Sunday, April 29, 2007

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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