Why vibrant capital markets are key to investors, businessesFriday September 02 2022
Outside of South Africa, Africa's financial markets are small and undeveloped, largely dominated by commercial banks. Worse, a disproportionate share of bank lending is allocated to the public sector. This has crowded out the private sector who are left to foreign borrowing which entails foreign exchange risk that increases its cost.
The outcome: credit for firms, especially for small and medium-sized enterprises (SMEs), is limited and produces low investment rates. The ratio of credit to the economy averages less than 20 percent of gross domestic product (GDP), compared with 138percent in East Asia and the Pacific region for instance. In short, the underdevelopment of capital markets hurts critical progress.
Why do we need vibrant capital markets? For the investor, they offer a gateway to both retail and institutional investors to participate in the financial economy. For the SME, they enhance the connection of savers and borrowers outside traditional banks that serve retail and corporate customers.
Often, they serve as a natural step for SMEs at their maturity in the corporate life cycle. Essentially, they serve as a fundraising platform to raise large amounts of capital for expansion and as a sales vehicle to let entrepreneurs lower their stake in the business. Their participation also provides businesses with higher name recognition.
But why aren’t our capital markets not vibrant? Unfortunately, most remain underdeveloped, with small market capitalisations, few listed companies, and less liquidity than exchanges in other developed economies.
Despite 28 African countries having stock exchanges, in contrast to 1989, when only five had them (with limited equity and bond market trading), outside of Johannesburg Stock Exchange, most remain thin and illiquid. Furthermore, most institutional funds are not well represented.
It is estimated that African pension funds hold an estimated Kes 70 trillion, but little of it is being deployed to support business growth. Historically, it’s been very much focussed on government securities and real estate. In addition, this money is also restricted from travelling abroad, where markets might be more appealing.
Kenyan insurance funds, for example, have a hard cap at 5percent on foreign investments. Similarly, our mutual funds to GDP ratio stands at 1.1percent, which is low compared to more developed countries such as the United Kingdom and United States which have a ratio of 174.0percent and 125.4percent respectively.
What’s the remedy? Regulators should allow institutional investors to embrace more risk. More facilitation of cross-border investment could also open up the markets to a diverse portfolio and capital raising opportunities. This is why the Africa Exchange Linkage project (AELP) is key.
Tied to this is the new African Continental Free Trade Area (AfCFTA) which is a great catalyst. AfCFTA provides great opportunities for African capital markets to expand by creating enlarged markets, economies of scale, increased competitiveness and more opportunities to invest in African markets and firms. More innovative products will also boost the markets.
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