U.S. AGENCY FOR INTERNATIONAL DEVELOPMENT
USAID Program and Operations Assessment Report No. 26
Center for Development Information and Evaluation
November 2000
A Key to Development
PN–ACG–620
Efficient
Capital
Markets
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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
By
James W. Fox
Center for Development Information and Evaluation
U.S. Agency for International Development
Washington
November 2000
Contents
Summary ................................................... v
1. Capital Markets
And Economic Development ............ 1
A Tale of Two
(Or Three) Cities ............................... 1
The Role of the Financial
Sector in Development ..................... 3
The Asian Financial Crisis ................... 4
Financial Markets
And Capital Flows ........................... 5
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
3. Program Performance
And Outcomes ...................................... 15
Program Outcomes ............................ 15
Rationale for USAID Assistance ......... 17
Performance Monitoring ...................... 19
Capital Markets And Poverty ............. 20
The Case of India ................................. 21
4. Lessons Learned .................................. 25
Bibliography
Summary
HIS STUDY EXAMINES USAID activities
to promote creation or strengthening
of capital markets in developing countries.
There are two basic conclusions.
First, USAID has been successful in
promoting capital market development.
The general approach promoted by
USAID—emphasizing the strengthening of
the government regulatory institutions—
is sound, and USAID has been able to con￾tract capable expertise to carry out such
projects.
Second, an efficient capital market
is an important ingredient of a successful
development strategy. Though the effects
of strengthening of capital markets on
poorer strata of society are indirect and
long term, they also have important con￾sequences in generating increased invest￾ment and creating more productive
employment. Moreover, the failure to pro￾vide strong oversight of capital markets,
evident in the Asian financial crisis of
1997–98, also can have severe adverse con￾sequences for poor people.
T
The conclusions are based on field￾work led by teams from USAID’s Center for
Development Information and Evaluation.
They reviewed recent USAID-funded capi￾tal markets projects in India, Kenya, Mo￾rocco, the Philippines, and Romania. A
CDIE researcher also studied an earlier
USAID capital market development effort:
creation of investment banks in Central
America in the 1960s.
Specific lessons learned from the
study include the following:
1. Effective capital market develop￾ment should not be left to the private sec￾tor. Government oversight is needed to
prevent market intermediaries from main￾taining monopolistic arrangements that
lead to high transactions costs, to an at￾mosphere permissive of self-dealing and
rigged transactions, and to insufficient
flow of information to potential investors.
2. Donor support should aim pri￾marily at strengthening this governmen￾tal regulatory framework. Payoffs to such
vi Efficient Capital Markets: A Key to Development
support are likely to be much higher than
direct support of individual enterprises or
investment houses.
3. Capital markets projects are un￾likely to stimulate economic growth where
economic conditions are unfavorable. In￾flation, large government budget deficits,
and uncertainty about the path of future
government policies all deter investment.
Capital market reforms will not produce
growth in a stagnant economy. Rather,
such projects are best suited to rapidly
growing economies where existing capi￾tal structures are limiting investment, and
where firms are actively interested in ad￾ditional financing.
4. In the longer term, creation of long￾term debt markets is essential to reduce
the risk of financial crises, such as the re￾cent Asian experience. That will require
improvements in government policy to
eliminate inflationary expectations and
reduce crowding out by government.
A Tale of Two
(Or Three) Cities
EVERAL DAYS A WEEK, one can travel
to Washington from Bombay with a
stopover in Amsterdam. Amsterdam and
Bombay have much in common. They are
both collections of islands that human ef￾fort, through landfills and swamp drain￾age, converted into cities. Each is its
country’s leading port, and a bustling
commercial center. They are both located
in countries that are among the most
densely populated in the world. At 986
persons per square mile, population den￾sity in the Netherlands is about 50 per￾cent higher than in India. The scale is dif￾ferent, though. India is a vast country,
while the population of the entire Neth￾erlands is about the same as the city of
Bombay alone.
The two airports do not differ dra￾matically from each other. Each has the
size, bustle, metal detectors, and jetways
common to today’s international traveler.
The latest technology in aircraft is avail￾able to move people from one airport to
the other. Both are about the same distance
(12–16 miles) from the center of the city.
It is on leaving the airport for the city cen￾ter that the dramatic differences appear.
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
quiet and comfortable. It passes through
a mix of residential and industrial areas.
Most of the residences are low-rise apart￾ment buildings, but with an abundance
of well-maintained green space and
parkland. Some factories can be seen in
the distance, but the more common work￾places are high-rise buildings where
armies of white-collar workers directly
produce nothing tangible. Like office
workers elsewhere, they talk on the tele￾phone, go to meetings, and write words
on paper. The result of these efforts is suf￾ficient for the average Dutch worker to
earn about $50,000 a year. On arrival at
the center of the city, one can stroll along
the streets with the same feeling of quiet￾ness, of clean, well-maintained buildings
and streets, of a general pleasantness and
“uncrowdedness.”
The contrast on leaving the Bombay
airport is stark. The taxi ride to downtown
1
Capital Markets
And Economic
Development
S
2 Efficient Capital Markets: A Key to Development
takes an hour unless traffic is bad. (A new
traveler might try to take a train, but mas￾sive overcrowding would dissuade most
from doing this a second time.) Most of
the trip is through areas that scream ex￾treme poverty. The basic vision that as￾saults the senses is of massive overcrowd￾ing, of taxation of the infrastructure to the
breaking point. Too many cars, too many
people, too much pollution, and too much
poverty. Some sights strain the imagina￾tion, as seeing women dressed in immacu￾late saris emerging from labyrinths of hov￾els on tidal mud flats. The bustle of the
individuals on their way to work is no less
than one sees in Amsterdam. The first im￾pression is that people work as hard in
Bombay as in Amsterdam. Yet the aver￾age Bombay worker earns about $1,000 per
year. (That is about 50 percent more than
the average for India as a whole.) What
explains the difference in the physical in￾frastructure that faces workers in these two
cities, and the difference in productivity
of the workers?
Until recently, any comparison of this
sort between Amsterdam and Bombay
would have seemed unreasonable. After
all, the Netherlands was probably the most
advanced country in the world three cen￾turies ago. The state of its infrastructure
reflects accretion over long periods of time.
This is true, but the experience of some
other Asian countries suggests that centu￾ries may not be needed to make the trans￾formation. One may also fly easily from
Bombay to Singapore, another island city
where much has been reclaimed from
swampland. Until the 1860s, Singapore
was a fishing village. Even as recently as
India’s independence in 1947, the differ￾ences in standards of living between
Singapore and Bombay were not stark.
Singapore had much of the overcrowding,
slums, poor water, sewerage and munici￾pal services characteristic of Bombay to￾day. Yet in a generation, it has made strides
that make it comparable to Amsterdam in
municipal amenities. It has a higher per
capita income than the Netherlands and a
longer life expectancy. How did such a
rapid transformation occur? Why has
Singapore been able to make it, and why
has Bombay not done so?
Issues of the amount of capital that
the society invests and—more important—
the efficiency of the capital investment
process seem to lie at the heart of the an￾swer to this question. The capital market
is the medium through which investment
is allocated among alternative uses in a
market economy. In such an economy, the
capital market is the investment planning
office. It decides how many resources will
be available for investment by firms
throughout the economy; how much, and
at what cost, will be available for infra￾structure investment; which companies
will be able to expand and which will not.
In India, the government, through central
planning, sought to play this role for de￾cades. The USAID capital markets devel￾opment project sought to assist in the
transfer of this function from the govern￾ment to the marketplace.
Capital Markets and Economic Development 3
The Role of the Financial
Sector in Development
The area of money, banking, and fi￾nance has long fascinated economists and
nonexperts alike. There is an old adage,
“not one man in ten thousand understands
the monetary question—and you meet him
every day.” The adage captures both the
esoteric nature of finance and the continual
production of theories or ideas about how
new approaches to finance will yield great
results.
Experts have long agreed that finan￾cial resources are a key factor in economic
development. The large differences in av￾erage income levels among countries re￾late much less to differences in the natural
resource base, including quality of land,
than to differences in the man-made re￾source base. This stock of man-made capi￾tal includes machinery, equipment, and
buildings used for productive activities,
but also economic infrastructure, includ￾ing roads, electric power grids, and com￾munications systems. In countries where
the supply of financial resources has made
these capital items abundant, they allow
the society’s workers to be highly produc￾tive, and therefore allow high levels of in￾come.
The differences between rich and poor
countries are evident in the structure of
capital stock. In poor countries, land rep￾resents most of the capital stock. In rich
countries, land’s relative value is dramati￾cally smaller, and most capital consists of
man-made structures. Vast differences in
nonmaterial aspects of the two types of
societies—notably in the knowledge base
of the workers, and in the institutions of
the society—are also an important part of
the reason rich countries are more produc￾tive.
In developed market economies, fi￾nancial markets play the pivotal role in in￾termediating between the society’s savers
and its investors. They are the vehicle for
moving savings into investments in pro￾ductive activities, both long term and short
term. In low-income countries, banks tend
to dominate financial markets, with the
market for long-term capital generally un￾developed.
An efficient financial market will
stimulate economic growth by encourag￾ing savings and by channeling it into the
most productive investments. In earlier
times, economists were frequently more
concerned about the quantity of invest￾ment than the quality. Development expe￾rience since the 1970s, however, has dem￾onstrated that quality is critical. Countries
such as India and the members of the So￾viet bloc have allocated high shares of their
gross national product to investment, yet
produced only modest results in economic
growth. Investment has flowed to the
wrong sectors, or used the wrong tech￾nologies, or was used for unproductive
activities.
The role of the financial sector in eco￾nomic development has been a subject of
some controversy. Some economists have
4 Efficient Capital Markets: A Key to Development
maintained that it is the “real” sectors (i.e.,
those producing goods and nonfinancial
services) that are the critical determinants
of economic development, and that the fi￾nancial sector grows and evolves in re￾sponse to conditions in those sectors. More
commonly, though, economists have come
to the view that the state of the financial
sector affects the possibilities in the rest of
the economy, particularly with respect to
the quality and quantity of investment. As
Levine (1997, 689) concludes in his survey
of financial markets and development:
A growing body of work would push even
most skeptics toward the belief that the
development of financial markets and
institutions is a critical and inextricable
part of the growth process and away
from the view that the financial system
is an inconsequential sideshow, re￾sponding passively to economic growth
and industrialization. There is even evi￾dence that the level of financial devel￾opment is a good predictor of future
rates of economic growth, capital accu￾mulation, and technological change.
Moreover, cross-country, case study,
industry- and firm-level analyses docu￾ment extensive periods when financial
development—or the lack thereof—cru￾cially affects the speed and pattern of
economic development.
The Asian Financial Crisis
The Levine survey was written
shortly before the July 1997 devaluation
of the Thai baht, which set off a financial
panic throughout much of Asia. South
Korea, Indonesia, and Malaysia were,
along with Thailand, the most severely af￾fected countries. All four countries had
been receiving massive amounts of foreign
capital, mostly in the form of (short-term)
bank loans. Except in Indonesia, where
foreign banks lent directly to enterprises,
most of the foreign lending was made to
local banks. The banks re-lent in local cur￾rency, assuming the foreign-exchange risk.
The devaluation thus immediately threat￾ened their financial position.
Faced with the prospect of future fi￾nancial problems for their clients, foreign
banks refused to roll over loans. There
ensued a scramble to withdraw capital
from these countries before conditions
worsened. This exacerbated the original
problem. Exchange rates fell sharply after
central banks ran out of reserves. Banks
and firms with large exposure of foreign
debt might have become bankrupt over￾night because of their losses. If not, they
were potentially bankrupt over the longer
term because the loss of operating capital
as banks called in loans threatened their
capacity to continue to operate.
The financial crisis was severe in all
four countries. In Indonesia, worsened by
an emerging succession crisis, it was cata￾strophic. In all four countries, the cascad￾ing bankruptcies led to severe recessions,
mass unemployment and dramatic falls in
overall production. In 1998, gross domes￾tic product fell by 14 percent in Indonesia,
9 percent in Thailand, 7 percent in Malay￾sia, and 6 percent in South Korea.
Fortunately, the Asian financial crisis
did not prove to be long lived. All the
countries began their recovery by late 1998.
Capital Markets and Economic Development 5
Korea recovered fastest, growing by 6.5
percent in 1999, and only Indonesia was
expected not to have recovered to the
precrisis level of production by the end of
2000.
The causes of the Asian financial cri￾sis are still being debated, and its conse￾quences are still being analyzed. The cri￾sis did underscore the vulnerability of
financial markets in many developing
countries to loss of confidence by foreign
investors. Two conclusions have been most
widely accepted as lessons from the cri￾sis. First, prudential supervision of banks
in countries going through financial liber￾alization is critical. Supervision of com￾mercial banks needs to be strong to ensure
that weakness in one or a few institutions
does not bring down the entire system.
Second, developing countries that have
heavy foreign capital inflows should en￾sure that such flows are diversified, with
substantial shares in the form of long-term
capital and equity investment, rather than
in short-term lending that can reverse it￾self quickly.
Financial Markets
And Capital Flows
While efficient financial markets are
important for efficiently allocating a
country’s financial resources, they can play
a second role that is particularly impor￾tant for developing countries—that of pro￾viding a means for attracting capital from
abroad.
Although the withdrawal of foreign
investors from emerging markets during
the Asian financial crisis was substantial,
that in no way changes the fundamental
factors that led to sizable foreign interest
in these markets before the crisis. There
are two reasons in particular.
First, the rate of return on investment
in developing countries that follow good
policies is likely to be higher than in other
parts of the world. As Sachs and Warner,
among others, have shown, these countries
are likely to be the fastest growing econo￾mies in the world, eventually catching up
with (or “converging”) with the industrial
countries. This rapid growth is sure to be
accompanied by high rates of return on
investment—higher than those available
in developed countries. This will create the
incentive for substantial flows of invest￾ment from the capital-rich industrial coun￾tries. Some of the capital inflow to these
countries can come through direct foreign
investment, but some should come
through portfolio investment in both eq￾uities and debt. Countries will need effi￾cient capital markets if they are to provide
a channel for such inflows.
Second, international portfolio diver￾sification is a useful means for reducing
risk. Even investment in relatively risky
foreign assets can simultaneously lower
the risk to an investment portfolio and
raise its expected rate of return. (Diversi￾fication of investments reduces overall
risk.) Portfolios of pension funds, insur￾ance companies, and other institutional
6 Efficient Capital Markets: A Key to Development
investors began to diversify internation￾ally during the past decade. There is po￾tential for those flows to become massive
during the next decade if the supply of
investment assets in developing countries
increases sufficiently. Again, development
of efficient capital markets is the critical
factor.
Financial Markets
And USAID’s Mandate
Even if financial markets are impor￾tant to development, there still remains the
question whether it is an appropriate area
of activity for USAID. Many aspects of fi￾nance would not appear to be a priority
for the Agency, given its interest in pov￾erty reduction. Perhaps financial markets
are important, but it is not immediately
obvious why this quintessential market￾based area should not be left entirely to
the private sector. Thus, the argument that
the poor will be helped if the wealthy are
helped has been derided as “trickle-down
economics.” Nevertheless, some aspects of
financial markets activities are directly
relevant to alleviating poverty. First, there
is the obvious connection that developed
financial markets are associated with low
levels of poverty. Countries with large
numbers of poor people have undevel￾oped financial markets, whereas countries
with little poverty have well-developed fi￾nancial markets.
At a less sweeping, more concrete
level, two obvious linkages exist between
the welfare of poor people and develop￾ment of capital markets. The most obvi￾ous one is through the creation of produc￾tive employment. As discussed earlier,
workers in higher income countries are
paid high wages because they are very
productive, and they are productive in part
because they use large amounts of capital
in the form of specialized equipment. This
dimension was explored by Buttari and
Manarolla of USAID’s Global Bureau in
1997. They showed that increased finan￾cial flows through the Jakarta stock ex￾change led to a substantial increase in in￾dustrial employment in Indonesia.
The second linkage between poor
people and financial markets is as consum￾ers of products and services. Capital in￾vestment makes production more efficient
and therefore cheaper; it may also provide
access to goods and services that would
not otherwise be available. This is most
obvious in basic services such as water and
electricity, where long-term finance is es￾sential to rapid expansion of coverage in
developing countries. Some academic re￾search has suggested a third linkage, re￾lating development of capital markets to
democratization and good governance.
That linkage is as follows: Regardless
of the desirability of working generally in
financial markets, there are specific aspects
of such markets that seem to be of particu￾lar importance to poor people. Such niches,
where USAID has long worked, include
small-farmer agricultural credit, financing
for small and medium-size enterprises,
Capital Markets and Economic Development 7
and—for the last decade or so—micro￾finance.
Finally, drawing on the experience of
the Asian financial crisis, one could argue
that developing sound financial markets
is of considerable importance to poor
people. Expansion of financial markets
may not help poor people in any large or
tangible way, at least in the short term, but
financial market collapse certainly hurts
poor people immediately and substan￾tially. A 10 percent drop in real income is a
major inconvenience for people in any eco￾nomic class; for the poorest, it can be cata￾strophic.
Earlier Financial Market
Evaluation Findings
The ideas of donors (who have money
to spend) and academic thinkers (who
have ideas but little money) about how the
financial sector can be used to promote
development have changed over time.
Evaluation findings from previous donor
projects provide one source of information
about what works and what doesn’t, and
so provide one important component of
changes in approach. Nevertheless, two
other sources of ideas or information are
also important.
First, theoretical developments in eco￾nomics can provide new insights that lead
to reshaping the ideas about how finan￾cial systems affect the rest of the economy
and impact on people’s lives. Second, em￾pirical research into the operation of finan￾cial systems and institutions also allows
increased insights that allow donors to
design better financial sector projects. Such
work can help adjudicate between alter￾native ideas about human behavior that
are equally plausible in theory but quite
different in the results they produce in
practical experiments.
In sum, the quality of USAID projects,
and USAID’S ability to draw proper lessons
from experience, depends not only on
evaluation of past projects but also on
keeping current with theoretical develop￾ments in economic thinking and on stay￾ing abreast of research conducted on re￾lated issues. All three aspects of learning
have been evident in USAID’s changing ap￾proach to financial sector development
over the past several decades.
One of the earliest cases of attempt￾ing to draw general lessons from USAID ac￾tivities in financial markets was in 1972,
when the Agency conducted a review of
its programs for credit to small farmers.
Small-farmer credit programs, usually
providing low-interest-rate loans, had
been a common feature of USAID programs
during the 1960s. The common belief at
the time was that low interest rates were
necessary because small farmers could not
“afford” to pay market rates of interest.
The review uncovered two serious
problems with preferential interest rates.
First, lending institutions following this
approach were unsustainable because
their interest collections could not cover
8 Efficient Capital Markets: A Key to Development
their costs. Consequently, they gradually
became decapitalized and unable to pro￾vide continuing support for the financial
needs of small farmers. Second, the sub￾sidy attracted more potential borrowers
than available funding could attend. The
usual response of bankers to this excess
demand for loans was to find some way
to ration the available funds. Depending
upon circumstances, rationing devices in￾cluded choosing those who had the best
collateral, or who were the most politically
well connected, or those willing to pay the
largest bribe to banking officials.
These findings led to further research
to substantiate the results and to develop
new approaches to small-farmer credit.
Much of the work was carried out by Ohio
State University under contract to USAID.
The Ohio State work led to development
of a new approach to small-farmer lend￾ing, emphasizing 1) positive real interest
rates, 2) emphasis on sound financial in￾stitutions, 3) attention to the nonfinancial
costs of borrowing, and 4) attention to re￾source mobilization.
USAID adjusted its approach to small￾farmer lending, and more broadly its ac￾tivity in the financial sector, to reflect these
lessons. Agency policy prohibited lending
at negative real interest rates and encour￾aged development of sound financial in￾stitutions. These lessons were gradually
introduced into USAID programs, though
other donors were much slower in apply￾ing them.
As part of an effort to disseminate this
understanding and to relate it to another
area of finance, USAID in 1990 prepared a
paper for dissemination to other donor
members of the Development Assistance
Committee of the Organization for Eco￾nomic Cooperation and Development.
That paper, Development Finance Institu￾tions: A Discussion of Donor Experience,
looked at the experience of USAID and
other donors in establishing investment
banks. Those banks, or development fi￾nance institutions (DFIs), had been seen as
a means of increasing productive invest￾ment in productive business enterprises by
providing long-term finance. Since com￾mercial banks specialized in short-term
credit, it was thought that long-term in￾vestment consequently was under￾financed. Consequently, donors, including
USAID, promoted creation of new, usually
government-owned institutions intended
to use donor funding and domestic sav￾ings resources to lend for “developmen￾tally oriented” investment.
As the OECD paper makes clear, do￾nor experience with this modality was
generally unsatisfactory. Most develop￾ment finance institutions failed to play the
developmental role envisioned for them,
and few DFIs even became financially sus￾tainable. Several factors were at work.
First, repayment experience was often un￾satisfactory, as projects financed by DFIs
frequently failed. Second, interest rates
charged by DFIs often were not inflation
Capital Markets and Economic Development 9
adjusted: when inflation rates rose, the
institution quickly began to decapitalize.
Third, many DFIs concentrated more on
channeling donor resources than on mo￾bilizing savings on their own. As donors
became disenchanted with them, DFIs had
no resources to lend.
A study by USAID’s Center for Devel￾opment Information and Evaluation (CDIE)
of one narrow segment of the financial
market—that for venture capital, equity
investment in emerging companies—con￾cluded that investment in this sector was
a mirage for donors. It appeared to be a
promising means for speeding the devel￾opment process by encouraging the
growth of dynamic new companies. In
practice, past USAID projects in this area
(and donor activity more generally) have
yielded only inconsequential results.
The study attributes the failure of
USAID projects to two main tendencies.
First, the Agency asks implementers to
produce results in too many dimensions
(e.g., asking venture capitalists to look for
promising companies in the agricultural
sector in the poorest regions of a country
that also employ many women). Second,
the ponderous way in which USAID moves
from concept to action, together with the
constraints on profit-making by USAID
implementers, makes Agency projects un￾attractive to people with the required ven￾ture capital expertise.
Finally, CDIE recently studied a par￾ticular mechanism for promoting private
sector development: the enterprise fund.
Enterprise funds are medium-term invest￾ment companies established in transition
economies to invest U.S. government grant
funds into private companies, with the
expectation that such investments will pro￾duce both a set of strong private enter￾prises and a strengthened equities market
in the countries where these firms oper￾ate. Several of the funds have had serious
problems. It is still too early to judge the
final outcome of the enterprise fund ex￾periment, but the results so far suggest that
both the profitability of the investments
and the ability of the funds to find suit￾able investments are dependent on the
overall economic policy regime and insti￾tutional environment in the country where
the investments are being made. If those
conditions are not favorable, an enterprise
fund will face great difficulties.
Drawing Conclusions
A careful reading of the three previ￾ous sections of this chapter will indicate
the tentative nature of much of our knowl￾edge about financial markets and their
contribution, actual and potential, to eco￾nomic development and to reducing pov￾erty. Economic researchers have been un￾able to make definitive statements about
the size of the contribution of this sector
to overall growth, or even to make strong
statements about how the sector should be
10 Efficient Capital Markets: A Key to Development
organized. The Asian financial crisis was
a total surprise to virtually all observers.
USAID has had to operate in a world where
such uncertainties have been prevalent,
making project choices on the basis of
judgments that have had to be tentative.
The same uncertainty has to surround
efforts to evaluate the success of USAID
projects in financial market development.
Failure is easier to judge than success. The
degree of success will depend upon the
viewer’s perspective, which is embedded
in historical context. The approaches taken
by the Asian “tigers” to financial market
development looked masterly until mid￾1997. The Japanese approach to corporate
finance drew on close long-term ties be￾tween banks and manufacturers. It looked
much more promising than the U.S. ap￾proach, which depended more on equity
finance subject to the vagaries of short￾term performance—until the Japanese
banking crisis exposed the weakness of
close ties between lenders and borrowers.
Today’s wisdom about these issues may
be exposed in another decade as an illu￾sion. Such problems do not make the
drawing of conclusions impossible, but
they do render them tentative.
sustainable development goals. Three
basic issues are being studied:
1. Can USAID do capital markets
projects well?
2. If so, do capital markets projects
spur economic growth?
3. Who benefits from the growth pro￾duced by such projects?
During 1997–98, CDIE-led teams car￾ried out fieldwork to review recent USAID￾funded capital markets projects in India,
Kenya, Morocco, Romania, and the Phil￾ippines. In addition, a CDIE researcher has
written a case study of an earlier USAID
capital market development effort: cre￾ation of investment banks in Central
America in the 1960s.
USAID Projects Studied
1. India. USAID’s principal activity to
promote capital markets is the Financial
Institutions Reform and Expansion (FIRE)
2
USAID Capital
Market Development
Activities in the
Case Study Countries
NE MEANS for avoiding crises like
that experienced in Asia is through
broadening of capital markets, so that busi￾nesses and governments are less depen￾dent on short-term bank lending. Short￾term loans expose the borrower to the risk
that the loan will not be renewed. If some
adverse piece of news causes lenders to
call their loans, the borrower can face a fi￾nancial crisis. Enterprises can reduce that
risk by long-term borrowing, in countries
where it is available, or by selling part
ownership of the enterprise. The reduction
in financial risk that access to long-term
finance implies for the firm may lead it to
make larger investments in projects with
longer gestation periods, possibly leading
to productivity growth over the long term.
A number of USAID projects in recent
years have sought to promote longer term
financial market development, primarily
through establishment or strengthening of
stock markets. This study examines a
group of those projects. Its purpose is to
examine the effectiveness of USAID assis￾tance, to draw conclusions about the
importance of such assistance for USAID
O
12 Efficient Capital Markets: A Key to Development
project. It was begun in fiscal year 1994,
with $20 million plus $20 million in hous￾ing guaranty funds, and terminated by the
Agency in 1998 following India’s nuclear
tests. FIRE activities included strengthen￾ing the government securities regulatory
agency, improving stock market institu￾tions including a screen-based securities
trading system and a securities depository
institution, and promoting improvements
in the debt market. Two earlier projects
also addressed aspects of capital market
development. The Program for the Ad￾vancement of Commercial Technology
helped spur the venture capital industry,
and housing guaranty assistance to the
Housing Development Finance Company
promoted development of a mortgage
market.
2. Kenya. USAID supported the devel￾opment of capital markets in Kenya be￾tween 1988 and 1996. The object of this
support was a newly created regulatory
body, the Capital Markets Authority
(CMA). The total level of support provided
during that period was less than $1 mil￾lion. The most significant component was
long-term technical assistance to the Capi￾tal Markets Authority and to the Nairobi
Stock Exchange. The adviser provided
day-to-day guidance and technical exper￾tise to the staff of the CMA. During his ten￾ure, the CMA drafted and put into opera￾tion the regulatory framework that gov￾erns the market. He helped set up a pub￾lic information center at the CMA and ini￾tiated public awareness seminars and
courses. At the Nairobi Stock Exchange,
the adviser prepared the trading floor op￾erating procedures, trained exchange
members in open-outcry trading, and
helped the NSE establish its operating pro￾cedures.
USAID financed computer equipment
and the installation of an NSE office and
trading floor. Kenyan capital market ex￾perts participated in USAID-funded train￾ing and study tours between 1990 and
1995. Officials of the Capital Markets Au￾thority received training at the U.S. Secu￾rities and Exchange Commission. Two
groups of CMA officials and NSE members
visited Southeast Asian markets. Others at￾tended international conferences and an￾nual meetings of securities market asso￾ciations.
3. Morocco. The USAID mission in Mo￾rocco explored options to support the de￾velopment of the capital market in 1991
by commissioning two studies. One exam￾ined the stock exchange; the other, estab￾lishment of a secondary debt market. Af￾ter considering its options, the mission
decided to undertake a large privatization
support program rather than a capital or
financial market support program. A sub￾sidiary interest in capital markets was car￾ried into the privatization support pro￾gram.
The program was a $25 million effort.
Of that amount, $20 million was non￾project assistance, and $5 million went to
USAID Capital Market Development Activities in the Case Study Countries 13
related technical assistance. The program
document concluded that “to take full ad￾vantage of the opportunities presented by
privatization, the weaknesses in Morocco’s
capital market will need to be addressed.”
Through conditionality, the program re￾quired a promotional and educational
campaign on the benefits (and risks) of
share ownership. It also required identifi￾cation of possible measures to promote
broader public share ownership and stipu￾lated that 6 of the 28 privatizations in the
program be done through the stock mar￾ket. A long-term adviser, funded from an￾other project, provided technical assistance
on the interbank market, the money mar￾ket, and the stock market.
4. The Philippines. In 1993, USAID be￾gan a five-year $13.5 million Capital Mar￾kets Development Project. Its goal was to
strengthen the integrity and capacity of the
capital markets to help increase the flow
of equity and debt securities, to encour￾age savings mobilization and increase the
quantity and quality of private investment.
The project included both public and pri￾vate sector components. The public sector
component included assistance to the se￾curities regulatory agency, the Securities
and Exchange Commission, under the
management of the Ministry of Finance.
The private sector component included
assistance to an umbrella association of
private sector financial institutions, the
Financial Executives Institute of the Phil￾ippines.
5. Romania. Although communism
ended in 1989, by 1995 only limited moves
toward economic liberalization had gone
forward. Strict state controls gripped most
markets, and state-owned enterprises
dominated the economy. Investment had
been misallocated, and the economy was
using the wrong processes to produce the
wrong commodities. The economy needed
to be opened up to world prices; state￾owned firms needed to be privatized and
a market created to allocate capital to firms
that could use it most effectively. An im￾portant move toward liberalization was
the planned mass privatization of 5,600
medium-size and small state-owned
firms—but there was no market to price
shares or to allow people to buy and sell
shares. If privatization was to succeed, a
stock market had to be created.
USAID wanted to help the privatiza￾tion effort and at the same time improve
capital allocation—but none of the neces￾sary institutions existed. Agency projects
helped create a stock market (Rasdaq), a
capital market regulator (a securities ex￾change commission), stock market laws
and regulations, self-regulatory organiza￾tions, a stock brokerage community, mu￾tual funds, and a stock registry, depository,
and transfer agent.
6. Central America. A somewhat differ￾ent type of study was carried out in Cen￾tral America. In that region, USAID estab￾lished a number of financial intermediar-
14 Efficient Capital Markets: A Key to Development
ies to promote long-term investment.
These development financial institutions,
or financieras as they were called in Latin
America, were intended to make loans or
equity investments in promising compa￾nies. By the 1970s, as described in the pre￾vious chapter, USAID had become disillu￾sioned with these institutions and sharply
reduced assistance to development finance
institutions.
3
Program
Performance
And Outcomes
Program Outcomes
OR EACH of the five projects reviewed
for this study, the CDIE evaluation
team prepared an impact assessment.
Those studies, listed in the bibliography,
provide detailed descriptions of the
projects and their outcomes. Briefly, the
findings are as follows:
1. India. The team found the project
to be highly successful in strengthening the
regulatory framework for the Indian se￾curities market. Substantial amounts of
technical assistance aided the Securities
and Exchange Board of India to improve
procedures and to move toward more ef￾fective regulation of the industry. This has
made the Indian securities market more
attractive for foreign and domestic invest￾ment.
2. Kenya. The evaluation team found
the project to be successful, helping the
Kenyan Capital Markets Authority and the
Nairobi Stock Exchange to acquire the ex￾pertise to carry out their mandate. The
very limited assistance provided by the
project (under $1 million) was important
because it came at the formative stage of
the development of these institutions.
Nevertheless, the evaluators found that the
strengthening of the equities market had
not contributed much to the financing of
private business expansion in Kenya.
Weak macroeconomic policy and an un￾willingness of closely held firms to under￾take the disclosure and other requirements
for listing have limited the impact of the
new institutions.
3. Morocco. This project was success￾ful in raising activity on the Casablanca
Stock Exchange and in broadening the in￾vestor base. As intended in the project
design, it provided a tool for privatization
of government enterprises. It also was able
to provide a means for connecting savers
with small and medium-size enterprises.
The project was much less successful in
inducing private Moroccan companies to
become listed on the exchange.
4. The Philippines. The Philippines
project successfully reoriented the Philip￾pines Securities and Exchange Commis￾sion away from approval of individual is￾sues to an American-style institution, en￾forcing disclosure on companies and
F
16 Efficient Capital Markets: A Key to Development
Long-Term
Sustainability
probable
uncertain
uncertain
probable
questionable
drawing upon self-regulatory organiza￾tions in the financial industry. A securities
depository was also created. The reform
of the Securities and Exchange Commis￾sion was seen as a great achievement by
the Philippine financial community.
Achievement of the reform required an
announcement by USAID that it would ter￾minate its project unless the government
made personnel changes to permit reform.
The ultimatum motivated the government
to make the necessary changes. That was
perhaps the most important action lead￾ing to project success.
5. Romania. The Romania project suc￾ceeded in creating a fully operating stock
exchange in less than a year, creating com￾petition for the existing stock exchange.
This provided a market for issues of
smaller companies, most of which had
been privatized by the Romanian govern￾ment. This was a clear technical success,
but the value of the new exchange’s mar￾ket niche, and its impact on the Romanian
economy over the long term, are uncertain.
Shortcomings in government economic
policies and the slow pace of privatizations
were serious obstacles to a larger role.
Project assistance to the government regu￾lators was seen as valuable, but the evalu￾ators concluded that the National Securi￾ties Commission still had significant prob￾lems, predominantly in its enforcement
powers.
6. Central America. USAID’s efforts in
Central America during the 1960s were de￾signed to promote long-term financing by
establishing new institutions. This experi￾ment largely failed. None of the institu￾tions established in any of the Central
Purpose
regulatory,
institutions
basic TA
basic TA
regulatory,
institutions
new stock
market,
regulatory
Table 1. Summary of Project Characteristics
Country
India
Kenya
Morocco
Phillippines
Romania
Direct
Outcome
successful
successful
successful
successful
successful
Financial
Impact
significant
small
small
significant
small
Systematic
Effects
considerable
significant
significant
considerable
uncertain
USAID
Project
Amount ($m)
20
1
5
13
25
Program Performance and Outcomes 17
American countries maintained itself by
following the original purpose for which
USAID assisted in its creation. Some of the
institutions failed and disappeared. Oth￾ers adapted to the environment in which
they were operating by shifting to short￾term lending. That reduced their risk and
allowed the institutions to balance their
lending portfolio to the term structure
(generally very short term) of the resources
that they were able to attract.
In summary, all five of the recent
projects were successfully completed.
They produced the institutional result in￾tended in the project design. Their higher
level outcomes were more mixed. Table 1
summarizes some of the characteristics of
the five case studies. The judgments there
are tentative, since there is much uncer￾tainty about what changes in actual activ￾ity can be traced to the projects, and some
outcomes may begin to appear only
slowly, and later in time than the exami￾nation of the projects. Nevertheless, the
matrix suggests that country policies are
important to project success and that the
link between strengthening of the equity
market and additional capital availability
for firms is a tenuous one.
Rationale for
USAID Assistance
That USAID stock market develop￾ment projects have been implemented suc￾cessfully does not itself provide a sufficient
justification for Agency involvement in
this sector. Nor does the conclusion that
stock markets are an important instrument
in reducing poverty over the long term (a
topic discussed later) provide a sufficient
justification. The fact that stock exchanges
are instruments for financial gain by their
participants creates an expectation that the
private sector should be able to undertake
any necessary and useful action in this
field. Why should USAID become involved
at all?
The basic answer seems to be that
capital markets developed by the private
sector alone will not produce the most sat￾isfactory development result. Capital mar￾ket development should not be left to mar￾ket forces, because it will produce poor
results. There are two areas where experi￾ence shows that regulation is needed to
make possible the development of a vi￾brant equities market: protection of inves￾tors from firms; and protection of both in￾vestors and firms from stock market in￾termediaries.
Protection of Investors
From Firms
Recent research (e.g., La Porta and
others, 1999) has shown that legal protec￾tion of minority stockholders and of credi￾tors from the managers and majority stock￾holders of firms is closely linked to the de￾velopment of capital markets. Countries
with such protections have larger and
broader capital markets, wider ownership
of shares, and more efficient allocation of
18 Efficient Capital Markets: A Key to Development
ers, will the market-makers gradually be￾gin to eliminate these obstacles to effi￾ciency.
Moreover, stock exchanges are what
economists call natural monopolies. One
can conceive of multiple stock exchanges
offering the same stocks (and the United
States once had numerous regional ex￾changes), but this situation is unlikely to
last. Both buyers and sellers are interested
in good execution of their transaction—
meaning a quick transaction at close to the
price existing when the decision was
made. The best execution is likely to be at
the exchange that has the largest volume
(i.e., the greatest liquidity) in the stock in
question.
Any advantage that one exchange has
in volume will thus lead to greater volume
and to a greater advantage over its com￾petitors. It ultimately ends up with all the
business. In most countries, the stock mar￾ket that emerges will be owned by its
members, whose interest is in limiting
competition among the membership and
in commission rates that provide for com￾fortable incomes for members. (In the
United States, it was only government ac￾tion during the 1970s that forced the lead￾ing U.S. stock exchange to allow commis￾sion rates to be negotiated—leading to the
lower commission rates that dramatically
expanded market volume.)
In sum, it is only through strong gov￾ernment regulation and supervision of the
financial markets that firms and market￾capital among firms than countries with￾out such protections. Another recent study
(Johnson and Shleifer, 1999) contrasts the
dramatic difference in development of
equities markets in Poland and the Czech
Republic. In Poland investors had legal
protection and the stock market has grown
rapidly. In the Czech Republic legal pro￾tections were missing and the stock mar￾ket has not been able to mobilize capital
for investment. The study provides a con￾vincing rationale why such protections
will not arise naturally by market forces.
Protection of Investors
And Firms From
Stock Market Intermediaries
Stock markets are established by nei￾ther the suppliers of capital nor the firms
needing capital, but by intermediaries.
From the point of view of suppliers and
demanders, and from the public at large,
the best intermediation process is one that
is transparent and has low transactions
costs. But observation of actual stock mar￾kets in countries without strong govern￾mental regulation will show that this situ￾ation does not occur naturally. Instead, the
market intermediaries are likely to create
monopolistic arrangements that lead to
high transactions costs, an atmosphere
permissive of self-dealing and rigged
transactions, and insufficient flow of in￾formation to potential investors. The mar￾ket is made for the convenience of the
market-makers. Only very slowly over
time, under organized pressure from oth-
Program Performance and Outcomes 19
listed companies would rise in line with
the country’s growth, as emerging com￾panies issue initial public offerings. The
stock market capitalization would also
increase, probably at a steady rate that is
faster than gross national product growth,
as prices of older companies rise and
newer companies are added. Trading vol￾ume would also rise steadily, as more
people began using the stock market and
as the market became more liquid.
Unfortunately, this conceptualization
does not describe the operation of real
stock markets. All real markets seem to be
characterized by periods of exuberance
and periods of decline. Moreover, none of
these variables is an unambiguous indi￾cator of progress. Stock markets are noto￾riously volatile, and rising values can
sometimes reflect speculative excesses, so
that declines represent a return to proper
pricing. The number of initial public of￾ferings is subject to market conditions as
well as regulatory factors. In India, USAID
chose the number of initial public offer￾ings as a performance benchmark under
the assumption that this would rise as
stock market oversight improved. But the
opposite happened, as the government
tightened listing requirements following
a series of financial scandals. It began
delisting companies that failed to provide
adequate financial information to inves￾tors.
The basic conclusion in this area is
that there is no easy way to monitor the
progress of an ongoing capital markets
makers can be forced to operate in a man￾ner that serves the public interest effi￾ciently. Efficient markets are a public good
that require government intervention if
they are to work well. USAID has shown
that it is capable of transferring the neces￾sary technology to developing-country
governments, and therefore has a useful
role to play in establishing this necessary
set of institutions.
Performance Monitoring
Current USAID practice is to give em￾phasis to monitoring performance of on￾going activities during implementation.
The Agency has shown a strong preference
for activities to establish benchmarks and
performance targets for each year of the
implementation process. Decisions about
whether to fully fund programs or to ter￾minate them sometimes depend in part
upon the performance in relation to tar￾gets. In the case of stock market projects,
this approach has been shown to have dan￾gers.
Stock markets would seem to be an
ideal candidate for quantitative measures
of performance. Such measures abound;
they include the number of stocks listed,
the market capitalization of listed stocks,
indexes of stock prices, number of new
issues, inflows to the stock market by for￾eign investors. Development planners con￾cerned with performance monitoring can
draw nice trend lines, showing an ex￾pected steady expansion of a country’s
stock market. Each year, the number of
20 Efficient Capital Markets: A Key to Development
come. Deductively, one can posit a vari￾ety of influences, some (e.g., the rise in
wealth of holders of securities) tending to
increase inequality and others (e.g., in￾creased demand for skilled workers and
increased access to financing by nonelites)
that would tend to decrease it. How these
various factors sum in practical cases,
though, is conjectural.
On the issue of the impact of capital
market development on poverty, the case
for a positive relationship is much stron￾ger, but still indirect and gradual. Of the
country studies, only the India paper dealt
with this issue in detail, and it did so in
terms of broad concepts. Before dealing
with those concepts, though, let us con￾sider the results of an earlier study.
Batchelder and Holt (1997) have
drawn upon the historical experience of
developing countries regarding the rela￾tionship between economic growth and
poverty to make projections for India and
other countries of future poverty levels.
They provide two scenarios for India,
based on assumptions about economic
policy. Under the “poor policy” scenario,
where government restrictions prevent
free markets from operating in capital mar￾kets and foreign trade, growth would av￾erage 1.2 percent per capita per year, while
it would average 5 percent per capita un￾der market-based policies.
The difference in poverty between the
two scenarios is stark. With poor policies,
the number of poor (those with per capita
project. The key judgments of progress
seem to be qualitative rather than quanti￾tative; they require people with substan￾tial experience in this area to make them.
USAID to date has not developed qualita￾tive indicators for capital markets devel￾opment. One of the conclusions of the
Kenya/Morocco case study provides per￾haps the best statement of the proper con￾clusion in this area:
Missions undertaking capital market
projects should be held accountable for
the quality of the institutions they assist
but not for the level of market activity.
Stock and bond markets reflect the state
of the national economy, which itself is
the result of host government economic
policies, the underlying structure of the
economy, and external factors. Market
indices will rise and fall during and after
the USAID activity. The goal of a USAID
activity should be to help put in place
institutions capable of meeting the fi￾nancial intermediation demands of the
private sector.
Capital Markets
And Poverty
One of the original goals of the study
was to include some analysis of the distri￾butional consequences—and particularly
the impact on poverty—of the develop￾ment of capital markets. That proved to
be beyond the capacity of the evaluators,
for the relationships involved are nuanced
and complex. The evaluators could find
no convincing empirical evidence regard￾ing the impact of the development of eq￾uities markets on the distribution of in-
Program Performance and Outcomes 21
incomes below $1 a day) increases slightly,
from 473 million to 476 million, though
their share in the population falls from 51
percent to 37 percent. With the faster
growth resulting from market-based poli￾cies, the number of poor falls from 473
million to 174 million, or from 51 percent
of the population to 14 percent. (This de￾cline is roughly in line with what occurred
in Indonesia over the last 25 years.)
Batchelder and Holt’s scenarios over￾state the difference in India. Its policies
have moved a substantial distance over the
past five years toward free markets for
goods and finance, and recent economic
growth rates have reflected those better
policies. Nevertheless, the basic point is
shown by experience. Countries with bet￾ter policies have substantially faster rates
of poverty reduction. This model, of
course, does not separate improvements
in capital markets from other policy
changes. Improvements in capital markets
alone would be expected to provide some
fraction of the impetus to growth found
by Batchelder and Holt.
In broad terms, the work of USAID ac￾tivities is intended to improve the effi￾ciency of capital markets. Increased effi￾ciency in the financial sector in turn is ex￾pected to direct financial resources into the
sectors where their productivity is high￾est. This in turn is expected to increase the
rate of economic growth in the country
receiving the assistance. Faster economic
growth in turn is expected to reduce pov￾erty. The link between increases in income
and reductions in poverty is empirically
strongly established over the medium and
long term. (For shorter periods of time, the
two can move in opposite directions be￾cause of a variety of factors. But extreme
poverty—the World Bank uses $1 a day
per person—is common only in countries
where average incomes are also low.) The
following section uses capital markets in
India as an example of the types of prob￾lems faced in many developing countries.
The Case of India
The empirical link between market￾oriented polices and growth is important
in the present context because the link be￾tween USAID capital markets projects and
poverty reduction is neither direct nor
immediate. At present, companies that
raise capital because of improvements in
the structure of the capital market will not
make major increases in employment as a
result. Nor will the Indian stock market
provide a means for the great bulk of small
and medium-size enterprises in India to
gain capital for expansion.
Improvement in the structure of the
equity market will directly affect perhaps
several thousand companies, not the mil￾lions of smaller enterprises that constitute
the mass of business enterprises. (Large
firms do dominate output: in India, the
3,000 largest companies account for half
of all manufacturing value added.) For
their capital needs, small firms will, as
elsewhere, need to rely primarily on in-
22 Efficient Capital Markets: A Key to Development
ternally generated savings, funds from
family and associates, and borrowing from
banks. Despite these limitations, work in
capital markets appears, in the longer
term, to be a critical element in the rapid
reduction in poverty in India.
From independence, the Indian gov￾ernment has given central importance to
investment and to capital. Successive gov￾ernments have believed that capital was
the key constraint in the Indian economy,
so capital was seen as needing to be allo￾cated carefully to avoid waste. The Indian
governments used central planning as the
vehicle to achieve this. Much investment
would be directly by government enter￾prises in response to the planners’ projec￾tions. Private companies would be pre￾vented from overinvesting in capacity by
a requirement that government permission
would be necessary for any expansion of
their factories.
In sum, the Indian planning model
was centered on concern about using capi￾tal efficiently. In 1950, the theory had con￾siderable plausibility. The West had recov￾ered from a lengthy depression only
through the onset of world war, and the
Soviet Union appeared to have made a
great leap forward into industrialization
through central planning.
This theory had two central assump￾tions that proved fallacious in practice. It
was assumed that efficient production re￾sulted more or less automatically from
modern technocratic management of in￾dustrial concerns. Getting maximum pro￾duction from a set of machines was seen
as a straightforward engineering problem.
The critical problem for economic growth
was to ensure that all factories had the
proper amount of capital so that the entire
productive structure could move forward
together. Second, the types of goods to be
produced were conceived of in simplistic
terms—tons of steel, numbers of automo￾biles, pairs of shoes—implicitly assuming
that each industry produced homogenous
products for which the needs of the
economy could be measured quantita￾tively.
The experience since 1950 demon￾strates that modern economies are not like
that. For the needs of steel-using industry,
the problem is not simply the number of
tons of steel produced, but the number of
tons of steel of particular specifications
available in a particular place at a particu￾lar time. Planning processes are powerless
to deal effectively with the qualitative, lo￾cation, and time dimensions. Only the flex￾ibility of a market system, where the pro￾ducer is rewarded for meeting these re￾quirements by the prospect of profit, and
punished for failing to do so by the pros￾pect of loss (and bankruptcy), has proven
capable of this. The problem of specifica￾tions is compounded with consumer
goods. If all consumers preferred size 9
brown penny loafers, the problem of pre￾dicting and meeting consumer demand for
shoes would be relatively straightforward.
But consumer preferences both vary
widely and change over time.
Program Performance and Outcomes 23
Another factor is technological ad￾vancement. Technology change in both
manufacturing processes in the world and
in design of consumer goods has been
rapid. Consequently, the idea of a know￾able and fixed capacity for production for
each factory disappears. To remain effi￾cient, managers in each factory have to
continually revise their production meth￾ods, adding machinery and techniques in
line with evolving technology. They need
to change the product in line with chang￾ing designs and new materials. In sum,
they must continually make new decisions
about what to produce and how to pro￾duce it. Once the magnitude of these prob￾lems becomes clear, it becomes evident
that central planning is simply not capable
of meeting the needs of a modern
economy.
The core of the process is what Joseph
Schumpeter called “creative destruction,”
which is at the core of modern market
economies. Companies and entire indus￾tries that do not maintain competitiveness
in the long run by adapting new technolo￾gies are simply pushed aside. Enterprises
go bankrupt, or are acquired by others, to
reorganize people and capital equipment
into arrangements that can produce effi￾ciently what is wanted by society.
As we look around India, it is clear
that much capital is wasted or mis￾allocated. Because of the uncertainty of
electric power, businesses have their own
generators. Dozens of ships wait in the
port of Bombay for their turn to offload or
load. Bungalows for government offices
and residences, relics of a quieter day, still
sit in the shadow of Bombay skyscrapers
on some of the most valuable land in In￾dia. More broadly, the amount of economic
growth that has occurred in India is not
commensurate with the amount of capital
investment that has been taking place. To
achieve faster economic growth, and faster
reduction in poverty, capital needs to be
used more efficiently.
This continuous revaluation of
capital assets provides three important
functions. First, it signals to other provid￾ers of capital, such as banks, the prospects,
and therefore the riskiness, of lending to
companies. Second, it provides incentives
for new firms to enter promising sectors,
and for investors to seek out and invest in
companies of the future. Third, it provides
the means, through takeovers of existing
companies by more efficient firms, to re￾deploy the capital in a more efficient way.
In the longer term, restructuring of the
capital base and the means by which capi￾tal can be drawn to the most efficient use
provides the most promising way for pro￾ductivity of labor to be increased. Increas￾ing labor productivity is the only sure
means for steadily increasing wage rates
and incomes.
ROM THE SIX COUNTRY CASE STUDIES,
a number of lessons can be drawn.
They are as follows:
1. USAID should continue to support
development of capital market institu￾tions. All the recent projects studied had
a considerable degree of success. They
strongly support the view that USAID can
do this type of project well. The evidence
that there is a high developmental payoff
to this kind of activity is much more tenu￾ous, for capital markets are institutions
whose importance cannot easily be mea￾sured—but the evidence suggests that it
may be quite high.
2. USAID activities should emphasize
the regulatory framework and avoid di￾rect financing of investment capital. A
good legal and regulatory framework and
strong government oversight are needed
to make capital markets work efficiently.
The primary emphasis of USAID support
should be on technical assistance and
training for this rather than financing of
hardware for the operation of the market
itself. Nevertheless, some support of the
4 Lessons Learned
F
latter may be useful in supporting goals
in the regulatory area, as in the Philippines
case.
3. USAID assistance should promote
the general approach used in the U.S. capi￾tal market. This approach—including a
strong governmental regulatory body—
has shown itself to be appropriate for de￾veloping countries. The emphasis in this
approach on disclosure of relevant circum￾stances rather than government approval
of individual issues provides more flex￾ibility and greater opportunity for new
activities than models based on govern￾ment approval of individual issues of capi￾tal stock. The projects reviewed show that
USAID can identify and contract appropri￾ate expertise to transfer the U.S. technol￾ogy.
4. USAID should undertake projects in
this area only where the economic climate
is favorable. A stock market is an institu￾tion that promotes faster economic growth
in a favorable environment, but is unlikely
to be an important catalyst for the adop￾tion of better economic policies. Success-
26 Efficient Capital Markets: A Key to Development
ful government efforts to privatize state￾owned enterprises can support stock mar￾ket development.
5. USAID should be skeptical of re￾gional approaches to stock market devel￾opment. Stock markets are subject to
economies of scale, so promotion of their
development is easiest in large countries.
In regions where USAID works that are
composed mainly of small countries (e.g.,
Central America or various parts of Af￾rica), efforts to promote a set of officially
promoted regional structures are likely to
arise. The literature indicates that such ap￾proaches are unlikely to work, and should
be resisted. The free flow of finance among
a group of countries will tend to lead to
one of the region’s stock markets becom￾ing dominant. Transactions will flow to the
most liquid market, which will have the
lowest transaction costs. Such an outcome
may be desirable from the region’s per￾spective, but it is likely to be resisted by
the individual governments in the region,
for whom a national stock market now has
the appeal that a national airline once had.
6. USAID should look for ways to pro￾mote development of debt markets. The lit￾erature demonstrates that in the longer
term, creation of long-term debt markets
is essential to reduce the risk of financial
crises, such as the recent Asian experience.
This will require improvements in govern￾ment policy to eliminate inflationary ex￾pectations and reduce crowding out by
government. Throughout the developing
world, substantial progress has been made
on these issues during the past few years,
so the prospects for persuading savers to
acquire long-term securities is much bet￾ter than it has been in the past. Long-term
finance for infrastructure has great poten￾tial for promotion of growth, and innova￾tions in debt markets can support this ob￾jective.
Batchelder, Alan; and Tyler Holt. 1997.
“2020 Visions: Creating Tigers, Cutting
Poverty, and Increasing Trade, 1995–
2020.” USAID Economists Working Pa￾per No. 6. Washington: U.S. Agency
for International Development.
Buttari, Juan; Jerre Manarolla; and Michael
Shea. 1997. “The Impact of Moderniza￾tion of the Indonesian Stock Exchange
on Employment.” USAID Economists
Working Paper. Washington: U.S.
Agency for International Develop￾ment.
Center for Development Information and
Evaluation. 1998. “Developing
Romania’s Capital Market.” Impact
Evaluation. PN–ACA–921. Washing￾ton: U.S. Agency for International
Development.
———. 1999. “Developing the Capital
Market in Kenya and Morocco.” Im￾pact Evaluation. PN–ACA–928.
Washington: U.S. Agency for Interna￾tional Development.
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