By Kingsley Chiedu Moghalu
Capital and Capitalism: The Strategic Context
There are three conditions for the success of capitalism in any society. These conditions exist in the industrialized countries of the Western world and (increasingly) in those of rising Asia. With very few exceptions, they do not yet exist in Africa’s economies. These conditions are: (a) property rights, (b) innovation, and (c) capital. The order in which I have mentioned them is no accident.
Regarding capital, the fact that it is scarce in our continent means that we are practicing capitalism without capital. Can we succeed as capitalists then?
Enter capital markets. We know that efficient financial systems, of which capital markets are an important part, are a necessary condition for sustained growth and economic transformation. But the link is not that straightforward, and we are not always certain at which point finance facilitates growth. Does finance come before growth or follow it?
There are other structural factors in any economy that are as important, if not more important, than finance. One of these factors is whether property rights exist and are respected in an economy, in the form of freehold ownership of land titles that can be turned into capital, or whether the state keeps this potential in abeyance by appropriating freehold title to land and leasing out land occupancy to citizens, as is the case in many African countries today. Another factor is that of production, which is unleashed by innovation. The mass production of goods and services, based mainly on innovation, combined with property rights, is what enables capital as the third tier of capitalism to reach its true potential.
Even as regardscapital, there is the fundamental question of whether or not an economy in and of itself generates enough capital through taxation (for public finance).
Efficient channels for accessing credit need to exist, because finance may be available but has not been turned into extensive credit. We know that access to credit is far easier in countries with highly developed systems of property rights.
And we know that access to credit is hard in countries with shallow financial markets dominated by banks. There may also be problems with the cost of credit as a result of weak infrastructure such as electricity, monetary policy decisions in response to inflation, or weak transmission channels for monetary policy.
Nevertheless, we know that greater financial depth, in which there are high ratios of total financial assets to national income or output, creates higher levels of productivity and thus income per person. We know, also, that more advanced financial structures in which there is a migration from banks, which produce mainly short-term credit, towards non-bank financial intermediaries and on to capital markets (which can provide longer term finance) are essential for transformation.
This does not mean that African countries should rush into establishing stock markets. We have about 26 stock exchanges in Africa today, but with few exceptions we must wonder to what extent they have contributed to structural economic transformation in the absence of pre-qualifying factors. One of those factors is the existence of productive real economies.
African countries need to think carefully about capital markets, and about the stage in a country’s economic and financial development at which such markets become useful. Failure to do so is why many stock markets in Africa face challenges such as illiquidity, very few companies listed, or dominance by a few companies. It is true that stock markets help companies with good potentials but limited funds grow by raising capital relatively cheaply. They also help to mobilize local savings, create liquidity and improve corporate governance while contribute to the development of the private sector.
But premature stock market development also poses risks. One major risk is that it could lead to a culture of financialization if it precedes the establishment of basic real economies. “Paper wealth” becomes an alternative to more predictable types of capital formation. Strong regulatory institutions are also required. Stock market crashes in countries with strong economic fundamentals are rare, and when they occur do not have the same kind of impact as they would in developing economies with structurally unsound economies. Nigeria’s stock market crash in 2008, in the wake of the global financial crisis, is a case of too-rapid stock market development at the time that was based on unsound fundamentals.
On the other hand, in countries like Nigeria, Egypt, Morocco and Tunisia that, according to Accenture’s Tipping Point Index rankings of financial market development in Africa now have “forging ahead” financial markets (as distinct from well- established financial services markets such as South Africa and Mauritius), the capital market can address the problem of excessive reliance on the banking system for capital formation and access to credit. Nigeria’s banks, for example, provide more than 90 per cent of financial needs in the country, overshadowing the potential roles of the capital market and other financial markets.
How Stock Markets Can Create the Wealth of Nations
Against this background, I believe that stock markets can help create national wealth if:
• They are based mainly on a foundation of a real economy. The absence of underpinning real economies is why many stock exchanges in Africa face severe liquidity problems. This real economy is what gives a stock exchange the valuation, stability, and the scope to have a high ratio in relation to a country’s GDP. It is only in South Africa today, among African countries, that we see this requirement fully met. The valuation of the Johannesburg Stock Exchange is 300 per cent of the country’s GDP. The Nigerian Stock is approximately 18 per cent of Nigeria’s GDP.
• There is financial literacy and education. Literacy levels about capital markets in Africa remain very low. This hampers economic development in two ways. First, it constricts the knowledge of opportunities that capital markets can offer to companies especially, but individuals as well, and so inhibits the development of a mature private sector-led economy. Second, this situations means that even when individuals invest in capital markets, they are unaware of, and so cannot manage, the downside risks by making well-informed investment judgments.
• Major foreign investments are required to go public on the stock exchange. This is an approach that involves an exercise of sovereignty, not in a manner that is unfriendly to markets, but to ensure that markets and foreign investments serve not just the purposes of investors but the domestic economy as well in a win-win scenario. This should be a selective approach that should be guided by the nature and type of foreign investment in question.
• Stock market flotations are used smartly as a means to avoid cronyism in the privatization of state owned companies. Again, this is one approach to ensuring inclusive economic growth. It avoids the many problems and failures of privatization in Africa, which have tended to turn into elite and crony affairs. These privatizations nevertheless remain necessary where states have not been able to run enterprises efficiently and profitably.
• Risk is well managed to prevent stock market crashes. Examples of risk management include the rules enacted by the Central Bank of Nigeria placing limits on margin lending for stock purchases during the banking sector reforms after the global financial crisis. Others include measures such as circuit-breakers that can suspend stock trading where prices collapse beyond a certain threshold.
• There is balanced ownership in stock market equities between local and foreign investors. Now, this is not to be achieved by discouraging free flows of capital from foreign investors into African countries. Rather, it should be achieved through other means such as encouraging increased local investment by individuals, creating enabling environments for the listing of local firms, including small and medium enterprises that meet appropriate thresholds, and the listing of privatized state owned firms.
This balance is important not just for inclusive growth but also for financial stability, as foreign institutional investors tend to be skittish and take a flight to safety in response to developments in their home economies or those in developing countries in which they are invested. One of the reasons for the stock market crash in Nigeria in 2008 was that foreign portfolio investors owned over 65 per cent of the equities traded on the Nigerian Stock Exchange at the time. When they exited in response to the global financial crisis, the market tanked. It is noteworthy that even in a market as globalized and developed as the Johannesburg Stock Exchange, the level of foreign ownership of equities is 40 per cent. I believe this is an appropriate weight of ownership allocation.
Fundamentals for Capital Market Development
The fundamentals to which we should aspire in a strategic development of capital markets include, therefore:
• Pursue industrialisation before creating capital markets, or do so at the same time. While many African countries have embraced the development of capital markets without thinking it through in terms of the fundamentals, it is not too late to pivot to aligning economic development in the real sector and services with the strategic fundaments for strong capital markets going forward. This means that in countries with significant manufacturing and service sectors, it is necessary to begin to find and nudge companies with the appropriate profiles towards listing on exchanges. Educating entrepreneurs on the pros and cons of listing for their companies and their growth prospects will be critical to achieving this shift.
• Ensure inclusive growth through a sectoral balance in the stock exchange, avoiding the dominance of a few companies and sectors, as well as more listings of SMEs. This has to be a conscious effort of doing business, regulatory and government policy effort, as well as the leadership of securities exchanges in African countries. In Nigeria today, for example, the NSE is dominated by three groups of companies, almost equally to the ration of one-third each: banks, consumer goods companies, and the Dangote Group. This is an unhealthy balance, and needs to be redressed with proactive policy measures, the education of business owners and entrepreneurs, and incentives.
• Reflect shifts in the global and African regional and national economies, for example by encouraging the floating of technology-based companies on stock exchanges. It is not all African countries that will successfully create a strong industrial sector. Especially for some relatively smaller countries such as Rwanda, the services sector, especially hospitality, and the IT sector in which the country is working to become a regional and continental hub, can provide a boost for the development of capital markets. The role of IT innovation and businesses in the continent is increasing markedly, and is a huge potential future growth path. Capital markets development should reflect this by encouraging of IT companies especially financial technology companies on exchanges.
• Create regional exchanges. There are several African countries whose economies, on their own, are unlikely to generate enough liquidity for a vibrant bourse. Regional exchanges are the way to go, and African nations should focus on policy reforms that remove the impediments to such regional listings, and development the political will to accept reality and abandon a national-pride perspective in this aspect of governance and economic management.
• Seriously expand and improve intra-African trade, and formalize the significant flows of informal trade between neighboring countries. Africa’s level of intra-continental trade, very low at 11 per cent companied to other continents, needs to improve dramatically for capital markets to boom in a sustainable manner. This is a strategic shift in trade architecture that will drive up the volume of economic activity in many African countries, which in turn will provide a strong foundation for capital markets development.
• Develop and deepen the bond market to fund infrastructure. Africa’s infrastructure financing deficit is about $75 billion annually. If anyone thinks all of this financing can come from the West and Asia, think again. Deepening capital markets with robust bond markets is an immediate task for the larger markets in Africa such as Nigeria, South Africa, Egypt, and the East African countries of Kenya, Uganda and Tanzania.
• Re-examine the potential roles of pension funds and other African institutional investors. Many pension funds in Africa are precluded or discouraged from investing in equities. This approach calls for a re-think, but with appropriate risk management. There are also other products in capital markets such as exchange traded funds (ETF) and real estate investment trusts (REITS) that offer good investment potentials for pension funds. It is especially necessary to link pension funds to the bond markets as a way to raise finance to the continent’s infrastructure needs.
I have sketched out a number of issues to provide a strategic context in which we should think as we work to develop the capital markets in many of our countries and regions in the continent. As we go into detailed discussions on various aspects of capital market development at this conference, I hope we can keep these dimensions of the challenge we face in our minds. We must keep in mind that, just as the love of money, not money itself, is the root of all evil in biblical ethics, it is not capital markets, but seeing them as ends in themselves rather than as means to the real end of economic development and transformation, that is our real problem. We must therefore begin to think of capital markets and other financial markets as part of a much larger construct: that of a development agenda in which participants create value and create wealth not just for themselves, but also the wealth of nations. Absent this mental framework, it is all vanity, and just a merry-go-round of money making money for a very few, while the millions of our citizens trudge on with their daily struggles.
Moghalu , a former Deputy Governor, Central Bank of Nigeria is Professor of Practice in International Business and Public Policy, The Fletcher School of Law and Diplomacy, Tufts University Medford, Massachusetts, USA. He delivered this speech at the 20th Annual Conference of the African Securities Exchanges Association (ASEA), Kigali, Rwanda on November 28, 2016