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# **1. Introduction**

Capital markets serve a fundamental purpose in allocating capital to its most productive uses. Their health and functioning is a central determinant of the growth and development process. Therefore a substantial part of the policy and research agenda of financial market development has focused on fostering the creation of stock and bond markets and increasing their size. Less attention has been paid to understanding the channels and policies to improve their efficiency.

Although the size of a market is in general correlated with other positive attributes, such as how they function of how stable they are, it is a distinctively different attribute from efficiency. Consider for example a large stock market as measured by market capitalization that only lists a few large firms which are rarely traded. Such a market will be ranked high in terms of size, but it will hardly be serving the purpose of an efficient allocation of resources. In that sense, the market will not be efficient.

The efficiency of a stock market is essentially its ability to intermediate resources from suppliers of capital to their most productive use. To do that, prices—the fundamental allocation instrument—must accurately reflect all information in the marketplace. The finance literature has thus tested an immediate implication of efficiency: the lack of stock return predictability. A broad literature has followed this path for mature markets. However due to the lack of data, cross-country studies of stock market development have instead focused on the determinants of size, leaving efficiency implicit in the analysis.

In this paper, we concentrate on the efficiency of the East Asian stock markets, drawing on an analysis of stock markets around the world. To do this we focus on liquidity, which is a necessary condition for efficiency. Liquidity is the ability to buy and sell a good, in this case an asset, with ease. That is, to be able to buy or sell a good at will, at market prices, without incurring substantial costs to trade. It follows that every efficient market has to be liquid, although the converse is not necessarily true—a market can be liquid but inefficient.

We present a framework to understand the channels that affect liquidity of capital markets. The size and depth of the market, the physical infrastructure of trading, the institutional foundations of markets, and the heterogeneity of the investor base interact to make a market more or less liquid. In turn, liquidity feeds back and affects the size of the market and the presence and willingness to trade of heterogeneous investors.

We then empirically study the determinants of two attributes crucially related to liquid and efficient markets, namely transactions costs and the quality of the informational environment. We use newly available data that benchmarks countries in the efficiency of their stock markets—trading costs and the use of firm specific information—independently of their size. We find that the quality of the physical and market infrastructure, along with certain institutional characteristics of stock markets is associated with lower transactions costs. Also we find that certain institutional and legal