The Increase in Market Capitalization for Different Markets

the world have experienced phenomenal expansion. The aggregated market capitalization of all national equity markets has grown from less than US$1 trillion in 1974 to over US$16 trillion by the end of 1997. Exhibit 1 presents evidence of the increase in market capitalization experienced by both developed and emerging markets. The process of growth in global equity markets is still imperfectly understood. One view points to improved macroeconomic and financial fundamentals as the source of the growth. Others who are more skeptical of efficiently functioning capital markets, suggest that investors in their “exuberance” may have been buying up stocks, disregarding the historical relationship between market fundamentals and equity valuation. In this paper, I adopt a modelling framework leading to the identification of sources of equity market growth. Specifically, I start with a valuation model where the dependent variable is the market capitalization of a country’s equity market relative to GDP. The model is a generalization of stochastic production frontier models which assume that comparable economic agents operate according to a common technology or production frontier (“frontier” here meaning the maximum technically feasible output given inputs). In this paper, I view countries as producers of their equity market capitalization (an output) given macroeconomic and financial characteristics (valuation inputs). Accordingly, countries can be thought of as operating either on or within the valuation frontier, and deviation from the frontier reflects market inefficiency (i.e., market discount or underpricing as in my particular application). Over time, due to government policy changes such as capital markets liberalization in emerging economies, improved legal systems and better institutions, a country’s equity market can become more highly valued and “catch up” to the valuation frontier. That is, the distance from a country’s equity market capitalization to its maximum possible value—the frontier assuming no market discount—could become smaller over time. Or investors could simply become more upbeat about the