Why Do Capital Markets Matter For New

Zealand?

Capital Market Development Taskforce Secretariat

Abstract: Capital markets are the markets in which firms and governments raise
capital, and where securities that represent claims to capital – such as shares and
bonds – are traded (Stulz, 2008). This paper looks at what is known about the links
between capital market development and economic growth, and shows why the
development of New Zealand’s capital markets matters.

Disclaimer: This paper has been produced by the taskforce secretariat, and does
not represent the views of the taskforce, individual taskforce members, or the
Ministry of Economic Development.

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Why Do Capital Markets Matter For New Zealand?

Executive Summary

Capital markets are the markets in which firms and governments raise capital, and
where securities that represent claims to capital – such as shares and bonds – are
traded (Stulz, 2008). This paper looks at what is known about the links between
capital market development and economic growth, and shows why the development
of New Zealand’s capital markets matters.

Capital markets are valuable because they mobilise and then pool savings from the
public and efficiently channel them into business investment. They also help
companies and individuals to manage risk and, properly structured, they provide
incentives for companies to raise their performance.

Capital markets complement other sectors of New Zealand’s financial system, such
as its banks. For firms, capital markets expand the range of funding sources -
including public equity markets, private equity, and the issuance of debt securities
such as bonds. For savers, they provide alternative investment opportunities and
risk-adjusted returns.

There is a significant body of international evidence that shows capital market

development leads to more investment, higher labour productivity, and faster
economic growth. Although globalisation has given New Zealand investors and
companies access to world capital markets, New Zealand’s own markets,
infrastructure and institutions will remain important to its economic success.

I Introduction

Capital markets are the markets in which firms and governments raise capital, and
where securities that represent claims to capital – such as shares and bonds - are
traded (Stulz, 2008). This paper looks at what is known about the links between
capital market development and economic growth, and shows why the development

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of New Zealand’s capital markets matters. In this paper, capital markets include
public and private equity markets, debt markets, and derivatives.

Section II of this paper describes the economic functions that capital markets (and to
some extent, financial markets more generally) perform. In Section III, the functions
of capital markets are distinguished from those of the broader financial markets, and
the paper describes the roles of specific capital markets, like listed equity, venture
capital and bond markets. Section IV reviews the international literature on the links
between capital market development and growth. Section V considers the argument
that New Zealand can gain the benefits of capital markets overseas without having its
own domestic capital markets. Section VI assesses the role of government policy in
capital market development. Finally, Section VII briefly discusses the possibility that
capital markets and financial services in general may provide new export
opportunities for New Zealand.

II Role of capital markets

Capital markets solve a number of problems that people face when they either raise
capital to fund productive activities or search for somewhere to invest their savings
(Levine, 1997). For the investor, these problems include deciding: which projects are
most worthy of funding; how much to pay for investments; whether to get “locked in”
to investments for long periods; how much of their savings to put into particular risky
investments, and whether the managers of the firm might use the investment
unwisely or to benefit themselves at the expense of the investor. In the absence of
capital markets to balance the demand and supply of investment products, these
problems can discourage savings and investment.

Consider the problem of converting an investment back into cash. People will be
much keener to invest if they have some means of getting their money out if they
need to. Long term investments that tie up money are particularly unattractive, so
capital market structures that allow investors to hold tradable shares and debt
securities for as long as they wish – but to sell when they need to - are desirable.

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Another problem is deciding how much to pay for an investment. For example, what
price should one pay for 100,000 shares in Telecom? Capital markets generate and
collect information about firms. By participating in capital markets – buying and
selling securities – traders unintentionally disclose information they have about firms’
prospects. This information is reflected in market prices, which tends to ensure that
investors pay approximately the right price for investments, given all that is known
about their risks and returns. In this way capital markets make resource allocation
decisions easier and more efficient.

A third problem for potential investors is dealing with risk. High-risk projects may be
worthwhile (because of the potential for high returns), but will be unattractive to risk-
averse investors if they have to invest large amounts in them. Capital markets allow
investors to hold a diversified portfolio with small quantities of many different
securities. This encourages investors to place some of their money into a given high
risk project knowing that most of their portfolio is invested elsewhere.

In solving the above problems, capital markets encourage people to invest more, and
more efficiently, than they otherwise would. This makes it easier for firms to raise
capital. For the firm, capital markets also solve a number of other problems, such as
locating potential investors, raising capital more cheaply, funding large projects, and
hedging risks. Some projects are too big to be financed by a single investor. For
example, few investors could, alone, pay for a power station or a cellular telephone
network. Yet these projects offer potentially high returns to investors and society.
The pooling of funds through capital markets allows much larger projects to be
financed than might be financed by individuals.

In summary, capital markets make investing and raising capital easier, more
rewarding, and less risky. In achieving this they promise to increase investment,
improve resource allocation and, ultimately, to hasten economic growth.

III Capital markets within the broader financial system

It should be recognised that capital markets are only one part of the broader financial
system. In particular, bank intermediation provides many of the same functions as

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capital markets, and banks are the dominant financial institutions in New Zealand.
Banking systems pool deposits from which long-term loans are sourced while
allowing short-term depositors to withdraw funds. Banks also more efficiently monitor
borrowers on behalf of depositors than depositors (investors) can do themselves.
Like capital market investors, banks also hold a diversified portfolio of loans, reducing
the overall risks from investing in high-risk projects.

There are, however, other functions necessary for economic growth and
development that capital markets are better equipped to fulfil. Capital markets can:
(i) foster greater incentives for a wide range of participants to research firms and pool
information in markets, resulting in more accurate price signals;
(ii) discipline companies by making it easier to take over underperforming companies
and providing mechanisms to tie managerial compensation to firm performance;
(iii) provide competition to banking, and reduce the excessive profits associated with
concentrated banking sectors;
(iv) fund a greater range of investment opportunities, for example by providing equity,
cheaper debt, or higher interest debt for projects that banks will not finance;
(v) provide additional services for firms, such as risk hedging (Levine, 2002).

Efficient capital markets should also increase the supply of funds to support growth
and development, as investors are able to better diversify their risks. Levine (2002)
argues that financial structure – for example, whether external financing comes
predominantly from stock markets or banks – appears to be less important to
economic growth than the overall level of financial development. In other words, both
bank and capital markets financing are necessary to maximise economic growth.

In contrast to the view that financial structure doesn’t matter, Boyd & Smith (1998)
argue that equity market activity becomes more important as an economy develops,
although it may be relatively insignificant during the early stages of economic
development. This is consistent with the idea that equity markets are more suitable
for financing intangible assets1, and where equity markets are less developed, firms
may have to hold otherwise unnecessary tangible assets to secure access to debt

1
See, for example, Allen (2001) for a discussion of the relevant arguments.

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financing (Carlin & Mayer, 2003). The gain in capital efficiency from the presence of
an equity market is material.

Banking and capital markets provide different types of investment and funding
opportunities. Firms make use of both equity and debt, and a range of capital
markets exist to fund investment opportunities with different combinations of risk and
return from those financed by banks.

The basic Modigliani and Miller (1958) proposition is that the debt/equity mix doesn’t
matter for firm financing. There are two key reasons why this doesn’t hold in practice:
tax, and bankruptcy costs. Firms will seek to maximise debt in order to reduce tax
costs, but they also need to hold equity to reduce the impact of failure on debt
holders. Debt holders are deeply interested in the likelihood that a firm may not
survive (probability of bankruptcy). The less certain the value of the firm’s assets the
greater the risk faced by lenders and other holders of debt. Higher risk projects and
those where the value of the firm’s assets are less certain need a greater proportion
of equity in their finances.

Equity markets

Equity markets provide an important source of financing for some companies and
industries. Certain sectors, such as R&D-intensive industries, tend to be more
dependent than others on issuing equity to finance investment. These industries are
expected to grow more rapidly in countries with better developed equities markets.2

From an investor point of view, equity holders are prepared to give up regular, fixed
interest payments for a share in the (theoretically unbounded) future profits of the
firm, as well as a stake in its ownership and control. Equities provide investors with
higher returns than other investments over the long run.

When companies raise equity from wholesale and retail investors at large, these
investment offers are subject to securities laws. And because liquidity is usually

2
Some empirical evidence indirectly supports this. For instance, Carlin & Mayer (2003) find that
equity-dependent industries grow more rapidly in countries with better accounting standards.

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important for those purchasing small stakes in companies, public offers are often
carried out by companies that are either listed, or intend to list, on stock exchanges.

In addition to public offers, much equity financing (as well as debt financing) occurs
through private issuance. For smaller firms these investments are initially dominated
by company directors and related parties. Later, companies with strong growth
prospects may receive outside investment such as venture capital and angel
financing.

Private equity is not only applicable to small firms. Large firms may also seek private
equity funding for transactions such as leveraged buyouts (LBOs); use private
placements of both debt and equity, and privately negotiate bank loans, in addition to
making public debt issues. A key factor here may include the time taken to organise
public issues. If the aggregate supply of private equity were constrained, the funding
of large firms might crowd out access to funding for small firms. But it is likely that the
aggregate supply of private equity is more related to share market conditions and
investors’ expectations of profitable exit.

There is a risk that non-expert investors may be exploited by unscrupulous operators,

which means that specified disclosures will be required for non-expert investors in
equity financing. Participation in private equity, where there is less disclosure, is thus
likely to be restricted to a limited pool of expert investors, including institutional
investors - although the funds available may still be substantial.

Venture capital

Business angels and venture capital funds are part of a larger market for financing
small firms, although they are distinct in that they focus on higher-risk ventures.3
Angel investors are generally involved in the early development of an enterprise, with
venture capital financing coming at a later stage. The firms that are financed by both
groups often have low tangible assets and low or negative cash flows, and thus are
unable to service or provide collateral for large amounts of debt. Empirical evidence

3
See Figure 1 in Berger & Udell (1998) for an outline of the functions of different financing methods in
a firm’s development.

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shows that venture capital funds are an effective way to fund young, high-risk firms
(Gompers & Lerner, 2001).

In part, such markets are important because small firms are regarded as providing
relatively more employment than larger firms, particularly in high-tech areas, and
their financing comes from private markets and directly from institutions, rather than
4
from public markets. Information asymmetries mean that venture capitalists are
likely to impose more covenants on firms than the firms would face if they borrowed
from banks (Winton & Yerramilli, 2008).

The venture capital and broader capital markets are linked in several ways.
Wholesale investors (such as managed funds) may be limited in their ability to invest
in high-risk ventures because of prudent man rules. But they may get the opportunity
to invest further down the track, if venture capital investors exit their investments by
publicly listing the company. US data suggest that venture capital exits provide a
major source of IPOs (Berger & Udell, 1998), although it is perhaps more common in
New Zealand for successful ventures to be sold by trade sale rather than through a
public listing. The link between venture capital and public listing works in the other
direction, too. Because of the impact on the likely exit price through an IPO, a
downturn in share markets will often discourage venture capitalists from investing.
Cumming (2007) has highlighted the importance of this relationship in the Australian
market.

Bond markets

Bonds are an alternative to bank lending, and can be a cheaper source of borrowing.
Banks impose interest margins to cover the costs of intermediation that can be
avoided by issuing securities directly to investors through capital markets. Higher
quality borrowers may also be able to borrow more cheaply than from banks if their
credit ratings are superior. On the other hand, compared to banks, bond holders
have greater difficulty obtaining information from borrowers and conducting ongoing
monitoring. This may raise adverse selection and moral hazard problems, and

4
As at December 2006, more than 50% of New Zealand’s work-force was employed in firms with 49
or fewer employees (Ministry of Economic Development, 2008).

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bondholders can lose more than banks in the event of default. Purchasers of bonds
may therefore demand a premium to compensate them for higher risk. Additionally,
issuing bonds attracts fees from investment banks and other parties. These costs
need to be weighed up relative to the cost of bank borrowing.

In general, an efficient bond market lowers the cost of debt for large companies with
strong cash flows, particularly in times of low interest rates5 (Cantillo & Wright, 2000).
Less creditworthy firms may use private debt placements (Denis & Mihov, 2003),
while in some countries they may also avail themselves of (public) junk bond markets
(Hale & Santos, 2008).

One segment of bond markets is asset-backed securities, which enable financial

institutions to transfer risks to others who are better positioned to bear them
(Greenbaum & Thakor, 1987). A number of reasons have been proposed for the
relatively small volume of securitisation in the New Zealand market - although in the
post-2007 financial environment these may be somewhat academic.

Government securities also play an important role in the functioning of bond markets,
as discussed below.

Derivative markets

Derivatives provide a way to buy and sell risk. Companies use derivatives to transfer
risk to others more able and willing to bear it. For example, companies buy foreign
exchange forwards and futures to hedge against changes in foreign exchange rates.
This enables them to undertake activities that they might otherwise not take part in,
such as producing goods for future export, where there is a risk that the New Zealand
dollar will appreciate. Most New Zealand derivatives trading is in over-the-counter
(OTC) markets. The most significant exchange-traded instruments are bank bill
futures.6 There is a general proposition that markets for derivative and physical
securities are dependent on each other, in that trading in physical securities will be

5
Low interest rates reduce the risk that firms default, and therefore reduce the benefits of financial
intermediation.
6
For a further discussion of derivatives markets in New Zealand, see Hawkesby (1999).

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aided by a well-functioning derivatives market (to allow positions to be hedged) and
vice versa.

IV The link between capital markets and growth

Financial systems of some sort have served as channels for the accumulation of
capital in all modern economies. And financial institutions remain large and persistent
despite the costs they impose on their users. This suggests that some level of
financial development is beneficial to economic activity and growth. But how much is
enough? If a country already has a functioning financial system, will further
development lead to faster growth? And if so, what kinds of financial development -
and in particular capital market development - lead to faster growth?

There are alternative arguments that economic growth causes financial market
development (rather than the other way around); financial development is harmful to
growth7, or even that financial markets don’t matter at all.

One line of argument is that economic growth leads to an increased demand for
financial services. Once an economy achieves a certain level of development, people
look to invest retirement savings, leading to the development of pension funds and
other collective investment vehicles. Similarly, if a country is expecting strong
economic growth, investors and banks are more likely to invest. Another argument,
based on a neoclassical model of economic growth, is that so long as resources are
efficiently allocated in the long run, only exogenous technological change (and not
the amount of capital) matters to growth. In either case, financial markets (including
capital markets) are a sideshow (Handa & Khan, 2008).

Turning to the econometric evidence, the majority of studies support either financial
market development leading to faster economic growth, or two-way causality. There
is a significant minority of contrary results, and the empirical literature suffers from a
number of methodological problems (Ang, 2008), but the basic results seem unlikely
to be overturned. Econometric studies remain some way off providing realistic

7
There is an argument associated with Joseph Stiglitz that more open financial systems engender
greater volatility, which is harmful to economic development. Greater openness would generally be
associated with more developed markets. See Stiglitz (2004).

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models of the interplay between financial markets and growth. However, history
suggests that financial markets do develop in response to economic opportunity
(hence, growth may “cause” financial development), while also enabling further
growth to occur (financial development “causes” growth). For example, venture
capital developed in the United States during the 1940s and 1950s in an environment
of new technological and economic opportunities. However, once venture capital
financing became established it enabled many new opportunities to be taken up that
otherwise would have been delayed or foregone altogether (Gompers & Lerner,
2001).

Based on our earlier discussion, we would expect to find that capital markets provide
benefits in addition to those a country receives from its banking system. This is
supported by the available evidence. Levine & Zervos (1998) present evidence from
24 countries showing that both stock market liquidity and banking development are
associated with future capital accumulation, productivity, and economic growth. This
result has been verified by Beck & Levine (2004) using more sophisticated panel
data techniques and a larger number of countries.8 In a review of a number of
studies, Rajan & Zingales (2001) argue that different parts of the financial system are
important for different industries or types of firm, and that the shape of a country’s
financial system influences its industry mix.

Even if one doesn’t agree that greater financial system development leads to
economic growth, there are still reasons why capital markets matter. Arguably those
who recently suffered losses from New Zealand finance company failures would have
benefited from better functioning capital markets and the availability of a wider range
of savings and investment products.

V Domestic vs foreign capital markets

8
The following are also noteworthy results: Atje & Jovanovic (1993) find that stock markets help
growth; Harris (1997) finds that stock markets help growth in developed economies, but not
developing economies; Ergungor (2008) contradicts Beck & Levine to show that countries with more
market-oriented financial systems grow faster when they also have a flexible judicial system; Deidda
(2008) shows that although both banks and stock markets have a positive effect on growth, the effect
of bank development declines as stock markets become more developed; Luintel et al (2008) also
show financial structure matters to growth; and Beck et al (2008) report that banks provide
disproportionate benefits to industries “naturally” dominated by small firms, while stock market
development is relatively ineffective at promoting the growth of these industries.

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Though capital markets benefit economic growth, in principle it is not necessary for a
country to have its own domestic capital and capital markets. In a world of perfect
international integration, domestic firms would not necessarily need domestic capital,
and domestic investors would not necessarily want to invest in domestic firms. New
Zealanders would be expected to hold investments in all countries according to each
country’s share of global capital markets, and foreign investors would invest a
proportionate share of their funds in New Zealand. There would also be no
relationship between the amount of savings generated by a country and the amount
of investment. However, that’s not what happens. Investments show substantial
home bias: investors disproportionately invest and trade in the securities of firms
based in their home country9, and a country’s investment rate is strongly correlated
with its saving rate.

There are a number of theories of home bias. One possible cause is the structure of
capital markets and cross-border trading costs. Home bias declines when foreign
firms cross-list on local stock exchanges (Ammer et al, 2004). Another cause of
home bias is the information advantage that local investors have over foreign
investors in being aware of, and valuing, local firms. There are also tax and
regulatory barriers that favour investments in local firms. For instance, franking
credits from Australian firms cannot be used by New Zealand resident investors, and
imputation credits from New Zealand firms cannot be used by Australian resident
investors.

In a careful study of differences in financial development between regions of Italy,

Guiso et al (2004) show that, after controlling for a range of other factors, local
financial development is a significant factor explaining regional growth differences,
even in a market united by a single tax and regulatory system. They conclude that if
degrees of financial development matter within a country, they are likely to be
important for the foreseeable future between countries.

9
Investment appears to follow a “gravity model” in which investors hold securities in geographically
close firms. This has been shown to hold across countries (Li et al, 2004) and within countries (Coval
& Moskowitz, 1999). Home bias has recently been studied at the level of individual investment funds in
a number of countries (Hau & Rey, 2008).

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To the extent that investment is home biased, New Zealand investors will require
markets to efficiently invest and trade the securities of New Zealand firms. In the
absence of such markets, the cost of capital for New Zealand firms will rise, and the
opportunities for New Zealand investors will diminish. It is likely that home bias is
particularly helpful for small and medium-sized firms.

Note that even if capital market activities in New Zealand dollars involving New
Zealand residents are important, it is not necessarily important to have capital market
infrastructure physically located in New Zealand. If barriers to cross-border issuance
and trading are low, both domestic participants and firms can use capital market
infrastructure located offshore. Similarly, it is not necessary for New Zealanders to
own capital market infrastructure. So far the academic literature has paid little
attention to the economic effects of capital market location or ownership, in part
because people have historically invested in local companies on local capital
markets. This is changing as capital markets around the world become more
integrated and the cost of trading across borders has reduced. These effects are
particularly evident in the Nordic and Baltic countries, where NASDAQ-OMX is
promoting a common securities trading platform, and in Central and Eastern
European countries where the Vienna Stock Exchange is expanding its influence
(Iorgova & Ong, 2008). International linkages can provide access to more
sophisticated trading technologies, and to a larger investor base (Andritzky, 2007).

A proponent of this view is Ben Steil (2001), who has argued that countries that do
not already have well developed capital markets ought to “encourage existing
purveyors and operators of trading infrastructure outside the country to offer services
locally”. So long as there is local demand for capital market infrastructure and
appropriate legal structures are in place, he suggests that there will be ready and
enthusiastic suppliers from around the globe. These suppliers should be able to take
advantage of economies of scale to reduce operating costs while having strong
commercial incentives to continually improve the functionality and robustness of
infrastructure. So, while local infrastructure may be important, its ownership need not
necessarily be local. Stoll (2008) further suggests that securities exchanges may no
longer be a natural national monopoly, with both technological change and
developments in regulatory policy leading to shifts in where trading occurs.

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In the various countries where there is substantial cross-country ownership of
exchanges, it will be some time before the implications for broader economic
development become clear. Relevant to this may be the experience of foreign
onwership in banking. Despite popular allegations to the contrary, Clarke at al (2003)
found that the presence of foreign banks in local markets was generally positive.
Research by Crystal et al (2002) and Dages et al (2000) showed that, in Argentina,
foreign-owned banks provided a stabilising effect on the financial marketplace by
providing more effective risk management practices and better access to foreign
capital markets.

Where capital markets activities are not conducted on exchanges, different

considerations may apply. Prowse (1998) notes that angel investment activity is likely
to be localised and segmented because of its dependence on informal contacts.
Similar arguments can be made regarding venture capital and the smaller end of the
private equity market.

Andritzsky (2007) strongly supports greater integration of Slovenia into foreign capital
markets. In areas such as derivatives Slovenian participation in the Euro means that
they are able to use the broader and deeper markets for Euro-denominated
instruments. He also argues, however, that accessing local capital through domestic
markets may be important for small and medium-sized firms. This is because of the
relatively higher cost of listing in foreign markets. Information asymmetries are also
likely to be greater for foreign investors seeking to invest in those firms.

One argument in favour of a country having its own capital markets is that they
provide a form of self-insurance against volatile cross-border funding flows and
overseas financial crises. A number of emerging economies that are highly
dependent on foreign borrowing have fostered capital markets, particularly bond
markets, in an attempt to create a more stable source of funding for both the public
and corporate sectors. Well developed local capital markets can mitigate the funding
difficulties created by “sudden stops” or reversals in cross-border capital flows. They
might also improve the efficiency and stability of financial intermediation by reducing

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the currency and maturity mismatches associated with cross-border lending (IMF,
2003).

VI The influence of government policy on capital markets

Merton (1990) has argued that governments have five roles in financial markets.
They act as:
• direct participants;
• industry competitors and benefactors of innovation;
• legislators and enforcers;
• negotiators in international markets; and
• unwitting interveners.

As participants they follow the same rules as the private sector. Merton cites the
example of open market operations, but it is generally recognised that the effective
functioning of bond markets is likely to be aided by the existence of deep and liquid
markets for government securities. A government securities market means that
investors gain access to instruments with no risk of credit default, and it thus
becomes possible to develop a risk-free yield curve, which can provide a benchmark
for the pricing of other bond-type securities. One of the shortcomings in the New
Zealand market is the availability of appropriate benchmark government securities,
with current outstandings much less than the US$100 to $200 billion estimated as
being necessary (McCauley & Remolona, 2000) and a lack of long-term issuance.

Government’s participation in capital markets may have more general advantages.

[to avoid repetition] Capital markets are subject to “network effects” in which the
benefits to each participant increase with the number of participants. An initial lack of
investors can lead to a vicious circle, undermining the development of markets. For
example, stock and bond markets provide liquidity only if there are many participants.
Also, the fixed costs of exchanges can be shared across many trades. If there are
too few participants, illiquidity and higher trading costs will deter those who do take
part, leaving the markets underdeveloped (Andritzky, 2007). It has been observed
that small Central and Eastern European countries such as Hungary, the Czech

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Republic and Slovakia may not find it easy to develop deep and liquid equity
markets. Larger firms in these countries choose to list in larger and more liquid
foreign markets (Iorgova & Ong, 2008).

Similar vicious circles can occur in other markets. It might be argued that some
capital markets, such as venture capital, fail to develop because there are few
investment opportunities. But potential entrepreneurs may be unwilling to generate
investment opportunities (which may require them to undertake costly R&D) if
venture capital is underdeveloped. The importance that is attached to early-stage
funding, and a belief that market failure inhibits development, has led many
governments to provide overt support (Lerner, 1998). Forms of government support
can include more favourable tax treatment of venture capital investments (particularly
in respect of capital gains) and government-created venture capital funds. The
Australian and US governments have contributed to private sector funds. In
Australia, the government established the Innovation Investment Fund (IIF)
programme in 1997, which has contributed significantly to start-up and early-stage
firms (Cumming, 2007). Similarly, the New Zealand government introduced the New
Zealand Venture Investment Fund (NZVIF) and the Seed Co-investment Fund
(SCIF).

Merton’s second role for government is as an industry competitor or benefactor of

innovation by supporting the development of - or directly creating - new financial
products. A historical example he cites is the inflation-indexed bond, which became
popular after the 1981 launch of the index-linked gilt by the British government.
Another example is many governments’ support of the provision of robust financial
infrastructure for clearing and settling transactions (IMF, 2003). This has aided the
development of equity and bond markets, including the markets for derivatives and
for securitised issues.

Merton further identifies a role for government as a legislator, setting and enforcing
rules and restrictions on market participants, product and markets. These can have
either positive or negative effects on capital market development. To give an extreme
example of the latter, outright bans on trading, such as in the former Soviet Union,
clearly hinder markets. The development of Russia’s stock market since the early

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1990s demonstrates that growth can be very rapid when restrictions are removed.
However, beyond this, regulation can help to overcome market failures, such as the
promoter’s incentives to utilise information asymmetries to disguise the quality of
stock being issued. Regulation can also curb the power of insiders to divert corporate
wealth to themselves at the expense of minority investors.

These issues can be ameliorated through minority investor protection and disclosure,
and research shows such regulation helps stock market development. For instance,
Djankov et al (2008) find that legal protection of minority shareholders against
expropriation by corporate insiders (anti-self-dealing) leads to greater stock market
capitalisation. La Porta et al (2006) present similar conclusions in favour of stronger
disclosure requirements and issuer liability - though interestingly public enforcement
of these rules (e.g. by the Securities Commission) appears to be less important in
their results. The effect of regulation on other capital markets is less studied, but the
basic principles are that regulation can help to overcome problems that arise due to
asymmetric information, legal costs and uncertainty, and transaction costs. As such,
appropriate regulation is an important component of well-functioning capital markets.

The final two roles for government that Merton identifies are as negotiators in
international markets, and as unwitting interveners, by changing general corporate
regulations, taxes and other laws or policies that frequently have significant
unanticipated and unintended consequences for the financial services sector. As with
regulation, in both roles government can have either a positive or negative impact on
capital markets.

VII Capital market integration and the international trade in services

Although we have argued that New Zealand’s capital markets can play an important
role in supporting economy activity in New Zealand, the financial services industries
that operate and participate in them are a valuable economic activity in their own
right. Financial services tend to have high output per worker and high wages, while
communications technologies have made possible the export of an increasing range
of financial services. This has led many countries to attempt to develop
specialisations in these industries, and a large number are competing to capture a

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share of the global market for financial services. Some countries have gone so far as
to create “international financial centres” supported (at least initially) by significant tax
concessions for financial services firms that locate themselves within the centre.
Prominent examples include Dublin and Singapore.

The credit crunch debacle and its fallout presents an opportunity to establish a capital
market that is renowned for:
(a) transparency;
(b) a regulatory framework that rewards high ethical standards;
(c) accountability of individuals that provide investment products to the public; and
(d) giving credence to the fiduciary duty of care that all investment advisors
should afford their clients.

New Zealand is a small market and accordingly should be sufficiently flexible to

adapt to a regulatory design that fosters all of the above. That is the opportunity.

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