www.ifc.org/thoughtleadership NOTE 77 • JAN 2020 Creating Domestic Capital Markets in Developing Countries: Perspectives from Market Participants By Dimitri G. Demekas and Anica Nerlich Domestic capital markets that are deep, efficient, and well-regulated can create access to long- term, local-currency finance. Interviews with market participants reveal four important findings. First, there are two distinct phases of capital market development, an embryonic phase in which the government is predominant and a mature phase in which the capital market starts to serve the private sector. Each phase has distinct preconditions and drivers that determine the success of capital market development. Second, capital market development requires continuous monitoring and policy interventions due to changing market stages, some of them stable but suboptimal. Third, while capital markets are a crucial source of large volume, long-term local currency finance, they often fail smaller countries and companies. Finally, as the capital market develops, intangible or “soft” factors become more important, including financial sophistication, a culture of trading and risk-taking, the quality of human capital, and an appreciation of transparency. What is a “developed” capital market? In the absence of a But how do countries reach this state of “development”? Are precise and universally accepted definition, for the purposes of there any rules that need to be followed, any preconditions these interviews—and therefore for this note—a “developed” that must be in place? The international development capital market is understood to be one in which participants community and various policymakers in developing and buy and sell freely a wide range of financial assets, including emerging markets have asked themselves these questions fixed income and equity, with reasonable regularity and price over many years. The answers, however, remain vague and transparency, and where liquidity is sufficient to make the unsatisfactory. While this note does not claim to provide the prices of these assets reflect underlying market conditions. remedy, it hopes to shed light from a different perspective. Anything short of this admittedly loose standard is considered Within the World Bank Group’s Joint Capital Markets Program an underdeveloped capital market, one with room to grow (see Box 1 below for details), 38 structured interviews were and mature. Note that this definition does not incorporate conducted during April-May 2019 with about 100 counterparts minimum market capitalization, volume of transactions, or from 16 countries, representing domestic and foreign market liquidity as criteria of “development” (there are no such institutional investors, investment banks, finance companies, broadly accepted quantitative thresholds in the literature), nor asset managers, debt issuers, market infrastructures, broker- does it require a certain contribution of the capital market to dealers, regulators, and other capital market participants. The investment and growth. It simply requires that a market exists Joint Capital Markets Program (J-CAP) interviews focused on for a broad range of domestic financial assets and that prices the conditions and policies necessary for the development of clear this market at least most of the time. domestic capital markets in emerging markets. The real-world About the Authors Dimitri G. Demekas, Visiting Senior Fellow at the Institute of Global Affairs, London School of Economics and Political Science (LSE), London, United Kingdom, and Anica Nerlich, Financial Analyst at Global Macro and Market Research, Economics and Private Sector Development, IFC. They can be reached via jcap@worldbankgroup.org. 1 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. insights from the interviews complement the theoretical and domestic investor base is likely to be dominated by banks. empirical literature and, in some cases, challenge the received Foreign investors may be present in this market—in smaller wisdom, particularly with regard to the ability of market forces markets they may indeed have a substantial presence—but are to deliver optimal outcomes and the role of the government. typically focused on yield, with a relatively short-term horizon. A “Rule of Thumb” for Capital Markets Development And there is a late phase, in which domestic companies start tapping the capital markets more frequently, issuing equity The market participant interviews highlighted a wide diversity and/or fixed income instruments. While this phase sees a of country experiences. Each country is different, so the pace of large spectrum of development ranging from small and infant capital markets development varies considerably with country capital markets that consist of only a few non-sovereign specific circumstances, global market conditions, and exogenous issuers (such as Kenya), to markets that are already fairly events. Such events could include market shocks or defaults of advanced and large (such as India), there are three common domestic companies. Even if these do not otherwise have a major characteristics. First, a domestic non-sovereign issuer base is or lasting economic impact, they could have a significant adverse emerging. In many countries, the market for equity appears effect on the confidence of market participants and slow the first and the market for corporate debt develops later. development of the market. In other cases, historical factors such There are some notable exceptions where corporate debt as a legacy of public ownership of companies play a key role in markets emerge early, many of them in Latin America. shaping the future development of the domestic capital markets. Second, domestic non-bank institutional investors (such as This diversity notwithstanding, on the basis of the experience insurance companies and pension funds) emerge and begin to of market participants, the development of the capital markets play a central role. Retail investors also start to participate, seems in most cases to follow a general pattern with distinct either directly or indirectly through mutual funds. Foreign stages. This general pattern should be treated more like a rule of investors may be present—in some cases they may even start thumb rather than a general law for capital markets development. becoming long-term or strategic partners for governments There are exceptions to the rule, and the length and specific and listed companies. And third, there is a fairly sophisticated characteristics of each stage can vary from country to country. legal and regulatory framework as well as a functioning But at least at a high level, there are sufficient similarities to allow market infrastructure, including an organized exchange or some useful generalizations. trading platform, a clearing house, and a depository. There We can distinguish two phases in the development of a domestic may be some secondary trading, at least for government debt. capital market. There is an early phase, in which the market Overall, a capital market in this phase of development may not is still embryonic. In almost all countries in this phase of yet play an important role in the overall allocation of savings; development, the government is the predominant—and in some it may not be a major source of capital or funding for private cases the only—issuer of debt in the market, in order to finance companies; and it may be illiquid. But it has started serving the fiscal deficit. The issuance is typically in domestic currency. the private sector, albeit in a limited way, and has acquired a The government may also be issuing foreign currency debt, degree of breadth and sophistication that distinguishes it from typically in offshore markets. There is little secondary trading more primitive markets in the first phase. and few if any other financial instruments. An organized To be sure, the distinction between these phases is somewhat exchange may exist but is likely to be limited in reach. The arbitrary, and not all capital markets fall neatly into either. BOX 1 Joint Capital Markets Program The World Bank and IFC launched the Joint Capital Markets Program (“J-CAP”) in mid-2017 to support the development of local capital markets. J-CAP mobilizes experts across the World Bank Group to advance deep, efficient, and well-regulated local capital markets that create access to long-term, local-currency finance. Such domestic capital markets are the foundation of a thriving private sector and the key driver for employment and sustainable growth. J-CAP initially focuses on six target countries—Bangladesh, Kenya, Morocco, Peru, Vietnam, and Indonesia — and one target region, the West African Economic & Monetary Union. Under J-CAP, World Bank and IFC experts work with investors to mobilize local and global savings, to prepare for market transactions through advisory services, and to develop institutional investors (i.e., pension funds and mutual funds) and new instruments for investment capital (i.e., SME securitization, mortgage securities, infra funds, and green bonds). For more information, see: https://www.ifc.org/wps/wcm/connect/Industry_EXT_Content/IFC_External_ Corporate_Site/Financial+Institutions/Priorities/Capital-Markets/ 2 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. Nevertheless, the two categories provide a basis for a structured even though a modern capital market law had been passed discussion of the key factors behind capital market development. by parliament, extended delays in preparing implementing regulations and in regulatory approval of new plain-vanilla Key Factors Behind Capital Market Development mutual funds—which in other Latin American countries There were several factors that interview participants took at most a few days—were seen as major obstacles for highlighted as important for the development of capital the establishment of a viable market. Technical assistance or markets. Some of these were seen as fundamental: They are knowledge transfer from abroad could help in these areas but necessary even at the earliest stages of market development. were not sufficient. Other factors become more important as the capital market Once these essential preconditions are in place and a grows, and they are needed for the market to continue functioning domestic capital market is established—usually, at maturing and move to the next phase of development. this early phase of development, just for government debt—a number of additional growth drivers were identified by Early Phase Factors interview participants as beneficial for the gradual deepening There was near universal agreement among interview of the market. These drivers would, over time, allow the capital participants on the indispensable preconditions for the market to mature into the next phase of its development. emergence of functioning capital markets. Consolidating and standardizing the issuance of government A basic legal and operational infrastructure. This comprises a debt on a regular schedule for a range of maturities would help legal and institutional framework that ensures the clarity and create an orderly and predictable market. This would encourage enforceability of property rights for capital market instruments the entry of new investors, including foreign investors, and and collateral; the transparency of the regulatory treatment of increase liquidity. Regular issuance of a few benchmark trading activity; and a reasonably effective dispute resolution maturities (say, one, two, five, and ten years) would also mechanism. (In the case of India, for example, the multiplicity establish a meaningful yield curve, which is critical to the pricing of laws and regulatory agencies involved in various aspects of other domestic currency instruments. of capital market activity, as well as the ease with which civil Being included in an internationally recognized index, such disputes could be turned into criminal disputes, were mentioned as the J.P. Morgan Government Bond Index (GBI) (for local as factors that had held back market development in the currency EM sovereign debt), provided that a strong central past.) It also includes the ability to open accounts and execute bank and a large domestic investor base are in place. Once a transactions efficiently, as this is a major hurdle in certain country is included in the index, global index-tracking funds jurisdictions, especially for foreign investors. Also needed is would have to invest in the country’s debt and large institutional the presence of custodians (typically local banks) with clear investors would also tend to make discretionary allocations. At separation between clients’ assets and their own. the same time, interview participants acknowledged that not Policy coherence and continuity. Most participants mentioned all countries could take this step: Smaller emerging markets, that at least up to a point, economic and political instability in particular, would find it difficult to meet the requirements were expected in frontier markets and did not deter for inclusion in such indices, especially those for minimum investors—including foreign investors. However, all agreed outstanding amount and trading liquidity. Further, market that regardless of the stability or political orientation of the participants pointed out that, if not managed well, foreign flows government, a certain degree of continuity in the fundamental can increase volatility and financial risk. A strong central bank approach vis-à-vis the capital market was necessary. This was is required as well as a sufficiently large domestic investor base especially crucial in the early stages of market development, that can counterbalance potential sudden stops. Nonetheless, when several institutional and legal reforms may be necessary all interview participants agreed that policymakers in emerging to establish a functioning market—reforms that often take markets should strive to have their country included in an years to prepare and sustained effort to implement. index, if at all possible. The quality of the regulator and public administration. Access to an International Central Securities Depository Many participants stressed that this factor was critical for (ICSD), such as Euroclear or Clearstream, is another step that early-phase market development. Since most initiatives and could allow local issuers to diversify their investor base and innovations at this stage are top-down and typically driven by access international investors. “Euroclearability” (the term is the regulator, the quality of the regulatory agency and, more used here for both ICSDs) is defined as an environment where broadly, of the public administration was essential for effective international investors are able to access the domestic capital planning and delivery. In the case of Argentina, for example, market easily, with efficient processes for asset ownership and 3 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. transfer. A number of emerging markets including Russia, Peru, the long maturities of their domestic currency liabilities and, Chile, and Poland have established these conditions and are in many cases, are required to invest the bulk of their assets at now Euroclearable. It has been estimated that Euroclearability is home. Retail investors also have a role to play but they typically associated with a reduction in sovereign borrowing costs of 28 come into the market later and through mutual funds. They basis points in primary bond issues.1 Some interview participants also have a shorter time horizon than institutional investors noted, however, that while the reforms required to prepare the and tend to be less sophisticated and more sensitive to political country for Euroclearability were beneficial, Euroclearability and economic uncertainty. As regards foreign investors, most itself was not necessary: A number of emerging markets with interview participants felt their presence has several benefits: relatively developed capital markets in which foreign investors It increases liquidity, opens up the market, and engenders had a sizeable presence, such as Brazil and India, did not have improvements in transparency and corporate governance, Euroclearable debt. In any case, participants saw Euroclearability etc. But as mentioned earlier, foreign investors play at best a as the “end game” for early-phase capital markets: A country that supporting role: They can’t be the main driving force behind had implemented the reforms required to achieve Euroclearability domestic capital market deepening. This requires large, already had a relatively mature capital market. committed, and reasonably sophisticated domestic investors. Late Phase Factors Once the capital market has matured into the late phase of development and the private sector has begun to access it, One of the key preconditions for a market to transition from interview participants identified a number of additional drivers the early to the late phase was a low and stable risk-free rate. that would help the market deepen further and broaden This was universally seen as a necessary condition for the its reach. The discussions, however, also highlighted two private sector to be able to tap the domestic capital market in important caveats. These challenge the neoclassical economics a significant way. This was crucial for corporate fixed income canon and underscore the importance of real-world insights. issuance but also important for equity. In countries where sovereign yields are persistently high, the government dominates First, as markets mature, idiosyncratic and intangible factors debt issuance and crowds out demand for other instruments, play an increasingly important role. Such factors include especially longer-term instruments. For example, in the case of the degree of financial sophistication, a tradition of public Argentina, as well as elsewhere, participants noted that there ownership, a culture of trading, as well as the interaction is currently little or no investor appetite for private long-term between the market and the broader economic and social domestic currency fixed income instruments, even if they are context. These factors are not typically covered in empirical inflation-indexed: The real returns on government debt are investigations into capital market development in the simply too high for private issuers to compete with. economic literature. A low and stable risk-free rate is usually associated Second, the process of capital market deepening is not with a stable macroeconomic environment. High yields necessarily continuous and self-sustaining. Even after the on government debt are often driven by a history of market has reached the late phase of development and appears macroeconomic instability—high inflation and large fiscal well established, continued deepening is not guaranteed: Stalls deficits—but could also reflect default risk. Macroeconomic and even reversals are possible. In a number of countries stability seems to be especially important in the early phase discussed in the interviews, such as Morocco, Colombia, and of a markets’ development. Once market participants have the Dominican Republic, the market had reached a certain level developed a certain level of trust, it seems to become less of capitalization and then stopped developing or, in some cases, important and more a matter of risk and price. started shrinking. Although there were no major institutional or regulatory obstacles to further deepening, the market seemed to A critical mass of domestic savings and large local investors have reached a stable, if suboptimal, equilibrium. was another factor underscored by most interview participants. While a rudimentary market concentrated in government debt With these caveats in mind, we turn to the discussion of the can be sustained with a few domestic investors—typically growth drivers that a majority of interview participants identified banks, which are required by regulation to invest part of their as important for capital markets in the late phase of development. portfolios in government paper—and some foreign investors, The role of domestic banks was discussed at length. Most it cannot start serving the private sector without a broader participants felt that domestic banks play a crucial role in set of domestic investors with a long-term commitment to the the early phase of market development: They act as primary market. Domestic insurance companies and pension funds are dealers for government debt, as investors, and as a bridge for the natural candidates to play this role: They need to match foreign investors trying to enter the market. As the market 4 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. develops, however, their role becomes more ambiguous. On information and submit to market scrutiny, fear of potential one hand, banks continue to be major players in the market tax consequences, and reluctance to share control with other and, in some cases, significant issuers of bonds. On the other shareholders were major obstacles to market deepening. These hand, their dominant position in credit provision becomes a factors, partly reflecting deep-seated cultural attitudes, were hurdle for the budding corporate debt market: In several of the difficult to overcome. In a number of countries, including India countries discussed in the interviews, domestic companies have and Brazil, interview participants mentioned that the stock little appetite to issue debt in the market—with the attendant exchange was playing a key role in addressing these concerns disclosure requirements and increased market scrutiny—since by educating and altering company owners’ attitudes and their credit needs are covered by banks. Moreover, some preparing companies for issuance. All stressed, however, that interview participants speculated that in countries where this process takes years and can sometimes go into reverse. domestic commercial banks own the largest broker-dealers Efficient market functioning was seen as an important factor by and investment bank outfits—for example in the Dominican all participants. Most mentioned liquidity in this connection: Republic—the latter may have limited incentives to encourage A shallow market with a small free float (for equities), corporate debt issuance. Thus, it is important for regulators infrequent issuance (for corporate fixed income paper), and a to clearly define the rules and functions of different financial preponderance of buy-and-hold investors is unlikely to become sector players and reinforce those by adequate regulation. a significant source of capital or funding for the private sector. Corporate attitudes toward transparency, governance, and Market liquidity is also a major consideration for foreign control and the broader corporate culture play a major role in investor entry. As with size, there was no consensus on a the development of the capital market. In interviews spanning threshold that defines a liquid market: Some global investors countries in Latin America, Africa, and Asia, participants even said they often invest in illiquid markets if the premium is mentioned that for many companies—especially smaller, right. Instead of a certain minimum amount of trading volume, family-owned companies—an unwillingness to disclose bid-ask spread, or other commonly used quantitative liquidity TABLE 1 Development of Domestic Capital Markets – Early and Late Phases EARLY PHASE LATE PHASE A basic legal and operational infrastructure Two Important caveats: • Ensures/enforces property rights Idiosyncratic and intangible factors play an increasingly important role, • Provides dispute resolution including financial sophistication level, culture of trading, interaction between • Enables efficient transaction execution market and economy, and Policy coherence and continuity The process of capital market deepening is not necessarily continuous and • Provides predictability of regulation and oversight self-sustaining, and stalls and reversals are possible. The quality of the regulator and public Low and stable risk-free rate administration • Government yields need to fall to allow the capital market to grow • Quality of human capital at the regulator is Size of individual transactions essential to effective planning and deliverability • A minimum feasible transaction size is needed to attract buyers Consolidating and standardizing the issuance of Total Size of the Market government debt • A threshold of $100M to $200M of government debt outstanding is • Helps create an orderly and predictable market needed for sufficient liquidity • Encourages entry of new investors, including foreign investors Size of the Economy • Increases liquidity and creates a meaningful yield • Stock market development is difficult in economies with GDP under $20B curve • A critical mass of domestic savings and large local investors is needed Inclusion in an index Critical role of domestic banks • Critical to attracting large foreign institutional • Act as primary dealers for gov’t debt, as investors and a bridge for foreign investors investors • Forces many global index funds to allocate funds Other factors needed to the market • Efficient market functioning and liquidity • Visibility of price formation • Hedging instruments and derivatives • Ratings agencies • Corporate acceptance of transparency, governance, and control Source: IFC 5 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. metric, what foreign investors seemed to care most about was the pool of capital available to finance domestic investment; a diversified and uniform investor pool and a level-playing field lengthening maturities; increasing competition to the benefit of that doesn’t segregate foreign and domestic investors. This domestic issuers; and spurring improvements in transparency provides some assurance that “there would be someone on the and governance of domestic companies. other side of the trade if we decide to get out.” Needless to say, these benefits materialize only if the intention A related aspect of market efficiency underscored by both to open the market to foreign capital is sincere, sustained, and foreign and domestic investors was visibility of price formation. supported by a consistent legal, tax, and regulatory framework. Absent that, it is difficult to price risk and there are concerns However, interview participants stressed that the decision to about market integrity. Visibility of price formation requires open the domestic market to foreign capital is, for practical a certain amount of transparency and access to data, as well as enforcement of mark-to-market rules. Postponing marking- HIGH to-market because the market price is below book means that INCOME funds will not sell (or buy) and liquidity will dry up. Lastly, efficient market functioning was a necessary condition for the emergence of more sophisticated financial products such as hedging instruments and derivatives. These products Domestic $36,603 US Billion are particularly important for foreign investors. Based on Eurobond $447 US Billion the country experiences discussed in the interviews, foreign Global $70 US Billion exchange hedging instruments tend to appear first and interest LCY Offshore $5 US Billion Other Foreign $6 US Billion rate hedging instruments—also important for domestic investors—come later. TOTAL $37,132 US Billion The Role of Foreign Investors The role of opening the domestic capital market to foreign investors was a recurring theme in the interviews. As discussed earlier, most participants stressed that foreign investors alone are not sufficient for the domestic market to develop in a sustainable way: A critical mass of savings managed by domestic long-term investors is necessary. The approach of Domestic UPPER $5,753 US Billion foreign investors to developing and emerging markets remains MIDDLE Eurobond $374 US Billion largely motivated by yield premia. Thus, their investments are INCOME Global $181 US Billion LCY Offshore $39 US Billion often short-term and more volatile in nature, and a sensitivity Other Foreign $11 US Billion for liquidity in particular has been noticed following the financial crisis of 2007-2008. TOTAL $6,359 US Billion However, for a few large markets, a shift in strategy has become visible: Interview participants mentioned the case of LOWER Domestic $2,124 US Billion MIDDLE Eurobond $237 US Billion India, where the first wave of foreign entry into the domestic INCOME Global $26 US Billion equity market in the 1990s and early 2000s took the form LCY Offshore $14 US Billion of passive minority stakes in domestic companies, mainly Other Foreign $3 US Billion to “ride the macro wave.” This did not generate substantial TOTAL $2,404 US Billion benefits either for the companies or for the market as a whole. More recently, however, foreign investors have become LOW Domestic 23.1 US$Billion INCOME Eurobond 2.7 US$Billion more selective, acquiring larger stakes and backing specific technologies, companies, and management teams, and this TOTAL $25.8 US Billion approach seems to be much more beneficial. Unfortunately, the Domestic Eurobond Global LCY Offshore Other Foreign motivation and strategy of foreign investors is something over which country authorities have little information or control. FIGURE 1 Government Bond Markets—Domestic Still, nearly all participants thought that foreign entry into the versus International Issuance0 (US$ Billions) market brings substantial benefits: deepening and diversifying Source: Thomson Reuters. Note: LCY = Local Currency. 6 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. purposes, irreversible: Reversing it would generate so much While not the only reason, the need for size is one of the financial and reputational damage that most country authorities reasons that the benefits of capital markets do not spread avoid it at all costs. It is therefore critical to time and sequence equally to the small business sector. Other reasons can be tax this decision appropriately, taking into account the country’s implications that deter smaller companies from moving to balance of payments and, more broadly, macroeconomic the formal economy, or the unwillingness to give up control, stability, in order to minimize the risk of sudden stops or and this applies in particular to smaller and less sophisticated reversals to capital flow. personal or family-owned businesses. Market Failure: Small Economies and Enterprises The topic of finance for small and medium enterprises (SMEs) is extensively studied—it has been a G20 priority for some years— There was a broad agreement among interview participants that and lies outside the scope of this note. Nevertheless, it came up size matters for the development of capital markets. Although repeatedly during the discussions, underscoring the sobering fact there is no widely-accepted specific threshold, small economies that even in a developed capital market, the SME sector is likely may not be able to develop sustainable domestic capital markets, to remain underserved. And market forces alone are unlikely to as some empirical estimates suggest that stock markets do not close this gap. Thus, sustained effort and policy interventions seem to develop in countries with a GDP below $20 billion.2 are needed to help SMEs share in some of the benefits of capital Interestingly, interview participants did not seem to think that market development. regional markets such as the African Exchanges Linkage Project3 could be the solution to this problem. While these have benefits An Expansive Role for the Government for investors and could in principle improve liquidity, companies The government—defined broadly to include the central and issuers that are too small for a single national market would bank, regulatory agencies, and all institutions with a public be even smaller in a regional one. This is not to say that small policy mandate—has a crucial role to play in the development economies cannot develop or benefit from capital markets. It of the domestic capital market. The experience of market just requires a different approach; for example, Luxembourg participants, however, suggests that this role is broader and and Singapore have developed certain competitive advantages to more complex than what is usually reflected in the standard attract foreign issuers and investors. neoclassical economic literature. To be sure, the primary The total size of the market is also an important element, as responsibility of the government is to ensure the preconditions it correlates with market liquidity. Empirical estimates by for the capital market to function: Establish the basic legal the Bank for International Settlements suggest that there is and institutional framework; protect property rights; furnish a threshold of $100 million to $200 million of government the regulator with adequate independence and budgetary debt outstanding, below which sustaining a liquid government and human resources to do its work, including enforcement bond market may be difficult.4 A total outstanding amount of regulations; and stay the course, avoiding arbitrary and equivalent to $500 million was also one condition for capricious policy shifts. inclusion of a country in the J.P. Morgan Emerging Markets In addition, the government can help the capital market to Bond Index (EMBI) (for dollar-denominated EM bonds). deepen and better serve the private sector by maintaining Finally, the size of individual transactions was mentioned a prudent fiscal position and sound macroeconomic repeatedly by investors. For fixed income instruments in management. Doing so should over time result in low particular, there was broad agreement that issuance below a yields on government debt, which would in turn allow certain size could not attract buyers: The fixed costs would private companies to attract investors. Regular issuance make it uneconomical, especially for foreign investors, since of government paper on a range of maturities would also they generally face higher transaction costs and rarely, if ever, contribute to this goal by facilitating the pricing of risk and cover the entire issuance. However, there was a wide variance the lengthening of maturities. Yet experience shows that the of views regarding the minimum feasible transaction size: government may need to play a much more expansive role. Representatives of large global asset managers and investment In most cases discussed in the interviews, the government banks felt that tickets less than the equivalent of $50 million (or the regulator) led market reforms or innovations and the to $60 million would be uneconomical; other investors, market followed. To be sure, many of these reforms involved including hedge funds, suggested that much lower ticket sizes reducing the footprint of the government, for example through were feasible, depending on other aspects of the transaction privatizations and market liberalization. It was also understood (Armenia and Georgia were cited as examples here). that constant interference with market functioning can lead 7 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. to distortions. But other cases involved targeted market market deepening. Even if the “right” initial conditions are set interventions or changing the incentives of private market and market forces are allowed to operate, policy interventions participants. It appears that simple laissez faire may not be may still be necessary along the way. sufficient for capital market development and, moreover, that As the capital market develops, intangible factors become there is no single recipe for the balance between laissez faire more important. These include “soft” elements such as and policy intervention that applies in all instances. financial sophistication, a culture of trading and risk-taking, The government is uniquely placed to address country-specific the quality of human capital, attitudes toward transparency, issues that, according to interview participants, become and the willingness to transition from direct ownership and increasingly important in the later stages of market development. control of a business to indirect control through shareholding. This cannot happen by decree but requires “smart” and This stands in sharp contrast to the theoretical and empirical imaginative policies. These may involve funding financial literature on capital markets that focuses on “hard” facts such education, sponsoring initiatives by exchanges or associations, as size, macroeconomic performance, and compliance with or using state-owned entities or development banks to promote international standards. All these elements were also mentioned changes in corporate culture. For example, Brazil’s national by interview participants, but rarely as the most critical. development bank BNDS played a key role as strategic investor Lastly, opening the domestic capital market to foreigners has in private companies during the 1990s, helping them modernize a positive impact but is not sufficient to generate a sustained management and bring corporate governance to international process of market deepening. Foreign entry in the domestic standards (although it was also criticized for growing “too big” market has benefits and costs. It can increase competition, and is now in the process of reducing its balance sheet). provide a crucial additional savings pool, and spur innovation Finally, the government has a key role to play in addressing the and improvements in market functioning and transparency. market failures that deprive SMEs the benefits of the capital Yet foreign capital can also be fickle and subject to herd market. behavior, increasing volatility. Nevertheless, almost all respondents—including domestic respondents—said the net Concluding Observations impact of foreign capital in their markets had been positive. There is no general law of capital market development. All stressed, however, that a domestic capital market cannot Every country is unique, and the speed of capital market develop through the inflow of foreign savings alone, and deepening in each country reflects a host of factors, including instead requires domestic savings. country-specific circumstances, global market conditions, and exogenous events such as market shocks or defaults that can ACKNOWLEDGMENTS shake confidence and inhibit market development. Since several The authors would like to thank Luxembourg for its support of these factors are outside the control of policymakers, there of this study. The authors would also like to thank the is no uniform script for policymakers to follow in all countries following colleagues for their review and suggestions: Chris and under all circumstances. Richards, Principal Financial Officer, Global Macro and Market The process of capital market development is characterized Research Economics and Private Sector Development, IFC; Ana Carvajal, Lead Financial Sector Specialist, Long-Term by multiple equilibria, some of them stable but suboptimal, Finance, Finance, Competitiveness & Innovation, Equitable requiring continuous monitoring and policy interventions. After Growth, Finance & Institutions, World Bank; from Global an initial growth spurt, countries sometimes find themselves Macro and Market Research, Economics and Private Sector “stuck” with a capital market that does not function to its full Development, IFC: Birgit Reuter, Financial Officer, and Halil potential. Although all the obvious institutional and regulatory Ibrahim Cagatay Ozdemir, Consultant; Aaron Rosenberg, impediments may have been removed, the private incentives of Principal Communications Officer, Risk and Public Affairs, market participants do not stimulate further deepening, leaving Partnerships, Communication and Outreach, IFC; and the market at a stable but suboptimal equilibrium. At that Thomas Rehermann, Senior Economist, Thought Leadership, point, only policy intervention can catalyze the next level of Economics and Private Sector Development, IFC. 1 Euroclear. 2019. “Impact of Euroclearability.” 2 Quoted in De le Torre, Augusto and Sergio L. Schmukler. 2007. “Emerging Capital Markets and Globalization: the Latin American Experience.” World Bank and Stanford University Press. 3 The African Exchanges Linkage Project is an initiative to link trading on the stock exchanges of South Africa, Morocco, Egypt, Kenya, Nigeria, Mauritius, and the West African Economic and Monetary Union (WAEMU). 4 McCauley, R. and E. Remolona. 2000. “Size and Liquidity of Government Bond Markets.” BIS Quarterly Review, November, pp. 52-60 (available at https://www.bis.org/publ/r_qt0011f.pdf). 8 This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group.