Financial Market Mechanism

Financial market is a place where investors make trading of commodities, financial securities and value at lower cost of transaction. The channel of financial market helps in brining funding to business without investment opportunities that helps in improving economy efficiencies. Segments of financial market comprise of direct and indirect finance. In segment of direct financing, funds are directly borrowed from lenders by borrowers by selling financial instruments in the financial market. In segment of indirect finance, funds are borrowed indirectly from lenders via the financial intermediaries by issuance of financial instruments that are claimed on future income and assets of borrowers. Large magnitude is involved in global financial market that reflects investor’s desire for making global investment and diversification creation (Liu et al. 2015).

Several regulators enhance financial stability in the financial market in the global financial system. Apex bank at domestic and international level in respective economies plays a crucial in regulating the mechanism of financial market. Supervision and regulation of banking system in different countries are the main activities of apex banks that ensures soundness and safety of banking system (James and Quaglia 2017). Moreover, the banking institutions protect credit rights of investors as they play a considerable role in nation’s payment system and depository institutions.

Mechanism of financial market is the system, structure and conventions that exist for trading of shares and facilitating the issue. International; financial market has several elements such as financial institutions, securities market, international currency market, international debt market, department of foreign exchange and currency exchange.

Financial market mechanism:

(Source: created by author)

The above figure depicts mechanism of flow of funds in the financial market through direct and indirect market segments. Here, the funds flow from lenders or savers through financial intermediaries into the financial market and they use that fund to person or borrower seeking money (Stiglitz 2017). Such lenders and borrower involves business firms, households, foreigners and government.

Financial instruments:

Many exchanges such as spot market, forward market and future market dominate the international capital market. Different countries have different stock exchanges that facilitate exchange of money and trading of securities. Some of the stock exchanges are London stock exchange, New York stock exchange, Shanghai stock exchange and National stock exchange. 

Over the counter and securities is one of the financial instruments that comprise of treasury bills, stock and bonds. Instruments that are included in the over the counter derivatives are interest rate swaps, forward rate agreements (Shankar 2015).

UK Financial Market and the Role of Apex Banks

Cash instruments- Cash instruments are transferred readily and value of such instruments are directly derive from market. Loans, receivables, financial assets, stock options and deposits are some of the cash instruments (Perera et al. 2016). 

Derivative instruments- Derivative are the financial instruments that derive value from underlying entities such as index, interest rate and assets. Derivative contracts comprise of future, forward, swaps, option that are regarded as arrangement of payment exchange or bilateral contracts.

UK financial sector is one of the largest financial service centers in London and European Union. Financial market of country helps in facilitating capital allocation within the country. Moreover, in the present economy situation, the extent of state ownership and capital allocation efficiency is negatively related. On other hand, there exist positive relationship between capital allocation efficiency and firm specific information in returns from domestic stock of country.  Thereafter, the legal protection of minority investors has positive correlation when the capital is efficiently allocated. This in turn assist declining industries in countries to curb the over investment made with the help of strong minority investors. There are three ways by which capital allocation within the economy is improved. Firstly, capital allocation is improved by declining ownership of state (Shen and Lei 2015). Secondly, countries have less synchronicity in stock price if specific information are impounded into the stock price (Quitzow 2015). Lastly, investor’s strong minority rights are associated with allocating capital in a better way.

In UK, one of the large markets for capital allocation is asset management. Asset management industry is one of the crucial intermediaries in the country’s financial system and such channel is facilitated because of underlying connection between investments and service of clients. Assets managers are actively involved in efficiently pooling the savings and allocating the capital. However, asset managers in channeling of capital for private and public companies play fewer roles.

Several financial activities sought by majority of UK households are provided by assets management firms and such activities involves provision of investment vehicles, diversification of portfolio, wide range of asset class and formulation of investment strategies. Asset managers run the investment vehicle that helps in diversification of portfolio and enabling investors to invest in wide assets range.

Occupational and personal pensions are the most common form of financial wealth ownership, which comprise of direct securities ownership and defined contribution schemes. Importance of asset managers in UK is growing over time due to prevalence of private pension funds. Wealth distribution of society is influenced by existing variations in financial assets size.

Asset Management and Capital Allocation in the UK

Financial assets ownership by UK households:

(Source: theinvestmentassociation.org 2018)

Profit potential players and risks- Money market activities help in distribution of liquidity that Bank of England supplies. However, it is not required to recourse the facilities provided by Bank of England liquidity distribution by market participants. In stressing situations, it might be difficult to manage the trading positions because of market liquidity and unevenness of order flows. Moreover, the management of foreign exchange market of pound sterling did not require any sort of official intervention in recent years. In some extreme circumstances, the channel of contagion is provided by the interbank system of money market of country. Existing banking relationship of UK helps in enhancing management of risk settlement. UK is seeking to resolve the issues faced by London clearinghouse due to its growing importance in the financial market of world because the intraday risk is threatening the integrity of clearing house.

Borrowing- The apex bank of UK that is bank of England is responsible for strengthening the financial position of all commercial banks in light of rapid growth in borrowing from households and business such as personal loans, credit cards and car financing. Lending conditions in the financial market of country is facilitated and consumer credits have witnessed rapid growth. In the upcoming year, it is expected that total amount of borrowings will increase and net debt of government as proportion of gross domestic product of country is increasing.

Net borrowing in UK:

(Source: Un.org 2018)

The elasticity of industrial investment to value added in developed and advanced countries like United Kingdom is several times higher than underdeveloped countries. Despite the pressure related to Brexit, United Kingdom has remained a hub for economic activity. The testament to the economy of UK and resilience of sterling comes from dramatic turnaround in the Great Britain pound fortunes. In fiscal year 2014, UK economy was best performing with a growth rate of 3.1% and the growth slipped to 1% in year 2018 (Guidi et al. 2016). However, there exist degrees of short-term profits in the UK despite this negative performance.

Fiscal policy of UK Government- Government of UK has taken several steps for boosting economic activities and there has been a shift to fiscal policy from monetary policy. Fiscal measures such as cutting down tax expenditure and increased spending on part of government helps in stimulation of economic growth. Fiscal policies is the efforts taken by government in the form of changing the aggregate demand level and altering demand compositions that helps in achieving desirable macro and micro economic activities. Fiscal policy intends to promote stabilization in economic growth, avoiding boom and bust in economic cycle and checking level of inflation. Government is able to increase aggregate demand in the economy by employing expansionary fiscal policy that is done by increasing expenditure and cutting down of taxes. UK government employs deflationary fiscal policy on other hand by lowering spending and increasing tax charged for decreasing overall demand in the economy.

Risk Management in the Financial Market of UK

Stock exchange- London stock exchange is one of the oldest stock exchanges that was formed more than three hundred years ago and is situated in the city of London. Stock market provides platform to investors for trading securities and buying and selling of stocks of listed companies. There is primary and secondary capital market, in the former market, public does the listing of shares for the first time. On other hand, secondary market is a platform for trading listed companies security (Dhingra et al. 2016).

Investment- London financial exchange plays an influential role in intermediation of funds and securities for both domestic and international investors. Debt and equity market in UK have to cope up with several changes relating to accounting and investment rules. There have been some development in financial market of country that has affected future regulations and such changes involves consolidation of securities regulators and an approach of supervising based on risks. Global financial marketing activities ongoing in London do not affect the stability of financial market of UK (Elliott et al. 2015).

 Several trade theories exists for explaining the allocation of capital in the international economies and the main reason attributable for countries engaging in trade is that economic disadvantage in prediction and goods and service. Engaging in trade for sourcing such products from other countries will incur lower cost on part of exporting countries. International trade theories comes with the nation that when transactions can be done at lower costs, then companies intend to develop their own internal market. Some of international theories that can be explained in this regard involve theory of comparative advantage, factor proportion theory and classical trade theory. As per the theory of comparative advantage, countries focus on industry that has largest comparative advantage for boosting economic growth. This theory forms the rationale free trade agreements among nations and addresses the reasons why trade protectionism should not be given importance. As per classical theory, the trading nations form the basis of extent of importing and exporting and countries produce goods and services in which they have competitive advantage. Products having economic disadvantage should be imported by countries and the basis of international trade basis is difference in resource endowment and production characteristics. However, this theory does not explain causes of difference in relative advantage. Factor proportion theory helps in explaining the difference that is exhibited between trading countries. Countries import goods that require scare factor of production and export goods that harness large amount of goods and services.

Fiscal and Monetary Policy of UK Government

In recent years, cross border flow of capital between countries have witnessed considerable increase. Developed as well as developed countries have increasing dependence upon international investors for receiving finance. Developed countries investors have inclination of making investment in emerging companies bonds. Proportion of investors basing capital allocation on the financial returns generated comprises of 47% after it takes into account risk and synergies (Zhou et al. 2015).

SWOT analysis of China’s financial market:

Strength-

• Overall efficiency of financial system can be enhanced due to proper allocation of capital. Financial system performs an outstanding job for mobilization of savings.
• Shifting of funding to production private enterprise has helped in improving operations for attracting source of finance.
• Economy of China is witnessing booming period that would assist in development of overall financial system (Du and Lai 2018).

Weakness-

• The banking system of China is responsible for poor allocation of capital and they have a number of weaknesses in their operations.
• High financial intermediation cost and existence of large volume of nonperforming loans (Sun and Davidson 2015).
• Underdeveloped bond and equity market of China.

Opportunities-

• There can be better choice of funding vehicles due resulting from development of bond and equity market.
• Implementation of system wide and coordinated programs has the scope of strengthening financial system.

Threats-

• Banks are likely to lose corporate customers due to increasing competitiveness of financial system of different economies and countries.
• Inappropriate regulations existence would not lead to development of corporate equity and bond market.

The financial system of China performs an outstanding task of mobilizing savings, and at the same time, there is a considerable room for improvement and increasing overall efficiency of capital allocation. Reforms in the financial system of China have helped in raising value of gross domestic product by $ 320 billion a year and spreading wealth throughout the country (Allen and Gu 2015). A shift in funding by regulators of China towards more productive process could help in accelerating lay off from state owned enterprise that are less productive. This shift will help in creation of strong job opportunities and increasing revenue generated from taxation. The overall lower productivity in China has resulted from the lending pattern that is attributable to explaining large volume of loans that are non-performing in the banking system of China. It has resulted in declining efficiency of investment in country (Dermody et al. 2015).

Stock market- Allocation of capital in the stock market is poor and the efficiency of stock market is reflected by function of capital allocation. The dominance of banking sector in the financial system of China helps in amplifying by the poor capital allocation. China witness mismatch and considerable wastage of capital that led to inefficient capital allocation. The stock market is not efficient in allocating the functioning of capital that has consequence of capital inefficiency. If the allocation of funds were done to more productive private enterprises, this would help in boosting the productivity. In order to attract the finance, operations of less productive enterprise should be improved. This effort would help in closing the productivity gap between private and state owned companies. Better capital allocation will help in benefitting the household of China by generating higher return on savings (Cowling et al. 2015).

Poor allocation of capital by banks and high cost of financial intermediation has resulted in dismissing of return of bank deposits. Compared to other countries, the earnings on financial assets of China have been declining. Country would be provided with ample benefits in the light of efficient allocation of capital and despite this fact; changes have been resistance on part of Chinese regulators for job preserving and stability maintenance. The factor that is detrimental to the financial system of country is underdeveloped equity and debt market along with inefficient banking system operations. Bond, debt and equity market in China is smallest at global level and corporate market bond represents only 1% of total value of gross domestic product when compared to other emerging economies (Arouri et al. 2015). An improvement in efficiency of equity market of China would help in reducing issuance cost of company. Moreover, capital markets of China are fewer for financing larger private enterprise and are suitable only for small enterprises. Slow development of corporate bond market in China is because of existence of inappropriate regulations. Restricted flow of capital and excessive regulations of country has been the reason attributable to holding back the growth of institutional investor’s growth (Carpenter et al. 2015). Therefore, it is required by China to fully develop their equity and bond market.

London Stock Exchange

Development of country and planning and managing of national economy is the explicit responsibility of Chinese government. Various direct and indirect mechanisms are used by government for implementation of economic policies and plan. Allocating supply of goods and services and physical output designation is the direct control that is exercised by government. While indirect mechanism involves undertaking of marketing initiatives and settlement process such as monitoring and controlling of financial transactions, levying taxes, controlling allocation of scare resources such as chemical fertilizers, skilled labors, steel and electronic power (Deng and Macve 2017).

GDP growth rate of China:

(Source: Deng and Macve 2017)

In China, foreign trade supervision is the responsibility trade bank of China, ministry of foreign economic relations, banking system and general administration of custom.

 Poor allocation of capital in the stock market of China is one of the challenges that would be faced by country. Returns of bank deposit are dismal due to higher cost of financial intermediation and poor allocation of capital by banks. Lending practice in country is influenced by political pressures rudimentary financial system. Underdeveloped state of debt and equity market and inefficient operation of banking system some other challenges. Banks incur higher operation cost in light of inefficiencies. It is required by banks to raise their operational efficiency to the benchmark that would help in annual reduction of operation cost. For providing competitions to bank, Chinese companies are required to develop bond and equity market so that they are provide with funding vehicles in a better way (Broadstock and Filis 2014). Moreover, Chinese government is required to strengthen dialogue and cooperation in this area for healthy intellectual property development. Restricted controlling of capital, usage of restricted measures and trade development model transition is another challenge faced by trading industry in China. It is required to dismantle discretionary regulatory reforms in association with several services of cross border supply. Another demanding challenge is witnessed in foreign interest such as institutionalized world and international collective actions (Beltratti et al. 2016).

Conclusion:

The report prepared above demonstrates the financial markets of developed country, United Kingdom and developing countries such as China. From the analysis several facts discussed above, it can be inferred that capital allocation of China is poor as against efficient capital allocation of United Kingdom. Better allocation of capital provides investor with several benefits such as capable of making investment in wide range of assets and wide diversification of portfolio. It is deduced from evaluation of financial market of respective countries that allocation of capital in the stock market of China is poor and the capital is not changed by stock market although stocks provide higher return. Nevertheless, in terms of capital allocation, several challenges are faced by Chinese economy. In this regard, Chinese government is required to enhance bond and capital market through development of policy and strict control of capital. Therefore, the overall financial system of China should be strengthening for facilitating the allocation of capital and elevating domestic investor’s growth.

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