U.S.

AGENCY FOR INTERNATIONAL DEVELOPMENT

USAID Program and Operations Assessment Report No. 26

Center for Development Information and Evaluation

November 2000

Efficient
Capital
Markets
A Key to Development

PN–ACG–620
 This report and others in the evaluation publication series
of the Center for Development Information and Evaluation
(CDIE) can be ordered from:

USAID Development Experience Clearinghouse (DEC)

1611 N. Kent Street, Suite 200
Arlington, VA 22209–2111
Telephone: (703) 351–4006
Fax: (703) 351–4029
E-mail: [email protected]
To access CDIE documents from the Internet, key in
www.usaid.gov. Click on Publications/Partner
Resources, then on USAID Evaluation Publications.

The CDIE Evaluation Publications Catalog and notices of

recent publications are also available from the DEC.

U.S. AGENCY FOR INTERNATIONAL DEVELOPMENT

The views and interpretations expressed in this report are those of the author
and not necessarily those of the U.S. Agency for International Development.
 USAID Program and Operations
Assessment Report No. 26

Efficient Capital Markets

A Key to Development

By

James W. Fox
Center for Development Information and Evaluation
U.S. Agency for International Development
By Washington

James W. Fox November 2000

Center for Development Information and Evaluation
 Contents

Summary ................................................... v 3. Program Performance

And Outcomes ...................................... 15
1. Capital Markets Program Outcomes ............................ 15
And Economic Development ............ 1 Rationale for USAID Assistance ......... 17
A Tale of Two Performance Monitoring ...................... 19
(Or Three) Cities ............................... 1 Capital Markets And Poverty ............. 20
The Role of the Financial The Case of India ................................. 21
Sector in Development ..................... 3
The Asian Financial Crisis ................... 4 4. Lessons Learned .................................. 25
Financial Markets
And Capital Flows ........................... 5 Bibliography
Financial Markets
And USAID’s Mandate .................... 6
Earlier Financial Market
Evaluation Findings .......................... 7
Drawing Conclusions ........................... 9

2. USAID Capital Market

Development Activities in the
Case Study Countries ......................... 11
USAID Projects Studied ...................... 11
 Summary

T HIS STUDY EXAMINES USAID activities The conclusions are based on field-
to promote creation or strengthening work led by teams from USAID’s Center for
of capital markets in developing countries. Development Information and Evaluation.
There are two basic conclusions. They reviewed recent USAID-funded capi-
tal markets projects in India, Kenya, Mo-
First, USAID has been successful in rocco, the Philippines, and Romania. A
promoting capital market development. CDIE researcher also studied an earlier
The general approach promoted by USAID capital market development effort:
USAID—emphasizing the strengthening of creation of investment banks in Central
the government regulatory institutions— America in the 1960s.
is sound, and USAID has been able to con-
tract capable expertise to carry out such Specific lessons learned from the
projects. study include the following:

Second, an efficient capital market 1. Effective capital market develop-

is an important ingredient of a successful ment should not be left to the private sec-
development strategy. Though the effects tor. Government oversight is needed to
of strengthening of capital markets on prevent market intermediaries from main-
poorer strata of society are indirect and taining monopolistic arrangements that
long term, they also have important con- lead to high transactions costs, to an at-
sequences in generating increased invest- mosphere permissive of self-dealing and
ment and creating more productive rigged transactions, and to insufficient
employment. Moreover, the failure to pro- flow of information to potential investors.
vide strong oversight of capital markets,
evident in the Asian financial crisis of 2. Donor support should aim pri-
1997–98, also can have severe adverse con- marily at strengthening this governmen-
sequences for poor people. tal regulatory framework. Payoffs to such
support are likely to be much higher than growing economies where existing capi-
direct support of individual enterprises or tal structures are limiting investment, and
investment houses. where firms are actively interested in ad-
ditional financing.
3. Capital markets projects are un-
likely to stimulate economic growth where 4. In the longer term, creation of long-
economic conditions are unfavorable. In- term debt markets is essential to reduce
flation, large government budget deficits, the risk of financial crises, such as the re-
and uncertainty about the path of future cent Asian experience. That will require
government policies all deter investment. improvements in government policy to
Capital market reforms will not produce eliminate inflationary expectations and
growth in a stagnant economy. Rather, reduce crowding out by government.
such projects are best suited to rapidly

vi Efficient Capital Markets: A Key to Development

 Capital Markets
And Economic
1 Development
A Tale of Two (12–16 miles) from the center of the city.
It is on leaving the airport for the city cen-
(Or Three) Cities ter that the dramatic differences appear.

S EVERAL DAYS A WEEK, one can travel

to Washington from Bombay with a
stopover in Amsterdam. Amsterdam and
From Amsterdam’s airport, one can
take a commuter train and be at the cen-
ter of the city in 20 minutes. The ride is
Bombay have much in common. They are quiet and comfortable. It passes through
both collections of islands that human ef- a mix of residential and industrial areas.
fort, through landfills and swamp drain- Most of the residences are low-rise apart-
age, converted into cities. Each is its ment buildings, but with an abundance
country’s leading port, and a bustling of well-maintained green space and
commercial center. They are both located parkland. Some factories can be seen in
in countries that are among the most the distance, but the more common work-
densely populated in the world. At 986 places are high-rise buildings where
persons per square mile, population den- armies of white-collar workers directly
sity in the Netherlands is about 50 per- produce nothing tangible. Like office
cent higher than in India. The scale is dif- workers elsewhere, they talk on the tele-
ferent, though. India is a vast country, phone, go to meetings, and write words
while the population of the entire Neth- on paper. The result of these efforts is suf-
erlands is about the same as the city of ficient for the average Dutch worker to
Bombay alone. earn about $50,000 a year. On arrival at
the center of the city, one can stroll along
The two airports do not differ dra- the streets with the same feeling of quiet-
matically from each other. Each has the ness, of clean, well-maintained buildings
size, bustle, metal detectors, and jetways and streets, of a general pleasantness and
common to today’s international traveler. “uncrowdedness.”
The latest technology in aircraft is avail-
able to move people from one airport to The contrast on leaving the Bombay
the other. Both are about the same distance airport is stark. The taxi ride to downtown
takes an hour unless traffic is bad. (A new swampland. Until the 1860s, Singapore
traveler might try to take a train, but mas- was a fishing village. Even as recently as
sive overcrowding would dissuade most India’s independence in 1947, the differ-
from doing this a second time.) Most of ences in standards of living between
the trip is through areas that scream ex- Singapore and Bombay were not stark.
treme poverty. The basic vision that as- Singapore had much of the overcrowding,
saults the senses is of massive overcrowd- slums, poor water, sewerage and munici-
ing, of taxation of the infrastructure to the pal services characteristic of Bombay to-
breaking point. Too many cars, too many day. Yet in a generation, it has made strides
people, too much pollution, and too much that make it comparable to Amsterdam in
poverty. Some sights strain the imagina- municipal amenities. It has a higher per
tion, as seeing women dressed in immacu- capita income than the Netherlands and a
late saris emerging from labyrinths of hov- longer life expectancy. How did such a
els on tidal mud flats. The bustle of the rapid transformation occur? Why has
individuals on their way to work is no less Singapore been able to make it, and why
than one sees in Amsterdam. The first im- has Bombay not done so?
pression is that people work as hard in
Bombay as in Amsterdam. Yet the aver- Issues of the amount of capital that
age Bombay worker earns about $1,000 per the society invests and—more important—
year. (That is about 50 percent more than the efficiency of the capital investment
the average for India as a whole.) What process seem to lie at the heart of the an-
explains the difference in the physical in- swer to this question. The capital market
frastructure that faces workers in these two is the medium through which investment
cities, and the difference in productivity is allocated among alternative uses in a
of the workers? market economy. In such an economy, the
capital market is the investment planning
Until recently, any comparison of this office. It decides how many resources will
sort between Amsterdam and Bombay be available for investment by firms
would have seemed unreasonable. After throughout the economy; how much, and
all, the Netherlands was probably the most at what cost, will be available for infra-
advanced country in the world three cen- structure investment; which companies
turies ago. The state of its infrastructure will be able to expand and which will not.
reflects accretion over long periods of time. In India, the government, through central
This is true, but the experience of some planning, sought to play this role for de-
other Asian countries suggests that centu- cades. The USAID capital markets devel-
ries may not be needed to make the trans- opment project sought to assist in the
formation. One may also fly easily from transfer of this function from the govern-
Bombay to Singapore, another island city ment to the marketplace.
where much has been reclaimed from

2 Efficient Capital Markets: A Key to Development

The Role of the Financial man-made structures. Vast differences in
nonmaterial aspects of the two types of
Sector in Development societies—notably in the knowledge base
of the workers, and in the institutions of
The area of money, banking, and fi- the society—are also an important part of
nance has long fascinated economists and the reason rich countries are more produc-
nonexperts alike. There is an old adage, tive.
“not one man in ten thousand understands
the monetary question—and you meet him In developed market economies, fi-
every day.” The adage captures both the nancial markets play the pivotal role in in-
esoteric nature of finance and the continual termediating between the society’s savers
production of theories or ideas about how and its investors. They are the vehicle for
new approaches to finance will yield great moving savings into investments in pro-
results. ductive activities, both long term and short
term. In low-income countries, banks tend
Experts have long agreed that finan- to dominate financial markets, with the
cial resources are a key factor in economic market for long-term capital generally un-
development. The large differences in av- developed.
erage income levels among countries re-
late much less to differences in the natural An efficient financial market will
resource base, including quality of land, stimulate economic growth by encourag-
than to differences in the man-made re- ing savings and by channeling it into the
source base. This stock of man-made capi- most productive investments. In earlier
tal includes machinery, equipment, and times, economists were frequently more
buildings used for productive activities, concerned about the quantity of invest-
but also economic infrastructure, includ- ment than the quality. Development expe-
ing roads, electric power grids, and com- rience since the 1970s, however, has dem-
munications systems. In countries where onstrated that quality is critical. Countries
the supply of financial resources has made such as India and the members of the So-
these capital items abundant, they allow viet bloc have allocated high shares of their
the society’s workers to be highly produc- gross national product to investment, yet
tive, and therefore allow high levels of in- produced only modest results in economic
come. growth. Investment has flowed to the
wrong sectors, or used the wrong tech-
The differences between rich and poor nologies, or was used for unproductive
countries are evident in the structure of activities.
capital stock. In poor countries, land rep-
resents most of the capital stock. In rich The role of the financial sector in eco-
countries, land’s relative value is dramati- nomic development has been a subject of
cally smaller, and most capital consists of some controversy. Some economists have

Capital Markets and Economic Development 3

maintained that it is the “real” sectors (i.e., been receiving massive amounts of foreign
those producing goods and nonfinancial capital, mostly in the form of (short-term)
services) that are the critical determinants bank loans. Except in Indonesia, where
of economic development, and that the fi- foreign banks lent directly to enterprises,
nancial sector grows and evolves in re- most of the foreign lending was made to
sponse to conditions in those sectors. More local banks. The banks re-lent in local cur-
commonly, though, economists have come rency, assuming the foreign-exchange risk.
to the view that the state of the financial The devaluation thus immediately threat-
sector affects the possibilities in the rest of ened their financial position.
the economy, particularly with respect to
the quality and quantity of investment. As Faced with the prospect of future fi-
Levine (1997, 689) concludes in his survey nancial problems for their clients, foreign
of financial markets and development: banks refused to roll over loans. There
ensued a scramble to withdraw capital
A growing body of work would push even from these countries before conditions
most skeptics toward the belief that the
development of financial markets and
worsened. This exacerbated the original
institutions is a critical and inextricable problem. Exchange rates fell sharply after
part of the growth process and away central banks ran out of reserves. Banks
from the view that the financial system and firms with large exposure of foreign
is an inconsequential sideshow, re- debt might have become bankrupt over-
sponding passively to economic growth
and industrialization. There is even evi-
night because of their losses. If not, they
dence that the level of financial devel- were potentially bankrupt over the longer
opment is a good predictor of future term because the loss of operating capital
rates of economic growth, capital accu- as banks called in loans threatened their
mulation, and technological change. capacity to continue to operate.
Moreover, cross-country, case study,
industry- and firm-level analyses docu-
ment extensive periods when financial The financial crisis was severe in all
development—or the lack thereof—cru- four countries. In Indonesia, worsened by
cially affects the speed and pattern of an emerging succession crisis, it was cata-
economic development. strophic. In all four countries, the cascad-
ing bankruptcies led to severe recessions,
The Asian Financial Crisis mass unemployment and dramatic falls in
overall production. In 1998, gross domes-
The Levine survey was written tic product fell by 14 percent in Indonesia,
shortly before the July 1997 devaluation 9 percent in Thailand, 7 percent in Malay-
of the Thai baht, which set off a financial sia, and 6 percent in South Korea.
panic throughout much of Asia. South
Korea, Indonesia, and Malaysia were, Fortunately, the Asian financial crisis
along with Thailand, the most severely af- did not prove to be long lived. All the
fected countries. All four countries had countries began their recovery by late 1998.

4 Efficient Capital Markets: A Key to Development

Korea recovered fastest, growing by 6.5 Although the withdrawal of foreign
percent in 1999, and only Indonesia was investors from emerging markets during
expected not to have recovered to the the Asian financial crisis was substantial,
precrisis level of production by the end of that in no way changes the fundamental
2000. factors that led to sizable foreign interest
in these markets before the crisis. There
The causes of the Asian financial cri- are two reasons in particular.
sis are still being debated, and its conse-
quences are still being analyzed. The cri- First, the rate of return on investment
sis did underscore the vulnerability of in developing countries that follow good
financial markets in many developing policies is likely to be higher than in other
countries to loss of confidence by foreign parts of the world. As Sachs and Warner,
investors. Two conclusions have been most among others, have shown, these countries
widely accepted as lessons from the cri- are likely to be the fastest growing econo-
sis. First, prudential supervision of banks mies in the world, eventually catching up
in countries going through financial liber- with (or “converging”) with the industrial
alization is critical. Supervision of com- countries. This rapid growth is sure to be
mercial banks needs to be strong to ensure accompanied by high rates of return on
that weakness in one or a few institutions investment—higher than those available
does not bring down the entire system. in developed countries. This will create the
Second, developing countries that have incentive for substantial flows of invest-
heavy foreign capital inflows should en- ment from the capital-rich industrial coun-
sure that such flows are diversified, with tries. Some of the capital inflow to these
substantial shares in the form of long-term countries can come through direct foreign
capital and equity investment, rather than investment, but some should come
in short-term lending that can reverse it- through portfolio investment in both eq-
self quickly. uities and debt. Countries will need effi-
cient capital markets if they are to provide
a channel for such inflows.
Financial Markets
And Capital Flows Second, international portfolio diver-
sification is a useful means for reducing
While efficient financial markets are risk. Even investment in relatively risky
important for efficiently allocating a foreign assets can simultaneously lower
country’s financial resources, they can play the risk to an investment portfolio and
a second role that is particularly impor- raise its expected rate of return. (Diversi-
tant for developing countries—that of pro- fication of investments reduces overall
viding a means for attracting capital from risk.) Portfolios of pension funds, insur-
abroad. ance companies, and other institutional

Capital Markets and Economic Development 5

investors began to diversify internation- the welfare of poor people and develop-
ally during the past decade. There is po- ment of capital markets. The most obvi-
tential for those flows to become massive ous one is through the creation of produc-
during the next decade if the supply of tive employment. As discussed earlier,
investment assets in developing countries workers in higher income countries are
increases sufficiently. Again, development paid high wages because they are very
of efficient capital markets is the critical productive, and they are productive in part
factor. because they use large amounts of capital
in the form of specialized equipment. This
dimension was explored by Buttari and
Financial Markets Manarolla of USAID’s Global Bureau in
And USAID’s Mandate 1997. They showed that increased finan-
cial flows through the Jakarta stock ex-
Even if financial markets are impor- change led to a substantial increase in in-
tant to development, there still remains the dustrial employment in Indonesia.
question whether it is an appropriate area
of activity for USAID. Many aspects of fi- The second linkage between poor
nance would not appear to be a priority people and financial markets is as consum-
for the Agency, given its interest in pov- ers of products and services. Capital in-
erty reduction. Perhaps financial markets vestment makes production more efficient
are important, but it is not immediately and therefore cheaper; it may also provide
obvious why this quintessential market- access to goods and services that would
based area should not be left entirely to not otherwise be available. This is most
the private sector. Thus, the argument that obvious in basic services such as water and
the poor will be helped if the wealthy are electricity, where long-term finance is es-
helped has been derided as “trickle-down sential to rapid expansion of coverage in
economics.” Nevertheless, some aspects of developing countries. Some academic re-
financial markets activities are directly search has suggested a third linkage, re-
relevant to alleviating poverty. First, there lating development of capital markets to
is the obvious connection that developed democratization and good governance.
financial markets are associated with low
levels of poverty. Countries with large That linkage is as follows: Regardless
numbers of poor people have undevel- of the desirability of working generally in
oped financial markets, whereas countries financial markets, there are specific aspects
with little poverty have well-developed fi- of such markets that seem to be of particu-
nancial markets. lar importance to poor people. Such niches,
where USAID has long worked, include
At a less sweeping, more concrete small-farmer agricultural credit, financing
level, two obvious linkages exist between for small and medium-size enterprises,

6 Efficient Capital Markets: A Key to Development

and—for the last decade or so—micro- cial systems and institutions also allows
finance. increased insights that allow donors to
design better financial sector projects. Such
Finally, drawing on the experience of work can help adjudicate between alter-
the Asian financial crisis, one could argue native ideas about human behavior that
that developing sound financial markets are equally plausible in theory but quite
is of considerable importance to poor different in the results they produce in
people. Expansion of financial markets practical experiments.
may not help poor people in any large or
tangible way, at least in the short term, but In sum, the quality of USAID projects,
financial market collapse certainly hurts and USAID’S ability to draw proper lessons
poor people immediately and substan- from experience, depends not only on
tially. A 10 percent drop in real income is a evaluation of past projects but also on
major inconvenience for people in any eco- keeping current with theoretical develop-
nomic class; for the poorest, it can be cata- ments in economic thinking and on stay-
strophic. ing abreast of research conducted on re-
lated issues. All three aspects of learning
Earlier Financial Market have been evident in USAID’s changing ap-
Evaluation Findings proach to financial sector development
over the past several decades.
The ideas of donors (who have money
to spend) and academic thinkers (who One of the earliest cases of attempt-
have ideas but little money) about how the ing to draw general lessons from USAID ac-
financial sector can be used to promote tivities in financial markets was in 1972,
development have changed over time. when the Agency conducted a review of
Evaluation findings from previous donor its programs for credit to small farmers.
projects provide one source of information Small-farmer credit programs, usually
about what works and what doesn’t, and providing low-interest-rate loans, had
so provide one important component of been a common feature of USAID programs
changes in approach. Nevertheless, two during the 1960s. The common belief at
other sources of ideas or information are the time was that low interest rates were
also important. necessary because small farmers could not
“afford” to pay market rates of interest.
First, theoretical developments in eco-
nomics can provide new insights that lead The review uncovered two serious
to reshaping the ideas about how finan- problems with preferential interest rates.
cial systems affect the rest of the economy First, lending institutions following this
and impact on people’s lives. Second, em- approach were unsustainable because
pirical research into the operation of finan- their interest collections could not cover

Capital Markets and Economic Development 7

their costs. Consequently, they gradually As part of an effort to disseminate this
became decapitalized and unable to pro- understanding and to relate it to another
vide continuing support for the financial area of finance, USAID in 1990 prepared a
needs of small farmers. Second, the sub- paper for dissemination to other donor
sidy attracted more potential borrowers members of the Development Assistance
than available funding could attend. The Committee of the Organization for Eco-
usual response of bankers to this excess nomic Cooperation and Development.
demand for loans was to find some way That paper, Development Finance Institu-
to ration the available funds. Depending tions: A Discussion of Donor Experience,
upon circumstances, rationing devices in- looked at the experience of USAID and
cluded choosing those who had the best other donors in establishing investment
collateral, or who were the most politically banks. Those banks, or development fi-
well connected, or those willing to pay the
nance institutions ( DFIs), had been seen as
largest bribe to banking officials.
a means of increasing productive invest-
ment in productive business enterprises by
These findings led to further research
providing long-term finance. Since com-
to substantiate the results and to develop
mercial banks specialized in short-term
new approaches to small-farmer credit.
credit, it was thought that long-term in-
Much of the work was carried out by Ohio
vestment consequently was under-
State University under contract to USAID.
financed. Consequently, donors, including
The Ohio State work led to development
USAID, promoted creation of new, usually
of a new approach to small-farmer lend-
government-owned institutions intended
ing, emphasizing 1) positive real interest
to use donor funding and domestic sav-
rates, 2) emphasis on sound financial in-
ings resources to lend for “developmen-
stitutions, 3) attention to the nonfinancial
tally oriented” investment.
costs of borrowing, and 4) attention to re-
source mobilization.
As the OECD paper makes clear, do-
USAID adjusted its approach to small- nor experience with this modality was
farmer lending, and more broadly its ac- generally unsatisfactory. Most develop-
tivity in the financial sector, to reflect these ment finance institutions failed to play the
lessons. Agency policy prohibited lending developmental role envisioned for them,
at negative real interest rates and encour- and few DFIs even became financially sus-
aged development of sound financial in- tainable. Several factors were at work.
stitutions. These lessons were gradually First, repayment experience was often un-
introduced into USAID programs, though satisfactory, as projects financed by DFIs
other donors were much slower in apply- frequently failed. Second, interest rates
ing them. charged by DFIs often were not inflation

8 Efficient Capital Markets: A Key to Development

adjusted: when inflation rates rose, the Finally, CDIE recently studied a par-
institution quickly began to decapitalize. ticular mechanism for promoting private
Third, many DFIs concentrated more on sector development: the enterprise fund.
channeling donor resources than on mo- Enterprise funds are medium-term invest-
bilizing savings on their own. As donors ment companies established in transition
became disenchanted with them, DFIs had economies to invest U.S. government grant
no resources to lend. funds into private companies, with the
expectation that such investments will pro-
A study by USAID’s Center for Devel- duce both a set of strong private enter-
prises and a strengthened equities market
opment Information and Evaluation (CDIE)
in the countries where these firms oper-
of one narrow segment of the financial
ate. Several of the funds have had serious
market—that for venture capital, equity
problems. It is still too early to judge the
investment in emerging companies—con-
final outcome of the enterprise fund ex-
cluded that investment in this sector was
periment, but the results so far suggest that
a mirage for donors. It appeared to be a
both the profitability of the investments
promising means for speeding the devel-
and the ability of the funds to find suit-
opment process by encouraging the
able investments are dependent on the
growth of dynamic new companies. In
overall economic policy regime and insti-
practice, past USAID projects in this area tutional environment in the country where
(and donor activity more generally) have the investments are being made. If those
yielded only inconsequential results. conditions are not favorable, an enterprise
fund will face great difficulties.
The study attributes the failure of
USAID projects to two main tendencies.
Drawing Conclusions
First, the Agency asks implementers to
produce results in too many dimensions
A careful reading of the three previ-
(e.g., asking venture capitalists to look for
ous sections of this chapter will indicate
promising companies in the agricultural
the tentative nature of much of our knowl-
sector in the poorest regions of a country
edge about financial markets and their
that also employ many women). Second,
contribution, actual and potential, to eco-
the ponderous way in which USAID moves nomic development and to reducing pov-
from concept to action, together with the erty. Economic researchers have been un-
constraints on profit-making by USAID able to make definitive statements about
implementers, makes Agency projects un- the size of the contribution of this sector
attractive to people with the required ven- to overall growth, or even to make strong
ture capital expertise. statements about how the sector should be

Capital Markets and Economic Development 9

organized. The Asian financial crisis was development looked masterly until mid-
a total surprise to virtually all observers. 1997. The Japanese approach to corporate
USAID has had to operate in a world where finance drew on close long-term ties be-
such uncertainties have been prevalent, tween banks and manufacturers. It looked
making project choices on the basis of much more promising than the U.S. ap-
judgments that have had to be tentative. proach, which depended more on equity
finance subject to the vagaries of short-
The same uncertainty has to surround term performance—until the Japanese
efforts to evaluate the success of USAID banking crisis exposed the weakness of
projects in financial market development. close ties between lenders and borrowers.
Failure is easier to judge than success. The Today’s wisdom about these issues may
degree of success will depend upon the be exposed in another decade as an illu-
viewer’s perspective, which is embedded sion. Such problems do not make the
in historical context. The approaches taken drawing of conclusions impossible, but
by the Asian “tigers” to financial market they do render them tentative.

10 Efficient Capital Markets: A Key to Development

 USAID Capital
Market Development
Activities in the
2 Case Study Countries

O NE MEANS for avoiding crises like

that experienced in Asia is through
broadening of capital markets, so that busi-
sustainable development goals. Three
basic issues are being studied:

nesses and governments are less depen- 1. Can USAID do capital markets
dent on short-term bank lending. Short- projects well?
term loans expose the borrower to the risk
that the loan will not be renewed. If some 2. If so, do capital markets projects
adverse piece of news causes lenders to spur economic growth?
call their loans, the borrower can face a fi-
nancial crisis. Enterprises can reduce that 3. Who benefits from the growth pro-
risk by long-term borrowing, in countries duced by such projects?
where it is available, or by selling part
ownership of the enterprise. The reduction During 1997–98, CDIE-led teams car-
in financial risk that access to long-term
ried out fieldwork to review recent USAID-
finance implies for the firm may lead it to
funded capital markets projects in India,
make larger investments in projects with
Kenya, Morocco, Romania, and the Phil-
longer gestation periods, possibly leading
to productivity growth over the long term. ippines. In addition, a CDIE researcher has
written a case study of an earlier USAID
A number of USAID projects in recent capital market development effort: cre-
years have sought to promote longer term ation of investment banks in Central
financial market development, primarily America in the 1960s.
through establishment or strengthening of
stock markets. This study examines a USAID Projects Studied
group of those projects. Its purpose is to
examine the effectiveness of USAID assis- 1. India. USAID’s principal activity to
tance, to draw conclusions about the promote capital markets is the Financial
importance of such assistance for USAID Institutions Reform and Expansion (FIRE)
project. It was begun in fiscal year 1994, courses. At the Nairobi Stock Exchange,
with $20 million plus $20 million in hous- the adviser prepared the trading floor op-
ing guaranty funds, and terminated by the erating procedures, trained exchange
Agency in 1998 following India’s nuclear members in open-outcry trading, and
tests. FIRE activities included strengthen- helped the NSE establish its operating pro-
ing the government securities regulatory cedures.
agency, improving stock market institu-
tions including a screen-based securities USAID financed computer equipment
trading system and a securities depository and the installation of an NSE office and
institution, and promoting improvements trading floor. Kenyan capital market ex-
in the debt market. Two earlier projects
perts participated in USAID-funded train-
also addressed aspects of capital market
ing and study tours between 1990 and
development. The Program for the Ad-
1995. Officials of the Capital Markets Au-
vancement of Commercial Technology
thority received training at the U.S. Secu-
helped spur the venture capital industry,
rities and Exchange Commission. Two
and housing guaranty assistance to the
Housing Development Finance Company groups of CMA officials and NSE members
promoted development of a mortgage visited Southeast Asian markets. Others at-
market. tended international conferences and an-
nual meetings of securities market asso-
ciations.
2. Kenya. USAID supported the devel-
opment of capital markets in Kenya be-
tween 1988 and 1996. The object of this 3. Morocco. The USAID mission in Mo-
support was a newly created regulatory rocco explored options to support the de-
body, the Capital Markets Authority velopment of the capital market in 1991
by commissioning two studies. One exam-
(CMA). The total level of support provided
ined the stock exchange; the other, estab-
during that period was less than $1 mil-
lishment of a secondary debt market. Af-
lion. The most significant component was
ter considering its options, the mission
long-term technical assistance to the Capi-
decided to undertake a large privatization
tal Markets Authority and to the Nairobi
support program rather than a capital or
Stock Exchange. The adviser provided
financial market support program. A sub-
day-to-day guidance and technical exper-
sidiary interest in capital markets was car-
tise to the staff of the CMA. During his ten- ried into the privatization support pro-
ure, the CMA drafted and put into opera- gram.
tion the regulatory framework that gov-
erns the market. He helped set up a pub- The program was a $25 million effort.
lic information center at the CMA and ini- Of that amount, $20 million was non-
tiated public awareness seminars and project assistance, and $5 million went to

12 Efficient Capital Markets: A Key to Development

related technical assistance. The program 5. Romania. Although communism
document concluded that “to take full ad- ended in 1989, by 1995 only limited moves
vantage of the opportunities presented by toward economic liberalization had gone
privatization, the weaknesses in Morocco’s forward. Strict state controls gripped most
capital market will need to be addressed.” markets, and state-owned enterprises
Through conditionality, the program re- dominated the economy. Investment had
quired a promotional and educational been misallocated, and the economy was
campaign on the benefits (and risks) of using the wrong processes to produce the
share ownership. It also required identifi- wrong commodities. The economy needed
cation of possible measures to promote to be opened up to world prices; state-
broader public share ownership and stipu- owned firms needed to be privatized and
lated that 6 of the 28 privatizations in the a market created to allocate capital to firms
program be done through the stock mar- that could use it most effectively. An im-
ket. A long-term adviser, funded from an- portant move toward liberalization was
other project, provided technical assistance the planned mass privatization of 5,600
on the interbank market, the money mar- medium-size and small state-owned
ket, and the stock market. firms—but there was no market to price
shares or to allow people to buy and sell
4. The Philippines. In 1993, USAID be- shares. If privatization was to succeed, a
gan a five-year $13.5 million Capital Mar- stock market had to be created.
kets Development Project. Its goal was to
strengthen the integrity and capacity of the USAID wanted to help the privatiza-
capital markets to help increase the flow tion effort and at the same time improve
of equity and debt securities, to encour- capital allocation—but none of the neces-
age savings mobilization and increase the sary institutions existed. Agency projects
quantity and quality of private investment. helped create a stock market (Rasdaq), a
The project included both public and pri- capital market regulator (a securities ex-
vate sector components. The public sector change commission), stock market laws
component included assistance to the se- and regulations, self-regulatory organiza-
curities regulatory agency, the Securities tions, a stock brokerage community, mu-
and Exchange Commission, under the tual funds, and a stock registry, depository,
management of the Ministry of Finance. and transfer agent.
The private sector component included
assistance to an umbrella association of 6. Central America. A somewhat differ-
private sector financial institutions, the ent type of study was carried out in Cen-
Financial Executives Institute of the Phil- tral America. In that region, USAID estab-
ippines. lished a number of financial intermediar-

USAID Capital Market Development Activities in the Case Study Countries 13

ies to promote long-term investment. nies. By the 1970s, as described in the pre-
These development financial institutions, vious chapter, USAID had become disillu-
or financieras as they were called in Latin sioned with these institutions and sharply
America, were intended to make loans or reduced assistance to development finance
equity investments in promising compa- institutions.

14 Efficient Capital Markets: A Key to Development

 Program
Performance
3 And Outcomes
because it came at the formative stage of
Program Outcomes the development of these institutions.
Nevertheless, the evaluators found that the

F OR EACH of the five projects reviewed

for this study, the CDIE evaluation
team prepared an impact assessment.
strengthening of the equities market had
not contributed much to the financing of
private business expansion in Kenya.
Those studies, listed in the bibliography, Weak macroeconomic policy and an un-
provide detailed descriptions of the willingness of closely held firms to under-
projects and their outcomes. Briefly, the take the disclosure and other requirements
findings are as follows: for listing have limited the impact of the
new institutions.
1. India. The team found the project
to be highly successful in strengthening the 3. Morocco. This project was success-
regulatory framework for the Indian se- ful in raising activity on the Casablanca
curities market. Substantial amounts of Stock Exchange and in broadening the in-
technical assistance aided the Securities vestor base. As intended in the project
and Exchange Board of India to improve design, it provided a tool for privatization
procedures and to move toward more ef- of government enterprises. It also was able
fective regulation of the industry. This has to provide a means for connecting savers
made the Indian securities market more with small and medium-size enterprises.
attractive for foreign and domestic invest- The project was much less successful in
ment. inducing private Moroccan companies to
become listed on the exchange.
2. Kenya. The evaluation team found
the project to be successful, helping the 4. The Philippines. The Philippines
Kenyan Capital Markets Authority and the project successfully reoriented the Philip-
Nairobi Stock Exchange to acquire the ex- pines Securities and Exchange Commis-
pertise to carry out their mandate. The sion away from approval of individual is-
very limited assistance provided by the sues to an American-style institution, en-
project (under $1 million) was important forcing disclosure on companies and
drawing upon self-regulatory organiza- been privatized by the Romanian govern-
tions in the financial industry. A securities ment. This was a clear technical success,
depository was also created. The reform but the value of the new exchange’s mar-
of the Securities and Exchange Commis- ket niche, and its impact on the Romanian
sion was seen as a great achievement by economy over the long term, are uncertain.
the Philippine financial community. Shortcomings in government economic
Achievement of the reform required an policies and the slow pace of privatizations
announcement by USAID that it would ter- were serious obstacles to a larger role.
minate its project unless the government Project assistance to the government regu-
made personnel changes to permit reform. lators was seen as valuable, but the evalu-
The ultimatum motivated the government ators concluded that the National Securi-
to make the necessary changes. That was ties Commission still had significant prob-
perhaps the most important action lead- lems, predominantly in its enforcement
ing to project success. powers.

5. Romania. The Romania project suc- 6. Central America. USAID’s efforts in

ceeded in creating a fully operating stock Central America during the 1960s were de-
exchange in less than a year, creating com- signed to promote long-term financing by
petition for the existing stock exchange. establishing new institutions. This experi-
This provided a market for issues of ment largely failed. None of the institu-
smaller companies, most of which had tions established in any of the Central

Table 1. Summary of Project Characteristics

Country USAID Purpose Direct Financial Systematic Long-Term

Project Outcome Impact Effects Sustainability
Amount ($m)
India 20 regulatory, successful significant considerable probable
institutions
Kenya 1 basic TA successful small significant uncertain
Morocco 5 basic TA successful small significant uncertain
Phillippines 13 regulatory, successful significant considerable probable
institutions
Romania 25 new stock successful small uncertain questionable
market,
regulatory

16 Efficient Capital Markets: A Key to Development

American countries maintained itself by this sector. Nor does the conclusion that
following the original purpose for which stock markets are an important instrument
USAID assisted in its creation. Some of the in reducing poverty over the long term (a
institutions failed and disappeared. Oth- topic discussed later) provide a sufficient
ers adapted to the environment in which justification. The fact that stock exchanges
they were operating by shifting to short- are instruments for financial gain by their
term lending. That reduced their risk and participants creates an expectation that the
allowed the institutions to balance their private sector should be able to undertake
lending portfolio to the term structure any necessary and useful action in this
(generally very short term) of the resources field. Why should USAID become involved
that they were able to attract. at all?

In summary, all five of the recent The basic answer seems to be that
projects were successfully completed. capital markets developed by the private
They produced the institutional result in- sector alone will not produce the most sat-
tended in the project design. Their higher isfactory development result. Capital mar-
level outcomes were more mixed. Table 1 ket development should not be left to mar-
summarizes some of the characteristics of ket forces, because it will produce poor
the five case studies. The judgments there results. There are two areas where experi-
are tentative, since there is much uncer- ence shows that regulation is needed to
tainty about what changes in actual activ- make possible the development of a vi-
ity can be traced to the projects, and some brant equities market: protection of inves-
outcomes may begin to appear only tors from firms; and protection of both in-
slowly, and later in time than the exami- vestors and firms from stock market in-
nation of the projects. Nevertheless, the termediaries.
matrix suggests that country policies are
important to project success and that the Protection of Investors
link between strengthening of the equity
market and additional capital availability From Firms
for firms is a tenuous one.
Recent research (e.g., La Porta and
Rationale for others, 1999) has shown that legal protec-
tion of minority stockholders and of credi-
USAID Assistance tors from the managers and majority stock-
holders of firms is closely linked to the de-
That USAID stock market develop- velopment of capital markets. Countries
ment projects have been implemented suc- with such protections have larger and
cessfully does not itself provide a sufficient broader capital markets, wider ownership
justification for Agency involvement in of shares, and more efficient allocation of

Program Performance and Outcomes 17

capital among firms than countries with- ers, will the market-makers gradually be-
out such protections. Another recent study gin to eliminate these obstacles to effi-
(Johnson and Shleifer, 1999) contrasts the ciency.
dramatic difference in development of
equities markets in Poland and the Czech Moreover, stock exchanges are what
Republic. In Poland investors had legal economists call natural monopolies. One
protection and the stock market has grown can conceive of multiple stock exchanges
rapidly. In the Czech Republic legal pro- offering the same stocks (and the United
tections were missing and the stock mar- States once had numerous regional ex-
ket has not been able to mobilize capital changes), but this situation is unlikely to
for investment. The study provides a con- last. Both buyers and sellers are interested
vincing rationale why such protections in good execution of their transaction—
will not arise naturally by market forces. meaning a quick transaction at close to the
price existing when the decision was
Protection of Investors made. The best execution is likely to be at
the exchange that has the largest volume
And Firms From (i.e., the greatest liquidity) in the stock in
Stock Market Intermediaries question.

Stock markets are established by nei- Any advantage that one exchange has
ther the suppliers of capital nor the firms in volume will thus lead to greater volume
needing capital, but by intermediaries. and to a greater advantage over its com-
From the point of view of suppliers and petitors. It ultimately ends up with all the
demanders, and from the public at large, business. In most countries, the stock mar-
the best intermediation process is one that ket that emerges will be owned by its
is transparent and has low transactions members, whose interest is in limiting
costs. But observation of actual stock mar- competition among the membership and
kets in countries without strong govern- in commission rates that provide for com-
mental regulation will show that this situ- fortable incomes for members. (In the
ation does not occur naturally. Instead, the United States, it was only government ac-
market intermediaries are likely to create tion during the 1970s that forced the lead-
monopolistic arrangements that lead to ing U.S. stock exchange to allow commis-
high transactions costs, an atmosphere sion rates to be negotiated—leading to the
permissive of self-dealing and rigged lower commission rates that dramatically
transactions, and insufficient flow of in- expanded market volume.)
formation to potential investors. The mar-
ket is made for the convenience of the In sum, it is only through strong gov-
market-makers. Only very slowly over ernment regulation and supervision of the
time, under organized pressure from oth- financial markets that firms and market-

18 Efficient Capital Markets: A Key to Development

makers can be forced to operate in a man- listed companies would rise in line with
ner that serves the public interest effi- the country’s growth, as emerging com-
ciently. Efficient markets are a public good panies issue initial public offerings. The
that require government intervention if stock market capitalization would also
they are to work well. USAID has shown increase, probably at a steady rate that is
that it is capable of transferring the neces- faster than gross national product growth,
sary technology to developing-country as prices of older companies rise and
governments, and therefore has a useful newer companies are added. Trading vol-
role to play in establishing this necessary ume would also rise steadily, as more
set of institutions. people began using the stock market and
as the market became more liquid.
Performance Monitoring
Unfortunately, this conceptualization
Current USAID practice is to give em- does not describe the operation of real
phasis to monitoring performance of on- stock markets. All real markets seem to be
going activities during implementation. characterized by periods of exuberance
The Agency has shown a strong preference and periods of decline. Moreover, none of
for activities to establish benchmarks and these variables is an unambiguous indi-
performance targets for each year of the cator of progress. Stock markets are noto-
implementation process. Decisions about riously volatile, and rising values can
whether to fully fund programs or to ter- sometimes reflect speculative excesses, so
minate them sometimes depend in part that declines represent a return to proper
upon the performance in relation to tar- pricing. The number of initial public of-
gets. In the case of stock market projects, ferings is subject to market conditions as
this approach has been shown to have dan- well as regulatory factors. In India, USAID
gers. chose the number of initial public offer-
ings as a performance benchmark under
Stock markets would seem to be an the assumption that this would rise as
ideal candidate for quantitative measures stock market oversight improved. But the
of performance. Such measures abound; opposite happened, as the government
they include the number of stocks listed, tightened listing requirements following
the market capitalization of listed stocks, a series of financial scandals. It began
indexes of stock prices, number of new delisting companies that failed to provide
issues, inflows to the stock market by for- adequate financial information to inves-
eign investors. Development planners con- tors.
cerned with performance monitoring can
draw nice trend lines, showing an ex- The basic conclusion in this area is
pected steady expansion of a country’s that there is no easy way to monitor the
stock market. Each year, the number of progress of an ongoing capital markets

Program Performance and Outcomes 19

project. The key judgments of progress come. Deductively, one can posit a vari-
seem to be qualitative rather than quanti- ety of influences, some (e.g., the rise in
tative; they require people with substan- wealth of holders of securities) tending to
tial experience in this area to make them. increase inequality and others (e.g., in-
USAID to date has not developed qualita- creased demand for skilled workers and
tive indicators for capital markets devel- increased access to financing by nonelites)
opment. One of the conclusions of the that would tend to decrease it. How these
Kenya/Morocco case study provides per- various factors sum in practical cases,
haps the best statement of the proper con- though, is conjectural.
clusion in this area:
On the issue of the impact of capital
Missions undertaking capital market market development on poverty, the case
projects should be held accountable for for a positive relationship is much stron-
the quality of the institutions they assist
but not for the level of market activity.
ger, but still indirect and gradual. Of the
Stock and bond markets reflect the state country studies, only the India paper dealt
of the national economy, which itself is with this issue in detail, and it did so in
the result of host government economic terms of broad concepts. Before dealing
policies, the underlying structure of the with those concepts, though, let us con-
economy, and external factors. Market
indices will rise and fall during and after
sider the results of an earlier study.
the USAID activity. The goal of a USAID
activity should be to help put in place Batchelder and Holt (1997) have
institutions capable of meeting the fi-drawn upon the historical experience of
nancial intermediation demands of the developing countries regarding the rela-
private sector.
tionship between economic growth and
poverty to make projections for India and
Capital Markets other countries of future poverty levels.
And Poverty They provide two scenarios for India,
based on assumptions about economic
One of the original goals of the study policy. Under the “poor policy” scenario,
was to include some analysis of the distri- where government restrictions prevent
butional consequences—and particularly free markets from operating in capital mar-
the impact on poverty—of the develop- kets and foreign trade, growth would av-
ment of capital markets. That proved to erage 1.2 percent per capita per year, while
be beyond the capacity of the evaluators, it would average 5 percent per capita un-
for the relationships involved are nuanced der market-based policies.
and complex. The evaluators could find
no convincing empirical evidence regard- The difference in poverty between the
ing the impact of the development of eq- two scenarios is stark. With poor policies,
uities markets on the distribution of in- the number of poor (those with per capita

20 Efficient Capital Markets: A Key to Development

incomes below $1 a day) increases slightly, and reductions in poverty is empirically
from 473 million to 476 million, though strongly established over the medium and
their share in the population falls from 51 long term. (For shorter periods of time, the
percent to 37 percent. With the faster two can move in opposite directions be-
growth resulting from market-based poli- cause of a variety of factors. But extreme
cies, the number of poor falls from 473 poverty—the World Bank uses $1 a day
million to 174 million, or from 51 percent per person—is common only in countries
of the population to 14 percent. (This de- where average incomes are also low.) The
cline is roughly in line with what occurred following section uses capital markets in
in Indonesia over the last 25 years.) India as an example of the types of prob-
lems faced in many developing countries.
Batchelder and Holt’s scenarios over-
state the difference in India. Its policies
have moved a substantial distance over the The Case of India
past five years toward free markets for
goods and finance, and recent economic The empirical link between market-
growth rates have reflected those better oriented polices and growth is important
policies. Nevertheless, the basic point is in the present context because the link be-
shown by experience. Countries with bet- tween USAID capital markets projects and
ter policies have substantially faster rates poverty reduction is neither direct nor
of poverty reduction. This model, of immediate. At present, companies that
course, does not separate improvements raise capital because of improvements in
in capital markets from other policy the structure of the capital market will not
changes. Improvements in capital markets make major increases in employment as a
alone would be expected to provide some result. Nor will the Indian stock market
fraction of the impetus to growth found provide a means for the great bulk of small
by Batchelder and Holt. and medium-size enterprises in India to
gain capital for expansion.
In broad terms, the work of USAID ac-
tivities is intended to improve the effi- Improvement in the structure of the
ciency of capital markets. Increased effi- equity market will directly affect perhaps
ciency in the financial sector in turn is ex- several thousand companies, not the mil-
pected to direct financial resources into the lions of smaller enterprises that constitute
sectors where their productivity is high- the mass of business enterprises. (Large
est. This in turn is expected to increase the firms do dominate output: in India, the
rate of economic growth in the country 3,000 largest companies account for half
receiving the assistance. Faster economic of all manufacturing value added.) For
growth in turn is expected to reduce pov- their capital needs, small firms will, as
erty. The link between increases in income elsewhere, need to rely primarily on in-

Program Performance and Outcomes 21

ternally generated savings, funds from dustrial concerns. Getting maximum pro-
family and associates, and borrowing from duction from a set of machines was seen
banks. Despite these limitations, work in as a straightforward engineering problem.
capital markets appears, in the longer The critical problem for economic growth
term, to be a critical element in the rapid was to ensure that all factories had the
reduction in poverty in India. proper amount of capital so that the entire
productive structure could move forward
From independence, the Indian gov- together. Second, the types of goods to be
ernment has given central importance to produced were conceived of in simplistic
investment and to capital. Successive gov- terms—tons of steel, numbers of automo-
ernments have believed that capital was biles, pairs of shoes—implicitly assuming
the key constraint in the Indian economy, that each industry produced homogenous
so capital was seen as needing to be allo- products for which the needs of the
cated carefully to avoid waste. The Indian economy could be measured quantita-
governments used central planning as the tively.
vehicle to achieve this. Much investment
would be directly by government enter- The experience since 1950 demon-
prises in response to the planners’ projec- strates that modern economies are not like
tions. Private companies would be pre- that. For the needs of steel-using industry,
vented from overinvesting in capacity by the problem is not simply the number of
a requirement that government permission tons of steel produced, but the number of
would be necessary for any expansion of tons of steel of particular specifications
their factories. available in a particular place at a particu-
lar time. Planning processes are powerless
In sum, the Indian planning model to deal effectively with the qualitative, lo-
was centered on concern about using capi- cation, and time dimensions. Only the flex-
tal efficiently. In 1950, the theory had con- ibility of a market system, where the pro-
siderable plausibility. The West had recov- ducer is rewarded for meeting these re-
ered from a lengthy depression only quirements by the prospect of profit, and
through the onset of world war, and the punished for failing to do so by the pros-
Soviet Union appeared to have made a pect of loss (and bankruptcy), has proven
great leap forward into industrialization capable of this. The problem of specifica-
through central planning. tions is compounded with consumer
goods. If all consumers preferred size 9
This theory had two central assump- brown penny loafers, the problem of pre-
tions that proved fallacious in practice. It dicting and meeting consumer demand for
was assumed that efficient production re- shoes would be relatively straightforward.
sulted more or less automatically from But consumer preferences both vary
modern technocratic management of in- widely and change over time.

22 Efficient Capital Markets: A Key to Development

 Another factor is technological ad- electric power, businesses have their own
vancement. Technology change in both generators. Dozens of ships wait in the
manufacturing processes in the world and port of Bombay for their turn to offload or
in design of consumer goods has been load. Bungalows for government offices
rapid. Consequently, the idea of a know- and residences, relics of a quieter day, still
able and fixed capacity for production for sit in the shadow of Bombay skyscrapers
each factory disappears. To remain effi- on some of the most valuable land in In-
cient, managers in each factory have to dia. More broadly, the amount of economic
continually revise their production meth- growth that has occurred in India is not
ods, adding machinery and techniques in commensurate with the amount of capital
line with evolving technology. They need investment that has been taking place. To
to change the product in line with chang- achieve faster economic growth, and faster
ing designs and new materials. In sum, reduction in poverty, capital needs to be
they must continually make new decisions used more efficiently.
about what to produce and how to pro-
duce it. Once the magnitude of these prob- This continuous revaluation of
lems becomes clear, it becomes evident capital assets provides three important
that central planning is simply not capable functions. First, it signals to other provid-
of meeting the needs of a modern ers of capital, such as banks, the prospects,
economy. and therefore the riskiness, of lending to
companies. Second, it provides incentives
The core of the process is what Joseph for new firms to enter promising sectors,
Schumpeter called “creative destruction,” and for investors to seek out and invest in
which is at the core of modern market companies of the future. Third, it provides
economies. Companies and entire indus- the means, through takeovers of existing
tries that do not maintain competitiveness companies by more efficient firms, to re-
in the long run by adapting new technolo- deploy the capital in a more efficient way.
gies are simply pushed aside. Enterprises In the longer term, restructuring of the
go bankrupt, or are acquired by others, to capital base and the means by which capi-
reorganize people and capital equipment tal can be drawn to the most efficient use
into arrangements that can produce effi- provides the most promising way for pro-
ciently what is wanted by society. ductivity of labor to be increased. Increas-
ing labor productivity is the only sure
As we look around India, it is clear means for steadily increasing wage rates
that much capital is wasted or mis- and incomes.
allocated. Because of the uncertainty of

Program Performance and Outcomes 23

 4 Lessons Learned
F ROM THE SIX COUNTRY CASE STUDIES,
a number of lessons can be drawn.
They are as follows:
latter may be useful in supporting goals
in the regulatory area, as in the Philippines
case.

1. USAID should continue to support 3. USAID assistance should promote

development of capital market institu- the general approach used in the U.S. capi-
tions. All the recent projects studied had tal market. This approach—including a
a considerable degree of success. They strong governmental regulatory body—
strongly support the view that USAID can has shown itself to be appropriate for de-
do this type of project well. The evidence veloping countries. The emphasis in this
that there is a high developmental payoff approach on disclosure of relevant circum-
to this kind of activity is much more tenu-stances rather than government approval
ous, for capital markets are institutions of individual issues provides more flex-
whose importance cannot easily be mea- ibility and greater opportunity for new
sured—but the evidence suggests that it activities than models based on govern-
may be quite high. ment approval of individual issues of capi-
tal stock. The projects reviewed show that
2. USAID activities should emphasize USAID can identify and contract appropri-
the regulatory framework and avoid di- ate expertise to transfer the U.S. technol-
rect financing of investment capital. A ogy.
good legal and regulatory framework and
strong government oversight are needed 4. USAID should undertake projects in
to make capital markets work efficiently. this area only where the economic climate
The primary emphasis of USAID support is favorable. A stock market is an institu-
should be on technical assistance and tion that promotes faster economic growth
training for this rather than financing of in a favorable environment, but is unlikely
hardware for the operation of the market to be an important catalyst for the adop-
itself. Nevertheless, some support of the tion of better economic policies. Success-
ful government efforts to privatize state- the individual governments in the region,
owned enterprises can support stock mar- for whom a national stock market now has
ket development. the appeal that a national airline once had.

5. USAID should be skeptical of re-

gional approaches to stock market devel- 6. USAID should look for ways to pro-
opment. Stock markets are subject to mote development of debt markets. The lit-
economies of scale, so promotion of their erature demonstrates that in the longer
development is easiest in large countries. term, creation of long-term debt markets
In regions where USAID works that are is essential to reduce the risk of financial
composed mainly of small countries (e.g., crises, such as the recent Asian experience.
Central America or various parts of Af- This will require improvements in govern-
rica), efforts to promote a set of officially ment policy to eliminate inflationary ex-
promoted regional structures are likely to pectations and reduce crowding out by
arise. The literature indicates that such ap- government. Throughout the developing
proaches are unlikely to work, and should world, substantial progress has been made
be resisted. The free flow of finance among on these issues during the past few years,
a group of countries will tend to lead to so the prospects for persuading savers to
one of the region’s stock markets becom- acquire long-term securities is much bet-
ing dominant. Transactions will flow to the ter than it has been in the past. Long-term
most liquid market, which will have the finance for infrastructure has great poten-
lowest transaction costs. Such an outcome tial for promotion of growth, and innova-
may be desirable from the region’s per- tions in debt markets can support this ob-
spective, but it is likely to be resisted by jective.

26 Efficient Capital Markets: A Key to Development

 Bibliography
Batchelder, Alan; and Tyler Holt. 1997. ———. 1999. “Developing the Capital
“2020 Visions: Creating Tigers, Cutting Market in India.” Impact Evaluation.
Poverty, and Increasing Trade, 1995– PN–ACA–922. Washington: U.S.
2020.” USAID Economists Working Pa- Agency for International Develop-
per No. 6. Washington: U.S. Agency ment.
for International Development.
———. 1999. “Developing the Philippines’
Buttari, Juan; Jerre Manarolla; and Michael Capital Market.” Impact Evaluation.
Shea. 1997. “The Impact of Moderniza- PN–ACA–933. Washington: U.S.
tion of the Indonesian Stock Exchange Agency for International Develop-
on Employment.” USAID Economists ment.
Working Paper. Washington: U.S.
Agency for International Develop- Fox, James W. 1996. The Venture Capital Mi-
ment. rage. Program and Operations Assess-
ment Report No. 17. Washington: U.S.
Center for Development Information and Agency for International Develop-
Evaluation. 1998. “Developing ment.
Romania’s Capital Market.” Impact
Evaluation. PN–ACA–921. Washing- ———. 1999. “Enterprise Funds: A New
ton: U.S. Agency for International Development Tool?” Unpublished
Development. Evaluation Special Study Report. U.S.
Agency for International Develop-
———. 1999. “Developing the Capital ment.
Market in Kenya and Morocco.” Im-
pact Evaluation. PN–ACA–928.
Washington: U.S. Agency for Interna-
tional Development.
Horkan–López, Kathleen. 1998. “USAID Levine, Ross. 1997. “Financial Markets and
Support for Development Finance Economic Growth: Views and
Institutions in Central America.” Agenda.” Journal of Economic Literature
Research and Reference Service. PN– 35.
ACD–310. Washington: U.S. Agency
for International Development. McKean, Cressida. 1990. “Development
Finance Institutions: A Discussion of
International Monetary Fund. 1999. “In- Donor Experience.” Program Evalua-
ternational Capital Markets: Develop- tion Discussion Paper No. 31. Washing-
ments, Prospects, and Key Policy Is- ton: U.S. Agency for International De-
sues.” Washington. velopment.

Johnson, Simon; and Andrei Shleifer. 1999. Sachs, Jeffrey; and Andrew Warner. 1995.
“Coase vs. the Coasians.” National “Economic Convergence and Eco-
Bureau of Economic Research Working nomic Policies.” National Bureau of
Paper No. 7447. Cambridge, Mass. Economic Research Working Paper No.
5039. Cambridge, Mass.
La Porta, Rafael; and others. 1999. “Inves-
tor Protection: Origins, Consequences,
Reform.” National Bureau of Eco-
nomic Research Working Paper No.
7428. Cambridge, Mass.

28 Efficient Capital Markets: A Key to Development

U.S. AGENCY FOR INTERNATIONAL DEVELOPMENT