It does not require investment of billions of dollars to build a capital market.
From a 'basket case' of the early 70s to one of the world's fastest growing economies, Bangladesh's turnaround has been truly amazing. With support from a favourable demography, Bangladesh's growth story is expected to continue for the coming decades.
There has been a transformation in the way the country's future is envisioned and action plans are taken. The country's development focus has shifted from ad hoc and short-term patchworks to long-term strategic goals. Now, we have national plans for the 2030s, 2040s and even 2100s. In recent years, the country has invested billions of dollars in mega infrastructure projects that will be completed soon and start benefitting the economy within two or three years, increasing its efficiency to a great extent for the decades to come. However, to fully harness the economic potentials of its 170 million people, Bangladesh must focus on soft infrastructures such as rule of law, markets and institutions, which are equally important as the hard infrastructures on which billions of dollars are being invested. This article focuses on how we can create one very important soft infrastructure, the capital market.
It does not require investment of billions of dollars to build a capital market. The money spent on foreign consultants since 1990s, including the sum spent for creating a market for securitized assets 19 years ago, were premature and unnecessary. Capital market only requires some initiatives and doing right things at the policy level, which must be done soon because a well-developed capital market is essential for taking our economic development to the next level---middle-income country.
Why a well-functioning capital market is essential
Households need to save for their future -- savings should generate reasonable risk-adjusted returns. On the other hand, businesses and governments need money to invest for creating productive capacity for the economy. Such investments, for example factories and infrastructure projects generate economic returns that businesses and governments pass on to the households, whose savings make those investments possible. Banks and financial institutions can play a role in channeling household savings to businesses and governments by working as an intermediary. But banks usually provide short-term loans to businesses and governments matching their short-term liabilities.
The market should be as efficient as possible, that is, the market should be such that the market prices of the instruments such as stocks and bonds fully reflect the economic fundamentals of the issuers of the instruments.
The capital market channels household savings towards building the productive capacities of the economy in better ways than banks and financial institutions. There are two reasons for it. First, capital market eliminates the need for intermediation by banks and financial institutions. As a result, the savers can enjoy the entire return their savings generate without sharing it with intermediaries. Better returns motivate them to save more and, as a result, more investments happen. Second, compared to banks and financial institutions, the capital market enables long-term investments because capital market instruments such as bonds and stocks are long-term in nature. As the investors in capital market instruments can sell the instruments in the market any time, they buy them without worrying too much about their long-term nature. In absence of a stock market, for example, the equity investors in a company would need to hold their investments in perpetuity. This also means, in absence of a secondary market for bonds, investors in a 20-year government or corporate bond would hold it for 20 years. Absence of a secondary market drastically reduces investors' appetite for long-term instruments such as stocks and bonds. As a result, long-term projects for building of power plants, roads, ports, factories are not funded adequately. In such circumstances, enough employment opportunities are not created and the economy operates at a suboptimal level, i.e., the economy does not produce goods and services up to its potentials to do so. So, we need to have a capital market.
The market should be as efficient as possible, that is, the market should be such that the market prices of the instruments such as stocks and bonds fully reflect the economic fundamentals of the issuers of the instruments. It is very often argued that our stock market is speculative and not at all efficient. If that is the case, then the investors are unable to generate optimum returns and companies are unable to raise capital at low costs. Such a market fails to deliver its ultimate purpose of contributing to the development and growth of the economy. For our market to be efficient, regulators need to ensure adequate and high-quality disclosures by the issuers of stocks and bonds and all professionals are educated and trained for the job.
Develop the bond market first
Holders of common stocks are not entitled of fixed amount of dividends every year. They can get a lot of dividends if the company performs very well or they get nothing if the company performs poorly. That's why prices of stocks are volatile and stock market is risky for investors.
On the other hand, when the government or a company issues bonds they commit to pay a pre-determined cash flows to investors in the form of coupon payments and redemption of the bond principals at maturity. As bond issuers promise pre-determined cash flows to the bond investors, bonds are less risky than stocks, i.e., the market price of bonds are less volatile than the market price of stocks. Therefore, bonds are ideally suited for certain category of investors such as retired individuals who have regular cash flow requirements. Also, bonds are suitable investment alternative for institutions such as insurance companies, provident/pension funds, endowments and other institutional investors who have rigid cash flow requirements to meet their own obligations to the policy holders or beneficiaries.
For these reasons, many countries created bond markets before creating stock markets. That should have been the case in Bangladesh as well because a lot of our retail investors are not sophisticated in terms of financial knowledge. It would be better if they can get used to investing in capital market with bonds that are less risky than stocks. The bond market also helps even sophisticated stock market investors in diversifying their portfolio and managing risk. For example, if the stock investors consider that the stock market is overvalued they can invest some of their money in bonds.
That is why the bond market is perhaps the most important component of the financial market in most countries. In many countries, the size of the bond market is much bigger than the stock market. In our case, there is a sizable amount of outstanding government bonds but they are mostly held by banks as part of the statutory liquidity requirement and their secondary market is confined to over-the-counter trading among banks. Individuals don't buy or sell them like stocks. Also, we have sizable amount of untraded corporate bonds held by banks and institutions. But a secondary market for corporate bonds is almost non-existent. Therefore, our main focus now should be on building a secondary bond market.
Saving certificates should go, gradually
Most governments in the world run fiscal deficits, i.e., they spend more money than the revenue they collect. Governments finance the deficit by borrowing from individuals and institutions. Governments mostly issue long-term bonds for such borrowing form individuals, banks, pension funds, insurance companies and other institutional investors. Those bonds trade in the market and, therefore, investors can sell them any time they want.
Our government issues savings certificates as well as bonds to finance our country's fiscal deficits. The problem with savings certificates is that they don't trade in the market and the government sometimes pay higher interest rates on them than bonds of similar maturities. As the government sets the interest rates of savings certificates once in every 2/3 years, the rates don't move in tandem with other interest rates in the market. As a result, the rates on savings certificates are sometimes a bit too high and, as a result, the government ends up borrowing massive amount money at high interest rates. For example, the interest rates on saving certificates have been so high in the recent years that, the government's outstanding borrowing from saving certificates has increased by about 600% in last 10 years and the outstanding amount is currently almost BDT 3 trillion. Consequently, interest expenses of the government have increased sharply in the recent years.
The government currently offers higher rates on certain categories of savings certificates for another reason. The government considers those savings certificates as tools for providing welfare benefits to certain groups of individuals such as retirees and women. It is arguable if that objective is being fulfilled or not. But it is clear that high interest rates on saving certificates are unintentionally distorting the financial market hampering its development and growth and increasing the interest payment burden of the government. The government should gradually discontinue issuing savings certificates and encourage retirees and women to buy government bonds instead. The government's objective of providing welfare benefits to women and old people through higher interest rates on savings certificates can be achieved through government bonds as well. Government can do this by exempting women and retirees from taxes on their interest income from government bonds. Banks, the main investors of government bonds, for example, pay 42.5% taxes on their income from government bonds. If the retirees and women pay zero or lower tax on their income from government bonds it is a big enough benefit for them compared to intuitions like banks.
Also, if we can create a liquid secondary market for these bonds, all investors including the retirees and women can benefit from the liquidity of the bonds, something that the savings certificates do not offer. Thus, by eliminating the saving certificates, the government can reduce its interest expense and help develop a capital market without affecting its objective of helping certain categories of vulnerable people.
The secondary market for government bonds needs to be liquid for all types of investors
The government of Bangladesh issues bonds with maturities as high as 20 years. As discussed earlier, investors buy such long-maturity instruments only if they have the option to sell them before the maturity. Therefore, a secondary market for government bond is extremely important. A liquid secondary market for government bonds is also a requirement for developing a proper market for other capital market products such as corporate bonds and stocks because the intrinsic values of these relatively riskier instruments are determined based on the yield at which the risk-free government bonds trade in a liquid secondary market.
We do have a secondary market for government bonds. But it is not ideal. Currently, only the banks and institutions participate in that market. The market needs to cater to all types of investors including individuals. Though some of the government bonds have been listed on Dhaka Stock Exchange a long time ago, they don't trade and no investors seem to have ever bought them through their stock brokers. Perhaps there are still some operational issues inhibiting such trades. The high interest rates of savings certificates might have also been a reason why there is no demand for government bonds from individuals.
If the government discontinue the savings certificates, does all its borrowing through issuing bonds, make the bonds easy to invest for both individuals and institutional investors, create a liquid secondary market of the bonds through stock exchanges as well as through over-the-counter transactions with banks, a solid foundation of a capital market will be created in the country and the government will be able minimize its interest expenses.
We desperately need a market for corporate bonds
So far, we talked mostly about the market for government bonds. But companies also need long-term funding for building factories, buying plants and equipment and creating intellectual properties. At absence of a corporate bond market, companies rely mostly on bank borrowing. As bank loans are typically short-term in nature, long-term corporate investments get hampered. In some case, companies have no other options than funding their long-term projects through short term loans. In such cases, many companies find it difficult to manage their corporate finances and some of them default on their bank loans.
To develop a corporate bond market, Bangladesh Securities and Exchange Commission (BSEC) should make it mandatory for the companies to have a track record in issuing bonds in the public market before they are approved to raise capital through selling stocks. It is easy for BSEC to protect the interest of bond investors than the interest of stock investors because bond investors are entitled of fixed cash flows from issuers. BSEC can identify potential non-compliance of bond issuers easily and take remedial actions quickly.
Sub-ordinated bonds issued by banks are not listed, why?
Banks have issued long-term, subordinated bonds worth thousands of crores of Taka in the recent years to comply with their capital adequacy regulations. If these bonds were tradable in the secondary market, investors would have options to sell them in the market before maturity. That would make the bonds much more attractive to the investors and there would be less interest expense for the issuing banks. But, for reasons absolutely unfathomable, none of the recently issued sub-ordinated bonds trade in the secondary market. Few years ago, subordinated bonds issued by BRAC Bank traded in the secondary market until their maturity. Currently, only a bond issue by Islami Bank trades in the secondary market. I request BSEC to make listing and secondary market trading mandatory for any new subordinated bond issuance that they approve.
Raising equity capital from public must not be open to all
Though companies are reluctant to issue corporate bonds in the public market, there is no lack of interests among them for issuing shares in the market. But BSEC should be extremely selective in allowing companies to raise equity capital from the public market. Only well governed companies with reliable financial disclosures should be allowed. Many large companies in Bangladesh are family-owned. Most of these companies hardly operate as distinct legal entities separate from their owners. Often there are too many transactions with other companies owned by the same family. The financial health of these companies is so intertwined with the financial health of the members of the owning families that these companies cannot even borrow from banks without owners issuing personal guarantees in favor of the loans. Therefore, these companies are not company in true sense and such companies should not be allowed to raise money from the public market. It doesn't matter whatever rosy financial pictures of such 'companies' the merchant banks submit to BSEC along with their capital raising applications.
Clean up the universe of listed stocks
It is perfectly normal that some companies will fail to run as going concerns in the long-run due to competition, strategic mistakes or management failures. But it is unusual anywhere in the world that the stocks of insolvent companies trade in stock exchanges. Some companies listed in Dhaka and Chittagong stock exchanges are insolvent according to their own reporting to the exchanges. Some have shut down their operations. Some others have defaulted on their bank loans. But they are still listed on the stock exchanges. Their share prices are often manipulated through spreading rumors and, as a result, many unsophisticated investors get affected.
It's not the quantity of the listed companies that matter. It is all about the qualities of the companies in terms of their corporate governance and financial health. BSEC and the stock exchanges need to set stringent criteria not only for new listing but also for companies to maintain their status as listed companies. Every listed company should be periodically judged based on those criteria. If a company fails to maintain the standard it should be delisted immediately.
We need to introduce short-selling
In Bangladesh, we can do only long-only trades. It means that we can buy stocks of listed companies from the market but we can sell stocks only if we own the stock at the time of selling. But in many countries, investors can sell stocks even if they don't own it at the time of selling. They can sell them after borrowing them from a broker for a certain period of time. On or before the expiry of that time period, the investor needs to buy the stocks from the market and return it to the broker.
In a long-only market like ours, investors can profit only from their positive expectations about a company, i.e., if an investor expects that a company will pay good dividends or the price of the stock will go up, she can buy it and profit from her expectation if the expectation turns out to be true and share price goes up. As we can't do short-selling in our country, investors cannot profit from their negative expectations about a company or the market.
Short-selling is extremely important for the market to reflect both negative and positive expectations of investors. In a long-only market, only the positive expectations of investors get reflected and often speculative bubbles are created. We had two episodes of such speculative bubbles in our country; one in 1996 and the other before the market collapse in 2010 and 2011. As it happens to almost all speculative bubbles, both of the bubbles resulted in massive market crashes and had tremendous negative impressions in people's minds about investing in stock market. The stock market bubble leading to 2010 was particularly massive. The market value of the companies that were listed in 1999 increased by about 2,000% in 11 years ending in 2010. The bubble and the ensuing correction were so massive that the market capitalization of the country's stock market is now significantly below the level that it achieved nine years ago despite Bangladesh being one of the fasted growing economies in the world in last 9 years.
To minimize the chances of recurrence of such bubbles and to provide investors opportunities to profit from their negative expectations about any company or the economy, we need to introduce short-selling as soon as possible. Short selling is also essential for creating a market for more advanced financial products such as financial derivatives.
Develop insurance industry
The level of insurance penetration in Bangladesh is one of the lowest in the world. Development of the insurance industry is important primarily because insurance companies provide very useful risk management tools to families and businesses. In addition, a well-developed insurance industry can help develop the capital market of the country very well. Insurance companies, especially the life insurance ones, are required to maintain large long-term reserves matching the long-term nature of their annuity payment obligations and contingent liabilities, i.e., potential claims from beneficiaries of life insurance coverages. Insurance companies invest in long-term government and corporate bonds matching their long-term contingent liabilities and create demand for capital market products.
Government pension fund: the sooner, the better
Bangladesh government's pension obligations to millions of its current and retired employees are unfunded. Currently, the government makes pension payments to its retired employees from its annual budget. The number of pensioners is expected to grow sharply as an increasing number of government employees are retiring every year and retired people are living longer. On the other hand, due to fast plummeting birth rates, Bangladesh's working age population is expected to start shrinking within a decade or two. So, the current 'pay as you go' system of government pensions will create massive burden to our future generations. Therefore, the government is considering setting up a pension fund. It's important that the government does it sooner. A government pension fund will not only reduce the fiscal burdens from our future generations but will also be a vehicle that will create demand for capital market instruments.
Bangladesh also needs a regulatory authority that can ensure that private sector provident funds are adequately funded and investments are made in securities that are suitable for the funds. Well-funded, regulated and professionally-managed provided funds will not only serve the best interests of the beneficiaries of the fund but also create demands for long-term government and corporate bonds.
[The writer is the CEO of VIPB Asset Management Company and the President of CFA Society Bangladesh.]