FPC001 T1 v4 - Lecture notes 1 PDF

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Topic 1:

Overview of global financial markets and participants

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Topic 1: Overview of global financial markets and participants

Financial Markets and Economic Principles

Contents Overview ...................................................................................................................................... 1.1 Topic learning outcomes ......................................................................................................................... 1.1 Part 1: Overview of market participants in the financial system..................................................... 1.2 1

The flow of funds in a financial system .............................................................................. 1.2

1.1

Main functions of the financial system ....................................................................................... 1.4

1.2

The flow of funds ........................................................................................................................ 1.4

1.3

Key financial instruments in the flow of funds ........................................................................... 1.5

1.4

What is a financial market?......................................................................................................... 1.7

1.5

Direct investment........................................................................................................................ 1.7

1.6

Intermediation (indirect investment) ......................................................................................... 1.8

1.7

Advantages of financial intermediation...................................................................................... 1.9

1.8

Disadvantages of financial intermediation ............................................................................... 1.10

1.9

Link between intermediaries and financial markets................................................................. 1.11

1.10

The importance of liquidity ....................................................................................................... 1.11

2

Key participants in the financial system ............................................................................1.12

2.1

Types of participants ................................................................................................................. 1.12

3

Intermediaries in Australia ...............................................................................................1.13

3.1

The government as an intermediary......................................................................................... 1.14

3.2

The RBA ..................................................................................................................................... 1.14

3.3

Banks and other ADIs ................................................................................................................ 1.14

3.4

Money market corporations (merchant or investment banks) ................................................ 1.17

3.5

Finance companies.................................................................................................................... 1.18

3.6

Friendly societies....................................................................................................................... 1.18

3.7

Superannuation funds ............................................................................................................... 1.18

3.8

Life insurance companies.......................................................................................................... 1.18

3.9

General insurance companies................................................................................................... 1.19

3.10

Stockbrokers ............................................................................................................................. 1.19

3.11

Fund managers and portfolio managers................................................................................... 1.19

3.12

Financial advisers ...................................................................................................................... 1.20

3.13

Do intermediaries drive the flow of funds? .............................................................................. 1.20

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Topic 1: Overview of global financial markets and participants

Part 2: Overview of global financial markets ................................................................................1.22 4

Globalisation of financial markets.....................................................................................1.22

4.1

Factors driving globalisation ..................................................................................................... 1.22

4.2

Implications of globalisation ..................................................................................................... 1.23

4.3

Australian perspective .............................................................................................................. 1.25

5

Major financial centres.....................................................................................................1.32

6

Emerging markets ............................................................................................................1.33

7

Australia’s place in global financial markets ......................................................................1.33

7.1

Importance of financial services to Australia............................................................................ 1.34

7.2

Australia’s markets in a regional context.................................................................................. 1.35

7.3

Australia’s funds management industry ................................................................................... 1.35

7.4

Australia and the Asian region .................................................................................................. 1.35

References ..................................................................................................................................1.36 Suggested answers ......................................................................................................................1.37

Economic, Legal and Ethical Context for Financial Planning | FPC001_T1_v4

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1.1

Overview This topic sets the scene for Economic, Legal and Ethical Context for Financial Planning (FPC001). Many of the concepts introduced here will be discussed in more detail in the topics that follow. The topic has been separated into two parts, the first part discusses some key concepts and the second part demonstrates the concepts in light of global markets. This topic introduces the financial system and the flow of funds. The financial system consists of an intricate network of markets, participants and intermediaries that facilitate the flow of funds to and from the various sectors of the economy. Understanding the interaction of the entities in those sectors and the roles they play is the key to understanding the operation of the financial markets and to interpreting movements in the economy. We then consider the current global financial system. Today, the world’s financial markets are inextricably linked in a globalised economy and no country, regardless of its geographic location, can operate in isolation. This topic looks at factors driving the globalisation of financial markets, highlighting the challenges it presents as well as the advantages. In order to understand how global markets operate, it is important to understand the role of major financial centres and Australia’s financial markets in this context. It is also important to consider emerging financial centres, as these centres present new opportunities in global markets. This topic specifically addresses the following subject learning outcomes: 1. Explore the role of intermediaries in financial markets. 2. Explain the impact of current issues and key economic and financial indicators on the Australian and global financial markets.

Topic learning outcomes On completing this topic, students should be able to: • explain the flow of funds in the financial system • explain the roles of participants in the financial services industry • explore the interrelationship between market participants • explain the process of intermediation and the advantages that intermediation brings to the financial markets • explain the factors that have caused financial markets around the globe to become interrelated • explain the advantages and disadvantages of globalisation for a country’s economy and its financial markets.

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1.2

Part 1: Overview of market participants in the financial system 1

The flow of funds in a financial system Modern economies are based on a financial system that facilitates the flow of resources, goods and services through the economy. The economy may be divided into a number of sectors, each owning, producing or purchasing the resources, goods and services that flow through the economy. These sectors include: • household sector: consumers of goods and services (and lenders) • business sector: producers of goods and services (usually borrowers) • finance sector: includes financial intermediaries that specialise in transferring funds between lenders and borrowers • government sector: includes the three tiers — federal, state and local government, together with the state semi-government authorities known as centralised financing authorities, which usually act as borrowers • overseas sector: where imports come from and exports are sent (usually lenders to Australia). The first four sectors make up the domestic sector. Another distinction is based on ownership — the private and public sectors. The private sector of the Australian economy is made up of the first three sectors; the public sector is the government sector. The economy is linked by the system of exchange. For the sake of simplification, consider the two most essential sectors in the economy: the producers (business sector) and the consumers (household sector). Both use the marketplace to exchange money for goods or money for labour. This is represented by the circular flow of goods and services (see Figure 1). Figure 1

Circular flow of goods and services

In Figure 1, money flows one way in exchange for goods and services for the purpose of consumption. Goods and services flow in the opposite direction. In the earliest primitive economy, all production was consumed. In the modern economy, less than our national production is consumed. This leaves us with a surplus — the nation’s savings. It is this surplus that accumulates as the nation’s stock of wealth. In a modern economy, that wealth can be converted into physical or financial assets, some of which are converted into securities. Businesses and households are the backbone of an economy. As shown in Figure 1, businesses employ people to make goods and services and this gives households their incomes. However, there are leakages and injections from the circular flow.

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1.3

Money is taken out of the flow when households buy imports, save or pay taxes. This means less domestic spending. Money is injected into the circular flow when households run down their savings or borrow, when the government sector spends tax revenue and when the overseas sector imports from our domestic sector. The development of our financial system — along with the financial services industry — arises from the nation saving part of the national income generated in producing national output (GDP). Saving differs fundamentally from consumption in that it creates an opportunity for future consumption. By deferring consumption, savings can be converted into equity securities through financial transactions. Alternatively, by consuming more than national output, the debt generated is converted into debt securities owed to investors.

Sources of saving Saving is distinct from investment. Whereas investment is spending on physical assets with a life of more than one year, savings is on the other hand, the deferring of consumption. For an economy the national savings rate is seen as important and represents the total of savings by the domestic and government sectors. Gross savings are the savings required to finance gross investment. Net savings are those required to finance investment net of capital consumption. The national savings ratio is savings as a percentage of GDP. The creation of debt and equity securities enables the channelling of savings to the users of savings (borrowers). The four sources of savings are: • households • businesses • governments • overseas investors. As businesses are typically net borrowers and governments maintain a revenue neutral budget over the long term, the main sources for Australian savings are the household and overseas sectors. This channelling of resources from one sector to another is crucial to our economy’s ability to build its capital stock and sustain economic growth. Savings and investment are important sources of the leakage and injection into the circular flow. Imagine, as means of an example, a simplified system in which businesses produce $100 million of goods p.a. In this system, assume households save $20 million. Output is $100 million. Incomes are $100 million and consumption is $80 million. As businesses only sell $80 million of their $100 million output the remainder is left in stock. The $20 million increase in stock is classed as investment spending. In order to meet their wages bill the businesses have to borrow $20 million from banks where the households have placed their $20 million in savings. Output is $100 million, incomes are $100 million and total spending is $80 million consumption plus $20 million investment which equals $100 million. The leakage of $20 million for saving is matched by an injection of $20 million for investment. Business savings can be cyclical as they hold variable liquid reserves dependant on the economic cycle and their plans for growth. Government savings reflect political philosophies and are also cyclical.

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1.4

Current account deficits (discussed in further detail in Topic 3) indicate the degree to which domestic sector investment is financed by overseas investors. A net inflow of overseas capital implies that domestic savings are less than domestic investment and overseas investors will fill the gap. Net overseas savings are defined as the balance on the current account of the balance of payments.

1.1

Main functions of the financial system The financial system encourages the productive use of both funds and resources and has the following functions: • Mobilisation of funds The financial system aids the mobilisation of the community’s savings and the transfer of the resources these savings represent to sectors that make productive use of them. The financial system makes efficient use of resources when: – funds are allocated to the most efficient users of the funds (allocative efficiency) – transfers are carried out at least cost (operational efficiency). • Flexibility in choice of investment The financial system also allows people to alter the composition of their existing investments (for example, by selling shares and buying other assets). • Implementation of monetary policy Through the financial system, government authorities affect holdings in financial assets, influence interest rates and ultimately the level of activity in the economy (i.e. spending on goods and services). The Federal Government relies on monetary policy — implemented through the RBA — to influence the level of economic activity, the rate of inflation and, indirectly, the level of the Australian dollar. Monetary policy will be discussed in further detail in Topic 3. • An efficient savings process Finally, by providing savers with a safe repository for their surplus funds, the financial system encourages saving and so increases the volume of resources available for investment in productive assets, such as plant and machinery.

1.2

The flow of funds The intricate network of markets and institutions that facilitates the flow of funds to and from the various sectors of the economy is more complex than previously...