Do stock market liberalization cause investment booms?
What is a stock market liberalization?
A stock market liberalization is when investors allowed to purchase shares from foreign exchange market. A decision from a foreign government to liberalize the stock market is believed to stimulate growth and boost the economy. However, some researchers still insist that investment booms have minimal correlation with a stock market liberalization decision.
Implications of stock market liberalization
- Stock market liberalization reduces the cost of equity, thereby the weighted average cost of capital is reduced. Subsequently, any expected future cash flow would increase which lead to higher company’s valuation. Thus, we should see an increase in the country’s market price as a result.
- A reduction in the cost of equity also leads to an increase in physical investments: Since physical investments are driven primarily by the required cost of capital in the calculation of net present value (NPV), which derived from cost of equity. A reduction in cost of equity would drive negative net present value to positive net present value, thus, more projects would then be accepted and initiated.
Why does the cost of equity of country decrease following the decision to liberalize the country’s stock market?
Portfolio Benefits of market liberalization
- Diversification: the purpose of diversification is to reduce the risk of the overall portfolio, a portfolio with only domestic stocks is limited to greater risk reduction. In other words, there is a limit to how diversifiable risk you could reduce if ones were to hold only domestic securities. However, if an investor expands his investment options to international securities, the risk of a portfolio could be reduced even further beyond the threshold. By looking at the chart above, we notice that only diversifiable risk (the risk of company), and market risk is nondiversifiable. And there is a limited to how far you can diversify your unsystematic risk. However, if ones were to place an international stock in its portfolio, the portfolio risk could be reduced even further down.
Will the cost of equity and the growth rate of the capital stock increase permanently?
The answer is no. Theory suggests that stock market liberalization only temporarily increase the growth rate of capital stock, and not permanently. Since the reduction of cost of equity following the market liberalization will also drive the marginal product of capital to the new cost of capital. Once the marginal product of capital equals the post-liberalization cost of capital, the growth of capital stock will return to its pre-liberalization rate.
Though stock market liberalization implies a decrease in the world’s cost of capital which results in higher private investment. It’s impossible to conclude that market liberalization causes a permanent investment boom. However, it’s empirically safe to conclude that capital market liberalization will cause a sufficiently temporary increase in the growth rate of investment.
Henry, Peter. “Do stock market liberalization cause investment booms.” Journal of Financial Economics, vol. 58, no. 1-2, 6 Sept. 2000. ScienceDirect. Accessed 20 Dec. 2018.