An Investigation of the Relationship between Capital Market Development and Economic Growth: The Case of Saudi Arabia Meshaal Jasem M Alshammary A thesis submitted in partial fulfilment of the requirement for the degree of Doctor of Business Administration School of Accounting and Finance College of Business Victoria University Melbourne, Australia, 2014 Abstract This thesis investigates the long-term and short-term relationships between capital market development and economic growth in the Kingdom of Saudi Arabia (KSA) for the period from 1970 to 2010. It employs a wide range of vector autoregression (VAR) and Vector Error Correction (VECM) models, Unit roots tests, optimal lag tests, Johansen-Juselius cointegration tests and Granger causality testes to evaluate the importance and impact of capital market development on economic growth. Using real GDP growth rate (RGDPR) and real non-oil GDP growth rate (RNOIL) as proxies for economic growth and LM1, LM2 and bank credit to private sector (LBCP) as proxies for the capital market development. The vector-autoregression models (VAR) indicates significant long-term causal relationship among all the variables in the system. Granger causality tests show a bidirectional causal relationship between the economic growth variable RGDPR and the capital market when proxied by the bank credit to private sector (LBCP). However, Error-correction models results show no relationships in the short-run. The thesis implications are as follows. Firstly, investment in real economic activities leads to economic growth. Secondly, the stock market might hinder economic growth due to its volatile and international risk sharing nature, low free-floating share ratio, number of listed companies, the domination of Saudi Individual Stock Trades (SIST) characteristics and the small size of the least active and limited bond and ETF markets. Thirdly, policymakers should seek to minimise stock market volatility and fluctuations, increase all the free-floating share ratio, number of listed companies, size and offering in the bond and ETF markets and shift investment domination toward corporate investors by considering its effect on economic growth when formulating economic policies. Fourthly, the banking sector might hinder economic growth due to its lack of small and medium enterprises lending and shareholder concentration issues. Finally, policymakers should seek to encourage banks toward more involvement in small and medium enterprises SMEs’ lending, which will strengthen the private sector role. ii Declaration iii Acknowledgements My absolute gratefulness to Allah ‘God all mighty’, my family, my friends and the King Abdullah scholarship program for their emotional, physical and financial support throughout my knowledge-seeking journey. My heartfelt appreciation goes to my principal supervisor Prof. Terrence Hallahan. Special thanks to Director (Research and Research Training) At Victoria University Professor Anne-Marie Hede and Dr. Mofleh Alshogeathri for their kind help and support during my research. iv Contents Abstract ...................................................................................................................................... ii Declaration ............................................................................................................................... iii Acknowledgements ................................................................................................................... iv List of Figures ........................................................................................................................ viii List of Tables ............................................................................................................................ ix List of Abbreviations ................................................................................................................. x Chapter 1: Introduction .............................................................................................................. 1 1.1 Aims and Context ............................................................................................................ 1 1.2 Statement of Significance ................................................................................................ 3 1.3 Capital Market Developments and Economic Growth .................................................... 4 1.4 Conceptual and Analytical Frameworks .......................................................................... 6 1.5 Data and Scope ................................................................................................................ 8 1.6 Overview of the Study ..................................................................................................... 8 Chapter 2: The Saudi Arabian Economy, Public Finance and Capital Market ....................... 10 2.1 Introduction .................................................................................................................... 10 2.2 Saudi Arabian Economy and Planning .......................................................................... 10 2.2.1 Framework .............................................................................................................. 10 2.2.2 Strategic Choices .................................................................................................... 10 2.2.3 Planning History ..................................................................................................... 12 2.2.4 Privatisation ............................................................................................................ 18 2.2.5 Economic Performance ........................................................................................... 19 2.2.6 Saudi Unemployment ............................................................................................. 29 2.2.7 Foreign Direct Investment ...................................................................................... 31 2.3 Saudi Arabian Monetary Agency (SAMA) ................................................................... 36 2.3.1 A Brief History of the Saudi Arabian Monetary Agency (SAMA) ........................ 36 2.3.2 SAMA: Performance Remarks ............................................................................... 38 2.4 The Saudi Banking Sector ............................................................................................. 45 2.4.1 History of The Saudi Banking Sector ..................................................................... 45 2.4.2 Saudi Banking Sector: Performance Remarks ........................................................ 53 2.5 The Saudi Stock Market: Tadawul ................................................................................ 64 2.5.1 A Brief History of the Saudi Stock Market ............................................................ 64 2.5.2 Tadawul: Performance Remarks ............................................................................. 65 v 2.5.3 Tadawul’s 2006 ‘Bubble’ ....................................................................................... 74 2.6 Saudi Arabia: Islamic Finance ....................................................................................... 75 2.7 Conclusion ..................................................................................................................... 77 Chapter 3: Theoretical and Empirical Studies of Capital Market Development and Economic Growth ..................................................................................................................................... 81 3.1 Introduction .................................................................................................................... 81 3.1.1 Capital market ......................................................................................................... 81 3.1.2 Economic Growth ................................................................................................... 82 3.1.3 Capital Market Development and Economic Growth Main Hypotheses (Views) .. 82 3.2 Economic Growth and Capital Market Development Theories ..................................... 86 3.2.1 Neoclassical Growth Model .................................................................................... 87 3.2.2 Endogenous Economic Growth Model ................................................................... 89 3.3 Channels to Economic Growth ...................................................................................... 92 3.4 Empirical Studies on the Relationship between Capital Market Development and Economic Growth ................................................................................................................ 96 3.4.1 The Independent View ............................................................................................ 97 3.4.2 The Demand-Following View .............................................................................. 100 3.4.3 The Supply-Leading View .................................................................................... 100 3.4.4 The Feedback View .............................................................................................. 115 3.4.5 The ‘bank versus stock market’ based variables Empirics ................................... 118 3.4.6 The Mixed Results Empirics ................................................................................. 120 3.4.7 Empirics on Saudi Arabia ....................................................................................