Don't Fear Capital Markets

Jul 9 , 2022
By Christian Tesfaye

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The Ministry of Revenues recently moved to introduce a new rule. Capital gains tax, which stands at 30pc in Ethiopia, will henceforth be adjusted for inflation. It is good news for individuals and institutions with a significant portion of their net worth tied up in shares of companies.

It is so uncharacteristic of the Revenue Ministry to do this since adjusting for inflation before the 30pc levy is applied will impact tax revenues. But then again, capital gains are only taxed when they are realised, and there is very little equity trading activity taking place owing to the reluctance to introduce a stock market for so long.

The government plans to collect a little over one billion Birr from capital gains tax next year. This is 0.25pc of the 400 billion Br in taxes it hopes to collect. It is pocket change, and it is no wonder. As trading activity grows, the revenue collected from capital gains will significantly grow with the introduction of stock markets. Lowering the capital gains tax rate can encourage more trading on a stock exchange and increase the pie. The government can also use it to incentivise sectors. For instance, capital gains from shares of a company in the agriculture sector could be lower than that of a hotel chain. Imagination is all that is needed.

Let us get it straight. Supporting the growth of the capital markets is not merely about creating a platform for the few (and it would be the few, at least in the short- to medium-term) to trade shares. It is about the financialisation of the economy. It is about creating an environment where credits and equity financing are widely accessible and risk is shared broadly because of innovative tradable products that balance investment grade with high risk projects.

Take a simple example of how a developed capital market could have supported the mobilisation of financing for the Grand Ethiopian Renaissance Dam (GERD).

First of all, bond sales would have been streamlined. Instead of going street-to-street blaring over megaphones soliciting passersby to purchase bonds, or cutting the salaries of poor civil service employees, there will be a platform where GERD debt securities could be available for purchase at any time. It will be from anywhere in the country and, hopefully (depending on the appetite of the government to open up), from external market players.

GERD bonds would be much more attractive if they could be bought and sold on secondary markets. For one, it pushes project developers and promoters (the government in the case of the GERD) to step up their game because bond terms (maturity, yield) will be scrutinised and compared to other debt and equity instruments on the market. It could be a new day for investment appraisal (especially in the public sector) if projects are financed through the capital markets. More importantly, it becomes more tempting to buy a GERD bond if I know I can liquidate at any time in the secondary market if I need the money or find a better investment opportunity. If the bond yield is stable enough, I could use it as collateral to access bank loans.

Secondly, any rise in bond yields that might arise from increased perceptions of business or investment risk could be mitigated by combining GERD bonds with lower-risk investment-grade bonds (say, from Ethiopian Airlines, if it is buying debt locally). The risk is further distributed and funds mobilised for the dam.

But, some will ask, what about the volatility and risk factors that are often exaggerated in the financial markets?

This is true. For instance, speculation accounts for an estimated 20 dollars added to the current 100-plus dollars per barrel of crude oil. But speculation can be reasonably regulated through disclosure and financial consumer protection laws, not to mention that the risks posed are more than counterweighted by the overall benefits of capital markets to the economy. And volatilities usually negatively impact over-priced and poor investments than they do those that make business and financial sense – it could be a much needed market correction.

Risk will never go away on any initiative or action that is taken. The key is careful deliberation, learning from countries that have already gone through this path and putting in place incentives such as adjusting for inflation capital gains taxes.

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PUBLISHED ON Jul 09,2022 [ VOL 23 , NO 1158]

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