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What factors explain stock market retardation inIslamic Countries☆
Ginanjar Dewandaru 1, Syed Aun R. Rizvi 2,Obiyathulla I. Bacha 3, Mansur Masih⁎,4
International Centre for Education in Islamic Finance (INCEIF), Kuala Lumpur, Malaysia
a r t i c l e i n f o
☆ The authors would like to express their deep graparticipants of the 15th Malaysian Finance Associatiosuggestions. The authors would also like to thank tFundamental Research Grant Scheme.⁎ Corresponding author. Tel.: +60 173841464.
Article history:Received 3 September 2013Received in revised form 25 April 2014Accepted 28 April 2014Available online 5 May 2014
Stock markets have been recognized in literature as a source of financialdevelopment and economic growth. Notwithstanding the recent trend ofthe stock market development in emerging countries, some argue thatIslamic countries' stock exchanges are still infantile. The central aim of thisresearch, therefore, is to investigate factors impeding stock marketdevelopment (SMD) in Islamic countries. We explore a panel annual dataof 11 main Islamic countries vis-à-vis the developed countries for theperiod of 1996–2011. The findings show that all of our concernedmacroeconomic determinantsplay amajor role in thedeveloped countries.On the other hand,financial openness has substantially less contribution inIslamic countries, while the financial intermediary development plays amajor role. The results are also indicative of the need for the Islamiccountries to improve their legal environment and economic freedom.Lastly,wealso attempt tomeasure the integration level,where thefindingstend to indicate a relatively lower and unstable pattern of integration forthe Islamic countries, suggesting the impact of volatile inflows.
Keywords:Stock market developmentEmerging Muslim countriesMarket integration
titude to the editor, Prof. Jonathan Batten, the anonymous referee and then Annual Conference held in June 2013 for their very helpful comments andhe Ministry of Higher Education, Malaysia for a generous grant under the
aching assistant at INCEIF. Currently, he is pursuing a PhD in Islamic FinanceMalaysia. Tel.: +60 142657731.urrently, he is pursuing a PhD in Islamic Finance at INCEIF, Lorong Universiti A,
59100 Kuala Lumpur, Malaysia. Tel.: +60 376514190.orong Universiti A, 59100 Kuala Lumpur, Malaysia.
Stock markets have been theoretically and empirically recognized as a source of financial developmentand economic growth. Many studies show that a well-functioning stock market can promote economicgrowth by providing much needed capital and liquidity for fuelling faster capital accumulation,productivity improvement, and by improving economic efficiency through effective resource allocation(Atje and Jovanovic, 1993; Beck and Levine, 2005; Caporale et al., 2004; Levine and Zervos, 1993, 1998b;Rousseau and Wachtel, 2000; Toda and Yamamoto, 1995; and others). Some argue that the stock marketsmay drive the economic growth through various channels (Enisan and Olufisayo, 2009). Firstly, they assistin mobilization of domestic savings by enhancing the set of financial instruments available for savers todiversify their portfolios. They also provide opportunities for individuals to have partial ownership inbusinesses, thereby providing a relatively liquid means of sharing risks. Lastly, they promote efficientallocation of capital to productive investments along with providing investment outlets for both domesticand foreign investments.
The important role played by the stock market in addition to the substantial growth of capital marketsaround the world in the last two decades, and the trend of integration, have set forth the necessity forgovernments to prioritize the development of domestic stock markets. This issue is very relevant for theemerging markets, which have shouldered an increasing share of world growth in the past few decades.
Many researches in recent times have been undertaken in emerging countries that include Latin America,India, China, and so on. However, relatively lesswork has been done in the context of Islamic countries. Islamiccountries comprise some of the richest countries with the largest oil and gas reserves as well as some of thepoorest nations. The region has seen some rapid growth countries, with immense potential owing to thehuman capital and cost efficiency. Notwithstanding the recent trend of the stock market development inemerging countries, some argue that Islamic countries' stock exchanges are still infantile. Literature show thatthese stock markets, both in MENA and emerging Asian countries, are smaller, less efficient, less liquid, morevolatile, prone to higher risk premium, higher cost of funds, and poorer quality of legal environment andgovernance (e.g. Abraham et al., 2002; Butler and Malaikah, 1992; Click and Plummer, 2005; Daratand Hakim, 1997; Domowitz et al., 1998; El-Erian and Kumar, 1995; Kim and Shamsuddin, 2008;Selçuk, 2004; Sharma and Wongbangpo, 2002; and others). This could be attributed to poor-quality ofinformation flow, high trading costs, disintermediation, and less competition due to international investmentbarriers (less integratedwith othermarkets). In the less developed countries, even though thefinancial systemis developing and becomingmore sophisticated and credit availability has increased, the allocation of resourcesis still inefficient (misallocation of resources), and the economy struggles to obtain the funds necessary torespond to an increase in the demand for output, thus hampering the growth of the economies (Chaiechi,2012; Deidda and Fattouh, 2008; and others). The system also cannot fully benefit from foreign capital inflowsthat may provide additional capital to local savings and promote capital accumulation, increasing growththrough knowledge spillover (Borensztein et al., 1998).
The central aim of this research is to investigate factors impeding stock market development in Islamiccountries. What is lacking in the existing literature is any rigorous empirical study focused on the criticalfactors impeding the stock market development in Islamic countries, in comparison to the developedmarkets. Therefore, we explore a panel data of 11 main Islamic countries, taking into account theavailability of complete dataset for the determinants of stock market development in these countries. Thisis studied in comparison with a panel data of 11 stock markets in the developed countries. The annualobservations are taken with the sample range from the year 1996 till 2011. The main contributions of thispaper are: (1) Analyzing the determinants of stock market development in Muslim countries, such asfinancial openness, financial intermediary development, legal framework, governance, economic freedom,and so on; (2) Comparative examination of the extent of underdevelopment of stock markets in Muslimcountries vis-à-vis more developed stock markets; and (3) Measurement of the integration level with theworld for both group of countries and, at the same time, exploring its key determinants. A comparativestudy of the determinants would hopefully result in a better understanding of the factors hampering thestock market development in Muslim countries in order to improve the contribution of their stock marketsto the economic growth of the countries. To the best of our knowledge, our study is the first comparativestudy in analyzing Muslim countries' stock markets with a major focus on deriving some policyimplications to boost the stock market development in those countries.
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Section 2 focuses on data and methodology, while Section 3 discusses the empirical results. Section 4will elaborate policy implications and conclusions.
2. Data and methodology
Our study compares the two groups; Islamic and developed markets in terms of their major indicatorsand determinants in order to explore the factors hampering the development of Islamic countries' stockmarkets.
2.1. Data
Our data set covers 11 countries each from Islamic and developed countries. The selection of thecountries from developed is based on the top 20 exchanges of the world by market capitalization andvolume traded. The annual observations will range from 1996 till 2011. For Islamic countries, we follow atwo tier classification, firstly, a Muslim majority country which is a member of the Organization of IslamicCountries (OIC) and secondly it should be amongst the top 15 markets in Islamic countries, according tomarket capitalization and value traded in the market. Due to the data availability limitations, we had toexclude Islamic Republic of Iran and Qatar, with the former not disclosing many economic data owing tointernational restrictions. For Qatar, the length of the data available was available only after 2005; postliberalization of policies, which in our understanding did not provide enough observation points for areliable study. The list of countries is provided in Table 1.
This study takes the variables of market capitalization (i.e. the value of listed domestic shares) andvalue of traded shares in the market as the indicator of market development stage. These indicatorsrepresent the measure of size and liquidity (Boutchkova et al., 2000; Demirgüç‐Kunt and Maksimovic,1998; Levine and Zervos, 1998a, b; Perotti and van Oijen, 2001).
As to the key determinants of stock market development, we have used two groups of determinants.
2.1.1. Macroeconomic variablesWe use the traditional macroeconomic variables that include gross domestic product, financial
openness, and financial intermediary development (Aggarwal et al., 2006; Boyd et al., 2001; Claessens etal., 2001; Garcia and Liu, 1999; Huang and Temple, 2005). Previous studies have demonstrated that stockmarket development varies according to the overall level of development of the country (La Porta et al.,1997a, 1997b; Porta et al., 2006; Levine, 1999; Rajan and Zingales, 2003). Therefore, our study will use ageneral proxy for development, which is GDP.
For another determinant, many studies have found evidence that financial openness is very essentialto: boost economic growth, improve factor productivity, lower cost of capital, promote better corporategovernance, increase size and liquidity (Bekaert et al., 2005); Gourinchas and Jeanne, 2006; Rajan andZingales, 2003; Quinn and Toyoda, 2008, and others). Liberalized capital account serves as a prerequisitefor companies to get access to foreign markets, as well as for foreign investors to enter domestic markets.
Table 1List of countries in the sample.
Developed countries Islamic countries
Australia BahrainFrance BangladeshGermany EgyptHong Kong IndonesiaJapan JordanNetherlands KuwaitSpain MalaysiaSweden OmanSwitzerland PakistanUnited Kingdom Saudi ArabiaUnited States Turkey
Therefore, to represent financial openness, we use two different indicators. The first one is the Chinn-Itoindex (KAOPEN) as an index measuring a country's degree of capital account openness. Secondly, we takeequity flows that capture both portfolio equity flows and foreign direct investment (FDI) flows as a proxyof de facto openness. This variable can serve as a measure of foreign demand for domestic equity; therebyrepresenting the effective integration with the global markets (Claessens et al., 2006). As to the stockmarket liberalization, a previous study by Bekaert et al. (2005) has come up with the official liberalizationdates that mostly comprise developing countries. Kaminsky and Schmukler (2003) also have a measure ofliberalization which includes both developing and developed economies. Nonetheless, we found thatsome Muslim countries were not included in their lists; thereby reducing the number of sample from 11Muslim countries may result in biased estimation. We consider this as a limitation of our study.
Lastly, Black (2001) demonstrated that stock markets cannot develop without the presence of anefficient system of financial intermediaries, i.e. banks, underwriters, market dealers, and so on.Demirgüç-Kunt and Levine (1996) studied 44 countries, developed and emerging, over the period1986–1993. They found that stock market development indicators are highly associated with the financialintermediary development (i.e. the size of the banking system, the size of firms other than banks, thecredit level to the economy, and so on). Leading from these findings, our study incorporates private creditwhich has been extended by the banking to the private sectors. We take the level of banking creditavailable as a proxy for the financial intermediary development.
Table 2Variables and proxies.
Market capitalization Market capitalization (also known as market value) is the share price times the number ofshares outstanding. Listed domestic companies are the domestically incorporated companieslisted on the country's stock exchanges at the end of the year. Listed companies do not includeinvestment companies, mutual funds, or other collective investment vehicles. Source:WorldBank Data
Value traded Total value of shares traded during the period. Source: WorldBank DataReal GDP GDP at purchaser's prices is the sum of gross value added by all resident producers in the
economy plus any product taxes and minus any subsidies not included in the value of theproducts. It is calculated without making deductions for depreciation of fabricated assetsor for depletion and degradation of natural resources. Real GDP is calculated by reducingthe nominal GDP by the GDP Deflator. Source: WorldBank Data
Legal origin Represents the origin of the legal framework in the country. English legal origin is assumed as 1,while non-English origin is 0. Source: Respective country’s legal and constitutional documents.
Financial openness The proxy is Chinn–Ito index. The Chinn–Ito index (KAOPEN) is an index measuring acountry's degree of capital account openness. The indexwas initially introduced in Chinn and Ito(Chinn and Ito, 2006). KAOPEN is based on the binary dummy variables that codify thetabulation of restrictions on cross-border financial transactions reported in the IMF's AnnualReport on Exchange Arrangements and Exchange Restrictions (AREAER). Source: Chinn–ItoIndex Database
Country credit rating Country credit rating is obtained from institutional investor. The rating is based on informationprovided by economists and risk analysts at leading financial and investment managementcompanies. Source: Institutional investor
Financial intermediarydevelopment
The proxy forfinancial intermediary development is bank private credit extended; Itmeasuresthe amount of credit which has been extended by the banking sector to the private sector.Source: WorldBank Data
Equity flows Foreign demand for domestic equity is represented by the sumofNet ForeignDirect InvestmentFlow and Net Portfolio Investment Flow. Source: WorldBank Data
Economic freedom It is derived from the World heritage Foundation's Economic Freedom Database. Financialfreedom is a measure of banking efficiency as well as a measure of independence fromgovernment control and interference in the financial sector. State ownership of banks andother financial institutions such as insurers and capital markets reduces competition andgenerally lowers the level of available services. Source: Heritage Foundation.
Governance The governance indicators encompass six parameters, voice and accountability, politicalstability and absence of violence, government effectiveness, regulatory quality, rule oflaw, control of corruption. Source: Worldwide Governance Indicators
110 G. Dewandaru et al. / Emerging Markets Review 19 (2014) 106–127
2.1.2. Legal environmentThere are many studies that mention the importance of socio-economic as well as legal environment
for stock market development. Many studies followed Bekaert et al. (2000) and used human capital by thesecondary school enrollment ratio as the proxy. Unfortunately, we found too many non-random missingpoints for some Muslim countries, which may potentially result in the biased estimation in the context ofunbalanced panel. Therefore, we will focus on the latter by using three different indicators that maycapture the legal and institutional environment. Firstly, La Porta et al. (1997, 1998) have shown that lawplayed a major role for stock market development, where a cross-country difference in marketdevelopment vary systematically with the legal origin of the country, which are German, English, Frenchor Scandinavian. The findings particularly show that common law countries have a better investorprotection than civil law countries. Our study therefore uses the binary variables developed by La Porta etal. (1998).
Secondly, we use the governance measures which represent transparency, regulation, the quality oflegal frameworks, the effectiveness of legal institutions, contract enforcement, as well as protection ofproperty rights (see, e.g., Ball et al., 2000; Gul FA, 2002; La Porta et al., 1998, 2000; Shleifer andWolfenzon,2002). The proxies include Country Credit Rating, the quality of institutions (derived from the HeritageFoundation's Index of Economic Freedom) and the quality of governance (derived from the WorldwideGovernance Indicators from the World Bank). The World Bank governance variable consists of voice andaccountability, political stability and absence of violence, government effectiveness, regulatory quality,rule of law, and control of corruption. The details and sources of all variables are provided in Table 2.
2.1.3. Stock market integrationShleifer and Wolfenzon, 2002 use a comparative analysis of cost of capital implied by the local CAPM
and the international CAPM as a proxy for market integration. The proxy is motivated from the empiricalresults of (Koedijk et al. 2002), who found that local CAPM and international CAPM produce almost thesame costs of equity capital with or without exchange rate adjustment. This leads to Koedijk et al. (2002)contending that if the fit between local beta and international beta is a better fit, the higher is the level ofmarket integration of the country with the world. Based on Bruner et al. (2008) arguments, we follow asimilar method for determination of integration. Our dataset comprises of monthly price data of 21countries from our original sample excluding United States. The rational for excluding US is based on a twotier approach. Firstly the global index is heavily constituted of US based companies, which may providebiased results for the measure of integration. Secondly with the financial crisis and near halt of capitalmarkets in the US in the sub-prime crisis, the level of integration may provide misleading results. The totalnumber of companies included in our study is 10,1565 from January 1996 to December 2011.
2.2. Descriptive analysis
Table 3 summarizes the descriptive analysis for both Islamic countries' stock market and developedmarkets. We note that the average mean of the stock market development indicators are substantiallyhigh for the developed countries in comparison to the Islamic countries.
The stark difference persists in the case of macroeconomic variables like GDP and Financialintermediary development. However this trend does not persist in Financial Flow, for which the meanvalues are similar but a difference occurs in the kurtosis. For Governance indicators, it is evident that thereis a huge difference between the governance levels of the two groups.
Figs. 1, 2 and 3 demonstrate the comparison of SMD indicators between Islamic countries' stock marketand developed markets. It is noted from the figures, that over the sample period of 1996–2011, Islamiccountries have lagged substantially in the case of market capitalization over GDP. In the case of valuetraded as a percentage of GDP, it follows a similar trend, except for a span of two years in 2002–2003 whenthe growth in Value traded is substantial and it matches the developed markets. Fig. 3 for Private credit
5 Indonesia 867, Malaysia 949, Bangladesh 373, Saudi Arabia 169, Bahrain 69, Kuwait 251, Jordan 273, Oman 160, Pakistan 532,Turkey 670, Egypt 535, Spain 116, Sweden 429, Switzerland 189, Hong Kong 817, Netherlands 228, France 735, Germany 604,Australia 495, Japan 849, and UK 846.
reports a substantially low number for Islamic countries. Although in all variables, the trend of growth inIslamic countries mimics that of Developed countries, the absolute difference holds throughout.
2.3. Research methodology
In our empirical model, we will run the following regression with variables described earlier:
SMDit ¼ at þMacroþ Legal Environmentit þ eit ð1Þ
We use panel data estimation approach that combines time series and cross-sectional information. Inthe conventional panel-data techniques, panel-data estimators are asymptotically normal. However, forsmall samples, these estimators will have overly optimistic standard errors, and thus lead tooverconfidence in the results (Beck and Katz, 1995). As our observations are subject to this condition,
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we therefore use a pooled OLS with panel-corrected standard errors, suggested by Beck and Katz. Thisprovides a correction for errors that are both heteroskedastic (i.e. they differ systematically acrosscountries) and correlated over time within countries. While the parameters are estimated by theconventional method
the es
β̂ ¼ X0X� �−1X0Y ð2Þ
timated variance matrix is given by
X0X� �−1X0Ω X0X
� �−1withΩ ¼ E0E=T� �
⊗IT ; ð3Þ
E denotes the T × N matrix of the OLS residuals and ⊗ fsis the Kronecker product.
whereSince the variance correction (weighting) matrix Ω does not assume a specific time-series error
structure, we conduct an ad hoc test for serial correlation, by estimating a common serialcorrelation coefficient r ¼ ∑iwiri where ri is the estimate of the within-country serial correlation,and wi is a weight derived from the reciprocals of the variances, which increases the efficiency ofthe estimates (Beck and Katz, 1995). The ad hoc nature of the test is that we consider the testsignificant if the serial correlation coefficient is close to or above 0.3, the rule-of-thumb forcorrection suggested by Grubb and Magee (1988). In our result, we find significant serial correlation inour models.
As to the measure of integration, we will use the model of Grubb and Magee (1988), where theycompare the cost of capital derived from the domestic CAPM and the international CAPM to serve as a
proxy for stock market integration. This refers to the empirical study by Koedijk et al. (2002) who showthat the domestic CAPM and the global CAPM (with or without exchange rate adjustments) generatealmost identical costs of equity capital for most countries in their sample. Therefore, Bruner et al. (2008)suggest that the higher integration level will be based on the better fit between the local and global beta.Frijns et al. (2012) have mentioned several advantages over alternative measures of market integration:(i) it treats the dynamic process, instead of a static one, of market integration, (ii) the estimation ofintegration over the cross-section of stock returns can effectively deal with structural breaks as comparedto the approach using a time-series basis, and (iii) by having the whole cross-section of stocks within acountry, it is less biased towards large-cap stocks, which commonly can be found in the approach usingmarket indices.
For each country, we estimate the domestic CAPM by running the regression of each company'smonthly excess return on its respective local market index over a rolling window of 36 months asfollowing,
wherefor stoof betacross-order
rit−rft ¼ αCit þ rCt
∪ −rft
� �þ εit ; ð4Þ
rit is the US dollar return on stock i, rCt is the US dollar return on the local market index (we use the
whereS&P Broad Market Index), rft is the risk-free rate, proxied by the 3-month US Treasury Bill and βit
C is themarket beta of stock i on the local index for window τ To obtain beta of each company within a country,we roll this regression on a monthly basis. Similarly, we run regressions on a global market index (the S&BWorld Broad Market Index) over a rolling window of 36 months as following,
rit−rft ¼ αWit þ βW
it rwt− rft∪�
� �þ nit ; ð5Þ
rwt is the US dollar return on the global market index and βitW is the beta on the global market index
ck i for window…. By combining the estimation of the first and second equations, we obtain a panelcoefficients for the local and global CAPM. Afterwards, we follow Bruner et al. (2008) by estimating
sectional regressions of the global beta on the domestic beta for all companies in each country into measure the degree of integration with the world, as following,
βWit ¼ γ0τ þ γ1τβ̇
Cit þ ζiτ
∪� ð6Þ
The measure of integration level will be obtained from the R-squared value of this regression. We will
estimate Eq. (6) per country on a cross-sectional basis for each window of τ, which provide a time-series ofR-squared for each country. The higher R-squared will reflect a better fit between the domestic and globalmarket beta, which further indicate a higher degree of integration. On the other hand, the lower R-squaredwill imply that the two betas generate different estimates of the cost of capital, thereby indicating that themarkets are segmented. The total observations for both Islamic and developed countries have 10,156companies.
Lastly, we observe the relationship between financial openness and integration level, taking intoaccount some control variables, on an annual basis using pooled OLS with panel-standard error correction,as following,
INTEGit ¼ αi þ FOPit þ CONTROLit þ eit ; ð7ÞINTEG is the integration level derived from the approach above, FOP is financial openness using
where
Chinn-Ito index, and CONTROL is our control variables that include the volatility of exchange rate, importand export (as a percentage of the world’s import and export).
3. Empirical analysis
3.1. Determinants of stock market development
This study investigates the determinants of stockmarket development for both Islamic and developedcountries. Tables 4 and 5 provide the results of our model with market capitalization as the dependent
Absolute values of z-statistics are in brackets. *, **, and *** mean significance at 1, 5 and 10% respectively.
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variable for both groups of the markets. The tables in the fifth column demonstrate the estimation of theregression with GDP, legal origin, financial intermediary development and financial openness. Here, weuse the Chinn–Ito index (KAOPEN) capital account openness while, in the sixth column, we have usedequity flows that represent foreign demand for domestic equity as a proxy for de facto openness. In othercolumns, we include variables that capture legal environment. The seventh column uses the averagegovernance measure of World Bank while the detailed analysis of six individual components of thisgovernance variable is observed in the next columns. We used institutional index as an alternative in thelast column to represent economic freedom.
The seventh column shows the regression results for macroeconomic determinants providing evidenceof market capitalization in developed markets being positively associated with GDP, country credit rating(CCR) and financial openness. On the other hand, CCR and especially financial openness have much lesscontribution in Islamic countries. It can be explained since Islamic countries are much less liberalizedalong with higher international investment barriers such as high transaction cost, foreign capital controland restriction, inefficient clearing and settlement for foreign transactions, and so on. Hence the marketscannot fully benefit from foreign capital inflows and higher competition in promoting capitalaccumulation, and thereby achieving efficient asset allocation in the economy. Also, the markets that
have lower contribution from international investors may potentially be less sensitive to the countrycredit rating.
The insignificant relationship with GDP for Islamic countries can be attributed to the fact that Islamiccountries' economy rely more on banking sector for resources allocation. In the underdeveloped stockmarkets, even though a country's financial system becomes more sophisticated and credit becomes moreavailable, the allocation of resources is still inefficient (misallocation of resources) (Bruner et al., 2008;Deidda and Fattouh, 2008; and others). The economy may have less alternative to raise the funds inresponse to an increase in the demand for output; hence it depends more on credit facilities to promotegrowth. As a result, the increasing growth will eventually boost the market development, with the mainchannel indirectly via credits provided by the banking sector. This is also particularly true when we look atthe estimation for Islamic countries. While the first column shows a significant relationship between GDPand market capitalization, it becomes insignificant when we include the financial intermediarydevelopment.
This evidence also can be supported further by comparing the contemporaneous impact of financialintermediary development on SMD. As the relationship is statistically significant for both of the two, thecoefficient of Islamic countries is substantially higher than that of developed countries, signifying the
Table 5Pooled OLS (panel-corrected standard errors) with market capitalization as dependent variable for developed countries (1996–2011).
Market capitalization
Variable 1 2 3 4 5 6
GDP 0.7394003(0.000)*
0.736496(0.000)*
0.7139734(0.000)*
0.7055111(0.000)*
0.5146443(0.000)*
0.5239725(0.000)*
Legal origin 0.6333746(0.000)*
0.7706233(0.000)*
0.8037208(0.000)*
0.8801664(0.000)*
0.7181835(0.000)*
Financial openness 0.543606(0.000)*
0.5863284(0.000)*
0.5831211(0.000)*
CCR 0.0690114(0.000)*
0.0702661(0.007)*
0.0607625(0.006)*
Financialintermediarydevelopment
0.2000945(0.118)
0.2225126(0.026)**
Financial flow 0.0334244(0.241)
GovernanceControl of corruption(governance)
Governmenteffectiveness(governance)
Political stability(governance)
Regulatory quality(governance)
Rule of law(governance)
Voice andaccountability(governance)
Institutional index(economicfreedom
No. of observations 176 176 176 176 176 176No. of countries 11 11 11 11 11 11Overall R squared 0.8966 0.9008 0.9092 0.9222 0.9234 0.9379Estimated serialcorrelation (rho)
Absolute values of z-statistics are in brackets. *, **, and *** mean significance at 1, 5 and 10% respectively.
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major role of credits facilitated by the financial intermediary in Islamic countries. In developed countries,on the other hand, there is a heavier reliance of both domestic and foreign firms to raise the funds from themarket, as well as the market can fully benefit from accessing foreign capital to reduce the cost of equity.
When we look at the legal environment as a determinant, we use three different measures to capturethe impact on SMD. Firstly, the legal origin has statistically significant relationship for the developedcountries,6 which is contrary to the evidence in Islamic Countries.7 This is understandable since commonlaw has been the governing legal cover for the historically major financial centers in the world. Thecommon law has developed into a mature system and provides ample legal cover and investor protectionowing to multiple legal actions and financial turmoils the financial centers have experienced. Secondly,our result shows the significant impact of weighted average governance variable for both the groups ofcountries, where the contemporaneous impact is relatively higher for Islamic countries. As a part ofemerging countries with lower degree of legal system, the governance level will serve as a major risk in
6 Common Law Developed countries are: Australia, United Kingdom, United States, and Hong Kong.7 Common Law Islamic countries are: Bahrain, Bangladesh, Malaysia, Pakistan, and Saudi Arabia.
Table 5Pooled OLS (panel-corrected standard errors) with market capitalization as dependent variable for developed countries (1996–2011).
investment decision for both domestic and foreign investors. The markets consequently will developaccording to the dynamic movement of this variable.
The comprehensive analysis will take into account the contribution of each individual component ofgovernance variable. As expected, the key governancemeasure formarket development in developed countriesis government effectiveness; whereas, it falls to “control of corruption, regulatory quality and rule of law forIslamic countries. The results can be understood as the Islamic countries primarily form the bottom quartile ofthe corruption levels according to Transparency International, thereby confirming the significant impact ofcontrol of corruption on the market development. In the case of regulatory quality that captures the ability ofthe local government to plan and implement sound policies and regulations in promoting private sectordevelopment, Islamic countries are still on an upward tangent. With the exception of Pakistan, Malaysia andTurkey, all the other equity markets in Islamic countries are less than three decades old, as compared to overhalf a century history of most of the markets in developed countries. To attract larger numbers of issuers andinvestors, it is therefore very essential for the local government to strengthen this framework in order to buildconfidence and reputation. On the other hand, rule of law is one of the major concerns in the emerging andIslamic countries, and its significant relationship withmarket development is a testament of the importance ofrule of law. The long bureaucracy process as well as low quality of contract enforcement for financialtransactions in many Islamic countries may potentially explain this evidence.
Table 6Pooled OLS (panel-corrected standard errors) with value traded as dependent variable for Islamic countries (1996–2011).
Value traded
Variable 1 2 3 4 5 6
GDP 1.598732(0.000)*
1.585321(0.000)*
1.563992(0.000)*
1.578815(0.000)*
0.6808005(0.003)*
0.7878672(0.002)*
Legal origin −0.5686957(0.140)
−0.641108(0.112)
−0.6286697(0.126)
−0.7979802(0.028)**
−0.6562318(0.071)***
Financial openness −0.0735571(0.550)
−0.0605779(0.633)
−0.155146(0.231)
CCR 0.0324422(0.470)
0.043326(0.324)
0.0337205(0.443)
Financial intermediarydevelopment
1.021666(0.000)*
0.8758432(0.000)*
financial flow 3.236903(0.052) ***
GovernanceControl of corruption(governance)
Governmenteffectiveness(governance)
Political stability(governance)
Regulatory quality(governance)
Rule of law(governance)
Voice andaccountability(governance)
Institutional index(economic freedom
No. of observations 175 175 175 175 175 175No. of countries 11 11 11 11 11 11Overall R squared 0.5963 0.597 0.596 0.5961 0.6269 0.6294Estimated serialcorrelation (rho)
Absolute values of z-statistics are in brackets. *, **, and ***mean significance at 1, 5 and 10% respectively.
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We also use institutional index in our model that captures economic freedom, and our findings show thepresence of a significant relationship only in developed countries. Within the context of equity markets, wemay relate economic freedom to the openness of the market, which ensures the independence fromgovernment control and interference in thefinancial sector. Less portion of state ownership of enterpriseswillpotentially strengthen competition and generally increase the level of available financial services. Ourfindings from this viewpoint can be understood since the openness of the market can be clearly observed inmajorfinancial centers amongst thedevelopedmarkets. In addition, since our study does not take privatizationmeasure due to limited data in Islamic countries, the institutional index may serve as a preliminary signal inasserting the importance of privatization to boostmarket development in Islamic countries. Overall, our resultsfor Governance and Institutional Index are similar to La Porta et al. (1998, 2000), Ball et al. (2000), Gul FA(2002), and Shleifer and Wolfenzon (2002), mostly for developed countries.
Moving on to the second indicator of the market development, we are interested to observe thedeterminants for activities level in the market. Tables 6 and 7 report the results for value traded as adependent variable. Looking at the seventh column, the regression results for macroeconomicdeterminants show that GDP has a significant impact in Islamic and developed countries, hence implyingthe contribution of the overall level of development to market activity. The underlying reason of the
Table 6Pooled OLS (panel-corrected standard errors) with value traded as dependent variable for Islamic countries (1996–2011).
significant relationship of financial openness in developed countries, and financial intermediarydevelopment in Islamic countries, would be in line with our earlier results in market capitalization. Asto the legal environment, we find that the legal origin is also significant in Islamic countries but with anegative sign. It may imply that non-common law countries have higher volume of shares traded in themarket. The empirical result also shows that controlling the corruption still remains significant to boostmarket activity for Islamic countries. For developed countries, regulatory quality and rule of law play avital role in addition to government effectiveness. The insignificant impact of governance measure overallin Islamic countries can be attributed to the relatively illiquid nature of the equity markets.
3.2. The impact of government ownership on stock market development
At this juncture in our study, an element that needs to be highlighted is the level of state ownership. Ithas been argued extensively in literature that government ownership in the stock markets tends to impactthe performance of the stock markets. This in turn would impact the stock market development, whichforms the crux of our study. Najid and Abdul Rahman (2011) claim that state-owned firms generally lacksufficient entrepreneurial drive and tend to be politically rather than commercially motivated, which leads
Table 7Pooled OLS (panel-corrected standard errors) with value traded as dependent variable for developed countries (1996–2011).
Value traded
Variable 1 2 3 4 5 6
GDP 0.8954844(0.000)*
0.8835804(0.000)*
0.8560911(0.000)*
0.8548274(0.000)*
0.764134(0.000)*
0..7501225(0.000)*
Legal origin 0.5681168(0.000)*
0.7420279(0.000)*
0.7593012(0.000)*
0.7952988(0.000)*
0.6059048(0.000)*
Financial openness 0.7372416(0.000)*
0.7598538(0.000)*
0.7571023(0.000)*
CCR 0.0343327(0.296)
0.0347364(0.287)
0.0327402(0.333)
Financial intermediarydevelopment
0.0950962(0.603)
0.1478449(0.391)
financial flow 0.0174491(0.668)
GovernanceControl of corruption(governance)
Government effectiveness(governance)
Political stability(governance)
Regulatory quality(governance)
Rule of law(governance)
Voice andaccountability(governance)
Institutional Index(economicfreedom
No. of observations 176 176 176 176 176 176No. of countries 11 11 11 11 11 11Overall R squared 0.9201 0.9246 0.9275 0.9292 0.9294 0.9307Estimated serial correlation(rho)
Absolute values of z-statistics are in brackets. *, **, and *** mean significance at 1, 5 and 10% respectively.
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to a poor financial performance. Mak and Li (2001) argue that government tends to be less active inmonitoring its investments; they claim the weaker accountability and monitoring of state-owned firms'financial performance, as well as easier access to financing, are likely to reduce the incentives of such firmsto adopt strong governance mechanisms. This may lead to an under development of the Stock market.
In order to address this phenomenon, this study adds another aspect, of exploring the impact ofgovernment ownership in free float market capitalization to Stock Market Development. The mainlimitation is the availability of data. In our sample period, only 2011 data is available for all our samplemarkets. We run a cross-sectional regression with stock market development as the dependent variableincorporating an interactive term, which is a dummy for Islamic countries multiplied by government-held.We take a market capitalization weighted average of government-held free float for all companies in oursample set. The average ownership of government in free float in Islamic countries is 17.91% while indeveloped countries it stands at a mere 2.61%.
Our results (see Table 8) tend to suggest that government ownership provides a significantcontribution towards stock market development with a highly significant negative impact in the case ofIslamic countries. In other words, the government ownership may deter, rather than improve, the stockmarket in Muslim countries. However, this relationship becomes insignificant when it is controlled forfinancial intermediary development or GDP of the economy. Our results imply that either financial
Table 7Pooled OLS (panel-corrected standard errors) with value traded as dependent variable for developed countries (1996–2011).
intermediary development or GDP plays the major role in stock market development, in line with ourprevious findings. The impact of government ownership in free float market capitalization might be drivenby these two major variables rather than purely from its own contribution.
3.3. The importance of stock market integration
Our earlier findings suggest the importance of financial openness for stock market development indeveloped countries. This section therefore does a comparative analysis by evaluating the level ofintegration over time for both Islamic and developed countries within the framework of internationalCAPM described earlier. Fig. 4 depicts the 36-month rolling windows of estimated R2 between domesticand global betas for each individual country for the sample period 1999–2011. As compared to Islamiccountries, developed countries generally have higher integration level with the world market. Also, thesmoother variation of the integration process over time has been the key feature for the developedmarkets. This evidence may signify substantially less investment restrictions for these countries.
Focusing on Islamic countries, we can see a relatively more stable pattern of integration level inMalaysia, Indonesia and Turkey, which is in line with their relatively higher stage of market developmentamongst the Islamic countries. A very weak integration level for Malaysia in 1999 can be attributable to
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the strict capital control related to one-year ban of removing portfolio capital for the foreign investors in1998. As it was replaced by a graduated tax on outflows in 1999, Malaysian market became moreintegrated but it was only up to the year 2002, post which the integration level started to fall again. Evenafter the removal of outflow restriction in 2003, the market response was only transitory and thedecreasing integration level continued till 2005, suggesting the long-term impact of capital control forMalaysian equity market. This is contrary to the Indonesian market that relied on IMF and thereforeavoided the penalty on the market. It can be seen that the integration level remained steady post-Asiancrisis for Indonesia. The reflection point in the earlier part of our sample is year 2001–2002, which wasmarred by the global impact of WTC terrorist attack, dotcom crisis, Enron's collapse and more importantlythe Bali's bombwhich substantially destroyed confidence of foreign investors in Indonesia. For the Turkishstock market, the weak integration level in the beginning period can be associated with substantialdivestment of foreign investors from the country due to political turmoil and especially huge budgetdeficit. The integration levels for Turkey rebounded from 2003 onwards which can be economicallyassociated with the structural reform of foreign investment regulation. Since Turkey has been historicallyabsorbing a substantial amount of foreign inflow beginning from the gradual liberalization in the 1980s,these reforms in 2003 may have boosted confidence post-crisis. In regards to the Pakistani market, whichis the oldest stock market amongst Muslim countries (established 1949) capital controls owing toeconomic embargo in 1998 post May '98 nuclear tests is reflected in the very weak integration with theworld through the major first half of the period. Post 2005, with a resurgence in the economy andregulatory improvements in the market, the foreign portfolio investment in the country increased, whichis reflected in a rising integration level. But the integration did not sustain as another round of capitalcontrols in stock market was imposed in 2008 as a result of a nearly 60% decline in benchmark index. Forthe remaining Islamic countries, they portray a very weak integration level with high short-termfluctuations, which is in line with the nature of emerging markets that are considerably exposed to volatileinflows.
On the other hand, there has been a commonality amongst the Islamic countries, whereby theintegration level shoots up in 2007–2008. The global transmission of shocks from US-born subprime crisismay explain the contagion effect to these emerging markets. The rationale of persistent high-integrationcan be due to the regime uncertainty during the Euro crisis. Also, substantial amount of foreign inflow tothe countries like Indonesia and Malaysia may lead the markets to become more integrated.
Table 9 exhibits the relationship between the integration level and financial openness for both Islamicand developed countries. The Chinn–Ito index is used for openness while we take exchange rate volatility,as well as import and export as a percentage of world import and export for our control variables. For thedeveloped countries, a positive relationship between integration level and financial openness is observed,even with control variables in the model. This may suggest the significant contribution of liberalizedcapital account for explaining the higher and stable integration with the world. The finding also shows thecontemporaneous impact of trade on the integration, while the higher coefficient of import may implythat the integration level has been driven by this component. This is understandable since manydeveloped countries more recently are exposed to substantial import from emerging countries like Chinaand India. On the other hand, these evidences can be argued to be unlikely in Islamic countries, where
Table 8Cross-sectional regression for government ownership in stock market.
Model 1 Model 2 Model 3
Government held 10.2059 0.6912 3.4403(0.046)** (0.889) (0.400)
Interactive term (dummy for Islamiccountries × government held)
neither openness policy nor trade is able to explain the dynamic of integration. The volatile inflows mayexplain the erratic fluctuation of the integration but, due to the data constraint for portfolio inflows inIslamic countries, this may be a limitation of our study. Overall, by combining the sample of Islamic anddeveloped countries, we find that these two variables appear to be the key determinants for theintegration with the world.
4. Conclusions and policy implications
This study has attempted to build on the previous research on stock market development, and identifythe key determinants of stock market development for Islamic countries and a comparative study with thedeveloped countries. The objective is to highlight the key areas, which should be addressed by theconcerned regulators in Islamic countries for the development of the stock markets. To sum up, themacroeconomic determinants for the developed countries are financial openness, financial intermediary
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124 G. Dewandaru et al. / Emerging Markets Review 19 (2014) 106–127
development, GDP, country credit rating, and economic freedom. On the other hand, the Islamic countrieshave a substantially less exposure to financial openness, whilst the financial intermediary developmenthas played a major role for stock market development. These have been the characteristics ofunderdeveloped stock market, where the economy may have fewer alternatives to raise the funds andthus depend more on credit facilities to promote growth. In other words, the increasing growth mayeventually boost the market development, with the main channel via credits provided by the bankingsector. Islamic countries are also much less liberalized coupled with the higher international investmentbarriers, and hence cannot fully benefit from more diverse fund availability and higher competition inorder to reduce the cost of equity. On the other hand, the developed countries may have broader optionsto access financing from banking, stock market as well as foreign capital, in order to achieve efficientallocation of resources.
An aspect that may impact the stock market development is the level of institutional versus retailownership in the stock markets. Recently some studies have explored the institutional investors' basefrom a foreign perspective; Stulz (1999a) and Stulz (1999b) argue that the participation by largeinternational financial institutions would enhance local market liquidity through better informationdisclosure and more active trading. Our study does not directly incorporate the level of institutional versusretail investor ownership owing to the non-availability of the data. But we take a cue from Levine andZervos (1998a, 1998b, 1998c, 1998d) and Bekaert et al. (2002), who studied the impact of financial marketliberalization and liquidity in the market. This is further in line with the recent Bekaert et al. (2007) whodemonstrate a positive effect from the level of openness to the foreign investors (including substantialinstitutional investors) resulting in an enhanced liquidity in the emerging equity markets. Hence our studytakes the ‘Financial Openness’ as a control variable. However, we do believe that this study can be furtherexpanded and made robust by factoring in the exact amount of institutional versus retail investorinvolvement, once the data are made available in the emerging economies.
Our study also attempts to measure the degree of integration for both the Islamic and developedcountries within ICAPM captured by the rolling R-squared, and we find that the developed countriesportray higher, and more stable pattern of integration with the world. The capital account openness, alongwith the fundamental trade, has been responsible for the integrated market. This is contrary to thefindings in Islamic countries, where only Malaysia, Indonesia and Turkey are found to be more integratedwith relatively small variation over time. As a benchmark, the overall evidence may signify the need forthe Islamic countries to develop the stock markets as one of the main channels of financing in theeconomy, as well as to open the market further for accessing foreign capital in order to boost the equitymarket development. In addition, our empirical finding also shows that Islamic countries have to improvethe legal environment. While the developed countries are concerned more on the governmenteffectiveness, Islamic countries should focus on controlling the corruption, shortening the bureaucraticprocess, creating effective enforcement of the transaction, and ensuring the soundness of the economicpolicy to build the confidence of the market participants. Islamic countries also should ensure theindependence from government control and interference in the financial sector, since the economicfreedom variable is found insignificant in explaining the SMD.
As to the policy implications of our study, Islamic countries should go through several phases toachieve a well-functioning stock market. Firstly, each country should remove the concentration rule byeliminating the barriers to entry for new exchanges in order to ensure a competitive environment in themarket. This may affect the best execution rules of trading decisions so that many different tradingplatforms are chosen to best meet the investors' needs. The increased competition therefore willeventually reduce the trading costs. Secondly, each market should decrease market abuses by ensuring themarket cleanliness. The supervision in the market should be enhanced to achieve transparency and, at thesame time, the legislation quality should be substantially improved, i.e. the speed of the court system forcontract enforcement. This may provide good protection for the investors and thus will increase themarket confidence. Thirdly, the trade across many different platforms may cause data fragmentationproblem. The high quality of investment banks as data providers and proprietary system thus may tacklethe problem in intermediate term, while the consolidation amongst the trading venues will serve as a finalaim. Fourthly, another priority would be to integrate the Islamic countries with the world and especiallyamongst themselves. A number of prospectuses need to be promoted into other countries in order topromote cross-border trading volume. This should go along with the harmonization with other countriesin terms of the disclosure of financial instruments, fair value accounting, statutory audit, prospectus, andso on. In addition, the competition between post-trading services should be increased and, at the sametime, is integrated by linking between clearing and settlement providers through the technologicalsolutions. As a result, the cross-border listing can be achieved through the efficient process as well as theavailability of comparable information. As an overall, these may enhance the liquidity, market depth, andachieve faster trading, as well as reduce trading cost, spreads and cost of equity.
Table 9The impact of financial openness on the integration level for Islamic and developed countries.
Absolute values of z-statistics are in brackets. *, **, and *** mean significance at 1, 5 and 10% respectively.
126 G. Dewandaru et al. / Emerging Markets Review 19 (2014) 106–127
Notwithstanding the advantage of opening the market for foreign capital, there are some crucial issuesthat need to be addressed. It is generally known that the pro-cyclical capital flows have been responsible forthe shock transmission in their propagation during the crisis, especially for emerging countries. The focus onthe speculative short-term gains is contrary to the needs for long-term growth. For Islamic countries, thismayexplain the nature of volatile pattern of integration level over time. It should be noticed that the consequenceof volatile inflows may lead to the volatile consumption, investment, and eventually the growth of thecountry, thereby resulting in welfare losses and high social cost. The rationale would be a violation ofunrealistic assumptions on perfect capital markets and perfect inter-temporal smoothing, since themarket isalways exposed to the waves of euphoria and pessimism, externalities and coordination failures. This is evenworse for Islamic countries which do not have high institutional quality as well as a complete risk markets tomitigate. Therefore, the market generally is not self-regulating and a prudent counter-cyclical, macroeco-nomic discipline with an effective intervention from the government should be put to minimize instability.The direct quantity-based and price-based regulation, as well as indirect intervention through prudentialregulations such as avoiding currency mismatch and strengthening financial and macroeconomic riskmanagement can serve as an option according to the characteristic of each Islamic country.
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