Sunday, April 29, 2007

FE 102|Final

FE 102

Section A:
1. “To understand the 1990s system of international finance, it is necessary to examine how the debt crisis evolved in the 1980s. Discuss this statement in the context of the following questions:
A. What were the main mechanisms and arrangements through which the debt crisis was managed and ameliorated?
As far as Mexico debt crisis of 1982, the IMF linked its willingness to lend to Mexico with the willingness of private banks to extend their lending to Mexico. IMF programs implemented before lending. Baker plan*
Change in attitudes: risk was no longer considered an either or (paid or defaulted). Secondary markets to manage risks besides the internal bank evaluations. The recycling of the ‘petrodollars’ through the system.
Increased amounts of capital available to the World Bank and the IMF for lending to LDCs.
IMF tough economic measures to improve their longer-term ability to service their debts. The IMF program (measures) summed up as devaluation, deflation (tight monetary and fiscal policies) and deregulation (market based reforms, reduce trade protectionism and removal of interest rate ceilings).
Baker plan of ‘growing out’ of the debt problems. This done by trade liberalization, cuts in government spending and relaxation of regulations relating to inward foreign investment.
Baker to Brady: secondary markets developed for selling outstanding loan assets. Provisioning of the debt to account for increased risk but not forgiving loans.
Brady: studied a case by case basis for deciding the right measures to take including voluntary debt forgiveness with funds set aside from the World Bank and IMF. Last was restructuring of the debt for 20 to 30 years and implemented medium term IMF stabilization programs.
B. What were the main effects on the international financial system of the debt crisis?
Provisioning of the debt to account for increased risk but not forgiving loans.
Developing secondary markets to evaluate risks.
The IMF and World Bank played a critically important role in encouraging adoption of sound macroeconomic policies in debtor countries and coordinating private sector claims, thus reducing the risk of defaults.
Banks were not bailed out at the public’s expense.

2. Explain the concept of arbitrage. In your answer, show how it relates to the purchasing power parity theory of exchange rates and how it relates to links between the spot and the forward exchange rates.

Arbitrage is the exploitation of price differentials for risk-less guaranteed profits. Taking price differences between different markets and making money.
For the spot exchange rates arbitrage, it is carried out by two methods. The first is arbitrage across different trading centers. The exchange rates would be the same in London as well as New York or the difference in prices can be arbitraged to gain a profit. The second is cross-currency arbitrage, and is profits derived from trading among 3 or more currencies. As long as there is differences in results from A to C is different than A to B to C.

Arbitrageurs can also make a profit with the forward exchange rates by using the Covered Interest Parity (CIP). By using the following formula:
F=((r(f)-r)*S)/(1+r)+S as F=forward, S=spot, r(f)=foreign interest rate 1 year, and r is the 1 year forward domestic interest rate.
If there is a difference between the calculated forward rates compared to the market rate then arbitrageurs will transfer monies until the rates match. “Covered interest parity is achieved as a result of arbitrage between the spot and the forward markets.”

A currency is said to be a forward premium if the forward exchange-rate quotation for that currency represents an appreciation of that currency compared to the spot quotation.
IRP (Interest Rate Parity) page 9-12 work book Unit 2.

Purchasing Power Parity is supposed to result from arbitrage between products in two different markets. If the price of product (tradable goods) is priced differently between markets then someone could purchase the products at the lower market and sell in the more expensive market.

3. The implication of the Marshall-Lerner Condition is that devaluation may be a cure for some countries balance of payments deficits, but not for others. Critically discuss this statement.
The effectiveness of the devaluation (in a fixed system) or depreciation (in a flexible system) of the currency for reducing a trade deficit depends on "well-behaved" demand and supply curves for foreign exchange. The precise conditions that guarantee that devaluations "work" are the Marshall-Lerner conditions. These conditions simply state that the sum of the absolute values of the elasticities of home demand for foreign goods and foreign demand for home goods must be greater than one. The Marshall-Lerner conditions link the effectiveness of a monetary instrument with analysis of the demands for home and foreign goods in the "real sector".
The basic idea behind the Marshall-Lerner conditions is that the exchange rate affects the terms of trade between two countries. Terms of trade are defined as the ratio of export prices, Px, over import prices, Pm. In domestic currency units, the price of imports Pm is equal to the exchange rate R multiplied by the world price level P. Thus, Pm = R P. A devaluation or deprecation thus implies a fall in the terms of trade, in domestic currency units. Similarly, in foreign currency units, a devaluation of the home currency raises the terms of trade of the foreign country.
Under the Marshall-Lerner Condition when the added values of the price elasticities of both demand for exports and demand for imports is greater than one, then devaluation/depreciation will lead to improvement in the balance of payments. The opposite holds that if the absolute sum of the elasticities is less than one then devaluation will lead to a worsening of the CA (current account) Balance. And if the sum is close to unity (1) then little effect will happen on the CA.
One assumption on this model is that only one country devalues their currency. If one country sees it to their advantage to devalue and everyone else does, then none of the countries that devalue will be better off and most will be worse off.
When devaluation occurs, it basically changes the terms of trade. It becomes more expensive for a given quantity of imports and returns less revenue for a given quantity of exports. But as the relative prices change then the volume effect will improve the CA. The question is whether the volume effect will more than offset the price effect.
For most small countries though, the relative price levels for exports and imports are fixed (near infinite elasticity) and they become price takers. This should always lead to an improvement in CA, as exports will increase without affecting the market.
And it is worth pointing out that over the short run price elasticities tend to be inelastic. This creates the J-curve effect of short run volumes that do not change much in the short run but in the longer term the market can adjust to the price levels by adjusting quantities.
But this approach leaves out some considerations that the Absorption Approach could be used to overcome. They are: 1) it does not deal with the indirect effects of devaluation (i.e. reducing real income for example) 2) It concentrates on the current account and not internal balance (e.g. full employment) 3) It concentrates on the effect of exchange rates but is not useful for analyzing the effect of other balance of payments policies.
4. Using the Mundell-Fleming model, explain the effect on internal and external equilibrium of a change in exchange rates. Explain and discuss the role of capital mobility in the model. ***

5. The Polak model is sometimes described as a version of the monetary approach to the balance of payments. Explain and discuss the main assumptions and conclusions of each theory.
The Polak model is often considered the precursor to the monetary approach to balance of payments and is derived from two simple equations:
1. M=kPy or written that a dM=k*dY
Where M is the money supply, k is the inverse of the velocity of circulation of money or in other words the parameter that measures the sensitivity of money demand to changes in nominal income, and P is the price level.
2. M=mY
Where M is the demand for imports, m is the marginal (as well as average) propensity to import and Y is a country’s income (Where applicable nominal values.). In the two above equations, m and k are assumed to be constants.
The conclusions are that changes in the money supply is the only instrument of macroeconomic policy, but that budget deficits are assumed to be the primary reason of changes in domestic credit (i.e. increases in the money supply is the primarily from bank lending to the state).
From above equations we could also conclude that changes in the money supply are by definition equal to the change in a country’s foreign reserves plus the change in domestic credit of the banking system.
D M(s)=d R + d D
And the change in foreign reserves is by definition equal to exports minus imports and plus net capital inflows of the non-bank sector.
The first significant difference the monetary approach has from the Polak model is that it defines the balance of payments as both the current account and the capital accounts. In addition to the assumption that velocity of money is constant, the monetary approach also includes two additional simplifying assumptions as in:
1. Fixed Aggregate Supply or the aggregate supply curve is vertical. That is there is no change in quantity from a change in the price level. Since Ms equals Md and k is constant then for a change in Ms then only prices can change. Even if not at full employment as Pilbeam assumes, the market could be rigid as well as wages can be sticky in the short run.
2. Purchasing Power Parity is the final assumption that underpins the monetary model. Exchange rates must change so the following equations are in equilibrium:
S= P/P(f) or P=S*P(f)
Where S is the exchange rate defined as domestic currency per unit of foreign currency, P is the domestic price level in the domestic currency and P(f) is the foreign price level in the foreign currency.
The conclusions of the monetary approach are that balance of payments disequilibrium is merely a reflection of disequilibrium in the money market. A deficit in BoP is due to an excess of the stock of money in relation to the MD. Surplus in BoP is a monetary flow resulting from an excess demand for money in relation to the stock MS.
While the Keynesian approach views the CA items as autonomous items and the capital account and reserve changes as the accommodating items, the monetarist approach is completely the reverse. Or in other words Keynesians look at the top of the balance of payments statistics (i.e. current account) and monetarists look at the bottom of the BoP (i.e. changes in reserves).
Agents decide firstly the amount of real balances they wish to hold and then spend accordingly, and not the other way around.
An important conclusion about the monetarist approach is that under a fixed exchange rate the authorities give up autonomy on their domestic monetary policy and thus inflation is not under the control by the authorities. Also whether the BoP imbalance comes from OMO (Open Market Operations) or FXO (Foreign Exchange Operations) is of little relevance. This should be emphasized that under a fixed exchange rates monetary policy is endogenously determined by the need to peg the exchange rate, while under floating authorities can exogenously determine its money supply.
6. “Since both fixed and flexible exchange rate systems have weaknesses, the optimum would be an intermediate system of managed exchange rates.” Explain and discuss that statement.
Variations of the Managed Float are the crawling peg, the gliding band and the dirty float. It should be noted that managed float may lead to one-way speculative gambles when the rates should change and has not changed yet.
The three main reasons presented for why to have a managed float is:
1. Authorities Might be able to produce a more appropriate exchange rate. That sounds like a tall order and even if they are able to produce a more appropriate rate they still may have to pay the price to go against the market. But intentions and open statements can sometimes indicate to the market what the intentions of the Central Bank are. It is also important that the officials do not become the destabilizing actor by holding to rates that are clearly indefensible.
2. Mitigate the costs of exchange rate overshooting also assumes that authorities know what the appropriate exchange rate should be. It could just as easily undershoot the mark.
3. Smooth the economic Adjustment Process is a process by which an economy is allowed time to transition. The transition can take many forms but many times if the transition is carried out too quickly then not only the economy may suffer but also the political structure may be weakened. This I feel is a very important point that transitions in economies tend to be good in the long run the short term pain can cause major problems. Price changes may prove more acceptable method of reducing real wages (Keynes) since all suffer more or less equally and do not upset the wage differentials much.
4. Since fixed exchange rates work best when the objective is price or output stability (i.e. money demand shock) and flexible exchange rates work best for aggregate demand or supply shocks when favoring income stability, thus it could be conceivable that a country may wish to switch to managed exchange rate to accomplish certain goals and switch to free floating exchange at other times.
Under perfect capital mobility then a nation’s interest rate and money supply are effectively taken away from the central bank.
7. Explain and discuss the principles of monetary unions in the light of European experience.
The first step in creating a monetary union is the setup of a currency bloc which is defined as when the currencies of all the countries are united by fixed exchange rates. This is hard to do at first so ‘Snakes’ are usually set up that maintain the exchange rates within bands usually defined as a percent change. In addition member countries attempt to follow compatible macroeconomic policies through policy coordination. This was used by most Western European countries during the 1970’s.
Eventually a single currency can replace the individual ones, and this arrangement becomes a monetary union. This system though must have coordinated monetary and fiscal policies encompassing all members. And in the system one state usually assumes the leadership role and as the key currency within the system (trading currency). For the EU experience it was the German State (especially in monetary policy) that members attempted to follow and the Deutschemark was the key currency during the process.
The European Monetary System (EMS) was setup during the 1980’s to arrange for co-operation between members through Exchange Rate Mechanism. ERM attempted to stabilize the cross exchange rates of a wider group of countries and again tied to the Deutschemark.
But some setbacks came when Britain abandoned fixed exchange rages with its partners in 1992.
Hierarchy of the three types of coordination: 1. exchange information 2. acceptance of mutually consistent policies and 3. joint action. This is versus coordination with no implied significant modification of national policies and thus little more that ‘consultation’.
European Union (EU), European Monetary Union (EMU), Exchange Rate Mechanism (ERM), European Currency Unit (ECU), European Monetary Fund (EMF),
In 1971, Snake (other EEC (European Economic Community) countries) in the Tunnel (USA exchange rate) and Belgium/Netherlands being the worm inside the snake.
In 1979, the European Monetary System was established to provide a ‘zone of monetary stability’. The ERM consisted of two parts: 1. bilateral exchange-rate bands (parities) 2. individual currency band against the ECU. The grid in #1 required mutual agreement to make changes and thus Finance Ministers of the currencies participating in the ERM decided these issues.
The ECU was a weighted basket of the 12 member currencies, and from this was an ‘indicator of divergence’. The idea was that it would single out the currency that was diverging from the average agreed parities before bilateral action was required, which in essence was an alarm bell to tell which country needed to take action.
The EMS also established the European Monetary Cooperation Fund (EMCF) where members deposited 20% of their gold dollar reserves in exchange for ECUs that were to be used for exchange market interventions instead of the US dollar. And like any other bank members could draw upon the funds to defend their exchange-rate parities and manage transitory BoP problems.
Results of EMS: Exchange Rate Stability, Anti-Inflation Zone.
Two main components of a Monetary Union; an exchange-rate union and complete capital market integration. More specifically the former means that the countries agree to no margin of fluctuation and thus by all intents and purposes creates a single currency. Complete market integration means that all obstacles to free movement of financial capital are removed and that financial capital is treated equally in all member states.
Implicit requirements: members harmonize their monetary policies, single union central bank, and central bank needs to be invested with a pool of reserves of third-country currencies.
A History of the Road to European Monetary Union:
The Rome Treaty of 1957 created the European Economic Community (No Monetary Union) and a priority was the creation of a customs union. The CU involved the adoption of a common tariff policy for third party countries and removal of trade barriers between members.
Hague Summit in 1969 the 6 agreed in principle to establish complete economic and monetary union commencing 1971 and expected completed by 1980. This set up the Werner Report (1972) which the main result was the snake in the tunnel which failed by 1978. This was because of the wide differences in how the economy was handled in each country as a result of the oil crisis and external supply shocks to the system of embargoes. Single European Act (1986) was aimed to create a single market by 1992. Delors report (1989) broadly outlined a proposal for achieving EMU which was initiated by the EEC in 1988 and was to commence in three stages:
1. Greater cooperation and coordination in fiscal and monetary policies as well as removal of financial integration which was the creation of a ‘Single Market project’. (90-93)
2. Phase II was the readying of the eventual permanent fixing of exchange rates and the amendment of the Treaty of Rome which resulted in the signing of the Maastricht Treaty. Established the European Monetary Institute which was to assist progress on economic convergence (European System of Central Banks) and make preparations for the final phase (Statute of the E Central Bank, European System of Central Banks). (1994)
3. Creation of a single monetary policy set by the ECB. 1999
8. In the light of a theory of capital flight from less developed countries, discuss policies that could reverse it.
Policy problems:
a. Debt overhang
b. Dual exchange rates causes a problem since most models are based on one exchange rate instead of one for transaction on the current account of the balance of payments (the commercial rate) and the one for capital account transactions (the financial rate).
c. Parallel Foreign Exchange Markets is the results of having ‘unofficial rates’ as well ‘black markets’.
d. Currency Substitution is when residents of a country uses currency of another country (e.g. Israel and Mexico during the 1980’s). Should have led to a North America Union.

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DF201|Assignment I

Development Finance: Principles & Experience was my hardest class so far. But now that I am again reviewing notes on Two-Gap model and Financial Repression, I thought I would post my assignment here.

Assignment One
Discuss by means of appropriate theoretical arguments and relevant examples, the links between financial reforms, stabilisation and regulation.
Before I begin to answer this question directly, I would like to shortly explain why the concepts of financial reforms, stabilization and regulation are important. Financial reforms most often started with “Financial Liberalization”. The purpose of financial liberalization in a nutshell is to increase the efficiency of investment and the efficiency of credit allocation. As financial markets are freed to charge the prevailing market rate determined by supply and demand, this reduces the economic dead weight.
But as we learned financial liberalization involved more than simply interest rate rises alone. The budget deficit, money supply and thusly inflation were all affected by financial liberalization which lead to stabilization concerns. The ideals of stabilization are to maintain relatively low but real rates of interest, constant and consistent growth of the money supply (M1, M2 or any other gage), low unemployment rates, consistent and steady economic growth and deficits that would not crowd out private investment without excessive monetization of debts.
Thusly, “There are also reasons for suspecting that liberalization itself may increase instability in the credit market, especially where it is done by means of sudden and extensive deregulation.” (Unit 3 Page 18) This shows that regulation is still needed to overcome either market inefficiencies or the basic lack of information on any and all parties. While deregulation can cause stabilization problems, new regulations and policies may not react in time or appropriately since new institutions with short histories may not know how to implement regulations under the new regime.
Let us look at the steps of financial liberalization while having an eye toward effects on stabilization and what regulators did and did not do to solve or make worse the general goals of financial liberalization. Before the advent of liberalization the simple model was largely known as ‘financial repression’ model. Under the repression model the government implemented regulations that not only restricted interest rate ceilings (deposits and loans) but also the borrowers were segmented based on which industry was considered more important by the government. This lead to a higher variance of interest rates for those who were favored and those were not, the latter having to finance through alternative means at much higher rates usually through secondary intermediaries. But much of the finance of developing countries was self financed. Though not definite, financial regression may actually lead to higher inflation. The reasoning goes that under financial regression the government does not have a market so that the private market may not be able absorb the government debt. This leads to monetized debt and thusly an increase in the monetary base and money supply through the money multiplier and lastly an increase of inflation.
The first effect of financial liberalization assumptions is a raise in real interest rates and nominal rates if stabilization is maintained, but this will only occur if there is some degree of competition. In an oligopoly, competition is limited and the banking group may favor low and even negative real rates of interest for savers. It also may not need to raise interest rates for the lenders because of symbiotic relationships.
Next higher real interest rates will increase the real savings rate. But according to microeconomics this may or may not be the case. If savers negative income affect of rising interest rates is greater than the substitution effect (as in a Giffen good) then they will actually save less. Unlike other goods, savings will increase net worth, so that a rise in interest rates can increase short time consumption as well as long term. Although the text believes that it is possible for “savers in developing countries are not behaving as utility-maximisers” (Unit 1 page 12). I believe that the basic assumption of consumers always being utility-maximisers is true and that in this case the maximum utility for these savers is to equalize income from savings over time derived. And on the borrowers side facing an inelastic demand curve may not decrease consumption or reduce negative savings to offset the increase in consumption of savers. Two possible explanations for inelastic demand curves are expenses related to health and education. Both would be time sensitive decisions and may not matter what the interest rate is in the short term. As Giovannini stated “Serious doubts are cast on the view that the interest elasticity of savings is significantly positive and easy to detect in developing countries.”(Volume 1, Page 59)
A side point I want to make is: when interest rates rise this will lead some creditors to become debtors. But considering that the transaction cost whether on the supply side or the demand side is greater than zero then the slope of the interest rate line (-(1+r))should be ‘kinked’.
Higher real interest rates will lead to an improved quality of investment by weeding out the projects that are not economically efficient investments. But lack of information at least asymmetrical and knowledge about risks involved in a project (including macroeconomic factors) may create conditions of lending to already existing customers (larger and older firms) and not to new ventures. This link may also be compromised if the banking structure is dominated by an oligopoly or monopolistic behaviors. Even if at no time does a ‘price war’ (oligopolistic war) breaks out causing stabilization problems, the oligopoly will create monopoly rents signified by widening interest rate spread. (It would have been fun to live in Canada in 1972!) These rents do not necessarily lead to “high accounting (reported) profits” according to Galbis on page 80 in notes. The rents are either used to “pad the nest” or to give subsidized loans to bank holding affiliates and owners. Even if the owners of the bank holding company and the borrowers are not directly related, there still may be informal ties that lead to collusion. Some of the problems of the Saving and Loan fiasco in the USA could be attributed to members of congress also having an interest in the S&Ls. Thusly people that should oversee the regulation process may have a vested interest in the outcome of regulation. Galbis points out that “In a number of countries one can observe symbiotic relationship between the groups and the political machinery” (Volume 2, page 88). The spread in interest rates also (in addition to excluding non-group) leads to income redistribution from lower to higher income groups. Since economic stability also rests on political stability this redistribution over the long run may cause instability.
Now that I have exhausted all the reasons that financial liberalization could not work for the intended purposes, let me assume that interest rates do increase and savings follow, since we know that it did have changes to many economies. The economic order of events that lead to many stability problems were as followed: (1) Interest rates rose for borrowers that previously had preferential rates. (2) These industries and businesses became distressed and were no longer able to make interest payments on their debt. (3) Banks not wanting the borrowers to go under may make distressed loans. (4) Eventually these loans made the banks themselves financially distressed. (5)These problems can remain hidden until liquidity may hamper the banks ability to create new loans. (6) Banks would often raise interest on deposits to try and increase amount available to lenders and to create some liquidity. (7) But these also lead to ‘riskier’ investments to recover the higher deposit rates. (8) Eventually it becomes completely insolvent whether caused by a run on the bank or not. (9) This may cause either other banks to have runs on them also or just a gradual liquidity problem of other banks. “One troubled bank’s customers may not be able to repay debts to the customers of another bank.” (Unit 3, Page 9) (10) The central bank must either close banks or risk shrinkage of the banking system or bail out the financially distressed banks. (11) Stabilization policies of the government are in jeopardy that is caused by monetizing the debts of the banking system and thusly the money supply increases. (12) Even unemployment in the banking sector can lead to instability policies not being effective.
It must be noted that the initial cause of the financial distress may be caused outside the banking system. This can be caused by deteriorating macroeconomic conditions, policy changes, and credit market structure and behavior.
Now let us look at ways that regulation needs to change or adapt after financial liberalization while still maintaining stability. The central bank did have mechanisms for adequate supervision in place but in many times failed to adequately implement such actions due to lack of knowledge or the will to carry out such policies.
One consideration to make is to make sure that competition is increased and not decreased in conversion from financial repression to financial liberalization. One way is allowing foreign banks to compete but with restrictions on how quickly they can enter the market. Though hard to implement it may be worth to separate the decision making of bank loans from the investment side. Banks just like business can tend to over imagine the business cycle will always be up. Even the USA was caught in the dot-com bubble. Though not the best solution at all times but breaking up the holding bank structure may be necessary to increase competition.
Ronald McKinnon response to failings of the financial liberalization policy was to state that sequencing of events is more important than sudden and drastic changes to the system through extensive deregulation. With this I think that the time frame of liberalization is very important. The US and UK economies have taken 100’s of years to develop and we expect LDCs to do it in 1 year? If McKinnon had an exact sequence of events of financial reform, I would have loved to seen it. As far as I see his main points were that: financial liberalization should be done in an environment without liberalization of other segments such as trade or capital markets. Secondly, keep short term indebtedness out and allow long term capital inflow. Thirdly, slow down capital inflows even if coming from the World Bank, and do not bribe the countries into liberalization. Fourthly, fiscal policy should be brought under control and it is best if there is a fiscal surplus before financial liberalization is begun. Lastly the IMF and World Bank should still play supportive roles in developing countries by providing technical assistance and manage international crisis in the short term.
According to Arnaudo and Conejero the use of early warning indicators could have been used to predict bank failures with the necessary data that had already been available. Duenas and Feldman had six indicators based on financial statements that could have predicted the problem of the banking system. Table 12 (Volume 2, Page 47) clearly shows that problem loans were increasing steadily from 1976 to 1980. I am certain that even the quarterly numbers would have been more dramatic in consistent growth.
Galbis makes a strong point of making sure to enforce regulations on individual lending limits and for interrelated groups. It does not say how to know about the groups of borrowers but inside transactions may also be hard to control if the use of “straw hat purchasers” is possible. Interlocking directorates may be easier to detect but “the more subtle informal relationships among directors and officers and shareholders” (Volume 2, Page 91) seems too difficult. Truth-in-lending provisions are important in a free market so that consumers have as much information about the products they want to purchase. In developing countries the lack of information available can hinder economic growth.
Even though Galbis seems to support democratic forms of government, he points out that at times economic efficiency could be compromised if individuals or groups create demands that do not have the concern of the national interest at heart. As noted: “Democratic regimes are subject to intense pressures from the groups, but their openness to scrutiny by the public is more likely to ensure the national interest than authoritarian regimes”. Long term stability and economic growth is more likely to occur under liberal democracies than any other form of government, so even if there are economic distortions in the short term we can expect better outcome over the long run.

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Sunday, April 22, 2007

DF201|Assignment Two

Yes high real interest rates should be of concern to not only the poor peasants but also to “all academic economists concerned with this subject” (Ref. 2, page 477). One fundamental assumption that both Bottomley and Bhaduri uses in their models is that the Money Lender is a monopolist and thus receives monopolistic profits (Ref. 1, page 249 “Monopoly Profit” and 2, page 468 monopolistic advantages). While yes by definition the poor have little in assets, I believe they have alternatives to the local money lender. Access to commercial banks and even State Agricultural Banks may be difficult, but the formal side can still provide alternatives with cooperatives as in Users Associations, Credit Unions, informal savings clubs and rotating savings and credit association (ROSCA). Next the poor have access to the informal sector by tapping into anyone that has excess liquidity for the short term. The first place that is available is friends and families with little or no interest, usually in a reciprocal manner. Local Merchants or input traders may want to lend for short periods to tide over their customers. Crop buyers may place more value for the peasant’s crop than what it is worth at the time of need, and may be expecting future harvests to pay for any opportunity costs of lending in the short term. Landlords, other wealthy individuals or even local politicians may be of assistance.

One reason that poor peasants have little access to formal markets is due to the cost structures of Money Lender’s cost or more broadly to include local lenders versus Urban Bank’s costs (Ref. 1, page 244). Bottomley’s theoretical cost structure shows that at lower denomination of loans the local lender is more cost effective that the Urban Bank. Since the personal interaction between the local lender and the borrower, administrative cost, default cost and overall risk premium are lower than the Urban Bank. As the size of the loan and borrowers net income is increased, the basic rate or pure rate takes up a larger share of the local lenders costs (75% local lender vs. 50% for urban bank. The basic rate for the local lender is greater since he/she may have idle cash for long periods with little investment opportunities in the short term. Even though at higher denominations default is less of a cost factor, Bottomley does not explain why the default would be lower for the urban bank. I would assume that at any level of loan the local lender would be best able to collect through a wide variety of intimidation and/or social pressures.

The second assumption is that poor peasants have an inelastic demand curve for the money lenders services. Taking into the fact that peasants have alternatives listed above and that even the poor have assets, then options are available. Even in some of the poorest in countries such as India, many families have jewelry or other non-productive assets that can be sold or pawned. And according to Patrick: “In developing countries, a considerable portion of the savings used relatively unproductively are probably hoarded by large numbers of relatively poor people.” (Ref. 3, page 57). When peasants are facing long term unfavorable conditions (as shown in Figure 5.1, Unit 5, Development Finance Handbook) then this should tell the economy to transfer resources to more productive uses. This is evident in the migration from rural areas to urban areas for quite some time.
Since we are looking at the problem of rural peasants having the feast or famine cycles, we could devise plans that tried to smooth out the cycles of liquid assets. While none of these require direct government control, the government should act as educator and facilitator. One is to grow food and basic needs for the family to avoid having to borrow for the basic needs. Another is to have more than one type of crop that alternates harvest times and thus income times.

Another problem facing poor peasants and most all farmers is inelastic demand curves for their products. If crops are bountiful, then per unit prices garnered goes down and may not help the farmer in total cash generated. One option is for the government to set up markets to purchase excess supply on the short term and distribute it in the long term.

Rural poor peasants face higher real interest rates because of the size of loan and underlying net income, and overall costs that the money lender has to factor into the loan (Ref. 1, page 244). Bhaduri believes there are perverse incentives for the money lender to undervalue the assets of the peasants and covet those assets. The reason for undervaluing the assets is there may be little to no market for the peasant’s assets and thus any price is more subjective than market derived. The money lender may create interest rates high enough that he feels default is most assured and then he can dispose of the assets at a profit (especially if he has access to outside markets) or use for his own benefit. If there were markets created for the peasants assets then this would reduce this market imperfection.

Some social pressures on money lenders because of the “highly personalized nature” (Ref. 2, page 476) limit the money lender from foreclosing on peasants assets. Large land owners, local merchants, input traders or crop buyers with excess liquidity may not want to alienate the local population to gain in the short term. And some groups may not want to deal with disposing of assets like the merchants. And lastly if a default occurs on a large scale, then even money lenders may be painting themselves as carpetbaggers and be dealt with harshly.

Laws and regulations can lessen the incentive for money lenders to seek to liquidate the assets of the poor peasant. Legislators need to balance the property rights of both the lender and the borrower and thus try to eliminate incentives to default or create defaults. Most countries continually work to make a good balance between these rights.

Given that poor peasants face high interest rates at times when liquidity of other groups may also be low, then the traditional approach to economic development has been to subsidize loans in the rural areas. Some reasons for this approach has been the view that credit was a major constraint for farmers, the credit shortage led to high interest rates, high interest rates caused a vicious cycle of poverty and indebtedness combined with limited savings resulted in the need for “supply led” strategies in the form of formal financial institutions (Page 4-5, Unit 6, Development Finance Handbook).

Government loans that are subsidized “rarely give a satisfactory profit compared with the returns from investments in agricultural research and extension or in social capital” (Page 5, unit 6, Development Finance Handbook). And “it is much easier to expand the supply of loans than to implement land reform, extend rural roads and infrastructure, improve irrigation and drainage, or diffuse new technology. (Page 15, unit 5, Development Finance Handbook)

Not only is government financed loans economically inefficient, they misguide the market and not accomplish the goals it assumes to fix. Just because interest rates are lowered and there is increased availability of loans does not mean that there will be a resulting increase in capital. “Both substitution and diversion create obvious difficulties for purpose specific credit programs” (Page 9, unit 6, Development Finance Handbook). This means that loans are fungible and can be used for whatever purpose the borrower so wishes. Even when granted in goods (for example food stamps), these goods can be exchanged for cash. Under microeconomic theory, subsidizing food or any other good may not increase the utility of the recipient more than cash transfers. The recipient may even sell his goods at a loss rather than keep the goods for self consumption.

Subsidized interest rates distort the market by creating negative real interest rates resulting in an income transfer (from saver to borrower), fails to reward savings adequately, undervalues the real costs of capital in different sectors, results in excess demand and conversely a shortage of savings, and does not reflect the social scarcity of capital (Page 9-10, unit 6, Development Finance Handbook). And in turn this leads to credit rationing that favors the richer borrowers as shown by Bottomley (Ref. 1). So the policy to increase loans to poor farmers actually resulted in fewer loans to poor farmers. This is shown by Gonzalez-Vega in “it has been estimated that only about 5 percent of farmers in Africa and perhaps 15 percent of farmers in Asia and Latin America have had access to formal credit” (Ref. 5, page 366).

To avoid the traps with subsidized credit and market manipulations with regard to interest rates, innovative institutions may be the solution. ROSCA is one such approach that rotates the members between creditor for multiple time periods and debtor for one time period (Page 15, unit 6, Development Finance Handbook). This can lead to “landless laborer buying land, a porter or driver purchasing a rickshaw or taxi, or a peasant household buying cattle” (Page 18, unit 6, Development Finance Handbook). But too often this looks to be a lottery that would be used for trivial and non-investment purposes. This is especially true if interest rates are high since it would entail a transfer of wealth from last debtor to the first debtor. The first to receive the bounty would pay back the “debt” at cheaper dollars while the last to receive the bounty would have paid in with expensive dollars and received cheap dollars in return. With high interest rates, the cycle would have to become shorter and shorter until it no longer had any savings value to the participants.

Other cooperatives may also play some role in allocating credit in rural areas. Just as Japan used Postal Savings, many LIC’s may benefit from this. The government can improve the cost of transactions and reduce the spread between saving and lending rates. Just as it was suggested that the government would be best to improve the infrastructure of the economy than to subsidize loans, the government could improve the infrastructure of the RFMs by disseminating information and training, providing group loans to get groups formed, using the postal services assets to provide banking services also, and lastly to advise and consent.

While groups lending has some benefits of reducing loan transaction costs, the “recent research on group lending shows results that are less positive than originally hoped” (Ref. 4, page 482). But “group loans appear to work best where groups have non-credit reasons for collective actions” (Ref. 4, page 482). Finding the social bonds that will make groups work does present a challenge, but once the social bonds are in place then the default rate should be low as well as transaction costs and administrative costs. Thus credit unions that are tied to a job should do better.

The last point I want to make is that even if governments want to promote the well being of poor peasants with subsidized investment and loans, it should first make sure that macroeconomic policies support the rural farmers. Stable prices and stable money supply would help more in the long run. Even massive inflows of aid can reduce the ability of farmers to compete in the world market. “Wuyts argues that the net effect of aid inflows was to foster a pattern of accumulation and industrialization that was not sustainable in the long term” (Page 19, unit 7, Development Finance Handbook).

1. Bottomley, Anthony (1975) ‘Interest Rate Determination in Rural Areas’, reprinted in Von
Pischke et al. (1983).
2. Bhaduri, A. (1977) ‘On the Formation of Usurious Interest Rates in Backward Agriculture’,
reprinted from Coats and Khatkhate (1980) pp 465–77.
3. Patrick, Hugh T. (1966) ‘Financial Development and Economic Growth in Developing Countries’,
Economic Development and Cultural Change, vol 14, no.2, January, The University
of Chicago Press, Chicago.
4. Adams, D.W. and Robert C. Vogel (1986) ‘Rural Financial Markets in Low-income Countries:
Recent Controversies and Lessons’, World Development, vol 14, no 4, April.
5. Gonzales-Vega, Claudio (1983) ‘Arguments for Interest Rate Reform’, Chapter 43 in Von
Pischke et al. (1983).


1. Washington Concensus???

Just like many words thrown around they soon lose any defined term that conveys from one person to another what it means. Much as Neocons, Neoliberalism and Globalization have all lost meanings of what they convey from one person to another. Maybe I am trying to be too technical but I think that each theory is made up of a set of assumptions or beliefs that frame the mindset. But many people start attributing ideas that have nothing to do with the core beliefs are, like in 'Neocon Economic Theories'.

When I first came across the phrase "Washington Consensus" all I could see that could possibly be related was the work done by Jacques J. Polak in the 1950s. One of his most recent articles was the working paper for the IMF entitled: The IMF Monetary Model at Forty (registration required for an original PDF here).
As you will see when you come to study this approach, the financial programming methodology of the IMF is in fact based on a simple model, first developed by the Dutch economist Jean Jacques Polak. Polak was a staff member of the IMF at the time he developed his model, almost a half century ago. Notwithstanding the fact that the model was developed many years ago, you will see that the basic assumptions contained in the Polak model remain as applicable today to the approach that the IMF takes in establishing a financial programme with its member countries as the model was when it was first proposed.

I also covered some of his theories in my assignment for FE201, and if anyone wants me to post more about his theories from class notes, let me know.

After reviewing my notes again preparing for my tests I ran across the following passage in regard to alternatives to the Financial Programming Approach:
3.3.1 What are those different theories?
One example is the ‘financial liberalisation’ model developed by Ronald McKinnon, Edward Shaw and their followers. It provides a theoretical framework for policies of high interest rates and the abolition of credit controls, the policies that both the IMF and World Bank have promoted vigorously since the early 1980s.

Another of the theories underlying major IMF and World Bank policies is the theory of ‘rent-seeking’ developed by Ann Krueger (1974). This models the incentives to ‘wasteful’ activity, which the existence of quotas and controls may stimulate by encouraging unproductive activities that seek monopoly profits. It has provided a theoretical justification for World Bank policies to abolish controls and quotas.

Similarly, the theory of ‘comparative advantage’ provides a logic for IMF and World Bank attempts to abolish barriers to international trade.

The point is that the financial programming and growth programming frameworks (which can be classified as ‘macroeconomic’) do not include these (‘microeconomic’) theories as integral parts, but the latter are important elements in the theoretical discourse of the IMF and Bank underlying their key policies.
3.3.2 Structuralist models of stabilisation policy
In the earlier sections of Unit 3, you met some of the key challenges that characterise the IMF’s approach to stabilisation. These issues revealed that although
the IMF approach to stabilisation policy has clearly become the dominant approach since the 1990s, it is by no means considered to be either the only or the best approach to stabilisation. In fact, the financial programming approach represents one of several alternate approaches that policy makers can apply Unit 3 Alternate Approaches to Stabilisation when trying to stabilise their economies. One of the most powerful of these alternative approaches is the structuralist approach.

The "Structuralist Model" was covered in much more depth but was of great interest to myself, and hopefully will be covered in other posts. But know we have name for it as well as a couple of names that correspond to what others say is the Washington Consensus.

I know that my posts can be pretty boring with just some cut and pastes, but this is a process of building a library of the different theories. This luckily now has tied in with my "Development Process: Principles and Experience". So this now leads to re-exploring "The Two Gap Model" and the "Financial Repression Model" that Shaw and McKinnon developed in the early 1970s.


Friday, April 06, 2007

Quotes of Note (In Defense of Globalization)

Quotes of Note:
Adam Smith The Wealth of Nations
It may sometimes be a matter of deliberation, how far, or in what manner it is proper to restore the free importation of foreign goods...when particular manufacturers, by means of high duties or prohibitions upon all foreign goods which come into competition with them, have been so far extended as to employ a great multitude of hands. Humanity may in this case require that freedom of trade should be restored only by slow graduations, and with a good deal of reserve and circumspection.

John Maynard Keynes
Paul Valery's aphorism is worth quoting-"Political conflicts distort and disturb the people's sense of distinction between matters of importance and matters of urgency." The economic transition of a society is a thing to be accomplished slowly...We have a fearful example in Russia today of the evils of insane and unnecessary haste. The sacrifices and losses of transition will be vastly greater if the pace is forces...For it is of the nature of economic processes to be rooted in time. A rapid transition will involve so much pure destruction of wealth that the new state of affairs will be, at fist, worse than the old, and the grand experiment will be discredited.

Note this was in 1933 and Bhwagwati notes: "of the danger of haste, citing ironically enough, the example of Russia moving toward socialism.

Xavier Sala-i-Martin
[T]he last three decades saw a reversal of roles between Africa and Asia: in the 1970s, 11% of the world's poor were in Africa and 76% in Asia. By 1998, Africa hosted 66% of the poor and Asia's share had declined to 15%. Clearly, this reversal was caused by the very different aggregate growth performances. Poverty reduced remarkably in Asia because Asian Countries grew. Poverty increased dramatically in Africa because African countries did not grow. As a result, perhaps the most important lesson to be that a central question economists interested in human welfare should ask, therefore, is how to make Africa grow.

President Bill Clinton: "as China's people become more mobile, prosperous and aware of alternative ways of life, they will seek greater say in the decisions that affect their lives."