Understanding the Success and Failure of Nascent Stock Exchanges

Well-developed and efficient financial markets play an important role in the economic development of emerging countries. Many low- and even middle-income countries, however, not only have underdeveloped financial systems, but they also have concentrated financial structures, dominated by banks and characterized by the absence of liquid public capital markets.

Our new study ‘Nascent Markets: Understanding the Success and Failure of New Stock Markets’ addresses the question why some countries have well-developed stock markets while others have shallow and illiquid markets. Specifically, we use an array of different methodologies to gauge the factors associated with the variation in success and failure of 59 newly established (‘nascent’) stock markets since 1975 in their first 40 years of activity. We thus complement an expansive literature that has considered cross-country variation in the development of relatively mature stock exchanges by shedding light on the early days of new stock exchanges.

We can draw on substantial cross-country experience over the past 40 years in setting up new or reviving closed stock exchanges. Since 1975, the number of countries with at least one stock market has more than tripled, from 53 to 165. However, the vast majority of academic studies to date (even in the ‘emerging markets’ literature) focuses on at most 50-60 of these 165 countries.

Nascent markets differ markedly in their success, as measured by the number of listings, the ratio of market capitalization to GDP, and trading activity (turnover). Some markets slowly but steadily come to fruition (such as in Vietnam), others perish after thriving initially (such as in the Czech Republic), and yet others essentially remain dormant (such as in Tanzania).

We clearly identify two clusters that represent the least and most successful markets after 20 years of trading. The most successful nascent markets on average fare significantly better according to each of the three success measures than the least successful markets. For example, the stock markets in Kuwait, Poland, and Thailand (in the cluster of most successful markets) each have more listings, a greater market cap to GDP, and higher turnover after 20 years than the markets in Kazakhstan, Panama, and Tanzania (in the cluster of least successful markets).

We find that long-term success is in part determined by early success: a high initial number of listings and trading activity are necessary, though not sufficient, conditions for long-term success. Markets that start out small in terms of market capitalization to GDP, but with a relatively high number of listings and turnover from the outset (such as China) can still develop into markets that are successful along all three dimensions of success later on.

We also evaluate the importance of different institutional, structural, socio-economic, and policy factors as potential determinants of long-term nascent markets’ success. Banking sector development at the time of establishment and development of national savings over the life of the stock market are the other two most reliable predictors of success. We find little evidence that structural factors such as legal and political institutions matter. In particular, we find no systematic effects of legal origin and proxies for the degree of democracy, regulatory quality, and law and order. Whether the exchange was established as a result of public and/or private initiative does have a bearing on the results.

Overall, our study sheds light on the factors explaining the success and failure of nascent stock exchanges. Scale is an important factor, with a large number of listed firms and sufficient liquidity being a critical condition for long-term success. But it is not only about a sufficiently large number of firms ready to go public and share control with a diverse set of owners, but also investor demand, as seen in a sufficiently large national savings rate that is critical for long-term success of nascent stock exchanges. Furthermore, our evidence suggests that having a well-established banking sector in place is key when opening a stock exchange, which is suggestive of the many important roles (such as deposits & payment services, brokerage, underwriting, and analyst coverage) that banks play around stock markets.

José Albuquerque de Sousa is a PhD Candidate at Rotterdam School of Management,Thorsten Beck is a Professor of Banking and Finance at the Cass Business School, Peter A.G. van Bergeijk is a Professor of International Economics and Macroeconomics at the international Institute of Social Studies of Erasmus University and Mathijs A. van Dijk is a Professor of Finance at the Rotterdam School of Management of Erasmus University.