THE RELATIONSHIP BETWEEN STOCK MARKET DEVELOPMENT

AND ECONOMIC GROWTH IN KENYA

BY:

OWITI JANET

A RESEARCH PROJECT PRESENTED IN PARTIAL FULFILMENT OF

THE REQUIREMENT FOR THE AWARD OF DEGREE OF MASTER OF
SCIENCE IN FINANCE, SCHOOL OF BUSINESS, UNIVERSITY OF

NAIROBI

NOVEMBER 2012
 DECLARATION
I declare that this projectis my original work and has never been submitted to any other
University for assessment or award of a degree.

Signature..
... Date... 111.
BY: OWITI JANET: D63/68428/2011

This project has been submitted with my authority as the university supervisor.

Signature.

Supervisor: HERICK ONDIGO

Lecturer, Department of Finance and Accounting

School of Business, University of Nairobi

iii
 DEDICATION

This study is dedicated to my family and my dear friends, for their support and encouragement
during the entire period of my study and continued prayers towards successful completion of this
course.

May God bless you all.

iii
 ACKNOWLEDGEMEMNT

This project could not have been successful without the spiritual, technical and moral support
from all those I interacted with in the process of its compilation. First I would like to thank the
almighty God for bringing me this far. His protection, blessings and endowment to pursue this
research to the end is much appreciated.

My profound thanks and appreciation goes to my supervisor Mr. Ondigo for having agreed to
supervise this research paper, his patience in reading the drafts and occasionally guiding me,
without which the research would not have been a reality.

My appreciation goes to my family for their encouragement and moral support throughout the
course. Special thanks to my dad for a great financial support to pursue this research. Finally, I
would like to acknowledge my friends who graciously shared their ideas and assisted me in this
research. All other people who contributed in the project in one way or another; I thank you all.

iii
 ABSTRACT

This study examines the relationship between stock market development and economic growth in
Kenya. Stock markets in the world individually and collectively play a critical role in the
national economies. However, controversies do exist on the role of stock markets in an economy.
For instance, Singh (1997) argued that stock market might not be important in attaining higher
economic growth while Levine and Zervos (1998) find that stock market development plays an
important role in predicting future economic growth.

Empirical evidence linking stock market development to economic growth has been inconclusive
even though the balance of evidence is in favour of a positive relationship between stock market
development and economic growth. Levine and Zervos (1998) emphasize on the fact that stock
market liquidity measured as the value of stock .raded relative to the size of the market and the
size of the economy is significantly and positively related to the rate of economic growth. Levine
(2001) also confirm this similarity of significance in stock market development in the course of
economic growth and he argues that the expansion of both banks and stock markets significantly
affects growth. The literature survey reveals that some key factors that explain economic growth
are as follows: initial level of development, which is proxied by real income per capita; gross
investment to GDP ratio; macroeconomic instability, which is proxied by inflation rate. Stock
market development and institutional factors are also identified in the literature as critical
determinants of economic growth.

This study has used data from 1990- 2010 and has employed a regression model technique. The
i
target population for this study is the Nairobi stock exchange as an organisation and the
performance of the overall economy is targeted and measured by the growth in GDP. The
objective was to establish the relationship between stock market development and economic
growth in Kenya. From the results, it was revealed that there was a positive relationship between
stock market development indicators and economic growth in Kenya. Thus, the study lends
support both to the financial intermediation literature as well as to the traditional growth
literature. The study used Granger causality te it to establish the link between stock market
development and economic growth in Kenya (i.e. whether stock market development cause

iii
economic growth or itself is a consequence of increased economic growth). The findings
exhibited a two-way causality between stock market development and economic growth in
Kenya.

The NSE plays an important role in the economic growth of Kenya and the study therefore
recommends that the government needs to do much to attract and encourage active participation
of stock markets sector. The study recommends that NSE needs to be developed further to
enhance domestic resource mobilization. Policymakers should encourage stock market
development. The study also recommends that various policies and programs that affect stock
markets such as tax, legal, and regulatory barriers need to be addressed.

iii
 T A B L E OF CONTENTS

DECLARATION »
DEDICATION iii
ACKNOWLEDGEMEMNT iv
ABSTRACT v
LIST OF TABLES ix
ABBREVIATION x
CHAPTER ONE: INTRODUCTION 1
1.1 Background of the Study 1
1.1.1 Stock Market Development 2
1.1.2Economic Growth 2
1.1.3 The Relationship between Stock Market Development and Economic Growth 3
1.1.4 The Nairobi Stock Exchange 4
1.2 Research Problem 5
1,30bjective of the study 7
1.4 Value of the study 7
CHAPTER TWO: L TERATURE REVIEW 8
2.1 Introduction 8
2.2 Theoretical Review 8
2.2.1 Neoclassical/Soiow Growth Model 8
2.2.2 Endogenous Growth Model 8
2.3 Stock Market Development and Economic Growth 12
2.4 Determinants Stock Market Development 13
2.6 Conceptual Framework 15
2.7 Empirical Studies 16
2.8 Conclusion 17
CHAPTER THREE: RESEARCH METHODOLOGY 18
3.1 Introduction 18
3.2 Research Design 18
3.3 Target Population 18
3.4 Data Collection 18

iii
3.5 Data Analysis 19
3.5.1 Analytical model 19
CHAPTER FOUR : DATA ANALYSIS, FINDINGS AND DISCUSSIONS 20
4.1 Introduction 20
4.2 Regression Analysis 20
4.2.1 Regression model one 20
4.2.2 Regression model two 21
4.2.2 Regression model three 23
4.3 Granger Causality Test 25
CHAPTER FIVE : SUMMARY, CONCLUSIONS AND RECOMMENDATIONS 26
5.1 Introduction 26
5.2 Summary 26
5.3 Conclusion 27
5.4 Recommendations 28
5.4 Limitations of the study 29
5.5 Suggestion for further research 29
REFERENCE 31
APPENDIX 1 35
APPENDIX II 36
APPENDIX III 37

vi!i
 LIST OF TABLES

Conceptual framework 15

Table 4.1- Regression model 1 21

Table 4.2- Regression model II 23

Table 4.3- Regression model III 24

Table 4.4- Granger Causality Test 26

iii
 ABBREVIATION
GDP - Gross domestic product

INF - Inflation

INV-Investments

MCP - Market capitalization

NSE - Nairobi Stock Exchange

PI - Consumer Price index

SMD - Stock market development

TR - Stock turnover

iii
 CHAPTER ONE: INTRODUCTION

1.1 Background of the Study

Stock markets in the world individually and collectively play a critical role in the national
economies. The markets perform a wide range of economic and political functions while offering
trading, investment, speculation, hedging, and aiuitrage opportunities. In addition, they serve as a
mechanism for price discovery and information dissemination while providing vehicles for
raising finances for companies. Stock markets are used to implement privatization programs, and
they often play an important role in the development of emerging economies (Levine, 1991).

According to Surya and Neupane (2006), Stock market development has assumed developmental
role in global economics and finance following the impact they have exerted in corporate finance
and economic activity. Paudel (2005)states that stock markets, due to their liquidity, enable firms
to acquire much needed capital quickly, hence facilitating capital allocation, investment and
growth. Stock market activity is thus rapidly playing an important role in helping to determine
the level of economic activities in most economies.

However, controversy does exist on the role of financial system in the economy. The
controversies started with Schumpeter (1912) who argued that in a well-functioning financial
system, banks help to facilitate economic growth by enhancing technological innovation through
identification and funding of entrepreneurs with the best chance of successfully implementing
innovative products as well as production process. Support : ng this view, Bagehot (1873) and
Hicks (1969) asserted that the developmei.. of the financial sector helped to trigger
industrialization in England by increasing the access of the people to funds, which in turn they
used to finance and execute capital projects.

Contrary to the views of Bagehot, Schumpeter and Hicks, some scholars argue that financial
system does not really matter in the growth of the economy. For instance, Shliefer and Summers
(1988) asserted that stockmarket development may hinder economic growth by promoting

1
counter-productive corporate takeovers. Furthermore, Singh (1997) argued that stock market
might not be important in attaining higher economic growth.
Given these conflicting views, this paper will try to determine whether stock market
development accelerates economic growth in Kenya.

1.1.1 Stock Market Development

A stock market in where shares are issued and traded through exchanges or over-the-counter
markets. Also known as the equity market, it is :.ne of the most vital areas of a market economy
as it provides companies with access to capital and investors with a slice of ownership in the
company and the potential of gains based on the company's future performance. The stock
market can be split into two main sections: the primary and secondary market. The primary
market is where new issues are first offered with any subsequent trading going on in the
secondary market (The Nairobi Stock Exchange, 2012).

Stock market development ismeasured by stock market size, liquidity, volatility, concentration,
integration with world capital markets, and the legal rule (regulation and supervision) in the
market.Some theoretical work shows how stock market development might boost economic
growth, and new empirical evidence supports this view. For example, Demirguc-Kunt and
Levine (1996), Singh (1997), and Levine and Zervos (1998) find that stock market, development
plays an important role in predicting future economic growth. The World Bank Economic
Review also dedicates in its May 1996 issue to the role of the stock markets in economic growth.
In this study, the researcher will use stock market capitalization and turnover ratio to measure
stock market development.

1.1.2 Economic Growth

Economic growth is an increase in gross domestic product (GDP). It represents the market value
of all goods and services produced by the economy during the period measured, including
personal consumption, government purchases, private inventories, paid-in construction costs and
the foreign trade balance. Increase in GDP means an increase in all the values of goods and
services produced in an economy (Pettinger, 2011).

iii
Some scholars postulate a causal relationship from economic growth to financial development.
In this view, financial development appears because of the overall economic development.
Continual economic expansion requires more financial services and new instruments. The
financial system adapts itself to the financing needs of the real sector and fits in with autonomous
development. Therefore, this type of financial development plays a rather passive role in the
growth process. For example, Gurley and Shaw (1955) and Goldsmith (1969) show that
economic growth propels financial development, lobinson (1952) consequently states, "It seems
to be the case that where enterprise leads finince follows". The same impulses within an
economy, which sets enterprise on foot, make owners of wealth venturesome, and when a strong
impulse to invest is fettered by lack of finance, devices are invented to release it and habit and
institutions are developed.

1.1.3 The Relationship betweenStock Market Development and Economic

Growth
There is now an abundance of scholarly literature documenting the link between the level of the
stock market development and economic growth of countries. A stock market is expected to
accelerate economic growth, by providing a boost to domestic savings and increasing the quality
of investments (Singh, 1997). The stock market encourages savings by proving individual with
an additional financial instrument that may increase the savings rate (Levine and Zervos, 1996).
Capasso (2003) argues that companies in countries with developed stock markets are less
dependent on bank financing, which can reduce the risk of credit crunch. Stock markets therefore
are able to positively influence economic growth through savings amongst individuals, and
providing avenues for firm financing. .

The stock market is supposed to ensure through t le takeover mechanism that past investment are
also most efficiently used. Theoretically, the threat of takeover is expected to provide
management with an incentive to maximize firm value. The presumption is that, if management
does not maximize firm value, another economic agent may take control of the firm, replace
management and reap the gains from the more efficient form. Thus, stock market promotes
corporate control, by proving financial discipline, which is expected to provide the best
guarantee of efficiency in the use of assets. Similarly, the ability to effect changes in the

3
management of listed companies is expected to ensure that managerial resources are used
efficiently (Morck, Shleifer and Vishny, 1990).

Efficient stock markets may also reduce the costs of information, f h e y may do so through the
generation and dissemination of firm specific information that efficient stock prices reveal. Stock
markets are efficient if prices incorporate all available information. Reducing the costs of
acquiring information is expected to facilitate and improve the acquisition of information about
investment opportunities and thereby improves resource allocation. Stock prices determined in
exchanges and other publicly available information may help investor make better investment
decisions and thereby ensure better allocation (f funds among corporations and as a result a
higher rate of economic growth (Adjasi, 2007).

Greenwood and Smith (1996) show that large stock markets can lower the cost of
mobilizingsavings and thereby facilitate investment in the most productive technology.
Bencivenga et al (1996) and Levine (1991) argue that stock market liquidity (the ability to trade
equity easily) is more important for growth. Although many profitable investments require a
long-run commitment of capital, savers do not like to relinquish control of their savings for long
periods. Liquid equity markets ease this tension by proving an asset to savers that they can
inexpensively and quickly sell. Simultaneously, firms have permanent access to capital raised
through equity issue. Additionally, Kyle (1994) and Holmstrom and Tirole (1993) argue that
liquid stock market can increase incentives for investors to get information about firms and
improve corporate governance.

1.1.4 The Nairobi Stock Exchange

In Kenya, dealing in stocks and shares started n the 1920s when the country was still under
British colony. There was however no formal ma ket, no rules and no regulations to govern stock
brokerage activities. Trading took place or gentlemen's agreement in which standard
commissions were charged with clients being obligated to honor their contractual agreements of
making good delivery and settling relevant costs. In 1951, an Estate Agent by the name of
Francis Drummond established the first professional stockbroker firm and other stock brokerage

4
firms were later established. The NSE came into being in 1954 when trading used to take place
over a cup of tea at the New Stanley Hotel. Itwas constituted as a voluntary association of
stockbrokers registered under the societies Act in 1954 and in 1991; the Nairobi Stock Exchange
was incorporated under the companies Act of Kenya as a company limited by guarantee and
without a share capital. Subsequent development of the market has seen an increase in the
number of stockbrokers, introduction of investment banks, establishment of custodial institutions
and credit rating agencies and the number of listed companies have increased over time.
Securities traded include, equities, bonds and preference shares (Muga, 1974).

In 1996 the largest share issue in the then history of NSE, the privatization of Kenya Airways,
came to the market. More than 110,000 shareholders acquired a take in the airline .The Kenya
Airways privatization team was awarded the Woild Bank award for Excellence in 1996 for being
a success story in the divestiture of state owned enterprise. In 1998, the government expanded
the scope for foreign investment by introducing incentives for capital markets growth including
the setting up of tax-free Venture Capital Funds, and removal of Capital Gains Tax.
Subsequently, listed companies split their shares at NSE while others issued bonus shares. In
November 2004 the Central Depository System was introduced thus automating settlement of
transactions at NSE.The NSE trading hours increased from 2 to3 hours (10.00 am- 1.00 pm) and
subsequently increased to 5 hours (lO.OOa.m -3.00p.m). The new system offers and has led to
greater transparency in the placement of bids and offers improvement in market surveillance.
Transmission is almost real time and trading information relating to index movements, price and
volume movements of traded securitiesis released on a timely basis. Subsequent development of
the market has seen an increase in the number of stockbrokers, introduction of investment banks,
establishment of custodial institutions and credit rating agencies and the number of listed
companies have increased over time. Securities traded include, equities, bonds and preference
shares (The Nairobi Security Exchange, 2012).

1.2 Research Problem

Since the past few arcades, the link between financial intermediation and economic growth is a
subject of high interest among academics, policy makers and economists around the world.
There have been attempts to empirically assess the role of stock market and economic growth.

5
The link between stock market and growth has varied in methods and results (Levine, 1997)
There exist two controversies in the predictions.

Ndung'u (2011) conducted a study on the relationship between stock market development and
economic growth in Kenya. He employed a regression model complemented by a granger
causality test. The result of the study indicates a positive relationship between economic growth
and stock market development in Kenya. Olweny and Kimani (2011) investigate the causal
relationship between stock market performance and economic growth in Kenya using Granger
causality test based on the Vector Autoregressive (VAR) model. The results inferred that the
movement of stock prices in the Nairobi stock e> change reflect the macroeconomic condition of
the country and can therefore be used to predict the future path of economic growth. Levine and
Zervos (1996) conducted a study on stock markets, banks, and economic growth focusing on 49
countries Kenya included. Their findings indicated a strong positive link between financial
development and economic growth and the results suggest that financial factors are an integral
part of the growth process.

There are also alternate views about the role stock markets play in economic growth. Apart from
the view that stock markets may be having no real effect on growth, there are theoretical
constructs that show that stock market development may actually hurt economic growth. For
instance, Stiglitz (1985, 1994), Shleifer and Vishny (1986), Bencivenga and Smith (1991) and
Bhide (1993) note that stock markets can actually harm economic growth. They argue that due to
their liquidity, stock markets may hurt growth since savings rates may reduce due to externalities
in capital accumulation. Diffuse ownership may also negatively affect corporate governance and
invariably the performance of listed firms, thus impeding the growth of stock markets.
Arestis, Demetriades and Kuintel (2001) utilized time series data from five developed countries,
to examine the relationship between stock market and economic growth, controlling for other
effect of the banking system and stock market volatility. Their result supports the view that,
although banks and stock market may promote economic growth, the effect of bank is more.

6
They suggested that the contribution of stock market to economic growth may have been
exaggerated by studies that use cross-country regressions.

Despite of alternative views empirical works continue to show largely some degree of positive
relationship between stock markets and growth. Traditional growth theorists believed that there
is no correlation between stock market development and economic growth because of the
presence of level effect not the rate effect. Singh (1997) contended that stock markets are not
necessary institutions for achieving high levels of economic development. This clearly indicates
that a group of studies argues that stock market does not help in economic growth of a nation
while the other group argues that it helps in economic development. These studies largely based
on developed countries. Only few studies have been conducted in context of Kenya stock market,
and those conducted studies show a positive relation but do not show a clear conclusion
regarding the direction of the relationship. This 4udy seeks to answer the following questions:
what is the relationship between stock market development and economic growth in Kenya?
What is the direction of the relationship?

1.3Objective of the study

To establish the relationshipbetween stock market development on economic growth in Kenya

1.4 Value of the study

This study will assist researchers in the area of stock market development and economic growth.
It will serve as a point of reference for the researchers as they conduct studies in this area.

This study will also contribute to both theoretical and empirical literature on the impacts of stock
market in Kenya's growth and development.

The findings of the study will equally enable policy makers to develop a keen interest on the role

of stock markets on the economy based on empirical evidence.

17
CHAPTER TWO: LITERATURE REVIEW
2.1 Introduction
This chapter reviews various studies that have been conducted in the area of stock market and
economic growth. Among the issues discussed include: theories of economic growth and
development; stock market development and economic growth; history of the Nairobi Stock
Exchange; determinants of stock market development; Conceptual framework andempirical
studies on the impact of stock market development on economic growth.

2.2 Theoretical Review

2.2.1 Neoclassical/Solow Growth Model
The Solow model is the starting point for almost all analysis of economic growth. The main
contributor to this model, Solow (1956) developed a relatively simple growth model which fit
available data on US economic growth with some success. The Exogenous growth model was an
addition to the Harrod-Domarmodel which incluc ed the new term, "productivity growth". Solow
growth model shows how saving, population growth and technological progress influence
economic growth over time. It also shows why countries experience differential growth rates
over time.

The main assumptions of this model are: production function has constant returns to scale;
diminishing returns to each factor input; constant saving rate; exogenous technology; the model
also shows how capital accumulation, population growth and technological advancement interact
to generate a country's output. The criticisms of the Model: Model fails to take into account
entrepreneurship which may be one of the vehicles behind economic growth and also the
strength of institutions which aid economic growth. Moreover, it does not make clear how or
why technological progress occurs. These limitations have led to the development of endogenous
growth theory, which try to endogenize technological progress.

2.2.2 Endogenous Growth Model

Neoclassical/Solow growth model is limited by the assumption of diminishing returns thus the
endogenous growth models attempt to overcome neoclassical weaknesses by endogenising

8
technological progress. These new growth models also include other factors of production for
example government policy, institutions, education and trade policies. Key contributors of this
model areRomer (1990) and Aghion and Howitt (1992). Main inspiration is that the production
function does not require exhibit diminishing returns. The simplest form of endogenous growth
model is an AK model, which says that MPK is constant and thus capital can generate growth in
the end.Other types of endogenous growth model: Learning-by-doing for example training and
re-tooling; Research and development and Technological diffusion for example internal trade
and factor mobility.

The assumptions of the model include: exogenous technology sustains growth in the long run or
steady state, the savings rate is constant exogenous, there is no depreciation and population
growth is exogenous. The critics to the model include Mankiw et al (1992), Barro and Sala-i-
Martin (1992). They showed that using data from the second half of the 20th century, which
most countries seem to be converging to roughly similar long-run growth rates, whereas
endogenous growth theory seems to imply that, because many countries have different policies
and institutions, they should have different long-run growth rates.

The finance-led growth hypothesis postulates thj supply-leading relationship between financial
and economic developments. It is argued thut the existence of financial sector, as well-
functioning financial intermediations in channeling the limited resources from surplus units to
deficit units, would provide efficient allocation resources thereby leading the other economic
sectors in their growth process. Indeed, a number of studies have argued that the development of
financial sector has significantly promoted economic development (Schumpeter, 1912; Levine,
1997). In contrast, the growth-led finance hypothesis states that a high economic growth may
create demand for certain financial instruments and arrangements and the financial markets are
effectively response to these demands and changes. In other words, this hypothesis suggests a
demand following relationship between financial and economic developments. The impact of
economic growth on the financial development has been documented in Robinson (1952) and
Romer (1990) among others.
Finally, the feedback hypothesis suggests a two-way causal relationship between financial
development and economic performance. In this hypothesis, it is asserted that a country with a
well-developed financial system could promote \ igh economic expansion through technological
changes, product and services innovation (Schumpeter, 1912). This in turn, will create high
demand on the financial arrangements and services (Levine, 1997). As the banking institutions,
effectively response to these demands, then these changes will stimulate a higher economic
performance. Therefore, both financial development and economic growth are interdependent
and their relationship could lead to feedback causality.

Several empirical studies analyze the correlation between the economic growth and the financial
development. Levine and Zervos (1996) examines whether there is a strong empirical association
between stock market development and long-run economic growth. The study used pooled cross-
country time-series regression of forty-one countries from 1976 to 1993 to evaluate this
association. The study tow the line of Demirgiiij-Kunt and Levine (1996) by conglomerating
measures such as stock market size, liquidity, and integration with world markets, into index of
stock market development. The growth rate of Gross Domestic Product (GDP) per capita was
i

regressed on a variety of variables designed to control for initial conditions, political stability,
investment in human capital, and macroeconomic conditions; and then include the
conglomerated index of stock market development. The finding was that a strong correlation
between overall stock market development and long-run economic growth exist. This means that
the result is consistent with the theories that imply a positive relationship between stock market
development and economic growth.

Greenwood and Smith (1996) argue that stock markets lower the cost of mobilizing savings and
facilitate investments into the most productive sectors and diversifying the risks.Obstfeld(1994)
indicates that international risk sharing through internationally integrated stock markets improve
resource allocation and accelerate growth. Levine and Zervos (1998) also emphasize on the fact
that stock market liquidity measured as the value of stock traded relative to the size of the market
and the size of the economy is significantly and positively related to the rate of economic
growth. They also suggest that the level of banking development measured as the ratio of bank
loans to the private sector to GDP is directly related with the level of economic growth. Beck and

10
Levine (2001) also confirm this similarity of significance in stock market development in the
course of economic growth and he argues that the expansion of both banks and stock markets
significantly affects growth.

Atje and Jovanovich (1993) have more so concluded that there is strong positive correlation
between the level of financial development and stock market development and economic growth.
Creane et al. (2003) argued that a modern and efficient financial system mobilizes savings,
promotes investment by identifying and funding good business opportunities, monitors the
performance of managers, enables the trading, hedging, and diversification of risk, and facilitates
the exchange of goods and services. These functions ultimately result in a more efficient
allocation of resources, a more rapid accumulation of human and physical capital, and in faster
technological progress, which in turn feed economic growth.

Tsuru (2000) also explained the finance-growth link by arguing that financial development can
promote economic growth via its positive impact on capital productivity or the efficiency of
financial systems in converting financial resources into real investment. However, its effect on
the saving rate is ambiguous and could affect the growth rate negatively. 'In net terms, the
impact on welfare is likely to be positive, since increased efficiency of investment in the long
term can offset any reduction in the propensity to save' (Tsuru, 2000).

The relationship between financial development and economic growth was in fact extensively
analysed more than two decades ago by Goldsmith (1969); McKinnon (1973); Shaw (1973).
They found strong and positive correlations between the degree of financial market development
and the rate of economic growth. King and Levine (1993) undertook more comprehensive
empirical research. They confirmed a very strong relationship between the development of stock
markets and economic growth. Pioneering work from Pardy (1992), Atje and Jovanovic (1993)
show that stock market development is strongly correlated with growth rates of real GDP per
capita. More importantly, they found that stock market liquidity predict the future growth rate of
economy. Levine and Zervos(1998) and Rousseau and Wachtel (2000) examined stock

11
|umivep",tv
r,r
"'^w1'
LOWfcfc ? \ A j £ T E i
I i J O ADV
market-growth nexus and exhibited positive casual correlation between stock market
development and economic activity.

There are also alternate views about the role stocc markets play in economic growth. Apart from
the view that stock markets may be having r.o real effect on growth, there are theoretical
constructs that show that stock market development may actually hurt economic growth. For
instance, Stiglitz (1985, 1994), Shleifer and Vishny (1986), Bencivenga and Smith (1991) and
Bhide (1993) note that stock markets can actually impair economic growth. They argue that due
to their liquidity, stock markets may hurt growth since savings rates may reduce due to
externalities in capital accumulation. Diffuse ownership may also negatively affect
corporategovernance and invariably the performance of listed firms, thus impeding the growth of
stock markets.

Despite these alternative views, empirical works continue to show largely some degree of
positive relationship between stock markets and growth. Kenny and Moss (2001) conclude that
stock market activity generates positive effects, which far outstrip any negative effect. Levine
and Zervos (1998) also observe that the speed of economic growth hinges on active and
developed stock markets and banks. Bekaerte/ a'. (2004) also go further to show the important
#

part that equity market liberalization plays in ooosting economic growth and for emerging
markets like those in Africa, further studies on the link between stock markets and economic
growth becomes more appealing given the potent al benefits in terms of additional growth points.

2.3 Stock Market Development and Economic Growth

According to Bencivenga and Smith (1991), stock market liquidity is expected to reduce the
downside risk and costs of investing in projects that do not pay off for a long time. With a liquid
market, the initial investors do not lose access to their savings for the duration of the investment
project because they can easily, quickly, and cheaply, sell their stake in the company.

12
However, critics of the stock market argue that stock market liquidity may negatively influence
corporate governance because very liquid stock market may encourage investor myopia. Since
investors can easily sell their shares, more liquid stock markets may weaken investors'
commitment and incentive to exert corporate •:ontrol. In other words, instant siock market
liquidity may discourage investors from having long-term commitment with firms whose shares
they own and therefore create potential corporate governance problem with serious ramifications
for economic growth (Bhide,1994).

Critics further point out that the actual operation of the pricing and takeover mechanism in well-
functioning stock markets lead to short term and lower rates of long-term investment. It also
generates perverse incentives, rewarding managers for their success in financial engineering
rather than creating new wealth through organic growth (Singh, 1997). This is because prices
react very quickly to a variety of information influencing expectations on financial markets.
Therefore, prices on the stock market tend to be highly volatile and enable profits within short
periods. Moreover, because the stock market undervalues long-term investment, managers are
not encouraged to undertake long-term investments since their activities are judged by the
performance of a company's financial assets, which may harm long run prospects of companies
(Binswanger, 1999).

In addition, empirical evidence shows that the takeover mechanism does not perform a
disciplinary function and that competitive selection in the market for corporate control takes
place much more based on size rather than performance (Singh, 1971). Therefore, a large
inefficient firm has a higher chance of survival than a small relatively efficient firm does.

2.4 Determinants Stock Market Development

A sound macroeconomic environment, well developed banking sector, transparent and
accountable institutions, and shareholder protection are considered necessary preconditions for
the efficient functioning of stock markets in Africa (Adjasi, 2007).

A stable macroeconomic environment is crucial for the development of the stock market.
Macroeconomic volatility worsens the problem of informational asymmetries and becomes a

13
source of vulnerability to the financial system. Low and predictable rates of inflation are more
\

likely to contribute to stock market development and economic growth. Both domestic and
foreign investors will be unwilling to invest in the stock market where there are expectations of
high inflation. The development of the banking sector is important for stock market development
in Africa. At the early stages of its establishment the stock market is a complement rather than
substitute for the banking sector.

Developing the financial intermediary sector can promote stock market development. Mirny East
Asian countries are successful examples. Support services from the banking system contribute
significantly to the development of the stock market. Consequently, liquid inter-bank markets,
largely supported by an efficient banking system, are important for the development of the stock
market. Conversely, a weak-banking system can constrain the development of the stock market.
Institutional quality is important for stock market development because efficient and accountable
institutions tend broaden appeal and confidence in equity investment. Equity investment thus
becomes gradually more attractive as political risk is resolved over time. Therefore, the
development of good quality institutions can affect the attractiveness of equity investment and
lead to stock market development. Stock market development is more likely in countries with
strong shareholder protection because investors do not fear expropriation as much. In addition,
ownership in such markets can be relatively dispersed, which provides liquidity to the market.

14
2.6 Conceptual Framework

GDP-Real Income Per

Capita

Source: Researcher (2012)

Market Capitalization/GDP equals the value of listed shares divided by GDP. The assumption
behind this measure is that overall market size is positively correlated with the ability to mobilize
capital and diversify risk on an economy-wide basis. Stock Turnover/GDP equals the value of
total shares traded divided by market capitalization. However, it is not a direct measure of
theoretical definitions of liquidity; high turnover is often used as an indicator of low transaction
costs. The turnover ratio complements the market capitalization ratio. A large but inactive
market will have a large market capitalization ratio but a small turnover ratio. Turnover also
complements the total value traded ratio. Whil the total -value-traded ratio captures trading
relative to the size of the economy, turnover measures trading relative to the size of the stock
market. A small liquid market will have a high tu-nover ratio but a small total value traded ratio.

Flow of foreign direct investment (FDI) to and from the country is used as a control variable
since we believe that FDI is an important determinant of economic growth. The level of inflation
has Also Been Used as a Control Variable.

15
2.7 Empirical Studies
Beck et al. (2000) analyzed the relationship between financial development and economic
growth, total factor productivity growth, physical capital accumulation rates and private savings
rates. The study reported that there is a large positive effect of financial intermediaries and total
factor productivity growth but a lesser effect for long-term economic growth and factor
productivity growth.

El-Wassal (2005) investigates the relationship between stock market growth and economic
growth, financial liberalization, and foreign portfolio investment in 40 emerging markets
between 1980 and 2000. The result shows that economic growth, financial liberalization policies,
and foreign portfolio investments were the leading factors of the emerging stock markets growth.

Adjasi and Biekpe (2006) study the effect of stock market development on economic growth in
14 countries in a dynamic panel data modeling setting. The results indicate a positive
relationship between stock market development and economic growth. Further investigations,
based on the level of economic development and stock market capitalization reveal that the
positive influence of stock market development on economic growth is significant for countries
classified as upper middle-income economies. The general trend in results shows that low-
income African countries and less developed stock markets need to grow more and develop their
markets to achieve economic gains from stock markets.

According to N'zue (2006), the relationship between the development of the Ivorian stock
market and the country's economic performance is positive. The result also reveal that gross
domestic product and stock market development are cointegrated when the control variables are
included in the analysis. Moreover, there is a unidirectional causality running from stock market
development to economic growth.

Capasso (2006) using a sample of 24 emerging ec onomies investigates the linkage between stock
market development and economic growth covering the period 1988-2002. The finding shows a
strong and positive correlation between stock market development and economic growth and

16
later concludes that stock markets tend to emerge and develop only when economies reach a
reasonable size and with high level of capital accumulation.

Rousseau and Watchel (2001) found that stock markets influence growth through value traded of
shares, while Arestis and Luintel ( 2001) using time series on five industrialized countries also
indicate that stock markets play a role in growth. Empirically it has been shown that the level of
financial intermediation is a good prcdictor of long-run rates of economic growth, capital
accumulation, and productivity improvements (King and Lavine, 1993).

Guha and Mukherjee ( 2008) employed time series econometric model in his study, Does stock
market development cause economic growth? A time series analysis for Indian Economy". This
involved use of Granger causality test and its subsequent improved version Toda Yamammotto
approach for analysis. Toda Yamammotto approach was used to assess the direction of causality
between stock market and economic growth. The research finding was that there is a strong
causal flow from the stock market development to economic growth. A bi-directional causal
relationship was also observed between market capitalization ratio and economic growth.

2.8 Conclusion
The relationship between financial and economic growth has important policy implications for
development strategies. If there is unidirectional causality running from financial development to
growth, this would mean that financial sector not only facilitates the allocation of financial
resources between deficit and surplus units, but also promotes economic growth through capital
augmentation and technological innovations (Levine, 1997). On the other hand, if the causal
process occurs in the opposite direction, it would mean that economic growth is a prerequisite for
a country to reform its financial sector because the evolution of a financial sector is highly
dependent on the demands created by market agents (Romer, 1990). Moreover, the process of the
financial sector development depends on the nat on's absorptive capacity such as human capital
development, investment policy and effective macroeconomic policies. If the causal process is
bidirectional, financial sector and economic growth have a reinforcing causal relationship.

17
 CHAPTER THREE: RESEARCH METHODOLOGY

3.1 Introduction
This chapter addresses the research design of the study. It discusses the population, sample size,
research procedures. A method of pretesting used is reviewed and so are the methods of data
collection and data analysis used.

3.2 Research Design

This study adopts a causal relationship research design. This is a type of conclusive research
where the major objective is to obtain evidence regarding cause-and-effect relationships.
This research design enables the researcher to un lerstand how one variable under study affected
is responsible for a change in another variable.Tl e research design is chosen because in business
research, the cause-effect relationship is less e> plicit. Cooper and Pamela (2006) pointed out
that, use of a causal research design eases the ui-Jerstanding, explanation, prediction and control
of anyrelationship between variables under study.Co-relational and time series research design
has been employed in the study.

3.3 Target Population

The target population for this research is the Nairobi stock exchange as an organisation.
On the other hand, the performance of the overall economy is targeted and measured by the
growth in GDP, which is a leading indicator about the health of the economy.

3.4 Data Collection

The study used secondary data in the form of yearly economic growth rates, stock market
liquidity and capitalisation ratios covering a period of 20 years (from 1990 to 2010). This data
was obtained from the NSE, the Central Bureau of Statistics, Kenya Investment Authority,
Central Bank of Kenya and the World Bank's financial structure database.

18
3.5 Data Analysis
The study used a regression model to estimate the impact of stock market development on
Kenya's economic growth. The Granger Causality test is used to indicate the direction of the
relationship between stock market development and economic growth.

3.5.1 Analytical model

In line with the works of Levine and Zervos (1996), the proposed test adopted the GDP per
capita growth (growth) as the dependent variable. This is used to proxy economic growth.
The researcher will also use consumer price index as a proxy for inflation rate (PI).
The Ordinary Least Square multiple regressionisused to estimate the various models. The
functional form of the model is specified as;

Yi = BI + B3X2i + B3X3l+ui. 0)

Where, Y is the dependent variable. X2 and X3 are the explanatory variables and U is the
stochastic error term, and i the ith observation since the data is time serial.

GDP, =/?, + p2CVt + P2SMD + e, (2)

GDP (dependent variable) is GDP per capita, CV is the control variable and SMD is the stock
market development variable. The researcher will use turnover ratio and market capitalization to
measure stock market development.
The basic relationship to estimate stock market development indicators and growth version of
equation (1), is of the following form:

GDP, =/?,+ pjRt + 03PI, + PJNV, + P,MCt + e, (3)

Where TR is the turnover ratio, PI is the consumer price index, MC is the market capitalization,
and INV is the Foreign Direct Investments and E is the stochastic error term

IE
 CHAPTER FOUR

DATA ANALYSIS, FINDINGS AND DISCUSSIONS

4.1 Introduction
This chapter presents the research findings to establish the existence of a relationship between
stock market development and economic growth in Kenya and to establish the direction of the
relationship between stock market development and economic growth in Kenya. The Granger
causality test has been used to determine the nature of the relationship. Secondary data was
collected and analyzed using SPSS to generate various regression analyses as stipulated in the
methodology. Data on Foreign Direct Investments and consumer price index is used as control
variables.

4.2 Regression Analysis

4.2.1 Regression model one

T a b l e 4 . 1 Table of model one coefficients

CoeffidentsJ

Standardized
Un>taridar« Coefficients Coefficients 95% Confidence interval for B Correlations CflraflSjjjsfcs
jfc B Std. Error Beta t Siq. LowerBound UoperBound Zero-ordet Partial Part Tolerance W
1 M 9.019 3MB 2.947 .009 1519 1.557E10
TO 1314E9 3.683E8 .596 3 567 .002 5.365E8 2.091E9 .736 .654 .533 .799 1.252
PI -1.190 1.218 -.193 -1.218 .240 -4.1E8 1.093E8 -.422 -.283 -.182 .888 1.126
TO 11.835 8 483 .222 1.395 .181 -6.063 29.733 .453 .321 .208 .882 1.134
i DependentVariable: GOP
Source: Researcher (2012)

From the table above, Tolerance and VIF values are given. Tolerance i$ an indicator of how
much of the variability of the specified independent is not explained by the other independent

2C
variables in the model. If this value is less than 0 1, it indicates that the multiple correlation with
other variables is high, suggesting a possibility or multicollinearity and if VIF (variance inflation
factor) values are greater than 10, it will indicate multicollinearity. From the table, no values of
tolerance are less than 0.1 and all the values of VIF are not greater than 10. Therefore, the
researcher has not violated the multicollinearity assumption.

Foreign direct investments (FDI) and stock turnover ratio (TR) correlate substantially with GDP
as seen from table 4.1.

The adjusted R square measures the proportion of the variance in the dependent variable (GDP)
that was explained by variations in the independent variables. The adjusted R square shows that
55.4% of the variance is explained as seen in model one summary on the appendix. R-squared
indicates the variation in GDP % changes with changes in Foreign Direct Investments, stock
turnover ratio and the consumer price index.

Stock turnover ratio has the largest beta in table 4.1. This means that this variable makes the
strongest unique contribution to explaining the dependent variable (GDP), when the variance
explained by all other variables in the model is controlled for. Consumer price index made less
of a unique contribution to explaining the dependent variable. FDI and PI have a significance
value of more than 0.05, which indicates that the variables do not make a statistically unique
contribution to the equation.

The coefficients in the table 4.1 were used in coming up with the model below:

GDP = 9.076E+9 + 11.835*FDI +1.314E+9*TR - 1.494E+9*PI

From the model, an increase in foreign direct investments (FDI) and stock turnover ratio (TR)
would lead to an increase in GDP % changes while an increase in consumer price index would
lead to a decrease in GDP % changes.

4.2.2 Regression model two

Foreign direct investments (FDI), consumer price index (PI) and market capitalization (MCP)
correlate substantially with GDP as seen from table 4.2.

21
The adjusted R square measures the proportion o'~ the variance in the dependent variable (GDP)
that was explained by variations in the independent variables. From the table 4.2, the adjusted R
square shows that 55.9% of the variance is explained. R-squared indicates the variation in GDP
% changes with changes in Foreign Direct Investments, market capitalization and the consumer
price index.

Table 4.2 Table of model two coefficients

Coefficients
Unstandardized Standardized Collinearity
Coefficients Coefficients Correlat ions Statistics
Std. Zero
B Error Beta t Sig. order Partial Tolerance VIF
(Constant) 1.08E+10 2.72E+09 3.977 0.001
PI -2.69E+08 1.16E+08 -0.348 -2.318 0.033 -0.422 -0.49 0.98 1.021
FDI 6.645 8.981 0.125 0.74 0.469 0.453 0.177 0.777 1.287
MCP 3.28E+08 9.06E+07 0.606 3.618 0.002 0.697 0.66 0.785 1.274
R square 0.626 Adjusted 0.559
Dependent Variable: GDP
Source: Researcher (2012)

Tolerance and VIF values are given as seen in ti e table above. Tolerance is an indicator of how
much of the variability of the specified independent is not explained by the other independent
variables in the model. If this value is less than 0.1, it indicates that the multiple correlation with
other variables is high, suggesting a possibility or multicollineanty and if VIF (variance inflation
factor) values arc greater than 10, it will indicate multicollinearity. From the table 4.2, no values
of tolerance are less than 0.1 and all the values of VIF are not greater than 10. Therefore, the
researcher has not violated the multicollinearity assumption.

Market capitalization has the largest beta in table 4.2. This means that this variable makes the
strongest unique contribution to explaining the dependent variable (GDP), when the variance
explained by all other variables in the model is controlled for. FDI has a significance value of
more than 0.05, which indicates that the variable does not make a statistically unique
contribution to the equation.

22
The coefficients in the table 4.2 were used in coming up with the model below:

GDP = 1.08E+10 + 6.645*FDI +3.28E+08*MCP - 2.69E+08*PI

From the model, an increase in foreign direct investments and market capitalization would lead
to an increase in GOP % changes while an inciease in consumer price index would lead to a
decrease in GDP % changes.

4.2.2 Regression model three

Table 4.3 table of model three coefficients

Coefficients'

Standardized
Unstandardized Coefficients Coefficients 95% Confidence Interval for B Correlations Cinearityfflstics
B Std. Error Beta 1 Siq. Lower Bound 1 JooerBound Zero-order Partial Part Tolerance f
1 (Constat) 8.905E9 2.985E9 2.982 .009 2.575E9 1.521E10
PI •1.9980 1.233E8 -.258 •1.611 .126 •4.622E8 6.255E7 -.122 -.374 -.234 .818 1.222
FDI 7.384 87/1 .138 .812 .112 •11.210 25.977 .153 .206 .122 .774 1.292
HCP 1.9210 1.324E8 .356 1.153 .166 •8.828E7 1.731 E8 .697 .341 .210 .350 2.860
(

1R 7.349E8 5.347E8 .333 1.371 .188 •3.986E8 1.868E9 .736 .325 .199 .356 2.811
s. Dependent Variable: GOP

Source: Researcher (2012)

From the table above, Tolerance and VIF values are also given. Tolerance is an indicator of how
much of the variability of the specified independent is not explained by the other independent
variables in the model. If this value is less than 0.1, it indicates that the multiple correlation with
other variables is high, suggesting a possibility of multicollinearity and if VIF (variance inflation
factor) values are greater than 10, it will indicate multicollinearity. In table 4.3, no values of
tolerance are less than 0.1 and all the values of VIF are not greater than 10. Therefore, the
researcher has not violated the multicollinearity assumption.

23
Foreign direct investments (FDI), market capitalization and consumer price index correlate
substantially with GDP as seen from table 4.3.

The adjusted R square measures the proportion c * the variance in the dependent variable (GDP)
that was explained by variations in the independent variables. The adjusted R square shows that
58.1% of the variance is explained as seen in model three summary in the appendix. R-squared
indicates the variation in GDP % changes with changes in Foreign Direct Investments, stock
turnover ratio, market capitalization and the consumer price index.

Stock turnover ratio and market capitalization have a larger beta as seen in table 4.3. This means
that these variables make a stronger unique contribution to explaining the dependent variable
(GDP), when the variance explained by all other variables in the model is controlled for.
FDI made less of a unique contribution to explaining the dependent variable since it has the
lowest beta of 0.138 as seen in table 3.

The coefficients in the table 4.3 were used in coming up with the model below:

GDP = 8.905E+9 + 7.384*FDI +7.349E+8*TR - 1.998E+8*PI+1.924E+8*MCP

From the model, an increase in foreign direct investments, market capitalization and stock
turnover ratio would lead to an increase in GDP % changes while an increase in consumer price
index would lead to a decrease in GDP % changes.

From the three models, stock market liquidity in licators (MCP and TR) made a stronger unique
contribution to explaining the dependent variable (GDP), when the variance explained by all
other variables in the model is controlled for. Market capitalization is seen to be a better market
liquidity indicator than the stock turnover ratio. The control variables seem to vary depending on
the factor being investigated. Increase in consumer price index leads to a decrease in GDP %
changes while increase in other variables in the models leads to an increase in GDP % changes.

24
4.3 Granger Causality Test
Table 4.4 Table of Granger causality test
Pairwise Granger Causality Tests

Sample: 1990-2010
Lags: 2

F-
Null Hypothesis: Obs Sutistic Prob.

GDP does not Granger Cause TR 19 5.79784 0.0146

TR does not Granger Cause GDP 7.00064 0.0078

GDP does not Granger Cause PI 19 0.84677 0.4496

PI does not Granger Cause GDP 0.35302 0.7086

FDI does not Granger Cause MCP 19 0.13093 0.8783

MCP does not Granger Cause FDI 4.93985 0.0238

GDP does not Granger Cause MCP 19 0.13093 0.8783

MCP does not Granger Cause GDP 4.93985 0.0238

From table 4.4, we do not reject the hypothesis that GDP does not Granger cause market
capitalization (MCP) but we reject the hypothesis that MCP does not Granger cause GDP.
Therefore, the Granger causality runs one way from market capitalization to GDP and not the
other way.

We reject the hypothesis that GDP does not Granger cause stock turnover (TR) as seen in table
4.4 but we do not reject the hypothesis that TR does Granger cause GDP. This means that the
Granger causality runs one way from GDP to TP

The above findings have exhibited a two-way causality between stock market development and
economic growth in Kenya

25
 CHAPTER FIVE
SUMMARY, CONCLUSIONS AND RECOMMENDATIONS

5.1 Introduction

From the analysis and data collected, the following summary of findings, conclusions and
recommendations were made. The responses were based on the objective of the study. The
researcher had intended to establish the existence of the relationship between stock market
development and ec gnomic growth in Kenya. The researcher also wanted to know the direction
of the relationship.

5.2 Summary

From the first model, the adjusted R square shows that 55.4% of the variance is explained. R-
squared indicates the variation in GDP % changes with changes in Foreign Direct Investments,
stock turnover ratio and the consumer price index.Stock turnover ratio has the largest beta in
model one. This means that this variable made the strongest unique contribution to explaining
the dependent variable (GDP), when the variance explained by all other variables in the model is
controlled for. Consumer price index made less of a unique contribution to explaining the
dependent variable. FDI and PI have a significance value of more than 0.05, which indicates that
the variables do not make a statistically unique contribution to the equation.From model one, an
increase in foreign direct investments and stock turnover ratio would lead to an increase in GDP
% changes while an increase in consumer price index would lead to a decrease in GDP %
changes.Below are the coefficients of model one:

GDP = 9.076E+9 + 11,835*FDI +1.314E+9*TR - 1.494E+9*PI

In the second model, foreign direct investments (FDI), consumer price index (PI) and market
capitalization (MCP) correlate substantially with GDP.In the second model, the adjusted R
square shows that 55.9% of the variance is explained. R-squared indicates the variation in GDP
% changes with changes in Foreign Direct Investments, market capitalization and the consumer
price index.

26
Market capitalization has the largest beta in model two. This means that this variable made the
strongest unique contribution to explaining the dependent variable (GDP), when the variance
explained by all other variables in the model is controlled for. FDI has a significance value of
more than 0.05, which indicates that the variable does not make a statistically unique
contribution to the equation.In model two, an increase in foreign direct investments and market
capitalization would lead to an increase in GDP % changes while an increase in consumer price
index would lead to a decrease in GDP % changeBelow are the coefficients of model two:

GDP = 1.08E+10 + 6.645*FDI +3.28E+08*MCP - 2.69E+08*PI

In the third model, Foreign direct investments (FDI), market capitalization and consumer price
index correlate substantially with GDP. The adjusted R square in model three shows that 58.1%
of the variance is explained. R-squared indicates the variation in GDP % changes with changes
in Foreign Direct Investments, stock turnover ratio, market capitalization and the consumer price
index. Stock turnover and market capitalization have a larger beta in model three. This means
that these variables made a stronger unique contribution to explaining the dependent variable
(GDP), when the variance explained by all other variables in the model is controlled for. FDI
made less of a unique contribution to explaining the dependent variable since it has the lowest
beta. In model three, an increase in foreign direct investments, market capitalization and stock
turnover ratio would lead to an increase in GDP % changes while an increase in consumer price
index would lead to a decrease in GDP % changes.Below are the coefficients of model three:

GDP = 8.905E+9 + 7.384*FDI +7.349E+8*TR - 1,998E+8*PI+1.924E+8*MCP

5.3 Conclusion

The study examined stock market development and economic growth in Kenya from 1990 -2010
using a regression model. The objectivewas to establish the relationship between stock market
development and economic growth in Kenya. In the process of doing this, the hypothesis that
stock market promotes economic growth in Kenyawas validated. The indicator (MCP and TR)
used to capture stock market development in Kenya was found to be positively related to

27
economic growth and significant but the two indicators gave two different results in the Granger
causality test. When the MCP is used in the Granger causality test, the Granger causality runs
one way from market capitalization to GDP and not the other way but when consumer price
index is used, Granger causality runs one way from GDP to TR.

In view of this ongoing debate on the relationship between stock market development and
economic growth, the result of the present study should not be viewed as conclusive empirical
evidence, but rather as an additional motivation for further research in this area.

5.4 Recommendations
/

The stock market plays an important role in the economic growth but the government needs to do
much to attract and encourageactive participation of stock markets sector. The country has
mainly focused on banking systems reforms: introducing interest rate controls, reducing
government involvement in credit allocation, minimizing taxationof financial intermediaries,
managing bank insolvency, now the country needs to focus on stock markets

This study therefore has important implications on prevailing policies. The study emphasizes that
to improve the economic growth in Kenya; the government should consider favourable
macroeconomic policies that encourage stock market development and investments, which
enhance economic growth. Inflation and its volatility have an important consequence on stock
markets. Therefore, the government should put in place measures to ensure that inflation rate is
controlled.Policymakers should encourage stock market development. They should remove
impediments tostock markets, such as tax, legal, and regulatory barriers.

Currently the NSE has less than 65 companies 'isted in the stock exchange market. The study
recommends that more companies and especiallythe small and medium enterprises should be
encouraged to be listed in the stock exchange ma ket, allowed access in order to access investible
funds from the masses thereby stimulating and boosting the financial system and the stock
market in particular, and consequently raise economic growth.

28
5.4 Limitations of the study

Foreign direct investments made less contribution to explaining the dependent variable. More
control variables should have been used instead of two control variables to enable the model to
explain the relationship between stock market development and economic growth adequately.

The regression equation used in the study is only an estimator of Y. One cannot possibly account
for every factor that goes into each Y value. Thus, the model did not adequately represent the
relationship between stock market development and economic growth in Kenya.

Stock market development indicators used in this study may not be adequate.Market
capitalization ratio and stock turnover ratio as proxies of stock market development has been
popular in literature, it clearly does not include other indicators of stock market development like
international integration, market concentration, regulatory and institutional indicators and stock
market volatility.

5.5 Suggestion for further research

This study sought to investigate the relationship between stock market development and
economic growth in Kenya. The findings of this study have concluded that thestock market has a
positive effect on economic growth. These results are consistent with earlier studies done by
Levine and Zervos (1996).

Although the paper sheds light on the role of stock market development on economic growth,
further work needs tobe done to establish whether other aspects of the stock market such as size,
volatility, and trade volume and, depth in terms of instruments on offer exhibits different results
from the ones reached in the conclusion of this tudy. Another direction for future research is a
cross-national study involving other developing countries such as the sub-Saharan African
countries as well, in order to bring out further empirical evidence with regard to the direction of
causality between tne stock market and economic activity. This study has been constrained
because the causality used in the study is Grange- causality. Thus, the need of further research is

29
obvious in order to get more evidence about the bi-directional relationship between the stock
markets and economic growth in Kenya.

30
 REFERENCE

Adjasi A. (2007, august), stock market development in sub-saharan africa: critical issues and
challenges. IMF working /?apper(WP/07/209).
Adjasi k. and Biekpe N. (n.d.). Stock market development and economic growth: The case of
selected African countries. African Development review, 75(1), 144-161.
Akinlo E. and Egbetunde T. (2010). Financial development and economic growth: The
experience of 10 Sub-Saharan African countries. The review of Finance and Banking,
2(1), 017-028.
Amaral P. and Quintin E.(2007). Financial intermediation and economic development

Arestis p. and Luintel K. (2001). Financial development and economic growth : the role of stock
markets. Journal of money and credit, J3( 1).

Atje R. and Jovanovic B. (1993). Stock markets and development. European Economic Review,
37.

Barro R. and Sala-i-Martin X. (1995). Economic gowth. New York Mcgraw-Hill.

Barro R. and Xavier Sala-i-Martin. (1992). Convergence. Journal of political economy.

Beck T., Levine R. and Loayza N. (2000).Finance and the Sources of Growth Journal of
Financial Economics, Vol. 58, pp. 261-300.

Beck T. and Levine R. (2001) Stock markets, banks, and growth: correlation or causality? Policy
Research Working Paper 2670.

Beck T. and Levine R. (2004) Stock Markets, Banks, and Growth: Panel evidence. Journal of
Banking and Finance, 28.

Bencivenga, V.R., Smith B, and Starr R. (1996) Equity Markets, Transaction Costs, and Capital
Accumulation: An Illustration. The World Bank Economic Review, Vol. 10.

Benhabib J. and Spiegel M. (1994) The Role of Human Capital in Economic Development:
Evidence from Aggregate Cross-Country ')ata. Journal of Monetary Economics.
Biekepe K. and Adjasi B. (2006) Stock exchange and economic growth: the case of African
countries. University of Stellenbosch Business School, Cape Town, South Africa.

Charles A. and Charles K. (2007). Stock market development in sub-saharan Africa: Critical
Issues and challenges. IMF working Paper Wp/07/209.

Capasso S. (2006). Endogenous Information Frictions, Stock Market Development and

Economic Growth. The Manchester School Vol. 76

Deb G. and Mukherjee j. (2008). Does stock market development cause economic growth? A
time series analysis for Indian Economy, international research journal of finance and
economics, 142-149.

Demirguc-Kunt A. and Levine R. (1996). Stock markets, corporate finance and Economic
Growth: An overview. The world hank Economic review, 10(2), 223-239.

Gelb H. (1989) Financial Policies, Growth and Efficiency World Bank Working Paper,
WPS 2002, 12-24

Greenwood J. and Smith B. ( 1996) Financial Markets in Development and the Development of
Financial Markets Journal of Economic Dynamics and Control, Vol. 21.

Holmstrom B, and 1 irole J. (1993) Market Liquidity and Performance Monitoring. Journal of
Political Economy, Vol. 101.

KingR.&Lavine R. (1993). Finance and growth; Schumpter might be right. World bank working
paper.

Kiran B., Yavuz N. and Guris B. (2009). financial development and economic growth: A panel
data analysis of emerging countries. International research journal of Finance and
economics.

Tsuru K. (2000) Finance and Growth: Some theoretical considerations, and a review of the
empirical literature. Economics Department Working papers no 228.

Levine R. and Demirguc K. (1996) Stock Market Development and Financial Intermediaries:
Stylized Facts. World Bank Economic Review, 10(2).

Levine R.( 2004) Finance and growth: Theory and evidence. NBER working paper series, 1076,
Cambridge, MA.

42
Levine R. (1997) Financial Development and Economic Growth: View and Agenda. Journal of
Economic Literature, 35.

Levine R. and King R. ( 1993) Finance and Growth: Schumpeter might be right. The Quarterly
Journal of Economics, 108(3).

Levine R. and David R. ( 1992) A Sensitivity Analysis of Cross-Country Growth Regressions."

American Economic Review.

Levine R. (1991) Stock Markets, Growth, and Tax Policy. Journal of Finance, Vol.46.

Misati R. N. and Nyamongo E. M. (2011) Financial liberalisation, financial fragility and

economic growth in Sub-Saharan Africa. Journal of Financial Stability .

Mankiw G, Romer D. and Weil D. ( 1992) A contibution to the Empirics of Economic

Growth. Quarterly Journal of Economics.

Muga D.N. (1974) The Nairobi Stock Exchange; it is History, Organization and Role in the Kenyan
Economy. Unpublished MBA Dissertation University' of Nairobi

National security exchange (2012). History of Nairobi Security Exchange Retrieved on

September 23, 2012 from www.nse.co.ke

N'zue F. (2006) Stock Market Development and Economic Growth: Evidence from Cote

D'lvore. Africa Development Review, 18(1).

Nyamongo, E. M., Misati, R. N., Kipyegon, L., and Ndirangu, L. (2012) Remittances, financial
development and economic growth in Africa .Journal of Economics and Business
(Accepted Manuscript).

Pardy R. (1992) Institutional Reform in Emerging Securities Markets, Policy Research Working
Papers (Financial Policy and Systems). World Bank, Working Paper Series, 907.

Pettinger T. (2011) Factors affecting economic growth.

3"».
R. B. (1989). Economic growth in a cross section of countries . RCER Woringpaers 201,
University ofRocheter - Center of Econot tic research.

R.B. (1997). Determinats of Economic Growth: A cross country empirical study. MIT press
Cambridge.

Rousseau P. and Watchtel P. (2000). Equity markets and growth: Cross country Evidence on
timing and outcomes 1980-1995. Journal of banking andfinance, 24:1933-57.

Tachiwou A. M. (2010, August). Stock Market Development and economic growth: The case of
west African Union. International Journal of Economics and Finance, 2(3).

Tobias O. and Danson K. (2011). stock market performance and economic growth: Empirical
evidence from kenya using causality test approach, advances in management & applied
Economics, 3, 153-196.

ShawS. (1973) Financial Deepening in Economic Development.Oxford University Press, New

York.

Shleifer A. and Vishny R. (1997) A survey of corporate governance Journal of Finance, 52(2).

Singh A. (1997) Financial liberalisation, stock irirkets and economic devdopmenl.Eronomic

Journal, 107.

Surya B. and Suman N. (2006). Stock Market and Economic Development: a casuality Test. The
journal ofNepalese Business Studies, UI(\).

Tsuru K.. (2000) Finance and Growth: Some theoietical considerations, and a review of the
empirical literature. Economics Department Working papers no 228.

34
 APPENDIX III

M o d e l one Summary

Change Statistics
Std. Error .
Mod R Adjusted R of the R Square F Sig.F
el R Square Square Estimate Change Change dfl df2 Change
1 ,788a .621 .554 5.458E9 .621 9.280 3 17 .001
a. Predictors: (Constant), FDI, PI,
TR
b. Dependent Variable: GDP

Model two S u m m a r y

Change Statistics
Std. Error.
R Adjusted of the R Square F Sig. F
Model R Square R Square Estimate Change Change dfl df2 Change
1 .788a .621 .554 5.458E9 .621 9.280 3 17 .001
a. Predictors: (Constant), FDI, PI, TR
b. Dependent Variable: GDP

Model three Summary

Change Statistics
Std Error -
Mod R Adjusted of the R Square F Sig. F
el R Square R Square Estimate Change Change dfl df2 Change
1 .816" .665 .581 5.288E9 .665 7.943 4 16 .001
a. Predictors: (Constant), TR, PI,
FDI, MCP
b. Dependent Variable: GDP

35
 APPENDIX II
STOCK TURNOVER, CONSUMER PRICE INDEX, FOREIGN DIRECT INVESTMENTS
AND MARKET CAPITALIZATION (1990-2010)
Stock
traded, Foreign direct Market
turnover Consumer investments capitalization (%
Year GDP (annual %) % price index current US$ of GDP)

1990 8590574252.40 2.10 11.20 57081096.18 5.27

1991 8152105054.25 2.43 19.10 18830976.84 5.56
1992 8220718082.65 2.20 27.33 6363133.14 7.75
1993 5751786609.50 1.65 45.98 145655517.11 18.43
1994 7148143144.01 3.00 28.81 7432412.60 43.09
1995 9046331923.21 2.62 1.55 42289248.46 20.85
1996 12045836991.71 3.59 8.86 108672931.62 15.32
1997 13115729422.01 5.78 11.92 62096809.78 13.91
1998 14093228424.71 4.11 6.72 26548245.97 14.36
1999 12896050251.69 4.32 5.75 51953455.95 10.93
2000 12691278914.24 3.53 9.96 110904550.40 10.11
2001 12986519857.43 3.41 5.73 5302622.94 8.08
2002 13149263398.53 2.94 1.97 27618447.06 10.82
2003 14903634448.25 7.46 9.81 81738242.64 28.03
2004 16096109637.49 8.54 11.79 46063931.45 24.17
2005 18737895400.78 9.83 9.87 21211685.40 34.07
2006 22502291403.39 14.63 6.04 50674725.18 50.56
2007 27236739895.94 10.64 4.27 729044146.04 49.15
2008 30519165008.69 11.83 15.10 95585680.23 35.77
2009 30580367979.31 4.59 10.55 116257608.99 35.17
2010 32198151217.22 8.60 4.09 185793189.89 44.91

36
 APPENDIX III
COMPANIES LISTED AT THE NAIROBI STOCK EXCHANGE
Kapchorua Tea Co. Equity Bank Ltd.
Kakuzi The Co-operative Bank of Kenya Ltd.
Limuru Tea Co. Ltd. . utilee Holdings Ltd.
5
Rea Vipingo Plantations Ltd. ar Africa Insurance Holdings Ltd.
Sasini Ltd. Cenya Re-Insurance Corporation Ltd.
Williamson Tea Kenya Ltd. CFC Insurance Holdings
British-American Investments Company (
Express Ltd.
Kenya).
Kenya Airways Ltd. CIC Insurance Group Ltd.
Nation Media Group City Trust Ltd.
Standard Group Ltd. Olympia Capital Holdings Ltd.
TPS Eastern Africa (Serena) Ltd. Centum Investment Co Ltd.
Scangroup Ltd. Trans-Century Ltd
Uchumi Supermarket Ltd. B.O.C Kenya Ltd.
Hutchings Biemer Ltd. British American Tobacco Kenya Ltd.
Longhorn Kenya Ltd. Carbacid Investments Ltd.
AccessKenya Group Ltd. East African Breweries Ltd.
Safaricom Ltd. Mumias Sugar Co. Ltd.
Car and General (K) Ltd. Unga Group Ltd.
CMC Holdings Ltd. Eveready East Africa Ltd.
Sameer Africa Ltd. Kenya Orchards Ltd.
Marshalls (E.A.) Ltd. A.Baumann CO Ltd.
Barclays Bank Ltd. Athi River Mining
CFC Stanbic Holdings Ltd. Eaagads Ltd.
Diamond Trust Bank Kenya Ltd. Bamburi Cement Ltd.
Housing Finance Co Ltd. Crown Berger Ltd.
Kenya Commercial Bank Ltd. E.A.Cables Ltd.
National Bank of Kenya Ltd. E.A.Portland Cement Ltd.
NIC Bank Ltd. Ke.iolKobil Ltd.
Standard Chartered Bank Ltd. Total Kenya Ltd.
Kenya Power & Lighting Co Ltd. KenGen Ltd.
Source: Nairobi Stock Exchange (2012)

37