Capital Allocation by Financial Markets


Financial markets are the arena where prices develop to allow businesspeople to exchange their financial assets (Bolton, Santos and Scheinkman, 2016). Historically, financial markets were real meeting areas where traders met face-to-face and traded by crying-out prices in the market. Today, this human dimension has become lost, and prices get displayed on a network of computers allowing traders to buy and sell goods through their computers without human intervention (Pilbeam, 2018). Therefore, the marketplace has become more virtual with a reduced need for physical proximity between individuals who are trading on assets. Financial markets have existed as a method of risk redistribution from risk-averse to less or reduced risk-averse. Some of the risks get linked to holding financial assets as the value of these assets can either appreciate or depreciate.

Those asset holders that are more risk averse often look for methods of using financial markets to acquire intermediaries that are willing to take risks instead of them but at a fee or reward (Madura, 2014).

The Concept of Trade and Development in Financial Markets

Trade, on the other hand, is a concept involving purchasing and selling of services or goods where the compensation is paid to a seller by a buyer. Trade can also include exchanging services or products between parties. However, money is the most common exchange medium in the transactions beside barter trade. Additionally, there is virtual payment using virtual currency with the most popular being bitcoins. Trading is also purchasing and selling securities in financial markets. For example, buying stocks. In financial markets, an investment is usually an item or asset acquired with an objective of generating appreciation or income. Investment is also viewed as the purchasing items or goods which are non-consumable today but for future use to develop or create wealth (Charles, Schmidleiny, and Watts, 2017).


Investment is also known as monetary assets acquired to provide income at a later time when it is sold for profit or at a higher price. There is also the concept of development in financial markets. The primary objective of growth in financial markets is to enhance the ability or capability to act or perform as the middle-person or intermediary efficiently. An efficient or effective financial market is that having proper breadth or depth regarding supply while using a vast range of instruments such as using credit risks or providing issuers choices with the intention of satisfying the asset demands of all classes. On the side of the market, there is a need for the demand of a sizeable investment from investors having different risk-return appetites (Hawkins and Bishop, 2016).

Besides, diversity among investors and issuers often result in an excellent market view mix causing an active financial assets exchange. A financial market which is highly liquid is good because it can accommodate various and sizeable financial instrument issuance at the lowest price effect allowing quick transfer of these financial instruments at reasonable costs (Van den Berg, 2016). This report will discuss capital allocation within a domestic economy and international markets. The report will also evaluate China as an emerging economy particularly the challenges the country is facing due to trade policies and industrialisation.

Capital Allocation within a Domestic Economy

States with developed or advanced financial markets often increase their investments in industries which are growing as compared to countries with financially undeveloped financial markets. They also reduce investment in those industries which are declining more than undeveloped states (Maggiori, Neiman and Schreger, 2018). It has become discovered that although developed countries financially may not carry out high-level investment, they often appear to allocate investments better (Korinek, 2018). In comparison with states having substantial financial markets, other states both underinvest in industries which are growing and overinvest in declining industries. It is apparent that economic development aid countries take good advantage of their investment opportunities. Therefore, financial markets can provide or allocate capital in domestic economies (Schmukler and Abraham, 2017).

Capital Allocation Strategies, Frameworks, and Models in the Domestic Economy

One dominant theory in the allocation of capital in a local economy involves the idea that effective secondary market prices aid investors to identify better investments from investments not worth pursuing. Another theory is that intermediaries and leaders identify projects or screen out good projects. There are also agency theorists who argue that external pressures and managerial ownership motivate managers to follow policies that foster maximising of value. States having stock markets which impound firm-specific data into stock prices have less synchronicity of stock prices and show better capital allocation as demonstrated by Aviso et al. (2015). It is suggested that secondary markets which are efficient regarding prices aid managers and investors to identify suitable investments from unworthy ones.

Besides, state ownership gets linked with the allocation of capital which is relatively weak. Countries having substantial state ownership in their economy cannot increase investment as much in the growing economies as well as fail to decrease investment in industries that are declining. These findings are similar to occurrences in government systems which are socialists dominated concerning capital allocation. According to Chiu (2018), the elimination of resource allocation which is politically motivated to favour market allocation has hugely benefited privatisation globally. Better allocation of capital domestically has also been associated with strong rights for minority investors. The allocation advantages of the minority investors are from limiting overinvestment particularly in industries which are declining as compared to increasing finance supply to sectors which are growing (D’Erasmo and Mendoza, 2016).

Efficiency and Effectiveness of Financial Markets in Allocating Capital

The effectiveness of the allocation of capital is correlated negatively with the extent of state ownership in the economy. The efficiency is also positively linked with the level of organisation-specific movement in returns of domestic stock as well as the investor’s legal protection. The ability or effectiveness in capital allocation depends on efficient investment which also depends on smooth operation of two main processes. The first process requires investors and managers to differentiate investment opportunities which are promising from those that are not. The second needs managers to have incentives that they can invest in promising opportunities and not concentrate on other goals or objectives.

Theoretically, financial development facilitates the two processes. Regarding identifying opportunities, economists have considered prices of a secondary market which often act as public signals (Stiglitz and Rosengard, 2015). The signals are usually very informative in more liquid and larger markets. Additionally, larger markets motivate arbitrage. Furthermore, size and liquidity increase acquisition of private information returns because traders who are informed can often hide their data through various or many trades. Economists believe that banks aid in aggregating relevant data about opportunities for investment. It has been demonstrated that centralised intermediaries often economise on the amount incurred while acquiring information regarding diverse opportunities.

Individual investors are thus saved from evaluating every project (Tietenberg and Lewis, 2016). Consequently, the level or extent of information acquisition becomes increased before a decision to supply is made. Regarding intermediary functions, even with clarity on the best investments, where there is lack of good governance, there is also no assurance that the insiders and managers will follow the investment policy which is to maximise value (Tietenberg and Lewis, 2016). Because of these agency problems, free flow of cash becomes wasted as the money produced from functions that are not earmarked for better projects or repay finance suppliers is reinvested in projects with poor prospects but offer some private benefits to insiders. The problems reach state-owned organisations with greater or equal force. In these state-owned organisations, allocation of capital is unlikely to be controlled or guided by maximisation of value. Instead, they get motivated by political motives. Besides, inadequate monitoring and limitations in budgets often give state-owned firm managers poor incentives for effectiveness or efficiency. Therefore, incentives offered by governance institutions or private ownership directly impact the allocation of capital (Restuccia and Rogerson, 2017).

Allocation of Capital Internationally by Financial Markets

Capital allocation internationally involves putting money or investing in either developed markets or emerging markets or both. The manner in which a fund’s capital gets allocated results to or determines its return, risk, and cost. Investments done on emerging markets might become conducted in various ways including buying financial assets from domestic market stocks directly, acquiring access through country funds that have the state’s financial assets secured by deposit firms or institutions like the global depository receipt or purchasing financial holdings of a particular emerging state directly through international markets (Bustos, Garber and Pontialli, 2016).

Generally, emerging markets are seen to be less institutionalised as compared to developed markets. The investment merits in markets which are emerging for a particular fund often rely on the risk/return tradeoff (Bandari and Javakhadze, 2017). Finding the tradeoff needs that these funds contemplate a specific characteristic of the emerging market, the associated risks of investing in the particular market and the different regulation and structure of the said market.

Equity funds that are private sometimes overinvest in a single area across the world while underinvesting in other regions. The pattern is notably observed while investments are made in emerging economies because some of the countries or regions get a larger share of investments from private equity (Razin and Sadka, 2018).

Capital Allocation Strategies, Frameworks, and Models Internationally

There are seven critical international trade theories, and the first one is Mercantilism theory which states that a country’s economic strength relies upon its gold holdings and silver amount. More independent countries economically are those with greater holdings. Additionally, the notion in support of greater exports as well as promoting minimising imports belong to this theory. If a state has more to pay for its imported goods or products, its economy is more likely to decline (Cheng et al., 2014). There is also the absolute advantage theory which is based on the idea of raising efficiencies in production processes. In this theory, high-efficiency processes of manufacturing products as compared to another state in the world provides the country with high advantage.

This concept relies upon the notion that when two states specialise in a similar product but that of one country is of better quality or less price, these will give that absolute state advantage than the other state (Forbes et al., 2016). There is also the theory of comparative advantage which supports relative productivity. The comparative advantage concept states that a state with absolute advantage is one that creates or develops more than a single product than the other state which has less efficient methods to develop the particular product, which is available readily to support or boost the country’s productivity.
Then there is the Heckscher-Ohlin theory of international trade which states that when the supply of a good increase as compared to its demand within a market, it is likely that its price will decline and vice versa. Therefore, a country’s export should majorly comprise the product which is abundant in the country. The other theory is the Lifecycle concept which says that as newly created good’s demand increases, the home state should begin exporting this product to other countries. When the demand rises, local manufacturers need to become open to satisfy the request. This scenario covers the entire globe occasionally, therefore, making the product on demands a standardisation. Besides, there is the global strategic rivalry model which is based on rivalry on a worldwide level, targeting corporations that are multinational as well as the struggle required to achieve advantage to other companies internationally. A new organisation should optimise some factors which can lead their brand in defeating all challenges to gaining influence and success to become recognised in the world market (Zkjadoon, 2016). The last theory is the national competitive advantage concept which considers factors such as resource availability within the local market as well as their prices as necessary for offering a stable and sustainable environment for the growth of trade. Besides, the capability of a firm to overcome competition and its ability to upgrade determines its brand’s success rate (Zkjadoon, 2016).

Evaluation of China as an Emerging Economy

China made their five-year plan (2010-2015) which was also the 12th and was considered a significant period for the country to realise their strategic objective of industrialisation before the year 2020. Their goal of becoming a highly industrialised country has met some challenges. The first challenge emerges in its highly growing economy which is restrained or limited through increasing demand for energy as well as other resources. For instance, the country is forced to rely heavily on iron and oil export from other states. Second, the country needs to put in place policies which are environment-friendly to decrease the intensity of energy consumption and emission of carbon dioxide (Shahbaz et al., 2015). Third, the traditional strengths of the country have been in its land and labour force and might lose their competitive edge due to the world becoming highly globalised and opening capital market where the competition is also becoming more depended on technology and knowledge. Fourth, the country’s industrialisation is both managed by the local and central government which have developed challenges like overcapacity and protectionism. Various local governments have also changed their land and labour costs to pursue and attract temporary growth of the economy. Besides these challenges, becoming highly industrialised has resulted in urbanisation and air pollution (Shabazz et al., 2015). Because of rapid growth, the country has experienced adverse ecological and environmental destruction with a quite significant damage. The adverse effects of China’s environmental issues on its economy are looked at as likely to result in an 8% GDP drain. Additionally, air pollution in

China has become an apparent ecological challenge and a significant health issue. The country’s indoor and ambient air pollution is majorly responsible for premature deaths. Various studies show that because of the damage caused by air pollution on health, 7.1% of the country’s income is used to tackle the problem (Su, Zhang and Su, 2015). There are at least 20 cites in China which are the most polluted in the world. The Chinese government said that approximately a fifth of the country’s urban people breath highly polluted air while only a third of their cities meet the minimum standards regarding pollution. There is also the problem of water shortage in China. Water is a crucial natural resource and is the most necessary item to maintain life. This makes it the most valuable national resource. However, water shortage in the country has severely restrained their development regarding living standards and agriculture. An increase in drought and reduction in farmland areas have affected the country since 1980 (Su, Zhang and Su, 2015). It is reported that the 1998-1999 drought was the biggest that affected the country in the 90s. Besides, arable land in China’s north is 40% of the entire arable land with only about 6.5% water resources available in these land. The rate of water consumption in China has also risen steadily with the increasing population which demands water availability and better living standards. China also faces water pollution which is one of the significant environmental challenges the state faces after fast growth. China has implemented numerous policy measures with the aim of controlling pollution of water, yet the problem is yet to become fully contained (Hamashita, 2017). There has also been the challenge of trade policies or barriers that have impacted the country’s international trade. The many trade barriers that are in place for international trade has caused higher costs for companies and customers. Both the manufacturers and distributors have been forced to incur

extra costs for the required goods to operate their business smoothly. For instance, the imports and exports have become more costly as compared to China’s domestic trade. The tariffs put on China exports have forced the companies to increase prices for their goods, and their customers have also been forced to pay for these more expensive goods (Gilpin, 2018). Moreover, the increase in costs of imports has led to limited products or choice of goods particularly Chinese products. Many small businesses are often not able to pay for increased costs due to higher tariffs and thus offer fewer goods. Despite all these, both South and East Asia have continued to put in place more trade restrictions to secure a market for their domestic industry as well as special interests. However, the long term effect of these policies is affecting economic growth as well as decreasing the efficiency of the overall economy (Gilpin, 2018).

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Through the background of financial markets, we realise that financial markets have existed as a method of risk redistribution from risk-averse to less or reduced risk-averse. With financial markets in mind, we understand that trade mostly refers to purchasing and selling securities in financial markets. The report has also shown that States with developed or advanced financial markets often increase their investments in industries which are growing as compared to countries with financially undeveloped financial markets. They also reduce investment in those industries which are declining more than undeveloped states. It has come out clearly that a dominant strategy used in the allocation of capital in a domestic economy involves the idea that effective secondary market prices aid investors to identify better investments from investments not worth pursuing. Additionally, we notice that the effectiveness of the allocation of capital is correlated negatively with the state ownership level in the economy. The efficiency is also positively linked with the level of organisation-specific movement in returns of domestic stock as well as the investor’s legal protection. We have also seen that Capital allocation internationally involves putting money or investing in either developed markets or emerging markets or both. Lastly, we have seen that although China is currently a growing economy due to high-level industrialisation, it faces challenges such as environmental pollution, water shortage as well as other challenges due to international trade policies.


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