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# IV. ASSET **PRICES, ECONOMIC ACTIVITY, AND GROWTH**

## A. **Stock prices and economic activity: Consumption and investment**

In LAC countries, we found a clear direction of causality running from stock market returns to consumption and investment (Table 9). The causality between stock returns and consumption can be justified on several grounds. First, there exists the wealth effect, according to which agents' consumption decisions depend on wealth, which in turn is affected by stock price movements. Given that stocks are not a widespread forrn of saving in LAC, this effect should not be important in explaining the observed statistical result. Second, stock prices might be signaling the future growth of the economy and, hence, the future growth of labor income (Ward, 1999), which will affect consumption. Third, as the perceived wealth of individuals changes positively, so does their creditworthiness, allowing agents to increase their indebtedness and/or to receive credit at a lower cost.

The observed causal relationship between investment and stock prices can be explained by Tobin's q theory: as stock prices change, then the ratio between the market valuation of existing capital and the cost of new capital (Tobin's q) changes. As stock prices rise, the cost of new capital falls relative to that of existing capital, and firms will acquire new capital (invest). A second explanation for the observed relationship between stock prices and investment can be found along the lines of the second explanation for consumption: stock prices convey information regarding the future growth of the economy and, therefore, affect investment through this channel. Finally, the balance sheet effect may also operate here: as asset prices change, so does firms' perceived creditworthiness and hence their access to credit.

Examining quarterly stock price and investment data for the 1990s (Graph 20), a clear positive relationship emerges. To incorporate stock prices into a longer-run perspective on the determinants of investment, we estimate a panel for five Latin American countries from 1980 to 1999 with SUR methods (Table 10). The dependent variable is the ratio of gross domestic investment to GDP while the explanatory variables were: foreign direct investment (Borensztein, De Gregorio, Lee, 1998), a dummy variable reflecting situations of state failure (from the Polity International database), government consumption expenditure, government capital expenditure, the log of stock prices, the volatility of stock returns, and lagged growth (Seven and Solimano, 1993 and Cardoso, 1993).39 All 39 The panel was estimated by Seemingly Unrelated Regressions (SUR) with instrumental variables. Appendix D shows that estimation with the original data does not alter the sign or significance of any of the results, and changes in the parameter values are relatively minor. The variables are all cointegrated according to tests proposed by Kao (1999) and Pedroni (1999), attenuating the autocorrelation of residuals problem. These tests require balanced panels; consequently, for this purpose only, we discarded Colombia from the sample, since it had stock price data only since 1984. (None of the results described in the text changes when Colombia is excluded from the sample.) The dynamics of investment should be explored by more elaborate methods, but the number of observations poses a problem. Notwithstanding this problem, we estimated the panel with variables expressed in changes and levels; this approach deals with serial correlation (Appendix D). The only significant variables turn out to be stock prices, the volatility of stock returns, the state failure variable, and government capital expenditure. With a larger set of countries and a longer time period, it can be shown (Herrera and Garcia, 2000) that govemment consumption and foreign