Why financial markets matter

A well-developed financial system comprising dynamic capital markets and a robust banking sector is considered a critical driver of investment, productivity, and sustainable economic growth.

Here, I discuss how the developed economy of the United States (US) and the emerging market economy of India have hugely benefited from the growth of the capital market and banking system. The US, being the largest and most developed market is not comparable with us, and even India, now the fifth largest economy, is no longer comparable with our economy. That said, their financial systems can highlight the close relationship and impact of robust financial systems on economic growth.

While the financial system remains the largest and most sophisticated in the world, over the past two decades, both countries and most other fast-growing economies have harnessed their financial systems to create an environment conducive to investment, innovation, competitiveness, and long-term expansion.

In stark contrast, Pakistan’s financial systems, especially its capital market and banking system have remained stagnant, leading to an underperforming economy that has struggled with low productivity, a lack of innovation, and a recurring need for international bailouts from the IMF to avoid default.

The role of capital markets in fostering economic growth is well illustrated by the experiences of the US and India. The US boasts the largest and most liquid capital market in the world, with a market capitalization of over $50 trillion as of 2023, equivalent to roughly 170 per cent of its GDP estimated at $29 trillion. This vast market allows companies to raise funds through equity and debt offerings, driving business expansion and innovation across industries.

Large corporations like Apple, Microsoft, Google and Amazon owe much of their growth to the deep pools of capital available through the US stock market. Additionally, venture capital and private equity funding, essential for startups and high-growth enterprises, are abundant, fueling the tech and innovation boom that has propelled the American economy much faster than the EU and China in recent years.

Within our region, India has seen impressive growth in its capital markets, which is one of the key factors in making India one of the fastest-growing economies. With a market capitalization of around $5 trillion in last June, approximately 128 per cent of the country’s GDP of $3.9 trillion, India's stock market has been a critical tool for raising capital for sectors such as technology, infrastructure, manufacturing and consumer goods.

The expansion of India's capital market together with a steep rise in venture capital and private equity has been instrumental in driving growth in its large corporations as well as in building a robust startup ecosystem that has created several unicorns. There have been several success stories – large tech companies like Tata Consultancy Services and Infosys, and great startups like Flipkart, Paytm, and Ola becoming billion-dollar companies in short periods, thanks to the availability of both domestic and international investment.

In sharp contrast, Pakistan’s capital market has remained underdeveloped. Despite a major upsurge in the index recently to 83000, the market capitalization of the Pakistan Stock Exchange (PSX) currently stands at a meager $39 billion, a minor fraction of 0.78 per cent of the Indian capital market, accounting for only around 10.5 per cent of the country’s GDP. This figure is minuscule compared to India and other emerging markets, reflecting the limited role that Pakistan’s capital market plays in financing the private sector.

Over the past two decades, the number of new listings has been sparse, and the stock market remains illiquid with less than 300,000 investors (one of the lowest in the world) deterring both domestic and foreign investors from deploying capital. Without access to equity or debt capital, Pakistani firms struggle to finance expansion or invest in innovation, contributing to the country’s low productivity and stagnant economy.

Unfortunately, the decision-makers in Pakistan think that the capital market of Pakistan is just a casino, and have rarely made any serious attempt to understand the key role of the capital market in mobilizing investment and economic development and the major issues that are responsible for its poor performance.

The banking sector in both the US and India has played an equally important role in supporting economic growth. American banks hold total assets of over $23 trillion, with deposits accounting for approximately 80 per cent of the GDP.

The advances-to-deposit ratio (ADR), a key indicator of a bank’s lending to private businesses relative to its deposit base, hovers around 70-80 per cent in the US, indicating that banks actively channel deposits into productive lending for businesses and households. This robust lending environment supports business growth, capital investment, and consumer spending, all of which drives economic activity.

India’s banking sector, though not as robust as the capital markets of the US and other developed markets, has a vital contribution to its economy. With total banking assets of around 85 per cent and deposits of about 80 per cent of GDP, India’s banks have also played a crucial role in financing both public and private sector initiatives. The ADR in India typically stands at around 75-80 per cent, reflecting a healthy level of lending that supports infrastructure development, corporates, small businesses, and entrepreneurship.

In Pakistan, the banking sector tells a much bleaker story in terms of its role in economic development. The total assets of Pakistan’s banks on June 30, 2024 amounted to $186 billion (approximately 50 per cent of GDP) with deposits of $117 billion (32 per cent of GDP). However, even out of this small deposit base, the advances-to-deposit ratio in Pakistan is alarmingly low, hovering at less than 37 per cent.

This low ADR reflects the fact that Pakistan’s banks have shifted heavily toward lending to the government and public sector to finance their unproductive expenditures and deficits, with nearly 98 per cent of the deposits invested in government securities rather than being used to finance private-sector growth. This crowding-out effect has left the private sector starved for credit, limiting its ability to invest in new technologies, expand production, or create jobs.

The impact of these financial disparities is clear: while India and other emerging economies have leveraged their financial systems to drive innovation and productivity, Pakistan’s underdeveloped capital market and banking sector, with a major portion of the banking sector diverted to the public sector, have stifled its economic progress. In the US, India and other emerging economies, access to capital through both equity markets and bank loans has enabled businesses to expand, invest in new technologies and create high-value jobs. This, in turn, has led to higher productivity, greater economic competitiveness, and sustained economic growth.

In contrast, Pakistan’s financial stagnation has left its economy struggling to keep pace with global trends. With virtually no venture capital, private equity, or access to bank credit, Pakistan’s private sector, especially SMEs and startups, is completely starved of necessary capital to enable them to develop new products or services, leading to abysmal levels of productivity and innovation.

Large and excessive governments, and their reliance on borrowing, have further deepened the country’s debt burden, forcing it to seek repeated bailouts from the International Monetary Fund (IMF) to avoid sovereign default. This cycle of debt and bailouts not only undermines economic stability but also discourages investment, further compounding the country’s economic woes.

Without significant reforms to its banking sector and capital markets, Pakistan risks continuing down the path of stagnation and indebtedness. Robust financial infrastructure is not a luxury – it is a prerequisite for sustainable economic growth and development.

The writer is a former managing partner of a leading professional services firm and has done extensive work on governance in the public and private sectors.

He tweets/posts @Asad_Ashah