Washington Consensus II

My last post entitled Washington Consensus I talked about Jacques J. Polak and his financial programing approach to financial stability. This simple financing accounting equations allowed the IMF to readily see how the economy was performing from data that was easily to gather and was more accurate than most data available especially during the 60s, 70s and 80s. These were incorporated into more broadly defined Structural Adjustment Programs (SAP).

Now turning toward development finance in the "Two-Gap Model:

The growth model used in the IFIs today, despite frequently expressed misgivings and caveats, is the Harrod 1939-Domar 1946 model as further developed by Chenery and Strout 1966 as the Two Gap Model. The model has two important features: (A) investment requirements to achieve a given growth rate are proportional to the growth rate by a constant known as the Incremental Capital Output Ratio (ICOR). (B) Aid requirements are given by the “Financing Gap” between the investment requirements and the financing available from the sum of private financing and domestic saving. I will call the Harrod-Domar-Chenery Two Gap Model the “Financing Gap Model” for short, because its most important use is to determine financing shortfalls. (A) and (B) imply the following testable propositions: (1) aid will go into investment one for one, and (2) there will be a fixed linear relationship between growth and investment in the short run. The constant of proportionality is one over the ICOR. Both predictions are about the short-run evolution of aid, investment, and growth; nothing in this paper addresses the long-run relationship between growth and investment or the long-run effectiveness of aid.The Ghost of Financing Gap-WB-PDF

Or in other words from class notes:

This is the assumption of a 'fixed capital-output ratio'; the amount of capital required for any increase in output would have to be supplied in fixed proportions. Labour was assumed to be plentiful and so not a growth constraint. (DF201-unit 1 page 6)

And another site that gives a nice break down of the Harrod-Domar Growth model and the two-gap model is located at: Economic Development Theory.
So basically lack of growth in LDCs was attributed to too low of investments deriving from lack of savings and lack of foreign capital.

The two constraints we started with can be translated into two kinds of 'gap'=the gap between investment and savings (demand and supply of capital) and the gap between import payments and export receipts. Foreign finance can fill both of these gaps, since it is both an inflow of foreign saving and of foreign exchange. The two-gap model has, therefore, been the basis for calculating the requirement for foreign financial inflows necessary to remove the constraints on reaching target growth levels.

Along with some of these issues, I also already brought up issues dealing with Financial Liberalization and the 'financial repression' model at DF201 Assignment I.

From UNCTAD #40:

Two different concepts of efficiency - cost efficiency and allocative efficiency - both need to be considered in this context. Cost efficiency is about the cost of financial intermediation, and may be measured by the spread between lending and deposit rates, allowing for the effects of such factors as required reserves. Allocative efficiency refers to the degree to which the allocation of financial resources among different sectors and activities reflects the social rate of return or, more broadly, serves to attain longer-term development objectives

The Quality Effect: Does Financial Liberalization Improve the Allocation of Capital?

This study documents evidence of a "quality effect" of financial liberalization on allocative efficiency, as measured by dispersion in Tobin's Q across firms. Based on a simple model, we predict that financial liberalization, by equalizing access to credit, reduces the variation in expected marginal returns. We test this prediction using a new financial liberalization index and firm-level data for five emerging markets: India, Jordan, Korea, Malaysia, and Thailand. We find strong evidence that financial liberalization, rather than financial deepening,
improves allocative efficiency.

So the answer at least in this study was yes financial liberalization is good for the economy.

Liberalization, Prudential Supervision, and Capital Requirements: The Policy Trade-Offs

This paper investigates the importance of the quality of prudential supervision during financial liberalization and its implications for the level of minimum capital requirements. The analysis is based on an extension of the theoretical model proposed by Hellmann, Murdock, and Stiglitz (2000). By now there is a consensus that financial liberalization, while necessary for financial development, needs to be handled with care. Furthermore, empirical studies have found poor prudential supervision to be an important factor behind more “bumpy” liberalizations. However, few theoretical papers address explicitly the role of prudential supervision during liberalization or highlight the trade-off between the quality of supervision and the level of minimum capital requirements. This paper finds that the level of capital requirements should be increased to compensate for poor supervision.

While there is an extensive literature on the benefits of financial liberalization,2 recent econometric studies have pointed out the importance of first strengthening prudential supervision: Lindgren, Garcia, and Saal (1996) have found that prudential regulation and supervision3 are weak in most countries that experienced financial crises; Williamson and Mahar (1998) have observed that the countries with high-quality supervision have experienced less costly financial crises; Demirgüç-Kunt and Detragiache (1998) have pointed out that the dangers of liberalization are more pronounced in countries where the institutions to support financial markets were less developed. Finally, Rossi (1999) has found that postliberalization financial fragility is exacerbated by weak supervision.

In practice, prudential supervision was often inadequate at the time recent liberalizations took place. In a series of papers, Caprio and Honohan4 have characterized the evolution of prudential supervision during financial liberalization. Prior to liberalization, there is often little need for prudential supervision: interest rates and credit allocation are under direct government control; the number of banks is small and competition is limited; public ownership of financial institutions is widespread. When liberalization occurs, bank competition and the sophistication of financial instruments both increase. Bank managers, often lacking experience in traditional banking, see the franchise value of their banks
deteriorate, while the opportunities for risky investments increase. To keep up with these developments, supervisory agencies need to redirect their efforts toward more
sophisticated, risk-based, supervision. But this takes time, in part because the number of supervisors, their skills, and the level of their remuneration may remain inadequate for a long period.5

A nice summary of research that shows financial liberalization is beneficial but needs to be done with proper safeguards which includes sequencing as a technique.

For an example of an example of sequencing of financial liberalization that resulted in success: CAPITAL ACCOUNT LIBERALISATION: THE INDIAN EXPERIENCE. It is a fairly long piece but has some important points about the liberalization process in India. It was interesting to note that India does not want their currency to be used for external transactions or as a reserve currency. It also limits dollarization of their citizens (transactions between citizens for debts). The article also has some good Appendixes on capital account liberalization including: Three proposals for “sand in the wheels” capital controls, and how they differ.
The article Capital Account Liberalization and the IMF is a bit old (98) but does point out some issues with the IMF:

But these developments, as the official community has acknowledged, raise important questions about the role of the IMF in financial liberalization. In September 1996, the Interim Committee (the committee of finance ministers and central bank governors that reviews IMF activities) requested the IMF Executive Board to analyze trends in international capital markets and examine possible changes to the IMF's Articles of Agreement so that the organization could better address the issues raised by the growth of international capital flows. In April 1997, the Interim Committee agreed that there would be benefits from amending the Articles to enable the IMF to promote the orderly liberalization of capital movements. It reiterated this position in a statement issued at the Annual Meetings of the World Bank and the IMF in Hong Kong SAR the following September.

This idea that the IMF should actively promote the liberalization of capital flows has not gone unchallenged. In the wake of the Asian crisis, which has seen sharp reversals of capital flows for a number of countries, officials and academics alike have questioned how desirable capital account liberalization is and whether it is advisable to vest the IMF with responsibility for promoting the orderly liberalization of capital flows.

It is important to note that even in 98 there was discussion in the IMF of sequencing.

Countries in which these problems are severe but that suddenly and fully open the capital account run the risk of incurring a serious crisis. This implies that countries should liberalize the capital account gradually, at the same time as they make progress in eliminating these distortions.

Links:
Fiscal Rules