A capital market is a system that allocates financial resources in the form of debt and equity according to their most efficient uses. Its main purpose is to provide a mechanism through which those who wish to borrow or invest money can do so efficiently. Individuals, companies, governments, mutual funds, pension funds, and all types of nonprofit organizations participate in capital markets. For example, an individual might want to buy her first home, a midsized company might want to add production capacity, and a government might want to develop a new wireless communications system. Sometimes these individuals and organizations have excess cash to lend and at other times they need funds.
System that allocates financial resources in the form of debt and equity according to their most efficient uses.
Purposes of National Capital Markets
There are two primary means by which companies obtain external financing: debt and equity. Capital markets function to help them obtain both types of financing. However, to understand the international capital market fully, we need to review the purposes of capital markets in domestic economies. Quite simply, national capital markets help individuals and institutions borrow the money that other individuals and institutions want to lend. Although in theory borrowers could search individually for various parties who are willing to lend or invest, this would be an extremely inefficient process.
Role of Debt
Debt consists of loans, for which the borrower promises to repay the borrowed amount (the principal) plus a predetermined rate of interest. Company debt normally takes the form of bonds—instruments that specify the timing of principal and interest payments. The holder of a bond (the lender) can force the borrower into bankruptcy if the borrower fails to pay on a timely basis. Bonds issued for the purpose of funding investments are commonly issued by private-sector companies and by municipal, regional, and national governments.
Loan in which the borrower promises to repay the borrowed amount (the principal) plus a predetermined rate of interest.
Debt instrument that specifies the timing of principal and interest payments.
Role of Equity
Equity is part ownership of a company in which the equity holder participates with other part owners in the company’s financial gains and losses. Equity normally takes the form of stock—shares of ownership in a company’s assets that give shareholders (stockholders) a claim on the company’s future cash flows. Shareholders may be rewarded with dividends—payments made out of surplus funds—or by increases in the value of their shares. Of course, they may also suffer losses due to poor company performance—and thus decreases in the value of their shares. Dividend payments are not guaranteed, but are determined by the company’s board of directors and based on financial performance. In capital markets, shareholders can sell one company’s stock for that of another or liquidate them—exchange them for cash. Liquidity, which is a feature of both debt and equity markets, refers to the ease with which bondholders and shareholders may convert their investments into cash.
Part ownership of a company in which the equity holder participates with other part owners in the company’s financial gains and losses.
Shares of ownership in a company’s assets that give shareholders a claim on the company’s future cash flows.
Ease with which bondholders and shareholders may convert their investments into cash.
Large financial institutions benefit borrowers and lenders worldwide in many ways. They underwrite securities and as asset managers they are caretakers of the personal financial savings of individuals. Pictured here, Citibank’s business director Weng Linnguo poses with lion dance troupes at the opening of a new Citibank branch in Beijing. Citibank has a truly global reach, with 200 million customer accounts in more than 100 countries.
Source: STR/AFP–Getty Images.
Purposes of the International Capital Market
The international capital market is a network of individuals, companies, financial institutions, and governments that invest and borrow across national boundaries. It consists of both formal exchanges (in which buyers and sellers meet to trade financial instruments) and electronic networks (in which trading occurs anonymously). This market makes use of unique and innovative financial instruments specially designed to fit the needs of investors and borrowers located in different countries that are doing business with one another. Large international banks play a central role in the international capital market. They gather the excess cash of investors and savers around the world and then channel this cash to borrowers across the globe.
international capital market
Network of individuals, companies, financial institutions, and governments that invest and borrow across national boundaries.
Expands the Money Supply for Borrowers
The international capital market is a conduit for joining borrowers and lenders in different national capital markets. A company that is unable to obtain funds from investors in its own nation can seek financing from investors elsewhere, making it possible for the company to undertake an otherwise impossible project. The option of going outside the home nation is particularly important to firms in countries with small or developing capital markets of their own. An expanded supply of money also benefits small but promising companies that might not otherwise get financing if there is intense competition for capital.
Reduces the Cost of Money for Borrowers
An expanded money supply reduces the cost of borrowing. Similar to the prices of potatoes, wheat, and other commodities, the “price” of money is determined by supply and demand. If its supply increases, its price— in the form of interest rates—falls. That is why excess supply creates a borrower’s market, forcing down interest rates and the cost of borrowing. Projects regarded as infeasible because of low expected returns might be viable at a lower cost of financing.
Reduces Risk for Lenders
The international capital market expands the available set of lending opportunities. In turn, an expanded set of opportunities helps reduce risk for lenders (investors) in two ways:
1. Investors enjoy a greater set of opportunities from which to choose. They can thus reduce overall portfolio risk by spreading their money over a greater number of debt and equity instruments. In other words, if one investment loses money, the loss can be offset by gains elsewhere.
2. Investing in international securities benefits investors because some economies are growing while others are in decline. For example, the prices of bonds in Thailand do not follow bond-price fluctuations in the United States, which are independent of prices in Hungary. In short, investors reduce risk by holding international securities whose prices move independently.
Small, would-be borrowers still face some serious problems in trying to secure loans. Interest rates are often high and many entrepreneurs have nothing to put up as collateral. For some unique methods of getting capital into the hands of small businesspeople (particularly in developing nations), see this chapter’s Entrepreneur’s Toolkit titled, “Microfinance Makes a Big Impression.”
ENTREPRENEUR’S TOOLKIT: Microfinance Makes a Big Impression
Wealthy nations are not the only places where entrepreneurs thrive. Developing nations are teeming with budding entrepreneurs who need just a bit of startup capital to get off the ground. Here are the key characteristics of microfinance.
■ Overcoming Obstacles. Obtaining capital challenges the entrepreneurial spirit in many developing countries. If a person is lucky enough to obtain a loan, it is typically from a loan shark, whose sky-high interest rates devour most of the entrepreneur’s profits. So microfinance is an increasingly popular way to lend money to low-income entrepreneurs at competitive interest rates (around 10 to 20 percent) without putting up collateral.
■ One for All, and All for One. Sometimes a loan is made to a group of entrepreneurs who sink or swim together. Members of the borrowing group are joined at the economic hip: If one member fails to pay off a loan, all in the group may lose future credit. Peer pressure and support often defend against defaults, however—support networks in developing countries often incorporate extended family ties. One bank in Bangladesh boasts 98 percent on-time repayment.
■ No Glass Ceiling Here. Although outreach to male borrowers is increasing, most microfinance borrowers are female. Women tend to be better at funneling profits into family nutrition, clothing, and education, as well as into business expansion. The successful use of microfinance in Bangladesh has increased wages, community income, and the status of women. The microfinance industry is estimated at around $8 billion worldwide.
■ Developed Country Agenda. The microfinance concept was pioneered in Bangladesh as a way for developing countries to create the foundation for a market economy. It now might be a way to spur economic growth in depressed areas of developed nations, such as in decaying city centers. But whereas microfinance loans in developing countries typically average about $350, those in developed nations would need to be significantly larger.
Source: Jennifer L. Schenker, “Taking Microfinance to the Next Level,” Business Week (www.businessweek.com), February 26, 2008; Steve Hamm, “Setting Standards for Microfinance,” Business Week (www.businessweek.com), July 28, 2008; Keith Epstein and Geri Smith, “Microlending: It’s No Cure-All,” Business Week (www.businessweek.com), December 13, 2007; Grameen Bank Web site (www.grameen-info.org), select reports.
Forces Expanding the International Capital Market
Around 40 years ago, national capital markets functioned largely as independent markets. But since that time, the amount of debt, equity, and currencies traded internationally has increased dramatically. This rapid growth can be traced to three main factors:
■ Information Technology. Information is the lifeblood of every nation’s capital market because investors need information about investment opportunities and their corresponding risk levels. Large investments in information technology over the past two decades have drastically reduced the costs, in both time and money, of communicating around the globe. Investors and borrowers can now respond in record time to events in the international capital market. The introduction of electronic trading after the daily close of formal exchanges also facilitates faster response times.
■ Deregulation. Deregulation of national capital markets has been instrumental in the expansion of the international capital market. The need for deregulation became apparent in the early 1970s, when heavily regulated markets in the largest countries were facing fierce competition from less regulated markets in smaller nations. Deregulation increased competition, lowered the cost of financial transactions, and opened many national markets to global investing and borrowing.
■ Financial Instruments. Greater competition in the financial industry is creating the need to develop innovative financial instruments. One result of the need for new types of financial instruments is securitization—the unbundling and repackaging of hard-to-trade financial assets into more liquid, negotiable, and marketable financial instruments (or securities). For example, a mortgage loan from a bank is not liquid or negotiable because it is a customized contract between the bank and the borrower. Thus banks cannot sell loans and raise capital for further investment because each loan differs from every other loan. But agencies of the U.S. government, such as the Federal National Mortgage Association (www.fanniemae.com), guarantee mortgages against default and accumulate them as pools of assets. They then sell securities in capital markets that are backed by these mortgage pools. When mortgage bankers participate in this process, they are able to raise capital for further investment.2
Unbundling and repackaging of hard-to-trade financial assets into more liquid, negotiable, and marketable financial instruments (or securities).