What Hinders Capital Markets?

Although Lithuania’s securities market is in its seventh year of existence, companies are still very reluctant to finance their activities through the issue of public securities, while investors are limited in their choice of issues that would offer a good return and security. This article intends to analyse the most pressing problems of the national securities market and proposes ways of solving them.
Limited choice
A transparent state fiscal policy is one of the main prerequisites for a profitable and secure capital market. If the state fiscal policy is transparent, while the tax and state debt burden is small, the market is very attractive to investors.
Lithuania’s fiscal policy is based on an ill-defined government role, faulty principles of budget formation and a state financial system segmented into separate monetary funds. This undermines the transparency of the fiscal policy, increases the state’s borrowing needs and leads to tax hikes, consequently impeding economic activity, reducing the rate of return on the market and increasing investment risks. The strong treasuries market, with its good rates of return, absorbs the small investments that are still being made despite all the obstacles, reducing investments in the securities of private companies.
To create conditions for economic growth, and thus capital market growth, it is necessary to revise the economic functions of the state, eliminate flaws in budget formation, consolidate the state monetary funds into a single fund approved through legislation, adopt laws setting limits on the pace and volume of borrowing relative to GDP, and to form a state revision fund to ensure compliance with the commitments undertaken.
Lithuania’s securities market is also weak because of the government’s privatisation policy. So far, opportunities of potential investors to take part in the privatisation of the largest and most attractive Lithuanian companies have been limited. As a rule, a single or several large investors purchased such items. This process resulted in the unnatural concentration of shares in the hands of a few, preventing the shares from going into public circulation. In addition, this method of privatisation did not ensure open, transparent sell-offs, while the so-called strategic investors managed to obtain preferential treatment from the government. As a result, the state received fewer proceeds than it could have and the public suffered because of the distorted market relations. These problems could have been avoided if state-owned shares were sold on the stock exchange and were made available to everybody. Another problem of the privatisation policy is the delay in the sell-off of infrastructure companies. It is likely that these companies would be very attractive to investors. Their speedy privatisation on the stock exchange would increase the volume of share trading and encourage the expansion of the national capital market.
Investment costs
Investments in securities also depend on the expenditure of time and money which investors incur when concluding transactions. Due to various formal constraints, restrictions on competition and flaws in taxation and investment costs in Lithuania are higher than they could be. For example, relations between financial intermediaries and clients are heavily regulated – to the extent that almost every step made by the investor and intermediary in carrying out securities transactions is subject to detailed documentation and accounting. This kind of regulation increases investment costs while at the same time restricting the freedom of intermediaries and clients to engage in business. The stage has already been reached where some brokerages are forced to introduce minimum commission charges for small clients or refuse to service them altogether.
Relations between the sides should be and are based on mutual trust. To protect the interests of investors, it would be enough to outline trading requirements in the general provisions of various acts of law and in the professional code of ethics, while the formalisation of contracts should be regulated in keeping with the Code of Civil Procedure. This would cut correspondence and accounting costs, reduce commissions and ensure faster service.
Investment costs are also increased by restrictions imposed on financial intermediaries. In Lithuania, financial intermediaries have to comply with owner’s equity requirements equivalent to those mandatory for brokerages in EU countries. However, notice should be taken of the fact that the EU requirements were established in view of the volume and turnover of the Union’s securities market as well as the ability of EU intermediaries to operate throughout the entire Union. The volume and turnover of the Lithuanian securities market is significantly lower. This fact makes it unreasonable to apply the same requirements in Lithuania until the country has become part of the EU market and Lithuanian intermediaries can operate on an equal footing with the rest of the EU. These measures raise market entry barriers for new financial intermediaries, reducing competition as a result.
Investment costs are also increased by the capital gains tax. The tax itself would be perfectly legitimate if taxation procedures could achieve the objectives the tax was intended for. The main purpose of the capital gains tax is to equalise the taxation of dividends and capital gains, thus achieving tax neutrality. However, tax neutrality is impossible to achieve when numerous tax exemptions in other areas and different tax rates are in place. Another objective of the tax is to expand the tax base. However, efforts to boost budget revenues through a tax that could be avoided and entails large administration expenditures are irrational to say the least.
It should be pointed out that the procedure for calculating and declaring this tax is very complicated and places high demands both of time and money on market participants. This discourages reinvestments and investment in securities. Any improvements in the existing taxation procedure would be a mere facelift and would not eliminate the flaws inherent in this taxation procedure. It is therefore likely that abolition of this tax would be more beneficial to both investors and the state.
In addition, investments in securities are also impeded by the ill-considered procedure of claiming a VAT tax rebate. In calculating this tax, trading in securities is attributed to the goods and services that are exempt from VAT. If there are items in a VAT payer’s turnover that are not subject to VAT, then only part of the purchase VAT is subtracted from the sale VAT, making the company pay higher VAT which often exceeds the return on investment. The government recognised the problem some time ago and had plans to deal with it back in April this year, but the problem remains unresolved.
Restrictions on institutional investments
In countries with developed securities markets, the main market participants that are shaping demand for securities are institutional investors – pension funds, insurance companies, investment banks and funds. In Lithuania, there are still no pension funds or investment companies, while the role of insurers on the market is meagre. Excessive regulations are the main cause of the absence of institutional investors.
One of the unfounded restrictions is the ban on investments abroad by pension funds, investment funds and insurance companies. Regulators imply that the main objective of these restrictions is to ensure the security of investments and improve the macroeconomic situation in the country (the balance of payments). However, these arguments are highly questionable for a number of reasons.
Restrictions on investments abroad could hardly improve the macroeconomic situation. To solve the problems of the national economy, it is necessary first of all to remove the fallacies of the state’s finances and solve problems related to taxation, regulation, privatisation, etc.
The aim to ensure investment security by restricting investments abroad is also very dubious. For instance, this restriction would result in the bulk of pension funds’ money being invested in Lithuanian treasury bills. At present, investments in Lithuanian treasuries are riskier than investments in some foreign securities, as the credit ratings granted to Lithuania indicate. The situation is similar with regard to insurance companies, who have to deal with much tougher regulations if they want to invest in foreign securities as compared with Lithuanian treasury bills. As a result, riskier investments are in fact being encouraged despite public assurances that the main objective of the restrictions is to improve investment security. These restrictions suggest that the government’s priority is to boost demand for its own treasury bills rather than increase the security of investments.
Pension funds and insurance companies also have to meet several other unfounded requirements. Pension funds’ investments are restricted by the capital adequacy, liquidity and open foreign currency position requirements that are now in force. These requirements only limit the risks that are not at all typical of pension funds, while the funds also have to comply with the requirement of a diversified investment portfolio. Market regulators are divided into two groups on this issue: some admit that these regulations are unfounded, while others believe the opposite to be true. Nevertheless, these requirements look likely to be abolished, but this must be done immediately.
Insurance companies are only allowed to invest their issued capital in central and local government bonds, real estate and time deposits in banks, while reserves can also be invested in company securities and mortgage loans. As discussed above, investments in Lithuanian treasury bills are riskier than other investments, so the path chosen hardly helps reduce investment risks to the minimum. Investment risks can be minimised through the investment portfolio diversification requirement, though this is not applied to insurance companies at the moment. In addition, insurance companies should be allowed to invest both their issued capital and reserves in company securities. These changes would not reduce the security of insurance companies’ investments and at the same time create conditions for the market to reach its maximum potential.
Investment funds, too, are subject to restrictions on investments abroad. Strict requirements have been adopted that regulate the types of foreign securities that funds can invest in. These requirements predetermine the choice of investors, totally ignoring their real needs. For instance, investment funds are not allowed to invest in securities in Russia and other developing countries. The ban blocks the way for the establishment of an investment fund specialising in that area, even though there may be people willing to invest in less secure issues, which tend to offer a higher return. Also, bearing in mind the strict owner’s equity requirements and unequal tax conditions, it maybe said that investment funds are operating in an unfavourable environment.
It must be pointed out that the objective of investment funds is to accumulate the funds of individual investors and invest them in the most efficient way. Investments of small sums of money (especially abroad) involve rather high investment costs. In addition, it is difficult, if not impossible, to manage the currency and interest rate fluctuation risks of a small investment portfolio. Meanwhile, investment funds are capable of accumulating large sums of money, reducing investment costs and improving risk management. Therefore, restrictions on foreign investments are unjustifiable. It is imperative that investors be allowed to choose their investment objects. This will also enable local investors to increase their knowledge through participation in foreign markets, start investment traditions, etc.
Constraints on public issues
For the reasons discussed above, Lithuania’s securities market is shallow and illiquid, while the prices of securities are low. Under the circumstances, companies cannot normally expect public issues of securities to be successful. These problems, rather than the alleged unwillingness of companies to go public, make companies choose other sources of financing, such as their own internal resources or bank loans. There are also several other problems originating from unfounded restrictions on companies, such as the ban on the sale of shares on the market below their face value, restrictions on reducing the face value of shares, and the option allowing companies to settle with the state and municipal budget by issuing securities.
Conclusions and proposals
The exclusive status of the Lithuanian capital market, over-regulation and short-term reforms cannot create favourable conditions for the capital market. Gradual development of the market cannot be expected unless a number of essential steps are taken. First, reform of the state financial system has to be carried out. Second, privatisation should be carried out exclusively through the stock exchange. Third, the procedure for the documentation of transactions must be simplified, opening the way for mutual trust between investors and financial intermediaries. Fourth, the capital gains tax should be abolished and the VAT calculation procedure improved. Fifth, restrictions on investments abroad should be lifted, and no exclusive conditions should be left for the securities of certain groups of issuers. Sixth, the regulation of institutional investors should be simplified. Seventh, greenhouse conditions should not be created for the Lithuanian market. Delays of these reforms would continue to discourage potential investors and issuers from participating in the Lithuanian capital market.