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Financial Markets in Emerging Economies - Coursework Example

7 pages
1735 words
Harvey Mudd College
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Course work
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Financial markets are essential in every economy as it improves capital allocation to a real economy, boosts the economic growth, increases efficiency and improves risk sharing. However, not all countries are able to enjoy these benefits due to lack of a well-developed capital market. Additionally, the incentives introduced by different governments to improve the local capital market have had its successes and failures. This paper reviews the background of financial markets, how capital is allocated in domestic and international markets and Indias capital market and the challenges they face. The paper concludes by giving a set of recommendation and policies that can be utilized to develop and make the capital markets in emerging economies efficient.

Executive summary

The financial market of a country is essential in the growth of the economy and improving the social welfare. The market plays an important role in both the public and the private sectors in raising funds, reducing over-reliance on banks, balancing stability in the financial system and driving the economy. It is also critical in creating the much-needed jobs for the population. A well-developed market is essential in reducing the fluctuations that can be caused by the fast flowing capita. However, there are various challenges that still affect the capital market from high transaction cost to limited financial products. The lack of effective regulatory framework has also been a major challenge in the financial market.


Finance is considered as the engine of every countrys economic growth and development. For any country to achieve the economic success they need to have a stable and well developed financial system. Financial market can be described as a marketplace where securities are traded. The type of securities ranges from bonds, derivatives, equities, and currencies. Different markets range in activities and their sizes. Some such are the New York Stock Exchange is big and busy trading billions of dollars worth of securities each day. However other capital markets such as those belonging to developing countries are less busy and do not trade as much as the New York Stock Exchange due to various factors such as the underdevelopment of the market structure.

Over the years, countries have strived to develop and reform their capital market to enable them to integrate with the global market. Some of the reforms included removing restrictions which controlled the capital accounts and the banking system. The reforms were seen as a necessary initiative which would ensure the capital market is well developed and the economy can flourish due to the availability of large capital inflows. However, despite these benefits, some countries have seen their economies stagnate while others collapse.

Background of Financial Markets

The financial market and stock exchange started in the 17th and 18th century with banks having major ownership stocks. The trading in these platforms constituted small-scale operation with little technology to help with the transactions (Wright & Edinburgh Business School, 2004). The disbursement of information in those days was slow and the cost of doing business was high. The industrial revolution had a huge significance in the everyday life from science to commerce. The invention of machines meant that people could get enough food and even have a surplus. With humans being able to get surplus food, the crude system of good for goods was abandoned human beings started trading with stocks and currency.

As countries started trading with each other, the concept of stock markets emerged. Additionally, as people wished to start companies, they realized they need a substantial amount of capital that they could not raise alone (Melitz, 2011). Consequently, a group of investors came together and pooled their saving and started a business as partners each with his share. The development of an exchangeable medium allowed shareholders to sell or buy stock with other shareholders. The idea was very successful and it spread to other countries around the globe (Chambers et al., 2016). The idea was used extensively during the industrial revolution to generate large amounts of capital for startups. The increase in the number of shares traded led to the development of a marketplace which came to be known as the Stock Exchange

Capital allocation within domestic economy

The primary job of an economy is the allocation of capital to all sectors efficiently. To achieve high growth, capital should be drawn from sectors that are performing poorly and channeled to areas that have high prospects of return. Prices of commodities in an efficient secondary market is a critical tool in informing investors which projects have the prospects of high return and which ones are performing poorly (Maggiori, Neiman, & Schreger, 2017). When investors have trust in the domestic and its financial system, they tend to make a decision on where to allocate funds based on the available data. The supply and demand, therefore, dictates how money is allocated in the domestic market. Finally, capital allocation in domestic markets varies depending on the level of state ownership in different sectors (Wurgler, 2000). Countries with extensive state control in various sectors do not have a rapid increase or decrease in investments since the decision made are mostly political and not value maximization

Additionally, investors rely on the agency theory to ensure their money will be well utilized. The theory is used to help in understanding the relationship between principals and agents. The agents represent principals in a particular transaction and are expected to work with the principles interest in mind (Karpenko, 2015). When an agent works for the principle with self-interest, a conflict is bound to occur. Countries ensure there is efficiency in capital allocation but setting rules that govern the corporate sectors. Ethical behaviors should be reinforced to ensure investors are interested in investing in a domestic economy (Chorafas, 2004). Additionally, countries allocate capital to their economy depending on the level of financial development. For example, developed counties tend to invest more in their developing industries and less in their declining companies. Hence underdeveloped countries allocate more funds to their low performing industries to revive them and less capital on companies that are performing well.

Capital Allocation within International Markets

In the world of technology, investors are able to move their funds across borders and invest in different countries. The development of reliable structures has given investors confidence that their capital will be moved efficiently through national borders and their value can be recouped. The allocation of capital within the international market is driven by demand and supply ( Wu Long, 2011). When there is a deficit of funds in a certain country and the demand is there, investors move in a fill the gap by investing in the available opportunities. The international community is also interconnected with set rules that govern trade, therefore, making the transaction easier.

The level of financial development plays a critical role on how capital is allocated within the international markets. Countries with sounder financial system tend to attract more investor than countries whose financial market is not well developed. Since the risk associated with international trade is high, investors tend to put their money in countries with a high guarantee that their investment is safe ( Wu Long, 2011). The stability in the market also plays a significant role on how capital is allocated in the international market. Stock prices in low-income countries move up and down as a whole (en masse )while the shares in developed countries moved a relatively stable manner and independently. The volatility in different markets, therefore, dictate how capital will be allocated among these economies.

India as an Emerging Economy

India has come a long way from relying on agriculture to a mixed economy of manufacturing and service provider. Before the liberation of Indias market, the country had trade barriers, red tapes and the government controlled most of the economy. However, the economic liberation of 1991 saw India becoming one of the fastest growing economies in the world (Basu, 2004). However, poor management of public resources, underdevelopment of resources and corruption undermine the countries growth. Despite these challenges, Indias economy has been able to establish a strong manufacturing and technology economy. Labor regulations in the country are still evolving and the informal sector plays a great role in employment (Basu, 2004). The overall imports and exports are equal to 49 percent of the countrys GDP. There has also been an increase of foreign investment although they are screened. However, despite the screening, the government have reduced the ownership restriction that existed though not in all sectors. The government still controls some parts of the economy a factor that affects the countries growth (The World Bank, 2014). The investors who would like to invest in India might not get an opportunity as the government has not fully liberalized the economy. Despite the economic modernization, state-owned institutions still dominate the capital market and the banking system.

Challenges faced by India due to industrialization and its trade policies

Industrialization in India has brought with it great benefits such as improved infrastructure and creation of jobs. However, industrialization has also brought with it several challenges. The neoliberal reforms in India ensure the existing tariffs on foreign trade and investment were removed (Siddiqui, 2015). The country also reduced the role that the government placed in the economy and increased the role of the private sector and the market in the economy. The new changes had some effects on the economy of the country. First, there was no job expansion with the removal of the restrictions on trade (Siddiqui, 2015). The economy was therefore not able to lift people from poverty. Additionally, the open economy meant that India had to compete with other countries for the international market. Since there are countries which had the more skilled manpower and enough resources, India did not have a competitive advantage in competing with them.

Environmental pollution was also another factor that affected the country. The growth of industries has led to the pollution of both land and air. However, measures are being put in place to curb the emission of pollutants by companies. Local companies have also faced severe strain from cheap and quality imported products. Indias foreign trade policy aims at increasing the countrys share in the global market by 1.4 percent. However lack of understanding of trade policy, a poorly developed manufacturing sector and constrained relationships with trading partners has been a major challenge. Indias trade policy should be supported by economic reforms which will ensure a competitive, technological driven and open economy if they want to achieve their goals.


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