Why African countries must invest in more robust capital markets infrastructure to facilitate the…
African countries can invest in more robust capital markets infrastructure to facilitate the inflow and outflow of investments through Domestic Direct Investments, Portfolio Direct Investments, and Foreign Direct Investments (FDI).
What are capital markets?
Capital markets are also known as securities markets. Capital markets are where savers having money converge to invest their capital in long-term investments such as equity-backed securities, corporate debt, and government bonds. So, entities come to capital markets to borrow money to finance different infrastructure projects they are undertaking
Capital markets deal with long-term debt, which allows businesses and governments to secure capital to allow them to invest and provide public services. The period can be anything over a year. Any period under a year or less isn’t a capital market but a money market where the money is a lot more liquid.
Capital markets infrastructure providers are the platforms and the facilitators of global finance offering various services, which support financial institutions, companies, governments, and investors in building businesses and contributing to growth in the wider economy.
Main functions of the capital markets
• They facilitate security trading.
• Providing continuous availability of funds to companies and governments.
• Capital markets improve the effectiveness of capital allocation.
Types of Capital Markets
• Primary markets. In such markets, new debts or stocks are issued. The primary market is where entities like companies, governments, and other institutions access funds through the sale of debt and equity-based securities. If a company chooses to go public for the first time by raising an Initial Public Offering, it’s done in the primary market.
Because the securities are sold for the first time here, a primary market is also referred to as the New Issue Market (NIM). During an Initial Public Offering, (IPO) the company sells its shares directly to the investors in the primary market. The whole process of raising investment capital by selling new stock to investors through an IPO is referred to as underwriting.
When the shares are sold, they are bought and sold by traders in the secondary market.
Essential functions of primary markets
Origination. This is the examination, evaluation, and processing of new project proposals in the primary market. Origination begins before a new issue is presented in the market with the help of commercial banks.
New Issue Offer. This is one of the main primary market functions. The primary market organizes the offering of a new issue, which hasn’t been traded on any other exchange before. It’s because of this that the primary market is also referred to as the new issue market.
Underwriting services. One of the important attributes of offering a new issue offer is underwriting. The role of an underwriter in the primary market is to buy unsold shares. In most cases, financial institutions play the role of underwriters and earn a commission in this process.
Usually, investors rely on underwriters to establish whether undertaking the risk would be worth the returns. It’s also possible for the underwriter to buy the whole IPO issue and then later sell it to investors.
Distribution of a new issue. This is another crucial function of the primary market. The distribution procedure is initiated with a new prospectus issue. The public is invited to purchase the new issue, and detailed information about the company and the new issue is given along with the underwriters.
• Secondary market. The secondary market handles the exchange of existing or previously issued securities amidst investors. When new securities are sold in the primary market, an adaptable practice must prevail for their resale. Secondary markets grant investors the capacity to resale or vend already existing securities. Another critical division in the capital market is made based on the nature of security bought or sold, i.e. bond market and the stock market.
Main functions of secondary markets
They regularly inform about the value of the security.
They offer liquidity to investors for their assets
They facilitate continuous and active trading.
Secondary markets provide a marketplace where securities are traded.
What are the instruments traded in the capital market?
• Debt securities.
• Exchange-Traded Funds.
• Foreign Exchange Instruments.
Why invest in capital markets?
• Well-developed capital markets are a driver of economic growth, and thereby yield positive impacts on employment. The correlation between capital market development and economic growth has been well established in the empirical literature. Capital markets mobilize additional savings into the economy, making more capital available to companies, which may then, in turn, create jobs and facilitate real-wage growth.
At the same time, some evidence exists that capital markets are linked to higher productivity levels as the allocation of resources becomes more efficient in terms of better communication, mechanisms to control good governance and the provision of capital for innovative projects.
• On a micro level, well-developed capital markets constitute an essential source of financing for corporations. For businesses that already enjoy access to banking finance, capital markets can provide an attractive option as they can give companies access to larger volumes of funding, longer maturities, and potentially better economic terms, thus lowering overall funding costs.
This funding can be a vital source for companies seeking to expand their business. Additionally, capital markets allow companies to diversify their funding sources, which can become particularly vital in times of distress in the banking sector, as a retrenchment in bank lending activities could leave companies without the financing necessary to continue functioning.
Capital markets can also fund uncertain and more collateral-limited businesses and activities that wouldn’t habitually be officiated by the banking sector because they attract investors with higher risk profiles. Equity markets in particular have been discovered to be key to the financing of new businesses, specifically those relying on intangibles, research and development, and human capital.
In this way, capital markets can also support innovation. For governments, the capital markets are a vital source to finance their fiscal deficits, including expenditures for social services and job creation. As government bond markets deepen, their funding costs are likely to also decrease.
• From the investor’s perspective, capital markets offer investment opportunities and risk management tools.First, capital markets can offer more attractive investment opportunities in terms of their return than bank deposits, even-though with a higher risk. Further, in case a wide variety of instruments exists, then capital markets can render investors with an assorted portfolio, which aids risk management.
This is of specific significance to pension funds and insurance companies in countries, which have young populations because higher rates of return are necessary to ensure an adequate pay-out in the future.
Also, well-developed capital markets provide risk management tools through the derivatives market.
• Besides economic growth, well-regulated and supervised capital markets may enhance financial stability. Domestic capital markets provide access to long-term local currency financing that helps companies, governments, and investors to manage inflation, foreign exchange risks, and maturity mismatches. This is particularly important for middle and lower-income countries because most of their previous financial catastrophes originated from a union of immenseaggregate currency mismatches, small foreign exchange reserves, and short-term debt liabilities.
Furthermore, there is empirical evidence that equity markets can lower corporate leverage and deterinsolvency threats, whereas bond markets can serve as a back-up in times of banking distress.
Foreign investors in domestic capital markets
Foreign investors’ interest in emerging and developing countries’ assets denominated in the local currency remains principally narrowed to government debt. Overall, foreign investor involvement is likely to base on a persistent robusttrack record of a nation’s local capital markets (non-sovereignand sovereign), including the following conditions;
• Accessibility and good settlement infrastructure. The ability to open an onshore account easily and access to at least one bank, which can service foreign investment flows and meet international standards. Additionally, foreign investors require an easy way in and out and therefore prefer economies with either no capital controls or predictable capital control policies.
• FX convertibility. Assurance in a country’s exchange rate regime, supported by a reduced and reliable inflation atmosphere over time. A well-established foreign exchange market that permits investment flows to be converted at any time.
• Legal and information infrastructure. The protection of property rights and contract enforcement. There should be a legal framework defining investors’ rights and obligations.
• Data. Quality data on a macroeconomic grade (for instance, government debt forecast, economic growth) and a micro level (for instance, a firm’s sales performance, and leverage, equity return), which are easily accessible.
• Liquidity. An exit option that’s independent of its price and available at any time. Investors highly value liquidity, especially after a financial crisis.
• Adequacy of cash flows in the sector. Investors give clear priority to adequate cash flows for ensuring a justifiable prospect of recovering costs and making an investment a triumph. Investors value payment discipline by customers coupled with a legal or administrative process, which can be invoked to enforce payment, or if payments aren’t made, a disconnection occurs.
Investors highly regard payment discipline and enforcement as even more vital in establishing the success of an investment.
• Investors’ control over their investments. Governments can increase the chances of investor satisfaction by allowing investors greater management and operational control over their investments and permitting them to derive the maximum value from their assets. In a recent survey, investors ranked their ability to exercise effective management and operational control second among the factors contributing to the success of investments.
And 55% of respondents considered this factor in their best investment experience-rated it a deal-breaker. But effective management and operational control ranked low (ninth out of 12 factors) among the supporters to the wretched investment experiences.
• Government responsiveness to the needs and time frames of investors. Delays in government certificationsand licensing have an opportunity cost for international investors replying to concession auctions and solicitations for bids. This opportunity cost is significant in the power sectors of developing countries.
Governments of developing nations must understand that international investors are less inclined than domestic investors to continue putting up with the costs of administrative inefficiency.
Investors ranked government unresponsiveness to their needs and time frames highest among factors in their worst investment experiences.
• Availability of credit enhancement or risk guarantee. Whereas investors don’t consider government guarantees key contributors to the success or failure of investments, they view the availability of guarantees as a vital factor in decisions on whether to invest in a country or not. According to some investors, the existence of a guarantee alone isn’t enough to establish an investment decision, but it’s a main consideration in finalizing deals in markets where cash flow is influenced by a government entity.
• Regulatory independence. The independence of regulatory institutions and processes from government interference also informs investors’ decisions.
What is Foreign Direct Investment (FDI)?
Foreign direct investment is a category of cross-border investment that’s associated with a resident in one economy having control or a significant level of influence on the management of an enterprise that is resident in another economy.
What is the variation between Foreign Direct Investment (FDI) net inflows and net outflows?
FDI net inflows are the worth of inward direct investment made by non-resident investors in the reporting African economy. FDI net outflows are the value of outward direct investment made by the residents of the reporting African economy to external economies.
Inward Direct Investment also termed direct investment in the declaring African economy, consists of all liabilities and assets conveyed among resident direct investment enterprises and their direct investors. Inward Direct Investment also entails transmissions of assets and liabilities amidst non-resident and resident familiar enterprises in case the conclusive controlling parent is a non-resident.
Outward direct investment also referred to as direct investment abroad comprises liabilities and assets transferred amidst resident direct investors and their direct investment enterprises. Outward direct investment also involvestransmission of liabilities and assets amidst non-resident and resident familiar enterprises if the conclusive dominant parent is resident.
What is Foreign Portfolio Investment (FDI)?
Foreign Portfolio Investment is known as investing in the financial assets of a foreign country such as bonds or stocks available on an exchange. This kind of investment is sometimes regarded as less favourable than direct investment seeing that portfolio investments can be sold off rapidly and are sometimes viewed as short-term attempts to make money rather than a long-term investment in the economy.
As with an equity investment, foreign portfolio investors normally anticipate to rapidly get a profit on their investments.
Since securities are efficiently traded, the liquidity of foreign portfolio investments makes them much easier to sell than direct investments. Foreign Portfolio Investments are more accessible for the average investor than direct investments because they need less investment capital and research.
Unlike Foreign Direct Investment, Portfolio Direct Investmentdoesn’t offer the investor control over the business entity in which the investment is made.
African countries must invest in more robust capital markets infrastructure to facilitate the inflow and outflow of investments because this aids in economic development from local and foreign investors.