the Long term Relationship between economic Growth and stock Market Development: A causality Analysis for 20 oIc

member countries
Zurina Shafii and Azlina Abd. Aziz

Abstract: This study examines the long-run relationship between economic growth and stock market development for 20 oIc member countries. Panel data from 1989 to 2006 was examined through cointegration estimation procedure that can detect the existence of long-run relationship between the variables. The Johansen cointegration method was used to determine the existence of cointegration relationship among the variables under consideration. our results indicate that such relationship exists among the variables in malaysia, United Arab Emirates, Turkey, Egypt, Bahrain, and Uzbekistan. In addition, both in Egypt and Uzbekistan, one cointegrating vector was found using the same method of analysis. This indicates that one variable would cause the occurrence of other variable/s if causal analysis were conducted.

JEL Classification: D53, G23, N25, P47.

I. Introduction with the increasing size and liquidity of stock markets, their relationship to economic growth is worth examination. levine and Zervos (1998) found

Zurina Shafii, lecturer in the faculty of Economics and muamalat, Universiti sains Islam malaysia, malaysia. Azlina Abd. Aziz, lecturer in the Economics Department, faculty of management and Economics, Universiti malaysia, Trengganu, malaysia. 2009, international association for islamic economics Review of Islamic Economics, vol. 13, no. 1, 2009, pp. 199206.

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positive and significant correlation between stock market development and long-term growth. There are two schools of thought on the relation of stock market development and economic growth: one holds that stock market development is important for economic growth, the other holds that it is not. Greenwood and smith (1996) showed that stock markets lower the costs of mobilizing savings and facilitate savings thus promoting economic growth. Bencivenga et al. (1996), levine (1996) and levine and Zervos (1998) argued that stock market liquidity plays an important role in economic growth. on the other hand, Demirguc-Kunt and levine (1996) pointed out that increased liquidity may reduce growth via the reduction in saving rates due to uncertainty about savings and adversely affect corporate governance on account of investors myopia about market liquidity. This paper extends previous research on stock market development and economic growth by examining the long-run relationship between the two variables. If a long-run relationship is found, persistence relationship between both variables is ensured. This knowledge is vital when a researcher wants to examine whether stock market development can cause economic growth in the long run. The method used in this paper is designed to capture the short and long-term causality between the two series. A study that examined this subject in developing countries was conducted by mohtadi and Agarwal (2001) using regression analysis, which estimated only the effect of stock market development and growth without attempting to look for any causal link. This study extends their research by offering more complex causal relationship which will contribute in this area of research massively. section 2, on the empirical aspect of this study, contains a discussion on the measures of stock market development and economic growth used in this research, and it reviews the methods employed, such as unit root test and cointegration test. section 3 presents the results obtained from our analysis, and section 4 draws some conclusions. II. empirical Approach In order to measure stock market development, we took market capitalization (mc) and stock Turnover (sT) as proxies. mc in our case is the ratio of capital for all stocks listed to GDP. It reflects the size of the stock market in relation to the size of the economy. sT measures the size of trading in relation to the size of the market, i.e. the liquidity of the market. Higher liquidity means higher volume of trading exists in a market as compared

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to an inactive market. Gross Domestic Product (GDP) at base year 2000 measured in Us dollars was used as a proxy for economic growth. The data was compiled from the world Bank database, world Development Indicators (wDI), which contains rich data on all the economies in the world. some data is available from the year 1963, but in relation to market capitalization and stock turnover, complete data for the economies discussed in our research are only available from year 1989 until 2006, and this paper is based on those data. The test of the causal relationship between GDP versus mc and GDP versus sT was conducted in three stages. first, a test was carried out to ascertain the order of integration in all variables. since the time span of the individual series is relatively short, panel unit root techniques were utilized to increase the power of such tests. next, having established the order of integration in the series, the panel cointegration tests were carried out to investigate the existence of long-run relationships between the variables. 2.1. Panel unit root tests In this paper, unit root was utilized using the levine et al. (2002) llc test. The llc test is a panel version of the Augmented Dickey fuller test, and is based on analysis of the equation:

yit = a i + t + it + i yi ,t 1 + it

i = 1,, N

t = 1,, T

(1)

where i represents a country and t a period of time. The test involves the null hypothesis of H 0 : i = 0 for all i against the alternative of H A : i = < 0 for all i. It is necessary to do the unit root test in order to determine whether the series used contains a unit root, meaning that it has a common factor that deviates the mean and variance away from zero, which is undesirable for our purpose. In order to perform a cointegration and causal test, the unit root has to be absent, i.e. the series must contain no unit root so that mean and variance are close to zero, indicating less shocks and volatility of the data series for 1989-2006. After establishing that the series contain no unit root at a certain level of data (level or differenced version), we need to test for the existence of long-term relationships between all series. Panel cointegration test serves the purpose.

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2.2. Panel cointegration test In the conventional time-series case, it is common to test for cointegration in the multivariate system using Johansens (1998) maximum likelihood approach. This procedure can be used to identify the number of cointegrating relationships between the variables of interest. However, the power of the conventional test in multivariate systems with small sample sizes can be severely distorted. To address this issue, therefore, it is necessary to combine the data across individual members, from time series as well as cross-section data. for this purpose, in this study, the larsson et al. test (2001) was utilized. They test the null hypothesis that there are at most r cointegrating relationships among the p variables. That is, the null hypothesis is written as: H0: rank ( i ) = ri r for all i = 1,, N, (2)

first, the hypothesis that r = 0 is tested. If this hypothesis fails, the hypothesis that r = 1 is tested. This procedure is continued until the hypothesis null is not rejected. III. empirical Results 3.1. test results for panel unit root The results of the panel unit root tests are summarized in Table 1. The results show that the null of a unit root in the llc cannot be rejected in any of the relevant variables. when this happens, we cannot be certain that the series contains no unit root; the desirable results we wish to achieve require that the data series have mean and variance close to zero, indicating minimal shocks and volatility in the data. The test also suggests that the series in first differences are stationary, i.e. contain no unit root. Therefore, the test suggests that all the series appear to be integrated of order one, i.e. unit root absence when the series were integrated of order one, I (1) over the sample under consideration.

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table 1: Panel Unit Root tests

Note: figure in the parentheses are p-values.

3.2. test results for panel cointegration test After doing the unit root test, the existence of cointegrating relationships between GDP, mc and sT could be investigated. In the conventional timeseries case, it is common to test for cointegration in the multivariate system using Johansens (1988, 1991) maximum likelihood approach. This procedure can be used to identify the number of cointegrating relationships between the variables. for the reasons given above, it was necessary to combine the data across individual members, from time series as well as cross-section data. for this purpose, in this study the larsson et al. (2001) test was utilized. larsson et al. (2001) proposed a likelihood-based panel test of cointegration rank in heterogeneous panel models based on the average of the individual rank trace statistics developed by Johansen (1995).The results of the cointegration tests are shown in Table 2. The table reports country-by-country (Johansens test) and panel cointegration test (larssons test) results. Given the non-stationarity of the variables at their level order, the existence of cointegrating relationships between GDP, MC and ST and the number of cointegrating vectors can be investigated. see Table 2. The column labelled r = 0 tests a null of no cointegration, while r = 1 and r = 2, refer to a null of at most one and two cointegrating vectors, respectively. Due to the small sample, T = 18, the lag length was chosen in all cases to be equal to 1. As mentioned above, the Johansen cointegration method is used to determine the existence of cointegration relationship among the variables

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under consideration. The trace tests reject the hypothesis of no cointegrating vector (r = 0) at the 5 percent level in malaysia, United Arab Emirates, Turkey, Egypt, Bahrain, and Uzbekistan. These results indicate that a cointegrating relationship exists among the variables in the countries indicated. Thus, long-run establishment can be estimated between economic growth, market capitalization and stock turnover in the countries indicated.
table 2: Johansen test statistics and Larsson et al., (2001) Panel cointegration tests between GDP, Mc, and st. r=0 (34.91) Individual countries trace statistics malaysia 36.01964* Indonesia 28.73168 sudan 10.90114 United Arab Emirates 42.43188* oman 29.40025 Kuwait 9.53466 saudi Arabia 9.45953 Turkey 34.96034* Iran 24.82841 nigeria 34.16390 Kazakhstan 22.89026 Pakistan 23.24230 Egypt 58.94186* Bahrain 42.43188* Tunisia 28.57809 morocco 20.28657 Bangladesh 18.90558 Uzbekistan 40.23598* Jordan 20.81852 lebanon 18.66764 The panel test statistics country
L R
N T

trace statistics Ho: rank = r=1 r=2 (19.96) (9.24) 6.98902 6.23890 0.38242 4.10871 0.51587 0.83702 1.04902 5.57002 6.77458 5.31699 3.92541 4.50969 25.03024* 4.10871 1.22707 3.23487 6.25116 13.08338* 7.18243 4.14041 5.5238 -0.7746 6.086 10.535 20 1.33096 0.19831 0.00030 0.00082 0.09043 0.13081 0.24724 0.08127 0.00036 0.91717 1.58028 1.57294 0.03899 0.00082 0.14558 0.05668 1.66627 0.38271 1.71187 1.30814 0.5731 -1.6956 1.137 2.212 20

r
Rank (ri)

1 0 0 1 0 0 0 1 0 0 0 0 1 1 0 0 0 1 0 0

27.7715 11.5251 14.9550 24.7330 20

YL R

test

E(Zk) var(Zk) n

Notes: (i) r denotes the number of cointegrating vectors; (ii) the panel rank test has a critical value 1.96 at 5% level; (iii) * indicates rejection of the null hypothesis of rank equal to r at a 5% level of significance.

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The test also reveals the number of cointegrating vectors that contribute to the long-run relationship between the variables. for Egypt and Uzbekistan, it can be confirmed that at least one cointegrating vector exists in the series with the possibility of two cointegrating factors. This means that were causal analysis to be performed, we know that one variable would cause another variable in the data series for Egypt and Uzbekistan. However, the results revealed that no country has two cointegrating vectors that contribute to the long run relationship among the variables, since the test performed failed to reject for r =2 for all countries. IV. summary and conclusion In summary, we found that there is a long-run relationship between economic growth, market capitalization and stock turnover in malaysia United Arab Emirates, Turkey, Egypt, Bahrain, and Uzbekistan. The results also suggest that these countries have one cointegrating vector that can be further examined in causal analysis. causal analysis is a more powerful tool that explains whether one variable causes another variables behaviour. further study on causal analysis of whether stock market development can cause economic growth can be extended from our analysis on the long run relationship by performing the Granger-causality test. RefeReNces
Bencivenga, v. r.; smith, B. and starr, r. m. (1996). Equity markets, Transaction costs, and capital Accumulation: An Illustration, The World Bank Economic Review, 10 (2) may, pp. 241-265. Demirguc-Kunt, A. and levine, r. (1996). stock market Development and financial Intermediaries: stylised facts, The World Bank Economic Review, 10 (2) may, pp. 291-321. Edison, Hali; levine, r.; ricci, luca and slok, Thorsten (2002). International financial Integration and Economic Growth, Journal of International Money and Finance, 21 (2), pp. 749-776. Greenwood, J. and smith, B. (1996). financial markets in Development and the Development of financial markets, Journal of Economic Dynamics and Control, 21(1), pp. 145-181. Johansen, s. (1988). statistical Analysis of cointegration vectors, Journal of Economic Dynamics and Control, 12 (2/3), pp. 231-254. larsson, r.; lyhagen, J. and lothgren, m. (2001). likelihood-Based cointegration Tests in Heterogeneous Panels, Econometrics Journal, 4 (1), pp. 109-142.

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levine, r. (1991). stock markets, Growth, and Tax Policy, Journal of Finance, 46 (4), pp. 1445-1465. levine, r. and Zervos, s. (1998). stock markets, Banks and Economic Growth, American Economic Review, 88 (3) June, pp. 537-558 mohtadi H. and Agarwal, s. (2001). Stock Market Development and Economic Growth. University of wisconsin, milwaukee working Paper. Available at: <Url:http://www.uwm. edu/~mohtadi/PA1-4-01.pdf>.