The Role of the Exchange for a Middle-Income Economy

Exchanges are important contributors to the growth and development of domestic economies. They help funnel domestic savings towards long-run investment, thus sustaining household consumption through additional returns and contributing to the accumulation of domestic wealth. At the same time, well-functioning exchanges enhance the ability of young growing companies, as well as more established corporations with expansion plans, to access the capital they need to grow their businesses.

Exchanges also provide information, offering direction, acting like benchmarks to the real economy. The development and sophistication of local capital markets can be measured along several dimensions (returns, volatility, size), with liquidity and price efficiency being perhaps the most important indicators of capital markets development.

The role of exchanges is particularly important in the case of markets like ours i.e. markets that have not yet attained the performance of developed markets and are in low/middle income country. Our kind of markets typically underperform when compared to developed markets: we are less liquid, less efficient, more volatile, and are sometimes characterized by lower corporate governance standards. Understanding what factors are constraining the development of our market is therefore of paramount importance to sustain our growth and to bridge the performance gap with developed markets.

Such understanding becomes more urgent given the impact of COVID-19 pandemic in the economy. We predict our economy to grow at estimated less of 5.6 percent, which is almost 1.5 percent of our pre-COVID projections. While, like other emerging markets, we will suffer less than developed economies, but there is an impact. As the pandemic slows down the growth prospects of some aspects of our market, it is of even more crucial importance to reignite the engine of our economic growth, by allowing capital markets to perform its activity by facilitating the allocation of funds to where they are most needed.

Capital market development and economic growth

There has been a substantial amount of research documenting how capital market development is positively related to economic growth, both in developed and in developing markets. Different channels through which capital markets affect economic development have been identified: well-functioning  capital markets increase domestic savings rates as well as the quantity and the quality of investments, they help growing companies to raise capital at a lower cost, making them less dependent on bank financing; they also encourage financial discipline and reduce the costs of information, which contributes to a better allocation of resources.

Therefore, nurturing capital markets development in a middle-income economy can be seen as an indirect way of enhancing the underlying economic conditions of a country, a task which has become even more urgent after the impact of COVID-19. Even, the most recent studies in countries such as South Africa (Khetsi and Mogale, 2015), Malaysia (Nordin and Nordin,2016), or Turkey (Coskun et al.2017), to mention just a few, have also confirmed the positive relation between stock markets and economic growth.

Against this background, some questions naturally arise: how can an exchange identify those elements that may be withholding it from further development? What changes to the ecosystem can have the greatest positive impact on the exchange’s performance? How can the exchange most efficiently stimulate the market in a way that is optimal? How can the exchange strengthen its role in rebuilding the economy in an inclusive and socially responsible way?

Each of these questions will have a different interpretation and may result in a different set of conclusions and recommendations. But regardless of the differences, it is useful for the economy to promote a general framework linking the characteristics of a market and of its ecosystem with the attributes of a well-functioning market. For example, various research shows that international investors are attracted by better stock market conditions, that is, by better liquidity, lower volatility, or higher corporate governance standards.

Research has also found that higher foreign participation and trading are in turn associated with better stock market characteristics, that is, with lower stock market volatility, an improvement of corporate governance standards and better competitiveness and profitability of domestic listed companies. This suggests international investors are attracted to better markets and, at the same time, exert a beneficial influence on them, generating a virtuous circle. Therefore, making middle-income markets, like ours, more attractive for international investors is a way to further stimulate stock market development, and, indirectly, economic growth.

However, other than that, stimulating financial inclusion on the demand side (investors), i.e. via the use of fintech as a tool to stimulate retail participation in the stock markets is recommended. As we know it, financial technology has made access to financial services easier, for companies and households alike. While this is a global trend, we, like other emerging markets face a more challenging environment than developed economies, in terms of existing infrastructure, attitude towards financial services, legal framework and overall level of technological developments. Success stories like that of mobile payments show that Fintech broadening financial inclusion need to develop tailored solutions for capital markets as well.

The element of enhancing the role of stock market in a middle-income economy would be to innovate financial products that enable retail participation in markets. As noted above, markets like ours have a challenging environment — financial institutions wishing to attract local savings need to consider that the local infrastructure, the attitude towards financial services, the overall level of financial literacy and the legal framework might not be as supportive as in developed markets. To attract domestic savings, especially from rural areas, stakeholders in the capital markets need to develop tailored and innovative solutions.

To stimulate financial inclusion on the supply side (issuers), financial literacy as a way to stimulate participation, by potential issuers, and especially small businesses is highly recommended. As it is, private companies often rely on traditional sources of finance (such as bank lending) because they are unaware of or do not have the necessary preparation to tap into alternative sources of finance. Supportive private companies with financial literacy programs can have a positive effect on listings.

Stock Markets, Development and Corporate Governance

It is self-evident that any modern economy needs, as its foundation, a solid infrastructure base: ports, roads, electricity, airports, telecommunications, railways, etc. As it were, the state, fund managers (for pensions and others), along with insurers and mutual funds do invest in assets with long term duration to match their long term obligation, and infrastructure development by nature are characteristically long dated; they offer the state, fund managers, insurers an ideal investment opportunity. For the state, it is by way of taxes and issuance of bonds. For the buyers of bonds issued by the Government, they benefit from good returns which are guaranteed, and with minimal risks. What is crucial in all of this is striking the balance, so savings and pensions also gets their way in other financial assets.

The recent trend of less money chasing the equity market and more money chasing bonds have at least two effects. First, they hurt funding private and its productivity, which is propelled by innovation and equity risk investment. Second, the trend may not be all bad, in that they do present opportunities and more attractive returns for growth investors who are willing to tolerate a longer investment horizon. At the highest level, investors – so crucial to driving capital into infrastructure, innovation and businesses that drive economic growth, to the detriment of growth tomorrow.

On the other hand, though, Tanzania’s median age is 18 years, and two third of the population is under 25 years – for such a young society, one would ask why there is an increasing preference to bond-like instruments and the structural movement of portfolios away from stocks? Pension funds, insurance companies, mutual funds/unit trusts, and retail investors are all into this trend where bonds allocation is by the day becoming relatively significant compared to equity allocation. This is also reflected to the domestic market capitalization vs. outstanding listed bonds, where the ratio has favorably changed towards bonds from the ratio of 58:42 three years ago into 43:57 ratio of domestic market cap to outstanding bonds today.  And the situation for the equity is not helped by the structural and regulatory fact in that savings in banks and pensions in pension funds don’t find their way into equity.

The recent shrink in our stock market is because investors are reducing the amount of money, they allocate to equity issued by companies, as the appetite to finance the growth of private sector firms wanes by the day. Making the situation even more difficult is our experience which indicate that our domestic portfolio investors are willing to finance, invest and trade equities of more matured companies compared to SMEs and start-ups, now amid slowing growth, investors are even increasingly pursuing stable income from investments. This means committing even greater proportions of their capital to safe assets like bonds, or established companies and projects rather than backing smaller, riskier investment in start-ups or SMEs. Smaller businesses are thus starved for capital, finding it hard to attract investments or borrow, even though they play a critical role in economy and job creation. 

The trend of less money chasing the equity market, and more money chasing bonds, diverts funds from equity risk investment and hurts productivity, reducing the capacity for innovation and enterprising, damaging sustainable growth. In as much as the stock markets represents a path for businesses to fund investment and create jobs, this “de-equitization” trend is worrisome and could be destabilizing to both the bonds and equity capital market in the near future. 

But then there is an argument that as a society we need to appreciate the march towards the existential importance of an equitable society where in part corporate entities may foster an influence as they may wish to pursue more democratized stance in their corporate and business conduct while becoming more inclusive, transparent and the willing to expand by using capital markets route. We need to weave these intents into our corporate conduct fabric. Especially the matter of corporate governance – but then where do we strike the balance, for achieving both ends? in any way we need more funds into the equity finance for private and public enterprises, and we need more investors.

A recent study by the Aspen Institute indicates that in the US more than half of all households own some stock, and for those with college graduates over 70 percent have stock holdings. This says that apart from companies accessing capital markets to finance their expansion and growth, but there is also willingness of citizens to participate in investing in such companies. In our case less than 1 percent of the populations have an investment account at the stock market.

But why does it matter? Stock markets produce much more than just numbers that scroll across a ticker. They are the center of corporate power and accountability. Each share of stock that one own, does not afford them only a share in the ownership of entities and factors of productions, but also a chance to make decision on how corporate Tanzania is run. Owners of stock elect Board of directors who oversee companies, select CEOs, establish corporate priorities – including expansions and growth which then creates jobs and revenue to the Government. And so, come to think of it, shareholding is so consequential that it enables “corporate democracy” which if understood, makes one more entrenched into the “political democracy”. Let us get more involved.

Macroeconomic Variables vs. Market Performance

There are several factors that influence share prices and the level of return for investors. Key factors are: (1) demand and supply; (2) economic variables i.e. GDP, inflation, interest rates and exchange rate; (3) corporate actions; and (4) psychological or market cycle-related factors. In today’s article, we will focus on the economic variables.

The value of the company, its return on investment and share price reflects the perception of its earnings performance and growth. If the stock market detects something about a company that may harm its earnings flow, its share price falls. If the stock exchange hears good news about the company — its earnings, new innovations, expansion to other geographical locations, etc that have future earnings growth potential — its share price in most cases will increase.

Share prices change because sellers and buyers are constantly reviewing companies’ news and especially its earnings prospects. Therefore, in this context, one may claim, there are two factors that determine a change in share prices – future expectations of earnings and the price to earnings multiples, as we have learnt in a previous article. Both factors depend on an evaluation from buyers and sellers as they learn more about and understand the listed companies.

Apart from fundamental company performance-related factors, investors are also looking at other market information, including economic news (such as economic growth, inflation, changes in exchange rates, change in interest rates, etc) and also political events that can cause share prices to rise or fall. In the short term, the share price is also affected by intangible factors such as hype and word-of-mouth.

Share prices performance on companies listed in the DSE, like other stock markets, are also influenced by the happenings of other markets and economies (though it may not be as direct for the case of the DSE). If there is a substantial fall in other major markets prices and indices, Tanzanian share prices are likely to be under pressure as well, mainly because of foreign investors participation in our market. Foreign strategic investors own a large part of companies listed in our stock market, and foreign portfolio investors commands almost two-third of our periodical trading activities.

Stock market performance largely depend on the state of the economy, economic activities, future outlook and quality of decisions made. Economic policies, among others affect economic variables which are then extended into companies’ earnings and prospects. Specifically, economic variables that affect the stock markets are:

  • Interest rates
  • Inflation or the rate of change in consumer prices
  • Rate of economic growth (measured by Gross Domestic product – GDP)
  • Exchange rate
  • The health of other key economies

Interest rates and inflation

Interest rates affect companies’ earnings directly because their debt repayment costs rise and fall depending on the interest rate changes.

Interest rates determine how much it costs the company borrows or what an investor should expect on their investments. A rise in interest rates increases the attractiveness of fixed interest investments (such as bonds) relative to shares. High interest rates also increase a company’s borrowing cost. It also means taking money directly from profit to pay the company’s bankers. Rising interest rates also affect the level of economic activity and consumer spending.

Alterations to interest rates is one of the economic monetary policy instruments used by Central Banks. Central may lift interest rates to choke off any stirring of inflation, as a result of bubbling economic activity. During a period of tight liquidity, interest rates rise increases production costs. Conversely, interest rates fall when there is ample liquidity. People have more purchasing power, which is positive for business expansion and share investment. During these times, interest rates are used as tools for mopping up excessive liquidity.

Inflation simply refers to how much the prices of the goods and services that you buy go up by each year. It is usually written as a percentage. One of the reasons that people invest in the share market is to try and beat inflation.

The stock market dislikes inflation: inflation pushes up costs for companies quicker than it can pass them on to customers, adversely affecting earnings. Conversely, when a central bank believes that economic growth needs to be stimulated or an economic decline reversed, it will cut interest rates.

Historically, low inflation has had a strong inverse correlation with valuations (low inflation drives high multiples, and high inflation drives low multiples). Deflation, on the other hand, is generally bad for shares because it signifies a loss in pricing power for companies.

The exchange rate

A company that exports or imports products or services, or has receipts or payments in other currencies, is affected by the exchange rate between the local currency and foreign currencies. The most important of these currency crosses is the rate of the local currency to the US Dollar. Higher local currency in relation to the USD, can be good for certain sectors of the economy, making both exports and local import-replacement industries more competitive. It’s particularly good for local producers and businesses who sell their products in USD but take their profits and report their earnings in local currency.

Apart from an indirect impact of foreign exchange to investors in securities (shares and bonds)— investors, especially foreign investors are also directly affected by the movement in the exchange rate. The fall of the local currency against the United States dollar have negative impact in market valuations, size of the market and indices performance but also in trading activities.


Gross Domestic Product (GDP) is the value of all goods and services produced in the economy. When GDP decreases, the economy contracts and companies’ earnings fall and when GDP increases, the economy expands, and companies’ earnings rises. Therefore, any prospects of positive economic (GDP) outlook attract investors in the market — but the opposite is also true, prospects of negative outlook in the economic activities reduces investment in the market.

The health of the key economies

Foreign (strategic and portfolio) investors accounts for more than two-third of ownership and trading activities in our local market. The recent and ongoing global case of COVID-19 pandemic has negatively impacted the equity segment of the market mainly because due to other emerging priorities, immediate cash obligations by fund managers, and the focus on less risky investments.

In the short term, when there is bad economic news – stock markets come under pressure and some of the immediate actions is the decline in liquidity, prices, indices and market size. Unless there are rescue policies and packages, it takes time before good news ensures.