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OP; market; economy; trading; market development; company; smaller economy; government securities market; country trading; market participant; Stock markets; Currency markets; Emerging and frontier financial markets; Interbank markets; Baltics; Central America; Africa; Southern Africa; West Africa; emerging market country; market player; market underdevelopment; Government securities; Caribbean
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Abstract

This paper surveys the foreign exchange markets, money and secondary government security markets, and stock exchanges in 107 smaller economy countries. The underdevelopment of these markets impedes risk transfer, monetary policy, corporate financing, and the capacity to absorb capital inflows. This study marks a first step toward formulating policies to develop essential smaller economy financial markets by documenting the stylized facts and presenting a framework for assessing the policy issues.

Annex I. Stylized Facts: Foreign Exchange Markets

This annex assembles stylized facts on foreign exchange markets in smaller economies and reports case studies with a view to providing a basis for the policy discussion in the main text. A lack of basic cross-country information is one of the central challenges to assessing foreign exchange market development policies in smaller economies. This annex aims to begin to fill this gap. Even the deepest and most liquid foreign exchange markets are a breed apart from other financial markets in that they are less efficient and do not reflect information on underlying fundamentals at high frequencies.42 The information reported in this annex suggests that foreign exchange markets in smaller economies are even more different. The first part of this annex summarizes the stylized facts about smaller economy foreign exchange markets based on the limited data sources and case studies of eight smaller economy foreign exchange markets, and the second part is made up of the case studies themselves.

Degree of Market Development

Foreign exchange markets are thin in smaller economies (Table A1.1). Foreign exchange market data are not available for most smaller economies, probably reflecting the informality of the markets.43 The paucity of hard data can be seen as an indication of the under-development of smaller economy foreign exchange markets. The data that are available indicate that foreign exchange market turnover to GDP for smaller economies is several times smaller than in emerging market countries, and orders of magnitude smaller than those of advanced countries. Further, the discrepancy is much larger when measured simply in dollar terms, which is the relevant metric for economies of scale.

Table A1.1.

Selected Countries: Foreign Exchange Market Annual Turnover

(In percent of GDP)

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Source: Bank for International Settlements (2004).

Interbank.

Reported by domestic dealers for 2004.

Also, a much smaller share of smaller economies report the existence of a forward foreign exchange market. All IMF member countries submit information for the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). As part of their submission countries indicate “The existence of a forward exchange market” and in most cases they provide a brief description. About half of smaller economies report the existence of a forward foreign exchange market, compared with 90 percent of both emerging market and advanced countries.

Smaller economy foreign exchange markets have relatively weak market-supporting arrangements. Survey data on the foreign exchange markets of a large number of smaller economies are available in Canales Kriljenko (2004). The survey results show that, compared to emerging market countries, a lower share of smaller economies have the market-supporting arrangements of committees of market players, a code of conduct, and dealer systems (Figure A1.1). Of course, the causality goes both ways here: thin markets undermine the incentive for players to incur the cost of setting up the market-supporting arrangements, while weak arrangements undermine market development.

Figure A1.1.
Figure A1.1.

Emerging Market Countries and Smaller Economies: Selected Foreign Exchange Market Aspects

Source: Canales Kriljenko (2004).

Smaller economy floaters have smaller median daily exchange rate movements (Figure A1.2). Exchange rate volatility for floating (managed float or independent float) exchange rate smaller economies and emerging market countries is compared by looking at the distribution of median daily exchange rate movements for the two country groups. The difference between the distributions of median daily exchange rate movements between smaller economies and emerging market countries is confirmed by Kolmogorov-Smirnov tests (Table A1.2). This outcome is rather a puzzle, because thin financial markets are typically associated with higher price volatility.

Figure A1.2.
Figure A1.2.

Median Daily Exchange Rate Percent Change, Emerging Markets and Smaller Economies with Floating Exchange Rate Arrangements

Sources: Bloomberg; Datastream; Reuters; and national authorities.
Table A1.2.

Kolmogorov-Smirnov Comparison Tests of Median Volatility of Daily Exchange Rate Movements for Smaller Economies and Emerging Market Countries

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Source: International Monetary Fund. Note: The null hypothesis is that distributions of the median volatility of daily exchange rate movements are the same between the two groups of countries. This hypothesis is rejected at the 1 percent level of all three years.

However, smaller economy floating exchange rate countries exhibit a relatively high share of days with large exchange rate changes. Compared to emerging market countries, the smaller economies have a much greater number of days with changes of more than 5 percent in the daily exchange rate (Figure A1.3). In this sense, smaller economies’ exchange rate markets are more volatile. The greater incidence of large daily exchange rate changes may reflect the greater susceptibility of smaller economy countries to shocks owing to the high concentration of their economy.

Figure A1.3.
Figure A1.3.

Maximum Daily Exchange Rate Percent Change, Emerging Markets and Smaller Economies with Floating Exchange Rate Arrangements

Sources: Bloomberg; Datastream; Reuters; and national authorities.

Potential Reasons for the Lack of Smaller Economy Foreign Exchange Market Development

The relatively small number of banks provides a likely explanation for the underdevelopment of smaller economy foreign exchange markets. The median number of smaller economy banks is only five, compared with 27 for emerging market floating exchange rate countries.

Foreign exchange market development is constrained by this small number of players, which also fosters collusion between the banks. In some countries there may be an informal understanding on the part of the banks, and even with the central bank, to limit exchange rate volatility, including by rationing (Table A1.3).

Table A1.3.

Smaller Economy and Emerging Market Floating Exchange Rate Countries: Number of Licensed Banks, 2004

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Source: Micco, Panizza, and Yáñez (2004).

Official capital flows for smaller economies are significantly higher than private flows. For emerging market countries, private net capital flows are about seven times official flows (Table A1.4), whereas this ratio is reversed for smaller economies. The low share of private capital inflows could help explain the thinness of smaller economy foreign exchange markets, because private capital flows are a key component of foreign exchange transactions and thus help drive foreign exchange market development.

Table A1.4.

Capital Inflows of Emerging Markets and Smaller Economies with Floating Arrangements, 2000–06

(Mean data; in percent except where noted)

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Central banks dominate foreign exchange markets in many, and perhaps most, smaller economies. The case studies, IMF technical assistance reports, and FSAPs indicate that central banks often dominate smaller economy foreign exchange markets by supplying most of the foreign exchange, and by dominating price setting. Central bank dominance can reflect structural factors, such as the dominance of official inflows, which are handled by the central bank and energy security (the central bank channels payments to oil importers). Central bank dominance can also reflect policy choices, including foreign exchange surrender requirements, the requirement that a dominant state-owned exporter or state bank sells its foreign exchange proceeds to the central bank. In some cases, central banks impose informal restrictions on the determination of the market rate or exercise moral suasion.

Case Studies

The following country case studies provide examples where active measures to establish an interbank market have been successful.44 The degree of market development differs among countries. In some cases, the interbank market structure has been successful in just enabling the central bank to reduce its role in distributing foreign exchange. In other cases, a move to full exchange rate flexibility has enabled the central bank to fully remove itself from an intermediation role, and allowed for the emergence of forward instruments.

Former Yugoslav Republic of Macedonia

Since enacting a new foreign exchange law in 2002, the former Yugoslav Republic of Macedonia has taken a series of measures to develop the foreign exchange market into a continuously traded interbank market system. Prior to the modernization of the foreign exchange market, Macedonia exhibited the distinct features of a shallow foreign exchange market: a significant role played by the central bank in intermediating and allocating foreign exchange, the absence of continuous interbank market trading, and a segmented market structure with four different exchange rates.

The development of an interbank market structure provided the benefits of a more liquid foreign exchange market and a more transparent price discovery mechanism. The elimination of market segmentation increased foreign exchange market liquidity and provided users with a more efficient price discovery mechanism. The commitment of market makers to providing continuous two-way prices strengthened the price discovery mechanism further and allowed the central bank to discontinue its market-making activity.

Current Market Structure

Macedonia implements a de facto conventional fixed peg against the euro, with a variation band of +/−0.5 per-cent.45 The interbank market is organized around four banks that have signed an agreement to act as the central bank’s market makers, which effectively transforms them into primary dealers of the central bank. This setup differs slightly from the typical market-maker agreement in which the interbank market is responsible for the setup of that agreement. These and other banks, which are not designated market makers by the central bank, trade on an electronic interbank platform. Market makers are requested to quote two-way prices for an amount of 350,000 euros at a maximum spread of 0.07 denar (MDen) among themselves. Against other banks, the central bank’s market makers quote a maximum spread of MDen 0.25 for a minimum amount of 30,000 euros. The central bank meets demand and supply by intervening through its own market makers, while other banks conduct foreign exchange transactions through the central bank’s market makers.

Market Development

The first stage of the reform process focused on expanding the role of the interbank market in intermediating foreign exchange. Market segmentation was eliminated by the establishment of two main segments: (1) the interbank market, where the central bank and commercial banks could trade freely using electronic transfers between foreign exchange correspondent banks; and (2) the cash market, where banks and foreign exchange bureaus could trade with their nonbank customers and among themselves. To increase liquidity, corporations were encouraged to transact with the interbank market instead of transacting among themselves, thereby increasing interbank market liquidity by redirecting intercorporate flows into the interbank market. Furthermore, surrender requirements for export proceeds to the banking system were abolished, allowing exporters to freely trade and manage foreign exchange flows across time. The central bank reduced its role further by discontinuing its practice of informing banks about the direction of the net open position of other banks. Finally, interventions were conducted according to more market-oriented techniques, intervening at a market rate rather than an official rate.

The increased role of the banking sector in intermediating foreign exchange boosted turnover, particularly because of the shift of intercompany flows into the banking sector. Still, the interbank market continued to lack efficiency, and the role of the central bank remained more important than is typical in a developed foreign exchange market. In particular, market functioning was inhibited by a relative scarcity of foreign exchange, a lack of pricing transparency, and weaknesses in market-making commitment.

The second phase of the reform process targeted the market guarantor role of the interbank market versus the role of the central bank. To encourage banks to trade among themselves, the central bank (1) raised the minimum amount at which it stood ready to transact, thereby forcing banks to also transact small amounts in the interbank market, and (2) widened its bid and offer spreads vis-à-vis the spreads in the interbank market. Simultaneously, a group of banks were identified as the central bank’s market makers and required to quote a minimum amount for a given spread. In return, the central bank committed to conducting its foreign exchange operations only through its market makers. The financial market infrastructure was upgraded to widen the dissemination of price and news information. Internationally recognized financial information and price systems, such as Reuters and Bloomberg, were more widely used, both by the central bank to disseminate information and by banks to provide two-way prices. In addition, the development of an electronic trading platform further increased pricing and trading efficiency.

Policy Issues

  • Redirection of intercorporate trading to the interbank market eliminated market segmentation and increased interbank market liquidity.

  • Placing financial disincentives on trading with the central bank strengthened the interbank market-making function and helped the central bank reduce its market role.

  • Improved financial market infrastructure—through the introduction of electronic trading—increased transparency and access to interbank market pricing.

Iceland

The gradual diminution of the role of the central bank of Iceland has made possible a relatively high degree of market development for a small country. The establishment of an organized interbank foreign exchange market in 1993 allowed the central bank to gradually withdraw itself from a dominant market position, and eventually transform its role from a market maker to intervening only on its own initiative. Central bank participation is now exclusively focused on either directly influencing the exchange rate or dealing with special situations that are not directly related to monetary policy (e.g., to achieve a certain objective for foreign exchange reserves).

The formation of an interbank foreign exchange market supported a more market-determined exchange rate and a more efficient allocation of foreign exchange. The role of the interbank market as market guarantor enabled the central bank to discontinue the practice of continuously intermediating foreign exchange. The setup of a market-maker system that guaranteed continuous price quotes was an essential step in providing these benefits. The well-functioning spot interbank market, the absence of prominent central bank market activity, and exchange rate flexibility have encouraged the development of a forward market that has benefited banks’ risk management capacity.

Current Market Structure

Iceland operates an inflation-targeting framework with an independently floating exchange rate regime. Three financial companies act as market makers, governed by rules set by the central bank, which oversees the market. Market makers undertake to give indicative quotes for buying and selling rates for 3 million euros, and these quotes, which are made on Reuters, may be accessed by market makers. The central bank publishes a daily reference rate, established on the basis of a daily snapshot of the position of the market at about 10:45 a.m.

Market Development

The interbank market structure was established in two steps (see Central Bank of Iceland, 2001). First, trading among authorized dealers initially took place in daily fixing meetings at the central bank. Second, fixing meetings were abolished and replaced by a market-making system in 1997. The fixing procedure was a significant first step in reducing the role of the central bank and moving toward a more market-determined exchange rate. Still, activity was confined to the fixing meetings, and limited interbank activity outside of these sessions implied that the central bank continued to play a dominant role in providing continuous pricing of foreign exchange.

The need for a more visible and continuous price discovery mechanism became more apparent following the liberalization of capital flows between Iceland and the EEA in 1995. To create a more robust market structure with market guarantors, fixing meetings were replaced by a market-maker system, which placed firm obligations on market makers (initially only four banks) to provide two-way prices for a set minimum amount.46 Market makers were also obliged to update quotes at inter vals of at least 30 seconds. In return, market makers (along with the treasury) were made exclusive counterparties to central bank foreign exchange operations.47

The market-making system created a market structure that could provide a continuously traded market without relying on the central bank. Between 1993, when the fixing meetings were established, and 1997, when the market-making system was introduced, the central bank entered the market on 93 percent of business days and accounted for between 80 and 90 percent of total turnover in 1995. In the first year of the market-making system, the ratio of trading with central bank participation declined from 80 percent to just under 37 percent, and thereafter continued to decline to only 0.4 percent in 2006.48

Interbank market liquidity was further boosted by measures that increased the flow of foreign exchange and incentives for market participants to manage exchange rate risk. First, the completion of the liberalization process for capital movements between Iceland and the European Economic Area (EEA) in early 1995 triggered an important increase in the underlying source of foreign exchange. Second, while Iceland had already implemented a flexible fixed exchange rate system at the inception of the interbank market in 1993, the gradual widening of the horizontal bands to 9 percent, and, finally, the full floating of the exchange rate in March 2001 increased the need for managing exchange rate risk more actively.49

The interbank foreign exchange market in Iceland is a small market, characterized by relatively low turnover and a small number of banks. In such a thin market, a few players can exert a great impact on market developments, and small trades can trigger significant market movements. When the central bank abolished the deviation bands and moved to a full float in 2001, the relatively concentrated interbank market coupled with initial uncertainty about managing exchange rate flexibility led initially to larger swings in the exchange rate. To encourage more competitive market behavior among the limited number of banks, the central bank introduced a commission-based market-making system, which rewards those who stand ready to always provide two-way prices that are competitive to the marketplace.

Policy Issues

  • The introduction of a market-making system provided the basis for a continuous foreign exchange market, enabling the central bank to withdraw from the market.

  • Liberalization of capital f lows with the EEA increased liquidity in the interbank foreign exchange market.

  • Greater exchange rate flexibility contributed to increased market activity and the emergence of hedging instruments.

Serbia

The establishment of an interbank market played a central role in the move toward greater exchange rate variability. The National Bank of Serbia (NBS), by gradually reducing its dominant market role, provided a favorable environment for the banking sector to develop an interbank market structure that could support more exchange rate variability alongside changes in the formal exchange rate regime.

The liberalization of foreign exchange market transactions was a key component in developing the interbank market. Freer banking sector access to foreign exchange boosted interbank market liquidity and made possible a continuous two-way market. The growth of the interbank market was highlighted by the June 2007 decision by the NBS to move from regular daily fixing sessions to holding sessions only when made necessary by foreign exchange market volatility. The phasing out of the fixing session was made possible by the significant increase in continuous interbank trading. In 2002, when the interbank market was first established, inter-bank market turnover accounted for only 19 percent of the activity of the NBS fixing session. In the first four months of 2007, interbank market trading reached $5.3 billion while foreign exchange traded through the fixing session accounted for only $647 million (Table A1.5).

Table A1.5.

Serbia: Foreign Exchange Market Turnover, 2002–07

(In millions of U.S. dollars unless otherwise indicated)

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Source: National Bank of Serbia (NBS). Note: IFEM = Central bank.
Current Market Structure

Serbia has a managed floating regime with no predetermined path for the exchange rate. The interbank market is organized around five to six banks that (implicitly) act as market makers, while approximately 10 to 12 banks regularly participate in the foreign exchange market (overall there are 30 banks). The standard ticket size is 1 million euros with a bid/offer spread of 10 percentage in points (pips). Following the removal of the daily fixing session, the main market segments are (1) the market between NBS and the (nonbank) foreign exchange bureaus, and (2) the over-the-counter interbank market. Spot market activity has developed significantly since the establishment of the interbank market, though the interbank market for foreign exchange forwards and swaps is less developed.

Market Development

Exchange system liberalization was initiated with a new law in December 2000 allowing the exchange rate to be determined by the market. This was followed by a series of reforms to develop an interbank market structure that could support a market-based exchange rate system. The reform process was further emphasized following the expressed intent to gradually move toward an inflation-targeting framework for monetary policy, implying a move to a flexible exchange rate system. A series of initiatives in the areas of foreign exchange regulation, interbank market structure, and trading infrastructure transformed the foreign exchange market to a system where the interbank market is increasingly setting the price for foreign exchange.

Further reforms in foreign exchange market regulation made it possible for banks and other entities to use and trade foreign exchange more freely. Between 2001 and 2002, authorities relaxed regulations governing foreign exchange transactions by (1) removing the requirement that banks had to surrender accumulated foreign exchange banknotes, (2) permitting citizens to freely accumulate foreign exchange, and (3) allowing banks to take foreign exchange positions guided by prudential limits on net open positions rather than foreign exchange controls. Furthermore, banks were free to quote their own exchange rates in the interbank market and to customers.

In parallel with the liberalization of the foreign exchange market, the technical infrastructure was upgraded with an electronic platform for the daily fixing sessions of the central bank (IFEM). This played an important role in developing a more transparent and efficient foreign exchange trading infrastructure. Furthermore, an electronic interbank information system (Reuters) facilitated transparency in interbank market pricing. These improvements in the technical infrastructure helped activate continuous interbank trading outside the fixing sessions, although the share of bank-customer trading remained the most important part of this activity for some time. Still, overall volumes increased and two-way quotations became more common.

Exchange rate variability was initially limited owing to the still-dominant role of the central bank in supplying foreign exchange. A commitment to gradually move toward more exchange rate flexibility was signaled with the 2001 decision to move from an exchange rate peg to horizontal bands. Still, de facto exchange rate variability was initially limited owing to a series of regulations that limited the development of market forces. In particular, banks had practically no source of foreign funds outside of the fixing sessions because of the requirement to surrender foreign banknotes to the central bank.

However, exchange rate variability increased over time with the elimination of surrender requirements and continued changes in exchange rate variability and foreign currency regulations. The elimination of surrender requirements removed the imbalance in the foreign exchange market and made it possible for the NBS to reduce participation caused explicitly by the need to continuously supply foreign exchange. Meanwhile, the gradual move toward greater exchange rate variability helped establish conditions for a continuous and active interbank market. In particular, interbank market activity picked up significantly in 2006 in connection with increased exchange rate variability. Furthermore, while the capital account remains broadly controlled, the liberalization of longer-term transactions contributed to establishing underlying conditions for a two-way market.

The emergence of voluntary market makers was an important step in creating the interbank market structure for pricing and trading foreign exchange. Among the larger group of foreign exchange market participants, about five to six banks, which were mainly foreign banks, emerged as the main source of continuous two-way prices. This was an important first step in creating interbank market liquidity and is an indication that the entrance of foreign banks had a positive impact on market developments in Serbia. Still, further measures to improve interbank market liquidity are necessary. These are factors that are part of a market-driven deepening and include a more formal interbank market-making arrangement, an electronic interbank trading infrastructure, and voice or electronic brokers to increase market transparency.

However, the development of the foreign exchange forward market has been inhibited by the lack of a reliable indicator for pricing forward instruments. While forward transactions have begun on a small scale, these are mostly bank-customer-driven and an active and continuously traded interbank forward market has not yet emerged. This is essentially a consequence of the lack of a reliable money market yield curve owing to a shallow money market, which is an important source for pricing forward foreign exchange rates. The lack of a reliable pricing indicator creates uncertainty in the market-making function because it increases the risk of hedging positions in the interbank market. Furthermore, uncertainties around the existing rules and regulations concerning accounting, documentation, and reporting of forward transactions, and remaining exchange restrictions may have contributed to the lack of development of the forward market.

Policy Issues

  • The development of an electronic infrastructure played an important role in providing the tools for market making and trading.

  • Regulatory changes to allow foreign exchange to flow into the banking system were fundamental in establishing a more balanced two-way market that could operate with less frequent intervention by the central bank.

  • A policy of allowing more exchange rate variability helped develop the market-based exchange rate system because banks were more free to set the exchange rate on the basis of supply and demand.

  • Foreign exchange forward volume is restrained by the lack of a money market yield curve.

Tanzania

Tanzania has made important progress in developing the interbank foreign exchange market since it was first established in 1994. The foreign exchange market is organized around market makers and governed by a set of guidelines established by the central bank. Central bank operating procedures and market intelligence gathering have been upgraded to support the market analysis process in a foreign exchange market organized around an interbank market.

The development of the interbank market provided important benefits to the foreign exchange market even though the central bank remains as market clearer. The interbank market supported the development of an increasingly market-determined exchange rate, which has raised the level of transparency for end users of foreign exchange. Still, most transactions are conducted between banks and their customers, and the markets rely on donor flows, thus placing the central bank at the center of the distribution process. This implies that the full benefits of a more liquid interbank foreign exchange market have yet to materialize.

Current Market Structure

Tanzania pursues a de facto independently floating exchange rate regime.50 The Bank of Tanzania intervenes in the market as a buyer or seller of last resort, without compromising the target on foreign exchange reserves. The foreign exchange market is characterized by two main segments: (1) the commercial bank sector, which is the larger of the two segments, consists of 28 banks, and dominates the interbank and corporate markets; and (2) about 60 bureaux de change, which conduct most of the cash-based retail business. Corporate demand is the main driver of foreign exchange volume, and bank-customer activity is estimated to be more than double the amount of interbank volumes.

Market Development

The interbank foreign exchange market was initially established as an open outcry system organized by the central bank. Commercial banks and foreign exchange bureaus were invited to participate, with the latter group required to maintain aminimum deposit at the central bank as cover for their purchases. The interbank market gradually evolved by permitting trading outside of the central bank open outcry system and, once a competitive interbank market emerged, foreign exchange bureaus were excluded from interbank market partici-pation.51 At the early stages of market development, market functioning suffered from (1) the lack of a clear commitment to the provision of two-way prices by market makers, (2) strong seasonality in foreign exchange flows, (3) a heavy central bank presence contributing to market perception that limited exchange rate variability was desired (despite a freely floating exchange rate), and (4) a virtually nonexistent forward market.52

The market developed in line with the export sector and as a result of specific measures. Over time, season-ality in foreign exchange flows diminished as the economy became more diversified with flows relating to tourism, mining, and foreign direct investment becoming increasingly important in the foreign exchange market. Market functioning was reinforced by additional measures addressing the interbank market structure, in particular the need for (1) strict adherence to the Interbank Foreign Exchange Market dealing limits, (2) an increase in the number of banks with the Reuters dealing system, and (3) raising dealer qualifications and data reporting up to the agreed-upon standards.

Despite the more diversified foreign exchange flows and strengthening of the market structure, the central bank has continued to dominate. A particular aspect of the foreign exchange market structure in Tanzania is the reliance on donor flows, which places the central bank at the center of the major source of foreign exchange supply. The method and tactics used for supplying donor flows play an important role for the capacity of the interbank market to develop independently and reduce its reliance on the central bank as a market clearer.

Policy Issues

  • The establishment of an open outcry system gradually developed into a continuously traded foreign exchange market.

  • The implementation of trading rules, requirements on market makers, and the upgrading of the technical infrastructure strengthened interbank market functioning.

  • Diversification of the underlying sources of foreign exchange reduced the seasonality of foreign exchange flows.

  • Reliance on donor flows places the central bank in a continued dominant market role that necessitates the development of market-oriented techniques for the distribution of flows into the interbank market.

Uganda

The interbank spot market can absorb routine transactions at low transaction costs without unduly affecting the exchange rate. Interbank market activity is guided by internationally compatible net open position limits, market makers that are committed to providing market prices for minimum amounts, and interbank market behavior that is enforced through a code of conduct. The formulation of a transparent framework for central bank sterilization and intervention operations has further supported activity in the interbank market.53

Market development has enhanced price discovery and transparency in central bank operations. Despite regular central bank participation in the interbank market (mainly because of the use of foreign exchange sales to sterilize domestic operations), the method of operation has been adjusted so that it is conducive to a market-determined exchange rate mechanism. Still, the lack of development of forward markets implies that market participants have not been able to build up a more efficient risk management capacity.

Current Market Structure

Uganda implements a monetary aggregate targeting framework combined with an independently floating exchange rate regime. The interbank market is organized around 15 banks that are authorized to deal in foreign exchange subject to a regulatory requirement to adhere to net open positions limits, and an obligation to post continuous dealing prices on Reuters for a minimum amount of $100,000. The Bank of Uganda participates in the interbank market for the purpose of sterilization or intervention. Interbank transactions have increased significantly over the past years, but remain a relatively small share of overall market turnover (about 17 percent in late 2005). Most transactions are in-house matching of customer orders and the central bank remains a regular counterparty in the interbank market.

Market Development

The central bank dominated the market in the early stages of its development. Conditions for interbank market activity were limited by the connection of only a few banks to the electronic information system (Reuters), foreign exchange flows exhibited a lumpy pattern, and transactions were mostly bank-customer-oriented. Measures to move toward a unified interbank foreign exchange system included (1) eliminating multiple currency practices, (2) reforming exchange controls and procedures, (3) liberalizing documentation requirements, (4) transferring certain transactions to the interbank market, and (5) reforming the framework for monetary and foreign exchange operations.

The Ugandan Information Service (UIS), a Reuters-based information system, was developed to widen interbank market access to price information. This was a less costly complementary information system that made it possible for smaller banks to access the market on the same terms as larger banks, which had the financial capacity to subscribe to Reuters Dealing. With the introduction of the UIS, indicative prices were made available more widely on a real-time basis and market activity increased. The number of market makers committed to posting continuous prices grew to include 15 banks in 2005, having been dominated by four foreign-owned banks in 2002.

Significant attention was given to reducing the role of the central bank in the interbank market. At the early stages, the central bank dominated interbank market activity, accounting for more than 50 percent of foreign exchange purchases and significantly impacting market developments through its conduct of irregular but frequent operations. Concern about volatility, including intra-day volatility, or undue appreciations or depreciations of the exchange rate triggered regular central bank smoothing operations. Lack of transparency in central bank operations and the resulting lack of price discovery for participating banks caused uncertainty among interbank market participants.

Central bank actions were increasingly characterized by a clearer and more transparent separation of the objectives of foreign exchange operations. Different operating procedures were established for foreign exchange sales to sterilize domestic liquidity conditions and interventions to affect the exchange rate.54 The dual role in the market specifically required an operational structure that enhanced operational transparency and reduced the risk that confusion about the central bank’s objectives might negatively impact market functioning. To avoid causing any undue impact on exchange rate developments and sending unwanted signals, sterilization operations were planned on the basis of liquidity forecasts, implemented with due consideration of the capacity of the foreign exchange market to absorb these operations, and made transparent through a schedule announced publicly on a quarterly basis. By making the conduct of sterilization transactions more transparent, interventions, which became less frequent along with improvements in market functioning, became more easily distinguished from nonpolicy operations.

The development of the interbank market structure and the reduction of the role of the central bank have put in place a foundation for the development of the forward market. Despite the progress made in the spot foreign exchange market, progress in developing an active and liquid forward market has been slower. Customer demand for forwards remains low, possibly owing to a lack of widespread understanding of forward instruments and their benefits, greater complexity of risk monitoring and accounting arrangements, or the absence of efficient pricing tools owing to a shallow money market. Still, an embryonic forward market has started to develop, with the largest banks showing a readiness to quote for maturities of up to two months.

Policy Issues

  • The reform of the exchange control system and liberalization of documentary requirements established the foundation for the modernization of the foreign exchange market.

  • The requirement for market makers to post two-way prices created a continuous foreign exchange market and enabled the central bank to withdraw from market making.

  • The development of a technical infrastructure increased market transparency.

  • Greater transparency in central bank operations and the adoption of market-oriented techniques conducive to the specific purpose of operations removed confusion about central bank objectives.

  • Development of forward markets appears to be constrained by a lack of understanding about the benefits of hedging instruments as well as the associated risk monitoring and accounting arrangements.

42

Even the most developed markets do not appear to be efficient and, at least at high frequencies, do not reflect information on the underlying fundamentals (Sager and Taylor, 2006; and Lyons, 2005).

43

A systematic examination of smaller economy central bank websites and Financial Sector Assessment Program (FSAP) reports showed that official foreign exchange market turnover data are not available for most of these countries.

44

These case studies are based on, in addition to specified references, various information sources including central bank websites, IMF Staff Reports, and unpublished papers at the IMF.

45

The AREAER notes that the regime operating de facto is different from its de jure regime.

46

At most, the number of interbank market makers reached six but has since declined to four.

47

The status as a counterpart to the central bank tends to be highly valued by banks for several reasons: (1) it has a positive impact on the reputation of a bank and is used as a marketing tool for attracting other client flows, (2) they can earn a premium on the intermediation business, and (3) it provides private information about central bank flows. For a discussion on the value of private information see Lyons (2005).

48

Since 1999, the central bank has operated exclusively within the policy objectives set by the inflation targeting regime or for purposes of strengthening its net foreign position. Transparency is a key aspect in the implementation of any operations (see Ísberg and Pétursson, 2003).

49

The horizontal bands were widened from +/−2.25 percent to +/−6 percent in 1995 and to +/−9 percent in 2000 before fully floating the exchange rate in 2001.

50

The AREAER notes that the regime operating de facto is different from its de jure regime.

51

The exclusion of foreign exchange bureaus at the early stages of market development initially led to a significant reduction in the degree of competition in the foreign exchange market. The more sophisticated foreign exchange bureaus were thus encouraged to develop into nonbank financial institutions or even banks, possibly through mergers.

52

Market participants perceived that exchange rate variations were subject to daily limits of +/–2 percent from the previous day’s weighted average rate and that deviations from what was perceived as a “desirable” level would result in less support for covering their foreign exchange position with the central bank.

53

Foreign exchange sales form part of central bank operations to sterilize the inflows under the Poverty Alleviation Fund expenditures financed by donor flows.

54

Spot foreign exchange sales withdraw domestic liquidity and may be resorted to as an instrument to reduce (or remove) a structural surplus of liquidity (as opposed to foreign exchange swaps, which only have a temporary impact on liquidity).

Annex II. Stylized Facts: Money and Secondary Government Securities Markets

This annex summarizes stylized facts on money and secondary government securities markets in smaller economies. Data on money markets are especially limited, although there is cross-country data on foreign trading of government securities. IMF (2005a) and Árvai and Heenan (2008) report country case studies for these markets.

Money Markets

The available information suggests that smaller economies offer a narrower range of money market products and have a smaller turnover. Money markets are for uncollateralized domestic currency, cash, or derivatives and are usually dominatedby banks. The available figures also suggest that turnover in smaller economies is but a fraction of that in other countries (Table A2.1). Further, overnight interbank cash transactions tend to be the main product in smaller economies, although some countries have longer maturities and repos, whereas others have trading derivatives (IMF, 2005a; and Lukonga, 2006). In contrast, advanced and larger emerging market countries usually have not only these products but also a variety of derivatives.

Table A2.1.

Selected Countries: Interbank Money Market Annual Turnover

(In percent of GDP)

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Sources: Central bank websites; Lukonga (2006); and case studies.

Money market funds.

Secondary Government Securities Markets

The number and turnover of smaller economy secondary government securities markets is growing, but lags far behind those of emerging market countries. Secondary government securities markets are relatively small and illiquid in smaller economies compared to those in emerging market countries. The Debt Trading Volume Survey of the Trade Association for the Emerging Markets (EMTA) appears to be the only cross-country data source for secondary trading in government securities.55 These data, which are from a survey of major international broker-dealers, banks, and investors, will in most cases underestimate total market volume because they exclude the transactions of local banks and other entities. However, they capture the relative size of markets across countries and over time.

The following patterns emerge from the data:

  • The number of countries with trading captured in the EMTA survey has trended slowly upward to 25 percent of all smaller economies in 2005 (Table A2.2).

  • The volume of trading varies quite widely across countries (Figure A2.1).

  • The total amount of trading in U.S. dollars in smaller economy countries nearly quadrupled from 2000 to 2005.

  • However, the amount of secondary market trading in relation to GDP looks lower than that needed to have an important economic impact.

  • The amount traded in smaller economies is dwarfed by the amount traded in emerging market countries by a factor of 200.

  • Further, emerging market country trading in terms of percentage of GDP is larger by a factor of 10 in comparison with smaller economies, indicating a larger economic impact in the emerging market countries.

  • Finally, the turnover-to-GDP gap between the smaller economies and the emerging market countries widened between the year 2000 and the year 2005 (Figure A2.2).

Table A2.2.

Government Securities Secondary Market Trading by Foreign Banks, 2001–05

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Source: Trade Association for the Emerging Markets (EMTA).
Figure A2.1.
Figure A2.1.

Market Turnover of Government Securities by Foreign Institutions

Source: Trade Association for the Emerging Markets (EMTA).
Figure A2.2.
Figure A2.2.

Market Turnover of Government Securities, Emerging Market Countries and Smaller Economies

Source: Trade Association for the Emerging Markets (EMTA).

Country sources suggest that the share of trading is low relative to the outstanding stock (Árvai and Heenan, 2008; IMF, 2007c). The low turnover-to-stock ratio in smaller economies reflects the buy-and-hold strategy of institutions owing to excess liquidity and a lack of alternative investments.

55

The reported data encompass instruments issued by the national government, regional and municipal governments, agencies, and local corporations.

Annex III. Stylized Facts: Secondary Equity Markets

This annex summarizes the stylized facts on secondary equity markets in smaller economies. Generally, the empirical and descriptive literature on equity markets in smaller economies is extremely limited and thus there is little to draw on (Box A3.1). The first part of the annex summarizes cross-country data and key patterns, and the second part consists of nine case studies.

Cross-Country Data and Patterns

Most smaller economies do not have formal secondary markets.56 Only 43 of the 107 smaller economies have secondary stock market data reported by the World Bank, compared to 37 with the 43 emerging market countries (Table A3.1).

Standard market indicators indicate that those equity markets that do exist in smaller economies are considerably less developed than those in emerging market countries. The median market capitalization across smaller economies is less than half that of emerging market countries, and the median stock turnover ratio is some five times smaller for smaller economies (Table A3.1 and Figure A3.1).

Table A3.1.

Smaller Economy Countries: Stock Market Indicators, 2005

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Source: World Bank. World Development Indicators. Note: Number of countries in parentheses.
Figure A3.1.
Figure A3.1.

Market Capitalization, 2005

Source: World Bank.Note: Excludes Jordan at 293.

Trading volume also varies considerably. Ten of the smaller economy markets have a total trading volume of less than $10 million, while trading volume exceeds $1 billion for four of the countries (Table A3.2).

Table A3.2.

Smaller Economy Equity Markets: Trading Volume, 2005

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Source: World Bank, World Development Indicators.

Smaller economy equity issuance in the two largest international secondary equity markets is much lower than for advanced and emerging market countries (Table A3.3). Only 17 smaller economy companies are listed on the New York Stock Exchange (NYSE) and London Stock Exchange (LSE), and only a small number of smaller economy companies are listed on regional stock markets, such as those in Singapore and South Africa. Most of the home countries of the listed companies are relatively large and advanced compared with the other smaller economies. Of course, the international capitalization of these companies is likely quite large compared with the size of their local equity markets.

Table A3.3.

Number of Listed Companies on New York and London Stock Exchanges, 2006

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Sources: New York Stock Exchange (NYSE) and London Stock Exchange (LSE) websites. Note: All three companies on the NYSE are from Panama, and the LSE-listed companies are from Croatia, Estonia, Jordan, Kenya, Lebanon (two companies), Lithuania, Malawi, Panama, Tunisia, Zambia, and Zimbabwe (three).

Number of countries that list at the NYSE or LSE.

Implications of the Literature for Secondary Equity Markets in Smaller Economies

The literature on equity markets in smaller economies is extremely limited. The literature generally suggests that the large emerging market and smaller economy companies rely more on external than internal financing compared with advanced country companies, use short-term debt as the main source of external financing, and use equity as the main source of long-term financing (Singh and Hamid, 1992; Singh, 1995; Glen and Singh, 2003; Mutenheri and Green, 2003). In particular, Yartey (2006) found that short-term debt is the main source of financing, with equity playing a small role.

Market turnover appears to have a bigger impact on economic growth than capitalization. This is one of the few conclusions of the limited number of studies of the impact of stock market development on growth. In a broad review of the literature, Levine and Zervos (1998) find that it is stock market liquidity rather than capitalization that facilitates long-run economic growth, which they attribute to liquidity serving as the better measure of the influence of the stock market on resource allocation. Adjasi and Biekpe (2006) analyze the effect of stock market development on economic growth in 14 African countries and conclude that it (1) operates through the value of shares traded rather than market capitalization, (2) is significant only for upper-middle-income countries, and (3) is significant only for the countries with higher market capitalization.

Equity markets can also enhance financial stability by providing a “spare tire” for corporate financing. The role of financial breadth, or the availability of a broad range of financing alternatives to the corporate sector, is generally recognized as helping limit the impact of a crisis on the real sector. The large output contraction caused by the recent Asian crisis has been attributed in part to the lack of nonbank financing alternatives, whereas nonbank financing helped limit the impact of the slowdown of U.S. bank lending in 1990 that resulted from a collapse in the value of real estate collateral (Greenspan, 1999). Davis (2001) and Davis and Stone (2005) conclude that the existence of active securities markets alongside banks (“multiple avenues of intermediation”) is beneficial to the stability of corporate financing, both during cyclical downturns and during banking and securities market crises. These benefits increase in line with the size of the securities market and intermediated financing, and the proportion of companies with access to both loan and securities markets.

Anecdotal evidence suggests that many companies listed in smaller economy stock markets have a relatively small share “free float,” or traded shares as a proportion of total shares. For example, the three largest companies on the Botswana Stock Exchange have an average free float of only 27 percent, and the average float of the top 10 companies in Fiji is 33 percent, and is much lower for the top three. There is no minimum issuance or minimum float requirement in most of Central America, and the only country to require a minimum issuance amount for equity is Costa Rica (the equivalent of about $2 million). There is very limited float in the Central America stock exchanges, including with respect to some of the largest listed companies.

Further, smaller economy secondary markets seem not to serve as a means of financing. Although crosscountry data are not available for initial public offerings (IPOs) in smaller economy secondary stock markets, reported information for Croatia, Guyana, and Mauritius indicate that IPOs are limited or nonexistent.

Importantly, stock market trading, whether measured as a share of GDP or with respect to market capitalization, is also much lower in smaller economies. Smaller economy and emerging market country secondary market prices also are more volatile (El-Erian and Kumar, 1995). This suggests that in smaller economies it is harder for investors to use secondary markets to exit, and the discipline exerted by secondary markets is relatively limited.

The trends over time of key stock exchange indicators for smaller economies suggest that they are not catching up with emerging market countries. The median number of listed companies across smaller economies rose by two from 36 in 2000 to 38 in 2005, while the median number of listed companies in emerging market stock exchanges actually dropped slightly to 214 (Figure A3.2). Meanwhile, the median across smaller economies of market capitalization rose from 10 percent of GDP in 2000 to 17½ percent in 2005 (Figure A3.3). However, the capitalization of emerging market country stock exchanges nearly doubled to 40 percent of GDP during the same period.

Figure A3.2.
Figure A3.2.

Smaller Economies and Emerging Market Countries: Number of Listed Companies

(Median)

Source: World Bank.
Figure A3.3.
Figure A3.3.

Smaller Economies and Emerging Market Countries: Market Capitalization

(Median)

Source: World Bank.

The median turnover-to-GDP ratio across smaller economies is stagnant and rapidly falling behind that of emerging market countries (Figure A3.4). The ratio is seen as a key indicator of the impact of the secondary market on the economy at large. This indicator is not only much smaller for smaller economies relative to emerging market countries, but it is stagnant, a trend that is at odds with the worldwide deepening of domestic and international markets.

Figure A3.4.
Figure A3.4.

Smaller Economies and Emerging Market Countries: Turnover

(Median)

Source: World Bank.

The presence of a market in smaller economies is related to the size and level of development of the economy. Less than a quarter of countries with a GDP of under $3.6 billion have a secondary market, and less than a third of countries with per capita income of under $3,100 have a stock exchange (Table A3.4).

Table A3.4.

Percent Share of Smaller Economies with Equity Market by GDP and GDP Per Capita

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Sources: IMF, World Economic Outlook database; and World Bank, World Development Indicators database.

Case Studies

This annex provides case studies of the stock exchanges of 10 smaller economies.57 They are mostly success stories and thus offer some positive policy lessons, and also serve to demonstrate some of the inherent constraints to market development in smaller economies.

Botswana

Botswana’s equity market has benefited from extensive government support but it remains relatively undeveloped (Table A3.5). The government’s initiatives include reduction of government loans, establishment of the Botswana Stock Exchange (BSE), public pension reforms, and tax incentives (Bank of Botswana, 2006). However, the value of trades has declined in recent years, and the impact of the equity market on the overall economy is likely to be limited.

Table A3.5.

Botswana: Stock Market Indicators, 1995–2005

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Sources: World Bank; Botswana Stock Exchange.
Description of the Equity Market

Activity in capital markets in Botswana has picked up over the past decade. Commercial banks dominate Botswana’s financial sector.58 The rapid growth of pension funds and other government initiatives has broadened domestic capital markets. At the same time, the limited investment opportunities in domestic markets have compelled private fund managers to move a large part of their funds abroad, contributing to a sizable capital account deficit.

The BSE was established in 1989 with only five listed companies. The number of listed companies increased to 28 by end-2005, nine of which are foreign companies. The listed companies represent a wide range of economic sectors, including manufacturing, wholesale/retail, banking, medical services, property, security services, mining, tourism, and information technology. The BSE established the Venture Capital Board in 2001, a separate bourse for newer businesses with a short track record, and it now comprises six companies.

Capitalization has trended upward from the inception of the BSE. The Domestic Companies Index (DCI), the most widely watched price index, gained 74 percent during 2006. Accordingly, market capitalization rose by 77 percent to P 23.7 billion, constituting approximately 50 percent of GDP, which is high relative to other African stock exchanges.

However, the BSE remains illiquid. Even in the most active years there has been an average of only slightly more than 10 trades per working day, and turnover has actually declined in U.S. dollar terms over the past several years. This is partly due to limited free-float shares; the three largest companies on the BSE have an average free float of only 27 percent. On an aggregate basis, the free-float portion was just under P 5 billion, of which pension funds held about half, at end-2005 when the total capitalization was P 13.4 billion. High brokerage fees are also cited as obstacles to greater liquidity.

Large institutional shareholdings are dominant, because the pension reforms (see below) have led to a large injection of funds in capital markets. For example, 90 percent of Sechaba, a brewery company with a relatively large free float of 58 percent, was controlled by only 25 shareholders. This suggests that the general public holds only a small percent of shares.

Market Development Over Time

The Botswana government has employed various initiatives to develop capital markets. The strategy for financial sector reforms was first outlined in the Seventh National Development Plan (1991–97). This and subsequent initiatives have provided good support for development of the capital markets, although further efforts are needed for the markets to become deeper and more liquid (Kim, 2004).

Reduction of Government Financial Arrangements

Botswana started its financial reform program by cutting back government financing. The government began to divest its interests in companies and require parastatals to rely on nongovernment financing. The establishment of the BSE in 1989 (originally as the Botswana Share Market) provided a secondary market for these privatized companies.

Public Pension Reform

The introduction of the defined-contribution pension scheme for public officers in 2001 boosted capital market development (see Poddar, 2002). Pension claims equivalent to 27 percent of GDP were transferred to private fund managers. By 2006, their assets grew to equal those of commercial banks. The funds have been partly invested in the domestic stock market, which boosted the BSE’s DCI. However, with few investment opportunities in the local capital markets, investment abroad has significantly increased. As of end-2006, the pension fund’s investment in Botswana’s equity markets, Botswana’s bonds (including the central bank’s certificates), and offshore investments were P 5.4 billion, P 3.2 billion, and P 18.8 billion, respectively, out of total assets of P 29 billion. Offshore investment has therefore risen to 64.8 percent, approaching the 70 percent prudential ceiling.

Tax Incentives

The authorities provide favorable tax treatment for companies listing on the BSE. These include an exemption from capital gains tax and lower income tax for listed companies. The double-tax burden on dividends was also abolished.

Government Securities Market Reforms

The government has also taken steps to develop domestic bond markets, which in effect benefit capital markets as a whole. In 2003, the government issued two-year, five-year, and 12-year bonds with a total value of P 2.5 billion aimed at developing the domestic capital market, as opposed to fiscal financing. These bonds created a quasi-representative sovereign yield curve as a benchmark for private and parastatal issuers, and they were listed on the BSE in 2005.59 The two-year bond was not rolled over and the five-year bond will be rolled over into securities of different maturities. Meanwhile, Botswana acquired investment-grade sovereign ratings by Moody’s Investors Service and Standard & Poor’s, which also provided a positive signal to potential investors both domestic and abroad.

Infrastructure

Efforts are under way to upgrade market infrastructure. Establishment of a central securities depository is being considered by the BSE. In addition, new securities legislation, which is planned to replace the outdated BSE Act, will be aimed at facilitating the trading of all types of bonds on the BSE, introducing electronic trading, and streamlining requirements for BSE members. It will also strengthen provisions to deter market manipulation as well as insider trading. Further, a nonbank financial institutions regulatory authority came into effect in late 2007 and was expected to become fully operational in 2008.

Offshore Financial Center

The International Financial Service Center (IFSC) could also help attract more internationally oriented financial business. The IFSC was established in 1999 with a view to making Botswana the financial service hub for sub-Saharan Africa. IFSC-registered companies can operate a wide variety of financial services, such as foreign currency banking, securities trading, and investment advice, with a preferential tax regime. However, its development has been slow; only 31 companies had been accredited to the IFCS as of 2005, representing a total investment of about P 74 million. This is partly due to the high cost of infrastructure such as telecommunications.

Privatization

In Botswana, privatization has not yet played a large role in increasing the supply of tradable corporate shares. The government unveiled the Privatization Master Plan in 2005, and this is expected to stimulate the growth of capital markets by making ownership of public institutions available to private investors.

Policy Lessons

  • The government financial sector development strategy has played a positive role.

  • But at the same time, government initiatives alone cannot lead to successful development of markets.

  • More diversified issuers and investors are necessary to realize active equity markets.

Croatia

Croatia’s equity markets boomed since 2005 but they are still underdeveloped compared with other central and eastern European emerging countries (Table A3.6). Market capitalization and trading surged significantly in a past few years partly owing to recent large IPOs. However, both market capitalization and trading are dominated by a small number of companies. The investor base is limited because only pension funds play a significant role in the recent surge in stock prices. In March 2007, two stock exchanges were merged into one aimed at greater liquidity in equity markets.

Table A3.6.

Croatia: Stock Market Indicators, 1995–2005

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Source: World Bank.
Description of the Equity Markets

The Zagreb Stock Exchange (ZSE), established in 1991, has 145 listed companies, of which market capitalization amounted to 68 percent of GDP in 2006. The ZSE merged with the smaller Varazdin Stock Exchange (VSE) in March 2007. The largest two companies account for more than 20 percent of total capitalization. Liquidity has greatly improved as trading value to GDP increased to 2.1 percent in 2005. However, this is substantially lower than in neighboring stock exchanges, such as Warsaw (trading value to GDP of 106 percent), Budapest (31 percent), and Prague (26 percent). Furthermore, market turnover is also dominated by a few companies, with the largest five companies representing 56 percent of total stock turnover.

Corporate financing through capital markets is quite limited. Despite a recent increase in IPOs and new bond listing, the capital market continues to play a lesser role in corporate finance than banks. In 2005 the ZSE saw four equity public offerings with a value of HRK 231 million, while there have been a total of only 19 equity public offerings since 1998. The bond market at the ZSE is also very thin and dominated by government securities.

Market Development Over Time

Although the ZSE has an advanced trading infrastructure, developments have been limited owing to the small investor base.

Trading Infras tructure

Trading at the ZSE is conducted through an electronic trading system. The brokerages and members of the exchange are connected by special telecommunication links with the exchange headquarters through which they enter their sell or buy orders directly from their offices. There is no single physical place, a traditional trading floor, where trading is conducted.

Investment by Pension Funds

The tight limits on overseas investment by pension funds have led them to invest in domestic markets. Pension assets grew by HRK 3.9 billion in 2005, of which HRK 2.5 billion was invested into domestic equity and bond markets. This contributed to the recent sharp increase in local stock prices. The authorities have started to relax the limits on foreign investment by pension funds.

Merger of Exchanges

As stated above, Croatian equity markets were finally unified in March 2007. The VSE closed its doors and was merged with the ZSE. Because stocks are traded at the single and central marketplace, market participants are able to observe a single trading price for each stock, which will enhance price transparency. It is also expected that the joining of the two order books will promote greater liquidity in the long run.

Policy Lessons

  • Pension funds with a regulatory focus on domestic investment have had a large impact on local stock prices. Though recent events such as large IPOs and the relaxation of investment rules for pension funds are encouraging, a broader investor base is required to sustain expansion of the markets with deeper economic impact.

  • Markets can benefit from an advanced trading infrastructure, which has yet to be fully materialized.

Estonia

Estonia provides an instructive case for regional integration of capital markets. The integration has been achieved with neighboring Baltic countries with similar market development (Table A3.7). Also, this is a part of the larger regional integration among Nordic and Baltic stock exchanges owned by the OMX group.60 While both markets are currently operated separately owing to a significant difference in development, the long-term goal of the Baltic Market is to merge with the Nordic Market, consisting of exchanges in Denmark, Finland, Sweden, and Iceland.

Table A3.7.

Estonia: Stock Market Indicators, 1997–2005

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Source: World Bank.
Description of the Equity Markets

Estonia’s equity market has recently expanded robustly. The rapid rise of the stock index OMXT in the Tallinn Stock Exchange slowed in 2006, reflecting global corrections, but the market still maintains its strong momentum owing to the growth potential in the Baltic region. The average daily turnover of transactions on the stock exchange has also continued to be high, reaching EEK 39 million in 2006. However, turnover has been dominated by the shares of a limited number of companies, such as Tallink, a shipping company, and AS Eesti Telekom.

The stock capitalization amounted to 26 percent of GDP, as of the end of 2005. Nonresident investors, mainly European and some U.S. participants, account for a large part of the capitalization; the share of nonresident holding dropped in 200561 after peaking at 87 percent in 2004, but still remained at about 60 percent in 2006. Among domestic investors, financial and nonfinancial sector companies play a primary role, representing 34 percent of the capitalization, but retail investors account for only 4 percent of the total value.

Market Development Over Time

Estonia’s stock exchange, established in 1996, took an important step with Latvia’s and Lithuania’s markets to provide regional integrated stock markets. In 2004, the Tallinn Stock Exchange (Estonia), the Riga Stock Exchange (Latvia), and the Vilnius Stock Exchange (Lithuania), all of which are owned by OMX group, jointly established the Baltic Market. This promotes greater interest and opportunity for investment in the region as a whole by enabling investors to transact and settle financial products seamlessly between the three countries. It also helps companies raise capital across the region.62 Further, the Baltic Market provides investors with access to more than 80 percent of trades in other larger OMX exchanges in Denmark, Finland, Sweden, and Iceland.

The integrated Baltic Market has continued to take measures to upgrade capital markets in the region. In 2006, a Baltic Fund Center started to provide investment fund performance information in all Baltic countries. This has enabled investors to compare investment funds and fund-management companies. In order to increase the presence and credibility of the Baltic Market, the Baltic Market Awards were introduced in 2006, highlighting best practices among listed companies and member brokers. Looking forward, the Baltic Market plans, among other things, to implement an Alternative Securities Market targeting small and medium-sized companies with lower entry requirements.

Policy Lessons

  • Regional integration can work to develop smaller economies’ equity markets, although its success would depend on history in the region, the degree of development of each member’s market, and a comprehensive strategy.

  • Initiatives and motivations by an owner of exchanges are key for market-led developments.

Fiji

Fiji’s equity market is quite small and illiquid, and has a high degree of market concentration (see Mala and White, 2006) (Table A3.8). The number of listed companies remains small and liquidity is fairly low. Fiji faces formidable challenges to develop its equity markets.

Table A3.8.

Fiji: Stock Market Indicators, 1996–2005

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Sources: World Bank; Mala and White (2006). Note: The increase in market capitalization in 2002 resulted from the listing of a large telecom company.
Description of the Equity Markets

The Suva Stock Exchange (SSE) was established in 1996. The establishment of the Capital Market Development Authority (CMDA), the market regulator, in 1997, helped development of the equity market through licensing intermediaries and enhancing disclosure requirements. In 2000, the SSE was renamed the South Pacific Stock Exchange (SPSE) to foster listing and investing opportunities elsewhere in the South Pacific. Currently, there are 16 companies listed at the SPSE with a market capitalization of $586 million, or approximately 20 percent of GDP. The number of trading sessions has increased from three (Mondays, Tuesdays, and Thursdays) to five per week since 2003.

Market liquidity at the SPSE is quite low. This may be attributed to the limited flotation of listed shares. For example, Amalgamated Telecom Holdings (ATH), the largest company at the SPSE, has only 0.3 percent of its total shares available for trading on the exchange. Also, the SPSE is a highly concentrated market with most of its activities centered on a few listed companies. Only five companies account for nearly 70 percent of market capitalization of the SPSE. In addition, many investors employ a buy and hold strategy.

Low SPSE liquidity also reflects the dominance of family-owned companies and easy availability of bank finance. The majority of businesses in Fiji are family-owned companies that are reluctant to dilute ownership and hesitant to disclose information to the public. It is also fairly easy for companies to obtain bank loans owing to excess liquidity. Even start-up companies can finance themselves through their own savings and borrowing from parent companies.

Market Development Over Time

The government has formulated various strategies, recognizing the development of the stock market as the engine for economic growth, but many challenges still remain.

Trading infrastructure

The number of sessions was increased from three to five weekly in 2003 in response to an increase in trading. But further upgrades of the trading system, such as introduction of an electronic automated system, may not be justified at this moment given the small number of listed companies. In addition, the location of the SPSE could be changed to a more suitable place for ensuring easy access by financial institutions.

Tax Incentives

Listed companies are exempted from paying taxes on dividends. There are no other tax incentives to encourage equity investment.

Privatization

The privatization of ATH in 2002 more than doubled SPSE capitalization. Nevertheless, market liquidity remains low, reflecting ATH’s very limited free float. The privatization has also caused market concentration to accelerate.

Public Awareness and Education

A lack of public awareness regarding the role of the stock exchange and the benefits of equity investment has likely inhibited market development. Unlisted companies cite a lack of knowledge among potential investors as a key impediment to listing at the SPSE. The CMDA and the SPSE have been initiating some concerted efforts through public seminars, but they appear to be insufficient to date in light of the challenges posed by Fiji’s diversity and geographical dispersion.

Policy Lessons

  • Limited flotation of shares and market concentration constrain market development.

  • Privatization of large state companies can boost market capitalization but not raise market liquidity.

  • The dominance of family-owned companies and the availability of bank finance have impeded market development.

Guyana

The Guyana Stock Exchange (GSE) is quite underdeveloped (Table A3.9). Although the market has grown considerably in its first three years of existence, it remains quite small with limited economic impact.

Table A3.9.

Guyana: Stock Market Indicators, 2003–05

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Source: World Bank.
Description of the Equity Markets

Only over-the-counter transactions are conducted on the GSE and volume is quite low, thus the economic impact is quite limited. The Guyana Association of Securities Companies and Intermediaries (GASCI) is a “self-regulatory organization” that runs the GSE. Only the four brokers who are both registered with the GSC and are members of GASCI are permitted to trade directly on the stock market, but anyone may place an order with a broker to buy or sell stocks and shares. There do not appear to have been any IPOs conducted via the GSE. As of May 2007, the GASCI Official List included one company and the Secondary List included 13 companies. The number of registered companies and trading volume are very low.

Market Development Over Time

Trading on the Guyana Stock Exchange started in 2003. In the late 1990s the government hired the Adam Smith Institute (ASI) as part of a project funded by the United Kingdom’s Department for International Development (DFID) to formulate the basic components of a stock market. The Securities Industry Act of 1998 provides for the registration of securities brokers and dealers, self-regulatory organizations, and certain issuers of securities, and for the regulation of securities issuances. It was not brought into operation until July 2002 upon the completion of supporting regulations. During 2000–02 the Guyana Securities Council and GASCI were created and provided with ASI technical assistance and budgetary support from DFID.

Market Infrastructure and Trading Systems

Infrastructure and trading systems are quite simple. Trading takes places on Mondays. Brokers execute orders by matching them against outstanding orders on the electronic order book, or, if there is no matching order, they leave their new order exposed on the book to await a matching incoming order when it arrives. Brokers settle with each other on a T+5 “Settlement Date.” GASCI is responsible for drafting the rule book, advising on procedures, devising the trading system, assisting in the development of the software, and in training, testing, and launching.

Regulation

The GSC is an independent autonomous body whose members are appointed by the Minister of Finance. ASI mandates that the GSC register persons engaged in trading or advising on securities and supervise their activities. GASCI is registered with the GSC to carry on a business as a stock exchange and an association of securities companies and intermediaries. Most of the costs of the GSC and GASCI are paid for by DFID.

Corporate Governance

Corporate reporting and governance is weak. Corporate reporting requirements are not rigidly enforced and company information can be difficult to obtain. A commercial court was only recently established, and the accounting and auditing infrastructure is limited.

Policy Lessons

  • A decision needs to be made on the long-term development potential of the market.

  • Possible links with a larger regional stock market could be considered.

Jamaica

Initiatives by the stock exchange and securities industry have helped the development of equity markets in Jamaica (Table A3.10). In addition, the authorities intend to initiate the integration of regional capital markets among Caribbean countries, although this has yet to be fulfilled.

Table A3.10.

Jamaica: Stock Market Indicators, 1995–2005

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Source: World Bank.
Description of the Equity Markets

Jamaica has a well-developed automated stock exchange with high market capitalization. The Jamaica Stock Exchange (JSE), established in 1969 as a center venue of equity markets, currently has 39 listed companies. Recently, trading volume increased significantly, and market capitalization has amounted to about 1.5 times the GDP. However, the financial sector accounts for about 75 percent of market capitalization, followed by the manufacturing sector with 10 percent.

The stock market has benefited from the Jamaica Central Securities Depository (JCSD). The JCSD provides a book entry service for investors, with the number of accounts increasing by 31 percent in 2005 to 79,000. The JCSD has also facilitated an increase in trading and transfer of shares between Jamaica and central securities depositories in Trinidad and Tobago and Barbados. This allows investors to take advantage of market opportunity across borders and prompts regional integration of stock markets.

Market Development Over Time

Not only the JSE’s initiatives but also the recent emergence of the securities industry have contributed to development of Jamaica’s capital markets.

The JSE has taken a number of initiatives aimed at developing capital markets, with an emphasis on promoting the confidence of stakeholders. The JSE, together with the Trinidad and Tobago Stock Exchange, held a trade show in New York to attract international investors to Caribbean markets. This has given further impetus to the integration of regional markets. To facilitate diversification of investment, the JSE and JCSD have proceeded with the implementation of the Fixed-Income Depository System. The JSE also continues to provide market education and training. Further, the Best Practice Awards, launched in 2005, stimulate greater interest by brokers and listed companies to achieve best practices and a high level of compliance.

Emergence of Securities Industry

The emergence of securities dealers, though nascent as an industry with vulnerability, has helped the development of capital markets. The legislation in 2002 separated banking from nonbanking activities, which resulted in the large transfer of funds under management from merchant banks to securities dealers. At the end of 2005, funds under management by securities dealers amounted to J$395 billion, representing 62 percent of GDP, and they now surpass the level of deposits with commercial banks. Dealers have initiated intermediation of these funds into capital markets, and have also encouraged the participation of retail investors. This is expected to stimulate capital markets if the industry addresses its vulnerability and establishes resilience to shocks.

Demutualization

The demutualization of the JSE is under consideration. This would enhance the flexibility and effectiveness of running the exchange. The JSE is assessing the relevant market conditions with a view to final implementation and devoting attention to ensure its independent regulatory position.

Policy Lessons

  • The ambition of the stock exchange to make an integrated market in the region can lead to faster development of equity markets.

  • The securities industry, an intermediary of funds, can add impetus to market development, provided that sound development of the industry is ensured.

Jordan

The Amman Stock Exchange (ASE), established in 1978, is an active equity market among smaller economies (Table A3.11). The ASE has shown strong performance in both primary and secondary markets with the participation of many foreign investors. This success reflects Jordan’s long-standing market reforms and privatization programs.

Table A3.11.

Jordan: Stock Market Indicators, 1995–2005

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Source: World Bank.
Description of the Equity Markets

The ASE has recently revealed strong performance in terms of both price and trading volume (see Saaqdi-Sedik and Petri, 2006). The number of listed companies increased steadily from 163 in 2000 to 201 in 2005. The market is dominated by the banking sector, which represented 62 percent of market capitalization as of end-2005, followed by the service sector (20 percent), industry (16 percent), and insurance (2 percent). The banking sector is itself dominated by Arab Bank, which accounts for 41 percent of the total market capitalization. The top 10 companies represent about 70 percent of the ASE market capitalization. The ASE share price index peaked at a historical high in November 2005, and maintained relatively strong momentum throughout 2006, given increased liquidity and improved economic fundamentals in the region owing to high oil prices. The trading volume also increased substantially, reaching $23.8 billion and 185 percent of GDP in 2005. Accordingly, the ASE market capitalization jumped to $37.6 billion at the end of 2005, constituting 292 percent of GDP.63

The recent large volume of non-Jordanian net purchases has led to a rapid increase in non-Jordanian ownership in the ASE’s stocks. During 2005, the net investment of non-Jordanians in the ASE soared seven times that of the previous year to $293 million, and the net purchases continued during 2006 albeit at a slower pace. As a result, non-Jordanian ownership in the ASE increased to 46 percent at end-2006 from 41 percent at end-2004, more than three-quarters of which may be attributed to investors from neighboring Arab countries. As for Jordanian ownership, individual and corporate investors represent 39 percent, the Social Security Corporation accounts for 11 percent, and the remainder belongs to the government.

The primary markets are benefiting from an active secondary market. In 2005, 64 public shareholding companies issued new shares to raise their capital through private subscription by the existing shareholders and certain investors, at a value of $489 million, compared with 31 companies with a capital of $125 million in 2004. Also, seven new public shareholding companies were registered with total capital of $39 million, while no new shareholding companies were established in 2004.

Market Development Over Time

Equity markets are starting to serve as an alternative source of funding in Jordan. Jordanian corporate sector investment and working capital is traditionally funded mainly from bank credit and retained earnings. Domestic nongovernment bank credit stands at more than 70 percent of GDP, representing a relatively high level among similar-sized countries. In addition, banks likely provide active advisory services to corporates through holding firms’ shares. However, the equity markets are beginning to play a larger role as suggested in vigorous primary markets and increased market capitalization.

Market Reforms

In 1997, the Amman Financial Market, established in 1978, was replaced by three new institutions. The Jordan Securities Commission (JSC), the Amman Stock Exchange (ASE), and the Securities Depository Commission (SDC) were newly established. This restructuring, aimed at separating the supervisory and legislative role, entrusted to the JSC, from the executive role of the capital market, assigned to ASE and SDC. Under the new framework, the ASE enhanced transparency of the markets by requiring publication of quarterly data, as well as its oversight function. The ASE also prompted foreign investors’ participation by allowing them to hold majority stakes in all sectors except construction, mining, and commercial service companies.

Privatization

The government’s privatization program has transformed many public enterprises into listed companies. These include Jordan Telecoms, Jordan Cement Factories, and the Jordan Investment Corporation Portfolio, which have deepened the markets through an increase in the supply of equities. The most prominent case was privatization of Jordan Telecoms, now the fourth-largest listed company by market capitalization.

Investor Base

The Social Security Corporation (SCC) plays a large role in the equity markets. The SCC, a scheme to protect workers under the social security umbrella, has assets of more than 25 percent of GDP. Recently, the SCC has increasingly moved its assets from bank deposits and fixed-income instruments to equity products in order to increase its return potential. Its equity investment reached JD 1.2 billion ($851 million) in 2004 (46 percent of its total assets), representing 11 percent of the ownership in the ASE.

Policy Lessons

  • The government’s privatization program provides opportunities for investing in good-standing companies such as telecoms.

  • Expansion of the investor base and diversification of the profile of listing companies are required for further sustainable development of equity markets.

Kenya

Trading performance at the Nairobi Stock Exchange (NSE) is relatively strong compared with those of other smaller economies (Table A3.12). A number of initiatives by the NSE, in addition to Kenya’s strong economic growth, supported development of equity markets. The NSE reinforces its activities through a three-year strategic marketing plan, with a view to integrating regional markets in cooperation with neighboring east African countries.

Table A3.12.

Kenya: Stock Market Indicators, 1995–2005

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Source: World Bank.
Description of the Equity Markets

The NSE consists of two equity markets and a fixed-income securities market. The equity markets are divided into the Main Investment Market Segment (MIMS), the main bourse of the NSE, and the Alternative Investment Market Segment (AIMS), aimed at facilitating new and smaller companies’ access to finance. On the fixed-income securities market, treasury bonds and corporate bonds are traded. There are 47 listed companies at the MIMS, with the number largely unchanged over the past decade. The equity market capitalization and turnover represent 35.5 percent and 2.8 percent of GDP respectively, but they are dominated by the two largest sectors, the “finance and investment sector” and the “industrial and allied sector.”

A cross-listing service with Uganda and Tanzania is provided at the NSE. This facilitates regional capital flows by enabling local firms to list their shares on all three securities exchanges simultaneously. Cross-listed companies, although just a few at the moment, can enjoy a wider capital base as well as the prestige of a regional presence.

Market Development Over Time

The development of Kenya’s equity markets, with its origins dating back 80 years, has accelerated in this decade. After starting stock trading with a gentleman’s agreement in the 1920s, when the country was still a British colony, the NSE was officially constituted as a voluntary association of stockbrokers in 1954. Since the 1990s, the NSE has undertaken extensive modernization efforts along with government-led market reforms. Most recently, the NSE presented a three-year corporate plan for 2006–08 with two clear strategic objectives: (1) to increase trading activity and the size of the market, and (2) to demutualize the organization by the end of 2007.

Facilitation of Foreign Ownership

The government has encouraged foreign ownership thorough repeated deregulations. The limit of foreign ownership was relaxed from 20 percent as of 1995 to 75 percent in 2002. Also, a restriction on the amount to be held by a single foreign investor was abolished (the previous ceiling was 2.5 percent of total shares). In addition, most exchange controls were abolished in 1995.

Trading Infras tructure

Trading infrastructures have been modernized. The NSE implemented a new trading cycle, T+5, in 2000. After the Central Depository System Act was passed, the Central Depository and Settlement Corporation (CDSC) became the legal entity that owns and runs the clearing, settlement, depository, and registry system for securities traded in Kenya. In order to boost liquidity in the capital markets and to enhance the price discovery function, the NSE implemented the Automated Trading System (ATS) in 2006, which is fully compatible with the CDSC.64

Cross-Listing

The NSE, the Uganda Securities Exchange (USE), and the Dar es Salaam Stock Exchange, Tanzania, have established cross-listing across the three exchanges. This aims to attract regional flows of capital to enhance economic developments in the area. Currently, two companies’ primary listing on the NSE is cross-listed on all the three exchanges: Kenya Airways and East African Breweries. The cross-listing initiative was reinforced through the memorandum of understanding (MOU) between the NSE and USE, which was signed in 2006.

Marketing Activities

The NSE has promoted improvements in corporate governance and investor education. The NSE is committed to the continuous development of corporate governance through initiatives including the “FiRe Award,” which is given to a company with excellent governance and financial reporting. This is designed to enhance the Corporate Governance Guidelineissued by the Capital Market Authority. The NSE is also committed to the Youth Investment Education Program, which recognizes that youth under 30 years of age constitute more than 70 percent of Kenya’s population and that they have thepotential to make a significant contribution to the economic development of the nation.

Demutualization

Demutualization may be a key milestone for the NSE. The purpose of the demutualization is to promote the strategic activities of the NSE by identifying and separating ownership and management rights from the execution of daily trading on the exchange. Shares of the NSE itself could even be listed if the ownership wishes.

Policy Lessons

  • A medium-term strategy for the exchange can clarify objectives and identify useful measures for developing markets. An organizational change such as demutualization may reinforce the exchange’s efforts to promote market reforms.

  • A move toward regional market integration, although a small step, may supplement market development through continuous cooperation with neighboring countries.

Mauritius

The Stock Exchange of Mauritius Ltd. (SEM) seems not to have realized its full potential (Table A3.13). The technical infrastructure of the SEM is modern and efficient and many supporting laws have been passed. However, the market is characterized by low volume, shallowness, and poor liquidity, and the number of companies listing on the SEM appears to have pla-teaued (Kim and Yao, 2005). The slow growth of the SEM, notwithstanding the solid laws and strong market infrastructure, can be attributed to the relatively small size of Mauritius, family ownership, and the slow pace of policy implementation.

Table A3.13.

Mauritius: Stock Market Indicators, 1994–2004

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Source: World Bank.
Description of the Equity Markets

The SEM operates two markets: the Official Market and the Development & Enterprise Market (DEM). Currently, there are 40 companies listed on the Official Market, representing a market capitalization of nearly $3.9 billion as of March 2007, with financial companies accounting for about 40 percent. There are 80 licensed capital market operators, including stockbrokers, fund managers, and investment schemes. Treasury bill trading on the market began in December 2003 with aview to developing an active secondary market for government instruments. The Stock Exchange is marginally profitable, generating MUR 12.3 million ($396,620) in net profit after tax for 2005/2006, of which 40 percent was distributed in dividends. Net foreign portfolio flows during 2005–06 increased to $42 million, the highest on record.

The broad economic impact of the SEM is likely to be limited. Less than 10 percent of the 450 large companies (defined as those with a turnover of more than MUR 80 million) list on the stock exchange and the market turnover ratio is not high. There has been only one IPO in the past several years, and that company has now delisted. Many of the companies listed on the exchange are controlled by a dominant shareholder, often a family-owned conglomerate, and free floats appear to be relatively low.

Market Development Over Time

The SEM was incorporated in Mauritius in March 1989 as a private limited company and opened to foreign investors in 1994. When the Official Market started its operations in 1989, there were five listed companies with a market capitalization of nearly $92 million.

Infrastructure and Trading Systems

Infrastructure and trading systems are advanced. The CDS was initiated in January 1997 with the Bank of Mauritius as the clearing bank. It provides delivery versus payment on a T+3 rolling basis and a Guarantee Fund Mechanism to guarantee settlement failures of participants. The automated trading system began operation in June 2001 and conducts trading through dedicated workstations located at intermediary dealers and linked by communication lines to the SEM. Capital gains and dividends are not taxed.

Market Reforms

The DEM aimed at SMEs was established in August 2006. As of May 2007, there were 50 companies listed on the DEM with a market capitalization of $1.5 billion. DEM listed companies must have a minimum market capitalization of MUR 20 million (about $600,000 as of May 2007), at least 100 shareholders, a minimum free float of 10 percent, and published accounts for at least one year prepared in accordance with International Financial Reporting Standards and audited without qualification.

The SEM joined the internationally recognized World Federation of Exchanges (WFE) in 2005. The exchange is only the second bourse in sub-Saharan Africa after Johannesburg to join the group. The WFE examined the SEM to verify its conformity with 20 criteria, including technological capability and organizational, regulatory, and supervisory infrastructure. The SEM joined the WFE with a view to attracting more foreign investors (the SEM opened to foreign investors in 1994).

Corporate Governance

Corporate governance is improving for private sector companies. The Companies Act 2001, new listing rules, and the consolidation of financial regulation within the Financial Services Commission (FSC) have enhanced shareholder protection and contributed significantly to corporate governance improvements. A Code of Corporate Governance, based on OECD Principles, was adopted in 2003 in the context of the publication of a “Corporate Governance Report on the Observance of Standards and Codes” (ROSC; World Bank). All designated companies (private and public) must either comply with the code or explain why they have not complied. The code has been seen as a success with respect to many private companies, but appears not to have led to improved governance of family and state-owned enterprises.

Regulation

The SEM operates under the control and supervision of the FSC. The FSC has ultimate oversight of the regulatory function of the SEM but delegates many regulatory functions to the SEM as “frontline” regulator of its listed companies and market intermediaries. The FSC has increased staff and training, and now conducts regular on- and off-site surveillance of market intermediaries. However, the allocation of regulatory authority for securities market activities among the Bank of Mauritius (BOM), the FSC, and the SEM is still unclear, including with respect to the interests of SEM shareholders and listed companies.

Policy Implementation

In many areas, implementation of policy reforms that could be expected to deepen the equity market has been slow. Inadequate staffing of the Financial Reporting Council has slowed implementation of the Financial Reporting Act. Key positions on important committees (the National Pensions Fund, the Financial Services Consultative Committee) have not been filled. The MOU between the BOM and the FSC was signed in December 2002 but has yet to be implemented. Implementation of the insurance and securities acts of 2005 has been delayed.

Policy Lessons

  • Important reforms have been enacted on a “top-down” basis often with foreign assistance, and actual implementation of the reforms has been quite slow, reflecting capacity constraints.

  • The high concentration of family ownership and large conglomerates has slowed the pace of improvement in corporate governance.

Sri Lanka

The 110-year-old Colombo Stock Exchange (CSE) has greatly contributed to development of equity markets (Table A3.14). Despite increased political and security concerns, the CSE has recently exhibited one of the best performances in the region. This is largely led by domestic investors, particularly retail investors, who have been influenced by the CSE’s initiatives.

Table A3.14.

Sri Lanka: Stock Market Indicators, 1995–2005

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Source: World Bank.
Description of the Equity Markets

The CSE, with more than 230 companies listed, has grown rapidly and significantly both in price and liquidity. In 2006, the All Share Price Index (ASPI) surged by more than 40 percent to a historically high level, owing to improved economic conditions and strong corporate earnings. The liquidity indicator also shows a strong performance because a high average daily turnover has been maintained. The market capitalization increased to $5.7 billion as of end-2005, representing 24 percent of GDP, which was close to the amount of domestic credit to the private sector.

Domestic investors have been the main contributors to market turnover, followed by the increasing involvement of foreign investors. The former account for more than 75 percent of purchases. In particular, retail investor participation remains high compared to corporate and institutional investors. Meanwhile, the strong domestic market influences foreign investors, who account for about 20 percent of market turnover with net purchases amounting to $62 million in 2005. A significant event was the California Public Employees’ Retirement System (CALPERS), the largest public pension fund in the United States, including Sri Lanka in its emerging markets investment eligibility list in 2005.

Primary market activities have also trended upward in tandem with an active secondary market. In 2005, $138 million was raised in the primary market, the largest mobilization of funds through the stock market. This was largely due to the listing of Dialog Telekom Ltd., which accounted for $85 million of the funds raised. The CSE continues to take several measures to make listing attractive, such as a clinical approach to potential companies. The CSE also plans to relaunch the Second Board as the “DiriSavi” Board, meaning “assisting effort,” in order to encourage smaller and medium-sized companies to list.65

Market Development Over Time

The CSE’s extensive initiatives have led to the high performance of the markets. The CSE, with its origins dating back to 1896, was incorporated in 1982, and became a formal stock exchange in 1995. Since then, the CSE has initiated a number of measures to improve the stock market.

Marketing

The CSE’s various marketing activities attract issuers and investors. The Issuer Relationship Division of the CSE establishes close relationships with companies and assists them throughout the listing process in cooperation with professionals such as accountants and auditors. On the investor side, the CSE conducts trade shows abroad to attract nonresident investors, mainly Sri Lankan expatriates. In 2005, the events were held in the United Arab Emirates, Australia, and New Zealand, which helped to increase investment inflows substantially. Further, the CSE hosted 243 seminars and workshops in 2005, reaching 10,500 participants, to enhance equity market awareness among current and potential investors.

Branch Network

The CSE has an effective branch network to facilitate local investor participation. The CSE established its first branch in 1999 and opened the third one in 2005. Approximately 10,000 new investment accounts were opened through branches in 2005, which represented more than 20 percent of new domestic retail accounts in the year. Also, the CSE’s branch network and its trading floor have accounted for about 10 percent of total turnover, helping geographical diversification of capital markets.

Investment Instruments

The CSE provides numerous investment instruments with different risk return profiles. This is initiated by the idea that different types of instruments complement and benefit each other if they are traded in a single market place. The first such measure was the introduction of the Debt Trading System, which provides an automated trading system for both government and corporate debt securities. The CSE also plans to implement a Securities Borrowing and Lending System to improve liquidity and the price discovery function. Further, the CSE conducts several derivative training programs for market participants with a view to expanding the derivatives markets.

Settlement System and IT Infrastructure

The CSE has enhanced its settlement system and information technology (IT) infrastructures to meet international standards. The CSE reduced the settlement cycle twice in 2005 by two days, thereby making the cycle T+3 (buyer) and T+4 (seller and participants). A further reduction has been proposed but is yet to be implemented. The interparticipant fund settlement of equity transactions directly through the real-time gross settlement system (RTGS) of the Central Bank of Sri Lanka is under consideration, and the introduction of a delivery versus payment settlement system for equities is also planned. To improve system reliability, the CSE continues to invest in IT infrastructures, recording an uptime of 99.6 percent in 2005, which satisfies international standards.

Demutualization

The CSE is planning to demutualize the organization to enhance adaptability to the changing environment. This will require amendments to be made to the Securities Act and Company Act. Further, member firms should decide the model for the distribution of shares in the demutalized exchange.

Policy Lessons

  • Market initiatives mainly taken by the stock exchange may be a driving force for developing equity markets.

  • Domestic individual investors, in addition to foreign investors, can form an important part of the investor base.

56

The data source with the broadest international coverage appears to be the Standard & Poor’s Emerging Markets Database, which is reported by the World Bank.

57

These case studies are based on, in addition to specified references, various sources including annual reports of central banks and stock exchanges, other information on their websites, and IMF Staff Reports.

58

The government has partly made up for shortfalls in bank lending in some areas, ranging from small enterprises to parastatal corporations. The Citizens Entrepreneurial Development Agency (CEDA) implements such programs aimed at supporting small and medium-sized enterprises by providing subsidized loans. Lending by the CEDA through August 2004 amounted to P 674 million (1½ percent of GDP) for use in more than 1,000 projects.

59

In addition, new bonds were issued in 2004 by Debt Participation Capital Funding, a vehicle to securitize the government’s loan book, and they are now listed on the BSE. This is also consistent with the strategy of developing capital markets, as well as of reducing government financial arrangements.

60

OMX is a private firm that is expert in the exchange industry, operating the exchanges in the Nordic and Baltic region. It develops and provides technology and services to companies in the securities industry around the world.

61

This was due to the buyback of Hansabank shares, one of the largest listed companies in the Tallinn Stock Exchange.

62

In 2006, the Olympic Entertainment Group’s stocks began to be traded simultaneously in Estonia, Latvia, and Lithuania. This is the first case in the Baltic Market.

63

In 2005, the average market capitalization for emerging Asia was 39.8 percent of GDP, emerging Europe was 54.7 percent, and Latin America was 49.5 percent.

64

The ATS is sourced from Millennium Information Technologies (MIT) of Colombo, Sri Lanka. MIT has also supplied similar solutions to the Colombo Stock Exchange and the Stock Exchange of Mauritius.

65

Separately, the government has made efforts to enhance access to finance for micro, small, and medium-sized companies. A new specialized bank, “Lankaputhra,” was established in 2005 to cater to the SME sector in the country. The Central Bank of Sri Lanka has continued to assist these programs.

Annex IV. Case Studies: Regional Integration

Market Integration in Europe

In Europe, cross-country market access is based on the “single passport” concept. Products and financial intermediaries authorized in one European Union (EU) country have free access to the other EU member countries, based on the authorization given by the home country. For that purpose the European Directives establish minimum common authorization requirements, as well as a certain minimum common approach toward the authorization process by all EU members. Supervision relies mainly on the home country, although under certain circumstances the host country can also exercise supervisory powers.

The Lamfalussy Committee in 2001 proposed a new structure to streamline the preparation of regulations and to foster supervisory convergence between national securities supervisors. This structure has three levels: (1) the Ecofin Council and European Parliament decide on the broad framework principles in Directives and Regulations, (2) regulatory committees (composed of high-level representatives from the ministries of finance) vote on the proposals of the European Commission for implementing technical measures, and (3) supervisory committees (composed of high-level representatives from the relevant supervisory authorities) advise the European Commission on promoting a consistent implementation of EU directives and convergence of supervisory practices.

These institutional and legal arrangements have provided the framework for private-company-led efforts that have deepened securities market integration. Euronext is a cross-border exchange that integrates trading and clearing operations on regulated and non-regulated markets for cash products and derivatives. It was formed in 2000 in response to the globalization of capital markets and, to create a pan-European exchange offering, its participants increased liquidity and lowered transaction costs. Euronext countries’ trading rules have been largely harmonized, under the responsibility of the exchange, but each local market remains subject to its domestic regulation (public law rules), under the supervision of the local authorities. The trading of most securities is done on a unified order-driven platform. Clearing involves a central counterparty—the LCH Clearnet Group—for all exchange-executed trades. In contrast, settlement is partially decentralized, and can be done on the books of several entities.

The Eurolist market operated by the Euronext group brought together the cash markets of France, Belgium, Portugal, and the Netherlands. Up until 2005, the markets used a com mon trading platform, but listing requirements were different. Since 2005, the four markets have shared the same listing requirements, thus facilitating the cross-listing of issuers. Clearance, settlement, and the depository are not fully centralized; rather, each market has its own arrangements. This example of business integration has forced the regulators to take additional steps to ensure proper coordination of their efforts through the signing of memorandums of understanding (MOUs) on the supervision of Euronext and Euroclear.

Notwithstanding all the progress already achieved, there are still concerns regarding the costs of cross-border transactions. On July 11, 2006, the Head of Internal Markets at the European Commission set out a voluntary code of conduct aimed at achieving interoperability between Europe’s many stock exchanges, clearing houses, and settlement firms, as well as a timetable for its implementation. Customers of Europe’s stock exchanges have been critical of the “vertical silo” model, in which a single owner-operator operates one country’s stocks and derivatives markets along with its post-trading services, which in the opinion of many is making trading in Europe more expensive than in the United States. The first phase will include measures aimed at achieving price transparency by the end of the year. Interoperability will come in the second phase; and it will require all stock exchanges, clearing houses, central counterparties, and central securities depositories to be able to send instructions to and from one another. This will allow any customer to choose its own provider of post-trading services. The third phase would encompass complete unbundling of all services and separate accounting for each service provided.

Integration of the Baltic Markets with Nordic Area Markets

The Baltic financial markets have achieved a significant but apparently slowing degree of integration with those of the Nordic area.66 Individually, each of the Baltic equity markets may be too small to be viable—at end-2005, the combined market capitalization of equity markets in the Nordic-Baltic countries was $1.2 trillion. Until the mid- and late 1990s, market integration of these countries was affected by restrictions on selected cross-border equity transactions and by limited foreign ownership of individual companies. After most barriers to cross-border equity transactions were removed in the context of EU integration, foreign ownership of listed companies rose sharply. For example, nonresident investors held 60 percent of market capitalization of the Talinn Stock Exchange in 2006.

Market integration was initiated by Norex, the strategic alliance, originally agreed to between Nordic stock exchanges. The alliance encompasses harmonized membership requirements and trading rules and the removal of cross-country entry fees. The Saxess trading platform, which serves as a single point of entry for the Nordic markets, supports trading in a wide range of cash and derivatives instruments, different trading models, and both order-driven and price-driven market structures.

Integration has been facilitated by the purchase of all but one of the regional stock exchanges by the OMX Group of Sweden.67 Integration has been furthered by harmonization of share indices, a common “Nordic List” organized by market capitalization and industry, new corporate governance codes for issuers, and harmonized listing requirements among the OMX Nordic exchanges.

Regional market intermediaries and remote membership are also enhancing integration. In 2002, banking groups from Denmark, Sweden, Norway, and Finland agreed to offer clearing, settlement, and custody to international and domestic customers. Ten brokers account for about 42 percent of global equity turnover in the region, with six belonging to global investment banking groups.

In 2004, the three Baltic stock exchanges jointly established the Baltic Market by integrating trading and settlement systems. This is part of the larger OMX group of exchanges, and it offers ease of access to more than 80 percent of the exchange trading in the Nordic and Baltic countries. However, the Baltic Market and the Nordic Market adopted separate operation frameworks for the moment, because they are at different stages of development. The Baltic Market offers for the three exchanges the advantages of easy cross-membership, a common trading system, harmonized market practices and rules, efficient cross-border trading and settlement services, one market information source such as a common securities list, harmonized corporate information, a common index, and a common data website. A Baltic Fund Center, which was established in 2006, allows investors to more easily compare investment funds and fund-management companies. Further, the Baltic Market introduced an Alternative Securities Market targeting small and medium-sized companies (First North Baltic) in 2007.

Further integration of the Nordic and Baltic markets as one entity is envisaged. The plans call for investors to have full access to all trading both in the Nordic and Baltic exchanges. This would be made possible by full integration of membership applications, trading systems, practices and rules, and information sources.

Supervision is taking the form of arrangements among regulators rather than institutional consolidation. Several Nordic market regulators have concluded an MOU on cooperation in the supervision of the OMX group, and Nordic central banks have signed cross-border MOUs on the oversight of stock exchanges and payment and settlement systems. Further, MOUs are being signed covering cross-border central securities depositories (CSD) groups.

Trading is well integrated for the Nordic-Baltic exchanges, but integration has slowed for clearing and settlement. Clearing and settlement systems use different technologies and are tailored for domestic markets. Upgrading and integrating these systems will be costly. Further, banks are in many cases shareholders of the CSDs and members of the exchange, and also provide other services to investors. Because integration of post-trading infrastructures can alter the profitability of various services, these different products can create conflicts and make it in their interest to slow integration.

The Baltic markets seem to be evolving as an integrated entity unto themselves rather than as part of the Nordic Market. For example, the Baltic exchanges are not part of a CSD created in 2004 by the Nordic exchanges. The divergence of the Baltic exchanges may reflect their smaller economic sizes, different corporate structures, and less-developed country markets.68 The separate path suggests that the Baltics are not fully integrated with their more developed Nordic neighbors, and that it is likely to take time for the Baltics to benefit from the full-fledged regional integration enough to attract global investors’ interests.

Central America69

The setting for market integration in Central America is mixed. On the plus side, financial groups own subsidiaries in almost every country in Central America, and the key shareholders of the most important financial groups are from the region. However, capital market integration is impeded by different currencies, restrictions on domestic institutional investors, the presence of as many as eight exchanges and custodians, the mutual structure of most exchanges, the presence of competing exchanges and custodians, and regulatory conflicts.

Steps toward regional integration have been mainly with respect to the regulators and stock exchanges of Costa Rica, El Salvador, and Panama. In 2003, El Salvador and Panama signed an MOU committing to a fast-track registration of primary issues and mutual funds, Panama granted El Salvador the status of recognized jurisdiction, and El Salvador and Costa Rica signed another MOU agreeing to streamline the registration process, but the impact of this cooperation has been limited. The stock exchanges of Costa Rica, El Salvador, and Panama signed an MOU in September of 2006 for the development of a common trading platform, but progress in implementation has been slow. Further, the exchanges agreed to seek the technical support from OMX.

The slow pace of integration reflects perceived differences in regulation and the challenge of passing new legislation in support of harmonization. There is a perception that the quality of supervision is uneven across countries, and countries that believe they have higher standards of regulation and supervision are not willing to compromise those standards. Other efforts to achieve broader harmonization in Central America have yet to bear fruit because the differences in the regulatory requirements are perceived as significant, and therefore efforts to harmonize them would require legislative amendments, for which it would be difficult to gain political support.

Policy measures are available to help set the stage for integration. Indeed, market participants seem to be positioning themselves through partnerships with regional counterparts to take advantage of regionaliza-tion. A decisive signal by the authorities to harmonize varying regulations could provide an effective signal to align issuers, investors, and intermediaries toward such a goal. Equity market integration could piggyback off of the already fairly liquid government securities markets by government efforts to foster listing and trading in a shared or linked marketplace.

Other Examples of Smaller Economy Regional Equity Market Integration

The first steps toward equity market integration are under way in several groups of smaller economies, in addition to the Baltics and Central America. The stock exchanges of Kenya, Uganda, and Tanzania offer a cross-listing service that enables firms to list their shares on all three exchanges simultaneously. Jamaica has also facilitated trading and transferring shares with Trinidad and Tobago and Barbados through a network of CSDs. These are examples of regional integration among countries at a similar stage of market development, rather than a merger of smaller markets with a larger neighbor. In Maghreb countries, measures fostering information and technology sharing, cross-listing, and cross-border investment would boost equity markets and ultimately lead to broad financial integration.

66

The Baltic Markets refer to stock exchanges in Estonia, Latvia, and Lithuania. The reference to the Nordic area means exchanges in Denmark, Sweden, Norway, Finland, and Iceland.

67

The Norex alliance remains valid even after the OMX group of exchanges was established.

68

The Baltic exchanges have much lower capitalization-to-GDP ratios compared to those of the Nordic countries, and they are dominated by equity issues, whereas bonds make up a significant share of the Nordic exchange capitalization.

69

This section draws on Shah and others (2007).

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230. Financial Stability in Dollarized Countries, by Anne-Marie Gulde, David Hoelscher, Alain Ize, David Marston, and Gianni De Nicolò. 2004.

229. Evolution and Performance of Exchange Rate Regimes, by Kenneth S. Rogoff, Aasim M. Husain, Ashoka Mody, Robin Brooks, and Nienke Oomes. 2004.

228. Capital Markets and Financial Intermediation in The Baltics, by Alfred Schipke, Christian Beddies, Susan M. George, and Niamh Sheridan. 2004.

227. U.S. Fiscal Policies and Priorities for Long-Run Sustainability, edited by Martin Mühleisen and Christopher Towe. 2004.

226. Hong Kong SAR: Meeting the Challenges of Integration with the Mainland, edited by Eswar Prasad, with contributions from Jorge Chan-Lau, Dora Iakova, William Lee, Hong Liang, Ida Liu, Papa N’Diaye, and Tao Wang. 2004.

225. Rules-Based Fiscal Policy in France, Germany, Italy, and Spain, by Teresa Dában, Enrica Detragiache, Gabriel di Bella, Gian Maria Milesi-Ferretti, and Steven Symansky. 2003.

224. Managing Systemic Banking Crises, by a staff team led by David S. Hoelscher and Marc Quintyn. 2003.

223. Monetary Union Among Member Countries of the Gulf Cooperation Council, by a staff team led by Ugo Fasano. 2003.

222. Informal Funds Transfer Systems: An Analysis of the Informal Hawala System, by Mohammed El Qorchi, Samuel Munzele Maimbo, and John F. Wilson. 2003.

221. Deflation: Determinants, Risks, and Policy Options, by Manmohan S. Kumar. 2003.

220. Effects of Financial Globalization on Developing Countries: Some Empirical Evidence, by Eswar S. Prasad, Kenneth Rogoff, Shang-Jin Wei, and Ayhan Kose. 2003.

219. Economic Policy in a Highly Dollarized Economy: The Case of Cambodia, by Mario de Zamaroczy and Sopanha Sa. 2003.

Note: For information on the titles and availability of Occasional Papers not listed, please consult the IMF’s Publications Catalog or contact IMF Publication Services.

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Cover Developing Essential Financial Markets in Smaller Economies
Developing Essential Financial Markets in Smaller Economies
Stylized Facts and Policy Options
ISBN:
9781589067752
ISSN:
0251-6365
Publication Date:
16 Dec 2008
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781589067752.084
Pages:
86
  • <xref ref-type="fig" rid="RA1lev1">Figure A1.1</xref>.
    View in gallery
    Figure A1.1.

    Emerging Market Countries and Smaller Economies: Selected Foreign Exchange Market Aspects

  • <xref ref-type="fig" rid="RA1lev2">Figure A1.2</xref>.
    View in gallery
    Figure A1.2.

    Median Daily Exchange Rate Percent Change, Emerging Markets and Smaller Economies with Floating Exchange Rate Arrangements

  • <xref ref-type="fig" rid="RA1lev3">Figure A1.3</xref>.
    View in gallery
    Figure A1.3.

    Maximum Daily Exchange Rate Percent Change, Emerging Markets and Smaller Economies with Floating Exchange Rate Arrangements

  • <xref ref-type="fig" rid="Rapp02fig01">Figure A2.1</xref>.
    View in gallery
    Figure A2.1.

    Market Turnover of Government Securities by Foreign Institutions

  • <xref ref-type="fig" rid="Rapp02fig02">Figure A2.2</xref>.
    View in gallery
    Figure A2.2.

    Market Turnover of Government Securities, Emerging Market Countries and Smaller Economies

  • <xref ref-type="fig" rid="RA3lev1">Figure A3.1</xref>.
    View in gallery
    Figure A3.1.

    Market Capitalization, 2005

  • <xref ref-type="fig" rid="RA3lev2">Figure A3.2</xref>.
    View in gallery
    Figure A3.2.

    Smaller Economies and Emerging Market Countries: Number of Listed Companies

    (Median)

  • <xref ref-type="fig" rid="RA3lev3">Figure A3.3</xref>.
    View in gallery
    Figure A3.3.

    Smaller Economies and Emerging Market Countries: Market Capitalization

    (Median)

  • <xref ref-type="fig" rid="RA3lev4">Figure A3.4</xref>.
    View in gallery
    Figure A3.4.

    Smaller Economies and Emerging Market Countries: Turnover

    (Median)

Figure A1.1.

Emerging Market Countries and Smaller Economies: Selected Foreign Exchange Market Aspects
Figure A1.2.

Median Daily Exchange Rate Percent Change, Emerging Markets and Smaller Economies with Floating Exchange Rate Arrangements
Figure A1.3.

Maximum Daily Exchange Rate Percent Change, Emerging Markets and Smaller Economies with Floating Exchange Rate Arrangements
Figure A2.1.

Market Turnover of Government Securities by Foreign Institutions
Figure A2.2.

Market Turnover of Government Securities, Emerging Market Countries and Smaller Economies
Figure A3.1.

Market Capitalization, 2005
Figure A3.2.

Smaller Economies and Emerging Market Countries: Number of Listed Companies

(Median)
Figure A3.3.

Smaller Economies and Emerging Market Countries: Market Capitalization

(Median)
Figure A3.4.

Smaller Economies and Emerging Market Countries: Turnover

(Median)

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  • Zervos, Sara 2004, “The Transactions Costs of Primary Market Issuance: The Case of Brazil, Chile, and Mexico,” Policy Research Working Paper No. 3424 (Washington: World Bank).

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