Equity Markets and Economic Development: What Do We Know

large and active secondary market in mitigating the problem of the availability of long-term
funds. Investors and corporations tend to have conflicting concerns over the optimal degree of
liquidity of financial transactions. Investors favour high liquidity whereas corporations need
to be assured of long term credits to match their long term assets. To reconcile these
conflicting concerns, transactions in the secondary markets are necessary as they enable new
issues in the primary markets to be successful. Equity market development therefore allows
easing the tension between savers’ preference for liquidity and entrepreneurs’ need for long-
term finance (Ndikumana, 2001).

Another line of reasoning, stemming from corporate finance theory, suggests that the
development of securities market helps to strengthen corporate capital structure and
governance. In countries where there are no viable equity markets, firms tend to rely heavily
on internal finance and bank borrowings to finance fixed assets and working capital, which
raises the debt/equity ratio. The resulting imbalanced capital structure increases interest rate
risk by creating maturity mismatches on balance sheets. This weakens the corporate sector in
periods of economic downturn, where banks tend to squeeze credit and limit overdraft lines.
By contrast, efficient stock markets increase the viability of investment projects by allowing
all firms to compare the cost of various sources of finance and to pick up the appropriate debt
to equity mix (Oshiloya&Ogbu, 2003). Additionnally, equity markets may improve corporate
governance by mitigating the issue of ‘moral hazard’. The latter is a standard corporate
finance concept stating that the interests of managers and owners may not necessarily
coincide if their incomes depend on different factors. In this context, inefficient managerial
decisions may arise, negatively affecting the firm’s value. One advantage of the stock market
is that it allows tying the manager’s income to stock prices, thereby reducing the incentive for
imprudent actions and increasing the firm’s long term value. Equity markets can also improve

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