Casablanca Stock Exchange (CSE) also know as Bourse de Casablanca. | © shutterstock.com
Why is issuer composition important?
Many firms, especially in low- and middle-income countries (LMICs), rely on bank borrowing, which is typically more restrictive in terms of amount, tenor, risk tolerance, and financial instruments. Therefore, many firms may be unable to access much-needed financing, limiting the rate and quality of firm growth. Capital markets can play a critical role in addressing this financing gap as they are better positioned to cater to a wider range of financing needs through various instruments spanning equity, quasi-equity, debt, and derivatives. They also reduce liquidity risk for investors through trading in secondary markets, thereby unlocking long-term financing for firms. Capital markets also tend to attract a broader pool of investors with varying investment horizons, risk appetites, and investment objectives. These factors can encourage a diverse range of issuers to participate in stock markets as they grow.
However, it is unclear to what extent stock markets have attracted a broader range of firms as they have grown. Primarily, stock market growth may result from growth at either an extensive (i.e., new issuers participating in the market) or an intensive margin (i.e., existing issuers raising further financing). Differentiating between these can be crucial for understanding how effective stock markets are in meeting financing needs across the economy. Furthermore, a more inclusive stock market can be beneficial in itself. For example, volatility in the market may increase if there are only a handful of dominant firms or if listed firms are concentrated in just a few sectors. The lack of a broad and diverse issuer base also makes capital markets less attractive to investors as it becomes more difficult to achieve low-cost diversification––one of the key advantages of capital markets. It also has implications for the real economy as research shows that equity markets are essential in financing more innovative and high-growth firms and longer-term projects (Didier et al., 2020; Bae et al., 2021). When stock markets are restrictive, such firms and projects cannot get funding, which in turn restrains innovation and productivity in the economy.
Does issuer composition change as stock markets grow?
To understand how issuer composition changes as stock markets grow, in a new working paper we examine the relationship between two dimensions of stock market growth––market size (market capitalization) and trading activity (value traded and turnover ratio)––and measures of issuer composition such as total number of listed firms, share of listed domestic firms, number of Seasoned Equity Offerings (SEOs), share of market capitalization of the 10 largest domestic companies, and sectoral diversity.
We find that market size, proxied by equity market capitalization as a share of GDP, is not associated with an increase in the number of total firms (Figure 1). This suggests that more firms do not necessarily enter the stock market as market capitalization increases. Instead, such growth may be driven by either existing issuers raising further financing or increasing asset prices. Our paper provides evidence in favor of the former, with the number and size of SEOs increasing as stock market size increases. The lack of new entrants also explains why market size is unrelated to the share of domestic firms listed in the local stock markets. These results suggest growth primarily on the intensive margin as stock market capitalization increases.
An increase in trading activity, however, is linked to increased participation in stock markets. This may reflect improved liquidity which can decrease the cost of capital, thereby encouraging the entry of new firms in the stock market. The entry of new firms contributes to diversifying the issuer base if entrants are sufficiently different. Of particular interest, especially for stock markets in LMICs which tend to be dominated by large firms, is whether access for smaller firms improves. We find no evidence that issuance size for Initial Public Offerings decreases as these markets grow either in size or activity. Similarly, we do not find that the share of market capitalization of the 10 largest companies in these markets decreases as stock markets grow. Our results suggest that while increased stock market activity may attract new entrants, the composition of the issuer base remains relatively stable.
Lastly, we examine if and how the sectoral diversity of issuers changes with stock market growth. Public listings in LMICs tend to be concentrated in a few sectors, especially the financial sector. More sectoral diversity can reflect a greater variety of financing needs being met and can also help make capital markets more resilient. However, our paper does not find evidence suggesting a greater diversity of issuances across sectors as stock markets grow in size or activity.
Why do these results matter?
Our results show that stock markets may not necessarily become more inclusive as they grow. Instead, a growing stock market is related to an increase in the number and size of SEOs, indicating growth at the intensive margin. While increased stock market activity attracts new entrants, our results show that the composition of the issuer base does not tend to change significantly. These findings have important implications for policy makers seeking to improve access to financing for firms. Participation of a broad and diverse set of issuers reflects a well-functioning stock market, which can meet various financing needs in the underlying economy. However, this may not naturally follow capital market growth. There is a clear need to go beyond headline growth indicators to ensure stock markets are more inclusive on the issuer side. Targeted policy measures, such as simpler listing requirements or SME exchanges, are likely more effective than broad stock market development.
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