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