Conspicuous growth of the stock markets

Economists plunged into considerable debate over the relationship between financial system and economic growth. Economists' paradigm can be seen from different perspectives. Manager-shareholders relationship (agency relationship) has got prominence in recent times. While the possibility of the divergence of interest of the managers and those of the shareholders was entertained, it was quickly dismissed because the discipline of the market place would ensure a congruence between the two. Another relatively new paradigm considers the significance of imperfect and costly information in the economy, the difficulties of enforcing contacts, choosing good managers and projects and providing them with incentives, not only to work hard and to appropriate risks but also to act in the interest of the shareholders in general.
However, all these have led to two basic issues of financing economic development. First, how best external finance can be provided for the business sector, the engine of growth. Second, how the behaviour and performance of corporate borrowers can be monitored under an effective system of corporate governance.
Stock markets are likely to promote corporate control. Stock markets signify stock performance through price implying that the owners would link managerial compensation with the stock price. Linking stock performance to managerial compensation facilitates alignment of the interest of managers with those of owners. However, there are disagreements about the importance of stock markets in corporate control. Insiders probably have better information than outsiders. Thus asymmetric information may reduce the efficacy of corporate takeovers as a mechanism for exerting corporate control. Asymmetric information and the resultant 'lemon's problem' suggest that the emerging markets can't be an effective means for channelising funds from savers to borrowers.
The concepts of 'moral hazard', 'adverse selection effect', 'agency costs', 'incentive effect' etc. are basic notions usually associated with asymmetric information. In case of management-controlled large firms, it may occur due to unequal access to information between managers and shareholders. Managers are likely to know more about the operations than the shareholders. Where there is a separation of ownership and control, there might be differences in the objectives of the two groups and a moral hazard stems from it. This means that managers may foster policies for their own interest at the cost of the stockholders, frequently known as principal-agent problem. The notion of agency costs arises from this fact which necessitates costs involving incentives and monitoring purposes.
EQUITY MARKET STRUCTURE IN BANGLADESH: Embryonic securities markets characterised by low liquidity, high volatility and reduced efficiency have become increasingly active as a result of increasing number of listed companies and volume and more suitable macroeconomic policies pursued by government. These markets are emerging throughout the developing world. Although they have their own idiosyncrasies, they are described by several phases common to all, (Papaioannou and Duke, 1993). First, equity markets tend to develop with the growth-oriented policies. It is possible only after a country has achieved a degree of economic and political stability. In this situation equity market gains prices with confidence of investors.
Second phase provides some degree of credibility as market liquidity increases and risk-adjusted returns rise and international investors begin to realise diversification benefits of investing in such markets.
Third phase entails expansion with higher and less volatile returns and investors easily absorb new issues of securities. If the risk premiums for stock fall to internally competitive levels relative to treasury bills rates then the stock markets begin to achieve the stable growth of mature markets. This may be considered as the final phase.
It is difficult to exactly define the phase of Bangladesh markets in the above terms for its own idiosyncratic condition. Optimism about the stock market of Bangladesh is gradually growing which is reflected in the growing size of the market in terms of participants, turnover, number of listed companies and market capitalisation. Bangladesh stock markets are represented by two stock exchanges, viz., Dhaka Stock Exchange (DSE) and Chittagong Stock Exchange (CSE). The Bangladesh government intended to open the capital market to foreign participation in order to attract foreign capital since 1994 along with easy convertibility of Taka into foreign currency. Investors were allowed to portfolio investment like the domestic investors. Government-owned corporations are being privatised gradually for the last few decades. Ahmed (2000) examined some variables to show the spectacular growth of the DSE. Basically, the growth of the market has been orchestrated by the government through various policies and programmes.
Although the market has reasonably long experience since 1954, investors lack confidence due to credibility gap prevailing in the market. The market structure is still questionable in terms of regulatory framework and its execution, market governance and so on. It is believed that the market is expected to overcome these shortcomings and the international investors will be encouraged to participate in our market. In view of the above, the market is likely to be aligned with the second phase in general.
Trading is conducted by the broker-members of the stock exchanges in Bangladesh. In order to execute an order to buy or sell securities on behalf of his client, a broker is supposed to provide services at the time of executing a sell order as well as provide services and funds for a buy order for commission. Thus, the stock markets in Bangladesh predominantly operate through the agents without responsible market makers.
All securities traded on the stock exchange are subject to daily price limitations in an attempt to discourage speculative investors known as circuit breaker. The exchange sets maximum upper and lower limits on daily price movements and transactions by shareholders. Sometimes, Bangladesh Securities and Exchange Commission (BSEC) also interferes in this process through regulating DSE activities. This practice can cause truncated returns and thus delay the effect of new information on stock prices.
Margin trading is limited to securities listed on the stock exchange and strictly guided. Margin requirements are subject to change from time to time as a tool for regulating the demand for stocks. The government also uses tax policy to regulate trading activities in the market. But there is controversy whether this is always effectively regulated.
Now-a-days, use of computer in trading system and a central depository system (CDS) have been introduced in order to bring efficiency in the market. In view of the frequent allegations about the market manipulation resulting market upsurges followed by sharp downswings in 1996 and 2010, credibility of the system as a whole has come into question. It was expected that use of computer in the trading system and introduction of a CDS would bring improvement of the situation but found little tangible result.
Demutualisation of ownership and management of DSE, which is believed to be a deterrent to market manipulation, is under active consideration for its introduction. Order flows are generated, at least partially, by subtle interactions of human activities on the floor, including the behaviour of the rivals, floor atmosphere, floor gossips and so on. All these can hardly be held by computer implying 'overshooting' or 'undershooting' in prices if traders are just reacting to price moves on the screen without well understanding the reasons behind such moves. The system, therefore, needs to combine the advantages of the technology - efficiency, accuracy and speed -with those of human interaction, visibility and information exchangeability on the trading floor in association with improved legal framework and their execution so that better market coordination with less price volatility can be ensured.
STOCK PRICE BEHAVIOUR: Stock price behaviour in terms of predictability is one of the most controversial issues in finance literature. This is possibly because of its critical role in market efficiency in terms of its implications on capital formation, wealth distribution and investor rationality. In many earlier studies it has been shown that capital markets are efficient at least in its weak form. Fama (1970) has indicated that the vast majority of the studies were unable to reject the Efficient Market Hypothesis (EHM) for common stocks. Many financial economists would agree with Jensen (1978) that 'there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis.' In an informationally efficient market, which is different from allocationally or Pareto-efficient market, price changes must be unforecastable if they fully incorporate the expectations and information of all market participants. The more efficient the market, the more random the sequence of price changes generated by such a market, and the most efficient of all is one in which the price changes are completely random and unpredictable (Lo, 1997). Grossman and Stiglitz (1980) argue that "perfectly informationally efficient markets are an impossibility, for if markets are efficient, the return to gathering information is nil, in which case there would be little reason to trade and markets would eventually collapse. Alternatively, the degree of market inefficiency determines the effort investors are willing to expand to gather and trade on information, hence a nondegenerate market equilibrium will arise only when there are sufficient profit opportunities, i.e., inefficiencies, to compensate investors for the cost of trading and information gathering."
When analysing prices of securities a commonly used assumption is that many of the fluctuations in market prices are the result of purely stochastic processes. One recognises, of course, the effects on prices of external influences such as political developments and a variety of macroeconomic factors.
The prevailing wisdom among analysts is that other price fluctuations are dominated by "noise" and can be represented by a stochastic process. To a great extent, however, these price movements are the result of the inherent nonlinearities in the market place. In order to understand nonlinearities, feedback effects in price movements need to be explained which may be either linear or nonlinear. If the feedback is linear, the market always responds by making price adjustments that are simply proportional to the amount by which the price varies from its 'correct' value. On the contrary, feedback is nonlinear if there will be corrective effective effects while the correction of the market appears to be not proportional to the amount by which the price deviates from the real value. This kind of dynamics might give rise to nonlinear effects which usually come in the study of market psychology. In such situations people and markets usually overreact.
Keynes in his General Theory of Employment, Interest and Money has questioned the role of stock market. In his words, "As the organisation of investment markets improves, the risk of the predominance of speculation does, however, increase. In one of the greatest investment markets in the world, namely, New York, the influence of speculation (in the sense of the 'activity of forecasting the psychology of the market') is enormous ........ Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubbles on a whirlpool of speculation. When the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill done. The measure of success attained by Wall Street, regarded as an institution of which the proper social purpose is to direct new investment into the most profitable channels in terms of future yield, can't be claimed as one of the outstanding triumphs of laissez-faire capitalism...."
However, for various reasons a general trend toward liberalisation, deregulation and privatisation has been dominating throughout the globe. A significant phenomenon of this development in Bangladesh is the conspicuous growth of the stock markets. The establishment and expansion of these markets have been favoured not only by Bretton Woods institutions, but also by many heterodox economists and those from the centrally planned economy.
Dr. M. Farid Ahmed is a Professor, Department of Finance,
University of Dhaka.