What Is The Role Of Capital Markets In Economic Development?

By Cytonn Investments / Published May 5, 2022 | 2:00 pm

KEY POINTS

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.

KEY TAKEAWAYS

The capital markets are a network of specialized financial institutions, a series of mechanisms, processes, and infrastructure that in various ways facilitate the bringing together of suppliers and users of medium to long-term capital.

Ensuring economic growth and development is a primary objective of all countries. According to the World Bank, an estimated USD 4.0 trillion in annual investment is required for developing countries to achieve the Sustainable Development Goals (SDGs) by 2030.

In light of the investment requirement, there is a greater need to develop and strengthen capital markets in order to mobilize commercial financing.

The role that capital markets have in financing infrastructure development, large enterprises, and Small and Medium Enterprises (SMEs), and the links with economic growth, are increasingly being highlighted.

Economists traditionally have looked to factors such as capital, labor, and technology as the major factors affecting economic growth.

The recent financial crisis has shown that there are substantial economic effects when there is a lack of confidence in the financial systems. Therefore, the functioning of financial systems has received special attention in academic literature in recent years.

A well-functioning financial system permits an economy to fully exploit its growth potential, as it ensures that the best investment opportunities receive the necessary funding, while the inferior opportunities are denied capital; in this regard, we endeavor to investigate the role that capital markets play in economic development.

What are capital markets?

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.

Key players in the capital market’s process are:

Suppliers of Capital: Also known as surplus units, suppliers receive more money than they spend or have an immediate use for. They can be termed, investors. They provide their net savings to the financial markets for a return on the capital provided. Examples include retail investors and institutional investors,

Financial Intermediaries: A financial intermediary is an institution or individual that serves as a middleman among diverse parties in order to facilitate financial transactions. Common types include commercial banks, investment banks, stockbrokers, fund managers, and stock exchanges,

Users of Capital: Also known as deficit units, users of capital spend more money than they receive or need funds for investments or development. They are also termed, borrowers. They access funds from the capital markets. Examples include businesses, the government, and individuals.

How Capital Markets Facilitate Economic Development

Capital markets connect the monetary sector with the real sector, which is the sector of the economy concerned with the production of goods and services.

Considering this role in the economy, the capital markets play an important role in economic development as they facilitate growth in the real sector by giving producers of goods and services, and entities tasked with infrastructure development. access to long-term financing.

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

Creating a Bridge Between Suppliers of Capital and Users: The contact between agents with a monetary deficit and the ones with a 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.

Promoting Saving and Investments: The capital markets increase the proportion of long-term savings (pensions, life covers, etc.) that are 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 households and channel them into long-term investments.

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 the large range of financial instruments allows investors to better allocate their funds according to their respective risk and return appetites, thereby supporting economic growth.

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 the development of essential utilities such as roads, water, sewer systems, housing, energy, and telecommunications, public transport, etc. These projects are ideal for financing through the capital markets via long-dated bonds and asset-backed securities.

Financing Private-Public Partnerships, “PPPs”: Capital markets promote PPPs, thereby encouraging participation of the private sector in productive investments. The need to shift economic development from the public to the 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, by raising long-term project-based capital.