Requirements for a
Successful Equity Market(1)
Antoine van Agtmael
The basic prerequisites for the establishment and continued success of an equity market include:
* a reasonably stable political environment;
* conducive macro-economic policies, to ensure an attractive long-term yield for equities in comparison with other domestic and foreign investment alternatives;
* a growing economy;
* a favorable government attitude and an economic structure in which private enterprise is allowed to play a significant role;
* a sufficient demand for and supply of stocks;
* reasonably well-developed accounting and auditing standards:
* non-discriminatory tax treatment of investment in shares in comparison with other investment alternatives, or even special temporary tax and other incentives;
* the existence of at least a small group of intermediaries (underwriters, dealers, and brokers); and
* an adequate legal framework, including protection of outside investors through securities
legislation and its enforcement.
Without these elements, a viable equity market cannot develop; it will either remain dormant or be
subject to excessive speculation. It is obvious that several of these factors are closely related to the
level of economic development which a country has achieved and the type of development path it has
1. Political and economic environment
Investors are very sensitive to political uncertainty. In countries which are in domestic turmoil, engaged in major border conflicts, or involved in a war, there is little interest in establishing a stock market and investing in shares. If a market exists, trading activity and prices are usually in decline. Political disruption nearly always affects economic activity because companies postpone investments and scale down their growth projections. In contrast, rapid economic growth leads to a sense of confidence among investors and entrepreneurs and opens up new markets, providing companies with a strong inducement to expand their operations. Their need for finance, including share capital, grows.
Economies dominated by government enterprises (as in many socialist and African countries) or with scarce entrepreneurial experience are not likely candidates for the establishment of a stock market. An exception is countries where the government has made a conscious decision to change course and sell its stake in government corporations to allow them to be run on a private enterprise basis.
Unfavorable or unstable macroeconomic policies (for example, high inflation, negative real interest
rates, frequent devaluations, discriminatory tax treatment of shares) are a major reason for the lack of
activity of securities markets in many developing countries. Erratic monetary policies create a
suspicion of all kinds of financial paper; frequent devaluations and negative real interest rates at home
tempt investors to invest abroad. Inflation has eroded return on equity in many countries for long
periods. Inevitably investors turn away from equity when the expected yield on shares is likely to be
lower than that on other less risky investment alternatives. Indeed, it is surprising how well many
emerging securities markets have developed despite the enormous handicaps under which they have
2. The demand for stocks
The demand for stocks depends on a variety of factors.
2.1 Individual demand
The first important factor is the number of financially sophisticated individuals with enough money
to purchase shares. In a country without a stock market, this number is difficult to estimate, although
the size of the population, in particular the urban population, and the level of per capita income give
rough indications. A better approximation can be derived from estimating the numbers of businessmen,
professionals (doctors, engineers, accountants, lawyers, and higher level employees in companies), and
senior civil servants. If such data are not available, the number of car owners, bank depositors, or
holders of government bonds can be useful. In their early stages, stock markets cater to as few as
10,000 shareholders, of whom only several hundred may be active traders. Remittances from workers
abroad can play a significant role in the demand for shares, as happens in Jordan and Turkey.
2.2 Institutional demand
In many emerging markets, demand from insurance companies, pension or provident funds, and
mutual funds is negligible; in some, like Brazil, Chile, Korea, Pakistan, and Indonesia, their presence
plays an important role. This is an area of extensive discrimination against equity markets in many
developing countries. Regulations governing the obligatory reserves of insurance companies have a
major impact on their investment activities. Government controlled pension funds are usually not fully
funded or can invest only in government securities. Private pension or provident funds can only be
active buyers if they are allowed to do so by rules channelling their investments into various categories
or pertaining to their fiduciary responsibility. Private parties and government authorities interested in
the development of a stock market are often not sufficiently aware of the potential importance of
institutional investment; without them there is a great risk of a market dominated by individual
2.3 Foreign portfolio investment
Only in a few emerging markets (Hong Kong, Singapore, Malaysia and Mexico) do foreigners play a
significant role. In many other markets, foreign portfolio investment has been discouraged. This
situation appears to be changing, however. Mexico, Brazil, Korea, and Taiwan have recently changed
their legislation to allow foreign investment through mutual funds. Korea is planning to internationalize
its market further and permit foreign institutions and individuals to participate more directly in the
2.4 Investment alternatives
The attractiveness of shares in comparison with other investment alternatives is crucial to individual as well as institutional investors. Rational investors look at overall return, risk, liquidity, and tax treatment in determining where and how to invest their money. In theory, they should calculate future expectations regarding these factors, but in reality most investors, especially the less sophisticated speculators, look primarily at recent performance. For example, hopes for capital gains play a major role in buying decisions when prices have begun to soar, but are easily ignored when a stock exchange does not yet exist or trading is dormant. In inactive markets, dividend yield tends to be more important than capital gains expectations. The overall return (or yield) on shares (including both dividends and capital gains) must be higher than the interest yield which the investor would receive on bank deposits or bonds because most investors view shares as more risky.
Since policies influence after-tax yield to the investor, government measures to improve the tax
treatment of shares can have a major impact. Liquidity, or investors' ability to sell shares quickly
without affecting the market price, is also important when investors compare the after-tax yields of
shares and bonds or deposits. A comparison of potential capital gains, including their tax treatment, is
especially relevant when land or real estate is appreciating rapidly.
Public awareness of the stock market and of shares as an investment medium is essential.
Promotional campaigns on television and radio and regular newspaper coverage of stock market
activities are helpful in educating the public. At a later stage, it is essential to have adequate disclosure
of information on traded stocks.
3. The supply of stocks
Not having enough stock issues to trade adequately is often a greater constraint on the development of an active equity market than the number of investors. Too few stocks may at first deter investors from entering the market at all; later, when trading is active, too many people may be chasing too few stocks, thus adding to price volatility.
Another potential problem frequently encountered in developing stock markets is the lack of float, the percentage of a company's capital available for stock market trading to outside investors rather than being held by the major existing owners.
Before a stock market can start at least 20 companies, each with a float of about 25 percent of their
capital, should be available for trading. Stock markets such as Korea, Thailand, and Jordan started
with such relatively small numbers. Active emerging markets now have 300 or more listed stocks, of
which at least 25-50 are actively traded on a daily basis.
3.1 Factors influencing supply of securities
Size. The size of the economy, its level of development and growth rate, and its free enterprise
orientation largely determine the number of sizeable corporations which are likely to be available for
listing their shares on the stock exchange.
Attitude. Equally important is the attitude of existing owners to allowing outsiders into the company
and opening up their books. This attitude usually depends on whether the companies are still managed
by the original owners or whether professional managers have been brought in. In the latter case,
existing shareholders are more likely to be willing to list their companies on a stock exchange and sell
some of their shares, especially if they can make an attractive profit.
Need. A major factor inducing companies to go public may be the need for a sizeable amount of
additional capital. Such a need exists when the company is growing so rapidly that internally generated
cash flow or the owner's resources are outstripped by the capital requirements of major expansion.
This happens frequently in rapidly growing economies. In such an environment, the availability of
other investment opportunities may provide new horizons for the original owners, while bank credits
may be in short supply and companies already over-leveraged.
Interest rate policies. When interest rates are generally held below inflation levels for sustained
periods or loans with a large subsidy element are easily available, entrepreneurs find it advantageous to
borrow rather than to issue shares to the general public. Such interest rate policies have been
widespread in many developing countries.
Tax policies and other inducements. These may provide an additional or even a key reason for
existing owners to sell their shares to the public, rather than transferring ownership to their heirs.
Legislation. No incentives can overcome the obstacle of unrealistically low or artificially determined
prices. In many countries, under outdated company laws, the prices at which shares can be sold to the
public are determined by government authorities on the basis of par or book value and rights issues
must be offered first to existing shareholders. It would be more advantageous for underwriters to
evaluate the earnings potential of the company and the expected demand for an issue in current market
Government participation. In some countries, governments dominate the ownership of major
enterprises. This means that they may be in a position to increase substantially the supply of stocks
available for trading, by divesting their interest in public sector corporations which are profitable and
4. Tax policies and other inducements
A flexible and positive government attitude to the establishment and development of an equity market is essential. Many countries discriminate against equity by a less than favorable tax treatment of dividends and capital gains. In contrast, interest on bank deposits, government bonds, and bank-sponsored bonds may be tax-exempt, giving these investment alternatives, which offer a high level of safety, an additional advantage. Share transactions may be registered (and thus be accessible to tax authorities), while bonds may be in bearer form and transactions in real estate may be difficult to trace.
Companies may not want to go public because they fear that tax authorities could catch them more
easily at tax evasion, a widespread practice among privately-held companies in many countries. Tax
incentives are designed to counter such fears and to provide a positive inducement for companies to go
public or for owners to sell (supply incentives) and for investors to buy shares (demand incentives).
4.1 Demand incentives
Examples of demand incentives are:
* Tax exemption or reduction for capital gains on shares of listed companies.
* Tax exemption or partial exemption up to a certain amount for dividends. Corporate income is usually already taxed and a withholding tax on dividends or their inclusion in taxable income would amount to double taxation. This may have the effect of deterring owners of private companies from letting their companies go public; it may also result in unequal tax treatment in comparison with bank deposits or bonds which are often officially or de facto tax-exempt.
* Special tax credits or deductions for individuals and possibly companies investing in shares of publicly held companies. Sweden, France, Brazil, Mexico, and Egypt have various forms of such incentives. Sometimes they are for investment in new issues or mutual funds only, in other cases for all investment in shares of listed companies. Usually there is a requirement that such shares must be held for a minimum period, perhaps two years. These tax advantages can take the form of a deduction from taxable income or a straight tax credit, and are usually limited to a specific amount or a percentage of taxable income.
* Tax-deferred retirement plans to stimulate long-term savings and investment. Special tax deductions or benefits may be given to long-term investments, which are committed until retirement age, in shares, bonds, and possibly other financial instruments. Dividends, interest, and capital gains on such investments may be exempt from taxation until paid out after retirement.
* Freedom from tax on the transfer of shares for shareholders of a listed company, while transfer
of shares in privately held companies is taxed.
4.2 Supply incentives
The most widely used supply incentive is a lower corporate income tax for public companies than for
privately held companies. The differential should be at least 10-20 per cent, sufficient to negate the
customary tax evasion of privately held companies. An insufficient differential, or none at all, would
be a deterrent rather than an incentive. An exemption from or reduction of tax paid on the profits of
such sales is a strong inducement to the existing owners of privately held companies to sell shares to
the general public.
4.3 Other inducements
Other measures to induce companies to go public include special investigations by the tax authorities
of companies identified as potential public companies but which have chosen not to go public (as done
in Korea) and limitations on the amount of, or conditions for, bank credit applying to private
companies but not to public companies. These approaches have proved successful in several countries,
inducing a large number of corporations to go public within a short time.
5. Financial intermediaries
An equity market cannot function without brokers, dealers, and underwriters. Brokers handle the mechanics of completing trades on the floor of the exchange (or in an over-the-counter market), the transfer of shares from the old to the new owner, and the payments involved. Brokerage houses may also have research departments which analyse the quality, prospects, and relative attractiveness of shares in comparison with other investment alternatives.
Dealers make a continuous market in shares, step in when price gaps develop and smooth out price fluctuations. Such dealers may be specialized companies (such as jobbers in the UK and specialists in the US) or may also act as brokers. In the latter case, regulation is necessary to ensure that broker/dealers give their clients equal access to the trading floor and do not give preference to transactions for their own account.
Underwriters assist companies in going public and increasing their capital by taking the risk of buying whatever portion of an issue is not sold to final investors. They also help to structure the deal, write the prospectus, find investors, and handle the mechanics of the distribution process.
A well-organized securities industry typically includes a number of brokerage houses. Some of these
may provide the full range of investment banking services from trading in shares, bonds, and money
market instruments to underwriting investment management and financial advisory services.
6. The Legal Environment
6.1 Company law
Changes are typically required in a country's company law (or civil and commercial code) to enable
securities underwriting and trading to take place. Items which need to be covered include the easy
transfer of shares; ownership registration in the name of intermediaries such as brokers, underwriters,
and central custodial facilities; regulations on take-overs, etc.
6.2 Securities legislation
Outside investors need to be protected against stock manipulation by insiders (major shareholders, directors, and management) and the risk that insiders will skim off profits before they ever reach outside investors. Other aspects of investor protection, are the need to establish standards for professional conduct by brokers and underwriters and to avoid excessive speculation caused by market rumors and too easy availability of margin loans.
Without some form of investor protection, stock scandals, swindles, or the bursting of speculative bubbles are too likely to occur. Such protection can be exercised by a securities commission or other government watchdog, or through self-regulation by the stock exchange and an association of stock brokers and underwriters. Usually both types of protection are found, with major responsibility allocated to one sector. In securities markets based on the US model, such as Korea and most of Latin America, the securities commission plays the major role through extensive securities legislation. In securities markets based on the UK model, such as Hong Kong or Singapore, self-regulation is the dominant factor. A third model with a combined securities exchange and commission has been chosen in several new, small markets such as Thailand and Jordan.
Typically, measures to protect outside investors include requirements relating to disclosure and financial reporting, accounting and audit standards, listing insider trading, margin loans, trading floor procedures, and professional standards.
It is politically impossible, and in practice unfeasible, to introduce too many rules or legislation at
the same time. "Overkill" can easily strangle a stock market during its early growth, so legislation is
usually introduced in distinct stages. On the other hand, a too gradual approach should be avoided
because it leads to uncertainty and confusion.
Disclosure and financial reporting requirements. Outside investors must be able to make an informed judgment regarding the operations of a company, its profitability, financial health, growth, and prospects. Even if the investors themselves do not study the financial information carefully, their brokers or investment advisors will be able to do so. Unless they are required to open their books, companies are usually reluctant to do so.
Ideally, disclosure requirements for public companies should also be applicable to private companies which have reached a certain size. In most cases, this requires changes in local company laws.
Disclosure should cover not only the need for a prospectus at the time of a new issue, but also
regular publication of financial information afterwards through audited annual reports, quarterly
reports, immediate release of material information to the stock market, etc.
Accounting and auditing standards. Financial information may not be accurate or comparable from
company to company without the adoption and enforcement of generally accepted accounting
standards. Such standards go along with the need for a strong and independent auditing profession.
Listing requirements. Independent of the disclosure requirements of a securities commission, a
stock exchange may set specific requirements before a company can be listed and thus traded.
Insider trading. Manipulation by directors or management, who are in a better position to know the
prospects of the company than outsiders, is not uncommon without regulation. Insiders may be asked
to disclose their sales and purchases of the company's stock on a periodic basis or may be otherwise
restricted. Legislation and regulations in the area are usually very controversial and difficult to police.
It may be necessary or desirable to control insider trading on an informal basis during the early days of
an exchange and only formalize regulations later.
Margin loans. Without some general guidance brokers have a tendency to over-extend margin loans
to customers, endangering not only their own financial health but also fuelling speculation. Examples
of limitations include:
* a list of shares which are eligible as collateral for margin finance;
* rules requiring brokers to know their customers through detailed account information;
* specific margin limits and margin calls;
* standard formats for margin loan contracts between brokers and clients; and
* limits on the amount of credit extended to any single customer or for any particular stock.
Trading floor procedures. A fair, open, and competitive market should give investors confidence.
Rules and regulations of the stock exchange, approved by the securities commission if it exists, are
aimed at this objective. Collusion between brokers, fraud by trading floor personnel, handling of large
blocks of shares by prearrangement at a price which is different from the current market price, and
transactions by brokers for their own account before purchases/sales are made for clients are common
problems in the absence of regulation. To control speculation in the short run, some stock exchanges
set daily limits on price changes, but such measures are usually not effective.
Professional standards of brokers and underwriters. Such standards can be established by
legislation or through self-regulation by brokers and underwriters associations. Incorporation of
brokerage houses with minimum capital is often desirable. Brokers and securities analysts may be
asked to undergo examinations before they are qualified to deal with the public or analyse corporate
statements for prospectuses.
7. Stages in the development of a stock market
No two stock markets develop in exactly the same way. Nevertheless, five stages can usually bc
observed: the dormant stage, manipulation, speculation, consolidation or crash and maturity.
7.1 The Dormant Stage
During the first, dormant stage, only a few people are aware of the existence of the stock market,
trading is low, few companies are listed and prices remain close to par. As time goes by, shares
become undervalued, especially in a dynamic economic environment. Inevitably, brokers or individuals
may discover that dividend yield even excluding potential capital gains exceeds the yield on other
investment alternatives. Then they may begin to buy shares, cautiously at first and actively later.
Manipulation begins when some market participants discover that the small supply of stocks, and thus limited liquidity, makes it possible to drive up the price of one or more stocks with even minor purchases. As soon as prices soar others are encouraged to buy, enabling the manipulators to get out of the market with quick profits.
The start of more active trading may also be induced by government measures making investment in
stocks more attractive. In other cases, a sudden dramatic upturn in the fortunes of a country or
company starts the buying fever.
As soon as some people begin to make substantial capital gains and boast of their profits, a wider
group of speculators is attracted. A speculative stage begins during which prices are driven up well
beyond their fundamental values and trading volume soars. New issues are so heavily oversubscribed
that many companies go public and the supply of available stocks is broadened because the original
owners see attractive opportunities to sell out. Responsible government action, such as an increase in
margin requirements, higher brokerage commissions, selling by institutional investors, increases in
board lots, divestiture of government owned shares, or activation of new underwriting of major
companies, may dampen speculation, but it is probably not possible to avoid it altogether.
7.4 Consolidation or crash
At some point the amount of new money available for investment dries up. New issues become less oversubscribed and investors begin to realize that prices have been driven so high that they no longer bear any relation to their underlying value. Quite suddenly, stock prices begin to waver and prices drop. Depending on the extent of the earlier boom during the speculative stage, prices either decline gradually or tumble deeply. The consolidation stage or crash has set in.
It may take investors months or even years to regain confidence in the stock market after such a
price decline. Much depends on the extent of the price drop as well as on interest rates, economic
growth, corporate profitability, inflation yields on other investment alternatives, new incentives to
restimulate buying, and the behavior of institutional investors. During this consolidation stage, many
speculators become, out of necessity, investors. Unwilling to sell their shares at a loss, they hold on to
them for long-term investment in the hope that prices will improve in the future.
A new stage of maturity can begin when the initial investors regain confidence and are joined by new groups of investors who were not hurt during the first price decline. An enlarged presence of institutional investors could also play an important role in making a market more mature. Trading volume is likely to be more consistent, investors more sophisticated, the supply of shares broader, and, thus, liquidity greater. Prices will continue to fluctuate but the swings may become less violent.
If large price volatility continues, it is often caused by problems other than market factors
themselves. These include:
* major political problems (e.g., Hong Kong in 1982)
* monetary and exchange rate policies (Argentina, Mexico in 1981-82)
* economic crisis (Brazil, Chile in 1982)
* changes in government-dictated dividend policies (Korea, Turkey in 1982)
* changes in tax policies (Thailand, Pakistan).