Establishing Capital Market in Ethiopia PDF

School of Management
Blekinge Institute of Technology
Establishment of Capital Markets in Least

Developed Countries (LDCs)
The case of Ethiopia
Amare Walle
Supervisor: Stefan Hellmer
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June 2008
TABLE OF CONTENTS
CHAPTER 1 INTRODUCTION ........................................................................................... 1
1.1 Background .................................................................................................................. 1
1.2 Problem Discussion ..................................................................................................... 2
1.3 Problem Statement ....................................................................................................... 3
1.4 Statement of Purpose ................................................................................................... 4
1.5 Delimitations ............................................................................................................... 4
1.6 Scope ........................................................................................................................... 4
1.7 Definition of key Terms .............................................................................................. 5
1.8 Research Method ......................................................................................................... 8
1.9 Organization of the Thesis ........................................................................................... 9
CHAPTER 2 CAPITAL MARKETS AND ECONOMIC GROWTH ............................. 11
2.1 Financial Markets: Overview .................................................................................... 11
2.2 Primary Markets versus Secondary Markets ............................................................. 12
2.2.1 Primary Markets ................................................................................................. 12
2.2.2 Secondary Markets ............................................................................................. 12
2.3 Money Markets versus Capital Markets .................................................................... 14
2.3.1 Money Markets .................................................................................................. 14
2.3.2 Capital Markets .................................................................................................. 14
2.4 Secondary Capital Markets ........................................................................................ 14
2.5 Capital Markets in Africa .......................................................................................... 16
2.6 Capital Markets and Economic Growth Linkage: Empirical Evidence..................... 17
2.7 The Financial Sector in Ethiopia: Recent Developments .......................................... 22
CHAPTER 3 CAPITAL MARKETS AND INSTITUTIONS ........................................... 26
3.1 General....................................................................................................................... 26
3.2 What are Institutions? ................................................................................................ 26
3.3 Institutions, Capital markets and Economic Growth ................................................. 27

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3.4 Financial Institutions ................................................................................................. 31
3.5 Capital Markets and Financial Institutions in Africa................................................. 33
3.6 Determinants of Stock Market Development in Africa ............................................. 34
3.7 Institutions in Ethiopia: some Indices ....................................................................... 35
CHAPTER 4 HOUSEHOLDS’ SAVINGS AND CAPITAL MARKETS ....................... 40
4.1 General....................................................................................................................... 40
4.2 Resource Mobilized by Banks and Microfinance Institutions (MFIs) in Ethiopia.... 41
4.3 Households and Capital Markets ............................................................................... 41
4.4 The Supply and Demand Aspects of Capital Markets ............................................... 44
4.5 Deposits Mobilized by Ethiopian Financail Institutions ........................................... 46
4.6 Returns of publicly held companies in Ethiopia ........................................................ 49
CHAPTER 5 CONCLUSIONS ............................................................................................ 51
FUTURE RESEARCH .......................................................................................................... 53
REFERENCES LIST ............................................................................................................. 54
APPENDIX 1 .......................................................................................................................... 60
APPENDIX 2 .......................................................................................................................... 61
APPENDIX 3 .......................................................................................................................... 62
APPENDIX 4 .......................................................................................................................... 64
APPENDIX 5 .......................................................................................................................... 65
APPENDIX 6 .......................................................................................................................... 68
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AKNOWLEDGEMENT
I would like to thank Dr. Stefan Hellmer whose help, suggestions, valuable guidance and
encouragement helped me throughout the dissertation process. I am also grateful to Prof.
Anders Nilsson, the dean of the school of management, who helped me not only to
accomplish this thesis but also in my endeavors throughout my academic program at Blekinge
Institute of Technology.
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ABSTRACT
Despite a surge of global investor interest in the 1980s and 1990s, Africa has been bypassed
by the massive international capital flowing to developing economies. Most of the economies
in the region didn’t efficiently mobilize their domestic financial resources either. African
countries, particularly those in Sub-Saharan Africa (SSA) remain the only developing region
in which development assistance flows exceeds private capital flows. Except a few countries
(such as South Africa, Mauritius, Botswana), most of the economies in the SSA region are not
still doing anything good.
These phenomenons can in part be attributed to lack of a well developed financial sector (such
as capital markets, banks, and other financial institutions) and the poor economic policies and
incompetent “institutions” in African countries.
The purpose of this thesis is to conduct a qualitative research on whether capital market
establishment and development is an alternative towards the economic growth of least
developed countries such as Ethiopia and investigate the role of institutions towards the
establishment, development and performance of capital markets and identify whether such
institutions exist in Ethiopia or not. In addition the research also integrated the importance of
domestic financial resource (households’ savings) to the performance of capital markets in
Africa.
The result which is based on the review, description and analysis of the existing literature
(theory and empirical studies) suggests that despite the different thoughts (1. a thought that
positively correlates capital markets and economic growth and 2. a thought that negatively
correlates capital markets and economic growth ) as to the capital market and economic
growth linkage; capital market establishment and development could lead to the economic
growth and prosperity of least developed African countries as well, including Ethiopia
provided that it’s backed by capable institutions of all sorts (rules, laws, constitutions; social
values and norms; financial, political etc) and domestic resources (Smaller households’
savings) are efficiently mobilized through strengthening the formal sector ( e.g. banks and
microfinance institutions) and the informal financial institutions.
Keywords: Capital Markets, Least Developed Countries (LDCs), Sub-Saharan Africa (SSA)
Economic Growth, Institutions, Households’ Savings.
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CHAPTER 1 INTRODUCTION
INTRODUCTION
This chapter explains the background, problem discussion, problem statement, purpose,
delimitations, scope, definition, method and organization of the remainder of the thesis.
1.1 Background
Today most economies around the world are judged by the performance of their capital
markets. Capital markets play an important role in the economic growth and prosperity of
nations. Most African countries including those in Sub-Saharan Africa (SSA) have recently
under gone financial sector reforms such as restructuring and privatizing of state owned banks
and establishment of capital markets. (See Appendix 1- map and list of SSA countries). In the
literature there are different views on the link between the establishment and development of
capital markets and economic growth and prosperity of a nation.
The other debatable issue in the literature is the role of institutions towards the economic
development of nations in general and to the performance of capital markets in particular.
North (1996) shows that, differences in economic institutions are the major sources of cross-
country differences in economic growth and prosperity. High quality institutions have a
positive influence on the depth and development of the financial sector of nations. Stallings
and Studart (2006), institutions are even more important with respect to the capital markets,
where the issue of confidence is crucial
This proposed research will mainly consult with the literature about the link between capital
market establishment and development and economic growth and the role that institutions
play in capital markets and try to pinpoint and relate these to the Ethiopian context.
In developed capital markets households are the major participants as investors. Saunders and
Cornett (2004) claimed that in the United States, households are the single largest holders of
corporate stock (holding 38.4 percent of all corporate stock outstanding in December 2001).
However, the capital markets of least developed countries are very shallow in terms of
capitalization because of a limited number of listed companies and limited participation of
households (savers) either due to lack of capacity or lack of awareness as to the capital
markets. Therefore this study will also examine the impact of the households (savers) in the
capital markets in least developed countries in Africa including Ethiopia.
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1.2 Problem Discussion

Despite a surge of global investor interest in the 1980s and 1990s, Africa has been bypassed
by the massive international capital flowing to developing economies. Aggregate capital
flows to developing countries have been rapidly exceeding official development assistance
flows since 1980s. However, Africa remains the only developing region in which
development assistance flows exceeds private capital flows (Senbet and Otchere, 2006). This
was mainly attributed to the lack or absence of a well developed financial sector (capital
markets, banks, finance companies, life insurance companies, and insurance companies) and
the poor economic policies and institutions in African countries. Capital markets are a vital
part of an economy making it possible for industry, trade and commerce to flourish without
any obstacle in terms of resources. The financial markets serve a vital purpose in the growth
and development of a company that wants to expand. For such companies with expansion
plans and new projects in need of funding and investors looking for a better return, the
financial market is the best platform.
The private sector usually lacks access to credit facilities. Investment, growth and economic
welfare are all too low in developing countries. This is more severe in Africa, particularly in
Sub-Saharan Africa (Platt, 1998).
Most African countries, particularly those in Sub-Saharan Africa, have recently undergone
extensive financial sector reforms. The reform package includes restructuring and
privatization of state owned banks, the introduction of private banking systems, along with
bank supervisory and regulatory schemes, the introduction of a variety of measures to
promote the development of financail markets; including money and stock markets (Senbet
and Otchere, 2006).
Ethiopia one of the oldest civilizations in Africa was engulfed for years severely with
economic and political problems. Currently Ethiopia has no formal capital market, though; it
had established a stock market in the Imperial era in 1960s.
A short-lived stock market started informally in the late 1950s and was formally established
in 1965. The National Bank of Ethiopia (NBE) was responsible to set rules and regulations for
the market. Government through the National Bank of Ethiopia tried to improve resource
mobilization by establishing a share-dealing group that brought together buyers and sellers to
participate in an auction process (Asrat, 2003). The study done by J.D.Von Pischke (1968)
and cited by Asrat (2003) indicated that the stock market was moderately successful in its
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pioneering efforts to provide an organized market for companies whose shares were relatively
widely held. Workable trading practices and standards had been developed, and a fairly
smoothly operating market mechanism had been created.
However, in 1974 the Imperial era ceases and the military government took power. The
military government declared a centrally planned command economy; industries (most of
which owned by foreign investors) were nationalized and the military government assumed
ownership and control of virtually all economic activities. The private sector was
marginalized and the infant stock market ceased to exist in 1975 (Asrat, 2003).
The Ethiopian economy is not still doing anything good. A few economies in Africa and those
in Asia and Latin America had performed well, in the 1980s and 1990s. There are different
factors or variables that expedite economic growth of a country. Financial sector reforms such
as establishment and development capital markets are believed to be one of the major
variables to expedite the economic growth of a country.
Given the existing economic policy, the banking sector and institutions, the business
communities, legal form of businesses, can Ethiopia embark on the establishment of a capital
market? Are there viable conditions that can be justifiable to do so? Are there capable
institutions in which the confidences of the capital market participants depend on?
International organizations like International Monetary Fund (IMF) and World Bank (WB) as
part of an effort of financial sector liberalization are pressuring Ethiopia and other African
countries to privatize the state owned banks and establish capital markets so as to integrate
with the rest of the world.
This study will come up with conclusions and recommendations to establish a capital market
in Ethiopia, if there are viable conditions that can be justified to do so.
1.3 Problem Statement

Both financial markets (mainly capital markets) and institutions were coined by various
commentators as to their respective role and significance to the economic growth and
prosperity of nations. In developed capital markets such as in U.S. households (savers) are the
major participants in the capital markets (Saunders and Cornett, 2004). Will this segment of
participants have a positive impact in the development of capital markets in least developed
countries? What about in Ethiopia?
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The objective of this proposed study is mainly to consult with the literature and will find out:
 Whether capital market establishment is an alternative towards the economic growth

of least developed countries such as Ethiopia.
 The role of institutions toward the establishment and development of capital markets
and whether capable institutions exist in Ethiopia to embark on the establishment of
capital markets or not.
 Whether households’ savings will make a real impact on the overall performance,
liquidity, and market capitalization of the capital markets in least developed African
countries (with as well as without capital markets) or not i.e. the supply (financial
instruments) and demand (investors) aspect of capital markets in Africa.
1.4 Statement of Purpose

The main purpose of this thesis is to investigate and review the literature on whether capital
market establishment leads to the economic growth and prosperity of least developed
countries and what impact will institutions have on the performance of capital markets? The
starting point will be to assume that as per Levine and Zervos (1996a) using data of 49
countries from 1976 through 1993; stock markets, measured by stock market liquidity
(a stock market indicator; measured by: (1) the value of stock trading relative to the size
of the market and (2) the value of trading relative to the size of the economy) is
positively and significantly correlated with current and future rates of economic growth.
This study will also examine the importance of institutions for the performance of capital
markets and households (savers) contribution to the capital market so that companies can
raise the required capital easily in a country where financing is limited to the banking sector
and yet accessible only to a few big private companies and state owned enterprise.
1.5 Delimitations
This study will have the following important limitations. First it will not be as such
substantiated by an empirical study. The majority part of the thesis is a description, review
and analysis of the existing literature (theory and empirical studies).
1.6 Scope
This study presents the different views as to the link between capital markets and economic
growth, and the role that institutions play in the performance of capital markets. The focus
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being the establishment of a capital market in Ethiopia; it also investigates the impact of
households’ savings on African Capital Markets and on the future capital market of Ethiopia.
1.7 Definitions of key Terms

Financial sector: The Reserve Bank of Australia (www.rba.gov.au/Glossary/text_only.asp),
defines financial sector as “the sector of the economy that comprises financial institutions and
financial markets”.
Financial institution: “A company whose primary function is to intermediate between

lenders and borrowers in the economy”. (www.rba.gov.au/Glossary/text_only.asp). Financial
institutions perform the essential functions of channeling funds from those with surplus funds
to those with shortages of funds (e.g. commercial banks, savings banks, credit unions, savings
associations, insurance companies, mutual funds, pension funds, stock and bond markets)
(Saunders and Cornett, 2004). As per Saunders and Cornett financial markets such as stock
and bond markets are also part of institutions.
Financial market: The Reserve Bank of Australia (www.rba.gov.au/Glossary/text_only.asp),

defines financial markets as “a generic term for the markets in which financial instruments are
traded. Financial instruments have no intrinsic value of themselves. They represent a claim
over real assets or a future income stream. The four main financial markets are the share or
equity market, the fixed interest or bond market, foreign exchange market, and the derivatives
market”.
 Capital markets: “a market where debt or equity securities are traded”

(Investorwords.com).
The capital markets consist of primary markets and secondary markets. Newly formed
(issued) securities are bought or sold in primary markets. Secondary markets allow
investors to sell securities that they hold or buy existing securities.
Stock markets: “a general term for organized trading of stocks through

exchanges and over-the-counter” (Investorwords.com).
Bond markets: “a market consisting of bond issuers, underwriters, buyers, and

brokers/dealers”. (businessdictionary.com)
 Commodity markets/Commodities exchanges: “Open and organized marketplace where

ownership titles to standardized quantities or volumes of certain commodities (at a specified
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price and to be delivered on a specified date) are traded by its members; such as fuels, metals,
and agricultural commodities exchanges” . (businessdictionary.com)
 Money market: “network of banks, discount houses, institutional investors, and money
dealers who borrow and lend among themselves for the short-term (typically 90 days). Money
markets also trade in highly liquid financial instruments with maturities less than 90 days to
one year (such as bankers' acceptance, certificates of deposit, and commercial paper), and
government securities with maturities less than three years (such as treasury bills), foreign
exchange, and bullion”. (businessdictionary.com)
 Derivatives markets, which provide instruments for the management of financial risk. The
main types of derivatives are futures, forwards, and options.
 Foreign exchange markets, which facilitate the trading of foreign exchange.
The terms that I interchangeably use; financial market, capital market and stock market are
directly taken from the literatures that I cited in this proposed study. These terms are used to
address the issue of capital markets, which is the central theme of this study.
Figure 1: Classification of the financial sector based on the definition of key terms above.
Financial Sector
Financial Financial
Institutions Markets
Capital markets
Banks
Stock market
Insurance
Bond market
companies
Money market
Mutual funds
Derivatives market
Credit unions
Commodities market
Pension funds
Foregin Ex. market
Saving
associations
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Institutions: in this proposed study institutions could be defined as follows:
 Definition 1 (Businessdictionary.com)
”Establishment, foundation, or organization created to pursue a particular type of

endeavor, such as banking by a financial institution”.
 Definition 2 (Businessdictionary.com)
“Consistent and organized pattern of behavior or activities (established by law or custom)

that is self-regulating in accordance with generally accepted norms. For example, political
institutions are involved with (and regulate) competition for power; and economic
institutions (such as markets) encourage and regulate production and distribution of goods
and services”.
Least Developed Countries (LCDs): In its latest triennial review of the list of Least
Developed Countries in 2003, the Economic and Social Council of the United Nations used
the following three criteria for the identification of the LDCs, as proposed by the Committee
for Development Policy (CDP):
a low-income criterion, based on a three-year average estimate of the gross national

income (GNI) per capita (under $750 for inclusion, above $900 for graduation);
a human resource weakness criterion, involving a composite Human Assets Index (HAI)
based on indicators of: (a) nutrition; (b) health; (c) education; and (d) adult literacy; and
an economic vulnerability criterion, involving a composite Economic Vulnerability Index
(EVI) based on indicators of: (a) the instability of agricultural production; (b) the
instability of exports of goods and services; (c) the economic importance of non-
traditional activities (share of manufacturing and modern services in GDP); (d)
merchandise export concentration; and (e) the handicap of economic smallness (as
measured through the population in logarithm); and the percentage of population
displaced by natural disasters. (See Appendix 2 for list of LDCs).
Source: (http://www.un.org/special-rep/ohrlls/ldc/list.htm)
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1.8 Research Method

A research method can be either qualitative or quantitative. The qualitative approach is
characterized by more of descriptions instead of numerical data and aim to create a common
understanding of the subject being studied. On the other hand the quantitative approach is
based on numerical observations and aims at generalizing a phenomenon through formalized
analysis of selected data. This research uses the qualitative approach to address the first and
the second research questions and for the third research question, qualitative and to some
extent quantitative approach. The majority part of this thesis is conducted based on the
existing literature (both theory and empirical studies) on the establishment and development
of capital markets in least developed countries as well as on institutions. The major aim of
this study is mainly to infer lessons from the literature and from somehow developed capital
markets in the African continent, how they went on all through. Particularly to address the
question of whether capital market establishment is an alternative towards the economic
growth of least developed countries in general and for Ethiopia in particular; this study will
critically review the relevant studies that were conducted by different researchers which are
for or against the linkage between capital market establishment and economic growth from
the perspective of least developed countries in Africa including Ethiopia. This proposed
research tries to relate those studies conducted to the economic and political situation of
Ethiopia.
To address the second research questions i.e. institutions vital for the performance of capital
markets; it’s more of a review and description of the literature on the role of institutions and
in the capital markets and identify those institutions that should be in place while embarking
on the establishment of a capital market in Ethiopia.
To address the third question this study considers reports from the National Bank of Ethiopia
(NBE) and other sources and the average annual savings mobilized by commercial banks and
microfinance institutions (MFIs) extracted from the reports. The study also considers the
average return of investments in public companies (in this case private banks). This is because
private banks are publicly owned companies in Ethiopia. The average return from such
investments will be compared with the average annual returns (interest) from savings in
commercial banks. This is to show; if domestic resources are aggressively mobilized, savings
(households) in Ethiopia will have a role to play in the capital market, in terms of savers to
get an alternative investment with a better return in the capital market instead of tiding their
savings to banks, and companies able to raise the required capital in the market easily.
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1.9 Organization of the Thesis

This thesis is organized as follows:
Chapter 2: This chapter is about capital markets and establishment and development of a
capital market in least developed countries in this case, Ethiopia. Consulting with the
literature, scrutinize the different view or thoughts as to the capital market economic growth
linkage and try to relate to the Ethiopian case and see whether capital market establishment
will make the Ethiopian economy better-off.
Chapter 3: This chapter presents a review of the literature on institutions; the role they play
in the economic growth for a nation in general and on the development of capital markets in
particular, for it in turn to positively influence the growth and prosperity of a nation. This
chapter will try to look at the existing institutions that are supposed to serve as a playing
ground upon embarking on the establishment of a capital market in Ethiopian. In addition the
chapter pinpoints the general guiding principles or policy guides to establish a capital market
and the lessons that Ethiopia should learn (from the capital markets of Africa). In general this
chapter will try to pinpoint how a capital market has to be organized (the guiding principles,
the regulatory frame work) or structured.
Chapter 4: This chapter is about the supply and demand aspect of capital markets. Because
of lack of capable financial institutions (mainly banks and other nonbanking institutions) and
capital markets in most Sub-Saharan Africa countries including Ethiopia, domestic resources
were not efficiently mobilized. However, African countries that have the capacity to mobilize
resources (because some African countries have pension funds, mutual funds in addition to
the banking sector and other nonbanking financial institutions such as microfinance
institutions) do not have competent capital markets. Because of lack or incompetence of
capital markets, households’ savings that are accessible through the banking sector and other
nonbanking financial institutions (microfinance institutions) are kept in commercial banks in
the form of deposits for an insignificant amount of interest or will be tied up to non-financial
assets.
On the other hand companies in most African countries are constrained by lack of capital
because banks are either accessible to a few big companies and/or lacks capacity to serve at a
wider scope and in most African countries constrained by government regulations not to
finance long-term projects. From this we can see that there is supply; private companies and
government with financial instruments, and demand; households, institutional investors with
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financial resources- looking for investment for a better return in a capital market. The capital
market, which is a platform to in balance the supply and demand aspects of capital markets,
will be discussed under this chapter considering the Ethiopian case.
Chapter 5: This chapter provides a summarized conclusion, recommendations, on the thesis

as a whole and tip-off further research in this area.
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CHAPTER 2 CAPITAL MARKETS AND ECONOMIC GROWTH
CAPITAL MARKETS AND ECONOMIC GROWTH

This chapter is about capital markets; and establishment and development of a capital
market in least developed countries in Africa. The chapter begins with an overview of
financial markets. The relevant literature on capital market and economic growth linkage
in least developed countries in Africa, particularly those in SSA including Ethiopian is
critically reviewed.
2.1 Financial Markets: Overview

Financial markets are structures through which funds flow (Saunders and Cornett, 2004).
Financial markets such as the bond and stock markets are important in channeling funds from
people who don't have a productive use for them to those who have shortage and who do
(Mishkin and Eakins, 2006).Well functioning financial markets are a key factor in producing
high economic growth 1, and poorly performing financial markets are reasons that many
countries in the world remain desperately poor. Activities in financial markets also have direct
effect on personal wealth, the behavior of businesses and consumers, and the cyclical
performance of an economy (Mishkin and Eakins, 2006).
Fabozzi and Modigliani (2003) identified the following economic functions of financial
markets: (1) the interaction of buyers and sellers in the financial market determines the price
of the traded security or equivalently the required return on the financial instrument is
determined (2) because financial markets provide a mechanism for an investor to sell
financial securities, it offers liquidity (3) financial markets reduce the search and information
costs (e.g. advertizing to sell or purchase a financial instrument) of transacting.
Financial markets can be distinguished along two major dimensions (Saunders and Cornett,
2004): (1) primary versus secondary markets and (2) money versus capital markets.
______________
1
Economic growth: is the sustained increase in welfare of an economy-nation, region, city-together with the
ongoing changes in that economy's industrial structure; public health, literacy, and demography; and distribution
of income. In the long run, as this economic transformation evolves so do social, political, and cultural norms.
Societies change profoundly and multidimensionally, as economic performance improves. In this study income
per capita is considered as the measure of economic growth of a nation. Income per capita is the, per head
measure of the total value of all goods and services produced in an economy. Taking national income-measured
by either gross national product (GNP) or gross domestic product (GDP) and dividing it by population gives a
convenient first measure on the state of economic well-being. Retrieved from
(http://econ.lse.ac.uk/~dquah/p/01iesbs.pdf) - International Encyclopedia of the Social & Behavioral Sciences.
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Fabozzi and Modigliani (2003) have also classified financial markets by the type of financial
claims (a fixed dollar amount claim - debt instruments and a residual amount - equity
instruments). A financial market in which debt instruments are traded are called debt or
generally bond markets and those in which equity instruments are traded, stock or equity
markets. As per Fabozzi and Modigliani (2003), the national or internal financial market
could be decomposed in to domestic market versus foreign market. The domestic market is
where issuers domiciled in the country issue securities and where those securities are
subsequently traded. On the other hand the foreign market is where securities of issuers not
domiciled in the country are sold and traded.
2.2 Primary Markets versus Secondary Markets
2.2.1 Primary Markets

Primary markets are markets in which users of funds (e.g. corporations) raise funds through
new issues of financial instruments such as stocks and bonds. Fund users issue securities in
the external primary markets to raise funds for new projects or expand existing ones. New
issues of financial instruments are sold to the initial suppliers of funds (e.g. households) in
exchange for funds (money) that the issuer or user of funds needs. Primary market
transactions between the issuing corporations (fund users) and investors (fund suppliers) are
2
arranged through financial institutions such as investment banks who serve as
intermediaries. Figure 1 illustrates the primary market exchange of funds.
2.2.2 Secondary Markets

Once financial instruments such as stocks are issued in primary markets, they are then traded
i.e. rebought and resold in secondary markets. Buyers of secondary market securities are
economic agents (households, businesses and governments) with excess funds. Sellers of
secondary market financial instruments are also economic agents in need of funds. Secondary
markets provide a centralized market place where economic agents know they can transact
quickly and efficiently. These markets therefore save economic agents the search and other
costs of seeking buyers and sellers in their own.
______________
2
Financial institutions: are what make financial markets work. Without them financial markets would not be
able to move funds from people who saves to people who have productive investment opportunities. They also
have important effects on the performance of the economy as a whole. (e.g. commercial banks, savings banks,
credit unions, savings associations, insurance companies, mutual funds, pension funds, stock and bond markets)
that perform the essential functions of channeling funds from those with surplus funds to those with shortages of
funds (Saunders and Cornett, 2004).
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When an economic agent buys a financial instrument in a secondary market, funds are
exchanged, usually with the help of a securities broker 3. Figure 1 illustrates how funds flow
in the secondary market. Security brokers are also depicted in the figure.
Figure 2: Primary and secondary market transfer of funds time line.
Primary Markets:
(Where new issues of financial instruments are offered for sale)
Users of funds Underwriting with Initial suppliers of funds

(corporations issuing investment banks
debt/equity instruments) (Investors)
Secondary Markets:
(Where financial instruments, once issued, are traded)
Financial Markets Securities Brokers Other suppliers of funds
Financial instruments/securities flow

Funds flow
Source: (Saunders and Cornett, 2004)
__________________
3
Securities brokers: also called securities firms, are firms that assist in the trading of existing securities and
underwriting (assisting in the issue of new securities).
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Thus, primary market securities include issues of equity by firms’ initially going public (e.g.
allowing their equity shares to be publicly traded on stock markets for the first time) which
are referred to as initial public offering (IPO) and also include the issue of additional equity
(e.g. stock) of debt(e.g. bond) instruments of an already publicly traded firm.
Secondary markets offer investors (suppliers of funds) the opportunity to trade securities at
market values quickly as well as to purchase securities with varying risk-return
characteristics. Secondary markets also exist for financial instruments backed by mortgages
4
and other assets, foreign exchange, and derivative Instruments/securities (e.g. futures,
forwards, options).
2.3 Money Markets versus Capital Markets
2.3.1 Money Markets

Money markets trade debt securities or instruments with maturities of one year or less. In the
money market economic agents with short-term excess supplies of funds can lend funds (i.e.,
buy money market securities) to economic agents who have short-term needs of funds (i.e.,
they sell money market instruments).
2.3.2 Capital Markets

Capital markets are markets that trade equity (stocks) and debt (bonds) instruments with
maturities of more than one year. The major suppliers of capital market securities (or users of
funds) are corporations and governments. Households are the major suppliers of funds for
these securities.
2.4 Secondary Capital Markets

This proposed study is on the establishment of Capital Markets in Least Developed Countries
As indicated above, financial markets could be classified in different ways; money market
versus capital market, debt or bond market versus stock or equity market, primary market
versus secondary market and domestic market versus foreign market. The term "Capital
Market", in this proposed study refers to all the above financial market classifications, except
money market, foreign market, and derivatives markets.
______________
4
Derivative Instruments/Securities: are financial securities whose payoff is linked to another, previously
issued security. Derivative securities have their own market. In fact these markets are the newest of the financial
security markets and are traded in developed financial markets (Saunders and Cornett, 2004)
14
As this study is about the establishment of a capital market in Ethiopia, the capital market
don’t include the derivate market as well, which is a recent development even in a well
developed capital markets of the developed world.
For a country to start with the establishment and development of financial markets, money
markets could serve the initial purpose. As per Saunders and Cornett (2004) money markets,
due to their short-term nature (considering United States money markets) do not operate in a
specific location rather, transactions occur via telephone, wire transfer and computer trading.
That is, money markets are over-the -counter (OTC) markets. They do not need a trading
place as such. A Treasury Bills market, in which bills are auctioned fortnightly, is the only
regular market where securities are transacted in Ethiopia. There is no secondary market in
Ethiopia. Government bonds are occasionally issued to finance government expenditures
and/or to absorb excess liquidity in the banking system. Participants in the Treasury bill bid
are commercial banks. As per the annual report of National Bank of Ethiopia (NBE) 2006/07
of the total T-bills sold (69.5 billion birr) 89.7 percent was purchased by commercial banks
(http://nbe.gov.et/).
The financial instruments or securities in a capital market are bonds and stocks. As per
Mishkin and Eakins (2006) a bond is a debt security that promises to make payment
periodically for a specified period of time. A bond in this study refers to long-term corporate
and government bonds. A stock (common stock) is a financial instrument that represents a
share of ownership in a corporation. Issuing stock (new issue or seasoned issue) and selling it
to the public is a way for corporations to raise funds to finance their activities.
Secondary markets: Already issued securities trade (rebought and resold) in the secondary
market. The theme of this study, "capital market establishment”, is intended to mean
establishing a secondary capital market in Ethiopia. Fabozzi and Modigliani (2003)
enumerated the functions of secondary markets as:
(1) Secondary market provides an issuer of securities, whether the issuer is a corporation or a
governmental unit, regular information about the value of the security. The periodic trading of
the security reveals the consensus price that the asset (security) commands in an open market.
Thus, firms can discover the price of their bonds and the implied interest rates investors
expect and demand from them. Such information helps issuers how well they are using the
funds acquired from earlier primary market activities and it also indicates how receptive
investors would be to new offerings in the future.
15
(2) Secondary markets provide the opportunity for the original buyers of the asset (security) to
reverse their investment by selling it for cash (liquidity). Unless investors feel confident that
they can shift from one financial asset to another as they may deem necessary, they would
naturally be reluctant to buy any financial asset. Such reluctance would harm potential issuers
in one of two ways: either issuers would be unable to sell new securities at all or they would
have to pay a high rate of return, because investors would demand greater compensation for
the expected illiquidity of the securities.
(3) Secondary markets also offers investors liquidity for their securities as well as information
about the assets' (security) fair or consensus value (price discovery function).
(4) Secondary markets bring together many interested parties and so can reduce the cost of
searching for likely buyers and sellers of securities. It also makes costs of transacting low.
2.5 Capital Markets in Africa

In Africa the banking system is the predominant sources of finance. In theory financial
markets reduce the dependency on banking. Most African countries did not established capital
markets until recently and those that exist in few African counties were stagnant for years in
their performance relative to the developed markets around the globe. However, as per the
article “The promotion of capital markets in Africa: Assessment of needs in capital markets
development southern, western, and central Africa”, November 1999, recently the evolutions
of capital markets in Africa have seen considerable developments. Prior to 1989 there were
only eight stock markets; five in Sub-Saharan Africa (SSA) and three in North Africa. At
present there are over twenty stock exchanges in the continent (see Table 1).
(http://www.uneca.org/eca_resources/Publications).
Stock market development has been central to the domestic financial liberalization programs
of most African countries. It seems any program of financial reform and liberalization in
Africa is incomplete without the establishment and development of stock markets (Yartey and
Adjasi, 2007). African countries have sought capital markets not only as a means of
mobilizing domestic resources but also to attract foreign direct investments (FDI) as well.
The study done by Murinde (1999) indicated that most African governments are now keen to
develop capital markets as a direct way of mobilizing risk capital for the corporate sector.
There has also been considerable support for the aim from international financial corporation
(IFC). It is expected that capital markets will improve domestic resource mobilization and
16
promote the efficient use of capital. African governments should also play the important role
of attracting foreign portfolio investment, there by integrating domestic economies to the
global economy (Murinde, 1999).
In African countries there is also indeed a growing body of research which points towards
capital market development and financial deepening in general and domestic stock markets
development in particular. Activity in a number of African capital markets that had been
dormant for years picked-up significantly and a number of new markets have emerged. In a
number of established stock exchanges, activity has been boosted by increased listings of
companies (Table 1); mostly made possible by privatization of state-owned enterprises (The
promotion of capital markets in Africa: http://www.uneca.org/eca_resources/Publications;
November, 1999).
Financial sector reform is now part of the development agenda. Recent shifts in the global
economy have also contributed to the increased urgency of financial sector reform in Africa
(Murinde, 1999). Table 1 shows the list of African countries which had established domestic
stock exchanges with their corresponding listings and year of establishment.
In addition to the list of countries in Table 1; Angola, Cameroon, Cape Verde, Libya,
Mozambique, Rwanda and Sudan, are also some of the African countries that had either
proposed or established domestic stock exchange markets most recently.
2.6 Capital Markets and Economic Growth Linkage: Empirical Evidence

Empirical studies to substantiate whether capital market establishment and development will
have a positive significant effect on economic growth of nations or not were made for years
by researchers. However, the various investigations made have varied results. This section
reviews some of the relevant empirical investigations made in this area.
The point of argument in the literature (the statement of this thesis) is that, if least developed
countries establish a capital market, it should contribute to the economic growth of a country.
In such circumstances companies will raise the required capital and savers (mainly
households) will search for an investment with a better return in the capital market.
17
Table 1: Number of firms listed on African stock exchanges, by country. (1992-2002)

Country Year of Number of Growth (1992-2002) Annualized growth
rate (percent)
Establishment listed firms percent
1992 2002
Algeria n/a 2 3 50 10.67

Botswana 1989 11 19 72.7 5.09
Côte d’Ivoire 1998 27 38 40.7 3.16
Egypt 1888 656 1151 75.5 5.24
Ghana 1990 15 24 60 4.37
Kenya 1954 57 50 -12.3 -1.18
Malawi 1995 1 8 700 34.59
Mauritius 1988 22 40 81.8 5.59
Morocco 1929 62 56 -9.7 -0.92
Namibia 1992 3 13 333.33 14.26
Nigeria 1960 153 195 27.5 2.23
South Africa 1887 683 472 -30.9 -3.30
Swaziland 1990 3 5 66.7 4.75
Tanzania 1998 2 5 150 20.11
Tunisia 1969 17 46 170.6 9.47
Uganda 1997 2 3 50 14.47
Zambia 1994 2 11 450 23.37
Zimbabwe 1993 65 77 24.12 1.99
Total 1780 2216 24.49 2.22
Source: Bourguignon, Francois (Editor). Annual World Bank Conference on Development

Economics 2006: Growth and Integration (Senegal Proceedings). Herndon, VA, USA: World
Bank, The, 2006. p 82. Retrieved May, 2008 from:
(http://site.ebrary.com/lib/bthbib/Doc?id=10116558&ppg=92)
18
Studies for example (Singh, 1999) shows that the establishment of capital markets in least
developed countries won't do anything good towards the economic growth of a country. Singh
(1999) establishing a capital market, for African economies particularly those in Sub-Saharan
African (SSA), at the present stage of their development is likely to do more harm than good,
because they are prone to high volatility; African countries would do better to use their
human, material, and institutional resources to improve their banking systems than to promote
capital market. His main argument is capital markets in developing countries are generally
less well regulated and more poorly organized than their counterparts in developed countries.
Mohtadi and Agarwal (n.d) indicated that there exists very little hard empirical evidence on
the importance of stock market development to long- run economic growth and almost none
exits regarding the developing countries.
Murinde (1999), mentioning the work of (Tayler 1991 and Murinde 1993) suggests that the
financial system has only an obscure role to play in growth, especially given that the financial
bottlenecks are intrinsic features of the African economies. The financial sector is small
relative to the size of the economy, and consists of narrow ranges of institutions
predominantly commercial banks. In most African countries the central bank is an appendage
of government (i.e. lack of independence) with top management of the bank including the
board of directors often changing with government. Central banks are motivated by political
expediency and their role in economic development is limited.
Stock markets, due to their liquidity, enable firms to acquire much needed capital quickly,
hence facilitating capital allocation, investment and growth (Adjasi and Biekpe, 2006). Stock
markets also help to reduce investment risk due to the ease with which equities are traded.
Capital markets make financial assets/securities tradable and thus reducing the liquidity risks
(Fabozzi and Modigliani, 2003).
Senbet and Otchere (2006) have found that well-functioning capital markets, along with well-
designed institutions and regulatory systems, foster economic developments. As per Levine
and Zervos (1996a), a study conducted using cross-country growth regression analysis by
using data of 49 countries from 1976 through 1993; stock markets, measured by stock market
liquidity (a stock market indicator: measured by the value of stock trading relative to the size
of the market and by the value of trading relative to the size of the economy) is positively and
significantly correlated with current and future rates of economic growth. The study further
concluded that stock market liquidity is a robust predictor of real per capita GDP growth,
19
physical capital, and productivity growth after controlling for initial capital, initial investment
in education, political stability, fiscal policy, macroeconomic stability. As per Levine and
Zervos (1996a) capital markets influence growth through a number of channels: Liquidity,
risk diversification, acquisition of information about firms, corporate governance and savings
mobilization.
As per (Murinde, 1999), Levine (1997) looked at the contribution of the financial sector to
economic growth in Africa from the macro-economic point of view and Levine and Zervos
(1998) in terms of the specific role played by capital markets and banks in economic growth;
the “supply leading hypothesis” and the “demand following hypothesis”. The “supply leading
hypothesis” predicts that growth in the financial system (e.g. banking, capital markets)
induces further growth in the real economy. It is implied that lack of developed financial
system (e.g. banks and capital markets) hinders economic growth of nations. On the other
hand the “demand following hypothesis” predicts that economic growth in the real economy
induces financial development. That is, increased growths as well as the commercialization of
agriculture and other traditional subsistence sectors create demand for financial services.
The study of St. Hill (1992), cited by Murinde (1999) finds moderate support for the supply
leading hypothesis for a sample of 37 least developed countries (LDCs) which is in line with
the positive correlation between capital market and economic growth linkage. The demand
following hypothesis is established for a sample of 19 industrial countries.
Murinde (1999) mentioning the seminal paper by Patrick (1966: 176-7), suggests that in the
early stages of economic development a supply leading pattern is the more likely, because a
direct stimulus is needed to garner savings for investment. During the later stages, when the
financial sector is fully developed, the demand following pattern takes over.
Study done by Platt (1998) by plotting countries as a function of rate of growth and country
risk 5, investigated whether stock market is an ingredient of economic growth for a nation.
_______________
5
Country risk: refers to the likelihood that changes in the business environment adversely affect operating
profits or the value of assets in a specific country; financial factors such as currency controls, devaluation or
regulatory changes or stability factors such as mass riots, civil war and other potential events contributing to
companies' operational risks. This term is also sometimes referred to as political risk, however country risk is a
more narrow term, which generally only refers to risks affecting all companies operating within a particular
country.
20
The study concluded that stock market countries showed a better GDP growth than those
countries without stock markets. However, the study showed that the risk index of a country
and a country’s income level are the best predictors of a functioning stock market. The higher
the country risk index and the lower the income level of a country the lesser is the functioning
of a capital market of a country and vice-versa. Thus, this study is a warning for lower income
countries like Ethiopia.
Adjasi and Biekpe (2006) indicated that capital market and growth linkage varies according to
6
income levels of countries and capitalization. They conducted an investigation of stock
market and growth linkages by applying the frame work that Levine and Zervos (1996a) used
(cross-country growth regression analysis) in their investigation towards this linkage.
However, to justify the Capital market growth linkage particularly for developing countries,
they made grouping of countries according to income levels (low income, low middle income,
upper middle income and high income) and capitalization. As per their study, stock markets
seem to play a significant casual role in economic growth within high income and upper
middle income countries.
Empirical studies made on links among foreign direct investment and capital markets showed
that countries with well-developed financial markets gain significantly from foreign direct
investment (Alfaro, Chanda, Kalemli-Ozcan, and Sayek, 2004).
________________
6
Income levels or group: Economies are divided according to 2006 GNI per capita, calculated using the World Bank Atlas
method. The groups are: low income, $905 or less; lower middle income, $906 - $3,595; upper middle income, $3,596 -
$11,115; and high income, $11,116 or more. Retrieved from:
http://web.worldbank.org/WBSITE/EXTERNAL/DATASTATISTICS/0,,contentMDK:20420458~menuPK:64133156~page
PK:64133150~piPK:64133175~theSitePK:239419,00.html
21
2.7 The Financial Sector in Ethiopia: Recent Developments

In order to create awareness about capital markets in Ethiopia among investors, financial
institutions (Commercial banks, insurance companies, credit unions, micro finance
institutions, and non-formal savings institutions), the business community, and the public at
large, studies on the establishment of capital markets have to be conducted vigorously and
seminars and workshops as well. There seems a pressure from IMF and the World Bank to
liberalize the financial sector of Ethiopia. Ethiopia is also queued for membership in the
World Trade Organization (WTO). These organizations may consider liberalizing the
financial sector (banking and insurance) and establishment of capital market as a precondition
for the country to get further development assistance and co-operation.
As per the National Bank of Ethiopia (NBE) Annual Report (2006/2007); the financial sector
in Ethiopia mainly consists of the banking system, insurance companies and microfinance
institutions. There are eleven banks operating in the country of which eight are private
commercial banks. The total number of bank branches throughout the country is 487. The
ratio of bank branches to total population is about 158,372 which still shows that Ethiopia is
one of the under banked countries in Sub- Saharan Africa (SSA). (See Appendix 3: Ethiopian
banking sector financial indicators- World Bank).
The distribution of bank branches indicates that 38 percent are located in Addis Ababa, the
capital city. Out of the total number of bank branches, the share of private banks is 47.6
percent. And the total capital of the banking system reached 9.3 billion birr of which the share
of private banks is 31.5 percent.
The numbers of insurance companies in the country are nine with 146 branches. This means
that in Ethiopia one insurance branch serves over 520,000 people. Of the total, 48.6 percent of
the insurance branches were located in Addis Ababa, the capital city. Private insurance
companies accounted for 75.3 percent of the total branches.
The total capital of the insurance industry is only 522 million birr. The share of private
insurance companies in total capital is 59.4 percent.
The number of microfinance institutions (MFIs) in the country is 28 out of which 11 (or 39.3
percent) were located in Addis Ababa, the capital city and mobilized total deposits of 1.04
billion birr and their total assets also reached 3.48 billion birr. MFIs are increasingly playing a
22
role in contributing to poverty reduction by providing loans to and mobilizing savings from
the low income groups.
There are around 4 commercial banks under establishment. One of these banks, Access Bank
had also proposed a new product (Investment banking) to the traditional Ethiopian banking
service.
National Bank of Ethiopia (NBE) is undertaking a three years financial sector capacity
building project (ending June, 2009) financed by the World Bank - International Development
Association (WB-IDA). Below is the excerpt of the project retrieved from (www.nbe.gov.et)-
PowerPoint Slides.
Financial Sector Capacity Building Project
Development objectives:
To assist in building transparent/more sound, well-governed, well-

regulated/supervised and competitive financial sector,
….allocate resources to the private sector more effectively and efficiently
Help ensure better access to finance for all
Financer: The World Bank – International Development Association (WB-IDA)
Recipient: Ministry of Finance and Economic Development (MoFED) - Ethiopia
Implementing Agency: National Bank of Ethiopia (NBE)
One of the project components is strengthening the financial sector infrastructure and within
which is the capital market infrastructure.
Capital market infrastructure:
Development of Government and corporate bond markets;
Feasibility study and implementation plan for the establishment of stock exchange;
Depository/clearance and electronic settlement mechanism for government debt,

corporate debt and equity markets;
Developing the legal, regulatory and supervisory framework for security markets
23
This is a signal that sooner or later Ethiopian will embark on the establishment of a capital
market and follow the footsteps of other African countries.
The relevant empirical studies made to substantiate whether capital markets have a causal role
for economic growth, were reviewed in this chapter. However, the empirical studies and the
literature in general have varied results or views. Some studies such as Singh (1999); Mohtadi
and Agarwal (n.d); Platt (1999) shows that the establishment of capital markets won't do
anything good towards the economic growth of least developed countries. In theory and some
other studies (e.g. Levine and Zervos, 1996a; Murinde, 1999) shows that, the establishment
and development of capital markets could contribute to the economic growth and prosperity
of the nations; including least developed nations.
Despite the two contradictory thoughts or views as to the capital market versus economic
growth linkage; the following point worth mentioning to further substantiate the hypothesis.
Had the developed economies (e.g. western economies) established capital markets at a
developed stage of their real economies as such? That is, whether capital markets were
established at the developed stage of their economies or not. Reviewing the historical
background of well performing African capital markets particularly those in SSA is also
very helpful in this area.
The short-lived Ethiopian stock market which was formally established in 1965 and
ceased to exist in 1975 is also a good starting point. The study done by J.D.Von Pischke
(1968) and cited by Asrat (2003) indicated that the stock market was moderately
successful in its pioneering efforts to provide an organized market for companies whose
shares were relatively widely held. The same study showed that workable trading
practices and standards had been developed, and a fairly smoothly operating market
mechanism had been created.
Mr. Malloch Brown 7 (April 16, 2003) spoke at the African Capital Markets Forum at JP
Morgan Chase & Co., organized by UNDP in partnership with the African Stock
Exchanges Association and the New York Stock Exchange: “The future of Africa's stock
markets is the future of the poor in Africa.
______________
7
Mr. Malloch Brown: UNDP administrator. Retrieved May, 2008 from:
(http://www.globalpolicy.org/socecon/develop/africa/2003/0416stock.htm)
24
The jobs, the businesses, the prosperity and the future of the region lie in its stock
markets."
As per Yartey and Adjasi (2007) the development of stock markets in Africa is expected
to boost domestic savings and increase the quantity and quality of investment. They
further stated the critics, that argue a stock market might not perform efficiently in
developing countries and that it may not be feasible for all African countries to promote
stock markets, given the huge costs and the poor financial structures. Yet, corporate
financing patterns in some African countries suggest that stock markets are an important
source of finance. The stock market in Ghana financed about 12 percent of total asset
growth of listed companies between 1995 and 2002, 16 percent in South Africa between
1996 and 2000, and 8 percent in Zimbabwe between 1994 and 1999. In all these countries,
the stock markets were the single most important source of long-term external finance.
The above points one way or another speculates that capital markets could play a positive role
not only for developed economies but also for least developed countries in Africa. If a capital
market performs well in an African country in SSA (as reviewed in this chapter capital
markets are contributing a lot for the growth of some African countries and for corporations in
some African countries, capital markets are an important source of finance); why not for other
African countries particularly those in Sub-Saharan Africa including Ethiopia? Should least
developed countries in SSA wait until their economies reach at middle income level to
embark on the establishment of capital markets?
At this point it’s difficult to endorse either of the two thoughts or views i.e (1) the view that
positively correlates capital markets and economic growth for developed as well as least
developed countries, and (2) the view that negatively correlates capital markets and economic
growth for the case of least developed countries. It seems there is some other factor behind a
capital market establishment and development for it in turn to play a positive and significant
role towards the economic growth and prosperity of least developed countries including
Ethiopia. In fact, the two contradictory thoughts have their own arguments. However, unless
the capital markets versus economic growth linkage is attested empirically; solely for capital
markets in least developed African countries particularly those in SSA it’s difficult to promote
either of the two views or thoughts based on the literature review conducted by this study.
This study will look at the capital market and economic growth linkage in least developed
countries in Africa from the perspective of institutions (Chapter 3).
25
CHAPTER 3 CAPITAL MARKETS AND INSTITUTIONS
CAPITAL MARKETS AND INSTITUTIONS

This chapter deals with institutions and capital markets; whether the type and quality of
institutions make cross-country differences in the development and performance of
capital markets for it in turn to positively influence the growth and prosperity of nations.
For this the relevant literatures are reviewed to promote whether the quality of
institutions have a positive significant effect on the establishment, development and
performance of capital markets in LDCs in Africa, including Ethiopia.
3.1 General
In chapter 2, “capital markets and economic growth”, this study critically reviewed the
relevant literatures; theory and mainly the empirical studies conducted on capital markets
versus economic growth linkage. Through the review, different views were revealed; (1) the
view that positively correlates capital markets and economic growth for developed as well as
least developed countries, and (2) the view that negatively correlates capital markets and
economic growth for the case of least developed countries. Commentators of second thought
(e.g. Singh, 1999) warns low income African countries, particularly those in Sub-Saharan
Africa (SSA) not to embark on the establishment of capital markets instead better use their
human, material, and institutional resources to improve their banking systems than to promote
capital market, affirming that if they do so, it will do harm than anything good for such
African economies.
3.2 What are Institutions?

The term “institution” is a broad concept and had been the center of discussion of
developmental economics. Oxford English Dictionary defines institutions as: “the giving of
form or order to a thing; orderly arrangement; regulation." Related to this is "an established
law, custom, usage, practice, organization, or other element in the political or social life of a
people; a regulative principle or convention subservient to the needs of an organized
community or the general ends of civilization." An institution could be economic (Banking,
Commerce & Finance and Entrepreneurship, Management, & Leadership subjects.), legal
(constitutions, laws and regulations) financial (Banks, credit unions, insurance or trust
companies), public (Institutions which are supported primarily through public funds), social
(A set of organized beliefs, rules, and practices that establishes how a society will attempt to
meet basic needs.), religious, organizational, political etc. web (definitions for institutions;
http://www.google.com/search: May 25,2008).
26
In this study, particularly in this chapter we use the term “institutions” mainly to legal,
political, financial, and organizational and others in some way as it deem necessary.
3.3 Institutions, Capital markets and Economic Growth

Rosenberg and Birdzell (1986) in their book “How the West Grew Rich: the economic
transformation of the industrial world” that explains the cause of the growth of the western
economy; put the western institutions as the fulcrum of the development of the western
economy. They explained that institutions adopted by western nations in the different eras
(e.g. feudalist, capitalist) of their endeavor played a significant role in the development
history of the western economy.
Recently institutions and their link to economic growth and to some extent to capital markets
are coined by institutional economists. North (1996) defines institutions “… the rules of the
game in a society, or, more formally, are the humanly devised constraints that shape human
interaction”. Constitution and the set of laws are the most obvious formal institution. Informal
institutions such as conventions and codes of behavior (“social norms” or “social values”) are
also important determinants of human interaction as per North (1996).
In the new institutionalist model institutions are more broadly defined as “a means to reduce
transaction and information costs that markets can operate with the kind of fluidity and
efficiency” (Stein, 1995).
(IMF: Islam, 2000) define institutions as “rules (informal customs as well as laws) that
govern behavior, the mechanisms (often organizations or reputations) that enforce these rules,
and the organizations (for example, clubs and banks) that affect peoples' incentives and
support market transactions”. To spur growth and reduce poverty, poor countries will need
efficient formal and informal institutions that support market activity.
As per Kasper and Streit (1998) institutions are rules in that, human interactions require a
degree of predictability; and individual interactions become more predictable when they are
bound by rules. Kasper and Streit (1998) defined institutions as “man-made rules which
constrain possibly arbitrary and opportunistic behavior in human interaction. Institutions are
shared in a community and are always enforced by some sort of sanction. Institutions without
sanction are useless; only if sanctions apply will institutions make the actions of individuals
more predictable.”
27
Rosenberg and Birdzell (1986) claimed that the relative autonomy of economic institutions
from government intervention was the key to the sustained economic growth of the west.
They warn that constraints on the free exercise of economic autonomy by governments’
would threaten economic growth and prosperity.
The work of Fergusson (2006), “Institutions for Financial Development: what are they and
where do they come from?” one of the most influential study that linked institutions and
capital markets, explained institutions are “one of the basics that cause cross-country
differences of long run economic performance among nations. High quality institutions and
infrastructures have a positive influence on the depth and development of financial markets
(capital markets in this case).”
As per Fergusson (2006), financial markets (capital markets in this case) are the single most
important markets where adequate economic institutions are critical because of the
characteristics of financial contracts. Financial markets require not only an appropriate legal
framework but also adequate enforcement of the rights and constraints of each of the parties
involved in the financial contract. He further emphasized that one of the channels where by
better institutions may have an effect on economic development is through the consolidation
of better financial markets.
In an empirical analysis on the link between financial intermediation (financial institutions)

and capital markets Yartey (2007) indicated that the development of a well-developed
financial intermediary sector is important for stock market development. The stock market is
a complement rather than a substitute for the financial sector (mainly banking sector)
particularly at the first stage of its establishment. Developing the financial intermediary sector
can promote stock market development. Support services from the financial intermediary
sector (particularly the banking system) contribute significantly to the development of the
stock market. He further elaborated that; liquid interbank markets, largely supported by an
efficient banking system, are important for the development of the stock market. Conversely a
weak banking system can constrain the development of the stock market.
Further elaborating the role of institutions North (1996), stated that “economic growth
depends on specialization, market exchange and the stock of human and physical capital.
When economic activity -investment, production, and exchange- is primarily in the hands of
private individuals, these individuals must believe that they have reasonable control over their
28
assets before they will risk them in exchange across time and space. Economic development
requires reasonably secure private and communal property rights. The expectation of arbitrary
confiscation either by the state or fellow citizens, shortness the individual actor's time
horizon, increases the subjective discount rate and creates disincentives for investment,
specialization and exchange.”
The state or government is in a unique position to provide economic actors with political
foundation of secure markets and property rights. It has also the power to alter property rights
in order to confiscate wealth of the economic actors arbitrarily. Therefore, the state or
government to build the confidence of economic actors needs to have a credible commitment
towards institutions. That is, if constitutions are to create stability and lay the political
foundations of securing markets, they must be enforced and also hard to change by the state or
government (parliament). For economic growth to occur the state or government must not
merely establish the relevant set of rights but must make credible commitment to them North
(1990).
Yartey (2007) had also touched upon the relevant institutions that should be in place in the
African capital markets while explaining that capital markets offer a great deal of promises
for economic development in Africa. Developments of capital markets can be seen as an
integral component of overall financial sector (capital market, banking sector and other
financial institutions) reform currently undertaken in most African countries because there are
complementarities between capital markets and the banking sector and other financial
institutions. The study of Yartey (2007) highlighted the following as an effort to the financial
sector reforms in African counties: (1) African countries needs to pass a comprehensive
company law (the conduct of public companies, disclosure requirements and stockholders’
rights), (2) build a strong regulatory agency (in the form of capital market authority). The
study emphasized that law enforcement is particularly important given the separation of
management and ownership in general and the poor accountability of most public companies
in Africa.
A World Bank study, “Economic Growth from the Very Long-Term Perspective of History:
World Bank; Country note 1”: countries’ growth performances lie in the incentives (to use
existing resources and accumulate capital factors that ultimately determine growth
performance) created by policies and institutions. As per this study long-term economic
29
growth is affected by three exogenous forces: geography, openness to foreign trade and
institutions. As per this study institutions remain deep causal factors towards the long-term
economic development of a nation. Institutions play a crucial role in long-term economic
growth.
Rodrik and Subramania (2003): “The Primary of Institutions (and what this does and doesn’t
mean)”, examined the huge differences in average incomes between the world’s richest and
poorest nations and puts foreword: Geography, International Trade and Institutions (in this
study institutions are the property rights and rules of laws) as the three standard of thoughts to
explain why such a vast difference emerge among nations.
Conducting a regression analysis Rodrik and Subramania (2003) indicated that the quality of
institutions overrides everything else to explain the huge difference in income between the
worlds’s richest and the poorest nations. Institutions particularly those that protect property
rights and ensure that contracts are enforced are very vital for economic growth. These set of
institutions are called market creating institutions. In the absence of these institutions markets
either doesn’t exist or perform very poorly.
The study had also included other types of institutions that are very crucial for long-run
economic development of nations.
• Market regulating institutions: namely, those that deal with externalities, economies of
scale, and imperfect information. Examples include regulatory agencies in
telecommunications, transport, and financial services.
• Market stabilizing institutions: namely, those that ensure low inflation, minimize
macroeconomic volatility, and avert financial crises. Examples include central banks,
exchange rate regimes, and budgetary and fiscal rules.
• Market legitimizing institutions: namely, those that provide social protection and
insurance, involve redistribution, and manage conflict. Examples include pension systems,
unemployment insurance schemes, and other social funds.
Emphasizing the critical role of institutions to the development process of a nation the study
also warn; institutional solutions that perform well in one setting may be inappropriate in a
30
setting without the supporting norms and complementary institutions. In other words,
institutional innovations do not necessarily travel well.
3.4 Financial Institutions

Financial institutions are what make financial markets work. Without financial institutions,
financial markets would not be able to move funds from who save to people who have
productive investment opportunities; and thus have important effects on the performance of
the economy as a whole. The most important financial institution in the financial system of an
economy is the central bank, the government agency responsible for the conduct of monetary
policy (Mishkin and Eakins, 2006). In addition to this, institutions in the financial system
include; commercial and savings banks, insurance companies, mutual funds, stock and bond
markets, credit unions and non-formal financial institutions (that are common in least
developed countries particularly in Africa, Sub-Saharan Africa including Ethiopia).
The financial system channels funds from savers to people with productive investment
opportunities in two different ways; without financial institutions and with financial
institutions (FIs) as an intermediation (Saunders and Cornett, 2004).
Figure 3: (a) flows of funds in a world without FIs
Financial Claims
(Equity and Debt Instruments)
Users of Funds Suppliers of Funds

(Corporations) (Households)
Cash
Source: Saunders and Cornett (2004)
31
Figure 3: (b) Flows of funds in a world without FIs
Users of Funds FI Suppliers of Funds
(Brokers)
FI
(Asset
Cash Cash
transformation)
Financial Claims Financial Claims
(Equity and debt securities) (Deposits and insurance policies)
Source: Saunders and Cornett (2004)
In a flow of funds (money) in a world without financial institutions, we have a direct transfer
of funds (money) from suppliers of funds to users of funds and financial claims (equity and
debt) in the reverse order. In an economy without FIs the level of funds flowing between
suppliers of funds and users of funds through financial markets is likely to be quite low. On
the other hand the flow of funds in a world with FIs; the indirect flow is quite high (Saunders
and Cornett, 2004).
Saunders and Cornett (2004) had also mentioned that due to monitoring costs, liquidity and
price risks, and other reasons (benefits that could be derived from FIs as an intermediation in
the financial market) individuals (households - suppliers of funds) prefer to hold the claims
(equity and debt) of FIs than the end user of funds (corporations). FIs provide various services
to an economy and the actors in the economy. So, they have to be regulated by the
government because failure to provide the required services to the economic actors in the
financial market/ capital market can be costly to the financial market (ultimate suppliers of
funds and users of funds in particular) and to the overall economy. For example bank failure
may destroy household savings and restrict a firm’s access to credit and in general individual
FI failures may create doubts in savers' minds regarding the stability and solvency of FIs and
the financial system in general cause panics and even withdrawal runs in sound institutions as
well. FIs are regulated to prevent such types of market failures.
32
3.5 Capital Markets and Financial Institutions in Africa

For a country to establish and develop a well functioning capital market it has to strengthen
financial institutions. Banks (saving, investment), mutual funds, pension funds, credit unions,
saving associations are the most important FIs that could mobilize financial resources from
households and inject fund back to the capital market. However, there are no as such
developed set of financial institutions in most African countries. Commercial banks, insurance
companies and financial institutions such as Microfinance Institutions (MFIs) are the only
institutions in most African countries including Ethiopia. Financial institutions such as MFIs
(usually in the form of saving and credit associations) and co-operative banks which are the
common FIs in rural areas of most African countries particularly those in Sub-Saharan Africa
(SSA) including Ethiopia are the means through which these countries could mobilize
financial resources from the rural community. However, FIs are not developed yet in most
African countries.
Yartey (2007) mentioned that the problem of most capital markets in Africa is that they have
only a limited number of listed companies in their stock exchanges; trading occurs in only a
few stocks which account for a considerable part of the total market capitalization (represents
the aggregate value of a company or stock: obtained by multiplying the number of shares
outstanding by their current price per share - investorwords.com). There are serious
informational and disclosure deficiencies for other stocks. Further, supervision by regulatory
authorities is often far from adequate. The less developed stock markets suffer from a far
wider range of such deficits.
If African countries strengthen FIs in the rural areas and create awareness in these institutions
including banks, insurance companies, and pension funds to actively participate in the capital
markets they can contribute significantly for the development of the capital market for it in
turn to contribute to the growth of the economy. It’s only through building the capacity of FIs
in rural areas that they can trap financial resources from rural area.
Murinde (1999) in most African countries the informal financial sector has a leading role in
the mobilization of domestic financial resources that are out of reach for the formal sector
(banking). The informal sectors are based on traditional foundations and they are not subject
to control. For African governments to exploit all possible domestic resources for the
mobilization of development finance the informal sector needs to integrate with the formal
33
financial sector. The formal sector (banking) has also capital inadequacy and inefficiency and
the insurance sector, performance problems. Thus, the central banks should be made better at
bank regulation and supervision and strengthening the informal sector as well.
Ethiopia for establishing capital markets first the availability and capacity of financial
institutions must be taken in to consideration. The central bank of the country; National Bank
of Ethiopia (NBE), the commercial banks (state and private), insurance companies and MFIs,
credit unions and co-operative banks should be strengthened before embarking on the
establishment of capital markets. Specialized banks (such as investment) and mutual and
pension funds need to be in place and their capacity strengthened by creating favorable
working environment and finance specialists and brokers needs to in place as well.
3.6 Determinants of Stock Market Development in Africa

The study conducted by UNECA (United Nations Economic Commission for Africa), “ The
Promotion of Capital Markets in Africa: Assessment of needs on capital markets
development; Southern, Western and Central Africa, 1999) ,capital markets to operate with
some degree of efficiency the conditions are: a stable macro-economic environment, an
appropriate capital market infrastructure (e.g. clearance and settlement) and an adequate
regulatory, legal and supervisory framework ( in order to protect investors, promote public
confidence, and guarantee market discipline).
As per this study shortage of skilled manpower (e.g. financial specialists) and lack of
appropriate training institutions are also some of the limiting factors in establishing and
developing financial markets in Africa. Increasing educational activities, public awareness
campaign, support the development of institutional investors 8 and training key market players
such as brokers should be under taken extensively to deal with the initial limiting conditions
for capital market development in Africa.
______________
8
Institutional investors: are organizations which pool large sums of money and invest those sums in
companies. They include banks, insurance companies, retirement or pension funds, hedge funds and mutual
funds. Their role in the economy is to act as highly specialized investors on behalf of others: Retrieved on May
29, 2008: (http://en.wikipedia.org/wiki/Institutional_investor).
34
Yartey and Adjasi (2007), “Stock Market Development in Sub-Saharan Africa: Critical Issues
and Challenges-IMF working paper ” after claiming that stock market activity should increase
economic growth through liquidity injection, saving mobilization and equity financing for
firms; puts forward the following question: What determines stock market development in
Africa? , and recommends the following:
Sound macroeconomic environment: Low and predictable rate of inflation, domestic
savings, domestic investment, high income level- GDP per capita,
Well developed banking sector: At the early stage of its establishment the stock market
is a complement rather than a substitute so the banking sector is important,
Transparent and accountable institutions: Good quality institutions such as law and
order, democratic accountability, bureaucratic quality as important determinants of stock
market development in Africa because they reduce political risk and enhance the viability
of external finance. Citing the general literature this study claims that the political risk is
priced factor for which investors are rewarded and that it strongly affects the local cost of
equity, which may have important implication for stock market development (Yartey
2007),
Shareholder protection: Legal rules and law enforcement for shareholder protection thus
investors don’t fear expropriation,
Minority rights protection, all contributes to the development of a stock market.
3.7 Institutions in Ethiopia: some Indices

Yartey (2007) in his study, “well-developed Financial Intermediary Sector Promotes Stock
Market Development: Evidence from Africa”, made empirical investigations and found out
that: institutional quality is an important determinant of stock market development in Africa.
Yartey (2007) constructed an index of institutional quality as: corruption, law and order,
bureaucratic quality, democratic accountability and government stability after considering the
work of (Edison, 2003) which considered three broad measures of institutions; (1) the quality
of governance, including corruption, political rights, public sector efficiency and regulatory
burdens, (2) the legal protection of private property and law enforcement, (3) accountability
and the limits placed on the executive and political leaders.
Yartey (2007) found that good quality institutions are important determinants of stock market
development. The development of good quality institutions such as law and order, efficient
bureaucracy, limited corruption and democratic accountability are therefore crucial for stock
35
market development in Africa. Countries with good quality institutions tend to have an
efficient regulatory environment. The regulatory environment is particularly important if
African countries are eager to integrate their stock markets with the international financial
system.
A study that examined the financial sector of Ethiopia specifically dealing with the banking
sector (Kiyota, Stern and, peitsch 2007), highlighted the following remarks as to the sector:
the closed nature of the banking sector, no foreign participation in the financial sector and the
banking sector is dominated by the state owned banks. After comparing the performance of
state owned and private banks in their case study; they found that state owned banks are
inefficient compared to private banks and the case study concluded that Ethiopia will benefit
from financial liberalization which will have a direct impact on the strengthening of the
economic growth of the nation. (See Table 2: some of the Ethiopian institutional capability
indices). Coupled with the establishment of a capital market (because the two are
complementary), the financial sector could play a significant role in the growth of the
Ethiopian Economy.
This study (Chapter 2) reviewed the literature (theory and empirical studies) on “capital
market and economic growth linkage”. Empirical studies conducted on capital markets and
economic growth linkage has varied results; a view that positively correlate capital markets
and economic growth of nations (Levine and Zervos, 1996a; Senbet and Otchere, 2006;
Murinde, 1999).The other set of studies (e.g. Singh, 1999; Mohtadi and Agarwal, n.d; Platt,
1999) negatively correlated capital markets and economic growth for the case of least
developed countries Africa particularly those in SSA including Ethiopia.
To promote either of the two views solely based on the review and analysis of the literature is
difficult, except a mere speculation. The two set of thoughts that argue differently on
capital market economic growth linkage (particularly the thought that negatively
correlated capital markets and economic growth for the case of least developed
countries in Africa) did not consider the role of institutions in the performance of the
overall economy and the role that institutions could play in the development and
performance of capital markets in least developed countries in Africa.
36
Table 2: some indices of the institutional capability of Ethiopia
Description Country data

Drivers growth
Domestic credit to the private sector (% of GDP) 25
Time to start a business (days) 16
Time to register a property (days) 43
Policy uncertainty as major constraint(% of firms) 38
Corruption as major constraint (% of firms) 38
Courts as major constraint (% of firms) 5
Courts and property rights as major constraint (% of firm) 18
Crime as major constraint (% of firm) 9
Protecting investors disclosure index (0 low and 10 high) 4
Time to prepare, file, and pay taxes (hours) 212
Average time to clear customs (days) 4
Rigidity of employment index (0 least rigid 100 most rigid) 34
Total tax payable (% of profit) 33
Tax rates as major constraint (% of firms) 72
Finance as major constraint (% of firms) 50
Labor regulation as major constraint (% of firms) 4.5
Labor skills as major constraint (% of firms) 18
Foreign direct investment, net inflows ($ millions) 150
Capable States
CPIA9 overall rating (IDA resources allocation index, 1 low to 6 3.4
high)
Corruption perceptions index score (0 corrupt to 10 clean) 2.4
Control of corruption (-2.5 worse to 2.5 better) -0.55
Political stability (-2.5 worse to 2.5 better) -1.82
Voice and accountability (-2.5 worse to 2.5 better) -1.08
Government effectiveness (-2.5 worse to 2.5 better) -0.61
Regulatory law (-2.5 worse to 2.5 better) -0.82
Rule of law (-2.5 worse to 2.5 better) -0.64
Source: The little data book in Africa 2007: World Bank

http://siteresources.worldbank.org/INTSTATINAFR/Resources/LDB_Africa_final.pdf: Retrieved on
May 20, 2008.
______________
9
Country Policy and Institutional Assessment (CPIA): rates countries against a set of 16 criteria grouped in
four clusters: (a) economic management; (b) structural policies; (c) policies for social inclusion and equity; and
(d) public sector management and institutions.
(http://web.worldbank.org/WBSITE/EXTERNAL/TOPICS/ENVIRONMENT/EXTDATASTA/0,,contentMDK:
21115900~menuPK:2935553~pagePK:64168445~piPK:64168309~theSitePK:2875751,00.html): Retrieved on
May 20, 2008.
37
To this effect the literature reviewed in this chapter (theory and empirical studies done before)
on institutions (legal, financial, political, and organizational and others) revealed that they are
the most vital economic variables that give impetus for the economic development of a nation.
Those studies reviewed in this chapter positively correlate institutions and economic growth
of nations (Fergusson, 2006; North, 1996; Stein, 1995; Yartey, 2007; Mishkin and Eakins,
2006; Rodrik and Subramania, 2003; Rosenberg and Birdzell, 1986) and concluded that
institutions do make cross-country differences among nations.
One way or another, these studies had tried to link the role of institutions (mainly legal,
financial political and somehow organizational) in a market place (capital markets in this
case). Fergusson (2006), one of the most influential studies in this area that linked institutions
and capital markets, explained institutions are one of the basics that cause cross-country
differences of long run economic performance among nations. High quality institutions have a
positive influence on the depth and development of financial markets (capital markets in this
case).
Financial markets (capital markets in this case) are the single most important markets where
adequate economic institutions are critical because of the characteristics of financial contracts
and one of the channels where by better institutions may have an effect on economic
development is through the consolidation of better financial markets (Fergusson ,2006).
Rosenberg and Birdzell, 1986 in their book: How the West Grew Rich: The Economic
Transformation of the Industrial World; which coherently summarized the development of the
western economy in the different eras had showed that western economies grew
unprecedentedly because of the “institutions” they adopt in the different eras of their
development history.
Therefore least developed countries in Africa particularly those in SSA including

Ethiopia which are in the pipeline to embark on the establishment of capital markets,
have to focus on building their respective institutions.
In order to be effective, institutions need to complement with the existing conditions in a

country. Thus, in designing institutions, policymakers need to take into account such factors
as the existence of supporting institutions, the availability of necessary technologies,
education and skill levels (IMF: Institutions to support markets; Islam, 2000) and:
38
Creating public awareness
Liberalizing their financial sector (Privatizing state owned banks) and creating specialized
banks such as investment banks
Strengthening the central banks (to play an independent role)
Strengthening financial institutions (formal- Banks, Insurance companies, credit unions,

and pension funds, mutual funds and MFIs and; non-formal-financial institutions in rural
areas of most African countries including Ethiopia). The informal financial institutions
can mobilize financial resources from the rural area which are out of reach for the formal
banking sector. And then integrating the informal sector with the formal financial
institutions.
Training institutes; to train finance specialist and brokers which are the major players in a
capital market.
Relevant laws, rules and regulatory systems including political commitment to the laws
and rules
This study after critically reviewing and analyzing the existing literature on capital
markets and economic growth linkage and capital markets and institutions; affirmed
that capitals will have a causal role towards the economic growth and prosperity of least
developed countries in Africa including Ethiopia as well, provided that the economy in
general and the financial sector (in this case capital markets) is backed by quality and
capable institutions of all sorts. Such a capital market will in turn positively influence
the growth and prosperity of a nation. To efficiently structure and organize a capital
market lessons from “emerging” economies capital markets in Africa, particularly from
SSA is very vital for Ethiopia before as well as after establishing a capital market.
39
CHAPTER 4 HOUSEHOLDS’ SAVINGS AND CAPITAL MARKETS
HOUSEHOLDS’ SAVINGS AND CAPITAL MARKETS

Most African counties, particularly those in Sub-Saharan Africa are under-banked. The
vast majority of households in rural and urban areas alike are out- of- reach to the formal
banking sector. The already existing capital markets in Africa are very thin in terms of
listed companies, trading volume and overall market capitalization. This chapter
considers these issues and discussed the supply and demand aspects of capital markets in
Africa particularly in SSA. How capital markets could play a crucial role in mobilizing
domestic resources through expanding the banking and the nonbanking sectors is also
discussed with particular emphasis on Ethiopia.
4.1 General
As per the literature that this study had critically reviewed under chapter 2 (Capital Markets
and Economic Growth) and chapter 3 (Capital Markets and Institutions) mainly in least
developed countries in Africa, particularly those in SSA including Ethiopia; capital market
establishment and development is considered to be one of the most critical economic growth
variables of these nations. Capital markets by mobilizing domestic resources as well as
foreign direct investments could contribute to the growth and prosperity of African countries.
However, to play this significant role capital markets should be backed by high quality
institutions of all sorts.
This study after reviewing the relevant literature (both theory and empirical studies) affirmed
that due to lack of institutional capability most of the existing capital markets in Africa
particularly those in SSA failed to play the economic growth and prosperity role that they
were expected to do so.
However, capital markets that somehow perform well in the continent and to some extent
backed by relatively better institutions are also engulfed with the problem of capital market
illiquidity. They have a few listed companies, trading volumes are low and overall the
markets are so tiny that the overall market capitalization is below 100% of GDP in most of
these capital markets compared to developed markets which is above 100% (Giles, November
2006) see Appendix 4. Thus, in addition to the lack of institutions that most African countries
and their capital markets encountered, the illiquidity and low market capitalization is another
troublesome aspect for the existing capital markets and a warning for those African countries
including Ethiopia which are in the pipeline to establish capital markets.
40
Financial institutions both the formal and informal ones’ are not structured in a way that they
could mobilize domestic financial resources. Households in rural and urban areas alike have
no access to the banking sector as such. Most African countries are under-banked.
Commercial banks in African countries have limited role in this regard. Some African
counties are strengthening other nonbanking financial institutions such as microfinance
institutions so as to reach out and mobilize their domestic financial resources.
4.2 Resource Mobilized by Banks and Microfinance Institutions (MFIs) in Ethiopia

As per the National Bank of Ethiopia Annual Report 2006/07; the financial sector in Ethiopia
mainly consists of the banking system, insurance companies and micro-finance institutions.
Banks operating in the country are 11, out of which three are state-owned and 8 privately
owned. The bank branches are 487 of which 38% (185 branches) are located in Addis Ababa,
the capital city. As per this the same report, the total number of population served by a bank
branch is 158,372 persons, which shows that Ethiopia is one of the under-banked countries in
sub-Saharan Africa.
There are 9 insurance companies with a total branch of 146 of which 48.6% (71 branches)
were located in Addis Ababa, the capital city.
The numbers of Microfinance Institutions operating in the country are currently 28.
Microfinance Institutions mobilized deposits close to Birr 1.0 billion and advanced loans
amounting to Birr 2.7 billion by the end 2006/07.
The banking system mobilizes resources in the form of deposits, collection of loans and
borrowings. Total resources mobilized by the banking system reached Birr 23.3 billion in
2006/07.
Deposit liabilities of the banking system reached Birr 53.9 billion at the end of June 2007.
4.3 Households and Capital Markets

Capital markets are important variables for the growth and development of an economy
provided that they are backed by capable institutions (Chapter 3). A capital market with this
feature which can mobilize enough resource domestically would in fact play a vibrant role to
the growth and prosperity of the real economy. The nonbanking financial sector and the
banking sector should also be strengthened so as to play a significant role in strengthening the
capital markets in African.
41
Saunders and Cornett (2004) in the United States, households are the single largest holders of
corporate stock (holding 38.4 percent of all corporate stock outstanding in December 2001-
Table 3). Most individuals in the United States either directly own corporate stock or
indirectly own stock via investments in mutual funds and pension funds.
In most African economies the non-banking financial institutions play a significant role in
mobilizing resources from households in rural and urban areas. If resources from rural and
urban areas are mobilized through strengthening the nonbanking sector and integrating it with
the formal banking sector; directly or indirectly households could play a significant role in the
less liquid capital markets of African countries.
Griffiths (Sept 2005) in his article: “smalltime savers, big time capital”; stated that Africa’s
money tends to head overseas or under the mattress. For this not to happen there should be a
strong fund management industry that can harness domestic savings.
It is widely acknowledged that significant private sector investment and growth are essential
to development. But for the private sector to invest, it needs access to capital, including local
capital, and local capital comes from local savers. Consultative Group to Assist the Poorest
(CGAP), a resource centre for microfinance based in Washington, estimates that up to 85
percent of the population of sub-Saharan Africa who could use financial services (in this case
for saving); particularly micro-finance facilities "are not being reached".
The only place for these people to save is under the mattress. As a result, African capital
markets are small in size (Griffiths, Sept 2005).
42
Table 3: Holders of Corporate Stock in the United States
(In billions of dollars)
Percent of
1994 1997 2000 2001
2001 total
Household sector $3,070.9 $5,689.6 $7,317.10 $5,832.2 38.4%
State and local governments 10.6 79.0 115.1 126.3 0.8
Reset of world 397.7 919.5 1,748.3 1,692.8 11.2
Depository institutions 180.6 331.4 315.2 261.8 1.7
Life insurance companies 246.1 558.6 940.8 935.2 6.2
Other insurance companies 112.1 186.0 194.3 185.2 1.2
Private pension funds 996.3 1,863.9 2,195.1 1,902.3 12.5
Public pension funds 557.4 1,431.7 1,335.1 1,215.7 8
Mutual funds 709.6 2.018.7 3,292.5 2,919.8 19.2
Closed-end funds 31.9 50.2 35.7 31.9 0.2
Brokers and dealers 20.1 51.9 72.2 82.8 0.6
Source: Federal Reserve Board, website, various issues. www.federalreserve.gov

Source: Saunders and Cornett, 2004
Fleeing or idle assets need to be turned into productive capital for Africa. The best way to do
this is through the financial services sector, either through the intermediation of financial
institutions, including micro-finance organizations and private equity firms, or through the
capital markets. In the context of Africa’s estimated investment needs of $50 billion per year,
this is what could be available if capital flight declined and the formal savings market could
capture some of the cash circulating in the continent (Griffiths, Sept 2005).
The PM of India, Atal Bihari Vajpayee (January 17, 2003) while launching a nationwide
securities awareness campaign “motivate savers to put money into shares, so as to attain 8
percent economic growth” had emphasized on the following:
43
Most of the household savings were going to less productive non-financial assets and banking
sectors. To avoid these:
Building the confidence of small investors to channel more savings in to the

capital market,
Motivate savers (households and others) to put their money into shares and
bonds so that the economy benefits through a vigorous and dynamic capital
market, and
Mobilize for high rates of domestic savings.
For African countries with thin capital markets in terms of overall market capitalization and
those countries like Ethiopia in the pipeline of establishing capital markets; mobilization of
savings from households dispersed in rural and urban areas and putting it back to capital
markets instead of tiding up to the banks in the form of deposits and to non-financial assets is
very crucial for the growth of their real economy. This is also a good lesson for African
countries like Ethiopia, in the pipeline of establishing capital markets in that those smaller
household savings could make big capital.
4.4 The Supply and Demand Aspects of Capital Markets

Giles (November 2006) in his article “making capital markets in Africa work for both savers
and entrepreneurs” viewed the two aspects of capital markets; the supply (investment
instruments) and demand (investors) aspect that must be matched. On the demand side sit
investors: institutional investors, such as pension funds, insurance companies and mutual
funds, as well as individual investors (households) who may invest directly or through an
investment institution and on the supply side are governments and enterprises, large and
small, which need to raise money to pursue their objectives by borrowing or issuing debt or
equity securities. In the middle sit banks, brokers, fund managers and other capital-market
intermediaries such as stock exchanges.
Giles (November 2006) further explained that; many African countries suffer from an
imbalance between demand and supply. On the demand side, pension funds are steadily
accumulating money from their members’ contributions, life-insurance funds are booming
and mutual funds are growing too (which could be the case in some African countries).
Institutions such as mutual funds and pension funds are not developed in most African
44
countries particularly in SSA including Ethiopia instead commercial banks and microfinance
institutions do mobilize domestic financial resources in most African countries).
These financial institutions need a diverse range of investment opportunities for the funds that
they are accumulating from savers but unfortunately these are lacking as well, so they are
accumulating capital that could be put to much more constructive purposes.
On the supply side, governments and companies are also hampered by the lack of vibrant
capital markets, because their access to the flow of capital gathered by the investment
institutions is restricted by the shortage of investment instruments. As a result:
Funds are deposited with commercial banks, which often have too much liquidity because
surplus savings have nowhere else to go, and therefore pay low interest rates and are
uncompetitive. Prudential regulation inhibits banks from providing long-term financing.
Investment funds move abroad either legitimately if permitted, or not and so cannot meet
local financing needs. They will not return until there is a reliable supply of domestic
investment opportunities.
Consequently, due to supply-demand imbalance problem in most African countries which
have stock exchanges, volume of trade is generally thin. For example in developed countries
stock market capitalization may account for 100% or more of GDP), African markets (with
the exception of South Africa’s) are much smaller (see Appendix 4).
African countries like Ethiopia which are in the pipeline of establishing capital markets
should critically consider the problem of supply versus demand imbalance. For least
developed sub-Saharan Africa countries like Ethiopia the major priority should be on how to
mobilize domestic resources and then the supply versus demand imbalance after creating the
playing ground (capital markets) to do.
An article “Microfinance in Africa: Combining the Best Practices of Traditional and Modern
Microfinance Approaches towards Poverty Eradication: www.un.org.” described that; the
economic performance of Sub-Saharan Africa (SSA) over the past three decades has been
closely associated with their savings and investments. The article stated that, Africa’s
relatively slow economic growth has been linked to its poor capital accumulation and the
other problem is the patterns of Africa’s saving include its dependence on public savings in
contrast to Asia, where private savings are critical. Promoting private savings in Africa is
45
crucial; evidence from South East Asian countries show that sustaining high economic growth
is contingent upon significant levels of capital accumulation.
4.5 Deposits Mobilized by Ethiopian Financail Institutions

The objective of this chapter and one of the objectives of this study is to show that the
resources mobilized through the existing financial institutions (banks and microfinance
institutions in this case) in the form of deposits would have been much more productive had
there been a capital market in Ethiopia.
In Ethiopia deposits pay 4% on average. The objective in this chapter is thus, to consider the
deposits mobilized by the commercial banks and some nonbank financial institutions of the
country (in this case microfinance institutions- MFIs) and the corresponding estimated
earnings obtained from interest (4%) on these deposits and compare it with the average
returns of publicly held companies (commercial banks in this case- publicly held companies
by the law in Ethiopia) and to show that savers (mainly households) will be beneficiaries had
there been a capital market that could make use of the deposits mobilized either with the
direct participation of the savers (households and others) or through an intermediation of
financial institution like mutual funds and pension funds.
46
Deposits mobilized by the banking sector (demand, savings and time) 10
Table 4: Deposits and Borrowings of Commercial Banks and Specialized Bank ((2006/07)
(In millions of Birr: $1=8.86Birr)
Demand Savings Time

Bank Total
Deposits Deposits Deposits
Commercial Bank of Ethiopia (CBE) 21,323.4 13,147.0 302.0 34,772.4
Development Bank of Ethiopia (DBE) 18.3 3.6 551.9 573.8
Construction & Business Bank (CBB) 182.6 722.3 231.4 1,136.3
Dashen Bank (DB) 1,360.9 2,842.9 656.8 4, 860.6
Bank of Abyssinia (BOA) 510.7 1,898.1 312.2 2,721.0
Wegagen Bank (WB) 1,231.5 802.9 711.2 2,745.6
United Bank (UB) 399.0 854.7 420.2 1,673.9
Nib International Bank (NIB) 423.0 1,084.6 371.4 1,879.0
Awash International Bank (AIB) 603.3 2,223.5 285.8 3,112.6
Cooperative Bank of Oromia (CBO) 166.2 86.1 25.0 277.3
Lion International Bank (LIB) 48.6 53.2 11.1 112.9
Total 26,267.6 23,718.8 3,878.9 53,865.3
Source: Commercial Banks &Staff Computation

www.nbe.gov.et
______________
10
Demand deposits (checking accounts) pay no interest and can be withdrawn upon demand. Savings deposits
pay interest typically below market interest rate (4% in the case of Ethiopia), do not have a specific maturity, and
usually can be withdrawn upon demand. Time deposits, also called certificate of deposits, set a fixed maturity
date and pay either a fixed or floating interest rate. (Source: Fabozzi and Modigliani, 2003).
47
Deposits mobilized by microfinance institutions (MFIs)
Table 5: Micro Finance Institutions Operating in Ethiopia as of (2006/07)

(Amount in Thousands of Birr: $1=8.86Birr)
No. Microfinancing institutions Region Savnings Credit
1 Amhara Credit & Saving Ins. Amhara 447,649.0 874,160.00

2 Dedebit Credit & Saving Ins. Tigray 261,329.60 853,259.60
3 Oromia Credit & Saving S.C Oromia 135,087.80 407,271.30
4 Omo Credit & Saving Ins. SNNP 62,768.80 135,418.50
5 Specialized Finan. & Pro.Ins. A.A 10,691.00 24,602.80
6 Gasha Micro-fin. Ins. A.A 5,128.20 13,448.20
7 Wisdom Micro-financing Ins. A.A 14,374.00 57,194.00
8 Sidama Micro-finance Ins. SNNP 7,096.80 20,781.40
9 Aser Micro-financing Ins. A.A 245.20 311.40
10 Africa Village Financial Service A.A 2,458.00 7,924.40
11 Bussa Gonofaa Micro-fin. Ins. Oromia 3,379.00 18,474.00
12 Peace Micro-finance Ins. A.A 7,091.20 30,024.80
13 Meket Micro-financing Ins. Amhara 507.80 2,165.10
14 Addis Credit & Saving Ins. A.A 51,529.00 166,037.00
15 Meklit Micro-financing Ins. A.A 4,948.00 14,181.90
16 Eshet Micro-financing Ins. Oromia 3,554.50 33,004.60
17 Wasasa Micro-financing Ins. Oromia 6,487.70 29,809.80
18 Benishangul-Gumz MFI Benishangul 7,687.80 25,004.40
19 Shashemene Idir Yelmat Agar MFI Oromia 819.10 2,581.10
20 Metemamen MFI A.A 820.10 4,984.70
21 Dire MFI Dire Dawa 1,457.90 4,295.70
22 Agar MFI A.A 1,720.30 3,807.10
23 Harbu MFI Oromia 1,612.00 3,849.0
24 Ghion MFI Amhara 310.60 348.10
25 Leta MFI Oromia 57.50 464.20
26 Digaf MFI A.A 778.50 583.40
27 Harar MFI 372.20 1,673.90
28 Lefayeda and Saving Institution*
Total 1,039,961.60 2,735,660.40
Source: Micro-finance Institutions

(www.nbe.gov.et )
Note: AA: Addis Ababa; SNNP: Southern Nations Nationalities and Peoples
* Recently established and hence data was not available
48
4.6 Returns of publicly held companies in Ethiopia

In Africa, particularly those in SSA including Ethiopia the banking system is able to mobilize
only a limited financial resource. By expanding the nonbanking system such as microfinance
institutions, some African countries are trying to reach out the rural households. The resources
mobilized by the banking system and the nonbanking system (in this case MFIs) in Ethiopia
are given below. (See Appendix 5, world’s top performing MFIs- www.forbes.com and
Appendix 6 legal frame work of MFIs in Ethiopia).
Table 6: Summary of deposits by commercial banks and MFIs
(Amount in millions of Birr: $1=8.86Birr)
Institution Demand deposits Savings deposits Time deposits Total
Commercial Banks 26,267.6 23,718.8 3,878.9 53,865.3

(Table 4)
MFIs (Table 5) 1,040.6 1,040.6
Total 54,905.9
On average the deposit mobilized by the Ethiopian financial institutions (only the formal
sector) which is about 54,905.9 billion Birr: $1=8.86Birr), could earn 4% interest in the form
of deposits in commercial banks; the minimum rate set by the National Bank of Ethiopia.
Private Banks and Insurance Companies are some of the publicly held companies (share
companies) by the Ethiopian Law. By considering the financial statements of the commercial
banks the average return on equity (ROE) could be computed. However, for some of the
banks data is not available to do so (which is the major problem in most African countries).
The following summary data which was taken from a “comparative study on the profitability
and performance of commercial banks in Ethiopia: Fifth International Conference” –
Ethiopian Economic Association - Addis Ababa, Ethiopia; a study conducted by Dhanuskodi,
Thangavelu, Dr. Venkatachalma, and Dr. Sudalaimuthu could be used serve as a bench mark.
49
Table 7: Return on Shareholders’ Equity (ROE) of Banks in Ethiopia (Percent)
No Average
Banks 2000 2001 2002 2003 2004
(ROE)
1 Commercial Bank of Ethiopia 40.41 1.49 (56.8) 39.6 28.4 10.62
(CBE)
2 Construction and Business Bank 0 (4.73) 0.77 5.45 8.08 1.91
(CBB)
3 Awash International Bank (AIB) 12.41 13.58 6.88 11.3 17.6 12.35
4 Dashen Bank (DB) 14.21 24.26 21.26 20.6 32.7 22.59
5 Bank of Abyssinia (BOA) 9.94 13.33 (1.69) 3.64 19.9 9.02
6 Wegagen Bank (WB) 5.48 10.85 10.09 11.8 24.6 12.55
7 United Bank (UB) 6.99 8.05 4.33 5.72 6.96 6.41
8 Nib International Bank (NIB) 2.15 17.86 12.89 10.4 19.3 12.53
Total 87.98
Average (ROE) 10.99
Source: Computed (Several Annual reports commercial Banks in Ethiopia)

(http://www.eeaecon.org )
Note: Currently there are 11 commercial banks in Ethiopia. In addition there are also around
4 banks under formation. The banking sector is booming unlike insurance companies.
The deposit rate (usually the savings and time deposits) being 4% and on average the return
on equity (ROE) 10.99% could give a hint that savings mobilized and tied up to banks are not
as such productive. In most developed nations the strength of their economy one way or
another is the result of the strength of their financial sectors (banks, life insurance companies,
other insurance companies, pension funds, mutual funds, capital markets). The financial
sector of an economy determines the strength of the other sector of the economy. Thus, the
growth and development of the financial sector one way or another determines the
development and growth of the economy.
Comparing the average deposit rate and the average ROE of the commercial banks we can see
that if resources are mobilized through the formal sector (e.g. banking and nonbanking) and
informal financial institutions and put into productive investments (that could be possible with
an active capital market) instead of tiding up to banks in the form of savings and to
nonproductive non-financial assets, it could play a significant role in strengthening capital
markets (attracting more participants-households, companies etc.). Integration of the banking
and nonbanking financial institutions (MFIs) with capital markets is also vital for the capital
markets to play a significant role towards the growth and development of the real economy of
African countries in this case Ethiopia.
50
CHAPTER 5 CONCLUSIONS
CONCLUSIONS
The strength and performance of the financial sector of a nation is an indicator of the strength
and performance of the overall economy of the nation. Capital markets being the major
components of the financial sector are supposed to play the vast majority of this role by
mobilizing the domestic resources of the nation as well as attracting foreign direct investment
to a nation. For the developed economies of the west and the recently “emerging economies”
in Asia and Latin America the financial sector in general and capital markets in particular
were the engines behind the strength of their respective economies.
African countries particularly those in Sub-Saharan Africa (SSA) including Ethiopia were not
fortunate enough to make use of this engine so as to develop and grew their economies. Their
financial sectors including capital markets (for countries with capital markets) are performing
poorly compared to the developed world.
This study had critically reviewed the relevant literatures (both theory and empirical studies)
to verify whether capital markets are positively correlated with economic growth of a nation.
The study found that, at least in theory there is a positive correlation between capital markets
and economic growth. However, empirical studies conducted so far have varied results.
Some studies (e.g. Levine and Zervos, 1996a; Senbet and Otchere, 2009; Murinde, 1999)
claimed that there is a positive correlation between capital markets and economic growth. On
the other hand some other set of studies (e.g. Singh, 1999; Mohtadi and Agarwal, n.d; Platt,
1999) speculated that there is no positive correlation between capital markets and economic
growth particularly for least developed countries. The latter set of studies particularly, Singh
(1999) warn least developed countries in African mainly those in Sub-Saharan Africa not to
promote capital markets and instead to use their human, material, and institutional resources
to improve their banking systems.
This study affirmed that it’s impossible to speculate on either of the two views based solely
on this study on whether capital markets are positively correlated with economic growth or
not, particularly in the case of least developed countries in Africa. Instead the study has
looked the capital market and economic growth linkage from the perspective of institutions.
To this effect the study had also conducted a qualitative research on institutions; the role they
play in the performance of the overall economy of a nation in general and the financial sector
(capital markets in this case) in particular. The literature reviewed in this study, positively
51
CHAPTER 5 CONCLUSIONS
correlate institutions and economic growth of nations (Fergusson, 2006; North, 1996; Stein,
1995; Yartey, 2007; Mishkin and Eakins, 2006; Rodrik and Subramania, 2003; Rosenberg
and Birdzell, 1986) and concluded that institutions do make cross-country differences among
nations. These studies had tried to link the role of institutions to the financial sector (capital
markets in this case). Fergusson (2006) explained institutions are one of the basics that cause
cross-country differences of long-run economic performance among nations and claimed that
financial markets (capital markets in this case) are the single most important markets where
adequate economic institutions are critical because of the characteristics of financial contracts.
Rosenberg and Birdzell (1986) in their book which coherently summarized the development
of the western economy in the different eras had showed that western economies grew
unprecedentedly because of the institutions they adopt in the different eras of their
development history.
Most of the existing capital markets in Africa are illiquid and market capitalization compared
to other developed capital markets is low. In the developed economies households directly or
indirectly are the major participants in a capital market. However, as the majority of the
households in African countries are dispersed in rural area, the poorly performing banking
sector of most African countries was not able to reach out these rural areas to mobilize
savings. If domestic resources (households’ savings) are efficiently mobilized and a capital
market is in place in least developed African countries, companies could easily access capital
and households will be better-off by putting their resource in the capital market.
The study affirmed that capital markets could lead to the economic growth and prosperity of
least developed countries as well provided that the capital market of an economy is backed
by quality institutions of all sorts and domestic resources (households’ savings) efficiently
mobilized through the formal sector (e.g. banks) and informal financial institutions. Least
developed African countries before embarking on the establishment of a capital market, they
have to build the necessary institutions and make sure that the domestic financial resource
efficiently mobilized. Smaller households’ savings in least developed countries in Africa
including Ethiopia could make big capitals, if efficiently mobilized. The supply (investment
instruments) and demand (investors) in balance should also be maintained in capital markets.
Ethiopia to embark on the establishment of capital markets has to critically consider

institution and build accordingly. “Political commitment” is also very crucial to this effect,
which lacks in most of the circumstances of Ethiopian history.
52
FUTURE RESEARCH
FUTURE RESEARCH
This thesis is conducted based on the review, description and analysis of the literature; both
theory and empirical studies and investigated: (1) the linkage between capital markets and
economic growth, (2) the role of institutions to the performance of capital markets and
whether these institutions exist in Ethiopia, and (3) households’ savings and capital markets
(focused on domestic resource mobilization). This study can serve as an initiating point for
future research in these areas.
The following areas worth further research: in the African continent, in the region (SSA) as
well as in a specific country.
 The study conducted by Zervos and Levine (1996a) to attest whether there is a
positive correlation between capital markets and economic growth, which adopted a
cross-country regression analysis, could be used to further empirically enrich the
capital market economic growth linkage for African countries by polling data’s of the
African countries, particularly those in SSA with capital markets.
 The poor economic performance of African countries could be attributed to a number

of factors. However, institutional economists claim that the failure to setup quality
institutions of all sorts and political commitment of African governments may override
all the other possible economic growth factors. Thus, institutions in Africa in general
(what?), institutional setups in African countries (how?) and the political commitment
of the African governments to that effect could be the areas that need thorough
research and analysis in the African continent; regionally as well as in the respective
African countries.
53
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59
APPENDIX
APPENDIX 1
This is a list of the countries that are considered to be under the designation of Sub-Saharan
Africa (SSA): Map and List
SSA Countries
Source: Canada International Development Agency (CIDA)
http://www.acdi-cida.gc.ca/CIDAWEB/acdicida.nsf/En/NIC-5595719-JDD
Sub-Saharan Africa (SSA) countries
Angola Gabon Niger

Benin Gambia Nigeria
Botswana Ghana Rwanda
Burkina Faso Guinea Sao Tome and Principe
Burundi Guinea-Bissau Senegal
Cameroon Ivory Coast (Cote d'Ivoire) Seychelles
Cape Verde Kenya Sierra Leone
Central African Republic Lesotho Somalia
Chad Liberia South Africa
Comoros Madagascar Swaziland
Congo, Republic of Malawi Tanzania
Congo, Democratic Republic of The Mali Togo
Djibouti Mauritania Uganda
Equatorial Guinea Mauritius Zambia
Eritrea Mozambique Zimbabwe
Ethiopia Namibia
60
APPENDIX
APPENDIX 2
List of Least Developed Countries (LDCs)
Africa (34 countries) Asia (10 countries)
Angola Madagascar Afghanistan
Benin Malawi Bangladesh
Burkina Faso Mali Bhutan
Burundi Mauritania Cambodia
Cape Verde Mozambique East Timor
Central Africa Republic Niger Lao People’s Democratic
Chad Rwanda Republic
Comoros Sao Tome and Principe Maldives
Democratic Republic of the Senegal Myanmar
Congo Sierra Leone Nepal
Djibouti Somalia Yemen
Equatorial Guinea Sudan Pacific (5 countries)
Eritrea Tanzania Kiribati
Ethiopia Togo Samoa
Gambia Uganda Solomon Islands
Guinea Zambia Tuvalu
Guinea-Bissau Caribbean (1 country) Vanuatu
Lesotho Haiti
Liberia
Source: Economic and Social Council of the United Nations.

http://www.un.org/special-rep/ohrlls/ldc/list.htm
61
APPENDIX
APPENDIX 3
Financial Indicators (Ethiopian banking sector)
Banks are the biggest source of formal finance in developing countries, according to
Financing Growth. Size, efficiency, and stability are the three key attributes or indicators of
any banking sector.
Banking Sector Indicators
2001 2002 2003 2004 2005
Banking Sector - Size Index 4.210 --- --- --- 3.637
Central bank assets to GDP 25.502 --- --- --- 27.129
Deposit money banks assets to GDP 37.397 --- --- --- 28.697
M2 to GDP 47.049 --- --- --- 46.222
Private credit to GDP 28.942 --- --- --- 21.884
Private credit to total domestic credit 0.482 0.454 0.430 0.418 0.461
Private credit to total funding 65.376 55.232 51.798 51.704 61.541
Financial system deposits to GDP 38.164 --- --- --- 37.217
Banking Sector - Stability Index --- --- --- --- ---
Market to book value of equity ratio,

--- --- --- --- ---
median (corporate sector)
Capital adequacy ratio --- --- --- --- ---
Debt to book value of equity ratio,

--- --- --- --- ---
median (corporate sector)
Interest coverage ratio, median

--- --- --- --- ---
(corporate sector)
62
APPENDIX
Liquid assets to total deposits and

29.297 30.204 31.196 37.873 ---
short-term borrowing
Liquid assets to total assets 23.629 25.059 25.173 29.688 ---
Market to book value of equity ratio,

--- --- --- --- ---
mean (banks)
Non-performing loans ratio --- --- --- --- ---
Real credit growth (adjusted) (%) --- 1.134 0.904 --- 1.143
Total return index volatility --- --- --- --- ---
Banking Sector - Efficiency Index 4.293 4.386 4.209 5.938 4.439
Three-bank concentration ratio (assets) 0.933 0.888 0.913 --- 0.892
Three-bank concentration ratio

0.939 0.904 0.916 --- 0.889
(deposits)
Lending-Deposit rates spread 4.590 4.690 3.530 3.500 3.418
Net interest margin 0.028 0.012 0.019 0.018 0.016
Operating costs to total assets 0.006 0.007 0.006 0.006 0.006
Return on Assets (adjusted i.e returns

on assets adjusted for cross country -0.023 -0.600 -0.438 -0.527 -0.300
risk)
Return on Assets (median) 1.740 0.635 1.170 1.820 2.845
Source: World Bank. Retrieved May 14, 2008, from:

http://www.financial-indicators.org/sector_banking.php?country=ETH
63
APPENDIX
APPENDIX 4
Stock Exchanges in Africa: Market Capitalization as % of GDP
Listed Firms Market Capitalization as % of GDP Turnover
Botswana 18 29.4 2.2
Cote d’Ivoire 38 13.6 2.5
Ghana 29 30.7 3.2
Kenya 47 24.9 8.0
Malawi 8 5.1 2.6
Mauritius 41 39.3 4.4
Mozambique 1 3.0 0
Namibia 13 8.1 4.7
Nigeria 207 20.1 13.9
South Africa 403 214.1 45.0
Swaziland 6 9.3 0.02
Tanzania 6 6.2 2.5
Uganda 5 1.4 0.2
Zambia 11 8.0 1.1
Zimbabwe 79 87.9 3.9
Source: FDSL (Giles, November 2006)

http://www.microfinanceclubuk.org/pdfs/6th%20Feb%202007%20Mark%20StGiles%20Article.pdf
64
APPENDIX
APPENDIX 5
The 50 Top Microfinance Institutions
RANK NAME COUNTRY SCALE EFFICIENCY RISK RETURNS
1 ASA Bangladesh 14 83 56 40
2 Bandhan (Society and NBFC) India 108 49 42 1
3 Banco do Nordeste Brazil 46 27 213 25
4 Fundación Mundial de la Mujer Colombia 58 72 193 1

Bucaramanga
5 FONDEP Micro-Crédit Morocco 119 26 196 1
6 Amhara Credit and Savings Ethiopia 56 126 118 42

Institution
7 Banco Compartamos, S.A., Mexico 15 24 295 11

Institución de Banca Múltiple
8 Association Al Amana for the Morocco 17 212 133 1

Promotion of Micro-Enterprises
Morocco
9 Fundación Mundo Mujer Popayán Colombia 53 181 141 1
10 Fundación WWB Colombia - Cali Colombia 27 206 155 4
11 Consumer Credit Union Russia 82 300 19 1

'Economic Partnership'
12 Fondation Banque Populaire pour Morocco 59 126 219 1

le Micro-Credit
13 Microcredit Foundation of India India 75 142 7 185
14 EKI Bosnia and 66 102 242 1

Herzegovina
15 Saadhana Microfin Society India 263 79 73 1
16 Jagorani Chakra Foundation Bangladesh 136 176 128 1
65
APPENDIX
17 Grameen Bank Bangladesh 8 280 100 62
18 Partner Bosnia and 64 169 230 1

Herzegovina
19 Grameen Koota India 209 106 156 1
20 Caja Municipal de Ahorro y Peru 48 99 222 119

Crédito de Cusco
21 Bangladesh Rural Advancement Bangladesh 10 159 126 205

Committee
22 AgroInvest Serbia 84 195 222 1
23 Caja Municipal de Ahorro y Peru 20 163 220 101

Crédito de Trujillo
23 Sharada's Women's Association India 229 207 55 13

for Weaker Section
24 MIKROFIN Banja Luka Bosnia and 60 240 205 1

Herzegovina
25 Khan Bank (Agricultural Bank of Mongolia 19 149 280 59

Mongolia LLP)
26 INECO Bank Armenia 96 173 202 39
27 Fondation Zakoura Morocco 51 268 194 1
28 Dakahlya Businessmen's Egypt 200 215 102 1

Association for Community
Development
29 Asmitha Microfin Ltd. India 80 254 73 111
30 Credi Fe Desarrollo Ecuador 28 252 206 34

Microempresarial S.A.
31 Dedebit Credit and Savings Ethiopia 50 246 80 154

Institution
Source: (Matthew Swibel, 2007). www.forbes.com
66
APPENDIX
“Forbes' first-ever list of the World's Top 50 (31 of them are listed here) Microfinance
Institutions chosen from a field of 641 micro-credit providers. This table gives the rank (out
of 641) for the top institutions according to scale, which is based on the size of their gross
loan portfolio; efficiency, which considers operating expense and the cost per borrower as a
percent of the gross national income per capita of their country of operation; risk, which looks
at the quality of their loan portfolios, measured as the percent of the portfolio at risk greater
than 30 days; and return, which is measured as a combination of return on equity and return
on assets. Each category is equally weighted for an institution's overall ranking.”
67
APPENDIX
APPENDIX 6
Legal Framework of Micro-Finance Institutions
The Federal Democratic Republic Government of Ethiopia has issued a proclamation No.
40/1996 for the Licensing and Supervision of the Business of Micro financing Institutions.
According to the proclamation, the purpose and duty of Microfinancing Institutions are:
1) Granting credit, in cash or in kind, the maximum amount shall be determined by the
National Bank.
2) Subject to conditions set under this proclamation, a micro financing institution may carry
out some or all of the following activities:
Accepting savings as well as demand and time deposits;
Drawing and accepting drafts payable within Ethiopia;
Borrowing money for its activities purposes against the security of its assets or
otherwise;
Purchasing such income generating financial instruments as treasury skills,
Acquiring, maintaining and transferring of any movable and immovable property
including premises for carrying out its business
Providing counseling services to its members;
Encouraging income-generating activities/projects for urban and rural micro
operators;
Rendering managerial, marketing techniques and instructive advice to borrowers
and assisting them advices in those fields;
Managing funds for microfinancing businesses, and engaging in other activities customarily
undertaken by microfinancing institutions.
Source: Ethiopian Business Development Services Networks (June, 2008)
http://www.bds-ethiopia.net/finance/microfinance-rules.html
68

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School of Management

Blekinge Institute of Technology

Establishment of Capital Markets in Least

Supervisor: Stefan Hellmer

CHAPTER 1 INTRODUCTION ........................................................................................... 1

1.1 Background .................................................................................................................. 1

1.2 Problem Discussion ..................................................................................................... 2

1.3 Problem Statement ....................................................................................................... 3

1.4 Statement of Purpose ................................................................................................... 4

1.5 Delimitations ............................................................................................................... 4

1.6 Scope ........................................................................................................................... 4

1.7 Definition of key Terms .............................................................................................. 5

1.8 Research Method ......................................................................................................... 8

1.9 Organization of the Thesis ........................................................................................... 9

CHAPTER 2 CAPITAL MARKETS AND ECONOMIC GROWTH ............................. 11

2.1 Financial Markets: Overview .................................................................................... 11

2.2 Primary Markets versus Secondary Markets ............................................................. 12

2.2.1 Primary Markets ................................................................................................. 12

2.2.2 Secondary Markets ............................................................................................. 12

2.3 Money Markets versus Capital Markets .................................................................... 14

2.3.1 Money Markets .................................................................................................. 14

2.3.2 Capital Markets .................................................................................................. 14

2.4 Secondary Capital Markets ........................................................................................ 14

2.5 Capital Markets in Africa .......................................................................................... 16

2.6 Capital Markets and Economic Growth Linkage: Empirical Evidence..................... 17

2.7 The Financial Sector in Ethiopia: Recent Developments .......................................... 22

CHAPTER 3 CAPITAL MARKETS AND INSTITUTIONS ........................................... 26

3.2 What are Institutions? ................................................................................................ 26

3.3 Institutions, Capital markets and Economic Growth ................................................. 27

3.5 Capital Markets and Financial Institutions in Africa................................................. 33

3.6 Determinants of Stock Market Development in Africa ............................................. 34

3.7 Institutions in Ethiopia: some Indices ....................................................................... 35

CHAPTER 4 HOUSEHOLDS’ SAVINGS AND CAPITAL MARKETS ....................... 40

4.2 Resource Mobilized by Banks and Microfinance Institutions (MFIs) in Ethiopia.... 41

4.3 Households and Capital Markets ............................................................................... 41

4.4 The Supply and Demand Aspects of Capital Markets ............................................... 44

4.5 Deposits Mobilized by Ethiopian Financail Institutions ........................................... 46

4.6 Returns of publicly held companies in Ethiopia ........................................................ 49

CHAPTER 5 CONCLUSIONS ............................................................................................ 51

FUTURE RESEARCH .......................................................................................................... 53

REFERENCES LIST ............................................................................................................. 54

1.2 Problem Discussion

1.3 Problem Statement

 Whether capital market establishment is an alternative towards the economic growth

1.4 Statement of Purpose

1.7 Definitions of key Terms

Financial institution: “A company whose primary function is to intermediate between

Financial market: The Reserve Bank of Australia (www.rba.gov.au/Glossary/text_only.asp),

 Capital markets: “a market where debt or equity securities are traded”

Stock markets: “a general term for organized trading of stocks through

Bond markets: “a market consisting of bond issuers, underwriters, buyers, and

 Commodity markets/Commodities exchanges: “Open and organized marketplace where

 Foreign exchange markets, which facilitate the trading of foreign exchange.

Institutions: in this proposed study institutions could be defined as follows:

”Establishment, foundation, or organization created to pursue a particular type of

“Consistent and organized pattern of behavior or activities (established by law or custom)

a low-income criterion, based on a three-year average estimate of the gross national

1.8 Research Method

1.9 Organization of the Thesis