Now that the Ethiopian capital market has become a reality, it is time that the regulator and finance professionals who are invested in the idea of shaping its development start thinking about how to ensure the market will gain momentum and achieve both depth and volume in the shortest possible time.

Among other things, the establishment of the capital market must demonstrate that the financing choices available to both private sector as well as public sector projects are widened compared to the situation which prevailed before the capital market came into existence.

One of the outstanding questions that the local capital market is eagerly awaited to address is whether it will manage to significantly increase the range of financing choices available to private sector firms. So far, the inability of firms to gain access to funds that can finance long-term projects whose returns can only be obtained after a significant wait has been the most significant handicap in the local financial sector. This has resulted in many paradoxical situations where projects which are not only potentially highly profitable for private firms but are also socially desirable, remain unfunded. To wit: even though there is a widely recognized pent-up demand for long-term mortgage loans with relatively long tenor, this has practically remained as a pipedream for the market.

The role of the new capital market in increasing the financing choices in the economy should not be limited to formalizing and broadening the equity market but also extend to introducing the hitherto unfamiliar debt market. So far, local experience with the latter type of market has been limited to bonds issued by the government in the form of treasury bills (maximum of 1-year maturity) and special-purpose bonds to finance unique national projects such as the Renaissance Dam Project.

Debt market instruments, such as government treasury and corporate bonds, have features which can make them more preferable to certain segments of the Ethiopian Economy. This is particularly true for those who prefer investments that offer predictable and stable income streams at relatively lower risk compared to equity investments.

"The role of the new capital market in increasing the financing choices in the economy should not be limited to formalizing and broadening the equity market but also extend to introducing the hitherto unfamiliar debt market."

Going forward, it is essential that the local capital market also offers opportunities for raising funds for financing productive long-term projects through the issuance of debt instruments. But before we hasten and recommend the establishment of a formal debt market along with the equity market, we should be familiar with the specific characteristics and peculiarities of this market. In this regard, drawing lessons from the experience of other developing countries’ capital markets would be advisable so that we can avoid starting the journey on the wrong foot.

An interesting study which was conducted by two researchers, (Dimitri G. Demekas and Anica Nerlich in 2020) through interviews with market participants identifies two key phases in the development of capital markets in emerging economies: an initial, government-dominated stage and a later phase involving private sector activity.

Not surprisingly, the study highlights that legal infrastructure and regulatory quality are crucial at the early stages of the development of such markets, while later growth depends on stable macroeconomic conditions and domestic savings. The study also underlines the increasing importance of intangible factors such as financial sophistication and corporate culture as critical elements for the market’s development in the second phase.

With regard to the patterns of the development of the two segments of capital markets, the study observes that even though there are some exceptions, the market for equity typically appears first in these capital markets, while the market for corporate debt develops later.

It will be reasonable to expect that a similar pattern of development of the two segments will also prevail in the Ethiopian context because the current momentum and trajectory shows that we are going in the same direction. The equity market which has so far been operating under an informal and unorganized market has naturally become the first - and logical – focus of our attention and the first candidate for taking root in the new capital market. The debt market, on the other hand, will likely take some more time before it can gain momentum and become a viable source of long-term funding, particularly for private sector companies which plan to issue corporate debt instruments.

Charting the way and accelerating the process for the development of a viable local debt market that can serve both the public and private sector as a long-term source of finance requires taking a number of preparatory measures - initially by the government and later by both the government as well as by private sector actors who intend to tap the debt market as a source of long-term financing.

In line with the familiar motto of first things first, the following sections focus on the most immediate priorities that need attention and need to be addressed through the direct involvement of the government in the process. 

Why should the government take the lead?

The government should take the lead in providing the initial impetus for the development of the local debt market for two practical reasons: (1) so far, it is the only actor which has any involvement and experience with issuing debt instruments in the domestic market and therefore has both the experience and the expressed need for using such instruments and, (2) the local capital market and investors need a reference point for a risk-free rate which is a critical input for making investment decisions. This rate can only be obtained through the direct participation of the government in the local debt market.

The first reason is more or less self-evident but the second needs some elaboration.

Supplying the market with a Risk-free Rate:

The initial involvement of the government in shaping the debt market by taking the initiative to issue its own debt instruments for subsequent trading of these instruments in the newly minted capital market will have a consequential effect on the local capital market as a whole. One consequential effect of this act will be providing a good reference point for establishing the risk-free rate and then the cost of capital in the economy.

As students of finance would quickly note, the cost of capital for evaluating investment opportunities in an economy is firmly anchored on what is considered as the risk-free rate in the market. At least from the perspective of local investors whose investment choices are limited by what is on offer in the local economy, this risk-free rate will be a cornerstone for evaluating all kinds of investment opportunities.

"The government’s early involvement in the debt market on the supply side will set the tone for the entire debt market, and indirectly for the equity market. This will provide a reference point for other market participants."

At the risk of oversimplifying a highly technical subject, we should note that the risk-free rate in a capital market is set by referring to the current yield on long-term government debt. The rationale for using the yield on long term government treasury bonds as the risk-free rate is based on the assumption that buying a government bond (which is equivalent to lending money to the government) is the safest investment one can expect to have in the market. At the technical level, it is only after this risk-free rate is determined that additional premiums will be added to compensate for the additional risks associated with other risky market instruments such as corporate shares and bonds.

The early involvement of the government in the debt market on the supply side will, therefore, set the tone for the rest of the debt market - and indirectly for the equity market - and provide a reference point for other market participants. For example, potential issuers of corporate debt instruments will use the current yield on government bonds as a reference point and mark up their coupon rates accordingly because corporate debt instruments will naturally be perceived by the market to be riskier than government bonds.

Maintaining a stable macroeconomic environment:

While the significance of direct involvement of the government at the introductory stage of a formal debt market in Ethiopia cannot be understated, the indirect role of the government in maintaining the health of the capital market through prudent macro-economic management so that a low and stable risk-free rate can prevail in the market will be its never-ending homework.

A low and stable risk-free rate is universally recognized as essential for the overall capital market and for the debt market to gain traction. It also enables the private sector to significantly tap into the domestic capital market. The study mentioned earlier indicates that persistently high sovereign yields in developing country capital markets tend to dominate debt issuance and crowd out the demand for other instruments, especially those coming from the private sector.

"A low and stable risk-free rate is universally recognized as essential for the overall capital market and for the debt market to gain traction. It also enables the private sector to significantly tap into the domestic capital market."

An unstable macro-economic environment which suffers from such things as a high inflation can affect the health of the debt market in many ways. As inflation rises, the purchasing power of the fixed income from bonds decreases and investors demand higher yields to compensate for this loss in purchasing power. Inflation expectations often lead central banks to increase interest rates and higher interest rates result in higher bond yields because new bonds must offer more attractive returns to compete with existing bonds.

It is therefore important that the government maintains a relatively stable macro-economic environment for the effective functioning of both the debt and equity markets as well as for the rest of the economy.

Promoting the development of a critical mass of domestic savings and large local investors:

The debt market will need a sustainable pool of local savings and large institutional investors for its sustenance – may be even more than the equity market needs such types of investors. Among other things, such large and committed local institutional investors serve as anchor investors who are likely to have a long-term view when assessing current developments surrounding the market. Such investors will have significant vested interest and a strong incentive to maintain any market, including the debt market, on an even keel.

The need for building domestic savings and mobilizing sizable funds through insurance companies, pension funds and similar mechanisms as a pre-requisite for generating a sustainable source of investment funds for the local capital market has already been flagged by many local authors and professionals and may not warrant detailed treatment here. However, it would be appropriate to reiterate, once again, that although the participation of a large number of retail investors in the capital market will be an important indication of trust on the market, it will be wholesale funding institutions which will be a more reliable and sustainable source of growth for the local capital market.

It should also be noted that while a government debt market can start with banks and some foreign investors, a broader set of domestic investors with a long-term commitment such as insurance companies and pension funds will be needed for the corporate debt market to develop.

It is therefore important that the government takes steps which will promote the mobilization of such sizable pools of funds that can be the backbone of the debt market.

Credit Rating Institutions

Once the debt market starts rolling, gains momentum and trust, non-sovereign actors such as city administrations, financial institutions, private corporations and others can start to meaningfully participate in the debt market by issuing their own debt instruments. Such debt instruments, of course, will have to offer coupon rates that reflect the risks they present to prospective bondholders compared to holding the equivalent tenor sovereign bond. Therefore, an objective and independent risk assessment of each prospective issuer becomes a critical matter for both potential bondholders as well as the regulator (ECMA) whose mission is protecting the interests of the investing public.

Since it would be very expensive and very impractical for each investor to do a due diligence on each company that issues corporate debt for recurring transactions, it is critical that independent credit rating institutions which can perform this service become part of the local capital market ecosystem before the debt market takes off.

In this regard, although the capital market authority has already indicated its readiness to issue licenses for credit rating companies, so far there is no news that such a license has been issued. This gap in the ecosystem will hopefully be closed before the debt market reaches a level of maturity where the non-sovereign issuers decide to participate in the debt market.

Conclusion

One of the benefits of being a latecomer is that it affords the opportunity to learn from the experience of others who have passed through the same process and avoid mistakes and build on what works.

"The debt market will need a sustainable pool of local savings and large institutional investors for its sustenance – may be even more than the equity market needs such types of investors."

This short article shows that there are two important observations that come from the development patterns of capital markets in emerging economies. The first observation is that there are two key phases in the development of such capital markets - an initial, government-dominated phase and a later phase involving private sector activity. The second observation is that, in such markets, the equity market tends to appear first with the debt market following later.

The article argues that, in the case of Ethiopia, the direct and indirect involvement of the government will be critical for the accelerated development of the capital market in both phases. The initial direct involvement of the government in the debt market will have an important consequential impact on the whole capital market through the provision of a market determined risk-free rate. This risk-free rate will be a cornerstone for estimating the cost of capital and the basis of valuation for all other capital market instruments traded on the local exchange.

"It is critical that independent credit rating institutions become part of the local capital market ecosystem before the debt market takes off."

The article also covers additional measures which will be needed for accelerating the development of the capital market and can only be realized through the involvement and proactive actions of the government. These include maintaining a macro-economic environment that can allow a low and stable risk-free rate to prevail in the economy and taking measures that will promote the mobilization of domestic savings and funds through insurance companies, pension funds and similar mechanisms. These types of funds will be the backbone and mainstay of both the debt and equity market.

Finally, the article underscores the importance of having independent credit rating service providers in the capital market ecosystem which can provide an objective assessment of the credit standing of potential non-sovereign issuers of debt instruments in the capital market.