1. Introduction “Given the close link between the financial sector and household and firm balance sheets, a key question is how these differences in financial systems affect macroeconomic behaviour.... Yet few empirical studies to date have analysed the effect of different financial structure on business cycle behaviour -attention has mostly focused on the role of overall financial development for growth performance.” World Economic Outlook, September 2006

2. Introduction (continued 1 ) large literature on the impact of finance and growth, but large literature on the impact of finance and growth, but few empirical work on the relationship between finance and volatility, even fewer work on the effects of capital market few empirical work on the relationship between finance and volatility, even fewer work on the effects of capital market theoretically, developed capital markets, not only better financial intermediation, help to smooth out economic fluctuations. theoretically, developed capital markets, not only better financial intermediation, help to smooth out economic fluctuations. existing studies provide only mixed support of the hypothesis that higher financial or capital market development leads to lower volatility existing studies provide only mixed support of the hypothesis that higher financial or capital market development leads to lower volatility

3. Introduction (continued 2 )

4. Theory Agency costs and balance sheet effect [Bernanke and Gertler (1995)] Agency costs and balance sheet effect [Bernanke and Gertler (1995)] Information asymmetries [Greenwald and Stiglitz (1993)] Information asymmetries [Greenwald and Stiglitz (1993)] Unequal access to investment opportunities [Aghion et al. (1999)] Unequal access to investment opportunities [Aghion et al. (1999)] Limited diversification [Acemoglu and Zilibotti (1997)] Limited diversification [Acemoglu and Zilibotti (1997)]

5. Theory (continued 1 ) Maturity mismatch in intermediaries’ portfolios, non-transferable specific knowledge, and lower transparency in a bank-based system. [Rajan and Zingales (2001)] Maturity mismatch in intermediaries’ portfolios, non-transferable specific knowledge, and lower transparency in a bank-based system. [Rajan and Zingales (2001)] Breaking up of relationship lending magnifies the initial shocks [Hann et al. (1999)]. Breaking up of relationship lending magnifies the initial shocks [Hann et al. (1999)]. Fire sales of a single troubled bank could cause asset-price deterioration that precipitates other banks into crisis [Fecht (2004)]. Fire sales of a single troubled bank could cause asset-price deterioration that precipitates other banks into crisis [Fecht (2004)].

6. Empirical Lopez and Spiegel (2002) analyse cross-section data and find that financial development does mitigate economic fluctuations. Lopez and Spiegel (2002) analyse cross-section data and find that financial development does mitigate economic fluctuations. Loayza and Ranciere (2004) shows a positive long- run relationship between financial intermediation and output growth co-exists with negative short-run relationship. Loayza and Ranciere (2004) shows a positive long- run relationship between financial intermediation and output growth co-exists with negative short-run relationship. Tiryaki (2003) finds that investment volatility decreases as financial secotor expands, but volatility of output business cycles is largely irresponsive to financial development. Tiryaki (2003) finds that investment volatility decreases as financial secotor expands, but volatility of output business cycles is largely irresponsive to financial development.

7. Measurement Issues Capital Market DevelopmentCapital Market Development Financial DevelopmentFinancial Development VolatilitiesVolatilities OutputOutput Growth VolatilityGrowth Volatility Business Cycle VolatilityBusiness Cycle Volatility Investment VolatilityInvestment Volatility Consumption VolatilityConsumption Volatility

8. Measures of Capital Market Development 1.Absolute measure identify the level of capital market development itself without reference to other development in the financial systemidentify the level of capital market development itself without reference to other development in the financial system Turnover ratio, Stock value traded ratio, Market capitalization ratioTurnover ratio, Stock value traded ratio, Market capitalization ratio 2.Relative measure gauge the development of capital markets relative to that of financial intermediaries, particularly the banking sectorgauge the development of capital markets relative to that of financial intermediaries, particularly the banking sector also know in the literature as “Financial Structure”, indicating whether the financial system is market-based, or bank-based.also know in the literature as “Financial Structure”, indicating whether the financial system is market-based, or bank-based.

9. Measures of Capital Market Development (continued 1 ) Absolute measures 1.“Turnover ratio” = the value of shares traded on domestic exchange divided by the total value of listed shares 2.“Value traded” = the value of trades of domestic shares on domestic exchange divided by GDP 3.“Market capitalization ratio” = the total stock market capitalization over GDP

10. Measures of Capital Market Development (continued 2 ) Relative measures [Beck et al. (2001)] 1.Structure-Activity = 2.Structure-Size = 3.Structure-Efficiency = 4.Structure-Aggregate = First principal component of the above three indices, but in this paper only the first two due to data limitation

11. Measures of Financial Development Ideally, a measure of financial development would indicate the effectiveness which the financial system performs its functions: Ideally, a measure of financial development would indicate the effectiveness which the financial system performs its functions: clearing and settlement, pooling resources, transferring resources across time and space, managing risk, providing information, and dealing with incentive problems [Merton and Bodie (2004)] clearing and settlement, pooling resources, transferring resources across time and space, managing risk, providing information, and dealing with incentive problems [Merton and Bodie (2004)] No such measures exist. Use proxies, which practically measure degrees of financial intermediation No such measures exist. Use proxies, which practically measure degrees of financial intermediation 1.Private credit ratio = ratio of domestic credit extended to the private sector by financial intermediaries to GDP 2.Liquidity ratio = ratio of liquid liabilities (usually M3) to GDP

12. Measures of Volatility Output volatility Output volatility Growth volatiliy = s.d. of growth rates of real gdp per capitaGrowth volatiliy = s.d. of growth rates of real gdp per capita Volatility of business cycle component of output = s.d. of filtered real gdp per capitaVolatility of business cycle component of output = s.d. of filtered real gdp per capita apply Chistiano-Fitzgerald (CF) band-pass filter apply Chistiano-Fitzgerald (CF) band-pass filter extract cyclical variations that last 2 to 8 years extract cyclical variations that last 2 to 8 years Investment volatility Investment volatility Investment volatility = s.d. of gross capital formation growthInvestment volatility = s.d. of gross capital formation growth Consumption volatility Consumption volatility Consumption volatility = s.d. of household consumption growthConsumption volatility = s.d. of household consumption growth

13. A reduced-form equation relating volatility, financial intermediation, and capital market σ is a measure of volatility. Depending on the specification, it could be log of standard deviation (sd.) of growth rate of output (g-vol), investment (i-vol), or consumption (c-vol), or sd. of CF-filtered log of output (b- vol). FD is a measure of financial development, namely log of private credit ratio (credit). FS is a measure of capital market development. An absolute and a relative measure would be log of turnover ratio (turnover) and financial structure-aggregate index (struc), respectively. X is a vector of standard controlled variables [see e.g. Lopez and Spiegel (2002), Beck et al. (2003)] Methodology

14. Methodology (continued 1 ) Controlled variables (X) include: Controlled variables (X) include: income level, trade openness ratio, government consumption over GDP, s.d. of changes in real effective exchange rate, s.d. of changes in terms of tradeincome level, trade openness ratio, government consumption over GDP, s.d. of changes in real effective exchange rate, s.d. of changes in terms of trade Instrumental variables (Z) in IV and Panel IV: Instrumental variables (Z) in IV and Panel IV: IV: time trend, legal origin, creditor’s protection index [La-Porta et al. (1998)]IV: time trend, legal origin, creditor’s protection index [La-Porta et al. (1998)] Panel IV: time trend, creditor’s protection, human capital indexPanel IV: time trend, creditor’s protection, human capital index

15. Data The panel covers annual data of 44 countries from 1975 to 2004. Data sources are International Financial Statistics (IFS), World Development Indicators (WDI), Barro-Lee data set [Barro and Lee (2000)], Legal Origin and Creditor's Protection data set [La-Porta et al. (1998)], and Financial Structure data set [Levine (2002)]. The panel covers annual data of 44 countries from 1975 to 2004. Data sources are International Financial Statistics (IFS), World Development Indicators (WDI), Barro-Lee data set [Barro and Lee (2000)], Legal Origin and Creditor's Protection data set [La-Porta et al. (1998)], and Financial Structure data set [Levine (2002)]. The annual data are transformed into six five-year-span panel data from 1975-2004. The annual data are transformed into six five-year-span panel data from 1975-2004. The transformation method is the average, but for volatilities (such as growth volatility), standard deviation is used. The transformation method is the average, but for volatilities (such as growth volatility), standard deviation is used.

16. Scatter Diagrams

17. Robustness check Alternative measures of financial and capital market development are used. Liquidity ratio (M3/GDP) is used instead of private credit ratio (private credit/GDP) to measure a degree of financial development. Value traded ratio (stock value traded/GDP) and market capitalization ratio (stock market capitalization/GDP) are used instead of turnover ratio (stock value traded/stock market capitalization) as a measure of capital market development. Major findings do not materially change with alternative measures. Alternative measures of financial and capital market development are used. Liquidity ratio (M3/GDP) is used instead of private credit ratio (private credit/GDP) to measure a degree of financial development. Value traded ratio (stock value traded/GDP) and market capitalization ratio (stock market capitalization/GDP) are used instead of turnover ratio (stock value traded/stock market capitalization) as a measure of capital market development. Major findings do not materially change with alternative measures. Inclusion of the effects of institutional quality and financial liberalization policy also does not change the result. Inclusion of the effects of institutional quality and financial liberalization policy also does not change the result. Other plausible relevant variables (e.g. standard deviation of inflation, average inflation rate, and investment ratio) are also included in the estimation, but have never been significant. Other plausible relevant variables (e.g. standard deviation of inflation, average inflation rate, and investment ratio) are also included in the estimation, but have never been significant.

18. Policy Implication The above econometric analysis supports theoretical prediction that the development of capital markets reduces output, investment, and consumption volatilities. The above econometric analysis supports theoretical prediction that the development of capital markets reduces output, investment, and consumption volatilities. Still the question whether the magnitude of the effects is economically meaningful. Still the question whether the magnitude of the effects is economically meaningful. Use a coefficient of log of turnover ratio (turnover) from fixed effects estimation (FEI) of growth volatility as a benchmark. The coefficient is -0.16. The inter-quartile range of turnover ratio in the sample is 49.36. In terms of log difference, it is 1.67. Therefore, the effect of an inter-quartile improvement in turnover ratio is -0.27 (-0.16 * 1.67) or a reduction of 27% of volatility. Use a coefficient of log of turnover ratio (turnover) from fixed effects estimation (FEI) of growth volatility as a benchmark. The coefficient is -0.16. The inter-quartile range of turnover ratio in the sample is 49.36. In terms of log difference, it is 1.67. Therefore, the effect of an inter-quartile improvement in turnover ratio is -0.27 (-0.16 * 1.67) or a reduction of 27% of volatility. The average growth volatility is 2.1%. A decrease of 27% would mean a decrease of 0.50 percentage point (2.1-2.1*exp(-0.27)) in standard deviation of growth rate. The average growth volatility is 2.1%. A decrease of 27% would mean a decrease of 0.50 percentage point (2.1-2.1*exp(-0.27)) in standard deviation of growth rate.

19. Conclusion This paper investigates the effect of capital market development on output, investment and consumption volatilities in forty-four countries using data from 1975 to 2004 period. This paper investigates the effect of capital market development on output, investment and consumption volatilities in forty-four countries using data from 1975 to 2004 period. The main result is that output, investment and consumption volatilities are negatively related to measures of capital market development after controlling for other relevant variables. The main result is that output, investment and consumption volatilities are negatively related to measures of capital market development after controlling for other relevant variables. However, the absolute magnitude of the effect is quite small. However, the absolute magnitude of the effect is quite small.