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Capital market development and need for fiscal incentives

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Capital markets, globally, are an integral part of the financial system, providing efficient delivery mechanisms for savings mobilization and allocations, risk and liquidity management and corporate governance.

In addition, they facilitate the management of the government’s debts, the conduct of monetary policy and provide a channel for privatisation.

Capital markets can also be a driving force and benefit from the development of institutional investors such as pension funds, insurance companies, and mutual funds, fiscal decentralisation and the development of mortgage markets.

A sound domestic capital market provides a market signal on currents situations and future expectations. Strong domestic capital markets help ensure the efficient and sustainable funding of large scale or long term projects.

Well functioning markets ensure that corporations efficiently mobilise capital for growth and that markets price well so that valuable projects will be financed.

Where a country does not have access to equity capital, it faces a higher cost of capital, leading to the segmentation of markets.

However, capital markets cannot function efficiently unless a number of elements are in place. These include exchanges and clearing and settlement systems, money market arrangements to facilitate settlements, and a legal system to enforce contracts.

Capital markets link issuers having long term financing needs with investors willing to place funds in long term interest-bearing securities.

A mature domestic capital market offers a wide range of opportunities for funding both the public and private sectors of the economy.

Capital markets are built on a number of elements, these include a number of issuers with long term financing needs, investors with a need to place savings or other liquid funds in interest-bearing securities.

Intermediaries bring together issuers and investors and the infrastructure that provides a conducive environment securities transactions and ensures legal title to securities and settlement of transactions and provides price delivery information.

Another important element to the development of the domestic capital market is the regulatory regime, which provides the basic framework.

Efficient capital markets are characterised by a competitive market structure, low transaction costs, low levels of fragmentation, robust and safe market infrastructure and a high level of heterogeneity among participants.
Benefits of the efficient domestic market

There are some important benefits of an efficient domestic capital market. At the macroeconomic policy level, an efficient market provides an avenue for domestic functioning of budgets, other than that of the central bank, thereby reducing the need for direct and potentially damaging monetary financing of government, especially its deficits.

Furthermore, it helps to avoid a build-up of foreign currency-denominated debt. It can also strengthen the transmission and implementation of monetary policy, including the achievement of monetary target inflation objectives, and can enable the use of market-based indirect policy instruments.

Also, a shift towards market-oriented funding of government budget and deficits will reduce debt service costs over the medium long term through the deep and liquid market for securities.

At the micro-level, the development of a domestic capital market can increase overall financial stability and improve financial intermediation through greater competition and development of related financial infrastructure, products, and services.

Development of the domestic capital market can help the financial system from a primary bank oriented to a multi-layered system, as the capital market can complement bank financing.

In an economy with a well-developed capital market, commercial banks are forced to develop new products to intermediate credit more competitively.

Fiscal incentives
If a country is not seen as having the ability to manage its public expenditures or collect tax revenue, or if it has built up substantial explicit or implicit domestic and foreign debt obligations, investors will perceive a high default risk and the cost of financing will rise.

The development of the capital market will be more successful when a consistent macroeconomic framework involving fiscal, monetary, exchange rate and capital accounts policies are in place.

The fiscal incentives are economic governance- institutional and legal framework that can ensure proper governance. A record of accomplishment of fiscal prudence will influence investor perception of default risk and help build the country’s ability to honour long term obligations.

Without such credibility, the development of a long term capital market will be more difficult and costly.

For instance, NewZealand, Argentina, and Brazil developed enforceable fiscal responsibility laws and this helped to create incentives for proper economic governance.

A reasonably robust fiscal regime is another credible fiscal incentive. Such a regime should have the capacity to collect direct and indirect tax revenues and effective budgeting and expenditure control.

For the capital market to develop and become relevant as providers of the efficient delivery mechanisms for savings mobilisation and allocation, risk and liquidity management and corporate governance, fiscal policies and incentives must be right in the context of sound macroeconomic management.

Fiscal incentives, among others, serve as a prerequisite for successful capital development. Others include sufficient supply of funds, sufficient demand for funds and adequate legal and regulatory framework.


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