Financial Management Environment

ACCA Director Author

Financial Management Environment

Financial Management Environment

Macroeconomic policy

Macroeconomic policy is a government policy to influence the performance of the whole economy.

Aims of the policy:

• Full employment
• Everyone has a job. However, it may cause inflation.
• Price stability
• To reduce the distortions of inflation (increased pricing) and deflation (decreased pricing).
• Balance of payments
• To balance between import and export.
• Import > Export – Deficit – Unfavourable exchange rates
• Import < Export – Surplus – Favourable exchange rates
• Economic growth
• The growth is affected by factors including productivity, human capital, political factors and new products or services.
• This could be measured changes in GDP (Gross Domestic Product) and GNP (Gross National Product).
• GDP measures the value of goods and services produced within the country, ie who buys these goods and services and the total value. GDP = Spending (from customers plus entities plus government) + Net exports (Exports - Imports).
• GNP measures the value of goods and services produced by country’s residents. GNP = GDP + Net foreign income (Foreign income - expenses). The difference between GDP and GNP could indicate the size of foreign investment from country’s residents.
• Sometimes, per capita value is calculated, ie taking GDP or GNP (often exclude inflation and expressed as real GDP or GNP) and divide by the total number of population. This measures the wealth per person.
• Fair distribution of income
• Gini coefficient is often used to measure the fairness of income distribution in the country. If Gini coefficient is near 1 (high), it implies inequality and if this is near 0 (low), it implies equality.

Case study – Employment rate (2019)

Source: OECD (https://data.oecd.org/inequality/income-inequality.htm)

Case study – GDP

World Countries by GDP (2020)

Source: https://worldpopulationreview....

Case study – Gini coefficient (2019)

Source: OECD (https://data.oecd.org/inequality/income-inequality.htm)

Components of the macroeconomic policy:

• Fiscal policy – by government
• o Tax (direct and indirect taxes)
• Tax rises – entities’ profits reduce
• Tax reduces – entities’ profits increase
• Government borrowing - government bonds
• Government spending - state pension and salaries, education, road maintenance, construction of new motorways, flood defence schemes, defence equipment.
• Monetary policy – by central bank
• Open Market Operations
• Central banks provide money (forcing interest rate to fall) to or take money (forcing interest rate to rise) from commercial banks.
• Reverse repurchase agreement (known as Reverse Repo) is where central bank buys government bonds from commercial banks and later, sells those bonds back to commercial banks. Cash is injected to the system when bonds are bought, ie increasing reserves in commercial banks.
• Repurchase agreement (known as Repo) is where central bank sells and then buys government bonds to and from commercial banks. Cash is taken from the system when bonds are sold, ie reducing reserves in commercial banks.
• Interest rates
• Either decrease or increase interest rates by central bank.
• Interest rate rises – inflation falls (money demand falls), entities’ profits reduce
• Interest rate falls – inflation rises (money demand rises), entities’ profits increase
• o Reserve requirement
• By reducing/increasing reserve requirement, commercial banks could lend more/less money to entities.
• Exchange rate policy – control the value of the currency to change the prices of imports and exports.
• Favourable exchange rates (home currency strengthens) – good for imports and bad for exports
• Adverse exchange rates (home currency weakens) – good for exports and bad for imports

Case study – Names of central banks in different countries

• USA – Federal Reserve
• UK – Bank of England
• Thailand- Bank of Thailand
• China- People’s Bank of China
• Netherlands, Italy, Ireland - European Central Bank
• Fiji- Reserve Bank of Fiji

Case study – Monetary policy in the UK by Bank of England (May 2020)

The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment. In that context, its challenge is to respond to the severe economic and financial disruption caused by the spread of Covid‑19. At its meeting ending on 6 May 2020, the MPC voted unanimously to maintain Bank Rate (the interest rate that banks and building societies earn on deposits, or ‘reserves’, placed with the Bank of England) at 0.1%. The Committee voted by a majority of 7–2 for the Bank of England to continue with the programme of £200 billion of UK government bond and sterling non‑financial investment‑grade corporate bond purchases, financed by the issuance of central bank reserves, to take the total stock of these purchases to £645 billion. Two members preferred to increase the target for the stock of asset purchases by an additional £100 billion at this meeting.

Source: Bank of England

Case study –Base Rate and Interbank Offered Rate

The base rate in the UK is reviewed and published by the UK central bank, ie the Bank of England. This rate is usually voted on by the Monetary Policy Committee (MPC) eight times a year. This rate stands for the cost of lending from central bank to other commercial banks.

The Interbank Offered Rate in the UK is called ‘London Interbank Offered Rate (LIBOR)’. This is the estimated cost (rate) where one commercial bank lends money to another commercial bank. This is rate changes every day, and in the UK, usually before 11:00 a.m. (UK time), the rate is published.

Commercial banks borrow money from each other mainly to satisfy the reserve requirement in the legislation.

This rate is usually quoted in five currencies including CHF, EUR, GBP, JPY and USD. The rate is quoted ranging from Overnight, 1 week, 1 month, 2 months, 3 months, 6 months and 1 year, and it is an annualised rate.

Taking a look at the LIBOR historical rate from 17 October 2019 quoted in GBP as follows:

Say for example, if a commercial bank borrows £100 million from another commercial bank, the total overnight interest cost would be £100 million x 0.66838%/365 = £1,832 million

Businesses need to be alert about the above rates as when they borrow money from commercial banks, the interest rate quoted would be based on LIBOR rate + Margin (reflect risks of businesses and this could vary from banks to banks).

Usually when market is liquid, ie borrowing money from commercial banks is relatively easy, LIBOR rate is more focused than Base Rate. When market is not liquid, ie commercial banks need to maintain a relatively high level of reserve, Base Rate is more focused than the LIBOR rate.

Base Rate and Interbank Offered Rate have different names in other countries. For example, in China, the Base Rate is called ‘China's benchmark interest rate’. The Interbank Offered Rate is called ‘Shanghai Interbank Offered Rate (Shibor)’.

The quotes for LIBOR could be found here https://www.theice.com/marketdata/reports/170 and for Shibor http://www.shibor.org/shibor/web/html/index_e.html

Government intervention in the economy

In an efficient market, resources are allocated to those who need them.

However, problems of monopoly, funding, environmental pollutions and market irregularities exist.

Therefore, government interventions such as regulation, taxation and subsidies are needed.

• Competition policy – To improve competition among entities and reduce monopolies. For example, according to the Competition Act 1998 in the UK, companies with more than 50% market share would generally be considered as dominant and could face fines for up to 10% of global group turnover.
• Mergers and acquisitions regulation – To protect stakeholders interest when companies are merged or acquired. For example, the City Code in the UK requires that a bidder must announce a bid only after ensuring that it can pay any cash consideration, if such is offered, and after taking all reasonable measures to secure the implementation of any other type of consideration.
• Taxation and subsidies – To offer tax cut policies and subsidies to entities to help with their cash flows. For example, 100% first-year allowance when assets are bought.
• Environmental laws – To enact environmental legislation to reduce environmental pollution problems, ie reflect environmental costs into product prices. For example, the Environment Protection Act.
• Corporate governance regulation – To ensure directors protect the public interest through a set of rules or principles governing operations of entities. For example, the UK Corporate Governance Code.

The nature and role of financial markets and institutions

Financial intermediaries

• A financial intermediary is an entity bringing together lenders and borrowers of money.
• Finance through intermediary is often known as indirect finance.

Examples of financial intermediaries are:

• Merchant (Commercial) banks – provide deposit and lending services.
• Building societies – give loans to borrowers for house purchase.
• Finance houses – provide hire purchase service.
• Insurance companies – collect money from entities and individuals to invest in debt and equity securities expecting money could be grown up sufficiently to pay insurance compensations.
• Pension funds – collect contributions to invest in debt and equity securities for pension purposes.
• Investment/Unit trusts – trusts invest money collected from other entities and individuals to other securities including debts and shares expecting a return from it. Money tied up in investment trust could not be withdrawn within a specific period of time whereas money tied up in unit trust could be withdrawn any time investors want.
• Venture capital organisation – provide capital to businesses expecting to sell or list them in the near future.

Benefits of financial intermediaries:

Value transformation

• Borrowers may require large sums of money. Financial intermediaries can pool together many smaller deposits and lend a smaller number of large amounts of money to borrowers.

Maturity transformation

• Depositors may only want to deposit money in the short term, or retain a level of liquidity. Borrowers may want to borrow money over a long period of time. By dealing with many customers over a long period of time, financial intermediaries can provide long-term funds to borrowers, whilst ensuring that depositors retain the level of liquidity they require.

Reduce transaction costs

• Financial intermediaries can reduce the transaction costs associated with, for example, writing contracts for borrowers and lenders.

Risk pooling

• If a borrower defaults on a loan, the savers should not be directly affected as the cost will be charged to the financial intermediary, not the depositors. The return on an individual’s savings are not reliant on the performance of one borrower.

Expertise

• Financial intermediaries have the specialist knowledge and resources to assess the risk and anticipated profitability of proposed projects, so reducing the risk to the lenders.

Convenience of borrowing

• Borrowers do not need to visit many banks to secure funding but visit one financial intermediary.

Financial disintermediation

The development of financial markets and securitisation leads to financial disintermediation.

• Borrowers do not need to approach a financial intermediary such as a commercial bank to lend money to other entities, but rather, they could buy debt securities directly from stock exchange to remove the ‘middle man’ (financial intermediary).
• Securitisation is the process to convert illiquid assets such as buildings into securities and sell them to investors whereas investors could get a return in the form of interest. Assets cash flows are backed up by, for example, future rental income. In this case, investors could buy securitised debts in the open market.

Financial markets

Sketch:

• Financial markets include money and capital markets where those requiring finance (deficit units) can meet those who can provide finance (surplus units).
• Finance through financial markets is often known as direct finance, ie removing intermediary (middleman).

Primary and secondary markets:

• The primary market is where securities are issued for the first time. It could be the money market financial instruments such as depositing a large sum of money into the bank (certificates of deposit) or capital market financial instrument such as issuing shares and sell them to the investment banks.
• The secondary market is where securities are then traded among investors. It could be money market financial instruments such as trading commercial papers among investors or capital market financial instrument such as selling shares to other investors directly through the stock exchange.

Money markets:

• These are markets for short term capital (less than one year).
• Three types of money market financial instruments:

1. Interest bearing instruments:

These pay interest where investors could receive interest and face value at maturity.

• Money market deposit
• This is a short term loan between depositor and bank. The interest rate is usually quoted as ‘LIBOR + Margin’.
• Certificate of Deposit (CD)
• This is a certificate of receipt for money deposited at a bank for a stated term and paying interest at a stated rate, usually benchmark against the market rate. The holder of CD could transfer (negotiate) it to other holders in the secondary market if the CD is negotiable.

• Repurchase agreement (Repos)
• This is an agreement to sell the security (usually a treasury bill or bond) to another party and agrees to buy this back at a later date at a higher price.

2. Discount instruments:

These are traded at a discount to the face value and repay at face value or premium to the face value.

• Treasury bills (T-bills)
• These are debts issued by government which usually mature between one month to one year. T-bills do not pay a regular interest but are sold at a discount to the fair value and redeem at the full face value when they are matured.

• Commercial paper
• This is short-term debt issued by good credit rating entities backed by its credit rather than secured asset with maturity up to 270 days.
• Banker's acceptances (BAs) or Bills of Exchange
• These are issued by sellers to finance commercial transactions such as purchase of goods or imports and signed by buyers to confirm payment obligations. BAs are guaranteed by banks and could usually be negotiated to other parties on a discounted basis.

3. Derivatives:

These are financial instruments where buyer and seller could agree to buy or sell an asset at some time in the future at a determined price. Examples include Forwards, Futures and Options.

Characteristics of derivatives:

• The value of derivatives changes as the price of the underlying variable changes.
• No or little initial investment is required.
• It will be settled at a future date.

International money markets

• A eurocurrency market is the money market for any currency deposited or borrowed outside of its home market.
• To simplify this, ‘euro’ means ‘in a foreign country other than the country issuing that currency’ and ‘currency’ means ‘borrow or deposit in that currency’.

For example:

• Eurodollar market – borrow or deposit US dollar outside US, ie A company takes a US dollar loan in London.
• Euroyen market – borrow or deposit Japanese Yen outside Japan, ie A USA company deposits Japanese Yen in its bank.
• Euroeuro market – borrow or deposit Euro outside European countries.
• Europound market – borrow or deposit UK Pounds outside the UK.

Capital markets

These are markets for medium (1-5 years) and long term (more than 5 years) capital.

• Examples of capital markets include Stock Exchanges (or stock markets, for buying and selling of shares) and the bond market (for trading of debt securities).
• There is also an international capital market that trades Eurobond suitable for larger companies.

Categories: : Financial Management (FM)