MARKET DATA REVIEW : The role of capital markets in financing development

Earlier this year, the Dar es Salaam Stock Exchange was admitted as an affiliate member of the World Federation of Exchanges (WFE), the global body of exchanges, clearing houses and depositories that advocate for their cause, which includes championing, educating and working with country and global policy makers and regulators to ensure regulatory initiatives are well thought out and contribute to orderly, fair and transparent markets across the world.

Last week the WFE held its annual assembly and general meeting in the city of Cartagena in Colombia, for which I had an opportunity to attend, interact and share our cause — this being a matter of necessity in our competitive world where global capital is sought after by almost everybody in order to finance their local development projects and enterprises.

And, obviously, for a meeting of such a global body, with some member exchanges making significant use of capital markets and having thousands of listed companies within their market infrastructure and billions of US$ in market capitalisation as well as several decades of existence; the agenda for such a conference would normally vary from issues that matters to small and emerging markets, like mechanisms for enhancing of market liquidity to complicated topics that are far fetching for our imagination, given the level and pace of our market development, ideas such as black pools or blockchains or Distributed Ledger Technologies, or roles of central counters parties (CCPs) in clearing and settlement of OTC and derivative instruments, etc — these are challenging ideas to digest and therefore it made me think of how long our journey still is.

However, I am also mindful of what we have achieved in these closer to two decades since the start of our capital markets journey. So, what have we achieved? and what is the potential of capital markets development for our economy? I will explain:

Since the enactment of the Capital Markets and Securities (CMS) Act, Cap. 79 of 1994 and the establishment of the Capital Markets and Securities Authority (CMSA) in 1996 there has been several development in the Capital markets space in our country; notably: the incorporation and operationalisation of the Dar es Salaam Stock Exchange;

Introduction of Collective Investment Schemes; Privatisation and Listing of some state owned entities; Listing and trading of Government Bonds at the Exchange; Listing of 25 equity issued companies and 15 corporate bonds in the Exchange; growth of capital markets contribution to the Gross Domestic Product (GDP), to about 25 percent (at the current market capitalisation of about Sh22 trillion); increase of number of Tanzanian investing through the Exchange to about 460,000; demutualisation of the DSE to make it more effective in responding to markets needs and competition, etc.

Despite the milestones achieved, the potential for capital market’s contribution to the economic growth and social economic development could be better. So, if it could be better, what would it mean? what is the role of the capital market in an open, liberal and democratised economy?

Existence and actually a growing capital market offers a variety of financial instruments that can enable economic agents with the country to raise efficiently priced capital and manage financial risks. Additionally, through assets with attractive yields, liquidity and risk characteristics, the capital market has the potential of encouraging savings in the long term financial form. Capital markets as an integral part of the financial markets plays a pivotal role, essential for government and other institutions in need of long term funds. Government uses the capital market for infrastructure development and private enterprises uses the market for business growth and development.

Taking into account its role in the market economy, the capital markets occupies an important place, through their specific mechanisms, capital markets can efficiently succeed to give its contribution to the economic development of the society.

The importance of the capital markets in more significant in the case of emerging markets, like ours (even though we are yet there), being well-known for their contribution in reorienting financial resources to efficient activities, contributing to the economic reform, but also it supports in the privatisation process of state-owned entities and also in implementing other economic empowerment and enterprises transparent-based policies. So far, we have only seven privatisation through the Exchange, but the upward potential is large, if we become more sensitive to the role of the capital market in the whole privatisation process.

Economic growth in a modern economy hinges on an efficient and effective financial sector that pools domestic savings and mobilises capital for productive projects. Absence of effective capital market leaves most productive projects which carry developmental agenda unexploited.

That way, Capital market connects the monetary sector with the real sector and therefore facilitates growth in the real sector and economic development. The fundamental channels through which capital market is connected to the economy, economic growth and development is as follows:

The contact between economic agents with deficit of money and the ones with monetary surplus can take place in a direct way (direct financing), but also by the means of any financial intermediation form (indirect financing), situation in which specific operators realise the connection between the real economy and the financial market.

In this case, the financial intermediaries could be banks, investment funds, pension funds, insurance companies or other non-bank financial institutions.

Furthermore, Capital market increases the proportion of long-term savings (pensions, life insurance, collective investment scheme funds, etc.) that is channeled to long-term investment.

Capital market enables contractual savings industry (pension and provident funds, insurance companies, health insurance schemes, collective investment schemes, etc.) to mobilise long-term savings from small individual household and channel them into long-term investments.

Capital markets fulfills the transfer function of current purchasing power, in monetary form, from surplus sectors to deficit sectors, in exchange for reimbursing a greater purchasing power in future. In this way, capital market enables corporations to raise capital/funds to finance their investment in real assets.

The implication of capital markets activities in an economy will be an increase in productivity within the economy leading to more employment, increase in aggregate consumption and hence growth and development. It also helps in diffusing stresses on the banking system by matching long-term investments with long-term capital.

The existence of the capital market in an economy encourages broader ownership of productive assets by small savers. It enables them to benefit from economic growth and wealth distribution, and provides avenues for investment opportunities that encourage a thrift culture critical in increasing domestic savings and investment ratios that are essential for rapid industrialisation. Additionally, the capital market mechanism allows not only an efficient allocation of the financial resources available at a certain moment in an economy – from the market’s point of view – but also permits to allot funds according the return and the risk – from the investor’s point of view – offering a large variety of financial instruments with different profitableness-risk characteristics, suitable for saving or risk covering.

The capital market allows risk dispersion between investors (for the diversifiable risk), the risk, that could be realised by the help of different operations, market orders or derivatives, makes the capital markets as a proper mechanism for risk diversification.

Capital market also provides equity capital and infrastructure development capital that has strong socio-economic benefits through development of roads, water and sewer systems, housing, energy, telecommunications, public transport, etc. These projects are ideal for financing through capital market via long dated bonds and asset backed securities. Infrastructure development is a necessary condition for long-term sustainable growth and development. In addition, capital market increases the efficiency of capital allocation by ensuring that only projects which are deemed profitable and hence successful attract funds. This, in turn, improve competitiveness of domestic industries and enhance ability of domestic industries to compete globally, given the current momentum towards global integration. The result is an increase in domestic productivity which then spill over into an increase in exports and, therefore, economic growth and development.

Moreover, capital market promotes public-private sector partnerships by encouraging participation of private sector in productive investments. The need to shift economic development from public to private sector to enhance economic productivity has become inevitable. Capital markets, therefore, assists the public sector to close the financial resource scarcity gap, and complement its effort in financing essential socio-economic development, through raising long-term project based capital. It also attracts foreign portfolio investors who are critical in supplementing the domestic savings levels. The capital markets facilitates inflows of foreign financial resources into the domestic economy.

The role of capital markets is vital for inclusive growth in terms of wealth distribution and making capital safer for investors. Capital markets creates greater financial inclusion by introducing new products and services tailored to suit investors’ preference for risk and return as well as borrowers’ project needs and risk appetite.

Therefore, in the overall, existence of the capital market in the country creates a sustainable low-cost distribution mechanism for multiple financial products and services across the country. It enhances efficient financial intermediation. It increases mobilisation of savings and therefore improves efficiency and volume of investments, economic growth and development.