REFORMS NEED TO NURTURE CAPITAL MARKETS / THE FINANCIAL TIMES MARKETS INSIGHT ( A MUST READ )

Reforms need to nurture capital markets

By Deven Sharma

Published: January 26 2011 18:06

A big question facing financial policymakers – and a key topic of debate at this week’s World Economic Forum – is whether capital markets can cope with the huge demand expected for credit worldwide in the coming years. The answer will be critical in determining the outlook for both developed and rising economies over the rest of the decade and beyond.


The numbers at stake are sobering. According to the WEF, credit supply must rise by more than $100,000bn in the next 10 years – double its current levels – to meet demand for new funding worldwide. S&P estimates that public and private sector borrowers worldwide will need to raise or refinance about $70,000bn of bonds between now and the end of 2015.


In the developed world, much of this total will be accounted for by sovereign issuers, but a large slice will be required by companies looking to finance growth and replace loans, bonds and structured securities issued at low cost before the crisis and now maturing.


To compound the task, a record amount of refinancing will be at the riskier end of the spectrum. For instance, more than $1,000bn of US non-financial corporate bonds and loans falling due in this period are rated subinvestment grade, while many banks are likely to focus on issuing new types of less creditworthy and more loss-absorbing hybrid capital.


But it is not just highly leveraged developed economies that will be hungry for credit. Demand will be even greater in the rising economies, as the two worlds’ economic paths continue to converge.


Against this backdrop, there is a risk that demand for credit worldwide will outstrip supply. Banks, especially in Europe and the US, face new constraints on lending, as they seek to rebuild balance sheets, deleverage, and meet new regulatory capital requirements. This leaves a large gap in the provision of credit that will need to be filled by the capital markets.


In the past couple of years, that is precisely what has happened. Corporate bond issuance – which remains far larger than equity issuance – has greatly outpaced bank lending in recent years and maintained a high tempo so far in 2011. But while capital market supply has expanded to meet demand recently, there may be a limit to its capacity.


The call for capital over the next few years will be greatest in those countries where financial markets are in an early stage of development and there is greatest reliance on traditional or informal banking systems. This is already creating credit blockages, for instance, for small- and medium-sized enterprises in the emerging world.


At the same time, there is a danger that ongoing global imbalances may prompt financial protectionism – or encourage further uncoordinated financial regulation – and that in turn may disrupt or slow global capital flows.


Recent reform efforts, in areas ranging from proprietary trading to credit derivatives and credit ratings, have been piecemeal and parochial. That risks creating more uncertainty for investors, disrupting capital flows and locking up much needed liquidity.


Such a mismatch in supply and demand for capital may contribute, alongside other macro trends, to higher long-term interest rates over the medium term, from current historically low levels.

But policymakers have an opportunity to minimise the impact. Well-calibrated and co-ordinated regulation and supervision, high levels of transparency and careful monitoring and management of systemic risk can all contribute to a sound and sustainable system.


Capital markets thrive on certainty. That calls for policy measures that are comprehensive and consistent, both across markets and across the capital formation and investment process – including, for instance, the fast growing and largely unregulated shadow banking sector.


Innovation is another ingredient. New initiatives will be required to facilitate funding for segments of the economy held back by capital shortages, such as the SME and environmental finance sectors. That includes reviving securitisation as a simple and transparent funding channel for banks.

Finally, further progress is needed to develop deeper, more efficient and more globally integrated capital markets in high-growth regions.


It requires a clear commitment to improving market infrastructure in the developing world, strengthening transparency and pricing of credit risk, and broadening participation by international companies and investors in local markets. In the next few years, capital markets will need to make an even bigger contribution to supporting growth, building infrastructure, and creating jobs worldwide. Nurturing their development as transparent, well-governed and liquid sources of funding must be a policy priority.


Deven Sharma is president of Standard & Poor’s


Copyright The Financial Times Limited 2011