DSE ARTICLE: Depth and Liquidity as Catalysts of Capital Market Development

Over the past one-year or so there has been a steady appreciation of stock prices at our stock market which has boosted the valuation of some counters that has made investors in these companies multi-millionaires.

Our domestic market capitalization has increased by more than TZS 6.5 trillion (from TZS 3.5 trillion in June 2013 to TZS 10.4 trillion this September) – if this increment in wealth was to be distributed equally among the 200,000 CDS accounts at the Exchange, each investor would have increased their wealth by TZS 32.5 million more. But we know that this can’t be distributed equally among investors as some have invested more than others, some have invested in most profitable and more price appreciating companies than others, etc – but in general that is how much wealth the stock exchange has created to its investors (i.e. pensions schemes, corporate entities, insurers, and private individuals through their savings investments either invested directly or through their asset managers). And our price-earning ratio (PER) has also almost doubled to 20 times relative to less than 10 times a year ago.

The DSE total market capitalization has increased by more than TZS 8.4 trillion (from TZS 13.7 trillion to TZS 22.1 trillion). Our indices (both total and domestic) has also reflected the same levels of increment – where the TSI index has increased by about 190 percent and DSEI has increased by more than 60 percent.

Trading turnover has also increased significantly to more than TZS 350 in the past 15 months – this is more than the past seven years trading turnover combined. Liquidity ratio is now at around 3 percent from levels of less than 1 percent during the same period.

Despite these recent significant growths in our stock market activities in terms of depth, breadth and liquidity – we still have a lot of work cut out for us. Our domestic market capitalization is still at about 20 percent of Gross Domestic Product (GDP) and liquidity ratio of 3 percent. For us to be able to improve from these levels we need to have more companies raising long-term capital and get listed into the Exchange and we need to see more trading activities in the market. In short we need to develop our capital market so it can facilitate mobilizing our local and foreign financial resources and put them into use in productive projects such as infrastructure, powers, energy, agriculture, finance extractive sector of our economy, etc.
Development of the capital market is key to the economic development of the country. As it stands, there is a strong need to deepen our capital market – and, for this to be achieved, it requires a combined effort by all parties and stakeholders -- the Government (through privatization policies for state-owned entities, local empowerment policies, implementing legislative actions meant to develop the local capital market, etc) – it is of every possible necessity that a country should focus in growing its capital market, as it facilitates implementation of its key economic policies – both fiscal and monetary. If the government takes a lead, as it is in most countries, the private sector will generally follow this lead, for capital raising purpose to sustainably finance their enterprises, for investors’ exit purposes, for better pricing of their assets, for proper valuation of their investments, etc.

Empirical evidence from other markets (especially emerging markets) indicates that development of capital markets has been driven to a great extent by offering of state owned entities (SOEs), with large-scale privatization programs typically being followed by substantial market capitalization and liquidity as well as strengthening of regulatory and corporate governance frameworks.

Secondary markets are created mainly to provide an exit route for investors and facilitate price discovery – the accurate valuation of instruments that ensures issuers are paying an appropriate price for their access to finance and investors are adequately compensated for the risk they take in providing it. Liquidity providers are crucial to this latter function, as they
take advantage of their superior expertise and information in order to arbitrage away inconsistencies in valuations as well as differences in risk appetites between investors.
There are a number of interesting relationships between market liquidity and the effect on capital market development on growth, this relationship is magnitude and very relevant.

Investors in capital markets need exit opportunities, usually through secondary markets, in order to match the maturity of available securities to their own preferred portfolios. This requires the function of market institutions, key being stock brokers and dealers willing to build inventories of financial instruments and, while sometimes these key market intermediaries are frequently denounced as mere speculative in their dealings with investors, their function is essential. In fact, insufficient liquidity is very often cited as the primary barrier to capital markets growth and development.

Evidence demonstrate that liquidity providers are generally attracted to critical mass of investors (including security borrowers and lenders) but equally they need a set of rules governing trading that are not unduly restrictive. They also benefit from trading mechanisms, including supporting clearing and settlement systems, which do not impose prohibitive transaction costs. To minimize learning costs, liquidity providers tend to require relatively large issue sizes and frequent and/or regular issuance or, alternatively, long maturities. Finally, liquidity providers rely on the existence of financial instruments whose risk profiles incorporate mostly or exclusively market risk as opposed to plethora of different risks; alternatively, other instruments through which market risks can, at least in theory, be isolated (e.g. by hedging all other sources of risk).

When market rules and trading conditions are much more benign for liquidity providers than for other investors, a market can accumulate liquidity in good times, sometimes from overseas, whose presence in the market is relatively volatile. Such excess liquidity during booms may be associated with the rapid loss of market liquidity that several developed markets saw during the financial crisis of 2008-9 and the sovereign debt crisis of 2010-12 in many developed countries. In fact, such phenomena could prove to be self-reinforcing as fear that liquidity may drain from the market at short notice is likely to drive investors away.

The strength of the disclosure system (disclosure rules, monitoring and enforcement and information dissemination) is positively correlated with stock market liquidity. The timely and credible disclosure of company information tends to not only to promote investor confidence and encourage more active participation in the market, but also to attract additional listings, thus broadening the benefits to the domestic economy. On top of mandatory disclosures, voluntary disclosures have also been shown to increase stock market liquidity by reducing bid-ask spreads. Disclosures also have an indirect effect on emerging bonds market liquidity.

It is however important to note that overall market liquidity is not an end in itself. Investors normally demands a premium from smaller firms listed in small stock markets above and beyond what would be justified by market liquidity. Thus, there is case for policies that ensures that capital markets not only attract liquidity, but also direct it towards the most productive firms, regardless of size.