Dow, J., Gorton G. (1995), ‘Stock Market Efficiency and Economic Efficiency: Is There a Connection?’ National Bureau of Economic Research Working Paper No. 5233.

Abstract

In a capitalist economy prices serve to equilibrate supply and demand for goods and services, continually changing to reallocate resources to their most efficient uses. However, secondary stock market prices, often viewed as the most 'informationally efficient' prices in the economy, have no direct role in the allocation of equity capital since managers have discretion in determining the level of investment. What is the link between stock price informational efficiency and economic efficiency? We present a model of the stock market in which: (i) managers have discretion in making investments and must be given the right incentives; and (ii) stock market traders may have important information that managers do not have about the value of prospective investment opportunities. In equilibrium, information in stock prices will guide investment decisions because managers will be compensated based on informative stock prices in the future. The stock market indirectly guides investment by transferring two kinds of information: information about investment opportunities and information about managers' past decisions. The fact that stock prices only have an indirect role suggests that the stock market may not be a necessary institution for the efficient allocation of equity. We emphasize this by providing an example of a banking system that performs as well.

Abstract

It is now well established that a sounder financial system is associated with faster economic growth. Recent research that examines the details of this connection has important implications for economies in transition. Stock prices in rich countries move in highly idiosyncratic ways that convey information about changes in firms’ marginal value of investment. This information is important because it facilitates the rapid flow of capital to its highest value uses. In contrast, stock prices in low-income countries tend to move up and down en masse, and thus are of scant use for capital allocation. Stock return asynchronicity is highly correlated with the strength of private property rights in general - and shareholder rights in particular. Many countries have avoided protecting these rights for many decades. In light of the research we survey, the persistence of such policies requires explanation. Another strands of new papers offer insights. In many countries an elite (often the descendants of industrial barons who grew rich off political “connections” during early stages of development) controls most large corporations through “pyramidal” corporate groups. This corporate control gives the elite vast rent-seeking powers, which it uses to limit outsiders’ property rights and outsiders’ access to capital. The latter is accomplished by keeping the stock market and financial system from functioning well. The initial stages of this process of “economic entrenchment” may be under way in many transition economies. Economic openness may limit this sort of “economic entrenchment”, and thus contribute to institutional reform and economic growth.

Abstract

Samuel, C. (1996), ‘Stock market and investment : the signaling role of the market’, World Bank, Policy Research Working Paper; no. WPS 1612

Abstract

The author examines the role of the stock market as a signal to managers in undertaking capital expenditures. He concludes that while both managerial and market perceptions are integral, managerial perception is of greater importance. The evidence suggests that, as a statistic, the Q ratio is not sufficient to explain firm ' capital expenditure decisions. Thus, the standard Q model of investment should be modified to provide a more meaningful description of a firm ' s capital spending decisions. Overall, the results suggest that stock market activity has only limited implications for the economy ' s resource allocation process. Evidence for the Q theory of investment confirms previous findings in the literature that the model ' s poor empirical performance was partly the result of using aggregate data for the whole economy. Also, since market perception plays only a limited role in determining capital expenditures, shareholder myopia is unlikely to result in managerial myopia. The implications for developing countries are: while the stock market may not be central to a firm ' s capital spending decisions, it is not a sideshow either. The market plays an important signaling role for managers. This is a powerful rationale for financial reform and capital development in developing countries. The results also suggest that complaints that stock market activity leads to misallocation of resources may be exaggerated.

Abstract

Tadesse, S. (2003) ‘The Allocation and Monitoring Role of Capital Markets: Theory and International Evidence’, William Davidson Institute Working Paper No624

Abstract

Capital markets perform two distinct functions: provision of capital and facilitation of good governance through information production and monitoring. We argue that the governance function impacts on the efficiency with which resources are utilized within the firm. Based on industry level data across thirty-eight countries, we present evidence suggesting a positive relation between market-based governance and improvements in industry efficiency. The measures of governance are also positively correlated with productivity improvements and growth in real output. The evidence underscores the role of capital markets as a conduit of socially valuable governance services as distinct from capital provision.

Wurgler, J. (1999), 'Financial Markets and the Allocation of Capital', Yale ICF Working paper No 99-08.

Abstract

Financial markets appear to improve the allocation of capital. Across 65 countries, those with developed financial sectors increase investment more in their growing industries, and decrease investment more in their declining industries, than those with undeveloped financial sectors. The efficiency of capital allocation is negatively correlated with the extent of state ownership in the economy, positively correlated with the amount of firm-specific information in domestic stock returns, and positively correlated with the legal protection of minority investors. In particular, strong minority investor rights appear to curb overinvestment in declining industries.

Wurgler, J. (2000), 'Financial Markets and the Allocation of Capital', Journal of Financial Economics, 58, pp. 187-214.