Financial markets and sovereign debt - Essay Example

?Financial markets and sovereign debt Financial markets and sovereign debt Introduction Just as is the case with the common notion of market, financial market is a platform in which people as well as other entities interact to trade on financial securities, valued fungible items as well as other committees at relatively lowered costs of transaction with prices reflecting the state of supply and demand. Among securities that are traded in the financial markets are bonds, stock as well as commodity materials such as the agricultural products and precious metals. It therefore adopts the notion of a common market in that it presents a platform in which interested buyers meets with interested sellers as well as the commodities on bargain. In a financial market, parties participating are government agencies, individual persons, firms as well as households. This is a common feature with a market economy where the government relies primarily on the structures of buyers as well as sellers in allocation of resources as contrasted to non-market or commodity economies. Besides, the effects vary depending on the stage of development of an economy where in the emerging economies; the governments largely take the responsibility in financial aid and financial management and participation especially for the reason of such eventual occurrences as the sovereign risks (Aizenman, Jinjarak and Park, 2013, para 1-5; Herrero, 2005, p. 5). Discussion Financial markets and the global economy Basic responsibilities of financial markets in finance include capital summation, risk transfers, discovery of prices, global participation in integrating financial markets as well as liquidity transfers (‘International Monetary Fund’, 2010, p. 1). Moreover, the essence of the financial markets is to aid in international trade where currencies are exchangedwithin currency markets. This therefore brings on board the global market where financial market institutes the framework in which foreign currencies are traded besides the exchange of tradable goods. Depending on the type of securities being traded, the markets are either classified as primary where IPO offers are traded or secondary where existing securities are traded (Broner, Martin, and Ventura, 2009, p. 1-4). The financial markets also brings together borrowers and lenders where in money markets, firms borrow finances on short term while capital markets provide long term based funding to corporations for expansion purposes.The following illustration is on the interactions that are engaged in financial markets as well as the parties to the transactions. Lenders Financial intermediaries Financial markets Borrowers Individuals as well as companies Banks, insurance firms, pension funds as well as mutual funds Interbank Stock Exchange, money Markets, Bond Markets as well as Foreign Exchange Individuals, Companies, Central Governments, Municipalities as well as Public Corporations The relationship depicted therefore shows that borrowers, lenders and financial intermediaries have a common link through the financial markets where stock exchange, bonds as well as foreign currencies are traded. It is worth noting that the interaction of these parties at the international scene depicts the actual picture of the global economy. Market efficiency is a critical concept that must be employed in the analysis of financial markets as well as the global economy and it involves three categories: strong, semi-strong as well as the weak form of efficiencies. However, the inefficiencies notable in financial markets result from ‘frictions’ which broadly represents asymmetries in information and taxes as well as costs of transactions. Value and liquidity in the transactions are therefore basic features in the consideration of efficiencies in financial markets. The concept of efficiency is very critical in investment decisions by investors within a country besides guiding on such decisions as arbitration and speculation. Information influences the behavior of prices within the market where ‘good news’ raises the prices and ‘bad news’ lowers the markets prices. Financial markets and sovereign risk The purposes of financial markets within an economy are numerous ranging from economic efficiencies in that the markets are involved in channeling funds from savers towards investors, and marketing activities influence individual person wealth creation and this has direct implication towards the general economy at large. Properly functioning of an economy and the resultant growth is greatly influenced by stability in financial markets, stock markets as well as the stability in foreign exchange. Sovereign risk has been seen to be a predominant feature in the modern world and especially in the frequencies of financial crisis that constantly shape the global economy. The probability that any sovereign country or corporate fails to honor agreements biding borrowing of finances from other countries or also from the internal financial institutions explains the sovereign risk (Arora, 2012, p. 5/34). The analysis by Arora however fails to substantiate the relationship between the sovereign risk as well as the effect of global markets. Moreover, sovereign risks emanates from the likelihood of countries not to honor agreements that bind the financial markets. In instances where countries speculate either a fall or a rise in a currency value, then there is the likelihood for the countries to deliberately fail to honor and observe the binding contracts in money markets. Countries fail to honor and eventually amend the contracts in manners that would be more favorable to them in terms of gains. Therefore, forex trade in many instances results to sovereign risk when countries fail to adhere to agreement contracts due to the fluctuations of currencies in exchange market. This is a global issue as no sovereign country is not prone to unfavorable economic conditions which would render it susceptible to forces of economic uncertainty and thus failing to honor financial agreements previously entered into. Strained government finances are major causes of the sovereign risk, which would be explained by macroeconomic factors and volatility factors regarding a country’s currency in comparison to the foregoing global market rates (Hilscher and Nosbusch, nd, p.2; Cantor and Packer, 1996, p. 37-40). The overall economic performance of a country is dependent on the performance of macroeconomic factors and the instability of these factors is a major cause to the sovereign risk. At its extremity, sovereign risk is catastrophic to foreign asset trade and hence requires regulatory tools to be devised in order to avert the adverse effects of the risk to be felt by other countries, which participate in the trade. The occurrence of financial crises in a country or at the global front have been claimed to have adverse effects to the likelihood that a sovereign nation will honor the terms of agreements in loans acquired. Other factors as seen to have effects on a country’s ability and willingness to repay loans from local as well as international financial institutions are the political factors. Countries are sovereign and as such enjoy the privilege that they cannot be sued to a court of law for the reason of defaulting payment of a debt or for the reason of delay as against the consented contracts.Financial markets influence the debt markets as well as the bond markets that allow governments to finance its activities (Perry, 2013, para 1-4). The following graph is a representation of the interest rates in US as influenced by the financial markets up to the year 2010. This therefore confirms that a country’s interest rates are influenced by its participation in the financial markets and this has effects to the global economy. There are links between the financial markets in an economy and the international lending and borrowing. Real investment and the decision revolve around financial markets, real savings in a country as well as such factors as the foreign debts within a country (Triandafil, nd, p. 14-15;Panetta and Davies, 2011, para 1-5). This paper therefore focuses on the sovereign risk as a direct factor that is influenced by financial markets in an economy as well as the resultant economic policies adopted by a country (‘OECD Public Debt Management Portal’, nd, para 2-3; ‘Bank for International Settlements’, 2011, p. 1). The factors that have direct influence on macroeconomic variables such as the interest rates in the financial markets and the government influence in economy has direct implications on sovereign risk in an economy.The links in international financial and asset markets are key determinants of a currency’s exchange rate in a financial market. Single currency or states supremacy cannot influence the rates that her currencies are accorded and this implies that interplay of many countries and trading blocks are the main determinants of the financial market rates. Macroeconomics teaches that multiple factors are put into play concerning determining a currency’s worth in the global market. Individual states’ currency is rated on a scale that is unanimously accepted within the trading scope against a common denomination; majorly the U.S dollar, yen or the euro. However, the rates are never constant varying on the prevailing economic performances as determined by the World Bank. ‘Purchasing power parity’ (ppp) compares rates of exchange and prices within a nation (Cumby and Obstfeld, 1982, 1-2). Therefore, at the macro and micro level performance of an economy, the policies made always have an impact to the valuation of her currency. For instance, the treasury as well as Federal Reserve has been credited in monitoring and regulating the performance of financial institutions in the US. To counter and monitor the effects of the financial crisis during and after the 2008 global economic crisis, US printed money to backstop banks and in the process undertook measures to ensure that financial institutions were restricted from increased default in credit repayments. Following is an illustration of an inflationary measure expectorations lead in US that shows US expected inflation as well as credit defaulting risks between some time in 2008 and 2010. (http://image.minyanville.com/assets/FCK_May2009/Image/LISACATCH/HOWARD1.jpg) Before the September of 2009 (at the green divide), the CDS market would welcome low rates of inflation. In the period, the Federal Reserve undertook deliberate measures to lower the interest rates to levels, which ensured that borrowing dollars was cheaper than the yen. However, the creation of more money would result to high inflation and as a result, analysts points that since the September of 2009, the US treasury has continuously experienced credit swaps and defaults of honoring the credit agreements by the government as well as the corporate. Therefore, the above illustration depicts the point of contrast between the periods before and after the September of 2009 in relation to inflation and the resultant sovereign risk experienced by the Federal Reserve as well as by the treasury (Simons, 2010, para 1-6). The governments rely on the financial assets as well as government bonds to offset the acquired debts. Therefore, any factor that has the capacity to influence the government’s or corporate ability to honor and observe the agreements assented to while borrowing the credit facilities have the capacity of rising the tendency of the country to deliberately overlook the repayment of the borrowed finances (Corsetti, Kuester, Meier, and Mueller, 2011, p. 20). Some other circumstances are explained in the probability that countries engaged in forex trade may be forced by circumstances not to pay debts accrued with the uncertainties that characterize the market. Speculations on which way the currencies would be going makes countries hesitant to repay debts in the speculation that they pay the debts at the most favorable exchange rates to them. Countries therefore reason just as economic agents and will evaluate the likelihood of the trading foreign currency to rise or to fall in value before making economic decisions. When the countries speculate that foreign currency is about to rise, they invest higher in buying the currency in order to realize higher returns when they sell the currency at the higher prices likely to be in future. This has direct implications to the willingness and ability of a country to honor agreements consented to while accepting credit facilities from other countries or financial institutions (Anon, 2005-2013, para 1-5; Du and Schreger, 2013, p. 1-2). Though sovereign risk is shown to be dependent on participation of a country in forex market, little is explained as to how individual participation in trading currencies influences a sovereign country. In the forex trade, sovereign risk is experienced when countries changes the rules that bound them while contracting with foreign investors. It therefore implies that the countries first dishonor the written agreements before they change the rules of the contracts. Equally, private investors always run at a risk when advancing credit services to sovereign countries because in the event that the countries fail to honor the agreements, the investor lacks ways and the right to sue a sovereign country. This therefore lenders the investor to who a country owes a debt vulnerable to loosing the debts because of sovereign risk. Moreover, the risk of the investor loosing on the agreement is heightened by the reason that countries will request for the loan because they are in a financial crises which is one basic reason for the occurrence of the sovereign risk. In mechanisms of management of foreign debts and sovereign risk it is therefore paramount that an economy considers the performance of the financial market; financial assets, contingent liabilities as well as the general structure of the foregoing debt portfolio. It is necessary that debt risk portfolio be maintained at prudent levels as much as possible in order to have minimized costs in operations within the economy (Das, Oliva and Tsuda, 2012, p. 380-390). Fiscal tightening as a policy mechanism has been widely adopted even where the private sector is weak. However, there is always the risk that the strains, because of foreign funding, have the capacity to spill to the private sector affecting the private credit markets. The resultant effect of the sovereign risk is that the public indebtedness rises, which on effect is disastrous to an economy by raising the financial costs of the private sector. Low public spending is blamed to lead to the contraction of the economy and thus analysts reason that upfront fiscal retrenchment may be instrumental in addressing the issues. Conclusion The above discussion reveals that sovereign risk can be influenced by global market as influenced by financial markets. The analysis of the sovereign risk shows that it leads to two possible outcomes; there may be the indeterminacy and or a belief-driven equilibrium. More specifically, the failure to monitor and address the issue may lead to a spillover of the private borrowing costs. A shift in the expectation implies that the projected government deficit may rise, the public dept premium rises and the spill be felt by the private sector borrowing through the sovereign risk channel. Higher private funding reveals that the economy has a slowed activity. However, under normal circumstance the central bank has the capacity to avert the effect of the sovereign risk by lowering the policy rates appropriately (Hannoun, 2011, p. 1). In instances where the sovereign risk raises too high, pro-cyclical public spending (fiscal tightening) would result to determinacy. Under certain factors, the operative capacity of the central bank regarding such an issue as the sovereign risk differs. For instance, while unconstrained, the sovereign risk channel is not operative while in otherwise, the spending multiplier is reduced by the central bank while in the constrained state (Corsetti et al, 2012, p. 1-4). The effects of such occurrences are therefore not only felt by the local economy but would be felt by all participants within a global market and trading partners. Bibliography Arora D., 2012.Country risk management in global financial markets. Available at: < http://www.slideshare.net/k_navita/country-risk-management-in-global-financial-markets-phifer-sachapow-armesto-parra>[Accessed 18 December, 2013]. Aizenman J., Jinjarak Y. and Park D. 2013.Fundamentals and sovereign risk of emerging markets. Available at: [Accessed 18 December, 2013]. Anonymous. 2005-2013. Sovereign Risk Explained. 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