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Significance of Capital Market for Economic Development

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Published: Tue, 13 Feb 2018

An Explotary Study On The Significance of Capital Market for Economic Development and It’s Further Growth Potential In Context of Bangladesh

Abstract

This research paper investigates whether the role of capital market is significant for the economic development of Bangladesh. Literature suggests that well developed stock market can provide an extra impetus to economic activity. Similar conclusions were also drawn from the in-depth interviews. This paper also reveals a well-scanned scenario of the capital market highlighting its setbacks, current weakness, recent improvements and its prospective signs of development through which we can foresee whether the capital market has further growth potential or not. Thus the present study can also contribute in providing essential information that can also be used for further research.

Abbreviations

  • ADB- Asian Development Bank
  • CDBL- Central Depository of Bangladesh Limited CDS- Central Depository System
  • CSE- Chittagong Stock Exchange
  • DGEN- DSE general index
  • DSE- Dhaka Stock Exchange
  • GDP- gross domestic product
  • IPO- initial public offering
  • SEC- Security and Exchange Commission

1.0 Introduction

The financial market contributes to the economic growth and development by providing the needed finance for provision of goods and services. The financial market consists of two division- money market and capital market. The money market is basically entitled to supply finance on short-term basis to individuals, businesses, enterprises, government and their agencies. The capital market, on the other hand, provides finance on medium to long-term basis to corporate bodies, government and their agencies (Al-Faki, 2006).

Capital Market plays a crucial role in any modern economy as they allow investors’ fund to flow to the most promising opportunities, i.e., the funds are mobilized and channeled efficiently from savers to the users of funds (Al-Faki, 2006; DSE, 2006; Hubbard and Thornton, 2006; Ahmed, 1997). In Bangladesh financial intermediation relies mostly on the banking sector which further resulted in lack of equity financing (Salahuddin Ahmed, 2007; Islam and Hassan 2002).

Furthermore out of 5 million urban-based middle class people only four hundred thousand are participating in the securities market and among them roughly hundred thousand are active investors. A large portion is still ignorant of the nature and benefits of the capital market (Abu Ahmed, 2006; DSE Review, 2006; Islam and Hassan, 2002).

Developing more complete and deeper capital market would enhance a countries growth potential and innovation (Andritzky, 2007). The forces of globalization, technology, new forms of competition have noticeably transformed capital market worldwide (Hassan, 2004). The chief advisor Dr. Fakhruddin Ahmed stated that “Only a vibrant and well-regulated capital market can bring sustainable economic development in the country through making the real sector capable of meeting the challenges of the competitive global economic realities” ( DSE Monthly Review, June 2007).

Regardless of recent improvements, Bangladesh’s capital market remains underdeveloped as its size is still very small in terms of market cap (ADB, 2006; Salahuddin Ahmed, 2007; Islam and Hassan 2002). The market cap represents just above 9% of the GDP (Dr. Fakhruddin Ahmed retrieved from DSE Review). As Bangladesh capital market is still quite small compared to other regional market and to the size of its economy (CSE, 2006) despite its existence for a long time, this paper applies a framework for analyzing the significance of capital market for economic growth and development of Bangladesh, identifying its growth potentials through exploration.

2.0 Problem Statement

Bangladesh’s capital market is still underdeveloped, in spite of recent improvements. The size of the country’s capital market is quite small mainly due to the excessive dependence of leading corporate entities on the banks for financing. Moreover the overall transparency of market transaction is also low compared to international standards and generally there has been slow development of the underlying market infrastructure.

The government is making effort to develop the reliability and efficiency of stock exchanges as investment market. Compared to the other neighboring countries the numbers of participants are much smaller in Bangladesh as investor lack confidence. There is a supply side constrains in the capital market as quality shares are lacking. For all this reason this research is done to explore the importance of capital market in the economy and what are the prospective sign of development of the stock market.

3.0 Purpose of the Study

The purpose of the study is to explore a well scanned scenario of Bangladesh capital market, its significance and its prospects. Although some research has been conducted relating to this topic but there is little empirical evidence about how essential stock market is to economic development of a country.

A sound capital market prompts better economic base and influence its future growth and so it can help realize Bangladesh’s growth potential. The capital market of Bangladesh is on the brink to play its due role as a medium for financing investment and thereby making a notable contribution to economic growth, employment creation and poverty alleviation.

The capital market plays an important role in quickening the pace of economic development but the existing state of the capital market is under-developed and not in a position to ensure economic progress of the country. Hence this research will try to highlight the significance of capital market for the nation and explore what are the probable signs of progress.

4.0 Research Timeline

  • 2007 SeptemberWriting Research Proposal
  • 2007 SeptemberDeveloping Literature Review
  • 2007 OctoberCollecting Data
  • 2007 October- NovemberData Analysis and Interpretation of the Findings
  • 2007 NovemberPreparing Draft and Finalizing the Research Paper
  • 2007 DecemberSubmission of Research Paper

5.0 Limitations of the study

During conducting the research I came across certain limitations and among them the foremost one is time constrain. Although I got the opportunity to work in an organization that is capital market based but it was difficult to find spare time that could be used for the report. Moreover the interviewed person could not provide all necessary information due to lack of time.

The research timeline also reveals that time constrain was actually a barrier as there was plenty to find about this research topic. As the research is conducted for the first time, I did not get much support from previous research paper and further research is suggested. A huge portion of the report is based on secondary data collected through websites and so the depth of reliability varies as by the nature of website.

6.0 Review of the Literature

6.1 Financial Intermediation

According to Joseph Yam (2004) financial intermediation is channeling savings into investments. Aziz and Duenwald (2002) referred that financial intermediation affects growth through the following channels – (i) it can increase the marginal productivity of capital by collecting information to evaluate alternative investment projects and by risk sharing (ii) it can raise the proportion of savings channeled to investment through financial development.

According to Conning and Kevane (2002) “intermediation implies an intermediary”. Gorton and Winton (2002) added that “it is the root institution in the saving investment process”. They referred that financial intermediaries are firms that borrow from those who have excess money, that is, the savers and lend the money to companies that need resources for investment.

6.2 Performance Indicators

According to R. N. Agarwal (2000) the most commonly used standard to measure the size of a country’s stock market is market capitalization ratio, that is, the ratio of market value of stocks which are currently listed on a bourse to Gross Domestic Product (GDP). A small ratio of capitalization to GDP reveals the small size of a stock market. Alternatively, the size can be measured by the number of listed companies on a stock market. The height of maturity of an economy’s financial system is essential for economic development.

Bekeart et al., (2007), Hubard and Thornton (2006), Rosul (2002) all investigated the significance and relation of stock market development with the economic growth and their conclusion suggests that capital market development is positively correlated with long term economic growth and the capital market plays an important role in the economic development of any country. The size of the equity capital market has an optimistic effect on economic growth of the country, that is, much higher market cap and turnover has a major positive influence on the economy (Institute for Advanced Studies, IHS, 2006).

It is seen that the ratio of market cap to GDP in neighboring countries like India, Pakistan and Sri Lanka is relatively much higher, that is, more than 60% of their GDP (DSE, Kh. Asadul Islam, 2007; Dr. Fakhruddin Ahmed,2007). In Bangladesh the market cap is very small proportion of the countries GDP (Islam & Hassan, 2002) and this is due to significant dependence on the banking sector (DSE Review, Fakhruddin Ahmed, June 2007).

Market capitalization as a share of GDP was around 2.5%-3.3% during 2001-2003 compared with 1.4-10.1% during 1993-1996 and 2- 4% during 1997-2000. However in the year 2004 market cap reached 6.8% reflecting the rise in the DSE index from 968 to 1,971 at the end of 2003 and 2004 respectively (ADB, May 2005). The trend of market cap as percentage of GDP and other capital market indicators of DSE and CSE are shown through the help of statistical data represented in the discussion section in Table 1.

Despite the existence of the bourse from 1954, the capital market still exhibits features of an emerging equity market (Islam & Hassan, 2002). The finance sector is immensely bank-based (Salahuddin Ahmed, 2007) as resource mobilization for industrialization and economic development is made primarily through the regular banking system (Islam & Hassan, 2002).

Borrowing requires fixed payments and over-reliance on banks can cause credit default risk. According to (Mochammad Rosul, 2002) excessive reliance on bank borrowing results in a mismatch with long-term investments being financed with short-term bank loans. He added that such a risky situation can further contribute to the economic crisis and so the job of the principal fund supplier for business should be transferred from banking sector to the capital sector.

6.3 Regulatory Bodies

6.3.1. The Security and Exchange Commission (SEC)

The Security and Exchange Commission (SEC) exercises power under the Security and Exchange Commission Act 1993 and established on June 8, 1993. SEC, the sole Capital Market Watchdog and Regulator, has been pursuing a vigorous capital market development process including amendments of its existing regulations, conduction of investor awareness programs, rigid monitoring and surveillance to bring in transparency in the trading mechanism (SEC, Annual Report 2003 -04).

The responsibility of SEC includes the following:

  • Regulating the functions of Stock Exchanges
  • Registering and regulating the business of stock brokers, sub broker, share transfer agents, underwriters, registrar, portfolio managers, investment advisors, and other middlemen related to security dealings.
  • Registering, controlling, and monitoring of all types of mutual funds
  • Controlling and monitoring of all authorized self regulatory organizations
  • Prohibiting fraudulent and unfair practices related to securities
  • Promoting investor’s education program and providing training of intermediaries
  • Regulating substantial acquisition of shares and takeover of companies
  • SEC are detects market manipulation and also keeps constant vigil on the activities of stock exchanges to ensure effectiveness of the surveillance system.
  • Conducts research and publishes information for above purposes

(Source: Security Exchange Commission Website: www.secbd.com)

6.3.2 Stock Exchanges

6.3.2.1 Dhaka Stock Exchange (DSE)

On April 28, 1954 DSE was first incorporated as the East Pakistan Stock Exchange Association Limited. Formal trading began in 1956 with 196 securities listed on the DSE with a total paid up capital of about Taka 4 billion. On June 23, 1962 it was renamed as Dhaka Stock Exchange (DSE) Limited.

After 1971, the trading activities of the prime bourse remained suppresses until 1976 due to liberation war and economic policy pursued by the then government. Trading resumed at DSE in 1976 with only 9 companies listed having a paid up of Taka 137.52 million (Bashar et al., 2000; M Farid Ahmed, 1997). As of today there are 342 listed companies in the prime bourse with market cap exceeding 700,000 million (DSE, 2007).

The reforms that DSE undertook recently for ensuring professionalism and transparency focused on the trading of securities. The measure were taken to implement transparent trading system, efficient reporting of trade, real time delivery of information, strong surveillance and monitoring over trade of securities and settlement of shares (Rahman,Uddin and Malik, 2006).

6.3.2.2 The Chittagong Stock Exchange Limited (CSE)

The CSE is the countries second bourse that started its operation from the year 1995. It is also a self-regulatory non profit organization. Currently the numbers of listed securities are 223 of which the number of listed companies are 208, mutual funds 14, and one debenture.

6.4 Recent Capital Market Scenario of Bangladesh

According to Dr Fakhruddin Ahmed (DSE, 2007) political uncertainty, corruption and lack of transparency in all section of the social and economic fabric are some of the reasons for capital market deficiency. Bangladesh Governor Salehuddin Ahmed (2007) reveals that foremost problems include political instability, under developed infrastructure, poor port management, short comings in legal system and corruption (Financial Express Report).

On the other hand DSE general share price index reached its pinnacle and crossed 3000 points (Newage: www.newagebd.com). In fact the capital market witnessed a robust growth in the current year. Both turnover and market cap crossed new milestones at Tk 3000 million and Tk 700,000 million respectively during the year (DSE, 2006; DSE, 2007, IDLCSL). Recently our market cap crossed USD 10 billion that accounts for only 13% of its GDP which was only 8% a year back. (DSE Monthly Review, Oct 2007).

Though the contribution of capital market to GDP is still inadequate when compared to neighboring countries but still its increase is significant for the development of our economy. Comparison of indices and market cap among different countries is shown in Table 2 and Figure 2 in the discussion part. Entry of 12 new issues worth Tk 11,322.95 million helped raise the market cap.

Some of the reason for the progress in capital market development is central depository system and the automated trading system (ADB, 2006; SEC, 2005). The DSE has upgraded its automated online trading system and investors are able to trade from different parts of the country (SEC Quarterly Report, April-June 2007; ADB, 2006). Another reason for the vigorous improvement of the equity capital market is due to strenuous efforts taken by the SEC that further boosted investors’ confidence (DSE, 2007).

7.0 Research Methodology

7.1 Research Design

The present study endeavored to explore importance of capital market for the economic development of Bangladesh and its future prospects. Exploratory research is selected as research design as little information exists about the capital market of Bangladesh. The aim of exploratory research is mainly to gain enough information before doing more thorough research. We basically start by gathering as much information about the object as possible and with a vague impression of what we should study (Cooper & Schindler, 2003).

7.2 Research Instrument

The research was conducted using both primary and secondary data. For collecting secondary data, various books, websites, newspapers, annual reports, monthly reviews and significant articles were chosen. Also for collection of primary data in-depth interviews with a range of designated professional, related to this field, were taken.

7.3 Data Collection

Secondary data used in the paper has been collected through access of different source of books, journals, publications of DSE, SEC, ADB and other news paper and articles. The DSE and SEC library were visited to acquire secondary information. Various websites were browsed to collect relevant articles that are circulated on online sites. For collecting primary data, in-depth interviews of experienced people related to this field of

capital market were taken. Appointments were fixed initially and then the interviews were taken. The interviewed persons are Kh. Asadul Islam, CEO, IDLC Securities Limited (IDLCSL); Anwarul Kabir Bhuiyan, SEC, Executive Director; Tania Sharmin, SEC, Assistance Director (Surveillance); Abul Ehsan, Senior Officer, IDLC Finance Limited; Moumita Manzoor, Research Associate, IDLCSL.

Each of them was interviewed for 40 minutes approximately during the office hour while taking break from work. They were asked some essential questions associated to this research topic. Some of the questions that were asked are as follows-

  • What is the role of capital market in the economy?
  • What are the setbacks of the stock market in Bangladesh?
  • Explain the current scenario of the capital market
  • What are the prospective sign of the development of the capital market?
  • How can we be sure of a sound growth of capital market in Bangladesh?
  • Do you see a better or worse scenario ahead of us and why?

8.0 Discussion

8.1 Role of Capital Market in the Economy

According to Dr. Mirza Azizul Islam (2006) capital market can play an essential role in enhancing economic development through efficient intermediation of savings into productive investments and in encouraging the expansion of private entrepreneurship (DSE, 2006). The primary market can contribute to the growth of private entrepreneurship by facilitating the entrepreneurs to raise funds from surplus savers and consequently finance investment in a cost-effective manner.

For instance, if an industrialist with a viable new investment or expansion proposal is unable to execute his plan due to financial crisis then he can issue securities to meet the required deficit. Moreover issuing shares have the additional advantage that they do not create fixed charges for the companies issuing them and hence endows a better option than, say, financing through bank loans. A proficient and vibrant secondary market can also contribute copiously to economic growth.

If a company, for instance, is well-managed and the secondary market prices are higher than face value, subsequent rights issue can obtain premium. Therefore the company can finance its development plan in lucrative and cost-effective approach. So the capital market not only provides opportunity for companies to borrow funds needed for long term investment purposes but also provides avenue for the marketing of shares and other securities in order to raise fresh funds for expansion of operations, leading to increase in output or productivity.

The equity market offers opportunity for government to finance projects aimed at providing essential amenities for socio-economic development. Such market encourages inflow of foreign capital when foreign companies or investors invest in domestic securities. The securities market can help attain higher productivity by restructuring of ownership and management of the company as secondary market provides an exit option for the original founders and it also creates an avenue for the populace to participate in the corporate sector of the economy and share in its wealth through ownership of securities.

So it not only reduces the over-reliance of the corporate sector on short term finance for long term projects but truly makes available the needed money for venture capital development which could serve as a vehicle for industrial development. So through its allocating mechanism, the capital market ensures an efficient and effective distribution of scarce financial resources for the optimal benefit to the economy.

8.2 Major Setbacks of the Capital Market

Investment in capital market is limited to a small proportion of the population. Investors’ confidence in the capital market has not entirely recovered since the stock market crash in 1996. Share market debacle in 1996 was mainly the result of market manipulation by a section of stockbrokers in collaboration with some other market participants (SEC, 1997).

Some of the other notable reasons behind the stock market crash includes insider-trading and off-loading of shares by directors of the company, absence of circuit breaker in the securities market, disclosure of unregulated rumors and sensitive information, lack of attention given by investors to the relation between stock price and company fundamentals, weak regulatory body to name a few. The diagram below shows clearly the catastrophe that took place during 1996.

Figure 1 DSE General Price Index (DGEN) 1993-2007 (Source: IDLCSL)

On November, 2001 the DSE introduced the benchmark price barometer DSE General Index (DGEN) with a base index of 817.62 points. The index excludes companies of Z category and is calculated on the basis of price movement of individual stocks. Figure 1 displays the monthly DSE general index from the year January 1993 to November 2007, the latest month for which the data was available. From the diagram we can tell that the market behaved irrationally during the year 1996.

The DSE all share price index rose from 832 in 1 January 1996 to 3567 in 14 November of the same year, i.e. DGEN rose from 1106 to 4738.83. This conspicuous rise in DSI was followed by a drastic fall to 2261.47 points in the last week of December 1996 and again to 1140.65 points on April 1997. The market was dreary for a long period of time after the 1996 collapse but between July 20003 and June 2005, DGEN more than doubled from 823 to 1727. It appears that the index is performing modestly in the current year followed by an uptrend as it shows an increase in the index from 1527.29 in November 2006 to 3011.60 in November 2007, reaching its pinnacle after 1996.

The devastating history of 96 crashes still persists in the mind of potential investors but without mass participation the market cannot sustain in the long-run. Also it needs to bring back the foreign investors that fled in the 1996 debacle. Inflows of foreign direct investment need to be restored to stabilize the economy.

From the statistical data below in Table 1 it can be observed that foreign investors are least attracted to the securities market of Bangladesh. There were significant foreign investment inflows into equities in the year 1994 amounting to $ 106 million but by the mid 1997, most of the foreign portfolio investors had divested holdings and have not since returned.

The following table contains the key capital market indicators reflecting that the pace of primary market development had been fluctuating and the market’s contribution to resource mobilization of the economy remains below potential and the secondary market remained stagnant during 1997-2003 but showed some sign of recovery in 2004. Overall, investor confidence has not yet fully recovered.

Table 1 Capital Market Indicators- Dhaka Stock Exchange

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Item

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

No of Listed

                       

Companies

143

157

183

186

202

208

213

223

231

242

248

337

Market Cap

                       

In taka (mn)

18099

41771

56518

168106

71302

50254

44789

62932

63777

71269

97587

224923

In $ (mn)

455

1038

1409

3960

1569

1036

881

1169

1119

1229

1685

3709

Market Cap as

                       

% of GDP

1.44

3.08

3.71

10.11

3.95

2.51

2.04

2.65

2.52

2.61

3.25

6.76