Capital Market and Economic Development of a Country

Capital, although scarce, is needed for the economic development of a country. Capital formation in the form of domestic capital formation, foreign direct investment and/or foreign aid is necessary to increase gross national product (GNP).

Therefore, in all developing countries, a high rate of capital formation is aimed to achieve objectives of development plans. Financial intermediaries such as commercial banks, development banks, investment and financial institutions, insurance, investment banks etc. are needed to channelize savings and attract foreign investment to accelerate economic growth.

The growth of capital market is a prerequisite to stimulate and guide capital formation. Capital market helps in encouraging investment and providing vitality and dynamism to corporate organisations in the country.

An efficient capital market helps the investors and capital providers in getting information about investment opportunity, making sound investment decisions and to diversify and reduce risk. Belkaoui has observed that capital markets in developing countries are best characterised by thinness and poor management.

As a result, the following consequences emerge:

1. The individual investor is reduced to financing his or her project out of their proper savings and to acting as the manager of the project.

2. The individual investor may shun risky investments and investments with long-term payoff as a result of hampering the risk sharing fund of a financial market.

3. There is a lack of communication between the management and the shareholders leading the potential investor to be unsure of the price to pay and of the quality of the security.

4. The security’s price is decomposed into fundamental value and noise.

In the inefficient and thin capital markets of the developing countries, the lack of knowledge about the fundamental value of the security reduces the determination of the security price to “noise”. Investing in the capital market now has the equivalence of playing the lottery.

The working of capital markets, efficient allocation of resources and making of investment decisions require confidence among the investors and other segments about the corporate operation and functioning of capital market.

Accounting plays a vital role in creating and sustaining the level of confidence needed for the success of capital market in a developing country. An adequate accounting system possessing the reliability and accuracy of the financial statements of business enterprises provides right climate of confidence for the functioning of capital markets.

The efficiency of capital markets, capital formation, efficient allocation of resources and economic development depend on the availability of financial information and financial reporting policies. Figure 1.4 shows the relationship among financial information disclosure, capital market efficiency and economic growth.

Gordian A. Ndubizu explains the relationships depicted (a-g) as follows:

(а) Accounting information disclosure minimizes the capital market uncertainty. This is accomplished through the disclosure of the value and risk of each asset traded on the capital market.

(b) The reduced capital market uncertainty encourages more investors to buy and sell securities in the capital market. It has been documented that higher capital market uncertainty induces security buyers to under-price high-quality security. Consequently the seller of such security will withdraw from the market, which reduces the size of the market.

(c) The capital market size affects both the market information processing (denoted c) risk sharing (denoted d). Other things being equal, the larger the capital market, the more efficient is the information processing. The capital market information processing generates the security prices. The security prices affect the ability of the capital market to efficiently allocate scarce resources (e).

(d) The larger the market portfolio, the smaller the market risk per asset is and the easier it is for investors to hold/purchase an efficient portfolio of securities. The optimal risk sharing leads to an efficient allocation of savings (denoted f).

(g) The capital market helps in the development of savings which effect economic growth through investment. The capital market transfers the accumulated savings to the most efficient investment opportunity. This function of capital market stimulates economic growth.