Research Proposal For:

Stock Market Development and Economic Growth in Saudi Arabia

Introduction

Saudi Arabia’s joint stock companies had their beginnings in the mid 1930’s, when

the first such company, the Arab Automobile Company was established. By 1975

there were 14 public companies. The rapid economic expansion and Saudisation of

foreign banks in the 1970’s led to the establishment of a number of large corporations

and joint venture banks. Major share offerings were made to the public during this

period. The market remained informal, until the early 1980’s when the Government

embarked on a rapid development program. In 1984, a Ministerial Committee

consisting of Ministry of Finance and National Economy, Ministry of Commerce and

Saudi Arabian Monetary Agency, SAMA, was formed to regulate and develop the

market.

With the aim of improving the regulatory framework, share-trading intermediation

was restricted to commercial banks. In 1984, the Saudi Share Registration Company

(SSRC) was established by the commercial banks. The company provides central

registration facilities for joint stock companies and settles and clears all equity

transactions. Automated clearing and settlement was introduced in 1989. The

Electronic Securities Information System (ESIS), developed and operated by SAMA,

was introduced in 1990. Tadawul, the new securities trading, clearing and settlements

was launched in October 2001.

And on 31/7/2003, The Capital Market Authority was established pursuant to the "

Capital Market Law". The authority represents the government apparatus which is

mainly entrusted with management and organization of the Saudi Capital Market, and
which reports directly to the chairman of the Council of Ministers. The authority is

financially and administratively dependant, it is main objective is envisaged in

organization and development of the capital market in the Kingdom, through

enactment and enforcement of the rules and regulations for protection of investors and

fairness and integrity of the capital market.

The Stock Market index has grown from 690 points to more than 13000 points, a

growth of more than 17000%, between 1985 to 2005Q2, and the number of

transactions, volume and value traded increased dramatically.

Goal of the Thesis

The goal of the thesis is to empirically investigate the linkage between stock market

development and economic growth using Saudi Arabia as a country case study. The

study will intend to answer the following questions:

1. How can the development of the Saudi Stock Market be explained?

2. What factors are behind the Market’s recent high growth?

3. What is the nature of the relationship between stock market size, liquidity, and

the economic performance?

4. What is the direction of this relationship? Is it going from stock market to

economic growth or the other way around?

Such questions are important to address because stock markets has been widely

considered as an important tool for economic development, investment mobilization,

and lowering firm’s cost of capital. In addition, understanding what account for stock

market growth may help identifying the tools by which policy makers can motivate

their activities.
Literature Review

Economists have long held the belief that the financial structure of an economy is a

crucial determinant of the level and rate of growth and its wealth. The economic

relationship between financial development and economic growth has been

extensively tested. There are three views explaining the relationship between financial

development and economic growth. The first view suggests that financial

development is a consequence of high growth that demands more and better financial

development (Partick 1966). Robinson (1952) contended that financial development

simply follows economic growth. The need for financial intermediation depends on

the variance in growth rates among different sectors of the economy. Arestis,

Demeriades and Luintel (2001) suggest that stock market development may actually

hamper rather than help economic growth.

The second view suggests that the supply of financial institutions and services

stimulates investments in more productive resources. The financial development

would then lead to economic growth. Shaw (1973) argued that a country’s financial

sector does matter for economic development. Financial liberalization can more

efficiently allocate savings by widening and diversifying the financial market within

which investment opportunities compete for the savings flow. Mickinnon (1973)

showed that the role of capital markets is crucial in the economic development

process. The last decade has produced several important contributions (e.g.,

Bencivenga and Smith (1991), Atje and Jovanovic (1993), Gaytan and Ranciere

(2003, 2004) etc.) in support of the view that financial structure is a crucial vehicle in

the development process.

A third view is supported by group of economists who regards finance as a relatively

unimportant factor in growth. Lucas (1988) declares that the finance growth

relationship is "over-stressed". This view suggests that the finance and economic

growth are causally independent.

In addition to the previous three views, a fourth view can be formed supporting a two

way relationship between financial sector development and economic growth.

Greenwood and Smith (1997) argue that this sort of causality pattern seems likely

over the long-run.

Empirical literatures

Goldsmith (1969) made the first finance-growth study that found a positive

correlation between economic growth and the size of the financial system.

Different correlation and causality patterns between finance and growth imply

different policy implications. Kaufman and Jacoby (1986) showed that the declines in

the stock market activities can explain much of the 1972-1978 slowdown of

productivity in six industrialized OECD countries ( USA, Canada, Japan, UK, France

and Germany). They also found that stock market declines often preceded a fall in

productivity growth. Levine (1991) investigated how the stock market affects

investment incentive and leads to change in the steady state growth rate. He identified

two channels through which stock markets promote economic growth: diversifying

portfolio and allowing investors to trade ownership of firms.

In 1996, Mckinnon and Shaw developed basic models to affirm the positive role of

financial intermediaries in the process of economic growth. They showed that

financial development accelerates the rate of economic growth, therefore

recommended liberalizing the financial system to spur economic growth. Rousseau

and Wachtel (1998) found that the intensity of financial intermediation measures
Granger-cause real output, with little evidence of feedback from output

intermediation. Darret (1999) examined the role of financial deepening in economic

growth in three countries: Saudi Arabia, Turkey, and the United Arab Emirates. He

concluded that a stationary relationship exist between real economic growth, the

currency ratio, and the monetization variable. Allen and Gale (2000) stress that the

competitive nature of markets encourages innovative, growth-enhancing activities.

Rousseau and Wachtel (2000) show that both banking and stock market development

explain subsequent growth. Stiglitiz (1985) and Bhide (1993), on the other hand,

emphasis that stock markets will not produce the same improvement in resource

allocation than banks.

Stock Market Growth Literature

Van Horne (1971) argued that the growth of stock markets around the world can be

attributed to the increasing number of mutual funds and other investment institutions.

Davidson (1978) presented a general description of how stock markets interact with

economic activities. Kitchen (1986) indicated that a well-functioning stock market

requires a substantial number of institutions that hold the savings of individuals.

Sudweeks (1989) argued that stock market growth development requires the

following a substantial positive economic growth rate and rational monetary policies.

In addition, it requires a reasonable political stability and a favorable environment and

legal framework.

Calderon-Rossell (1990a) examined the structure and evolution of world stock

markets. In Calderon-Rossell’s 1991 paper, a basic model of stock market growth was

presented. Rossell presented a partial behavioral structural model of stock market

growth that establishes a linkage between stock market and economic activities.

Rossell suggested that stock market capitalization growth is determined by economic

growth, measured by GNP per capita, and additional stock market liquidity,

determined by increase in the turnover ratio.

Empirical Methodology:

The thesis will focus mainly on two issues: (1) Examining the relationship between

Saudi stock market development and economic growth and what accounts for stock

market growth and (2) Determining the direction of the relationship between the stock

market and economic growth.

In this thesis, the Calderon-Rossell’s partial behavioral structural model of stock

market growth will be the foundation for estimating a regression equation that would

empirically determine which factors stand behind the growth of the Saudi stock

market from 1985Q1 to 2005Q4. Elements such as GDP growth, oil prices, and

privatization policies will be included in the model to examine their relation to

economic growth.

To investigate the second issue, the thesis will examine data for the Saudi market

between 1985Q1 and 2005Q4 to test if the causality is from stock market to economic

performance or from economic performance to stock market- or does it work both

ways? To answer these questions, the Johansen Cointegration Test and the Granger

Causality Test techniques will be applied to investigate the empirical association

between stock market and economic growth. Levine and Zervos (1996) recognized

the importance of causality issue, and recommended that future research should

examine the time series between stock market development and economic growth.