The development of a capital market
Sunday Stabroek Perspective
April 25, 1999
This article will describe what a capital market consists of, the state of the capital market in Guyana at present and the steps that need to be taken to develop it. However, in order to comprehend the nature, role and functioning of a capital market it is important to have a clear understanding of the critical role of savings and investment in the creation of employment and development of an economy.
If there is one thing known about economic development it is that investment must increase relative to consumption as a proportion of national income. One of the key factors which influences the amount of investment in an economy is the level of savings. It is an important judgement, therefore, to determine how much of the national income should be saved and how much should be consumed. The objective is to ensure that today's consumption is sufficient while, at the same time, allowing investment to increase tomorrow' s consumption. A key factor, also, is to ensure that wise investment decisions are taken.
In summary, investment is the fuel for the engine of growth and investment is made possible through savings. Economic development, therefore, is about accelerating the rate of capital formation. Capital formation implies investment expenditure over and above the level required to offset the depreciation of existing capital items.
SavingsThe state of the economy, the standard of living and the level of employment in Guyana today are the result of the amount and quality of investment previously expended. In turn, such investment was itself dependent on the level of savings available at that time. Thus, it follows that the future state of the economy, standard of living and level of employment in Guyana will depend on the amount of savings available today and the quality of the investment that will be made from those resources.
Savings can be accessed from both domestic and foreign sources. The latter can come in the form of either direct investment or borrowings. However, no country can depend solely on such sources of financing. Access to foreign savings is a helpful contributor to meeting the investment requirement but it can be no substitute for the availability and utilisation of domestic savings. In fact, the higher the level of local savings and the wiser the investment the greater the likelihood of gaining access to foreign savings.
InvestmentThe standard of living that we enjoy today is the cumulative result of the investments that have been made in the past. There are two main types of investment---namely, directly productive investment in, for instance, areas such as resource development, agricultural production, value-added manufacturing and the service industry. Such investment takes the form of buildings in most cases, of machinery and equipment of various kinds and in vehicles. Such directly productive investment is intended to generate a flow of income from the sale of goods and/or services.
The other main type of investment is that of indirectly productive infrastructural investment in utilities and human resource development. The output generated by such utilities investment is an essential condition for directly productive investment to take place. However, without an adequate availability of a trained and motivated human resource base, it is most unlikely that successful productive activity can be achieved. It is essential, therefore, that there must be an appropriate level of investment in health, education and skills training.
In an ideal situation the level of national investment would only be adequate if full employment were to be accomplished. However, this is not achievable in practice and, therefore, it is an issue of identifying which areas of investment can yield the highest returns to the country. Factors in this decision-making process would include, inter alia, consideration of the cost of investment per job and whether the investment will generate foreign exchange earnings. With respect to the latter consideration, it is important to evaluate the share of national investment which is being allocated to foreign exchange earning activity.
The most important point to remember always is that if we are to achieve an increase in economic wealth and employment then the rate of investment must be greater than the rate of depreciation of the existing capital stock. Thus, in the market economy of Guyana, where the private sector has been charged with being the engine of economic growth, investment is the fuel.
There are two main categories of investors---namely, domestic and foreign. Within the former category we can identify the Government and the private sector. Within the latter most investment comes from the private sector. The level of private investment in any country is determined by the perception of the reward to be gained from making the investment having made adjustment for the perception of the risks involved.
There are a number of factors over which the Government has control which will influence the nature and level of the investment that the private sector is prepared to undertake. These include, inter alia, taxation, incentives, interest rates, the level of efficiency of the State bureaucracy and the level and efficiency of the Government's own investment in the infrastructure needed by the private sector. This latter category would feature human resource investment in health, education and skills training, and investment in roads, bridges, public transportation (if any), water, electricity, drainage, irrigation and sea defences.
The financial marketInvestment can be financed from the retained earnings (savings) of the investor, be it the Government or a private sector entity, and/or borrowings from entities possessing surplus funds at their disposal. The credit transaction is usually carried out through the intermediation of the financial institutions comprising the financial market. Such institutions include commercial banks, merchant/investment banks and stockbrokers. The function of the financial market is to facilitate the transfer of savings from surplus entities to deficit spending entities thus enabling them to invest more than they have been able to save.
The commercial banks are the major counterpart for borrowers in Guyana.
The total assets of the commercial banks at the end of June 1998 amounted to G590.1 bn of which G$45. lbn (50.0%) represented loans and advances to the private sector (comprising business enterprises and individual customers). It is most illuminating to analyse the maturity profile of the private sector assets held by the commercial banking system in Guyana. Of the G$45. lbn total, G$29.6bn (65.6%) was in the form of demand loans and advances and G$15.5bn (34.4%) in the form of term loans and advances.
On the liabilities, capital and reserves side of the balance sheet of the commercial banks at the end of June 1998, total residents and non-residents deposits amounted to G$71.7bn of which G$8.5bn (11.9%) represented demand deposits, G$38.3bn (53.4%) represented savings deposits and G$24.9bn (34.7%) represented time deposits. However, an analysis of the maturity profile of the time deposits reveals that G$18.0bn (72.3%) have a maturity up to 3 months and a further G$5. lbn (20.5%) have a maturity exceeding 3 months and up to 6 months.
Thus, the financial market in Guyana is characterised by short-term assets and liabilities.
The absence of adequate financial capacity explains the strong bias towards consumption in developing countries. In Guyana, over the past number of years, total consumption has been rising relative to total investment and this is one of the factors that has led to the decline in economic activity that we are currently experiencing. It also has to be noted that our economic deterioration has been aggravated further by the decline in international prices for the commodities that are produced in and exported from Guyana. This occurrence was partially the result of the turmoil in the financial markets of certain Far East countries and Russia.
However, the impact of such falling prices would have been less if we had diversified our productive base through the facilitation of private sector investment in value-added production during the economic boom conditions of the 1990's. This emphasises the point made earlier that it is not only the amount of investment that will determine the level of economic activity but also, and perhaps more importantly, the quality of that investment. The financial market comprises both the money market and the capital market. The basic functions of both these markets are, first, the facilitation of payments within the market environment and, second, the mobilisation of savings.
Although it is common and generally considered necessary to distinguish between the money and capital markets, the dividing line between them is not always clear. As a rule, it is accepted that the money market constitutes the short-term part of the financial system and the capital market the long-term part. Long-term is generally regarded as a period of one year or more and short-term as anything less than a year. Transactions within the money and capital markets usually involve the exchange of funds for securities. Generally speaking, a security is a written document which conveys a legal right to the investor to receive prospective future benefits under stated conditions.
A security can usually be transferred from one investor to another with all its rights and conditions intact. The ease with which an investor can convert a security into cash depends on the liquidity of the market for those securities.
There is a move underway towards a deepening of the financial market which will lead to longer terms and a more equitable distribution of savings. The first steps have already been taken in the form of:
1. Financial Institutions Act 1995
2. Implementing Regulations of the Financial Institutions Act issued by the Bank of Guyana as the Supervisory Authority
3. Foreign Exchange (Miscellaneous Provisions) Act 1996
4. Financial Institutions (Amendment) Act 1996
5. Bank of Guyana Act 1998
6. Insurance Act 1998
7. Securities Industry Act 1998
The standard approach to the development of the financial market is to start with the promotion of the money market.
The Bank of Guyana Act 1998 was one of the early steps towards deepening the financial market
The money marketThe money market brings short-term lenders into contact, through specialist financial intermediaries, with borrowers who require short-term funds.
The money market embraces both the primary and secondary markets for short-term securities that mature within one year. Money market instruments include short-term deposits, treasury bills, commercial paper and bankers acceptances. Trade bills are used to finance trade transactions as, for example, to purchase stock or raw material and the treasury bill is used simply as a means of short-term borrowing by the Government. However, the treasury bill is also an instrument that is used by the Government to control the liquidity within the banking system. Treasury bills have been the main monetary instrument for some time.
Commercial banks and the Central Bank are the main players in the money market in Guyana. The Central Bank is the issuer of treasury bills (with maturities varying up to one year), the total outstanding issues of which amounted to G$27.3bn at the end of June 1998. Of this amount, G$15.5bn was held by the commercial banks and represented 17.2% of their total assets, G$6.4bn by the non-bank financial institutions and G$4.3bn by the National Insurance Scheme.
The standard approach to the development of the financial market is to start with the promotion of the money market. The Budget of 1996 announced measures to improve the efficiency of the money market through the introduction of weekly auctioning of treasury bills to regulate liquidity conditions and a re-discounting policy to provide for the trading of the bills, the objective being to make them very liquid assets within the financial system. However, secondary market trading of money market instruments has not developed in a manner that is necessary for the overall development of the financial market in Guyana. The reason for this is the absence of a formal institutional structure capable of operating a secondary market and providing the liquidity within the financial system.
We established earlier that capital investment needs to be financed using longer-term funding. What is really required in Guyana, therefore, in order to drive economic development, is the establishment of a capital market as the source of longer-term finance and a Stock Exchange to act as a market facilitating the transfer of ownership in existing stocks and bonds. In the absence of a Stock Exchange, it is the illiquidity of medium- and long-term corporate, and even of Government, securities that is the disincentive for surplus economic entities to hold the long-term debt needed to support capital investment.
Thus, it should be recognised that the importance of a Stock Exchange (the securities market) is not primarily that of being a source of new capital. Its critical importance is that it sustains the liquidity of the securities accumulated by the public over a period of time.
It is fair to say that sustainable growth in a market economy where the private sector is charged with being the engine of economic growth is unlikely to be achieved in the absence of an effective capital market and Stock Exchange.
This in turn explains much of the dependence of developing countries on foreign sources of capital for investment.
The commercial banks are the major counterpart for borrowers in Guyana
The Capital MarketWe have established that the capital market constitutes the long-term part of the financial system where long-term is generally regarded as a period of one year or more. The capital market is the source of the longer-term funds required for the capital investment that is needed to drive economic development. Longer-term funding can be for a fixed number of years, for an indefinite period or in perpetuity. The capital market, therefore, is the source from which, for instance, a Government can borrow long-term by the issuance of bonds repayable after a number of years or an industrial or commercial business can obtain either long-term loans by the issuance of bonds or permanent capital through the issue of stock.
However, it is the existence of a Stock Exchange whose primary function is to act as a 'secondary' market where securities may be bought and sold by both domestic and foreign investors that is crucial. It is the very existence of such a market and the liquidity it provides that encourages investors to hold the longer-term securities required to finance capital investment.
Although capital is supplied to the capital market by individuals, the significant aspect of the capital market is the existence of a number of institutions, mainly insurance companies, pension funds, unit trusts or mutual funds and investment trusts which provide a large proportion of the new money to be raised.
There is a need for all the institutions in the market place to increase their knowledge concerning capital market issues.
It is important, also, that potential issuers in such a market should be sensitised to the possibilities that a capital market is able to offer.