What Defines Liquidity of the Stock Market? The Case of the Nairobi Stock Exchange
Discussion Paper No. 29
Abstract
ABSTRACT
Liquidity of the stock market is vital if the market is to play a significant role in the development by facilitating mobilisation of long-term capital. During the revitalisation period, a lot of efforts have been made to enhance market liquidity by instituting institutional and policy reforms. This has seen shifts in trading system to enhance transparency in the price discovery process, and to strengthen investors’ protection to boost investors’ confidence in committing their resources to the stock market. There has also been tightening of disclosure rules, rationalisation of tax policy to create a level ground for financial assets competition and continued lobby for government to provide a favourable policy environment. A question of interest to policy makers and researchers is whether the implemented reforms have had any significant contribution to the stock market liquidity.
This study analyses the response of trading activity and liquidity of the NSE to the implemented institutional and policy reforms during the revitalisation process. The study covers the period January 1990 to June 2002. We invoke the microstructure theory for empirical analysis testing for market response to the following main changes: shifts in trading system, tightening of the regulatory system, reform of taxation policy, and relaxation of capital controls. Descriptive statistics and simple regression analyses are used to test hypotheses.
The main findings of this study are eight-fold: First, the level of stock returns influence to a large extent the volume of trading activities. However, it takes quality of information and therefore efficiency of the market to achieve market resiliency and depth. Second, enhancing transparency in the price discovery process by shifting to floor trading increases investors’ participation, but does not necessarily improve the transactional properties. Shifts in trading system achieve more if coupled with institutional change that reduces information costs. Third, taxation policy plays a major role in facilitating share trading especially if aimed at reducing transaction costs and ensuring competitiveness of shares among the financial assets. However, a tax policy that tilts preferences to dividend income may not be conducive in sustaining market liquidity especially if this is accompanied by concentration of shares among a few individuals. Fourth, our results show that high concentration of shares among a few shareholders in one firm and across the market makes the market less liquid. Fifth, growth of the bonds market may be detrimental to share trading especially if there are huge differences in yields and investment risk across financial assets. In addition, a high concentration of government bonds may crowd out the private sector in the stock market like it did in the banking sector. Sixth, although foreign investors enhance trading activity, their significant contribution to liquidity is curtailed by their noise trading behaviour and weak regulatory system of the domestic market that transient institutional investors thrive on for trading activity. Enhancing the pull factors for foreign investors in the market is important in order to experience gains in trading activities. Seventh, volatility of the stock market is inversely related to gains in market liquidity. Volatility is partially attributed to information asymmetry and therefore adequacy of the market microstructure infrastructure including the tightness of disclosure rules. Our results show that any efforts made to tighten disclosure rules and protect the investors go a long way in improving liquidity as information costs are reduced. Eighth, economic performance has a direct influence on investors’ participation especially because it affects their earnings and therefore their ability to participate in the market. Therefore, in conclusion, we observe that improvement requires not only NSE to invest in improving the market microstructure, but also requires a favourable policy environment.
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