Indicators Measuring Financial Market Development

ameliorate (but not necessarily eliminate) the effects of information costs, contract enforcement costs, and transaction costs.

Thus, the development of financial markets is important for encouraging savings, encouraging investment, promoting the capitalization process in the economy (Nguyen Thi Canh et al., 2011; Levine, 2005), and the gradual transition from debt markets to stock markets (Chakrabarti, Sethi and Bhattacharjee, 2018). Theory shows that government intervention in financial markets (mostly in the form of directed capital allocation) hinders development (Chakrabarti et al., 2018).

Financial market development can also be considered from two aspects: stock market development and bond market development.

Stock market development

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The stock market is essentially the heart of the financial system. The main function of the stock market is to act as a mechanism to convert savings into finance for the economic sector. From a theoretical perspective, the stock market can promote economic growth by mobilizing and promoting domestic savings and improving the quantity and quality of investment. Better mobilization of savings can increase the savings rate; and if the stock market allocates savings to investment projects with higher returns, the increasing rate of return to savers will make savings more attractive. Therefore, more savings will be transferred to the corporate sector. An efficient stock market makes companies compete on a level playing field for access to capital and makes investment more efficient. In addition, the stock market performs many other important functions. The stock market helps long-term investments to be financed by funds provided by individuals in both the short and long term. In addition, the stock market can increase the efficiency of the financial system through competition between different types of financial instruments. This can therefore increase the returns for savers and also reduce the cost of raising capital for borrowers. The stock market can also improve accounting and tax standards when investors demand

more and better information to compare the performance of different companies; and logically, it is in the best interest of the company to provide that information to facilitate thorough comparisons between competing companies. A prominent benefit of the existence of a stock market is its ability to impose greater discipline in the area of economic management, which is sensitive to policy changes, especially monetary policy. The existence of a stock market has helped to enhance the effectiveness of policy (El-Wassal, 2013).

Although the term “development” is widely used in the literature on stock markets, no precise definition of the term can be found (Salameh and Ahmad, 2020; El-Wassal, 2013). According to Garcia and Liu (1999), stock market development is a multidimensional concept that can be measured by stock market size, liquidity, volatility, concentration, integration with global capital markets, and market regulation and supervision. According to El-Wassal (2013), the measures commonly used to assess stock market development are market size and liquidity indicators. However, in principle, it must be said that growth and development are not the same. For a stock market to grow means to increase in size or liquidity, while development means to increase or improve the market’s ability to serve the needs of the economy as set out in the main functions of the stock market. The development of a stock market is better reflected in the quality of services provided by the market than in its size, liquidity or performance. If a stock market is flooded with money, it will be more liquid but not necessarily more “developed”. On the other hand, a well-developed market can serve the economy better with its size and liquidity than a less developed market of the same size and liquidity. This does not mean, however, that size and liquidity are irrelevant; larger size and greater liquidity can improve the market’s ability to serve the economy, but they can best be used for this purpose through developed markets. For many emerging stock markets, stock market growth may be too

levels, but could it be argued that they are capable of over-development? Furthermore, market growth and development are not in conflict – they can be mutually reinforcing. The distinction between stock market growth and development is best understood by the traditional analogy between economic growth and economic development. Although there has been a great deal of research on stock market development, there is no single criterion that can be used to measure market development. A stock market can be large, but illiquid; or it can be quite liquid, but trading only takes place in a small number of stocks that account for a significant portion of the total market capitalization. Alternatively, a stock market can be large, liquid, and reasonably decentralized but may be unlinked or may not even reflect performance in the real sector. Therefore, just one or two indices will not be enough to capture all aspects of stock market development (El-Wassal, 2013).

Based on the above arguments, El-Wassal (2013) defined stock market development as follows: A “developed” stock market is “a sufficiently large and liquid market – relative to the size of the economy – with a decentralised market capitalisation and a full linkage with real sector activity”. At the same time, the author noted that national institutions are also one of the important aspects of stock market development. According to Pradhan, Arvin, Norman and Bahmani (2018), stock market development is defined as the process of improving the quantity, quality and efficiency of services in the market. This process involves the aggregation of many activities, and therefore cannot be captured by a single measure.

Bond market development

The main difference between bank loans and corporate bonds depends on how to deal with the problems of information asymmetry between the ultimate creditors and the ultimate borrowers. In the case of bank finance , the ultimate creditors are the depositors who make investments in the form of deposits in commercial banks. However, it is not the depositors but the banks that bear the burden of

direct risk when lending to businesses. Commercial banks cannot transfer that risk to depositors, although they act as intermediaries between deposit-taking and lending businesses. This means that commercial banks must minimize their own risk by carefully monitoring borrowing firms. Through this, commercial banks attempt to deal with the information asymmetry problem between borrowing firms and themselves. In general, commercial banks face three stages of information asymmetry: before lending, during lending, and after lending (in case of financial difficulties of borrowers). Therefore, commercial banks manage credit risk through three actions: (1) monitoring, (2) accepting collateral, and (3) diversifying loans. However, the monitoring functions play the most important role because assessing the future value of collateral is difficult and loan diversification cannot eliminate bank credit risk. To effectively monitor their investment projects, commercial banks need to have useful “inside” information on the strategic planning, management performance, profitability and asset holdings of the borrowing companies. Access to such unique information can be obtained through repeated transactions to establish long-term relationships with the borrowing companies; and this information is not “transferable” in the market. In the case of bond financing , in contrast to bank loans, the ultimate creditors are public investors. These investors make their own investment decisions and therefore bear the risk of those decisions. Since investors are numerous, diverse, dispersed and directly accept investment risks, information about issuing companies needs to be standardized and transferable so that the characteristics and operations of companies in terms of coupon rates, risk premiums, maturity, etc. can be easily grasped. Providing standardized information to public investors is an important factor in minimizing problems arising from information asymmetry between issuing companies and public investors and thus promoting the development of the corporate bond market (Yoshitomi and Shirai, 2001). In other words, bond financing spreads the risk to a large group of bondholders that is extremely diverse, much wider than the level of financing.

bank financing can be achieved. In addition, bond financing does not involve maturity shifting, as investors are fully aware of the yield and time horizon of their investment; on the other hand, bank financing certainly involves maturity shifting, as banks' liabilities are typically short-term, while assets have longer maturities. The existence of a domestic bond market can also reduce the need for foreign borrowing and thus reduce potential exchange rate risk. An economy with a well-developed corporate bond market has stronger market discipline than an economy dominated by bank lending, as investors will demand disclosure and transparency in corporate operations to protect their interests and reward good performers with lower funding costs (Jiang, Tang, and Law, 2001).

The importance of bond market development has been recognized by both developing and developed economies following the repeated occurrences of financial crises over the past few decades, including the 1997 Asian financial crisis, the 2007–2008 global financial crisis, and the 2011–2012 European debt crisis. One of the main causes of these crises has been identified as over-reliance on the domestic banking sector. The banking system mainly provides short- and medium-term financing. However, sovereigns and enterprises have borrowed from banks to finance their long-term investments, which has created a mismatch between the maturity of lending and borrowing, and has repeatedly pushed economies into default. In addition, excessive sovereign borrowing from banks tends to affect the capital available for business investment, which in turn impedes the rate of investment in the economy. As a result, at some point a credit crunch will occur and the economy will have difficulty in paying off maturing debts. Therefore, a depreciation of the domestic currency will add to the burden of existing debts (Aman, Isa and Naim, 2020).

The over-reliance on the banking sector was largely due to the absence of well-developed and deep bond markets in many developed economies until 1990 and most developing countries until 2000. As a result, global economies

recognize the need to reduce dependence on the banking system and develop a deeper and more efficient domestic bond market. The presence of a developed bond market not only provides diversification in the financing of the government and businesses but also makes the economy more resilient to financial crises (Bhattacharyay, 2013). Moreover, the bond market increases the efficiency of the country's overall financial system (Mihaljek, Scatigna, and Villar, 2002). Therefore, debt securities are a suitable source for generating long-term finance with the flexibility of domestic or foreign currency, so that the maturity mismatch problem disappears (Aman, Isa, and Naim, 2020).

For Asian economies, the importance of bond market development is increasing. These economies have been involved in creating infrastructure connectivity between regional economies, which requires large and long-term financing. Therefore, long-term bonds are the best available tool to generate the necessary financing using regional resources (Aman, Isa, and Naim, 2020). In addition, bond market development in developing economies has once again attracted foreign capital inflows to these economies, which were previously reversed due to the absence of capital markets and uncertain investment (Burger and Warnock, 2007). Therefore, bond market development is good in combating economic crises, converting regional savings into investments, and attracting foreign capital inflows (Aman, Isa, and Naim, 2020). A well-developed debt market can also increase economic welfare because it complements other financial instruments to provide a full range of investment vehicles, the characteristics of which cannot be easily replicated by other securities in the market. For example, some classes of investors (such as pension funds and insurance companies) prefer to hold low-risk debt instruments, with a steady income stream that equity markets cannot provide.

However, an efficient stock market can help develop the bond market by reducing information asymmetries in the market. In addition, a well-developed stock market reduces the cost of issuing bonds and increases the

high corporate governance (Demirguc-Kunt and Levine, 1996). Furthermore, investors who have invested in stocks have no difficulty investing in debt securities (Smaoui, Mimouni and Temimi, 2017). A well-developed bond market can reduce the cost of raising capital for the best-quality borrowers, since the intermediation costs for bonds are lower than for bank financing (Jiang, Tang and Law, 2001).

2.1.3.3. Indicators measuring financial market development

Most empirical studies since the 1970s have used private credit to GDP and stock market capitalization to GDP to measure financial market development. However, in practice, if only based on such indicators, the assessment of financial market development will be distorted; typically, Korea and Vietnam both have private credit to GDP ratios of nearly 100%, meaning that the two countries are assessed to have the same financial depth; but in reality, most Koreans have bank accounts, while in Vietnam, only about 25% of adults have accounts. In addition, the efficiency of the financial system is a very important factor because even if the financial system is large in scale and wide in scope, its contribution to the economy will still be limited if the system operates wastefully and inefficiently (IMF, 2015).

Therefore, the International Monetary Fund (IMF) (2015, 2016) has introduced a new set of indexes (including 8 variables) to evaluate the development of the financial market in three aspects: depth, accessibility and efficiency; however, the IMF does not stop at considering each individual index, but will synthesize them into 4 groups of indexes: FMA (Financial Markets Access Index), FMD (Financial Markets Depth Index), FME (Financial Markets Efficiency Index) and FMI (Financial Markets Index); each index has a value ranging from 0 to 1 with the higher value indicating better financial development (Table 2.1).

Table 2.1: Variables measuring financial market development of the IMF

Financial Markets Index (FMI)

Market Depth (FMD)

1. Stock market capitalization

GDP

2. Value of stocks traded over GDP.

3. Value of government bonds issued on the international market over GDP.

4. Value of financial corporate bonds over GDP.

5. Value of non-financial corporate bonds over GDP.

Market Access (FMA)

Market efficiency

(FME)

1. Stock market capitalization (excluding the 10 largest companies) as a percentage of total capitalization.

2. Number of organizations issuing bonds both domestically and internationally.

Ratio of stock trading value to market capitalization.

Source: IMF (2015, 2016)

Data were collected for 176 countries (including 25 advanced economies, 85 emerging markets and 66 low-income developing countries) from a variety of sources, specifically from the World Bank's Global Financial Development Database and World Bank Statistics, the IMF's Access to Finance Survey, the Dealogic Corporate Debt Database and the Bank for International Settlements (BIS) Debt Securities Database.

The TTTC Development Index is constructed using the standard three-step approach found in the literature on reducing multidimensional data to a summary index: (1) standardizing the variables; (2) aggregating the standardized variables into sub-indices representing a specific function; and (3) aggregating the sub-indices into a final index. This procedure follows the OECD Handbook on the Construction of Composite Indicators (OECD, 2008), which is a good reference for methodological recommendations. In addition, several choices need to be made during the index construction process: (i) which

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