As one of the most powerful drivers of economic growth and wealth creation, capital markets account for USD 178 trillion globally. Governments and companies can access long-term finance in local currency through a well-developed domestic capital market, increasing investments in innovation and fostering sustainable growth with more significant employment opportunities.
Capital markets will play a crucial role in facilitating the mobilization of private capital in sectors such as infrastructure, housing, SME financing, and climate action financing in the future. Capital markets offer many benefits, but many emerging and developing economies cannot take advantage of them.
Emerging markets accounted for 11% of equity and debt issuances in 2019, excluding China. As a result, understanding the conditions for well-functioning domestic capital markets is crucial for policymakers and other key stakeholders.
What Are Capital Markets?
The term “capital markets” describes a portion of the financial system designed to direct an economy’s savings to individuals needing money. Financial instruments and securities facilitate these capital transfers.
Several assets can be considered for these types of investments, such as money market assets, sovereign bonds, non-sovereign bonds, securitized assets, mortgage-backed securities, and shares of companies.
As opposed to deposits, these investments involve risk for investors. Investors purchase financial instruments from issuers (governments, companies, collective investment schemes, special purpose vehicles) and then trade them in the secondary market. It is possible to offer securities in a private placement or a public offering.
Only institutional and knowledgeable investors can participate in private placements, and there is little price transparency and trading activity. All investors, including retail investors, can access securities issued under a public offering, and they are traded on regulated markets with sufficient price transparency before and after trading.
For capital markets to function, a series of market infrastructures are necessary. Among them are trading platforms, clearinghouses, central securities depositories, and a capital markets-specific legal and regulatory framework overseen and enforced by the government.
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Why Capital Markets?
The development of capital markets contributes to economic growth, which in turn contributes to creating jobs. It is well documented in the empirical literature that capital market development is associated with economic growth.
Companies may be able to hire more people and increase real wages as a result of capital markets as they mobilize additional savings into the economy.
Well-developed capital markets provide corporations with an essential source of financing. The capital markets can be attractive to companies with access to bank funding since they can offer more significant volumes of funding, longer maturities, and, potentially, better terms, thereby reducing overall funding costs. For companies seeking to expand their operations, this funding can be essential.
Investors benefit from capital markets by accessing investment opportunities and risk management tools. First, although having a larger risk than bank savings, capital markets might provide more enticing investment options. Additionally, capital markets can help investors manage risk by providing a diverse portfolio of instruments.
Capital markets that are well regulated and supervised may contribute to financial stability in addition to economic growth. Investors, companies, and governments can access long-term, local currency financing on domestic capital markets to manage inflation, foreign exchange risks, and mismatches in maturity.
However, capital markets are not risk-free. To provide helpful advice to investors and appropriately manage their financial positions, market participants will need to understand the risks associated with any new financial instrument.
What is the State of Capital Markets Development in Economies?
Despite their importance, capital markets remain underdeveloped in most emerging and developing economies. Developed capital markets do not have a universally accepted definition; however, they have four key characteristics: size, accessibility, depth, and efficiency.
According to an analysis of three of those four attributes, emerging and developing economies’ capital markets are still in the early stages of development. However, some aspects of them are improving.
A few companies have used the capital markets to fund themselves in most emerging and developing economies, primarily financial institutions; the domestic capital markets still lack liquidity, especially for non-sovereign issuances.
Pension funds have already experienced significant growth in some emerging and developing economies, while other institutional investors typically lag. However, in many countries, retail investors are also starting to play a more prominent role, primarily through mutual funds.
Capital markets, as a result, only play a limited role in channeling resources to corporations and providing investment opportunities to investors in most emerging markets and developing economies.
In this context, it is essential to comprehend how capital markets evolve, especially whether there are any prerequisites for this development to take off.
With the Sustainable Development Goals (SDGs) as a challenge, capital markets have an even greater potential to contribute to the growth of emerging and developing economies. To achieve the SDGs, significant financing gaps exist in key sectors. Deep, effective, and well-regulated capital markets can open access to long-term, local currency financing.
The evolution of the capital market may be divided into two separate stages: the early stages, during which the government dominates, and the later stages, during which the capital market begins to service the private sector.
The success of capital market development depends on the preconditions and drivers of each phase. With the development of capital markets, intangibles such as financial sophistication, a culture of risk-taking, and human capital quality become more significant.