RESEARCH PROPOSAL EFFICIENCY IN THE AFRICAN CAPITAL MARKETS SAMPLE

RESEARCH PROPOSAL EFFICIENCY IN THE AFRICAN CAPITAL MARKETS SAMPLE TABLE OF CONTENTS 1 INTRODUCTION......................................................................................................... 2 1.1 1.2 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 2.11 2.12 3 4 5 6 7 8 9 GENERAL OVERVIEW OF AFRICAN STOCK MARKETS .............................................. 2 THE EMERGENCE OF AFRICAN STOCK MARKETS .................................................... 4 AFRICAN STOCK MARKETS: A COMPARATIVE ANALYSIS WITH EMERGING MARKETS OF ASIA AND LATIN AMERICA ................................................................ 5 FACTORS AND RISKS INFLUENCING INVESTMENT IN AFRICA: POLITICAL, ECONOMIC AND REGULATORY .................................................................................................. 6 FINANCIAL LIBERALISATION AND ECONOMIC GROWTH IN AFRICA ......................... 7 DOES SIZE MATTER IN THE ROLE OF STOCK MARKETS IN ECONOMIC GROWTH? ... 8 THE SIGNIFICANCE OF STOCK MARKET LIQUIDITY IN AFRICA’S ECONOMIC GROWTH ................................................................................................................. 8 THE IMPACT OF AFRICAN STOCK MARKET VOLATILITY IN ECONOMIC GROWTH: IS IT SIGNIFICANT?...................................................................................................... 9 AFRICAN STOCK MARKET INTEGRATION WITH WORLD EQUITY MARKETS: THE IMPACT ON ECONOMIC GROWTH ............................................................................ 9 INFORMATION ASYMMETRY: HOW SERIOUS IS THE PROBLEM? ............................... 9 THE WEAK FORM EFFICIENCY OF AFRICAN STOCK MARKETS .............................. 10 ARE THE AFRICAN STOCK MARKETS BY ANY CHANCE SEMI-STRONG OR STRONG FORM EFFICIENT? ................................................................................................. 11 THE ROLE OF STOCK MARKET EFFICIENCY IN ECONOMIC GROWTH IN AFRICA .... 11 ASSESSING THE IMPORTANCE OF STOCK MARKET FEATURES IN ECONOMIC GROWTH ............................................................................................................... 12 THEORETICAL FRAMEWORK .............................................................................. 5 STATEMENT OF THE PROBLEM ........................................................................ 12 RESEARCH OBJECTIVES ...................................................................................... 13 RESEARCH METHODOLOGY .............................................................................. 13 DATA; ORGANISATION AND ANALYSIS .......................................................... 15 PRECONCEIVED IDEAS OR HYPOTHESIS....................................................... 16 SIGNIFICANCE OF THE STUDY .......................................................................... 17 JUSTIFICATION OF STUDY .................................................................................. 18 10 LIMITATIONS OF THE STUDY ............................................................................ 18 11 CONCLUSION ........................................................................................................... 19 BIBLIOGRAPHY............................................................................................................... 19 1 1 1.1 INTRODUCTION General Overview of African Stock Markets Africa is the second largest continent after Asia with 54 independent countries of which 48 are mainland and 6 are island states and an estimated population of 700 million people. Of all the 54 African countries, only 19 have (or at one point had) a national stock exchange. These are the Ivory Coast (Cote D’Ivoire), Nigeria, Botswana, Egypt, Morocco, Ghana, South Africa, Sudan, Zambia, Malawi, Mozambique, Mauritius, Kenya, Namibia, Nigeria, Swaziland, Tanzania, Tunisia, Uganda and Zimbabwe. The stock markets in Africa increased from only 7 before 1988 to 20 in 2000. Stock markets operating before 1990 include the Abidjan, Casablanca, Tunis, Nairobi, the Nigerian and Zimbabwe stock exchanges, established in 1974, 1929, 1969, 1954, 1960 and 1896 respectively. The oldest is the Johannesburg Stock exchange, which was established in 1887 and is by far Africa’s largest. The Johannesburg Stock Exchange saw a listing of 101 new companies in 1998 only. However, the highest public offer within a year was in 1987 when 211 new companies were listed. 150 of its quoted companies have dual listings on foreign bourses with foreign trade in these shares amounting to 142% of the trade in the same shares on the Johannesburg Stock Exchange. Some of the African Stock Markets were established in the late 1980s but did not start operations until the early 1990s. These include the Botswana and Ghana stock exchanges both established in 1989 and the Mauritius Stock Exchange, which was established in 1988. The Botswana share market officially became the Botswana Stock Exchange in 1995, whilst the Ghana Stock Exchange only commenced operations in 1990. Egypt’s Alexandra and Cairo Stock Exchanges were established in 1888 and 1903 respectively but suspended operations between 1961 and 1992. By November 1998, there were 833 listed companies on the exchange with a market capitalisation of approximately LE71.3 million. The establishment of some stock exchanges were a much longer process. An example is the establishment of the Khartoum Stock Exchange in Sudan. The idea was first brought up in 1962 with the Act for a securities market being passed only in 1982, 20 years later. In 1990 progress started in putting the necessary framework of the required liberalisation policies. In November 1992, the Council of Ministers approved an amendment of the Securities Market Act of 1982. An Act to establish the exchange was passed by the Transitional National Assembly in June 1994 with the primary market starting operations in October of the same year and the secondary market commencing operations in 1995. Africa has got some of the youngest stock exchanges. The Swaziland, Namibian and Ugandan stock exchanges were established in 1990, 1992 and 1997 respectively. The Malawi, Ugandan and Tanzanian stock exchanges started operations in November 1996, January 1998 and April 1998 respectively. The youngest is Mozambique’s Maputo Stock 2 Exchange, which had been postponing operations only to be officially recognised in October 1999. The smallest of emerging markets, both in terms of the number of listed companies and market capitalisation are also in Africa. In 1999, the Casablanca Stock Exchange had a securities listing of around 50 and a total market capitalisation of $8.6 million, while listing on the Tunis Stock Exchange was a little over 30 companies and the Ghana Stock Exchange had around 20 listed companies and 2 corporate bonds. During the same year, the Nigerian (Lagos) Stock Exchange had a listing of 180 companies. There were over 50 listed companies and a market capitalisation of $1.9 million on the Nairobi Stock Exchange in 1995. On the same exchange, market capitalisation went up to around $3 billion at the end of 1997. In July 2001, the Zimbabwe Stock Exchange had 75 listed companies. The Mauritius Stock Exchange operates two markets, the Official Listing with over 40 listed companies and the Over-the-Counter Market with around 80 quoted companies. The Exchange in Swaziland is considered small but thriving with a handful of listed companies (5) whilst Zambia also boasts of 9 listed and 3 quoted companies. Market capitalisation at the end of 1997 on the Swaziland Stock Exchange was dramatically down to US$110.9 million from the 1996 figure of US$471.2 million. Listing on the Malawi Stock Exchange is said to be modest, whilst the Tanzanian Stock Exchange is considered the smallest in terms of market capitalisation. In 1999, the Uganda Stock Exchange had just one instrument listed, a bond issued by the East African Development Bank. There have been some reforms taking place on Africa’s stock markets. The Casablanca Stock Exchange experienced reform in 1993 resulting in the use of an electronic trading system. This exchange, together with the Johannesburg, Namibian and Lusaka stock exchanges are among those in Africa that operate using this system. The majority are still using the open-outcry or call-over systems. In Zimbabwe, reforms resulted in the opening up of the Stock Exchange to foreign investment in 1993. The circumstances under which stock exchanges were established in Africa are very unique and interesting. Whilst the Mauritius Stock Exchange was established as a private limited company under the Stock Exchange Act 1988, the Namibian Stock Exchange was formed as an association by 37 Namibian businesses and individuals who each contributed N$10,000 to raise start-up capital for the Exchange. The circumstance behind the establishment of the Botswana Stock Exchange was the need for a vehicle to sell the Botswana Development Corporation’s investments in 1989. In some cases the establishments were driven by the desire for privatisation. Africa also boasts of having the world’s first regional stock exchange, the Bourse Regionale des Valeurs Mobilieres (BRVM) in the Ivory Coast. This regional stock exchange was formed in September 1998 after the closure of the Abidjan Stock Exchange on 31 December of 1997. It serves the 8 French-speaking (francophone) member countries of the West African Economic and Monetary Union (UMOEA) namely Benin, Burkina Faso, Cote d’Ivoire, Guinea Bissau, Mali, Niger, Senegal and Togo. The BRVM started with a listing of 35 companies and a total market capitalisation of 2,904 billion CFA francs. 3 Market capitalisation rose by more than 20% in October of the same year after the listing of Sonatel, a Senegalese telecommunications company. One of the greatest achievements of Africa is to have some of its stock exchanges ranked among the top performers of emerging markets. The Egyptian Stock Exchange (as the Alexandra and Cairo Stock Exchanges are jointly known) was very active in the 1940s and ranked fifth in the world. Ghana was ranked the sixth best performing emerging stock market in 1993 with a capital appreciation of 116% and the best performing of all emerging stock markets in 1994 with an index growth of 124.3%. In 1996, Zimbabwe had an increase in market capitalisation of 165%, making it one of the star emerging markets. This was partly attributed to the listing of the Ashanti Goldfields Corporation following its takeover of Cluff Resources. The Lusaka Stock Exchange was also quoted a star performer in Africa in 1997, whilst the Johannesburg Stock Exchange competes globally. 1.2 The Emergence of African Stock Markets Stock markets emerged in Africa mostly from the privatisation drive by the African governments. In the Kenyan economy, the Nairobi Stock Exchange has been playing an important role in the privatisation of state-owned enterprises. The 10 years 1988 to 1998 saw the privatisation of 9 public enterprises through the stock exchange. In Africa, stock markets have been used as vehicles for indigenising the key companies of African economies, a process known as native empowerment. This was one of the driving forces behind the establishment of the Maputo Stock Exchange. The Mozambican state desires to distribute its holdings in privatised companies to the public in order to broaden ownership. The government retains up to 20% of the share capital in about 900 companies that have been privatised. These privatised companies include the country’s largest cement, plastics, milling, soap, cooking oil and clothing manufacturing companies. The Lusaka Stock Exchange tried to achieve both the privatisation and the public empowerment objectives. In March 1998, it became the official market for trading in Government bonds. By the fourth quarter of 1999, the Lusaka Stock Exchange had seen five public offerings, all of them on the back of Zambia’s privatisation program in which shares were only offered to Zambians. The only instance in which shares were also offered to international investors was in 1996 when the Zambia Sugar Plc was listed. This was mainly because the shares on offer were a combination of those warehoused by the Zambian Privatisation Trust Fund (ZPTF) and those owned by the Commonwealth Development Corporation (CDC). The major drawback Lack of information by the ordinary man about the existence, functions and benefits of the stock market has slowed the pace of using the stock market as a way of empowering the general public. Even those with a little knowledge on investment are usually more comfortable with the money market due to less risk involved. This shows how risk averse the general African populace is, which is exacerbated by their inability to comprehend the stock market as a form of investment. For despite the high returns on African stock markets, the investment is too risky. 4 Part of the problem is attributed to colonisation. When the Nairobi Stock Exchange in Kenya (former British colony) was constituted in 1954, it got clearance from the London Stock Exchange and was recognised as an Overseas Stock Exchange. This gave it value and credibility. However, business of dealing in shares was then confined to the resident European community, since Africans and Asians were not permitted to trade in securities until after the attainment of independence in 1963. In Kenya, this partly explains why it has been difficult to convince the local people that the stock exchange was a means of diversifying ownership of economic wealth. 2 2.1 THEORETICAL FRAMEWORK African Stock Markets: A Comparative Analysis with Emerging Markets of Asia and Latin America There has been a great response by international investors to emerging markets. However, Asia and Latin America have attracted most of the investment community’s attention as compared to Africa. These are the same regions among emerging markets that have absorbed most of the equity flows from developed countries. The emerging markets of Asia have attracted almost all the private equity investment from Japan and half the equity dollars invested in developing countries by the United States in 1993 (IFC [1997]). Africa and the Middle East remain largely ignored yet their economies represent 16% of all emerging markets (IFC [1997]). There must be an explanation for the investors’ preferences of Asia and Latin America to Africa (and the Middle East). East European countries, formerly in the same category with African countries, have attained for themselves the name of ‘Newly Industrialised Countries’ (NICs) whilst African countries still take the bottom positions in economic development rankings. Emerging markets are on top of the list of the world’s best performing stock markets. In 1996, they swept the top 15 positions for annual performance measured in dollar terms from a list of 76 world stock markets (IFC, 1997). The worst performers also happen to be concentrated in emerging markets. Of the 21 world equity markets that dropped in price in 1996, 19 were emerging markets (IFC [1997]). Even though the IFC did not group these emerging markets according to regions in the rankings, it is most likely that only a handful of African markets took the top positions but made the majority of the worst performers. The increase in interest by private equity investors in developing markets has been accredited to the push and pull factors. The push factor is for better profits and more diversification because of the knowledge that returns in emerging markets are generally higher even with adjustments for risk than in mature markets (World Bank, 1995). The investment community has increasingly recognised a low or even negative correlation of stock markets in the developing and in developed nations. Therefore, investing in the developing world is a means to reduce overall portfolio risk (World Bank, 1995). The pull factor is a result of wide-ranging reforms, legislative as well as economic in many developing countries. Governments have liberalised or eliminated capital restrictions, improved the flow of financial information and strengthened investor protection thereby earning the attention of the investment community. 5 However, if there is any region that deserved to benefit from these push and pull factors, it is Africa. African markets are characterised by high returns and lacks contagion with other emerging markets (Collins and Biekpe [2001]). Therefore, investing in Africa would be a good way of diversifying one’s portfolio. The pull factor should have been stronger in Africa, considering that the late 1980s and 1990s witnessed a number of financial liberalisation programs in Africa. However, the problem in Africa is that financial liberalisation is only partial and not fully implemented. The level of stock market development, in terms of size, liquidity, volatility and integration with world equity markets in the regions of emerging markets, that is, Asia, Latin America, Eastern Europe, Africa and the Middle East, are most likely to be different. The regulatory environments in which stock markets in these regions operate are also different. This is why this research will use these measures of stock market development as the basis for comparison between development in Africa and the other regions. 2.2 Factors and Risks Influencing Investment in Africa: Political, Economic and Regulatory Bekaert and Harvey [1997] pointed out three specific risks of emerging markets namely, liquidity risk, political risk and economic risk. They also pointed out that foreign investors value solid macroeconomic policies and a stable regulatory framework, features that are difficult to find in Africa. The political environment in Africa is, in general, unstable and is characterised by civil wars, military coups and other political unrests, crime and violence. This political instability is another contributory factor to international investors’ absconding of Africa. Zimbabwe, for instance, is currently undergoing an economic crisis characterised by shortage of foreign currency, political instability, high unemployment (at 70%) and high inflation (76%) among other things. More than 80% of the population are living below the poverty datum line. The shortage of foreign currency has resulted in industries that depend on imports of raw materials and the energy sector in particular being negatively affected. Many companies are scaling down operations and some are even going under. This scenario has repelled the international investment community leaving only the locals who have nowhere else to put their money, to partly contribute to the mushrooming of the Zimbabwe Stock Exchange. Markets in Africa differ in regulations with some having stringent exchange control regulations on the remittance of investment capital, capital gains, dividends, interest payments, returns and other related earnings. Foreign investment regulations, the tax system and stock trading requirements, among other things, impact on investment. The lax legislation was the main cause of insider trading on the Johannesburg Stock Exchange. In Ghana, plans are underway to improve the legal/regulatory framework and increase market surveillance. This is done in an effort to control for insider trading and attract investors, who are particular about investing in countries with sound institutional and regulatory frameworks for capital markets. 6 The stock exchanges are very often affected by changes in interest rates, which are always fluctuating in most African countries. High inflation and interest rates were partly the cause of the small growth in the index of the Ghana Stock Exchange in 1995. In early 2001, the Reserve Bank of Zimbabwe published a new monetary policy and advocated for a reduction in interest rates. The Treasury bill rate fell to as low as 5% and the highest on 90-day Treasury bills ranging from 11% to 13%. It has become less favourable to invest on the money market due to the low interest rates. More and more people, including the laymen on the streets are now considering the stock market as the alternative. The question is, how sustainable is the stock market performance induced by these factors. 2.3 Financial Liberalisation and Economic Growth in Africa Many of the developing countries still have some form of restrictions on foreign investments. For most African stock markets, the majority of the foreign investors are offshore from Europe, North America and Australia and very few from other neighbouring African countries. In Ghana, for example, Osei (1998) noted that apart from Nigeria, no foreign securities investors came from any sub Saharan African country to invest on the Ghana Stock Exchange. The Zimbabwe Stock Exchange saw a significant increase in stock purchases by foreigners from nil in 1992 to US$84 million in 1996, an amount equivalent to 40 –60% of its annual turnover in the late ‘90s after the relaxation of the foreign investment controls in 1993 (Oyama, 1997). However, Oyama (1997) also noted that the liberalisation of interest rates in Zimbabwe had a negative impact on the stock exchange. The liberalisation resulted in an increase in nominal interest rates and a serious slump in stock prices in 1991 and 1992. During 1998, there was a decline in turnover and the value of shares sold on the Zimbabwe Stock Exchange, which was partly attributed to the high interest rates. Bekaert, Harvey and Lundblad [2001] used both emerging and developed markets in analysing the effect of financial liberalisation on equity markets. Bekaert, Harvey and Lundblad [2001] showed that liberalising equity markets, on average, lead to a one percent increase in annual real economic growth over a five-year period. They also found that the investment/GDP ratio increases after liberalisation, with investment partially financed by foreign capital inducing worsened trade balances. A number of African countries are undergoing financial liberalisations and these liberalisation programs are concentrated in the late 1980s and early 1990s.The efforts by African countries to liberalise their financial systems, and most important, their equity markets, is probably a move in the right direction. Bekaert, Harvey and Lundblad [2001] showed that financial liberalisation affect economic growth by attracting foreign investors, as they try to enjoy the benefits of diversification. This would drive up local equity prices permanently thereby reducing the cost of capital. Bekaert and Harvey [2001] pointed out that foreign investors might also demand improved corporate governance to protect their investments. This would reduce the gap between the costs of external financial capital and internal financial capital and further increase investment. In the work of Bekaert, Harvey and Lumsdaine (1999), the evidence showed that capital inflow leads to a permanent 7 positive effect on equity prices (Bekaert and Harvey [2001] and thereby lower the cost of capital. 2.4 Does Size Matter in the Role of Stock Markets in Economic Growth? African stock markets are relatively small compared to emerging markets in other regions with the exception of the Johannesburg Stock Exchange, which is by far the largest in Africa. The small size nature of African stock markets, especially in terms of the number of listed stocks, limits the ability of the stock markets to mobilise and allocate resources efficiently. Mobilisation and allocation of resources are the key roles of stock markets in economic development. It also thwarts the stock market’s role in enabling investors to diversify firm-specific risks. However, Levine [1996] argued that stock market size, as measured by the market capitalisation to GDP ratio, is not a good predictor of economic growth. 2.5 The Significance of Stock Market Liquidity in Africa’s Economic Growth Most African Stock Markets suffer from lack of liquidity. Examples are the Tunis Stock Exchange and the BRVM, just to mention two. However, stock market liquidity is an important factor for economic growth (Levine and Zervos, 1996). Liquid stock markets can increase the incentive to get information about firms and to improve corporate governance (Levine and Zervos, 1996). According to the World Bank (1995), liquidity indicators are a measure of trading volume and not simply prices and they are closely associated with growth predictions of an economy. These indicators are defined as follows: (a) Turnover Ratio equals the value of domestic shares traded divided by market capitalisation. It measures the trading of domestic equities on domestic exchanges relative to the size of the market. (b) Value Traded Ratio equals the total value of domestic shares traded on the stock market divided by GDP. It measures the organised trading of firm equity as a share of national output and should therefore positively reflect liquidity on an economywide basis. Stock markets in Africa are trying to achieve more liquidity by encouraging investments on the stock market by pension funds, mutual funds and insurance companies. A market is liquid if large transactions can be made instantaneously and continuously without moving prices significantly. Competition among the funds can lower costs, thereby attracting more investment. Levine [1996] argued that multiple regression procedures suggest that stock market liquidity helps forecast economic growth even after accounting for a variety of nonfinancial factors that influence economic growth. According to Levine [1996], countries with both liquid stock markets and well-developed banks grew much faster than countries with both illiquid markets and underdeveloped banks in 1976. 8 2.6 The Impact of African Stock Market Volatility in Economic Growth: Is it Significant? Generally, volatility on African equity markets is known to be very high (Erb, Harvey and Viskanta [1996]). Volatility of stock returns is measured as a 12-month rolling standard deviation estimate based on market returns. However, Erb, Harvey and Viskanta [1996] measured volatility using the countries’ risk ratings. On average, expected annual volatility for Africa in 1996 was 35.6% compared to 21.4% for the Morgan Stanley Capital International (MSCI) developed equity markets (Erb, Harvey and Viskanta [1996]). Lower volatility is, in general associated with a more developed stock market. 2.7 African Stock Market Integration with World Equity Markets: The Impact on Economic Growth Emerging (African) markets are known to be segmented, that is, the investors on these markets are local residents and foreign participation is limited, mainly due to regulatory, institutional and tax barriers, among other things (Bekaert and Harvey [1997]). Investors in a segmented capital market require compensation for the risk exposure they incur. This compensation is in the form of higher expected rates of return, which translates into higher cost of capital. Investors in integrated capital markets hold securities from many countries providing a natural hedge for country-specific events. Bekaert and Harvey [1994b] suggested that the cost of capital could be reduced in many emerging markets by increasing their integration with world capital markets. Bekaert and Harvey [1997] emphasised that the reduced cost of capital promotes investment thereby creating jobs and other benefits to the economy. Lower cost of capital also impacts on multinational corporations’ willingness to make direct investments in emerging markets leading to transfer of knowledge or international expertise to the local population and thus a positive contribution to economic growth (Bekaert and Harvey [1997]). One measure of integration of a national stock market with the international capital market is asset pricing (or mispricing). The asset pricing measures are a way of determining whether a stock market prices risk efficiently. In perfectly integrated markets, capital flows across international borders to equate the price of risk. Greater mispricing usually reflects poor information about the firms issuing securities, high transaction costs, and most importantly, the official barriers to the movement of capital (World Bank [1995]). Markets that are closed to international capital, such as Nigeria and Zimbabwe as opposed to Japan and the United States, have high mispricing values (world Bank [1995]). 2.8 Information Asymmetry: How Serious is the Problem? The mispricing of African stocks comes as result of poor information dissemination. This results in market inefficiency and this is a problem that is faced by many African markets. There are two concepts of efficiency of share prices, “fundamental valuation” efficiency and “information arbitrage” efficiency. With “fundamental valuation” efficiency, share prices of firms reflect their true long-term expected earnings through rewarding of 9 profitability and management performance. “Information arbitrage” efficiency, on the other hand, refers to how quickly all available information is disseminated throughout the market and is incorporated in share prices. Information asymmetry in a market would imply market inefficiency especially in the strong form. Information asymmetry in a stock market refers to the presence of different groups of traders, those with more information and those with very little information. It is mostly the insiders who are more informed or have quick access to information than the other investors. Those with very little information are usually referred to as noise traders. Insiders are investors who either hold more than a certain percentage of outstanding shares of a corporation or are part of the firm’s management or directorship. These investors are likely to have access to information on the internal state, dividend earnings and access to the financial statements of the company before it is available to the public. Insider trading has been one of the problems historically faced by the Johannesburg Stock Exchange (JSE). Insider trading is defined as profiting from the use of price sensitive information that has not been disclosed to the rest of the market. No prosecution for insider trading has taken place in South Africa due to the inadequacy of the legislation and the existence of lax and unenforceable laws. The Johannesburg Stock Exchange is undergoing transformation with the first major change that took place being the enactment of the Stock Exchange Control Act in early November 1995. One of the other main changes that have taken place includes the launch of a real-time Stock Exchange News Service (Sens) in 1997 in an attempt to enhance market transparency and investor confidence. The JSE listing requirements include the dissemination of any corporate news or price sensitive information on the Sens prior to using any other media or outlet. The JSE automated ‘Jet’ trading system gives warning when company-specific, price-sensitive information is about to be released on Sens, so that investors can reconsider their share dealings. 2.9 The Weak Form Efficiency of African Stock Markets In a price efficient market, security prices at all times fully reflect all available information that is relevant to their valuation. Investment strategies pursued to outperform a broadbased stock market will not consistently produce superior or excess returns after adjusting for risk and transaction costs. Weak form efficiency of a stock market refers to a case whereby the current price of the security reflects all the information on the past price movements and trading history of the security. The weak form efficiency test is based on the Random Walk Hypothesis. This hypothesis says that the direction as well as the size of change in the price of a share is random and cannot be predicted from past information about the share prices. According to this hypothesis, a market always adjust instantaneously to take account of all available information, so no individual analyst has more information than the information that is already reflected in the security’s price. 10 2.10 Are the African Stock Markets by any Chance Semi-Strong or Strong Form Efficient? The general perception has been that African stock markets are not efficient even in the weak form, let alone the semi-strong and strong form. In a semi-strong efficient market, the security price fully reflects all public information, which includes but is not limited to historical price and trading patterns, changes in annual earnings and declared cash dividends, changes in the management of the firm, among other things. On the other hand, a market is strong form efficient if the security price reflects all information, whether it is publicly available or only known to insiders (private). Husselmann in 1988 used the “P/E Anomaly” to determine the efficiency of the Johannesburg Stock Exchange. His research question was: If everybody knows about the P/E anomaly, why does not everybody buy shares with low P/E ratios so that the efficient market can wipe out the higher returns? His statement of the problem was that in the USA, shares with the lowest P/E ratios have the highest returns. He cited Drean (1985) to have analysed 1800 companies in the USA for a period of 10 years and found that companies of low P/E ratios yielded an average return of 26.1% while companies of high P/E ratios yielded an average return of 14.4%. However, Husselmann’s findings were that the “P/E Anomaly” is not active on the Johannesburg Stock Exchange. This might be a result of its smaller size compared to the American Market. He concluded that the Johannesburg Stock Exchange is efficient in that it takes all the information including the P/E Ratio in determining the share price. 2.11 The Role of Stock Market Efficiency in Economic Growth in Africa Efficient stock markets play an important role in mitigating the moral hazard problem by tying the manager’s compensation to stock prices. This would reduce the incentive for imprudent actions, increase firm value and consequently increase productivity (Bekaert and Harvey [1997]). Stock markets compel managers to refrain from productivity decreasing actions through takeover threats and also promote innovation and the entrepreneurial spirit (Bekaert and Harvey [1997]). Singh (1992) alleged that, though efficient prices are a necessary condition for the stock market to perform its developmental sense, they are not sufficient. According to his argument, sufficiency requires, in addition, the existence of an efficient takeover mechanism, which can ensure that all those companies whose profitability under their existing managements may be lower than it could be under some other management can be acquired by the latter. Singh (1992) was probably looking at efficiency from the weak form point of view, whereby it is information on the historical price trends that is incorporated into current prices. African stock markets, as indicated before, are believed not to be efficient in any form, and are therefore most likely to satisfy neither the necessary nor the sufficient condition for development. 11 2.12 Assessing the Importance of Stock Market Features in Economic Growth Bekaert and Harvey [1997] pointed out that the role of the stock market in economic growth is relatively unexplored as most studies along the same lines focused on the role of the banking sector. Stock markets enable individual investors to diversify firm specific risks, thus making investment in firms more attractive (Bekaert and Harvey [1997]). Researchers have been mostly concerned about the causal relationship between financial market development and economic growth (Filer et al [1999], Bekaert and Harvey [1997]). King and Levine (1993), however, had managed to prove that financial development is an important determinant of future economic growth. In 1996, Levine and Zervos confirmed that stock market development is positively related with long run growth and positively correlated with the development of financial intermediaries. They also found that there is substitution of equity finance for debt finance in developed countries. This they did through cross-country regressions using the banking sector financial development indicators and found that these indicators have strong positive correlation with economic growth. Beck and Levine (2001) concluded that stock markets and banks do positively influence economic growth. On the role of stock markets in economic growth, Bekaert and Harvey (1997) found that stock markets are indeed important in economic development and that of paramount importance is their efficiency and liquidity. The primary role of financial institutions and capital markets is to allocate capital efficiently, that is, allocate funds to the investment projects with the highest marginal product of capital and also promoting firm specialisation (Bekaert and Harvey [1997]). Efficiency and liquidity are very much related. As Bekaert and Harvey [1997] pointed out, the most important symptoms of inefficient stock markets are increasing transaction costs and illiquidity. Bekaert and Harvey [1997] used the rank correlation between the different stock market development measures and economic growth for eighteen countries for the period 1986 to 1992. The evidence they found broadly confirmed that stock market development is positively associated with economic growth. Levine and Zervos (1998) found that equity market liquidity is correlated with rates of economic growth and that banking and stock market development independently influence economic growth (Bekaert, Harvey and Lundblad [2001a]. 3 STATEMENT OF THE PROBLEM Africa is known to have some of the poorest, socially and economically underdeveloped countries. Some of these countries have had stock markets for a long time but have lagged in their economic development when compared to their Asian and Latin American counterparts. Harvey and Bekaert [1997] and Levine [1996] pointed out that efficiency and liquidity are of paramount importance in the role of the stock market in economic growth. Efficiency in a stock market boost investor confidence and can enhance growth by mitigating moral hazard and consequently increasing productivity (Harvey and Bekaert [1997] and Levine [1996]). Liquidity enables the easy buying and selling of shares by investors. Levine 12 [1996], however, argued that other measures of stock market development are not good predictors of economic growth. African stock markets are not just inefficient and illiquid, but also suffer from thin trading, high volatility and lack of integration with world markets. Some of the African markets still operate in an environment with restrictions. Which of these problems have suppressed the role of African stock markets in economic growth? How significant are these stock market deficiencies in explaining the poor economic performance of Africa? Is this why Africa is economically backward when compared to other regions of emerging markets such as Asia, Latin America and East Europe? 4 RESEARCH OBJECTIVES The objective of this research is to define the characteristics of stock markets that are of ‘paramount importance’ in economic growth and that can be developed to steer economic growth in Africa. The other objective is to find out whether the deficiencies of African stock markets explain why Africa is economically underdeveloped than the regions of Asia and Latin America. Does this also explain why ‘countries in Africa have lagged the economic performance of the rest of the world’ (Erb, Harvey and Viskanta [1996])? 5 RESEARCH METHODOLOGY It is important to test efficiency of the stock markets before using ‘efficiency’ as an argument or explanatory variable in the economic growth model. The focus in this research will be on weak form efficiency, even though other forms of efficiency shall be tested. There are two basic methodologies that can be used in measuring weak form efficiency. These are regression analysis (parametric tests) and the runs test (non-parametric tests). If the two tests confirm the random walk theory, then the conclusion would be that the respective market is weak form efficient. Moore (1988) used the runs test to study the market efficiency of the South African bond market. Snell (1990) used three methods to investigate improvement in efficiency on the South African futures market over the period June 1987 to December 1989 and to investigate if and how market performance has affected hedging effectiveness and optimal exposure management on this market. The three methods were (a) year-on-year comparisons of the square mispricings; (b) regression analysis with absolute mispricings as response variables and contract age and time as independent variables and (c) estimation of the implied dividend yield by the market compared to actual yields. Even though the random walk hypothesis is the popular method for testing weak form efficiency, Osei (1995) used both this method and the law of one price (test for arbitrage) to test the market efficiency of the Ghana Stock Exchange. In the ‘test for arbitrage’, Osei (1995) used the dual listing of the Ashanti Goldfields Corporation on the Ghana and the London Stock Exchanges. His argument was that if the market is efficient, then the share price of the Ashanti on the Ghana Stock Exchange should be equal to the share price on the London Stock Exchange at the existing exchange rate. 13 Semi-strong efficiency is usually tested using the ‘event studies’ methodology. This involves studying price reactions to the announcements of changes in money supply, exchange rates, interest rates, dividends, earnings and stock splits, among other things (Levy and Sarnat, 1984). In an efficient market, the information should be incorporated into stock prices the moment it is announced. If it is possible for an investor who knows about the forthcoming ‘event’ to exploit this information and to obtain an excess return, the market is said to be semi-strong inefficient. Strong form efficiency tests involve studying the performance of professional money managers such as mutual funds or “insiders”. However, it is usually the study of insiders used, as the study of mutual funds does not give conclusive results. If insiders make excess returns and the outsiders who follow insider transactions do not, the market is said to be semi strong efficient but inefficient in the strong form. One event that is often used to test both semi strong and strong form efficiency is the announcement of earnings. The general opinion among practitioners has been that stocks with low price/earnings (P/E) ratios yield higher returns than those with high P/E ratios. Before the earnings information is announced, it is considered private. An investor who wants to follow the recommendation to invest in low P/E stocks will not be able to make his investment decision until such information is made public. The investor will not earn excess profits if the market is semi-strong efficient, because by the time the information is made public it is worthless. Only the insiders, who can have access to earnings information before it is made public, can make excess profits by investing in low P/E stocks. In this study, the regression analysis method for testing weak form efficiency will be adopted. In testing the stronger forms of efficiency, the ‘event’ adopted will depend on the availability of data on the stock market being tested. In using events such as money supply, exchange rate and interest rate announcements, the insiders are not necessarily company managers as is the case with dividends and earnings. However, it is important to know the expected price reaction to the event prior to using it in these tests. In studying the impact of the stock market on economic growth, the easiest method to use in this kind of research is regression analysis with economic variables such as real GDP per capita as the response variables. The stock market development indicators will be used interchangeably in the growth model as explanatory variables. The variables for stock market efficiency and financial liberalisation in the growth models will take the form of ‘dummies’. The main interest in this research is testing the significance of these stock market variables in the economic growth models. With growth models, it is important to test for specification bias, multicollinearity, autocorrelation and heteroscedasticity, as these are likely to be present and can impact on the results. This study intends to examine the role of stock markets in economic growth by addressing the following issues: • Highlight the risks and factors, political, economic and regulatory, that affect investment in Africa • The reason why African stock markets have not attracted as much foreign portfolio investment as the emerging markets of Asia and Latin America. Does this rest on their level of development? 14 How significant is information asymmetry on African stock markets as compared to the emerging markets of Asia and Latin America? • Does the inefficiency of African stock markets explain why Africa lags behind in economic development? This will involve: - First of all finding out which markets are efficient and which ones are not in weak form. - Testing the semi-strong and strong form efficiencies of the weak form efficient markets - Regression analysis with the efficiency ‘dummies’ as the explanatory variables • Investigate whether liberalisation of equity markets has significantly contributed to economic growth in some African countries and whether those that have liberalised are better off than those that have not liberalised. • Find out what impact the liberalisation of African equity markets have had on stock market variables such as liquidity and integration with world equity markets. • Test the impact of stock market liquidity on economic growth in Africa • African stock markets are known to lack integration with world equity markets. Does this undermine the role of the stock market in economic growth? • Investigate if stock market size and volatility are of any significance on the role of stock markets in economic growth since African markets are generally small and the stock prices are highly volatile • Which variable is significantly more important in the role of the stock market in economic growth, or are they all equally important? This will help in giving recommendations on what to focus on first in developing stock markets in Africa. Should the focus be on liberalising equity markets, or improving efficiency or liquidity, or increasing the stock market size? The study would perform comparative analysis between African and other emerging markets. • 6 DATA; ORGANISATION AND ANALYSIS Data needed for testing weak form efficiency: - Stock prices - Stock market indices To test for semi-strong and strong form efficiency, we need the following data: - Events and dates e.g. stock splits, earnings announcements and dates - Stock prices before and after the event - A list of corporate executives who own shares in the company making the announcement and their transactions, dates and the corresponding stock prices To test for the role of the stock market on economic growth, the following data will be required in addition to the one above: - GDP, population size and the inflation rate (or real GDP per capita) - The exchange rate to the US dollar - Interest rates - Number of listed stocks/companies - Market capitalisation 15 - Total value traded - Financial/stock market liberalisation dates From this data, one can derive the economic and stock market development indicators: Economic Development Indicators: - e.g. real per capita GDP Stock Market Development Indicators: - size, liquidity, volatility and integration with world equity markets In addition, statistics on the usual explanatory variables in economic growth models, that is, investment, consumption, government expenditure and the trade sector will be required, unless held ceteris paribus in models used in this research. Other factors/data such as number of stock brokers, technology used, trading rules and clearing and settlement procedures can also be collected if found necessary. Prospective data sources - ACIA database - International Finance Corporation - IMF’s International Finance Statistics - Central Banks of the countries under study - Statistical bureaus - Stock Exchanges under study and their websites - Stock Brokerage firms - Listed companies financial statements - Reuters 7 PRECONCEIVED IDEAS OR HYPOTHESIS The general perception is that African stock markets are not efficient at all, even though one or two studies (Husselmann [1988] and Osei [1995]) have confirmed efficiency of individual markets in the weak form. Singh (1992) pointed out that a number of investigations on the “efficient market” hypothesis for emerging markets do not always reject the weak form of the hypothesis. He went on to say that one would not expect the efficient market hypothesis to hold even in the weak form for third world markets, as they appear to be very imperfect. However, as Singh noted, the non-rejection of the efficient market hypothesis is not a guarantee of “information arbitrage” efficiency in share prices, let alone that of “fundamental valuation” efficiency. Small markets tend to be more efficient than the larger markets. Evidence is from the Tunis Stock Exchange, which had only 44 listed companies in 2000, but is said to be efficient (UN [2001]), though with low liquidity. The Tunis Stock Exchange is said to be nonspeculative and has put in some measures to protect the market efficiently against speculators. Reforms were put in place in 1998 to increase transparency and efficiency on the Tunis Stock Exchange. The Johannesburg Stock Exchange, on the other hand, which has 660 listed companies, has been characterised by insider trading. 16 Stock markets with electronic trading systems tend to be more efficient and more liquid than those with the open outcry system. The Ghana Stock Exchange is contemplating the introduction of automated trading in an effort to make “the exchange more relevant, more efficient and more effective” in its trading, clearing and settlement deals. The trading system on the Johannesburg Stock Exchange (JSE) also became an automated, screenbased, computer driven trading system (JET system), followed by the launching of the Stock Exchange News Service (Sens) in 1997, in an attempt to enhance market transparency, investor confidence and efficiency. The Namibian Stock Exchange adopted the JSE computer screen trading system and has seen a listing of companies that have their primary listings on the JSE. Namibia also intends to link to a paperless real time clearing and settlement system known as the Southern African Financial Instruments Clearing and Settlement System (SAFICAS). This system is “being introduced by the Johannesburg Stock Exchange based on the Swiss Stock Exchange system, to bring Southern African markets up to the latest global requirements for transparency, efficiency and speed, and featuring real time gross settlement with simultaneous payment”. A developed stock market plays a significant role in economic development. Inefficiency diminishes the role of the stock market in economic development. If a market is efficient, it is likely to result in more liquidity, integration with world equity markets and less volatility. 8 SIGNIFICANCE OF THE STUDY Most studies on stock markets have concentrated on testing efficiency, volatility and returns, liquidity and integration with world stock markets. Only recently, from the early 1990s, very few have tried to address the role of financial markets (with emphasis on banks rather than stock markets) in economic development (Levine and Zervos [1993], Levine [1996], Bekaert and Harvey [1997], Bekaert, Harvey and Lundblad [2001], etc.). Very few have made some reference to Africa (Bekaert, Harvey and Lundblad [2001]). The few African countries included in these researches are those that are relatively older, bigger or are performing better than others. Of interest have been stock markets such as the Johannesburg, Ghana, Nigeria, Lusaka and Zimbabwe stock exchanges. Some international investors look at Africa as one investment block. The United Nations [2001] reported that some foreign portfolio investors have shied away from the West African sub-region, as they perceive it to be politically and economically unstable. The main market indices of the BRVM in Cote d’Ivoire and the Ghana Stock Exchange fell by 15.8% and 32.9% respectively in US dollar terms in the first half of 2000 (Africa Recovery, UN [2001]). The fate of Ghana came from the events in the neighbouring countries of Sierra Leone and the DRC. The conclusion is that any event in one African country sends shock waves among investors in other countries. This research, by assessing the whole of Africa, and not just one particular stock market, is valuable, as it will paint a clear picture of Africa as a region. Not much research has been done with meaningful comparisons of economic development between emerging market regions basing arguments on stock market development. These regions are different and investors need assurance that situations such as the Mexican peso 17 crisis and the Asian crisis are not obvious happenings in Africa. The economic crisis in Asia sent some shock waves that were perceived by some of the African countries reducing overall economic growth in Africa by 1% (Africa Recovery, UN [2001]). The South African economy, the largest on the African continent slowed down drastically as a result of the Asian conclusions (Africa Recovery, UN [2001]). Most African countries, though less directly exposed to unstable equity and financial markets, have nevertheless, been hit by the mounting global economic crises (Africa Recovery, UN [2001]). Africa is said to be the most vulnerable continent to exogenous and persistent shocks, whilst Asia plays a major role in dragging down world trade and growth. The Asian crisis affected Africa through shrinking markets for African commodities, falling prices of primary commodities and most of all loss of confidence by investors in emerging markets (Africa Recovery, UN [2001]). Investors, who were already on edge because of the Asian crisis, are said to have stampeded out of South Africa in May 1998 in response to the rumours about the dismissal of the Reserve Bank governor and an impending devaluation of the Rand, both of which were unfounded (Africa Recovery, UN [2001]). The Asian crisis sends one key message to African markets, that, in the absence of efficient information flows, adequate regulation and market transparency; they are very susceptible to high volatility and risk. An efficient market attracts more investors, which translate into market liquidity and thus economic growth. 9 JUSTIFICATION OF STUDY African stock markets, which also fall under the emerging markets umbrella, are probably the least researched in finance studies. However, some of the top performers, though not many, among emerging markets are in Africa. The sudden emergence of stock markets in Africa in the 1990s raises a lot of interest among researchers. Investigating the efficiency of the stock markets is very important. This is because stock market efficiency (a) is important in boosting investor confidence (b) is a necessary condition for the stock market to perform its developmental sense and (c) makes equity funding available for a range of ventures. The importance of efficiency in a stock market has also been brought to light by the efforts being made by the existing stock exchanges to improve efficiency. These include improving information dissemination, making stock price information accessible to a broader range of investors through the Internet and the introduction of electronic or computer-based trading systems. By investigating the relationship of the African stock markets to economic growth, this research will bring out the possibilities of using the stock markets in Africa to steer economic development in the region. African stock markets still have potential to grow and most of them are still young compared to stock markets in other regions. 10 LIMITATIONS OF THE STUDY The major limitation that I foresee in undertaking this study is the timeframe. 18 The second limitation is the availability and accuracy of data. African stock markets are diverse in terms of age, size and trading systems. Not all of them will have data for the required time period. A stock market like the Maputo Stock Exchange is still very young and is of no significance in this research. The Egyptian stock exchanges are old but have been dormant for some time. The Johannesburg Stock Exchange is too large (in terms of market capitalisation) to be included in the same regression analysis with stock markets such as the Uganda Securities Exchange, which is both young and small. This will result into another limitation of constraining the sample size of the African stock markets. The main focus of the study will be mostly the African stock exchanges that have been in existence for at least ten years. Most of these are included in the African Markets Overview of the African Centre for Investment Analysis. This will make accessibility of ‘available’ data easier as contacts are already established. Effort will also be made to establish contacts in the emerging markets of Asia and Latin America. Testing of African stock markets efficiency will be laborious and tiresome. However, tests for semi-strong and strong form efficiency can be left out without changing the scope of this research. This study will not go deeper into facts. The depth will depend on how much of the available time and resources will allow. 11 CONCLUSION With the recent emergence of stock markets in Africa, this research is valuable in that it will show how this can be used as an opportunity for the betterment of Africa. It will be difficult to determine the role of stock markets in economic growth using African stock markets data only. Most of these markets are either too small or too young to have had any significant impact on economic growth. The representation of Africa is therefore going to be minimal in the regression models. The model obtained will however, be useful in predicting economic growth, not just in Africa, but in other emerging markets. BIBLIOGRAPHY Africa Recovery Online, United Nations: Africa’s Struggling Stock Exchanges Bekaert G. and Harvey C.R and Lundblad C. (April 2001): Does Financial Liberalisation Spur Growth? NBER, Cambridge Bekaert G. and Harvey C.R (May 1997): Capital Markets: An Engine for Economic Growth, NBER Cambridge Bekaert G. and Harvey C.R (spring 2001): Economic Growth and Financial Liberalisation, Research Summaries, NBER Reporter 19 Durham J. 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