Class 2 role of finance in development 2018

Financial repression consists of various measures, such as interest rate ceilings, high bank reserve requirements, liquidity ratio requirements, government directives on the directions o

Class 2 Role of Finance in Development

1 Roles of the Financial System

(1) Definition of “Finance in Development”

Finance in Development can be defined as a “Financial System at Large.” The financial system does, therefore, encompass financial markets (e.g money market), financial institutions (e.g banks), and financial policies and related policy measures

as a whole

(2) Three Functions of the Financial System

(i) Settlement Function or Administering the Country’s Payments Mechanism

This function permits that, through a bank’s A/C, buyers and sellers can settle the

transaction of commodities without handling cash, which implies less risk and less trouble

(ii) Intermediation Function or Intermediating between Savers and Investors

In the financial system, funds flow from those who have surplus funds to those who

have a shortage of funds, either by direct, market-based financing or by indirect, bank-based finance

(iii) Function to Provide Stages Where a Variety of Economic Policies are Exercised Via the financial system, various economic policies are exercised Some of these are

the monetary policy vis-à-vis the price stabilization policy, the foreign exchange policy and the industrial policy vis-à-vis the credit rationing/incentive interest policy

These functions prevail not only within developed countries but also developing

countries

2 Economic Development and the Financial System

(1) Financial Repression and Keynesian Economics (From 1945 through the Middle of the 1970s)

(i) Why the repression policy was widely accepted and exercised?

Financial repression consists of various measures, such as interest rate ceilings, high

bank reserve requirements, liquidity ratio requirements, government directives on the directions of credit and so forth And policies of financial repression were exercised between 1945 to the middle of the 1970’s

There are two fundamental reasons why the repression policy was widely

supported and exercised during this period (a) Keynesian economics which is characterized as economics of effective demand to which government interventions are regarded essential and (b) central planning economies of the socialist countries were experiencing a relatively successful economic growth Thus, the role of government was well regarded as an intervening measure to manage economic growth

(ii) Components (policy measures) of the repression policy

a. Interest rate ceilings

Interest rate ceilings are set deliberately below the competitive free market equilibrium rate of interest so that credit can be allocated on non-price criteria

In this way, the private sector can be encouraged to undertake the centrally planned investment even though those projects might well be unprofitable at the market interest rate For instance, the loan interest rate ceilings have been used

in conjunction with import restrictions to encourage industrialization through import substitution (an industrial development policy)

Structuralists and neo-structuralists insist that raising interest rates increases inflation in the short run through a cost-push effect and lowers the rate of economic growth at the same time by reducing the supply of credit in real terms available to finance investment Thus, their models (of, say, interest rate ceilings) provide an intellectual justification for financial repression

Governments often impose a ceiling on the interest rate that banks can offer

to depositors Interest ceilings function in the same way as price controls, and thereby provide banks with economic rents These rents benefit the incumbent banks and provide tax sources for the government, paid for by savers and borrowers

b High bank reserve requirements

High bank reserve requirements are another policy measure of financial repression A bank must hold cash in reserve against deposits made be customers, which is usually kept in the central bank Governments require banks to meet high reserve ratios, and use the reserves as a method to generate revenues Because reserves do not earn interests, reserve requirements function

as an implicit tax on banks and also restrict banks from allocating a certain portion of their portfolios to investments and loans Consequently, the high bank reserve requirements reduce the money supply in the economy and result

in interest rate hike Thus, the reserve requirements have fiscal as well as monetary implication

c Liquidity ratio requirements

A variant of the reserve requirements includes required liquidity ratio which refers to highly liquid assets held by banks to meet short-term obligations For instance, banks are required to allocate a certain fraction of their deposits to holding government securities that usually yield a return lower than could be obtained in the market Another fiscal implication as a source of government revenue

d Government directives on the direction of credit

Financial repression also takes the form of government directives for banks to allocate credit at subsidized rates to specific firms and industries to implement industrial policy Government directives and guidance sometimes include detailed orders and instructions on managerial issues of financial institutions to ensure that their behavior and business is in line with industrial policy or other government policies

(iii) Fiscal implication of financial repression

In practice and reality, however, the predominant rationale for financial repression lies in its fiscal implications Interpreted as a discriminatory tax on the financial intermediation, financial repression comprises high reserve requirements, liquidity ratio requirements, interest rate ceilings and government directives on the direction

of credit and exchange controls This implies that, if institutional constraints prevent the government from collecting adequate normal tax revenue to finance the level of government expenditure it regards as optimal, financial repression may

be justified as a second-best strategy

The combined effect of the above financial repression measures implies that the government can funnel funds to itself without going through legislative procedures and more cheaply than it could when it resorts to market financing

The financial repression policy is meant to make more use of the third function, namely, “stages where various economic policies are practiced” within the financial system

(2) McKinnon-Shaw (Ronald I McKinnon and Edward S Shaw) Model and Financial

Liberalization (~From the Middle of 1970s through the Early 1980s~)

The financial repression measures described above, which are often introduced under fiscal exigencies, reduce the incentive to hold money and other financial assets, and

so reduce the overall availability of loanable funds to investors Not only may the

credit shortage encourage more low-yielding self-financed investment, but low subsidized interest rates to priority borrowers may also reduce the average return on credit-financed investment

The McKinnon-Shaw model formalizes these ideas, showing that financial

repression reduced both the quantity and the quality of investment in the economy as

a whole The McKinnon and Shaw model, thus, advocates financial liberalization which allows market forces to determine the rate of interest -the model postulates that as interest rates rise towards competitive equilibrium, it will have a positive effect on savings and investment This leads to the efficient allocation of capital, which perpetuate the development process or economic growth Since 1973 the McKinnon-Shaw financial liberalization paradigm has exerted considerable influence on macroeconomic policy in developing countries, particularly through the recommendations of the IMF and the World Bank

McKinnon also pointed out that financial repression encourages economic dualism,

while Krugman (Paul Robin) shows that financial repression can worsen income distribution, but need not necessarily cause economic dualism However, Galbis showed that financial repression not only worsens income distribution but also maintains economic dualism

The financial liberalization policy is meant to make more use of the second function, namely, “intermediation function” within the financial system

⇒ McKinnon’s Model

(See Maxwell J Fry, Money, Interest, and Banking in Economic Development, 1995 and Emancipating the Banking System and Development Markets for Government Debt, 19)

(3) The Financial and Banking Crisis ~1982 onwards~

(i) Banking Crises Experienced in the Past

Although the financial liberalization policy was pursued since the mid-1970s, quite

a number of developed and developing countries experienced banking crises According to an IMF survey, 133 countries out of 181 member countries experienced serious banking crises from 1980 through the late 1990s Such proliferation of large-scale banking sector problems has raised widespread concern,

as banking crises disrupt the flow of credit to enterprises and households, reducing investment and consumption and possibly forcing viable firms into bankruptcy A

banking crisis may also jeopardize the functioning of the payments system and, by undermining confidence in domestic financial institutions, they may cause a decline in domestic savings and/or a large-scale capital outflow Finally, a systemic crisis may force sound banks to close their doors

The definition of a banking crisis may be as follows:

 Financial Distress: “when a significant fraction of the banking sector is insolvent but remains open”

 Financial Panic: “when bank debt holders suddenly demand that banks convert 　　 their debt claims into cash to the extent that the banks are forced

to suspend the convertibility of their debt into cash”

The four indicators below may define a banking crisis more objectively and systemically

- Non-performing loans occupy at least 10% of total assets

- Cost of rescue operations is more than 2% of GDP

- Banking problems result in largescale nationalization of banks

- Emergency measures, such as deposit freeze, prolonged bank holidays, generalized deposit guarantees are introduced

(ii) Causes of Banking Crises

The causes of banking crises can be divided into two categories: microeconomic ones (bank specific or bad banking), and macroeconomic ones (bad operational environment)

a Microeconomic/Bad Banking Factors

A banking crisis often has its roots in poor bank operations including one of even

possibly more of the following: poor lending practices, excessive risk taking, poor governance, lack of internal controls, focus on market share rather than profitability, and currency and maturity mismatches in the banks themselves or among their borrowers

b Macroeconomic/Bad Operating Environment Factors

A banking crisis can arise from macroeconomic causes that are external to the

banking system as well Even a well-run banking system operating in a strong legal and regulatory framework can be overwhelmed by the effects of a poor macroeconomic environment against inadequate policies Macroeconomic difficulties may arise from lending booms, possibly stoked by excessive capital inflows or changes in tax rules; real estate and/or equity price bubbles that

inflate and burst; slowdown in growth and/or exports, or the loss of export markets; growing excess capital/falling profitability in real sector; lower overall investment; rising fiscal and/or current account deficits; weakened public debt sustainability; sharp changes in exchange rates and real interest rates; and so on Not all of these developments are under the control of the authorities but governments must be ready to adapt macro policies that take the conditions of a systematically distressed banking system into account

(See Speech Manuscript of Mr Stefan Ingves, Director of IMF, delivered on April 8, 2003 in Buenos Aires)

(iii) Sequential Responses to Banking Crises by the Banking Authorities

a A Ten Step Approach

Steps 1 to 4 The acute crisis phase: measures to stop the panic and stabilize

system.

Step 1 The crisis usually begins because, in one form or another, there is

excessive leverage in the economy In the early stages there may also be a degree of denial on the part of the banks and the

government

Step 2 Bank runs by creditors and depositors start and intensify The central bank

responds by providing liquidity support to the affected banks Step 3 When central bank liquidity is unable to stop the runs, the government

announces a blanket guarantee for depositors and creditors Such a measure is intended to reduce uncertainty and to allow time for the government to begin an orderly restructuring process

Step 4 All along, the central bank tries to sterilize its liquidity support to avoid a

loss of monetary control

Steps 5 to 8 The stabilization phase: measures to restructure the system

Step 5 The authorities design the tools needed for a comprehensive restructuring,

including the required legal, financial, and institutional framework Step 6 Losses in individual institutions are recognized The authorities shift the

focus from liquidity support to solvency support

Step 7 The authorities design a financial sector restructuring strategy, based on a

vision for the post-crisis structure of the sector

Step 8 Viable banks are recapitalized, bad assets are dealt with, and prudential

supervision and regulations are tightened

Steps 9 to 10 The recovery phase: measures to normalize the system.

Step 9 Nationalized banks are re-privatized, corporate debt is restructured, and

bad assets are sold

Step 10 The blanket guarantee is revoked, which, if properly handled, is a

nonevent because the banking system has been recapitalized and is healthy again

(See Carl-Johan Lindgren and Others (1999), Financial Sector Crisis and

Restructuring: Lessons from Asia, IMF Occasional Paper No 188.)

b Short-term and Long-term Approach

Short-term Responses:

In order to prevent the financial/banking system from collapsing, macroeconomic

as well as bank-specific responses are required In case that a currency crisis is involved, a comprehensive macro stabilization policy whose formulation and implementation are supported by IMF has to be implemented In this case, therefore, the banking crisis has to be taken care

of within the macroeconomic stabilization policy

Bank-specific responses include interest rate increase(s) to absorb liquidity and

prevent capital flight, liquidity supply and blanket guarantee (together with deposit insurance organizations, if any) to restructure banking institutions (suspension, nationalization, closure, and so on)

Long-term Responses:

Bank’s Corporate Governance; banks are required to pursue accountable and transparent management One of the measures would be the introduction of new accounting rules and regulations vis-à-vis evaluating land and other assets values, reflecting risks of foreign exchange fluctuations and so on

Prudential Regulations; prudential regulations cover factors such as

Capital adequacy, Asset quality, Management ability, Earnings and Liquidity (CAMEL in short) Through strengthening these factors,

banks upgrade their soundness

Strengthening the Bank Inspection Capacity of the Banking Authorities; the banking authorities must acquire knowledge and the expertise to supervise banks on and off site

　Promotion of Sound Competition among Banks and Pursuance of

Self-responsible Management; the banking authorities must introduce effective policy measures to promote competition among banks and

establish objective and clear criteria to suspend, transfer or liquidate banks upon their performances

(iv) Costs of Instability in the Banking System

According to empirical research, the costs of banking crises measured in terms of

fiscal expenditure tend to be larger in lower-income countries and those with higher degrees of banking intermediation Countries with large fiscal costs of crisis have in the past often experienced a simultaneous currency crisis, especially those that had in place a fixed exchange rate regime Further, the output losses that incurred during the crisis period are large, 15% to 29% on average of the annual GDP Output losses are usually much larger in the event of

a twin banking/currency crisis than if there is only a banking crisis, particularly

in emerging market countries

(See Hoggarth, Glenn and Others (2001), Costs of banking system instability: some empirical evidence, Working Paper, Bank of England)

3 Economic Development and Capital Fund Flows

In view that external capital fund inflow into developing countries plays an important role in their economic growth, let us review how economic growth of developing countries has been supported by the capital funds of developed countries (Figure 1) (1) From 1945 to First Oil Crisis of 1973

During this period, capital funds were supplied mostly by the governments of developed countries in the form of ODA and multilateral development banks (MDBs) such as the World Bank and the IMF Fund flows by international private commercial banks into developing countries (Private Flows) were quite limited during this period As the terms and conditions of the loan funds provided by the developed countries and MDBs were quite soft, there was little risk of foreign debt accumulation during this period on the part of LDCs

Thus, this was the period when government or public sector played the crucial role

in supplying most of required capital funds of development of the Third World This period coincides with Keynesian financial repression

(2) From the First Oil Crisis (1973) to the Late 1980s

During this period huge amount of oil dollars circulated, through international

commercial banks of the developed countries, into non-oil-producing LDCs The terms and conditions of these loan funds were quite harsh (dollar denominated variable interest rates) in comparison with ODA This is the age of “ODA + PF” in

the 1980s’ with strong dollar and high interest rates that deteriorated the B/P conditions of LDCs and the second oil crisis of 1978/79 triggered to surface the debt crisis of quite a number of non-oil-producing LDCs In 1982, Mexico declared

“default” as the first moratorium country

Thus, this was the period when capital fund for development had increasingly been supplied through private sector market This period coincides with McKinnon-Shaw’s financial liberalization However, multiple banking crises emerged continuously during the ‘80s and ‘90s

(3) Late 1980s and onwards

In addition to FDI, portfolio investment to LDCs considerably increased during this period In this connection, institutional investors of developed countries (Insurance Companies, Pension Funds, Investment Trust Funds and so on) played the central role On the other hand, both the developed and developing countries have jointly started to work to establish a sound, accountable and transparent financial system within the LDCs

4 Lessons Learned

(1) Regarding Financial Repression Policy

Keynesian economics reviews economic growth on the basis that macro savings equals macro investment However, it misses or does not explain the processes on how savings turn into investment In other words, the financial repression policy did not take into account of the intermediation function which was then left in a black box As a result, the financial repression policy was justified and implemented without scrutinizing the grand picture of the sound financial system development as a whole

(2) Regarding the Financial Liberalization Policy

On the other hand, the financial liberalization policy placed exclusive and excessive importance on the intermediation function of the financial system It then did not pay adequate attention to risks involved in the settlement function Further, it was assumed that the financial liberalization would bring about a well-functioning optimal financial market through its market mechanism and did not take necessary pre-cautious measures to prevent market failures such as the moral hazard case As

a result, it can be said that thus the banking crises occurred during the ‘80s and

’90s

Generally speaking, economic theories are constructed on selected influential assumptions If policies are formulated and exercised without fully understanding the limitations of those theory assumptions, they tend to result in serious consequences

In formulating and implementing policies, one should not forget that they must continuously be scrutinized from a comprehensive point of view

Figure 1 Capital Fund Flows to Developing Countries

0

100000

200000

300000

400000

500000

Net grants by private voluntary organisations Private capital flows

Source: DAC

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