Recently we have seen fast and profound changes in the money and capital markets but the old definitions for describing them is still in use. Bearing this in mind, the purpose of this paper is to challenge the widely-used definitions of money and capital markets. It claims that duration, as a dividing line, is no longer capable of reflecting the constant development of the banking and financial systems. With the help of reviewing the related literature, the ‘one-year’ and ‘more than one-year’ differentiation and its relevance is discussed, also the similarities and the differences of the two markets are highlighted. When evaluating the factors affecting the two markets, the effects on banks, the capital and money markets are taken into consideration. Among the results, the paper finds that the old definitions are no longer adequate when it comes to understanding the current money and capital markets. Secondly, it introduces more appropriate definitions with which it tries to highlight the importance of complementarity. The paper concludes that the old definitions used in describing the fast changing financial markets are to be reconsidered because and the notion of complementarity is gaining importance.
Keywords: financial markets, money market, capital market, economic features, complementarity
JEL classification: A23, B00, G15,
The structure of financial markets is a constantly developing system showing permanent changes of the weight (Mallinguh & Zeman, 2020) in the financial market structure of its constituents: money market, capital market, and the market of financial derivatives (Jasiene & Paskevicius, 2009). A number of reasons and factors are causing changes and new developments in these markets not to mention the interactions between them. Following and understanding these changes are important for the investors and for the investment portfolio managers alike.
In two of our previous studies (Kovacs & Kajtor-Wieland, 2017; Wieland & Kovacs & Savchenko, 2020) more light was shed on the legal aspects of the capital and money markets just to discover that there are no proper and widely accepted definitions for the two. Recently a couple of papers (Mihajlovic, 2016; Jasiené & Paskevicius; 2009) were trying to define the difference between to two markets and this papers intends to join the discussion with a new approach. By continuing the previous arguments of the previous studies, the goal of this study is to point to the fact that the definitions used for understanding the two markets from an economic perspective are no longer appropriate and do not really serve the better understanding of the terms. Also the study tries to better understand the two markets and to what extent they are interrelated. The paper argues that making a differentiation based on duration only no longer gives a clear understanding of the two markets as the economic aspects of the differences are also to be highlighted.
When browsing the relevant literature and economic textbooks for secondary school and university students, it is quite easy to conclude that short-term and one year are regarded the same (Fazekas, 2010a; 2010b; Solt & Lázár, 2002a; 2002b; Pearson, 2016; Mishkin, 2018; Nordhaus & Samuelson, 2019; Sági et al., 2020). No surprise that the younger generations of economists simply accept this similarity and the international literature is short of those papers which challenge it.
When digging a bit deeper, and when for example it comes to the factors of production available, most textbooks make a kind of differentiation and argue that there is a very short run, a short run, a long run, and a very long run (Mankiw, 2019). In case of the very short run they usually highlight the fact that the factors of productions are fixed and cannot be changed. In the short run at least one factor of production is fixed and this is a period of less than four or six months. In the long run all factors of production are variable and the period is greater than four or six months or one year. In the very long run every single factor of production can be changed and also the factors outside the control of the company. The period is as long as seven years (Mankiw, 2019). Basically, no proper explanation is given for the exact timeframes and the international literature is not really interested in rethinking and challenging them. However an explanation for the ‘one year or more’ versus the ‘less than one year’ division is explained and it is also introduced how it filtered into finance and investments and how it made its way to the general economic way of thinking.
First of all, the paper argues that centuries ago when the economies were built on mainly agriculture and agricultural activities, the most important crops had, and still has, an exact growing season which were definitely less than one year. (The seeds were bought, and planted, the harvest took place a couple of months later, and the products were sold in the local markets and from the revenue new seeds were purchased.) Also, those economies were almost closed and the communities consumed what they produced and produced what they consumed (Baldwin, 2016). At that time there were no geographical divisions between the places of production and consumption so the products were made mostly for satisfying the immediate needs of the locals. In the agrarian societies, certain crops were available for a limited period only and the inclemency of weather may have caused serious disruptions in the supply. In this way a kind of short-termism started characterising the economic activities from the very beginning: at that time it was relatively easy to calculate the growing season and the supply available after harvesting, so it became relatively comfortable and easy to equate business activities with one year or less.
When bookkeeping became widespread, the accountants mostly pointed to the fact that there were assets which equalled cash or would be converted into cash within a year in parallel with those assets which could not be converted into cash within a year. In this respect the timeframe for short term was created and since then, mostly because of complying with accounting standards and largely because it is comfortable, it is still in use. In the terminology of the accountants, the word current refers to short-term and they regularly use it when, for example they deal with current assets and current liabilities. In this way the paper argues that the growing importance of bookkeeping helped the spread of this distinction. Also it is to be highlighted that there are a number of business activities which are definitely shorter than one year. These may be repeated several times in a business year and they are not always related to agriculture. In retail and animal husbandry for example, the business cycle does not follow the one-year principle and in case of these activities highlighting the period of one year is pretty much useless.
According to Gursamy (2009) the financial market has seen a massive transformation in its role and size for many decades. As there are a lot of instruments available in this market it is quite comfortable to label those instruments short-term which could be converted into cash within a year. This kind of differentiation is still one of the most important guidelines of the financial markets as well and it is a well-known fact that the money market is regarded as a short-term and the capital market is a long-term market (Madura, 2014). Every single section of the financial market started to be seen in this light and a clear division was made between long-term and short-term investments as well. Long term investments were/are those investments that are intended to be held for more than one year or for several years. In the light of this, short term investments are held for one year or less. As it will be discussed later, the timeframe is one of the most important indicators when it comes to comparing the two markets (money and capital) and actually this kind of comparison is poorly justified. Mihajlovic (2016) argues that the financial markets in the modern world are associated with the other segments of the world economy. The author claims that the financial markets are complex, many participants take part in it, the regulation and supervision is important and basically we have to take into consideration so many factors that understanding the financial markets today is more complex than ever before.
After doing some research it becomes obvious that finance simply followed the logic of the previously presented economic activity differentiation largely for the sake of simplicity. No matter what kind of financial instruments it is being discussed, some of the current ones simply did not exist a couple decades ago, still the importance of two types are highlighted and a strong differentiation between the money markets and capital markets are being made. Most of the authors claim that the timeframe is the best way of comparing the two but in the next section the paper tries to show that the other features for comparison seem to be better options as well.
2.1. Similarities and Differences between the Money and Capital Markets
An equation sign is being put between the money market and the capital market as they are integral parts of the financial market (Weston & Copeland, 1992) but until money markets are good for depositing funds to be used in a shorter period, capital markets are good for those investors who are usually patient and not shying away from shouldering more risk. Stocks, bonds, deposits, bills of exchange, collateral loans and acceptances are those financial instruments which are used in capital markets. The institutional network of the market consists of mainly acceptance houses, commercial banks, central banks. The money markets are an unorganised aspect of the financial markets and they are unsystematic as well. It means that trading is mainly done over the counter (OTC) as the two counterparts agree to the terms.
When it comes to liquidity, money markets are important for the corporate and government entities and for the individuals as well. Operating expenses or working capital are covered by issuing short-term debts. Also when companies want to invest funds overnight or when they have to cover payroll, they turn to the money market. The main purpose of the money market is to maintain the appropriate level of liquidity of companies and governments on a daily basis at the lowest price possible. As money markets are said to be less risky than capital markets, the risk-averse investors invest funds and they can still access them as they are liquid. These markets are so safe that individuals making a fixed income also use them without encountering any types of excessive risks.
Basically, there is one obvious reason why they tend to equate the capital markets with the money markets: much data is available in the capital markets and many people follow it. Bond and stock markets are important indicators when it comes to the general economic conditions of the world markets. In the capital markets there are non-bank financial institutions (insurance companies, mortgage banks), stock exchanges, and commercial banks. For the participants of the capital markets the long-term purposes (for example mergers and acquisitions, new line or a completely new type of business, capital projects) are vital and they try to raise capital. There are many capital markets like the bond market where companies issue corporate bonds, also governments and federal governments may issue bonds in a different bond market. Stock market is mainly for those companies which would like to raise money by issuing equity. The investors are not only buying these stocks or bonds but they trade with them as well. The sellers and the buyers may trade on the primary and on the secondary market, depending on whether the securities have been already issued or not. The buyers of securities usually use funds that are targeted for longer-term investment and large-scale projects so the capital markets are riskier than the money markets. The investors have a lengthy time horizon and they save for retirement or education.
Most of the time the differences are quite obvious between the two markets. Money markets offer safer, less risky assets and the returns are lower but at least steady. In case of the capital markets there are mainly higher-risk investments. Apart from these, the differences can be classified and ten well-defined features can be pointed to.
Maturity period. The money markets are about lending and borrowing in the short-run, while the capital market is clustered around lending and borrowing in the long-run.
Credit instruments. The main credit instruments of the money market are bills of exchange, call money, treasury bills, certificates of deposit, commercial papers, collateral loans, and acceptances while in case of the capital market there are bonds, securities, stocks, shares, debentures, and derivatives.
Nature of credit instruments. There is a difference between the levels of heterogeneity as well. The credit instruments in the capital markets are more heterogeneous than in the money market. In the European Union for example the small and medium sized enterprises usually turn to the banks for commercial credit which seems to be more primitive than the American practice where the companies can issue bonds and shares as well.
Institutions. Among others, the institutional network is also different. There are non-bank financial institutions, bill brokers, central banks, acceptance houses, and commercial banks in the money market. In case of the capital market there are insurance companies, stock exchanges, non-bank institutions, mortgage banks, building societies, and commercial banks.
Purpose of loan. As the money market greases the wheels of the companies with working capital, it meets the short-term credit needs of business. In case of the capital market, the long-term credit needs are met. Also fixed capital is provided to buy assets.
Risk factor. In the money market the general level of risk is smaller than in the capital market. The reason is quite simple: the maturity of one year or even less leaves little time for a default to happen so the risk is minimised. In case of the capital market the level of risk and its nature differs quite significantly.
Basic role. The main function of the money market is liquidity adjustment. In case of the capital market the focus is on providing capital related to long-term, secure and productive employment.
Relation with central bank. Until the capital market only “feels” the influence of the central bank through the money market, the money market is directly and closely linked with the central bank of a country (Chen Wu, 2013). The key interest rate has a strong effect on the reference interest rate and plays an important role when allocating the resources.
Market regulation. There is a significant level of difference between the overall regulations. Banks had been always better regulated. In addition the year of 2008 left a truly remarkable mark on the regulation as with the Basel III regulatory framework, the commercial banking industry became even more regulated than the capital market.
Accessibility. Money markets are not easily accessible to the general public with the exception of commercial paper and certificate of deposits. Capital markets are easily accessible especially in the secondary market. Largely because of the high amount of liquidity, transactions are larger and higher in volume.
When the money and capital markets are being discussed, the differences are highlighted but it is crucial to highlight the similarities and interrelations as well. These are clustered around interdependence, institutional network, and complementarity.
Interdependence. The money markets and capital markets are interdependent as the policies and activities of one market have a direct impact on the other. When there is a decreased demand for funds in the capital market, the demand is also reduced in the money market. The monetary policy has a direct influence on the capital market as well.
Same institutions. Commercial banks for example are present in both the money markets and the capital markets so certain institutions can be found in both markets. This trend has been visible because of the growth of time deposits and higher rate of return on long-term loans.
Complementarity. The money market and the capital market are not competitive, they are complementary to each other. The short-term and long-term programmes of economic development are too integrated and without a proper coordination between the short-term and long-term it would be quite difficult to manage the funds. From the investor point of view, the two markets are permeable.
Bearing these differences and similarities in mind it is important to highlight that a number of factors are contributing to the continuous change of the two markets. These factors affect the different markets in various ways and lead us to rethink our views on them.
2.2. Factors affecting the money, capital and stock markets
When the most important factors shaping the financial world are collected, the study of Foley (1994) can be regarded as a seminal one. The author separates the factors into two major groups: global ones, internal ones. Damodaran (2002) turns to the risk factors related to the market and entities, and among others highlights the importance of currency exchange changes, interest rate, inflation, and various economic development indicators. Among the most important factors, Schröder (2001) points to labour productivity, economic development, savings, inflation, budget deficit. According to Jasiene & Paskevicius (2009) household savings, gross domestic product (GDP), consumer price index (CPI), gross public debt to GDP, foreign direct investment (FDI), and unemployment level are those factors which affect the capital and money markets but in very different ways (for more aspects see: Vasa and Angloska, 2020). The authors point to the fact that GDP has a positive effect upon the capital market but plays a negative role in the money markets. Also they claim that in the rapidly developing countries the competition between the capital and money markets is more prominent and the capital and money markets develop in a complementing way. Demirgüç-Kunt & Maksimovic (2002) reminds us a well-known fact: in the Anglo-Saxon countries, the ratio between GP (gross profit) and stock market capitalisation is much higher than in the other European countries. Based on Indian stock market indicators Deb & Mukherjee (2008) turned to time series analysis and pointed to the fact that there is bidirectional causality between the real GDP growth and market capitalization. However from the perspective of stock market activity and real GDP growth there is a unidirectional connection. Tsaurai (2018) tries to find the building blocks of stock market development in emerging markets. He argues that the major factors influencing stock market development includes FDI, trade openness, savings, inflation, economic growth, infrastructural development, exchange rates, banking sector development and stock market liquidity. According to Zafar (2013) the banking sector development has a minor impact on the development of the stock market. It is also true that the real interest rates negatively affect stock market developments. Others, for example Drazenovic and Kusenovic (2016) focus on the new member countries of the European Union (EU). According to their argument there is a positive connection between financial development and economic growth. They highlight the complementary development of intermediation in the capital market and in the banking sector. Levine and Zervos (1998) go so far that they include measures of macroeconomic and institutional determinants of capital market development in a number of countries and found positive and significant effects on economic activity. According to their results, banks and capital markets are integral parts of a co-evolving system and they complement each other. Darrat (1990) takes into consideration the changes in fiscal policy (government debt) on stock market and equity returns. His results confirm that fiscal policy plays an important role in determining stock prices in the US. Namely, changes in fiscal policy have significant effect on aggregate stock prices. According to Andrews (2004) the general market impacts more than half of a stock’s price, while earnings account for most of the rest. Stocks, commodities and existing bond prices tend to rise when the interest rate are falling in general.
Many papers confirm the fact that there is a strong relationship between changes in money supply and stock prices. Basically, the growth rate of the money supply could serve as a leading indicator of stock price changes (Reilly & Brown, 2003). Also they claim that stock prices reflect expectations of earnings, dividends, and interest rates. As investors try to estimate these future variables, their stock price decisions reflect expectations not related to the current but to the future economic activity.
Based on our literature review, it is clear that among the determinants of capital market development we have to point to the (i) legal and institutional framework, (ii) political and macroeconomic stability, (iii) broadening the pool of investors (King & Levine, 1993; Tvaronaviciene & Michailova, 2006; Yartey, 2008; Cherif & Gazdar, 2010). As far as the stock markets are concerned, among others, we have to point to the level of economic growth, interest rates, stability, confidence and expectations, related markets and the world market, bandwagon effect, price to earnings ratio(s), internal developments within companies (Mishkin, 2018). When we talk about the factors influencing the money markets basically we are referring to the elements of the monetary policy within which three parts are to be mentioned: (i) instruments, (ii) intermediate targets, and (iii) final targets. The instruments of the monetary policy are the required reserve ratio, the open market operations and other tools, and the rediscount policy. The intermediate targets are money supply and interest rate. As for the final target, it is quite clear that in case of the advanced economies the key role for monetary policy is the maintenance of price stability (Jing-xin & Yuan, 2012).
Bearing the above mentioned in mind, it is clear that a number of factors are affecting the money, capital, and stock markets in their own ways. Quantifying the possible effects is not in the focus of this paper and we try to call the attention to the fact that, among a couple of other things, the influencing factors are blurring the boundaries of the durations of the financial instruments as well.
As it was presented, the finance and accounting related regulations indicate that we have to follow the one-year principle even if it is not properly justified and counts to be obsolete. When claiming this, we are not referring to extending or shortening the period, instead we are pointing to a rule which is used extensively without challenging it. In economics, we can find many old models and theories which count to be long-standing and actually they do not serve the purpose of understanding the current trends. Keynes (1936) has already called our attention to the fact that “the difficulty lies not so much in developing new ideas but in escaping from old ones” (p. viii) so in the followings we try to argue why it is irrelevant to use the old duration pattern in financial markets. As we will see most of the authors refer to short-term and long-term only without mentioning the exact duration.
Cortina et al. (2016) focuses on corporate borrowing and debt maturity and they take into consideration the effects on market access and crises. In one of their footnotes they acknowledge that there is no widely accepted benchmark of what long term is. Also they highlight the opaque maturity of corporate bond in case of developing countries and throughout their paper they try to claim that financial conditions deteriorate during crises. In a different paper Heyman et al. (2007) focus on the mix of debt. They conclude that maturity matching between debt and the duration of assets plays an important role in deciding the length of the debt maturity. Hernandez-Canovas and Koeter-Kant (2008) run an econometric analysis and suggest that the important variables determining small and medium-sized enterprises (SMEs) long-term debt include the length of the banking relationship and the number of banks involved. Alfaro and Kanczuk (2007) claim that prior to the financial crisis of 2008 many emerging market countries borrowed large amounts of short-maturity liabilities. Later they had to build up a large amounts of short-term debt to meet the payment obligations. Thus the latest financial crisis has also contributed to the changing interpretation and relevance of short-term and long-term in international finance.
Moro et al. (2009) highlight that short-term debt is the best financing tool because it is perceived to be cheaper. Thus, both the entrepreneurs and banks prefer short-term debt (Landier & Thesmar, 2009). Choe (1994) examines the impact of debt maturity changes on the expected returns of common stocks. It is claimed that a rise in short-term debt which replaces the same amount of long-term debt increases the expected returns of common stocks. It is because the move shifts risk from long-term debtholders to shareholders. When reading the paper it becomes clear that the author is not focusing on giving a definition for short-term and long-term. These papers and a couple of others (Garcia-Terul & Martinez-Solano, 2007; Alfaro & Kanczuk, 2007) are using the words short-term and long-term without pointing to any type of duration. In most of the cases, the readers and researchers simply follow the mental association stemming from the old textbooks and put an equation sign between short-term and one year.
When it comes to creating a more meaningful definition which better represents the ongoing changes happening in the capital and money markets, highlighting the issue of complementarity is vital. Also we claim that the ‘one-year’ and ‘more than one-year’ dichotomy had been already built on this feature and the simplicity of the approach gave rise to its popularity. We go further and we claim that for a better understanding of the two markets there is a need for thinking in dichotomies. By using them we can shed more light on the main differences and we not only focus on the issue of duration but on the other important features as well. Our recommended dichotomies are as follows:
These dichotomies help us better understand the main differences between the money and capital markets and directly point to the fact that focusing on the duration only is over-simplistic and tells less and less about the true nature of the two. When a proper definition is to be made, it is to be highlighted that the capital and money markets complement each other in many different ways: what is true for one of them, may not be true for the other. The differences can be understood by pointing to the existing and non-existing features. Capital markets are where there are mainly securitised assets clustered around longer-term goals with a longer duration and higher risk. Also, the connections are not clear and direct between the parties. Money markets are pretty much the complementary of these most important features.
Our study was clustered around challenging two well-known definitions in finance. Capital and money markets are differentiated mostly by pointing to the average duration and the capital markets are for long-term (usually more than one year) while money markets are for short-term (usually less than one year) transactions. Throughout the paper it was argued that this approach is obsolete and after showing why the one-year principle became popular the most important similarities (ten) and differences (three) between them were summarized. As the financial markets have been undergoing deep changes, understanding the nature of the changes are also of great importance. Apart from this, with the help of a literature review the paper tried to shed more light on the most important factors leading to the transformation. Based on this summary and the comparison of the two markets, one feature is striking: there is a strong complementarity between the two markets. These markets cannot be understood separately. When rethinking the definitions, the complementarity and other features are to be taken into consideration. Finally the paper tried to create an own definitions for capital and money markets. When formulating them, the duration remained an important factor, but a couple of other features were also highlighted.
The research was financed by the Research Institute of Competitiveness and Economy in University of Public Service.
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Secretary General of the Hungarian Banking Association professor, University of Miskolc, Miskolc, Hungary
professor, Sumy State University, Ukraine
associate professor, National University of Public Service, Hungary advisor to the secretary general of the Hungarian Banking Association, Hungary
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