How Capital Markets Transform Business Growth in Developing Economies

The study by the IFC and World Bank highlights the growing role of capital markets in financing firms in low- and middle-income countries, leading to increased investment, employment, and economic growth. Policy reforms, domestic market expansion, and improved investor confidence have driven this shift, though challenges remain in ensuring broader access to market-based financing.

Research conducted by the International Finance Corporation (IFC) and the World Bank highlights the rising importance of capital markets in low- and middle-income countries as a key source of financing. Over the past three decades, firms in these economies have increasingly turned to capital markets instead of relying solely on traditional bank lending. The study, "Financing Firm Growth: The Role of Capital Markets in Low- and Middle-Income Countries," explores how firms raised approximately $4 trillion through bonds and equities between 1990 and 2022. This shift towards market-based financing has played a crucial role in improving productivity, employment, and economic growth. The research delves into the patterns of capital market expansion, the economic benefits of firm participation, and the policy measures that can facilitate further growth.

Expanding Access to Capital for More Firms

The expansion of capital markets has reached beyond a few large corporations to include a growing number of smaller and younger firms. Between 2000 and 2022, companies from 32 new middle-income and 13 new low-income countries accessed capital markets for the first time. This expansion indicates a more inclusive financial system where a broader range of firms can raise capital to fund their business activities. The study reveals that new participants accounted for over 60% of cumulative net capital issuance (CNI) in low- and middle-income countries by 2022. The increasing number of firms participating in capital markets has led to more efficient financial resource allocation, benefiting both individual businesses and national economies.

Firms that secured capital market financing have shown remarkable improvements in financial and operational performance. Investment in physical assets, hiring more workers, and expanding business activities have contributed to increased productivity. The study finds that issuing capital is associated with an 11% increase in sales, a 17% rise in physical capital, and an 8% increase in employment within a year. Equity issuances had an even stronger impact than bonds, with issuing firms experiencing a 13% increase in physical capital, compared to a 5% increase for bond issuers. These effects were particularly significant in low-income countries, where financial constraints are more pronounced. By tapping into capital markets, firms with high marginal returns to capital (MRK) that previously faced funding challenges were able to expand their operations, improving overall economic output.

The Rise of Domestic Capital Markets

The development of domestic capital markets has played a vital role in making financing more accessible to firms. Between 1990 and 2022, domestic markets accounted for 79% of equity issuances and 53% of bond issuances in low- and middle-income countries. The growing reliance on domestic markets has enabled companies to raise funds in local currencies, reducing their exposure to foreign exchange risks. Smaller firms, which previously depended on bank loans, have increasingly turned to domestic bond markets for financing. A notable trend has been the declining size of first-time bond issuances in domestic markets, which fell by about 30% between 2000–09 and 2010–22. This decline suggests that domestic capital markets are becoming more accessible to smaller businesses, allowing them to secure financing that was previously out of reach.

While domestic capital markets have grown substantially, many firms still rely on international markets for larger bond issuances. The study indicates that firms issuing bonds internationally typically raise more capital than those issuing domestically, with international issuances averaging $503 million compared to $154 million in domestic markets. This difference reflects the larger investor base and more favorable borrowing terms available in international markets. However, as local financial markets continue to mature, domestic capital markets will likely become an even more critical source of funding for firms in emerging economies.

Policy Reforms Driving Market Expansion

Several policy measures have contributed to the growth of capital markets in developing economies. Economic growth has been a significant factor, as it increases both the supply of investable savings and the demand for financing. Pension fund reforms have played a crucial role in boosting domestic capital markets. Countries that implemented pension reforms saw a fivefold increase in domestic capital market activity within four years. The introduction of sovereign bond markets has also facilitated corporate bond issuance, as government bonds serve as pricing benchmarks that help firms price their securities more effectively.

Regulatory measures have further strengthened investor confidence, leading to greater participation in capital markets. Policies focused on improving investor protections, corporate governance, and transparency have enhanced market stability and attracted more issuers and investors. Additionally, financial liberalization in some countries has allowed firms to access international capital markets more easily, increasing their financing options. The study suggests that a combination of these policy measures has been essential in fostering deeper and more resilient capital markets.

Challenges and the Road Ahead

Despite significant progress, capital markets in developing economies still face several challenges. Market concentration remains high, with a few large firms dominating issuance activity. Many smaller firms struggle to access capital due to financial constraints, limited investor confidence, and regulatory hurdles. The research highlights the need for further policy efforts to address these gaps, particularly by improving financial intermediation and expanding the base of institutional investors. Strengthening credit rating agencies, enhancing disclosure requirements, and implementing investor-friendly regulations can help create a more inclusive financial ecosystem.

The findings suggest that well-functioning capital markets are crucial for economic development, enabling firms to grow, create jobs, and enhance productivity. Continued policy support is essential to sustain and accelerate capital market expansion in low- and middle-income countries. Governments and financial institutions must work together to promote more inclusive financial markets, ensuring that a larger number of firms can benefit from market-based financing. The study serves as a valuable resource for policymakers, investors, and researchers seeking to understand the evolving landscape of capital markets in developing economies and their impact on long-term economic growth.