary of Findings . . . . . 107

5.2 Conclusion . . . . . . 108

5.3 Recommendations 109

5.3.1 Recommendations for Further Studies . . . 111

5.3.2 Contribution to Knowledge . . . . 111

References 113

Appendices 114

Bibliography . . 118

List of Tables

Table 4.1 Quantum Values of Model Proxies . . . 79

Table 4.2 Computed Model Ratio Proxies . . . 80

Table 4.3 Two-Stage Least Squares Results of Hypothesis One 88

Table 4.4 Correlation Results of Hypothesis One 89

Table 4.5 Two-Stage Least Squares Results of Hypothesis Two 90

Table 4.6 Correlation Results of Hypothesis Two 91

Table 4.7 Two-Stage Least Squares Results of Hypothesis Three 92

Table 4.8 Correlation Results of Hypothesis Three . . 93

Table 4.9 Two-Stage Least Squares Results of Hypothesis Four 94

Table 4.10 Correlation Results of Hypothesis Four . . 94

Table 4.11 Two-Stage Least Squares Results of Hypothesis Five 95

Table 4.12 Correlation Results of Hypothesis Five . 96

Table 4.13 Pairwise Granger Causality Tests lagged 2 . 97

List of Figures

Fig. 4 Graph of Representation of Model Proxies for the period 1996-2010 . 80

List of Appendices

Appendix I Quantum Values of Model Proxies . . . 114

Appendix II Extract of Model Proxy Data . . . 115

Appendix III Results of Regression Analysis . . . 116

CHAPTER ONE

INTRODUCTION

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.

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