Capital Markets Formation in Ethiopia

Capital Markets Formation in Ethiopia

By Ezana Kebede

December 12, 2012



Executive Summary

Ethiopia at present has no Capital Market to transact stocks (equity) and bonds (debt instruments) in the secondary markets. The stock market facilitate the purchase of shares while the bond market provides a means by which to sell and trade bonds  in the secondary market to enable participating governments, institutions and companies raise long term capital. As it stands today, Ethiopia has fallen behind in creating or implementing such a resourceful financial mechanism.  The Ethiopian National Bank (Central Bank) lacks a transparent platform that will allow injecting long term capital into the economy. And according to the December 2011 data from the Federal Democratic of Ethiopia, The Ministry of Finance had USD12 billion in total public debt outstanding, of which USD 8 billion was financed by external debt.  Therefore, USD 4 billion or one-third of the total public debt that is outstanding was financed by domestic debt. These figures provide a strong case for a potential and need for establishing a domestic debt market in Ethiopia.

Another strong indication for the establishment of stock market in Ethiopia is the recent privatization of public enterprises, where the government’s Privatization Agency declared the privatization of 394 companies in manufacturing, construction, agro-industries, transport, export-import and mining. This year alone, the agency has identified 20 more companies in its pipeline slated for privatization and marketed the firms as direct sale (auction). Unfortunately none of these firms were privatized as equity or share companies to the public.

The paper explores if Ethiopia should establish or implement a debt (bond market) or equity (stock market). It also studies which market would be relevant to the country’s current capital and economic needs. My initial proposal was to implement both debt and equity markets, however research shows otherwise. The establishment of stock markets in Ethiopia should be a prerequisite for the establishment of bond markets for both corporate and public debt.  However, the development of equity or bond markets depends on the development of the financial sector and the overall economy.

Overview-Sub-Saharan African Debt Market

The domestic debt consists of Treasury Bills, Treasury Certificate, Bonds, Government Stock and Discount Notes. Since the debt forgiveness of the Heavily Indebted Poor Countries (HIPC) was launched in 1996, external debt for sub-Saharan African (SSA) countries external has fallen considerably, from average 103 percent of GDP to about 34 percent (2001 to 2008). In contrast, between 1989 and 2008 the domestic debt as a share of GDP has doubled to 22 percent from 11 percent (Adlegan & Badezwicz).  However, the easy access to the concessional loans continues to reduce the need to develop domestic bond markets in Africa.  Most SSA countries have access to long term foreign financing (aid and grants) at a rate below the market interest rate. Also, International Monetary Fund (IMF) statistics shows that SSA countries rely less on domestic bonds and more in bank financing (Adelegan & Badewick).

On the other hand, Ethiopia’s domestic debt was 24 percent of its GDP and until very recently the domestic debt market consisted of only short term Treasury Bills issued by the Central Bank to government owned banks. Until 2011 there was no significant market for government bonds, and currently there is no long- term bond issued by both the public and private entities.  In the absence of corporate debt market, SSA countries rely more in bank financing and stock markets. This is true for most African countries except for a few countries like Botswana, Kenya, Namibia, South Africa and Zambia that have some sort corporate bonds, and in these countries stock market capitalization to GDP seems to be higher.

In the case of Ethiopia, post 1974 all private banks and insurance companies were nationalized and it was only during the 1990’that private bank banks started to emerge.  After the 1990s, government owned commercial banks continued to dominate the banking sector and where forced to purchase the Central Bank issued T-bills with minimal yield. This was unattractive to the private sector because 57 percent of government debt was purchased by the stated owned commercial banks. This is common in most SSA countries.  On average the holding of SSA countries debt across sectors was: 54 percent by commercial banks, 29 percent by non-banks (insurance companies and pension funds) and the remaining17 percent was held by central banks (Christensen 2004).

It is only in 2010, that the government of Ethiopia began issuing short debt (bonds) to the public i.e. Agency Bond (Millennium Bond) and Savings bond issued by Development Bank of Ethiopia. However, without the secondary market, the bond holders cannot redeem or cash out its investment before the bond maturity date. Without a secondary market it difficult to determine the true market value of the bond that is been sold by the government to the public. Considering the current inflation rate the bond holder will not realize a capital gain by holding the bond as investment until maturity. It is more visible that policy makers in Ethiopia did not see the need to establish a secondary market (bond market) with the country ambitious financing of the Growth Transformation Plan (GTP).

From 2010- 2014/15, the government of Ethiopia in its GTP Table 12 has a total projected expenditure of Birr 690 billion (USD 37 billion), 80 percent is allocated to capital expenditure and road construction, of which only 27 percent or  Birr 150 billion is earmarked to road construction and large chunk 72 percent going to capital expenditure.  Also during the GTP (2010-2015) out of the total Birr 75 billion deficit financing, 76 percent or birr 50 billion (USD 4.02 billion) projected deficit financing. Considering the appetite for large capital expenditure and domestic debt financing and GTP ending in the 2014, FDRE needs to consider a secondary bond market for its deficit borrowing program.

However, in order to have a successful bond market there has to be a stable macro-economic policy, improved regulation and investor protections. All these factors are weak in Ethiopia and need to be improved. In the presence of default risk and high inflation, the market will not be willing to hold long term debt. Therefore, the debt issuer, which is the Ethiopian government, will be constrained to issue only short term debt. This is not beneficial to the National Bank of Ethiopia, because short-term debt has more frequent roll-over, and high administrative cost.  While longer term maturing(duration) debt must yield high interest rate, and can increase the funding cost. Specially, under the current inflationary trend, the bond market in Ethiopia may not be an alternative financing tool for both public and private debt. Poor domestic saving can also be a major constraint for SSA countries hindering the development of bond market.  Especially when the National Bank of Ethiopia (NBE) requires its commercial and private banks to purchase 27 percent of government debt for each lending they make, the action is tapering into domestic saving that would otherwise have been available by the banks to the private sector. Therefore, there is a tendency that NBE “27 percent rule” could crowd-out the private sector lending and investment.

Overview-Sub-Saharan African Stock Market

The African continent suffers a history of currency fluctuations, political risk and macro-economic instability. Despite these challenges, the number of stock exchanges in Africa has risen. Before 1989 there were only 5 stock exchanges, but since then the number of exchanges have increased by more than three fold.  Except for South Africa, the single most significant challenge faced by most stock markets in Africa is liquidity.  The average value of traded stocks to the percentage of GDP in Africa is below 10 percent. This is true for the entire continent except for four countries; South Africa, Morocco, Egypt and Kenya. In comparison, most Emerging Market countries show above 30 percent turn-over rated, indicating that shares of African companies are traded rarely.  Contrary to these challenges, the study done by the United Nations Development Program (UNPD) shows that between 1992- 2002, the number of listed companies increased by 80 percent from 1,771 to 2,213. During this time, African stock capitalization has also increased by 46 percent.

At present, in Ethiopia there are a growing number of share companies in formation that are promoting initial public offering in the primary market. However, there is no regulated primary or secondary stock market in the country that enables investors to create a market for these share companies in a secondary market. Another strong indication for the establishment of a stock market in Ethiopia is the recent privatization of public enterprises. The government’s Privatization Agency has announced to privatize 394 firms, to highest bidder without voucher or share offering.

There are two different competing perspectives about the formation of stock market in Africa, and in particular Ethiopia. The first perspective is common among “Afro-pessimists”. The group argues that Africa’s past and present is faced with structural issues and that these problems are likely to remain.  The second perspective is an “Afro-optimist” view that argues that the continent’s history of poor performance was due to inappropriate policies, corruption, and undisciplined governance, and that these shortcomings can be fixed and are changing as evidenced by increased activities of stock markets in SSA countries.

            An “Afro-pessimists” perspective

Ajit Singh, Professor of Economics at the University of Cambridge, argues against launching stock markets in SSA countries’ economies at the current stage of their development. His rationale is that stock markets are costly enterprises and are likely to do more harm than good.  Instead, he believes that African countries would be better off using their scarce human, material, and institutional resources to improve their current banking system rather than to promote stock markets.

In considering the pros and the cons of establishing stock markets in Sub-Saharan Africa, Singh acknowledges the textbook and theoretical considerations that stock markets can promote growth through; (i) increasing saving and investments, (ii) improving the productivity of investments, and (iii) raising the profitability of existing stocks.  He, therefore, begins his argument by stating that “stock markets are potent symbols of capitalism, but paradoxically capitalism flourishes better without them” (Singh 1997a).

Singh further argues that, stock market encourage short-termism or immediate financial gain as opposed to long term growth.  He also refers to tremendous economic growth over the last decade [Taiwan and South Korea], and the post-World War II German economic miracle. Equally in Italy, he mentions the tremendous growth in manufacturing and GDP growth that happened without increased capitalization in stock markets.  This was achieved independent of stock markets and instead attributes the growth, to the pivotal role of state-owned banks to promote long term industrialization (Singh 1999).

Singh concludes his study by emphasizing that, for a typical African economy, even when no harm is done to the economy, establishing stock markets will be an irrelevant cost.  Stock markets can only benefit small urban population, neglecting the great majority of the population engaged in agriculture or other informal economies.

An “Afro-optimist” perspective

Chares Adjasi, Assistant Professor at University of Ghana and visiting scholar at the International Monetary Fund (IMF), argues that stock markets have contributed to the financing and growth of large corporations in some African countries.  He also states that there is conclusive evidence that stock markets can be positive and significantly be associated with growth in these African countries. His analysis shows that corporate financing patterns suggest that stock markets are an import source of financing.  For example, the equity market financed 12 percent of total asset growth of listed companies on the Ghana Stock Exchange.  18 percent is financed by equity in South Africa and 7.8 percent in Zimbabwe.

He pointed out that, countries with developed stock markets are less dependent on bank- based financing, which he argues will reduce the risk of a credit crunch. On the contrary, a weak banking system can constrain the development of stock exchanges. Therefore, stock markets are able to influence economic growth by encouraging saving and facilitating capital for the financing of firms. Stock markets also ensure corporate takeover if a publicly traded company is unable to maximize its profit.  He also argues that the information that is available by stock markets will help investors make better investment decisions and better allocation of their capital.

Other advocates of stock markets in Africa look at capital market development from the strategic interest of the United States. The Washington policy Think Tank, Center for Strategic and International Studies (CSIS) looks at capital markets and financial sector development in Sub-Sahara Africa as a prerequisite for the success of U.S multilateral initiatives, counter terrorism efforts, transparency and improved governance.

Short-Term Recommendations

In the short term, Ethiopia should establish a stock market in an effort to restructure the financial sector and encourage economic activity and higher level of wealth in the country. Stock markets are expected to enhance market mechanisms and elevate  and distribute scarce financial resource. They are expected to attract foreign capital, mobilize domestic capital and allocate resources to the most important projects the country needs. In Africa, stock markets are also expected to help privatize state-owned enterprises.

Kenny and Moss (1998) of the School of Oriental and African Studies (SOAS) at the University of London argue in support of stock markets in Africa as well. He states that the banking sector in Africa is weak, corrupt, and in many countries, in crisis. However, no scandal or major corruption has been encountered in stock markets.  Therefore stock markets can be a means to replace cronies determined to get easy access to credit.  Since the early 1980s thirty eight African countries have faced serious banking problems.  Also, government owned banks lend to unsound enterprises and projects.  According to a study conducted by a consulting firm, Global Solution LLS, for the World Bank in 2012, there was 20 percent non-performing loan for the stated owned banks in Ethiopia and  in particular 70 percent for the Development Bank of Ethiopia.

Reforming the banking sector in Africa and Ethiopia is highly political and economically costly, and writing-off bad loans to parastatal and political cronies is very expensive. On the contrary, setting up a new institution such as a Stock Market is less costly.  First, there is no political group to upset; there is no cartel to break because in most cases it is a brand new institution. Second, the promotion of stock market can be seen from the context of a structural financial sector reform.  Third, the opening of stock markets will help to off-load newly privatized companies to the public, and it will also give the private sector access to international capital market.

Long-Term Recommendations

In SSA countries stock market capitalization and domestic bond as share to GDP has a positive correlation (Adelegan & Badezewicz-Bak). Countries with higher stock market capitalization tend to have smaller debt market. Further supporting my finding that stock markets are a prerequisite for bond markets and therefore Ethiopia should establish a bond market after it has successfully implemented a stock market.  Although this varies across SSA countries, the comparison of financial intermediaries indicates that the banking sector and stock markets seem to be more important than the debt market.

The development of the bond markets is contingent upon sound macroeconomic management and institutional reform. This could be a challenge to the Ethiopian government. If we look at the development in East Asian bond markets, the emergence of bond markets is linked to financial liberalization. It is only during the 1980s that East Asian bond markets start growing from $150 billion to $ 340 billion (1989-1994)  (World Bank, 1995. The emerging Asian Bond Market).

Similar to some SSA countries, 1994 data shows that East Asian countries’ total market was dominated by stock market capitalization which amounted to 71 percent of GDP, while bond represented 22 percent of GDP. Except for Korea, the East Asian bond market was dominated by national government debt, and corporation debts were not very active in the early stages of the bond market development. (Dalla & Khatkhate).

The cost of sovereign borrowing directly relates to economic policies, therefore a government with sound economic policy is rewarded with lower funding cost. The largest institutional investors in the bond market are primarily commercial banks, pension funds and insurance companies. This is also true for Ethiopia Intuitional investors tend to buy and hold bonds for long term, to minimize asset liability mismatch. Therefore there is very little need for active bond trading. Also, secondary markets require efficient clearing, settlement, payment system, bond insurance and credit rating agencies.

A sovereign bond i.e., (Eurobond) can help to establish a benchmark and a yield curve to price other municipal (public) and corporate bonds that both the Ethiopia government and the private could use to raise long term capital (debt). Therefore, it is helpful for Ethiopia to have a sovereign rating to have a well-functioning financial infrastructure, before it can establish a secondary bond market.  Besides entering the international capital market to raise long term capital the government of Ethiopia must overall the financial sector. Establish a financial regulator framework for deposit insurance, capital markets for both equity and debt and form a  government/private pension  management programs.

Unless there is strong commitment by the government of Ethiopia to reform its financial sector and come up with robust commercial and banking laws and establish a capital market, it is unlikely that the recently issued government debts; Millennium Bond (Agency bond) and Diaspora bond would trade successfully and add value.  A good example, is the Grand Ethiopian Renaissance Dam, out of the projected cost  of USD 4.5 billion Birr 5 billion ( USD 263 million) has been raised from the public by selling bonds, Bloomberg News quoting the minster of communication a high level government official. “The Diaspora purchase bonds as long as they believe to have influence on policies” Dilip Ratha


African economies have been liberalizing their banking sector and Ethiopia should do the same and the stock market will only encourage this process.  Lately, there has been a trend of off-loading newly privatized companies in Africa and the stock market seems to be a suitable mechanism.  The privatization process in Ethiopia has been conducted in the form of “private placement” to the highest bidder, with limited information being available to the public.  The lack of available information in “private placement” can be addressed by the creation of a stock market, giving transparency to the deal process, empowering local individual investors, and spreading ownership by lessening the political impact.

Finally the government of Ethiopia can facilitate the formation of stock market by making public the government owned firms to local Ethiopian investors as voucher or share privatization. The effective way of sharing wealth among wide groups of stakeholders rather than a few individual or groups is the formations of robust capital market in Ethiopia.




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