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Note 28 | January 2017
THE IMPORTANCE OF LOCAL CAPITAL MARKETS FOR
FINANCING DEVELOPMENT
Rudimentary markets for capital—for raising money and investing—exist in even the remotest places around
the world. However, prudent macroeconomic management, regulation, investor protection, and innovation
are necessary to transition these nascent markets, which are often speculative ventures prone to fraud, into
modern, efficient, and well-functioning markets capable of serving the needs of investors and entrepreneurs,
borrowers and lenders alike.
The Value of Capital Markets
A growing economy in need of new forms of financial Capital markets have several beneficial features for different
intermediation to finance investments that are either too long- participants in the economy. For a company or entity in need of
term or too risky for commercial banks is one of the most funding, domestic capital markets provide an alternative source
important drivers of capital markets growth. It is also now well of funding that can complement bank financing. Capital
understood that fostering the development of capital markets markets can offer better pricing and longer maturities, as well
can itself be a strong spur to innovation and economic growth. as access to a wider investor base. They can also offer funding
The role of capital markets in development has been the focus for riskier activities that would traditionally not be served by
of considerable research over the years. 1 the banking sector, and by doing so contribute significantly to
innovation in an economy.
In the simplest terms, a marketplace where buyers and sellers
can engage in the trade of financial securities broadly defines While some governments can access international capital
the market for capital, or capital markets. Financial markets markets, the development of local capital markets can increase
comprise both capital and money markets. Capital markets refer access to local currency financing and thereby help manage
to markets that trade financial instruments with maturities foreign exchange risk and inflation better. For governments,
longer than one year. Money markets trade debt securities or this is a valuable benefit since it can allow them to finance fiscal
instruments of maturities of a year or less. deficits by borrowing from local markets without exchange rate
risk. Government borrowing has been done in international
Markets are further segregated by the type of instrument—debt markets in local currency and/or indexed to the exchange rate,
or equity—used to raise capital, and the derivatives market, but local markets have the benefit of more easily tapping local
which is used to manage risk. Capital markets are also investors, and often local banks. The creation of local capital
distinguished as either primary or secondary. Users of funds markets is enormously beneficial to governments attempting to
raise them in primary markets via primary issuances of stocks finance development internally.
or bonds. Once these instruments are issued, they can be traded
in secondary markets. For investors and savers, capital markets can offer more
attractive investing opportunities—with better returns—than
Intermediation between lenders (or savers) and borrowers (or bank deposits, depending on risk profile, liquidity needs, and
users of funds) is a fundamental function of the financial system other factors. Further, with a wider range of securities and
in an economy and is performed primarily by commercial banks instruments offered, capital markets can help investors
and primary capital markets. The key distinction is that capital diversify their portfolios and manage risk.
markets provide direct funding from saver to user via the
issuance of securities, while bank intermediation involves This is particularly important for institutional investors,
indirect funding with banks as the go-between connecting the including pension funds and insurance companies. In this way,
saver and user. capital markets have a deeper impact on society. Through the
use of derivatives, well-developed markets provide risk The housing gap in these countries poses similar challenges.
management tools not only to market participants, but also to Globally, one billion people in urban areas lack access to
end users as diverse as companies and agriculture producers. adequate housing. By 2030, three billion people, or 40 percent
Well-developed capital markets also provide benefits at the of the global population, will need new houses. That translates
macroeconomic level by supporting monetary policy into some 565 million new housing units. Yet mortgage
transmission, which is facilitated through liquid securities penetration remains between 1 and 2 percent in most low-
markets. Further, they can serve as a “spare tire” for the income countries. Neither the government nor the banking
financial sector, enhancing financial stability and reducing sector can provide the investment funding needed in such key
vulnerabilities to exchange rate shocks and sudden interruptions strategic sectors. The only real alternative is greater use of
of capital flows. World Bank Group research has shown that primary capital markets—both local and international—to help
emerging market countries with robust government bond close the gap.
markets were better able to manage the 2008 global financial For emerging markets, the benefits enumerated above render
crisis, averting major economic dislocations and helping firms more extensive use of capital markets for investment financing
and citizens maintain financial solvency and liquidity.2 both desirable and beneficial.
Moreover, in most countries, as a result of rapid economic
growth, population growth, and urbanization, the financing Varying role of Capital markets
needs of infrastructure, housing, and climate adaptation and The map below illustrates the relative size of each country or
mitigation are staggering. territory’s free-float stock market, via relative land area. The
stock market capitalization of emerging market countries,
On infrastructure alone it is estimated that an additional $1 including those in Asia, remains significantly smaller than that
trillion to $1.5 trillion in annual investment will be needed in of advanced economies.
low-income and middle-income countries through 2020 in
order to meet the demand from industry and households.
Figure 1: Global Free-Float Stock-Market Capitalization by Country, in $ Billions
Source: Bank of America Merrill Lynch, Transforming World Atlas, August 4, 2015
There is also a wide variation among emerging market countries countries where capital markets currently play no role (usually in
in terms of the development of capital markets, ranging from smaller and low-income countries) to countries where they already
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play a role in providing financing for the government and larger Capital Markets as formalized Security Markets
firms in the corporate sector (including the banking sector). In
some of the larger emerging market countries, capital markets are Capital markets have existed in some shape or form for
beginning to play a role in the housing sector and infrastructure hundreds of years, often with fascinating and colorful histories.
In Europe, the roots of modern, highly sophisticated stock
financing. But in the majority of emerging markets, the use of
exchanges such as the London Stock Exchange can be traced
capital markets for investment financing still has a long way to go
to the 17th century. The London Stock Exchange played a key
to help countries enhance the availability of long-term funding. role in the Industrial Revolution, when many new ventures
were launched that needed financing.
Challenges in Developing Capital Markets
While the benefits are clear, the potential for and timing of capital In the United States, the New York Stock Exchange (NYSE)—
market development are to a large extent dependent on the level a powerhouse of transactions, technology and innovation—
of economic and structural development of a country. That is, a evolved from humble beginnings on a Manhattan street corner
country’s starting point heavily dictates the recipe for timing, where intrepid, all-weather street traders, once called curbstone
sequencing, and even the feasibility of what can be done in terms brokers, plied their trade. The NYSE was formed by brokers
of developing local capital markets. under the Buttonwood Agreement of 1792, so called because it
was signed under a buttonwood tree.
There is a high correlation between fundamentals —in particular
The Bombay Stock Exchange was established in 1830 and is
the size of the economy in terms of aggregate gross domestic
one of the oldest exchanges in Asia. The Hong Kong securities
product and per capita income—and the level of development of market can be traced back to 1866 but the stock market was
the local capital markets. This explains in large part why, in formally set up in 1891 when the Association of Stockbrokers
general, capital markets are at an embryonic stage in smaller and in Hong Kong was established.
low-income countries. For larger and middle-income countries,
significant differences across countries are explained more by In larger and middle-income countries, near-term improvements
institutional development, the size of the institutional investor can more easily be achieved through policy reform and
base, the level of contractual savings such as pension funds, and institutional development. However, in almost all middle-income
macroeconomic stability. countries, development of bond markets for all but the largest
An essential condition for a well-functioning financial system— non-financial corporations remains quite low and is the most
with both banks and capital markets—is the existence of sound important challenge for further local market development.
macroeconomic and policy frameworks.3 The institutional Typically, capital market offerings of debt securities start with the
framework is also critical, as markets depend on investor highest credit quality issuers that are able to attract investors in a
confidence and strong institutions provide the basis for investor nascent market.6 The highest quality issuer, particularly in local
and creditor protection.4 5 currency, is typically the government, and government bond
markets—beginning with short term money market instruments
As with any economic activity, capital markets are not without and extending to longer tenor bonds—form a basis for further
risks. These include the potential for asymmetric information market development by establishing price points along a yield
between savers and users, non-transparency and lack of adequate curve and providing instruments for liquidity management.
regulation and monitoring of issuers, lack of adequate and
efficient market infrastructure for issuing, trading, clearing and They also provide a critical mass of securities to support market
settlement, and the potential for increased volatility due to infrastructure development. Banks are often the next issuers able
liquidity, interest rate and rollover risks. to come to market. While banks may benefit from including
capital market instruments in the funding mix to better match
At their best, capital markets enable tailored matching of cash liabilities to assets, they tend to have a ready source of liquidity
flow profiles and risk appetites between investors and issuers, from deposits available to service their obligations. As regulated
enhancing economic welfare for all parties. To reliably extract the institutions, there is often more transparency about banks’ cash
benefits of well-functioning markets, adequate regulation for flows and the capital necessary to support meeting a debt
issuers, investors, and intermediaries in addition to robust obligation.
supervisory arrangements to protect investors, promote deep and
liquid markets, and manage systemic risk are critical. Thus, in many markets banks are the first corporates to issue
bonds, and in some markets the types of funding extend to covered
Such a framework in turn needs to be anchored in a good bonds or other securitization structures that are more closely
investment climate that includes a sound taxation and accounting linked to the banks’ underlying loan books. Eventually other
framework, reliable and quality accountancy, creditor rights, sectors may follow as the investor base builds familiarity with the
property rights, and bankruptcy and competition law. Finally, market and instruments. Utilities, which typically have long-term
markets need an infrastructure—exchanges and trading platforms, capital investment needs but steady and predictable cash flows,
clearing houses, and custodians—to develop. may follow, and then other corporates. In parallel, it is critical that
efforts be focused on developing the investor base. Some and advisory support, including a broad range of activities aimed
countries may be able to tap international investors, but this will at developing both government and non-government bond
require adequate macro stability to make the country attractive to markets.
external investors, in addition to investor protections and In the government bond market, the Bank Group assists
transparency to make the capital market instruments attractive. governments in improving their debt management, building more
For most countries, however, the most reliable and stable investor liquid yield curves to serve as a benchmark for private bond
base will be local. Nurturing domestic investible asset pools via markets, and enhancing market infrastructure. In the non-
pensions, insurance, and savings vehicles for individuals to government bond market, the Bank Group actively works with
deploy into capital markets is critical for local sustainable capital local regulators to improve regulation and supervision of the
market development. Pension reform, development of the local markets (including issuers, market infrastructure, intermediaries,
insurance industry, and an increase in household savings are often and institutional investors), to improve market infrastructure, and,
part of a comprehensive capital market development program. depending on the country, to promote an enabling environment,
For countries that lack the scale or size for rapid and efficient especially in terms of taxation and accounting issues.
development of local markets, capital markets linkages—these Case Study: Local Currency Issue of Umuganda Bond
include safely accessing international capital markets, promoting
foreign listings, and regional exchanges—could also be Issued in May 2014, this bond marked IFC’s inaugural
considered, although World Bank Group experience shows these issuance under the Pan-African Domestic Medium Term Note
to have mixed outcomes. Programme in East Africa. It was also the first international
AAA-rated Rwandan Franc bond issuance in Rwanda and the
While greater reliance on international markets and investors is first non-sovereign issuance since 2010. The bond was
not a perfect substitute for local markets in every respect, their use intended to increase access to long-term local-currency finance
may be a feasible option for the foreseeable future for many small for local businesses while strengthening the country’s domestic
countries (including poorer and fragile and conflict countries), to capital markets.
have a more direct form of access to foreign savings other than The bond is listed on the Rwanda Stock Exchange. The
official flows and interbank transfers for lending to their private issuance attracted strong participation from both local and
sectors. international investors and was more than twice
For many emerging economies where domestic savings rates are oversubscribed. Issuance managers were Standard Bank/
low, attracting greater portfolio inflows into private sector Stanbic Kenya, and Bank of Kigali, Rwanda.
securities could be an attractive option. This requires proper Bond characteristics: Senior Unsecured Notes with a 5-year
safeguard rules, however, to handle risks such as currency tenor and a bullet repayment due 2019; a semi-annual fixed rate
mismatches and “sudden stops”, or abrupt reductions in net capital coupon (12.25%); and no 5-year government benchmark yield.
flows into the economy. International institutional investors have Its regulatory status features include 0% risk weighting for
hundreds of billions of dollars that can be put to work in emerging computing capital adequacy; liquid asset status; repo
markets. At present, however, the investible universe is almost eligibility; and 100% admissibility as an asset for insurance
exclusively government bonds and bonds of the largest company solvency ratios.
corporates. At the same time, international investors have an
Source: IFC Debt Capital Markets Solutions, IFC 2016
increasing appetite for local currency bonds or bonds indexed to
the exchange rate. Even after emerging market economies began Bank Group programs have been implemented in countries as
to slow in 2015, there remains an appetite for the higher yields diverse as Costa Rica, Egypt, Kenya, Lebanon, Morocco, Nigeria,
available in the developed world. Romania, and Turkey. In a few larger emerging economies—
including Brazil, Colombia, Indonesia, Peru, and South Africa—
Achieving these objectives will be challenging. Given the small
the Bank Group through its advisory services supports the
size and relative non-transparency of most emerging market
corporates, bank loans are likely to remain the preferred form of mobilization of institutional investors in the funding of strategic
funding over bond issues. One approach to capital market sectors such as infrastructure financing. A key component of such
development might likely involve new forms of packaging loans support is the development of instruments and guarantees to align
the risk-return appetite of institutional investors.
into securities and involvement of International Financial
Institutions to assist with structuring and credit enhancements. The Bank Group also promotes the development of innovative
global products to further catalyze local market development. In
Supporting Resilient Capital Markets
Brazil, an issuer-driven exchange-traded fund structure aimed at
Since its founding, the World Bank Group has been helping enhancing market-making and consolidating local currency
countries develop capital markets and access international indices is being implemented for government bonds. In Kenya,
markets for investment financing. This includes both transactions the Treasury Mobile Direct project is focused on improving retail
This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group.
access to government instruments by distributing these happens in stages. Therefore some sequencing of policies is
instruments through mobile phones. essential.
This is particularly true for debt markets, which require well-
IFC plays an important role in catalyzing capital market functioning money markets to create government bond markets,
development by investing in private sector transactions either as and they in turn are essential for corporate bond markets.
a sole investor or as an anchor investor in bonds, structured Understanding the linkages between different segments of the
securities (securitizations across different asset classes), as a market and their building blocks is critical to ensuring a proper
credit enhancer or anchor investor, and in new products, sequencing of policy and regulatory reforms.
instruments and investment funds aimed at bringing new asset
classes to the market or supporting strategic sectors with private The experiences of countries across the globe shows that capital
financing. IFC also provides local currency solutions and credit markets development is a gradual process requiring strong
enhancements to facilitate access to capital markets for its clients. leadership from government authorities as well as a significant
And IFC has a robust local currency bond issuance program and commitment of time and resources. If done correctly, the payoffs
has issued bonds in 17 countries. can be substantial and long-term. The strategic imperative,
As one of the world’s largest financiers of climate-smart projects however, is to develop strategies that fit the particular country
for emerging markets, IFC was one of the earliest issuers of green circumstances.
bonds. It launched a green bond program in 2010 to help catalyze
Meera Narayanaswamy, Senior Investment Officer – Financial
and unlock investment for private sector projects that support
Institutions Group, IFC (mnarayanaswamy@ifc.org)
renewable energy and energy efficiency.
Charles Blitzer, Senior Advisor – Financial Institutions Group,
Conclusion IFC (cblitzer@ifc.org)
Capital markets development rarely follows a linear path.
Developing local capital markets and making greater use of them Ana Carvajal, Lead Financial Sector Specialist, Finance &
to fund private investment and strategic economic needs tends to Markets, World Bank (acarvajal2@worldbank.org)
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This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group.