Chapter 5
MONEY MARKETS AND CAPITAL MARKETS
85 Money Markets and Capital Markets
Money is the medium of exchange commonly employed in selling and purchasing goods and services. The parties to a business transaction agree on the value of the good or service and this value is expressed in terms of money. Each nation has a monetary system with hard currency of gold, silver, or copper, paper currency, or a combination of the two. The relative values of national currencies are established through trading and international banking agreements. In fact, prevailing free trade practices and instantaneous wire fund transfers have made the exchange of currencies a global market operation influencing worldwide monetary conditions. Real estate is priced in terms of money and real estate investments are money, so the value of money influences real estate prices. Therefore, it is imperative that appraisers understand domestic and global monetary values.
The term money is difficult to define and various definitions are used by economists. Some believe that money is "currency in the hands of the public plus demand deposits at commercial banks." Demand deposits are funds that can be withdrawn at any time such as in money chequing accounts. Others say that money is "currency plus demand and time deposits at commercial banks." Time deposits are funds that can be withdrawn only after proper notification such as money in certificates of deposit. Money has also been defined as "currency plus demand and time deposits plus the liabilities of nonbank financial intermediaries."1
The Bank of Canada disaggregates the money supply further into five components, the most commonly used definitions of which are as follows. M1 is currency (coins and paper currency, or fiat money) and demand deposits (less private sector float) and excluding Government of Canada deposits. M2 is considered to include all those items in M1 plus personal savings deposits and nonpersonal notice deposits held at chartered banks. M2+ is comprised of the components of M2 plus deposits at trust and mortgage loan companies, and deposits and shares at caisses populaires and credit unions, deposits at Province of Ontario Savings Office and Alberta Treasury Branches, holdings of money market mutual funds and annuities issued to individuals. M3 is M2 plus nonpersonal fixed term deposits of residents booked in Canada.2
Most of the money in circulation is in chequing accounts. Whether the money supply is defined in terms of currency, account balances, or both, its value is influenced by its availability. The value of money is a global, rather than simply domestic, consideration. Important relationships are well established, but subject to variable exchange ratios between national currencies and the rapid movement of freeflowing funds.
MONEY SUPPLY AND DEMAND
Supply and demand relationships set the cost, or price, of money. When money becomes plentiful, the price declines; as it becomes scarce, the price rises. The price of money is expressed as an interest rate, i.e., the cost to borrow funds. Interest rates are particularly important in the real estate industry because most investments are created by combining debt and equity funds. When the demand for money is high and its supply is low, the cost of capital, or interest rates, increase. These higher interest rates affect real property values.
There is a difference between money and other commodities on the supply side of the pricing formula. The demand for money is a product of the operation of economic forces. The supply of money available for lending is a function of the
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level of savings, which reflect personal, corporate, and governmental accumulation, both domestic and foreign.
Economics determines the amount of savings, but the quantity of Canadian currency is subject to regulation by the Bank of Canada. The Bank of Canada has the power to regulate, through the "Bank Rate," general interest rate levels, which strongly influence the discount rates and overall capitalization rates used in real estate valuation. In foreign countries, various central banks perform the same functions as the Bank of Canada, and they generally have the same powers. Because monetary operations are global, the availability of funds must be considered on a worldwide basis. This has been especially true in recent years as Canada has become a net importer of capital, which has to be sought on terms and conditions established not by the Bank of Canada, but by international trading and exchange rates.
Trading Money Instruments
A money market represents the interaction of buyers and sellers who trade money instruments, usually of a term less than one year. Money instruments include Government of Canada securities (including guaranteed securities); provincial securities; bills of exchange and promissory notes, endorsed, accepted or issued by a chartered bank; mortgage backed securities; Special Drawing Rights issued by the International Monetary Fund; certificates of deposit or term deposits; commercial paper; bankers' acceptances; municipal notes or debentures; and Eurodollars. Although it is called a "market," the money market is not formally organized like the Toronto Stock Exchange. Rather, it is an overthecounter operation which employs sophisticated communications and computer systems to provide traders with accurate, readily available information on national and international transactions. Because the Bank of Canada regulates the money supply, it influences daily trading activity in the money market and the cost (i.e., interest rates) of money market funds. The money market, in turn, greatly affects the real estate industry because its shortterm financing vehicles are needed to fund real estate construction and development. This is one of many ways in which the availability and cost of money regulates the volume and pace of the real estate industry.
A capital market reflects the interaction of buyers and sellers trading long or intermediateterm money instruments. Long and intermediateterm instruments usually mature in more than one year and include bonds or debentures, term deposits, stocks and mortgages. Although stocks are capital market items, they are equity investments with no fixed maturities. The distinction between money markets and capital markets is not sharply defined because both involve trading in funds for varying terms and both are sources of capital for all economic activities, including real estate.
In money markets and capital markets, there are observable relationships between various instruments that stem from differing interest rates, maturities, and investment risks. Normally, an individual who invests in a longterm instrument is believed to assume greater risk than one who invests in a shortterm instrument. Therefore, the longterm investor is compensated with higher yields. In other words, longterm instruments usually offer higher yields than shortterm instruments. This situation is graphically portrayed in what has come to be known as the normal yield curve. (See Figure 5. 1.)
87 Money Markets and Capital Markets
Figure 5.1Normal Yield Curve: Low Inflation Period
Certificates of Deposit
7.0%
6.5%
6.0%
5.5%
5.0%5.25%
4.5%
4.5%
4.0%
3.5%
6 months 1 year18 months2 years30 months
Term
Figure 5.2Inverse Yield Curve: High Inflation Period
Certificates of Deposit
16% 15%
14%
12%
10% 10%
8% -
6%-
4%-
2%-
6 monthsI yea r18 months2 years30 months
Term
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The relationship can be reversed. In periods of high inflation, investors are reluctant to take longterm positions. They fear that escalating interest rates will erode their capital, so they try to keep their money in shortterm instruments. The Bank of Canada, however, wants to combat inflation, so it causes interest rates to rise. This action is intended to be temporary, lasting just long enough to dampen investors' inflationary expectations. Consequently, in inflationary times shortterm yields may be greater than longterm yields, and the yield curve is said to be inverse. (See Figure 5.2.)
Fractional Reserve Banking
When a commercial bank makes a loan to a business or an individual, it credits the chequing account of that business or person with the amount loaned. In a sense, banks manufacture money through this loan process because they create money by monetizing debt. Commercial banks effectively fund a large volume of loans by entering the money market. They raise the required cash by selling their paper e.g., certificates of deposit or term deposits to a broad group of investors. Of course, the moneycreating activities of banks are restricted because the Bank of Canada requires that they maintain reserves equal to specified percentages of their deposits. If a bank has a 20% reserve requirement, each dollar of its reserves can support four dollars of deposits, which can be created by extending four dollars in loans and crediting them to the borrowers' accounts. This arrangement is called fractional reserve banking and it is used by central banking systems throughout the world.
FUNCTIONS OF THE BANK OF CANADA
The Bank of Canada was founded in 1934 as a privately owned corporation. By 1938, ownership had passed in two stages to the Government of Canada and, since that time, the Minister of Finance has held the entire $5 million share capital issued by the Bank. The Bank of Canada Act provides that the annual profits of the Bank go to the Government of Canada for credit to the consolidated fund.
The responsibility for the affairs of the Bank of Canada rests with a Board of Directors composed of the Governor, the Senior Deputy Governor and 12 directors. The 12 directors selected from various regions of Canada and having diversified backgrounds are appointed for threeyear terms by the Minister of Finance and with the Approval of the Governor in Council. The Minister of Finance is also a member of the Board but does not have the right to vote; other members each have one vote. No director can be a director, officer or shareholder of a chartered bank, a Quebec Savings Bank Act institution, any member of the Canadian Payments Association that maintains a deposit with the Bank, or an investment dealer that acts as a primary distributor for new Government of Canada securities.
The head office of the Bank of Canada is located in Ottawa, and offices are maintained in Halifax, Saint John, Montreal, Ottawa, Toronto, Winnipeg, Regina, Calgary and Vancouver. The Bank is also represented in Saint John's and Charlottetown.
The duties of the Bank are stated in a very general way in the Bank of Canada Act:
“... To regulate credit and currency in the best interests of the economic life of the
nation, to control and protect the external value of the national monetary unit and to
89 Money Markets and Capital Markets
mitigate by its influence fluctuations in the general level of production, trade, prices
and employment, so far as may be possible within the scope of monetary action, and
generally to promote the economic and financial welfare of the Dominion."3
The Act does not specify the methods by which the Bank should pursue its objectives but certain powers it grants to the Bank, together with certain provisions of other legislation, enable the Bank to influence the rate of monetary expansion and credit conditions.
The Act also does not specify which of the several duties it specifies are to be given priority when matters of conflict between these mandated areas arise. By the early 1990s, the Bank had issued policy statements that inflation control was considered the priority goal. In February of 1991, the Governor of the Bank of Canada jointly announced with the Minister of Finance targets for reducing inflation and reaching price stability in Canada. The announced goals provided for a reduction to 2% in yearoveryear inflation by the end of 1995, with the objective thereafter being "further reductions in inflation until price stability is reached."
The Act gives the Bank the sole right to issue banknotes in Canada. It also gives the Bank the ability to establish primary and secondary cash reserve levels for chartered banks, to buy and sell a broad range of financial assets, which, in conjunction with the Bank's management of the Government of Canada's bank balances, enable the Bank to vary the amount of cash reserves available to the banking system, thus influencing the rate of growth of the banking system, the level of shortterm interest rates, and the trend in the money supply.
The Bank may make advances to charted banks and other financial organizations. It may also make shortterm advances to the Government of Canada or the government of any province. The minimum rate at which the Bank is prepared to make these advances is called the "Bank Rate" which is established weekly based on an auction it undertakes of funds. The "Dealer Rate" is established at the same level as the Bank Rate. Lending is done in the form of Sale and Repurchase Agreements and Bank of Canada Advances.
In periods of economic crisis, the Bank of Canada supplies financial markets with necessary liquidity. For example, when the stock market crashed in October of 1987, the Bank of Canada immediately reduced the bank rate.
In fulfilling its mandate, the Bank of Canada regulates money and credit, which are the lifeblood of the real estate industry. Therefore, appraisers should be familiar with the Bank's daytoday activities as they affect the supply of money and interest rates. Because of the global nature of financial markets, the prevalence of instantaneous communications, and the securitization of realty interests, the monetary activities of the central bank can have an immediate impact on real estate markets.
Reserve Requirements
Within statutory limits, the Bank of Canada can fix the amount of reserves that member banks must maintain. One requirement of membership in the system is that member banks cannot make all their deposit liabilities available for business loans; they must agree to keep part frozen in reserve, held in the form of coin, Bank of Canada notes and in deposits at the Bank of Canada. Alternatively, a bank that does not participate directly in the daily settlement and clearing process may, with the approval of the Bank of Canada, satisfy its reserve requirement by
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holding deposits in a reserve account with another chartered bank. The reserves of the latter will then be increased to reflect this arrangement.
The Bank of Canada changes the amount of its reserve requirements from time to time and these changes expand or contract the volume of money and credit available within the banking system. If the Bank wants to restrict the money supply, it increases deposit reserve obligations; if it wants to increase the supply, it lowers the obligations. Demand deposits (i.e., chequing accounts) can be subject to a reserve requirement of up to 10%, and time funds (i.e., savings accounts) can be subject to a reserve requirement ranging up to 3%.
The Bank Rate
The Bank Rate is a major creditregulation tool. Banks regulated by the Bank of Canada can borrow from the Bank and obtain funds for their customers even in periods of great demand. To get these loans, member banks agree to pay interest at a rate determined through weekly auctions, at a level onequarter of a percent above the yield on newly issued federal 91day Treasury bills, sold at weekly auctions. The borrowing privilege of these banks is not unrestricted, however. The Bank of Canada can deny loan requests when it believes that borrowing is not in the best interests of the economy.
The borrowing privilege is a vehicle for expanding the monetary supply; its curtailment limits or contracts credit. When the Bank Rate is low, banks are encouraged to borrow and the amount of money available to the economy expands. When the Bank Rate is high, member banks are reluctant to borrow and credit is generally restricted. Thus, the Bank Rate helps determine the prime rate, the interest rate that a commercial bank charges for shortterm loans to borrowers with high credit ratings. The Bank Rate is generally about two percentage points below the prime rate, or bank prime as it is also known.
FISCAL POLICY
While the Bank of Canada determines monetary policy, the Department of Finance manages the government's financial activities. Parliament, Cabinet, and on rare occasions the Senate, shape fiscal policy through decisions involving the federal budget, expenditures, and revenues. The Department of Finance implements these policy directives. Essentially, this ministry pays bills and its sister Department of National Revenue raises funds. Expenditures for national projects and activities are made pursuant to Parliamentary approval.
When income matches or exceeds spending, the federal budget is balanced. When the outflow of funds exceeds collections, a federal deficit results. Spending that is not covered by tax funds produces deficits, which are financed by the sale of public debt instruments such as government bonds and treasury bills, or Tbills as they are sometimes described. When deficits are monetized by selling large amounts of debt, the Bank of Canada is tacitly expected, though not mandated, to cooperate by supplying the banking system with sufficient reserves to accommodate the debt sales program and still leave enough credit for the private sector.