Understanding Market Institutions and Credit Systems
Institutions of the Market
Central Bank
The Central Bank is responsible for issuing currency and operating monetary policy. It balances the money supply to control inflation, typically keeping it between 2-4% annually in a capitalist economy. Deflation (falling prices) is undesirable as it indicates low consumer spending.
Commercial banks also issue currency. The government encourages lending to increase currency supply and restricts lending to decrease it.
Basic Functions
The Central Bank’s core functions are issuing currency and acting as a rediscount bank. It provides an unlimited overdraft (rediscount line of credit) to commercial banks in exceptional situations, ensuring financial system security and credibility. Banks utilize this when facing abnormally high withdrawals.
Special Feature
The Central Bank controls short-term credit, stimulating it for economic growth and discouraging it during economic downturn. Idle capacity (production capacity exceeding demand) can cause inflation. Restricting credit during a downturn can worsen an economic crisis. Main instruments include changing the open market rate and reserve requirements.
Debt
External Debt
External debt is any debt a resident owes to a non-resident (person or entity), typically in foreign currency.
Domestic Debt
Domestic debt is public sector debt within the national market, using national currency.
Debt is normal in capitalism. Brazil’s domestic debt, though recently increased due to BNDES capital injections, is relatively low. The issue is high interest rates, a legacy of past high inflation. To decrease circulating currency during high inflation, the government borrows, creating debt without spending.
Open market operations are government financial operations involving debt acquisition or repayment, managing currency liquidity. Increased U.S. dollar inflows can raise inflation as people exchange dollars for the local currency, increasing circulating currency. The government must then counteract this increase. Currency should be neither undervalued nor overvalued.
Credit
Credit is crucial in a capitalist society. It involves lending currency with the promise of repayment and compensation.
Credit enhances economic liquidity and dynamism. For example, savings allow banks to lend to those in need, keeping money circulating and stimulating the economy.
Banks act as intermediaries, facilitating credit flow. They primarily work with others’ money, capturing and lending it.
Types of Credit
Credit is categorized into short, medium, and long term.
- Short-term credit (up to 2 years) finances consumption and working capital for businesses. For instance, a supplier might take a short-term loan to cover expenses until a customer pays.
- Medium-term credit (2 to 5 years) finances investments requiring longer repayment periods, enabling capital expansion.
- Long-term credit (over 5 years) finances major investments like property or machinery.
Commercial banks in Brazil primarily handle short-term credit, financing trade. Term funding must align with the loan period.
Debentures and Capital Loans
A debenture is a document signed when a business borrows money. The bank acts as an intermediary between the borrower and lender, raising funds from the market.
Medium to long-term loans can be repaid or converted to equity, as agreed in the debenture. Borrowed money is called a capital loan.
Repayment involves interest, while equity participation offers returns based on company performance. Capital invested in a company is called venture capital, reflecting the inherent risk.
Money and Capital Markets
- Money Market – Short term
- Capital Market – Medium term
- Capital Market – Long term
Capital markets, unlike money markets, generate new capital.