Stock Market Liberalization , Stock Market Performance and Economic Growth in Kenya

The study empirically examined whether stock market liberalization improves the functioning of domestic stock market and accelerates economic growth in Kenya. The study also assessed the kind of relationship between liberalization, stock market performance and economic growth in Kenya. Liberalization was assessed by stock market capitalization while turnover was used to asses stock market performance. The study used quarterly time series data collected through secondary sources and covered a period of 22 years from January, 1991 to December, 2012. The study utilized econometric techniques of Vector autoregressive and Granger Causality Tests to investigate the relationships. The results displayed a one way causality that runs from stock market development to economic growth. The results also show that stock market liberalization indirectly impacts on economic growth through investment. The study found that stock market liberalization has a significant positive impact on the economic growth in Kenya.


Introducation
Stock market liberalization can be defined as a decision by a country's government to allow foreigners to purchase shares in that country's stock market. The theory of the standard international asset pricing model (IAPM) predicts that stock market liberalization may reduce the liberalizing country's cost of equity capital. There are two important empirical implications for stock market liberalization (Henry, 2000). First, stock market liberalization tends to boost the stock market liquidity. The second implication is that there is an increase in physical investment following stock market liberalization, due to a fall in a country's cost of equity which spurs real private investment. Research has shown that on average, countries experience large, temporary increases in the growth rate of real private investment following stock market liberalization (Henry, 2000). If other factors are held constant, such as political and economic reforms, oil prices among others, the relationship between private investment growth and stock market liberalization is observed. Akingunola et al. (2013), opines that, the financial sector of any economy in the world plays a vital role in the development and growth of the economy. The development of this sector determines how it will be able to effectively and efficiently discharge its major role of mobilizing fund from the surplus sector to the deficit sector of the economy (Akingunola et al., 2013). If a financial system is well-developed, it will enhance investment by identifying and funding good business opportunities, mobilize savings, enable the trading, hedging and diversification of risk and facilitate the exchange of goods and services (Akingunola et al., 2013). Liberalization can result in a more efficient stock market, which can in turn result in economic growth.
The impact of foreign investors on the performance of the stock market is, however, not clear. There is a controversy concerning the role of financial opening in the development and growth of the economy. It is for example observed that greater foreign participation in the market may cause stock volatility. Sellin (1996), regards foreign investors' participation as noise trading, therefore a source of excess volatility in the market. Krugman (1993) also argues that financial integration is unlikely to spur economic development. Table 1 shows the trend of improved development of the stock market including the openness (market capitalization) and performance (shares turnover) after stock market liberalization in 1995.

Literature Review
Several studies reveal that liberalization encompasses a positive impact to the economy. Liberalization increases stock market liquidity which in turn leads to a large underlying impact on economic growth by affecting total factor productivity growth. The review focused on studies that were conducted to evaluate the effects of stock market liberalization on stock market performance or economic growth. McKinnon (1973) and Shaw (1973) in their separate studies put forward the financial liberalization thesis contending that a government restriction on the financial system has pinned down the quantity and quality of investment. They postulate that the poor performance of investment and growth in developing countries is a function of interest rate ceiling, high reserve requirement and restrictions in credit allocation mechanism. These elements were the sources of financial repression, the main symptoms of which include low savings, credit rationing and low investment. They also postulate that removing financial restrictions in any economy can influence a positive effect on growth rates as interest rates rise toward competitive market equilibrium.
There is a growing body of literature stressing a direct relationship between the extents to which financial liberalization can improve performance and the various measures of efficiency. Liberalization is most likely accompanied by an increase in the amount of research done on individual stock and market conditions in the equity markets. This will lead to improved information availability to both foreign and domestic investors (Henry, 2000). It can also be noted that increased monitoring associated with opening a firm's stocks to foreign investors may improve the governance of the firm, which could force the firm's managers to improve on efficiency, profitability and other measures of operating performance (Henry & Chari, 2002). Stock markets may also stimulate greater corporate control by making it easier to tie managerial compensation to performance (Diamond & Verrecchia, 1982).
Stock markets may also influence risk diversification and avoid liquidity risk. Liquid equity markets make long-term investment more attractive because they allow savers to sell equities quickly and cheaply if they need access to their savings. Simultaneously, companies enjoy permanent access to capital raised through equity issues. By easing longer term, more profitable investments, liquid markets improve the allocation of capital and thereby enhance productivity growth (Levine, 1997). Henry (2000) employs an event study method that assesses the growth rate of private investment during stock market liberalization periods with the growth rate of private investment during non-liberalization periods. The study comprised a sample of 11 developing countries that liberalized their stock markets. The study found that the mean growth rate of private investment in the three years immediately following stock market liberalization exceeds the sample mean by 22 per cent. This shows that there was a temporary increase in growth rate of private investment after liberalization. Levine (2000) used data from 15 emerging economies to assess whether international financial liberalization, by improving the functioning of domestic financial markets and banks, accelerates economic growth. The study used Perron's (1989) test for structural breaks to evaluate whether stock market liquidity changes after the policy change date. The study found that liberalizing restrictions on international portfolio flows tends to enhance stock market liquidity. In turn, enhanced stock market liquidity accelerates economic growth mainly by improving productivity growth. (2001) analyzed the effects of stock market liberalization on financial and macroeconomic development using a cross-sectional data from twenty-seven countries. The study found an increase in real private investment growth by 6 percentage points in the second year after liberalization and cumulatively by about 14 percentage points in the four years following liberalization. The study also found a rise in real GDP per capita growth of about 1 per cent during the first four years after liberalization and a permanent growth effect of about 0.4 per cent per annum. The study concluded that growth tends to be greater where institutional reforms precede liberalization. The study also concluded that stock market and private investment happen to be two essential and interrelated avenues through which liberalization boosts real growth. It found that stock market liberalization stimulates stock market development which facilitates private investment, which in turn stimulates growth.

Fuchs-Schundeln and Funke
Ngugi (2003b) did a study on liquidity of NSE and found that although foreign investors boost trading activity; their significant contribution to liquidity is inhibited by their noise trading behaviour and regulatory system that short-lived institutional investors thrive on for trading activity. The study found that increasing the pull factors for foreign investors in the market is important in order to experience gains in trading activities. This could be coupled with creation of a favourable macroeconomic environment for investment. The study invoked the microstructure theory for empirical analysis testing for market response of trading activity and liquidity of the NSE to the www.ccsenet.org/ijef International Journal of Economics and Finance Vol. 6, No. 4;2014 implemented institutional and policy reforms during the revitalization process.
Tswamuno, Pardee and Wunnava (2007) in their study on financial liberalization and economic growth asserted that liberalization of the equity and bond markets in South Africa did not intensify economic growth. The study opined that even though liberalization absolutely led to a strong upsurge in capital flowing into South Africa, investor speculation, instigated by an unhealthy macro-economic environment and political uncertainty led to huge fluctuations of capital flows and subsequent capital flight. The study demonstrates that liberalization of the capital account is an essential, but not adequate necessity for economic development.
In summary, the above literature shows the beneficial effects of liberalization to stock market liquidity and economic growth. It is also clear from the various studies cited above that liberalization is most effective in emerging economies. Emphasis was placed on literature that covered stock market liberalization. Even though there are many studies on stock market liberalization, this study differs from other studies in some dimensions. First, the data used were from 1991 to 2012 so as to enable the study to examine both pre and post-liberalization periods. Second, the study used a detailed country level analysis since it was focusing on impact of stock market liberalization in Kenya only. Henry (2000), Levine (2000) and Fuchs-Schundeln and Funke (2001) examined the effects of financial liberalization in a cross-country setting and Kenya was not among the countries under their study. There is a possibility of differing results in the case of Kenya. Third, the study closed the knowledge gaps by looking into impact of stock market liberalization on stock market performance and economic growth in Kenya.
The study by Ngugi (2003b) was not specifically analyzing the impact of stock market liberalization.

Introduction
The broad objective of this study was to measure the impact of stock market liberalization on economic growth in Kenya. This chapter discusses the data and empirical model used to measure this objective. To ascertain whether stock market liberalization produces positive effects, it is necessary to ultimately observe its effect on economic growth (Fuchs-Schundeln & Funke, 2001). To better apprehend the processes behind the liberalization effects, two possible channels through which liberalization can nurture stock market development are focused, namely; its impact on stock market capitalization and its subsequent impact on stock market liquidity. Stock market liberalization will increase market capitalization through foreign portfolio investments.

Research Design
A research design includes the methodology and process employed to conduct a research. The choice of a research design is critical as far as every research is concerned. For the purpose of this study, non-experimental design was used. The reason is because data are already in existence and the study was intended to examine the impact of one variable on the other variable.

Model Specification
The principal variables in the analysis were measures of economic growth and stock market development. Gross domestic product (GDP) per capita was used as a measure of the level of economic growth while market capitalization (% of GDP) was used as a proxy for liberalization and turnover ratio (TOR) was used to reflect the level of stock market performance. The control variable used to avoid possible omitted variable bias is Gross fixed capital formation (% of GDP) as a proxy of investment (INV). Thus, the framework contains four variables-GDP per capita growth rate, turnover ratio, market capitalization and investment. The study used a vector autoregressive (VAR) structure to examine the relationship between the variables. This was done once stationarity tests had been carried out using the Augmented Dickey Fuller unit root.
Denote X = (GDP, TOR, MC, INV), the following VAR model is used in the analysis; Where; which is a vector of variables and β i are vector of coefficients, α i is a vector of constant terms while u t is a vector of error terms. www.ccsenet.org/ijef International Journal of Economics and Finance Vol. 6, No. 4;2014 Since the variables were not integrated of the same order, an unrestricted VAR model was estimated instead of a Vector Error Correction Model.

Definition and Measurement of Variable
The study used GDP per capita growth rate as a measure of the level of economic growth since it focuses on real domestic production per. GDP per capita is the favored measure of economic growth by Ibrahim, 2011 andZivengwa et al. (2011).
Turnover ratio (TOR) was used as proxy for stock market performance. The TOR is a common indicator for stock market activities within the financial system (Levine & Zervos, 1998). Stock market liquidity is the extent to which an asset or security can be bought or sold without causing a major movement in the price and with minimum loss of value. Liquidity is indicated by a high level of trading activity. To measure stock market liquidity, the study used the turnover Ratio, which equals the value of stock transactions divided by market capitalization.

Market Capitalization
Stock market liquidity is expected to have a positive link with economic growth (Levine & Zervos, 1998).
Market capitalization (MC), was used as a proxy for stock market liberalization. Stock market liberalization increases market capitalization or size of the stock market through foreign portfolio investment. Market capitalization refers to the product of outstanding shares and market price of equities on a stock exchange. This portrays the size of the stock market and is expected to be positively related with economic growth. Market capitalization as a percentage of GDP is preferred measure of stock market development as it is used to show the growth in terms of size of the stock exchange (Ibrahim, 2011;Zivengwa et al., 2011). (1998)

Data Sources
The study used secondary quarterly market level data from the period January, 1991 to December, 2012. The data was obtained from The NSE, Kenya National Bureau of Statistics (KNBS) and the World Bank databank.

Data Analysis and Interpretation
The variables were found to be integrated of different orders and an unrestricted VAR was used to make inferences on the impact of the stock market liberalization on economic growth. Impulse response functions and variance decomposition functions were analysed from the unrestricted VAR. The Engle-Granger test was used to give the causality relationship among variables.

Introduction
The data are quarterly spanning the period 1991 quarter one to 2012 quarter four. Data on GDP per capita growth rate and Gross fixed capital formation were obtained from the Kenya National Bureau of Statistics and World Bank data base. The data for market capitalization and turnover ratio are from the Nairobi Securities Exchange. All the data were only available annually and thus a frequency conversion to quarterly was done using Eviews. The frequency conversion was done using the linear-match last method. This inserts the low observation value into the last period of the high frequency data, and then performs linear interpolation on the missing values.

Stationarity Test
Each time series variable is subjected to ADF test to test for stationarity as a preliminary analysis. Both drift and constant terms were included in the test equation and the AIC was used for the optimum lag order in the ADF test. Table 2 presents the results for unit root tests in levels. GDP and INV were stationary at the 5% level of significance implying that they were integrated of order 0 that is I(0).  Note. the test equations include both drift and trend terms. The lag order in the ADF test equation is based on AIC. *, ** and *** denotes significance at 1%, 5% and10% respectively.
After first differencing (Table 3), the results showed that MC and TOR were still not stationary and further differencing was required. After second differencing (Table 4), market capitalization and turnover ratio become stationary at the 1% level of significance. This shows that MC and TOR were integrated of order 2 that is I(2). Since the variables were integrated of different orders, the study considered an unrestricted VAR model which was constructed using stationary variables. A suitable optimal lag length was found to be 4 using both the Schwarz information criterion (SC), the Akaike Information Criteria (AIC) and Hannan-Quinn information criterion (HQ). Table 5 presents the VAR lag order selection criteria. The lowest value for each criterion is its chosen VAR lag length.   Vol. 6, No. 4;2014 203 and DDTOR shows that market capitalization and turnover ratio respectively were differenced twice i.e. they were integrated of order 2. GDP and investment were integrated of order 0.

Granger Causality Tests
The results of granger causality are presented in Table 7. The results show that there is one-way causality that runs from stock market liberalization (MC) to economic growth (GDP). Stock market liberalization (MC) was also found to granger cause stock market performance (TOR). Therefore, the results indicate that liberalization has a positive effect to both economic growth and stock market performance. Liberalization increases market capitalization which depicts better and higher investment opportunities.

Variance Decomposition
Variance decomposition functions trace changes in each of the variables. The variables were ordered as follows; DDMC, DDTOR, GDP and lastly INV.  Variance Decomposition of DDMC (market capitalization). An average of 93.7% of the deviations in stock market capitalization in all the periods is attributable to its own shocks. GDP has the biggest contribution of the deviation in market capitalization with an average of 3.2%. Investment contributes the lowest of the deviation in market capitalization in all the periods.
Variance Decomposition of DDTOR indicates the variance decomposition of turnover ratio. From the table, it can be seen that turnover ratio is not wholly exogenous. Much of the deviation in turnover ratio is attributable to market capitalization (MC) with 12.1% in first period and an average of 10.1% in all periods. Investment and GDP contribute an average of 0.3% and 1% respectively of the deviation in turnover ratio indicating that the relationship between TOR with GDP and investment is weak.
Variance Decomposition for GDP indicates the variance decomposition of GDP per capita growth rate. GDP is highly exogenous in the first period with 79.99% of the deviation in the variable attributable to its own shocks but the impact declines over time up to 65.7% by the tenth period demonstrating the importance of other variables that explain economic growth. The variables measuring liberalization and stock market performance, namely; market capitalization and stock turnover ratio, contributes an average of 10% and 9.6% respectively to deviations in GDP www.ccsenet.org/ijef International Journal of Economics and Finance Vol. 6, No. 4;2014 per capita growth rate. This shows that stock market development plays a role to economic growth.
Variance Decomposition for INV (Investment). Investment is a highly exogenous variable with an average of 79% of deviation in the variable being a result of its own shocks. Turnover ratio has the most impact with an average of 18.2% in all the periods. This shows that turnover ratio is a major determinant of investment in Kenya. Figure 3 presents the graphs for impulse response functions.

Figure 3. Impulse response functions
Impulse response functions show how each endogenous variable responds over time to innovations or shocks to each of the endogenous variables in the model and eventually how it affects the original variable itself. In this study, the response of stock market capitalization (DDMC) to turnover ratio (DDTOR), GDP per capita growth rate (GDP) and investment (INV) was insignificant. The response of turnover ratio (DDTOR) is also insignificant to the other variables. The response of GDP per capita growth rate (GDP) to turnover ratio (DDTOR) was negative for all the periods. The response of GDP to itself, stock market size (DDMC) and investment (INV) was positive for all the periods. The response of investment to itself was positive for all the periods. The response of investment to GDP is positive from period one to seven. The response of investment to turnover and stock market capitalization was insignificant.

Summary
The study presumed to test whether stock market liberalization had an impact on economic growth and stock market performance. Stock market liberalization had a significant positive impact on stock market capitalization and liquidity of NSE. The study also assessed the causality between the variables. The results of the granger causality tests disclosed a one-way causality running from market capitalization to both GDP per capita and turnover ratio. Response of DDMC to GDP The results of the variance decomposition indicated that market capitalization (MC) and turnover ratio (TOR) are significant variables in explaining both investment and GDP per capita growth rate. Market capitalization also explains most of the deviations in turnover ratio.

Conclusions and Policy Implications
Variance decomposition and Granger Causality tests display a direct positive impact of market capitalization to both GDP per capita growth rate and stock market performance. The incremental effect of stock market liberalization, as measured by stock market capitalization, had a positive effect on economic growth. The impact also came through investment and turnover. That is, market capitalization positively affecting investment and stock market liquidity and consequently investment and stock market liquidity, influencing real GDP per capita. Stock market capitalization attracts investment which has a substantial positive impact on GDP per capita growth rate.
The results propose that stock market Liberalization has a significant positive impact to both economic growth and stock market performance. It is, therefore, crucial to encourage policies that can significantly influence market capitalization and turnover ratio with an expected considerable increase in GDP per capita. It is of much significance that the government prioritizes the development and efficiency of the stock market. Subsequent policies on liberalization to further open up the NSE to foreign participation should be encouraged. Despite the role of foreign capital in the domestic economy, consideration should also be given to improving local investment and ensuring macroeconomic stability as these will improve market confidence by reducing uncertainty and drive stock market growth.