The Building Blocks of Capital Markets

The Ethiopian government is busy establishing a local capital market after a long deliberation. A lot of initiatives are underway to complete the plan. This is probably one of the few shifts the new government has taken from the old revolutionary democrats.

A capital market is another form of financial intermediation, like banks, to supply the necessary finance for economic investments. In some instances, however, it takes a different route than banks; it thrusts into investments that are too risky and too long for commercial banks.

In the Ethiopian context, commercial banks are the sole financial intermediaries in channelling funds from the saver to the borrower or user of the fund. It links the two market actors; however, more is needed to play the necessary role in an economy short of resources to spur economic growth. Hence, a capital market can provide additional choices for private businesses by connecting savers directly with users of funds or borrowers through its unique platform.

Governments also need funds to cover their budget deficit as local companies need to expand their businesses – the capital market can provide alternative funding sources besides banks. The capital market, the corporate sector, and the government can source long-maturing funds with a relatively competitive price from a broad investor base.

Domestic capital markets that are deep, efficient, and well-regulated can create access to long-term local currency finance. It also becomes a vehicle to utilize ideal national savings and untapped communities, like the diaspora, to engage in economic activities and help governments execute flagship projects, like the Grand Ethiopian Renaissance Dam (GERD), that in turn nurtures innovation and spurs job creation efforts for the youth.

The government of Ethiopia has realized these advantages and has taken a solid stride to establish a structured, regulated, and functional capital market. The formation of the Ethiopia Capital Market Authority (ECMA) and its actions in the last couple of years, particularly in furnishing the proper legal ground, testify to the government’s policy commitment.

However, globally, there needs to be well-defined and precisely articulated capital market formation steps. Every country is different by its inherent nature and has been taking its path considering its socio-economic circumstances, macroeconomic conditions, financial liberalization, legal structure, and domestic market structures. The pace of its development is also diverse due to these and other factors like political stability, past and historical events, and global market conditions.

Based on past experiences, capital market development takes a general pattern with unique phases from country to country. There is always an exception from the practice regarding approach, length, sequencing, and characteristics of the phases. Meanwhile, it is possible, subjectively, to make a high-level generalization based on similar features of the stages. This writing also attempts to amalgamate the necessary key steps, from a practical perspective, in three phases and present in chronological order. The distinction between these phases is not a hard line; instead, it is somewhat arbitrary.

Phase I – Nascent Stage

This phase is the initial period of establishment. Its limited financial streams characterize it. Banks and other traditional domestic sources likely dominate the primary source of finance, and investor bases are limited, essentially locals and unsophisticated. Commercial banks predominantly serve the private sector, and banks act as primary dealers and intermediaries.

This is an early phase in which the capital market is still in the infant stage. In all countries in this stage of development, the government is the predominant player, initiator, and promoter of the initiative. Here in Ethiopia, as well, the government is driving the initiative, and others are contributing to its success.

There is universal agreement between scholars on the necessary preparatory tasks in the early phase of developing a functioning local capital market.

From the start, the presence of an enabling policy framework and clear policy direction from the government are central. A  certain degree of policy continuity also helps to smooth the take-off process. Since the government is the major promoter of the idea, political and economic stability is imperative to pursue the idea. This stability assures investors, both local and foreign, to be part of the process. As part of policy continuity, a few institutional and legal reforms and liberalization of the financial sector need to be in place to create conducive environment and secure the trust of the investors and the broader public in the capital market vision and goals. It takes a few years but requires aggressive public engagement and education. Time is of the essence here to have the right policy, regulations, and institutions.

Establishing quality regulatory institutions and legal frameworks are necessary pillars for creating a strong and viable market. At the early phase of market development, the quality of the regulatory agency determines the success and the pace of the market development. Since most of the laws, legal frameworks, guiding principles, and overarching goals are set by these government agencies – in a top-down approach- the result, therefore, depends on the quality and innovativeness of the agencies’ human capital. The capacity, experience, and exposure of the existing agency and its staff determine the future functionality of the market. In our case, the Ethiopian Capital Market Authority’s (ECMA) vision and capacity are crucial to the success of instituting a functioning and sustainable domestic capital market.

Investing in operational infrastructure is another precondition for developing a reliable market. This includes the ability to register and execute trade transactions in an efficient, transparent, and reliable system. It also requires the presence of intermediaries, including well-established, trustworthy local banks, depositories, clearing houses, and other financial service providers. On top of the operational infrastructure, related legal frameworks that assure investors of the integrity of the transactions system, like the clarity and enforceability of property rights for market instruments and a reasonable dispute settlement mechanism, are essential.

In the initial phase, the government is, in some cases, the central market player and the only issuer of debt to finance its fiscal deficit in domestic currency. Equity market and secondary trading of other instruments are little and sometimes informal, traded in an unofficial channel. An organized exchange is non-existence. If it exists, it will likely be limited in reach and illiquid.

Phase II – Emerging phase

Following the proper installation of the preconditions in phase I of capital market development, a functioning capital market starts to operate, especially for government debt and equity markets, in a limited way. However, there are several growth drivers in the emerging phase of the capital market to benefit from deep and liquid markets.

A stable macroeconomic environment is one driver. To some extent, freely operating the financial sector is crucial at this stage of development. Macroeconomic stability is essential in the early phase but also relevant in the emerging phase. High inflation and large fiscal deficits drive the government yield curve upward and dry up the interest in other instruments. Besides, unstable macroeconomic conditions and political instability wring local savings and investable resources and draining investors’ confidence in the process. So, it is wise to wait for the right time and economic circumstances to propel the formation of the local capital market.

Captivating mass domestic savings is essential for the sustainability of the market. The government debt market commonly can be sustained by a few domestic banks – which are obliged to invest a percentage of their portfolio in government financial instruments. There needs to be more than the participation of local banks to create a critical mass of domestic savings to satisfy the economic demand. So, at this stage, institutional investors like domestic insurance companies and pension funds participation is crucial. Considering their future local currency liabilities, investing much of their asset pool in the local market has paramount importance for the development of the capital market.

Moreover, retail investors participate at this stage in a limited number through individual investment and different fund management schemes in the equity market. A lot of education and awareness creation work is expected from the government, as a promoter of the idea, to attract many local individual investors, sole and family-owned enterprises, and larger public entities to participate in the market. The role of the Capital Market Authority here is indispensable. It should be their primary responsibility.

A low and stable risk-free rate is another vital driver to transition from the nascent to the emerging phase of capital market formation. This step is a necessary indicator for the private sector to leverage the capital market both for corporate fixed-income issuance and invest in equity. This rate is derived from government local currency debt issuance to narrow budget deficits. So, a stable, risk-free rate is essential at this stage to spur the development aspirations of the government.

To have a positive transition to the next phase, local capital market development, a solid corporate attitude change, transparency, progressive governance, and broader cultural change are required to develop. Fear of listing small and family-owned companies by owners and managers due to concern about disclosure requirements is a significant obstacle to market deepening. In our case, however, the proliferated share markets and privatization initiatives by the government could be a base to develop a liquid equity market and attract investors – If it is appropriately managed, nourished, and regulated.

During the second phase, the capital market will play the necessary role in providing alternative finance for the private sector and overall allocation of savings. But it is starting to serve, albeit in a limited way, until it acquires a degree of breadth and sophistication.

Organized stock exchanges are not active at this stage because it has a minimal investor base; outreach, influence, and liquidity until the government make a significant interception in the equity market. There is also a fragile secondary market, with few instruments available for trade. Once market participants have developed a certain level of trust, it becomes more of a matter of risk and price.

Phase III Advance Phase

In this last phase, there are three common characteristics. First, domestic non-bank institutional investors (such as insurance companies and pension funds) emerge and begin to play a central role. Retail investors also start to participate, either directly or indirectly, through mutual funds or other options. Foreign investors may be present for the long term and create partnerships with exchange-listed companies. Second, the equity market appears and evolves first, and the demand for corporate debt develops later. A domestic corporate debt issuer base visibly emerges. Third, there is an upgraded, reliable, and sophisticated legal and regulatory framework and a functioning market infrastructure, including an organized exchange or trading platform, a clearing house, a rating agency, a depository and other players. There is active secondary trading, at least for the government debt and equity markets.

Becoming a member of an internationally recognized index assures the advancement of the market. It creates scale and broader the market base. It is registering in major international indexes such as the Government Bond Index (GBI) and International Central Securities Depository (CSD), a specialized financial organization holding securities like shares, allowing ownership to be easily transferred through a book entry rather than by a transfer of physical certificates. This can be done in this stage of the capital market development phase to diversify the investment base. Once included in these global indices, service providers like CSD and international index-tracking funds would be encouraged to invest in the country. Even though it is difficult to fulfil the requirement to be included in these kinds of indices, being included can increase the market breadth and liquidity.

During this phase, it is possible to benefit from foreign and big institutional investors as far as capable central bank and capital market authorities are in place. Otherwise, foreign-based investors can increase volatility and financial risk to the market. These foreign investors have advantages as well to increase liquidity, open the market, and bring improvements in transparency and corporate governance. So, foreign investors should always have a supportive role. They can’t be the main driving force behind the functioning domestic capital market. The market requires a large, committed, reasonably sophisticated local investor base.

As markets develop, country-based unique intangible factors emerge and play an increasingly important role in the development of the capital market. The degree of financial inclusion, education, a tradition of transparency, a culture of trading, and the interaction between the market and the broader economic environment determine the speed and success of the local capital market establishment.

In the later stage, the efficiency of the market becomes essential for market players with its liquidity, ability to create a deep equity market, and frequent issuance of fixed-income instruments. That is when the fruits of the local capital market start to reap.

12th Year • December 16 2023 – January 15 2024 • No. 124