stock market development and financial intermediaries: stylized...

THE WORLD BANK ECONOMIC REVIEW, VOL 10, NO. 2: 291-321

Stock Market Development and FinancialIntermediaries: Stylized Facts

Ash Demirgiic-Kunt and Ross Levine

World stock markets are booming, and emerging stock markets account for a dis-proportionate share of this growth. Yet economists lack a common concept or mea-sure of stock market development. This article collects and compares a broad arrayof indicators of stock market and financial intermediary development, using datafrom forty-four developing and industrial countries during the period from 1986 to1993. The empirical results exhibit wide cross-country differences for each indicatoras well as intuitively appealing correlations between various indicators. The articleconstructs aggregate indexes and analyzes them to document the relationship be-tween the emergence of stock markets and the growth of financial intermediaries. Itproduces a set of stylized facts that facilitates and stimulates research into the linksamong stock markets, economic development, and corporate financing decisions.

The growth and globalization of emerging stock markets are impressive. In 1994,emerging market capitalization was $1.9 trillion, compared to $0.2 trillion in1985. Similarly, $39 billion flowed into emerging equity markets from abroadin 1994, compared with $0.1 billion in 1985.' These developments have at-tracted the attention of academics, practitioners, and policymakers. Several stud-ies focus on measuring the benefits of holding a globally diversified portfolio(for example, see Harvey 1995 and De Santis 1993); and many countries arereforming regulations and laws to foster capital market development and at-tract foreign portfolio flows. Yet, economists have neither a common conceptnor a common measure of stock market development.

This article gives empirical content to the phrase "stock market development"by collecting and comparing a broader array of empirical indicators of stockmarket development than any previous study. Using data on forty-four develop-ing and industrial countries from 1986 to 1993, we examine different measuresof stock market size, market liquidity, market concentration, market volatility,institutional development, and integration with world capital markets. Sinceeach indicator suffers from statistical and conceptual shortcomings, we use avariety of indicators, which provide a more accurate depiction of stock markets

1. One billion is 1,000 million; one trillion is 1,000 billion.

Asli Demirguc-Kunt and Ross Levine are with the Policy Research Department at the World Bank.This article was originally prepared for the World Bank conference on Stock Markets, Corporate Finance,and Economic Growth, held in Washington, D.C., February 16-17,1995.

© 1996 The International Bank for Reconstruction and Development/THE WORLD BANK

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2 9 2 THE WORLD BANK ECONOMIC REVIEW, VOL. 10, NO. 2

than any single measure. Furthermore, stock market development—like the levelof economic development—is a complex and multifaceted concept. No singlemeasure will capture all aspects of stock market development. Thus, our goal isto produce a set of stylized facts about various indicators of stock market devel-opment that facilitates and stimulates research into the links among stock mar-kets, economic development, and corporate financing decisions.

After describing each of the stock market development indicators, we exam-ine the relationships among them. We find enormous cross-country variation inthe stock market indicators. For example, five countries have market capitaliza-tion to gross domestic product (GDP) ratios greater than 1, and five countrieshave market capitalization to GDP ratios less than 0.10. We find attractive cor-relations among the indicators. For example, large stock markets are more liq-uid, less volatile, and more internationally integrated than smaller markets; coun-tries with strong information disclosure laws, internationally accepted accountingstandards, and unrestricted international capital flows tend to have larger andmore liquid markets; countries with markets concentrated in a few stocks tendto have smaller, less liquid, and less internationally integrated markets; and in-ternationally integrated markets are less volatile.

Although many stock market development indicators are significantly corre-lated in an intuitively plausible fashion, the individual indicators produce differ-ent country rankings. Thus, to produce an assessment of the overall level ofstock market development across countries, we produce indexes of stock mar-ket development that average together the information contained in the indi-vidual indicators. Developing aggregate indexes that summarize the extent of acountry's stock market development in a single figure is especially helpful foranalysts who are interested in making comparisons across countries. These in-dexes can be used in empirical studies linking stock market development andother economic phenomena, as in Levine and Zervos (1996) and Demirgiic-Kunt and Maksimovic (1996). We find that from 1986 to 1993 the most devel-oped stock markets in the world are in Japan, the United States, and the UnitedKingdom, and the most underdeveloped markets are in Colombia, Venezuela,Nigeria, and Zimbabwe. The data suggest that Hong Kong, Singapore, the Re-public of Korea, Switzerland, and Malaysia have highly developed stock mar-kets; Turkey, Greece, Argentina, and Pakistan have underdeveloped markets.Furthermore, although richer countries generally have more developed stockmarkets than poorer countries, many markets labeled emerging are more devel-oped than those in France, the Netherlands, Australia, Canada, Sweden, andNorway.

We use the assortment of stock market indicators to evaluate which stockmarkets have been developing fastest over the last eight years. Using measuresof size, liquidity, and international integration, Indonesia, Turkey, Portugal, andVenezuela stand out as the most rapidly developing markets in the world.

This article documents the relationship between the various stock marketindicators and measures of financial intermediary development. Since debt and

Demirgiif-Kunt and Levine 293

equity are frequently viewed as alternative sources of corporate finance, stockmarkets and banks are sometimes viewed as alternative vehicles for financingcorporate investments (see Demirgiig-Kunt and Maksimovic 1996). Conse-quently, we document the cross-country ties between stock market develop-ment and financial intermediary development. We use measures of the size ofthe banking system, the amount of credit going to private firms, the size ofnonbank financial corporations, and the size of private insurance and pensioncompanies. We find that most stock market indicators are highly correlatedwith the development and efficient functioning of banks, nonbank financial cor-porations, and private insurance companies and pension funds. Countries withwell-developed stock markets tend to have well-developed financial intermedi-aries.

Section I presents indicators of stock market development and describes theirtheoretical relevance. Section II ranks countries using the different indicators ofstock market development and studies the correlations among the indicators.Section III examines which countries have the fastest-developing stock markets.Section IV analyzes the links between stock market development and financialintermediary development. Section V summarizes the results.

I. INDICATORS OF STOCK MARKET DEVELOPMENT

A growing theoretical literature examines the relationship between particularattributes of stock markets and both economic growth and firms' financing de-cisions. For example, Devereux and Smith (1994) and Obstfeld (1994) showthat by facilitating risk sharing, internationally integrated stock markets affectsaving decisions, the allocation of capital, and long-run economic growth rates.Greater risk diversification and liquidity have theoretically ambiguous effectson saving rates, however, because saving rates could fall sufficiently for en-hanced liquidity and risk diversification to lead to slower economic growth.Levine (1991) and Bencivenga, Smith, and Starr (1996) emphasize that stockmarket liquidity—the ability to easily trade securities—facilitates investmentsin longer-run, higher-return projects that involve more transactions. On stockmarket size, Pagano (1993) studies the increased risk-sharing benefits of largerstock markets due to thick market externalities. Besides stock market size, li-quidity, and integration with world capital markets, theorists have examinedstock return volatility. For example, DeLong and others (1989) argue that ex-cess volatility in the stock market can hinder investment, and therefore growth,although there is considerable disagreement over the existence of excess volatil-ity in stock returns (see Shiller 1981). In terms of corporate finance, some theo-ries link stock market functioning with firms' financing and investment deci-sions. Pagano (1993) models the ties between risk-diversification and corporatefinancing decisions, while Boyd and Smith (1996) analyze complementaritiesbetween debt and equity financing for capital investments. Yet, as Demirguc,-Kunt and Maksimovic (1996) discuss, the effect of stock market development

294 THE WORLD BANK ECONOMIC REVIEW, VOL. 10, NO. 2

on firms' financing decisions is theoretically inconclusive. Thus, theory providesa rich array of channels through which stock markets—market size, liquidity,integration with world capital markets, and volatility—may be linked to eco-nomic growth and corporate financing decisions.

There is very little empirical evidence on the links among stock markets, eco-nomic development, and firms' corporate financing decisions. To facilitate em-pirical research, this article collects and compares a broad array of stock marketindicators motivated by the above theoretical studies and constructs aggregateindexes of overall stock market development. Demirgiic-Kunt and Maksimovic(1996) and Levine and Zervos (1996) use these indexes to examine the empiri-cal relationship among stock market development, firms' financing decisions,and long-run economic growth.

The rest of this section presents and discusses an array of stock market devel-opment indicators. We focus on indicators identified by existing theoretical stud-ies. We describe measures of market size, market liquidity, market volatility,market concentration, asset pricing efficiency, regulatory and institutional de-velopment, and conglomerate indexes that aggregate the information containedin the individual measures. For developing countries, we use data from the In-ternational Finance Corporation's (lFC's)Emerging Markets Data Base. For in-dustrial countries, data are from Morgan Stanley Capital International (MSCl).We also use macroeconomic data from IMF (various issues). The data cover theperiod from 1986 to 1993 for up to forty-four developing and industrial coun-tries. The appendix provides details of data construction and discusses cross-country comparability issues.

Stock Market Size

The market capitalization ratio equals the value of listed shares divided byGDP. Analysts frequently use the ratio as a measure of stock market size. In therest of the article, we refer to this measure as market capitalization. In terms ofeconomic significance, the assumption behind market capitalization is that mar-ket size is positively correlated with the ability to mobilize capital and diversifyrisk. For example, Pagano (1993) motivates his theoretical model by observingthe great variation in market capitalization and in the number of listed compa-nies in different economies. As indicated in table 1, South Africa, Hong Kong,Malaysia, Japan, and Singapore all had market capitalization ratios greater than1 from 1986 to 1993, while Nigeria, Argentina, Indonesia, Colombia, and Tur-key all had market capitalization ratios of less than 0.10 during the same period.

We include statistics on the number of listed companies as an additional mea-sure of market size. Although marginal differences in the number of listed com-panies are uninformative, extreme values can be useful. It is not very interestingthat Australia averaged 1,184 listed companies and Canada averaged 1,118 listedcompanies during the period from 1986 to 1993. But the fewer than 70 listedcompanies for Finland and Zimbabwe suggest that these countries have verylimited markets (table 1). Similarly, the fact that in Indonesia, Turkey, and Por-

Demirgii(-Kunt and Levine 295

tugal the number of listed companies grew at over 20 percent a year from 1986to 1993 suggests rapid stock market development (see table 3 in section HI).

Liquidity

Although economists advance many theoretical definitions of liquidity, ana-lysts generally use the term to refer to the ability to easily buy and sell securities.Since liquidity allows investors to alter their portfolios quickly and cheaply, itmakes investment less risky and facilitates longer-term, more profitable invest-ments. Liquidity is an important attribute of stock market development becausetheoretically liquid markets improve the allocation of capital and enhance pros-pects of long-term economic growth. A comprehensive measure of liquidity wouldquantify all the costs associated with trading, including the time costs and un-certainty of finding a counterpart and settling the trade. Because we want tocompare liquidity across countries and because data are very limited, we simplyuse two measures of realized stock trading.

Total value traded/GDP equals total shares traded on the stock market ex-change divided by GDP. The total value traded ratio measures the organizedtrading of equities as a share of national output, and should therefore positivelyreflect liquidity on an economywide basis. Japan, Hong Kong, Malaysia, theUnited States, and the United Kingdom all had total value traded/GDP ratiosabove 0.40, while in Pakistan, Zimbabwe, Colombia, and Nigeria, the totalvalue traded/GDP ratio was about 0.01 from 1986 to 1993. The total value traded/GDP ratio complements the market capitalization ratio. Although market capi-talization may be large, there may be little trading. For example, South Africaand Chile had above-average market capitalization but below-average total valuetraded/GDP (table 1). Together, market capitalization and total value traded/GDPinform us about market size and liquidity.

A second measure of liquidity is the turnover ratio. Turnover equals the valueof total shares traded divided by market capitalization. High turnover is oftenused as an indicator of low transactions costs. Korea and Germany (largelyreflecting massive trading around reunification) had turnover ratios above 0.90,while Nigeria, Zimbabwe, and South Africa had turnover ratios below 0.05.The turnover ratio complements market capitalization. A small but active mar-ket will have small market capitalization but high turnover. For example, Nor-way and India had below-average market capitalization but above-average turn-over (table 1). Alternatively, South Africa's market capitalization to GDP ratiowas the highest in the world, but its turnover ratio was one of the smallest.

Turnover also complements total value traded/GDP. Although total value traded/GDP captures trading compared with the size of the economy, turnover measurestrading relative to the size of the stock market. Put differently, a small, liquidmarket will have a high turnover ratio but a small total value traded/GDP ratio.For example, there was not much equity trading in Brazil relative to the size ofits economy, but Brazil's turnover ratio was high, reflecting a small but activestock market. By contrast, Malaysia had the third-highest market capitalization

Table 1. Indicators(annual average)

Economy

ArgentinaAustraliaAustriaBelgiumBrazilCanadaChileColombiaDenmarkFinlandFranceGermanyGreeceHong KongIndiaIndonesiaIrelandIsraelItalyJapanJordanKorea, Rep. ofLuxembourgMalaysiaMexicoNetherlandsNew ZealandNigeria

iof Stock

Marketcapitalization'

Rank

40103518341311381926202232

23139

2529

49

15

324121641

Value

0.060.540.100.360.110.480.520.070.280.190.270.240.121.360.160.06

0.210.161.080.570.40

1.280.220.490.390.04

Market Development, 1986-93

Total valuetradedJGDP*

Rank

3412222826133040232718

837

22536

1529

114

6

319112441

Value

0.020.170.070.040.050.150.040.010.070.040.090.350.020.590.060.02

0.110.040.620.130.37

0.460.090.210.060.00

Number of listedcompanies0

Rank

265

3927

96

21401742

81134142

38

15193

3610231625182033

Value

1871,184

90182579

1,11822587

26762

641551126318

4,61491

312227

2,027103576205291193239226127

Turnover6

Rank

1921

53511203738233016

13412

927

324

829

2

267

143241

Value

0.340.310.690.120.480.310.080.070.240.210.351.470.130.440.500.23

0.720.240.540.220.93

0.240.560.410.170.01

Volatility'

Rank

371114

636

52523

13151031

24

211820127

30

1732

316

Value

0.340.040.050.040.250.040.060.06

0.050.050.040.10

0.06

0.060.060.060.040.040.08

0.050.100.030.05

Marketconcentration1

Rank

15

78

1926

61517

3

223

9

1210

21

Value

0.64

0.260.270.500.74

0.260.410.47

0.22

0.190.590.28

0.360.36

0.51

Institutionaldevelopment*

Rank

10

4

511

18

817

123

12

20

Value

1.16

1.54

1.521.16

0.77

1.340.96

1.161.55

1.631.61

0.64

APTpricing error**

Rank

1413

24

1719

16

79

12

10

1121

8

Value

4.984.94

7.26

5.565.62

5.29

3.333.68

2.392.553.73

3.905.94

3.66

ICAPMpricing errorh

Rank

2412

23

1315

19

78

419

521

11

Value

11.584.14

6.92

4.254.82

5.23

2.893.03

2.262.053.18

2.455.77

3.72

NorwayPakistanPhilippinesPortugalSingaporeSouth AfricaSpainSwedenSwitzerlandTaiwan (China)ThailandTurkeyUnited KingdomUnited StatesVenezuelaZimbabwe

AverageNumber of

economies

2733233051

2114

7

1737

68

3628

41

0.190.110.240.161.041.540.250.460.77

0.360.080.920.640.100.18

0.41

17383132

7212016

9

1033

54

3539

41

0.090.010.040.030.350.080.080.100.31

0.220.030.410.410.020.01

0.15

3512302931

7133228242237

41

4143

43

126487152162147700383133176197210

911,9327,087

8257

627

103628311839172515

422136

3340

41

0.480.080.230.200.340.050.350.240.39

0.700.280.440.650.150.03

0.36

271

294

1922

8342635

92

3328

37

0.070.030.080.03

0.060.060.040.150.070.170.040.030.130.07

0.08

52214

20131118

41

2416

26

0.250.520.41

0.500.400.360.500.240.140.630.44

0.40

1396

167

14

1519

20

1.091.321.37

0.981.361.06

1.000.66

1.19

31512

206

2254

2318

24

2.595.264.02

5.683.126.382.942.716.675.57

4.49

21620

141022

63

1718

24

2.154.905.28

4.543.186.662.562.245.155.18

4.34

Note: For each indicator, the stock market development of each economy is ranked from high to low. Thus, for market capitalization, total value traded/GDP, number oflisted companies, turnover, and institutional development, the ranking by value of the indicator is from high to low. For volatility, market concentration, APT pricing error, and1CAPM pricing error, the ranking by value of the indicator is from low to high.

a. Market capitalization is the value of stocks divided by GDP.b. Total value traded/GDP is total value of traded shares divided by GDP.c. Number of companies listed represents the number of shares listed on the exchange.d. Turnover is given by total value traded divided by market capitalization.e. Volatility is the twelve-month rolling standard deviation estimate based on market returns.f. Market concentration is the share of market capitalization held by the ten largest stocks.g. Institutional development is an average of institutional indicators as described in the text.h. APT and ICAPM pricing errors are obtained from Korajczyk (1994).Source: Authors' calculations and Korajczyk (1994).


and total value traded/GDP ratios from 1986 to 1993, but it had below-averageturnover (table 1). Thus, incorporating information on market capitalization,total value traded/GDP, and turnover provides a more comprehensive picture ofdevelopment than any single indicator can provide.

Concentration

In some countries a few companies dominate the market. High concentrationis not desirable because it may adversely affect the liquidity of the market. Tomeasure the degree of market concentration, we compute the share of marketcapitalization accounted for by the ten largest stocks and call this measure concen-tration. The United States and Japan have very low concentration. The ten larg-est stocks account for less than 20 percent of the markets. In Venezuela, Argen-tina, and Colombia, where the concentration ratio averaged above 0.60 in theperiod from 1986 to 1993 (table 1), concentration is three times larger than thatin the United States and Japan.

Volatility

We include a measure of stock market volatility, because volatility of stockreturns is another attribute that has received significant attention in the litera-ture and is of great interest to practitioners. This indicator is a twelve-month,rolling, standard-deviation estimate based on market returns. We cleanse thereturn series of monthly means and twelve months of autocorrelations using aprocedure defined by Schwert (1989). Greater volatility is not necessarily a signof more or less stock market development. Indeed, high volatility could be anindicator of development, so far as revelation of information implies volatilityin a well-functioning market (see, for example, Bekaert and Harvey 1995). Herewe refer to "less volatility" as reflecting "greater stock market development"for simplicity. As with the other indicators, there are great cross-country differ-ences in volatility. Volatility in Pakistan, the United States, and the Netherlandsaveraged about 0.03 from 1986 to 1993; volatility in Brazil and Argentina wasabove 0.25.

Asset Pricing

Academic researchers and market practitioners have devoted prodigiousresources to measuring the degree of integration between national stockmarkets and the world market and to gauging whether markets price riskefficiently (see Bonser-Neal and others 1990; Cho, Eun, and Senbet 1986;Claessens, Dasgupta, and Glen 1995; Errunza and Losq 1989,1985a, 1985b;Errunza and Senbet 1981; Errunza, Losq, and Padmanabhan 1992; Gultekin,Gultekin, and Penati 1989; Jorion and Schwartz 1986; Korajczyk and Viallet1989; Solnik 1974; Stehle 1977; and Wheatley 1988). Although a marketneed not be integrated into the world capital markets to be developed, ana-lysts generally refer to countries that are more integrated and that price riskmore efficiently as more developed.


To measure asset pricing efficiency, we use estimates of asset pricing errorscomputed by Korajczyk (1994,1996). Unfortunately, the data only permit com-putation of these pricing errors for twenty-four countries. As argued in Korajczykand Viallet (1989), the capital asset pricing model (CAPM) and arbitrage pricingmodel imply that the expected return on each asset is linearly related to a bench-mark portfolio or linear combination of benchmark portfolios. In domestic ver-sions of these asset pricing models the benchmark portfolios include only secu-rities traded on the local exchange, but in the international versions the portfoliosinclude all securities. If the models are correct, then the benchmark portfolio, orcombination of portfolios, should explain all of the systematic expected returnson assets above the risk-free interest rate.2 Thus, we term systematic deviationsof expected returns as pricing errors under the maintained hypothesis that themodel is correct. Using different asset pricing models, Korajczyk (1994) com-putes the systematic deviation between actual returns and those implied by themodels.

The asset pricing theory (APT) and international capital asset pricing model(ICAPM) compute pricing errors using an international arbitrage pricing modeland international capital asset pricing model, respectively. Korajczyk (1994)computes the extent of pricing error under the maintained hypothesis thatthe models are correct. We take the average of the absolute value of thepricing errors for the stocks in a country as a measure of capital marketintegration. Thus, under the maintained hypothesis, greater values of the APTand ICAPM measures reflect less international integration. Greater pricingerrors may reflect poor information about firms, high transactions costs,and official barriers to international asset trading. We refer to greater pric-ing errors as indicating less stock market development. The APT and ICAPMpricing errors give similar country rankings. Brazil, Turkey, and Mexico hadrelatively large pricing errors, but the United States, Japan, Jordan, and Pa-kistan yielded lower pricing errors, which suggest a high level of interna-tional integration.

These two pricing-error estimates—APT and ICAPM—rely on the success ofequilibrium models of asset pricing that investigators sometimes have rejectedas good representations of the pricing of risk. However, these measures allow usto incorporate indicators, albeit imperfect indicators, of the ability of agents todiversify risk domestically and internationally. Furthermore, we analyze theevolution of the degree of integration between each domestic market and theworld market over time.

Regulatory and Institutional Indicators

Regulatory and institutional factors may influence the functioning of stockmarkets (see Pagano 1993). For example, mandatory disclosure of reliable in-formation about firms and financial intermediaries may enhance investor par-

2. Since no asset is riskless in real terms, Korajczyk and Viallet (1989) test the restrictions implied bya zero-beta asset.


ticipation in equity markets. Regulations that instill investor confidence in bro-kers and other capital-market intermediaries should encourage investment andtrading in the stock market.

To measure the institutional development of emerging stock markets, we useinformation provided by the IFC and construct seven regulatory-institutional in-dicators. The first indicator shows whether the firms that are listed in a stockmarket publish price-earnings information. We give a value of 0 or 1, where 1indicates that the information is comprehensive and published internationally.The second indicator measures accounting standards. We assign values of 0, 1,or 2, for countries with poor, adequate, or good (internationally accepted) ac-counting standards. The third indicator measures the quality of investor protec-tion laws as judged by the IFC, where 0, 1, and 2 are used to indicate poor,adequate, or good investor protection laws. The fourth indicator shows whetherthe country has a securities and exchange commission. The fifth, sixth, and sev-enth indicators measure restrictions on dividend repatriation by foreign inves-tors, capital repatriation by foreign investors, and domestic investments by for-eigners. We assign values of 0, 1, and 2, indicating whether capital flows arerestricted, have some restrictions, or are free, respectively. We compute an aver-age institutional development indicator, which simply averages the seven regu-latory-institutional indicators. These indicators are available on an annual basisfrom 1986'to 1993 for twenty developing countries.

There is substantial variation across countries and indicators. For example,Jordan freely allowed international capital flows to cross its borders, but did notpublish regular price-earnings information and had poor accounting standards.India had accounting standards of internationally accepted quality, but restrictedcapital inflows and the repatriation of capital and dividends. Nigeria tightlyrestricted capital flows over most of the period and did not publish price-earnings information on firms in a comprehensive and internationally acceptedmanner. In contrast, Malaysia, Mexico, Korea, Brazil, and Chile had very highinstitutional development indicators overall (table 1).

Correlations between Various Indicators of Stock Market Development

Many stock market indicators are significantly correlated in an intuitivelyplausible fashion.3 First, market size is significantly positively correlated withtotal value traded/GDP and the average institutional indicator, and significantlynegatively correlated with pricing error and volatility. Countries with big stockmarkets have less volatile, more efficient stock markets with a high volume oftrading relative to GDP. Second, countries with highly concentrated markets havemarkets that are underdeveloped. Market concentration is significantly nega-tively correlated with market size and market liquidity, and significantly posi-tively correlated with pricing error. Third, countries that have stock marketswhich are more integrated internationally—as measured by low APT and ICAPM

3. We do not report the actual values here due to space constraints. For these and for more detailedstatistics throughout the article, see Demirguc-Kunt and Levine (1995).

Demirguf-Kunt and Leirine 301

values—have less volatile stock returns. Fourth, countries with well-developedregulatory and institutional systems, as defined by the IFC, tend to have large,liquid stock markets.

Although many stock market development indicators are significantly cor-related in intuitively attractive ways, the correlation coefficients are frequentlybelow 0.60. The correlations suggest that the different indicators capturedifferent aspects of stock market development. For example, the correlationbetween the two measures of market liquidity, total value traded/GDP andturnover is only 0.50. Thus, although the degree of trading relative to thesize of the economy is significantly correlated with the degree of tradingrelative to the size of the market, the two liquidity measures do not moveone for one. Instead, they provide complementary information about stockmarket liquidity. Therefore, to measure how well stock markets function ingeneral, that is, to compute an index of overall stock market development,we need to incorporate the information contained in a broad selection ofthese indicators.

II. WHICH STOCK MARKETS ARE MOST DEVELOPED?

Which stock markets are most developed overall? To answer this question, weconstruct four conglomerate indexes of stock market development that aggregatethe information contained in the individual indicators. We then use these conglom-erate indexes to rank countries in terms of overall stock market development.

The Indexes

To compute the conglomerate indexes of stock market development, weaverage the means-removed values of particular stock market developmentindicators. To construct each index, we follow a two-step procedure. iNDEXlaggregates information on market capitalization, total value traded/GDP, andturnover. First, for each country, /', we compute the means-removed marketcapitalization, total value traded/GDP, and turnover ratios. We define themeans-removed value of variable X for country / as X(i)m = [X(i) - mean(X)] /[ABS[ mean(X)]}, where the term in the denominator is the absolute value of theaverage value of X across all countries from 1986 to 1993. For the pricing-errormeasures (APT and ICAPM) and the market concentration measure, where largernumbers refer to less stock market development, we multiply the indicator num-bers by negative 1 before computing the means-removed values. Second, wetake a simple average of the means-removed market capitalization, total valuetraded, and turnover ratios to obtain an overall index of stock market devel-opment, INDEXl.4 INDEXl is calculated for forty-one countries (see table 2).INDEX2 is constructed in the same way. It aggregates information on the three

4. We computed principal components indexes of the indicators, which allow the data to choose theweights rather than talcing a simple average. However, we do not report these indexes because the rankingsthey produce are very highly correlated with the indexes we report.


Table 2. Aggregate Indexes of Stock Market Development, 1986-93INDEXl' INDEX2b INDEX3C INDEX4*

Economy

ArgentinaAustraliaAustriaBelgiumBrazilCanadaChileColombiaDenmarkFinlandFranceGermanyGreeceHong KongIndiaIndonesiaIsraelItalyJapanJordanKorea, Rep. ofMalaysiaMexicoNetherlandsNew ZealandNigeriaNorwayPakistanPhilippinesPortugalSingaporeSouth AfricaSpainSwedenSwitzerlandThailandTurkeyUnited KingdomUnited StatesVenezuelaZimbabwe

AverageNumber ofeconomies

Rank

3213192824142740263021

336

223351529

11668

1812254120393133

7102217

91134

45

3738

41

Value

-0.590.19

-0.15-0.47-0.29

0.09-0.46-0.88-0.37-0.53-0.21

1.38-0.732.01

-0.26-0.71

0.08-0.512.02

-0.081.050.90

-0.140.32

-0.33-0.96-0.18-0.82-0.54-0.61

1.040.48

-0.25-0.100.750.38

-0.611.231.21

-0.74-0.81

0.02

Rank

157

11

1223

18

917

1845

10

20

161413

61932

2221

23

Value

-0.470.12

-0.38

-0.40-0.71

-0.61

-0.13-0.52

1.630.040.840.72

-0.16

-0.67

-0.51-0.43-0.42

0.36-0.61

1.011.01

-0.68-0.67

-0.07

Rank

237

12

1122

17

914

1845

10

21

161315

61932

1820

23

Value

-0.870.15

-0.37

-0.34-0.68

-O.60

-0.11-0.48

1.630.070.850.79

-0.17

-0.67

-0.49-0.42-0.49

0.36-0.62

1.021.03

-0.61-0.66

-0.07

Rank

15

10

1321

16

7

18459

19

111412

61732

2018

21

Value

-0.50

-0.23

-0.37-0.73

-0.52

-0.01

1.41-0.06

0.730.60

-0.11

-0.59

-0.33-0.40-0.34

0.31-0.54

0.890.94

-0.66-0.56

-0.05

Note: Details of the calculation of the indexes are discussed in the text. Definitions of the indicatorsare given in table 1. The ranking order, by index, is from high to low. The indexes represent averagesduring the period from 1986 to 1993.

a. rNDExl is the average of market capitalization, total value traded/GDP, and turnover.b. INDEX2 adds APT pricing error to INDEXl.c INDEX3 adds ICAPM pricing error to INDEXl.d. INDEX4 adds market concentration to INDEX2.Source: Authors' calculations.

Demirgiif-Kunt and Levine 3 03

indicators used in iNDEXl and APT pricing error to obtain an overall indicator ofstock market development that incorporates international integration. INDEX2

includes only the twenty-three countries with APT estimates. INDEX3 combinesINDEX 1 with the ICAPM pricing error. INDEX3 includes only the twenty-three coun-tries with ICAPM pricing-error estimates. INDEX4 averages the means-removedvalues of market capitalization, total value traded/GDP, turnover, APT pricingerror, and market concentration. We compute this index only for the twenty-one countries with data on all five underlying indicators.

Rankings of Stock Market Development

Table 2 gives the country-by-country values and rankings for the four aggre-gate indexes. Although there are variations in country rankings, the indexes arevery highly correlated, with correlation coefficients of 0.96. Thus, the variousconglomerate indexes give very similar country rankings. Here we briefly sum-marize the results from table 2.

Consider first INDEX4, which aggregates the largest number of individual stockmarket development indicators but has the fewest countries. The INDEX4 vari-able says that Japan, the United States, the United Kingdom, and Korea have themost developed stock markets when aggregating information on market size,liquidity, international integration, and market concentration. Colombia, Ven-ezuela, Nigeria, and Zimbabwe have the four lowest rankings in this twenty-one-country sample.

Next, consider INDEXl, which aggregates the least information but includesthe most economies (forty-one) with data on all the underlying indicators. INDEXlranks Japan, Hong Kong, Germany, the United Kingdom, the United States,Korea, Singapore, and Malaysia as having very highly developed stock marketswhen aggregating information on market size and liquidity. INDEXl implies thatNigeria, Colombia, Pakistan, and Zimbabwe have the least developed stockmarkets. As noted above, Germany's high ranking is strongly influenced by thetumultuous years surrounding reunification when there was an explosion of eq-uity transactions. If Germany's two years of exceptionally high trading are re-moved in computing its averages during the period from 1986 to 1993, Ger-many falls from the top ten.

Although it is difficult to answer unambiguously the question of which stockmarkets are most developed, our evaluation of the indexes presented in table 2suggests that the three most developed markets are in Japan, the United States,and the United Kingdom. The most underdeveloped markets are in Colombia,Venezuela, Nigeria, and Zimbabwe. Furthermore, the data suggest that HongKong, Singapore, Korea, Switzerland, and Malaysia have highly developed stockmarkets, and Turkey, Greece, Argentina, and Pakistan have underdevelopedmarkets.

Note that there is a close correspondence between income per capita and stockmarket development. Poorer countries have lower stock market development thanricher countries on average. Also note that there are important exceptions. Fre-

304 THE WORLD BANK ECONOMIC REVIEW, VOL 10, NO. 2

quently, many markets termed emerging—such as Korea, Malaysia, and Thailand—are uniformly ranked higher than markets termed developed—such as France, theNetherlands, Australia, Canada, Sweden, and many other European countries.

III. WHICH STOCK MARKETS ARE DEVELOPING MOST RAPIDLY?

Which stock markets are developing most rapidly? To answer this question,we rank countries according to the growth rates of the individual indicators ofstock market development.

Growth Rates of Individual Indicators of Stock Market Development

Table 3 presents the average annual growth rates of the individual indicatorsof stock market development from 1986 to 1993. Here we highlight three points.First, in terms of market size, Indonesia and Turkey boomed over this period,growing at average annual rates of more than 100 percent a year. As a bench-mark, market capitalization in the United States grew at 4 percent annually. Atthe other extreme, Finland, Japan, Germany, Sweden, New Zealand, and Italysaw their market capitalization ratios shrink from 1986 to 1993. Using anothermeasure of market size, Indonesia, Turkey, Portugal, and Thailand saw the num-ber of listed companies grow at an annual rate of over 18 percent.

Second, as measured by total value traded/GDP, Indonesia, Portugal, Turkey,Venezuela, and Greece experienced rapid liquidity growth (more than 200 per-cent), while Japan and Italy weathered rapid declines (-12 and -14 percent,respectively). As with total value traded/GDP, the turnover measure of liquidityidentifies Indonesia as the fastest-growing market in terms of liquidity.

Third, some cross-country quandaries emerge from studying stock marketgrowth. Consider, for example, the cases of Mexico and Portugal. Both coun-tries liberalized their capital markets and privatized public enterprises, and bothcountries experienced very rapid improvements in international integration (asmeasured by the APT pricing error). In terms of market volatility, Mexico sawrapid declines in return volatility as it liberalized its economy and privatizedstate enterprises. In contrast, stock return volatility in Portugal exploded as itliberalized its capital markets and privatized its public enterprises. Another note-worthy difference between the two countries is that while market concentrationgrew dramatically in Mexico, it shrunk steadily in Portugal.

Growth Rates of Aggregate Indexes of Stock Market Development

Using individual stock market development indicators, we found it diffi-cult to assess which markets experienced the most rapid overall develop-ment. Thus, we now evaluate the growth rate of overall indexes of stockmarket development. In section II, the goal was to compare the level of stockmarket development across countries. Here, however, we seek to measurethe growth rate of each country's level of overall stock market development.Consequently, we now use the growth rate of each country's stock market


indicator. We average these growth rates to compute an overall index ofstock market development.

We construct iNDEXGl, which aggregates information on market capitaliza-tion, total value traded/GDP, and turnover, by computing the average annualgrowth rate for each indicator for each country. We then take a simple averageof the growth rates to obtain an overall index of stock market development foreach country. This index allows us to examine the growth rate of each country'soverall level of stock market development.

INDEXG2 combines the growth rates of market capitalization, total value traded/GDP, turnover, and the APT pricing-error measure. INDEXG2 includes only coun-tries with APT pricing-error estimates. INDEXG3 is similar to INDEXG2, exceptthat INDEXG3 uses the ICAPM pricing-error estimates instead of the APT pricing-error estimates. Finally, INDEXG4 averages the annual growth rates of marketcapitalization, total value traded/GDP, turnover, APT pricing error, and marketconcentration. We compute this index only for the twenty-five countries withdata on all five underlying indicators for the period from 1986 to 1993.

Table 4 reports the aggregate indexes of overall stock market growth. Themain findings are straightforward. Regardless of the index, Indonesia, Turkey,Portugal, and Venezuela experienced the most rapid overall stock market devel-opment over the eight years. Although these countries began the period withunderdeveloped markets, other countries with similarly underdeveloped stockmarkets—such as Colombia, Pakistan, and Zimbabwe—did not enjoy the ex-plosive development experienced by Indonesia, Turkey, Portugal, and Venezuela.

We investigated whether stock markets that were initially underdevelopedgrew faster. There is some evidence in support of convergence. Markets thatwere initially small and illiquid grew faster and became more liquid. Marketsthat initially were volatile and priced risk poorly tended to grow larger but notnecessarily more liquid.

IV. Is STOCK MARKET DEVELOPMENT LINKED TO THE

REST OF THE FINANCIAL SYSTEM?

Do countries with well-developed stock markets have well-developed banksand nonbank financial intermediaries? To address this question, we discuss fourtypes of measures of financial intermediary development: financial system, banks,nonbank financial corporations, and insurance and pension companies. We lookat correlations among the indicators. We then construct aggregate indexes offinancial intermediary development, which we use to examine the correlationbetween stock market development and financial intermediary development.

Indicators of Financial Intermediary Development

Here we discuss the size of the financial system, the size and efficiency of thebanking system, the size of nonbank financial corporations, and the size of pri-vate insurance and private pension funds.

Table 3. Growth Rates of Indicators of Stock Market Development, 1986-93

Economy

ArgentinaAustraliaAustriaBelgiumBrazilCanadaChileColombiaDenmarkFinlandFranceGermanyGreeceHong KongIndiaIndonesiaIrelandIsraelItalyJapanJordanKorea, Rep. ofLuxembourgMalaysia

Marketcapit

Rank

33112331635191124362338

92615

1

741372017

14

alization

Value

0.870.020.370.000.300.000.270.420.06

-0.020.07

-0.030.510.060.321.89

0.53-0.10-0.03

0.120.28

0.34

Total valuetraded/GDP

Rani

834

6372138231514283224

52229

1

1641401218

7

i Value

1.180.081.480.010.340.010.270.540.550.190.090.262.500.310.16

17.74

0.50-0.14-0.12

0.580.43

1.31

Numberof listed

companies

Rani

413213383730253534231626179

291

5192733

86

10

z Value

-0.030.000.06

-0.02-0.01

0.010.03

-0.01-0.01

0.030.050.020.050.090.020.37

0.150.050.020.000.090.120.09

Turnover

Rank

2129

53

4232433713183015111740

1

7223919362

12

Value

0.170.060.911.54

-0.110.05

-0.11-0.03

0.380.240.060.300.430.25

-0.081.82

0.540.16

-0.070.24

-0.011.660.40

Volatility

Rani

315

268

24221635

2733

229

32

2125

628

718

3

i Value

0.09-0.02

0.04-0.02

0.040.030.010.15

0.050.10

-0.050.08

0.09

0.030.04

•-0.020.06

-0.020.01

-0.05

Marketconcentration

Rank

22

21251518

198

10

12

25

24

3

Value

0.08

0.070.090.020.05

0.06-0.02

0.00

0.00

-0.09-0.05

0.09

-0.08

Institutionaldevelopment

Rank

6

14

1610

2

1720

1215

19

Value

0.09

0.04

0.030.05

0.22

0.02-0.06

0.040.03

0.01

APTpricing error

Rani

188

5

1117

23

419

32412

14

z Value

0.14-0.01

-0.03

0.000.09

0.19

-0.060.14

-0.100.260.03

0.04

ICAPMpricing error

Rani

2410

13

1423

18

81

320

9

5

i Value

0.430.01

0.05

0.060.27

0.13

0.00-0.26

-0.070.160.01

-0.02

MexicoNetherlandsNew ZealandNigeriaNorwayPakistanPhilippinesPortugalSingaporeSouth AfricaSpainSwedenSwitzerlandTaiwan (China)ThailandTurkey

^ United Kingdom5 United States

VenezuelaZimbabwe

AverageNumber of

economies

10324021251858

2928343922

62

3027

413

41

0.490.01

-0.050.100.060.270.610.510.040.040.00

-0.050.07

0.571.020.030.040.660.35

0.27

113126251019132

2030333935

93

2736

417

41

0.620.130.200.230.670.400.573.250.340.130.09

-0.020.05

0.762.870.200.042.770.45

1.02

222143123911183

1520244214742

40363128

43

0.040.04

-0.110.08

-0.030.08

o.os0.200.060.040.03

-0.050.060.120.180.23

-0.03-0.01

0.010.02

0.05

344

2435

941381410272526162031

62333

828

43

0.011.390.10

-0.010.45

-0.09-0.06

0.350.430.080.100.090.290.170.050.650.100.020.480.06

0.31

1

124

23111737

203019101534149

3613

37

-0.06-0.01-0.03

0.03-0.01

0.010.85

0.030.080.02

-0.020.010.130.00

-0.020.270.00

0.05

26

9

2320

7

1761

13141611

4

26

0.23

0.00

0.080.07

-0.03

0.02-0.03-0.12

0.010.020.020.00

-0.07

0.02

13

4

79

18

811

1

35

20

0.04

0.11

0.090.060.02

0.090.040.29

0.170.11

0.07

1

9

21132

162220

76

1510

24

-0.15

-0.01

0.160.04

-0.14

0.050.170.14

-0.02-0.02

0.04-0.01

0.04

4

15

2262

1716197

112112

24

-0.07

0.06

0.250.00

-0.26

0.120.090.140.000.010.240.04

0.06

Note: Growth rates are the average annual growth rates. Definitions of the indicators are given in table 1. For each indicator, economies are ranked by the rate of growthof stock market development, from high to low. Thus, for market capitalization, total value tradedVGDP, number of listed companies, turnover, and institutional development,the ranking by value of the indicator is from high to low. For volatility, market concentration, AFT pricing error, and ICAPM pricing error, the ranking by value of the indicatoris from low to high.

Source: Authors' calculations.


Table 4. Growth Rates of Aggregate Indexes of Stock Market Development,198&-93

Economy

ArgentinaAustraliaAustriaBelgiumBrazilCanadaChileColombiaDenmarkFinlandFranceGermanyGreeceHong KongIndiaIndonesiaIsraelItalyJapanJordanKorea, Rep. ofMalaysiaMexicoNetherlandsNew ZealandNigeriaNorwayPakistanPhilippinesPortugalSingaporeSouth AfricaSpainSwedenSwitzerlandThailandTurkeyUnited KingdomUnited StatesVenezuelaZimbabwe

AverageNumber of

economies

INDEXC1

Rank

736

6102438261816283425

52229

19

40411721

814113331132315

3203235392712

23037

419

41

Value

0.740.050.920.520.180.020.140.310.330.140.070.171.150.200.147.150.52

-0.03-0.07

0.310.230.680.370.510.090.110.390.200.371.370.270.090.060.010.140.461.510.110.031.300.29

0.53

1NDEXG2

Rank

621

15

1812

5

161

231314

78

20

17103

92

1922

411

23

Value

0.520.04

0.14

0.110.21

0.81

0.125.33

-0.030.170.170.500.32

0.08

0.110.271.06

0.301.100.090.030.970.22

0.55

INDEXG3

Rank

721

15

1714

5

161

231213

69

20

18103

82

1922

411

23

Value

0.450.04

0.12

0.090.17

0.83

0.105.43

-0.040.190.170.520.30

0.06

0.080.281.09

0.321.100.080.020.920.21

0.54

INDEXG4

Rank

5

16241712

2214

4

18

259

136

11

20

1582

1971

2123

310

25

Value

0.54

0.12-0.01

0.100.22

0.040.140.86

0.10

-0.030.250.150.530.22

0.08

0.130.261.04

0.100.371.130.080.020.980.23

0.31

Note: Growth rates of indexes are obtained by averaging the growth rates of different stock marketindicators, depending on the index. Indexes are defined in table 2. The ranking, by growth rate of eachindex, is from high to low.

Source: Authors* calculations.


FINANCIAL SYSTEM. On the basis of work by King and Levine (1993), we usethree measures of financial system development. The ratio of liquid liabilities ofthe financial intermediaries to GDP is M3 money supply divided by GDP. Theratio is a measure of the overall size of the formal financial system. If the size ofthe financial system is positively related to the provision of financial services,then this ratio should be a good indicator of the provision of financial intermediaryservices.

The ratio of quasi-liquid liabilities to GDP is M3 money supply minus M l ,divided by GDP. It subtracts narrow money from the liquid liabilities measure offinancial intermediary size. Analysts sometimes use the quasi-liquid measureinstead of liquid liabilities because Ml/GDP represents highly liquid bank depos-its and therefore may not be as closely associated with efficient financial inter-mediation as longer-term investments in financial intermediaries. The quasi-liquid measure focuses on longer-term liabilities.

Liquid and quasi-liquid liabilities that finance government deficits may notreflect the provision of efficient financial intermediary services (such as acquir-ing information about firms, monitoring managers, and facilitating transactionsand risk diversification). Therefore, we compute a third variable, domestic creditto private firms divided by GDP. Unfortunately, although IMF (various issues)classifies credit as "claims on the private sector," some of these claims in somecountries include credit to public enterprises.

Table 5 indicates that Hong Kong, Japan, and Switzerland had well-devel-oped financial systems as measured by liquid and quasi-liquid liabilities to GDPand domestic credit to private firms. In contrast, Argentina, Brazil, Mexico,Colombia, and Nigeria had underdeveloped financial systems as revealed bythese three indicators.

BANKS. TO measure the level of development of the banking system, we usethe ratio of the total claims of deposit money banks to GDP. The three countrieswith the largest values for this indicator were Switzerland, Luxembourg, andJapan. At the other extreme, Nigeria, Argentina, and Venezuela had the lowestratio of bank credit to GDP during the period from 1986 to 1993.

We compute a measure of banking efficiency, which we call spread, that equalsthe difference between bank lending and borrowing rates. This measure maynot accurately capture banking efficiency because the interest rate data may notaccurately reflect borrowing and lending costs. The spread indicator will notprovide accurate information on how well banks monitor firm managers, norwill it capture government intervention in the banking system in a very informa-tive way. But the spread indicator is widely used and available across countries.We include it for completeness. For better measures of financial repression for afew select countries see Giovannini and De Melo (1993). According to the spreadindicator, the banking systems of Switzerland, Canada, and the United King-dom were among the most efficient, whereas Argentina, Israel, and Turkey hadthe least efficient banks.

Table 5. Indicators of Financial Intermediary Development, 1986-93(annual average)

Economy

ArgentinaAustraliaAustriaBelgiumBrazilCanada

S- Chile0 Colombia

DenmarkFinlandFranceGermanyGreeceHong KongIndiaIndonesiaIrelandIsraelItalyJapanJordanKorea, Rep. ofLuxembourgMalaysia

Liquid liabilitiesto*

Rank

4424

931432136412325161712

1333732201324

2968

GDP'Value

0.231.131.720.940.261.270.720.471.191.101.361.341.543.910.870.650.881.301.473.572.400.962.361.89

Quasi-liquidliabilitiesto GDP*

Rank41

197

334214 '28382721201591

3135261023

28

22

5

Value

0.150.891.440.550.140.970.610.280.620.820.870.941.213.530.570.440.641.190.753.001.410.78

1.51

Domestic creditto private sector

to GDPRank

391611293824224021

865

33

3228311727

21519

12

Value

0.261.071.360.610.290.860.930.250.981.601.771.800.45

0.510.660.521.010.712.271.240.99

1.33

Total claimsof deposit

banks

Rank

41224

20362829

211485

27

333430

724

31625

213

to GDPValue

0.371.192.391.200.510.930.90

1.201.602.002.160.95

0.680.650.872.071.012.581.521.002.591.61

Spread0

Rank

3828

26

230332312342231

8162137321124645

Value

45.286.28

5.70

1.386.969.705.353.55

10.575.157.19

3.004.235.10

20.957.343.315.562.902.312.68

Assets of privatenonbank financial

corporations toGDP

Rank

5

6

21151210

22

9

173

8

Value

0.45

0.42

0.060.120.210.28

0.02

0.33

0.080.55

0.39

Assets of privateinsurance andpension funds

to

Rank

8

6

1859

1110

177

1612

14

GDPValue

035

0.48

0.030.540.330.200.33

0.060.430.070.14

0.10

Mexico 42 0.42 37 0.29 37 0.29 38 0.48 35 13.76 18 0.08 19 0.02NetherlandsNew ZealandNigeriaNorwayPakistanPhilippinesPortugalSingaporeSouth AfricaSpainSwedenSwitzerlandTaiwan (China)ThailandTurkeyUnited KingdomUnited StatesVenezuelaZimbabwe

AverageNumber of

economies

Note: The financial

102740223538147

261530

35

193911183428

44

1.611.030.481.260.790.631.472.261.061.440.962.832.381.310.611.591.330.800.96

1.33

112940303934164

2418

36

123617133225

42

1.160.610.230.610.250.480.931.800.720.90

2.261.491.120.410.920.990.550.70

0.95

9234214303625

7261320

14

1835

3103441

42

1.530.920.241.270.550.340.841.640.741.310.983.141.800.990.361.971.420.400.24

1.01

9234215323717123111

1816

193510264039

42

1.971.100.331.570.700.481.491.870.781.891.413.262.101.230.541.970.990.450.45

1.31

29171915

2027

9101825

1

1336

37

14

38

6.924.494.604.21

5.045.963.023.204.595.680.87

3.6019.50

1.823.00

3.90

6.81

25

19

2320

2

111

13241647

14

25

0.00

0.08

0.010.07

0.84

0.240.89

0.150.010.080.530.400.13

0.26

1

2220

13

154

21

23

22

1.08

0.000.01

0.11

0.080.56

0.01

0.920.67

0.30

intermediary development of each economy is ranked from high to low. This ranking is shown by ranking the value of the indicator from high

nonbanks to GDP, and assets of private insurance and pension funds to GDP; for spread, the ranking by value of the indicator is from low to high.a. Liquid liabilities of the financial system are the M3 definition of money.b. Quasi-liquid liabilities are M3 minus Ml money.c. The spread is the difference between bank lending and borrowing rates.Source: Authors' calculations.

312 THE WORLD BANK ECONOMIC REVIEW, VOL- 10, NO. 2

NONBANK FINANCIAL CORPORATIONS. We use the ratio of assets of privatenonbank financial intermediaries to GDP to measure the size of nonbank financialcorporations, such as finance companies, mutual funds, and brokerage houses.The four economies with the largest values for this indicator were Sweden,Singapore, Korea, and the United States. Indonesia, Pakistan, Turkey, and theNetherlands had very low values.5

INSURANCE AND PENSION COMPANIES. Finally, we use the ratio of assets of privateinsurance companies and pension funds to GDP to measure the size of privateinsurance and pension companies. The three countries with the largest valuesfor this indicator were the Netherlands, the United Kingdom, and the UnitedStates. The Philippines, Thailand, and Pakistan had very low values.

Correlations between Various Indicators ofFinancial Intermediary Development

The measures of financial system size—the liquid, quasi-liquid, and domesticcredit to private firms indicators—are very highly correlated. The correlationcoefficients are 0.79 or higher and significant at the 0.01 level. The correlationsbetween the indicators of the size of the financial system and indicators of thesize of banks, private nonbank financial corporations, and private insuranceand pension companies are not as strong. Although all of the correlations arepositive, many are not significant. Furthermore, the correlation coefficient ofthose that are significant is frequently below 0.50.

The different financial intermediary indicators give different country rankingsof financial intermediary development. These differences reflect financial struc-tures across countries, that is, different combinations of financial intermediar-ies and financial markets that compose a country's financial system. Differencesin financial structure may reflect legal differences. For example, countries withuniversal banking, as distinct from the more segregated legal and regulatoryimpediments of the United States, may develop different combinations of finan-cial intermediaries. The overall size of the financial system across countries withdifferent financial structures, however, may be similar, as may be the provisionof financial services to investors. For example, countries with big financial sys-tems have big banks and nonbank financial corporations, but the correlationbetween financial system size and private insurance and pension companies isnot strong.

Aggregate Indexes of Financial Intermediary Development

Because we want to compare an overall measure of financial intermediarydevelopment with our aggregate indicators of stock market development, weconstruct conglomerate indexes of financial intermediary development. Using

5. We collected data on private nonbank financial corporations, insurance companies, and pensionfunds from individual country reports, including documents published by ministries of finance, centralbanks, and regulatory agencies.


the same procedure for constructing conglomerate indexes discussed above, thissection constructs three financial intermediary indexes. FINDEXl averages themeans-removed values of the ratio of liquid liabilities to GDP and the ratio ofdomestic credit to the private sector to GDP. FINDEX2 averages the means-removed values of the ratio of liquid liabilities to GDP, the ratio of domesticcredit to the private sector to GDP, the ratio of assets of private nonbank finan-cial corporations to GDP, and the ratio of assets of private insurance and pensionfunds to GDP. FINDEX3 combines the means-removed values of the ratio of totalclaims of deposit banks to GDP, the ratio of assets of private nonbank financialcorporations to GDP, and the ratio of assets of private insurance and pensionfunds to GDP. Table 6 provides the country rankings and the values of theseindexes from 1986 to 1993. The aggregate indexes of financial intermediarydevelopment are highly correlated, with correlation coefficients above 0.73 andP-values less than 0.01.

The results in table 6 on FINDEX3—which aggregates information on banks,private nonbank financial corporations, and private insurance companies andpension funds—suggest that the top five economies with the most developedfinancial intermediaries were Switzerland, Sweden, Luxembourg, Australia, andSingapore. The five countries with the least developed financial intermediarieswere Colombia, Pakistan, the Philippines, Turkey, and Mexico. We prefer FINDEX3to the other financial intermediary indexes because it combines information onparticular financial intermediaries: banks, nonbank financial corporations, andinsurance companies and pension funds. The other aggregate indexes mix infor-mation on particular intermediaries with information on liabilities that spanacross different types of intermediaries.

Stock Market Development and Financial Intermediary Development

Do countries with well-developed stock markets have well-developed banksand nonbank financial intermediaries? Table 7 presents the correlations betweenindividual indicators of stock market development and individual indicators offinancial intermediary development. Here we highlight three points.

First, stock market size (market capitalization) and liquidity (as measured bytotal value traded/GDP) are positively correlated with all of the indicators offinancial intermediary development. They are significantly correlated with all ofthe indicators of financial intermediary development except the ratio of the as-sets of private insurance and pension companies to GDP. Second, volatility issignificantly negatively correlated with all the indicators of financial intermedi-ary development except the ratio of assets of private nonbank financial corpora-tions to GDP. Thus, countries with well-developed financial intermediaries, largebanks, and large private insurance companies and pension funds tend to haveless volatile stock markets. Third, APT and ICAPM pricing errors are negativelycorrelated with indicators of financial intermediary development. Countries withstock markets that are internationally integrated tend to have larger financialsystems and banks than countries with less internationally integrated markets.


Table 6. Aggregate Indexes of Financial Intermediaries, 1986-93FINDEX1' FlNDEX2b FINDEX3'

Economy

ArgentinaAustraliaAustriaBelgiumBrazilCanadaChileColombiaDenmarkFinlandFranceGermanyGreeceIndiaIndonesiaIrelandIsraelItalyJapanJordanKorea, Rep. ofLuxembourgMalaysiaMexicoNetherlandsNew ZealandNigeriaNorwayPakistanPhilippinesPortugalSingaporeSouth AfricaSpainSwedenSwitzerlandTaiwan (China)ThailandTurkeyUnited KingdomUnited StatesVenezuelaZimbabwe

AverageNumber of economies

Rank

42112029411728402113

89

263032311922

26

24

1039

72338153337184

271425

13

1636

5123534

42

Value

-0.790.23

-0.12-0.35-0.75-0.06-0.29-0.72-0.120.120.310.30

-0.23-0.44-0.46-0.45-0.07-0.13

1.310.42

-0.21

0.29-0.710.34

-0.20-0.71

0.03-0.46-0.61-0.06

0.56-0.230.11

-0.211.450.64

-0.02-0.59

0.450.14

-0.52-0.52

-0.08

Rank

7

6

201210

9

15

1411

8194

1718

1

132

16

53

20

Value

0.23

0.27

-0.78-0.020.030.09

-0.17

-0.160.02

0.10-0.77

0.53

-0.72-0.73

0.70

-0.150.67

-0.36

0.530.59

-0.00

Rank

374

12233413284319201814273336291026

731173

2139

62538154241165

3024

21

113240

98

2235

43

Value

-0.720.750.34

-0.06-0.58

0.32-0.32-0.82

0.010.010.060.31

-0.30-0.48-0.72-0.36

0.54-0.23

0.62-0.45

0.080.940.00

-0.770.65

-0.19-0.72

0.16-0.81-0.780.110.68

-0.39-0.14

1.041.390.51

-0.48-0.78

0.550.60

-0.06-0.59

-0.02

Note: Details of the calculation of the indexes are discussed in the text. The ranking order, by growthrate of each index, is from high to low.

a. FINDEXl is the average of the ratio of liquid liabilities (M3 money) to GDP and the ratio of domesticcredit to the private sector to GDP.

b. FINDEX2 is the average of the ratio of liquid liabilities (M3 money) to GDP, the ratio of domesticcredit to the private sector to GDP, the ratio of the assets of private nonbank institutions to GDP, and theratio of assets of private insurance and pension funds to GDP.

c. F1NDEX3 is the average of the ratio of total claims of deposit banks to GDP, the ratio of the assets ofprivate nonbank institutions to CDP, and the ratio of the assets of private insurance and pension funds toGDP. FINDEX3 does not include the last two terms if data are not available.


Demirguc-Kunt and Levine 315

Table 7. Correlations between Indicators of Financial Intermediary and StockMarket Development, 1986-93

Stock market indicator

Market capitalizationCorrelation

Number of observations

Total value traded/GDPCorrelation


TurnoverCorrelation


APT pricing errorCorrelation


ICAPM pricing errorCorrelation


VolatilityCorrelation


Market concentrationCorrelation


Liquidliabilitiesto GDP1

0.66[0.00]

41

0.75[0.00]

41

0.18[0.25]

41

-0.49[0.01]

24

-0.51[0.01]

24

-0.41[0.01]

37

-0.24[0.24]

26

Institutional developmentCorrelation -0.05

[0.84]Number of observations 20

Financial intermediary indicatorTotal

claims ofdepositbanks to

GDP

0.40[0.01]

40

0.58[0.00]

40

0.42[0.01]

40

-0.48[0.02]

24

-0.47[0.02]

24

-0.42[0.01]

37

-0.28[0.16]

26

0.21[0.37]

20

Domesticcredit toprivatesector

to GDP

0.52[0.00]

40

0.70[0.00]

40

0.38[0.01]

40

-0.54[0.01]

24

-0.55[0.01]

24

-0.40[0.01]

37

-0.32[0.11]

26

0.26[0.27]

20

Quasi-liquid

liabilitiesto GDPh

0.67[0.00]

40

0.78[0.00]

40

0.22[0.16]

40

-0.45[0.03|

24

-0.46[0.02]

24

-0.37[0.03]

36

-0.24[0.23]

26

0.04[0.86]

20

Assetsof privatenonbanksto GDP

0.47[0.02]

25

0.46[0.02]

25

0.27[0.20]

25

-0.06[0.84]

16

-0.23[0.39]

16

-0.12[0.60]

21

-0.42[0.11]

16

0.42[0.15]

13

Note: P-values are in brackets. Indicators of stock market development are defined

Assets ofprivate

insuranceand pension

funds to GDP

0.29[0.20]

22

0.33[0.14]

22

0.11[0.61]

22

-0.40[0.20]

12

-0.38[0.22]

12

-0.52[0.02]

20

-0.56[0.04]

14

0.51[0.20]

8

in table 1.a. Liquid liabilities are the M3 definition of money.b. Quasi-liquid liabilities are M3 minus Ml money.Source: Authors' calculations.

INDEX1

0.72[0.00]

40

0.67[0.00]

20

0.62[0.00]

40

Stock1NDEX2

0.83[0.00]

23

0.89[0.001

11

0.79[0.00]

23

market index1NDEX3

0.84[0.00]

23

0.89[0.00]

11

0.79[0.00]

23

1NDEX4

0.81[0.00]

21

0.92[0.00]

10

0.80[0.00]

21


Table 8. Correlations between Aggregate Indexes of Financial Intermediaryand Stock Market Development, 1986-93

Financial intermediary index

F1NDEX1Correlation


FINDEX2Correlation


FINDEX3Correlation


Note: P-values are in brackets. The stock market indexes are defined in table 2, and the financialintermediary indexes are defined in table 6. Details of the calculation of the indexes are discussed in thetext.


Using the conglomerate indexes of stock market development and the con-glomerate indexes of financial intermediary development, the strong positivecorrelation between stock market development and financial intermediary de-velopment emerges even more strongly. As shown in table 8, the aggregate in-dexes of stock market development are all significantly correlated with the ag-gregate indexes of financial intermediary development at the 0.01 level.

Furthermore, measures of stock market pricing errors, as represented by APTand ICAPM, are positively correlated with banking inefficiency as measured bythe interest rate spread (table 9). Stock market development (including mea-sures of pricing errors) and financial intermediary development (including mea-sures of banking efficiency) go hand in hand. These results are consistent withBoyd and Smith's (1996) model, where there is a role for both banking andequity markets as economies develop. Thus, with increases in per capita incomeand wealth, stock markets emerge and complement (but not replace) bank lend-ing. As economies develop, their financial systems display a wide array of insti-tutions and markets.

V. SUMMARY

This article collected and summarized information on a wide assortment ofindicators of stock market and financial intermediary development. To describedifferent characteristics of equity market development, we used measures ofstock market size, liquidity, integration with world capital markets, volatility,


Table 9. Correlations between Stock Market Pricing Errors and FinancialIntermediary Inefficiency, 1986-93

APT ICAPMIndicator Spread' pricing error pricing error

SpreadCorrelation 1.00 0.20 0.81

[0.00] [0.39] [0.00]Number of observations 39 21 21

APT pricing errorCorrelation 1.00 0.68

[0.00] [0.00]Number of observations 24 24

ICAPM pricing errorCorrelation 1.00

[0.00]Number of observations 24

Note: P-values are in brackets.a. The spread is the difference between bank lending and borrowing rates.Source: Authors' calculations.

concentration, and features of the regulatory system. To describe the develop-ment and structure of financial intermediaries, we used measures of the overallsize of the financial intermediary sector, the allocation of credit, the spread be-tween borrowing and lending interest rates, and the size of particular types offinancial intermediaries, such as banks, insurance companies, and pension funds.No single measure is the correct measure of stock market or financial interme-diary development. Indeed, each indicator may be the appropriate measure for aparticular question. Consequently, this article's major contribution is the collec-tion and comparison of a wide variety of indicators. The article constructs ag-gregate indexes of stock market and financial intermediary development thatcombine the information reflected in several individual indicators.

There are enormous cross-country differences for each indicator of stockmarket development. For example, the ratio of market capitalization to GDP isgreater than 1 in five countries and less than 0.10 in five countries. Even so,there are intuitively appealing correlations among the individual stock marketindicators and between the stock market indicators and measures of financialintermediary development. Big markets, for example, tend to be less volatile,more liquid, and less concentrated in a few stocks; internationally integratedmarkets tend to be less volatile; and institutionally developed markets tend to belarge and liquid. Moreover, we find that across countries the level of stock mar-ket development is highly correlated with the development of banks, nonbankfinancial corporations, and insurance companies and private pension funds.

When we compute conglomerate indexes of overall stock market develop-ment, plausible and educational patterns emerge. We find that the three most


developed markets are Japan, the United States, and the United Kingdom. Themost underdeveloped markets are Colombia, Venezuela, Nigeria, and Zimbabwe.The data suggest that Korea, Switzerland, and Malaysia have highly developedstock markets, while Turkey, Greece, Argentina, and Pakistan have underdevel-oped markets. Furthermore, although richer countries generally have more de-veloped stock markets than poorer countries, many markets labeled emerging—such as Korea, Malaysia, and Thailand—are systematically more developed thanmarkets labeled developed—such as France, the Netherlands, Australia, Canada,Sweden, and Norway.

During the period from 1986 to 1993, some markets exhibit very rapid devel-opment in terms of size, liquidity, and international integration. Indonesia, Tur-key, Portugal, and Venezuela have experienced explosive development. Futurecase studies into the underlying causes of and the economic consequences of thisrapid development could yield valuable insights.

In this article, the goal has not been to test specific hypotheses rigorously.Rather, our objectives have been to compile and compare different indicators ofstock market development, highlight some important correlations, and, mostimportant, stimulate future research into the links between stock market devel-opment and economic development.

APPENDIX. THE CROSS-COUNTRY COMPARABILITY OF STOCK MARKET DATA

The IFC began calculating emerging market indexes in 1981. IFC selects stocksfor inclusion in the indexes on the basis of three criteria: size, liquidity, andindustry. The indexes include the largest and most actively traded stocks in eachmarket, targeting 60 percent of total market capitalization at the end of eachyear. The index targets 60 percent of trading volume during the year. Size ismeasured by market capitalization, and liquidity is measured by the total valueof shares traded during the year. Selection criteria used by Morgan Stanley CapitalInternational (MSCI) in creating industrial country stock indexes are comparableto those of the IFC. In constructing the MSCI indexes, 60 percent coverage of thetotal market capitalization of each market is the primary objective. In contrastto the IFC indexes, MSCI indexes have no secondary objective regarding volumeof trading. Instead, they try to replicate the industrial composition of the localmarket and take a representative sample of large, medium, and small capitaliza-tion stocks. MSCI uses liquidity as a consideration in choosing among the me-dium and small capitalization stocks.

The IFC indexes represent value-weighted portfolios of the stocks in eachmarket. Each stock is weighted by its market capitalization in the same way inwhich the MSCI country indexes are formed, using the chained Paasche method.

Most of the stock market indicators compiled in this study are constructedusing complete market information, and are fully comparable. For example, themarket capitalization ratio is the value of all listed shares in the stock exchangedivided by GDP in all countries. This is true for all our indicators except the


volatility and asset pricing indicators, which use index information or individualstock prices for those indicators included in the indexes. For volatility and assetpricing, differences in constructing MSCI and IFC indexes may introduce a bias.However, as discussed above, the magnitude of this bias is likely to be small,and MSCI and IFC indexes have been used in cross-country empirical studies inthe literature (see for example Bekaert and Harvey 1995 and De Santis 1993).6

6. This appendix is mostly based on IFC (1993) and Schmidt (1990).

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