Narrowing the Finance Gap

Developing Capital Market in Ethiopia

An article published on the February 2020 edition of Ethiopian Business Review investigated whether Ethiopia is ready to establish a stock market. The article incorporates views of several notable finance and investment advisers who are both for and against setting up a stock exchange. This article argues for establishing a stock market and highlights strategies for developing a successful stock market.Ethiopia is the largest country in the world without a stock market. However, despite the absence of a formal stock market, private share companies have flourished in the past 15 years, issuing and selling shares under the unregulated market.

Should Ethiopia focus on banks or stock/debt markets?
What is capital market in the first place? Capital market is a market where debt and equity-backed securities are traded. Stock market and the bond market are the two most common capital markets, consisting of primary market where new securities are issued to be sold for the first time whereas the secondary market is a place where the existing securities are traded between investors.

Banks are lenders, providers of deposit and payment services; they tend to know their customer better and lending decision is based on customer relationship which helps increase credit availability. The information advantage that banks have over capital markets makes banks dominate the financial system in several countries, according to the IMF. On the other hand, capital market is better at promoting innovative and high growth firms.
In this case, SMEs in Ethiopia such as RIDE and SoleRebels could benefit from the introduction of stock market by going public; hence, raising large volume of capital to expand their businesses, which in turn helps boost employment opportunities for the young and growing workforce. On the other hand, as bank–based financial system is better in risk sharing mechanisms, capital markets help put pressure to replace incompetent managers and improve the overall corporate governance system.

Hence, banks and capital markets should not necessarily be considered as substitutes but instead as complementary institutions. Well-developed banking system is also important for capital market development as banks serve as investors, dealers and liquidity providers.

Yet the development of capital markets may hurt commercial bank profitability. Experiences show that the profitability of traditional lending activities has fallen over time, and banks have been obliged to have riskier loan portfolios in order to retain profits. However, the presence of capital market does not always mean that it competes with banks and reduces bank profitability. Stock market can be a new opportunity for banks to tap. Banks can become successful underwriters, primary dealers and liquidity providers in the securities market, a lucrative business. Banks can also raise additional capital from the market through issuing stocks. Overall, the presence of a stronger banking sector and capital market is helpful for more developed and efficient financial intermediation system.

Why capital markets
The private sector is inevitably the engine of economic growth and poverty reduction worldwide, but finance is central and key to the private sector development. Ethiopia’s low and fragile private sector is critically hit by lack of sufficient access to finance. The Enterprise Survey conducted by the World Bank in 2015 shows that Ethiopian firms that use banks to finance working capital and investments accounted only 16Pct and 13Pct respectively. The United Nations Conference on Trade and Development (UNCTAD) estimates between 70Pct and 90Pct of SMEs in Ethiopia lack access to formal financial institutions.

On the public sector side, development financing continues to be a big challenge for developing countries that require huge financial resources to lift countries out of poverty. Some estimate that over USD200 billion a year is needed for energy, irrigation, roads, rail and other infrastructures in Africa. Ethiopia must meet its financing needs to achieve its goal of becoming a middle income country. Hence, access to capital markets could serve as alternative source of finance to fulfil the demands of both the private and public financing needs.

Building successful capital market is not an easy task
According to the IMF, successful capital market development requires the following preconditions that are going to be a big challenge for Ethiopia.

Sound macroeconomic conditions should be in place for well-functioning capital markets. Even though Ethiopia has registered fast economic growth over the past one and half decades, the economy has been struggling with double-digit inflation. This discourages investment in the securities market, particularly on securities with a longer maturity period. It also hurts the banking sector, making real interest rate negative.

Lack of adequate legal and institutional framework is another challenge affecting the development of a strong capital market in Ethiopia. Security market investors will not be attracted due to legacy issues of poor regulatory framework, weak property rights and creditor and shareholder rights as well as corruption and weak institutions. Ethiopia’s regulatory enforcement, particularly contract enforcement and business dispute resolution remains low. Disclosure and information system in the country is also inadequate with weak accounting and reporting standards and practices.

The capital market can also be hindered by the small and relatively undeveloped banking sector. The size of the banking sector in Ethiopia measured by private credit to GDP is below 20 Pct. This is very low when compared to the East Asian emerging economies such as Vietnam which is over 110 Pct. Moreover, the cost of financial intermediation is also high in Ethiopia. The bank Net Interest Margin (NIM) of Ethiopia is 4.7Pct whereas it is 2.8Pct in Djibouti. As banks become inefficient, they tend to transfer the cost of inefficiency to clients, making cost of borrowing high for businesses. High interest spread and NIM have their own roles for aggravating inflation in the economy. Besides, institutional investors such as pension funds and insurance companies remain underdeveloped.

All these limitations, however, should not prevent us from developing capital market because we have seen that several emerging markets such as Vietnam, Malaysia and Indonesia have successfully developed their capital markets under a lot of challenges.

Strategies for developing successful stock market in Ethiopia
The macroeconomic and institutional framework is very crucial for any successful capital market development. So, we need sound macroeconomic and quality institutions. On top of this, the country should employ supply and demand side strategies for increasing firm listing and investments in the stock market.

Supply side interventions: the number of companies to be listed on the stock exchange becomes the life blood of the market. The market will be dormant if firms don’t go public. When firms go public by selling their stock to the public, they can benefit by raising highly needed capital. But this also has its disadvantages. Companies become subject to greater scrutiny by the regulators, stringent accounting practices and loss of management control. It can also be costly to go public, particularly for small firms due to the underwriting and administration fees during the IPO process. Companies should pay these sacrifices to access large amounts of capital.

However, for some companies, the drawbacks outweigh the benefit; hence, their preference to stay private. These challenges, however, can be addressed through introducing incentives that encourage firms to go public such as tax incentives, subsidized initial listing costs and simplifying listing procedures. The government can also introduce B-shares (non-voting shares) that do not threaten the control of management. Moreover, it is advisable to start with the IPO of credible state-owned enterprises such as Ethiopian Airlines, Commercial Bank of Ethiopia (CBE) and Ethio- telecom to bolster stock market development, particularly during the initial stages.

Demand side interventions: Investors buy financial instruments in the security market. The investment needed comes mainly from long-term savings particularly from institutional investors such as pension funds, mutual funds, investment banks and insurance companies.

The government should promote long-term saving through easing regulation to allow institutional investors and fostering competition among financial institutions. Retail investors should also be encouraged through enhancing better cost-to-trade models and promoting financial literacy programs.

Lower transaction cost and financial literacy programs attract individuals towards investment and trading. Financial literacy also helps minimize negative public perception of stock markets as an act of gambling and wealth-destruction, which has happened in developing countries such as Egypt. Retail investors contribute positively to market liquidity, and diversify the investor base. Furthermore, having individuals involved in the stock market contributes to income equality and economic growth.

The strategies will help us build stronger capital markets unlike most of the Sub-Saharan African countries with dormant and illiquid stock exchanges. Evidences show that almost half of the stock exchanges established in the region since 1990 list fewer than 20 firms. Rwanda stock exchange, which was established in 2005, for instance, consists of only eight listed companies with total market capitalization of USD3.3 billion. On the other hand, several Southeast Asian countries have been successful in developing strong stock markets. In 19 years of stock market operation, Vietnam managed to list 749 companies with stock market capitalization of USD188 billion, which is equivalent to 72Pct of the country’s GDP.

Ethiopian Commodity Exchange (ECX), was a new initiative for Ethiopia and the first of its kind in Africa. No one believed it was possible when it commenced in 2008. The exchange linked 2.4 million smallholder farmers to markets and traded commodities worth over ETB 35 billion in a year. Several African countries have set up exchanges, inspired by the success of the ECX. The success proves that it would be difficult to make progress if we only look at what we don’t have and wait until everything is in place. Rome was not built in a day. Let’s think big, start small and strive to scale it up. It would be difficult during the initial stages as the beginning is always the hardest.

9th Year • July 1 – July 15 2020 • No. 88

Tamrat Abera

who holds an MBA from the University of Bologna in Italy, is a financial expert. He can be reached at

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