- Fostering the development of capital markets can itself be a strong spur to innovation and economic growth
- SMEs are poorly served by traditional banking institutions as they are high-risk borrowers and capital markets are alternative source of funding for SMEs and infrastructure
- A consistent national investment policy aimed at supporting and developing the local institutional investor base will support domestic institutional base, institutionalize the market and maintain the flow of foreign funds
Kuwait Financial Centre “Markaz” stated in a recent whitepaper that Kuwait has pioneered many things at a regional and global level and it was the first country in the world that created a sovereign wealth fund and today has one of the biggest sovereign fund. However, this has not helped build a strong capital market ecosystem due to absence of a national investment policy in Kuwait’s 2035 vision.
Markaz added that a stable, properly functioning financial system plays a fundamental role in ensuring the efficient allocation of resources, especially capital. Capital market is a place where variety of financial instruments are offered that shall enable economic agents to pool, price and exchange financial risks. Through assets with attractive yields, liquidity and risk characteristics, it encourages saving in financial form. This is essential for various institutions that are in need of long term funds. Capital market could also be seen as a network of specialized financial institutions, series of mechanism, processes and infrastructure that, in various ways facilitate the bringing together of suppliers and users of medium to long term capital for investment in economic developmental project[1].
Need for Capital Markets
Markaz said that the need to finance large scale capital needs of an economy is an important driver of capital markets growth. Capital markets essentially serve as a financial intermediary that allows to raise capital that are long-term or riskier in nature. Thus, fostering the development of capital markets can itself be a strong spur to innovation and economic growth.
Capital markets are segregated by the type of instrument, debt or equity, which is used to raise capital. Capital markets are also distinguished as either primary or secondary. Users of funds raise them in primary markets via primary issuances of stocks or bonds more commonly referred to as Initial Public Offering (IPO). Once these instruments are issued, they are usually traded in secondary markets (stock exchanges).
Serve as Key Financial Intermediaries
The function of financial intermediation that involves connecting savers with borrowers is performed by multiple financial institutions including banks and financial markets. While, banks do it indirectly by serving as an intermediary between savers (depositors) and borrowers (lenders) capital markets enable direct intermediation from saver to users of capital through issuance stocks. Often metrics such as stock market capitalization-to-GDP ratio are used to understand the size of capital markets in the country under consideration. Stock market capitalization-to-GDP ratio is usually above 100% for developed markets since most business are listed and a high proportion of economy falls under the formal sector. Higher ratio could also sometimes indicate overvaluation.
Benefits of Capital Markets
a. Alternative Source of Funding
Markaz added that capital markets act as a useful institution by catering to a variety capital needs of an economy, which range from long-term financing to riskier ventures. Capital markets are often used as a venue to raise capital for riskier activities that would traditionally not be served by the banking sector, and by doing so contribute significantly to risky entrepreneurial ventures or innovation in an economy. For instance, SMEs are poorly served by traditional banking institutions as they are high-risk borrowers. The SME sector in the GCC accounts for USD 360bn per year, or about 26% of GDP and expected to more than double over next five years. Most of this growth is expected to come from the UAE and Saudi Arabia. A majority of SMEs in the region will require financing needs over the next couple of years. From a credit perspective, SME access to formal credit from the banking system in the GCC is low. SMEs therefore majorly rely on equity market for their financial requirements. Boursa Kuwait for instance, recently introduced over the counter market (OTC) that will create and diversify investment opportunities for business and investors both, thereby strengthening the economy. Saudi Arabia also launched a parallel market (NOMU) to drive SME’s contribution in the GDP. The Musharakah program is an example of an initiative that aims to boost the growth of SMEs at the start-up level.
b.Investment Avenue
For investors and savers, capital markets can offer more attractive investing opportunities—with better returns—than bank deposits, depending on risk profile, liquidity needs, and other factors. Long-term (116 years) data set across countries shows that equity has delivered positive long-term performance in each and every country, even those that were ravaged by wars. Also, equity significantly outperformed government bonds in every country, with a world average annual return of 5% versus 1.8%. The long-term Sharpe ratio on world equity has been 0.24 versus 0.09 for bonds[2]. Further, with a wider range of securities and instruments offered, capital markets can help investors diversify their portfolios and manage risk. This is particularly important for institutional investors, including pension funds and insurance companies. In this way, capital markets have a deeper impact on society.
c.Infrastructure Financing
In most countries, as a result of rapid economic growth, population growth, and urbanization, the financing needs for augmenting infrastructure capacity including providing for housing, addition of power capacity, expansion of capacity at airports and seaports, development of roads, and climate adaptation and mitigation are massive. For instance, Kuwait has envisioned over USD 100bn worth of infrastructural projects as part of its National Development Plan. It would not be prudent to entirely rely on the government or the banking sector for funding the investments. An alternative is greater use of primary capital markets—both local and international—to help close the gap. Private sector debt raising and equity finance are important sources of financing for Public Private Partnership (PPP) projects. Developing local debt capital markets is crucial in providing innovative financial solutions in an economy towards successful PPP. Debt capital markets can mobilize private sector funds to finance infrastructure, housing and other priority sectors, thereby reducing dependence on government financing. Some projects are financed through corporate loans which is the financing raised in the form of debt while some funds can be raised at the corporate level and passed through to the project entirely as equity. Institutional investors, which are an important part of capital markets, could be a significant source of financing for PPP projects.
Challenges in Developing the Capital Markets
The potential for and timing of capital market development are to a large extent dependent on the level of economic and structural development of a country. Significant differences across countries are explained more by institutional development, the size of the institutional investor base, the level of contractual savings such as pension funds, and macroeconomic stability. An essential condition for a well-functioning financial system— with both banks and capital markets—is the existence of sound macroeconomic and policy frameworks.
Capital markets are prone to manipulation if sufficient safeguards are not in place. The risk of information asymmetry runs high as the disclosures made by the companies are not always timely and those with critical sensitive information often front run to the disadvantage of public participants. The complexities involved and the need to have sufficient financial literacy, often precludes majority of the public from participating in the capital markets.
To obtain the benefits of well-functioning markets, adequate and well-defined regulations for issuers, investors, and intermediaries are critical. Robust supervisory arrangements on an ongoing basis is required to protect investors from market manipulation and to manage systemic risks. Such a framework in turn needs to be anchored in a good investment climate that includes a sound corporate governance framework, reliable and quality accountancy, creditor rights, property rights, and bankruptcy and competition law. Finally, markets need an infrastructure—exchanges and trading platforms, clearing houses, and custodians—to develop.
Developing Capital Markets
Near-term improvements are usually achieved through policy reforms and institutional development. This is especially true in the case of capital markets. However, in most countries, development of bond markets remains quite low and is the most important challenge for further local market development.
To develop debt markets that are usually nascent, government should take the lead with sovereign issues across multiple maturities. This apart from setting the ball rolling would also help in the establishment of yield curve, which shall enable in better pricing of private issuers. Large organizations with superior credit ratings could follow up. Banking institutions that are usually well regulated are often the foremost participants both as issuers and investors in debt market. Confidence of the participating public is enhanced as the fundamentals of most banks are robust. As the domestic participants become familiar with the functioning of debt markets, it could eventually lead it to further growth and development. .
Eventually other sectors may follow as the investor base builds familiarity with the market and instruments. Utilities, which typically have long-term capital investment needs but steady and predictable cash flows, may follow, and then other corporates[3].
Nurturing a diverse investor base is also critical for the development of robust capital markets. A thriving market place usually consists of variety of institutions and investors, foreign and domestic, with varying risk-return appetites. In order to enhance their participation, the capital markets need to be made attractive in terms of macro-economic stability, adequate investor protection norms and greater transparency. Large scale institutions such as domestic pension funds, insurance assets, and savings vehicles designed to funnel individual savings into financial assets typically form the bedrock in most capital markets. Developing them through appropriate reforms and incentives could lead to sustainable development of the regional capital markets, which could protect them from wild swings in foreign capital flow.
For countries that lack the scale or size for rapid and efficient development of local markets, capital markets linkages—these include safely accessing international capital markets, promoting foreign listings, and regional exchanges—could also be considered.
National Investment Policy
Markaz stressed that the role of capital market should also be understood from a national investment policy perspective. Kuwait is generally funded by oil revenues that builds up its coffers through the sovereign wealth fund i.e., Kuwait Investment Authority (KIA). Nurturing a domestic institution base to grow and represent strong alternate financial intermediation, apart from banks, is an important step to foster sustainable growth. In the absence of domestic institutional base, attracting capital (both for projects and for stock markets) can be volatile and short-term. An active and growing domestic institutional base can foster capital market development that will be professionally enduring and enhance the image of Kuwait as a serious contender for a “financial hub” tag. This can also provide the long-term finance that is required for project execution especially under Public Private Partnership mode (PPP). Hence, a coordinated national investment policy that aims to support, nurture and grow the domestic institutional base (like mutual funds) can institutionalize the market and make it less volatile.
Concluding Thoughts
Capital markets development rarely follows a linear path. Developing local capital markets and making greater use of them to fund private investment and strategic economic needs tends to happen in stages. Therefore some sequencing of policies is essential. This is particularly true for debt markets, which require well-functioning money markets to create government bond markets, and they in turn are essential for corporate bond markets.
The experiences of countries across the globe shows that capital market development is a gradual process requiring strong leadership from government authorities as well as a significant commitment of time and resources. If done correctly through appropriate sequencing of reforms across different categories of markets, the payoffs can be substantial and long-term.
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References: IFC, The Importance of Local Markets for Financing Development
- (Al-Faki, 2006)
- (Financial Market History – Reflections on the Past for Investors Today, The CFA Institute Research Foundation)
- (IFC)
About Kuwait Financial Centre “Markaz”
Established in 1974, Kuwait Financial Centre K.P.S.C “Markaz” is one of the leading asset management and investment banking institutions in the MENA region with total assets under management of over KD 1.06 billion as of 30 September 2018 (USD 3.51 billion). Markaz was listed on the Boursa Kuwait in 1997.