Want to prevent capital flight? Build a functioning capital market

There is an uncomfortable truth about capital markets that is rarely stated plainly: Capital markets are, among other things, mechanisms for transferring wealth.

People who allocate capital well accumulate more of it. Those who allocate it badly lose it. Patient investors can gain at the expense of impatient ones. Investors who understand valuation, cycles and risk can buy assets cheaply from those who do not. Entrepreneurs who deploy capital productively become wealthy; businesses that destroy capital eventually lose access to it.

There is something Darwinian about this process. But wealth transfer happens in every economic system. The important questions are how that transfer occurs, who can participate in it, can anyone learn and participate in it, and whether the wealth stays home, compounds and benefits the country. 

This is where functioning capital markets become enormously important.

In an economy with weak capital markets, wealth does not stop transferring. It simply transfers through other mechanisms. 

The difference is that these forms of wealth transfer are largely inaccessible to ordinary citizens.

A functioning capital market changes the mechanism. 

A salaried professional does not need to own a factory to participate in industrial growth. She can own shares in the company. A young executive does not need to know the owners of a bank to participate in its profitability. He can become a shareholder. 

Savers can finance businesses through bonds. Pension funds, mutual funds, insurance companies and other institutional investors can aggregate relatively small pools of savings into enormous pools of productive capital.

Capital markets therefore do something politically and economically important: they make participation in wealth creation more democratic. 

They do not make outcomes equal. Nor should we pretend that markets eliminate informational advantages, insider networks or unequal starting positions. But they create a mechanism through which people outside traditional centers of power can gradually accumulate ownership of productive assets.

For Bangladesh, however, there is another function of capital markets that may be even more important.

A place to park domestic capital

Capital markets give domestic capital somewhere to stay.

This is particularly relevant to the perennial Bangladeshi discussion about capital flight.

Consider the problem from the perspective of someone who accumulates substantial wealth in Bangladesh. Where does that person preserve it for 20 or 30 years?

The banking system offers deposits, but deposits are primarily instruments for preserving liquidity rather than participating in long-term economic growth. Real estate absorbs enormous amounts of Bangladeshi savings, but it is concentrated, illiquid and subject to its own cycles. Government savings instruments and bonds provide another alternative, but a shallow bond market limits the range of investable opportunities. 

If the equity market is perceived as poorly governed, excessively volatile, manipulated or incapable of producing reliable long-term returns, another major domestic store of financial wealth disappears.

The wealthier the individual becomes, the larger this problem becomes.

Someone with Tk5 lakh may be satisfied with deposits and savings certificates. Someone controlling Tk500 crore faces an entirely different asset-allocation problem.

If Bangladesh cannot provide credible instruments through which that wealth can be diversified, preserved and compounded, foreign jurisdictions become increasingly attractive. Property abroad, foreign currency, offshore financial assets, overseas businesses and eventually foreign residency all become ways of solving a portfolio problem that the domestic financial system has failed to solve.

This does not mean that every instance of capital flight is caused by weak capital markets. Capital leaves countries for many reasons: political uncertainty, fear of expropriation, currency depreciation, taxation, corruption, personal security, education and simple geographic diversification. 

Where does someone who accumulates substantial wealth in Bangladesh preserve it for 20 or 30 years? Banks offer deposits, but they are primarily instruments for preserving liquidity rather than participating in long-term economic growth. Real estate is concentrated, illiquid and subject to its own cycles. Government savings instruments and bonds provide another alternative, but a shallow bond market limits the range of investable opportunities. 

Illicit wealth has an additional incentive to leave because its owners may wish to place it beyond the reach of domestic authorities.

But weak capital markets dramatically reduce the opportunity cost of taking capital out.

If keeping $10 million in Bangladesh provides access to deep equity markets, liquid government and corporate bonds, professionally managed funds, sophisticated wealth-management products and credible long-term returns, moving that money abroad means giving something up.

If those opportunities barely exist, what exactly is the owner sacrificing by leaving?

Capital market development as capital-retention policy

This is why capital-market development should also be understood as capital-retention policy.

The consequences go considerably beyond finance.

Once financial capital begins migrating, human capital can eventually follow it.

A Bangladeshi family that gradually moves its assets abroad may educate its children abroad. Businesses establish foreign subsidiaries. Entrepreneurs develop international networks. Professionals discover that their skills command higher salaries in economies with greater concentrations of capital.

This creates a potentially dangerous feedback loop: Weak financial institutions = shallow capital markets = fewer credible domestic investment opportunities = capital flight = weaker domestic investment = lower productivity = lower wages = human-capital flight = still weaker domestic capital formation.

This helps explain why capital markets should not be viewed as a playground for stock traders; they are national economic infrastructure.

Bangladesh's banks can perform part of the capital-allocation function, but banks cannot efficiently perform all of it. 

A modern economy needs equity capital capable of absorbing entrepreneurial risk. It needs long-duration bonds for infrastructure and corporate investment. It needs pension funds, insurance companies, asset managers and other institutional investors capable of transforming household savings into patient capital. And it needs secondary markets sufficiently liquid that investors know they can exit investments when circumstances change.

The deeper question, then, is not whether capital markets transfer wealth. They do.

The question is what the alternative looks like.

In a dysfunctional system, wealth may transfer through political connections, preferential credit, inflation, currency depreciation, banking losses and regulatory privilege. Much of the resulting wealth may subsequently leave the country.

In a functioning capital market, wealth also transfers, but increasingly through ownership, risk-taking, information, entrepreneurship and successful allocation of capital. Ordinary citizens at least have the possibility of learning the rules and participating.

Most importantly, the accumulated capital has somewhere productive to go without leaving Bangladesh.

That may be one of the most underappreciated dimensions of Bangladesh's development challenge. We spend considerable time asking how to attract foreign capital. We should spend at least as much time asking how to prevent Bangladeshi capital from wanting to become foreign capital in the first place.

A country that cannot provide a credible home for its own wealth will struggle indefinitely to persuade the world's wealth to make it home.

Developing Bangladesh's capital markets is therefore not merely about raising the DSEX. It is about building an ecosystem capable of preserving, allocating and compounding Bangladeshi wealth inside Bangladesh.

Because capital goes where it feels it can survive and multiply.

And eventually, people follow it. Even foreigners. 

Sajid Amit, PhD is an experienced development sector professional, academic and investments professional, with work experience in Morgan Stanley and BRAC EPL. He has received awards for his investment research from Morgan Stanley and BlackRock. He can be reached at sh2367@caa.columbia.edu.

Disclaimer: The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions and views of The Business Standard.