The development of a capital market
Sunday Stabroek Perspective
Stabroek News
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.
Savings
The 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.
Investment
The 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 market
Investment 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 market
The 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 Market
We 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.
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