Importance of Stock Market in the Development of Economy
Flabia Maharjan
Stock market refers to a regulated public market where stocks are issued and traded. Stocks represent fractional ownership in a publicly-traded company and a stock market is a place where the ownership of such financial securities are bought and sold. It facilitates companies to raise capital, contributing to the growth and expansion of companies which in turn results in increased productivity and employment in the country. It plays a crucial role in the creation and development of a robust and competitive economy. With efficient stock markets, a weak and rigid economy could transform into a more flexible and secure economy that is immune to shocks, volatility, and a lack of investors’ confidence.
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Efficient stock markets are said to have a positive relationship with economic growth. Let us understand why.
Increase In GDP
Gross Domestic Product (GDP) refers to all the goods and services produced in an economy. An increase in the real GDP signals that an economy is heading in the right direction as it reveals strong economic performance. To define the relation between stock market and economic development, we focus on two major components of GDP i.e., investment and spending.
Investment fuels economic growth and development. This is the reason government formulates fiscal and monetary policies i.e., with a motive to increase investment which injects money into the productive sectors of the economy. Stock market is one of the most prominent sources for the public to invest money in.
Stock market encourages the mobilization of domestic savings through the issuance of equity shares and allocation of collected funds to productive sectors which require financial sources to perform and function in an economy. On one hand, investors can benefit from capital gain and dividend payments which encourages spending and on the other hand, companies can have easy access to capital from the public which can be used to finance their operations. This flow of resources from the surplus unit to the deficit unit will allow companies to grow their businesses by expanding operations, funding new projects, investing in new technologies and creating employment opportunities. As a result, the rate of production accelerates, and the unemployment rate deteriorates.
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Similarly, rising stock markets i.e. bull market raises confidence towards the future growth of the economy. It creates wealth effect since investment portfolios rise in value. This leads people to spend more money on costly products increasing consumer spending. Increased consumer spending translates to higher demand for goods and services. Thus, sales of businesses would increase resulting in higher profits, encouraging more investment which serves as an important indicator of GDP growth. Investors’ confidence in the stock market will also make it easier for companies to raise capital while issuing shares due to demand for equity.
Government spending is likely to increase through increased tax revenue collected from companies listed on the stock exchange because the companies can generate a higher profit. The government will use the revenue to increase re-investment and generate employment in the country. An increase in consumer spending (household expenses), investment and government expenses increase the aggregate demand of good and services in a country demonstrating growth in real GDP which indicates that an economy is doing well.
Thus, the provision of capital through the stock market spurs economic growth as it surges spending and investment, reduces unemployment, increases the purchasing power of individuals thus, improving the living standard of people in the country.
Stock Market Liquidity
Stock markets ease liquidity shortages thereby promoting growth. The liquidity offered by the stock market reduces investment risks because investors can modify their portfolio saving themselves from possible losses. This makes investment more attractive as it has allowed people to exercise control. After purchasing stocks, savers can sell them quickly and inexpensively whenever they wish to, allowing savers access to their savings. However, this is impossible without an efficient financial system. This encourages banks to work on their efficiency to ease out transactions. We also know that stock markets mobilize resources for long-term investments through financial intermediaries. This promotes the growth of a strong financial system which contributes to the development of an economy.
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Superiority Of Equity Financing Over Debt Financing
The presence of stock market allows companies to acquire perpetual, non-debt, equity capital over debt capital, thus improving the corporate debt-to-equity ratio. The debt-to-equity ratio indicates the financial stability of a company as it demonstrates what percentage of the company’s activities are being funded by debt compared to what percentage of them are being funded by equity. A lower debt-to-equity ratio is preferable which means a lower level of debt and a higher level of equity investment. This is because when companies borrow, they are liable to pay back the principal along with the interest which can fluctuate concerning change in market interest rates. Inability to pay back the debt within the stated time frame may result in bankruptcy. However, capital raised from stock market need not be paid back to the equity shareholders. Rather, bonus shares can be issued, or cash dividends can be distributed to them when the company earns a profit. Thus, equity financing is a more secure form of acquiring funds for business operations and it lowers the debt-to-equity ratio signaling positive economic health of a company which maintains investors’ confidence. Even lenders can benefit from a low debt-to-equity ratio as there are fewer chances of loan default.
Risk Diversification
Stock market positively affects economic growth by improving risk diversification through international stock market integration. An increase in the degree of international integration of stock markets reduces the level of risk on average investment through diversification. Portfolio diversification spreads an investor’s risk across different asset classes, economic sectors and geographical locations which increases the chances for positive returns in one’s portfolio. Investors can invest in companies that show immense growth potential across national boundaries. Investors will then have a global portfolio and the diversification results in a shift of investment from safe low-yield projects to riskier high-yield projects. International stock market integration opens a door of investments that can boost the rate of investment in diversified portfolios which in turn enhances economic growth through increased capital mobility and productivity.
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Who Is Affected By A Stock Market Crash?
Stock market crash indicates a drastic decline in the prices of stocks listed on the stock exchange which is often led by panic selling and other economic factors. The stock market crash in the 1920s led to the Great Depression that lasted for about 10 years. Although it originated in the United States, it impacted the economies worldwide causing a great decline in the outcome, severe unemployment, and acute deflation.
Stock market also affects people who do not invest. When stock market bubbles burst, it does not only hurt investors, the entire economy also gets affected; people lose jobs, companies go under and pensions get pummeled. Pension funds and retirement funds are affected by low stock prices since the value of such accounts are directly linked with the stock market. In such a situation, the company starts cutting down its costs. Less money is spent on employee benefits, job security is under threat and many employees might end up losing their jobs.
All the points discussed earlier spread light upon how important stock market is for the development of an economy. Stock market raises capital for long-term investments, mobilizes savings and encourages investment. It is highly correlated with the development of banks, pension funds and other financial intermediaries. Developed stock markets reduce liquidity shocks and productivity shocks. Stock market covers a wide array of sectors, from commerce, information technology to health, hence, efficient stock markets lead to the overall development of an economy.
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