Importance of Capital Markets in a Modern Economy - Assignment Example

Importance of Capital Markets in a Modern Economy Introduction The role of capital markets in a modern economy is very important for sustainable growth and development of a country. Globalization of capital markets and liberalization drive of nations have considerably increased their importance in the recent years. The governments need to foster the development of capital markets through various economic policies, legislations and by establishing suitable regulatory framework for their growth and development in the interest of various stakeholders. Stock markets reflect health of the financial sector and economy of a country. Stock market index is considered as one of the important economic indicators for the government to watch and formulate its economic policies and strategies to appropriately deal with the economic situation in a country. 2. Role of Capital Markets The benefits of capital markets in a country are multifarious. The capital markets play an important role in capital formation of the country which is essential for the governments’ plans with regard to investment in various sectors of the economy for a balanced economic growth. The governments are not in a position to effectively intervene in the economic process of the nations due to ever-increasing proportion of non-plan expenditure in the budgets. Government spending is very important for generating employment when there is slowdown in economy, to prevent recession. Therefore, the diminishing proportion of funds allocated to plan expenditure by the government should be compensated by private investment through stock markets for maintaining the pace of economic growth. Due to inefficiency of the public sector undertakings and their poor contribution to the economic development in spite of heavy investments made in these undertakings in countries like China and India there has been perceptible shift in policy making by the governments. Most of the public sector undertakings have been privatized by selling their shares in the open market by listing these companies in the stock exchanges by these governments. It has also been noticed that these undertakings’ performances have increased significantly after privatization. These companies are now competing with private companies and are able to mobilize funds for their expansion through the stock markets. This has reduced the financial burden of the respective governments considerably. The stock markets play a crucial role in developing the savings habit of the people. The stock markets are responsible to a considerable extent for entrepreneurial development internationally by diverting these funds towards investment in businesses and industries. Capital formation The growth in capital formation is an important determinant in growth and development of economy. Mobilization of funds for the developmental process strengthens the planning process of the government and makes is fiscal policies effective. Capital markets are effective in pooling of the savings of the people by offering variety of choices of instruments depending upon the expectation of the investors. The new entrepreneurs having good business plans with potential for growth as well as the existing successful entrepreneurs with a good track record of performance have access to the funds through stock markets for their projects. Generation of employment is an important benefit of capital formation which is essential to keep unemployment level in a country under control. In the backdrop of globalization, mobilization of resources for huge infrastructure projects requiring massive investments has become easier through international capital markets. The stocks of leading multinational corporations have been listed in the major stock exchanges of the world including emerging markets like India and China. Availability of information and easy accessibility to information through stock exchanges and media are useful to the investors for taking informed investment decisions. Regulatory controls over the companies listed in the stock exchanges are imposed to ensure dissemination of information related to the businesses and industries properly to the investing public. The statutory requirements with regard to board meetings, publication of quarterly and annual results in the prescribed format easily understandable by the people and the efficiency in price discovery of the stocks listed and traded in the stock exchanges have been primarily responsible for the awareness about the stock markets created among the public in developed countries. The emergence of internet and mobile telephony and trading though these platforms has made investment and trading in stocks and bonds in capital markets easier in the recent years. The phenomenal growth and development of stock markets in the emerging economies and the listing of the shares of these companies in the international markets has expanded the scope of the financial service sector on global scale. Avenue for savings and income Savings of the people could be effectively mobilized through the stock markets, because investment even in small amounts in stocks and securities is possible. There are various types of stocks and securities traded in the capital markets in tune with the multiplicity of needs of the investing public. Depending upon the risk appetite of the investors, their ability to take risk and age profile, an individual has choices to invest in stocks, derivatives or bonds. Generally salaried people want to earn on their savings to beat inflation or earn regular income by way of interest on savings after retirement. People would also like to invest and trade in stocks of companies to maximize their return on investments with business motive to earn money. There are various schemes in mutual funds to suit the needs of various types of investors. These mutual funds are in turn investing the mobilized funds in capital markets to maximize the returns of the small investors. Black and Gilson (1998, p. 246) observed “The United States has a large number of funds and the funds themselves are larger relative to each country’s economy.” The small investors who have no knowledge of the capital market operations or no time to analyze the markets for this purpose prefer to save/invest through mutual funds. Honohan (1995, p. 18) stated “The rate of return at which resources can be transferred between different periods of a household’s life-cycle is the most obvious financial factor which needs to be taken into account in considering saving behavior.” Stock market is considered as an alternative avenue for savings, since the return on investments in stock could beat inflation in the long run compared to bank interest. Entrepreneurship development Risk-return ratio of various projects, gestation period involved and the size of the projects vary from company to company. There are several barriers in availing loans from the banks which vary according to the nature and size of the project. For example, in an infrastructure project involving heavy investment and longer gestation period, interest in respect of long term loans is an important impediment in obtaining loans from the banks, since the banks are worried about cash flow and the ability of the company to service and repay the loans. However, if the project has long term growth potential, the investors would like to apply for the shares in an initial public offering of stock by the companies through stock markets. The risk return profile of a project may not be acceptable to a banker. However, there are investors who prefer high risk-return ventures or venture capital companies who in turn provide capital for such projects. In the absence of capital markets, several successful projects in the economic history of the world would not have seen the light of the day. Vehicle for credit growth Credit is an important element in the business and industrial landscape of a nation. Free availability of credit at a reasonable and competitive rate with flexible terms and conditions is an important determinant in the industrial and economic development of a nation. Successfully managed companies with a good track record of performance and integrity would be in a position to avail credit for their long-term projects easily through issue of securities which are tradable in stock markets. Mergers and acquisition plans of these companies could be easily financed by issuing stocks, bonds or both through capital markets, since the instruments floated by these companies would be subscribed willingly by the public and financial institutions. Getting finance through banks for infrastructure projects involving huge capital or acquisition of bigger sized company will be difficult, since the risk involved in lending is very high. Moreover, in such cases finance may have to be arranged through syndication by a group of banks. Organizing credit facilities in such cases would be difficult for the companies as well as the banks. However, the settlement to various parties in the case of mergers and acquisitions can be conveniently done through allotment of stocks or bonds which could be sold by them in stock markets at convenient times. Continuity of the business A limited company is a legal entity independent of its share holders. Transferability of shares ensures continuity of business for several generations. The permanence in its existence lends the companies several legal and social advantages. The organization structure enables blend of family values and professionalism in the public limited companies’ management. Promoting professionalism in management Professionalism in corporate management is primarily responsible for its continuity and growth. Continuity of the business acts a strong motive even for a family owned enterprise to restructure the organization for introducing professionalism in its management for a sustainable growth and development from the long-term point of view. The business acumen and intuition of an entrepreneur or promoter group needs to be complemented with suitable managerial skills drawn from premier education institutions of the nation for creating confidence among the investors. When investors are convinced about the professionalism exhibited in the management of affairs of a company, they would be willing to invest and grow along with the company in the current era of specialization. Economic growth The economic growth of a nation is linked to the employment situation. Unemployment in a country involves expenditure by way of unemployment benefits by the government, which acts as a drag on economic growth. The role played by capital markets, in mobilization of savings for fulfilling the investment strategies planned by the government, is greatly responsible for employment generation. Additional employment leads to more consumption resulting into additional demand which will lead to further investment for establishing new manufacturing and service facilities. The multiplier effect set into motion in this process accelerates the economic growth of a nation, though it is also fraught with the dangers of inflation. The government on its part regulates economic growth to avoid overheating through fiscal and monetary policies to ensure orderly and sustainable growth in the long run. The growth of stock market and economy are interdependent. Gomme (2005) stated “the stock market’s ups and downs can have very real, if not direct, effects on the macro economy. Stock market bubbles are a case in point. The inevitable crash that follows a bubble has the potential to cause recessions—the Great Depression being the worst case example of that connection to date.” Corporate Social Responsibility Capital markets and the other regulatory agencies impose several obligations on the companies with reference to corporate social responsibility (CSR). When a corporation uses the resources provided by communities, they have moral responsibility to adopt certain codes of practices relating to social and environmental behaviors. Since there are budgetary constraints for the government to invest in environmental and social projects, these responsibilities devolve on corporations which use natural resources and capital provided by the communities for their operations. For example, White (2012) stated “Several U.S. government agencies, such as the Environmental Protection Agency (EPA), the Securities and Exchange Commission (SEC), and Federal Trade Commission (FTC) are increasing their scope of sustainability disclosure oversight.  In February 2010, the SEC issued an interpretive release to provide guidance to public companies regarding the SEC’s non-financial disclosure requirements as they apply to climate change matters.”  Capital markets are expected to play a dominant role in CSR front in the years to come, and any noncompliance of their statutory responsibilities would be viewed seriously by the government and public. 3. Role / impact of government policies on development of capital markets Fiscal policies Fiscal policies are mainly related to taxation and government spending. At the time of economic slowdown, a government steps up spending to provide employment for mitigating the negative effects of economic slowdown. The government may also resort to cutting tax rates to propel economic growth. These policies would have a positive impact on the investors’ sentiment with expectation of revival in economy. The efficacy of the policies and the quantum of government spending depend upon the factors such as accumulated fiscal deficit, GDP per capita, debt to GDP ratio and the country’s balance of payments position. Also, the political will to continue reforms in various sectors by a government in line with globalization and liberalization policies will have a strong impact on capital markets, especially in the emerging economies. A nominal growth or slightly negative growth in GDP in the case of developed countries with high GDP per capita will not affect the pattern of consumption in the country drastically. Whereas, negative growth or significant fall in GDP growth in the case emerging economies would cripple the economy due to base effect of GDP per capita. Therefore, release of economic indices is closely watched by the capital market players to reorient their investment strategies in line with the developments in economy. Burch, Jr and Foerster (2011, p. xx) stated “The securities industry has come under close scrutiny from both Congress and the financial media with an intensity perhaps not seen since the period immediately after the filing of a civil anti-trust suit against 17 leading investment banks in 1947 by United States Attorney General.” Impact of monetary policies Monetary policies of the central bank in a country influence capital markets as they are regulatory in nature with regard to inflation, employment and growth. The central bank seeks to maintain sustainable growth in an economy by fine tuning the interest rates and regulating money supply in economy and thereby aggregate demand or aggregate supply to achieve the desired objectives. For example, increase in supply of money and reduction in the rate of interest during economic slowdown send right signals to the capital markets. Because, these two activities either independently or together will increase consumption level of the people and thereby demand for the products. The monetary policies thus can complement the fiscal policies to make it more effective for revival of the economy or set the multiplier effect in force by creating more employment. The capital markets would be at the bottom in economic slowdown. Therefore, announcement of positive changes in the interest rates (reduction in bank rate) and reserve requirements of the banks or open market operations of the central bank for regulating money supply (increase in money supply) would have imminent impact on capital markets inducing fresh buying into securities heralding revival of the markets. A change in the bank rates will have a chain effect on long term and short term interest rates, foreign exchange, bonds and stock prices or entire market spectrum. Regulatory framework Government regulatory agencies exercise their regulatory powers to ensure transparency and consistency in dissemination of financial information by the companies listed in the stock exchanges or others stakeholders like banks and the financial institutions for enhancing predictability of returns expected from capital markets by the investors or other crucial information related the businesses. Fama (1991, p. 1609) stated “The recent evidence on the predictability of returns from other variables seems to give a more reliable picture of the variation through time of expected returns.” Regulatory frame work established in financial services sector aims at transparency and efficiency in the market mechanisms and operations. Healy and Palepu (2001, p. 407) stated “Information and incentive problems impede the efficient allocation of resources in a capital market economy. Disclosure and the institutions created to facilitate credible disclosure between managers and investors play an important role in mitigating these problems.” Financial Services Authority and Panel of Takeovers and Mergers are the important regulatory bodies in UK. “The government is responsible for the overall scope of our regulatory activities and powers. We regulate most financial services markets, exchanges and firms. We set the standards that they must meet and can take action against firms if they fail to meet the required standards” (FSA, 2012). Strong and efficient legal and judiciary setup and reforms in labour law in the country in tune with globalization process are essential for the development of the businesses, industries and capital markets. 4. Growth of Capital Markets Chart of the index FTSE 100 (Annexure – I) illustrates the growth of stock market over the period of time. The FTSE 100 is the London Stock Exchange Index of 100 companies with the highest market capitalization and considered as a representative index of the business growth. The index started its journey from the base of 1000 in 1984 and reached 6950.6, on 30 December 1999 which was the peak level. The business in stock exchanges has shifted to online trading in tune with the developments taken place in the technological front. Movement of funds across the borders of the nations, exchange rate differences, volatility in currency and capital markets and growth of multinational companies called for adoption of International Accounting Standards and introduction of International Financial Reporting Standards in various countries which have facilitated comparisons in the industries on global level. Kothari (2001, 208) stated “The areas of greatest current interest appear to be research on discretionary accruals, influence of analysts’ incentives on the properties of their forecasts, valuation and fundamental analysis, and tests of market efficiency.” These developments have increased the efficiency of the capital markets over the period of time globally. 5. Conclusion Consequent upon globalization drive in many countries, the national laws have been suitably amended in line with the international laws for efficiency in participating in the international trade and financial markets. Reforms in financial services sector, insurance sector and labour laws are also essential to attract foreign direct investments into the country. The entry of FDI’s in countries like China and India has made the capital markets of these countries wider and deeper which led to participation by the global players in these markets. Several companies of China and India have listed their stocks in London, NASDAQ and New York Stock Exchanges which enable access to capital for these companies in the international markets. 6. References Black, B. S. and Gilson, R. J., 1997. Venture capital and structure of capital markets: banks versus stock markets, Journal of Financial Economics, 47 (1998) pp. 243-277 Burch Jr., J. C. and Foerster, B. S., 2011. Capital Markets Handbook, Aspen Publishers. Fama, E. F., 1991. Efficient Capital Markets: II, Journal of Finance, Vol. 46, Iss: 5, Dec. 1991, pp. 1575-1617. FSA, 2012. What we do: who we regulate, [online] Available at: [Accessed 9 March 2013]. [Accessed 9 March 2013]. Gomme, P., 2005. Why Policymakers Might Care about Stock Market Bubbles, Federal Reserve Bank of Cleveland, [online] Available at: Healy, P. M. and Palepu, K. G., 2001. Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature, Journal of Accounting and Economics 31 (2001) 405–440. Honohan, P., 1995. The impact of financial and fiscal policies on saving, The Economic and Social Research Institute, Working paper No. 59, World Bank research project on saving, [online] Available at: [Accessed 9 March 2013]. Kothari, S. P., 2001. Journal of Accounting and Economics, 31 (2001) pp. 105–231 White, S. E., 2012. The rising global interest in sustainability and corporate social responsibility reporting, Thomson Reuters, 5 October 2012, [online] Available at: [Accessed 9 March 2013]. Yahoo! Finance, 2013. FTSE 100, [online] Available at: [Accessed 9 March 2013]. 7. Appendices Annexure – I Source: Yahoo! Finance, 2013. Read More