DF201 Exam|Question 1

1. To what extent does empirical evidence support the view that higher real interest rates lead to increased quantity and improved quality of investment?

From title link, it shows that it does not increase quantity of investments but does increase the overall quality.
A rise in interest rates could reduce saving if debtors' propensity to save is higher than creditors'. It is then possible that lenders' current consumption might increase and that it might increase more than borrowers' current consumption fall.
Also, it may be the case that savers in developing countries are not behaving as utility-maximizers, but have some kind of fixed target for their savings.



References:
UNCTAD No. 40, August 1991, Yilmaz AKYÜZ & Detlef J. KOTTE, Financial policies in developing countries: Issues, and experience
The main question is why a similar policy approach has generated different results in different countries. Two basic factors stand out:

Macroeconomic stability is essential. [Note: from research and most notably the East Asian Crisis it is not the sole factor.]
...the degree to which governments have been able to ensure that the support and protection provided by them have been well-targeted and used for the purposes intended rather than as a handout.

In the handful of cases of financial liberalization where these problems were avoided, two factors were especially in evidence:

Financial liberalization came often not before a considerable degree of industrialization had been achieved, and it came out of strength rather than as a response to weakness.
Liberalization was undertaken only to the degree compatible with the pursuit of an active industrial policy.

...pushing interest rates up in order to match inflation can make matters worse by reducing incomes [borrowers] and increasing price instability which, in turn, can reduce savings and distort resource allocation further.

Higher interest rates could discourage corporate investment from retained earnings, and also reduce aggregate private savings by transferring income from firms to households.

Fry, Maxwell (1978)'Money and Capital or Financial Deepening in Economic Development'
Journal of Money, Credit and Banking, Vol. 10 No 4, November 1978, Ohio State University Press, USA

Giovannini's Critique of Fry

From notes: In Giovannini's results, the interest elasticity of savings appears to be not statistically significant and in several cases it is negative; and so Giovannini doubts the very hypothesis that Fry felt his won estimates supported.

The models were based on savings behavior and the data was only on aggregate domestic savings which included the Government sector. Household behavior over time is also reflected in life cycle model or permanent income hypothesis and portfolio allocation (added).

I agree with Giovannini thatRicardian Equivalence is not a worthy argument for keeping aggregate savings together as the two "sorts of savings as substitutable".

Ricardian equivalence, (also known as Barro-Ricardo equivalence proposition or Ricardian rent), is an economic theory which suggests that government budget deficits do not affect the total level of demand in an economy.

This is because tax payers have perfect knowledge about the deficit and will increase savings in the exact amount as "rational expectations".

# A perfect capital market where any household can borrow or save as much as is required at a fixed rate which is the same for all persons at a given date.
# The path of government spending is fixed
# Intergenerational concern. The tax rise required may not occur for centuries, and will be paid off by the great-great-grandchildren of the population around at the time the debt was incurred.

National savings may then be unaffected by changes in aggregate domestic savings, anyway.

Aggregate savings as a residual, that is that aggregate savings in developing countries was derived as a residual of some other function as in: GNP-C.

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

'Financial Repression Model'|Beneficial Effects of Elimination

Again a little bit of notes from class:

Raising interest rates is argued to have beneficial effects on economic growth eventually, through a chain of effects. We could summarise the steps in the argument as these:
* higher real interest rates raise real savings
* higher real interest rates raise financial forms of savings, specifically saving in the bank deposits, so that financial intermediation also increases
* higher real interest rates lead to greater domestic credit availability (because of increased financial saving) and hence an increased quantity of investments
* higher real interest rates lead to improved quality of investment also, because low-return projects will not receive funding if funds are rationed by price only; this is said to improve the 'efficiency' of investment
* increased financial intermediation leads to higher economic growth, so that higher interest rates bring about higher real growth eventually, also, through the effects on investment.

The "financial repression" theory states that while saviers may ignore small and transitory changes in real interest rates (from say, 4 to 6 per cent), savings behavior will change significantly when real interest rates undergo a large, sustained swing from negative to positive levels (e.g. from double-digit behative to double-digit positive levels) as a result of financial liberalization. Thus, according to this view savings do not simply depend on the level of interest rates, but also on the philosophy underlying the determination of interest rates. The theory also predicts a strong savings response to liberalization of interest rates under relatively high inflation, when such large jumps in the real interest rate can occur. (UNCTAD #40)

Washington Consensus III/Financial Repression

I have not found a very good explanation of the Financial Repression Model so will type in a section of my class notes:

The simple model of a financial system in which the price of credit is administratively controlled and in which the quantity of credit is rationed as a result, was labelled the 'financial repression' model. Building upon the writings of Ronald McKinnon and E(dward) S. Shaw and others, many economists have expressed criticisms of financially 'repressed' financial systems since the early 1970s. In practice too, many governments, including those of many developing countries, have attempted to abandon such 'repression' and its component policies of controlled interest rate ceilings and government policy influence over the quantities allocation of credit to favoured sectors or firms.

During the 1980s, there have been many examples of governments setting interest rates free from controls and turning to more market-based systems in which credit allocation is done by price, within private financial institutions. In this process, known as 'financial liberalisation' or 'financial deregulation', many governments have attempted to refashion their financial systems into conformity with the second simple model. In the 'liberalised' or market-based model, credit allocation is pictured as working by means of effects of credit demand and supply on the price of credit - that is, the interest rate.

Well I finally did find a nice summation of the financial repression model from the IMF:

Box IV.1. Financial Repression and Economic Growth: Theoretical Background
The existence of interest rate ceilings is usually associated with financial repression, leading to financial underdevelopment and lower economic growth.33 In the McKinnon/Shaw framework, interest rate ceilings inhibit financial development mainly through keeping real interest rates below their market level. This, in turn, leads to the rationing of credit that affects negatively economic growth. Also, growth is hampered by the sub-optimal allocation of financial resources caused by the elimination of the price discrimination system that allows financial markets to allocate financial resources to those investment projects with the highest returns.

Financial repression, defined as the set of policies, laws, regulations, taxes, qualitative and quantitative restrictions and controls imposed by the government which directly interferes with the allocation of financial resources and the price discovery function of financial markets, was common prior to the 1970s. According to Roubini and Sala-i-Martin (1995, p. 276) financial repression was favored on the basis that (i) anti-usury laws were needed for social reasons; (ii) tight control and
regulation of the banking system was considered necessary to ensure banking soundness and proper monetary policy transmission mechanism; (iii) determining the allocation of financial resources to certain sectors or projects was a policy issue to be decided according to the government’s notion of socially “strategic” sectors or projects; and (iv) maintaining interest rates below market rates reduced the cost of servicing government debts.

Empirical research (Roubini and Sala-i-Martin, 1992 and 1995) suggests three main channels through which financial repression impacts negatively on economic growth: (i) productivity of investments is negatively affected; (ii) the overall level of investment and savings in the economy is reduced; and (iii) intermediation costs are increased. Recent research has found that the relationship between financial liberalization and economic growth is more relevant via the effect of liberalization on the efficiency of the financial system to allocate financial resources than via its effect on financial deepening. Increased financial system efficiency has been measured through higher access to external finance (Demigurc-Kunt and Maksimovic, 1996, and Rajan and Zingales, 1998), lower default rates (Jayaratne and Strahan, 1996), enhanced total factor productivity (Beck, Levine and Loayza, 2000), and lower variation in expected returns to investment (Abiad, Oomes and Ueda, 2004).

So I kind of went full circle with this journey and now back to the first post on this issue:

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. Washington Consensus???

Let me add a passage of Unit Two of DF201:

The 'financial liberalisation' school of thought therefore sees the aim of financial liberalisation as linked with controlling monetisation of government budget deficits and with controlling the money supply and inflation. They make a link between financial liberalisation and some aspects of stabalisation policy.

In conclusion, I thought I would link to Ronald McKinnon's academic web site where he teaches at Stanford still.

Key terms:
'Financial Repression' Model
Ronald McKinnon
Edward S.Shaw
'Financial Liberalization'='Financial Deregulation'

Three-Gap Model
Schumpeterian system of economic development

The Interest Elasticity of Savings in Developing Countries: The Existing Evidence

The Interest Elasticity of Savings in Developing Countries: The Existing Evidence by Alberto Giovannini, Massachusetts Institute of Technology, 1983.

Fry and Mason in a variety of studies from the 70s covering data mostly from the 60s shows:

He finds that an increase in the real rate of interest 1% would raise the ratio of domestic savings to income by 1.6 to 2.1 tenths of 1%, asymptotically from 1.8 to 2.2 tenths of 1%.

3. Concluding Remarks

Serious doubts are cast on the view that interest elasticity of savings is significantly positive and easy to detect in developing countries.
...
We discuss what we think are the most serious drawbacks in the list below.
1. The first problem, and certainly the hardest to solve, is the quality and homogeneity of the data.
2. The savings variable used in the regressions is aggregate domestic savings: households and corporate savings plus the government budget surplus. [Yes treating the different sectors as homogeneous is a problem when trying to look at savings from the general households]
3. Absence of any tax considerations. ...cases like Singapore, the marginal capital income tax rate has varied significantly in the 1970s.
4. The exclusion of relevant variable from the regressions reported is suggested by the magnitude of the lagged dependent variable.

Notes:
Life Cycle Theory?

P2: DF201 Exam|Question 1

4. Interest Rates, Resource Allocation and Investment

...Ronald McKinnon, regard increase money balances, rather than increased credit availability, as the crucial constraint on investment. This is because McKinnon pictures most investors in physical capital in developing countries as engaging in self-finance. He also argues that a certain build-up of money balances necessarily precedes investment because investment is so typically 'lumpy'.

Even if the quantity of saving and investment has not clearly been shown to increase with financial liberalization, it might still be possible to argue that beneficial effects result through the improved quality of investment undertaken.
1. Has the efficiency of investment increased...
2. Has the efficiency of credit allocation increased...

comparing the period before and after liberalization?

4.1 The Efficiency of Investment

...the efficiency of investment through examination of the amount of extra investment necessary to produce a unit increase in output, and the way this ratio changes over time. This ratio is known as ICOR or 'incremental capital: output ratio', where 'incremental capital' is an alternative term for physical investment. ...the Harrod-Domar growth model assumed this ratio to be fixed, for the purposes of an aggregate growth model.

When ICOR gets smaller this implies an increasing efficiency of investment. Estimates for ICOR from Turkey by Ercan Uygur (1993, "Liberalization and Economic Performance in Turkey", UNCTAD Discussion Paper No. 65, Geneva) is with mixed results. But ultimately ICOR can change for a whole host of reasons and thus is not helpful.

4.2 The Efficiency of Credit Allocation
Yoon Je Cho (1988) The Effect of Financial Liberalisation on the Efficiency of Credit Allocation Journal of Development Economics 29.

...a difference in the marginal returns obtained from credit implies that credit is being allocated inefficiently, Measuring the extent to which marginal returns to credit vary would then give us a measure of efficiency of that credit allocation.
...
...the variance of the cost of credit could also be taken as a more indirect measure of the efficiency of credit allocation (Cho). The reason is the simple one that the cost of credit is fairly easy to measure, while the returns to credit are not.

For each sector:
(total interest and discount payments)/(total debt)

Cho concludes that the McKinnon-Shaw financial liberalisation (financial repression model) was beneficial in decreasing variance of credit costs during the 1980s/70s.

But...Amsden, Alice and Yoon-Dae Euh (1993) "South Korea's 1980s Financial Reforms: Goodbye Financial Repression (Maybe) Hello New Institutional Restraints", World Development Vol 21 No 3

...as industrialisation proceeds, the number of new industries requiring special assistance falls. Therefore, as the number of industrial enterprises grows, the variance in heir borrowing costs will fall. This the see as a result of industrialisation rather than a cause of industrialisation.

Jaramillo, Fidel "The Effects of Financial Liberalistion on the allocation of credit, Panel Data Evidence for Ecuador" Country Economics Department, The World Bank, WPS1092 PDF

...the larger and older firms which had benefited from the reallocation of financial resources following liberalisation. (Study book)

Of course asymmetry of information is a higher hurdle for the smaller firms which leads to smaller firms having less access to short-term credit.

Summary: The authors discuss two effects of financial liberalization, using panel data for Ecuadorian firms. After describing the main thrust of the reforms and the general macroeconomic developments, they document the changes that occurred in the firms' financial structure and in the allocation of credit. Descriptive evidence suggests that there has been a reallocation of resources towards older, larger firms after liberalization. The authors also investigate econometrically whether financial reform has helped direct credit to more efficient firms. The results, based on measures of technical efficiency obtained from estimating stochastic production frontiers, show that this has indeed been the case in Ecuador. (Above link)

Summary:

The authors discuss two effects of financial liberalization, using panel data for Ecuadorian firms. After describing the main thrust of the reforms and the general macroeconomic developments, they document the changes that occurred in the firms' financial structure and in the allocation of credit. Descriptive evidence suggests that there has been a reallocation of resources towards older, larger firms after liberalization. The authors also investigate econometrically whether financial reform has helped direct credit to more efficient firms. The results, based on measures of technical efficiency obtained from estimating stochastic production frontiers, show that this has indeed been the case in Ecuador.

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. Abiad, Oomes, Ueda-Jacques Polak Annual Research Conference.2005

DF201 Exam| Question 2

#2. Why may financial liberalization policy and stabilization policy be incompatible? Discuss with respect to Chile 1973-83.

...

The immediate macroeconomic effects of financial liberalization may not be favourable to external adjustment for two reasons that are commonly overlooked. First, by raising costs, higher interest rates adversely affect the supply side, especially when the corporate sector is highly indebted. Second, and more important, imperfections in domestic goods markets can produce perverse results.

Especially with regard to monopolistic powers in the market that can pass on prices in the market, thus the increase in interest rates may therefore act like a currency appreciation, and thus discouraging investment in exports and import substitutes.


"Stabilization with Liberalization: an Evaluation of Ten Years of Chile's Experiment with Free Market Policies, 1973-1983" Sebastian Edwards (PDF)

"The International Capital Market and Economic Liberalization in LDCs" Ronald McKinnon for Institute of Developing Economies


And since we started talking about this subject let me include some of the comments here:

Growth of Monetary Aggregates, Chile

Annual Inflation, Chile

Annual Inflation Rate, Chile 1985-2000

Yeah, who'd have thought a recession was in the cards?

The IMF and Chile, A Parting of Ways?
It does not seem so since after 24 years they are still members of the IMF.

In effect, the revaluation of the peso tended to generate an excess supply in the nontraded goods sector at a time when what was needed was a reduction in the excess supply already created by the decline in the rate of growth of domestic credit. In addition, the subsequent use of the exchange rate as the major stabilization tool resulted in an important real appreciation of the peso and a significant loss in the competitiveness of the domestic industries. ...the adoption of the fixed exchange rate-with inflexible real wages-in June of 1979, as the final step of stabilization process, was a serious policy mistake, which precipitated the 1982-9183 recession.

DF201|Question 3|Chile 73-83

#3. Can the widespread 'financial distress' among banks in the 1980s be explained satisfactorily by 'market failure' within the banking sector? Discuss with respect to Chile or Argentina.

First we need to look at the Financial Distress and "Market Failures" as opposed to Financial Distress arising from the business cycle. This identifies 'market failures' arising within the credit market itself which can be described as a microeconomic approach.

In the Stiglitz-Weiss model, very high interest rates increased the perceived riskiness of returns on loans, reducing expected returns for banks and inhibiting lending at very high rates. This produced an optimum interest rate below the maximum possible.

Credit rationing would avoid the market failures of moral hazard and of adverse selection to banks perceived as less risky.

...there may be circumstances where interest rates for some reason rise above the banks' optimum rate and, at these very hight interest rates, no new equilibrium rate can be found.

'Perverse' Credit Allocation and Loan Concentration
Credit rationing that occurs at very high interest rates creates a perversion by lending to existing borrowers that already have non-performing loans-which then is defined as a 'mis-allocation' of credit allocation. The banks may be afraid that the lender may go bankrupt and thus may lose any chance of getting their principle back.

It results in a phenomenon known as 'loan concentration' among existing borrowers, which goes against the principle of risk diversification. The 'market failure' in question is that of adverse selection, as the mix of borrowers becomes worse at high interest rates.

Business may also create moral hazards by allocating new funds for highly speculative (gambling) investments based on need to create even hight rates of return to pay back the initial loan as well as the secondary, and all in a way to avoid bankruptcy. Prisoners dilemma.

Lastly, the increased perceptions of the riskiness of investments brought about by the difficulties of existing borrowers cold cause the banks to over-estimate the riskiness of projects of prospective new clients who approach them for a loan. This again increase loan concentration and denies credit to some 'worthy' loan applications.

It seems that this implies that banks are judging the macroeconomics of the economy based on a very small sample of their clients.

These kinds of market failures can be exacerbated by the 'interlocking' ownership of directorships of banks and the productive enterprises that borrow from them. If there are special links or relationships which lead banks to favour certain borrowers, both adverse selection and moral hazard are likely to increase in difficult times.

Before discussing the question with regard to Chile let me briefly cover the 'financial distress' arising from the Business Cycles and Money Supply.
The Business Cycles can easily be described as 'self-perpetuating philosophies'. If the business climate is good then everyone assumes that it will continue forever. Unfortunately there are not enough bears in the market when things are good and not enough Bulls when things are bad. This ingrained beliefs creates expectations that overshoot the long term full employment or industrial capacity equilibrium.

Financial Distress and Money Supply

If the monetary authorities tighten the money supply too much, banks run short of the necessary reserves and have to sell of their assets in order to boost their reserve positions.
...
...financial distress in the 1980s was not associated with monetary contraction.

Distress Borrowing

Many of the symptons fo financial distress point to 'distress borrowing', that is, an inelastic credit demand from borrowers attempting to stay liquid though unable to service existing loans. Such borrowing is also known as 'artificial' or 'false' credit demand because the demand does not relate to new economic activity.
...
"The signs for the interest rate and inflation coefficients are the oppposite of what would normally be expected: the estimated coefficients for loans rises in real terms when the real cost of credit goes up.

4 Financial Liberalisation Policy and Financial Distress (Unit 3 Page 18-19)***

You may be puzzled by the fact that the World Bank reading here appears to blame both financially repressive policies, such as selective directed credits to priority sectors, and also financial liberalisation policy.

5.2 Oligopoly and a Bank Holding Company Structure in Chile
From Galbis paper:

The Chilean experience is especially revealing because of the purity of the deregulation model that was followed and the rather serious difficulties that the system generated in the course of time. The Chilean financial reform was initiated in May 1974 with a view to freeing all interest rates, denationalizing the banks, and opening the financial system to competition by foreign institutions. Simultaneously, the authorities focused their policies on pursuing basic stabilization objectives-the reduction of inflation and the achievement of balance of payments equilibrium-starting from an initial position of hyper-inflation (around 500 per cent) and entrenched inflationary expectations.

For a long period of time, the achievements of these policies appeared to be considerable. Since interest rates were freed in 1975, deposit interest rates stayed at highly positive real levels, facilitating thereby a rapid real growth of the financial sector. Previously nationalized banks were quickly returned to private ownership and control and in order to moderate their market power, were increasingly subject to a degree of competition from foreign banks. At the same time, with the reduction in the rate of growth of domestic credit and inflation (from over 500 percent in 1975 to 29 percent in 1979) it became possible to eventually fix the exchange rate with respect to the U.S. dollar in July 1979, thereby making growth of monetary aggregates endogenously determined by money demand responses. In this connection, the authorities also began to remove capital inflow controls in order to integrate the domestic financial market with external markets and increase domestic competition.

Paradoxically, measures designed to increase competition in financial markets had only limited effect on reducing the high interest rate levels and spreads prevailing in the Chilean domestic financial markets. With the benefit of hindsight, it appears that the restoration of the bank holding company structure that resulted from the de-nationalization policies, together with the unbounded pressures of domestic and foreign competition, created an unrestrained drive on the part of the groups for market shares in order to finance the group's projects. The maintenance of abnormally high real interest rates contributed to the eventual illiquidity and bankruptcy of large segments of the Chilean business sector. With widespread bankruptcy in the business sector component of the bank holding companies, bad and doubtful loans and arrear accumulated in the financial sector, and created an unprecedented financial sector crisis (1982.83). A number of banks and other institutions had to be liquidated and the remaining ones had to be supported with central bank funds.

The collapse of the Chilean economy was also participated by rapid real wage increases and the overvaluation of the peso. However, it is important to realize that these macroeconomic disturbances which contributed to the deteriorating position of the nonfinancial firms, should have led, under competitive conditions, to a decline in the demand for the credit on the part of the firms, and also to a more selective approach in the supply of credit by financial institutions, because of the higher risks involved in lending during a cyclical downturn. In these circumstances, the rate of interest should have tended to decrease especially after the authorities abolished all capital inflow restrictions, a measure which was directly intended to increase the supply of credit and thus to reduce the domestic rates of interest to the international level. Finally, it is possible that, despite the success already achieved in reducing inflation to a very low level and the maintenance of extremely tight fiscal and monetary policies, market participants might have continued to hold relatively high inflationary expectations in relation to actual inflation during the post-1980 period, just as they had during the period until 1980, But, as Mathieson has pointed out, this behavior was only consistent with an interest-inelastic demand for bank loans on the part of nonfinacial sector portfolio owners and a relatively slow adjustment on the part of banks towards increasing the real supply of bank loans. In turn, these characteristics of the credit market are consistent with the pressure generated by the bank holding company groups to attract aggressively financial resources to finance nonfinancial firms of their respective groups.

Some more important considerations are "Insider Transactions" and "Interlocking Directorates".

The conclusion that the problem of financial repression in LDCs (or alternatively instability) would not necessarily go away by lifting existing regulation means that different and better regulations, unleashing new market forces must be relied upon to achieve needed corrections. Banking concentration and the bank holding company structure are realities which, however unsettling, cannot easily be altered. Indeed, the attempt to a free market policy by eliminating those structural obstacles to market competition would involve the seeming contradiction of attempting to free markets by means of more policy decisions and regulations. Of course the nature of these regulations would be of the market-making type as against the market-destroying type.

References:
"Stabilization with Liberalization: an Evaluation of Ten Years of Chile's Experiment with Free Market Policies, 1973-1983" Sebastian Edwards (PDF)

Galbis, V. (1986) 'Financial Sector Liberalisation under Oligopolistic Conditions and with a Bank Holding Company Structure', Savings and Development, Vol X No. 2

The World Bank 1993 The East Asian Miracle

The World Bank (1989) 'Financial Systems in Distress', World Bank Development Report, Ch 7 pp 70-83.

[url=http://www-wds.worldbank.org/external/default/main?pagePK=64193027&piPK=64187937&theSitePK=523679&menuPK=64187510&searchMenuPK=64187283&theSitePK=523679&entityID=000009265_3961214175618&searchMenuPK=64187283&theSitePK=523679]Bank restructuring : lessons from the 1980s-World Bank[/url]

DF201|Question 4

What are the inherent contradictions in the role of development banks and how may these difficulties be overcome?

Inherent difficulties of Development Banks fall into two categories:
1. Their scope as Financial Institutions.
2. Development Banks' role as an arm of government policy.

1. Difficulties as Financial Institutions
1. Problems of specialization that can concentrate risk and non-diversification of portfolios.
2. By the very nature that development banks are designed to fill a highly risky endeavors but still maintain the profit motive of a normal bank. It can always be easier if it was just handing out money.
3. "The low funding costs also open up the possibility of private rent-seeking by individuals in a position to affect credit allocation."
4. In the case of small agricultural borrowers and small business, monitoring costs ate prohibitive and in some cases repayment proportions may be very low. There are no economies of scale in monitoring borrowers, in this situation. If the development bank operates as a revolving fund, where repaid loans are then lent out again, and repayment rates are low, the bank can find itself short of liquidity as a result.

Difficulties with Government Policy Criteria
A man that serves two masters serves neither...
Development objectives:
employment creation, foreign exchange earning, income distribution, diversification of industry, modernization of agriculture, development of small business, encouragement of entrepreneurship, development of the capital market...

2.2.1 Benefits and Costs of Specialization
There is an economic advantage to this (specialization) in one sense; namely, that there are cost economies in getting to know one sector and its borrowers in detail. This may or may not offset the greater risk from specialization.
2.2.2 Allocation by Social versus Economic Criteria
...credit allocated by criteria such as those listed above, is not necessarily allocated to the technicaly most efficient or most profitable enterprises.
2.2.3 Development Banks and Capital Market Development
...development banks may become rather passive channels of cheap funds rather than acting as an active financial intermediary between national savers and borrowers.

Overcome Difficulties
Creation of a "Post Office Savings system" thus reducing one of the "Two Gaps" internally.

Dynamic Comparative Advantage
If investment is being made in increasing a country's capital stock relative to its labor force, or in introducing new technologies, arguably it is the future pattern of comparative advantage that is relevant and not the current one.

Community Banks-Policed by Members
Credit Associations or Credit Co-operatives. Mujin in Japanese (mutual financing associations).

Development Banks are criticized, for the most part , for participating in a system where subsidies distort price signals; the wrong borrowers receive the subsidies anyway, and the bested interests perpetuate the system. These features indicate that directed credit systems are ineffectively operated and cause waste.

Part 1|DF201|Question 5

A Clear understanding of the rural interest rate formation is at the heart of a successful rural credit and finance policy. Discuss.

Factors and Aspects of Rural Credit
1. Many peasant households live an insecure and precarious economic life. Thus it creates emergency aspects of borrowing that thus making interest rates inelastic on the demand side.

2. Thus a large percentage of loans are of present consumption and may be even due to the lack of investment opportunities. Lack of information may also lead to this market failure. Outreach programs may increase the knowledge base to create an enterprise mentality.

3. Cyclical nature of the farming. As crop harvest tends to be seasonal then liquid savings will also rise and fall as the harvest season is occurring. And this can be even compounded by community having this same cyclical manner-especially in regions of distinct seasons.

4. Lending tends to be short-term and less than a year. This tends to create higher interest rates since what are the holders of the capital to do with the assets during the other parts of the year?

5. And since the whole community will be facing the same general production and consumption factors then all in the community may have booms or busts that can stretch the savings pretty tight.

6. Informal Sector is composed of two sub-sectors: Commercial (people with excess liquidity-local merchants, landlords, input traders, crop buyers, wealthy individuals and professional money lenders) and Non-Commercial (Friends and Family-no interest on reciprocal basis).

7. Much criticism of professional money lenders for their exorbitant interest rates. But the fact that they remain around must signify some benefit of such arrangements. Some positive factors of non-institutional sources of rural credit are: proximity to and more intimate knowledge of borrowers (lower default risks); minimal protocol; easy access to and speed of operations; repayment flexibility; lower transaction costs and better rates of loan recovery, etc.

3.2 The Formal Sector
Commercial Banks even if mandated to build offices in rural areas have lack of penetration to the landless families and small peasant households. And the effectiveness in extending rural credit is widely disputed.

State Agriculture Banks have come under severe criticism and scrutiny as in:
1. Their large commercial farmer bias-less costly to administer and manage.
2. Their over-dependence on state resources.
3. The one way nature of their operations from the state to the rural sector-as opposed to intermediaries between rural savers and borrowers. But considering the cyclical nature of savings it may not even possible to do this.
4. Their susceptibility to political manipulation and personal favoritism.
5. Their high transaction costs and low recovery rates.

Cooperatives have many advantages over s-such as group lending resulting in lower transaction costs and better access to small farmers, for example. Despite this, however, the building up of effective cooperative movements has been fraught with difficulties.

1. lack of management expertise
2. political manipulation
3. insufficient supervision and auditing
4. top-down structures of credit delivery
5. low membership involvement and participation
6. poor loan recovery rates
Types: users' associations, credit unions, informal savings clubs, and Rotating Savings and Credit Associations (ROSCAs)!

Peak Resources Part III...Copper

In my other posts on More peak resource information...Copper!, I showed how when copper prices rose then the market found substitutes. One was the elimination/reduction in the use of copper in coinage. And the second one was the rise of the use of fiber optics in communications instead of copper. There was also another development that helped extend recovery of copper (Man's knowledge of copper must date back for at least six thousand years):

At the beginning of the present century the world's annual demand for copper was about half a million tons; the United States produced about half this total, whilst Britain's output had fallen to a mere token figure. Today the annual consumption is now more than nine times as large. This dramatic rise in the intervening sixty years can be attributed partly to population growth but mainly to the tremendous technological advances which have received impetus from two World Wars. In the Second World War the demand for copper most certainly could not have been satisfied, but for an invention in 1921, when Perkins patented his process of chemical flotation. This made it possible to mine ores which, up to that time, had been regarded almost everywhere as worthless. Some attempts at flotation of crushed ores had been made ever since 1860, but the process only became commercially important after the 1914-18 war. The Raw Material

This site should also be noted for the history of Copper.

Without going into a great deal about Hubbert peak theory, I want to show his basic bell curve that he uses for his theories on "Peak Oil":

So now let us look at Yearly Silver Production in metric tonnes (1900-to-2001)

This is very important since we can see at least 4 "peaks" with the tail looking like another peak. So much for copper showing any aspect of Peak production even after 6 thousand years. We have to wonder if "Peak Oil" has any merit also.

Haha, fooled my self, that was silver above and now for copper:

The Y scale is Metric Tons. Again we see at least three peaks earlier in the 20th century. But even after 6 thousand years we are not at the "Peak"?
Note: the two previous charts are derived from numbers out of Historical Statistics for Mineral and Material Commodities in the United States.

Links:
Penny less than sum of parts

Interesting facts from Copper.org:

The Hubbert Peak for World Oil

Part 2|DF201|Question 5

4 The Determination of Rural Interest Rates
The four components of interest rates specified by Bottomley are:
1. the opportunity cost of capital (cyclical nature of loans)
2. the administration premium
3. the risk premium
4. monopoly profit (are there barriers to entry-ie no other capital is available?)

The summary of costs of Moneylender and Urban Banks costs.
1. Basic rate is 15% for ML-I assume that the opportunity costs are quite high vs. liquid banks that can obtain other revenues to have 5% opportunity costs. Also as noted above that seasonal nature of the ML then his capital may be idle for longer periods.
2. Administrative costs start are 1/2 what it is for Urban for all loan sizes.
3. Default is highly in favor of ML at low size loans but approaching 1000 it goes to Urban Banks.
4. Overall risk premium is much lower at smaller loan sizes for ML but goes to Urban at higher size loans. Urban banks do get to Average Risk as compared to ML that may not be able to diversify risk as easily.

Risk Premium= (assumed default rate*(principle + lending costs)/principal actually repaid

Causes of Default:
1. Loan size: the more a man borrows, the larger will be the probability of his being unable to repay. I am not sure nominal size matters, loan size to net worth. But some of the other factors are listed below.
2. Borrower net income: there will often be a positive relationship between net income and levels of payment but the correlation is not always as great as one might expect.
3. Debt-equity ratio.
4. Value of collateral.
5. Defaulters brought to court. Lack of an adequate legal system of property rights.
6. Income variance. Thus an inelastic demand curve based on consumption needs instead of basic investments.
7. Administrative costs of collection.
8. Real rate of interest. If negative-subsidization then defaults should be low since why bite the hand that feeds you (free gifts). Which is a wealth transfer.
9. Type of lender. The closer the relationship from lender to borrower is the more likely to repay, for example Cooperatives before urban banks.

It is also important to understand that even if borrowers have the ability to repay there may also be the factor of willingness to pay as we saw above.

References:
Bottomley, Anthony (1975) "Interest Rate Determination in Underdeveloped Rural Areas", Reprinted in Von Pischke (1983)

Part 3|DF201|Question 5

A Clear understanding of the rural interest rate formation is at the heart of a successful rural credit and finance policy. Discuss.

Micro-Finiance Institutions/PDF Stiglitz/Weiss Model.

By “refusing” to charge higher interest rates (i.e. prices), which would in turn reduce the demand which exists at imax, the banks render the market mechanism ineffective: The existing excess demand for funds cannot be absorbed by increased prices, but instead remains at the level plotted on the graph.
Thus, it may be concluded that even without legal interest rate restrictions, information asymmetries can lead to “implicit” interest rate ceilings; this in turn prevents markets from clearing and leads to credit rationing.7
...
The assumptions made by Stiglitz/Weiss which are problematic
in this respect are that
a) all borrowers demand credit in equal amounts,
b) all borrowers have the same expected RoI on their projects, and
c) transaction costs need not be taken into account.
...
The relevant best practice suggests that the Stiglitz-Weiss model overestimates the importance of adverse selection as a reason for credit rationing insofar as it is possible – albeit with a certain amount of effort – to resolve or alleviate this problem.
...
Items of collateral are, in the words of O.E.Williamson,11 hostages to support exchange and cooperation, and a rational collateral policy is one that is designed according to this principle.

Adverse selection

On the most abstract level, it refers to a market process in which bad results occur due to information asymmetries between buyers and sellers: the "bad" products or customers are more likely to be selected. A bank that sets one price for all its checking account customers runs the risk of being adversely selected against by its high-balance, low-activity (and hence most profitable) customers. Two ways to model adverse selection are with signaling games and screening games.

Moral hazard

In economic theory, the term moral hazard refers to the possibility that the redistribution of risk (such as insurance which transfers risk from the insured to the insurer) changes people's behaviour. For example, a person whose automobile is insured against theft may be less vigilant in locking the vehicle than an individual who is not insured.

References:
Bhaduri,A (1977) "On the Formation of Usurious Interest Rates in Backward Agriculture", reprinted from Coats and Khatkhate (1980)


Stiglitz

Part4|DF201|Question 5

Bhaduri,A (1977) "On the Formation of Usurious Interest Rates in Backward Agriculture", reprinted from Coats and Khatkhate (1980)

Indian Political Economist Amit Bhaduri has wrote about two things that help determine rural interest rates.
1. Power relationships explicitly play into the analytical framework.
2. Subjective factors are allowed into the valuation of securities and collateral for which there are no established markets. Thus the monopolist may be able to extract the monopoly profits from ceasing assets that he valued for security too low. And he describes as "gross undervaluation". u=p/p^ and u>=1

Thus neither the opportunity cost of capital nor the default rate can be considered to be exogenous.

Two specific mechanisms make life difficult for peasant borrowers:
The Interest rate (money lenders can accumulate assets priced too low through the transfer of collaterals)
Undervaluation of collateral (mentioned earlier) also represents 'personal power' in unorganized/rural markets.

p=nominal market value (assuming one exists-and probably highly unstable in prices)
p^=price at which lender will accept
p(b)=borrowers personal valuation
p(l)=lender personal valuation
z=(p(l)/p)*(p/p^)

Thus, the nature of the "equilibrium" solutions is now clear: the lender will push the optimal interest rate so high that repayments of principal plus interest will exceed the value of the collateral transferred to him; but the borrower may still be willing to repay the principal and interest at that rate rather than default, only because he attaches a personal value to the asset which exceeds its market value and its vale to the lender.

But this seems to assume there is no societal pressures that hinder the lenders ability to confiscate the collateral. If the lender is the most powerful individual in society he may also face a diminishing marginal value from confiscating property.

...forced default is the very essence of the economic phenomenon of usury and emerges as a logical consequence of our model. The rate of interest is then seen to operate as a convenient device in the hand of the rural money-lender for accumulating assets, through the transfer of undervalued collateral deliberately brought about by large-scale default. This reason for ruinously high rates of interest has always been well known to poor peasants taking loans on desperate terms...

Links:
For a nice discussion of Developing Economics, [url=http://www.ciat.cgiar.org/webciat/planificacion_rural/Taller_Territorio/FAO/SDAR/Typology_Decentralization/CD_typology/docs/ac158e08.htm]Country case studies: Thailand[/url] and it also talks about cooperatives including Credit Cooperatives.

Decentralized Rural Development and the Role of Self Help Organizations

A nice but long piece on rural financing atFINANCIAL SERVICES FOR THE POOR AND POOREST: DEEPENING UNDERSTANDING TO IMPROVE PROVISION by: Imran Matin, David Hulme and Stuart Rutherford

Part 5|DF201|Q 5 Summary

Unit 6.2.1 The Traditional Rural Credit Policy Re-examined
Main Assumptions
1. Credit was considered to be a major constraint for farmers.
2. The existing credit shortages led to high interest rates on loans.
3. Concessionary institutional loan arrangements were needed in order to break or counteract the vicious circle of poverty and indebtedness.
4. The equity considerations of high interest rates were reinforced by their likely implications for borrowing decisions.
5. The limited savings capacities of poor rural households reinforced the case for credit intervention so as to relieve the financial constraint in rural economic development.
6. Rather than wait for economic activity to expand the demand for financial services, 'supply-led' strategies were needed to stimulate such activities and to cater for the credit 'needs' of the rural sector.
7. Formal financial institutions were seen to be the forefront of these strategies to ration and direct funds to target groups and activities, and to enforce strict loan supervision.
And then for Policies:
1. Targeted credit programs.
2. The instruments used loan guarantees, concessionary lines of credit and subsidized interest rates to end borrowers.
3. Little attention paid to mobilizing rural savings.
4. Relying almost exclusively on government and donor funds.
5. Distribute loans quickly and to reward staff on the basis of loans made (rahter than on results achieved or other indicators such as loan recovery or returns on investment.
6. State intervention in the agricultural sector.

D.H. Penney:
...but the resources used in credit programs rarely give a satisfactory profit compared with the returns from investments in agricultural research and extension or in social capital (such as roads).

It is not difficult to discover whether farmers need additional capital...simply ascertain whether farmers can afford fertilizer, new tools, and so on. ...many peasant farmers can afford to finance some investments from their own resources.

But even if some is being purchased is it fairly being distributed? Not to say that we could not expect some marginal farmers to choose different lines of work.

Why are credit programs advocated an pursued so vigorously?
1. Governments and economists are unaware of the attitiudes of peasant farmers toward debt and credit.
2. They forget that credit does not necessarily represent capital. Capital is not created merely by increasing the supply of money.
3. ...they fail to realize that the growth of such institutions is as much a result of as a cause of development.
4. do not recognize the powerful economic reasons for the high nominal rates of interest charged in so-called unorganized money markets.

A Rural Financial Market (RFM) consists of relationships between buyers and sellers of financial assets who are active in rurla economies.

DF201|Q6 | Part I

#6. Discuss Howard White's view that the aid literature has failed to advance our understanding of the macroeconomics of aid because it neglects the mechanisms by which aid may affect savings.

There are three common sources of External Finance:
1. aid or foreign assistance
2. debt
3. direct (foreign) investment (FDI)
Official Development Assistance (ODA for short):
1. grants (including technical assistance)
2. concessionary loans
3. contributions in kind
4. suppliers' credit
5. reparations payments
(not all are 'give aways', to qualify for ODA the grant element of flows must be at least 25%)

Capital Bottleneck Theories like the Dual Gap Model-Three Gap...

Harrod-Domar type model of growth.
g=s/c
g: growth rate (dY/y)
s: net investment or savings ratio (dK/Y)
c: incremental capital-output ratio or ICOR (dK/dY)
Three ways to overcome this gap:
1. increasing domestic savings (assumed to be impossible-LICs by definition)
2. reducing capital-output ratio
3. resorting to overseas savings
g=i*m
i: import ratio
m: is the incremental out-import ratio (dY/dM)

...dual gap model explained in simple terms:
if the export-import gap is larger than the saving-investment gap, then growth will be trade-limited. This means that unless additional external resources are provided, part of the mobilized domestic savings will go un-utilized.
...
The reason why the largest of the two gaps applies is because the two gaps are not additive since domestic investment requirements can be met by imported capital goods.

If the capital-output and import-output ratios are flexible there can only be one gap, not two.

There are at least two reasons why concessional loans (or grants) may be preferable to non-concessional loans.
First reason-many aid programs fund projects with a strong element of externality- in such areas health, education, social services and infrastructure.
Furthermore, given the long gestation period over which benefits accrue, there may also be a debt-servicing mismatch for commercial loans.
Second reason, concerns the difficulties in servicing debt in foreign currency and possible implications for 'crowding out' domestic investment.

Four adverse affects of foreign aid are postulated:
1. Lowering domestic savings.
2. Distorting the composition of investment.
3. Frustrating the emergence of an indigenous entrepreneurial class.
4. Inhibiting institutional reforms. (Democracy for one.)


Notes:
1. RIMSM model is the World Bank's dual gap model.
2. The third gap of the government budget deficit has been used by Taylor [1990] for the purpose of forecasting aid requirements.
3. The rapid increase in aid during the second half of the 1970s was accompanied by deteriorating growth performances. Several countries in Africa have experienced negative income growth during the 1980s, despite high and rising aid inflows.

DF201|Q6 (Howard White)| P2

#6. Discuss Howard White's view that the aid literature has failed to advance our understanding of the macroeconomics of aid because it neglects the mechanisms by which aid may affect savings.

Critiques of Dual Gap Theory:
First, it is a very sticky model, with no substitution in production (either between factors to reliever capital shortage or to reallocate factors between sectors).
Second, the underlying Harrod-Domar model is too simplistic a representation of the growth process: many other factor besides capital accumulation affect growth. (Like human capital.)
Finally, the two gap model does not incorporate any mechanisms by which aid may not be matched by one-for-one increases in investment, government development or foreign exchange.

The Savings Debate:
...an anticipated aid inflow will be treated as an increase in income and so, unless the marginal propensity to save is one, allocated between both savings and consumption.
1. Griffen's Presentation of the Negative Impact of Aid on Savings.

Four adverse effects on foreign aid are postulated:
1. lowering domestic savings
2. distorting the composition of investment
3. frustrating the emergence of an indigenous entrepreneurial class
4. inhibiting institutional reform

Four sets of issues are critically analyzed:
1. whether domestic savings should be defined as being determined by income alone
2. the secondary (feedback) effects of aid via future increases in income
3. fungibility of aid between consumption and investment
4. the centrality of savings in the determination of growth potential

...it may be argued that aid inflows reflect low savings rates in developing countries (rather than vice versa).
...the share of exports in GNP is found to provide a better explanation of changes in the savings rate compared to aid.

Harrod-Domar Growth Model:
g=s/c
g: is growth (dY/Y)
s: the net investment or savings ratio (dK/Y)
c: incremental capital-output ratio or ICOR (dK/dY) the quantity of capital needed for attaining a one unit increase in output, thus:
dY/Y=(dK/Y)*(dK/dY)

Phases of Growth in Chenery and Strout's Dual Gap Model:
Phase-Growth Constraint----Foreign Capital Determined by
IA----Ability to invest----Savings Gap
IB----Ability to invest----Trade Gap
II----Growth target--------Savings Gap
III---Growth Target--------Trade Gap

The point may be clarified by using the leontief fixed-coefficients production function, as done by McKinnon [1964]
Y=min{aK(d),bK(m))
K(d) is domestically produced capital goods
K(m) imported capital goods
a and b are the output capital ratios for both d and m respectively.

...aid...will cause indirect effects on savings that will be difficult to isolate, and their inclusion on the right hand side is inappropriate.
...aid will affect savings including:
1. there will be a relationship between aid and the savings rate.
2. aid will affect the interest rate
3. aid alters income distribution in ways that are imperfectly understood.
4. aid will affect the level of exports.
5. public savings will vary directly according to how government responds to changes to its income from aid.
...
It is possible that high aid inflows per capita and low average savings propensities are both caused by some third, exogenous, factor...
The problem of simultaneity.
Studies have found aid allocation to be more strongly influenced by donor interests than by recipient need.

Conclusion:
The radical position that aid displaces savings, most strongly associated with the name of Keith Griffin, was shown to have a weak theoretical foundation. It is therefore not surprising that the empirical data do not, contrary to the claims of some, support their arguments.

...three channels for aid impact on the growth of output:
direct impact
crowding out
crowding in
Dennison's study for 1950-62 found that increases in capital stock accounted for only 25% of growth.
Joshi and Findlay's Critique of the Dual Gap Model:
the impossibility of substituting domestic for imported inputs in to the production of the investment good sector. The assumption of rigidly fixed technical coefficients may be valid in each particular line of investment, but the overall proportions can be changed by varying the composition of investment so the model assumes that not only techniques but also demand patterns are rigidly determined.
Edwards on Real Exchange Rate (RER)
aid is a transfer from the rest of the world, and as such it will generate an equilibrium real appreciation. That is, foreign aid-perhaps paradoxically-will reduce the degree of international competitiveness in the recipient country, making the country's exports less competitive internationally.
Notes:
Bacha's three gap model [1990]

DF201|Q7|Fishlow

'An effective debt strategy is part of an overall development strategy' (Fishlow). Discuss.

The Baker Plan (Structural change, increase reliance on the private sector.):
1. Tax Labor Market
2. Financial Reforms
3. Trade Liberalization

One (differs from other plans) is the greater emphasis upon fundamental, structural change in developing countries and a prescription of growth, tather than adjustment, strategy. The other is the direct involvement of the US government, rather than the IMF, in inducing greater finance.

Banks have taken their profits in the form of commissions and fees rather than in interest income. (I.E. "Securitization" and this developed into a secondary market.)

To close the financing gap requires three complementary actions. The first is an increase in official flows to restore an appropriate public-private balance in development finance that was discarded in the 1970s. The second is a reduction in the disproportion between outflows to service private sector debt and voluntary inflows. The third is a domestic development strategy that emphasizes not only export growth but also efficient import substitution as a means of conserving foreign exchange.

Baker Plan needs these three amendments:
1. They are simply not large enough.
2. narrow balance of payments approach to finance.
3. assumption that the principal source of the debt problem is the inadequate macroeconomic policies of developing countries: the balance of payments deficits were caused by excessive public sector expansion and corresponding internal expenditure.
Three types of policy lessons:
1. appropriate size of the debt
2. to its management
3. the need for development strategies that better integrate financial openness.

???
2. to reduce the uncertainty inherent in exchange rate variability, borrowing in different currencies should correspond more closely ot the flows of foreign exchange earnings.
3. maturity mismatches should be reduced as much as possible
4. interest rates for bank borrowing should be specified in terms of the bank cost of resources (LIBOR?).
5. more information exchange among debtor countries.
6. (final) an effective debt strategy is part of an overall development strategy.

D=M-X+iD Foreign Exchange Gap
D=I-S+iD Saving Gap
D=G-T+iD Public Sector Gap
i: average interest rate
D: debt stock outstanding
Thus Fishlow is based on the three-gap model.

Even the frequently cited rule "export growth must exceed the rate of interest for countries to be able to pay" depends on the presumption that countries are unwilling to accept continuing export surpluses.

References:
Fishlow, A. (1988) 'External Borrowing and Debt Management' Chapter 9 in R Dornbusch and F. Leslie C.H. Helmers 'The Open Economy', Oxford University Press for the World Bank, pp187-222

DEBT AND THE PRSP CONDITIONALITY: THE KENYA CASE

Duplicat