Global Financial Markets – Affecting Factors And Real Economy

Financial Markets In The Real Economy – Interlinkages

The need for developed financial markets in India is also due to the increasing interlinkages with global financial systems. The concept of globalization today is no longer restricted to its traditional sense, i.e., variety of cross-border transactions in goods and services, but also extends to international capital flows, driven by rapid and widespread diffusion of technology. In fact, most of the literature in recent years on globalization has centered on financial integration due to the emergence of worldwide financial markets and the possibility of better access to external financing for a variety of domestic entities.

Integration of domestic economy with the global economy provides immense benefits. At the same time, globalization can lead to exposure to price volatility in international markets. Thus, it becomes imperative to facilitate market participants to hedge against price volatility.

During the 1980s, capital account liberalization came to be seen as necessity, and even as an inevitable step on the path to economic development. This was analogous to the earlier reductions, in barriers to international trade in goods and services. However, capital account liberalization also exposes the domestic economy to certain risks. Large capital flow causes volatility, i.e., tendency of financial markets to go through boom and bust cycles in which capital flows grow and then contract.

Another risk is contagion, which refers to the inability of the market to distinguish between one type of borrower and another. These risks, if not managed well, could have serious implications as was observed in the case of East Asian crisis in the mid-1990s. This is also evident in the recent global credit crisis of 2008. The collapse in the housing market was due to the sub-prime borrowers. Inadequate or mismanaged domestic financial sector liberalization has been a major contributor to crises that may be associated with financial integration. Thus, with greater financial integration, a developed, vibrant, effective and stable financial systems assumes considerable significance.

With enhanced globalization of trade and relatively free movement of financial assets, risk management through derivative products has also assumed significance in India. The Indian corporate sector is exposed to global markets, thereby, leading to increased economic integration. They may be required to access international capital markets or have currency exposure. This has lead to development of a broad-based, active and liquid foreign exchange derivatives market which provides them with a spectrum of hedge-products for effectively managing their foreign exchange exposures.

Derivative markets re-allocate risk among financial market participants and reduce information asymmetry among investors. Derivative markets also facilitate efficient price discovery and enable risk mitigation.

Thus, if benefits from financial integration are to be maximized, it is imperative to pursue efforts towards a greater sophistication of financial markets and develop instruments that allow appropriate pricing, sharing and transfer of risks.

Developed and well-integrated financial markets are critical for achieving the following:

• • Sustaining high growth.
  • Effective conduct of monetary policy.
  • Developing a diversified financial system.
  • Ensuring financial integration and stability.

Efforts are being made to fully develop financial markets and the financial system, Financial markets today deal with complex and sophisticated products such as derivatives. Introduction of such products would require clear regulatory framework, intermediaries and development of human resource skills. The progress of financial markets would thus depend on how quickly we are able to meet these requirements.

Enhancing efficiency, while at the same time avoiding instability in the system, has been the challenge for the regulators in India. This approach to development and regulation of financial markets has imparted resilience to the financial markets.

From the point of view of the economy as a whole, while developing financial markets, it is essential to keep in view how such development helps overall growth and development. The price discovery of interest rates and exchange rates, and integration of such prices across markets helps in the efficient allocation of resources in the real sectors of the economy. Financial intermediaries like banks also gain from better determination of interest rates in financial markets so that they can price their own products better. Moreover, their own risk management can also improve through the availability of different financial instruments.

The accessibility of real sector entities to finance is also assisted by the appropriate development of the financial markets and the availability of transparent information on benchmark interest rates and prevailing exchange rates. The approach of the Reserve Bank in the development of financial markets has been guided by these considerations, while also keeping in view the availability of appropriate skills and capacities for participation in financial markets, both among financial market participants and real sector entities and individuals.

The Reserve Bank’s approach has, therefore, been one of consistent development of markets while exercising caution in favor of maintaining financial stability in the system. In the last few decades and especially since 1991, several reform measures have been initiated to develop the financial markets in India. As a result, various segments of the financial markets are now well developed and integrated. Despite considerable progress made so far, financial markets need to develop further in line with the evolving conditions.

In a well integrated financial system, close linkages develop between the money market, the Government Securities (G-sec) market, the corporate bond market, the securitized debt market, the forex market and the derivatives market. The increase or decrease in commodity prices depending on demand and supply of the physical commodity may invariably affect performance of economies. At the same time, adverse currency price volatility or interest rate fluctuations can impact commodity prices.

Volatility in anyone of the market segments gets transmitted to other market segments, although the magnitude of the impact will depend upon the extent of integration. Interest rates prevailing in different market segments would reflect their risk-reward relationships. Exchange rates and interest rates are interlinked. For example, in an efficient market, the forward rate differential on the exchange rate is usually a function of the interest differential between the two currencies for the specific time period considered. As regards the interest rate linkages between the G-sec market and the corporate bond market, any changes in interest rate in one market should lead to corresponding changes in the rate structure of the other markets if markets are well developed and efficient.

For example, the yield curves for AAA rated corporate bonds and G-sec should reflect a healthy difference (although not necessarily remaining parallel) along different maturities. If the gap/differential between the two yield curves vary excessively for different maturities, it is likely because either or both of these markets are not well-developed.

Thus, having identified the interlinkages between different financial markets and asset classes, it may be noted that one of the major reasons for increasing interlinkages is due to automation. The impact of Information Technology on financial markets has been immense, especially in the last two decades. Let us analyze the impact of technology and automation on the global financial markets landscape.

 

Factors Affecting Global Financial Markets

Global Financial Markets are governed predominantly by the factors impacting different asset classes including commodity, currency, equity and debt markets.

Excess demand for commodities or supply constraints can result in price volatility. For example, the price of copper increased from USD 3000 per tonne to more than USD 8,800 per tonne between 2003 and 2006. Subsequently by Feb 2009, the price of copper decreased to USD 3700 per tonne. The increase in copper price led to decrease in the operating profit margin of manufacturing companies (that are predominantly consumers of copper). This adverse impact on the operating profit margin of companies has resulted in a decline in their share prices.

At the same time, the US Federal Reserve, over a series of Federal Open Market Committee (FOMC) meetings, increased the bank rate prevailing in US from 1% to 5.25%. This led to a collapse of the financial system in US, due to the increase in interest costs for sub-prime borrowers. Housing prices also declined due to declining demand. Repayment of mortgage loans depends on the prevailing interest costs. Increase in the interest rate had an immediate adverse impact on the repayment schedule of sub-prime borrowers. This led to a chain reaction in the economy. By Sep 2007, the US Fed was already decreasing the interest rates. But it was too late. The collapse of Lehman Brothers led to a series of default in the international financial markets.

Declining confidence among the public (consumer sentiment about the confidence in the economy) resulted in decreasing consumption trends. The entire series of events also resulted in declining growth rate of global economies. USA being the largest economy in the world has a direct bearing on the economies of other developed and developing countries. India has a direct exposure in the form of exports of IT software solutions and services. India also provides manpower to USA in the IT and IT-enabled field. India’s very own Business Process Outsourcing (BPO) and Knowledge Process Outsourcing (KPO) are dependent on the US economy.

Thus, it is important to understand the performance of the international markets before making critical decisions of financial investments or borrowings. A thorough understanding of the economic indicators is required to analyze the markets worldwide.

Financial transactions always require the services of banks (whether acting as principal or a agent) as well as the financial markets in which they can operate. Banks have also expanded their operations to international markets – with the advent of concepts such as global banking and universal banking to ensure a single client window interface.

In the late 1800’s, the industrial revolution resulted in increasing requirement for funds for infrastructure growth. This led to frequent instances of American companies raising capital through new issues in European markets and vice versa, European companies were raising capital in USA. Increasing cooperation and financial integration between the financial markets in USA and Europe laid the foundation for the formation of “Allies” during the World wars.

The Great Depression of 1929 resulted in 3 prominent events that had great effect on American banking:

1. • The passage of the Banking Act, 1933 that provided for the Federal Deposit Insurance System and the Glass-Steagall Provisions that completely separated commercial banking and securities markets activities (or investment banking operations).
   • A 30-year period in which banking was confined to basic, slow-growing deposit taking and loan making within a limited local market only.
   • The rising importance of the government in deciding financial matters, especially during the post-war recovery period. As a consequence, there was comparatively little for banks or securities firms to do from the early 1930s until the early 1960s.

By then, world trade had resumed its vigorous expansion and U.S. banks, following the lead of First National City Bank (subsequently Citicorp, now part of Citigroup), resumed their activities abroad.

The year 1971, witnessed the collapse of the fixed exchange rate system, in which the USD was linked to Gold (and other currencies were linked to the dollar). Floating exchange rates set by the market replaced this system, thereby, effectively removing government capital controls. In turn, this led to widespread removal of restrictions on capital flows between countries, and the beginnings of the global financial system that we have today.

The effects of competitive capitalism have been seen and appreciated during the past five decades as they had not been since 1929. The 1980s witnessed further rounds of deregulation and privatization of government-owned enterprises, indicating that governments of industrial countries around the world found private-sector solutions to problems of economic growth and development preferable to state-operated, semi socialist programs.

Most large businesses are now effectively global, dealing with customers, suppliers, manufacturing, and information centers all over the world. Many corporations are repositioning themselves strategically because of changes in their industry and in traditional markets and among their competitors.

In Europe, for example, most sizeable firms must consider themselves as at least continental players, not just national players. The European market, in aggregate, is as large as the market for goods and services in the United States; indeed, it is larger if you include Eastern Europe. It is important for a competitor in any industry to be active in such a market, and equally in the United States. And all competitors seem interested in the emerging markets for goods and services that are developing in the BRIC countries (Brazil, Russia, India and China), South Asia and Latin America since these regions began to adopt market economies in a capitalistic form.

Global companies have thus become active in world markets as never before, and as a result have become major consumers of international financial services of many types: for capital raising, mergers and acquisitions, and foreign direct investments; for foreign exchange and commodity brokerage; and for investment and tax advice. Governments and financial institution also have become major users of these financial services for the investment of reserves, the issuance of debt securities, the privatization of state-owned enterprises, the sale of deposits and other bank liabilities, mutual funds, and a variety of investment and hedging services.

Global banking and capital market services proliferated during the 1980s and 1990s as a result of not only an increase in demand from companies, governments, and financial institutions, but also because financial market conditions were buoyant and, on the whole, bullish. Indeed, financial assets grew then at a rate approximately twice the rate of the world economy, despite significant and regular setbacks in the markets in 1987, 1990, 1994, 1998, and 2001.

Such growth and opportunity in financial services, however, entirely changed the competitive landscape-some services were rendered into commodities, commissions and fees were slashed, banks became bold and aggressive in offering to invest directly in their clients’ securities without the formation of a syndicate, traditional banker-client relationships were shattered, and, through all this, a steady run of innovation continued-new products, practices, ideas, and techniques for improving balance sheets and earnings. As a result, many firms were unable to remain competitive, some took on too much risk and failed, and others were taken up in mergers or consolidations.

Market integration has been accelerated by several factors that have occurred during the past 20 years. The absence of need for foreign exchange controls has resulted in a free flow of capital between markets of industrially developed countries. Deregulation has removed barriers that impeded access to markets in different parts of the world, by both issuers and financial service providers. Massive improvements in telecommunications capability has made it possible for information available in one part of the world (such as bond prices) to be simultaneously available in many other places. For example, in 1997, the U.S. Federal National Mortgage Association (FNMA) issued five-year notes denominated in Australian dollars that were sold in the United States, Europe, Asia, and Australia. These notes were priced at a rate very close to the Australian government bond rate, taking advantage of very strong market conditions in Australia.

With India adopting best industry practices for financial systems, increasing integration with global financial markets is inevitable.

 

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