Foreign Trade University

Faculty of English for Specialized Purposes

The Role of Capital Markets in Economic Development

Authors:
Do, Thi Thanh Trang 1813310164

Pham, Minh Hieu 1813320033

Bui, Ngoc Khanh 1813320039

Nguyen, Thi Thu Trang 1813320069

Nguyen, Thu Trang 1813320071

Hanoi, 2021
 ABSTRACT
This article addresses issues concerning the role of capital markets in financing
investments, enhancing economic performance, facilitating job creation and improving
living standards, trying to highlight the importance of this system, shown both to
macroeconomic agents and to all citizens.

Key words: capital market, economic development, investment, productivity,

macroeconomic stability, employment, wage
INTRODUCTION
The capital market today is a reality met in any modern economy. It is a market
the necessity of which is unchallengeable, a highly dynamic and innovative structure,
permanently adapting to the economic environment while also being an influential
factor of it, generating opportunities and to the same extent risk for all categories of
participants to the economic activity, being a replica of a country’s economy to a small
scale, but nevertheless highly representative.

Our main thesis is that well-developed capital markets result in a variety of

economic benefits, including higher productivity growth, increased job opportunities,
and improved macroeconomic stability. To focus on these major benefits, we examine
three issues: (1) the important role of capital markets in facilitating superior economic
performance, (2) how the capital markets promote job creation, and (3) how the capital
markets enhance income.

Our analysis focuses on two particular sets of comparisons. First, how has
macroeconomic performance in the United States improved over time as capital markets
have become more developed? Second, can countries with well-established capital
markets, such as the United Kingdom and the United States, explain the higher
macroeconomic performance seen in recent years compared to countries with less
developed capital markets, such as Germany and Japan?

We highlight the impact of capital market development on the economic

performance of the United States since the capital markets are most well-developed in
this country.

Section 1. Introduction to Capital Markets and Economic Development

1.1. Capital Markets
1.1.1. Definition
Capital markets are a general category of markets that facilitate the buying and
selling of securities with medium-term and long-term maturity, of one year or more.
Capital markets channel savings and investment between suppliers of capital and users
of capital through intermediaries.
 1.1.2. Key Players in the Capital Markets’ Process
Suppliers of Capital: Also known as surplus units, suppliers receive more money
than they spend or have immediate use for. They can be termed as investors. They
provide their net savings to the financial markets for a return on the capital provided.
Examples include retail investors and institutional investors,

Financial Intermediaries: A financial intermediary is an institution or

individual that serves as a middleman among diverse parties in order to facilitate
financial transactions. Common types include commercial banks, investment banks,
stockbrokers, fund managers, and stock exchanges,

Users of Capital: Also known as deficit units, users of capital spend more money
than they receive or need funds for investments or development. They are also termed
as borrowers. They access funds from the capital markets. Examples include businesses,
the government and individuals.

1.1.3. Key Products in the Capital Markets

Products in the capital markets are also referred to as capital market securities.
These are debt securities, with a maturity of more than one year, and equity securities.
Funds received from these products are mostly used to purchase capital assets, such as
buildings, equipment, or machinery. The key capital markets securities are as follows:

Bonds: These are medium to long-term debt securities issued by firms and
governments to raise large amounts of funds. Bonds are differentiated by the issuer and
can be classified as Treasury bonds, municipal bonds, or corporate bonds,

Equity Securities: An equity security represents ownership interest held by

shareholders in an entity realized in the form of shares of capital stock, which includes
shares of both common and preferred stock. They are classified as capital market
securities because they have no maturity and therefore serve as a long-term source of
funds.

1.1.4. Functions of Capital Markets

Savings mobilization: The capital market is an important source for mobilizing
idle money from people to invest in more production channels of the economy.
 Capital creation: Capital markets help in capital formation through the
mobilization of resources ideally used for investment for other economic development
goals.

Provide an investment channel: The capital market provides an investment

channel for those who want to invest resources for a long time with a reasonable rate of
return through financial instruments such as bonds, stocks, policies. insurance book.

Service provision: The market offers a variety of services including long-term

and medium-term loans for the consulting, financial, and other industries.

Increase liquidity of funds: Capital markets are highly liquid, both buyers and
sellers can easily buy and sell securities as they are readily available.

Accelerate economic growth: Markets provide long-term financial capital to

meet the financial requirements of businesses, thereby increasing output and
productivity in the economy by creating jobs and developing economies. infrastructure
development.

1.2. Economic Development

Economic development is economic growth associated with the improvement of
economic structure and institutions and improvement of the quality of life.

Economic development manifests itself as follows:

(1) The increase in GNP, GDP or GNP and GDP per capita, i.e. economic growth
must be greater than population growth.

(2) The economic structure changes in the direction that the share of services and
industry in GDP increases while that of agriculture decreases, but the absolute value of
all sectors increases.

(3) The quality of life of the majority of the population must be improved and
increased.

In this research we mainly discuss the impacts of capital markets on promoting

investments, economic strength, job creation and quality of life.
Section 2. The Impacts of Capital Markets on Economic Development
2.1. Creating a Bridge Between Capital Suppliers and Users
Agents with a monetary deficit and those with a monetary surplus can
communicate directly through direct financing, but they can also communicate
indirectly through a financial intermediary in the form of indirect financing, which is a
situation in which specific operators facilitate the connection between the real economy
and the financial market. In this case, the financial intermediaries could be banks,
investment funds, pension funds, insurance companies, or other non-bank financial
institutions.

2.2. Promoting Savings and Investments

The capital markets increase the proportion of long-term savings (pensions, life
covers, etc.) that is channeled to long-term investment. Capital markets enable the
contractual savings industry (pension and provident funds, insurance companies,
medical aid schemes, collective investment schemes, etc.) to mobilize long-term
savings from small individual house-hold and channel them into long-term investments.
It fulfills the transfer function of current purchasing power, in monetary form, from
surplus sectors to deficit sectors, in exchange for reimbursing a greater purchasing
power in future.

In this way, the capital markets enable corporations to raise funds to finance their
investment in real assets. The implication will be an increase in productivity within the
economy leading to more employment, increase in aggregate consumption and hence
growth and development. It also helps in diffusing stress on the banking system by
matching long-term investments with long-term capital. It encourages broader
ownership of productive assets by small savers. It enables them to benefit from
economic growth and wealth distribution, and provides avenues for investment
opportunities that encourage a thrift culture critical in increasing domestic savings and
investments that translate to economic growth.

2.3. Facilitating Efficient Allocation of Scarce Financial Resources

The capital markets facilitate the efficient allocation of scarce financial resources
by offering a large variety of financial instruments with different risk and return
characteristics. This competitive pricing of securities and large range of financial
instruments allows investors to better allocate their funds according to their respective
risk and return appetites, thereby supporting economic growth.

2.4. Financing Utility and Infrastructure Development

The capital markets also supply equity, debt, and infrastructure development
finance for the development of critical utilities such as roads, water and sewer systems,
housing, electricity, telecommunications, and public transportation, among other things.
These projects are well-suited to capital markets financing via long-term bonds and
asset-backed securities. Infrastructure development is a precondition for long-term,
stable growth and development. Furthermore, capital markets improve capital
allocation efficiency by maintaining that only profitable ventures may effectively attract
funding. As a result, the competitiveness of domestic industries will improve, as will
their ability to compete abroad, given the current desire for global integration. Therefore,
domestic production will rise, perhaps leading to an increase in exports, so economic
growth and development.

2.5. Financing Public – Private Partnerships (PPPs)

Collaboration between a government agency and a private-sector enterprise that
can be utilized to fund, create, and operate projects such as public transit networks,
parks, and convention centers are known as a public-private partnership. Financing a
project through a public-private partnership can help it be done faster or even get started
in the first place.

According to Yaru Tang and associates' research, "Can public-private

partnerships (PPPs) increase the environmental performance of urban sewage
treatment?" PPPs have the potential to improve the environmental performance of
sewage treatment in cities. One of the main reasons for wastewater entering and
damaging aquatic habitats is a lack of sewage treatment facilities. The public-private
partnership (PPP) model, which has become one of the fastest-growing modes of public
service delivery in recent decades, is seen as an efficient solution to reduce the pressures
of financing shortages and increase sewage treatment efficiency. However, the
effectiveness of PPPs has been questioned, particularly in terms of service quality, due
to the intrinsic character of the private sector's desire of economic profit maximization
and the flaws in incomplete contracts. This study assesses the PPP mode's service
quality, specifically its environmental performance, in China's urban sewage treatment
industry.

Exhibit 1: Urban Sewage Treatment Plants under the PPP Mode

They found that the PPP model has improved pollution treatment performance
and that increased operating costs and enhanced sewage treatment efficiency serve as
the major mechanisms for improving environmental performance, based on specific
firm-level data in Jiangsu Province, China.

PPPs are encouraged by capital markets, which encourage private sector

engagement in productive investments. As resources become rarer, the requirement to
shift economic development from the public to the private sector to improve economic
productivity has become unavoidable. It aids the public sector in overcoming the
funding shortfall, and to supplement its efforts in obtaining long-term project-based
funds to fund critical socio-economic development. It also draws foreign portfolio
investors, who play an important role in complementing domestic savings and
supporting the entrance of foreign financial resources into the domestic economy, so
promoting economic growth.

2.6. Higher Productivity Growth

The growth rate of labor productivity in the United Kingdom and the United
States has risen in recent decades, expanding the performance gap with Europe and
Japan (see Exhibit 2).

Exhibit 2: Productivity Growth Higher in the US (source: OECD)

Part of the US's stronger performance, as shown in the graph above, is due to
two factors: (1) the more rapid development and dissemination of technology in the US,
and (2) the greater flexibility of the US labor markets. The ability to adjust labor needs
quickly means that US firms have greater incentives to rapidly adopt new labor-saving
technologies compared to countries where labor markets are more rigid.

The capital markets have played an important role in this process. First, capital
markets supported efficient capital allocation, thereby raising the average return on
capital. Second, capital markets helped startups raise capital by assisting risk allocation
and providing a mechanism for them to do so.
 2.7. Greater Macroeconomic Stability
The macroeconomic environment should be stable. If inflation is dynamic,
lending at a fixed rate exposes the lender to significant interest rate risk. In an uncertain
environment, lenders will usually transfer this risk to borrowers, who are less likely to
fully appreciate it, by only providing floating-rate loans. Significant interest rate risk,
regardless of who bears it, will hamper the expansion of the home financing system, as
the lender would go out of business (as happened in the 1980s with US savings and
loans) or borrowers will be unable to repay their loans (or both). Lenders must have
abundant access to capital in order to lend if the requirements for long-term lending are
met.

In the early twenty-first century, both the UK and US economies have become
far less volatile. This is obvious in the UK's current expansion, which has now lasted
nearly 12 years, making it the country's longest post-World War II economic boom.

In the United States, business cycles have also shown to be more adaptable. The
most recent expansion, which ended in 2001, was the longest in the post-World War II
era. The previous expansion, which lasted until 1990, was the third-longest in postwar
history.

Exhibit 3: US recession/unemployment rises have been milder

(source: US Department of Labor, Department of Commerce)

 Furthermore, recessions have tended to be milder when they have happened. In
the United States, for example, both the 1990-1991 and 2001 recessions were brief, with
very minor increases in the unemployment rate (see Exhibit 3).

As a result, the civilian unemployment rate has become less unstable. In the
United States, for example, the unemployment rate rose only 2.4 percentage points from
trough to peak during the 2001 crisis, the second-lowest increase in the postwar era. In
comparison, the rise in the unemployment rate linked with recessions has averaged 3.6
percentage points in the postwar period. For more than a decade, the unemployment
rate in the United Kingdom has not risen by more than one percentage point.

In three ways, capital markets have supported in the reduction of economic

volatility.

First, because capital markets utilize mark-to-market accounting, deferring

difficulties is more difficult. As a result, suffering is experienced in real-time, which
means that the ultimate shock to the economy tends to be smaller. When a group of
depository institutions is in crisis, however, the pressure for regulatory forbearance
increases. The magnitude of the problem grows as a result of deferral. As evidenced by
the US savings and loan crisis and Japan's decade-long banking crisis, forbearance
usually results in a much larger problem that poses a greater threat to macroeconomic
stability.

Second, by giving policymakers instant feedback, capital markets have boosted

the benefits of excellent policies while increasing the cost of following bad policies.
Lower risk premia and greater financial asset prices are the results of good policy.
Investors are supportive. Bad policies result in poor financial market performance,
putting pressure on authorities to change their policies. As a result, over the last two
decades, the quality of economic policymaking has increased, resulting in improved
economic performance and macroeconomic stability.

Third, in the United States, capital markets have contributed to reducing the
volatility of the housing market. “Credit crunches” of the type that regularly cut off the
supply of money to home buyers and destroyed the homebuilding sector between 1966
and 1982 are a thing of the past, thanks to the establishment of a secondary mortgage
market and the elimination of interest rate ceilings on bank deposits.

Exhibit 4: US home ownership rate (source: statista.com)

Today, the supply of credit to qualified home buyers is virtually assured. As a

result, the US homeownership rate is increasing (see Exhibit 4). And the volatility of
activity in the economy's most interest-sensitive sector has been reduced by about half.
This is a big step forward since it indicates the most credit-sensitive sector of the
economy is now more stable.

Section 3. How Capital Markets Enhance Income

3.1. Greater Job Opportunities
The fact that millions of businesses run smoothly each year creating millions of
jobs around the world is closely linked to capital markets. The capital market has a very
important meaning in supporting capital for businesses, and at the same time helping
businesses have higher profits when they do not have to depend too much on bank
capital. It can be said that the achievements in the years of establishment and
development are remarkable when the stock market has gradually become an effective
medium and long-term capital mobilization channel for businesses. Its steady
development helps to ensure jobs for employees in all fields.
 Exhibit 5: Employment growth (source: OECD)

Exhibit 6: Unemployment rate (source: OECD)

The period 1990 – 2004 in the US saw many breakthroughs in capital markets,
enabling businesses to thrive, which explains why the US unemployment rate dropped
significantly compared to Europe and Japan (see Exhibit 5). It is easier for American
businesses to raise capital through capital markets, which has resulted in significantly
higher job growth in the UK and US than in the European Union and Japan (see Exhibit
6), where capital markets are underdeveloped, where development and capital
mobilization mainly relied on banks. So businesses in this period mainly existed in the
form of small and medium sized enterprises.

3.2. Higher Real Wage Growth

Trade in capital between nations has implications for real wages that are every
bit as important as cross-border movements of goods and people. In emerging
economies, where capital is scarce and labor abundant, opening up to free trade in
capital should reduce the rental rate and increase the real wage. Capital market opening
drove up real wages in liberalizing and nonliberalizing countries alike.

Exhibit 7: Real wage growth rises in the wake of capital account liberalizations

Exhibit 7 demonstrates that the level of the average annual manufacturing real
wage in a sample of 25 emerging economies increased significantly after they
liberalized restrictions on inflows of foreign capital between 1986 and 1996. Formal
estimates show that the growth rate of the real wage in local currency terms jumped
from 1.8 percent per year in the pre-liberalization period to an average of 5.7 percent in
the year liberalization occurred and each of the subsequent three years. The 3.9
percentage point increase in the growth rate of the real wage during this window drives
up the level of average annual compensation for each worker in the sample of
liberalizing countries by the local currency equivalent of US $487—an increase equal
to 18 percent of their annual pre-liberalization salary.

It is not surprising that higher productivity growth accrues to workers in the form
of higher real wage growth. Exhibit 8 illustrates the respective performance of real wage
growth on a 5-year moving average basis. It can be seen that the performance of England
and the US is tending to improve over time. Furthermore, continuous real wage growth
tends to be higher in the UK and US than in France, Germany or Japan.

Exhibit 8: Supporting real wage growth (source: OECD)

3.3. More Home Ownership

It has been our view that linking housing finance systems to the capital market,
which is capable of offering attractive rates saving for homeownership will enhance
financial liberalization and assist low-income earners to efficiently save towards
homeownership as part of the overall government’s development strategy. It is in this
regard that real estate and capital market players lobbied for the passing of Registered
Home Ownership Saving Plans to include Fund Managers and Investment Banks under
the Capital Markets Act. This is also because a well-developed capital market that is in
sync with the housing finance system is a prerequisite for a sustainable, low-cost capital
raising mechanism for affordable housing for both developers and potential
homeowners. The current attractiveness of capital market schemes to stakeholders
stems in part from the financial and housing market conditions that prevail today capital
market characterized by lack of long-term savings, the huge housing shortage,
affordability problems as evidenced by extremely high price-to-income ratios, relatively
high and volatile inflation, as well as reduced wage incomes. As it is, there exists a
direct correlation between the existing housing finance system and the level of informal
settlements in the country, which the World Bank estimated to be 61.0% of urban
dwellers as at 2017.

The revolution in mortgage finance has increased the ability of households to

buy a home. The closing costs associated with obtaining a home mortgage have dropped,
and the terms (for example, loan-to-value ratio) have become less stringent. Sometimes
a homeowner can get 100% financing to buy a home. As a result, the share of US
households with their own home rose to 69.3% in the second quarter of 2004, up from
63.7% in the late 1980s.

EXECUTIVE CONCLUSION
The development of capital markets have been improved macroeconomic
performance. Over the last three decade, US labor productivity has risen and the United
States has outperformed economies dominated by banking-based systems. Because the
development of the capital markets has introduced new discipline into policymaking.
As a result, the quality of economic policymaking has improved over the past few
decades.
 The development of the capital markets has provided significant benefits to the
average citizen. Most importantly, it has led to more jobs and higher wages.

By raising the productivity growth rate, the development of the capital markets
has enabled the economy to operate at a lower unemployment rate. In addition, higher
productivity growth has led to faster gains in real wages.

The capital markets have also acted to reduce the volatility of the economy.
Recessions are less frequent and milder when they occur. As a result, upward spikes in
the unemployment rate have occurred less frequently and have become less severe.

The development of the capital markets has also facilitated a revolution in

housing finance. As a result, the proportion of households in the US that own their
homes has risen substantially over the past decade.

A well-developed financial system is a spur to growth, macroeconomic

performance, and more rapid growth in living standards.
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