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Capital Markets as a Catalyst of Economic Development

by kraju

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In the United States after the World War II, its geographical position and natural resources helped the economy develop immensely, while other countries particularly in Europe faced several disruptions. This helped in the development of the capital markets in U.S. which in turn helped its citizens, foreign investors and domestic trade in the country. In this article, let us analyze how well developed capital markets generate economic benefits to the countries, including higher productivity, greater employment opportunities and macroeconomic stability.

Modern capital markets have two related parts:

  1. The debt and equity markets that intermediate funds between savers and those that need capital
  2. The derivatives market that consists of contracts such as options, interest rate and foreign exchange swaps which are associated with the underlying debt and equity instruments.

In the U.K and U.S. both of these parts have grown rapidly over the last few decades. The capital markets in U.S. and U.K dominate these countries financial systems, in stark contrast to France, Germany and other European countries, capital markets have been the driving force behind the development of the U.K and U.S. financial systems.

Why is Canary Wharf and Wall Street Ahead of Europe?

The shift from depository institution intermediation to capital markets intermediation appears to be driven mostly by technological progress. Computational costs have fallen significantly, technology has improved and information can be sourced easily by the people. Due to this depository institutions have lost their ability to charge a premium for their services. Borrowers and lenders now interact directly, as they find that the lender can earn more and the borrower can pay less by cutting out the depository intermediary as a middleman.  Another reason for the development of capital markets in these countries is due to the economies of scale and  stringent banking regulations, this fact has aided capital market development because securities issuance is characterized by relatively high setup costs and low incremental costs, as the size of a security issue increases, this condition implies, that as the cost of a transaction increases, the capital market solution becomes much more compelling than the alternative of using depository intermediaries.

In contrast, in Europe and Japan, the financial systems have been characterized by universal banks that have been able to compete in both the commercial banking and investment banking businesses; such systems have stifled the incentives to develop capital market substitutes for depository institution intermediation. Universal banks in Europe have not had strong incentives to undercut their own commercial banking business in order to boost the capital markets side of their business, on the contrary the U.S. commercial banking system was regulated with the goal of preventing the concentration of economic power from individual banks. In the U.K. the development of the capital markets was spurred by London’s long history as a major financial centre in the global economy, for example: until the World War II the sterling pound was the world’s reserve currency. Scale and first mover advantages are also some of the important reasons for Canary Wharf to take a centre stage over their European counterparts. Investors and issuers want to do business in the most liquid markets, London’s availability inhibited the development of Paris and Frankfurt as major capital market centers. Finally, in both the United States and the United Kingdom, the development of capital market was triggered by the development of private pension system. The growth of large corporate pension plans created a large group of institutional investors who had strong incentives to operate directly in the capital markets in order to increase the returns on their plans’ assets.

Economic Benefits- Improved Capital Allocation and Risk

The development of the capital markets has generated two major sets of economic benefits, firstly, it has improved the allocation of capital, because the prices of corporate debt and equity respond spontaneously to shifts in demand and supply, changes in the outlook for an industry are quickly embodied in current asset prices. The scenario created by a price change encourages investors (higher prices in company’ stock) or discourages (lower prices) capital flows into the industry. Businesses with high returns attract additional capital quickly and easily. When returns drop due to added capacity or a decline in demand, prices drop, and this signal causes investors to cut the flow of new capital to that industry. The ability of companies which are in their early stages of development to raise funds in the capital markets is also beneficial as it helps fund their development activities, R&D, developing new product lines and diversification. The development of capital markets has also helped to distribute risk efficiently. Part of the efficient allocation of capital is the transfer of risk to those who are best able to bear it, either because they have the ability to bear the risk or because the new risk is uncorrelated or negatively correlated with other risk in a portfolio.

The development of capital market also helps to stabilize the banking system, the decline in banking failures, especially in the U.S. is evidence that derivatives have helped to distribute risk more broadly throughout the economy.

Boon to Startup Companies

A well developed capital market can provide equity capital to new startup companies. In the first stage venture capitalists and other investors make private equity investments. Later, in cases where companies have established their business, they can go for an Initial Public Offering (IPO) for their future capital requirements. According to a study by Pricewaterhouse Coopers, global venture capital and private equity fund raising and investment have been dominated by the United States.

Improved Policymaking

The emergence of investor class in the capital markets has seen improved decision making among policy makers. The rise in the number of households who invest in the equity market and mutual funds means any fluctuation or fall in the price of these investments will lead to erosion of political support. Every household in the U.S. or U.K. invest in the stock market or equity mutual funds, and the defined contribution pension plans have proliferated at the expense of defined benefit plans, in these plans the household assumes the market risks associated with these pension plan investments.

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