Chapter 13: The economic environment

Chapter learning objectives

Upon completion of this chapter you will be able to:

• explain the main objectives of macroeconomic policy
• explain the potential conflict between the main objectives of macroeconomic policy and its impact on policy targets
• explain the impact of general macroeconomic policy on planning and decision making in the business sector
• define monetary policy and explain the main tools used
• discuss the general role of monetary policy in the achievement of macroeconomic policy targets
• discuss use of interest rates in the achievement of macroeconomic policy targets
• define exchange rate policy and discuss its role in the achievement of macroeconomic policy targets
• explain the impact of specific economic policies on planning and decision making in the business sector
• define fiscal policy and explain the main tools used
• discuss the role of fiscal policy in the achievement of macroeconomic policy targets.
• explain the need for competition policy and its interaction with business planning and decision making
• explain the need for government assistance for business and its interaction with business planning and decision making
• explain the need for green policies and their interaction with business planning and decision making
• explain the need for corporate governance regulation and its interaction with business planning and decision making
• define financial intermediary and explain the role such intermediaries play in the UK financial system
• explain the role of financial markets in the UK financial system
• identify the nature and role of capital markets, both nationally and internationally
• identify the nature and role of money markets, both nationally and internationally
• explain the main functions of a stock market
• explain the main functions of a corporate bond market

1 Macroeconomic policy

The objectives of macroeconomic policy

Macroeconomic policy is the management of the economy bygovernment in such a way as to influence the performance and behaviourof the economy as a whole.

The principal objectives of macroeconomic policy will be to achieve the following:

• full employment of resources
• price stability
• economic growth
• balance of payments equilibrium
• an appropriate distribution of income and wealth.

The objectives of macroeconomic policy

The full employment of resources applies in particular to the labour force. The aim is both full and stable employment.

Price stability means little or no inflation putting upward pressure on prices.

Economic growth is measured by changes in national income from oneyear to the next and is important for improving living standards.

The balance of payments relates to the ratio of imports to exports.A payment surplus would mean the value of exports exceeds that ofimports. A payment deficit would occur where imports exceed exports.

Obviously what is considered an appropriate distribution of incomeand wealth will depend upon the prevailing political view at the time.

Potential for conflict

The pursuit of macroeconomic objectives may involve trade-offs –where one objective has to be sacrificed for the sake of another, e.g.:

Potential for conflict

Both economic theory and the experience of managing the economysuggest that the simultaneous achievement of all macroeconomicobjectives may be extremely difficult. Two examples of possible conflictmay be cited here.

There may be conflict between full employment and price stability.It is suggested that inflation and employment are inversely related. Theachievement of full employment may therefore lead to excessiveinflation through an excess level of aggregate demand in the economy.

Rapid economic growth may, in the short-term at least, havedamaging consequences for the balance of payments since rapidly risingincomes may lead to a rising level of imports.

Government reputation and business confidence will both be damagedif the government is seen to be pursuing policy targets which are widelyregarded as incompatible.

Policy objectives may conflict and hence governments have toconsider trade-offs between objectives. The identification of targetsfor policy should reflect this.

Making an impact – how macroeconomic policy affects the business sector

In order for macroeconomic policy to work, its instruments musthave an impact on economic activity. This means that it must affect thebusiness sector. It does so in two broad forms:

Aggregate demand

Aggregate Demand (AD) is the total demand for goods and services in the economy.

Note: National income is AD that has been satisfied by the provision of goods and services, etc.

The broad thrust of macroeconomic policy is to influence the levelof AD in the economy. This is because the level of AD is central to thedetermination of the level of unemployment and the rate of inflation. IfAD is too low, unemployment might result; if AD is too high, inflationinduced by excess demand might result.

Changes in AD will affect all businesses to varying degrees.

Thus effective business planning requires that businesses can:

• predict the likely thrust of macroeconomic policy in the short- to medium-term
• predict the consequences for sales growth of the overall stance of macroeconomic policy and any likely changes in it.

The more stable government policy is, the easier it is forbusinesses to plan, especially in terms of investment, employment andfuture output capacity.

Business costs

Macroeconomic policy may influence the costs of the business sector.

Not only will the demand for goods and services be affected bymacro­economic policy, it also has important implications for the costsand revenues of businesses. Three important areas may be identified:

Exchange rates

Macroeconomic policy may involve changes in exchange rates. Thismay have the effect of raising the domestic price of imported goods.Most businesses use some imported goods in the production process; hencethis leads to a rise in production costs.

Taxation

Fiscal policy involves the use of taxation: changes in tax rates orthe structure of taxation will affect businesses, e.g. a change in theemployer's national insurance contribution (NIC) will have a directeffect on labour costs for all businesses. Changes in indirect taxes(e.g. a rise in sales tax or excise duties) will either have to beabsorbed or the business will have to attempt to pass on the tax to itscustomers.

Interest rates

Monetary policy involves changes in interest rates. These changes will directly affect firms in two ways:

• Costs of servicing debts will change, especially for highly- geared firms.
• The viability of investment will be affected since all models of investment appraisal include the rate of interest as one, if not the main, variable.

2 Monetary policy

Monetary policy is concerned with influencing the overall monetary conditions in the economy in particular:

• the volume of money in circulation – the money supply
• the price of money – interest rates.

Monetary policy

It is clear that money is crucial to the way in which a modern economy functions. Money is any financial asset which has liquidity and fulfils the task of a medium of exchange.

Monetary policy is concerned with influencing the overall monetary conditions in the economy.

Two particular problems with the use of monetary policy are:

• the choice of targets
• the effects of interest rate changes.

The choice of targets

A fundamental problem of monetary policy concerns the choice ofvariable to operate on. The ultimate objective of monetary policy is toinfluence some important variable in the economy – the level ofdemand, the rate of inflation, the exchange rate for the currency,etc.However monetary policy has to do this by targeting some intermediatevariable which, it is believed, influences, in some predictable way, theultimate object of the policy.

The broad choice here is between targeting the stock of money or the rate of interest:

(a)The volume of money incirculation. The stock of money in the economy (the ‘money supply’)is believed to have important effects on the volume of expenditure inthe economy. This in turn may influence the level of output in theeconomy or the level of prices.

(b)The price of money. Theprice of money is the rate of interest. If governments wish to influencethe amount of money held in the economy or the demand for credit, theymay attempt to influence the level of interest rates.

The monetary authorities may be able to control either the supplyof money in the economy or the level of interest rates but cannot doboth simultaneously. In practice, attempts by governments to control theeconomy by controlling the money supply have failed and have beenabandoned. However, growth in the money supply is monitored, becauseexcessive growth could be destabilising.

The measurement of the money supply (stock)

Currently, in the UK, two measures of money supply are monitored.

(a) M0: a narrow money measure, incorporating:

(b)M4: a broad money measure, incorporating:

The effects of interest rates

The problem for the monetary authorities is that controlling thelevel of interest rates is rather easier than controlling the overallstock of money but the effects of doing so are less certain.

If governments choose to target interest rates as the principalmeans of conducting monetary policy, this may have a series ofundesirable effects. These principally relate to the indiscriminatenature of interest rate changes and to the external consequences ofmonetary policy.

When interest rates are changed, it is expected that the generallevel of demand in the economy will be affected. Thus a rise in interestrates will discourage expenditure, by raising the cost of credit.However, the effects will vary:

(1)Investment may be affected more than consumption. The rate ofinterest is the main cost of investment whether it is financed byinternal funds or by debt. However, most consumption is not financed bycredit and hence is less affected by interest rate changes. Since thelevel of investment in the economy is an important determinant ofeconomic growth and international competitiveness there may be seriouslong-term implications arising from high interest rates.

(2)Even where consumption is affected by rising interest rates, the effects are uneven.The demand for consumer durable goods and houses is most affected sincethese are normally credit-based purchases. Hence active interest policymay induce instability in some sectors of business.

The second problem arises from the openness of modern economies andtheir economic interdependence. There is now a very high degree ofcapital mobility between economies: large sums of short-term capitalmove from one financial centre to another in pursuit of higher interestrates. Changes in domestic interest rates relative to those in otherfinancial centres will produce large inflows and outflows of short-termcapital. Inflows of capital represent a demand for the domestic currencyand hence push up the exchange rate. Outflows represent sales of thedomestic currency and hence depress the exchange rate. This may bringabout unacceptable movements in the exchange rate.

Monetary policy in the UK

It is useful to look at the current monetary policy in the UK.Similar policies are pursued in the US and the Euro-zone countries.

In the UK, the central bank has been given responsibility by thegovernment for controlling short-term interest rates. Short-terminterest rates are controlled with a view to influencing the rate ofinflation in the economy, over the long-term. In broad terms, anincrease in interest rates is likely to reduce demand in the economy andso lower inflationary pressures, whereas a reduction in interest ratesshould give a boost to spending in the economy, but could result in moreinflation. The aim of economic policy is to find a suitable balancebetween economic growth and the risks from inflation.

Central governments can control short-term interest rates throughtheir activities in the money markets. This is because the commercialbanks need to borrow regularly from the central bank. The central banklends to the commercial banks at a rate of its own choosing (a rateknown in the UK as the repo rate). This borrowing rate for banks affectsthe interest rates that the banks set for their own customers. Actionby a central bank to raise or lower interest rates normally results inan immediate increase or reduction in bank base rates.

Interest rate smoothing

Interest rate smoothing is the policy of some central banks to moveofficial interest rates in a sequence of relatively small steps in thesame direction, rather than waiting until making a single larger change.

This is usually for the following reasons:

• economic (e.g. to avoid instability and the need for reversals in policy) and
• political (e.g. higher rates are broken to the electorate gently).

Impact of monetary policy on business decision making

All the above factors will also therefore influence inflation, whichhas a significant impact on business cash flows and profits. Inflationmay be:

• demand-pull inflation – excess demand
• cost-push inflation – high production costs.

Both can have negative impact on cash flows and profits.

Impact of monetary policy

Changes in monetary policy will influence the following factors.

The availability of finance. Credit restrictions achieved viathe banking system or by direct legislation will reduce the availabilityof loans. This can make it difficult for small- or medium-sized newbusinesses to raise finance. The threat of such restrictions in thefuture will influence financial decisions by companies, making them morelikely to seek long-term finance for projects.

The cost of finance. Any restrictions on the stock of money,or restrictions on credit, will raise the cost of borrowing, makingfewer investment projects worth while and discouraging expansion bycompanies. Also, any increase in the level of general interest rateswill increase shareholders' required rate of return so unless companiescan increase their return, share prices will fall as interest ratesrise. Thus, in times of 'tight' money and high interest rates,organisations are less likely to borrow money and will probably contractrather than expand operations.

The level of consumer demand. Periods of credit control andhigh interest rates reduce consumer demand. Individuals find it moredifficult and more expensive to borrow to fund consumption, whilstsaving becomes more attractive. This is another reason for organisationsto have to contract operations.

The level of exchange rates. Monetary policy which increasesthe level of domestic interest rates is likely to raise exchange ratesas capital is attracted into the country. Very many organisations nowdeal with both suppliers and customers abroad and thus cannot ignore theeffect of future exchange rate movements. Financial managers mustconsider methods of hedging exchange rate risk and the effect of changesin exchange rates on their positions as importers and exporters.

The level of inflation. Monetary policy is often used tocontrol inflation. Rising price levels and uncertainty as to futurerates of inflation make financial decisions more difficult and moreimportant. As prices of different commodities change at different rates,the timing of purchase, sale, borrowing and repayment of debt becomescritical to the success of organisations and their projects. This isdiscussed further below:

Impact of inflation on business cash flows and profits

The real effects on the level of profits and the cash flow positionof a business of a sustained rate of inflation depend on the form thatinflation is taking and the nature of the markets in which the companyis operating. One way of analysing inflation is to distinguish betweendemand-pull inflation and cost-push inflation.

Demand-pull inflation might occur when excess aggregatemonetary demand in the economy and hence demand for particular goods andservices enable companies to raise prices and expand profit margins.

Cost-push inflation will occur when there are increases inproduction costs independent of the state of demand, e.g. rising rawmaterial costs or rising labour costs. The initial effect is to reduceprofit margins and the extent to which these can be restored depends onthe ability of companies to pass on cost increases as price increasesfor customers.

One would expect that the effect of cost-push inflation on companyprofits and cash flow would always be negative, but that withdemand-pull inflation, profits and cash flow might be increased, atleast in nominal terms and in the short run. In practice, however, evendemand-pull inflation may have negative effects on profits and cashflow.

Demand-pull inflation may in any case work through cost. This isespecially true if companies use pricing strategies in which prices aredetermined by cost plus some mark-up.

• Excess demand for goods leads companies to expand output.
• This leads to excess demand for factors of production, especially labour, so costs (e.g. wages) rise.
• Companies pass on the increased cost as higher prices.
• In most cases inflation will reduce profits and cash flow, especially in the long run.

3 Fiscal policy

Fiscal policy is the manipulation of the government budget in order toinfluence the level of aggregate demand and therefore the level ofactivity in the economy. It covers:

• government spending
• taxation
• government borrowing

which are linked as follows:

public expenditure = taxes raised + government borrowing (+ sundry other income)

Fiscal policy

The role of the Chancellor is to balance the budget:

Balancing the budget

All governments engage in public expenditure, although levels varysomewhat from country to country. This expenditure must be financedeither by taxation or by borrowing. Thus the existence of publicexpenditure itself raises issues of policy, notably how to tax and whomto tax. But, in addition, the process of expenditure and taxationpermits the use of fiscal policy in a wider sense: the government budgetcan be manipulated to influence the level of AD in the economy andhence the level of economic activity.

The government budget (including central and local government) is astatement of public expenditure and income over a period of one year.Expenditure can be financed either by taxation or by borrowing. Therelationship of expenditure to taxation indicates the state of thebudget.

Three budget positions can be identified.

A balanced budget: total expenditure is matched by total taxation income.

A deficit budget: total expenditure exceeds total taxationincome and the deficit must be financed by borrowing. In the UK thebudget deficit was known as the public sector borrowing requirement(PSBR) but has been renamed to the (PSNCR) public sector net cashrequirement.

A surplus budget: total expenditure is less than totaltaxation income and the surplus can be used to pay back public debtincurred as a result of previous deficits.

Taxation

The obvious means by which public expenditure can be financed is bytaxation. The government receives some income from direct charges inthe public sector (e.g. health prescription charges) and from tradingprofits of some public sector undertakings, but the bulk of its incomecomes from taxation.

Taxes are divided into broad groups.

Direct taxes are taxes levied directly on income receiverswhether they are individuals or organisations. These include income tax,NICs, corporation tax, and inheritance tax.

Indirect taxes are levied on one set of individuals ororganisations but may be partly or wholly passed on to others and arelargely related to consumption not income. These include VAT and exciseduties. By their very nature, indirect taxes tend to be regressive whichmeans they have a relatively greater impact on individuals with lowerincomes.

Impacts of excessive taxation

Taxation can raise very large flows of income for the government.However excessive taxation may have undesirable economic consequences.Those most frequently cited are as follows

• Personal disincentives to work and effort: this may be related mainly to the form of taxation, e.g. progressive income tax (earn more, pay more), rather than the overall level of taxation.
• Discouragement to business, especially the disincentive to invest and engage in research and development (R&D), which results from high business taxation.
• Disincentive to foreign investment: multinational firms may be dissuaded from investing in economies with high tax regimes.
• A reduction in tax revenue may occur if taxpayers are dissuaded from undertaking extra income-generating work and are encouraged to seek tax-avoidance schemes.

If the tax rate exceeds a certain level, the total tax revenuefalls. It should be noted that these disincentive effects, whileapparently clear in principle, are difficult to identify in the realworld and hence their impact is uncertain.

Government borrowing

Broadly the government can undertake two types of borrowing:

It can borrow directly or indirectly from the public byissuing relatively illiquid debt. This includes National Savingscertificates, premium bonds, and long-term government bonds. This isreferred to as 'funding' the debt.

It can borrow from the banking system by issuing relatively liquid debt such as Treasury bills. This is referred to as 'unfunded' debt.

Long-term government bonds (gilts) is issued for long-termfinancing requirements, whereas Treasury bills are issued to fundshort-term cash flow requirements.

Problems of fiscal policy

Two difficulties associated with fiscal policy have dominated debates about macroeconomic management in recent years:

• the problem of 'crowding out'
• the incentive effects of taxation.

Both have had a major impact on the way in which fiscal policy has been conducted, especially in the US and UK.

Crowding out

It is suggested that fiscal policy can lead to 'financial crowdingout', whereby government borrowing leads to a fall in privateinvestment. This occurs because increased borrowing leads to higherinterest rates by creating a greater demand for money and loanable fundsand hence a higher 'price'.

The private sector, which is sensitive to interest rates, will thenreduce investment due to a lower rate of return. This is the investmentthat is crowded out. The weakening of fixed investment and otherinterest-sensitive expenditure counteracts the economy boosting benefitsof government spending. More importantly, a fall in fixed investment bybusiness can hurt long-term economic growth.

Doubts exist over the likely size of any crowding out effect ofgovernment borrowing on other borrowers but a very large PSBR may welllead to a fall in private investment.

However, when the economy is depressed, and there is not much newprivate sector investment, government spending programmes could help togive a boost to the economy.

Incentives

It is likely that all taxes have some effect. Indeed, the structureof taxes is designed to influence particular economic activities: inparticular, taxes on spending are used to alter the pattern ofconsumption. Here are two examples.

• High excise duties on alcohol and tobacco products reflect social and health policy priorities.
• Policies to use excise duties to raise the real price of petrol over time is designed to discourage the use of private cars because of the environmental effects.

Thus taxes as instruments of fiscal policy can fulfil a variety of useful functions.

However, there has been a growing concern among some economiststhat taxes have undesirable side effects on the economy, notably onincentives. As we have seen, it is argued that high taxes, especiallywhen they are steeply progressive, act as a disincentive to work.

Moreover some taxes have more specific effects. For example,employer national insurance (NI) payments raise the cost of labour andprobably reduce employment.

4 Government intervention and regulation

As well as the general measures to impact business operationsdiscussed above, governments can also take more specific measures toregulate business.

These measures will cover aspects such as:

• Competition policy
• Provision of government assistance
• Green policies
• Corporate governance guidelines

Competition policy

It is not the government's place to set prices for goods andservices provided by businesses in the private sector. In a competitivemarketplace, prices will be set within the industry according to demandand supply. All producers have to accept the prevailing market price,unless they are able to add distinguishing features to their products(e.g. branding, superior technology) that enable them to charge higherprices.

However, some markets are characterised by various degrees ofmarket power, in particular monopolies, whereby producers become price makers rather than price takers.

(A monopoly is where a firm has a sufficient share of the market to enable it to restrict output and raise prices.)

The absence of competition results in disadvantages to the economy as a whole.

• Economic inefficiency: output is produced at a higher cost than necessary. For example, there may be no incentive to reduce costs by improving technology used.
• Monopolies may be able to engage in price discrimination: charging different prices to different customers for the same good or service, e.g. peak and off-peak pricing. This may act against the interests of customers.
• Disincentive to innovate: the absence of competition may reduce the incentive to develop new products or new production processes.
• Pricing practices: monopolies may adopt pricing practices to make it uneconomic for new firms to enter the industry, thus reducing competition in the long run.

These potential problems of companies with monopoly power must beconsidered in the light of some possible advantages that may beassociated with such firms:

• Large firms may secure economies of scale: it is possible that there are significant economies of scale, reducing production costs, but that these require large firms and hence the number of firms in an industry is restricted. In this case the benefits of economies of scale may offset the inefficiencies involved.
• The special case of natural monopolies: this is the case where the economies of scale in the provision of some basic infrastructure are so great that only one producer is feasible. This may be the case of the public utilities in energy and water.
• Research and development: it may be that monopoly profits are both the reward and the source of finance, for technological and organisational innovation. Thus some static welfare losses have to be accepted in order to ensure a dynamic and innovative business sector.

Economic theory concludes that, all other things being equal, economic welfare is maximised when markets are competitive.

Government responses

Fair competition: public provision and regulation

The response to the problems associated with monopoly power cantake a variety of forms. The first of these is public provision. This iswhere an economic activity is nationalised. The advantages of this areas follows:

• unfair pricing practices and/or excessive prices can be eliminated
• cost advantages of economies of scale can be reaped.

Traditionally, public utilities have presented the most convincingcase for nationalisation because they are natural monopolies. However,nationalised industries may have disadvantages, notably a greaterpotential for cost-inefficiency.

The alternative response to the dangers of monopoly is regulation.

Self-regulation is common in many professions where theprofession itself establishes codes of conduct and rules of behaviour(e.g. the Law Society, the British Medical Association).

The alternative is some form of public or legal regulation.An example in the UK is the establishment of regulatory bodies for theprivatised utilities such as OFTEL and OFGAS. These were established inrecognition of the monopoly power of the privatised utilities and have adegree of power over both prices and services in these industries.

Another UK regulatory body is the Financial Services Authority(FSA) which has responsibility for regulating the financial services,banking and insurance markets. The FSA does not have to controlmonopolies, but it is concerned with ensuring fair competition andprotecting the public against unfair treatment by financialorganisations.

Fair competition: the control of monopoly

Formal competition policy has typically centred upon two broad issues.

• monopolies and mergers
• restrictive practices.

The concern for monopolies is with firms which have a degree ofmonopoly power (defined as having more than 25% of the market for a goodor service) or with mergers which may produce a new company with morethan 25% of market share. The underlying presumption is that monopoliesare likely to be inefficient and may act against the interests ofcustomers.

The concern over restrictive practices is with trading practices offirms which may be deemed to be uncompetitive and act against theinterests of consumers.

Legislation typically prohibits:

(a)anti-competitive agreements (such as price-fixing cartels); and

(b)abuse of a dominant position in a market.

Government assistance

The political and social objectives of a government, as well as itseconomic objectives, could be pursued through official aid interventionsuch as grants and subsidies. The government provides support tobusinesses both financially, in the form of grants, and through accessto networks of expert advice and information.

For example to:

• boost enterprise
• encourage innovation
• speed urban renewal
• revive flagging industries
• train labour force
• sponsor important research.

There is always strong competition for the grants and the criteriafor awards are stringent. These vary but are likely to include thelocation, size and industry sector of the business.

Green policies

When a firm appraises a project it may, rationally, only includethose costs it will itself incur. However, for the good of society,external costs (such as damage to wildlife) need to be taken intoaccount.

This has led to:

• green legislation
• punitive taxation on damaging practices
• which force companies to consider the negative impacts of potential projects in any appraisals.

Externalities are costs (benefits) which are not paid(received) by the producers or consumers of the product but by othermembers of society.

The need for green policies arises from the existence of externalenvironmental costs associated with some forms of production orconsumption. An example of each is given below:

• production: river pollution from various manufacturing processes
• consumption: motor vehicle emissions causing air pollution and health hazards.

If external costs (and benefits) exist in the production orconsumption process and if they are large in relation to private costsand benefits, the price system may be a poor mechanism for theallocation of resources. This is because private producers and consumersignore (and indeed may be unaware of) the external effects of theiractivities.

Thus the price system, in which prices are determined by theinteraction of supply and demand and which determines the allocation ofresources, may lead to a misallocation of resources.

It is likely that policies to control damage to the environmentwill become more and more common as concern for the environmentincreases. Many countries already have a differential tax on leaded andunleaded petrol with governments taking the decision to use taxes toraise the real price of petrol each year. There is also a continuingdebate in the EU over the possible introduction of a wider 'carbon tax'.

Externalities lead to a misallocation of resources and imply the need for policies to correct this. In particular, green policies are needed to tackle externalities that affect the environment.

Corporate governance

Corporate governance is defined as 'the system by which companies aredirected and controlled' and covers issues such as ethics, riskmanagement and stakeholder protection.

Regulation

Following the collapse of several large businesses and widespreadconcern about the standard of corporate governance across the businesscommunity, a new corporate governance framework was introduced.

A variety of rules have been introduced in different countries but the principles, common to all, contain regulations on:

• separation of the supervisory function and the management function
• transparency in the recruitment and remuneration of the board
• appointment of non-executive directors (NEDs)
• establishment of an audit committee and a remuneration committee
• establishment of risk control procedures to monitor strategic, business and operational activities.

Corporate governance was also discussed in the chapter on the financial management function.

Corporate governance guidelines

Corporate governance is defined as 'the system by which companiesare directed and controlled' and covers issues such as ethics, riskmanagement and stakeholder protection.

Regulation

Following the collapse of several large businesses and widespreadconcern about the standard of corporate governance across the businesscommunity, a new corporate governance framework was introduced.

A variety of rules have been introduced in different countries but the principles, common to all, contain regulations on:

• separation of the supervisory function and the management function
• transparency in the recruitment and remuneration of the board
• appointment of non-executive directors (NEDs)
• establishment of an audit committee
• establishment of risk control procedures to monitor strategic, business and operational activities.

A further constraint on a company's activities is the system ofcorporate governance regulation which has been introduced to improve thestandard of corporate governance in companies. The framework wasintroduced following a series of high profile international businesscollapses. There was widespread belief that the traditional systems withthe board of directors responsible for a company and the auditorsappointed by the shareholders but remunerated by the directors, wasinsufficient to control modern companies.

Key issues in corporate governance

Governance reports, codes and legislation vary from country to country but typically cover the following:

• Membership of the board to achieve a suitable balance of power. The chairman and chief executive officer (CEO) should not be the same individual. There should be a sufficient number of non-executive directors on the board, and most of these should be independent.
• NEDs on the board should prevent the board from being dominated by the executive directors. The role of the NEDs is seen as critical in preventing a listed company from being run for the personal benefit of its senior executive directors.
• A remuneration committee to be established to decide on the remuneration of executive directors. Service contracts for directors should not normally exceed one year. There have also been efforts to give shareholders greater influence over directors' remuneration.
• The role of the audit committee of the board. This should consist of NEDs, and should work with the external auditors.
• The responsibility of the board of directors for monitoring all aspects of risk, not just the internal control system. For example, the Turnbull Committee was set up by the ICAEW to report on the risk management element of corporate governance.

The Turnbull report produced recommendations, and a risk report isnow provided by listed companies in their annual report and accounts.

Audit committees

Many global listed companies now have an audit committee, or equivalent.

An audit committee:

• is a committee of the board of directors, normally three to five
• is made up of NEDs with no operating responsibility
• has a primary function to assist the board to fulfil its stewardship responsibilities by reviewing the:
  • systems of internal control
  • audit process
  • financial information which is provided to shareholders.

5 The role of financial markets and institutions

Financial intermediation

Intermediation refers to the process whereby potentialborrowers are brought together with potential lenders by a third party,the intermediary.

There are many types of institutions and other organisations thatact as intermediaries in matching firms and individuals who need financewith those who wish to invest.

Intermediaries

Clearing banks

The familiar high street banks provide a payment and chequeclearing mechanism. They offer various accounts to investors and providelarge amounts of short- to medium-term loans to the business sector andthe personal sector. They also offer a wide range of financial servicesto their customers.

Investment banks

Investment banks, sometimes called merchant banks, concentrate on the following.

(a)Financial advice to business firms

(b)Providing finance to business

(c)Foreign trade

Savings banks

Public sector savings banks (e.g. the National Savings Bank in theUK) are used to collect funds from the small personal saver, which arethen mainly invested in government securities.

Building societies

These take deposits from the household sector and lend toindividuals buying their own homes. They also provide many of theservices offered by the clearing banks. They are not involved, however,in providing funds for the business sector. Over recent years, many haveconverted to banks.

Finance companies

These come in three main varieties:

(a)Finance houses, providingmedium-term instalment credit to the business and personal sector. Theseare usually owned by business sector firms or by other financialintermediaries. The trend is toward them offering services similar tothe clearing banks.

(b)Leasing companies, leasingcapital equipment to the business sector. They are usually subsidiariesof other financial institutions.

(c)Factoring companies, providingloans to companies secured on trade debtors, are usually banksubsidiaries. Other debt collection and credit control services aregenerally on offer.

Pension funds

These collect funds from employers and employees to providepensions on retirement or death. As their outgoings are relativelypredictable they can afford to invest funds for long periods of time.

Insurance companies

These use premium income from policyholders to invest mainly inlong-term assets such as bonds, equities and property. Their outgoingsfrom their long-term business (life assurance and pensions) and theirshort-term activities (fire, accident, motor insurance, etc.) are onceagain relatively predictable and therefore they can afford to tie up alarge proportion of their funds for a long period of time.

Investment trusts and unit trusts

Investment trusts are limited liability companies collecting fundsby selling shares and bonds and investing the proceeds, mainly in theordinary shares of other companies. Funds at their disposal are limitedto the amount of securities in issue plus retained profits, and hencethey are often referred to as 'closed end funds'. Unit trusts on theother hand, although investing in a similar way, find that their fundsvary according to whether investors are buying new units or cashing inold ones. Both offer substantial diversification opportunities to thepersonal investor.

The role of the financial markets

The financial markets, both capital and money markets, are placeswhere those requiring finance (deficit units) can meet with those ableto supply it (surplus units). They offer both primary and secondarymarkets

Primary and secondary markets

Primary markets provide a focal point for borrowers and lenders tomeet. The forces of supply and demand should ensure that funds findtheir way to their most productive usage. Primary markets deal in newissues of loanable funds. They raise new finance for the deficit units.

Secondary markets allow holders of financial claims (surplus units)to realise their investments before the maturity date by selling themto other investors. They therefore increase the willingness of surplusunits to invest their funds. A well-developed secondary market shouldalso reduce the price volatility of securities, as regular trading in'second-hand' securities should ensure smoother price changes. Thisshould further encourage investors to supply funds.

Secondary markets help investors achieve the following ends.

(a)Diversification

By giving investors the opportunity to invest in a wide range ofenterprises, it allows them to spread their risk. This is the familiar'Don't put all your eggs in one basket' strategy.

(b)Risk shifting

Deficit units, particularly companies, issue various types ofsecurity on the financial markets to give investors a choice of thedegree of risk they take. For example company loan stocks secured on theassets of the business offer low risk with relatively low returns,whereas equities carry much higher risk with correspondingly higherreturns.

(c)Hedging

Financial markets offer participants the opportunity to reduce riskthrough hedging, which involves taking out counterbalancing contractsto offset existing risks, e.g. if a UK exporter is awaiting payment ineuros from a French customer he is subject to the risk that the euro maydecline in value over the credit period. To hedge this risk he couldenter a counterbalancing contract and arrange to sell the euros forward(agree to exchange them for pounds at a fixed future date at a fixedexchange rate). In this way he has used the foreign exchange market toinsure his future sterling receipt. Similar hedging possibilities areavailable on interest rates (see chapter 12).

(d) Arbitrage

Arbitrage is the process of buying a security at a low price in onemarket and simultaneously selling in another market at a higher priceto make a profit.

Although it is only the primary markets that raise new funds fordeficit units, well-developed secondary markets are required to fulfilthe above roles for lenders and borrowers. Without these opportunitiesmore surplus units would be tempted to keep their funds 'under the bed'rather than putting them at the disposal of deficit units.

However, the emergence of disintermediation (reduction in the useof intermediaries) and securitisation (conversion into marketablesecurities), where companies lend and borrow funds directly betweenthemselves, has provided a further means of dealing with cash flowsurpluses and deficits.

The capital markets

Capital markets deal in longer-term finance, mainly via a stock exchange.

The major types of securities dealt on capital markets are as follows:

• public sector and foreign stocks
• company securities
• Eurobonds.

Eurobonds are bonds denominated in a currency other than thatof the national currency of the issuing company (nothing to do withEurope or the Euro!). They are also called international bonds.

The money markets

Money markets deal in short-term funds and transactions areconducted by phone or telex. It is not one single market but a number ofclosely-connected markets.

Division of sources of finance

Funds can be divided between short- and long-term funds:

Durations of each are roughly:

International capital markets

An international financial market exists where domestic funds aresupplied to a foreign user or foreign funds are supplied to a domesticuser. The currencies used need not be those of either the lender or theborrower.

International capital markets

The most important international markets are:

• the Euromarkets
• the foreign bond markets.

Eurocurrency is money deposited with a bank outside its country oforigin, e.g. money in a US dollar account with a bank in London isEurodollars.

Note that these deposits need not be with European banks, although originally most of them were.

Once in receipt of these Eurodeposits, banks then lend them to other customers and a Euromarket in the currency is created.

The Eurocurrency market

This incorporates the short- to medium-term end of the Euromarket.It is a market for borrowing and lending Eurocurrencies. Various typesof deposits and loans are available.

Deposits vary from overnight to five years. Deposits can be in theform of straight-term deposits, with funds placed in a bank for a fixedmaturity at a fixed interest rate. However, these carry the problem ofinterest rate penalties if early repayment is required.

Alternatively, deposits can be made in the form of negotiableCertificates of Deposit (CDs). There is an active secondary market inCDs and investors are therefore able to have access to their funds whenrequired. Deposits can be made in individual currencies or in the formof 'currency cocktails' to allow depositors to take a diversifiedcurrency position. One common cocktail is the Special Drawing Right,consisting of US dollars, yen, Euros and sterling.

Euromarket loans may be in the form of straight bank loans, linesof credit (similar to overdraft facilities) and revolving commitments (aseries of short-term loans over a given period with regular interestrate reviews). Small loans may be arranged with individual banks, butlarger ones are usually arranged through syndicates of banks.

Much of the business on the Eurocurrency market is interbank, butthere are also a large number of governments, local authorities andmultinational companies involved. Firms wishing to use the market musthave excellent credit standing and wish to borrow (or deposit) largesums of money.

The Eurobond market

A Eurobond is a bond issued in more than one countrysimultaneously, usually through a syndicate of international banks,denominated in a currency other than the national currency of theissuer.

This represents the long-term end of the Euromarket.

The bonds can be privately placed through the banks or quoted onstock exchanges. They may run for periods of between three and 20 years,and can be fixed or floating rate. Convertible Eurobonds (similar todomestic convertible loan stocks) and Option Eurobonds (giving theholder the option to switch currencies for repayment and interest) arealso used.

The major borrowers are large companies, international institutionslike the World Bank, and the EC. The most common currencies are the USdollar, the Euro, the Swiss franc, and to a lesser extent sterling.

Stock markets

The syllabus does not require you to have a detailed knowledge of anyspecific country's stock market or exchange. We may, however, makereference to the markets that operate in the UK for illustrationpurposes.

The role of the stock market is to:

• facilitate trade in stocks such as:
  • issued shares of public companies
  • corporate bonds
  • government bonds
  • local authority loans.
• allocate capital to industry
• determine a fair price for the assets traded.

Speculative trading on the market can assist by:

• smoothing price fluctuations
• ensuring shares are readily marketable.

Market-makers:

• maintain stocks of securities in a number of quoted companies
• continually quote prices for buying and prices for selling the securities (bid and offer prices)
• generate income by the profits they make from the difference (or 'spread') between the bid and offer prices.

Countries may have more than one stock market. In the UK there are three:

(1)London Stock Exchange – main market

(2)Alternative Investment Market (AIM) – for smaller companies

(3)Ofex (off exchange) – trade via specialist brokers.

Stock markets

A country's stock market is the institution that embodies many ofthe processes of the capital market. Essentially it is the market forthe issued securities of public companies, government bonds, loansissued by local authority and other publicly-owned institutions, andsome overseas stocks. Without the ability to sell long-term securitieseasily, few people would be prepared to risk making their moneyavailable to business or public authorities.

A stock market assists the allocation of capital to industry; ifthe market thinks highly of a company, that company's shares will risein value and it will be able to raise fresh capital through the newissue market at relatively low cost. On the other hand, less popularcompanies will have difficulty in raising new capital. Thus, successfulfirms are helped to grow and the unsuccessful will contract.

The role of speculation

Any consideration of a stock market has to face up to the problemof speculation, i.e. gambling. It is suggested that speculation canperform the following functions:

It smoothes price fluctuations. Speculators, to be successful, haveto be a little ahead of the rest of the market. The skilled speculatorwill be buying when others are still selling and selling when others arestill buying. The speculator, therefore, removes the peaks and troughsof inevitable price fluctuations and so makes price changes lessviolent.

Speculation ensures that shares are readily marketable. Almost allstock can be quickly bought and sold, at a price. Without the chance ofprofit there would be no professional operator willing to hold stock oragree to sell stock that is not immediately available. The fact thatthere are always buyers and sellers is of considerable importance to theordinary individual investor, who may have to sell unexpectedly at anytime with little warning.

Stock markets help in the determination of a fair price for assets, and ensure that assets are readily marketable.

Buying and selling shares or loan notes

An investor will contact a broker in order to buy and sellsecurities. The broker may act as agent for the investor by contacting amarket-maker (see below) or he may act as principal if he makes amarket in them himself (i.e. buys and sells on his own behalf). In thelatter case he is a broker-dealer.

Trading via a broker-dealer

Trading via a broker and a market-maker

Market-makers maintain stocks of securities in a number of quotedcompanies, appropriate to the level of trading in that security, andtheir income is generated by the profits they make by dealing insecurities. A market-maker undertakes to maintain an active market inshares that it trades, by continually quoting prices for buying andprices for selling (bid and offer prices).

If security prices didn't move, their profits would come from thedifference (or 'spread') between the bid and offer prices. This profitis approximately represented by the difference between the 'bid' and'offered' price for a given security – the price at which amarket-maker is prepared to buy the stock and the price at which hewould be prepared to sell it.

For example, assume a quotation in respect of the shares of a fictitious company, Clynch Co.

The dealer might quote 145, 150.

This means he will buy the shares at $1.45 each and sell at $1.50 each.

Quotations are based on expectations of the general marketabilityof the shares and, as such, will probably vary constantly. For example,if an investor wants to buy 10,000 shares, the dealer might decide toraise his prices to encourage people to sell and thereby ensure that hewill have sufficient shares to meet the order he has just received.Thus, his next quote might be 150, 155.

Conversely, if the investor wants to sell 10,000 shares, the dealerwill be left with that number of additional shares, and he may wish toreduce his quotation to encourage people to buy; thus he may quote 140,145.

If sufficient numbers of people wish to buy and sell the shares ofClynch Co, eventually a price will be found at which only marginaltransactions are taking place.

If the general economic climate is reflected by each company'sshares, it follows that there will be times when in general people wishto sell shares and hence prices drop, and other times when in generalpeople are buying shares and prices rise.

Share prices are dictated by the laws of supply and demand. If thefuture return/risk profile of the share is anticipated to improve, thedemand for that share will be greater and the price higher.

Broker-dealers in the UK act as both brokers for clients and tradeon their own account as dealers. In the UK, their activities in sharedealing are restricted largely to listed companies whose shares aretraded on SETS, the electronic 'trading book' of the London StockExchange.

Types of stock market

A country may have more than one securities market in operation. For illustration, the UK has the following:

The London Stock Exchange – the main UK market for securities, onwhich the shares of large public companies are quoted and dealt. Costsof meeting entry requirements and reporting regulations are high.

The AIM – a separate market for the securities of smallercompanies. Entry and reporting requirements are significantly less thanthose for the main market of the London Stock Exchange.

An 'Ofex' (off exchange) market in which shares in some publiccompanies are traded, but through a specialist firm of brokers and notthrough a stock exchange.

Chapter summary

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