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Growing financial markets for socioeconomic development

In my pieces in the recent past, I explained the importance of connecting financial markets with economic growth. As an economy that is following the financial sector and economic liberalisation policies, Tanzania has made relatively good progress in the banking sub-sector aspect of the financial markets. For example, we currently have over 40 banks whose total asset size (at Sh36 trillion) is about 20 percent of the Gross Domestic Product (GDP) - and, although this is comparatively on the lower side, it is still good progress.

On the other hand, the capital markets segment of the financial sector, which is only about 20 years old, has seen less progress — and, understandably, so! There are only 28 listed companies in the stock market, with equity market cap of Sh15 trillion: less than 10 percent of GDP.

Banks’ vital mandates and operating model provide loan finances to businesses and households. Banks are particularly well-placed to monitor their borrowers’ cash flows through the movements in the bank accounts of the people and corporates to whom they lend - somehow making it easier for the banks to identify and manage risks. In order to attract funds which they then on-lend to business and households, banks raise finance by: (i) taking and creating deposits; (ii) issuing other capital raising instruments (such as bonds and commercial papers); and (iii) increasing equity investment via retaining profits or issuance of new shares to their equity investors. By their prevalence, strategic and operating model, the banking aspect of financial markets is well-understood and used by many, compared to the other aspect of the financial market i.e. capital markets.

As for the capital markets... Much as the finances raised are long-term in nature (mobilised as they are from individuals and institutions who are not only savers, but also have investment motives), this entails an immediate degree of risk where funds are invested - but whose outcome depends on how well the business is governed and managed. There is also a relatively lesser degree of safety, as invested funds can either grow or decrease in value. On the positive side - especially on the savers/investors perspectives - capital markets provide a high degree of liquidity, particularly if the capital market is vibrant enough, and where resources (time and money) required to raise finances by the issuer and liquidate an asset are relatively minimal. There is an upside potential for savings and investment increment emanating from capital growth and dividend income. This sub-industry requires investment banks, stockbrokers and dealers, investment advisers, fund managers and custodian banks as essential intermediaries to facilitate its existence, and in enabling a vibrant market.

In our local capital markets where there is a very minimal investment banking activities, collective investments schemes and fund managers, transactions underwriters, market makers, corporate finance and transactions advisory activities and services coupled with a stock exchange whose domestic market capital is less than 10 percent of the country’s GDP, and less than 100,000 active investors; definitely more is required — in terms of creating more awareness, in terms of encouraging businesses to use this long-term financing models, in terms of policies and legislative actions that enhances the use of capital markets for enterprises and projects financing as well as using this tool for savings and investment purposes.

Building on the background above, in today’s article explain further the relevance of a vibrant financial market to an economy and why this consideration to our society is important, especially now - read on:

A growing economy requires investment to add into the stock of capital (plant and machinery, the built infrastructure, inventories, and buildings, including offices and housing) which, when harnessed to the labour force and supply of raw materials, produce the output that we call GDP. And that investment is financed from the supply of savings from both home and foreign savers.

Savings can be transferred to investors, whether businesses or households, in several ways. Businesses can retain profits to reinvest rather than distributing them as dividends, they can sell new issues of shares or bonds directly to savers; or they can borrow from banks. Equity, bonds and bank finances are the essential building blocks of the methods companies use to finance themselves - although they be combined in a complex way. Several factors influence the form in which savings are transformed into investment, including tax treatment of different forms of saving and the willingness of different savers to take risk. But perhaps the most important concerns are the difficulty of assessing and monitoring the potential and actual profitability of investment projects. Equity finance (whether the sale of new shares or the retention of profits by companies) requires careful and continuously monitoring of a company’s activities. In contrast, one attraction of debt financing (whether bond or bank loan) as opposed to equity finance is that monitoring is required only when the borrower fails to make scheduled repayment.

Companies sizeable enough and willing to be listed in the stock exchange produce annual accounts showing profits as well as assets and liabilities, which are verified by independent auditors and scrutinised by many analysts. Savers who do not wish to rely on such public information can choose to invest in an array of financial intermediaries, such as mutual funds, collective investment schemes, unit trusts, hedge funds, pensions funds or [life] insurance companies. In that case, savers are relying on the judgement of the fund or assets managers of these intermediaries.

Over the past century, financial intermediaries have grown significantly as the wealth of the middle class has generally increased across nations. Substantial amount of wealth is now invested through pension funds, hedge funds and mutual funds. In other countries, retail/individual investors are discouraged to invest in their own, they are rather encouraged to invest through fund managers who possess the competence and skills to research, analyse and invest in a more informed fashion compared to retail investors.

It says there is a need for more fund managers, investment advisers, corporate finance and transactions support services advisers, collective investment schemes, which can mobilise retail savings and intermediate them for productive investment activities in various sectors.