Capital Market and Economic Growth

Nadeem Naqvi, Managing Director, KSE

This article was published in the Special Report of

Business Recorder

Pakistan Capital Markets Conference (July 03, 2013)

Economic growth provides answers to a myriad of problems

faced by any country and Pakistan is no exception. Whether
it is unemployment, poor law & order, mass illiteracy, or
insufficient infrastructure and consequent social problems,
one of the root causes is low economic growth. By several
estimates, including the World Bank, Pakistan requires real
GDP (national income) growth of over 6% to absorb the
young population as it reaches labour force joining age.
What leads to the growth of national income (or GDP)? One
way to define GDP is to sum up the spending by
household/consumers [C], investments (e.g. buying capital
equipment to produce final goods) by businesses and new
residential construction [I], government spending excluding
transfer payments [G] and Net Exports (Exports minus
Imports)[NX]. This can be shown as an equation:
Y= C + I + G + NX ,
Where,

is National Income

is Household Spending / Consumption

is Investments

is Government Spending

NX is Exports - Imports
If we ignore the external sector for a moment, the equation
would be:
Y=C+I+G
Another way to define national income is to look at the
income side. From this perspective, National Income or GDP
[Y] equals household Consumption [C] plus private sector
Savings [S] plus Tax minus transfer payments [G]. Thus, from
the income perspective:
Y=C+S+G
That is, Savings equal Investments and we can now add the
external sector so that national savings equal investment
and surplus exports (over imports)
We can rewrite the above as:
Investment + Government deficit = Private Savings + Trade
deficit

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This equation shows that businesses borrow to finance

investment and government borrows to fund its deficit.
Where do these 'loanable' funds come from? (i) private
domestic savings (ii) borrowing from other nations (via the
trade deficit).
From the above, it would be clear that when the government
runs a deficit, it borrows to fund its expenditure. This
government borrowing "crowds out" business borrowing for
investment as, at any given period of time, there is only a
certain amount of private savings available. When exports
are less than imports, i.e. when there is a trade deficit, then
borrowing is also from other nations. Over quite a few years
in the past, Pakistan has been facing this situation - i.e. the
twin deficits (government deficit & trade deficit). Not only
is this constraining economic growth in the short term, but
it is also not sustainable in the long term.
It is worth noting that savings create capital. And here the
word 'capital' is used in the widest sense to include: physical
capital (equipment & infrastructure) that is used to produce
final goods & services, human capital (education & training
and therefore productivity of the workforce), technology
advancement (that enables more output from the same
quantity of input-again improved productivity), and natural
capital (land-agriculture & minerals).
When people save, they increase the stock of loanable funds
in the economy. Borrowers (business & govt.) then use these
loanable funds to build physical capital, human capital and
achieve technological advancement. Borrowers borrow by
using bank loans or issuing securities, i.e. bonds or shares
(or both).
In the case of bank borrowings, borrowers use the funds
deposited by savers. In the case of securities, savers buy
bonds and shares of issuing companies or the government.

LIMITATIONS OF THE BANKING SECTOR

Between borrowers and savers are financial intermediaries
- either the banking sector or the non-bank financial sector
including the capital market, which is part of the loanable
funds market. This recalls the earlier equation: S = I (Savings
= Investment = Capital Formation)

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Banks engage in three basic functions:
1. Facilitate the payment mechanism in the economy (you
deposit money in the bank, you write a cheque against
it and the bank makes the payment)
2. Extend credit to borrowers of loanable funds, either the
government or businesses
3. Linked to 2 above, engage in maturity transformation i.e. obtain shorter term funds as deposits and lend longer
term to borrowers.
These functions also create limits to the extent that banks
can lend loanable funds to business to invest in capital
creation. If the government borrows from the banking sector,
private sector borrowing is curtailed simply because, by
definition, sovereign (govt.) risk is less than private sector
risk. Even if government borrowing from banks is low, banks
are unlikely to supply all of their shorter duration deposits
to private sector business borrowers because of their capital
adequacy and maturity risk management requirements. So
where can businesses turn to obtain loanable funds to fund
their capital investment? This is where capital market comes
into the picture.

ROLE OF THE CAPITAL MARKET

The primary role of the capital market is to provide a market
place for longer term loanable funds in the economy. That
is, beyond short term (usually self-liquidating) working capital
financing, businesses looking to fund longer tem capital
projects have an avenue to approach savers willing to invest
for longer term. And why would savers want to invest for
longer term? In simplest terms, because savings in the form
of bank deposits usually tend to provide return that is below
the inflation rate and this destroys the savers' purchasing
power, reducing their 'real' wealth over time. When borrowers
of loanable funds borrow funds in the capital market, they
usually provide a significant premium over bank deposit
rates to savers in terms of higher rates of return. This premium
covers credit risk, longer maturity risk and other factors.
In well functioning capital markets, long term borrowers have
a broad based and diverse financing source to tap in order
to invest in capital which in turn leads to economic growth,
and this not limited to the private sector only. Even the public
sector, be it the federal government or provincial/municipal
(city) governments and public sector corporations, can tap
the capital markets to borrow long term funds to invest in
infrastructure, health, education, and key industries (e.g.

Energy). If the financing is structured carefully and investors

can have confidence in future promised cash flows and
returns from such investments, they are likely to allocate a
percentage of their savings to such long term borrowers whether private sector or public sector.
Indeed, in the case of Pakistan, the government has benefitted
directly in two ways by using the capital market; (i) Between
2003-2007 alone, the Government raised PkR122bn from
the capital market by selling shares of government owned
corporations to savers/investors directly in the stock markets
and, (ii) The value of shares in government controlled
companies has increased significantly over time raising the
value of the entire portfolio of government held companies
listed on the stock market. In other words, the overall value
of the nation's capital tied up in these companies has risen.
This enables the well-performing government sector
companies to expand and invest more by tapping funds
from the capital market directly and thus provides impetus
to future economic growth.

USING CAPITAL MARKET FOR ACCELERATED

ECONOMIC GROWTH
There are several initiatives that can enable the government
to fruitfully use the capital market to accelerate economic
growth in Pakistan. First and foremost, the government
should actively encourage the development of the debt side
of capital market.
1. The government, which is the largest issuer of debt
securities in the economy, should list all funded debt on
the capital market, enabling savers to directly fund federal
government borrowing.
2. Follow Malaysia's example of making it mandatory that
all borrowing by public sector entities of more than oneyear should be funded through the capital market. Banks
can of course underwrite and invest in such securities but
these securities would be issued and listed on the capital
market, where banks could become market - makers if
they wanted to. This single factor enabled Malaysia to
create a thriving debt market where not only domestic
savers invest but foreign portfolio investors have also
become major participants.
3. Linked to 2 above, given that development of most longterm public infrastructure is related to physical capital
creation, (roads, bridges, dams, hospital and school
buildings, railway tracks, ports, power plants etc.) and
these have underlying assets, Islamic finance instruments

Capital Market and Economic Growth 02

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such as SUKUKs can be issued to fund such infrastructure
projects and can be listed on the capital market. There is
a growing demand of Islamic mode of savings in Pakistan,
Middle East & Far East where people are looking for
Shariah Compliant investments. The government should
take full advantage of this trend and attract global Islamic
capital to Pakistan via this mode.
4. In the arena of Public-Private-Partnership projects and
Build-Operate-Transfer (BOT) projects, using capital markets
to raise debt/equity finance provides another alternative
source of funding to the government and its private sector
partners. The greater transparency that comes from listing
on capital markets due to higher corporate governance
and financial reporting standards means that many
international funding agencies - both governmental,
transnational and private equity, would have greater
confidence in participating in the funding of such projects.
As an example, consider the Lahore - Islamabad Motorway.
It is a good example of PML (N)'s successful infrastructure
project. Now, if the government and operator list, say,
25% equity of this project in the capital market and provide
longer term dividend stream to investors from appropriate
toll income, then fresh funds generated by such listing
can be used to partially provide equity for another
successful 'toll motorway' project.

Government reduce its own funding allocation for the

solar project. Financial resources so saved can be deployed
for other development projects.
B. As investors realize that this is a profitable investment
with relatively stable returns in terms of dividend yields,
(guaranteed return on equity ranking from 15% to 17% in
US$ terms) the interest in such projects will increase. This
can become another successful model which can be
replicated quickly and both the government and private
sectors can expand the solar industry very rapidly over
the next 2-5 years
C. As the industry grows, a whole new sector will open up
for employment of construction workers, electrical
engineers, maintenance personnel, etc., other than the
direct benefit of reducing the country's power deficit.
This article has focused on the macro level benefits of the
capital market for accelerating economic growth. There are
many micro/individual company level benefits which enable
the corporate sector to use the capital market for funding
their long term growth. Indeed, a visionary section of Pakistan's
corporate sector has used the capital market for raising such
long term funding. Between 2002 to 2012, PkR509bn has
been raised via primary issues (IPO's), secondary issues (rights
shares) and bond issues (TFC's) by such companies.

5. In similar vein, provincial and local (municipal) governments

can issue longer term bonds to meet their needs of
infrastructure development finance.
One more example can be the alternative energy sector. The
PML(N) Government has specifically declared that one of its
priorities is to diversify Pakistan's energy supply mix and it
will focus on alternative energy generation also. Recently,
the Punjab Government is reported to have concluded an
MoU with a foreign partner to develop a fairly large solar
farm to supply electricity to the national grid. This is an
excellent opportunity for the Punjab Government to utilize
the capital market for partially supporting the funding for
this pioneering initiative in the solar sector. And it can have
tremendous positive implications for the development of
solar / photovoltaic industry in Pakistan which will directly
help economic growth.
The benefits can include:
A. Portion of equity and long-term debt funding requirement
can be raised from the capital market, helping the Punjab

Disclaimer: Investing in stocks & shares carries various risks, including loss
of the principal amount. Investors are advised to conduct their own research
before investing or take advice from professional investment advisors.

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