Stock and Bond Issues and Capital Markets in Less Developed Countries
Author: U Tun Wai and Hugh T. Patrick
Publication Date:
01 Jan 1973
eISBN:
9781451947403
ISBN:
9781451947403
Language:
English
Keywords:
SP; company; EEC-AAC arrangement; EEC country; interest rate; central bank; at par; secondary market; share price; Securities; Stock markets; Stocks; Bonds
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IN THE 1950S, FOREIGN AID was considered by some to be the most important means of alleviating the financial difficulties associated with capital formation and economic development in the less developed countries (LDCs). In the 1960s, foreign aid grew less rapidly, and a certain disillusionment set in as to its effectiveness. The favored solution then became government fiscal policy: taxation to raise the rate of gross domestic savings, and government investment expenditure and development loans to allocate that saving. Again, some disillusionment had set in by the late 1960s. Governments had done perhaps all they could to raise their revenue share in gross national product (GNP) quickly, and it did not seem to be sufficient for development goals. A significant portion of increased revenues had been used for nondevelopment government consumption expenditures. Moreover, government allocation of its investible resources had not always been efficient, nor had government lending programs, which so often were subject to noneconomic (i.e., political) criteria.

Abstract

IN THE 1950S, FOREIGN AID was considered by some to be the most important means of alleviating the financial difficulties associated with capital formation and economic development in the less developed countries (LDCs). In the 1960s, foreign aid grew less rapidly, and a certain disillusionment set in as to its effectiveness. The favored solution then became government fiscal policy: taxation to raise the rate of gross domestic savings, and government investment expenditure and development loans to allocate that saving. Again, some disillusionment had set in by the late 1960s. Governments had done perhaps all they could to raise their revenue share in gross national product (GNP) quickly, and it did not seem to be sufficient for development goals. A significant portion of increased revenues had been used for nondevelopment government consumption expenditures. Moreover, government allocation of its investible resources had not always been efficient, nor had government lending programs, which so often were subject to noneconomic (i.e., political) criteria.

IN THE 1950S, FOREIGN AID was considered by some to be the most important means of alleviating the financial difficulties associated with capital formation and economic development in the less developed countries (LDCs). In the 1960s, foreign aid grew less rapidly, and a certain disillusionment set in as to its effectiveness. The favored solution then became government fiscal policy: taxation to raise the rate of gross domestic savings, and government investment expenditure and development loans to allocate that saving. Again, some disillusionment had set in by the late 1960s. Governments had done perhaps all they could to raise their revenue share in gross national product (GNP) quickly, and it did not seem to be sufficient for development goals. A significant portion of increased revenues had been used for nondevelopment government consumption expenditures. Moreover, government allocation of its investible resources had not always been efficient, nor had government lending programs, which so often were subject to noneconomic (i.e., political) criteria.

The new emphasis for the 1970s, for some, is to raise the rate of private domestic voluntary saving and to allocate that saving more efficiently through the development and effective use of capital markets in LDCs. This view, indeed hope, has manifested itself more at the policy and operational level than it has in academic circles.

Policymakers in a large number of LDCs have tended to emphasize the benefits of capital market development without close examination of opportunity costs—indeed, neither benefits nor costs have been estimated carefully. The key issue, in our view, is not whether market-oriented LDCs should have capital markets or not but the degree to which government policy should aid their development. Should a capital market evolve in response to the demand for its services (demand-following), subject only to legal regulation to improve the market, or should its development be actively encouraged (subsidized) by the government, in effect providing its services in advance of the demand for them and, hence, generating that demand (supply-leading)? 1

One difficulty in discussing the appropriate role of the capital market in LDCs lies in the ambiguous and multiple ways in which the expression “capital markets” is used. In the broadest connotation, capital markets refer to the entire organized financial system, including commercial banks and all other financial intermediaries, and to short-term as well as long-term primary and indirect nonmonetary financial claims.2 While short-term (money) and long-term (capital) markets are typically closely related, we prefer to distinguish between the two. An intermediate definition of capital markets includes all organized markets and institutions dealing in long-term credit instruments (conventionally defined as having a maturity in excess of one year), including stocks (equities), bonds (government and private), term loans, mortgages, and time or savings deposits.3 Here the focus is on the demand for and supply of long-term funds, presumably to finance fixed investment.

The narrowest, and probably most commonly used, definition of a capital market is the one that we have adopted, viz., the locus of the organized market where stocks (common and preferred claims of equity ownership) and bonds (including debentures and convertible bonds) are bought and sold using the services of brokers, dealers, and underwriters. Also, we use “stocks and bonds” and “securities” synonymously. The emphasis is on the activity of market transactions (buying and selling); characteristically this occurs in a specified physical location, usually institutionalized in the form of a securities exchange. The capital market can be dichotomized in two ways: the new issues market (the initial public sale of securities supplied by newly listed firms or of new issues by previously listed firms) versus the secondary market (trading in issues previously issued publicly); and the private securities market (trading in the stocks and bonds of privately owned corporations) versus the government securities market (normally government bonds, since public trading of privately held shares in government-controlled corporations is considered to be part of the private securities market).

In this preliminary study we attempt a cross-country survey of the actual experience of LDCs with issues of stocks and bonds and with capital markets. The sequence is first to consider the goals of capital market development, next to examine the general characteristics of capital markets in LDCs, then to discuss policy proposals to improve capital markets, and finally to summarize our main conclusions.

I. Some Conceptual Issues

The theory of the role of issues of stocks and bonds, together with issues of other primary claims, and of capital markets is one component of standard Anglo-American theory (i.e., the blending of neoclassical and Keynesian assumptions and analyses) and does not require detailed explanation here. Increasing the supply of the factors of production, enhancing their quality, and combining (allocating) them efficiently are important in achieving development. Theoretically, issues of stocks and bonds, like other forms of finance, increase the saving rate by making saving more attractive and allocate that saving to the most efficient investors and investment activities. Moreover, investment bankers, like other financiers, in some circumstances may take on entrepreneurial functions in encouraging the development and growth of businesses. Also, the causal chain from financial variables to real variables (via the interest rate, the cost of capital, the marginal efficiency of investment, the wage rate/capital cost ratio) to the growth of output and employment is well stated in the standard body of theory.

This causal chain can be, and often is, vitiated or broken by the market imperfections that are more prevalent in most LDCs than in most economically advanced countries (EACs). Imperfections exist in capital and money markets, foreign exchange and trade, government revenues and expenditure, and labor markets, as well as in markets for stocks and bonds. While governments seldom try to control the price or yield of shares directly, they are much more likely to control (peg) government bond prices and yields directly and, through legislation or administrative suasion, to request certain categories of financial institution to purchase and hold government debt, as secondary reserves, etc. Capital market imperfections are discussed further in Section III.

Two important goals of LDCs are increasing the rate of growth of output and improving the distribution of income, wealth, and economic power.

How do issues of stocks and bonds and capital markets affect achievement of these goals? First, the main and most direct impact of stocks and bonds on real economic variables comes from their issue by spending units (government and corporations), whereby funds are made available to them for expenditure (presumably investment) purposes. The holding or exchanging (trading) of previously issued securities has less direct effects, although there are probably some indirect effects on consumption and saving (via changes in wealth and portfolio composition) and on investment (depending on how sellers use their acquired funds and how buyers might otherwise have used them).

Second, how important are stocks and bonds in relation to other sources of finance? By no means all—indeed, often relatively little—of the new issues of stocks and bonds are sold initially through the capital market; private placement is an important alternate mechanism. Direct finance (sales by spending units to savings units) is distinguished from indirect finance (sales by spending units to financial intermediaries). These alternatives are delineated schematically in Chart 1. In this schema, underwriters and brokers are included as part of the capital market rather than as financial intermediaries.4 The difference between direct sale (private placement) and sale through the facilities of a capital market is important both conceptually and empirically; evidence on this is presented in the next section.

Chart 1.
Chart 1.

Issues of Securities: Private Placement versus Sale Through Capital Markets, and Direct versus Indirect Finance1

Citation: IMF Staff Papers 1973, 002; 10.5089/9781451947403.024.A001

1 Dotted line divides direct from indirect finance. A direct sale by issuers of stocks and bonds to financial intermediaries is part of indirect finance.

Sufficient information on capital markets in LDCs is not available to test any complete set of hypotheses. However, scattered evidence permits some generalizations to be made. One generalization, put in extreme form, is that the narrowness or breadth of the capital market for issuing stocks and bonds has relatively little effect on the aggregate rate of private savings at the level of development of most LDCs. This derives from the assumption that there exist sufficiently close financial substitutes for them. It is possible that those who are willing to take the risks of equity ownership can fairly readily find direct investment opportunities, either of their own, or those of relatives or friends; perhaps the greater liquidity of publicly traded shares is sufficiently important in LDCs, as in EACs, to attract to that level of risk those savers who would not be willing to accept the illiquidity of investment in their own or their friends’ projects. Most savers are averse to taking risks, or at least appear so because of capital market imperfections.5 For them, savings deposits (in any of a variety of financial institutions) are a close substitute for bonds, private or government. To the extent that rather wide interest rate differentials exist between savings deposits and bonds of the same maturity—because of, say, government or oligopolistic restrictions on interest rates on savings accounts and market-determined rates on bonds—and to the extent that saving is responsive to interest rate incentives, our generalization is incorrect.

The allocative effect of capital markets—of directing saving to the most efficient investors—is perhaps more important than the effects on the rate of saving. Presumably the most efficient firms are the most profitable, and the most profitable can sell new stock and bond issues cheaply and most readily. Several problems, however, relate to market imperfections, which are greater in LDCs than in EACs.

First, do differences in profit rates—presumably adjusted for risk—reflect efficiency reasonably well, or are they due primarily to market distortions: monopoly positions, import quotas, credit rationing, etc.? To the extent that capital market development helps firms whose profits are high owing to market imperfections rather than to efficiency in resource allocation and use, its allocative effect is harmful rather than beneficial.

Second, allocation of saving through the capital market discriminates in favor of large firms, even more so in LDCs than in EACs.6 Typically, only the largest, best-known firms in LDCs are able to issue stocks and/or bonds publicly, mainly because of the lack of information for potential buyers. Frequently, these firms are foreign controlled. Smaller firms are able to issue securities through capital markets only when large numbers of investors are willing to take risks and reliable information is available, and then at a higher cost than for large firms.

However, the allocative effect is much more complex than this, since it involves possibilities of substitutability and/or complementarity on the part of both corporate issuers and purchasing individuals. It can be argued that in LDCs only the most creditworthy firms can sell their securities via a capital market, that these firms also have prime access to bank loans, and hence that such firms have greater freedom of choice between different sources of finance (in terms of availability of funds), for example, between bank loans and security issues. Development of capital markets provides no reallocation of resources to such firms. We have to examine instead where the buyers of securities obtain their funds, and how they would have used them alternatively; and how the lending bank derives its loanable funds, and to what use it would have put them alternatively.

A simple example would be that the individual buyer uses savings from current income to purchase the new security issue rather than placing them in a bank savings account, and that if he had placed them in a savings account the bank would have made a loan to the company or bought its securities. Here, there would be no reallocation of resources (ignoring reserve requirements against savings deposits). This example is clearly too simple; we would expect the individual’s new savings to result in a comprehensive adjustment of his entire asset portfolio, and, similarly, for additional savings deposits to affect the composition of the asset portfolio of the commercial bank. Until we have this information, we do not know the allocative effects of capital market development.

It may be that corporate issuance of stocks and bonds is not a complete substitute for bank loans, constituting an additional source of credit. Then, capital market development favors the large firms in availability as well as in cost of funds. Indeed, in some circumstances, corporate security issues (particularly of equity) may complement other forms of external finance, so that a leverage (or multiplier) effect benefits the firm. In many countries, business management and lending institutions have rules of thumb about the optimal, or at least the unacceptable, mix of a borrowing firm’s liabilities and about the ratio of its net worth to total liabilities. These rules seem to vary widely among countries, apparently based more on historical circumstances than on rational assessment. In some countries, such rules may even be formalized in legislation.7 In these circumstances, enhanced opportunity to issue securities increases the share of such firms in total loanable funds even more than otherwise. Whether or not this is an efficient allocation depends on whether these firms use capital more efficiently than the small firms who are precluded from such sources of credit, and whether profitability reflects efficiency or market distortions.

But, raising the savings ratio and allocating savings efficiently for growth of output and employment may have side effects on the distribution of income, wealth, and economic power. It is difficult to hypothesize on this matter. However, it appears that until a wide range of firms (by size) and of savings units (by size, distribution of income, and wealth) participate in the capital stock market directly or indirectly (through mutual funds, pension funds, insurance companies, etc.), the development of the capital market, particularly the market for equities, is likely to increase the inequality of income and wealth distribution. However, if a country had a vigorous program of wealth redistribution by capital, estate, or inheritance taxes (we know of no market-oriented LDC with such policies), a developed capital market would not have adverse effects. It would enable corporations to change ownership without serious disruption, and wealthy taxpayers could diversify their portfolios.

One further presumed advantage of capital markets is that it would open up family or other privately owned corporations to public scrutiny and partial public ownership and, hence, to share in the benefits of growth. A major problem in many LDCs is that most privately owned large firms do not want to go public; they fear loss of control and loss of secrecy. The former fear is probably exaggerated, as the controlling group almost always continues in control. The secrecy issue is trickier, combining both behavioral traits and a rational sense of loss of possible competitive advantage. Presumably a social benefit is that publicly owned (but family controlled) firms will be more subject to pressures to maximize profits relative to other goals, and more likely to hire professional managers with more skills. Income reporting, auditing, and tax collection will also be improved.

Opening firms to partial public ownership does not necessarily reduce the power and wealth of those who still control the firm. It depends on the use to which the management or individuals put the funds received from selling the stock. It might well enable them to expand their holdings and their economic power further. One clear-cut example is the zaibatsu families in Japan prior to World War II, who used funds from the sale of minority shares in their corporations for further expansion.

II. Characteristics of Securities Issues and Capital Markets in LDCs

Our search for national data for cross-country comparisons has been in two interrelated directions: to obtain aggregate estimates of net securities issues, government and private, in absolute amounts and relative to real variables, such as gross domestic investment and GNP; and to obtain evidence on the size and functions of capital markets, particularly the amount of new issues, also absolutely and relatively, (Throughout this paper, the terms “net issues” and “new issues” are used interchangeably. The data collected are designed to measure the amount of funds raised, not conversions or the rollover of existing government or private debt.) Considerable use was made of information in the Data Fund of the International Monetary Fund (IMF), much of which is published in International Financial Statistics. In addition, a variety of national sources was used, such as central bank reports, annual reports, and special national flow-of-funds reports. A questionnaire was also sent to stock exchanges in LDCs, but only a few of them responded.

Issues of stocks and bonds

The relative size of new securities issues in LDCs can be appraised not only in intercountry comparisons but also by comparison with the situation in developed countries. The total supply of securities issues for both government and private sectors varies among developed countries themselves in relation to GNP. Thus, according to statistics from the Organization for Economic Cooperation and Development (OECD),8 the developed countries with a high ratio of new securities issues, equivalent to 8–11 per cent of GNP, are Belgium, Denmark, Italy, Japan, the Netherlands, and Switzerland. The next category of countries, between 4 and 7 per cent, are Canada, Finland, Spain, Sweden, and the United States. Countries below 4 per cent are France, Germany, Norway, Portugal, and the United Kingdom. This distribution of developed countries between high, medium, and low ratios of net issues to GNP does not appear to be correlated with either per capita income or growth rates. It depends primarily on how investments are financed rather than on the relative importance of investments. It is surprising that the United States and the United Kingdom, which are normally considered to have important capital markets, have such low ratios. The reason for this phenomenon is that the financial and capital markets in these two countries, although large in comparison with other countries, are not large in relation to investment because of reliance on other sources of finance.9

Data on new issues in relation to GNP in 9 selected developed and 13 developing countries are presented in Table 1. Among developing countries, we note a wide variation between those with high ratios of 6–8 per cent, as in Brazil, Colombia, the Republic of China (referred to as China throughout the remainder of this paper), Nigeria, and Venezuela; medium ratios of 3–6 per cent, as in Korea, Malaysia, Mexico, and Thailand; and ratios of less than 3 per cent in Argentina, Chile, India, and Kenya. As yet we have no data for other LDCs, but most of their ratios would probably be less than 3 per cent of GNP. The mean and median ratios for the 13 LDCs listed in Table 1 have been about 5 per cent in recent years, which compares rather favorably with the average of about 6 per cent for 16 developed countries. The range of the ratios of LDCs, not surprisingly, overlaps those of EACs. Regarding trends, the ratios in LDCs are generally rising, except in Argentina, where the ratio has declined since 1964, in Chile, for which data end in 1964, and in China, where the ratio was more or less stable until 1968. An analysis of the data on China and Chile (summarized in Tables 2 and 3 but given in detail in Tables 8 and 9, in the Appendix) reveals that the main reason for the decline in these two countries is the reduction in central government debt issue.

Table 1.

Selected Countries: New Securities Issues, 1960–71 1

(As percentage of gross national product)

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Sources: International Monetary Fund, Data Fund, and International Financial Statistics, for gross national product, gross domestic product, etc. For securities issues, see Sources Used in Preparing Tables (in the Appendix), Nos. [2], [4], [8, 9], [13], [15], [23], [25] (December 1964, March 1967, July 1969), [26], [29] (10th Anniversary Commemorative Issue, 1969), [33], [36], [38], [44], [47], [55, 56], [69], [74, 75].

Sum total of shares, bonds, and debt certificates.

As percentage of gross domestic product.

Estimates based on growth in securities issues of government sector with an assumed constant ratio of other sector issues to gross national product of 0.9 per cent.

Total sales.

As percentage of national income.

Net issues of fixed-income securities only.

Total of 16 countries. In addition to the 9 selected countries, these include Denmark, Finland, Germany, Italy, Japan, Portugal, and Spain.

Table 2.

Selected Countries: Supply of New Issues of Securities—Selected Ratios1

(In per cent)

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Source: Table 8 (in the Appendix).

Changes in M may not always equal ΔM, owing to rounding, or to occasional inconsistencies in the sources themselves, or to differences arising from averaging.
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Table 3.

Selected Countries: Domestic Purchases of Net Issues of Securities1

(In per cent)

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Source: Table 9 (in the Appendix).

Government securities only.

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Table 4.

Selected Countries: Government and Private Securities Issues, by Major Holders

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Sources: Tables 8 and 9 (in the Appendix).

Listed by the ratio of new issues to GNP.

For Brazil, Malaysia, Thailand, and Kenya, no data are available.

Based mainly on 1965, 1966, and 1967.

Based on data for 1970–71 only.

Table 5.

Selected Countries: Stock Market Relationships, 19711

(In per cent)

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Source: Table 11 (in the Appendix).

Or latest year available.

Includes 5 selected and 14 European countries.

Australia, Canada, Japan, South Africa, and United States.

The 14 countries as shown in Table 11, but the coverage for each column varies considerably.

Israel, Kenya, Lebanon, Morocco, Nigeria, and Turkey.

Argentina, Brazil, Chile, Colombia, Jamaica, Mexico, Peru, Uruguay, and Venezuela.

Ceylon, China, India, Indonesia, Korea, Malaysia, Philippines, and Thailand.

Table 6.

Argentina: Securities Distributions Authorized for Industrial, Commercial, and Financial Companies

(In per cent of total)

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Sources: Banco Central de la República Argentina, Memoria Anual, various issues.

In millions of new Argentine pesos (i.e., the rate that became effective on January 1, 1970).

As a percentage of gross national product.

Table 7.

Selected Countries: Evidence of Seasonality in Monthly Stock Market Price Indices, 1957–71

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Sources: International Monetary Fund, Data Fund, and International Financial Statistics.

Ratio of irregular component to seasonal component.

Table 8.

Selected Countries: Supply of New Issues of Securities1

(Cols. (1) and (2) in millions of national currency units; cols. (3)–(7), ratios in per cent)

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Sources: International Monetary Fund, International Financial Statistics, for gross national product and gross domestic investment. For other information, see Sources Used in Preparing Tables (in the Appendix), Nos. [2], [4], [8, 9], [13] (February 1973), [15], [23], [25] (March 1967, July 1969, February 1972), [26], [29], [33], [46, 47, 48], [54, 55, 56], [65], [69], [74, 75] (1969).

Data for issues of securities by the nongovernment sector refer to changes in the issued capital of companies listed on the Nairobi Stock Exchange.

Estimates based on growth in issues of securities by the government sector and the assumption that the ratio of issues by other sectors to GNP remains unchanged.

Data refer to net investment and net national income.

Average, 1963–64.

Data for issues of securities by nongovernment sector refer to changes in paid-up capital of newly registered companies.

Data for 1968–70 differ slightly from those in Table 1, mainly because issues of securities by other sectors in this table are actual, whereas in Table 1 they are based on authorizations, as in Table 6.

Averages derived from amount of securities outstanding at the end of 1963, 1966, and 1969, and national accounts data for 1966 and 1969.

Data relate only to fixed-income securities. The 1970–71 ratios are derived from gross domestic product, not gross national product.

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Table 9.

Selected Countries: Domestic Demand for Net Issues of Securities1

(Col. (I) in millions of national currency units; cols. (2)–(7), ratios in per cent)

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Sources: See Sources Used in Preparing Tables (in the Appendix), General and Nos. [2], [4], [8, 9], [13] (February 1973), [15], [23], [25] (March 1967, July 1969, February 1972), [26] (1970), [29], [33], [46, 47, 48], [56], [60], [69], [74, 75].

Conceptually, the total amount under this column should equal ΔM in Table 8, but there are differences owing to sectoring and rounding problems, and also to the existence of sinking funds of governments. The main sectoring problem is that Table 8 is the sum of domestic issues, while Table 9 is the sum of domestic holders of domestic securities, and thus foreign holders are excluded. Furthermore, the sum of the ratios in this table does not always equal 1 because of differences in recording between creditors and debtors. Foreign holders are not shown separately. (For Argentina, the amount is given in millions of new pesos, i.e., the rate that became effective on January 1, 1970.)

For China, includes Sino-American Development Fund Account.

The 1971 figures are based on net issues through September only.

The part of the treasury bills outstanding that was not classified by sector has been included in the holdings of private financial institutions. Government holdings include securities of state governments.

The ratios have been calculated on the basis of the sum of the purchasing sectors of government securities in 1969, or NTS813 million.

Holdings by state and local governments are included in the category of government enterprises.

Private business holdings include those of government-controlled corporations but not of government enterprises.

Investments of the Government Employees’ Provident Fund are included in the government sector, while those of other trust and provident funds are included in private financial institutions. All treasury bills not held by the Central Bank are assumed to be held by private financial institutions.

Issues of securities by the nongovernment sector (ΔMo) refer to changes in paid-up capital of newly registered companies and partnerships.

Includes holdings of Exchange Equalization Fund.

Includes holdings of social security funds.

Includes government financial institutions.

Averages derived from amount of securities outstanding at the end of 1963, 1966, and 1969.

Including issues by government enterprises.

Including changes in holdings by government.

Defers only to fixed-income securities.

Central Bank purchases of variable-income securities are included with private financial institutions. Social security purchases of fixed-income securities are included under government, while purchases of variable-income securities are included with government enterprises.

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