Should Ethiopia Promote the Development of a Stock Exchange Market?

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A few years ago, enamored by global channel television stock market reports, a very close friend of mine expressed his wish to see local stock exchange market summary reports on local TV screen minute-by-minute. As I was aware of some frustrated initiatives by individual promoters for setting up a stock market in Ethiopia in early 2000, my reflexive answer to my friend was that the Ethiopian government should take the blame for not allowing/delaying the establishment of a stock exchange market.

After the exchange with my friend, I had to engage in a more seriousand deliberatestudy which allowed me to understand the role of stock markets in the economic development of countries.Because of this opportunity, I gained a deeper understandingof the issues for myself–butdid not get anything that would encourage me to echo my friend’s wish again!

In the course of this short article, I will present the experience of some developing countries which have stock markets and the pre-requisites for successfully establishing such markets. My recommendations on whetherEthiopia shouldfollow in the footsteps of these countries and setup a full-fledged stock exchange market will be based on the empirical evidence from these countries.

As a financial infrastructure, a good stock exchange market performs basic functions including serving as: a source for financing new investments; a mechanism for mobilizing savings; a key platform for investment diversification and efficient use of capital through a market for corporate control; a mechanism for monitoring investments through information dissemination.

The promises of a stock market are so enticing that most political leadersfind it difficult to resist the temptation to accept the recommendationsof international institutional promoters of the market as a panaceafor accelerating economic development.The big and practical question, which is often unasked and unanswered however, is whether the claimed benefits are automatic and, if not, what it would take to get these benefits.

At present, there are 29 stock exchanges that ‘serve’ about 38 countries in Africa but the major exchanges that have notable contributions to their respective countries’ economy are only four: Johannesburg Stock Exchange (South Africa), Nigeria Stock Exchange; Casablanca Stock Exchange (Morocco) and Egypt Stock Exchange. The rest are not worthy of the name.

 

The common and traditional methods of measuring the development and depth of a stock market aremarket capitalization and market turnover. Market capitalization is the number of shares traded in the stock market multiplied by the stock price whilemarket turnover is the value of shares traded in the market during a certain period. Both market capitalization and market turnover can be expressed against a country’s GDP to measure the depth of the stock market in an economy.

Measured in terms of market capitalization of companies listed in stock exchange, the Johannesburg stock exchange is about five times bigger than the combined market capitalization of the next three top stock exchanges in Africa.The above top four stock exchanges raised USD 10.6 billion from 2010 to 2017, out of the total USD 12.8 billioncapital raised through Initial Public Offerings (IPOs) in all of Africa’s stock exchanges. This was about 83% of all of Africa’s IPOs.

An important indicator of a useful stock market is liquidity.Stock market liquidity refers to the market’s ability to purchase or sell a financial asset (share, bond etc.) without causing a drastic change in the asset’s price. In an illiquid stock market, selling a financial asset may require some reduction in the price of the asset… There are studies which argue that investors are unlikely to commit funds for long-term investments in the absence of well-functioning stock markets that can provide them with a reasonable level of liquidity.

,Achieving liquidity in a small economy and in an open systemis easier said than done. To my knowledge, there is no agreed economic or financial model thatcan predict stock market liquidity and viability before its establishment.However, the stages of development of the key institutions that supporta smooth working of stock market can be observed beforehand.

Setting aside macro-economic factors which also need to be managed by an independent and professional central bank for the good of any economy, there are many empirical studies that suggest key ‘pre-requisites’for establishing a stock exchange market. These are:the contractual saving institutions; the accounting andauditinfrastructure; the legal and governance structure and the independent regulatory and supervisory infrastructure (this can be established upon setting up the market).I would like to highlight the current state of development of some of these key pillars in Ethiopia.

Contractual savings (pension funds and life insurance) institutionsare the powerhouseswhich ensure the continuous supply of long-term funds that are critical for the development of stock markets in an economy.Unlike commercial banks, contractual saving institutions have long-term and illiquid liabilities in their balance sheet and are the prime pillars for stock market development and the market for long-term government bonds.

Studies made in this regard predominantly suggest that developing countries should first focus on developing contractual saving institutions before establishing a stock market. However, such institutions are not well developed in Ethiopia to provide the required long-term finance to a stock market.

The pensioninstitutions which are currently collecting money both from the public and private sectors are currently owned by the Ethiopian government. The institutions are the main sources of long-term finance for the Ethiopian public sector as well as for the government priority projects. It is also necessary to notethat the funds of the institutions are channeled through government owned banks. In the short term at least, the pension institutions cannot withdraw their funds from government owned banks to invest in a stock market without seriously affecting the activities of the banks.

It is also noteworthy that both the life and non-life insurance markets are too thin to provide the long-term finance needed for a stock market. Even in comparison with neighboring countries, the size of the Ethiopian insurance market is too small to sustain a stock market. For example, Ethiopia’s insurance market is less than 25 percent of the insurance market of Kenya.

The accounting and audit profession is the prime supplier of financial information to stock marketsand is a critical backbone for information intermediation.However, a survey conducted on 102 top accounting and financial professionals in 2008revealed that 86 percent of the respondentsbelieve that thecountry’s accounting and audit profession is weak to provide reliable financial information to primary users.Since then, however, the Ethiopian government has passeda financial reporting law that recognizes international reporting standards and established an Accounting and Audit Board to regulate the profession. Establishment of the Board and recognition of international reporting standards for wider use in Ethiopia are in the right direction. As a practitioner in the profession;however, I have the opinion that the accounting and audit profession still requires close monitoring to discharge its responsibilities and to properly serve an open financial system such as a stock market.

Various corporate finance literatureemphasizes the importance of legal infrastructure and governance system for stock market development with the objective of protecting the right of investors and creditors and ensuringtransparency in the management of listed companies. The company law which was enacted in 1960 but remained dormant for most of its life needs a complete overhaul to make the required amendments for outdated provisions and additions that are necessary for protecting local as well as cross border investments.

Public confidence in the workings of a stock market system is paramount not only for mobilizing local savings, but also for attractinginward capital inflows for investment opportunities in the country. However, with the exception of the Financial Institutions, there is no widely used corporate governance code that is applied in Ethiopia. The recent big profile scandal in relation to alleged misappropriation of mega project funds indicate that the country still requires time to set up appropriate institutions that enhance transparency in management of the economy and build public confidence before setting the‘rule of the game’ for aformal stock exchange marketso that our current bank based financial system will usefully be complemented.

Unlike bank based financial system, stock markets work on the basis of accurate, transparent and timely public information.Notwithstanding the macro-economic factors in a country, I have the opinion that poor liquidity of stock markets may result from: problems of weak corporate governance in the economy;weakcompany laws; an inefficient and weak legal structure; low level of development of the accounting and auditing institutional framework and low level of development of financial intermediaries. Weaknesses in all these institutions have a bearing on the processing, accuracy, reliability and timely supply of required information for the effective operation of this open financial system.In absence of strong institutional safeguards, a stock market can easily be turned into a gambling platform with serious economic and political consequences

Because of institutional challenges and size of the economy,many studies state that the costs of a stock market financial system for many African countries outweigh the benefits.This isa very serious finding.There are also studies that ascribe the 1997-1998 Asian financial crisistopoor governance system, weak accounting and auditing standards and structural problem in financial intermediation than to macro-economic factors.

The study made in East Africa Stock Exchanges in 2008 (Kenya, Tanzania and Uganda) revealed that lack of public confidence in the system, loss of control in a company and fear of public disclosure were the prime factors for the small number of companies listed in the exchanges. In 2008, the total number of companies listed in the three stock exchanges was less than 70 (Kenya 54, Uganda 6, Tanzania 6). After ten years and including Rwanda, the number of companies listed in the four East Africa Stock Exchanges is less than 115 (Kenya 64, Rwanda, 8, Uganda 17, Tanzania 25).

The most important motiveof developing countries forestablishing a stock market is to solve problems associated with long-term financethrough attracting inward capital flows and mobilizing local savings. However, the use of a stock market as a source for financing new investments has very little empirical support. For instance, the study made on UK and US stock exchanges from 1970 to 1985 demonstrated that most companies do not use the stock market as a source for financing growth. Once listed, companies prefer to use internal finance instead of the stock market.

Coming closer to home to East Africa,the Nairobi Stock Exchange which was established in 1954 – and is by far the better performing exchange in East Africa- has not been used by non-finance companies listed in the exchange to raise additional capital from the stock market between 1990 and 2007. During this period, only two finance companies raised Kenyan Shilling 3.2 billion (USD 45.6 million) from the stock market.From 2013 to 2017, only two IPOs with a value of USD 42million raised capital fromthe Nairobi Stock Exchange.

Stock market financial systemrewards short term financial performance of companiesat the expense of long-term growth prospects because of analysts and investors pressure to get results in the short-term.  A company which might have an attractive long-term growth potential but does not deliver results in the short-term can be wiped out of the system. In a growing economy, this is a determinant to the development of a country. As witnessed even in developed countries, this short-term pressure may even encourage companies to resort to all sorts of tricks including ‘creative accounting’ to boost share price regardless of the true underlying performance of the companies.

There are studies which argue that countries get the best out of stock exchanges once their economic growth reached a certain level of development. For instance, the engine of economic development for Germany, Italy, France and Japan is not stock market even if all of these countries have later supplemented their bank based financial system with a stock market. This is because both bank-based financial systems and stock market based financial systemscan bring economic development to a country.There is no empirical evidence which suggests thatstock market based financial system is better than bank based financial system.The advantage of a predominantly bank-based financial system is thatfinancial transaction disclosures and personal affairs of investors is limited between the banker and the investor only. This limited and closed relationship is good in a country that has weaker institutions to govern proper functioning of an open stock market.

It would be difficult to establish a robust stock market by simply transplanting the market structure, trading system and even regulations from a well-functioning stock market. Although it is easier to copy any laws or trading systems, it is not easy to copy institutional structures and users’ confidence.An open system which is embedded and routinizedin a particular economic systemcannot be copied to analien environment. For instance, there are studies which highlight that from 1990-1999, 20 of the 26 transition economies established stock markets; however, many of these markets remainedunderdeveloped or dormant because of poor development of basic infrastructure necessary for a well-functioningand vibrant stock market.

The proposed privatization of big public enterprises by Prime Minister Abiy’s government should not be a push factor for establishing the stock market. This is because, once listed, the market will not be big enough to raise subsequent growth finance by the companies. The bigger stock market in Africa, the Johannesburg stock exchange serves as a secondary market for its top ten listed companies. The big companies use the London Stock Exchangeas their primary listing. Hence, rather than running a possibly illiquid local stock market, it is possible to buy the services of a liquid stock market by allowing companies to be listed in a foreign liquid market. But this requires liberalization of the Ethiopian economy, particularly the foreign exchangeand a great deal of work by the companies to be listed. 

In conclusion, I have a strong opinion that giventhe present stage of itseconomic development and weak institutional infrastructures,Ethiopia can benefit more by using the bank-ledfinancial model as its prime financial systemrather than sharing the meager savings to both systems.

The government may alsoallow thesetting up institutional and approved,but closed,dealers network that can buy and sell shares in a secondary market on behalf of companies that have already thousands of shareholders.

I also recommend that the government need to develop medium to long-term institutional development plan supported by appropriate national policies to build: contractual saving institutions and legal, governance, accounting and audit infrastructures to serve as strong foundation for a stock market development.Once this is done, the country can establish a full-fledged strong stock exchange market system that usefully supplement the bank based financial system forsustainable economic development of the country.

 

Solomon Gizaw is a Managing Director of HST Consulting. The opinion expressed in this article arehis own and not reflect the views HST. He can be reached at solomon.gizaw@hst-et.comfor any comments on his views.