Domestic capital markets have an important role to play in mobilizing private capital to finance domestic development. By giving companies the ability to borrow domestically in local currencies, domestic capital markets can also reduce currency mismatches for borrowers, thus reducing systemic risks. At the same time, government bond markets create tools to manage macroeconomic and fiscal risk and provide important pricing benchmarks. However, the Addis Ababa Action Agenda emphasizes that capital markets can increase risks in the real economy, for example, due to market herding and boom and bust cycles. The Addis Agenda stresses the importance of regulations aimed at reducing volatility and incentivizing longer term investment.
In the Addis Agenda, Governments commits to:
- Work towards developing long-term bond markets
- Work towards developing insurance markets, including crop insurance on non-distortive terms
- Strengthen supervision, clearing, settlement and risk management
- Recognize that regional markets can provide scale and depth
- Increase local currency lending from MDBs
- Enhance international support in domestic capital markets; strengthen capacity building, including through regional and international forums for knowledge-sharing
- Stress the importance of managing volatility associated with foreign inflows
- Endeavour to design capital market regulations that promote incentives along the investment chain that are aligned with long-term performance and sustainability, and that reduce excess volatility
While countries have tried to harness the benefits of capital market development, they have not always succeeded. In several countries where stock exchanges have been created, there are only a few companies listed. For example, a study of 20 middle-income countries found that the 10 largest companies represent more than half of the market capitalization in almost half the countries. Countries face multiple challenges in developing capital markets, such as inadequate market infrastructure, weak or inappropriate regulation and supervision, and the lack of reliable information on issuers. In addition, they also often face both limited demand and supply. To function, capital markets need a critical mass of investors, such as pension funds and insurance companies. These investors play a catalytic role in market development and add liquidity to the system. However, such an investor base remains limited in many developing countries. One study found that while pension assets account for about 50 per cent of GDP on average in developed countries, they account for only 20 per cent on average in many developing countries, as of 2017.72 At the same time, there is often limited supply of issuers. The number of issuers willing and capable of accessing markets is limited in many developing countries, with the cost and complexity of issuing securities restraining interest. Extremely low liquidity from insufficient supply and demand tends to lead to extremely high volatility, as there could be no demand when someone tries to sell a position, causing the price to collapse.