Introduction
The process of industrial development requires, as one of its accompanying
structural changes, the development of a capital market. The capital market should
be capable of meeting the requirements of credit and finance of the private
entrepreneurs. The capital market should also help in sustained national industrial
development.
The capital market provides an alternative mechanism of reallocating resources; it
channelises household savings to the corporate sector and allocates funds among
firm. In this process, it allows both firms and households to share risk. The capital
market enables the valuation of firms on an almost continuous basis and it plays an
important role in the governance of the corporate sector.1
Sound development of various segments of the capital market is a pre-requisite for a
well functioning financial system. The capital market in India has been modernised
over the years and is now comparable with the international markets. There has
been a visible improvement in trading and settlement infrastructure, risk
management systems and levels of transparency. These improvements have brought
about a reduction in the transaction costs and led to improvement in liquidity.2
II. Legal Framework and Investor Protection
A Framework for Capital Market Analysis
THE purpose of a framework is to provide a systematic, comprehensive, and consistent
description and analysis of the facts in order to establish functional relationships that
permit us to understand the modus operandi of the capital market. The selection of the
specific framework is a matter of choosing among alternatives the one that makes best use
of the available data, that embodies the maximum of internal checks against errors and
omissions, that is flexible enough to permit multiple analytical uses, that requires the
least effort on the part of the user, and that can be most easily adapted to testing the
various economic theories of the subject without being indissolubly wedded to any one of
them.3
Macroeconomic stability provides the foundations for
investors to invest long term. The negative impact of macroeconomic instability is
self-evident. By undermining the ability to assess the creditworthiness of most
prospective issuers, volatility exacerbates the degree of informational frictions, the
prime deterrent to investor participation. In other words, risky projects become riskier
1
Indian Financial System Ensuring Growth and Stability PP 68
2
IBID
3
: Raymond W. Goldsmith. A Framework for Capital Market Analysis .: (p. 43 - 79)
in the eyes of the prospective financiers, inhibiting the supply of funds into capital
markets.4
Under Ethiopia its defined by PROCLAMATION NO. 1248 /2021 THE FEDERAL
DEMOCRATIC REPUBLIC OF ETHIOPIA CAPITAL MARKET PROCLAMATION
WHEREAS, it has become necessary to establish a capital market to support the
development of the national economy through mobilizing capital, promoting financial
innovation, and sharing investment risks;
WHEREAS, it is necessary to adopt a legal framework for the regulation and
supervision of the capital market to ensure the fairness, integrity, and efficiency of the
market and protect investors;
WHEREAS, it is necessary to legislate uniform requirements for the regulation of
issuers who desire to raise capital from public investors;
WHEREAS, it is necessary to adopt a legal framework for effective monitoring and
surveillance of the capital market to detect, mitigate, and prevent systemic risk to the
country’s financial system;5
LONG-TERM FINANCE AND INSTITUTIONAL DEVELOPMENT
The promotion of long-term finance and capital markets is essential to
improve investment incentives consistent with external adjustment, as well as to
avoid excessive reliance on short-term funds to finance investments — a practice
which in the past led to liquidity crisis (and at times bankruptcies) of enterprises
and financial institutions. Because of their expertise in development finance, the
World Bank Group and, in particular, the International Finance Corporation have
played a leading role in this area. In a supplementary role, recent fund technical
and economic issues relating to policies aimed at lengthening the maturities of
loans and deposits.6
WHAT IS CAPITAL MARKET?
It is an organised market mechanism for effective and efficient transfer of
money capital or financial resources from the investing class (a body of individual
or institutional savers) to the entrepreneur class (individual or institutions engaged
in industry business or service) in the private and public sectors of the economy.
4
The inability to forecast cash flows and interest rates may also reduce the corporate demand for
funds, except in the case of opportunistic
issuers.
5
PROCLAMATION NO. 1248 /2021 THE FEDERAL DEMOCRATIC REPUBLIC OF ETHIOPIACAPITAL
MARKET PROCLAMATION8(hereafter refer proclamation). preface
6
Supra note no .2 IBID
In a very broad sense, it includes the market for short-term funds. H.T.
Parikh has referred to it as, “By capital market, I mean the market for all the
financial instruments, short-term and long-term as also commercial, industrial
and government paper.”
In the words of Goldsmith, “the capital market of a modern economy has two
basic functions: first the allocation of savings among users and investment;
second the facilitation of the transfer of existing assets, tangible and intangible
among individual economic units.”
Grant defines capital market in a broad sense as “a series of channels through
which the savings of the community are made available for industrial and
commercial enterprises and for public authorities. It embraces not only the system
by which the public takes up long-term securities directly or through
intermediaries but also the elaborate network of institutions responsible for short-
term and medium-term lending.”
From the above definitions, it may be deducted that the function of capital
market is the collection of savings and their distribution for industrial investment.
Thus, capital formation is sine qua non of economic development. As such, the
relationship between the market, instrument, and services are integrated as well as
inter-dependent.
Capital market is generally understood as the market for long-term funds.
The capital market provides long-term debt and equity finance for the government
and the corporate sector. By making long-term investments liquid, the capital
market mediates between the conflicting maturity preferences of lenders and
borrowers. The capital market also facilitates the dispersion of business ownership
and the reallocation of financial resources among corporations and industries.7
III. Comparative Insights from Emerging Markets
DIMENSIONS OF CAPITAL MARKET
The Capital market is directly responsible for the following activities: (1)
Mobilisation or concentration of national savings for economic development, (2)
Mobilisation and import of foreign capital and foreign investment capital plus
skill to fill up the deficit in the required financial resources to maintain the
expected rate of economic growth, (3) Productive utilisation of resources, and (4)
Directing the flow to funds of high yields and also strive for balanced and
diversified industrialisation.
CLASSIFICATION
The capital market comprises of two markets, viz., the Primary market and
the Secondary market.
THE PRIMARY MARKET
The primary market consists of new issues of capital (equity, debentures,
bonds, etc.), by new/existing companies. In this case, the corporate body invites
applications to its issue of equity or debentures by filling a prospectus or letter of
offer. The application forms can be obtained from the bankers/merchant bankers
of the issues, brokers, etc.
7
IBID
Investors subscribe to these issues by filling in the application forms and
remitting the requisite amount to the designated banks (listed on the reverse of the
application) within the time period for which the subscription list is open. The
subscription list is generally kept open for three days.
The company in consultation with its merchant bankers and the Stock
Exchange authorities is expected to finalise the list of successful applications
within 10 weeks. Thereafter, the share/ debenture certificates are dispatched to the
successful application while refund orders are posted to others.
If the amount paid on application is only half the face/nominal value, the
company must mention the date by which the successful applicants are required to
pay the balance. The company normally gives an allotment advice and after
remittance of the first/final call, the fully paid share certificate is sent to the
investor.
THE SECONDARY MARKET
The secondary market is where listed securities are bought and sold.
The secondary market is thus an important adjuct of the primary market. The
activity in these two markets is inter-linked and the indicators are also related
although separate in themselves and the starting link is listing of issues on the
Stock Markets.
In the secondary market, the move to an electronic trading system has
resulted in transparency in trades, better price discovery and lower transaction
costs. The efficiency of the market has improved through faster execution of
trades. The operational efficiency of the stock market has also been strengthened
through improvements in the clearing and settlement practices and the risk
management process. Almost the entire delivery of securities now takes place in
dematerialised form.
CAPITAL MARKET STRUCTURE
An important segment of the organised financial system comprises of the
new issues market and stockmarket. The term capital market is a wide term,
encompassing all long-term claims of money-lendings and borrowings. It thus
includes all term lendings by banks and financial institutions and long-term
borrowings from foreign markets and new issues by companies and raising of all
resources from public through issue of new securities, deposits, loans, etc.
capital market includes issues of two major categories — marketable and non-
marketable. Whether marketable or not, these are issued by government and
government departments, companies, public sector units, mutual funds, UTI, etc.
LIC and GIC sell policies and collects savings from public, which are not
marketable. The other non-marketable securities or claims are issued by post offices
as savings certificates, deposit receipts, etc., non-securitised loans and advances of
banks and financial institutions, deposits with banks and companies and securities
of private limited companies and finance company deposits/loans, chit fund etc. The
marketable securities are issued through the new issues market and are traded
through the stock market.
The contributors to new issues are promoters, collaborators, if any,
employees, NRIs, banks, FIs, Mutual Funds and the public at large. The players
through whom these issues are managed are mainly merchant bankers, registrars,
brokers, mutual funds, etc., which are dealt with in detail in later chapters. The
ancillary functions and complementary to the above are those of underwriters,
collecting bankers, printers, advertising agents etc. The main players in the stock
market, namely, brokers, investment consultants, portfolio managers, investment
managers, etc., are also discussed in later chapters.
The capital market study should authentically encompass both the
marketable and non-marketable segments. In view of the fact that demand and
supply forces and trading activity is confined only to the segment of marketable
securities, this book is using the term ‘Capital Market’in the sense of marketable
securities. Thus, more prominent issuers of such securities are public limited
companies and, government and the more popular instruments traded in the
market are equity, debentures, bonds, etc., which are discussed in this book. UTI
and the mutual fund schemes being popular for trading, they are also dealt with.
Briefly the major players — instruments and activity in capital market are covered
from the point of management.
CONSTITUENTS OF CAPITAL MARKET
The constituents of the capital market comprise of development banks,
specialised financial institutions, investment institutions, state level development
banks, mutual funds, lease companies, financial service companies, commercial
banks and other specialised institutions were set up by development banks for the
growth of the capital market,
III. Comparative Insights from Emerging Markets
The economic theory and empirical research have emphasized three sets of
factors as economy-wide determinants of capital markets development: the
macroeconomic environment, the state of development of the financial sector, and
the strength of basic institutions.14 While the theoretical background dates back
from the 1980s and 1990s, the empirical evidence has been regularly produced
from the 1990s to the present, revealing a sharp interest on the part of the policy
and academic research community in examining both advanced and developing
and emerging economies.8
8
As will be further explained in section 5, there are technical challenges in establishing
whether true causality or a simple correlation exist. Overall, this note leans toward supporting
the existence of causality when (a) a strong and large body of theory justifies such a belief and
(b) a large number of the empirical studies apply and get positive results from state-of-the-art
methods to test causality. Also important to note is that, as expected in applied economics and
finance, no absolute unanimity can be found across studies on the sign and statistical significance
of any given correlate. In light of this, the effects highlighted in the main text of this note reflect
the those found in the majority but not the totality of the available research. Cases of mixed
Although GDP per capita is customarily employed as
an explanatory variable of equity and bond market
development in both advanced and emerging economies,
total (as opposed to per capita) GDP is also included in
a number of studies. In both cases, the effect has been
found to be almost invariably positive.17 Along with GDP,
the saving and investment rates have also been used in
some studies9.
Because uncertainty is not a directly observable variable,
empirical proxies are used to capture its effect, with the
inflation rate being the most popular, and to a lesser
extent the inflation and the exchange rate volatilities. The
negative impact shows up consistently in studies related to both the equity and the
bond markets in emerging and
advanced countries alike10
According to the studies reviewed, the fiscal deficit to
GDP, by fostering the government bond market, exerts a
and doubtful overall results will be noted as well. These remarks extend to the analysis of capital
markets effects in section 3 and CAPITAL MARKETS DEVELOPMENTn pp 14
9
See Garcia and Liu (1999); Ben Naceur, Ghazouani, and Omran (2007); Billmeier and Massa (2009);
and Bebczuk (2007).
19 The inability to forecast cash flows and interest rates may also reduce the corporate demand for
funds, except in the case of opportunistic
issuers
10
In particular, an active market for long-term government bonds is required for the establishment of
a yield curve. The monetary policy— by altering the interest rate and the yield curve—and the
exchange rate policy—by changing the incentives to issue in different currencies and countries—may
also have some impact on capital market outcomes.
positive effect on the private sector bond market in both
advanced and emerging countries. Some other studies
directly use the size of the government bond market as
an explanatory variable, reaching the same conclusion.
Against the background of this crowding-in effect of
fiscal deficits on the development of the private sector
bond market, little evidence has been produced on their
influence on the equity market.11
Financial markets preconditions
A common thread across the theoretical literature is
that capital markets development is likely to coincide
with deeper financial markets as a whole. Three
different conduits can be distinguished—namely, (a) the
preexistence of a well-developed banking system, (b) the
emergence of institutional investors, and (c) the degree of
international financial openness
The bulk of the evidence confirms this positive effect. The
ratio of domestic credit to the private sector to GDP is
a usual explanatory variable in bond and equity market
regressions featuring both developed and emerging
11
For instance, De la Torre, Gozzi, and Schmukler (2008); Claessens, Klingebiel, and Schmukler
(2007); and Eichengreen and
Luengnaruemitchai (2004) include the fiscal balance in their econometric specifications, whereas
Fløgstad (2017) and Luengnaruemitchai
and Ong (2005) work with the government debt market outstanding to GDP. Bebczuk (2007), in turn,
finds that fiscal deficits crowd out
equity issuance, using data for 31 countries in 1989–2001.
economies.12 Other variables used include the bank
interest net margin and the bank lending to deposit ratio,
as proxies for efficiency of the credit market. In addition,
the literature mostly sees a link between credit registries
and the depth of the banking sector (see, for instance,
Djankov, McLiesh, and Shleifer 2007)
The institutional investors industry may become instrumental in igniting, on behalf of
its clients, the appetite for a broad set of assets that are issued and traded in capital
markets. Armed with sizable resources, institutional investors create the necessary
demand for the securities issued by both the private and the public sector. In this
sense, this demand should be able to gradually create its own supply, even if the
assets in demand are not available in the first place. In addition, institutional investors
may strengthen financial innovation, transparency, information disclosure, and
corporate governance, as well as reinforcing economies 13
Empirically, it appears that the positive effect prevails
in connection with both equity and bond market
development in advanced and emerging countries. 14
Some studies include the legal family
to which the country belongs (with the Anglo-Saxon
framework associated with more legal assurances to
the financier; the Continental, with less). Some, but not
all, studies control for the effectiveness with which the
legal framework is enforced—that is, the time and cost
involved in the settlement of contractual disputes. In
all cases, the results strongly support the enhancing
role of those variables on the development of corporate
12
The trust-based argument also can be invoked to postulate that the initial level of capital markets
development is likely to trigger its
own subsequent expansion, along with the fact that, via economies of scale, the larger the market, the
lower the transaction costs
13
CAPITAL MARKETS DEVELOPMENT pp 16
14
ibid
equity and bond markets across emerging and developed
economies.15
At the empirical level, a majority of papers uncover a
positive effect of secondary stock market development—
measured by capitalization, value traded, and turnover—
on GDP growth, both total and per capita.16 The research
covers both emerging and advanced economies.
Interestingly, no paper addresses specifically the impact
of the corporate bond market on growth, but many focus
on the size of capital markets (stock plus private sector
bonds) relative to the banking system
Another line of research looks at capital markets
development (stock and bond capitalization as well as
stock value traded) relative to banking depth. Recent
15
Ibid pp 17
16
Inspired by the 2008 global financial crisis, researchers have revisited the long-standing consensus
around a linearly positive effect of
banking depth on economic growth, postulating that the beneficial effect vanishes and even reverts
once the banking system becomes too
large (see Arcand, Berkes, and Panizza 2012 and Popov 2018). Sahay and coauthors (2015) delve into
this issue by constructing a broad index
of financial development, reaching a similar conclusion, regarding not only growth but also stability (as
measured by the standard deviation
of economic growth). However, when decomposing their index into a bank index and a capital markets
(bonds and equity) index, they find
that, in the latter case, the nonlinearity applies to stability but not to growth. In other words, capital
markets that are too large would not
jeopardize economic growth but might threaten economic stability. Having said that, this potential
problem should not be a major concern for
most emerging and developing countries at their current, in general incipient, stage of capital market
development.
contributions on this bank-based versus market-based
financial system approach, published mostly from the
2000s on, seem to cluster around the conclusion that
market-based systems are associated with faster GDP
growth. Relatedly, stock market development appears
to bring about more investment in intangibles, research
and development (R&D) and technological innovation
in general (for example, a larger number of patents
and volume of high-tech exports).39 The latter effect is
observed in macro-, industry-, and company-level studies
for advanced and emerging economies spanning the past
three decades.
Turning to the empirical evidence, the development of the
stock and bond market has been found to be associated
with higher financial stability in both advanced and
emerging countries. Most studies are recent and were
triggered by the 2008 crisis (see for instIvashina, 2014). The evidence shows, for
instance, that post-recession recoveries and investment is stronger in countries
with a deeper bond market relative to bank credit. Likewise, recessions in
countries with bank oriented systems have been much more severe than in those
with a market-oriented financial structure, as measured by the sum of corporate
bond and stock
capitalization. In the same vein, measures of financial systemic risk increase
with bank credit deepening and diminish with nonfinancial bond debt and stock
market capitalization. Moreover, the recent literature on the 2008 crisis has
unveiled that, at least in advanced economies, firms were able to substitute bond
market financing for bank loans during the credit crunch taking place in the
aftermath of the 2008 crisis, with the bond market acting as a spare tire for
these firms and hence turning into a financial stabilizing force.17
The studies claim that financial development
produces a positive impact up to some threshold and
17
Supra note no 13 pp 23
negative afterwards (see Beck and Levine 2018 for a
survey). Although this research has for the most part
been centered around the banking system, the limited
evidence available shows that financial development
as a whole that encompasses both banks and capital
markets displays the same nonlinear effect (see Sahay
and others 2015).18 However, given that the negative
impact manifests itself at high levels of financial depth,
it is unlikely to affect most developing and emerging economies19
Finally, sequencing clearly emerges from Demirgüç-Kunt, Feyen, and Levine (2012),
who closely
inspect a dataset of 72 countries spanning the period
1980–2008 and confirm that bank credit precedes, in
earlier stages of economic development, the growth of
capital markets (as measured by either stock or stock
plus bond capitalization)
IV. Future Outlook and Policy Recommendation
Future Outlook
Regarding savings, well-accepted consumption theories
indicate that, by widening the gap between disposable
income and subsistence consumption, higher GDP per
capita entails a higher capacity to save. The impact of
18
Further Sahay and others (2015) argue that “a faster pace of financial deepening means a greater
risk of crisis and macroeconomic
instability, other things being equal
19
Supra note no 13 pp 23
GDP growth depends on whether people perceive that
income as permanent (in which case the additional
income would be entirely consumed) or temporary (in
which case saving would take place). The evidence
supports the latter, which is consistent with the fact
that the growth rate tends to display unpredictable
swings in the short run. Grigoli, Herman, and Schmidt Hebbel (2018) uncover
strong supporting evidence in
their comprehensive empirical study of 165 countries
over the period 1981–2012. As for investment, the early
accelerator theory and subsequent approaches, such as
the Tobin’s q model, all posit that higher growth stimulates
capital accumulation. Once again, an extensive body of
evidence lends strong support to this investment-growth
nexus. More controversial is the relationship with the
level of GDP per capita. In principle, higher GDP per capita
implies higher capital per capita and, by way of the law of
diminishing returns, a lower marginal productivity, which
discourages investment. However, richer economies tend
to exhibit higher levels of total factor productivity, and
this behavior may neutralize and even revert the previous
effect. Lim (2013), among others, finds that both the level
and growth of GDP per capita foster investment in a large
country panel.16
The third and last macroeconomic channel runs through
fiscal policies, in particular budget imbalances, which
may act by creating a sovereign debt market at different
maturities, thus providing, by way of a yield curve,
benchmarks against which to value corporate bonds
(Dittmar and Yuan 2008).20
Also, in favor of macroeconomic stability, and as a result
of their higher contractual flexibility regarding debt
contracts, equity markets make issuers more resilient
to financial distress. The inability to repay debt triggers
default, a more traumatic and insurmountable outcome
than a drop in stock price, the latter being a fact likely to
cause material damage to investors but not directly to
the issuer.41 If trouble is temporary (a liquidity rather thaThat said, secondary
markets may affect financial
stability if stock price volatility is transmitted to the real
economy.42 This could happen because price movements
have a wealth effect on security holders, because firms
(listed or otherwise) make investment decisions based
on market valuations and/or because consumers at
large, regardless of whether they participate in capital
markets, somehow feel more or less confident or fearful
depending on whether stock prices go up or down. In
this context, the speed at which security prices react to
current and prospective bad news may make it a good
20
In particular, an active market for long-term government bonds is required for the establishment of
a yield curve. The monetary policy—
by altering the interest rate and the yield curve—and the exchange rate policy—by changing the
incentives to issue in different currencies and
countries—may also have some impact on capital market outcomes.
predictor of trouble on the real side of the economy, but
not necessarily the underlying trigger. On the question of
whether it is a trigger, there is no sound evidence in the
literature surveyed of such a causal link.43
Finally, it is important to highlight that the development of local capital markets
could favor financial stability by enhancing the ability of investors to manage
risk via the introduction of derivatives such as options, futures, and swaps.
However, the introduction of derivatives also carries risk that, if not well
managed, could amplify vulnerabilities.
Policy Recommendation
This essay has been triggered by the increased attention given to capital markets
as a mechanism that can potentially help channel private sector funding to key
strategic sectors of the economy, from corporates to infrastructure, housing,
small and medium enterprises, and climate change. Thus, it is important to have
a common understanding of the drivers of capital markets development and
potential sequencing issues, as well as on the potential impact that capital
markets development could have on economic growth and financial stability.
Accordingly, this review constitutes a background note that will set the
foundation for further work, both knowledge and policy related. By itself,
however, this note does not intend to set policy
The third and last macroeconomic channel runs through
fiscal policies, in particular budget imbalances, which
may act by creating a sovereign debt market at different
maturities, thus providing, by way of a yield curve,
benchmarks against which to value corporate bonds
(Dittmar and Yuan 2008).2
Capital markets may have an effect on financial stability
through a few channels.
In the case of the volume of funding available to firms,
capital markets will play a stabilizing role if bond
markets, equity markets, or both counteract credit
crunch episodes that hit the banking system. Bank credit
is known to be procyclical (see Borio 2012), which implies
that negative macroeconomic shocks may be magnified
by an unexpected shortage of loans—when explained by
lower supply and not by lower demand—and by higher
interest rates.40 If investors in capital markets are less
sensitive to the cycle (because they are have a more
risk-taking attitude and longer horizons), they may be
willing to provide the needed financing to the firms, thus
acting as a spare tire to bank lending. Of course, if capital
markets behave in the same way that banks do, that
would just reinforce the negative feedback between the
real side and the financial side of the economy.
The interpretation of regression coefficients as mere correlations or causal
effects
is by far the most pervasive concern in the econometric arena. The problem lies
in the notion that, while the correlation between two given variables is directly
observable, the underlying causality is not, thus imposing a serious challenge on
policy design
that the (equity and bond) primary market has not
received much attention either.62 Just a handful of papers
study the drivers and consequences of security issuance
activity. However, once it is acknowledged that the most
genuine form of capital markets development is the entry
of new issuers and investors, it would be important to get
a deeper understanding of the incentives and barriers that
these players face in deciding to enter, stay, and leave
public capital markets. For example, limited research
exists about why firms choose between different private
and publicly traded external sources, or what investors
are most likely to participate in primary and secondary
markets. From this analysis, policy measures may be
taken to move in the direction of igniting a larger demand
and supply for new corporate securities. This assumption
reinforces the need to integrate macro- and micro-data
studies to better inform capital market policies