Ethiopia should be aware that the establishment of a stock market will not be risk free. The Ethiopian Stock Market has to be established and managed properly. In preparation to its establishment, the government must clean house: getting rid of corruption and cronyism; lack of transparency, outdated financial regulation, and skewed exchange rates. After getting these things done, the country can inaugurate the “Addis Ababa Stock Exchange” and finally join the global community of countries with stock exchanges, writes Yonnas Kefle.
Talk of creating a stock market in Ethiopia is in the news again. Last week, the media reported that the Ethiopian government is prepared to set up the country’s first stock market by 2020. As an evidence journalists cited a document recently issued by the government indicating its intention to establish a capital market in Addis Ababa by 2020. Since the turn of the 21st century, Ethiopian scholars, business leaders, consultants and government officials have been debating the need to establish a stock exchange. Even today, experts disagree on the timing. Some assert that the country needs a capital market now, while others argue that it is not yet ready for stock trading. Those who argue for the immediate establishment of a stock market in Ethiopia cite several justifications: Ethiopia’s attachment to global economy, the country’s large economy compared to those of smaller African countries that have developed their own stock markets, presence of indigenous companies ready to be listed in a stock exchange, the World Bank’s offer of technical assistance for establishing a stock market; and Ethiopia’s imminent membership in the World Trade Organization. Those who feel that Ethiopia is not presently ready for the stock market point at its weak financial infrastructure; lack of regulatory institutions; non-existence of reliable accounting information; absence of financial media; shortage of trained manpower, and shortfall of technological infrastructure to support their argument.
Ethiopia will have a stock market sooner or later. The timing is not that relevant. If not in 2020, Ethiopia can put the basic requirements in place and establish its stock market within the next five years or less. The most important issue to debate in my opinion, is not whether the country is ready for the stock market. It should be whether the stock market, once established, would help the country’s economic growth and development. Would stock market development influence Ethiopia’s economic performance? Can it be employed as a development policy strategy in Ethiopia? What had been the records of stock markets in other emerging economies that had them for several years? To shed light on the impact of establishing a stock market on Ethiopia’s economy, I will discuss the nature of stock markets, their impact on some emerging economies and related issues around stock market development.
Anatomy of a Stock Market: Stocks are basically shares of ownership in companies. The stock market is an organized market for buying and selling stocks and other financial instruments known as securities on specific locations called stock exchanges. Beside stocks, securities include bonds, options, and futures. Bonds are promissory notes (“IOUs”) issued by companies to borrow money from buyers through investment banks. Options are financial contracts traded on organized stock exchanges giving the owners the right to buy or sell particular assets, including stocks, commodities, real estate, and most other goods and services at a specified price, usually within a given period of time. Futures are, just like options, contracts traded on stock exchanges, containing agreements to sales or purchases of commodities including agricultural products, metals, oil and natural gas, bonds, currencies, and other goods at fixed prices on fixed dates.
Stock Markets trades are conducted on stock exchanges. Companies that need to raise capital and satisfy specific requirements must be listed in order for their stocks to be traded at these exchanges. The capital raised through the sale of the company’s stock, giving a portion of its ownership to investors in exchange for cash, is called equity financing. Brokers and dealers handle stock exchange transactions. These professionals facilitate the transactions of financial assets. Brokers execute trades on behalf of clients and receive commissions and fees in exchange for matching buyers and sellers. Dealers have their own inventories of securities and trade from their own portfolios. They earn income by selling financial instruments at prices that are greater than the prices the dealers have paid for them. Dealers and brokers may act purely as agents of their clients or trade as owners of inventory of financial assets. Some stocks can be bought and sold outside of stock exchanges. Stocks traded outside of stock exchanges are referred as unlisted, or over-the-counter (OTC) stocks. These stocks are usually traded by telephone or by computer.
Global Omnipresence of Stock Markets: Presently, the world is full of stock markets. Africa, with 29 stock exchanges, is no exception. There are two regional stock exchanges in Africa, one in Abidjan, Ivory Coast; and another in Libreville, Gabon. Benin, Burkina Faso, Guinea Bissau, Ivory Coast, Mali, Niger, Senegal and Togo use the exchange in Abidjan, known as the Bourse Régionale des Valeurs Mobilières (BRVM). The exchange located in Libreville is called the Bourse Régionale des Valeurs Mobilières d’Afrique Centrale (BVM-AC), and trades the stocks of companies in the Central African Republic, Chad, Democratic Republic of Congo, Equatorial Guinea and Gabon. In the northern part of Africa, Morocco has established the Casablanca Stock Exchange as early as 1929, while Egypt founded the Egyptian Exchange in 1883. Similarly South Africa, Nigeria, Namibia, and Zimbabwe have their own vibrant stock exchanges. All in all the continent has 29 stock exchanges representing the capital markets of 38 African countries.
Scanning the globe, we notice that most of the industrialized nations have stock exchanges, each with its own central location for trading. The larger international exchanges are located in London, England; Paris, France; Milan, Italy; Hong Kong, China; Toronto, Canada; and Tokyo, Japan. The European Association of Securities Dealers Automated Quotation system (EASDAQ) is the major OTC market for the European Union (EU). In the United States, the major stock exchanges are the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX), both located in New York City. In addition, America has nine smaller regional stock exchanges located in Boston, Massachusetts; Cincinnati, Ohio; Chicago, Illinois; Los Angeles, California; Miami, Florida; Philadelphia, Pennsylvania; Salt Lake City, Utah; San Francisco, California; and Spokane, Washington. The NASDAQ (National Association of Securities Dealers Automated Quotation) Stock Market is America’s major OTC market in the United States.
Role of Stock Markets: When properly managed and run, stock exchanges play important positive roles in national economies. By providing places for buyers and sellers to trade stocks and other securities, stock markets ideally encourage investment, enabling corporations to obtain funds and expand their businesses. Corporations usually issue new securities in what is known as the primary market, with the help of investment banks. Investment banks generally buy the initial issue of stocks from corporations at negotiated prices and then makes the stocks available for investors in an initial public offering (IPO). Corporations usually receive the proceeds of stock sales in these primary markets. After the initial offering, the stocks are bought and sold in the secondary market. Corporations are not usually involved in the trading of their stocks in the secondary market. Stock exchanges are centers of secondary markets. The stock exchanges support the performance of the primary markets by providing investors with a venue to trade stocks and other financial instruments. These arrangements enable corporations to raise the finances they need to build and expand their businesses. Stock exchanges also protect investors by upholding rules and regulations that ensure buyers are treated fairly and receive exactly what they pay for. Generally, stock exchanges have state-of-the-art technology to promote the efficiency of brokering. A developed technological infrastructure helps traders buy and sell stocks quickly and efficiently.
In recent decades, global stock markets continued to flourish, and to a large extent, developing economies have accounted for their expansion. Emerging economies, many of which are in Africa, establish new stock exchanges, expecting stock markets to promote economic growth and development. The fact that stock markets help growing companies in emerging countries raise capital is indisputable. There is a near consensus that stock markets contribute positively to corporate finance in emerging as well as developed economies. The controversy around stock markets is whether or not they can be credited with fostering economic growth in emerging economies. Some schools of thought insist that stock markets fuel economic growth, while others minimize the contribution of stock markets to growth and development. Still others consider stock markets inconsequential or harmful to the economic development of emerging economies. These anti-stock market thinkers believe that banks and other financial intermediaries can substitute stock markets and provide capital through borrowing – debt financing – as opposed to equity financing to companies in emerging economies. Advocates and detractors make interesting arguments to draw policymakers to or away from stock markets
Advocating for Stock Markets: Stock Markets are generally perceived to help economic growth through three of their functions: raising national savings; efficiently allocating investment resources, and making the best use of existing resources. Advocates of stock markets argue that banks in emerging economies could not perform these functions as stock markets do. They point out that banking systems are constrained by government policies as governments in emerging economies own or control the banking industry. Entry barriers and high reserve ratios further constrain the ability of banks to raise capital. Banks also suffer from technological deficiency and the resulting lack of accurate information in credit markets and cannot possibly achieve efficient capital allocation. On the other hand, advocates like to point out that stock markets use more accurate market data and provide better return to investors through equity financing as opposed to debt financing. Proponents of stock markets state that while both banks and stock markets compete to maximize the quality of information processing and to minimize transaction costs, stock markets are more efficient than banking systems on both grounds. They contend that the development of stock markets could stimulate banks to reform through the competition between them. According to these proponents, efficient stock markets contribute to long-term growth in emerging economies through efficient allocations of national savings and improved utilization of capital. Foreign private inflows of capital, they add, have positive impacts on real economies because they lower the cost of capital and induce positive asset effects. Advocates assert that the substantial development of stock markets as necessary conditions for financial liberalization and economic growth in emerging economies.
Advocates also portray Foreign Portfolio Inflows (FPIs) as promoters of economic growth and development. They believe the entry of FPIs, including large investors such as banks; pension funds and mutual funds; into the secondary markets of emerging countries’ stock exchanges contributes to resource mobilization. Proponents argue that FPIs may lift the share prices of emerging market stocks and reduce the issuing cost through lowering their price-earnings ratios (P/E ratios), measures of companies’ current share prices relative to their per-share earnings. It is thus safe, according to stock market advocates, to assume that FPIs have a stimulating effect on domestic investment and, thus, mobilization of savings. In addition, the participation of foreign institutional investors is likely to promote technological progress of emerging host countries’ stock transactions, thus contributing to more efficient allocation of capital. Moreover, if an emerging economy is experiencing foreign exchange constraint, foreign portfolio inflows could alleviate the foreign currency crunch, allowing further economic growth.
A World Bank research group conducted a study on the relationship between stock market development and economic growth that seems to support the position of advocates. It found that the development of stock markets is positively correlated with long-run economic growth. Its findings also included that the development of stock markets is positively associated with the development of financial intermediaries such as credit unions, and savings and loan associations. The group concluded that while stock market development induces the substitution of equity finance for debt finance in developed economies, it can also promote more debt finance in emerging economies. According to the research group, stock markets and financial institutions can complement each other and grow together.
Discounting the Importance of Stock Markets: Economists who had investigated the performance of stock markets in some emerging economies tend to discount the role of stock market development to economic growth. They see little or no evidence that stock markets contribute to economic growth, mobilization of savings or allocation of resources. They suggest that the enormous stock activities in emerging economies simply shift financial portfolios of investors and households from bank deposits to securities. They observe weak correlations between the annual growth ratio of capital raised externally and the corporates’ own fixed capital formation. The growth rate of real value added in the unregistered corporate manufacturing sector was lower than that of the manufacturing sector registered in stock exchanges. Smaller corporations which did not have access to stock market funds grew at a faster rate than the larger stock market listed corporations. Based on these observations, they question the contribution of the stock market to economic growth. Detractors believe that stock markets do not influence domestic savings as both gross domestic savings and the share of the financial assets of the household sector had been shown to stagnate in emerging economies where the stock market boomed. Therefore, according to them, stock markets do not appear to contribute to economic growth through domestic savings mobilization.
Detractors are not enthusiastic about foreign private inflows either. They argue that FPIs can be harmful because they are inherently volatile. They point out that what usually rush to emerging economies are not productive investment but short-term finance capital in the form of “hot money.” These are highly speculative funds as opposed to traditional foreign direct investments which have flowed into emerging economies taking advantage of liberal account convertibility rules. Such investors are only interested in short-term high investment returns. The moment they perceive declining returns or notice other opportunities with potentially higher returns, they sell their stocks and move their funds away. According to detractors, the consequence of foreign private inflows and stock market developments in most financially liberalized emerging economies had been temporary financial bubbles followed by balance-of-payment and financial crisis, as witnessed in Mexico and several other emerging economies. The 1997-1998 series of stock market and currency crises that hit the “Asian Tigers” loom large in the memory of detractors. The contagion of stock market crisis that began in Thailand, swept through the most stable economies of Malaysia, Indonesia, the Philippines, Singapore; and later reached Brazil Russia, and South Korea. Korea and Thailand suffered balance-of-payment crisis and experienced sharp drops in short-term capital inflows. Mexico also encountered sharp decline in Foreign Portfolio Inflows and fell into balance-of-payment crisis. It took external bailouts followed by the imposition of painful austerity measures to rescue the economies of many of these economies from total devastation. Gathering these observations led detractors to conclude that FPI’s contribution to economic growth in emerging economies is implausible. Detractors insist that FPIs are not linked to sustained economic growth in emerging economies.
The World Bank group’s hypothesis is correct in stating that stock market and financial intermediaries achieved simultaneous development. But it did not establish a positive correlation between bank credit to the commercial sector and indicators of stock market development. According to critics, the hypothesis is exposed to be challenged in these regards. If there is a substitutive function between stock market and financial intermediaries in terms of financing private investments, an increase in financing in the primary market does not necessarily lead an economy to higher growth and economic development. While the research group proved the complementarity of stock markets and financial intermediation, it failed to corroborate its claim of a positive relationship between stock markets and economic growth. Therefore stock market detractors conclude that the functional relationship between stock market development and economic growth is doubtful at best.
A Stock Market Culture: The emergence of stock market in Ethiopia will likely introduce a new set of personal investment risks and rewards as well as personal behavior associated with such events. Let me cite two incidents that I personally observed in the United States. On October 20 1987, my graduate Econometrics professor at Howard University came to class looking extremely agitated. The normally jovial professor who started his lectures with pleasantries was extremely disturbed and distracted. Even before we asked what went wrong, he broke the news to the class: He lost large bundles of money because the stock market crashed the previous day. During that stock market crash, the Dow Jones Industrial Average (DJIA) – the sum of the value of 30 large American stocks – lost 22.61 percent of its value and fell by 508 points over one day’s trading. The crash was attributed to the use by traders of new markets for low-margin stock index futures. Apparently, the government’s October release of pessimistic economic forecasts, prompted traders to rush into selling their stocks on the futures markets with low margin backing. The crash persuaded the government to introduce higher margin requirements in stock markets. It also pressured the government to institute circuit breakers, a temporary suspension of trading that is automatically triggered when stock prices fall by a particular amount. Presently, a 10-percent fall in average stock prices by 2:00 PM Eastern Standard Time would stop trading for one hour to cool the markets.
One of my colleagues at the Bureau of Labor Statistics was a habitual stock trader. Most late afternoons he was overheard from his cubicle either expressing joy by clapping or venting frustration by swearing at the stock market performance that day. He felt exuberant when the value of his stocks rose and lethargic when the value of his stocks dropped. Investing his personal finance in stocks, my colleague bought shares of ownership in several companies and receives dividends – a portion of any profits – every year. He was rewarded by capital gains, obtained when the price at which the stock he sold was greater than his purchase price, that arise through his trading activities. However, he also faced risks like all stockholders do. One of his risks was that the company may experience losses and not be able to continue the payment of dividends. He also experienced capital losses whenever he sold shares at a price below the purchase price during his frequent trades. His mood reflected the stock performance of the companies of which he was a stockholder. Unfortunately, stock prices are never predictable because they are influenced by a myriad of factors including political unrest, inflation, interest rates, energy prices, and international events such as war.
Conclusion: A stock market is a double-edged sword that can be beneficial or detrimental to Ethiopia’s economy. Development of stock markets has been a main feature of many emerging markets. The record of its contribution to economic growth has been mixed. Stock markets have been shown to boost emerging economies in several ways including making more investment funds available for investments, providing mechanisms for investor risk sharing and diversification, allocation of savings to productive investments, and reducing transaction costs. Many developing nations had established stock markets and managed to boost their economy’s long-term growth. On the other hand, stock markets have negative aspects. They have been observed to introduce market volatility and destabilizing speculation that could sink thriving economies. Ethiopia should be aware that the establishment of a stock market will not be risk free. The Ethiopian Stock Market has to be established and managed properly. In preparation to its establishment, the government must clean house: getting rid of corruption and cronyism; lack of transparency, outdated financial regulation, and skewed exchange rates. After getting these things done, the country can inaugurate the “Addis Ababa Stock Exchange” and finally join the global community of countries with stock exchanges.
Ed.’s Note: Yonnas Kefle, Ph.D., CEO of GTDC, have served as an Economist at the Bureau of Labor Statistics, as a Labor Attaché at the U.S. Department of State, and as an Adjunct Professor of Economics at Frederick Community College and Pennsylvania State University. He can be reached at: [email protected].
