Role of Capital Market in Rapid Development of Country

(The essay was selected among the top 3 essays in a national level essay competition organized by Employees Union of Securities Board Of Nepal (EUSEBON), an authorized employee union of SEBON.)

In 1993, a recent graduate working on a hedge fund sees the opportunity on the internet, resigns from his job and plans to start an online bookstore with a small fund. The business grows and he needs more capital to expand the business. Therefore, on May 15, 1997, the initial public offering (IPO) floated in the market collecting $54 million. The company is Amazon.com, Inc. The business continues to grow and in 2020, it becomes the highest valued company in the world with a market valuation above $1 trillion. The investors’ wealth has grown by more than 120,000% since 1997. The company has created over a million jobs and contributed heavily to the US GDP.

Sounds unimaginable?

Well, that is the perk of the modern economy, specifically financial or capital markets. It’s possible because of the capital market where we can collect capital to turn ideas into a billion-dollar business conglomerate, where investors and businesses meet, capital gets raised in the form of shares, bonds and long-term investments, investors can put their money to work, institutions grow, the economy prospers and the country develops. Capital Markets plays a crucial role to keep the economy functioning and the economy would collapse without it. The most advanced economies have the most efficient capital markets.

So, how does the capital market work and why is it so important for the country’s development?

Literally, the capital market is the kind of financial market place that facilitates the buy and sell of a wide range of long-term financial securities such as equity (shares/stocks) and debt (bonds, debentures, commercial paper and certificates of deposit) along with short term funds such as treasury bill (debt). The market where these securities are created is called the primary market and where already existing securities are traded is called a secondary market. Capital markets are the most important components and form a considerable proportion of the present-day economy. It resides in the core of capitalism as it opens the way for privatization of state-owned enterprises and financial liberation. The stock market is the main element of the capital market. Johnson (1983:32) suggested that: “The stock markets are a complex of institutions and mechanisms through which funds for purposes longer than one year are pooled and made available to business, government, and individuals and through which instruments already outstanding are transferred. The stock markets are well organized and are local, regional, national, and world-wide in scope.” [1]

Economic growth and prosperity in the modern economy are unimaginable without the efficient capital market and this is equally true for the growing economy in developing countries like Nepal. Capital market, together with banks, constitute the most prominent sources of external financing for individuals, firms and government. However, their role is not only limited to the source of finance as they are also the means of transferring and distributing the risks across the economy and facilitates the mobilization and channelling of the savings.

Capital markets and economic functions are interrelated. They represent a relationship between the disparate sectors in social society between savers and producers. The saving sector needs to employ their savings in more advantageous and ambitious projects. On the other hand, the productive sectors always require financial sources to assist them to continue to perform. This is where the capital market comes in - to transfer funds from people who have combined surplus to those who have a scarcity of funds. Therefore, suppliers of capital (investors), financial intermediaries (financial institutions or authorized individual middlemen) and users of capital (borrowers) are the three components of the capital market.

An efficient capital market represents people are more trusting of the financial system of the country. A well-functioning financial system of a country allows an economy to fully exploit its growth potential by ensuring the investments with good growth potential receive the funding in exchange for ownership and the inferior businesses are denied capital. In this way, the flow of money is transferred from the surplus group to the deficit group and is put into a productive field. The country’s economic development is determined by its productivity, spending, GDP, status and effectiveness of financial institutions, trade, capital formation, employment rate and human resource which is directly affected by the efficiency of the capital market. The essay further explores the needs and roles of the capital market for the economic development of the country, especially developing countries including Nepal and attempts to discover the constraints to the efficient capital markets.

As discussed above, the capital market plays an essential role in transforming savings into productive investments (DSE, 2006).[2] It creates a platform for the populace to participate in the corporate sector of the economy and share in its wealth through ownership of securities.[3] It also enhances the private entrepreneurship by facilitating the entrepreneurs to raise funds from the surplus groups through the primary market. Similarly, if the investment performs well and has a good valuation (above face value) in the secondary market, the company can have additional right issues in the premium. Thus, a cost-effective investment is enabled. The above example of Amazon.com Inc is based on this functionality of the capital market. This leads to great ideas being changed into profitable businesses. Profitable businesses increase productivity and contribute to the GDP of the country. The tax income is increased. Moreover, if companies are large enough, the goods and services can be exported which decreases the import and trade deficit and strengthens the currency of the country. Likewise, profitable businesses and corporations create employment opportunities with higher wages which increases the spending capacity of the consumers.

In short, capital market paves the way for the increase in aggregate supply (productive capacity) and the aggregate demand (consumer spending) which is crucial for the short-term and long-term economic development of the country.[4] The economic development prompted by the capital market is not limited merely to the economic growth but macroeconomic stability, a developed legal environment and the free flow of financial information among the investors and the investee groups and corporations. In other words, the stream of capital is moved from the individuals and institutions through financial intermediaries such that the rational allocation of resources is achieved and funds get utilized in the productive and profitable sector by the businesses, industries and government that increases the country’s income and economy and strengthens legal and information framework which is necessary for the rapid development of the country.

Nevertheless, a counter-argument exists - If the capital market’s major role in a country's development is through the supply of finance, why not strengthen the money market or banks and rely on them?

Well, there is a problem. It increases the vulnerability to massive shocks that can disrupt the whole economy of the country. Any country strives to achieve the seamless markets as the allocation of its crucial resource is quick, efficient & scalable. This is not possible through bank financing as it is expensive, relatively unstable & the shock, if any, is absorbed by the few participants opposed to the capital market where not only cheap and stable financing is available but also the presence of a large number of participants which decreases the shock per participant and the stability in the country is maintained. Although economic slowdowns and market crashes are unavoidable harsh realities it can be highly managed by increasing the capital market efficiency and guiding both the money markets and capital markets and the proper combination of it has to be encouraged. One such example is the 1997 Asian Crisis. The heavy reliance on the banks for financing is one of the major reasons why the crisis prevailed and therefore, the heavy reliance on banks for financing increases vulnerability to shocks.[5] The lesson that the Asian Countries learned after the crisis was the over-reliance of banks was a faulty way of financing and the substantial efforts were made to develop the bond market as finance-source alternatives.

Let’s consider the example of India, one of the fastest-growing economy right now. From 2000-2008, the country observed the noticeable increment in the savings and investment rates. Capital markets played an imperative role in pumping the household savings into the productive field. Until around 2000, the investment rate was around 24% of GDP. It steadily raised to around 35% until 2008-2009 which is a massive rise. Simultaneously, the rates of financial savings of the household sector and the private corporate sector increased. Similarly, FDI and FII increased as a result of the reforms, changes in regulations on the financial and capital markets, astonishing corporate performance and enhanced investors’ confidence.[6] FDI mostly inflowed towards the service sector, financing and real estate. Likewise, in the same period, the businesses witnessed a huge increase in their share in FDI inflows. This is the same period where the GDP growth was substantial, evidently signalling that the increase in performance of the financial market and capital market induces the economic growth of the country.

The development of the country is the product of infrastructural development and that’s where the capital market comes in -as the essential financing machine for the government by issuing government bonds which result in the advancement of the prerequisites such as the development of roads, energy, housing, telecommunications, provisions of socio-economic benefits, the building of roads, water, drainage and sewage systems. Inherently, low risks and the guaranteed pay-back with fixed-term interest rate makes these bonds attractive to the investors. Besides, the shift of economic development from the public sector to the private or the better public-private partnership enabled primarily by the capital markets fills the resource gap, and complement the government’s effort in the financing of crucial socio-economic development by raising the long-term capital for projects. This highlights the need for the capital market in assistance of the government to achieve its developmental objectives. Moreover, the capital market increases the portion of savings being channelled into long-term investment through the contractual saving institutions such as pension funds, private pension schemes, national provident funds, insurance companies, medical aid schemes, collective investment schemes etc. [7]

The capital market performance influences each member of the society, whether they invest in capital market or not. When the stock price is down, the people with pension funds and retirement accounts are affected. This is because the value of their account is tied to the capital market. The employee benefits such as pensions are reduced, and consequently, this can result in delayed retirement ages. Also, job security is heavily influenced when the company’s share price goes down. This way the employees will be lost and several people will lose jobs. The rates of taxes and interest rates set by the government are heavily influenced by the capital market, especially the stock market. The general scenario in the Great Depression suggests that the.US government had decreased the taxes to increase borrowing, but as soon as the economy was out of depression, the government increased interest rates. This way, the general non-investor is also affected by interest rates, because the person renting a house doesn’t have to pay interest on a home loan but the landlord is more likely to increase the rent to cover the high-interest expenses. So, that is to say, each member of society is influenced by the capital market and the well-performing and efficient capital market is likely to benefit the general public. [8]

The fact that capital market empowers the government strategy of social inclusiveness and economic growth by providing the avenue for the industries to compete globally, endures private-public partnerships and enables global integration, [9] magnificently establishes the capital market as the core of internationalization. Besides, the efficient capital market functions as a medium of capital transfers across borders, more precisely, from the wealthy nations to the developing countries in the form of Foreign Direct Investments (FDI) and Foreign Institutional Investments (FII). China and India are some instances that the ability to attract FDI and FII significantly boosts the economic development and the efficiency of the financial market in the country, especially in the developing economies. These investments are important sources of long-term capital for the companies. Such companies improve in terms of financial and technological innovation, have better corporate governance, the greater pool of knowledge and have good capital structure. Additionally, the investments via capital markets are often completed in foreign currency which helps in increasing the foreign reserve of the country strengthening the domestic currency which makes exports competitive and supports the domestic industry. In short, this increases productivity and decreases the risk of organizations. The corporate growth triggers the overall economic growth. Hence, capital markets can be taken as a new tool for globalization.

In developing countries like Nepal, the capital market is not efficient. The government has not been able to provide such incentives to the public into saving. The one who saves invests in unproductive sectors such as real estate, land, jeweller, gold etc. The capital market, on the other hand, is a productive field which allows the industries to establish and grow and encourages private entrepreneurs. It also provides finance for diverse government projects. Similarly, secondary markets assist in setting the price of the security based on what the crowd agrees and provides the incentives for the company to perform well to increase the market price of the securities as well as maintains the liquidity in the market which is imperative in the functioning of the overall financial system. One of the reasons why people invest in items such as gold is their fear of loss of purchasing power in the future. This fear comes from the instability in the banks or from the existence of government-imposed interest rate ceilings. [10] The imposed interest rate engraves the fear that the inflation rate would exceed the interest rate ceiling and, as a result, the actual value of the savings would be decreased. One of the major reasons why the companies have not been able to grow in Nepal is the system and policy of the country that encourages them to rely on the debt of the banks which is riskier. The concerned authorities must devise the plans and policies such that it establishes efficient capital markets, stabilizes the banking system, and the system of the market-determined rate of return is established.

Capital Markets are trustworthy, organized and systematic. The transactions are performed according to certain principles, norms and rules known and accepted by participants. These regulations create and preserve the conditions for the unfolding of free competition, so it can be taken as a system for ensuring the free and open character of all transactions. [11] Sometimes, this is not the case in the developing countries and the efficient capital market is not achieved, particularly, due to lack of government focus. In developing countries, the development of financial and capital markets has to be given equal priority as it is given to building roads and other infrastructure of development because in the transition economies the reorientation of resources from the unproductive and inefficient segments to the productive ones is next to impossible to achieve without the well-functioning capital market. A sound capital market ensures the efficiency in the economy, supports the economic and financial reform process and even encourages the privatization auctions. Although these markets should not be a government bureaucracy and monopoly for attaining efficient capital markets, it should surely be ‘guided’ by the government ensuring the investors’ wealth is secured and safe and the companies have easy access to the economy. Even though the capital markets of such underdeveloped countries have gone through radical reform the capitalization is still very low. This can be attributed to two major reasons. First, there are limited listed companies and next, there is limited participation of household savings either due to lack of capacity or lack of awareness as to the capital markets. [12]

One example is Nepal where there are only 245 companies as of now and that too highly dominated by the banks.

It is often argued that the capital markets, more specifically stock markets, can predict the economic direction and is taken as the tool of measurement to study the economic conditions of the country. Daniel Mminele, former deputy governor of the South African Reserve Bank, in 2013, noted capital markets can provide real-time feedback on the merits of policy decisions as perceived by the economic actors driving a country’s growth (Mminele, 2013).[13] The World Bank’s survey in 2014 revealed that access to capital is the largest barrier to the success of businesses in developing countries. The barrier, interestingly, outweighs the corruption, access to electricity, political instability and tax rates. The line graph below published by the world bank clearly shows the relationship between real GDP per capita and market capitalization (% GDP) -

This clearly shows the role and importance of the capital markets in providing the triggering factor for the growth of productive industries, companies and manufacturing houses.

Historically, the capital market dates back to the 1600s. The issues of Nepal Banks share in 1994 BS marked the inception of the stock market. The secondary market got motion only after 2033 BS with the establishment of Securities marketing centre and the separation of the regulator as Nepal Securities Board and exchange as Nepal Stock exchange in 2050 BS. Other remarkable reforms that provided Nepal’s capital market with momentum are the issuance of licenses to the stockbrokers, issues and sales managers and the start of mutual funds. Similarly, the replacement of open outcry system by the automated computerized system in 2064 BS, the inception of a real-time surveillance system, circuit breaker practice, OTC market, promoter shares trading system, and increment of the number of a stockbroker, establishment of central depository system and a credit rating company ICRA are other remarkable reforms and improvements that modernized the stock and overall capital markets in Nepal.

In the last few years, some other milestones have been added such as compulsory dematerialization of securities and Demat Accounts, full automation and online trading of secondary shares, formulation of margin lending regulations, centralized application backed-up by C-ASBA etc. These measures have shown the effect and the number of investors and the money floating in the capital markets has increased. Many businesses from new sectors such as telecommunication, manufacturing and hotels are slowly emerging and the future of the capital market only seems to go up. The amount of annual turnover and market capitalization has witnessed exponential growth. This can be said the private sector and household savings are making their way towards stock markets and this has a positive impact on the country’s economy. The trend of market capitalization and the annual GDP up to the fiscal year 75/76 is shown below.

The capital market in Nepal has mainly assisted the financial sectors, namely, banks, insurance companies and microfinance in raising the public finance. This is also due to the fact that there are now the regulatory requirements of mandatory issuance of the shares to the public by the institutions in these sectors. This has contributed towards transparency among banks, strengthening the role of the regulatory body of these institutions, Nepal Rastra bank. Apart from that, the public-private partnership and the financial knowledge and awareness among the wide range of general public has been achieved. The ‘saving habit’ of the public has raised and the public is positive and somehow satisfied with the return from the capital markets which, when invested through proper research, is certain to beat the returns from banks and other financial institutions.

Although, as said above, fewer companies other than the finances and hydropower are attracted towards the capital market and the question remains, is the capital market of Nepal actual representative of the country’s economy? Is capital market financing actually perceived as a lucrative financing option by the businesses? Is the capital market financing accessible to the public? The short answer is the businesses are still sceptic about the capital market financing and rely heavily on bank loans. The startup culture has not fully flourished. The real sectors such as manufacturing, technological startups and innovative industries, pharmaceuticals, airlines etc. are not yet listed in Nepal’s stock exchange.

In other words, Nepal has failed to attract the real sectors and this restricts the capital market from being the true barometer of Nepal’s economy. Similarly, one critical aspect of the investment is the portfolio diversification which cannot be truly achieved in Nepal because of the fewer sectors and fewer security products. This has made many investors reluctant to the capital market. Regulators are taking positive initiations towards the developing the efficiency of the capital market by making reforms on the trading system, requirements of reporting, credit rating requirements etc. as well the steps such as premium pricing provisions, tax rebates and recently, book-building has provided some inducements for companies to go public but there is room for more such incentives. Other than that, the cost of compliance can be decreased and the procedural and legal issues that are extremely elaborate and stringent can be made simpler so that companies are encouraged to go public.

Other reforms for the overall development of Nepalese capital market (supply and demand side) include, additional tax facilities, reduction of corporate income tax, reduction of final income tax on the sale of shares, expansion of brokers network to whole of the country, conducting financial awareness and literacy awareness programs and campaigns for the public, encouraging and attracting FIIs through macroeconomic and political stability plus effective policies targeted at foreign investments, better provisions to facilitate NRN in the market, concessions for long-term investors, introduction of derivative products such as options, futures, put and call, easing the trade of commodities, structured, systematic and affordable financial advisory services and establishment of research centers dedicated to development of capital market [14]can radically develop the capital market which in turn, improves the economic and social condition of the country through appropriate resource allocation, encouragement of private entrepreneurship, the wake of start-up culture, infrastructural development, inclusive investments and the money flow from surplus group to the deficit and productive fields.

To conclude, in the modern economy, when we talk about the macroeconomic stability, infrastructural development, economic liberalization, development projects, attracting foreign investments socio-economic upliftment of the countrymen, industrialization and the globalization, we talk about the role of the capital market and as biased as it may sound, the achievement of the true economic development of the country and the attainment of the true economic potential of the nation is not possible without the efficient functioning and the liberalization of capital markets. To quote from Richard Grassson, the former chairman and chief executive of the New York Stock Exchange, - “The globalization of the capital market is actually part of economic globalization. This will create a change in the entire world economy, not just restricted to some fields in some countries.”

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References

[1] Johnson, T.E. (1983), Investment Principles. New Jersey: Printice-Hall, Inc.

[2] https://www.dsebd.org/ecobd.php

[3] All Answers Ltd. (November 2018). Significance of Capital Market for Economic Development.

[4] Pettinger, Tejvan (2019), Causes of economic growth.

[5] Ba, Alice (2020), Asian Financial crisis. Retrieved from https://www.britannica.com/event/Asian-financial-crisis

[6] Jarwal, Devendra (2012), Role of Financial Market in Economic Growth of India.

[7] Joshi, Madhusudan (1972), The Role of Contractual Savings.

[8] Premkumar, Divya (2020), Why do Stock Markets Exist? And Why is it so Important?

[9] Imarticus (2019), What is the role of the capital market in economic development?

[10] Garcia, Márcio & Bekaert, G. & Harvey, C.R. (1995). The role of capital markets in economic growth.

[11] Andries, Alin (2009), The importance of the capital market in the economy.

[12] Mbugua, Anne (2009), The Role and Impact of Capital Markets in Developing Economies.

[13] Mminele, Daniel. 2013. “The importance of well-developed and functioning capital markets for growth and development.”

[14] Thapa, Thakar (2019), Overview of Capital Market’s Role in Nepal.

15. https://www.sebon.gov.np/

16. https://www.nepalstock.com/

17. https://blog.imarticus.org/what-is-the-role-of-capital-market-in-economic-development-capital-market-blog/