lecture_1_2_financial_development_[EDocFind.com][1]

LECTURE 1.2 FINANCIAL DEVELOPMENT

C S LEONARDUNIVERSITY OF OXFORD

Emerging Markets

18/03/2009

1

Leonard GSOM Emerging Markets March 2009

Outline

Repression and LiberalizationSetting the issuesSetting the historical contextGetting the controversies clearChecking the evidenceFinancial Repression (from Calomiris)

Characteristics, Constraints imposed (6) Varied impact?

Financial and Capital Account Liberalization How/when did it happen

Changing international order in the 1990s Trade conditions International organizations

18/03/2009

2


SETTING THE ISSUES

Financial Repression and Financial Liberalization

18/03/2009

3


Role of Government in the Economy

Story as presented by Calomiris West: two processes democratic and market development Law as social contract (moral consensus) Merchants as powerful force in development By contrast with, say, self-isolating China (1400-1800) This is a story of governments

Taxes and rents by government suppress financial activity Banking: securing money, check clearance Investment: securities market intermediation (no permanent

middleman) and bank intermediation, both require laws ensuring contract enforcement, protecting against fraud

18/03/2009

4


Crises

Continuous depreciation, like collapses, tax the financial sector

Dev of law to support system difficult, political pressures for rent, military pressure for the inflation tax

20th century various means found to repress financial systems

18/03/2009

5


Financial Repression

Imposed ceilings on interest rates paid by banks for deposits (fear for banks’ safety in competitive environments, outdated by securities markets)—banks gain, see C fig 2.1

High reserve requirements on banks (gain to government, no interest on reserves), inflation adds to tax on banks, C fig 2.2

Lending to industry, and or direct creditOwning or micromanaging banks (Asian model of

development, control over credit alloation: Krugman [Singapore/Soviet style allocation])

Restricting entry into the financial system, especially by foreigners (protectionism) Japan—to mid-1980s, effectively forbidden: domestic corporate bonds and

commercial paper, ie, all securities markets

18/03/2009

6


7

Eun & Jarakiramannan (1986)

18/03/2009Leonard GSOM Emerging Markets March 2009

Number of expropriations of foreign assets in different countries: development leading

to new globalization8

DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument of LDC policy, 1980-1992”, Journal of International Business Studies, 1994, pp. 177-188.


Number of countries expropriating foreign assets9

DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument of LDC policy, 1980-1992”, Journal of International Business Studies, 1994, pp. 177-188.


Controls on capital flows

Restricting international capital flows (strengthens power of government to direct flows to particular industries) Capital controls widespread in all countries during

Bretton Woods period of fixed exchange rates (1948-1973)—brief experiences of severe control (Chile, Malaysia, Brazil in 1990s)repealed

18/03/2009

10


Measuring Financial Repression

1970s to 1980s, 1990s, remarkable lowering of reserve ratios (fig 2.3)

Negative real interest rates (measures restrictions on deposit interest rates) ended in burst of financial liberalization in 1990s

Commercial bank borrowingRelative size of stock marketCalomiris index (financial and economic

development correlated)

18/03/2009

11


SETTING THE HISTORICAL CONTEXT


18/03/2009

12


Financial Development, 1970s-2000s

Longer run Foreign financing in Ems moves from bonds (19th

century) to banks after WWII, to bonds (Brady bonds), to equity

Countries move from protectionist policies, import – substitution, forced upon them in the 1930s, to period of GDP and rapid trade growth in the 1970s (even during the two oil price spikes of 1973 and 1979, with non-oil producing countries spending to meet demand, to the 1980s, a period of stagnation in some countries (LA), to official relief, to privatization and equity markets

General state: from crisis, to stability, to crisis International arrangements: GATT (Tokyo Round)

imposes discipline and provides incentives for trade

18/03/2009

13


More clearly..

Oil shocks and crises and government interventionDivision between oil exporting and oil importing

countries, with banks loaning funds of former to the latter -- against background in 1970s of structural reform, turning away from protectionism Tariffs reduced Crawling exchange rate pegs to maintain competitiveness Asia, subsidation of non-traditional exports Huge global liquidity world wide in times of inflation, banks

search for higher yields abroad Despite two major recessions in developed world, growth

averaged in 1970s 4% per annum World trade grew by 9% per annum Debt/export ratios held down

18/03/2009

14


Tokyo Round

GATT, most comprehensive round, 1973-1979 6 codes dealing with non tariff measures Tariff reductions by industrialized countries at 35% Developing countries given escape clause against terms

of trade shocks

1980-1983 situation changed Debt export ratios rose dramatically, 1979 recession Slows of transfers to developing world, rise in real

interest rates, Asia strengthened against this, LA ran into debt

Syndicated bank loan rose as vehicle of capital transfer Banks counted on official support, sovereign lending rose

18/03/2009

15


Era of debt 1980s

IMF assistance coupled with efforts to protect banks

Baker Plan showed continued emphasis on private sector

Baker plan also fostered privatization as way outBy 1987, banks showing greater reluctanceBail out of Mexico in Brady bonds, debtors and

creditors given new menu of options, conversion bonds—writing off about 1/3 of all debt, collateralization paid for by IMF, WB and Japanese Import Export Bank

18/03/2009

16


1990s

Era of restored growth, long period of US productivity growth, GDP globally av annual at 3%, despite Soviet Union’s collapse and Japanese recession

Uruguay Round of GATT showed successFar reaching changes in globalization

Communications and information New production technologies Outsourcing International division of labor 1970s, lending went to governments, 1990s, went to the

poor and rich (see China), heterogenous component Dense network of interfirm linkages

18/03/2009

17


WHAT ARE THE CONTROVERSIES?


18/03/2009

18


Arguments against

Second best theory, removing one distortion does not work, when others are present

If industries protected, funds may flow where not efficiently used

Misallocations (where wages are inflexible downward), say, toward capital intensive industries, can be furthered

18/03/2009

19


Arguments for Liberalization

Sheltering financial intermediaries from competition does not improve them

Weakens market discipline felt by policy makers

Place additional power in hands of bureacratsEncourage rent seeking and resource

dissipation by interest groups seeking privileged access to foreign capital

Evidence not conclusive, which wayBenefits and disadvantages to liberalization

18/03/2009

20


MEASUREMENT, WHO LIBERALIZES?


18/03/2009

21


Methods of measuring it

Zero one dummy for controls, since intensity of effort to control is fuzzy in cross country studies

Quinn (1997) some effort to index intensity for 56 countries, 1954-1994

Effort to measure international integration Stock market correlations? (returns vary as function

of underlying assets) Onshore-offshore interest differentials (limited info for

countries and years)Conclusion: liberalization is part of a larger

package, hard to measure all of it

18/03/2009

22


Who liberalizes

Currency pegs difficult to operate with liberalized controls

Countries with pegs don’t liberalizeAdvanced countries liberalize (causality?)Countries where domestic savings are scarce

don’t liberalize—governments tend to channel resources

Accounts are closed when public authorities hope to use inflation tax or to force banks to hold reserves at a certain amount, for a certain sector

Where Central Bank is independent, this is not useful, and so, less control

18/03/2009

23


Recent Views

1980s and 1990s a policy wavePolicy contagion

Countries herded in abandoning pegs and opening capital accounts

Policy emulation and signalling

18/03/2009

24


CHARACTERISTICS

Financial Sector Reform

18/03/2009

25


Objectives

A. Objectives of Financial Sector ReformB. Measuring Financial DeepeningC. Main Areas of Reforms

1. Improve Mobilization of Resources2. Improve Resource Allocation3. Improve Prudential Supervision of

Financial Institutions4. Strengthen Financial Competition

18/03/2009

26


A. Objectives of Financial Sector Reform

A first objective of financial sector reform is to bring the bulk of capital accumulation in a country through the formal financial system, away from the informal financial markets.

In other words, the objective is to induce “financial deepening” by increasing the volume of savings going to physical investments through formal, supervised financial institutions. An increase in the proportion of savings going to

investments through the financial system should lead to an improvement in the use and allocation of these savings.

Potential borrowers will have to compete for these savings and those with the most profitable opportunities and higher returns will have an advantage in obtaining these funds.

The deepening or increase in the size of the financial system, therefore will improve the allocation of resources in the economy.

18/03/2009

27


Term and Size Transformation

A second objective in reforming the financial system is to facilitate "term transformation"; that is, to convert relatively short-term savings and deposits into long-term financing, which is needed by capital investments with a relatively long depreciation period.

A third objective of the financial system is “size transformation”; that is to consolidate relatively small private savings into larger blocks of finance that can be used to fund large profitable investments. Otherwise large projects would not be financiable.

A fourth objective of an adequate financial system is to achieve “financial efficiency”; that is, to intemendiate between savings and investments with minimum intermediation costs and minimum risks (which requires prudential supervision).

18/03/2009

28


B. Measuring Financial Deepening

In most Emerging Markets, the banking system is the mainstream of the financial system.

Therefore, the degree of financial deepening can be measured by the actual flow of bank loans granted by the banking system.

Since this flow is difficult to measure, a rough indicator of the size of the financial/banking system is the ratio of M2 (Currency in circulation plus demand and savings deposits) to GNP.

Changes in the M2/GNP ratio over time indicate changes in the flow of private savings through the system. It indicates real additions to the ongoing loanable fund capacity of the banks.

Typical M2/GNP ratios are: Latin America, 0.35, Transition Europe, 0.45, Emerging Asia, 0.75, USA/Canada, 0.60, Western Europe, 1.00, Japan, 1.20

Excessive M2/GDP ratios may also indicate over-reliance on banks and inadequate capital market development.

18/03/2009

29


C. Main Areas of Reform

A precondition for the soundness of the Financial Sector is Macroeconomic Stabilization. With high inflation and devaluations, the financial systems will not be viable over the long term.

The health of the Financial Sector also depends on the soundness and creditworthiness of its borrowers. In turn, this will depend on the sustainability of economic growth. Economic Liberalization and Public Governance are key to achieve sustainable rates of growth.

In fact, the financial sector "reflects" the real economy. Within these preconditions, the following measures are needed

to develop a sound financial sector:1. Improve Mobilization of Resources (the liability side of the system)2. Improve Resource Allocation (the asset side of the system)3. Improve Prudential Supervision of Financial Institutions4. Strengthen Financial Competition by Opening International Capital Flows

and by Developing Capital Markets

18/03/2009

30


1. Mobilization of Resources

A major purpose of the reform of a financial system should be to increase its size by mobilizing increasing amounts of private resources through the financial system.

To increase the flow of private savings to the formal financial system, the following measures are needed:

(i) Liberalize Deposit interest rates.(ii) Expand Competition & Banking

Coverage.(iii) Diversify Savings Instruments.

18/03/2009

31


(i) Liberalize Deposit Rates.

Furthermore, rationing of credit by the banking system inhibit innovation, as the funds would be normally channeled to well established firms.

In many EMs, interest ceilings on savings are a major cause of financial repression.

With low deposit rates (rd vs Rd), savers will supply a lower level of deposits to the banking system (Q1 instead of Q2, with "x" being intermediation costs).

Savers will tend to bypass the banking system, increasing risks of resource misallocation.

It generates nepotism rather than economic criteria in allocating the lower amounts of credit available though at higher lending rates (rl instead of Rl).

18/03/2009

32


In EMs, with greater market orientation to deposit rates, competition among financial institutions is bound to take interest rates on savings to the level of around 5% - 9% p.a. in real terms.

Liberalization of deposit rates should be accompanied by measures to remove barriers to competition in the mobilization of resources (particularly by enabling the entry of foreign banks). Otherwise, monopolistic banks will pay low deposit rates.

Liberalization should also be accompanied by the development of deposit insurance for small depositors, to ensure that small depositors will not suffer if a bank gets into trouble.

18/03/2009

33


(ii) Expand Competition & Banking Coverage.Eliminate restrictions to the creation of more branches to

provide easier access to depositors and induce additional private savings throughout the country.

Facilitate the establishment of well-capitalized banks, in order to introduce competition and technology.

(iii) Diversify Savings Instruments.Banking laws in some countries list only “permitted”

instruments. This inhibits innovation. A better system is just to prohibit certain types of undesirable instruments.

In order to attract different types of depositors, banks should be legally allowed to offer a diversity of types of interest bearing instruments (passbook savings, time deposits, and certificates of deposits) with different maturities, risks and rates.

18/03/2009

34


2. Improved Resource Allocation

Another major objective of financial sector reform is to encourage the allocation of resources to the most economically viable investment opportunities

This will improve economic efficiency and accelerate economic growth.

For this purpose the following measures are normally included in financial sector reforms:

(i) Liberalize Interest Rates on Lending.(ii) Eliminate Preferential and Directed Credits.(iii) Reduce Intermediation Cost.

18/03/2009

35


Liberalize Interest Rates on Deposits

Interest rates on lending should not be controlled by Government. Otherwise, the formal system will be by-passed.

As deposit rates are liberalized and becomes positive, lending rates will also become positive in order to cover deposit cost, the cost of reserve requirement and intermediation cost.

If determined by free market forces, lending rates will reflect the opportunity cost of capital the country.

Lending rates may become excessively high if the Government introduces excessive regulations, such as:

forced holdings by banks of low interest government securities,

interest transaction taxes, high reserve requirements (the proportion of the bank

deposits that must be placed for precautionary purposes at the Central Bank free of interest rates), and

18/03/2009

36


(ii)Effects of Inflation and High Reserve Requirements

The effect of high reserve requirements is to increase the lending rate that the banks will need to charge on its loanable funds, to compensate for the fact that a portion of the deposits is not earning any interest.

High reserve requirements will also reduce the interest rate that the banks can pay to depositors.

Either depositors or other borrowers as a whole end up paying for the high reserve requirements and the financial system becomes weaker and bypassed.

18/03/2009

37


High Reserve Requirements

Furthermore, high reserve requirements in the presence of high inflation can have an devastating effect by increasing dramatically the level of nominal and real lending rates.

The combination of high inflation and high reserve requirements requires banks to charge very high real interest rates on loans, to enable them to pay positive rates to the depositors; e.g.: With a 55% inflation rate and a 5% real deposit rate, the

nominal deposit rate will be 60%. On a $100 deposit, the bank needs to earn $60 to pay

depositors. If the reserve requirement is 30%, the bank will not earn any

return on $30 out of the $100 deposit. Therefore, the bank will need to recover the needed $60 just

on $70 of investments. The lending rate on these $70 will need to be $60/$70, or 85% This represents a real lending rate of 30% (85%-55%) or five

times the real deposit rate of 5%.

18/03/2009

38


(ii) Eliminate Preferential and Directed Credits.

Many Governments in Emerging Markets have established special facilities to provide preferential and subsidized credits for sectors they wish to encourage, such as agriculture, small scale industries, exports, etc.

In some cases, banks are forced to have a share of its loans in these preferential sectors normally at lower interest rates.

Experience has shown that these subsidies are normally ineffective: In fact, most investments are not sensitive to the level of interest rates, as interest rates represent a small share of total costs.

If special assistance needs to be provided, it is preferably and economically more efficient to provide it directly, such as through investment tax credits accelerated depreciation, etc. rather than indirectly through interest rates.

18/03/2009

39


(iii) Reduce Intermediation Cost.

To reduce intermediation costs, a key measure is to eliminate excessive Government regulations on the kind of activities permitted to banks.

This excessive regulations may just lead to excessive fragmentation of activities, with heavy overhead costs, as banks will just established different companies to operate in the various activities.

Reducing fragmentation in the financial market will allow banks to cover a wide set of activities and to have a wider regional representation.

This will also help in narrowing the disparities of lending rates in the financial sector, and reduce operating cost.

18/03/2009

40


3. Improve Prudential Supervision of Financial Institutions

Banking Institutions: The “Core Principles for Effective Banking Supervision and Regulation”

of the Basle Committee on Banking Supervision (composed of G-10 Senior Bank Supervisors), provides a good assessment of the components of an effective system.

Its main five elements include:

I. Organization of the Banking Supervisory Authority: Clear objectives and a regulatory framework set by legislation. Operational independence to free it from political pressures. Accountability and enforcement powers to achieve its main

objective: Enforcement of bank regulations that set out the minimum standards that banks must meet.

For this, the authorities should: Strengthen bank surveillance capacity Improve in-site and off-site audit examination procedures

18/03/2009

41


II. Bank Licensing To define institutions to be supervised, there should be clear

bank licensing arrangements The licensing authority should determine that the new bank

has suitable shareholders, adequate capital, feasible operating and financial plans and management with sufficient experience and integrity to operate the bank prudently.

Objective and clear criteria for licensing should be issued.

III. Prudential Requirements. Prudential regulations and enforcement play a key role to

ensure that inherent banking risks are recognized, monitored and managed.

The Basle Accord established prudential measures and regulations that all banks should follows.

Some countries with weak banking supervisory authorities may wish to have stronger prudential regulations, as a cushion for weak supervisory capacity.

18/03/2009

42


The main prudential regulations include: Capital adequacy standards, based on the riskness of assets. Loan classification (Standard, Watch, Substandard, Doubtful,

Loss) and provisioning requirements, with clear criteria to define performing vs non-performing loans (qualitative as well as quantitative criteria).

Limits on Large Exposures (including country limits). Limits on Connected Lending (groups). Requirements for Liquidity and Market Risk Management. Internal Control Standards

IV. Accounting and Information Requirements Introduce generally accepted International

Accounting Standards for all banks. Introduce regular information reporting requirements. Introduce external audit of banks by qualified auditors

V. Exit Procedures for Bank Failure. In order to permit expeditious action, develop Prompt

Corrective Action and exit procedures in cases of bank failures.

18/03/2009

43


4. Strengthen Financial Competition. A degree of competition in the financial sector is needed to bring

competition to financial services and improve service quality.International Financial Liberalization Competition can be brought by opening of the financial sector to

foreign banks and liberalizing the flow of international capital. However, liberalization of International Capital should be

preceded by the development of strong prudential regulations and supervision, as well as a “stable” foreign exchange rate system. Otherwise, it would lead to Moral Hazard problems

Domestic Capital Markets Development A second way to bring competition in the financial sector is by

developing alternative mechanisms for firms to get financing. For this, the development of domestic capital markets is

essential.

18/03/2009

44


Domestic Capital Market

The main measures to develop a domestic capital market include: Strengthening security trading systems, including stock exchanges, regional

exchanges, and over-the-counter markets. Develop modern capital market infrastructure, including a central depositary,

custodians, clearance and DVP settlement. Improve the legal and regulatory framework for capital markets, including

protection of ownership rights and small shareholders, prevention of abuses, prevention of fraud, conflict of interest, inside information, broker/dealer regulations.

Improve the functions of Prudential Supervision by the Capital Market Supervision Board

Improve financial disclosure requirements, such as compensation of senior management.

Improve accounting and financial reporting according to international standards.

Encourage self-regulation. Encourage or establish rating systems.

18/03/2009

45


Significance of Financial Market Development

Focussing more closely on the 1990s

Financial markets still very imperfect With trade costs, causing “sudden stops” in EM

Mexico 1995 Contagion to Argentina Russian crisis of 1998 Asian crisis of ..

In other words, EM s different from DE, because the debt/equity ratio can rise rapidly. (1) collateral constraints, in the form of a margin requirement that limits the ability of an emerging economy to use domestic finane3This is a “fire sale” in the sense that domestic agents rush to adjust their equity position below the position they would optimally hold in the absence of margin constraints. Collateral constraints, in the form of a margin requirement that limits the ability of the Ems cannot use equity to leverage foreign debt, and (2) asset trading costs, intended to capture the effects of informational or institutional frictions affecting the ability of foreign traders to trade the equity of emerging economies.

18/03/2009

46


SEE YOU NEXT HOUR


47

The End

lecture_1_2_financial_development_[EDocFind.com][1]

Documents

financial liberalization12

financial liberalization3

financial repression6

financial repression11

evidence financial repression

financial activity banking

s commercial bank

emerging markets1 lecture