Introduction to Financial Markets and the Economy

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FINANCIAL MARKETS

A financial market is an organized trading platform for exchanging financial instruments under a regulated framework[1]. The participants of the financial markets are borrowers (issuers of financial instruments or securities), lenders (investors or buyers of financial instruments) and financial intermediaries that facilitate investment in financial instruments or securities. The financial markets comprise two markets[2] – (A) Money markets, which are regulated by the Reserve Bank of India (RBI) and (B) Capital markets, which are regulated by the Securities Exchange Board of India (SEBI) and.

Financial Markets

 

(A) Money Markets

Money markets is “… the collective name given to the various firms and institutions that deal in the various grades in near money”[3]. The definition implies that the money market caters to short-term demand and supply of funds. The major participants of the money market are as follows:

  • Lenders: Lenders include the regulator RBI, commercial banks and brokers. These participants facilitate the expansion or contraction of money in the market
  • Borrowers: Borrowers include commercial banks, stock brokers, other financial institutions, businesses houses and governments provide financial instruments to other investors depending upon the money borrowed from lenders

Accordingly, the characteristics of money market include the following:

  1. Short-term – The instruments in the money market have maturities mostly less than a year and cater to short-term demand and supply of funds.
  2. Highly liquid – The money market is considered highly liquid wherein securities (financial instruments) are purchased and sold in large denominations to reduce transaction costs[4] (because they are a close substitute to cash)[5]. The market distributes and redistributes cash balances in accordance to the liquidity needs of the participants
  3. Safe – The instruments are considered safe with RBI playing a pivotal role in monitoring regulating and managing monetary requirements of all participants.
  4. Lower returns – The transactions are on a same-day-basis and the returns on these investments accordingly, are low.
  5. Institutional investors – Retail or individuals investors cannot directly participate in money markets. The money market mainly caters to institutional investors who require instant cash for running their operations in the financial system. However, retail or individual investors indirectly participate in money markets by lending money to institutions (large corporations and government) through bonds to gain high returns.
  6. Monetary policy – The money markets are governed and influenced by changes in the monetary policy. For example, changes in interest rates announced by RBI play a critical role in determining liquidity requirements in the overall financial system
  7. Interrelated sub-markets – The money market consists of the following interrelated markets[6]:
    1. Call money market
    2. Commercial bill or ‘Bill’ market
    3. Treasury bill market
    4. Commercial Paper (CP) market
    5. Certificates of Deposits (CD) market

Each and every abovementioned sub-market is characterised with different money market instruments with different maturities offered in mostly different trading platforms and cater to different borrowers/ lenders with the objective of maintaining different liquidity requirements. For example, in the call money market, banks borrow call money / notice money from other banks and non-banks to maintain CRR[7] requirements[8]. The exchange occurs in Over-the-Counter (OTC) market (without brokers) and the maturity period of call money instruments vary between one day and a fortnight.

(B) Capital Markets

Capital market is an organized mechanism for effective and smooth transfer of long-term capital money or financial resources from borrowers (corporates / government) to lenders. This market enables channelizing of savings from investors to raise productive capital for borrowers, which in turn provides higher returns to investors for their investments through relevant profits.

The securities or issues or instruments in capital markets include equity and debt securities. Capital markets (equity and corporate debt) in India are predominantly regulated by the SEBI[9]. However, government securities (in the debt market) are regulated by the RBI. Based on the aforementioned description, following are some characteristics identified for the capital markets:

  1. Primary and secondary securities – To raise productive capital, lenders issue and/or trade financial securities (instruments) through primary and secondary markets. Primary markets deal with issuance of new capital (or financial securities), whereas the secondary market (or stock market) deals with buying and selling of already existing securities that are listed on the stock exchanges[10]. Primary and secondary markets are inter-dependent and important for creation of long-term funds in the capital markets. For the new issues or securities introduced and sold by the lenders in the primary markets, the proceeds of the same go directly to the lenders (to raise capital). These proceeds are however, dependent upon favourable macroeconomic conditions of an economy. Subsequently, these issues are traded in the secondary market (or stock exchanges) that also provide the basis for determining possible prices of primary issues. Thus, depth and performance of the secondary markets depends upon the new issues / securities in the primary markets because the larger number of new securities issued in primary markets lead to availability of larger number of instruments for trading in secondary markets. Thus, the primary markets facilitate liquidity in the secondary markets further leading capital formation. The secondary market can also divert funds to the primary market for new issues of large size and bunching of large issues also affecting the stock prices. Lenders can raise its capital in primary markets either through any of the following – public issue, rights issue, bonus issue and private placement (Private placement is securities to sold to few select investors like large banks, insurance companies, mutual fund companies, etc). The interrelationship between primary and secondary markets lead to provision of long-term securities to raise capital.
  1. Risk-returns – Capital markets are characterised with equity and debt instruments that allow diversification of risks between high-risk equity instruments and low-risk debt instruments. Nevertheless, capital markets are considered as high-risk markets in comparison to money markets.
  2. Low-information and transaction costs[11] – The capital markets are mostly transparent and information about the trends in the market is available and accessible in comparison to money markets. Also, due to ease in availability and accessibility of long-term securities, transaction costs are comparatively lower than money markets. For example, retail investors can invest in stock markets through a dematerialised account provided by banks.
  3. Retail & institutional – The capital markets is an inclusive market that enables all kinds of investors to invest and gain higher returns. The investors include – individual or retail investors, small-medium-large businesses, financial or non-financial institutions and government
  4. Capital allocation – Capital markets are a medium of efficiently allocating capital in the system through a competitive pricing mechanism

(C) Linkages between money and capital markets

There are significant linkages between money and capital markets and are discussed as follows[12]:

  1. Involvement of financial institutions (and regulators) exists in both the markets. Financial institutions act as intermediaries and facilitators of short-term and long-term liquidity requirements of all kinds of investors (individual, corporations and governments)
  2. Capital and money markets involve trading of a variety of financial instruments for a specific time period and investors depending upon the nature of investment and risks further leading to risk diversification
  3. Short-term funds raised in the money market are used to provide liquidity for long-term investments and redemption of funds raised in the capital market
  4. For the development of financial markets, development of money markets generally precedes the development of capital market

Characteristics of financial markets

Financial Markets

The description of capital and money markets leads to understanding the following characteristics of financial markets:

  1. Financial markets enable large volume of transactions and mobilize financial (short-term and long-term) resources at real-time basis through investments in stocks, bonds and money
  2. Financial markets generate a scope of arbitrage across different markets. This implies, that investors can take advantage of price differences across different markets and diversify risks
  3. Financial markets are characterised with volatility directed by trade of large volume of securities. Mostly, these markets are influenced by macroeconomic and political changes in India and the world
  4. Markets are dominated by financial intermediaries who take investment decisions as well as risks on behalf of depositors (savers)
  5. Financial markets are also characterised by externalities. An externality refers to cost or benefit that are not transmitted by prices but influenced by a stakeholder’s actions in the financial markets leading to market failures. For example, speculation in prices of stock markets could affect the workings of the money market
  6. Domestic financial markets are also becoming integrated with global financial markets that not only enables capital mobility at a global level but spread of risks across the globe

 

FINANCIAL SYSTEM & THE ECONOMY

An economy consists of two kinds of economic structures that encompasses the financial system – Savings structure and Borrowing Structure

Savings structure

The savings structure in an economy consists of savers or entities that save in the form of financial assets (deposits, life insurance, etc) or cash balances. Savings can be estimated as the remainder or surplus from incomes earned after expenditures (food, rent, home supplies, etc).  This surplus or savings can be directed in the form of financial assets or withheld as cash.

Savers or entities that save can be further categorised into the following:

  1. Household sector – The household sector include individuals, unincorporated businesses, farm production units and non-profit businesses. Savings for the household sector is mostly in financial such as includes deposits, life insurance, shares & debentures, provident and pension fund, loans for durables and real estate.

    Savings Structure: Household Sector

    Savings are mostly considered synonymous to deposit accounts (offered by banks) though savings can be directed towards life insurance, provident and pension funds or loans on durables / real estate that are regarded as productive investments. Thus, household sector demand for financial assets to make productive use of their savings. The household sector contributes to a majority of the savings in India in comparison to the private and government sector

  2. Private sector – This sector includes non-government, non-financial companies, private financial institutions and co-operative institutions that are involved in production and/or distribution of goods and services. The sector mostly includes profit-making companies that are driven by various social, political, economic, technological, legal and demographic factors. Savings in this sector are in the form of net profit generated by businesses
  3. State and Government sector – This sector includes government, administrative departments and enterprises both departmental and non-departmental. Savings for this sector is the difference between government receipts and government expenditure. Receipts of government are classified into the following[13]:
    1. Revenue receipts such as tax revenues (corporate tax, income tax, other taxes on incomes & expenditure, taxes on wealth, customs, excise duties, service tax, other taxes / duties on commodities and services and surcharge transferred to national calamity and contingency fund) and non-tax revenues (consisting of interest receipts[14], dividends[15], profit from public enterprises and fees/charges for providing various services)
    2. Non-debt capital receipts such as recoveries of loans and disinvestment of government’s equity holdings in Public Sector Undertakings (PSUs)

Expenditures of government are classified into the following:

  1. Non-plan expenditures that include interest, subsidies, defence, pensions, police, grants-in-aid, loans, etc
  2. Plan expenditures include expenditures as per the Central plan and central assistance to state and Union Territories’ (UT) plans

Borrowing structure

The borrowing structure in an economy comprises of “borrowers” or entities that finance their needs through borrowing. The needs of borrowers could involve incurring expenditures on labour, plant and equipment, constructing residential, industrial or commercial sites and building additions to inventories. The borrowers include the government sector (central and state level), public sector and private sector corporations. The borrowers provide or supply financial assets to savers by issuing primary securities in financial markets, which in turn are reissued by financial intermediaries as secondary securities (in financial markets) for the savers as investments. The flow of savings (from the savings structure) to the flow of investments (to the borrowing structure) leads to capital formation or long-term investments

Capital Formation

Capital formation

The flow of money from savings to investments leads to formation of capital stock in the form of equipment, buildings, intermediate goods and inventories. Capital formation reflects the country’s capability of producing and distributing goods and services across different sectors and industries thus leading to an increase in the country national incomes of economic growth. National income of a country or economic growth can be measured by calculating the Gross Domestic Product (GDP) or Gross National Product (GNP) that comprises economic activities in sectors like agriculture, industry and services requiring financial resources to allocate labour, capital and other factors of production.

 

Economic Growth

Circular Flow of the Economy

 

 

 

 

 

 

 

 

 

 

 

 

 

The savings and borrowing structure converge to build up capital in the country, which in turn leads to economic growth. The economic growth of an economy can be explained based on the association between household sector and the private/government sector[16]. The household sector contributes to the market of factors of production (land, labour and capital) which act as expenses for firms in private and government sector incurred for production and distribution of goods and services in a market. This market is the common platform where the household sector can purchase finished products / services for consumption. The returns from consumption are translated as profits to the firms which in turn are redistributed as wages and/or rent in the market of factors of production to the household sector. This circular flow of money between the household and firms in private / government sector characterises the development of national incomes of an economy which is measured as Gross Domestic Product or GDP that encompasses consumption, investments, government spending or expenditures and net exports (exports minus imports). GDP can also be calculated as the sum of capital formation, consumption expenditure and net exports.

 


[2] Indian financial markets also consist of the commodities market regulated by the Forwards Market Commission (FMC). Commodities market involves trade of select commodities at the Multi-commodity Exchange (MCX) market. This market was recently introduced in India’s financial system and is in a nascent stage of integration with other financial markets such as capital and money markets.

[3] Crowther, Geoffrey (1974): An Outline of Money, Universal Book Stall, New Delhi, p. 64

[4] The Indian Financial System: Markets, Institutions and Services

[5] Indian Financial System, 5E, M YKhan

[6] Financial markets and financial services, Clifford Gomez

[7] CRR – Cash Reserve Ratio is a liquidity requirement for scheduled commercial banks who need to maintain an average cash balance prescribed by the RBI

[11] Transaction costs are costs incurred for buying and selling securities in markets

[12] The Indian Financial System: Markets, Institutions and Services, 3rd Edition, Bharati V. Pathak

[14] Interest received from States / Union Territories, Railways, Posts and Telegraph, PSUs, etc

[15] Major sources of dividends are from PSUs, LIC, Nationalised banks, Industrial development bank of India (IDBI)

[16] Economics: Principles and Applications, N. Gregory Mankiw, South Western, 2007