(Abstract)

The paper is based on the framework of information asymmetry, principal-agent problems, transaction costs, and taxes. Proper assessment of the theory and empirical evidence as to what a capital market can and cannot do is essential so that, at least, there will be no illusion about its role. Both theory and empirical evidence show that capital market (external finance), where it exists, is neither the most preferred (low-cost) source of finance for firms nor is it easily accessible. Empirical studies indicate that in developed as well as developing countries external finance is not the most important source of investment finance either. Moreover, competition for savings with financial intermediaries (banks in particular) may affect the availability of loanable funds by banks which in turn may affect policy-based lending, thereby frustrating industrial policy. Even if the market is introduced, it is likely to continue to be thin both on the supply and demand side. The former because standard listing requirements exclude many firms while those that satisfy the requirements may choose not to participate for a number of reasons; the latter because of limited domestic capital, absence of large number of blue chip firms to attract investors, etc. Yet, in view of the importance of developing a wide-based financial system, the corporate governance & control function, and the time involved in developing a vibrant capital market, creating the market sooner rather than latter and nurturing it is desirable. However, developing the necessary market infrastructure is costly which raises the question of whether it is worth incurring the costs, especially if they are to be born by the government (with tax payers’ money for which there are many competing uses).

* Ethiopian Development Research Institute (EDRI) and Department of Economics, AAU. The opinions expressed here are those of the author and do not necessarily represent the views of the institutions with which the author is affiliated. For full text contact CPRD