Kollaborative Klassroom

Praxis Business School, Kolkata, India

The Importance of Capital Market for the Economic Development of India

Introduction

Capital Market is a channel through which the wealth of savers are put into long-term productive use. Both the Equity and Bond markets are parts of Capital Markets. Governments and Companies use Capital Markets to raise money for their long-term investments. The capital is raised through debt and equity instruments. Capital Markets are of two types: Primary market is a market for new shares and secondary market is a market for trading existing securities.

History of Capital Markets

The origin of Capital Markets goes back to the early 17th century. The Dutch were the pioneers in capital markets and they successfully leveraged the power of capital markets to withstand the British and won three wars against them, despite being a smaller nation in all aspects. Finally, British collaborated with the Dutch and became an expert in leveraging Capital Markets that led to the rise of the British Empire. One major reason for the success of British Empire over the French, despite France having population three times that of the British, was that they were able to raise capital from public at low interest rates, whereas it’s counter parts, such as French didn’t have superior financial markets and their cost of raising the capital from public was very high.

In the United States of America, the stabilization of securities market begun with the passing of the “Blue Sky Law” in 1911 in the Kansas State to protect investors through anti-fraud provisions, regulation of brokers, dealers and registration of securities. The technology innovation in United States made them the biggest economy in the world. Information Technology led to paradigm shift and revolutionized the structure and functioning of Capital Markets by reducing information asymmetry and assisting faster settlements of transactions. The most significant development in Capital Markets is the way the technology has erased the geographical boundaries.

The story of Capital Markets in India dates back to the 18th century when trading shares of East India commenced. The real story of India’s Capital Markets started in July 1875 with the formation of Stock Exchange in Mumbai by the brokers. India’s Capital Market in terms of GDP raised from 75 percent in 1995 to 130 percent of GDP in 2005. But the relative growth compared to US, Malaysia and South Korea remains low, indicating immense untapped potential.

 

Significance of Capital Markets

Allocation of Capital: One of the major economic benefits generated by development of the Capital Markets is improved allocation of capital. The prices of Equity and Debt respond immediately to change in market conditions and quickly embodied in current asset prices. The signal created by the price change encourages or discourages capital inflow to an industry/company.

Allocation of Risk: The other major economic benefit generated by development of the Capital Markets is improved allocation of Risk. Capital Markets facilitates investors to earn returns based on their risk taking ability. Investors invest in high-risk instruments either because they are less risk averse or because the new risk is unaffected or negatively correlated with other investments in the portfolio.

Mobilization of Savings: Capital Markets is a good channel to move idle savings to most productive units in the economy. In any economy savings are moved to borrowers through Capital Markets or through Banking Financial Corporations/ Non-Banking Financial Corporations. In the first case the transaction occurs through the exchange of securities. In case of common stock the transfer results in ownership and in case of debt there is a contractual obligation to pay interest rate and debt. The advantage of investing in Capital Markets is the price of the securities fluctuates in response to change in supply and demand and can be brought and sold to third parties. As a result, the investor usually has a good idea of what the securities are worth and can obtain liquid funds by selling the securities. On the other hand, in the second case the investor doesn’t have claim over the ultimate beneficiary of the funds and the price of the claim doesn’t fluctuate in response to shift in supply and demand.

Policy Making: Capital Markets play an important role in improving policy framework of a country. This is because when policy makers embark on bad policies the equity and bond prices tend to fall. Capital markets anticipate the future prospects of a country thus they reduce politicians incentives to do things that provide short-term gains, but that brings long-term costs that will hurt the economy. 

The postponement of new GAAR proposal and Retrospective taxation amendments shows how Capital Markets impact policy making. After amendment of GAAR and Retrospective taxation amendments in budget last year (2012) both FDI and FII inflows dropped and stock market fell down that led to fall in rupee value and credit rating by top rating agencies.

Micro, Small and Medium Enterprises (MSME): Traditionally MSME are the ones that faced difficulty in obtaining capital at low interest rate, but MSME sector contributes 8% of the country's GDP, 45% of the manufactured output and 40% of our exports. It provides employment to about 6 crore people and are the largest generator of employment in Indian Economy.

Apart from the facts mentioned above, about the significance of Capital Markets, there is a vast amount of empirical data that supports the importance of Capital Markets facilitating economic growth. The view that Capital Markets is associated with superior economic performance can be verified by looking the correlation between Real GDP VS performance of Capital Markets in developed economies. Below is the list of superior economic performance in five major respects in countries with good Capital Market environment. 

  • Higher productivity growth 
  • Higher real-wage growth 
  • Greater employment opportunities
  • Greater macroeconomic stability
  • Greater homeownership

Conclusion

If one looks into history and traces back the reasons for flourishing of economies such as Dutch and United Kingdom the reasons for the success of these economies lies in piping the public saving in to long-term investments. The Dutch were the first to procure funds from public; they raised capital to trade and maintain battle ships in order to protect their ships from the pirates. British had replicated the Dutch financial system and became an Empire and eventually the countries that replicated good Capital Market practices, like United States, also flourished.

The Capital Markets play a significant role in any economy from allocation of Capital and Risk to Policy Making. If there is any single factor that makes a huge impact in improving the GDP of a country, it is the effective allocation of capital to the Industry and Government. Capital Market is the best channel to route the savings into long-term productive use. If we look in to the economy and find the enterprises that were hit by high cost of capital, one can observe that MSME that provides highest number of employment opportunities were worst hit by it. If a country develops and adopts best Capital Market practices they create multiple effects and helps in reviving the economy. The SME Exchange is a welcome move for the Small and Medium Scale Enterprises, but it is alone not enough to revive MSME. 

Capital market is the heart of any economy through which the savings are channelized into effective long-term investments. A developed and vibrant Capital Market will immensely contribute towards speedy economic growth and development.

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