You may be surprised to discover the number of stock markets blanketing the globe. Even a country not known for having a sophisticated economy, like Rwanda, relies on its stock exchange to help businesses raise capital and give investors opportunities to back new and established enterprises. Rwandans are as likely to invest in their stock market to build wealth as people in other nations, which proves that the role of the stock exchange in any economy is universal.
In the words of Professor Gustav Cassel, of Sweden, The Stock Exchange has often been represented as an astonishingly sensitive barometer, which indicates beforehand what is going to happen in economic life. Recent experience, however, forced the conclusion that the economic recession in 1937 was in a marked degree, the effect of the distrust shown by the Stock Exchange, and thus might have been avoided if the Stock Exchange had not been exposed to the serious disturbance of confidence which a vacillating monetary policy is always bound to entail.
The ability of the stock exchange to fulfil its functions and to make a firm resistance to a panicky pessimism was greatly impaired by a number of restrictive measures, which, even if they had a grain of justification; unfortunately were framed under the influence of dilettante ideas about the stock exchange as the root of all evil.
Indicator of Healthy Economy
A stock exchange can serve as a barometer of a nation’s fiscal health, broadcasting the ups, downs, trends and shifts that are the benchmarks of a society’s financial infrastructure. According to financial website UpDown’s Investment Education Center, the symbiotic relationship between a society and its stock exchange can be synchronized to such a high degree that prognosticators and analysts can develop confidence that encourages more investing based on the previous performance of products and the health of the companies issuing these stocks.
A healthy economy attracts foreign capitalists to invest in the country.
Liquidity
The main function of the stock market is to provide ready market for sale and purchase of securities. The presence of stock exchange market gives assurance to investors that their investment can be converted into cash whenever they want. The investors can invest in long term investment projects without any hesitation, as because of stock exchange they can convert long term investment into short term and medium term.
Providing Scope for Speculation
To ensure liquidity and demand of supply of securities the stock exchange permits healthy speculation of securities, due to which the market value does not reflect the fundamental value of the security.
Accountability
Sophisticated financial market systems require credibility and accountability if they are to function on behalf of businesses and investors and be as interested in ethics as they are in profits. For this reason, a stock exchange benefits from a formal structure upheld by rules, laws and regulations. Management and operational standards set by governments, bureaus and agencies overseeing stock exchange operations add authority and oversight to the institution, giving stockholders, investors and businesses, checks and balances necessary for investor confidence.
Effects
The direct effect of stock market activity can impact a nation’s economy in multiple ways. Stocks fall, spending stops, consumers lose confidence and a nation’s financial state begins to falter. Conversely, stocks rise; confidence spreads, spending and investments grow. A nation’s mood can rise or fall on stock market activity and performance, which shows how important the role played by a stock exchange can be in a society’s social and fiscal fabric.
Is GDP Growth and Stock Market Return equal?
In a theoretical environment stock price increases should exactly match real GDP growth. The underlying economy of a country translates into a company’s profits, thus into Earnings per Share (EPS), which eventually determines the price of a company’s stock. However, this only works if a country’s economy is closed, valuations remain constant and if only domestic companies are listed on a country’s stock market. As we know it, the world economy isn’t ‘theoretical’, hence this example may not be an appropriate comparison, however understanding the basic principles of stock market returns are crucial for this experiment.
Theoretical versus Real Economy
Studies have shown that in many countries there is somewhat of a correlation between GDP growth and stock market returns. In theory, and over the long-term, aggregate corporate earnings rise when the economy grows, and vice versa.
However, there are plenty of examples where the stock market was clearly disconnected from the real economy. Looking at shorter timeframes, we note dramatic variations of the two key variables, especially in times of significant volatility. During the 2008 Great Financial Crisis (‘GFC’), stock markets around the world plummeted approximately 40-60%, but of course, the real economy did not shrink ~50% within a few months. The following bull market saw the S&P 500 nearly triple in just 6 years, which is also not reflective of real GDP growth.
However, if we are looking at a longer timeframe we note a more ‘moderate correlation’, albeit still not perfect. Over the past 50 years the US economy expanded at an average compound rate of between 3%-3.5%, however the past 10 years have been significantly slower with average GDP growth less than 1.5% according to data provided by the World Bank. Between December 2006 and December 2014, the US benchmark index S&P 500 gained 45%, an average simple growth rate of 5.6%, four times higher than the average growth rate of ~1.5%
The above image shows the relation between Stock market and GDP of 16 countries. It can be clearly seen that the stock market returns are much more as compared to the Nation’s GDP. Only Japan and Belgium have marginal difference. Italy is the only country whose GDP is marginally more than stock market returns.
According to me, Stock Exchange plays a very important role in making the economy of any nation strong. If people gain confidence in the stock exchange the economy will be facing a boom but a marginal decrease in confidence, the stock exchange would collapse. Stock exchange helps the economy in all sectors i.e. generation of additional revenue for the government, generation of employment, inflows of foreign capital and the main role mobilization of savings.
Written by- Vijay Parekh