prospects and challenges for developing securities markets in ethiopia an analytical review

Prospects and Challenges forDeveloping Securities Markets inEthiopia: An Analytical Review

Asrat Tessema*

This paper is an analytical review of the prospects and challenges of developing securities

markets in Ethiopia. With the fall of communism and the emergence of capitalism, many

countries around the world are moving toward market-oriented economies and securities

markets are springing up on all continents around the globe. Securities markets have come to

symbolize to many the essence of capitalistic economic relations. When studying the econo-

mies of developing countries, the first thing that becomes apparent is the existence of

immense and, to a considerable extent, unemployed human resources as well as an acute

shortage of capital. Shortage of capital is a major constraint in the realization of economic

development. Recognizing the role that securities markets play in mobilizing capital, more

than a dozen African countries have established stock markets. Ethiopia is not one of them.

There is little current research which focuses on Africa’s securities markets. This study helps

to contribute to that effort by focusing on Ethiopia, the second largest country in sub-

Saharan Africa plagued with major economic problems. The paper concludes by recommend-

ing the establishment of a stock market and providing suggestions on how to do it.

1. Introduction

Governments in developing countries faceincreasing difficulties in funding public

enterprises through government allocationsbecause of budget constraints due to low savingsand population explosion. It has also becomeincreasingly difficult to expect an increase in theflow of foreign private and government capitalbecause of the recent debt crises experienced bysome developing countries as well as budgetaryuncertainties in the developed countries them-selves. This situation has been exacerbated bythe opening up of Eastern Europe and the crum-bling of the Soviet Union. These European coun-tries have better industrial bases than sub-Saharan African countries like Ethiopia, andthus are likely to attract most of the limitedfunds available from external sources.

According to the International Finance Cor-poration (IFC, 1997), sub-Saharan Africaattracted only $11.8 billion in private capital in1996 or less than $1 for every $20 invested indeveloping countries. This region, however,received about 50 per cent of the $20 billionannual aid to developing countries and is stillmired in extreme poverty due mainly to politicaland economic turmoil. However, many Africancountries, including Ethiopia, are in the processof overhauling their economic and political sys-tems and may be opening up the last untappedmarket in the world. Therefore, if Ethiopia wantsto become self-reliant through economic growthand modernization, it will have to develop itsdomestic capital markets and rely less on foreignsources of capital. Research has shown thatdevelopment of securities markets1 contributes toeconomic development through the mobilization

*Professor of Finance, Department of Accounting and Finance, College of Business, Eastern Michigan University,Ypsilanti, MI, 48197, USA; e-mail: [email protected]. This study was conducted when the author was aFulbright scholar during the 1997/98 academic year at Addis Ababa University’s Faculty of Business and Economics.

50 R&D Management 15, 1, 2003. # Blackwell Publishing Ltd, 2003. Published by Blackwell Publishing Ltd

9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

of savings and their channeling to the mostproductive enterprises.The development of securities markets is not

an easy task, however, since many of the funda-mentals of capitalism required for the develop-ment of securities markets represent a major shiftin culture for many developing countries. Thesedeveloping countries have little or no experiencewith modern market-driven economic mechan-isms as a whole, much less with even more com-plex securities markets. Nevertheless, somedeveloping countries, eager to avail themselvesof the benefits of securities markets, sometimesdisregard the costs and requirements and pushahead with policies that may not produce thedesired effect. About a dozen African countriescurrently have stock markets in place; Ethiopia isnot one of them.The purpose of this study is to explore the

possibilities of developing securities markets inEthiopia. The study is organized into five sec-tions. The first section provides an historicaloverview of the Ethiopian private sector. Thesecond section reviews the rationale for develop-ing securities markets. The third section discussesthe costs and requirements for developing secur-ities markets. The fourth section deals with thecurrent Ethiopian economic environment andhighlights the prospects and challenges for devel-oping securities markets. The last section pre-sents conclusions and recommended actions.

2. A Historical Overview of the EthiopianPrivate Sector

Ethiopia, with a population of about 60 million,is the second most populous country in sub-Saharan Africa. It is the only country in Africathat has never been colonized. The last emperor,Haile Selassie, was forced to abdicate in a coupin 1974. From 1974 to 1991 the country wasruled by the Derg, a communist military dictator-ship. The present government is controlled by aparty that acquired power in 1991 when it won along civil war against the Derg. The relative roleof the private sector in Ethiopia’s economicdevelopment has evolved with changes in govern-ments. The changes depended very much on thetype of economic system adopted by the govern-ments. The Ethiopian economic environmentover the years can be classified into three distinctphases: mixed economy, command economy andmarket-oriented economy.

The first phase covers the period prior to the1974 revolution. This period may be characterizedas a feudo-capitalistic economic system in whichland ownership was the source of income. Landwas disproportionately owned by the ruling classand had always been a source of complaintagainst the government. This period marks thebeginning of modernization of the country andthe encouragement of private sector participationin economic development. The government issuedseveral proclamations to encourage privatedomestic and foreign investments. Manufacturingwas given a central role with the hope that itwould stimulate other sectors of the economy.The government provided several incentives suchas tax holidays, tariff protection, remittance ofprofits, repatriation of invested capital, taxexemptions on imported capital goods and con-cessions in the form of land leases or land grants.As a result, the manufacturing sector had madesteady progress. The contributions of medium andlarge scale manufacturing industry to GDP grewfrom about 2 per cent in 1961 to about 5 per centby 1973 (UNIDO, 1991, p. 21).

During the third five-year plan (1968–73, thelast for the imperial era), 41 per cent of themanufacturing activities was done by the publicsector; the remaining 59 per cent was done by theprivate sector (third five-year development plan,p. 231). The share of the private sector in con-struction was as high as 79 per cent.

Although the private sector was given a pro-minent place, foreign investors dominated it, andthe local entrepreneurs’ participation was verylow, partly because of cultural bias by the intelli-gentsia against business and shortage of capital.Business was meant for less educated people.Most educated people regarded governmentemployment as a dignified profession. This atti-tude was an impediment to development of entre-preneurship. Moreover, the financial sector wasunderdeveloped and largely owned and con-trolled by the government. The banks that domin-ated the financial sector were unable to mobilizeenough capital to meet the demand, mainlybecause of low savings.

A short-lived stock market started informallyin the late 1950s and was formally instituted in1965. The stock market was administered by theNational Bank of Ethiopia (the equivalent of theFederal Reserve Board in the United States). Thegovernment through the National Bank tried toimprove resource mobilization by establishing ashare-dealing group that brought together buyersand sellers to participate in an auction process.

Developing Securities Markets in Ethiopia

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The bank laid out rudimentary rules and regu-lations for the auction market. According to astudy by J.D. Von Pischke (1968), former lec-turer at Haile Selassie University’s College ofBusiness, the stock market was moderately suc-cessful in its pioneering efforts to provide anorganized market for companies whose shareswere relatively widely held. Workable tradingpractices and standards had been developed,and a fairly smoothly operating market mechan-ism had been created.It was a good start, and no crisis of public

confidence had occurred. Market capitalization,however, remained small and did not have muchimpact on the economy since the participation ofthe general public was limited. Investors werenaturally reluctant to invest in a corporation inwhich they do not have any personal involve-ment. Businesses in many developing countriesare carried out in a secretive environment, some-thing not possible for a listed stock that is pub-licly traded. Moreover, opportunities for taxevasion, which is rampant in many developingcountries including Ethiopia, would vanishbecause of a stock market’s requirements forproper bookkeeping and regular reporting offirm activities necessary to safeguard investorsfrom the abuses of corporate insiders.The private sectors accessible to most Ethi-

opians were the trade and service industries,which in many cases require relatively less capitalthan manufacturing, construction and mining.Thus, investors stayed away from projects requir-ing long-term commitment. Yet, manufacturingincreased modestly. Despite a steady growth inmanufacturing, there were some problems. First,the sector depended heavily on imported inputsand did not help the development of localresources. Second, due to tax exemptions onimported capital goods, capital intensive technolo-gies were used in most industries. Third, sincemanufacturing companies were located in only afew urban centers where less than 10 per cent ofthe population lived, the majority of the popula-tion did not feel the impact.Agriculture remained primitive. There was

very limited use of modern technology in agricul-ture which would have helped increase product-ivity to meet the growing demand for consumergoods. As a result, prices soared and the spreadof drought in the northern parts of the countryworsened, triggering the revolution that culmin-ated in ousting the government of Emperor HaileSelassie in February 1974. A new governmentheaded by the military was instituted.

The second phase started in 1974 with adeclaration of a centrally planned commandeconomy. The military government’s first orderof business was to nationalize most of the indus-tries and assume ownership and control of vir-tually all economic activities. The private sectorwas marginalized.

The infant stock market ceased to exist in1975. The government introduced a series ofpolicies and reorganized the manufacturing sec-tor into corporations. All medium and largecompanies came under these corporations. Com-pany managers reported to corporate managers.The government set input and output prices.Company managers had one duty: comply withset goals at any cost. Policies of collectivism at alllevels and anti-market policies retarded the econ-omy, and consequently foreigners who ownedand operated most of the industries left the coun-try. High-caliber Ethiopian entrepreneurs and aqualified work force migrated to neighboringcountries and elsewhere in the world. Domesticprivate investments virtually ceased.

The development policy denied investmentincentive to small-scale industries. Their accessto credit was limited by the stringent require-ments placed on them by the banks, which wereall now under government ownership and con-trol. Little institutional support existed to intro-duce new technology in the private sector; as aresult, most small enterprises had very low prod-uctivity using basic and outdated machinery andequipment.

The continued adoption of a fixed exchangerate (2.07 Birr for US $1) resulted in the over-valuation of the domestic currency and under-mined the competition of the local firms in theexport sector, and thus limited the country’saccess to foreign exchange. Moreover, the escal-ation of the civil war in the north and the severedrought that struck the country once again dis-rupted normal economic activities. The need toincrease the size of the military and to acquirearms necessitated an increase in the defensebudget. These increases put further pressure onthe country’s meager foreign exchange reserve.

In 1983 the government introduced a new pol-icy encouraging participation by private invest-ors. Among the incentives were tax relief,import and export duty relief, repatriation ofcapital, and protective tariff measures. Despitesuch measures, the private sector, most of whichhad lost confidence in the government, showedlittle interest in investing in the country. Lack ofinvestment was also reflected in a severe shortage

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of the foreign exchange needed to finance theimport of spare parts and foreign inputs.Shortage of foreign exchange also resulted in a

significant decline in capacity utilization by pub-lic enterprises, making it difficult to generateadequate revenue. Since the mid-1980s, GDPgrowth declined steadily, reaching negative fig-ures at times. This resulted in budget deficits thathad to be offset by higher external financinggrants and higher money supply growth, all ofwhich increased domestic inflation.In 1990, the government declared a move from

a centrally planned to a mixed economy in whichthe private sector was once again encouraged andsome favorable concessions were introduced.However, it was ‘too little too late’ to changethe trend in light of the unfortunate fall of inter-national coffee prices (the major export of thecountry). Armed insurgents overthrew the gov-ernment in 1991.The third phase started in 1991 and it still

continues. By this time the economic and polit-ical landscape around the world had changed.With the fall of communism and the emergenceof a global economy, many nations around theworld were slowly moving towards a market-oriented economy. It became clear that market-based economies fared better than those guidedby socialist ideologies.Despite the socialist orientation of the leaders

of the new government, it was in the country’sinterest to comply with the new economic order.That meant transforming the economy from acentrally planned to a market-oriented system.Since 1992 the government has undertaken eco-nomic reforms by adopting the StructuralAdjustment Program that meets InternationalMonetary Fund (IMF)/The World Bank require-ments. The program’s main emphasis was theliberalization of both factor and commodity mar-kets, as well as privatization and commercializa-tion of state-owned enterprises.As a result, new investment codes aimed at

stimulating both domestic and foreign privatesector investments have been enacted. In October1992 the Ethiopian currency, birr, was devaluedby a sizable amount to a level that reflected itsapproximate value. In May 1993, foreignexchange auctioning was introduced and, assuch, allocation of foreign exchange to the pri-vate sector improved. The government also lib-eralized foreign trade policy by abolishing exporttaxes on various items.In general, the relative role of the private sec-

tor is being enhanced by the new economic policy

with the professed intent of creating an enablingenvironment, which would unleash the potentialof the private sector. At the same time, Ethiopia’shistory of state intervention in the economy andthe antipathy and suspicion towards private busi-ness still lingers. The financial sector reform soimportant for the realization of the private sectorpotential is not moving at an appropriate pace.The government has allowed establishment ofprivate banks by private citizens. As a result, sixprivate commercial banks and eight privateinsurance companies have started operating, butthey are not large enough to have much impact.

The largest and oldest commercial bank whichhas many branch offices in the country is stillowned and controlled by the government. Forthe most part, interest rates are still determinedadministratively in favor of public enterprisesand major private companies, thus crowdingout most of the smaller enterprises. The dynamismof the economy is curtailed by the near exclusion ofthis segment from economic activities.

The country suffers from poor economic andsocial infrastructures such as roads, power, tele-communications services, water supply, appro-priate schools and hospitals. Anotherimpediment to private sector development is thelack of securities markets. The recent border con-flict with Eritrea (once a province of Ethiopia,independent de facto since 1991, de jure 1993) isanother problem diverting the government’sattention away from economic development.The outcome of the conflict is uncertain. Politicaldisruption almost always affects economic activ-ity as businesses postpone investments, scaledown growth projections and may even considermoving capital elsewhere.

3. A Review of the Rationale forDeveloping Securities Markets

The nearly universal goal of nation-states is tobecome ‘strong’ through economic growth andmodernization. They want to see the rate ofincrease in GNP go up, per capita income rise,and efficiency and employment increase. A grow-ing literature argues that stock markets provideservices that boost economic growth and contrib-ute to the achievement of these goals (seeBencivenga et al., 1996; Levine, 1991; and Obstfeld,1994). Theoretical disagreements about the impor-tance of stock markets for economic growth alsoexist (see Mayer, 1988; Stiglitz, 1985, 1993; Dever-eux and Smith, 1994; Shleifer and Summers, 1988;and Morck et al., 1990a, b).



Levine and Zervos (1996) conducted anempirical study and reported a strong positivecorrelation between stock market developmentand long-term economic growth. Furthermore,they provided data on the trend in stock marketactivities in the recent past.During the period between 1985 and 1995,

world stock market capitalization rose from$4.7 trillion to $15.2 trillion, and emerging mar-ket capitalization jumped from less than 4 percent to almost 13 per cent of total world capital-ization. Over this decade, the trading of sharesin emerging stock exchanges rose from less than3 per cent of the total value of transactions onthe world stock exchanges to 17 per cent. Inaddition, Korajczyk (1996) shows that emergingmarkets have become more integrated with worldcapital markets2 during the past seven years.Consequently, portfolio equity flows to emergingmarkets jumped from $150 million in 1984 toover $39 billion in 1995.However, due to the relative underdeveloped

nature of equity markets in Africa, the region hasattracted a disproportionately small share ofrecent international private capital flows todeveloping countries. Little current financialresearch focusing on African equity markets isbeing done. The region has not received theattention that Latin America and South-eastAsian countries received in the literature.Recently, however, recognizing the potential

benefits of a well-functioning equity market, sev-eral African countries have made important

efforts to establish and invigorate stockexchanges. These include Botswana, Egypt,Ghana, Ivory Coast, Kenya, Mauritius, Mor-occo, Namibia, Nigeria, South Africa, Tunisia,Uganda, Zambia and Zimbabwe. With theexception of South Africa they are all smallboth in terms of size (capitalization) and num-bers of listed companies; and are infrequentlytraded (see table 1).

In the developed countries the existence ofsecurities markets is frequently taken for grantedsince their development is considered a naturaloutgrowth of the free-market system. Only intimes of considerable turmoil in the markets ispolicy toward them given much attention. Fordeveloping countries in transition from a cen-trally planned to a free-market economy, how-ever, policy with regard to securities marketsmust be more deliberate, and should involve con-sideration of sensitive economic, political andsocial issues. In analyzing the net effect of devel-oping securities markets, one must understandbenefits to developing securities markets as wellas their costs and requirements.

Review of the literature indicates that well-functioning securities markets have the followingbenefits:

1. Enhanced savings mobilization. Stock andbond issues serve to increase the nationalsavings rate by creating incentives to invest.Since securities are risky investments, theygenerally earn higher returns than more secure

Table 1. Sub-Saharan African stock markets.

Year established Listings (No.of domesticcompanies)

Capitalization (US$ million) Value traded(US$ million)

1996 1990 1996 1996

Botswana (1989) 12 NA 326 31Ivory Coast (1976) 31 549 914 19Ghana (1989) 21 NA 1492 17Kenya (1954) 56 453 1846 67Malawi (1996) NA NA NA NAMauritius (1989) 40 268 1676 78Namibia (1992) 12 NA 473 38Nigeria (1961) 183 1372 3560 72South Africa (1887) 626 137540 241571 27202Swaziland (1990) 6 17 1642 8Zambia (1994) 5 NA 229 3Zimbabwe (1946) 64 2395 3635 255

Malaysia 621 48611 307179 173568Brazil 551 16354 216990 112108UK 2433 848866 1740246 578471USA 8479 3059434 8484433 7121487

Source: IFC (1997). NA denotes not available.

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instruments such as bank savings deposits.They also offer investors the option to diver-sify across industries, thus improving theirrisk/return tradeoff. This is a better optionthan putting all one’s savings into a smallbusiness where one’s entire livelihood wouldhave to depend on the success of that particu-lar business.

2. Help in resource allocation. In a market econ-omy, issues of securities help raise capital forprojects whose outputs are in the highestdemand by society, and those enterpriseswhich are most capable of raising productiv-ity. Thus, efficient enterprise management isrewarded by access to investment funds. Secur-ities prices serve as a means by which investorsexpress their confidence in enterprise prospectsand management. Without securities markets,companies must rely on internal resources(retained earnings) for investment funds, onbank financing or on government grants orsubsidies. Such forced reliance on self-financepenalizes young companies whose productsmay have greater future demand. These newand growing enterprises often have little in theway of retained earnings.Bank loans are an important source of cap-

ital throughout the world, but are limited bythe amount of deposits banks are able tomobilize. As a result, banks tend to be veryconservative in their lending policies, therebypenalizing younger or emerging companieswhose business risk is higher than thosefaced by established firms, and yet contributeto the dynamism and future growth potentialof the economy through innovations. Thus,the role of the private sector is limited by theexclusion of this important segment from theactivity.

Since banks in emerging economies aremostly owned and run by governments, theyextend loans to priority sectors in response togovernment directives without due regard toquality, and often at interest rates below thebank’s cost of funds. This leads to inefficientresource allocation and widespread loan delin-quencies. The prevalence of these problemsreduces the level of investments, productivityof capital and the volume of savings.

Even if government grants and subsidies areavailable, they tend to introduce marketimperfections that contribute to the distortionof financial prices. These imperfections sub-vert the positive allocation role of securitiesmarkets. Governments generally are not

known to process the enormous amount ofinformation necessary to make sound alloca-tion decisions. The result is irrational invest-ment patterns, further distortion due topolitical influences over economic decisions,and discrimination against smaller, youngerand innovative undertakings.

Securities markets create better opportun-ities for small emerging companies to raisefunds in the venture capital market since ven-ture capitalists would be more comfortableinvesting in new ventures with the knowledgethat possible future divestment can take placethrough a public offering at a potentially sub-stantial profit.

3. Promote efficient financial system. Securitiesmarkets break the oligopoly that would beenjoyed by the banks in the absence of secur-ities markets. The government does not auto-matically have privileged and subsidizedaccess to funds and must compete on equalterms. Securities markets provide impetus forthe establishment of financial prices based onscarcity values rather than on administrativefiat. Such market-determined financial pricesand investment options, in turn, attract moresavings, creating a virtual circle of innovationand mobilization that contributes to the over-all efficiency of the financial system.

4. Help term transformation and improve capitalstructure. Healthy debt/equity ratios areimportant for a robust economic system. Cor-porations in many developing countries areundercapitalized. In the absence of equitymarkets, debt/equity ratios inevitably rise.First, in growing companies, retained earningsand fresh cash injections from the controllingshareholders usually cannot keep pace withthe needs for more capital, thus slowinggrowth. Second, outside investors requireliquidity and some sense of security that canbe provided only by an organized market-place.When active secondary markets for secur-

ities exist, savers can be induced to provide thelong-term funding that corporations seekbecause savers are assured that the marketscan provide them with liquidity. Thus, whatis the equivalent of short-term investment forthe security purchaser is transformed intolong-term financing from the issuer’s perspect-ive. The more efficient matching of asset andliability maturities that result means lessfinancial risk for companies and thus a morestable economic environment in general.



Moreover, the availability of equity capitalthrough the markets decreases the overalldebt/equity ratios of business, which may (inthe absence of such financing) reach levels atwhich default risk outweighs the advantage ofincreased leverage.

5. Allow deconcentration of ownership. Equitysales provide for a wider participation inenterprise management and for a wider distri-bution of corporate profits. These factorswould help allay the fear that a few individu-als or groups linked to the ruling partywould dominate the private sector. Wider dis-tribution of corporate profits develops a gen-eral sense of ownership and an assumption ofresponsibility on the part of the citizen. Peoplewill now be united by their common defenseof their business interests, and ethnic and reli-gious differences would gradually dissipate.

6. Improve accounting and auditing standards.Securities purchasers rely in part on corporateinformation provided in financial reports tomake their investment decisions. The develop-ment of securities markets is usually accom-panied by increased reporting standards andrequirements, which contribute to the effi-ciency of the markets and their mobilizingand allocating functions. A regular disclosureof adequate, reliable and timely informationmakes it possible to compare performance ofvarious companies. The development ofwidely accepted accounting procedures,checked by independent external auditors isalso an important benefit derived from thedevelopment of securities markets. Availabil-ity of good information helps corporationsmake better decisions and provides better stat-istics for economic policy makers. Goodinformation may even help tax authoritiescollect taxes in a more efficient and equitablefashion. The need for disclosure of financialinformation is a strong incentive for theimprovement of accounting and auditingstandards.

7. Provide effective tools for monetary and fiscalpolicy. When an economy has well-developedsecurities markets, it can conduct monetaryand fiscal policies through these markets.The Anglo-American style economies conductmonetary policy through open-market opera-tions. These economies affect the marketinterest rate and money supply by buyingand selling securities in the open market. Gov-ernments in these countries can finance theirdeficits by issuing bonds in the open market.

Therefore, a government deficit does notnecessarily bring about an increase in moneysupply and thus inflation.Economies with only a commercial banking

system have to conduct their monetary policyand deficit financing through the banking sys-tem. Open-market operation is not available.The only effective tools are direct credit con-trols, ceilings on loans and interest rates, aswell as reserve requirement manipulations.Also, deficit financing is carried out by eitherborrowing directly from the central bank orby selling bonds to commercial banks. Conse-quently, deficit financing puts pressure on themoney supply and leads to inflationary pres-sures. As a result, financial repression is com-mon in countries with banking-orientedfinancial systems. Full-scale financial sectorreform (liberalization) may be impossibleunless the economy has well-developed secur-ities markets.

8. Help privatization efforts. Public investmentsvastly exceed private investments in transi-tional economies. Economists widely believethat privatization of state enterprises willreduce losses and create efficiency. However,transitional economies generally lack thefinancial infrastructure and the legal frame-work to engender privatization efforts. Yet,these economies often like to privatize stateenterprises. One of the most notable problemsassociated with privatization of state enter-prises is the lack of well-developed domesticequity markets. An inadequate supply of cap-ital due to low savings, low gross nationalproduct and limited access to internationalcapital markets has been an impediment.One of the main challenges for transitionaleconomies is, therefore, to improve the qualityof financial intermediation and resource allo-cation to contribute to a more rapid rate ofeconomic growth that would lead to higherlevels of savings and investments.

The establishment of securities markets wouldensure the existence of not only a primary marketfor the initial public offering but also a secondarymarket for shares after firms have been pri-vatized. Without such markets, individual shareowners would be unable to adjust their portfoliosas required. This would increase the risk anduncertainty faced by investors, thus increasingthe cost of capital to firms issuing equity toraise capital. The marketability of shares is akey element in the ability of firms to attract

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private investors who would have options toliquidate their holdings. Securities markets devel-opment and privatization of state enterprises aretwo sides of a coin in the sense that a governmentcannot hope to carry out meaningful privatiza-tion unless securities markets adequate enough tofinance them exist.

4. Costs and EnvironmentalRequirements for Securities MarketsDevelopment

The benefits of securities markets do not comewithout certain problems, which are inherent inthe system. Some of the costs inherent in secu-rities markets as discussed in the literatureinclude:

1. Market cycles. During the early stages ofsecurities markets development the supply ofstocks and bonds is limited, manipulation isrelatively easy, investors are unsophisticated,underwriters and brokers are inexperienced,and securities legislation often has loopholes.As a result, economic cycles are more difficultto predict. Thus, the job of a financial analystwould be very difficult during the early yearsof development.

2. Interest rate fluctuations. The fluctuations ininterest rates, which occur in a financiallycompetitive environment, make planning moredifficult for both borrowers and savers. Theadditional efforts required for informationgathering and decision making in such environ-ments, together with the need for borrowersand savers to adjust their positions morefrequently over time, constitute costs broughtabout by a liberalized financial system.

3. Intermediation and regulation. The institutionsand individuals that constitute the securitiesmarkets fall into the following categories:

* participants who are the savers and users ofcapital (individuals, corporations and gov-ernments);

* the financial institutions and intermediariesthat channel capital from savers to users;

* supporting and supervisory entities which aretypically government bodies that facilitateand regulate the activities of the participants.

The market itself has two levels:

* the primary market where newly issuedsecurities of newly created or existing enter-prises trade;

* the secondary market where trading in out-standing shares is done.

The specialized services of financial intermedi-aries in securities markets are costly, yet indis-pensable. The strategic position that financialintermediaries hold in the market system interms of access to information and controlover transactions can lead to profiteeringbehavior that decreases the benefits accruingfrom the mobilizing and allocating functionsof the securities markets system as a whole.The reporting requirements also representcosts to participating firms. In addition,firms have incentives to falsify such reports,which result in distorted investment decisionson the part of securities purchasers that maylead to decreased government tax revenues.Such expenses related to the organizationand function of regulatory agencies as secur-ities commissions, stock exchanges andadministrative organs represent monitoringcosts associated with the control of securitiesmarkets abuses.

4. Income inequalities. While securities marketsprovide wider investment choices for saversand also serve to spread ownership in compa-nies, it is likely that in the initial stages ofsecurities markets development, the benefitsof securities ownership will accrue to a limitedgroup of investors. According to Wai andPatrick (1973), until a wide range of firms (interms of size) and savings units (in terms ofdistribution of income and wealth) participatein the securities markets directly or indirectly(through mutual funds, pension funds, insur-ance companies, etc.), the development of thecapital market, particularly the market forequities, is likely to increase the inequality ofincome and wealth distribution. A vigorousprogram of wealth distribution through highlyprogressive income taxation is one counter-measure, although it is fraught with its ownproblems.

Obviously, each of these costs of securities mar-kets operation is significant and may have thepotential to undermine the concomitant benefitsthrough both economic and political reaction.However, the experience of many countries inintroducing securities markets shows that theexistence or creation of certain political, econ-omic, policy and institutional environments cansmooth the process of securities markets devel-opment for the following reasons:



1. Political environment. Political uncertainty isdetrimental to any investment. Investors’ pro-jection of future political conditions, bothdomestic and international, directly affectstheir willingness to invest in such risky finan-cial assets as stocks and bonds. Governmentstability and consistency in applying financialand economic policies tends to increase invest-ors’ confidence and to increase the flows ofcapital from savers to productive investments.

2. Economic environment. The key environmen-tal factors for the success of securities marketsinclude sufficient demand for and supply ofsecurities. Financial and commodities pricesthat do not depart too much from scarcityvalues and low or predictable inflation arenecessary. Demand for securities depends onthe amount of capital available for investmentin the hands of individuals and institutions. Invery low per capita income nations and wherecorporate investment funds are in short sup-ply, demand for securities cannot be expectedto be high.The degree of familiarity of potential invest-

ors with the securities markets operationaffects demand. The existence of investmentalternatives affects both the demand for andthe supply of securities. Thus, bank depositinterest rates, tax policies, and the capitaliza-tion of securities markets are all considered byowners of capital when they make investmentdecisions. Investors must be convinced thatthe risks of securities ownership are likely tobe offset by returns that sufficiently adjust forthose risks as compared with more secureinvestments.

The supply of securities is as important tothe smooth operation of a market as the pre-sence of demand for them. When too fewsecurities are available for purchase and trad-ing, it may be difficult to attract investors,who may doubt that a large enough marketexists to ensure the liquidity of their invest-ments. The result will be a shallow, sluggishmarket that does not perform its function. Incases where demand for securities is high butfew issues are available, securities prices mayrise to unrealistic levels. Experts believe that aminimum number of issues required for thesuccessful institution of a stock market is 20profitable companies (Wai and Patrick, 1973).

3. Policy environment. To encourage develop-ment of healthy securities markets, legal induce-ments that affect the supply and demand forsecurities are helpful. Such incentives include

tax exemptions or reductions for incomederived from capital gains and/or dividendsfrom securities issued by publicly traded com-panies; tax credits for owners of publiclytraded shares; tax deferral for dividends, inter-est and capital gains from securities purchasedfor retirement funds; and tax breaks for com-panies that list their shares on exchanges.While governments have important policyroles in the early stage of securities marketdevelopment, their future involvement shouldbe primarily catalytic and supervisory to createa sense of confidence in the public about themarket.

4. Institutional environment. Four related insti-tutional areas are very important for the suc-cess of securities markets. First, corporationand securities laws are important for protect-ing both the interests of companies and thosewho purchase the securities they issue. Sec-ond, securities markets work most efficientlywhen such intermediaries as brokers, dealers,underwriters and the like are knowledgeable,professional, skillful, honest, and have suffi-cient resources to perform their functions.Third, legal or regulatory standards for theseprofessionals are important for the assurancethat financial intermediaries possess such qual-ities. Enforcement of securities laws, account-ing regulations, and professional standardsshould be carried out by government securitiesand exchange agencies, or through the auspicesof such self-regulating bodies as exchangeadministration organizations. Fourth, account-ing and auditing standards are necessary toprovide comparable financial information.This information is critical to making soundinvestment decisions.

In summary, despite the impetus to economicgrowth that the development of securities mar-kets can provide, the costs associated with suchdevelopment can be substantial. The magnitudeof such costs and the capacity to manage themdepend on a complex set of factors in manyspheres. The experience of a range of developingcountries in instituting securities markets indi-cates that their beneficial effects do not comeautomatically, and that cyclic phases of develop-ment are the rule. Securities markets remain sens-itive to changes in the macro and micro-environments affecting issuers and purchasers.The degree of government intervention in sup-port of capital market development through fis-cal and monetary policies is critical.

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Furthermore, the question of how much mar-ket orientation of the economy as a whole isrequired in order for securities markets to playa beneficial role is uncertain, but clearly it mustbe substantial. These observations must be keptfirmly in mind as we now examine the environ-ment for developing securities markets in Ethiopia.

5. Environment for Developing SecuritiesMarkets in Ethiopia

Research shows a strong positive correlationbetween overall securities markets developmentand long-term economic growth and that theassociation is robust (see Levine and Zervos,1996). As a result, a worldwide movement existsto encourage development of securities marketsin developing countries and transitional econ-omies of Eastern Europe, and countries of theformer Soviet Union.In Africa, the African Capital Market Forum

(ACMF) is leading the effort assisted by theOrganization of African Unity (OAU) and theAfrican Economic Commission, both headquar-tered in Addis Ababa, Ethiopia. At the 6th Con-ference of African Finance Ministers in mid-September of 1997 held in Addis Ababa, theACMF and the inter-governmental group ofexperts discussed financial market developmentand integration in the African continent. Theparticipants made several strong recommenda-tions including developing stock exchanges inAfrica and integrating them. They endorsed theidea of regional exchanges that would allowmember states access to a much larger pool ofexternal funds besides increasing mobilization ofdomestic capital. Of course, these changes callfor harmonizing security laws and accountingand auditing standards.For its part, the Ethiopian government has

been studying the possibilities of developing astock exchange. The government has sent a dele-gation of experts from the National Bank ofEthiopia to some African and Asian countriesto see how securities markets operate. Pressurealso may be coming from the InternationalMonetary Fund (IMF) and the World Bank toopen up the economy by developing securitiesmarkets. As recently as September 1998, a paneldiscussion organized by the Addis Ababa Cham-ber of Commerce underscored the need todevelop a stock exchange in Ethiopia. Thepanel highlighted the need to look beyond thebanking system for additional capital by provid-

ing investors with choices that induce them tosave and invest.

In the last ten years, Ethiopia has been in theprocess of transforming itself from a centrallyplanned to a market-oriented economic system.Early on, the government redefined its role insuch a way that it would be engaged only inregulatory aspects and strategic economic activ-ities, while playing a primary role in creating anenabling environment for the private sector.

In Ethiopia, public enterprises are beingrestructured and some have been privatized. Inaddition to privatization, commercialization ofstate enterprises is underway. The governmentissued a series of investment proclamations(1992, 1996, 1998) with many incentives intendedto attract both domestic and international invest-ors. The incentive package, however, does notcompare favorably with those found in manydeveloping countries, thus placing Ethiopia at acompetitive disadvantage (see Teklu, 1994).

Moreover, the existing barriers to investmentin Ethiopia are so great as to render the benefitsprovided in the proclamations immaterial to theinvestment decisions by investors. The most fre-quently cited complaints by potential investorshave to do with the bureaucratic process. Theworking relations between the central andregional governments do not seem to be clearlydefined. As a result, potential investors run intomany obstacles in getting access to land, powerand telecommunications services. This may beone of the reasons why the number of investmentprojects implemented by the business communityis far below the number of licenses issued. For-mulation of favorable policies and issuance ofregulations alone are not sufficient to encourageprivate sector activities. A faulty implementationputs the finest blueprints into disarray. Further-more, some aspects of the proclamations limitthe areas of investment by foreigners. The latestproclamation (1998) addresses some of these limi-tations, and allows foreign investors to invest inenergy projects, telecommunications and thetransport industry.

Ethiopia needs massive investment to upgradeits road network, supply of energy, water andtelecommunication services to provide the neces-sary infrastructure to potential investors. Theseare areas, perhaps, in which foreign investorswith capital as well as new technology shouldbe invited to participate. Investments in thosemajor infrastructures would create employmentopportunities for those who would be laid off asstate enterprises are restructured and privatized,



and thus alleviate the problem that would beencountered when the breadwinner in anextended family loses his/her job which is typicalin countries like Ethiopia.Ethiopia also needs to overhaul its educational

system in such a way that it addresses the coun-try’s manpower need. The current system is elitistand does not prepare students for anything otherthan entering the university. High school gradu-ates are functionally illiterate. If they do notmake it to college, they simply have to join theranks of the unemployed. The magnitude of thisproblem is exacerbated by the percentage of highschool graduates who do not make it to college.For instance, 160,000 students took the collegeadmission test during the 1997/98 academic yearand only 12,000 (less than 8 per cent) made it.The remaining 148,000 will be added to thealready bloated unemployed work force. Ethio-pia would have a competitive advantage of lowwages and a large labor force if its labor forcewere trained properly.Higher education continues to be the respons-

ibility of the central government while primaryand secondary schools are run by the regionalgovernments. Education in Ethiopia for the mostpart is still free to students. The Addis AbabaUniversity (AAU) system is the largest in Ethi-opia and one of the oldest universities in Africa.Its graduates have proven without any doubtthat they could compete at a global level andmake it in any field imaginable.Newer colleges in the various parts of the

country are being elevated to universities forwhat seems to be political reasons. The nationaluniversity (AAU) operates under conditions ofovercrowded classrooms, deteriorating physicalfacilities, lack of resources for such things astextbooks, reference materials, computers,laboratory equipment and consumables. Lackof textbooks, reference materials and the inabil-ity to make copies of handouts for students havebeen major impediments to effective teaching.Faculty members have to learn to improviseand make do with minimal resources. Given therelatively high cost of establishing and operatinguniversities, it would not be in the country’sinterest to add universities when the existingone is suffering from lack of adequate support,financial or otherwise. This simply divertsresources from Addis Ababa University, affect-ing the quality of its programs.Lack of a skilled labor force has been cited as

one of the reasons why foreign investors are notattracted to developing countries like Ethiopia.

The government, instead of adding universitiesby opening one in each regional state, shouldstrengthen the national university and expandintermediate schools for high school graduates(who could not make it to college) to learnsome skills they could use. Thus, a skilled laborforce would be readily available and would beattractive to foreign investors coming to thecountry.

Although the 1998 Investment ProclamationAct expands the areas in which foreign invest-ment is encouraged, foreigners are still notallowed to invest in the financial sector. Ethi-opian law forbids any foreigner, including a for-eign bank, to own shares in an Ethiopian bank.The law also forbids foreign banks from con-ducting any banking activities in Ethiopia. Thisisolation of the Ethiopian banking system fromthe international banking community has per-haps the most important and far-reaching of theseveral consequences emanating from the restric-tions upon foreign investment imposed by theEthiopian government. By denying foreignersany role in the Ethiopian banking industry, thegovernment has closed an obvious source ofmuch-needed capital for banks.

Perhaps more significantly, the governmenthas also closed an important source of impartialinformation to potential foreign investors. Manyinvestors, especially those who are new to acountry or region, rely upon their internationalbanks not only for banking services but also forinformation. For most businesses contemplatingstarting operations in a foreign country in whichthey have not previously invested, an importantpart of their due diligence investigation is anappraisal of the investment environment andthe general business climate.

A local branch of their bank can usually betrusted to provide the kind of information aninvestor needs about the practical realities (asopposed to the theoretical legal opportunities)of the local business climate. Because of its con-tacts with the local business community, the localbranch of a potential investor’s bank can alsoperform a second valuable function by findingand evaluating particular investment opportun-ities. Ethiopia deprives foreign investors of theseservices from their international banks.

If a potential foreign investor is unable to getinformation from their bank, they must relyupon the government’s investment promotersand other local sources which have interestswhich differ from those of the foreign investor.Information from these sources not only lacks

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the impartiality which an investor expects of theirinternational bank, but these national sources areunable to perform a comparative analysis which canassist the investor to determine in which country,among many possibilities, to make an investment.Similarly, the restriction upon foreign insur-

ance companies and upon foreign investment inEthiopian insurance companies also deprives thecountry of badly needed capital. Another effectof these restrictions in the financial sectors of theeconomy is that foreign banking and insurancebusinesses do not establish branches or subsid-iaries in Ethiopia in which Ethiopians can receivetraining in the latest techniques and proceduresand thereby develop skills needed both by themand by the country. This increases the difficultyof every investor because it inhibits the growth ofa pool of skilled personnel.The financial sector requires highly skilled

manpower to undertake the vast range of tasksneeded to mobilize and allocate resources aseffectively as possible. It also needs help fromthe government. The role of the governmentshould take the form of regulations to monitorand enhance bank solvency and limit financesector instability. Building the confidence of thegeneral public in the operation of the capitalmarket in general, and securities markets in particu-lar, is a critical aspect of development of capitalmarkets. A well-functioning private sector enhancesthe development of securities markets.Developing securities markets in Ethiopia face

several direct challenges:

* Low level of public awareness about securitiesmarkets (the degree of awareness by potentialinvestors of investments in stocks and bondsaffects demand for securities).

* Lack of public confidence in share investment(after 17 years of socialism, there is neither thetradition nor the trust in share companies).

* Lack of institutional capacity to facilitatesecurities trading.

* The underdeveloped state of the bond (debt)market due to the historical prominence ofbank financing.

* A low level of private sector development and alow level of market orientation in the economy(there is still government interference in themarket).

* Easy access to loans by wealthy and financiallysophisticated Ethiopians, and probably thosewith a strong link to the party ruling the country.

* Problems with the supply and demand forsecurities at least initially (a reasonable num-

ber of companies whose shares are publiclytraded and a variety of individuals and institu-tional investors).When too few stocks and bondsare available for purchase and trading, it may bedifficult to attract investors who may doubt theexistence of a large enough market to insureliquidity. On the other hand, in a very low percapita income country like Ethiopia and whereinvestment funds are in short supply, demand forstocks and bonds cannot be expected to be high.

* Absence of input by the business communityin the formulation of economic policy by thegovernment (there is no mechanism in place tosolicit input from the business community).

Many prospects (opportunities) for developingsecurities markets exist in Ethiopia:

* Ethiopia has considerable unexploitedresources. Ethiopia’s known natural resourcesinclude gold, platinum, tantalum, soda ash,potash and natural gas. Except for gold,none of these resources has been exploited ona large scale. Ethiopia also has considerableunexploited fertile land. Agriculture plays akey role in the economy, although the countrystill uses primitive technology and the climateis subject to recurrent droughts due to irregu-lar rain.

* Ethiopia, with over 60 million people (secondmost populous in sub-Saharan Africa), pro-vides one of the largest potential markets inAfrica.

* Ethiopia’s process of transition from a cen-trally planned to a market-oriented economicsystem and the process of economic liberaliza-tion underway is encouraging.

* The privatization efforts going on would helpwith the supply problems, particularly if apublic offering of shares is used as the methodof privatization.

* The existence of many profitable companies,which can potentially benefit from floatingshares to the public.

* The existence of institutions like the country’sPension Fund, insurance companies, creditunions, etc., with large sums of money. Ifallowed to invest, they would boost thedemand for securities.

* The gradual improvements of the incentivepackages in the successive investment proclam-ations help attract new investors includingEthiopians with foreign passports.

* The debate going on in academics, the busi-ness community at large and the governmentcircle is encouraging.



6. Conclusion and Recommendations

One of the main challenges for developing coun-tries like Ethiopia is to improve the quality offinancial intermediation and resource allocationto contribute to a more rapid rate of economicgrowth. Recent developments in sub-SaharanAfrica hint at benefits to be gained as a resultof opportunities from the domestic capital mar-ket. More than a dozen African countries havenow put in place stock exchanges.At the same time, the interest in emerging

stock markets by international investors isincreasing largely due to the possibilities ofabove average long-term capital gains. In Ethi-opia, bank-based financing of investments is stillprevalent. Such a system leads to a greater degreeof control over the private sector by a relativelysmall group of agents. This stricture could beavoided by putting more reliance on market-based financing. Reliance on debt financing, onthe other hand, has weakened domestic entrepre-neurship and has favored government or familygroup ownership with excessive debt ratios. Toavail capital to the most productive enterprises,there seem to be strong arguments for developingan equity market in Ethiopia as an alternative todebt financing. Unlike banks, equity investorswill share in both the benefits and costs of riskyprojects (enterprises) and, unlike banks, theirreturn is not limited to a fixed interest rate butwill rise with the profitability of an enterprise.Ethiopia is in the midst of economic transfor-

mation from a centralized to a market economy.A successful transformation requires gradualdevelopment of the capital markets to supporteconomic activities. International experienceshows that no universal blueprint or model canaddress every country’s needs. This suggests theneed for flexibility in the choice of methods ineconomic reform that must take into account theunique features of a country, particularly interms of the level of economic development andadministrative capacity. The success alsodepends on how carefully it is implemented, asthere is much potential for good or bad. It takestime to develop the country’s rudimentary insti-tutional infrastructure to run the operations ofsecurities markets.The following recommendations are suggested.

They should not be taken as a blueprint butrather as a general road map, which can berevised as experiences are gained.The successful development of securities

markets requires the existence of sufficient

demand and supply of stocks. Demand for stocksdepends on the amount of capital available forinvestment in the hands of individuals and insti-tutions. The supply depends on the number ofcompanies willing to list their company to tradeshares publicly.

The first and foremost task in increasing thedemand for securities is to educate the publicabout securities markets using the publicmedia. Organize forums where the businesscommunity and the general public can learnabout the benefits and costs of investing insecurities markets. At the same time improvethe political and legal environment in order tobuild the confidence first of the domestic busi-ness community and then of the internationalinvestors.

A legal system which not only allows for aclear definition of the rights and responsibilitiesof the contracting parties, but also provides forcost effective enforcement of covenants. Throughits regulatory power, the government can domuch to reduce uncertainty by increasing infor-mation flows, by punishing those who engage inforbidden activities, and by taking measures toenhance investor confidence. The securities lawsmay be copied from countries with situationssimilar to Ethiopia.

Another way of creating demand forsecurities is lifting all the legal restrictionsfrom institutional investors like the largest gov-ernment pension fund, public and privateinsurance companies and credit unions so thatthey can fully participate in the securitiesmarkets.

As far as the supply side is concerned, move-ment towards active private sector development,in conjunction with enabling privatizationprograms and liberalization of trade and capitalflows, will help boost the supply of securities.The Ethiopian government can help this processby using public offering of shares in futureprivatizations of state enterprises. Althoughthe lack of dependable financial data posesvaluation problems, public offering of shares asa modality of privatization would result in broadownership of firms. Broad ownership of firmswould give citizens a stake in the country’seconomy, thus reducing the resistance generatedby the discomfort of the layoffs due to privatiza-tion and the suspicion that state enterprises arebeing sold to individuals or groups with politicallinks to the ruling party. Other private firms mayalso benefit from going public. The advancednations have a number of reasons why firms in

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general consider going public. Among thesereasons are:

* availability of significant funds for such pur-poses as working capital requirements, devel-opment of new products, expansion of existingones, paying off debt and for research anddevelopment activities;

* a publicly traded company is in a more favor-able situation to finance acquisitions with itsown stock as an alternative to using cash;

* issuance of equity would help expand debtcapacity thus allowing the firm to accessmore readily available sources of debt atattractive interest rates.

Many of these advantages also exist for com-panies going public in Ethiopia. Experts believethat the minimum number of issues required forthe successful institution of a stock market is 20,each representing a ‘float’ of 25 per cent of enter-prise capital (see Van Agtamael, 1984, p. 45).Ethiopia definitely has more than 20 profitablefirms that can pay more in dividends than whatbanks currently pay in interest.Reducing government securities-holding

requirements by banks and savings institutionswould encourage government agencies and stateenterprises to issue bonds to raise capital in theopen market by offering attractive rates. Thebanks and savings institutions would then beable to invest in the securities markets, thuscreating demand. In order to avoid bank runs,however, the government, through its regulation,may limit the equity participation by banks andsavings institutions to protect depositors. Othermeasures the government should take to encour-age public ownership of private firms include taxexemptions or reductions for income derivedfrom capital gains and/or dividends from stocksissued by publicly traded companies.Most importantly, the government should

help in the development of the debt marketby expanding auction programs for treasurybills, and federal investment bonds, togetherwith the development of a framework for pri-mary dealer networks in the secondary market.Along with the public debt market, the corpor-ate debt market, which will expand financingoptions for private enterprises, needs to bedeveloped. The establishment of bond-ratingagencies will facilitate the development of thedebt market. This is important, because inmany countries the development of the bondmarket precedes the development of the equitymarkets.

Securities markets work most efficiently whenbrokers, dealers and the like are knowledgeable,professional, skillful, honest, and have sufficienttraining and resources to perform these func-tions. The government, among other things,should permit private and state banks to act asmarket makers until such time that the stockexchanges start issuing licenses to dealers andbrokers. The government should enlist the ser-vices of the International Finance Corporation(IFC) for operational and technical advice intraining government staff and staff of financialinstitutions (e.g. accountants, financial analystsand lawyers) responsible for the operational,supervisory and regulatory aspects of securitiesmarkets activities. This would help in upgradingthe quality in terms of technical skills and analyt-ical capacity of the personnel in the securitiesmarkets business.

Furthermore, substantial banking sectorreform, including privatization of the largestcommercial bank, is necessary. It is also import-ant to enhance the authority and capacity of thecentral bank in order to improve the health andcompetitiveness of the financial sector. For theNational Bank of Ethiopia to fulfill its role as themonetary and supervisory authority more effect-ively, its authority and capabilities may have tobe considerably enhanced by ensuring greaterautonomy and improving its technical capacity.A vigorous and independent regulatory body isessential for conducting monetary policy throughopen-market operations and purely on economicconsiderations.

The dissemination of market information isanother integral part of securities markets devel-opment. Since the competition among developingcountries to attract foreign capital is very intense,there is a need to make concerted efforts to dis-seminate market information to potential invest-ors abroad. A coherent and integrated strategy tomarket the country based on providing pertinentand timely information to the internationalinvestors would help attract direct and indirect(portfolio investment through an Ethiopiancountry fund) investments and invigorate thesecurities markets.

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Notes

1. Securities markets are markets that provide med-

ium- and long-term equity and debt funds in nego-

tiable forms that are issued by corporations and

governments through financial institutions directly

to individuals and different holders.

2. Capital markets include both securities markets and

‘non-securities markets’. Non-securities markets

provide non-negotiable medium- and long-term

debt funds through financial institutions such as

commercial banks and savings and loan institutions.



prospects and challenges for developing securities markets in ethiopia an analytical review

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