The Role of the Capital Markets in Economic Development

A well-developed capital markets creates a sustainable, low-cost distribution mechanism for multiple financial products and services across the country.

This in turn helps the business community to raise long-term funds that are used to purchase capital goods, thereby propelling their growth and supporting the country’s economic growth.

Capital markets are a general category of markets that facilitate the buying and selling of securities with medium-term and long-term maturity, of one year or more. Capital markets channel savings and investment between suppliers of capital and users of capital through intermediaries.

Products in the capital markets are also referred to as capital market securities. These are debt securities, with a maturity of more than one year, and equity securities. Funds received from these products are mostly used to purchase capital assets, such as buildings, equipment, or machinery. The key capital markets securities are:

1. Bonds:

    These are medium to long-term debt securities issued by firms and governments to raise large amounts of funds. Bonds are differentiated by the issuer and can be classified as Treasury bonds, municipal bonds, or corporate bonds,

2. Equity Securities:

    An equity security represents ownership interest held by shareholders in an entity realized in the form of shares of capital stock, which includes shares of both common and preferred stock. They are classified as capital market securities because they have no maturity and therefore serve as a long-term source of funds.

Capital markets, according to Cytonn Investments weekly report dubbed ‘The Role of the Capital Markets in Economic Development’ enhances efficient financial intermediation.

The report goes ahead to state that capital markets increases mobilization of savings and therefore improving efficiency and volume of investments, economic growth and development. It can create 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. 

How Capital Markets Facilitate Economic Development

The fundamental channels through which capital markets are connected to the economy, economic growth and development can be outlined as follows:

1. Creating a Bridge Between Suppliers of Capital and Users:

    The contact between agents with a monetary deficit and the ones with monetary surplus can take place directly through direct financing, but also through a financial intermediary in form of indirect financing, which is a situation whereby specific operators facilitate 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,

2. Promoting Saving and Investments:

    The capital markets increase the proportion of long-term savings (pensions, life covers, etc.) that is channeled to long-term investment. Capital markets enable the contractual savings industry (pension and provident funds, insurance companies, medical aid schemes, collective investment schemes, etc.) to mobilize long-term savings from small individual household and channel them into long-term investments.

3. Facilitating Efficient Allocation of Scarce Financial Resources:

    The capital markets facilitate the efficient allocation of scarce financial resources by offering a large variety of financial instruments with different risk and return characteristics. This competitive pricing of securities and large range of financial instruments allows investors to better allocate their funds according to their respective risk and return appetites, thereby supporting economic growth,

4. Financing Utility and Infrastructure Development:

    The capital markets also provide equity capital, debt capital and infrastructure development capital that have strong socio-economic benefits through development of essential utilities such as roads, water and sewer systems, housing, energy, telecommunications, public transport, etc. These projects are ideal for financing through the capital markets via long dated bonds and asset backed securities.

5. Financing Private Public Partnerships, “PPPs”:

    Capital markets promote PPPs, thereby 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 as resources continue to diminish. It assists the public sector to close the resource 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 and who facilitate inflows of foreign financial resources into the domestic economy, thereby supporting economic growth.

Challenges of Developing Capital Markets

Economic growth in a modern economy hinges on an efficient and effective financial sector that pools domestic savings and mobilizes capital for productive projects. The absence of effective capital markets could leave most productive projects that carry developmental agendas unexploited.

However, there are challenges in developing capital markets as they are to a large extent dependent on the level of economic and structural development of a country. Factors affecting the development of capital markets include;

1. Country Fundamentals

   : The size of the economy in terms of aggregate gross domestic product and per capita income affect the development of capital markets. This explains in large part why, in general, capital markets are at an embryonic stage in smaller and low-income countries, while more developed countries have more robust capital markets. This can be explained as more developed economies have greater institutional development, a larger institutional investor base, higher levels of contractual savings such as pension funds, political stability and macroeconomic stability.

2. Macroeconomic Policies Framework

   : An essential condition for well-functioning capital markets is the existence of sound macroeconomic policy frameworks. Capital markets depend on investor confidence. Strong institutions thrive in stable macroeconomic conditions and investors can also be confident that their capital will not be eroded by factors such as hyper-inflation and exchange rate risks when there is a strong macroeconomic framework in place.

3. Access to Information

   : Access to information is a major factor that affects the development of capital markets. Access to information gives investors’ confidence in the functioning of the capital markets. Access to information and transparency allows for the monitoring of users of funds, which increases investor confidence.

4. Regulatory Framework

   : To reliably extract the benefits of well-functioning markets, adequate regulation of users of funds, investors, and intermediaries in addition to robust supervisory arrangements to protect investors, promote deep and liquid markets, and manage systemic risk are critical.

5. Efficient Market Infrastructure

   : Lack of adequate and efficient market infrastructure for issuing, trading, clearing and settlement is a major issue for capital market development as it pushes away potential investors to an economy.

6. Knowledge of Retail Investors

   : The lack of investor education for retail investors is another factor affecting the development of capital markets. It is important to educate retail investors on investment products and the benefits of saving, in order to channel savings to the capital markets.

Steps Kenya Should Take to Expand its Capital Markets as Complementary to Bank Funding

According to Cytonn, Kenya should adopt the following recommendations that will address the existing bank dominance, reduce the funding reliance we have on banks, and support the expansion of capital markets as an alternative to banks:

1. Focus Legislation and Policies to Stimulating the Capital Markets and Alternative Products, as Opposed to Focusing Mainly on Banks:

    

2. Support Product Development and Innovation: 

   The capital markets regulators and participants need to look at how to enhance non-bank funding, by encouraging product development and innovation.

3. Consumer Education and Protection:

    The implementation of a strong consumer protection, education agency and framework, to include robust disclosures on cost of credit, free and accessible consumer education, enforcement of disclosures on borrowings and interest rates, while also handling issues of contention and concerns from consumers.

4. Promote an Efficient Capital Markets Infrastructure:

    Efficient capital markets infrastructure is crucial to developing deep and vibrant capital markets.

5. Addressing the Tax Advantages that Banks Enjoy:

    Level the playing field by making tax incentives available to banks to be also available to non-bank funding entities and private investment funds.

6. Freeing Capital Markets Infrastructure from Banking Sector Control:

    To spur growth of capital markets in areas such as Unit Trust Funds / Mutual Funds, we need to reduce the dominance of banks in the capital markets infrastructure.

Increased Transparency:

 This can be achieved through a reduction of the opacity in debt pricing. This will spur competitiveness in the banking sector and bring a halt to excessive fees and costs. Recent initiatives by the CBK and Kenya Bankers Association (KBA), such as the stringent new laws and cost of credit website being commendable initiatives.