Money, credit and finance are related but somewhat different and all three are connected with financial markets. Financial system is a set of complex and closely connected or inter-mixed institutions in the economy.
Economists have given varied opinions on the role of financial system in economic development. Bagehot and Schumpeter viewed that an efficient financial system is of great relevance for an economy to operate efficiently. Ross Levine has pointed out that well functioning financial system help in technological innovation by offering funding to entrepreneurs who have innovative abilities.
But recently, there has been a change in the opinions of economists in this regard. Joan Robinson has viewed that economic growth creates demand for financial institutions. It means first economic development takes place and then financial sector development follows. Similarly, Robert Lucas has stated that economists “badly over-stress” the role of financial institutions in economic growth.
However, in recent years, on theoretical side many complex models have been developed for understanding relation between economic growth and financial markets. These channels include the facilitation of:
(a) Trade Hedging,
(b) Diversifying,
(c) Pooling of risk,
(d) Efficient utilization of resources
(e) Mobilization of savings, and
(f) Monitoring of managers and exerting corporate control.
On empirical side, a strong correlation has been observed between financial sector growth and economic growth.
NATURE OF FINANCIAL SYSTEM
A financial system is a set of complex, and interconnected institutions, agents, practices, markets, transactions and claims and liabilities in the economy.
It has four constituents:
(a) Financial Institutions
(b) Financial Markets
(c) Financial Instruments
(d) Financial Services
Financial Institutions
Financial institutions are mobilizers and depositors of savings and providers of credit and loans. Financial institutions can be classified into:
(a) Banking institutions and Non-Banking Institutions.
(b) Intermediaries and Non-Intermediaries.
Financial Markets It is a market in which people deal in financial securities like shares, debentures etc. Demand and supply of such securities determine their price.
Financial markets can be classified into:
(a) Primary and Secondary Markets
(b) Money Market and Capital Market
However, financial markets are also classified into:
(i) Organized and unorganized,
(ii) Formal and informal,
(iii) Official and parallels,
(iv) Domestic and foreign.
Financial Instruments
A financial instrument can be defined as a claim against either a person or an institution for the payment on a future date. Payment may be a lump sum amount or a periodic amount like interest or dividend. Financial securities vary from each other in terms of:
(i) Marketability liquidity reversibility,
(ii) Types of options,
(iii) Returns,
(iv) Risks involved, and
(v) Transaction costs
These instruments can be primary securities or secondary securities.
Financial Services
Financial services include merchant banking, leasing, hire purchase, credit rating, etc. these are performed by financial intermediaries. They bridge the gap between knowledge of investors.
EQUILIBRIUM IN FINANCIAL MARKETS
It is assumed that perfect completion exists in the market. Equilibrium is attained by the tools of demand and supply. When there is equality between expected demand for lonable funds and supply of funds generated from savings and credit creation, market is in equilibrium. Any change in demand or supply will bring about a change in market equilibrium.
The supply of lonable funds is generated from saving of households, firms and government. Saving is the gap between disposable income and consumption.
Saving = Disposable income – Consumption
Many factors determine the volume of savings in an economy.
(i) Level of current and expected income,
(ii) Cyclical changes in income,
(iii) Distribution of income,
(iv) Rate of interest,
(v) Inflation rate,
(vi) Degree of certainty of income and wealth,
(vii) Desire to provide for old age etc.
FUNCTIONS OF THE FINANCIAL SYSTEM IN THE PROCESS OF ECONOMIC DEVELOPMENT
To understand the relevance of financial system let us analyze an economic system in which there is absence of sound financial system.
Lack of Financial System and Vicious Circles
- Lack of sound financial system results into low level of investment due to lack of investment. It retards the rate of economic growth.
- In such an economy, rate of savings will be low. It will, in turn, lower the rate of investment and hence the rate of economic growth slows down further.
- When there is absence of sound financial system, the cost of information is high making investments less profitable and more risky.
- Lower savings and high information costs together aggravate the problem of low capital formation. It gives birth to a vicious circle. In such situation, economy falls into a poverty trap.
Functions of the Financial System
It is very much clear from that it is a must to have a sound financial system for a rapid economic growth. It can contribute to economic development via three routes:
(a) Technical progress which is endogenous calls for higher savings and higher investments. It is provided by financial sector.
(b) No production can take place without capital. Capital formation depends upon timely availability of financé in right amount and on proper terms.
(c) It expands the size of market over space and time. It improves efficiency of function of exchange.
Functions of Financial System for playing its role in economic development:
1. Financial System acts as a link between savers and investors. In this way it improves efficiency in allocation of resources.
2. It provides a mechanism where investors can monitor the performance of their investment.
3. An efficient financial system minimizes the risk of investment. It also helps reducing the cost of collecting information.
4. It provides updated information on price and returns that helps to take right decisions.
5. It reduces the instances of cheating and fraud.
6. It provides insurance services, pension funds and portfolio adjustment facilities.
7. It creates an impulse to save more.
8. It reduces cost of transactions.
9. It helps in increasing financial assets as a percentage of GDP.
10.It also increases variety of participants and instruments in the financial market.
FLOW OF FUNDS IN THE FINANCIAL MARKET
A concept is a flow concept when it is measured over a period of time. In a modern economy, income is not entirely spent. Some part of it is saved and converted into investment using financial system. These markets provide funds to borrowers and return to savers on their investment. Financial investment has varied degrees of risks, returns and liquidity. When investment is made in physical assets, it is called real investment. It is saving that ultimately gets converted into real investment.
Savings & Investment and National Income Accounts
National income is the sum total of final expenditure by households, firms, government and foreigners. From income view point, it is sum total of wages, rent interest, profit received by the residents of a country. This income may be used either as consumption or as savings. Savings can be invested directly in real assets or in financial instruments. Financial investments can take place directly or via financial intermediaries. These institutions then invest the funds received by them either in securities or consumer loans. In both cases, these funds will be used for buying real assets or consumer goods. It will increase national income.
Flow-of-Funds Accounts
It includes all the sources and uses of funds for the various sectors of the economy and by summation of all sectors. These are financial counterparts of the national income accounts of the real sector of the economy. Therefore, it is very important for a financial analyst to understand flow of funds accounts. It is flow of funds account that brings real and financial sectors together.
In an economy ex-post saving is equal to ex-post investment. Saving is one source of funds and investment is one use of funds. But it is not necessary practically that saving and investment are equal.
Data for Flow-of-Funds Accounts
For obtaining data for flow of funds accounts, we need to follow following steps:
(i) Classify the economy into sectors;
(ii) Preparing a statement showing inflow and outflow of funds in each sector;
(iii) Summing these sources (inflow) and uses (outflows),
(iv) Placing the sector accounts side by side to form a table matrix.
Firstly, we develop a matrix wherein the economy is classified into few sectors like households, firms, government and rest of the world. If we can handle complex matrix, these sectors may be given sub-sectors. But too complex matrix will not be able to serve the purpose. The ideal number of group will depend on the purpose of the analysis and the degree of segregation necessary.
Thereafter, we collect information on sources and uses of funds in each sector. It is done by examining the balance sheets of different sectors in the beginning and end of a quarter. The relative importance of different items might have undergone change. It is necessary that uses are equal to sources.
It is to be noted that inter-sectoral flows are not included and only net increases in assets are treated as use of funds. Debt repayments are dissavings and they are treated as negative sources of funds. For a given sector, the following equality is obtained:
Change in net worth + change in liabilities = change in real assets + change in financial liabilities.
It is extended by summing up all sectors. It makes it clear that if in one sector savings exceeds investment then lending will exceed borrowing and it will be a surplus sector and vice versa.
We have given a hypothetical matrix below in table given below.
U: Uses of funds
S: Surplus of funds
In the above table the uses and surplus of funds has been shown by each sector. It is to be noticed that for each sector, use and surplus is equal. Households saved Rs. 600 crores and out of it invested 100 crores in real assets and 500 crores in financial assets. Business units invested 800 in real assets of which 400 crores were arranged from their own savings and 400 were taken as loans from financial institutions. Government sector is a deficit sector as it has done dissaving of Rs. 800 crores. Overall, financial assets increased by Rs. 100 crores and the total of all sectors is 1900 crores.
From the figures obtained in the matrix we can form a credit market summary table as below:
We have not allowed for the fact that government borrows funds directly from the government sector and from each other. It is further assumed that non-financial sector acquired financial assets and financial liabilities. It is a simplifying assumption.
Significance of Flow of Funds Accounts
- It provides useful framework for classifying and measuring the sources and uses of both internal and external funds.
- It reflects the relationship among different sectors of the economy.
- It provides historical data that can be used to draw trend line and thereby helps in forecasting.
- It provides statistics on relation on credit flows to total spending goods and services.
- It is used to test hypothesis concerning the portfolio behaviour of consumers and firms.
No comments:
Post a Comment