Stock Markets, Not as Pertinent as They Sound

Jan 18 , 2019
By Ahadu Yeshitela

---

Calls for the establishment of the stock market are loud these days but the side effects it can inflict are barely discussed. Stock markets, while beneficial when well regulated and supported with a robust financial infrastructure, have been known to improve corporate profitability while harming the national economy, opines Ahadu Yeshitela (ahadu.yeshitela@gmail.com), a law graduate currently doing his masters at the University of Greenwich in london on international and commercial law.

---

Debates around the establishment of a stock market have recently become common after the government showed its intention to establish a stock market in Ethiopia by 2020. And with the debates and discussions, confusion and misunderstanding as to what it is and what it entails have become rampant.

To understand stock markets, it helps to imagine a small business. Take Abebech, who has a juice business that is doing well. She wants to grow the business but unfortunately does not have the money to expand. Banks or microfinance institutions offer no opportunities as they reject her for being too risky. So, she sells a piece of her business to the public through an Initial Public Offering (IPO), giving the public a chance to own a piece of her juice business.

Abebech sells the shares and grows the juice empire - more shops mean more profit. She can use this money to expand the business further or invest in research and development. Or she can share the profits with the shareholders, paying dividends, which mean that people are receiving profits from their investments. This builds excitement about Abebech’s juice business and captures the attention of those who did not buy shares during the IPO.

Kebede, an interested business person, believes that Abebech is smart, and witnessing the profitability of the business, buys a share from an original shareholder for twice the price. He now thinks that if the juice business keeps thriving, he would be able to sell his share for even more.

This is the stock market. It is a market where people buy and sell small pieces of companies based on how much they think those pieces would be worth in the future.

In reality, of course, this process is a lot faster, and transactions are a lot higher. The idea of stock markets developed when corporations began to realise the model Abebech used. It is easier and faster to grow when shares are sold to the public.

Shareholders want to make money. Thus, if Abebech shows a glimpse of a higher payout in the future, people would be encouraged to invest, and this drives up the share value for her business. And if she makes a bad decision, people would start to worry and start selling their shares, driving the value down.

But this may not be the case. It is not the real value of companies that drive the prices high, but the most important popular story people believe about those companies. If a prominent figure in Ethiopia praises Abebech’s juice and how great it is, the value of the shares will rise up. Same is true for the reverse.

The stock market undeniably has positive sides. It encourages companies to make good decisions, leading to more profit. More profit leads to more dividends and more jobs and higher wages for employees. This is great for all citizens and the economy. Corporations used this model, especially in the United States.

But then came Milton Friedman, an American economist who received the 1976 Nobel Memorial Prize in Economic Sciences. He had a famous article published in the New York Times in 1970 titled “The Social Responsibility of Business is to Increase its Profits.”

He argued that corporations are responsible for their shareholders and their only obligation was to make profits. Corporations took this advice and started tying CEO pay to stock prices. Thus, CEOs had to do everything to get stock prices higher to receive higher pay even when their decisions harmed employees, society, the environment and the company itself.

And this is one of its possible flip sides. It promotes "short-ism". Abebech might want to cut costs in the short run to increase the stock prices. She might start adding water to the juice, which will inevitably hurt the company in the long run but is perfect for short term goals as it will cut costs. Or she might buy back the shares of the company to make them scarce in the market which will bump up the price artificially.

This was the typical case in the US for almost a decade since 2007. Companies spent more on dividends and buybacks of their shares leaving only six percent for things such as increasing wages and research and development expected to be good for the economy. And in the US, even though stock markets have been in place and performing well, except for the intermediary bubbles and collapses, the GDP, average income and wealth of the middle class has not increased much.

Between 1964 to 2018, the average wage only increased by just about two dollars and the worth of the middle class has not yet recovered from the 2008 depression.

The stock market measures the short-term goals of the company without considering the long-term impacts on the economy. Laying off workers, keeping wages low, cutting costs are generally bad for the economy as a whole but can be good for a company’s short-term profits.

And this has resulted in a serious increase of CEO paychecks in the US and other major stock markets. In the US again, the average CEO pay was 22 times higher than the average worker in 1973. This number was 271 in 2016 and is still increasing. And the reach of the US stock market to the population has diminished in number with the middle class dropping in higher percentage from the market. The gap between that one percent and the rest of the population has increased.

Of course, it does not have to be this way. Stock markets do provide a chance for people to gamble on companies and decide which ideas deserve a future. Shareholders can influence how companies behave since most people do think about their long term future, their community, environment and the world. And Ethiopia wants to join the many countries in Africa and the world and open a stock market.

Yet for Ethiopia to open a stock market by 2020, the foundations need to be laid down. It is true that there are companies that can be traded in the stock markets. The recent frenzy of ridiculous share prices for banks illustrates that setting up a properly regulated stock market might work similarly.

But we still have more important tasks ahead. We need better infrastructure, electricity and telecom services, to cope up with a stock market. We need to bring the entire population out of the poverty line and expand the middle class to ensure they can participate in the stock market.

But we also lack the financial infrastructure to support it. Focus should be given to the financial sector, encouraging banks to develop already existing or innovative new products and services for customers and increasing their reach to the public.

Having improved these, we will need to work on introducing corporate social responsibility to the country. Friedman said that companies should be run by “greed” and only make profits disregarding corporate social responsibility.

Most countries are realising this now and are implementing rules for this. The UK puts a responsibility on company directors to consider all stakeholders - employees, suppliers, communities and the environment. In Ethiopia, however, this is a new concept. Corporations are in the early stages and it is difficult to ascertain the extent of corporate social responsibility.

The ultimate fear is that the stock market and those who push for it represent a tiny percentage of the population in the capital. And this will mean ownership of a company and involvement in the stock market will not reach most people in the country. It is also hard to imagine the country will have the skilled labour force to tackle the complicated world of a stock market – investment, banking and financial advisories.

Where does that leave us?

A stock market will be necessary in the near future. But 2020 is not enough time for Ethiopia. Experiences of other countries and adopting a stock market that benefits all should be a goal. And if one thinks we need it fast to grow the economy, the Kenyan experience should be taken note of.

Kenya had the Nairobi Exchange since the mid-1950s, and still, Ethiopia became the biggest economy in East Africa without a stock market and arguably without the financial infrastructure that Kenya had. This is not to say that it did not help Kenya’s economy, but Ethiopia has come this far without the need for it. This shows a glimpse of what the country can achieve if a proper course is set. Let us improve the infrastructure and the financial sector first and it will only be natural that a stock market follows.

---

PUBLISHED ON Jan 18,2019 [ VOL 19 , NO 977]

---