THE ROLE OF THE CAPITAL MARKET IN THE ECONOMY
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Capital market is defined as the market where medium and long terms finance can be raised (Akingbohungbe, 1996). Capital market offers a variety of financial instruments that enable economic agents to pool, price and exchange risk. Through assets with attractive yields, liquidity and risk characteristics, it encourages saving in financial form. This is very essential for government and other institutions in need of long term funds (Nwankwo, 1999). According to Al-Faki (2006), the capital market is 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”.
Taking into account the role in the market economy, the capital market occupies an important place, through their specific mechanisms, succeeding to give its contribution to the economic development of the society. In consequence, the public authorities must notice the importance of the capital market in the national economy and, on the other hand, to make the efforts for insuring the necessary framework for the normal functioning of its specific mechanisms. The valences of the capital could be even more interesting in the case of emerging markets being well-known its contribution in reorienting financial resources to efficient activities, contributing to the economic reform, but also being interesting in the privatization process.
Again the capital market was instrumental to the initial twenty five Banks that were able to meet the minimum capital requirement of N25 billion during the banking sector consolidation in 2005. The stock market has helped government and corporate entities to raise long term capital for financing new projects, and expanding and modernizing industrial/commercial concerns (Nwankwo, 1991).
Economic growth in a modern economy hinges on an efficient and effective financial sector that pools domestic savings and mobilizes capital for productive projects. Absence of effective capital market could leave most productive projects which carry developmental agenda unexploited. Capital market connects the monetary sector with the real sector and therefore facilitates growth in the real sector and economic development.
The fundamental channels through which capital market is connected to the economy, economic growth and development can be outlined as follows:
The contact between agents with deficit of money and the ones with monetary surplus can take place in a direct way (direct financing), but also by the means of any financial intermediation form (indirect financing), situation in which specific operators realize 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.
Even if, traditionally, the companies appeared only as agents with deficit of money, in the last two or three decades it could be noticed a change in the financial behavior of the modern firms: these are not considering anymore the financial market (both the capital and the monetary market) only as sources for rising funds (as issuers of financial assets), but appears more often as buyers of financial assets. The capital market fulfills the transfer function of current purchasing power, in monetary form, from companies which have a surplus of funds to those which have a deficit, in exchange for reimbursing a greater purchasing power in the future; in this way the capital market makes possible to separate the saving act from the investment one. Capital market has played major roles during the privatization of public owned enterprises, recent recapitalization of the banking sector and avenue of long term funds to various government agencies and companies in Nigeria.
Capital market increases the proportion of long-term savings (pensions, funeral covers, etc.) that is channeled to long-term investment. Capital market enables 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. It fulfills the transfer function of current purchasing power, in monetary form, from surplus sectors to deficit sectors, in exchange for reimbursing a greater purchasing power in future. In this way, capital market enables corporations to raise capital/funds to finance their investment in real assets.
The implication will be an increase in productivity within the economy leading to more employment, increase in aggregate consumption and hence growth and development. It also helps in diffusing stresses on the banking system by matching long-term investments with long-term capital. It encourages broader ownership of productive assets by small savers. It enables them to benefit from economic growth and wealth distribution, and provides avenues for investment opportunities that encourage a thrift culture critical in increasing domestic savings and investment ratios that are essential for rapid industrialization.
In addition, the capital market mechanism allows not only an efficient allocation of the financial resources available at a certain moment in an economy – from the market’s point of view – but also permits to allot funds according the return and the risk – from the investor’s point of view – offering a large variety of financial instruments with different profitableness-risk characteristics, suitable for saving or risk covering. Nowadays, the protection against financial risks becomes a necessity, imposed by the transformations in the global economy, by the accented instability and the financial crisis that affects without discrimination both developed and emerging stock markets.
Covering the risk, that could be realized by the help of different operations, market orders or derivatives, defines the function of insurance against risks, specific function of the capital markets. The capital market allows risk dispersion between investors (of the diversifiable risk), exactly in the same measure in which each of them is willing to assume it, too.
From the issuers’ point of view, the money which is necessary for the development or the unfolding of their activity can be mobilized by the help of the capital market at accessible costs, theoretically speaking smaller than those possibly obtained by the help of the banks or by other financial intermediaries.
Capital market also provides equity capital and infrastructure development capital that has strong socio-economic benefits through development of roads, water and sewer systems, housing, energy, telecommunications, public transport, etc. These projects are ideal for financing through capital market via long dated bonds and asset backed securities. Infrastructure development is a necessary condition for long-term sustainable growth and development. In addition, capital market increases the efficiency of capital allocation by ensuring that only projects which are deemed profitable and hence successful attract funds. This will, in turn, improve competitiveness of domestic industries and enhance ability of domestic industries to compete globally, given the current momentum towards global integration. The result will be an increase in domestic productivity which may spill over into an increase in exports and, therefore, economic growth and development.
Moreover, capital market promotes public-private sector partnerships to encourage 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 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. It facilitates inflows of foreign financial resources into the domestic economy.
Recent empirical research linking capital market development and economic growth suggests that capital market enhances economic growth and development. Countries with well-developed capital markets experience higher economic growth than countries without. Evidence indicates that, while most capital markets in African countries are relatively underdeveloped, those countries which introduced reforms that are geared towards development of capital markets have been able to grow at relatively higher and sustainable rates. A study in 2011 showed that South Africa, the country whose capital market is the largest and most developed in Africa, in terms of market capitalization and trading volume, has been growing significantly since 2000.
Its average per capita real GDP over the last 8 years has been at 3.2 %. Countries like Egypt, Ghana, Tanzania, Botswana and Mauritius, whose capital markets have been developing recently, were able to realize average per capita growth rates of more than 2.8% for the past 8 years. However, some economies which did not have formal or effective capital market like Lesotho, Seychelles and Ethiopia could not manage to realize average per capita growth rates above 2.7 % over the past 8 years. Even those countries with small and less developed capital market like Swaziland and Uganda did not manage to realize average per capita growth rates above 2.7 % during the past 8 years (CBL Economic Review, August 2009, No. 109).
The role of capital markets is vital for inclusive growth in terms of wealth distribution and making capital safer for investors. Capital markets 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. Innovation, credit counseling, financial education and proper segment identification constitute the possible strategies to achieve this.
A well-developed capital market creates a sustainable low-cost distribution mechanism for multiple financial products and services across the country. This writing has sought to demonstrate an important role played by capital market in economic growth and development. Capital market enhances efficient financial intermediation. It increases mobilization of savings and therefore improves efficiency and volume of investments, economic growth and development.
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- Al-faki M. (2006). The Nigerian capital market and socio-economic development. A paper presented at the 4th distinguished Faculty of Social Science, Public Lectures, University of Benin, 9-16
- Kolapo, F. T., & Adaramola, A. O. (2012). The Impact of the Nigerian capital market on economic growth (1990-2010). International Journal of Developing Societies, 1(1), 11-19.
- Nwankwo G.O. (1991): “Money and capital market in Nigeria today”. Lagos: University of Lagos Press.
- Obamiro, J.K. (2005). Nigerian economy: Growth and the role of stock market. Journal of Economic and Financial Studies, 2 (2).
- Perkins, D. H., Radelet, S., Lindauer, D. L., & Block, S. A. (2012). Economics of development.