n FINANCES - Development - IMF eLibrary

June 1997 • Volume 34 • Number 2

n FINANCESDevelopmentFINANCIAL FLOWS TO AFRICA3 How Can Sub-Saharan Africa Attract More Private Capital Inflows?

Amar Bhattacharya, Peter J. Montief, and Sunii Snarma

7 Financial Liberalization in Africa and AsiaHow PHI and Mahmood Pradhan

RURAL ENERGY

11 Tackling the Rural Energy Problem in Developing CountriesDouglas F. Barnes, Robert van der P/as, and Willem Floor

GUEST ARTICLE 16 Japan's Economy Needs Structural Change

ALSO IN THIS ISSUE 22 Growth and the Environment: Allies or Foes?Vinod Thomas and Tamara Belt

25 The Reform of Wholesale Payment SystemsDavid Folkerts-Landau, Peter Garber, and Dirk Scj&toaker

29 Creditors' Crucial Role in Corporate GovernanceCheryl W. Gray

33 Interest Rales: An Approach to LiberalizationHassanali Meriran and Bernard Laurens

38 Improving India's Sating Performance

42 Islamic Financial Systems Zamir Iqbal

Maritn muhleisen

Takatoshi Ito

©International Monetary Fund. Not for Redistribution

A QUARTERLY PUBLICATION OF THE INTERNATIONAL MONETARY FUND AND THE WORLD BANK

DEPARTMENTS2 Letter from the Editor

20 World Economy in TransitionBias in the US Consumer Price Index: WhyIt Could Be Important Paul A. Armknechtand Paula R. De Masi

36 Global Financing TrendsDeveloping Countries Get More PrivateInvestment, Less Aid

46 Development FocusEducation and Health Care in theCaribbean Vinaya Swaroop

55 Readers' Comments

BOOKS49 The Banking Panics of the Great Depression by Elmus Wicker

James M. Boughton

49 The Foreign Aid Business: Economic Assistance and Development Co-operationby Kunibert Rafter and H.W. Singer

David Dollar

51 The Clash of Civilizations and the Remaking of World Order by Samuel P. HuntingtonKe-young Chu

52 Fifty Years of Bretton Woods Twins (IMF and World Bank) by S.L.N. SimhaMargaret Garritsen de Vrles

52 Institutions lor Environmental Aid: Pitfalls and Promise, edited by Robert 0. Keohaneand Marc A. Levy

David Freestone

53 Central Banking in Developing Countries by Anand ChandavarkarManuel Guitian

54 Against the Tide: An Intellectual History of Free Trade by Douglas A. IrwinJ.M. Finger

© 1997 by the International Monetary Fund and the International Bank for Reconstruction andDevelopment/The World Bank. All rights reserved. Requests for permission to reproduce articlesshould be sent to the Editor. Finance & Development will normally give permission promptly, andwithout asking a fee, when the intended reproduction is for noncommercial purposes.

FINANCEDevelopment is published quarterlyin English, Arabic, Chinese, French,German, Portuguese, and Spanishby the International Monetary Fundand the International Bank forReconstruction and Development,Washington, DC 20431, USA.

Opinions expressed in articles andother materials are those of theauthors; they do not necessarily reflectIMF or World Bank policy.

Claire LiuksilaEDITOR-IN-CHIEF

Asimina CaminisSENIOR EDITORPaul GleasonASSISTANT EDITOR

Luisa MacdonaldART EDITORJune LavinEDITORIAL ASSISTANT

Jessie HamiltonADMINISTRATIVE ASSISTANT

ADVISORS TO THE EDITOR

Adrienne CheastyWilliam EasterlyEmmanuel JimenezNaheed KirmaniAnne McGuirkGobind NankaniLant PritchettPeter J. QuirkOrlando RoncesvallesGarry ScninasiMarcelo Selowsky

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LETTER FROM THE EDITOR

GOVERNMENT UNDER THE SPOTLIGHT

World Development Report 1997The State in a Changing World

World BankPublications

Government is in the spotlight in this twentieth annual edition of the WorldDevelopment Report. This year the World Bank's flagship publication isdevoted to the role and effectiveness of the state, a topic that ranks high on theagenda in developing and industrial countries alike. The Report looks at whatthe state should do, how it should do it, and how it can do it better in a rapidlychanging world.

June 1997.354 pages.English editions:Paperback: Stock no. 61114-F (ISBN0-19-521114-6). $25.95.Hardcover: Stock no. 61115-F (ISBN 0-19-521115-4). $49.95.Translations forthcoming in paperback.

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1265

WW w hile many developing countries elsewhere are enjoying rapid growth, fueled in significant part by inflows of private for-

eign capital, many sub-Saharan African countries are stuck in low gear. As official capital flows dwindle in a climate of aid fatigueand budget pressures in industrial countries, sub-Saharan Africa's political leaders increasingly agree that the region's prospectshinge on its more thorough integration into the global economy. But how can this be accomplished? The lead articles in this issuediscuss two specific areas in which sub-Saharan African countries might usefully undertake reforms.

The article by Amar Bhattacharya, Peter Montiel, and Sunil Sharma notes that although the recent surge in international privatecapital flows to developing countries has largely bypassed sub-Saharan Africa, some countries in the region have received consider-ably more than others. It examines the reasons for their differing success and suggests ways in which the sub-Saharan Africancountries might attract more foreign private capital.

Since financial liberalization is now widely recognized as a crucial element in countries' economic development, developing coun-tries have become increasingly interested in how they can successfully bring it about. In their article, Huw Fill and MahmoodPradhan examine the experiences of Asian and sub-Saharan African countries in liberalizing their financial systems. They notethat Asian countries' liberalization efforts generally have been more successful and highlight some lessons from the Asian experi-ence that might be applied to countries in sub-Saharan Africa.

Over the past five years, the economic situation in much of sub-Saharan Africa has improved. An increasing number of countrieshave persevered with adjustment and structural reform, and their efforts are beginning to bear fruit. Still, the road to sustainableeconomic growth in the region as a whole will be neither short nor easy. But, as the authors of these articles observe, sub-SaharanAfrican countries can derive substantial benefits if they make determined efforts to reform their economies.

Claire Liuksila

Editor-in-Chief

'.- i'in<nii'( A- I h T t ' l t i / / / ! / ! i t l ' l i u i t t(.t(.>i


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International private capitalhas largely bypassed sub-Saharan Africa. But this factmasks significant differencesamong countries. Whataccounts for these differences,and what actions can sub-Saharan countries take toattract more private capital?

O

FFICIAL FINANCE accounts fora higher proportion of externalfinancial flows to sub-SaharanAfrica than to any other devel-

oping region (Chart 1). Despite the sharpincrease in official finance to Europe andCentral Asia in the 1990s, sub-SaharanAfrica continues to account for thelargest—and, indeed, a growing—share

Amar Bhattacharya,an Indian national, is an Economic Adviser inthe World Bank's International EconomicsDepartment.

of official development finance; during1990-95, the latter region received 26 per-cent of total official development financeprovided to all developing countries. Al-most 95 percent of this was made availableon either highly concessional or grantterms.

In contrast, the share of long-term pri-vate capital—defined as the sum of privateloans (bank loans plus bond finance), port-folio equity flows, and foreign direct invest-ment—flowing to sub-Saharan Africa islower, as a percentage of GNP, than that ofall other developing regions except SouthAsia. Private transfers and other privateflows (including returning flight capital)play a relatively important role in sub-Saharan Africa, as they do in such otherregions as South Asia and the Middle Eastand North Africa. Nonetheless, adding inthese flows does not change the picture; infact, total private flows (including unre-quited transfers) to sub-Saharan Africa arelower, as a percentage of GNP, than for allother developing regions.

Along with Latin America, sub-SaharanAfrica saw the sharpest decline in privateflows in the aftermath of the debt crisis(Chart 2). Private flows to sub-SaharanAfrica began to recover in the second halfof the 1980s, but, in contrast to the experi-ence of most other developing regions, theydeclined again in the early 1990s beforerecovering modestly during 1993-95. Formost years during 1982-95, annual long-term private capital flows have been lessthan half the peak of $5.5 billion reached in1982.

Why has sub-Saharan Africa been leftout? A survey of commercial banks, invest-ment banks, and mutual fund managersconducted by the authors reveals thatinvestors perceive the risks to be higherthere than in other regions and face greaterimpediments to identifying and exploitingprofitable opportunities in sub-SaharanAfrica than elsewhere. Despite these handi-caps, some countries in the region areattracting private capital flows. Theirefforts to adopt outward-looking policies

Peter J. Montiel,a US national, is Professor of Economics atWilliams Cottege.

Sunil Sharma,an Indian national, is a Senior Economist in theEmerging Markets Studies Division of the IMF'sResearch Department.

Finance & Development /June 1997 3

How Can Sub-Saharan Africa Attract MorePrivate Capital Inflows?

AMAR BHATTACHARYA, PETER J. MONTIEL, AND SUNIL SHARMA



ChartsPrivate flows to sub-Saharan Africa 1

(percent of GDP)

Chart 4

Composition of private flows tosub-Saharan Africa 1

Source: Amar Bhattacharya, Peter J. Montiel, and Sunil Sharma, 1996, "Private CapitalFlows to Sub-Saharan Africa: An Overview of Trends and Determinants," unpublished,World Bank and International Monetary Fund (Washington).

1 Excluding Angola and South Africa.

Source: World Bank, Debtor Reporting System.1 Excluding South Africa.

into Uganda are estimated to have reached$112 million in the 1995/96 fiscal year(partly, it should be noted, as the result of areclassification of private transfers), whichamounted to 23 percent of total net officialinflows and 2 percent of GNP.

Most countries in sub-Saharan Africahave received very modest amounts of FDI,however, despite the fact that rates ofreturn on FDI have generally been muchhigher in sub-Saharan Africa than in otherdeveloping regions. During 1990-94, ratesof return on FDI in the region averaged24-30 percent, compared with 16-18 per-cent for all developing countries. This sug-gests that risks are perceived to be higher insub-Saharan Africa than in other regions.

Experience in other regions has shownthat investors choose countries with stablepolitical and economic environments. Openmarkets, minimal regulation, good infra-structure facilities, and low productioncosts are also key factors in attracting andholding foreign investment. Bringing thesefactors together has proven difficult formany countries in sub-Saharan Africa.Specifically, they suffer from

• Civil strife. On the one hand, during thepast 15 years, a relatively large number ofcountries in the region have been affectedby civil strife, which, in the most extremecases (Liberia, Rwanda, Somalia, Sudan,

and Zaire), brought FDI inflows to a stand-still. On the other hand, several countriesthat have seen an end to civil conflicts (suchas Angola, Mozambique, Namibia, SouthAfrica, and Uganda) have benefited fromsignificant increases in FDI inflows duringthe 1990s.

• Macroeconomk instability. Large struc-tural fiscal deficits, erratic monetary andexchange rate policies, and weaknesses infinancial systems in many sub-Saharancountries have contributed to high and vari-able inflation and interest rates and a highdegree of volatility in real exchange rates.These factors have all worsened the generalinvestment climate. Countries that havemade progress in reducing macroeconomicinstability have, however, enjoyed somesuccess in attracting FDI inflows.

• Slow economic growth and smalldomestic markets. Although FDI invest-ments in the primary sectors (notably, agri-culture and mining) in Africa have, onaverage, earned high rates of return, thepoor growth performance of sub-SaharanAfrica and the limited size of its domesticmarkets have deterred broader-based FDI.Annual GNP growth in sub-Saharan Africa(excluding South Africa) averaged 2.3 per-cent during 1983-89 and 1.4 percent during1990-95, compared with 3.8 percent and 5.1percent for all other developing countries

(excluding the former Soviet Union), duringthese periods.

• Inward orientation and burdensomeregulations. Compared with other develop-ing regions, which have seen dramaticshifts to more outward-oriented andmarket-based investment regimes since themid-1980s, sub-Saharan Africa has re-mained relatively inward-oriented, with for-eign investment often subject to excessiveand discriminatory regulation.

• Slow progress on privatization. In con-trast to many Latin American and EasternEuropean countries, which have usedaggressive privatization programs to boostFDI, progress in privatizing state-ownedenterprises has been slow in sub-SaharanAfrica. During 1988-94, the proceeds fromprivatization amounted to $2.4 billion insub-Saharan Africa, compared with $63.4billion in Latin America and $16.3 billion inEurope and Central Asia (World Bank,1996).

• Poor infrastructure. Sub-SaharanAfrica's physical, financial, human, andinstitutional infrastructure are all generallyless developed than in other regions and, inmany cases, have actually deterioratedsince the early 1980s. This has reflectedsub-Saharan countries' low and declininginvestments in all areas of infrastructure,heavy state intervention coupled with poor



implementation capacity, and limited suc-cess thus far in expanding private provi-sion of basic infrastructure.

• High wage and production costs. As aresult of the macroeconomic and micro-economic factors listed above and, in somecases, countries' labor market policies,wage costs in the region tend to be highrelative to productivity levels. Overallcosts of production are also generallyhigher than elsewhere—for example,almost double those prevailing in low-income Asian countries.

Private loans. Private loans have beenon a declining trend for all country groupsin sub-Saharan Africa. Unlike other devel-oping regions where commercial bankloans have shown a sharp turnaround inthe 1990s, such lending to most sub-Saharan countries has remained negativeor at very low levels. In part, this hasoccurred because most African countrieshave not yet restored their access to finan-cial markets. In contrast to other regions,where creditworthiness ratings have showna marked improvement in the 1990s, credit-worthiness ratings for sub-SaharanAfrican countries have remained muchlower, on average, and are only just begin-ning to improve. The main factors believedto have contributed to sub-Saharan coun-tries' generally low levels of creditworthi-ness are high political risk, weak growthand export performance, macroeconomicinstability, and high levels of indebtedness.Low levels of commercial bank borrowingalso reflect decisions made by many coun-tries to restrict such borrowing, especiallyfor general budgetary support.

Portfolio equity Hows, Althoughportfolio investment into sub-SaharanAfrica (with the notable exception of SouthAfrica) is still extremely small comparedwith flows into other emerging markets,there are encouraging signs of growinginvestor interest. Since 1994, more than 12Africa-oriented funds have been set up witha total size of more than $1 billion. Initially,the focus of these funds was primarily theSouth African market, but the base hasbeen broadening to encompass a growing(though still limited) number of otherAfrican countries, including Botswana,Cote d'lvoire, Ghana, Kenya, Mauritius,Zambia, and Zimbabwe. This growing poolof portfolio investment is already perceivedto bring important benefits including liq-uidity, incentives for privatization, andpressure for policy reforms and improve-ment of the financial infrastructure.

Investors, looking ahead, expressguarded optimism about making portfolio

6 Finance & Development /June 1997

investments in Africa. In sharp contrast tothe situation only a few years ago, virtuallyall stock markets on the continent have nowbeen opened up to foreign investment, andin many countries there has been a shiftaway from state-centered ideologies. Anumber of factors are, however, still seen asconstraining portfolio investment: inves-tors view political instability and weakmacroeconomic fundamentals as the mostimportant impediments.

Many structural weaknesses are alsoviewed as inhibiting investment. A reduc-tion in the transaction costs of doing busi-ness will be critical. The setting up of anefficient securities trading and settlementsystem and the presence of internationalcustodians are important elements of thefinancial infrastructure that is needed toattract foreign investors. Corruption in thepublic sector, including the judiciary, iscited by many investors as not only increas-ing transaction costs but also acting as adeterrent in its own right.

The supply of assets is still very limited,and, in addition to the public companiesalready listed on stock exchanges, the num-ber of private firms listed needs to beincreased. In some cases, privatization ofpublic assets offers the best avenue forincreasing the supply of assets in the econ-omy and attracting foreign investors. Whilefcireign investment can play a valuable roleiri stimulating capital markets in Africa, thegrowth and stability of these markets willrequire the development of a healthy baseof domestic investors. Pension reform andthe promotion of mutual funds couldencourage domestic investment in fledglingstock markets. Over the longer term, defi-ciencies in human capital, infrastructure,and institutions need to be addressed ifmore African countries are to attract thegrowing pool of portfolio investment.

The futureAid fatigue and fiscal pressures in the

industrial countries have made it more diffi-cult for developing countries to attract offi-cial capital flows. In such an environment,sub-Saharan Africa has no recourse but totap private foreign capital to raise produc-tivity levels necessary for sustainedincreases in living standards. With manyAsian and Latin American countries grow-ing rapidly and far ahead of most Africancountries in terms of putting in place thefinancial infrastructure needed to effi-ciently absorb foreign capital, most Africancountries will have to undertake speedypolicy and structural reform to attract pri-vate flows. Market discipline is likely to be

severe in the initial stages, and countriesthat backtrack on reform will find theiraccess to international capital limited andwhat is available to them will be providedon costlier terms.

At the micro level, sub-Saharan countrieswill need to take concerted action on manyfronts:

• improve infrastructure;• strengthen banking systems;• develop capital markets by accelerat-

ing the pace of privatization and broaden-ing the domestic investor base;

• formulate an appropriate regulatoryframework and a more liberal investmentregime;

• introduce competitive labor marketpolicies while creating and maintaininginstitutions for upgrading human capital;and

• reform the judiciary system and con-tain corruption.

It needs emphasizing that a piecemealapproach, even one including tax holidaysand other investment incentives, is unlikelyto sway investor decisions and attract inter-national resources on a sustainable basis.

While microeconomic factors are difficultto quantify, the macroeconomic factorsused in the empirical analysis we havecarried out (Bhattacharya, Montiel, andSharma, 1996) yielded clear-cut conclu-sions. In sub-Saharan Africa, economiccharacteristics like output growth, open-ness, relative stability of real effectiveexchange rates, low external debt, and highinvestment rates have encouraged privatecapital flows. The first three of these havebeen crucial for drawing in FBI and the lasttwo factors, coupled with output growth,have been particularly important forobtaining foreign private loans. IF&DI

Suggestions for further reading:Amar Bhattacharya, Peter J. Montiel, and

Sunil Sharma, 1996, "Private Capital Flows toSub-Saharan Africa: An Overview of Trendsand Determinants," unpublished, World Bankand International Monetary Fund(Washington).

Louis Kasekende, Damoni Kitabire, andMatthew Martin, 1996, "Capital Inflows andMacroeconomic Policy in Sub-Saharan Africa,"Jerome Levy Economics Institute, Bard College,Working Paper No. 158.

Peter J. Montiel, 1995, "Financial Policiesand Economic Growth: Theory, Evidence andCountry Specific Experience from Sub-SaharanAfrica," Special Paper No. 8, African EconomicResearch Consortium (AERC).

World Bank, 1996, World Debt Tables(Washington).


ylsfaw countries have gener-ally been more successful thanAfrican countries in liberaliz-ing their financial systems.Why have their outcomes dif-fered? Asia's experience withliberalization offers some use-ful lessons for Africa.

B OTH ECONOMIC theory and

practical experience suggest thatfinancial liberalization can stimu-late economic development. Until

the 1980s, extensive government interven-tion was the norm in the financial marketsof developing countries. Ceilings wereimposed on bank interest rates; credit wasallocated by administrative decision ratherthan market criteria; and inflows of foreign

capital were strictly controlled. Over thelast twenty years, however, many develop-ing countries—persuaded by both the theo-retical arguments made in support ofliberalization and the experience of manyof the rapidly growing countries—havebegun to liberalize their financial marketsby abolishing these types of controls.

The results of financial liberalizationappear quite different for Asia and Africa.If one uses the ratio of broad money (cashplus deposits in the commercial bankingsystem) to national income as a measure offinancial deepening and the success ofreform, liberalization appears to have beenmuch more successful in Asia (see chart).However, this simple comparison can bemisleading. Financial reform was imple-mented much earlier in most Asian coun-tries than in Africa; for example, Malaysialiberalized interest rates in 1978. In con-trast, even the earliest African liberalizers(The Gambia and Ghana) began to intro-duce reform only in the late 1980s.Moreover, financial development is only

one part of a broader process of economicdevelopment, of which it is both a causeand a consequence. The generally moresuccessful economic performance of Asianeconomies over the last two decades hasunderpinned and enlarged the benefits offinancial sector reforms.

Nevertheless, the Asian experience offerssome important lessons for Africa.Comparison of the experiences of the twocontinents suggests that if financialreforms are to succeed, they must be imple-mented in an appropriate macroeconomic,financial, and institutional environment.

Benefits of liberalizationIn most developing countries, the bank-

ing sector dominates the financial systemand securities markets are not well devel-oped. Restrictions on bank behaviorimposed by the government often result innegative real interest rates and an excessdemand for credit, requiring banks toration their lending. Consequently, credit isallocated to favored sectors and firms by

Huw Pill,a UK national, was a visiting scholar in the IMF's Research Departmentwhen undertaking the research on which this artick is based and is cur-rently an Assistant Professor in Harvard University's Graduate School ofBusiness Administration.

Mahmood Pradhan,a UK national, is a Senior Economist in the IMF's Asia and PacificDepartment.


ipclfliberalizap'tn Africa and Asia .--z

• fUW PILL AND MAHMOOD PRADrlAN '%|

OTH ECONOMICTHERY AND


Indicators of financial deepening 1

Source: Huw Pill and Mahmood Pradhan, "Financial Indicators and Financial Change in Africa and Asia," IMF WorkingPaper No. 95/123 (Washington: IMF, November 1995).

1 All aggregates are constructed using 1987 GDP weights.

2 Indonesia, Korea, Malaysia, the Philippines, Sri Lanka, and Thailand. Data for 1993 exclude Indonesia.

3 The Gambia, Ghana, Kenya, Madagascar, Malawi, and Zambia.

administrative decision, rather than bymarket mechanisms.

Following financial liberalization, marketdetermination of interest rates shouldresult in modestly positive real interestrates. These, in turn, will increase theresources available to the financial system,since bank deposits offering a competitivereturn will attract savings that were previ-ously held outside the formal financial sec-tor (possibly as excess inventories ofintermediate goods). Moreover, positive realinterest rates will provide an incentive forborrowers to invest in more productiveactivities, thereby improving the productiv-ity of the economy as a whole. Conse-quently, financial liberalization should leadto an increase in both the quantity and thequality of financial intermediation by thebanking system.

Financial liberalization can thereforestimulate economic development through avariety of channels. Since the financialsystem performs the vital function of rais-ing funds for, and channeling funds to, pro-ductive investment, successful financialliberalization is usually an important com-ponent of a country's strategy for economicgrowth.

Implementing liberalizationFinancial liberalization entails the aboli-

tion of explicit controls on the pricing andallocation of credit. Direct governmentintervention in bank credit decisions is

8 Finance & Development I June. 1997

brought to an end. Liberalization may alsoinvolve the abolition of controls on interna-tional capital movements. However, govern-ment policies will continue to play a centralrole in determining how the financial sectorperforms. Financial liberalization does notmean "free banking." Governments willcontinue to intervene in the financial sectorin a number of ways: banks will be super-vised for prudential reasons; some banksmay be publicly owned; and the govern-ment may be a major borrower. How suc-cessfully the authorities perform their roleas supervisor, owner, or customer will be animportant determinant of the success ofreform. Moreover, financial liberalization isonly one component of a successful devel-opment strategy. Appropriate macroeco-nomic policy, institutional development,and structural reform must accompanyfinancial liberalization and create the stablecontext required for it to succeed.

Macroeconomic stability is a prerequisitefor successful financial liberalization. In thegenerally successful Asian cases, macro-economic imbalances were largely elimi-nated before financial reforms wereintroduced. Balance of payments and fiscaldeficits were manageable, and inflationwas relatively low. The Asian countriesthat were exceptions to this rule—thePhilippines and Sri Lanka—were notablyless successful in expanding their financialsectors following reforms. For example,in Indonesia, where macroeconomic

conditions were favorable, the ratio ofbroad money to GDP rose dramatically,from a preliberalization level of 9 percent in1983 to well over 40 percent in 1991. In con-trast, in Sri Lanka, the ratio of broad moneyto GDP was largely unchanged after thereforms. Only credible and sustainedmacroeconomic stabilizations produce theincreased demand for money that is thecounterpart to financial deepening.

The situation is markedly different inAfrica, where a number of countries haveattempted to implement financial liberaliza-tion in an environment of ongoing inflation—largely a consequence of excessive fiscaldeficits. In Ghana, inflation was more than20 percent a year when interest rates werederegulated; in Zambia, inflation exceeded100 percent at the time of reform. Attaininglow but positive real interest rates is diffi-cult when inflation is high and volatile.

While macroeconomic stability is essen-tial for successful financial liberalization, asound banking system is also extremelyimportant. The benefits associated withfinancial reform are contingent on the finan-cial system being "well behaved" through-out the liberalization process. Wheresignificant market failures exist, or govern-ment intervention in the financial systemcontinues, the freedom that liberalizationoffers banks may be exploited in ways thatharm the overall development strategy. •

For example, banks in many Africancountries are publicly owned and thereforeremain susceptible to government interfer-ence even after controls on credit pricingand allocation have been formally abol-ished. Moreover, because of the stock ofnonperforming loans inherited from theadministratively directed lending programsof the prereform era, the solvency of manyprivatized banks may remain dependent onsubsidized credit from the central bankeven after liberalization. In these circum-stances, loans provided by these banks aremore akin to government subsidies.Liberalization will do little to improvecredit allocation or spur financial deepen-ing in such circumstances, since the banksremain wholly dependent on the govern-ment, and their lending decisions are sub-ject to its discretion.

Similarly, if competition among banks inthe newly deregulated financial sector isweak, liberalization may result in lower realdeposit rates rather than the anticipatedmovement toward modestly positive, equi-librium levels. Monopolistic banks canexploit the opportunity offered by the aboli-tion of interest rate controls to widen themargins between their deposit and lending

Finance & Development /June 1997


rates to increase profits. In those Africancountries where this has happened—Kenya, Madagascar, and Malawi in oursample—liberalization has resulted in littlefinancial deepening, since the attractive-ness of bank deposits to domestic savershas, if anything, been reduced.

When financial deregulation is imple-mented—and especially where nonperform-ing loans are inherited from the prereformera—interest rate liberalization should beaccompanied by structural reforms, includ-ing restructuring bank balance sheets toremove bad debt, privatizing publiclyowned banks, and introducing measures topromote competition in the banking sector.The implementation of concurrentstructural reforms in several Asiancountries explains an importantpart of their greater success com-pared with reform efforts in Africa.

Of course, deregulation also cre-ates opportunities for banks tomake poor lending decisions. If,prior to reform, banks have notmade loans based on market crite-ria, their ability to manage creditevaluation and allocation is likely tohave either atrophied or never beendeveloped. Moreover, the process offinancial liberalization itself will introducenew uncertainties into the economic sys-tem. Newly liberalized banks may thereforebe prone to making poor lending decisions.Strengthening the management and riskevaluation capabilities of bank managers ina newly liberalized environment should bean integral part of the restructuring pro-cess. This is likely to require governmentaction. For example, the government mayrelax restrictions on foreign ownership ofdomestic banks so that foreign "best prac-tice" managerial and credit assessmenttechniques can be introduced.

Systemic risk also needs to be managedmore carefully in a deregulated financialsector. Paradoxically, the need for effectiveprudential supervision of financial institu-tions may be greater in a liberal environ-ment than under a government-controlledregime of financial repression. The exis-tence of controls on bank behavior priorto reform may make the financial sectorstable, albeit at considerable expensein economic efficiency. Deregulation willundermine this controls-based stability andtherefore necessitate much greater empha-sis on prudential supervision. If bankschoose to use the new freedoms implied byliberalization to exploit potential marketfailures, the effects on macroeconomic andfinancial stability can be catastrophic.

Financial liberalization cannot be imple-mented in a vacuum. Macroeconomic stabil-ity prior to reform is essential. Butpolicymakers also need to strengthen insti-tutional development in the financial sys-tem before liberalization is introduced. Ifthe legal, accounting, management, andsupervisory infrastructures of the financialsector are weak, then deregulation alone isunlikely to generate the expected benefitsand, in fact, highly destabilizing forces maybe unleashed. Accompanying structuralmeasures are therefore vital. This ismost apparent in Africa, where economicinstitutions remain underdeveloped andhighly fragile. Even in the more successful

"If financial reforms are tosucceed, they must be imple-

mented in an appropriatemacroeconomic, financial,

and institutionalenvironment."

Asian cases, there is considerable scope forimprovement. The large number of non-performing loans on many Asian banks'balance sheets is testament to the dif-ficulty of implementing effective bankingsupervision as liberalization proceeds,even in relatively benign macroeconomicenvironments.

Measuring resultsConventionally, the success of financial

liberalization has been assessed using twocriteria: the extent of financial deepeningand the evolution of real interest ratestoward plausible equilibrium levels. Indeed,these criteria have been used in this article.These two measures, however, suffer fromcertain drawbacks that may obscure someof the important differences between theAfrican and Asian experiences with finan-cial reform.

Abstracting from institutional details, itis clear that reform occurs in several stages.Typically, domestic financial liberalization—the abolition of controls on interest ratesand credit allocation—precedes interna-tional financial liberalization—the elimina-tion of capital controls and restrictions onthe convertibility of domestic currency intoforeign exchange. Conventional measuresof the success of financial reform focus ondomestic deregulation, although in many

cases international liberalization is at leastas important.

For example, if abolishing capital con-trols on the balance of payments results ingreater integration of domestic and inter-national financial markets, arbitrage pres-sures may keep the domestic real interestrate close to world levels. Therefore, wheredomestic real interest rates are initiallyabove world rates owing to a shortage ofdomestic savings, international financialliberalization that offers domestic firmsaccess to international capital may lower,rather than raise, real interest rates.

Similar concerns affect financial deepen-ing. Prior to international financial liberal-

ization, broad money offers a goodindication of the banking system'sscope for credit expansion, sincedomestic bank deposits are themain source of finance for banklending. When capital controls areabolished, however, capital inflows—in the form of deposits madeby foreign residents in domesticbanks—add to the funds bankshave available for credit expansionbut do not increase broad money(since they are excluded from it bydefinition). Money-based measures

of financial deepening may therefore bemisleading when capital inflows are impor-tant (see chart).

Capital flows are not the only reasonwhy money and credit-based measures offinancial deepening may diverge, however.In general, government borrowing from thebanking system will, for a given level ofbroad money, reduce the amount of creditavailable to the domestic private sector. Ifprivate sector activity is more productivethan government expenditure, then thiscrowding out of private borrowing mayhave strong negative repercussions for eco-nomic performance that would not, how-ever, be reflected in the conventionalmeasure of financial deepening.

The chart suggests that several financialliberalizations undertaken in Africa sincethe late 1980s—before fiscal deficits wereeliminated—have been adversely affectedin this way. In the absence of well-developed government securities markets,deficits were financed largely by govern-ment borrowing from banks. Consequently,these countries' apparent success in achiev-ing financial deepening (as indicated bychanges in the conventional money-basedmeasure) during the early 1990s is beliedby what private sector credit measuresshow. Since theory suggests that credit islikely to be more important for economic



Financial liberalization in Indonesia and Kenya

IndonesiaForeign exchange controls were eliminated in Indonesia in 1971, partlyat the urging of the IMF but also because these controls reduced theefficiency of international trade and payments, and were extremely dif-ficult to enforce given Indonesia's proximity to an open internationalfinancial center in Singapore. However, extensive controls on thedomestic financial system remained in place until 1983. Only then wereinterest rates liberalized and controls on credit allocation relaxed.Prudential supervision was strengthened in 1984, after the initial liber-alization of the banking system. Similarly, after relaxing controls on theentry of new banks and easing restrictions on the extension of bankbranches in 1988-89, stricter prudential regulations were introduced bythe centra] bank to constrain the explosion of bank credit that followedderegulatioa

Indonesia's experience is therefore characterized by the implementa-tion of several large reforms, each followed by retrenchment and con-solidation. Although problems have emerged because institutionaldevelopment, especially in the area of prudential supervision, hastended to lag behind deregulation measures, the overall success ofreform has been considerable. Real interest rates have been positivesince 1983, and financial deepening has been extensive. Privatelyowned banks now constitute a much larger proportion of the bankingsector, as the relative importance of publicly owned banks has declined,and securities markets, especially the Jakarta Stock Exchange, have

become more important. Although there have been occasional set-backs, and institutional weaknesses in the accounting and legal sys-tems remain, overall the financial liberalization strategy pursued inIndonesia has been supportive of wider economic development.

KenyaFinancial liberalization in Kenya is much more recent. Ceilings on banklending rates were not removed until July 1991. The central bank con-tinued to announce guidelines for the sectoral composition of bankcredit expansion, although these were not strictly enforced after inter-est rate liberalization. International financial liberalization is even morerecent. Offshore borrowing by domestic residents has been permittedonly since early 1994, and portfolio capital inflows from abroad wererestricted until January 1995. Supporting structural and institutionalreforms have yet to be fully implemented. Many banks remain publiclyowned and competition among them is limited.

Deregulation of interest rates in this monopolistic environment per-mitted banks to widen their margins such that real interest rates onbank deposits fell substantially. Partly in consequence, financial deep-ening has been modest, especially when measured by the ratio of pri-vate sector credit to national income. Although it is too early toevaluate the success of financial liberalization, the lack of accompany-ing institutional and structural reforms suggests that financial sectorreforms will provide only modest benefits to the overall Kenyan devel-opment strategy'.

development than the supply of broadmoney, these findings help to explain whythe initial results of the African experienceswith financial liberalization are generallyregarded as disappointing, despite someprogress on the usual financial deepeningmeasure. In Asia, where fiscal deficits werereduced prior to financial reform, bothmoney and credit measures indicatethat significant financial deepening hasoccurred and the beneficial impacts ofreform on countries' real economies havebeen greater.

As liberalization proceeds, banks ceaseto dominate the entire financial system.Securities markets emerge and become anincreasingly important source of funds formany firms. This process is quite advancedin many Asian countries. As alternativesources of external funds become availableto domestic firms, neither broad money norbank credit will be an adequate comprehen-sive indicator of either the success of reformor its likely impact on real economic perfor-mance, because they do not include thefinancial flows that occur outside banks'balance sheets. In Asia, equity and bondmarkets now play an important role infinancing domestic firms' investment pro-jects, and the conventional measures offinancial deepening will not capture theireffects. In such circumstances, broader

measures of credit, which encompass newissues on the securities markets, are betterindicators of the success of financial reform.

Lessons for liberalizersFinancial liberalization is an extremely

important component of a successful devel-opment strategy. If financial deregulation isimplemented in isolation, it is unlikely topromote growth and may, in fact, impedeeconomic development. The importance ofachieving macroeconomic stability prior toreform is well known, yet structural reformand institutional development in the finan-cial sector, especially prudential financialsupervision, are equally essential as liberal-ization proceeds.

Liberalization has been implemented in anumber of African and Asian countries.Reforms in Asia were introduced both ear-lier and in more favorable macroeconomicenvironments. Although the creation ofeffective supervisory institutions remains achallenge in some countries, the Asianexperience has been very successful over-all. In comparison, financial liberalizationin Africa, where reforms were introducedmore recently, has yielded modest results,although some of the benefits have yetto accrue. Nevertheless, concerns remain.The environment in Africa is far lessfavorable—considerable macroeconomic

imbalances persist and institutional devel-opment is not well advanced. The Asianexperience offers some important lessonsfor Africa in both respects.

Measuring the results of reform isextremely important if policy is to be welldesigned and implemented. The effects ofliberalization itself may distort the infer-ences drawn from conventional measures offinancial deepening about the success ofreform. Consequently, a wide range ofperformance indicators should be moni-tored by policymakers. This is especiallyimportant in Africa, where conventionalmeasures may exaggerate the success ofcountries' reform programs in their earlystages and thereby obscure underlyingproblems—notably, fiscal imbalances—that will require attention if financial reformis to be successful in the medium term. If&Dl

This article is based on the authors' paper,"Financial Indicators and Financial Change inAfrica and Asia," IMF Working PaperNo. 95/123 (Washington: IMF, November1995).Reference

Ronald!. McKinnon, 1993, The Order ofEconomic Liberalization: Financial Control inthe Transition to a Market Economy, second ed.(Baltimore, Maryland: Johns Hopkins UniversityPress).

10 Finance & Development I'June 1997


Tackling the Rural EnergyProblem in

\ Developing CountriesD O I J G L A 5 F . B A K N E S , 8 0 H K K T V A N D E R P L A S .

A N D \ \ LI.BM F L O O R

Many people in the developingworld lack access to energysources such us oil, gas, andelectricity, and slill depend onbiomass. The problems of sup-plying them with modern fuelsappear daunting, but practi-cal and financially sustain-able solutions exist.

E NERGY MARKETS do not func-tion efficiently in many developingcountries, particularly in ruralareas, where nearly 2 billion peo-

ple do not have electricity or access to modern fuels such as oil and gas. The problemis likely lu worsen in coming decades. Thepopulation of the developing world is

Douglas F. Barnes*.a US national, is an Etiergv Planner until tlieI'ower Dewlupmt'nl. Efftdency aiiif HouseholdFuels Division uftlie World flank's Finance andPrivate Stctor Development Virp Presidency

expected i" mnvu-e by 3.billion Ov.er tin-next torn1 vc;irs, mid ylttrgy, Oematld p'.-rr.-ipim w i l l j i iuvv lapidlyvAsCOunrries' ecu-[nimic develfipmem proceeds, Llltii pelcapita nm-mnpnon < > i " commercial energyimTeascs. rVi kapiw c»nsHnipnab of onii-mrif ia l entity ir. Mv Unittd Stales. I'mexamplr, is fit) liiut'ri l i i g l i c r t l i un in Atnni.40 limes higher than IF South Asia. 1.1lime-; higher rlrin in f{a>i Asia, and 6 linic-r-hipher than in Latin America^

Inadequate energy markeS threalt'ii lodampen economic growth, ijotiblu develdpment, and keep living Ji|andards low.Allhuugh grid electrificMm IK the tradi-tional means of providingHiablc electricitysupplies, coiincclion to dapnt gnds v$\ heloo expensive to be cost-.efftrrive for manyruiâl areas. Fortimateljfterc ai'e a numberof promising altcrnjfts for increasinj;energy supplies evetv»very remote areas,ranging from more Spdcnl use of tradi-tional fuels lo advai«3 technologie.s basedon renewable energjfwces.

Kubcrl MIII (Ifi'ffcis.a Uuli'li natiiiiinl.fllii l-jierfy ilanner icillt llu-Puuvr Developtnaf, Kffiaency anil HouseholdI-'ini-, !>it/-:i"ii i'ftit< W>>r!Aiiui;}:.'< FiiMim mill^f;Private Sector KflafimeaKiec Pre.iidt'icy

W ' *The current situationKHoi';-- -ii;ice 197U tn incrrasr ckilricily

-;uppHep sr developing counlues have been•vivarkHi)l\ successful Bee table). Btitbccaitst i > ! \njpulntHjn firowth, the numberdt" liousi-hdlfl-: wirhou' i-!i'i-i:ui!.\ in -n i ll-'ir^ft and ::• r\cn ^niwirii; in ••nine i v i ; i < > n Ôin'-tbL'd ')' all eiit-rgj' cunsnmed in diudevetopiiijT wor!4 ciniifo hum biomass. Inaddition !'i Ui-ing their primary M H I I T C ofcnedfe biomass als< i provides many peoplein tl»ipvel()ping%orl^fcith a livelihood.In Afrii'ii alum;, theprnductmn anri m;irkel-ing ofcfood fuels (rSfKvood;mdcliarcoiil) isa SSfeillion business tliat employs morethan 400,000 people.

Wood and nihcr trathlioiial kiflv- ,îcii t^dung H-IVI- numerous diwidvaniage^.. !mw-evtr. Tliej are fÛK effic«t than otherenergy soiinv-;; S kf t^ra in <ii wm.d. furex.'implf. generate:- oniy "ne tenth ut rhcliRat jiclded by a kil"irnm trf Hiiuidpetroieum gas d.IJ(i\ Miwver, burningthese types oi" [\n-l? in an enclosed, pxir lv

Willem Flour.Dutch nati">-i :f a Seititifnrrgt' Flmiu'r

:'->th the Ann r lAwhpnienffficit'tKyTmJHfimttttMI'tii-if. Itti-ifiiii! n/ tltt l\'i<t!i!Rattl;':i-:nance. an<; I'nratf Nr,'.^ Dtrrli>j>i>iti:! Vii,I'irsidsii£\

Finance .<. /)<•/; hptm-at •'jtoirW/ I I


North Africa and the Middle EastLatin America and the CaribbeanSub-Saharan AfricaSouth AsiaEast Asia and the PacificAll developing countries

Total served (in millions)

1970

65

67

28

39

51

52

320

1990

8182

3853

82

76

1,100

1970

14

15

412

25

18

340

1990

35

40

825

45

33

820

ventilated space presents a major healthhazard. According to some estimates,smoke contributes to acute respiratoryinfections that affect 4 million infants andchildren a year. Studies have shown thatnonsmoking women in India and Nepalwho have cooked on biomass stoves formany years have a higher-than-normal inci-dence of chronic respiratory disease. Theuse of wood fuels has also taken a serioustoll on the environment in many regions,leading to deforestation, soil erosion, andreduced soil fertility. Deforestation, in turn,has forced many poor people to resort toeven less efficient sources of energy, such ascrop residues and dung—materials thatcould otherwise have been used for fertil-izer. Finally, many children and adults indeveloping countries must spend up to sev-eral hours per day gathering fuel; thisleaves them less time for schooling and pro-ductive activities and thus perpetuatespoverty.

Moving up the energy ladderIn poor countries with annual per capita

incomes of $300 or less, at least 90 percentof the population depends on wood anddung for cooking. But people move up the"energy ladder" as their incomes grow,eventually switching to electricity for light-ing and fossil fuels for cooking; in agricul-ture and industry, diesel engines andelectricity replace manual and animalpower. The transition to modern fuels isusually complete by the time annual percapita incomes reach $1,000-$1,500. Withtechnological progress and reductions inthe costs of modern fuels, the income levelat which people make the transition candecline significantly. For example, a transi-tion that took nearly 70 years in the United

States (1850-1920) took only 30 years inKorea (1950-80). But such transitions willnot happen overnight. Even in East Asiaand the Pacific, a region that has experi-enced rapid economic growth and signifi-cant increases in the supply of commercialenergy, biomass still accounts for 33 per-cent of energy supplies and its use isexpected to decrease by only 50 percentover the next 15-25 years.

What are the options?Because biomass use will continue

throughout the developing world for sometime to come, energy policies must supportways to use wood fuels more efficiently andsustainably, while creating the necessaryconditions for supplying modern fuels tothose who lack them.

Farm forestry and local forestmanagement. Farm forestry—plantingtrees, shrubs, and grasses on farmlandsand between crops—and forest manage-ment have long played an important role inalleviating wood shortages in China, India,and many other countries. Because farmersoutnumber foresters in most countries byseveral thousand to one, involving them inplanting trees and shrubs can dramaticallyaccelerate afforestation. And the incentiveto participate in farm forestry programs isstrong: wood fetches a high price in someurban markets, and trees and shrubs cansupply farmers with fodder, building mate-rials, green mulch, fruit, and other byprod-ucts that may be as valuable as thefirewood itself.

Experience suggests that effective man-agement of existing forest resourcesdepends on letting local people take respon-sibility for forests or woodlands. Some suc-cessful participatory effects have now been

pioneered in several countries. In these pro-grams, farmers get to sell all the woodextracted from local woodlands; however,they must participate in a resource-man-agement program developed in collabora-tion with the national forestry department.

Improved charcoal efficiency.Charcoal represents an intermediate rungon the energy ladder, between wood andkerosene or LPG. It burns without smoke ordangerous flames and requires only a sim-ple stove whose heat output is relativelyeasy to control. However, local charcoal pro-ducers often use inefficient charcoalingkilns that consume more wood than neces-sary. Kilns based on traditional designs butthat are more energy efficient have beendeveloped in collaboration with end usersin Madagascar, Rwanda, and Thailand andsuccessfully disseminated through exten-sion programs and training. Programs pro-moting technical innovation have beenmost successful when accompanied by theforest-management programs describedabove, which give villagers custody of localforest resources.

Efficient use of biomass. One way toimprove wood fuel use is for governmentsto encourage the private sector to developand market improved stoves in rural areasby supporting stove design and testing,and conducting publicity campaigns andtraining programs. Relatively simple andinexpensive stoves—for example, withimproved chimneys—can reduce theamount of fuel needed for cooking by asmuch as 30 percent, yield substantialhealth benefits, and free women and chil-dren from hours of gathering firewood.Experience has shown, however, that suchprograms need to be targeted. For example,the successful Chinese National ImprovedStove Program, the largest ever undertaken(120 million stoves have been installed inrural households), was concentrated onareas with the greatest shortages of woodfor fuel.

Although fuels from biomass are gener-ally much less efficient for cooking thanmodern fuels, biogas derived fromdigesters of dung and farm residues is anexception. Both China and India have donemuch to develop biogas and encourage itsuse. However, only farmers who raise live-stock can easily acquire biogas; it is thus acost-effective option for less than 10 percentof most rural populations.

Rural electrification. Rural demandfor electricity comes mainly from house-holds that use electricity for lighting andfrom farms, agro-industries, and small com-mercial and manufacturing establishments,


Source: World Bank project and sector reports, and surveys of electricity statistics by the World Bank's regionalstaff in Asia and Latin America.

Note: Figures are estimates.

BljM?niWsTiTfMMfifnB*TsiSr>lLs*K*jiiinTH^TfBt*T^MH<iHii ^^^B^ ^ ^ ^ ^ • V^ Mra ffli ^ ^QQ^ ^ ^ ^ ^ ^ ^ I

(PERCENT OF POPULATION)

uRBAB rURAL


which use electricity for productive pur-poses such as irrigation pumping, watersupplies, crop processing, refrigeration, andmotive power. Most rural electrificationprograms have focused on connecting ruralareas to national or local grids (see box).However, grid-supplied electricity is not thelowest cost alternative under all conditions.

For example, technologies involvingwind power, solar thermal power (sunlightused to heat air or water), photovoltaic (PV)cells (which produce electricity directlyfrom sunlight), and small-scale hydropowermerit more attention from policymakers.They are often an ideal way to get energyto rural areas and have significantenvironmental advantages relative tofossil fuels. Solar power is a particu-larly attractive option for countrieswith abundant sunlight and a poorlydeveloped rural grid electrificationsystem.

The costs associated with thesetechnologies, once prohibitive, havedecreased significantly over the pastdecade. Today, PV systems supplyelectricity economically to rural areasthroughout the developing world forlighting in homes and schools, domesticappliances, refrigeration in health clinics,village water pumps, telephones, and streetlighting.

Rural energy policiesEvidence suggests that people are will-

ing to spend a significant portion of theirincomes on higher quality energy thatimproves their quality of life and enablesthem to be more productive. Governmentshave an important role to play in creatingconditions that provide consumers withmore energy choices and encourage innova-tion and investment in new technologies.Prices should be liberalized to reflect costs,and regulatory policies need to encouragecompetition and level the playing field forall types of energy markets, whether theyare served by public utilities, private firms,or community enterprises. For example"off-grid" power companies and coopera-tives are often totally excluded by electric-ity regulations from serving people, andpolicies that artificially hold down pricessometimes provide little incentive for suchlocal initiatives to get started.

Pricing and market reforms. Ingeneral, energy subsidies (prevalent indeveloping countries) should be avoided.Subsidies undermine incentives both forconsumers to make least-cost choices andfor investors to develop alternative energyforms, and more often disproportionately

benefit higher-income households, whichuse more energy than poor households. Insome cases, subsidized fuels never evenreach the poor. In Ecuador, for example,kerosene for cooking and lighting was sub-sidized until recently, but retailers preferredto sell the kerosene for use in vehicles,which was more lucrative than selling it tothe poor. Electricity subsidies are a particu-lar problem. They have left many utilitieseconomically crippled, unable to financethe extension of services to rural areas.Moreover, they distort the market, encour-age consumers to buy grid-suppliedelectricity, and discourage the development

"Subsidies undermine incen-tives both for consumers to

make least-cost choices andfor investors to develop alter-native energy forms, and...disproportionately benefit

higher-income households."

of decentralized, off-grid companies.Universal pricing (charging the same pricescountrywide), a common practice, also cre-ates disincentives for electric utilities toserve rural markets, where costs tend to behigher.

Even when subsidies do benefit the poor,they may represent an unsustainable finan-cial burden on the state. Market liberaliza-tion is usually a far more effective strategy.In Hyderabad, India, for example, only therichest 10 percent of households used LPGin 1980. Middle-class households usedkerosene because they could not obtainLPG, a more efficient fuel. There was nokerosene for the poor because the limitedamounts available for public distributionwere bought by middle-class households.As a result, the poor had to use wood,which was even more expensive thankerosene. When the Indian government lib-eralized energy markets and relaxedrestrictions on the production and importof LPG, more middle-class householdsswitched to LPG. Supplies of kerosene werethen more plentiful and more available tothe poor. Now more than 60 percent ofhouseholds in the city use LPG.

One subsidy that can be justified is a life-line rate for grid electricity. Most poorpeople use very little electricity and needonly the most basic service. Thus, the appli-cation of lower tariffs for consumption ofsmall amounts of electricity provides a

direct benefit for the poor and usually doesnot represent a significant financial drainon the distribution company. Any financiallosses can be recovered by chargingslightly higher prices to large-volume cus-tomers, who usually have higher incomes.

Alleviating problems with firstcosts. In developing countries, the firstcosts associated with getting access to mod-ern sources of energy are often prohibitivelyhigh for the rural poor, who are also usuallyunable to obtain credit. The fees for beingconnected to an electricity grid can rangebetween $20 and $1,000; a solar home sys-tem costs between $500 and $1,000.

Installing a microgrid can cost a com-munity tens of thousands of dollars.

There are two ways of dealingwith the high initial costs of ruralenergy services—lowering systemcosts through design innovationsand giving rural consumers access tocredit.

Many distribution companiesdesign systems with the capacity todeliver between 3 and 7 kilowatts ofservice and that require heavierwires, larger transformers, and gen-

erally more expensive distribution systemscomponents. The entire system design canbe lightened to provide service at less cost.Similarly, the standard household PV sys-tem promoted by many development agen-cies provides about 50 watts of power, butrecent evidence from Kenya shows that peo-ple there are purchasing more affordable PVsystems that provide only about 12 watts.

Many practical options exist for provid-ing affordable credit for rural energy. Forexample, electricity companies could allowcustomers to pay access charges overseveral years. In a recent project inIndonesia, banks are advancing credit toconsumers for the purchase of householdPV systems. Some nongovernmental orga-nizations (NGOs) in Nepal and Peru aremaking credit available for the installationof microgrid systems based on micro-hydroelectric systems.

Emphasizing participation andinstitutional development. Local par-ticipation is crucial for the success of ruralenergy policies. Cooperatives, NGOs, andcommunity organizations can be highlyeffective vehicles for supporting the deliv-ery of energy services and managingresources.

Participatory efforts must be properlydesigned, however. The first attempts topromote community biogas systems in theIndian village of Pura failed because theywere aimed at getting villagers to use



Options for rural electrificationBetween 1970 and 1990, nearly 1.3 billion people, 500 million ofdiem in rural areas, were newly supplied with electricity fromnational grids. But the population in some developing regionsgrew faster than electricity supplies. The number of people insub-Saharan Africa with electricity increased by only 18 millionbetween 1970 and 1990, while the total population grew by 118million. Similarly, in South Asia, 140 million people gainedaccess to electricity during the same period, but, because of pop-ulation growth, the number of people without service grew bymore than 100 million.

Surveys of rural energy use show that many people spendsignificant sums on candles, kerosene, and batteries for lightingtheir homes. Many rural people in Bolivia, for example,spend $4-$5 per month on candles.Switching to electricity and usingjust one 40-watt bulb or a 20-wattincandescent lamp would cost a fewdollars more per month but wouldprovide 25 to 75 times more lightthan a candle.

regions with the necessary resources. The costs per kWh of elec-tricity generated by micro-hydropower can be as low as 20-30cents, depending on the site; 90 cents for PV panels; and 40-90cents for small wind sets. Electricity for local distribution canalso be generated from such fuels as biogas or biomass.

Micro-hydropower can be one of the cheapest options for pro-viding electricity to rural areas too remote to be connected to agrid Much care needs to be given to selecting the site for amicro-hydro project, however, given possible variations instream flows during the year and from river to river, and theircosts can vary significantly, depending on the terrain. In moun-tainous countries like Nepal, for example, transportation ofequipment and materials can account for as much as 25 percent

of total project costs.

"Grid supplies areusually the cheapestoption in areas withhigh load densities,as well as in areasnear the grid. Butconnecting small,

isolated villages to agrid can be expensive.

The choicesMany people without electricity

in rural areas are therefore willingto pay to get it. Grid supplies areusually the cheapest option in areaswith high load densities, as well asin areas near the grid. But connect-ing small, isolated villages to a gridcan be expensive because of the nec-essary investment in transmissionlines, poles, transformers, and otherinfrastructure. In some instances, other options—includingdiesel generators, renewable energy (solar energy, micro-hydropower, wind, and small biomass-fired generators), and"hybrids" combining several of these—are more cost-effective.

Grid electrification. The high initial costs of grid electri-fication can be reduced considerably if design standards suit-able for areas with less demand are used. Most rural consumersneed from 0.2 kilowatts to 0.5 kilowatts, much less than the typ-ical minimum service connection ratings in developing coun-tries' utilities. The costs of installation and wiring provided byutilities are also high, but these can be lowered by simplifyingwiring codes and using load limiters (circuit breakers) to encour-age lower levels of consumption. Other cost-cutting strategiesinclude using cheaper utility poles and involving local people inconstruction and maintenance.

Micro-grids supplied by diesel generators. De-centralized, isolated distribution systems have been common inremote population centers for many decades—in most develop-ing countries, they predate the establishment of grids. The costsof such systems typically range between 20 and 60 cents perkilowatt hour (kWh). However, diesel generators can be hard tomaintain and expensive to operate because of their remote loca-tions and the costs of spare parts and fuel.

Renewable energy sources. Energy from solar, wind,and micro-hydropower schemes is an attractive option in

Successful approachesCountries that have succeeded in

making grid electricity service avail-able to rural people have done sothrough strong public leadershipand highly strengthened financialsupport. There are many ways topay for rural expansion withoutdestroying the financial viability ofthe electricity industry.

In Thailand, the public distribu-tion system serving areas outside ofBangkok—the Provincial ElectricityAuthority—was successful inexpanding grid electrification. Itdealt with the problems of lowerloads in rural areas by extending

service first to the highest-load villages, developing low-costconnection techniques, and promoting load development. Costswere reduced through standardization of systems design andprovision of a financially sustainable lifeline tariff for meetingthe minimal requirements of the poorest consumers.

In Costa Rica, rural cooperatives were able to establish arural grid in the early 1960s with long-term capital from the USAgency for International Development and the Inter-AmericanDevelopment Bank.

A regulatory regime requiring distribution companies toexpand service to a blend of high- and low-income householdswithin an assigned territory while requiring full-cost recoveryfor the system as a whole, is a possibility. There are also exam-ples of communities, innovative private companies, coopera-tives, and individuals that are successfully distributingelectricity through minigrids without subsidies. However, otherpotential innovations have often been thwarted by regulationsand policies that prohibit private enterprises other than thenational utility from selling electricity and by the absence oftraining and technical support. Another policy that discouragesprivate sector participation in rural electrification is uniformcountrywide pricing, which effectively makes small local gridsfinancially unsustainable.

14I'~tiM>n'i- £ !>i vc.lopment /Jitm- 1997


biogas for cooking instead of wood. Butsince wood is abundant and easy to collectin Pura, people had no incentive to switch.When the villagers revealed their desire forclean and reliable water supplies, the com-munity established a system that producedbiogas for fueling a five-horsepower dieselgenerator. Electricity from the generatorwas supplied to households through amicro-grid and used to power a deep tube-well pump. Each household participatingin the program received a tap providingclean water in front of its house.

Identification of the appropriate socialunit to work with is also crucial. SeveralWorld Bank-financed community woodlotand forestry projects in the late 1970s andthe 1980s had disappointing resultsbecause communities had been mistakenlyviewed as units of social organizationwhen, in reality, the interests of subgroupswithin those communities frequentlyclashed. And insufficient attention wasgiven to other complicating factors: com-munity land was limited and the tenure ofcommon lands uncertain; the influence of

local authorities was uneven; and distribu-tional arrangements for the products werecontested.

Creating enabling conditions.Investments in rural energy may falterbecause of economic conditions. For exam-ple, in rapidly developing agriculturalregions, electricity helps to raise theproductivity of local agro-industrial andcommercial activities by supplying motivepower, refrigeration, lighting, and processheating. Increased earnings from agricul-ture and local industry and commerce thenlead, in turn, to greater household demandfor electricity. However, when developmentefforts fail because of, say, poor croppricing, flawed marketing policies, andinadequate roads, programs to improveelectricity supplies are also likely tolanguish.

ConclusionHelping people in rural areas gain access

to energy is a great challenge, but themeans available for realizing this goal haveexpanded considerably in recent years. As

renewable energy systems come down incost, they are becoming an increasinglyattractive way to provide electricity to ruralareas. The costs of grid electrificationschemes can also be reduced to make elec-tricity more affordable to a broader spec-trum of rural people, and new, off-gridrural companies and cooperatives canemerge if competition is promoted, barriersto entry are reduced, and the pricing play-ing field is leveled. Moreover, continued useof biomass need not deplete the environ-ment, thanks to farm-forestry and forest-management programs that involvefarmers. Concerted efforts by governments,policymakers, the private sector, andNGOs, coupled with significant local partic-ipation, can lead to impressive results. IF&DI

This article is based on Rural Energy andDevelopment: Improving Energy Supplies forTwo Billion People, a study published by theWorld Bank in 1996 in the Development inPractice series (Washington).

Keep up with the world economyWhat are the prospects for economic growth and inflation in the advancedeconomies, developing countries, and countries in transition?How are the forces of globalization, including increased trade and capitalflows, affecting the world economy? What are the effects on wages andunemployment in the industrial countries? How are these trends influencingthe tendency of per capita income levels in developing countries to convergetoward those of advanced economies?What policies would lead to the best outcomes?The answers may surprise you.

The World Economic Outlook, May 1997A Survey by the Staff of the International Monetary FundAnnexes, boxes, charts, and an extensive statistical appendix supplement the text.ISSN 0256-6877.

Available in English, French, Spanish, and Arabic.$35.00 (academic rate: $24.00). (paper)

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GUEST ARTICLE

Japan's Economy Needs Structural ChangeT A K A T O S H I I T O

Japan's economic miracleappears to be waning. Struc-tural changes are needed toput the economy on a reason-ably high growth path onceagain.

I N THE four years from 1992 to 1995,Japan's growth rate was around1 percent or lower, the lowest amongthe G-7 countries. Although the reces-

sion touched bottom in October 1993, therecovery has been extremely weak; thegrowth rate did not pick up again until1996, when it is thought to have risenabove 3 percent. The appreciation of theyen during most of this period and the neg-ative effect on wealth of the collapse of the1980s' share and land price bubble havebeen singled out as immediate causes ofthe recession. However, the slowness of therecovery suggests that other factors musthave been at work as well. Specifically, fea-tures of the Japanese system that wereonce considered its strengths may now beholding back growth.

The Japanese systemJapan's growth record, especially from

the 1950s to 1990, was certainly re-spectable for an economy without majorresources (see chart). Several institutional

features of the Japanese economy are fre-quently cited as contributing to this rapidgrowth.

Lifetime employment. The conven-tional wisdom highlights the importancefor growth of the long-term relationshipbetween Japanese firms and their workers:regular workers are virtually guaranteed ajob for life. As a result, involuntary jobchanges are rare and the unemploymentrate has been low—around 1-2 percent inthe 1950s and 1960s, and between 2 and 3percent since the mid-1970s. Althoughemployment is to some degree guaranteed,job assignments, work hours, and rates ofpay are quite flexible. Given that workersare unlikely to quit, a firm can afford to pro-vide often costly on-the-job training.Rotation through different job skills, which

makes workers versatile and prepares themfor higher positions, is common. Thisinvestment in firm-specific human capitalhelps to increase worker productivity in thelong run.

It is often said that productivity increasesin Japan were due mainly to a combinationof innovations in the manufacturing pro-cess and better communication betweenemployees at all levels in the firm. This wasmade possible by teams of versatile work-ers who went through on-the-job trainingtogether. In addition, competition in thedomestic labor market and a system of"deferred" payments—characterized by asteep age-earnings profile and substantialseverance pay upon retirement linked tolength of service and final salary—detersworkers from shirking work or quitting

(percent changePrices and growth in Japan

Takatoshi Ito,a Japanese national, is a Professor at the Institute of Economic Research, Hitotsubashi University. He was a Senior Advisor in the IMF's ResearchDepartment when this article was written.


Source: IMF, International Financial Statistics Yearbook, various issues.


altogether. Thus, lifetime employment issupported by a system of implicit contracts.Moreover, it is self-sustaining: lifetimeemployment contributes to the growth of afirm, and growth makes it possible for thefirm to maintain lifetime employment.

The system works especially well in anexpansionary environment, since the rela-tively large pool of "underpaid" youngerworkers makes possible more "deferred"payments to retiring workers. When theorganizational hierarchy of a corporationgrows, more management positions are cre-ated, and therefore "deferred" paymentsincrease. Thus, lifetime employment canalso be seen as a type of pay-as-you-gocompany pension scheme.

The main bank system. Stronglong-term relationships betweenbanks and firms are often cited as asource of strength in the Japaneseeconomy. Typically, a firm develops arelationship with a particular bankand relies on its financial support overthe long term. The bank not only pro-vides loans to, but also holds sharesin, the firm. In return, the firm usesthe bank for major transactions fromwhich the bank earns profits. A bankthat has this type of primary relation-ship with a firm is called a main bank.

The main bank acts as an agent forinvestors and lenders to the firm,examining the viability of investmentprojects and monitoring the perfor-mance of management. Individualstockholders do not monitor manage-ment efforts, and Japanese institu-tional investors have not exercised thekind of monitoring power, such aspressing for higher dividends, thatinvestors have in the United States, forexample. Because a main bank takes along-term view, a firm's managementis able to embark on long-term investmentprojects with committed funding.

Keiretsu. In addition to the strong rela-tionship between banks and firms, theJapanese economy is characterized by long-term relationships between businesses inthe form of keiretsu, or enterprise groups.There are horizontal keiretsu (acrossdifferent industries) and vertical keiretsu(between a manufacturer and its suppliers,or its wholesale distributors, dealers, andretailers).

Conventional wisdom on the significanceof the keiretsu to the Japanese economy issimilar to that for the main banks; theymonitor the performance of management.Since group firms hold each other's shares,they are effectively safe from hostile

takeovers. Management can therefore con-centrate on long-term investment projects,rather than on dressing up quarterly earn-ings reports. Conversely, if the managementof a company has failed, the group firmscan collectively decide to replace those whoare responsible.

Industrial policy. Despite the popularimage of interventionist government, publicexpenditure as a percentage of GDP inJapan has been relatively small comparedwith other industrial countries. Never-theless, public policy has been used topromote growth in a variety of ways.During the 1950s and 1960s, the govern-ment targeted certain industries as sunrise

Takatoshi Ito

industries, providing them with variousadvantages to stimulate their expansion.They were given low-interest loans throughgovernment financial institutions andreceived hard-to-obtain foreign exchangeallocations. The government also restrictedentry to markets that were consideredimportant and crowded, and some marketswere segmented to limit competition.

One influential but controversial inter-pretation of the industrial policy of thisperiod goes as follows. When a chosen sun-rise industry was in its infancy, the gov-ernment protected the domestic marketthrough quotas and high tariffs, butallowed domestic firms to compete withinthe captive market. Japanese firms eitherlicensed foreign technology or reverse engi-neered foreign products to catch up. As the

economy grew and firms gained experiencein production, the successful ones were ableto expand. Increasing returns to scalebrought down production costs, andreturns to scale were further enhancedwhen these firms started to export andbecame more competitive in the world mar-ket. When the sector reached this stage,restrictions on imports were liberalized.This strategy was most visible in the steeland shipbuilding industries.

In fact, this kind of targeting was almostinevitable in the 1950s because the yen wasovervalued and import restrictions (includ-ing quotas, tariffs, and foreign currency allo-cations) were necessary to maintain the

exchange rate. The Ministry ofInternational Trade and Industry(MITI) and the Ministry of Financeeffectively "promoted" particular in-dustries simply by allowing them touse foreign currency allocations tobuy raw materials.

Opponents of this view point tofailures in the government's attemptto identify prospective sunrise in-dustries: coal, petrochemicals, oilrefining, and aluminum are exam-ples. In fact, some studies suggestthat if productivity increases arerelated to loans from the JapaneseDevelopment Bank at the industrylevel, the relationship is negative.Consumer electronics, probably oneof the most successful export indus-tries, never was on MITI's list. Theautomobile industry is another inter-esting case. In the early 1960s, MITIattempted to merge several automo-bile manufacturers into two groupsof firms, arguing that there were toomany automobile manufacturers inJapan. The firms fought back andmaintained their independence. If

MITI had succeeded in reducing their num-ber, domestic competition would have beenstifled and Japanese automobiles might nothave dominated the world market in the1980s.

There is a broader consensus on the ben-eficial effects of the government's com-mitment to exports in general. Pushingexports was certainly an important aspectof industrial policy in the 1950s and 1960s,but it too was largely a necessary responseto the overvalued currency. The evidencesuggests that the phenomenal success ofJapanese exports reflects a variety of fac-tors, including the rapid response of privatefirms to changing market opportunities.Indeed, the composition of Japaneseexports changed quite rapidly during the



Productivity growth has been slowing

Source: Author's calculations based on Organization for Economic Cooperation and Development, NationalAccounts, Vol. 2, Detailed Tables (various years).

Note: Productivity growth in a given sector is the annual percentage change in the ratio of total production to totalemployment for that sector.

1 Annual percentage growth in productivity.

postwar period, shifting from textiles andtoys to other light manufactured goods inthe 1950s; to consumer electronics, steel,and ships in the 1960s and 1970s; to sophis-ticated optical products in the 1970s; and toautomobiles and semiconductors in the1980s. The structural transformation ofindustry was one source of Japan's continu-ous success in achieving trade surplusesand rapid economic growth.

Saving and investment. The Japa-nese household saving rate—which hasfluctuated between 15 and 20 percent sincethe 1950s—has long been the highestamong the major OECD countries andexplains a good part of the country's highinvestment rate. Japan's high saving ratehas been the focus of much study. Opinionsdiffer on whether the saving rate can beunderstood purely in terms of the life-cyclehypothesis—the idea that people save dur-ing their productive years for retirement.Although this theory seems to fit theJapanese experience, the size of this effecthas been questioned. In particular, someeconomists have suggested that, in Japan,household saving decisions are dominatedby the bequest motive—the desire to leavean inheritance for future generations.Determining which hypothesis best fits theJapanese experience is important. If indi-viduals save mainly for retirement, then ademographic shift toward a larger, olderpopulation would have important negativeconsequences for the saving rate. In con-trast, if the bequest motive predominates insaving decisions, the saving rate should berelatively unaffected by the aging of thepopulation.

Education. Illiteracy is extremely rarein Japan. Elementary and high school edu-cation emphasize basic skills in languageand mathematics, as well as group activi-ties. Curriculums are nationally standard-ized, and it is not possible to skip a grade.University admission is by examination,with stiff competition. It is widely acceptedthat the Japanese educational systemproduces highly qualified and effectiveworkers.

From asset to liabilityThe very features for which the Japanese

economy has been praised in the past maynow be holding back growth. Decliningproductivity may be one symptom of theproblem (see table). Productivity has beenslowing over the past three decades. Theeffect is seen across the board, but is espe-cially noticeable in the nontradables sector.Slower productivity growth, particularlyafter the very high levels reached in Japanfrom the 1960s through the early 1970s,may be inevitable as the economy matures.However, it may also be a sign of the needfor fundamental structural change. Let usconsider how Japan's key institutionalstrengths may be affecting growth in the1990s.

Lifetime employment. The system ofdeferred payments to motivate workers thatis implicit in the lifetime employment guar-antee is now in danger of self-destructionfor the same reasons that a pay-as-you-gopension system runs into difficulties in anaging economy: arrangements that workedin a high-growth environment begin to fail.If slow growth continues for about another

decade, it is quite likely that workers whoare now in their forties will retire to findthat their age-earning profiles have notbeen as steep as those of the previousgeneration—a subtle breach of impliedcontract. The recent increase in the unem-ployment rate foreshadows this prospect,although firms, concerned to maintain theirreputations in the eyes of prospectiverecruits, have so far honored their implicitcontractual obligation not to lay offworkers.

The type of innovation needed fortoday's environment seems to be difficult togenerate with the current Japanese systemof labor relations. The growth industriesof the future are in the high-technology,service-oriented sectors, such as computersoftware, communications, and financialproducts. These industries are typicallyfinanced by venture capital and employworkers with highly specialized skills. Inthis context, the Japanese way of educatingand training workers to perform a widevariety of jobs within a typical manufac-turing firm may be counterproductive.Moreover, international competition in thetradables sector requires more flexibility onthe labor front, both from the standpoint ofproduct innovation and to prevent Japaneseproduction operations from moving abroadto take advantage of cheaper labor costs,

The main bank system. The role ofthe main bank system in the 1990s is alsoopen to question. There are two strands tothe argument. First, and this is not reallyspecific to Japan, banks generally play adiminishing role in financial intermediationas industrial economies mature. Second, thebehavior and performance of the Japanesebanks during the 1980s' asset price bubbleand its collapse have cast doubt on the con-ventional view of the rational, farsighted,and growth-enhancing role of the mainbanks.

Throughout the 1980s, the industrialcountries, including Japan, rapidly liberal-ized their financial markets. Regulations oninterest rates were abolished; entry intonew services and geographical regions(domestic and international) was increas-ingly liberalized; and new products andmarkets, most notably derivatives, weredeveloped. In Japan, most controls on capi-tal inflows and outflows were lifted in thefirst half of the 1980s. On the domesticfront, all interest rate regulations wereeffectively lifted by the beginning of the1990s. The Bank of Japan's restrictions onlending increases by the major banks wereabolished in 1994. As regulations on capitalcontrols, corporate bond issues, and new


TradableTotalAgricultureManufacturing

NontradableTotalEnergy and transportationConstructionDistribution and financeServices

Difference (tradable less nontradable)Whole economy

1960-71

10.224.64

10.16

6.838.085.818.754.00

3.398.92

1971-81

5.673.185.31

2.531.950.274.791.06

3.143.96

1981-92

4.592.793.99

1.902.821.992.860.48

2.692.88

99

028

8

1

78

35796

46

4

38

92

50


stock offerings were dismantled, corpora-tions were able to raise funds directly indomestic and international capital marketsinstead of borrowing from banks. Bor-rowing costs started to reflect the creditrisk of corporations, and corporate infor-mation was made available to the market,rather than being hidden in earningsreports that could be deciphered only bythe main banks. Some firms took advan-tage of the new environment and repaid allof their bank loans, thus freeing themselvesfrom the main banks.

In Japan today, healthy manufacturingfirms can raise funds from capital marketson more favorable terms than banks arewilling to offer. And the banks' decision toextend large amounts of debt to the realestate sector in the speculative environ-ment of the 1980s—and the sizablelosses they subsequently sustained—suggests that they are no more prudentthan other corporations in a deregu-lated world. If the banks are so smart atmonitoring the investment projects andmanagement performance of the firmsto which they lend, surely they couldhave monitored themselves to avoidbeing saddled with nonperformingloans worth billions of yen.

Keiretsu. The keiretsu system does notseem to have served Japan well in the1990s. The current frontier of technologicalinnovation touches industries and compa-nies that are not traditionally affiliated withkeiretsu. The horizontal keiretsu are typi-cally composed of large companies in thefinance and manufacturing sectors. It is notthese established firms that are likely toexperience the next wave of expansion, butservice industries, such as transportation,discount retailing, and entertainment.

For their part, the vertical keiretsu arenot generally suited to the organizationalneeds of the service sector. In manufactur-ing, further efficiency gains will depend onthe initiatives of large discount stores andother retailers to eliminate intermediariesor at least to reduce transportation costsand the profit margins of wholesalers,rather than on the keiretsu relationship.Moreover, the relationship between themanufacturers and suppliers faces a differ-ent challenge. Although the yen has depre-ciated against the dollar recently, its longperiod of prolonged strength has led agrowing number of manufacturers to investabroad, creating the so-called hollowing-outphenomenon. Some small suppliers thathave provided these firms with just-in-timedeliveries in Japan are finding it difficult tofollow them to assembly sites abroad.

Industrial policy. The role of tradi-tional industrial policy and export promo-tion is unquestionably minimal in Japan inthe 1990s. Export expansion is not likely toplay the key role in Japanese growth that itonce did. As a result of trade conflicts withthe United States in the late 1980s and theearly 1990s, the opening of the Japaneseeconomy through the promotion of importshas begun to be emphasized at the expenseof exports.

Saving and investment. Rapid dem-ographic change is projected to give Japanone of the oldest populations in the worldby 2025. The ratio of productive persons(ages 15 to 64) to retired persons (ages 65and over) is projected to decline from 5.8 in1990 to 2.3 in 2025. Even this estimate may

"What is needed in Japanis a reorientation ofpolicies, from the

manufacturing to theservice sectors."

be too optimistic, since it was made in 1992,and in the past few years, the birth rate hasfallen further. As noted earlier, the life-cyclehypothesis suggests that the more retiredpersons there are, the lower the saving ratebecomes. A lower saving rate will reduceJapanese current account surpluses (byincreasing domestic consumption withoutchanging investment) or reduce growth (bylowering investment), or both. In any case,demographic change over the next 30 yearswill probably bring down the growth rate,unless productivity increases can morethan offset the lower investment rate. Evenif the bequest motive may have pushed upthe saving rate in the past, it is not certain(or even likely) that it remains strong today,since the value of households' assets(durables and financial assets) is nowso much greater. Taking these factorstogether, it seems inevitable that theJapanese saving rate will decline in comingyears.

Investment in Japan is decreasing in the1990s. This is partly a correction after thehigh levels of investment sustained duringthe period of the asset-price bubble, but it isalso partly a result of the fact that high pro-duction costs and rigidities in the systemare pushing manufacturing firms to investabroad. If investment abroad is only a tem-porary phenomenon, then domestic invest-ment in manufacturing will recover soon.However, given the rigidities in the econ-

omy, and if the real exchange rate remainshigh, recovery is unlikely to be imminent.

Education. The Japanese educationsystem has successfully produced a homo-geneous, group-oriented labor force thatis well versed in basic skills. However,many now argue that the current systemdoes not foster the creativity and special-ized skills needed to make breakthroughsin research. In particular, it appears thatstudents are not developing the sort ofhighly specialized computer-oriented skillsthat will be necessary for tomorrow's thriv-ing industries.

The strong pressure to pass universityentrance examinations encourages highschool students to study hard without ques-tioning the material and trains them to

memorize facts rather than to thinkindependently. Moreover, since stu-dents cannot enter university early, cre-ative thinking and specialized trainingtypically must wait until students are18. Some students are burned out bythat time. Finally, the use of computersis limited in elementary and highschool education. The ratio of comput-ers to students is typically lower inJapan than in the United States, for

example, and it appears that Japanese cur-riculums lag behind those in the UnitedStates in terms of information technology.

Policies for the futureWhat is needed in Japan is a reorienta-

tion of policies, from the manufacturing tothe service sectors, and a move away fromgovernment guidance to deregulation ofmarkets. More competition in the nontrad-able sectors, such as telecommunications,airlines, and distribution, will enhance pro-ductivity gains and lead to lower prices.Thus, both industries and consumers willbenefit from structural reform. Hollowingout of the manufacturing sectors may slowdown if the costs of production are reducedat home. However, the transition to a dereg-ulated environment will no doubt be diffi-cult for many sectors. Structural reformsare needed not only in industrial organiza-tion but also in employment practices andthe education system. Careful implementa-tion of the necessary changes should pro-vide new engines for growth withoutcausing too much friction in Japan'seconomy. IF&DI

This article draws on the author's paper, "Japanand the Asian Economies: A Mirack inTransition,"published in Brookings Papers onEconomic Activity: 2 (1996).



\wjMiwinMiiiMMiiiM

Bias in the US Consumer Price Index:Why It Could Be Important

PAUL A . A R M K N E C H T A N D P A U L A R . D E M A S I

The US consumer price indexmay be overstating the infla-tion rate, thereby distortingcalculations of inflationadjustments in both govern-ment expenditures andincome tax brackets andswelling the federal deficit.

C HANGES IN the consumer priceindex (CPI) provide the mostcommonly used measure of infla-tion in all countries (see box). In a

recent study, the US Advisory Commis-sion to Study the Consumer Price Index(more commonly known as the BostonCommission, whose chairman was MichaelBoskin, former chief of the US Council ofEconomic Advisers) estimated that the USCPI overstated inflation by 1.1 percentagepoint in 1996 and by slightly more in eachof the previous 20 years. Thus, althoughthe official rate of inflation for 1996 was 2.9percent, the true rate may have been in theneighborhood of 1.8 percent. This upwardbias arises because the CPI methodologydoes not adequately capture shifts in con-sumer purchases when relative pricesmove, the effects of changes in the dualityof goods and services, the introduction of

Paul A. Annkneclu,ii US national, ivas formerly Assistant Commissioner fnr Consumer Pricesu'itli Ihc US Department of Labor's Buretat of Labor Statistics and is cur-rently a Consultant to the Krai Sector Division of the IMF's StatisticsDepartment


Pnulsi R. l)t Masi,a US national, is an Eftwomist in the World Ecnuamk Studies Division ofthe IMF's Research Department.

new products, or the growing number of reduced tax revenues. Recent estimatesdiscount stores. While some experts have indicate that if the current inflation biasdisputed that the upward bias is as large as continues for the next 11) years, the federalhas been suggested by the Commission, government deficit will increase on thisthere is a growing consensus that there account alone by $140 billion, and $650 bil-may indeed be significant bias. lion will be added to Ihe national debt by

Upward bias in the official inflation rate the end of the period (see chart),has important implications. First, real The Boskin Commission's report identi-wages—which were widely thought, on the fied and quantified three sources of bias, allbasis of official data, to have stagnated over of which arise because of limitations in thethe last two decades—may, in fact, have methodology used to calculate the CPI (seeincreased considerably. Second, in regard to table):fiscal policy, upward bias has considerable • Qualify change and new pmduct bias,budgetary costs: expenditures indexed to the largest source of bias, arises becausethe CP[ rise by more than is needed to offset the CPI does not immediately take intoinflation, and inflation adjustments made to account either improvements in the qualitytax brackets are overstated, resulting in of goods and services or the introduction of

How the US CPI is computedIn the United States, the consumer price index (CPi) is used to estimate the overall price level inthe consumer sector of tile economy each month. The US Department of Labor's Bureau ofLabor Statistics (ISI^S) is responsible for calculating the CPI, which is based on individual pricesfora fixed market basket of goods and sendees, which includes food, clothing, shelter, fuel,transportation, medical sen-ices, and other items.

Using statistical sampling techniques to select specific items, the BLS crjllecis prices eachmonth for about 71,000 goods and services from about ffi.OUO outlets in 44 geographic areas.For example, the cost of housing is included in the data collection by surveying about 5,000rentera and 1.000 homeowners each month. The price quotations the BLS obtains are then com-bined to form the consumer price index. Some simplifying assumptions liiive to be made tomake this complex calculation practicable. The formula the 81,5 uses to aggregate all of theseprices assumes that consumers purchase fixed quantities of goods—that is, that their spendinjjpatterns remain the same—over time. The CPI, then, is designed to reveal how much it costsconsumers to purchase the same market basket of goods and services today compared withwhat it cost in a previous month or year.


Sources ol bias Percent per year

Quality change/new product bias 0.6

Substitution bias D.4

Outlet substitution btas 0.1

Total 1.1(Plausible range) (0.8-1.6)

Source1 United Slates, Advisory Commission 10 Study the Consumer Price Index. 1996, Toward a MoreAccurate Measure ollhe Cost ol living. Final Report to the Senate Finance Comminee (Washington).

new products. To the extent that the CPIfails to account for changes in quality, theindex will not reflect "true" changes inprices. And new products need to be incor-porated into the CPI on a timely basis, sothat the early declines in price tliat are anormal part of the product life cycle arecaptured.

• Substitution bias occurs because theformula used for CPI calculations assumesthat consumers purchase a constant mix ofvarious goods and services despite changesin their relative prices. In actuality, if theprice of one good rises relative to that ofanother good, consumers will tend to sub-stitute cheaper goods for higher-pricedones. Because the weights of goods in theCPI are adjusted infrequently (about onceevery 10 years), substitution is not takeninto account.

• Outlet sttbstitu/ion bias occurs becausethe CPI does not adequately take intoaccount the extent to which new discountstores have offered lower prices and enticedconsumers away from the traditional out-lets that tend to be more fully representedin the CPI market basket.

To eliminate the various biases, theCommission recommends replacing the

method used in calculating the CPI withone that more accurately takes into accountchanging spending patterns. Otherchanges recommended include adoptingnew procedures for annual updates ofweights and revisions to historical data,changing the price data and methods ofcollection, and establishing a committee ofoutside experts to review and advise theUS Department of labor's Bureau of LaborStatistics on statistical issues.

The Commission's conclusions have beencriticized by some commentators. Most ofthe criticism has been directed at the largeestimates of quality and new product bias.Measuring quality improvements is partic-ularly difficult because direct quantitativeevidence is scarce, and no new substantiveinformation on this issue was provided inthe Commission's report. Some critics havenoted that the report does not take intoaccount the fact that the duality of somegoods and services included in the CPI mar-ket basket has deteriorated.

Although the debate aluoul upward biasin tlie CPI has Ijeen most active in theUnited States, the findings of the Com-mission's study are relevant more generally,since many countries use methodologies

that have much in common with that usedin the United States. Analyses of theCanadian CPI suggest that there may be anupward bias of 0.5-1 percent, somewhatlower than in the United States, reflectingin part the more frequent updating inCanada of the weights of the goods and ser-vices in the CPI market basket. A study ofthe United Kingdom's retail price indexsuggests a plausible range of bias of0.35-0.8 percent, although further work isunder way to assess whether the bias mayactually be larger.

More generally, the magnitude of bias inother countries depends on. among otherfactors, the frequency with which the CPIweights and the items sampled areupdated; the extent to which new andimproved products are brought to market;the formula used in estimation; and theextent to which quality adjustments aremade. For example, indexes of consumerprices in countries where the weights usedare updated annually—such as Norway,Sweden, and the United Kingdom—arelikely to lie less susceptible to substitutionbias. Although most industrial countries—including the United States—make someattempt to allow for quality changes, theyare not entirely successful in eliminatingthis form of bias. In most of the developingand transition countries, however, no qual-ity adjustments are made, suggesting thaithis form of bias may have an importantimpact on their consumer price indexes—and, thus, on the inflation rates theyindicate—particularly when newly openedmarkets increase the variety and qualityof goods and services available to con-sumers. JE&D]

Far a mnrn detailed discussion <>t'the data rottec-tion procedures and methodology used to pre-pare the US consumer price index, sec I'aii! A.Armkncrhl. JfXMi. "Improving the Efficiency ofllif US. CPI."IMF Working Paper No. 96/103(Washington: International Monetary Fund).

This article is derived from a box entitled"United States: Sources ami Iin/Jications ofKius in the Consumer I'ria' Index " published inthe tyring 1997 edition of lite IMF's WorldEconomic Outlook tWnslangtmt).

Reference:United States. Advisory Commission to

Study the Consumer price Index, 1996, Towarda More Accurate Measure of ihe Cost of Living(Washington).


ssOURCES OF BIAS IN us CONSUMER PRICE INDEX, 1996

Impact of correcting a 1 percentage point overstatementin the CPI on the US deficit

Source: United States, Congressional Budged Office, 1997, The Economic and Budged Outlook (Washington).


Growth and the Environment: Allies or Foes?V I N O D T H O M A S A N D T A M A R A BELT

Newly industrializing econ-omies have shown the way tohigh growth and rapid povertyreduction, but at the expenseof severe environmental losses.This experience shows that thechallenges of growth and theenvironment must be ad-dressed simultaneously.

O VER THE PAST quarter of a cen-tury, economic growth per capitain the southeast part of EastAsia—Indonesia, Malaysia, Sing-

apore, and Thailand—averaged 5 percent ayear. Socioeconomic well-being improvedenormously. In Indonesia, Malaysia, andThailand, the percentage of the populationliving below the poverty line is estimatedto have declined by some 50-70 percent.Starting from even earlier periods, HongKong, Japan, Korea, Singapore, and TaiwanProvince of China made dramatic economicgains. Over the past decade and a half,China experienced very high growth ratesand a sharp reduction in poverty.

At the same time, environmental lossesin East Asia have surpassed in manyrespects those of other regions. For exam-ple, 9 of the world's 15 cities with the high-est levels of particulate air pollution are inthis region. About 20 percent of land cov-ered by vegetation suffers from soil degra-dation owing to waterlogging, erosion, andovergrazing at levels above world averages.Fifty to 75 percent of coastlines and marine

protected areas are classified as areas withhighly threatened biodiversity, and theregion has witnessed some of the highestdeforestation rates in the world.

One lesson is that rapid growth can be agreat ally of poverty reduction when sup-ported by certain policy fundamentals. InEast Asia these have included substantialand efficient investments in education, a rel-atively good income and asset distribution,a labor-intensive export orientation, and anemphasis on agricultural development. Asecond lesson, however, is that rapidgrowth has come at the expense of theenvironment. Rapid growth does notautomatically improve the environment—environmental policies must also be put inplace.

To be sure, many growth-inducing poli-cies, such as clarifying property rights,investing in sanitation, improving educa-tion (especially for girls), and sound eco-nomic policies, help to improve resourceuse and contribute to a better environment.But in crucial areas, such as the control ofpollution or sustainable forest use, environ-mental actions such as imposing taxes andstandards, investing in technology, improv-ing production methods, and recycling arenecessary. Rapidly growing economies arelearning this lesson the hard way and someare now taking corrective actions.

It is also interesting to focus on CentralAmerica. For a variety of economic andsociopolitical reasons, the Central Americaneconomies have grown slowly in recentdecades, although their potential for sus-tainable development remains high. Anexception is Costa Rica, a country with astrong record in promoting human develop-ment. But, more generally, the economies ofCentral America have been dominated by

traditional exports, which have faceddeclining terms of trade; by a highlyunequal income distribution; and by inade-quate educational investments—all exacer-bated by political instability. Costa Ricaremains a notable exception. Becausegrowth rates have been low, poverty levelshave remained stubbornly high—asin other regions with slow growth.Environmental quality has deteriorated—there are large deforested areas, soildegradation, overfishing, and pollutedwater in coastal zones.

The experiences of East Asia and CentralAmerica show that both slow- and fast-growing economies can suffer from severeenvironmental degradation. The questionthen is whether, with the right priorities andpolicies, the environment can be protectedirrespective of the pace of growth.

Growth per se is not to be blamed forenvironmental degradation, but, in somerespects, rapid growth appears to makethe problem worse. When .the sourcesof environmental problems—underpricedresources (forests, water, or air), weak insti-tutions, and unclear property rights—arenot addressed adequately, rapid growthseems to aggravate them. However, growthand high incomes can mitigate environmen-tal degradation and improve resource useif accompanied by timely environmentalactions.

Grow first and clean up later?The human and ecological costs of envi-

ronmental deterioration have been widelystudied. In many instances, convincing evi-dence is available of the large social gainsfrom environmental actions. And yet, envi-ronmental actions have been inadequate.The literature has emphasized a basic

Vinod Thomas,a national of India, is the Director of the World Bank's EconomicDevelopment Institute.

Tamara Belt,a national of the United States, is a consultant in the Environment andNatural Resources Division of the Economic Development Institute.



reason: the divergence between what isbeneficial to society and what is beneficialfor the private individual. When coupledwith the lack of resources at low incomelevels, the pattern worldwide has been togrow first and clean up later.

Experience that calls this approach intoquestion is accumulating. For one thing, itis a costly strategy socially and ecologi-cally, and might threaten the sustainabilityof growth itself. Furthermore, new institu-tional arrangements, technologies, produc-tion methods, and targeted investments arebeginning to offer opportunities to addressgrowth and environmental protection inways that are good for governmentfinances as well as for private business.

The high costs of cleaning uplater. Ecological damage is often irre-versible. Cleaning up later is not an optionwhen terrestrial and aquatic biodiversityhas been lost because of habitat destruc-tion. For example, pollution and destructivefishing techniques have damaged a largeproportion of coral reefs in some areas. Asup to one-fourth of all marine species andone-fifth of known marine fish species livein coral reef ecosystems, the loss of reefhabitats disproportionately threatens ahigh percentage of the ocean's plant andanimal life. Complete reversal of this dam-age is unlikely; therefore, efforts need tofocus on preserving global biologicalresources before they are damaged.

Environmental pollution causes consid-erable health costs, which are compoundedwhen pollution control is postponed. Someof the evidence comes from widely publi-cized episodes—for example, mercury poi-soning from a manufacturing firm inMinamata, Japan resulting in severe neuro-logical afflictions ("Minamata Disease") forpeople in the area since the mid-1950s, orexposure to toxic materials causing acuteillness or death as in the Bhopal, Indiatragedy of 1984. Other evidence, even if lessvisible, is widely prevalent, such as thesteady health losses to children and adultsfrom air pollution.

The cost is usually far less than the bene-fits to society of investing in pollution con-trol. In this regard, an ounce of preventionis worth a pound of cure. It is usuallycheaper to control pollution at its sourcethrough policy reforms, especially byremoving subsidies, than by investing inpollution control later.

Better use of resources. With properconcern for the environment, scarceresources can be put to high-return andsustainable uses. For example, in parts ofSoutheast Asia, uplands can be used for

sustainable planting of fruit trees or otherperennials rather than for planting maizeor cassava for a few years and then aban-doning cultivation as yields decline.Similarly, in areas of Latin America, forestscan be protected for their higher socialvalue rather than converted to ranches thatgenerate negative returns. And in manycases, putting a resource to multiple usesgenerates a large net benefit. For example,management of tropical forests for multipleuses that include nontimber goods, waterand soil conservation, biological diversity,and other environmental services, as wellas timber, could generate higher socialreturns as well as revenue.

Bringing in revenue. Applying pol-lution taxes, in addition to inducing loweremissions and better conservation ofresources, can raise revenues that allowgovernments to scale back more distor-tionary forms of taxation. In Thailand, forexample, a 10 percent tax on the coal andlignite used in manufacturing could yield areturn of 1 to 2 percent of government rev-enue. The cost of such a tax is usually afraction of the estimated health benefits ithelps to produce.

It's good business. Finally, there is theeconomy-wide link between a country'scompetitiveness and the environment. Inone direction, trade liberalization withoutenvironmental policies makes the environ-ment more vulnerable. The higher pricesfor forest resources resulting from trade lib-eralization can lead to excessive deforesta-tion if property rights are unclear andlogging rights fail to incorporate theresource costs. In the other direction, tradeliberalization can increase the profitabilityof industries that have environmental safe-guards in place.

How can it be done?Although the record is limited, innova-

tive approaches in East Asia and LatinAmerica offer the promise of growth withsustainable resource use. To take one exam-ple, a coalition of conservation and researchorganizations in El Salvador developed anecolabeling initiative, ECO-OK, to give cof-fee farmers the incentives and informationto produce coffee in an eco-friendly way.The program simultaneously raises aware-ness and motivates consumers to seekproducts from socially and environmentallyresponsible farms. ECO-OK products meetenvironmental standards that protect rain-forests, workers, and wildlife.

User charges and tradable re-source rights. Experience with market-based instruments and regulations,

notwithstanding the obstacles to theirenforcement, illustrates the range of poli-cies that are possible and widens the debateon options. In East Asia, considerableprogress has been made in removing subsi-dies on gasoline, diesel, and kerosene. InLatin America, there are several examplesof the application of market-based instru-ments (see table). Some have been ineffec-tive in achieving their full objectives as aresult of institutional weaknesses such asunder-funding, unclear jurisdiction, moni-toring requirements, and legal designrequirements. Nevertheless, there are somepromising examples:

• Resource user charges. Brazil, Co-lombia, and Venezuela charge a forestry taxwhen tree harvesting is not compensatedby equivalent reforestation. So far the taxeshave been set at too low a level, andenforcement has been weak; nonetheless,the principle is sound.

• Joint Implementation Agreements. Cen-tral America is relatively advanced in thecreation of agreements for carbon seques-tration through forest protection underJoint Implementation programs. Costa Ricahas just initiated such an agreement withNorway. The development of such agree-ments will depend in part on an emerginginternational consensus, but initial activi-ties are promising.

Participation and community in-volvement. Where institutions are weakor enforcement is expensive, public partici-pation and community involvement can beeffective in enforcing sustainable resourceuse and adapting local conditions to devel-opment needs. Traditional communitieshave known and used this approach forages. It could be strengthened for today'smarket economy, as evidenced in Japan.The local government and resident groupsin Japan negotiate with firms to arrive at adetailed written agreement on emissionslevels. Between 1971 and 1991, the numberof agreements increased from approximate-ly 2,000 to 37,000. Once standards wereagreed upon, they were effectively imple-mented. This consensual approach benefitslocal governments, residents, and compa-nies alike.

Mainstreaming environmentalconcerns. A crucial approach involvesmainstreaming environmental concernsin national plans and policies. This meansthat the environmental consequences ofactions pursued by finance and plan-ning, as well as environmental, ministriesare made explicit within core economicpolicies. In some countries innovativeapproaches to confront environmental

Finance & Development / June 1997 23


BarbadosBoliviaBrazilChileColombiaEcuadorJamaicaMexicoPeruTrinidad and Tobago

Creditsubsidies

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Tax/tariffrelief

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schemes

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Wastefees and

levies

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renewable conventionalForestry Pollution resource tax Tradable Eco-taxation charges taxes levy permits labeling

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/ // / / /

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problems are beginning to be applied.Mainstreaming them would mean thatthese options are put on the table at thetime key fiscal, trade, and industrial poli-cies are discussed. Their benefits and costswould be revealed, providing the basis topursue the best approaches.

Inserting the environment into policy-making can produce much stronger resultsfor economic growth and environmentalsustainability than responding to individ-ual environmental concerns along the way.Practical ways to do this are beginning toemerge, and there would be great benefitfrom disseminating them. More generally,integrating environmental awareness ineducation programs, especially at the earlystages, and influencing values and behav-ior would be a fundamental step in main-streaming environmental concerns.

UncertaintiesTough questions remain with respect to

both policy choices and the implementationof environmental actions. Win-win policychoices (for example, reducing energy sub-sidies to benefit both economic perfor-mance and the environment) should berelatively easy for the policymaker tomake. Pushing ahead with them shouldtherefore be a high priority. But even in thiscase, there will be winners and losers fromthe changes, requiring the policymaker tomanage the political economy of reforms.

Policy choices involving trade-offs to thepolicymaker are more difficult to make,even if society would benefit on balance(for example, financial investments forpollution control that produce net gains in

health and welfare). This difficulty is com-pounded if the benefits accrue later andespecially if future benefits involve uncer-tainty, or if some of the benefits accrue tothe rest of the world (for example, part ofthe gains from biodiversity from the protec-tion of forests). Financial constraints makethe decision hard to take even if it issocially beneficial.

Higher incomes eventually contribute tothe demand for a more sustainable environ-ment, especially in the so-called "brown"areas such as urban pollution. Higher in-comes also provide the resources to helpaddress the problem. However, this chain ofevents is particularly delayed in the case ofthe "green" dimensions of the environment,which faces severe deterioration in theearly phases of rapid growth. And they alsoinvolve unacceptable thresholds of degra-dation, and irreversible losses, such as bio-diversity. Protecting the "green" aspectsduring rapid growth remains a tough chal-lenge.

Countries' institutional capacity to make,implement, and enforce difficult decisions isa key consideration. Even the best solutionsrequire the support of well-functioningmarkets and property rights. Where trade-offs are involved, additional measures toalign the social and private benefits(through taxes, quotas, investments, etc.)are needed. When the benefits go beyondindividual countries, financial and institu-tional arrangements across borders mightbe called for.

These dilemmas need to be recognized.Clearly, priorities have to be set, resourcelimits acknowledged, and systemic pro-

cesses put in place to help make toughchoices. There is a growing body of experi-ence on how innovative approaches canhelp address trade-offs and institutionalrigidities. Meanwhile, the evidence on the.high costs of not taking these measures ismounting.

ConclusionIn the main, the experience of rapidly

growing countries has been to grow firstand clean up later. However, this neglect ofthe environment has resulted in irreversiblelosses and high cleanup costs. Currentexperiences and policies, even if limited,demonstrate that it is possible to protectthe environment, promote growth, andenhance competitiveness at the same time.Most developing countries can benefit fromboth the positive and the negative lessonsof rapid growth elsewhere. If they can takeeconomic and environmental actions now,they could become the "green tigers" of thefuture. HID]

ReferencesDanielEsty, 1997, "EnvironmentalProtection

During the Transition to a Market Economy," inWing Woo, Steven Parker, and Jeffrey Sachs,eds., Economies in Transition, Asia and Europe,(Cambridge, Massachusetts: MIT Press).

Jeffrey S. Hammer and Sudhir Shetty, 1995,"East Asia's Environment," World BankDiscussion Paper No. 287 (Washington).

Andrew Steer, 1996, "Ten Principles of theNew Environmentalism," Finance &Development (December).

World Resources Institute, UNEP, UNDP, andWorld Bank, 1996, World Resources, 1996-97(New York: Oxford University Press).


Source: Richard M. Huber, Jack Ruitenbeek, and Ronaldo Seroa da Motta, 1996, "Market Based Instruments for Environmental Policymaking in Latin America and theCaribbean," World Bank, Washington./ In place.-ir 1 Inrlpr intrnrliirtion

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Protecting the enviroment

eARMARKDEDeARMARKDED

vENEZUELA


The Reform of Wholesale Payment SystemsDAVID F O L K E R T S - L A N D A U , P E T E R C A R E E R , A N D D I R K S C H O E N M A K E R

Central and commercialbanks in the major industrialcountries are combiningefforts to reduce the risksinherent in the world's whole-sale payment systems. Thesereforms are beneficial, butcould have an adverse impacton the liquidity of financialmarkets.

T HE EXPLOSIVE growth in thevolume of transactions in highlyliquid national and internationalfinancial markets during the past

10 years has produced a correspondingincrease in payment flows. These flows arefacilitated by an interlocking network ofwholesale payment systems that is at thecore of the world's major financial systems.A disturbance in one of these paymentsystems—an operational mishap, the fail-ure of one institution to pay another, a liq-uidity problem in one of the moneymarkets—could have serious consequencesfor global trade and finance.

Payment systems are vulnerable becauseof the ubiquitous presence of unsecuredand sometimes uncontrolled credit in settle-

ment systems. Because financial institu-tions make payments during a settlementperiod in anticipation of incoming pay-ments, the failure of a major institution tosettle its obligations could have a dominoeffect: banks that were counting on thatinstitution's payments might be unable tomeet their own obligations.

Reforms in the technically demandingand unglamorous area of payment systemshave been implemented without the fanfarethat has accompanied efforts to implementa regulatory capital structure based onvalue-at-risk models for the trading activi-ties of global banks. Payment systemreforms are, nevertheless, crucially impor-tant and should be regarded as a key com-ponent of ongoing efforts to create soundand efficient financial systems. By strength-ening payment systems to reduce systemicrisk, central banks have increased theirdegrees of freedom. Indeed, they may soonbe able to strengthen market discipline byletting financial institutions fail, perhapseven those currently perceived as too big tofail, without threatening the stability of theentire financial system.

Wholesale payment systemsBroadly, there are two types of wholesale

payment systems: net periodic settlementsystems and real-time gross settlement(RTGS) systems. Each is associated withparticular risk control measures. A bank'sexposure to settlement risk is eliminatedonce it receives payment in central bank

funds—so-called good funds. So, the crucialdeterminants of settlement risk are the sizeof a bank's exposure and the time lapsebetween sending a payment instructionand final settlement.

Net periodic settlement. In net peri-odic settlement systems, participants sendpayment instructions to each other over agiven period of time, which are settled atthe end of the period on a net basis. Asthere is no guarantee of their completionuntil settlement, payments become finalonly after settlement. Settlement is typi-cally not achieved before the end of the day,although it may occur earlier through morefrequent settlement.

Large-value netting schemes usuallyemploy multilateral netting, in which thenet amount of a bank vis-a-vis the clearinggroup as a whole is calculated. Netting sig-nificantly reduces the need for good funds,because transactors need only have a suffi-cient volume of the settlement medium—reserve balances at the central bank—tocover net amounts at the end of a settle-ment cycle. But netting arrangementsexpose the participants to risk as theyextend large volumes of payment-relatedintraday credit to each other. This credit isthe lubricant of the financial system: it rep-resents the willingness of participants toaccept payment messages on the assump-tion that the sender will cover any net debitobligation at settlement. The settlement ofpayments, by the delivery of reservesat periodic (usually daily) intervals, is

David Folkerts-Landau,a German national, is Assistant Director in theIMF's Research Department.

Peter Garber,a US national, is Professor of Economics atBrown University.

Dirk Schoenmaker,a Dutch national, was Research Officer at theLondon School of Economics when this articlewas written and is currently working in the Bankof England's Regulatory and Supervisory PolicyDivision.



Settlement flows are huge and growing

Source: Bank for International Settlements, 1993, Payment Systems in the Group of Ten Countries, Basle.Note: EAF: Elektronische Abrechnung mil Filetransfer; EIL-ZV: Eiliger Zahlungsverkehr; SIPS: Sistema

Interbancari di Pagamenti; BISS: Banca d'ltalia continuous Settlement System; Zengin: Zengin data telecommuni-cations system; FEYCS: Foreign Exchange Yen Clearing System; BOJ-NET: Bank of Japan Financial NetworkSystem; SIC: Swiss Interbank Clearing System; CHAPS: Clearing House Automated Payment System; CHIPS:Clearing House Interbank Payment System.

1 Daily payment flows.2 This system also handles payments between banks and the Banca d'ltalia or the Treasury, which are settled

across centralized accounts held at the Banca d'ltalia.- Indicates not yet in operation.

therefore a key test of the solvency and li-quidity of the participants.

The most serious risk in netting systemsis the risk that the failure to settle by oneparticipant will lead to a system crash.Recognizing the risk, the central banks ofthe G-10 countries have formulated mini-mum standards for netting schemes. Theseso-called Lamfalussy standards stress thelegal basis of netting. In addition, nettingschemes should include adequate proce-dures for the management of credit and li-quidity risks. One way to contain suchrisks is to set limits on the size of each par-ticipant's net debit position. In addition,netting schemes should have a reserve fundto complete settlement if a large participantdoes not meet its obligations.

Real-time gross settlement. InRTGS systems, each payment is immedi-ately settled on a gross basis. Settlement inall major wholesale payment systemsoccurs on the books of central banks. Thedirect finality of gross settlement preventssettlement failures, with their potential sys-temic consequences. In some RTGS sys-

tems, the central bank grants daylight over-drafts to the participating banks by guar-anteeing all outgoing payment instructions,thereby preserving the liquidity and theprocessing efficiency of net settlement sys-tems. Participants can make paymentsthroughout the day and have to squaretheir positions or erase their overdraftsonly at the end of the day.

In the absence of collateral for such day-light overdrafts, however, the central bankassumes credit risk until the overdrafts areeliminated. Collateral requirements, or eventhe more stringent prohibition of over-drafts, minimize credit risk, but they alsomay significantly reduce the liquidity of thesystem. If good funds or acceptable collat-eral are not available, payments could berejected or at least delayed until cover isobtained.

Some RTGS systems have, or are plan-ning to add, queuing facilities. Paymentmessages, for which no cover is available,enter a queue to be processed when suffi-cient funds have been delivered to coverincoming payments. Heavy reliance on

queuing may generate significant settle-ment risks and thus undermine the essenceof real-time gross settlement. But, in prac-tice, only a small proportion of paymentsmay be queued for a short time.

Which approach? In most of themajor industrial countries discrete-timepayment systems with end-of-day net set-tlement predominate. In 1992, more dailypayment flows went through these systemsthan through other types of payment sys-tems in all but two of seven major indus-trial countries (see table). The exceptionswere the United States, where a little morethan half of fund transfers were settled on anet basis, and Switzerland, where all large-value payments were settled on a net basis.In Japan, the main system, BOJ-NET,allows for net and gross settlement, but thevast majority of payments were, and stillare, settled on a net basis.

In 1996, the United Kingdom switched allwholesale payments to RTGS. While theBanque de France is planning to introducean RTGS system in 1997, the commercialbanks will establish a parallel electronicnetting system, for less time-critical pay-ments, to save on the required collateral.Germany improved its main netting systemin 1995; this now allows for 20-minute set-tlement cycles. The Bundesbank plans tomerge the revamped netting system withits own gross settlement system in fiveyears. Finally, Italy is currently overhaulingits RTGS system to make it more attractivefor participating banks, and the currentnetting schemes will be phased out.

Advances in domestic payment systemsare frequently accompanied by efforts toimprove settlement in money markets. Byadopting electronic book-entry systems formost government and short-term moneymarket securities, most countries havereduced the cost of trading. These countriesrealize that electronic book-entry systemsare crucial for establishing a flexible andcost-effective means of pledging collateralin the newly planned RTGS systems.

System reformsReforms in the major industrial countries

are motivated by a greater awareness of thesystemic risk inherent in discrete-time netsettlement arrangements and, in particular,the recognition that a central bank wouldbe obliged to intervene to avoid systemicdisruption should a serious failure occur.Reforms are also driven by the growingcredit-risk exposure of central banks inRTGS systems. These reforms aim toimprove the safety features of domesticwholesale payment systems and to force


FranceParis clearing houseSAGITTAIREBanque de France credit transfer system

GermanyEAF (daily electronic clearing)Daily local clearingEIL-ZV (intercity credit transfer system)Local credit transfer system

ItalySIPSElectronic MemorandaBISS2

JapanBill and check clearing systemsZenginFEYCSBOJ-NET

SwitzerlandSIC

United KingdomTown clearingCHAPS

United StatesFedwire (funds)Fedwire (securities)CHIPS

1988

77.28.7

20.9

-171.7

10.015.3

—-4.0

124.639.8

117.2692.8

69.0

54.880.4

640.0367.6661.6

1990

94.126.027.2

61.9213.3

20.720.8

18.817.25.5

132.451.6

200.41,017.9

87.5

34.1134.9

796.4399.6888.4

1992

97.044.732.1

212.9142.034.921.6

38.933.99.3

112.654.5

196.11,133.8

95.1

9.8147.9

796.8558.8953.2

699

51

9

071

1

102

937882

6

519

084

29

03

68

0(billion dollars)


banks to internalize the cost of third-partyrisk.

Reforms in the United States. Tocontrol risk on the Clearing HouseInterbank Payment System (CHIPS)—themajor international net payment system forsettlement of the US dollar leg of foreignexchange transactions—the New YorkClearing House imposed a system of netdebit caps in 1986 and a loss-sharingarrangement backed up by collateral in1990. The net debit cap is the sum of thebilateral credit limits granted to a bank byall other banks. The loss-sharing rulesspecify that each surviving bank's share inthe losses should be proportional to itsshare in the sum of bilateral limits thatwere granted to the bank that failed to set-tle. Banks thus have an incentive to monitorthe creditworthiness of other banks andto intervene by reducing their bilateral lim-its. But the US Federal Reserve System, inits role of lender of last resort, may stillhave to provide liquidity to prevent a sys-temic crisis.

To control risk on Fedwire (an RTGS sys-tem), in 1994 the Federal Reserve began aprogram to impose charges for overdraftsbeyond a permissible allowance. The initialcharge was 10 basis points (one tenth of 1percent) at an annualized rate on averageoverdrafts during the day, beyond theallowance. Peak overdrafts—the highestlevel of banks' overdrafts during the day—immediately fell from nearly $125 billionto approximately $70 billion. A subsequentrise in the fee to 15 basis points inApril 1995 had little marginal impact.

Reforms in Europe. The major EUcountries, in the context of discussing thefuture monetary system in Europe, havedeclared their strong support for RTGSsystems for wholesale payments. Threefactors have led to this support. The first isthe fast-growing volume of payments thathas resulted in massive intraday creditexposures between banks. Rather thanreducing settlement risk by net debit capsand loss sharing as in CHIPS, someEuropean central banks would like to gofurther by removing interbank payments-related credit from the payment systemaltogether. The second factor is the doubt-ful legal status of netting in some countries.The third factor underlying support forRTGS systems is the opportunity that theyoffer for real-time delivery-versus-payment(DVP) settlement for securities transac-tions. Most European countries have intro-duced, or are on the brink of introducing,real-time book-entry systems for the trans-fer of securities.

Recently, the European Monetary Insti-tute, the precursor of the future EuropeanCentral Bank, published a blueprint for thenew payment system for the single cur-rency to be introduced on January 1, 1999.The new system, called TARGET (Trans-European Automated Real Time GrossSettlement Express Transfer), will buildupon national RTGS systems and providean interlinking mechanism. Each prospec-tive member country will have to imple-ment an RTGS system before it can jointhe EMU.

Intraday liquidityA common principle underlying the

introduction of RTGS in Europe is thatthere should be no extension of uncovereddaylight credit to the participating banks.These banks must have settlement funds,in the form of reserves or collateral at thecentral bank, before they can make pay-ments. Otherwise, settlement delays couldoccur, thereby defeating the purpose ofintroducing RTGS—namely, ensuring thedirect finality of payments. In short, a cer-tain amount of intraday liquidity is crucialfor the smooth running of the system. Twosources of intraday liquidity are reservesand daylight overdrafts. In Europe, day-light overdrafts extended by central bankswill be subject to collateralization.

Reserves. Although some centralbanks consider reserves important, reserverequirements—expressed as a percentageof banks' eligible liabilities—are rapidlydeclining while payment flows are increas-ing. Non-interest-bearing reserve require-ments are increasingly difficult to enforcein today's global financial markets, asbanks tend to find ways around them. In anenvironment with low or zero reserverequirements, reserves are not enough toprovide the intraday liquidity needed fora smoothly functioning RTGS system.Central bank overdrafts, whether collateral-ized or not, are then necessary to achieveadequate intraday liquidity.

Collateral. As a second source of intra-day liquidity in the newly designedEuropean RTGS systems, central bankswill provide collateralized daylight money.This will effectively convert collateralpledged by commercial banks into centralbank money that can be used for settlementduring the day. A crucial issue centers onwhich securities can be used as collateral.Not surprisingly, because of the creditwor-thiness of the issuer, government securitiesappear prominently on the lists of eligiblesecurities. Pledging collateral is expensive.In the United Kingdom, for example, it is

estimated that the opportunity cost ofpledging collateral to guarantee timely set-tlement could be as high as 25 basis pointson an annual basis.

Electronic book-entry securities settle-ment systems, in conjunction with securi-ties depositories, are crucial for flexibleand cost-efficient pledging of collateral atcentral banks. The United Kingdom andFrance already have well-functioning book-entry systems, which allow for the transferof securities in real time. The recently intro-duced Italian system for real-time transferof government securities is not yet widelyused, while the German system is not capa-ble of transferring securities in real time.

Impact on market liquidityThe United States and various European

countries use two different methods forreducing the risk faced by central banks inRTGS systems. The Federal Reserve allowsuncollateralized overdrafts, but it chargesfor daylight overdrafts. By contrast, vari-ous European central banks allow over-drafts that are collateralized by eligiblepaper, but they do not levy a financecharge. Both methods give users incentivesto avoid tapping daylight credit from cen-tral banks, but they differ in two importantrespects: namely, central banks' credit riskand pricing of money market instruments.

Credit risk. Under the Federal .Re-serve's system, the Fed continues to bearcredit risk but is partially compensated byoverdraft receipts. Fees are not based oncredit risk calculations but are designed toprovide an incentive to reduce overdrafts.Nevertheless, the evidence suggests thatthe overall risk from overdraft default mayhave been reduced very little by the over-draft charges. Large losses most likely willbe incurred when a large bank fails or dur-ing a liquidity crisis, when payment trafficis abnormally high and imbalances areunusually large. Under such conditions, thecharges are not a disincentive for a failingbank to fire out payments.

By contrast, various European centralbanks allow collateralized overdrafts, butdo not levy a finance charge. Thus, thesecentral banks eliminate their day-to-daycredit risk from the RTGS systems, butthey forgo revenue from overdrafts. In asevere situation, however, there may beinsufficient collateral to manage paymenttraffic. Collateral may have to be deliveredto the central bank in overnight discountoperations, and uncovered payment trafficmay surge. In this case, there must be anescape mechanism, whereby the centralbank provides uncovered credit rather than



allow the payment system to seize up. Insuch a situation, weak institutions wouldlikely collapse, leaving the central bankwith an uncovered loss. To prepare for thiseventuality, il niay be desirable to chargeinterest on daylight overdrafts lo establisha loss reserve.

Pricing of securities. The two meth-ods also have different impacts on the pric-ing of money market instruments. TheFederal Reserve method tends to increaseyields or treasury securities relative tothose on non-treasury securities, while theEuropean method tends to reduce yields ontreasury and other eligible securities rela-tive to those on non-treasury securities.

lxx)king at the United Stales, treasurysecurities typically are the most liquid secu-rities and therefore carry a liquidity pre-mium that is reflected in relatively lowyields and narrow bid-ask spreads. Li-quidity is provided by a massive tradingand dealer financing operation, whichmeans that treasury securities generate alarge share of the overdrafts in paymentsystems. Alternatively stated, the existence

until very recently—of unpriced over-draft facilities is one of the underpinningsof treasury security liquidity.

Charging for overdrafts amounts to acharge on the most liquid securities, forthese generate the bulk of total paymentvolume. Banks will pass this charge on todealers, who must respond by wideningspreads to cover the added costs. Thismakes treasury securities less liquid—andless attractive—so their yields must rise tocompensate the ultimate holder for thiserosion in quality. Other, less liquid securi-ties—non-treasuries and off-the-rim trea-suries -will, on average, attract a farsmaller pass through of overdraft charges,because trading in them is less frequent.Thus, their yields should rise less than theyields on liquid securities, such as trea-suries. In sum, a charge on payment ser-vices more strongly affects securities thatgenerate extensive payment flows.

Next, consider the effects of imposing100 percent collaleralization on overdraftson RTGS systems, like those that prevail invarious European countries. Though someprivate paper will be eligible as collateral,here we concentrate on government securi-ties, because they probably comprise thebulk of eligible paper. We assume that theincreased usefulness of such paper inallowing overdrafts will increase banks'demand for it—that is, the collateral con-straint is binding. The cost of pledging col-lateral is analytically similar to charging afee for daylight overdrafts. Again, the yield

on nongovernment securities—that is,"ineligible" paper—will rise because of thiscost, but not that much, as such paper typi-cally trades little and makes relatively rareuse of overdrafts. For government securi-ties, the story is different. On the one hand,their liquidity is reduced by the new collat-eral cost, resulting in higher yields. On theother hand, demand for such securities bybanks must increase because of the needfor government securities to collateralizeoverdraft positions. For this reason, theyield on government securities must fall.The net impact is not clear. What is clear,however, is that the European method ofcollatcralization favors government securi-ties and other eligible securities over pri-vate securities.

ConclusionThe growth in the volume of national

and cross-border financial transactionsduring the 1980s and the correspondingincrease in the siê of the flows through theworld's principal wholesale payment sys-tems—domestic and inter nalioiial—haveled the major central banks to focus on therisks inherent in current wholesale pay-ment arrangements. Uy now, it is well rec-ognized that any interruption in wholesalepayments carries with it the Llireat of a pay-ment gridlock that ultimately could haveserious consequences for the real economy.This threat has provided the urgency forthe ongoing reform of wholesale paymentsystems.

In evaluating the success of currentefforts lo strengthen the world's wholesalepayment systems, two related issues mustbe taken into consideration. The first issueis that reductions in systemic risk come at aprice. In particular, a reduction in payment-related credit reduces liquidity in financialmarkets—that is, it increases bid-askspreads for financial instruments roughlyin relation to the share of daylight over-drafts that arise as a result of trading inthese instruments. Payment pailerns canbe altered to lower overdrafts, but tradingpatterns in securities markets cannot easilyhe rearranged. Yet separating the timingof payments would only increase settle-ment risk.

In any event, intraday credit lias eco-nomic value; therefore, intraday credit mar-kets are likely to develop: payments madeearly in the day may command a discount,while payments made late in the day maycommand a premium. A quantitative analy-sis of the relation between the size of pay-ment-related overdrafts and liquidity infinancial markets lias proved elusive thus

far, hut once data from ongoing experi-ments become available, such an analysiswill be both possible and beneficial.

The second issue that must be taken intoaccount in evaluating reforms is that theymay lead to private sub-netting systems.Such systems may be established as low-cost alternatives to RTGS systems, wherethe cost of daylight credit has beenincreased through collateralization or inter-est charges on overdrafts. Thus, deter-mined efforts to reduce daylight credit incentral banks' wholesale payment systemsmay only shift il into private netting systerns, and doing so might distort paymentpatterns. Managing risk in an environmentwhere it can be clearly observed may bepreferable.

The main cost of reducing payment-related credit is its negative impact on mar-ket liquidity. The main benefit of reducingsuch credit is that a financial disturbancewould no longer pose the threat of paymentgridhx;k in a large part of the financial sys-tem. Once this tlireat is minimized, centralbanks will no longer need lo stand ready torescue a large number of institutions thatare perceived as Ux> big to fail. Paymentsystem reforms thus hold the promise ofstrengthening the market mechanism inbanking and finance and of reducing theextent of the financial safety net.

While payment system reforms havebeen largely successful, a host of technicalissues have yet to be addressed. Some ofthese arise in the context of continuedgrowth in international cross-border pay-ments and securities transactions. Thisgrowth will require linking the majorRTGS systems (for example, linkingEurope's national RTGS systems underTAKGliT) and linking RTGS systems withsecurities settlement systems to pul trans-actions on a delivery-versus-payment basis.

Another set of issues arise in the contextof the increase in national RTGS systems.At the moment, only a few commercialbanks are members of more than one sys-tem, but the number of such banks willlikely increase. With the globalization ofsecurities markets, banks will need to keepcollateral balances in European-type sys-tems. Yet doing so will he highly inefficientfor global institutions, as these balancescould remain idle most of the time. Thus,arrangements for a global collateral poolmay have to be explored. The successfulresolution of all these issues will requirecontinued cooperative efforts among themajor central banks. \f&R\



Creditors' Crucial Role inCorporate Governance

C H E R Y L W. GRAY

Effective debt monitoring andcollection play a crucial rolein corporate governance inmarket economies and re-quire adequate information,creditor incentives, and anappropriate legal framework.

BOTH FINANCIAL sector reformand private sector developmenthave received considerable atten-tion in developing and transition

economies in recent years. But the criticalnexus between banks and firms—not onlyfor financing but also for efficiency andultimate survival—has been underempha-sized. Banks and other creditors have anextremely important role to play in foster-ing efficiency in medium and large privateor state-owned firms. Creditors, in turn,rely for their survival on debt repayment

by their borrowers. Without dependabledebt collection, no amount of supervision orcompetition can make banks run efficiently.

Debt appears to be slowly emerging as adevice for exerting control over mediumand large enterprises in some transitioneconomies. The powers and incentives ofcreditors in these countries are still weak,however, compared with their counterpartsin more mature market economies. Strongcreditors are as critical to the efficient func-tioning of enterprises as are strong owners.External financing for private firms comesessentially from two sources: debt andequity. While control by equity holders isappropriate in profitable times (whenentrepreneurial risk taking is needed), cred-itor monitoring and control become bindingin times of financial distress, particularlywhen tight controls on spending andinvestment are needed. Indeed, foreclosureand bankruptcy laws typically shift controlof firms to creditors at such times. Thus,the development of effective creditor con-trols is a crucial element in successful eco-nomic transition.

The requirements for good control, or"corporate governance," by owners havebeen extensively analyzed. The legal andinstitutional requirements for effective debtmonitoring have not been as thoroughlyanalyzed but are no less important. Likeequity holders, creditors can monitor firmseither actively or passively. The activemode involves hands-on evaluation of afirm's operations, investment decisions, andcapacity and willingness to repay. The pas-sive mode depends on collateral for secu-rity. To the extent analysis is carried outbefore a lending decision is made, the valueof the firm's collateral is what is analyzedrather than the operations of the firm.

There are three crucial underpinnings tocreditor monitoring and control in marketeconomies: adequate information, market-oriented creditor incentives, and an appro-priate legal framework for debt collection.The experiences of Hungary and Poland inthe first half of the 1990s provide fascinat-ing lessons about how—and how not—tostrengthen creditors as agents of gover-nance and restructuring for medium and

Cheryl W. Gray,a US national, is a Lead Economist in the Finance and Private Sector Development Division of the World Bank's Policy Research Department.



large enterprises. Although this articlefocuses on these two countries, their prob-lems have much in common with thosefaced not only by other countries inEastern Europe but also by many develop-ing countries in Africa, Asia, and LatinAmerica.

InformationThe first requirement is information.

Lenders need information on the creditwor-thiness of potential borrowers, and de-positors and bank supervisors needinformation on bank portfolios. While thismay seem obvious, the constraints imposedby the poor quality and asymmet-ric distribution of informationin developing and transitioneconomies should not be underes-timated. Inadequate financial andcost accounting can hide the truevalue of firms' assets, and dra-matic changes in the structure ofinput prices, demand, competi-tion, and distribution channelsreduce the value of prior information.Reputation, the basis for much lending instable market economies, is less binding,owing to the phenomenal pace of change.In sum, every firm currently operating ina transition economy is to some extent anew firm, even if it has been operating for50 years.

Even if information on firms is availablefrom potential borrowers, bank employeesare often not trained in techniques of mar-ket analysis and loan appraisal, and thushave difficulty using that information.Similarly, bank supervisors often lack notonly the technical ability but also the politi-cal will to carry out tough supervision.Furthermore, the "watchdog" professions—including accounting, law, securities, andcredit rating services—are still in theirinfancy, making it difficult for outsideinvestors to monitor firms and preventfraud or misuse of their investments.

When information asymmetries are sig-nificant, adverse selection may make itcostly, if not impossible, for outside in-vestors to fund the growth of a firm witheither debt or equity. If formal lendingoccurs, it will typically be based on collat-eral (or perhaps reputation) rather than onactive monitoring of the firm's operations.

Creditor incentivesThe second requirement for debt to serve

a control function is the existence of appro-priate market-based incentives for credi-tors, whether banks, trade creditors, orgovernment.

Bank credits. Banks should play apivotal role among creditors in maintainingborrower discipline and financing newactivities. By 1992, many of the state-ownedcommercial banks in Hungary and Polandwere in serious financial difficulty whenevaluated using internationally acceptedaccounting principles. This difficulty wasthe result of several factors, including badloans inherited from the socialist era, tran-sition-induced defaults on existing loans,and defaults on new loans extended afterthe onset of relative price reform.

Both countries moved to reinvigorateexisting banks through recapitalization. On

"Banks and other creditors havean extremely important role toplay in fostering efficiency inmedium and large private or

state-owned firms."

the one hand, a one-time recapitalizationearly in the transition process may be nec-essary (but not sufficient) to establishviable institutions, given the under-capitalized state of most commercialbanks when they were initially created.Undercapitalized banks cannot operate forlong without government support and mayface perverse incentives to continue dis-tress lending and engage in ever riskierbehavior to avoid bankruptcy. On the otherhand, growing experience from aroundthe world shows that recapitalization isrisky, particularly if undertaken repeatedly.

Until mid-1994, Hungary's efforts toreform its banks paid little attention tothe dangers of recapitalization. Hungarianbanks were effectively recapitalized fourtimes during 1991-94. Yet little elsewas done to create strong incentives forbank restructuring. No independent, in-depth portfolio audits were undertaken.Performance-oriented management con-tracts were not implemented, nor werebank managers given strong and clearincentives to increase the value of thebanks they managed. The government didnot formulate a clear plan for privatizingstate banks, although two of them under-took privatization programs largely ontheir own initiative. Most observers agreethat banking supervision was weak.

Poland, after a rocky start, madestronger efforts than Hungary in the fouryears ending in mid-1994 to deal with theperverse incentives faced by the managersof a group of state-owned banks. Like

Hungary, it opted to recapitalize its com-mercial state banks, but, unlike Hungary, itcarried out only one round of recapitaliza-tion. Furthermore, this recapitalization wasembedded in a much larger program,the Enterprise and Bank RestructuringProgram (EBRP), designed to change incen-tives and promote privatization. Amongother actions, it prohibited new lending toproblem borrowers and required banks toset up workout departments and takeactions to resolve those loans that had beenclassified as nonperforming at the end of1991. It also required banks to undergorepeated, in-depth portfolio audits by out-

side auditors. The program wasmade credible by the strong andconsistent leadership of the PolishMinistry of Finance from 1990through early 1994.

In sum, during 1991-94,Poland's banking reforms werefar more comprehensive thanHungary's. Because the Polishreforms forced greater trans-

parency and were tougher and more credi-ble, they were more successful in slowingany further deterioration of the state-owned commercial banks and—mostimportant for this discussion—in strength-ening banks' resolve to pursue debt collec-tion vigorously.

Trade credit. Suppliers were 'alsoweak creditors in the early years of transi-tion. In 1993 and 1994, a significant portionof the debt to trade creditors in Hungaryand Poland consisted of overdue payables,many of which had resulted from the tran-sition-induced demand and liquidity shocksof 1991 and 1992. This stock of interenter-prise arrears undercut discipline, owing tothe fear of "domino" bankruptcies occur-ring if any creditor attempted to collectdebts. Yet the incentives of trade creditorsto monitor debtors are growing steadilystronger as the private sector continues togrow. Trade creditors, particularly pri-vately owned ones subject to their ownhard budget constraints, have increasinglyprevented the emergence of new overduereceivables by requiring payment inadvance—that is, before they ship goods toproblem firms.

Government credit. Debt owed to thegovernment—including arrears to the taxoffice, the social security service, and thecustoms office—became a substantial por-tion of the debt on the books of problemfirms in Hungary and Poland in the early1990s. Yet these agencies were weak credi-tors, not known for active law enforcementand collection of arrears. In contrast, their



legacy from the years before 1990 was oneof pervasive bargaining and redistributionfrom profitable firms to loss-making ones.Habits are not easy to change overnight,and tax and social security arrears continueto be a major source of "financing" forfirms in financial distress. There is, how-ever, some evidence that budget pressuresare beginning to make government credi-tors more vigilant in both countries.

Debt collectionThe third requirement for creditor moni-

toring and control in a market economy isan appropriate legal framework and effec-tive procedures for debt collection. Withoutan effective system of debt collection,debtors lose repayment discipline, the flowof credit is constrained, and creditors maybe forced to turn to the state to cover theirlosses if they are to survive. In informalcredit markets, the effectiveness of debt col-lection depends on nonlegal or extralegalsanctions—such as the threat of a debtor'sostracism by the business community or, inextreme cases, self-help (sometimes violent)on the part of creditors or their agents.Formal credit markets depend more onlegal procedures involving collateral(secured lending), workouts (creditor-man-dated reorganization of the debtor firm),and bankruptcy (liquidation). Well-designed and implemented rules facilitaterapid and low-cost debt recovery in cases ofdefault, thereby lowering the risks of lend-ing and increasing the availability of credit(particularly bank credit) to potential bor-rowers. Poorly designed and implementedrules make lending more costly and stiflethe flow of credit. The recent experiences ofHungary and Poland provide interestingillustrations of both flaws in the debt-collec-tion processes and attempts to addressthem.

Collateral. In the early 1990s,Hungarian and Polish laws on collateraldated from the prewar period and failed toprovide an adequate foundation for astrong financial system. First, the definitionof property that could be used as collateralwas narrow, and movable property had tobe in the possession of the lender (therebymaking it useless to the debtor firm) toserve as security. Second, there was essen-tially no way to register liens on movableproperty in either country; it was commonfor several liens to be secured by the sameproperty, and banks often took liens onproperty -worth much more than the valueof the corresponding loans. Third, prioritiesamong creditors favored the governmentover secured creditors. In Poland, for

example, the government had an automaticlien (whether or not formalized in any way)over all property of any party in arrears toit for taxes, social security payments, orcustoms duties. Fourth, executing liens wasextremely difficult and time-consuming,requiring a court decision and then actionby a bailiff (to whom a large fee had to bepaid up front). Finally, even if a creditorsucceeded in executing a lien, it was oftendifficult to sell the collateral and thus col-lect on the loan. For residential propertieson which the mortgagors had defaulted, forexample, it was virtually impossible toevict tenants and sell the properties unen-cumbered by tenants' liens.

Poland provides the first test case incomprehensive collateral law reform. In late1996, it adopted a new and modern collat-eral law that reforms creditor priority rules,provides for a central registry for liens onmovable property, and simplifies foreclo-sure procedures. Hungary has also recentlytaken steps to improve its collateral system.

Debt workouts. A second critical com-ponent of the legal framework for debt col-lection is the procedure for informalworkouts and formal reorganizations, themechanisms a problem debtor may use inan effort to negotiate a reduction in itsimmediate debt-service costs in order tostay in business. In return for agreeing tosuch procedures, creditors may insist onpartial debt payments and/or on fundamen-tal changes in the firm's size or functioningin order to increase the creditors' chances ofrecouping the remaining debt. From a pub-lic policy perspective, these procedures areintended to promote reorganization of firmswhose value as going concerns (after theirreorganization) exceeds their liquidationvalue. Firms seeking reorganization may,for example, have assets, such as special-ized machinery or unique trademarks, thathave little value in alternative settings.

Since 1991, both Poland and Hungaryhave taken far-reaching steps to adopt mar-ket-based workout processes. Poland hadboth a judicial procedure and an extrajudi-cial one. Judicial debt workouts occur underthe law on "arrangement proceedings,"whose main disadvantage is its inflexibility.To overcome its deficiencies, Polandadopted a new temporary procedure forworking out bad loans—the bank concilia-tion agreement—as part of the 1993 EBRP.Under this procedure, which could be useduntil February 1996, power shifted from thecourts and the borrowers to the banks.Banks were empowered to negotiate, andrequired to monitor, workout agreementson behalf of all creditors, providing they

received approval of creditors representingmore than 50 percent of the value of adefaulting borrower's outstanding debt.The conciliation process was used quiteextensively, along with other options forhandling problem debts. This temporaryprocess has expired, but the shortcomingsof Poland's permanent judicial process havenot yet been addressed.

In 1991, the Hungarian parliamentadopted a tough new bankruptcy/liquida-tion law, which took effect on January 1,1992. It required managers of firms withany arrears of 90 days or more to file forreorganization or liquidation. On their face,the reorganization provisions of the law aresimilar to those of bankruptcy laws inadvanced market economies, includingChapter 11 of the US Bankruptcy Code.Managers of a bankrupt firm retain theirjobs after filing and have the first opportu-nity to present a reorganization plan.Creditors may then vote on the managers'plan and present alternative plans. If anagreement cannot be reached between afirm and its creditors, the procedure revertsto liquidation. From the first filing until thefinal agreement is reached, the courts haverelatively little substantive involvement.

The 1991 law led to a wave of filings forboth reorganization and liquidation. Some5,000 reorganization cases and 17,000 liqui-dation cases were filed during 1992 and1993. The law was widely criticized asoverly ambitious, and amendments made inSeptember 1993 removed both the filingrequirement (the "stick") and the debtorfirm's assured protection from creditors(the "carrot"). The number of reorganiza-tion filings under the bankruptcy lawdeclined dramatically in 1994.

Liquidation. Liquidation is the finalstage of the debt-collection process.Creditors' control rights over defaultingdebtor firms derive ultimately from the for-mer's power to force liquidation, yet inmany transition economies the laws gov-erning liquidation give little power tocreditors.

In Poland, the liquidation of financiallydistressed firms may occur under the 1934bankruptcy law or under Article 19 of thelaw on state enterprises (a legacy of social-ism). Creditors or the debtor may file forbankruptcy or liquidation, and the lawsprovide standard rules for appointing liq-uidators, winding up estates, and satisfy-ing claims in order of priority. But thepriority list for creditors discourages activecreditor involvement by favoring almosteveryone else. If the government and proce-dural costs do not consume the debtor's



Characteristics of Polish firms,by resolution path, 1991/92

(percent)

Source: Cheryl Gray and Arnold Nolle, 1996, "Bank-ledrestructuring in Poland: The conciliation process in action,'Economics of Transition, Fall, pp. 349-70.

entire estate, employees' claims may welldo so.

In addition, the law provides few meansfor a receiver or judge to void fraudulenttransactions made by a debtor firm's man-agers or owners, at the expense of credi-tors, prior to filing. Such transactions arethought to be common, and Poland's legalsystem must find a way to identify andpunish them if the bankruptcy process (or,indeed, any debt-collection process) is to becredible. Although only companies that arestill solvent are legally eligible for stateenterprise liquidation, many companiesin liquidation are actually insolvent. Inpractice, creditors recover even less underArticle 19 liquidations than under bank-ruptcy proceedings.

In Hungary, liquidation procedures arecontained in the same law as the reorgani-zation process already discussed. As inPoland, the process is a fairly standard one,at least on paper. Either creditors or thedebtor petition for liquidation, a liquidatoris appointed, a list of assets is drawn up,and the assets are then supposedly sold to

satisfy claims in the order of creditorpriority. While the Hungarian law doesnot include the counterproductive prior-ity rules incorporated in the Polish law,the compensation formula for liquida-tors leads them to keep firms in opera-tion for as long as possible and to actmore as restructurers and privatizersthan as agents of creditors. Fur-thermore, the process is thought to offermany opportunities for fraud, both bymanagers (who may remove valuableassets before filing for liquidation) andby liquidators (who may find manyways to profit from their near-monopolycontrol over the process). In Hungary,the problem is not so much the existinglegal framework as the difficulty ofadministering it properly in an environ-ment characterized by poor informa-tion, little accountability, and confusedincentives.

Debt's emerging roleSurveys of Polish firms involved in

the EBRP and Hungarian firms in-volved in bankruptcy show that the out-comes of these processes have beenmixed (see references). The EBRPforced Polish banks to confront theirproblems, and both countries' processesfurthered the difficult task of weedingout and closing unviable firms andhelped build institutional capacity inbanks (Poland) and in courts and thetrustee profession (Hungary). Loans

were written down in both cases withoutcreating an environment of general debtforgiveness. Better-off firms entered reorga-nization, while weaker ones tended to gointo liquidation. Size also mattered, particu-larly in Poland (see chart). Larger firmswere more likely to enter reorganizationregardless of their profitability. This shouldnot be surprising, since these firms arepolitically more difficult to close.

The workout and liquidation processesdid not, however, impose strong restructur-ing mandates on problem debtors or effi-ciently close insolvent firms. The first twoyears of implementation of the bank concili-ation agreements in Poland, for example,saw a slowdown (over earlier years) in therate of layoffs, a decline in average operat-ing profitability, and very little real privati-zation. In both Poland and Hungary,liquidations have been slow and havereturned very little to creditors. Continuedreforms of laws, court procedures, andcreditor incentives are needed to buildstrong banks and effective legal processesthat allow debt to serve as a device to exert

control over firms in times of financialdistress.

ConclusionThe facts regarding firm financing, bank

incentives, and the mechanisms for debtcollection may differ from one country orcontinent to another. Some underlyingthemes are constants, however, and applyas much to Africa, Asia, and Latin Americaas to Central Europe. First, strong, market-oriented creditors are good for an economy.They can afford to provide financing to awide range of clients at reasonable ratesand play an important role in corporategovernance, particularly in the restructur-ing of firms in financial distress. Second,creditors must have strong legal rightsunder contract, collateral, workout, andbankruptcy laws if they are to play thisgovernance role. Giving them those rightsmay require extensive legal reform insome developing and transition economies.Third, creditors must also have informationon their borrowers if they are to play thisrole. Credit information or credit-ratingservices can be extremely valuable in facili-tating firms' access to financing, and gov-ernments should encourage their formationand growth. Accounting services, cham-bers of commerce, the business press, andother parts of civil society also providemuch-needed information in well-function-ing market economies. Finally, creditorsmust have strong incentives to ensure thatdebts are repaid, and this means they mustdepend on the market to survive. Thisimplies competitive markets, financial dis-cipline, predominantly private ownership,and a true risk of failure for both banks andfirms. ED]

ReferencesHerbert L. Boer and Cheryl W. Gray, 1996,

"Debt as a Control Device in TransitionalEconomies: The Experiences of Hungary andPoland," in Corporate Governance in CentralEurope and Russia, Roman Frydman, Cheryl W.Gray, andAndrzejRapaczynski, eds.,Vol. 1(Budapest: Central European University Press).

Cheryl Gray and Arnold Hotte, 1996, "Bank-led restructuring in Poland: The conciliationprocess in action," Economics of Transition,Vol. 4, FaU, pp. 349-70.

Cheryl Gray and Arnold Hoik, 1997, "Bank-led restructuring in Poland (2): Bankruptcy andits alternatives," Economics of Transition,forthcoming.

Cheryl Gray, Sabine Schlorke, and MiklosSzanyi, 1996, "Hungary's BankruptcyExperience, 1992-93," World Bank EconomicReview, Vol. 10, September, pp. 425-50.

32 Finance & Development / June 1997


Interest Rates: An Approach to LiberalizationIIASSAN.HI M E H S A N A N D B E R N A R D L A U R E N S

Interest rate Uberalfaatianmay not produce Ihe expectedbenefits if lite timing, pace,and sequencing are off. Theseshould be determined by thedegree of macroeconomic sta-bility, conditions in the bank-ing and state enterprisesectors, and the central bank'scapabilities.

I

\ l \ ' | - . i r ; \ i " v,-,'ix nir inv Ji.'v<.-]'>|'iriyand transition countries have allowedmarket forces lo play a greater role intheir economies. In the financial sec

tor, this means liberalizing interest rates sothat they are allowed to be set by ihe mar-ket, and developing financial markets sothat credit can be allocated more efficiently.

Although each country must design itsown blueprint for financial reform, somegeneral principles scum to be universallyapplicable, at least in countries what1 poli-cymakers have some control over the liberalization process. First, policymakers needto decide when to start liberalizing interestrales and how fast to move. In making thisdecision, it is important to consider how faradvanced the country is in reforming thestale enterprise sector and in establishing a"credit culture" thai is, the extent towhich hanks have become accustomed tousing market principles in assessing creditrisks. Second, they need to determine the

appropriate sequencing of liberalization—the order in which interest rales on differentfinancial instruments can be freed withoutitirealwiing the health of the country'sbanking system. Third, the central bankneeds to develop a strategy for conductingmonetary policy within the framework ofa liberalized financial system. To allowmarket forces to determine the allocationof financial resources, countries need todevelop an efficient money market. And.policymakers need to be prepared for thefinancial innovations that will inevitablyfollow liberalization.

Starting point ami speedThere is growing consensus among poli-

cymakers that the speed of liberalizationneeds to be determined in the context ofa country's overall reform program. Finan-cial sector reforms need to bp supported bystructural reforms in other economic sec-tors. Countries with serious macroeconomicand financial imbalances, or inadequateregulatory and supervisory frameworks, orwhose financial institutions are insolvent,arc likely Lo run into serious problems ifthey liberalize interest rates too early or loorapidly, [f liberalization is premature, controls on interest rales may need to be rein-troduced. as happened in Turkey at ihebeginning of the 1980s and in Korea in thelate 1980s. Thus, llic better the fundamen-tals, the faster a country can go with inter-est rate reform.

Reform of the state-owned enterprise ter-ror is particularly important. For interestrate liberalization to succeed, the main economic players (business enterprises andfinancial institutions) need to be subject tohard budget constraints so that they will

avoid borrowing and lending unwisely.Otherwise, credit could be directed lo so-called pathological borrowers—those whoare likely to lake the greatest risks and whowould borrow no matter how high ihu cost.

Moreover, unmmpetitive banking systerns, inadequate regulatory frameworks,and borrowers that are insensitive to inter-est rales undermine the efficiency of mar-ket based credit allocation and disrupt Ihetransmission of monetary policy signals,with adverse consequences for macroeco-nomic policy. When these conditions pre-vail, interest rates are not likely to move totheir market-clearing levels.

Rapid liberalization in a country whoseenterprises and financial institutions lackexperienced management could also provecounteiproductive and result in an unsoundfinancial sector.

Liberalizing too fast poses certain dan-gers—but too slow a pace can also defeatreform programs. Reforms may losemomentum and new distort ions couldemerge if liberalization takes too long. Tokeep interest rate liberalization on trackrequires close cooperation between themonetary authorities and governmentagencies responsible for structural reformsin the real sector. This is particularly Lrite iftemporary interest rate subsidies are usedto protect certain borrowers whose accessto credit is seen as a priority but who wouldbe unable to switch immediately to borrowing on commercial terms, a common situa-tion in many countries even those w i t hhighly competitive and deregulated markets. Eliminating some subsidies whilemaintaining others presents a particularchallenge for transition and developingcountries, where most administered rales

Hiissimali Mehran.mi Iranian nalmnal. m a Sewnr Advisor itt tlif IMF's Maiii'laiy andExchange Affaifs IJepartmenl.

Bernard l.aurens.11 French national, is a Senior txonomi.it in thf IMF's Monetary midEcchaujn1 Affairs Department.

I'iiaiare. X- neivloftmeat /June 19!)7 33


are subsidized and lower than market-clear-ing rates.

The distortionary effects of subsidizedcredit facilities can be minimized, however,through the application of certain princi-ples. First, the allocation of subsidies mustbe transparent to ensure that only targetedsectors benefit from below-market interestrates. Second, relationships between com-mercial banks and their customers shouldbe based on an assessment of risks, inaccordance with market principles. More-over, decisions about which interest ratesubsidies to eliminate should be made bythe government, not the central bank, andthe costs of interest rate subsidies shouldalso be borne by the government.

Refinancing by the central bank, whichhas been a source of subsidized credit insome countries, should be either at penalrates or, at the very least, at market rates todiscourage excessive recourse to the centralbank as lender of last resort and avoid thetypes of distortions that occurred in China sinterbank market in the early 1990s.Chinese banks used some of the centralbank's subsidized refinancing to make high-risk investments in real estate and securi-ties rather than to finance priority sectors,and it was the interbank market that servedas a channel for this speculative financing.

SequencingIn determining the appropriate sequenc-

ing of interest liberalization, the authoritiesneed to distinguish not only between loanand deposit transactions but also betweenwholesale and retail transactions. Interestrates on wholesale transactions betweensophisticated entities should be liberalizedfirst, followed by lending rates and, last,deposit rates. This gradual approach safe-guards the profitability of banks whileallowing time for people and firms to adjustto liberalization.

Sequencing in which interbank marketrates are liberalized first, followed by lend-ing rates, and, last, by deposit rates stemsfrom a desire to treat financially sophisti-cated entities (financial institutions andgovernment agencies) differently fromthose with less financial awareness (busi-ness enterprises and the general public).Ifecause the interbank market rate does notaffect the public directly, its liberalizationhas the least political and social exposure.Korea, Malaysia, and Turkey adopted thissequencing. China has also followed thismodel, to allow time for the learning pro-cess—deposit rates will be liberalized lastto give the general public time to get usedto a new way of setting rates.

The rationale for liberalizing lendingrates before deposit rates is that thissequencing makes it possible to avoidoverly fierce competition in the bankingsector, which could adversely affect theprofitability of financial institutions, and,thus, "buys time" for commercial banks tostrengthen their operations and financialstructure. During this transitional period,governments should enact legislation oncollateral and bankruptcy—essential if thefinancial sector is to operate on a commer-cial basis.

A mechanism for monitoring the profitmargins of financial institutions may proveto be a useful tool to gauge the impact ofliberalization on bank profitability. Forinstance, in Thailand, the central bank andthe bankers association agreed to establisha minimum retail lending rate, which linkslending rates to deposit rates and providesa benchmark for small borrowers, whilestrengthening the latter's bargaining power.Also, during Malaysia's transition to fullinterest rate liberalization, all rates wereanchored to each bank's declared base lend-ing rate, which was tied to the bank's fund-ing costs. These monitoring mechanismscan also be used to promote fair competi-tion by providing reliable information toborrowers. They presuppose, however, theexistence of standardized accounting rulesfor asset valuation, provisions for nonper-forming loans, and the calculation ofincome, expenses, and profits before taxes.

To avoid unstable deposit flows betweenfinancial institutions, it is prudent not towait until all lending rates are fully lib-eralized before beginning to liberalize rateson some types of deposits -large timedeposits, for example, which are usuallyheld by large companies and institutionalinvestors, in contrast with "retail" depositsheld by individuals. Early liberalization ofrates on large deposits is also justifiedby the fact that they will increasinglybe competing with money market instru-ments (treasury bills or repurchase agree-ments). Many industrial countries—including Japan, the United States, andmost Western European countries- liberal-ized "wholesale" deposit rates at an earlystage. Of the developing countries, Koreaalso freed interest rates on wholesaledeposits, as well as on large-denominationrepurchase agreements, early in its reforms.

Monetary policyAn early liberalization of interest rates

on wholesale transactions is also critical forthe reform of monetary policy. It facilitatesthe development of an interbank market

and a secondary market for governmentsecurities, laying the foundation for futuremanagement of the money supply throughopen-market operations (outright sales pirpurchases of government securities by the;central bank in the open market or repur-chase transactions for the purpose of con-trolling money supply).

Money markets. The central bank hasa key role to play in the development ofmoney markets. First, any measures itadopts to enhance the soundness of com-mercial banks indirectly pave the way forthe development of a healthy interbankmarket. Second, it may participate directlyin the development of the interbank market.

In Turkey, for example, all interbanktransactions were initially intermediated bythe central bank. To cover for the creditrisk, all transactions had to be backed byacceptable collateral, such as governmentsecurities. In Thailand, a repurchase mar-ket was created within the central bankwith a view to further developing thefledgling money market and giving the cen-tral bank a mechanism for monitoring and,if necessary, intervening in the market. InItaly, although an over-the-counter inter-bank market had been operating for a longtime, the central bank established a com-puter-based market to increase market li-quidity and reduce volatility. Korea's cen-tral bank promoted the establishment ofbrokers and dealers of call transactions toenhance the adjustment function of theinterbank market and curtail market seg-mentation. China's central bank, seekingto improve the flow of funds betweenprovinces and create a forum for conduct-ing monetary operations, followed theItalian model in setting up new arrange-ments for the interbank market.

As different money market instrumentsare introduced, the central bank needs astrategy for using them to conduct mone-tary policy. For instance, secondary mar-kets in government securities can be used toconduct open-market operations. However,difficulties arise when the volume of trans-actions in the secondary market is small incomparison with the central bank's open-market operations. Turkeys central bank,for example, has increasingly used repur-chase operations in the interbank marketfor its open-market operations to avoid con-flicts with the Turkish treasury. Often,when the central bank was selling govern-ment securities to absorb excess liquidity,the treasury objected on the ground that thecentral bank's open-market operations werecausing interest rates on government secu-rities to rise. To gain greater autonomy in



economic indicators—for example, com-modity prices, exchange rates, and yieldcurves. Similar challenges have arisen inmost countries that have liberalized theirfinancial sectors. Ultimately, these changeshave led to a more eclectic approach toframeworks for designing monetary policy,including inflation targeting.

Lessons for central banksVery few would challenge the desirabil-

ity of interest rate liberalization. However, anumber of countries have adopted a grad-ual approach, with the risk of losingmomentum, on the grounds that liberaliza-tion could be bad if it occurred at the"wrong" time, and that it should thereforebe postponed until complementary reformsare in place. Others have achieved a highdegree of liberalization but do not seem tobe reaping the benefits.

Whether liberalization should be post-poned or not has been hotly debated. Insome cases, policymakers have little controlover sequencing and can therefore not post-pone liberalization. In others, however,gradualism is a workable option that allowsa country to address the structural issues

raised in this article and lay the ground-work for a smooth liberalization process. Inthis respect, building a sound and profitablebanking system is the cornerstone of finan-cial reforms. Liberalization will not producethe expected benefits unless the allocationof credit has improved. In addition, develop-ing a healthy money market facilitates thereform of monetary management and theuse of indirect frameworks that allow thecentral bank to influence underlyingdemand and supply by influencing the gen-eral level of interest rates through its open-market operations. 'f&p\

This article draws on discussions at an interna-tional seminar sponsored by the IMF'sMonetary and Excliange Affairs Departmentand the. People's liank of China and held inBeijing in August 1995. The seminar focusedon lessons learned from financial reforms inItaly, Korea, Malaysia, Turkey, and the. UnitedStates, and their relevance to China's liberaliza-tion program. The seminar proceedings werepublished in 1996 under the title Interest RateLiberalization and Money Market Development:Selected Country Experiences edited byHassanali Mehran, Bernard Laurens, and MarcQuintyn (Washington: IMF).

Don't panic!

1268

The World Debt Tables hasn'tdisappeared—it's been renamed!In Global Development Finance, you'll find all the information you're used toseeing in the World Debt Tables—external debt and financial flows data for 150countries, including the 136 that report to the Bank's Debtor Reporting System.Only the name has changed for this two-volume annual reference work. GlobalDevelopment Finance is a must for economists, bankers, country risk analysts,financial consultants, and anyone involved in international trade, payments, andcapital flows. April 1997. Volume 1: Stock no. 13788-F (ISBN 0-8213-3788-2) $40.00. Two-volume set (Volume 2 not sold separately): Stock no. 13789-F (ISBN 0-8213-3789-0) $300.00.

Global Development Finance is also available on CD-ROM and diskette. View,select, and extract the data you need through the World Bank's Socioeconomic Time-

series Access and Retrieval System ("STARS*). Contains data from both volumes and text fromVolume 1. Files may be exported to other databases, Lotus 1-2-3™, or ASCII. CD-ROM individual version: Stock no.13792-F (ISBN 0-8213-3792-0) $300.00. CD-ROM network version: Stock no. 13793-F (ISBN 0-8213-3793-9) $825.00. Diskette individualversion: Stock no. 13790-F (ISBN 0-8213-3790-4) $200.00. Diskette network version: Stock no. 13791-F (ISBN 0-8213-3791-2) $545.00.

The World BankPO Box 7247-8619 • Philadelphia, PA 19170-8619 • USA

telephone 202.661.1580 • fax 202.661.1501


rie ojjaiJuct of their open-market opera-tionsj&e'ntral banks have increasingly beeniss*j g their own securities.

financial innovation. Over time, the•-iSrvelopment of financial instruments such,*s nejpgible ShoR-term securities and repufifti4S&-agreem<jits results in greateringJdiJjftSP °f money demand. It becomes

in^jSiistBfely difficvjt to identify a monetaryvarajSCthat is sttble enough to be used toforfMpfethe b^^Vior of other nominal pol-icy vStiSfctf'such the GDP. Although thesetypes of problems do not affect the sound-ness of quantitative monetary frameworks(as opposed to more subjective approaches),especially for countries that have notachieved a high level of financial liberaliza-tion, they do add to the complexities of pol-icy implementation and coordination. In theUnited States, for example, because thevelocity of money became more unstablefollowing the financial innovations of the1970s and 1980s, the Federal Reserve had toshift its focus a number of times, movingfrom the narrowest definitions of moneyto broader measurements of liquidity. Italso increased the number of variablesmonitored to include a wider range of


GLOBAL FINANCING TRENDS

Developing CountriesGet More Private Investment, Less Aid

A World Bank report showsthat while private investmentflows to developing countriescontinued to grow in 1996,official flows declined.

A RECENTLY published WorldBank report, Global DevelopmentFinance, shows that flows of pri-vate capital to developing coun-

tries increased for the sixth consecutiveyear in 1996, surging to $244 billion, up $60billion over 1995. Private capital accountedfor more than 80 percent of total net long-term flows to developing countries, whichcame to $285 billion in 1996 (Table 1).

The pie was not equally distributedamong all developing countries, however—73 percent of foreign investment went tojust 12 countries, with China receiving 52percent of total flows (Table 2). Nonetheless,the situation has improved since 1990,when the top 12 beneficiaries received 84percent of all foreign private investment.Even Africa, which receives only a modestshare of total private capital flows, hasenjoyed a tenfold increase in foreign privateinvestment over the past six years.

Declining official flows were, however, acause for serious concern because long-term development aid catalyzes and com-plements private investment. And aidcutbacks affect even countries that receiveprivate investment—the most likely vic-tims are health, education, and environmentprograms for which private sector financ-ing is in short supply.

Private flowsTwo factors were seen as driving for-

eign private investment toward emergingmarkets—investors' desire for portfoliodiversification and higher profits, andmacroeconomic and structural reforms indeveloping countries. Investors have be-come increasingly discriminating and showa marked preference for countries withsound policies.

All categories of private flows rose in1996—portfolio investment (Chart 1), com-mercial lending, and foreign direct invest-ment. Roughly half of new lending was forproject finance—in large part, for infras-tructure projects. Private financing for

infrastructure projects in developing coun-tries grew to $22 billion per year over thepast three years. Most of this went toprivate sector projects in power generation,telecommunications, and transport, withEast Asia receiving the lion's share(Chart 2). The availability of guaranteesfrom host governments, export credit agen-cies, and multilateral institutions such asthe World Bank did much to boost privatesector interest in this area.

Official aidThe leveling off of official aid put pres-

sure on a number of poor countries thatwere reliant on long-term development aid.

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^Total flows

Official development financeGrantsLoans

Total private flowsDebtCommercial banksBondsOthers

Foreign direct investment

Portfolio equity flows

100.6

56.329.227.1

44.416.63.02.3

11.3

24.5

3.2

146.0

55.431.623.9

90.635.912.59.9

13.5

43.6

11.0

237.2

53.032.620.4

184.256.626.528.5

1.7

95.5

32.1

284.6

40.831.39.5

243.888.634.246.1

8.3

109.5

45.7


^^^H[^^^^Hj^^^^^^^^^^^l^^^^^^^lHS^^^TO^WI^^^S^^J^^MMyHj^^^^ffin^^^^^M^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^1

Source: World Bank, 1997, Global Development Finance.Note: Low- and middle-income developing countries are defined as those having 1995 per capita incomes of

less than $765 (low) and $9,385 (middle), respectively.1 Aggregate net long-term resource flows.2 Preliminary.

Table

321

46

469

6

064

83

655

62

9

56 5 5

7

1

1

5

2

5


ChartlPortfolio investment flows to

developing countries surged in 1996

Net private capital flows to developing countries

1990 1992 1994 19961

All developing countriesSub-Saharan AfricaEast Asia and PacificSouth AsiaEurope and Central AsiaLatin America and CaribbeanMiddle East and North Africa

Income groupLow-income countriesMiddle-income countries

Top five country destinations 2

BrazilChinaIndonesiaMalaysiaMexico

44.40.3

19.32.29.5

12.50.6

11.432.0

0.58.83.21.88.2

90.6-0.336.92.9

21.828.70.5

25.464.8

9.821.34.66.09.2

161.35.2

71.08.5

17.253.65.8

57.1104.2

12.244.4

7.78.9

20.7

243.811.8

108.710.731.274.36.9

67.1176.7

14.752.017.916.028.1

Source: World Bank, 1997, Global Development Finance.Note: Low- and middle-income developing countries are defined as those having 1995 per capita incomes of less

than $765 (low) and $9,385 (middle), respectively.1 Preliminary.2 Country ranking is based on cumulative 1990-95 private capital flows received. Private flows include commer-

cial bank loans guaranteed by export credit agencies.

Concessional aid, which constitutes thebulk of development assistance to low-and middle-income countries, dropped bynearly $1 billion in 1996—in real terms,3 percent less than in 1995. Moreover, therehas been a marked shift in the compositionof concessional flows over the past fewyears. Although the largest share of conces-sional aid is still devoted to poverty reduc-tion and long-term economic assistance(for example, through the InternationalDevelopment Association (IDA), the WorldBank's concessional lending arm), theamount targeted at refugee and emergencyrelief is growing. An estimated 12 percentof all official development assistance wasdevoted to emergency aid in 1996, com-pared with less than 2 percent in 1990. iF&Dl

This article is based on World Bank, 1997,Global Development Finance (Washington),which was formerly published by the WorldBank under the title World Debt Tables.


Chart 2East Asia ahead in raising external funds

for infrastructure

Source: Euromoney Loanware and Bondware, and World Bank staff estimates.Source: World Bank, Debtor Reporting System.

Note: Funds raised on international capital markets on a gross basis, except fordirect investment in equity markets, which is on a net basis.

1 Preliminary.

table2

(billion dollars)


Improving India's SavingPerformance

MARTIN M0HLEISEN

One of the prerequisites forputting India on a high growthpath is a substantial rise indomestic saving. This willrequire tighter fiscal policiesand strong structural reforms,including liberalization offinancial markets.

T HE DOUBLE task of alleviatingpoverty and keeping up withfast-growing Asian neighborsprompted the Indian government

to announce a target of 7 percent or morefor annual GDP growth over the next 10years. A key question is whether India willbe able to finance the investment necessaryto reach this target through increaseddomestic saving and avoid a much greaterrecourse to foreign saving with its associ-ated risks on the external front.

A strategy to improve India's saving per-formance needs to take account of recentinsights in the saving literature. Over thepast few years, several studies of savingin developing countries have found thattax and interest rate incentives have

Martin Muhleisen,a national of Germany, is an Economist in theIMF's Asia and Pacific Department.

been largely ineffective. Moreover, empiri-cal studies suggest that higher growth gen-erally tends to precede higher saving. Inlight of this evidence, it may be moreeffective to increase domestic saving byraising public saving and implementing astrong structural reform program, includ-ing financial liberalization.

Measuring savingIndia's saving rate is relatively high,

compared with that of other countries. Ithas shown an uneven upward trend overthe past four decades (Chart 1), and therehave been considerable changes in its com-position. Historically, domestic saving has

been dominated by household savingin physical assets. However, the recentincrease in saving has been driven mainlyby financial household saving, partlyreflecting a continuing expansion of finan-cial institutions' branch networks into ruralareas and, more recently, the increasingavailability of alternative investmentopportunities. Private corporate saving hasalso shown a steady increase over the lasttwenty years, although it remains below 5percent of GDP. Public saving weakened inthe early 1990s to reach a low of 0.5 percentof GDP in 1993/94, a significant reductioncompared with the levels of 4-5 percent ofGDP seen in the early 1980s.

Chart 1

Components of domestic saving in India


Source: India's National Accounts.


Measurement problems. The inter-pretation of Indian saving trends is com-plicated by a number of weaknesses inthe Central Statistical Office's (CSO)methodology for measuring both invest-ment and saving. The most importantshortcomings are:

• The estimate for physical householdsaving is set equal to household invest-ment, which itself is calculated only indi-rectly as a residual. Not surprisingly,measured physical household saving hasbeen highly volatile.

• There are errors and omissions in theestimates of both savings and investment,but adjustments are made only to invest-ment. The CSO thinks the saving estimateis more reliable (based on the greater accu-racy of public, financial, and corporate sav-ing data) and therefore adjusts investmentto equal the sum of domestic and foreignsaving.

• The commodity flow method used toestimate total investment—based on fixedproduction coefficients—has remained un-changed for decades. While it might still beuseful for comparing investment in adja-cent years, new technologies and the grow-ing amount of investment in the informalsector are not adequately reflected in theestimates.

• The estimates of corporate saving andinvestment are based on a small, unrepre-sentative sample, and rely largely on volun-tary responses from enterprises.

• Finally, the CSO estimates do notcover some assets preferred by households,namely jewelry and gold. Household savingin gold probably increased after importrestrictions were liberalized in 1992, imply-ing an increase in the underestimation ofsaving.

What can be said about underlying sav-ing trends in the face of these problems? Wehave tried to generate alternative estimatesof saving in two ways:

• First, reversing the present CSO prac-tice, we adjusted domestic saving to includeerrors and omissions, so that the sum ofadjusted domestic saving and foreign sav-ing equals the original investment estimate.This yields a much smoother, more plausi-ble path for domestic saving (Chart 2).

• The second approach is based on analternative estimate of physical saving, theweakest component in the CSO's methodol-ogy. Assuming that physical saving is neg-atively related to financial saving, weestimated physical saving using an econo-metric regression on financial saving and atime trend to obtain a second path fordomestic saving.

Although these two alternative savingmeasures differ in some respects, they bothsuggest that the recent fluctuations indomestic saving may have been exagger-ated. Both measures show that the savingrate was fairly constant for most of the1980s, before it picked up in the early-to-mid-1990s.

Sufficient savings? Econometric re-gression analysis suggests that private sav-ing is likely to continue to increase—albeitgradually—over the coming years, drivenby rising per capita income and continuedfinancial deepening. In addition, a lowershare of agriculture in the economy and anincrease in the age dependency ratio wouldtend to increase private saving. Taking intoaccount likely developments in public sav-ing, this would result in a saving rate ofabout 28 percent of GDP after 2000. But thisis not likely to be enough to finance the in-vestment needed to reach the government's

growth objective. Even assuming someimprovement in investment efficiency (inthe absence of reliable employment and cap-ital stock data, there are no estimates oftotal factor productivity growth), thegrowth target implies that the investmentrate would need to increase to well above30 percent, which—even with higherrecourse to foreign saving—would requirea domestic saving rate of around 30 percentby the turn of the century. If the growth tar-get is to be achieved, stronger action onboth the public and private saving fronts iscalled for.

Strategy for higher savingWhile higher domestic saving is needed

to finance faster growth, policies aimeddirectly at mobilizing saving are not neces-sarily the best instrument to achieve thistarget. In the case of India, it has beenargued that growth has suffered less from alow saving rate than from inefficient invest-ment, in part because of the dominant roleof the public sector in the economy.

There is also a growing literature that,based on cross-country studies, has foundlittle evidence that policy efforts to boostsaving have been very effective. Thisresearch suggests that the main policyfocus should be on initiating a virtuousgrowth-saving circle by fostering growththrough fiscal consolidation and 'strongstructural reforms, including privatizationand financial liberalization. Under such astrategy, initially, growth would need to befinanced mainly through higher public sav-ing. Private saving, which eventually wouldhave to provide the bulk of additionalinvestment financing, would follow with alag, responding to higher growth. Financialliberalization—in particular, reform of


Source: India, Central Statistical Office (CSO), and IMF staff calculations.

Charts

Alternative estimates of saving in India(percent of GDP)


long-term saving instruments—would helpto ensure that private saving was efficientlyallocated.

The case for an indirect approach tohigher private saving is supported byrecent findings that traditional saving pol-icy instruments—like higher interest ratesor special tax incentives—fail to raise theprivate saving rate in the long run.Although these results were establishedmainly for industrial countries, they arelikely to apply just as forcefully in develop-ing countries. For example, Ogaki, Ostry,and Reinhart (1996) have found that theresponsiveness of private saving tochanges in real interest rates is less atlower levels of per capita income, as ahigher share of income must bedevoted to subsistence consump-tion. They estimated that theresponse of saving to changes ininterest rates in India was amongthe lowest in the developingworld. Moreover, Chelliah (1996)and others have pointed out thatmost Indian households do notpay income tax, either because their incomeis too low or because they fail to report tothe tax authorities. Changes in the taxregime would therefore affect only a smallpart of the population, and would beunlikely to significantly alter overall savingbehavior.

Public saving. Studies suggest thatthe most direct way to raise domestic sav-ing is by generating higher public saving.However, India has seen a steady decline inpublic saving over the past two decades,both at the central and state governmentlevels. This trend has been partly reversedsince 1993/94, but further strong effortswould be needed to restore public saving tothe level of the early 1980s. Such effortswould need to involve a series of actions inthe areas of tax policy, expenditure man-agement, center-state relations, and publicenterprise reform.

To some extent, higher public savingmay be offset by lower private saving.However, judging from an estimated long-run relationship between private and pub-lic saving, the offset factor for India couldbe as low as 25 to 30 percent. Nevertheless,in the short run, the trade-off could besomewhat larger, as fiscal consolidationwould have to be achieved partly throughhigher taxation.

Incentives for private saving.While instruments to directly raise privatesaving have proven largely ineffective,structural reform measures could have alarge impact on growth and, indirectly, on

private saving, mainly by improving theefficiency of resource allocation and raisingtotal factor productivity growth. Broadly,the reform agenda for India would includepublic enterprise restructuring and privati-zation; increased private involvement ininfrastructure; agricultural reform; labormarket reforms and exit policies; lifting ofprivileges for smaller enterprises; and,especially, financial reform.

The impact of financial sector reformcould be large. In India, the link betweenlow growth and the inefficient allocation ofsaving has become increasingly relevant,particularly in infrastructure. Althoughoverall investment has increased in recentyears, investment in infrastructure has

"Efforts to raise private savingshould focus on financial

liberalization, particularly onthe development of long-term

saving instruments."declined, and worsening infrastructure con-ditions have become a major obstacle togrowth. The Mohan Committee on infra-structure development recently concludedthat the lack of long-term financing was asubstantial hindrance to such investment,and listed the development of domesticdebt markets and the effective use of long-term saving among the highest reformpriorities.

Consequently, efforts to raise private sav-ing should focus on financial liberalization,particularly on the development of long-term saving instruments, such as pensions,life insurance, and mutual funds. Whileproviding an attractive investment vehiclefor individual savers, their main role wouldbe to improve the allocation of savings,ensuring that funds would flow to the mostproductive investment projects, thus gener-ating the highest rate of growth for a givenamount of investment. As a result, the vir-tuous growth-saving circle would becomemore dynamic, and savings could accumu-late faster.

Long-term instrumentsIn India, unlike other countries, the share

of major instruments for long-term house-hold saving—pension and life insurance—in gross financial saving has stagnatedover the past 30 years. By contrast, mutualfunds had growing success through theearly 1990s, particularly after the sectorwas opened to competition from the privatesector. However, they have also experienced

considerable problems in recent years.These developments reflect two fundamen-tal weaknesses:

• The markets are dominated by thepublic sector. The three largest institutionalinvestors in India—the Life InsuranceCorporation of India (LIC), the Unit Trust ofIndia (UTi), and the Employees' ProvidentFund (EPF)—account for about a third oftotal financial saving. These public sectorinstitutions face little competition. In thepension and life insurance sectors, the EPFand the LIC hold a near monopoly, while theUTI still accounts for more than 80 percentof the mutual fund business.

• Portfolio allocation is heavily regu-lated, resulting in comparatively low re-

turns and little flexibility to reactto market developments.

Owing to these weaknesses,long-term saving markets havefailed to attract investors at atime when more lucrative alter-natives have emerged in othermarkets, particularly as interestrates on bank deposits and cor-

porate paper have increased. A sustainedincrease in long-term saving would requiregiving market participants greater flexibil-ity in portfolio allocation, while greater pri-vate sector involvement would help toboost competition and more innovativeproduct development. The government hastaken preliminary steps in this direction,but a stronger reform impetus is stillrequired in some areas.

Provident funds. The Indian provi-dent fund system—consisting of the EPFand a number of smaller provident funds—provides fully funded defined-contribu-tion retirement schemes for about 8 percentof the labor force. Those not covered underthese schemes—over 90 percent of the pop-ulation—rely mainly on extended familynetworks and informal saving arrange-ments for old-age security. The entire port-folios of provident funds are invested ingovernment or quasi-government securitiesand special deposit schemes.

The funds have been a sizable factor inthe financing of the public sector deficit;however, their investment yields have beenrelatively low. The average real rate ofreturn was below 1 percent in the 1980sand only slightly higher—1.5 percent—in1994/95. These returns are too low to gener-ate a sizable accumulation of pension assetsduring a lifetime, and they also encouragewithdrawal of funds when allowed undercertain defined circumstances.

The government has begun to respond tothese problems. Mutual funds have been



allowed to offer pension plans—althoughthey are still subject to provident fund port-folio allocation rules—and the recent in-troduction of an LIC pension plan wasdirected mainly at workers in the informalsector who had no access to the systembefore. Moreover, the government hasrecently changed the investment schedulefor private pension funds, increasing theceiling for investment in debt instrumentsissued by the public financial institutionsto 40 percent, and lowering the ceiling onspecial deposit schemes that earn a lowerrate of return. As a result, the return oninvestment could increase by up to 2-3 per-centage points.

The Indian provident fund system couldbe reformed to follow the examples of coun-tries like Chile that have successfully raisedtheir saving rates through pension andfinancial market reforms. Key aspects ofreforms would involve providing an in-creased role for private pension fund man-agement and substantially liberalizingportfolio allocation rules, with an appropri-ate regulatory structure to ensure prudentinvestment allocation.

Life insurance. The life insurancesector was nationalized and consolidatedinto the LIC in 1956, jointly with the gen-eral insurance sector. Since then, the LIChas been a monopoly operator, chargedwith the tasks of making life insuranceavailable throughout the country, particu-larly in rural areas, and mobilizing savingsby providing attractive insurance products.On the first count, LIC has been fairly suc-cessful. Having built up a large regionaldistribution network comprising some2,000 branches, rural areas now account forover 40 percent of new policies. However,the Indian insurance market, with an esti-mated $5 in annual premiums paid percapita, has not made a significant contribu-tion to savings mobilization.

Like other long-term saving instruments,life insurance has experienced a relativedecline recently, mainly owing to the com-paratively low interest rate paid on lifeinsurance funds. The LIC is subject to simi-lar, although somewhat less restrictiveportfolio allocation constraints as pensionfunds. Some 75 percent of annual portfolioinvestments must be allocated to govern-ment securities or socially oriented pur-poses, while the remaining 25 percent canbe invested in private sector debt. The aver-age yield has remained low, reaching only1-2 percent in the early 1990s. In addition,high administrative costs, related to highstaffing levels and insufficient computeriza-tion, have dampened profitability.

Based on far-reaching recommendationsby the Malhotra Committee, the govern-ment has been considering plans to openthe insurance sector to private competitors,including those from abroad, within thenext four years. So far, an InsuranceRegulation Authority has been set up toestablish rules for the broader marketstructure. In order to prevent private com-petitors from focusing exclusively on prof-itable, specialized (urban) markets, theMalhotra Committee recommended thatnew entrants be obliged to cover to someextent rural sectors and to contribute to thefinancing of socially oriented projects. Italso recommended strengthening the LIC'scompetitiveness by lowering the currentmandatory investment norm to a level thatallowed portfolio allocation more in linewith international levels.

Mutual funds. When the mutual fundsindustry was liberalized in 1992, the UTIhad held a monopoly in the market foralmost 30 years. Indian retail investors(some 24 million shareholders) had beenaccustomed to guaranteed high returns ontheir UTI investments. This good record,combined with aggressive marketing bynew entrants, led to expectations of highprofits by investors who began to investstrongly in the new private mutual funds.However, they were generally unpreparedfor the risks they were taking after liberal-ization.

The net asset value of mutual fundsdeclined when stock prices began to fall in1992. The situation was exacerbated be-cause existing market regulations did notallow portfolio shifts into alternativeinvestments, leaving funds with no choicebut to hold cash or continue investing inshares. Moreover, since only closed-endfunds had been introduced in the market,investors who wanted to disinvest had tosell their holdings at a loss in the secondarymarket. These losses, the after-shocks ofthe 1992 stock market scandal, and the lackof transparent rules rocked confidence inshares and mutual funds. Partly owing to arelatively weak stock market performance,mutual funds have not yet recovered, withfunds trading at an average discount of10-20 percent of their net asset value.

The stock market supervisory authorityhas recently adopted a set of measures cre-ating a transparent and competitive envi-ronment for mutual funds. These includerelaxing investment restrictions into moneymarket and debt instruments, listing open-ended funds, and permitting mutual fundsto launch pension schemes. In response tothese changes, the UTI is to be reorganized

internally into a number of separate, com-peting units, and foreign banks have againbegun to launch new funds. The intentionis that mutual funds could become the keyinstrument for long-term saving, offering avariety of investments ranging from pureequity funds to pension plans.

These measures should help to increasepublic confidence in the stock market.Nevertheless, the key to a revival of in-vestor interest would be a solid recovery ofIndian stock markets—something thatdepends to a large extent on governmentpolicies. As long as public financing needscontinue to keep real interest rates high,both lower enterprise profitability and thehigher attractiveness of competing invest-ment alternatives will have a negativeimpact on Indian stocks.

Looking to the futureHow should India raise its domestic sav-

ing rate? Traditional tax and interest rateincentives are unlikely to lead to a strongresponse of the private saving rate. Instead,the most promising way to boost domesticsaving is through increased public savingand a strong structural reform program,including financial liberalization, whichwould initiate a virtuous circle in whichhigher growth would prompt further in-creases in private saving. With a view toincreasing the efficiency of savings alloca-tion and financing the heavy infrastructureneeds of the Indian economy, particularattention should be paid to long-term sav-ing instruments.

A sustained increase in long-term savingwould require two major policy changes.First, the government would need tosharply reduce its recourse to captivefinancing from pension funds and the LIC,thus giving market participants greaterflexibility in their portfolio allocation. Atthe same time, greater private sectorinvolvement would be required to helpboost competition and more innovativeproduct development, which would makesaving instruments more remunerative andthus attractive to individual investors. iF&Dl

References:R. CheUiah, 1996, "How to Hike Savings,"

Economic Times, July 12.Martin Miihleisen, 1997, "Improving India's

Saving Performance," IMF Working PaperNo. 97/4 (IMF: Washington).

M. Ogaki, J.D. Ostry, and CM. Reinhart,1996, "Saving Behavior in Low- and MiddleIncome Developing Countries," IMF StaffPapers, Vol.. 43 (March), pp. 38-71.



Islamic Financial SystemsZ A M I R I Q B A L

Islamic finance is emerging asa rapidly growing part of thefinancial sector in the Islamicworld. Islamic finance is notrestricted to Islamic countries,but is spreading whereverthere is a sizable Muslimcommunity.

A CCORDING to some estimates,more than 100 financial institu-tions in over 45 countries practicesome form of Islamic finance, and

the industry has been growing at a rate ofmore than 15 percent annually for the pastfive years. The market's current annualturnover is estimated to be $70 billion, com-pared with a mere $5 billion in 1985, and isprojected to hit the $100 billion mark by theturn of the century.

The growth in Islamic finance initiallycoincided with the current account sur-pluses of oil-exporting Islamic countries.But its continued growth in the face oferoding oil revenues reflects the influence ofother factors, such as the desire for sociopo-litical and economic systems based onIslamic principles and a stronger Islamicidentity. In addition, the introduction ofbroad macroeconomic and structuralreforms—in financial systems, the liberal-ization of capital movements, privatization,and the global integration of financial mar-kets—have paved the way for the expan-sion of Islamic finance.

What is Islamic finance?Islamic finance was practiced predomi-

nantly in the Muslim world throughout theMiddle Ages, fostering trade and businessactivities with the development of credit.In Spain and the Mediterranean and Balticstates, Islamic merchants became indis-pensable middlemen for trading activities.In fact, many concepts, techniques, andinstruments of Islamic finance were lateradopted by European financiers andbusinessmen.

In contrast, the term "Islamic financialsystem" is relatively new, appearing only inthe mid-1980s. In fact, all the earlier refer-ences to commercial or mercantile activitiesconforming to Islamic principles weremade under the umbrella of either "interest-free" or "Islamic" banking. However,describing the Islamic financial systemsimply as "interest-free" does not provide atrue picture of the system as a whole.Undoubtedly, prohibiting the receipt andpayment of interest is the nucleus of thesystem, but it is supported by other princi-ples of Islamic doctrine advocating risksharing, individuals' rights and duties,property rights, and the sanctity of con-tracts. Similarly, the Islamic financial sys-tem is not limited to banking but coverscapital formation, capital markets, and alltypes of financial intermediation.

Interpreting the system as "interest free"tends to create confusion. The philosophi-cal foundation of an Islamic financial sys-tem goes beyond the interaction of factorsof production and economic behavior.Whereas the conventional financial systemfocuses primarily on the economic andfinancial aspects of transactions, theIslamic system places equal emphasis on

the ethical, moral, social, and religiousdimensions, to enhance equality and fair-ness for the good of society as a whole. Thesystem can be fully appreciated only in thecontext of Islam's teachings on the workethic, wealth distribution, social and eco-nomic justice, and the role of the state.

The Islamic financial system is foundedon the absolute prohibition of the paymentor receipt of any predetermined, guaran-teed rate of return. This closes the door tothe concept of interest and precludes theuse of debt-based instruments. The systemencourages risk-sharing, promotes entre-preneurship, discourages speculative be-havior, and emphasizes the sanctity ofcontracts (Box 1).

An Islamic financial system can beexpected to be stable owing to the elimina-tion of debt-financing and enhanced alloca-tion efficiency. A "two-windows" model forIslamic financial intermediaries has beensuggested in which demand deposits arebacked 100 percent by reserves, and invest-ment deposits are accepted purely on anequity-sharing basis. Analytical modelsdemonstrate that such a system will bestable since the term and structure of theliabilities and the assets are symmetricallymatched through profit-sharing arrange-ments, no fixed interest cost accrues, andrefinancing through debt is not possible.Allocation efficiency occurs because in-vestment alternatives are strictly selectedbased on their productivity and theexpected rate of return. Finally, en-trepreneurship is encouraged as entre-preneurs compete to become the agents forthe suppliers of financial capital who, inturn, will closely scrutinize projects andmanagement teams.

Zamir Iqbal,a national of Pakistan, is an Information Officer in the World Bank's Treasury Information Services Department.



Box1

Principles of an Islamic financial systemThe basic framework for an Islamic financial system is a set of rulesand laws, collectively referred to as shariah, governing economic,social, political, and cultural aspects of Islamic societies. Shariaii origi-nates from the rules dictated by the Quran and its practices, and expla-nations rendered (more commonly known as Sunnah) by the ProphetMuhammad. Further elaboration of the rules is provided by scholars inIslamic jurisprudence within the framework of the Quran and Sunnah.The basic principles of an Islamic financial system can be summarizedas follows:

Prohibition of interest. Prohibition of riba, a term literallymeaning "an excess" and interpreted as "any unjustifiable increase ofcapital whether in loans or sales" is the central tenet of the system.More precisely, any positive, fixed, predetermined rate tied to the. matu-rity and the amount of principal (i.e., guaranteed regardless of the per-formance of the investment) is considered riba and is prohibited. Thegeneral consensus among Islamic scholars is that riba covers not onlyusury hut also the charging of "interest" as widely practiced.

This prohibition is based on arguments of social justice, equality,and property rights. Islam encourages the earning of profits but for-bids the charging of interest because profits, determined ex post, sym-bolic successful entrepreneurship and creation of additional wealthwhereas interest, determined ex ante, is a cost that is accrued irrespec-

tive of the outcome of business operations and may not create wealth ifthere are business losses. Social justice demands that borrowers andlenders share rewards as well as losses in an equitable fashion and thatthe process of wealth accumulation and distribution in the economy befair and representative of true productivity.

Risk sharing. Because interest is prohibited, suppliers of fundsbecome investors instead of (Teditors. The provider of financial capitaland the entrepreneur share business risks in return for shares of theprofits.

Money as "potential" capital. Money is treated as "potential"capital—that is, it becomes actual capital only when it joins hands withother resources to undertake a productive activity. Islam recognizes thetime value of money, but only when it acts as capital, not when it is"potential" capital.

Prohibition of speculative behavior. An Islamic financial sys-tem discourages hoarding and prohibits transactions featuring extremeuncertainties, gambling, and risks.

Sanctity of contracts. Islam upholds contractual obligations andthe disclosure of information as a sacred duty. This feature is intendedto reduce the risk of asymmetric information and moral hazard.

Shariah-approved activities. Only those business activities thatdo not violate the rules of shariah qualify for investment. For example,any investment in businesses dealing with alcohol, gambling, andcasinos would be prohibited.

Basic instrumentsIslamic markets offer different instru-

ments to satisfy providers and users offunds in a variety of ways: sales, tradefinancing, and investment (Box 2). Basicinstruments include cost-plus financing(murabahd), profit-sharing (mudarabd),leasing (ijara), partnership (musharaka),and forward sale (bay' salam). These instru-ments serve as the basic building blocks fordeveloping a wide array of more complexfinancial instruments, suggesting thatthere is great potential for financial innova-tion and expansion in Islamic financialmarkets.

Market trendsBanking is the most developed part of

the Islamic financial system. The stateconstitutions of Iran and Pakistan, forexample, require their banking systems tobe fully compatible with Islamic law. InEgypt, Indonesia, Malaysia, Sudan, and theGulf Cooperation Council (GCC) countries,Islamic banking exists alongside conven-tional banking. Islamic banking is cur-rently practiced through two channels:"specialized" Islamic banks and "Islamicwindows." Specialized Islamic banks arecommercial and investment banks, struc-tured wholly on Islamic principles, andthey deal only with Islamic instruments.Islamic windows are special facilitiesoffered by conventional banks to provideservices to Muslims who wish to engage inIslamic banking. Both Western banks and

banks headquartered in Islamic countriesprovide Islamic windows.

Traditionally, specialized Islamic bankshave been well positioned to attractdeposits from Muslims, but these institu-tions have generally lacked the technicalability to invest efficiently. This gap hasbeen bridged by the services of Westernbanks that swiftly and efficiently deployfunds into Islamically acceptable channels.But this has often meant lower returns forIslamic investors owing to the second layerof intermediation. This trend is changing.Islamic banks are becoming resourcefuland are going global, in part owing to theirincreased integration with internationalmarkets. At the same time, aware of thepotential of Islamic markets, Westernbanks are reaching out to investors directlyand eliminating the middleman—theIslamic banks or Islamic windows of banksin Muslim countries. For example, Citibankopened its first Islamic bank subsidiary inBahrain in 1996.

Historically, Islamic financial marketshave lacked liquidity-enhancing instru-ments, thus eliminating a large segment ofpotential investors. However, more liquid in-struments are emerging through securitiza-tion; Islamic funds, with a current marketsize of $1 billion, represent the initial appli-cation of securitization (see table). There arethree types of Islamic funds: equity, com-modity, and leasing. Equity funds, thelargest share of the Islamic funds market,are the same as conventional mutual funds

but with an Islamic touch that requires aunique "filtration" process to select appro-priate shares. The filtration process ensuresthat the mode, operation, and capital struc-ture of each business the fund invests in arecompatible with Islamic law, eliminatingcompanies engaged in prohibited activitiesand those whose capital structure reliesheavily on debt financing (to avoid dealingwith interest). For this reason, companieswith a negligible level of debt financing (10percent or less) may be selected, providedthat the debt does not remain a permanentfeature of the capital structure. The futureof Islamic equity funds is bright in partbecause of a new wave of privatizationunder way in Muslim countries such asEgypt and Jordan, and in high-growthIslamic countries such as Indonesia andMalaysia, where the demand for Islamicfinancial products is growing rapidly. Com-modity and leasing funds are other forms ofIslamic funds. Commodity funds invest inbase metals. Leasing funds pool auto, equip-ment, and aircraft leases and issue tradablecertificates backed by the leases.

International and regional institutionsare working with Islamic finance and arecontemplating the introduction of deriva-tive products and syndication to enhanceproject finance. The International FinanceCorporation (IFC) has successfully exe-cuted several transactions in the MiddleEast and Pakistan that conform to Islamicprinciples. While the introduction of deriva-tive products is being cautiously studied, it



Box 2

Islamic financial instrumentsSome of the more popular instruments in Islamic financial markets are

Trade with markup or cost-plus sale (murabaha). One ofthe most widely used instruments for short-term financing is based onthe traditional notion of purchase finance. The investor undertakes tosupply specific goods or commodities, incorporating a mutually agreedcontract for resale to the client and a mutually negotiated margin.Around 75 percent of Islamic financial transactions are cost-plus sales.

Leasing (ijara). Another popular instrument, accounting forabout 10 percent of Islamic financial transactions, is leasing. Leasing isdesigned for financing vehicles, machinery, equipment, and aircraft.Different forms of leasing are permissible, including leases where aportion of the installment payment goes toward the final purchase(with the transfer of ownership to the lessee).

Profit-sharing agreement (mudaraba). This is identical toan investment fund in which managers handle a pool of funds. Theagent-manager has relatively limited liability while having sufficientincentives to perform. The capital is invested in broadly defined

activities, and the terms of profit and risk sharing are customized foreach investment The maturity structure ranges from short to mediumterm and is more suitable for trade activities.

Equity participation (musharaka). This is analogous to aclassical joint venture. Both entrepreneur and investor contribute to thecapital (assets, technical and managerial expertise, working capital,etc.) of the operation in varying degrees and agree to share the returns(as well as the risks) in proportions agreed to in advance. Traditionally,this form of transaction has been used for financing fixed assets andworking capital of medium- and long-term duration.

Sales contracts. Deferred-payment sale (bay' mu'ajjal) anddeferred-delivery sale (bay'salam) contracts, in addition to spot sales,are used for conducting credit sales. In a deferred-payment sale, deliv-ery of the product is taken on the spot but delivery of the payment isdelayed for an agreed period. Payment can be made in a lump sum orin installments, provided there is no extra charge for the delay. Adeferred-delivery sale is similar to a forward contract where deliveryof the product is in the future in exchange for payment on the spotmarket.

is suspected that these incorporate interestand may also support speculative activi-ties. Simple derivatives, such as forwardcontracts, are being examined because theirbasic elements are similar to those of theIslamic instrument of deferred sale. Projectfinance, which puts emphasis on equityparticipation, is another natural fit forIslamic finance. The successful experimen-tation with long-term project financing inthe construction industry in Malaysia is apositive development in this area.

Issues and challengesIslamic financial markets are operating

far below their potential because Islamicbanking by itself cannot take root inthe absence of the other necessary compo-nents of an Islamic financial system. Anumber of limitations will have to beaddressed before any long-term strategycan be formulated:

• A uniform regulatory and legal frame-work supportive of an Islamic financialsystem has not yet been developed.Existing banking regulations in Islamiccountries are based on the Western bankingmodel. Similarly, Islamic financial institu-tions face difficulties operating in non-Islamic countries owing to the absence of aregulatory body that operates in accor-dance with Islamic principles. The develop-ment of a regulatory and supervisoryframework that would address the issuesspecific to Islamic institutions would fur-ther enhance the integration of Islamic mar-kets and international financial markets.

• There is no single, sizable, and orga-nized financial center that can claim to befunctioning in accordance with Islamicprinciples. Although stock markets in

emerging Islamic countries such as Egypt,Jordan, and Pakistan are active, they arenot fully compatible with Islamic princi-ples. The stock markets in Iran and Sudanmay come closest to operating in compli-ance with Islamic principles. Moreover, thesecondary market for Islamic products isextremely shallow and illiquid, and moneymarkets are almost nonexistent, since vi-able instruments are not currently avail-able. The development of an interbankmarket is another challenge.

• The pace of innovation is slow. Foryears, the market has offered the same tra-ditional instruments geared toward short-and medium-term maturities, but it has notyet come up with the necessary instru-ments to handle maturities at the extremes.There is a need for risk-management toolsto equip clients with instruments to hedgeagainst the high volatility in currency andcommodities markets. In addition, the mar-ket lacks the necessary instruments to pro-vide viable alternatives for public debtfinancing.

• An Islamic financial system needssound accounting procedures and stan-dards. Western accounting procedures arenot adequate because of the different natureand treatment of financial instruments.Well-defined procedures and standards arecrucial for information disclosure, buildinginvestors' confidence, and monitoring andsurveillance. Proper standards will alsohelp the integration of Islamic financialmarkets with international markets.

Islamic institutions have a shortage oftrained personnel who can analyze andmanage portfolios, and develop innovativeproducts according to Islamic financialprinciples. Only a limited number of

Islamic institutions can afford to train theirstaffs and deploy resources in productdevelopment.

• There is lack of uniformity in the reli-gious principles applied in Islamic coun-tries. In the absence of a universallyaccepted central religious authority, Islamicbanks have formed their own religiousboards for guidance. Islamic banks have toconsult their respective religious boards, orshariah advisors, to seek approval for eachnew instrument. Differences in interpreta-tion of Islamic principles by differentschools of thought may mean that identicalfinancial instruments are rejected by oneboard but accepted by another. Thus, thesame instrument may not be acceptable inall countries. This problem can be ad-dressed by forming a uniform council rep-resenting different schools of thought todefine cohesive rules and to expedite theprocess of introducing new products.

Future directionsThe further growth and development of

the Islamic financial system will dependlargely on the nature of innovations intro-duced in the market. The immediate need isto deploy human and financial resources todevelop instruments to enhance liquidity;develop secondary, money, and interbankmarkets; perform asset/liability and riskmanagement; and introduce public financeinstruments. The Islamic financial systemcan also offer alternatives at the microfi-nance level.

Securitization is a step in the rightdirection but even this requires moresophistication. The scope of securitization—the process of unbundling and repackag-ing a financial asset to enhance its mar-



Emerging Islamic funds

Fund TypeYear

launched Financial institutionSize

(million dollars)

IIBU Fund II Pic Leasing 1994Faysal Saudi Real Estate Fund 1995GCC Trading Fund 1996Oasis International Equity Fund Equity 1996Faisal Finance Real Estate Income Fund II Real estate 1996Unit Investment Fund (all tranches) \ncomelmudaraba 1996

syndicationAl Safwa International Equity Fund Equity unit trust 1996Ibn Khaldun International Equity Fund Equity 1996Adil Islamic Growth Fund Equity 1996

United Bank of Kuwait 51.5Faysal Islamic Bank of Bahrain 27.0Faysal Islamic Bank of Bahrain 10.0Robert Fleming & Co. (United Kingdom) 16.6Faisal Finance (Switzerland) S.A. 100.0Islamic Development Bank (Saudi Arabia) 500.0

AI-Tawfeed Company for Investment Funds Ltd.. 27.0PFM Group (United Kingdom) 25.0Faisal Finance (Switzerland) S.A. 10.0

Source: Islamic Banker, 1995-96, various issues.

ketability, negotiability, and liquidity—inIslamic financial markets is very promising,because current market operations arerestricted by the dearth of liquidity-enhanc-ing products; secondary markets lack depthand breadth; and, more important, instru-ments for asset/liability management aresimply nonexistent. With the expansion ofsecuritization, the customer base of Islamicfinancial systems will grow as institutionalinvestors, who have access to broader matu-rity structures, are attracted to the market;the secondary market will develop; and

asset/liability management will become areality. Other strong candidates for securiti-zation include real estate, leasing, and tradereceivables because of the collateralizednature of their cash flows.

Microfinance is another candidate forthe application of Islamic finance. Islamicfinance promotes entrepreneurship and risksharing, and its expansion to the poor couldbe an effective development tool. The socialbenefits are obvious, since the poorcurrently are often exploited by lenderscharging usurious rates.

An Islamic financial system can play avital role in the economic development ofIslamic countries by mobilizing dormantsavings that are being intentionally keptout of interest-based financial channels andby facilitating the development of capitalmarkets. At the same time, the developmentof such systems would enable savers andborrowers to choose financial instrumentscompatible with their business needs,social values, and religious beliefs. iF&Dl

World BankPublications

1266

A NEW WORLD BANK POLICY RESEARCH REPORT ||

Private Capital Flowsto Developing Countries:The Road to Financial Integration

The world's financial markets are rapidly integrating into a single globalmarketplace. Developing countries are being drawn into this process start-ing from different points and moving at various speeds—some are pre-

pared for the change but others are not. This World Bank report looks at theimportant challenges both sets of countries face in a new age of global capital.The book presents new and compelling evidence that private capital flows haveentered a new phase, driven by increased financial integration. Thereport analyzes the causes and effects of integration, with a particular emphasison how developing countries in the nascent stages of integration can learn fromthe experiences of the more rapidly integrating developing countries.

May 1997. 300pages. Stock no. 61116-F (ISBN0-19-521116-2). $40.00.Published for the World Bank by Oxford University Press

Visit our Website: http://www.worldbank.org

For US customers, contact The World Bank, P.O. Box 7247-8619, Philadelphia, PA 19170-8619.Phone: (703) 661-1580, Fax: (703) 661-1501. Shipping and handling: US$5.00. Airmail deliveryoutside the US is US$13.00 for one item plus US$6.00 for each additional item. Payment hy US$check drawn on a US hank payable to the World Bank or by VISA, MasterCard, or AmericanExpress. Customers outside the US, please contact your World Bank distributor.



http://www.worldbank.org

Education and Health Care in the CaribbeanVINAYA S W A R O O P

The Caribbean countrieshave achieved impressivelevels of public spending oneducation and health care.But in many countries, thequalitative results have notbeen encouraging.

GOVERNMENTS have long recog-nized the importance of primaryand secondary education and pre-ventive health care in improving

the welfare of the poor. Not only doimprovements in education and healthdirectly affect the well-being of the poor,they also promise greater productivity andexpanding income opportunities. Countriesthat have succeeded in providing universal

education and reducing infant mortalityrates have been shown to have higher eco-nomic growth rates.

The Caribbean countries appear to havemade significant progress in education andhealth, judging from the high level of publicspending on these sectors (Chart 1). But acloser look at the numbers reveals that thepoor are not always the main beneficiariesof government-subsidized education and

Vinaya Swaroop,an Indian national, is a Senior Economist in the Public Economics Division of the World Bank'sPolicy Research Department.

Chart 1

Public spending on education and healthin the Caribbean is high

(average spending as a share of GDP, 1991-95)

Source: Author's calculations using raw data from IMF.Government Finance Statistics Yearbook, various years;and country financial and statistical bureaus.

Note: All Caribbean countries in the chart belong to thelower-middle-income grouping except Barbados and Guyana,which have been classified by the World Bank as upper-middle-income and low-income countries, respectively.

1 Organization of Eastern Caribbean States. The figure shownhere is an average for Dominica, Grenada. St. Kitts and Nevis,and St. Vincent and the Grenadines.

46 . Finance & DevelAment /June W97:

DEVELOPMENT FOCUS


health programs; and, in many countries,the quality of education and health care hasfailed to improve because of a misallocationof resources.

Social indicatorsMost education and health indicators

place the Caribbean countries well abovethe average for developing countries withsimilar income levels (Chart 2). Throughoutthe Caribbean, primary schooling is nearlyuniversal; enrollment ratios for secondaryeducation are generally above the averagefor middle-income countries; and literacyrates are high. Infant mortality rates havedeclined steadily and consistently, from56-167 per thousand births in the 1960s to10-48 by the mid-1990s. Although there aredifferences between countries, and muchremains to be done, the overall picture isone of sustained progress.

The UNDP's Human Development Re-port of 1994 ranked Barbados first amongdeveloping countries with respect tohuman development (measured by combin-ing indicators of life expectancy, educa-tional attainment, and income—see Chart3). One of the strengths of the Barbadoseconomy has been the high average level of

educational attainment. Primary and sec-ondary education, provided free by the gov-ernment, has been universal since 1985,and Barbados has the highest literacy ratein the developing world.

Public sector involvementAverage expenditures on education and

health care in the Caribbean countries, as apercentage of GDP, are higher than in otherdeveloping countries. Governments are theprincipal providers of primary and sec-ondary education. The public sectoraccounts for a substantial proportion ofhealth care spending as well; in 1990, theprivate sector's share of total health expen-diture in the Caribbean countries rangedfrom a low of 29 percent in Trinidadand Tobago to a high of 53 percent inSuriname and St. Lucia. But are govern-ments getting the best possible returns ontheir investments?

Allocation of resources. To assessthe quality of publicly provided services, itis necessary to take a more detailed lookat the numbers. First, an examination ofexpenditure allocation between basic andtertiary levels would reveal whether thepoor are really benefiting from public

education and health care services.Numerous studies have shown that govern-ment subsidies for services at the tertiarylevel (university education and hospital-based curative care) disproportionatelybenefit higher-income families who couldafford to pay a significant portion—if notall—of the cost of such services. Second,low or declining public spending on educa-tion and health care does not necessarilyindicate lack of service—it could mean thatunit costs are low or that some services areprovided by the private sector. In Jamaica,for example, public expenditure on healthhas stayed roughly the same, as a share ofGDP, over the past 15 years, but the shareof total expenditure on health—public andprivate—increased from 5 percent of GDPin 1980 to nearly 9 percent in 1993-94, withthe private sector accounting for all of theincrease.

There is no single prescription for how acountry should allocate its education bud-get—but putting nearly all of the budgetinto teacher salaries is clearly not a soundallocation of resources. The evidence fromdeveloping countries demonstrates thathigher wages do not make for better teach-ers (Hanushek, 1995). In fact, it has been

Chart 2 Charts

Health and education indicators are high inthe Caribbean countries

Some Caribbean countries rank high in theUNDP's human development index

Sowce: UNDP, 1994, Human Development Report (New York: Oxford University Press).Note: UNDP's human development Index, which is based on adjusted per capitareaj.

GOP combined with e^^sMs^^Âo^J^Mamasa^mM^^^yy^^f,COUnWeS'

Source: World Bank, 1994, Social Indicators of Development !fmm^,f*K^mi: Johns HoplÛnfcsity Press).1 Data not available for Antigua and Barbuda, Grenada, St. Lucia, and St. vWcVrTf 'anS tte Srenaofnss.lftw*-''? - T> -•<

enrollment may exceed 100 percent because some pupils are younger or older than the country's standardprimary school age.

Finance & Development /hptf 7 Ws^ft&lHli


shown that devoting more resources toteacher education has the biggest positiveimpact on schooling. Yet in many Ca-ribbean countries, the bulk of the recurrenteducation budget is allocated to wages andsalaries; very small sums are budgeted formaintaining facilities and buying supplies.In Jamaica, for example, salaries and otherallowances account for nearly 95 percent ofthe government's budget for primary edu-cation. However, facilities are physicallyrun down, and most public schools sufferfrom a shortage of equipment and teachingaids. Although enrollment is nearly univer-sal, test results show that about half of thestudents finishing the sixth grade are func-tionally illiterate. The picture is much thesame in St. Vincent and the Grenadines.

Similarly, public health services are notcost effective in some Caribbean countriesbecause of the inefficient allocation ofresources. In Trinidad and Tobago, forexample, government spending on healthservices, which are offered free of charge toall individuals, is fairly high. But resourceshave increasingly been allocated to the hos-pital sector—the ratio of expenditures forhospitals to expenditures for primary andpreventive care rose from 5 to 1 to 10 to 1during the 1980s. As a result, the quality ofbasic health care has severely deteriorated.This deterioration has led, in turn, to agrowing volume of unnecessary and costlyself-referrals to hospitals, which raiseshealth care costs. Other countries—forexample, the Dominican Republic andGuyana—show a similar pattern.

While this pattern tends to be the rule inthe Caribbean, there are exceptions. InDominica, for example, primary care is rec-ognized to be one of the most cost-effectiveapproaches to health care. Provision of pre-ventive care (e.g., immunization) and basichealth education through health centershas significantly improved the country'shealth indicators—by 1993, 100 percent ofDominica's children had been immunizedagainst polio, diphtheria, tetanus, andmeasles.

Beneficiaries of public spending.In an equitable society, all income groupshave equal access to publicly provided (orfunded) social services. Notwithstandingprogress on this front, public education andhealth care remain largely inequitable inthe Caribbean. In Guyana, for example, theshare of education and health in govern-ment spending has increased since 1992,after a sharp decline during 1990-91. Butnearly one-third of total public expenditureduring 1992-94 was absorbed by the reha-bilitation of Georgetown Hospital in the

country's capital. Similarly, subsidies forsecondary schools and universities are sub-stantially higher than those for primaryschools. Based on student enrollments andspending on education in 1991, educatingone student at the tertiary level cost thesame as providing a primary school educa-tion to 33 children.

Although the objective of mostCaribbean countries is to provide universalbasic education, the public schooling sys-tem tends to favor the nonpoor. For exam-ple, in Jamaica, all children have access topublic primary schools, but the better-qual-ity publicly funded secondary schools—the"traditional schools"—accept only studentswho have passed the Caribbean CommonEntrance Examination (CEE), a test admin-istered at the end of the primary cycle in allEnglish-speaking Caribbean countriesexcept St. Kitts and Nevis. Many middle-and upper-income families send their chil-dren to private primary schools to improvetheir chances of getting into the traditionalhigh schools. The poor, however, cannotafford private primary schools, so theirchildren are less prepared for the CEE.Children who fail the CEE attend inferior"all-age" or new secondary schools. A simi-lar system exists in Trinidad and Tobago,where few students graduating from publicprimary schools get high enough grades onthe CEE to be accepted into secondaryschools with a strong academic curriculum.In Belize, the system is also similar andonly 60 percent of primary-school gradu-ates go on to get a higher education.

In Belize, where most health services arepublicly provided (public spending on themhas been as much as 5 percent of GDP inrecent years), access to health care isgrossly inadequate for the poor in ruralareas. Nearly three-fourths of the resourcesdevoted to public health are absorbed bythe country's hospitals (which are locatedpredominantly in urban areas); cost recov-ery is insignificant; and higher-income peo-ple are the main beneficiaries.

Quality over quantity. The key tohuman resource development is not justeducating more students but also ensuringthat students get a good education. Whilethe number of students enrolled in primaryand secondary schools in the Caribbeancountries is impressive, instruction, partic-ularly in rural areas, is poor; the curriculaare deficient; and schools lack appropriateinstruction materials. In Belize, theDominican Republic, and the countries ofthe Organization of Eastern CaribbeanStates (Anguilla, Antigua and Barbuda,Dominica, Grenada, Montserrat, St. Kitts

and Nevis, St. Lucia, and St. Vincent andthe Grenadines), learning is hampered bythe large number of poorly trained teachersand the paucity of teaching materials,particularly textbooks. Although primaryenrollment rates in the Dominican Republicand Guyana are very high, the poor qualityof education results in low examinationscores, low attendance rates, and highdropout rates.

Policy implicationsGovernments in the Caribbean realize

that inefficient public social services cannotbe sustained and that the public sector'srole needs to be more focused. Almost all ofthe Caribbean countries are taking steps toimprove their public sectors, although thepace of reform is slow.

In the areas of education and health, theexperiences of the Caribbean countries sup-port the theory that public sector financingshould focus on basic services, where thereturns to society are likely to be higher.If the public sector is the predominantprovider of tertiary services, which tend tobenefit the nonpoor, costs can be recoveredfrom high-income users through appropri-ate charges. Most Caribbean countriesurgently need to improve the quality ofbasic services and to extend the reach ofthese services to include all who need them.

This article is based on the author's paper,1996, "The Public Sector in the Caribbean:Issues and Reform Options," Policy ResearchWorking Paper 1609 (Washington: WorldBank).

References:EJ. Hanushek, 1995, "Interpreting recent

research on schooling in developing countries,"World Bank Research Observer, Vol. 10,August, pp. 227-46.

United Nations Development Program, 1994,Human Development Report (New York: OxfordUniversity Press).

The Caribbean countries referred to in this arti-cle are those belonging to the Caribbean Groupfor Cooperation in Economic Development:Antigua and Barbuda, The Bahamas,Barbados, Belize, Dominica, the DominicanRepublic, Grenada, Guyana, Haiti, Jamaica,St. Kitts and Nevis, St. Lucia, St. Vincent andthe Grenadines, Suriname, and Trinidad andTobago.

48 Finance & Development I June 1997


BOOKS

m 1930 to 1933, the economy of theUnited States suffered its worst collapse inhistory and entered into a decade ofdepression that traumatized the entirenation and much of the rest of the world.No analysis can hope to comprehend thesocial forces that shaped the twentieth cen-tury unless it first clarifies the economicforces that shaped the Great Depression.At the heart of that problem lies a technicalpuzzle: Why did the US monetary andbanking system disintegrate, and was thatfinancial breakdown a fundamental causeof the massive loss of output and employ-ment that followed?

This new book by Elmus Wicker,though brief and eminently readable, repre-sents a lifetime of research on this puzzle.In contrast to the sweeping canvases onwhich the most prominent studies ofmoney in the 1930s have been drawn—Milton Friedman and Anna J. Schwartz'sA Monetary History of the United States,1867-1960 and Peter Temin's DidMonetary Forces Cause the GreatDepression?—Wicker constructs a "micro-history" from a series of finely detailedminiatures. To know that more than 9,000out of an initial 24,000 American banksfailed during 1930-33 can send one off insearch of grand effects—as it did forFriedman, Schwartz, Temin, and many oth-ers—or it can send one off in search ofsmall causes. Which specific bank failuresgenerated the rippling effects that broughton the panics? Why did those banks fail,and not others?

Wicker makes sense out of what couldhave been a confusing jumble of minutefacts. He begins with a startling revelation:

"The banking situation on the eve of theGreat Depression was better than at anytime in the preceding ten years, except per-haps for small rural banks." Those "smallrural banks" were failing at unprecedentedrates, but their losses "were of purely localsignificance." Then, beginning in Novem-ber 1930, four distinct "panics" occurredand led inexorably to the declaration of anational banking holiday in March 1933,the first dramatic step by the new presi-dent, Franklin D. Roosevelt, to try to steadyand ultimately reverse the course of thesinking economy.

Wicker offers a detailed history of eachof the four panics and draws some reveal-ing conclusions. First, after examining thelargely rural and regional quality of the1930 panic, he rejects the Friedman-Schwartz view that those failures consti-tuted a national crisis. Second, he arguesthat the next panic, in the summer of 1931,was similarly confined to a few regions anddid not infect the national money marketcentered in New York City. What initiatedthe national crisis was the third panic,which he believes followed directly fromthe collapse of the banking systems ofAustria and Germany in the summer of1931 and especially from Britain's depar-

ture from the gold standard in September.The fourth panic, which led to the finaland total collapse of the national bankingsystem and generated a disastrous reduc-tion in the money supply, need never havehappened. Wicker carefully documentshow, in the absence of a comprehensive orcomprehensible national policy, state offi-cials overreacted to small tremors by arbi-trarily suspending deposit withdrawalsand closing banks until all confidence inthe system was lost.

A major implication of this study is thatFederal Reserve policy aggravated but didnot cause the reduction in the US moneysupply that was a key component of theonset of the depression. Never before had abanking crisis originated and spread out-side the central money market. Lackingany foundation for understanding the phe-nomenon, Federal Reserve officials concen-trated on insulating and protecting theNew York market. They achieved remark-able success in that limited task, but theywere impotent in efforts to carry out theirlarger responsibility of preserving thesoundness of the national money supply.

In the final chapter, Wicker tackles thequestion that must be answered if a defini-tive history of the twentieth century is everto be written: "Did bank failures cause theGreat Depression?" For better or worse,however, he is too cautious and honest topretend to have a definitive answer. "Thejury is still out— More work needs to bedone to resolve this issue." It may not sat-isfy the reader, but this conclusion doessummarize fairly the state of knowledgein this area at the end of the twentiethcentury.

James M. Boughton

On the positive side, the study puts for-eign aid into historical context and reviewsthe development of different types of assis-tance in the postwar period. Much of for-eign aid has gone to promote donors'self-interest, and this may account for theoften poor results. One of the best examplesof this self-interest is the practice of tying


A\.unibert Raflfer and Hans Singer havewritten a thoughtful and provocativereview of the foreign aid business. What isgood about the book is its forthright dis-cussion of some of the problems of develop-ment assistance and creative proposals forreform. The book is weak, however, whenit lapses into unsubstantiated polemics.

FOThe Banking Panics

Depressionthe GreatPanics of

Elmus Wicker

Cambridge UniversityPress,1996,xviii+174pp,.$39.95(cloth).

Co-operationDevelopment

The Foreign AidBusinessEconomicAssistance and

Kunibert Rafter andH.W. Singer

Cambridge Universitykingdom 1996xiipp.,700(cioth)


bilateral aid to the purchase of goods and services from the donorcountry. This distortion reduces the real value of assistance andshifts the focus of bilateral programs from what recipients needto what donors can provide. The authors argue persuasively thatuntying aid—currently under discussion among OECD coun-tries—would make assistance more effective.

The book also takes up issues of the developing country debtcrisis. While in many countries debt problems resulted primarilyfrom commercial borrowing, in some cases official loans con-tributed. The authors point out, on the one hand, that donors'determination to lend money to developing countries resulted inthese problems. They fail to note, on the other hand, that thepoor economic policies of many recipient countries were a rootcause of their debt crises. It was the combination of borrowingcountries' poor policies and easy financing that resulted in largeaccumulations of debt without the investment and growthneeded to service it.

Raffer and Singer have a bold proposal for dealing with debtproblems of poor countries. They note that US bankruptcy lawhas a provision for bankruptcy of local governments, underwhich the local government can file for protection from creditors.In this case, the bankruptcy court allows the local government tocontinue to provide "essential public services" while it works outa rescheduling of its debts with its creditors. The authors pro-pose an international analogue: a bankruptcy court in whichnational governments could file for protection from internationalcreditors and work out a scheme for debt rescheduling thatwould allow them to continue providing essential public services.While this proposal may not be politically realistic in the nearfuture, it may serve a useful role by highlighting some problemswith current practices. The closest thing to an internationalbankruptcy court for official lending is the Paris Club. The prob-lem, however, is that this is a club of creditors and its delibera-tions tend to produce reschedulings that do not put countries ona sustainable financial basis. That countries often return to theParis Club for further debt reschedulings is evidence of this. Thelocal government provision of US bankruptcy law ensures thatlenders to local governments can lose some or all of their invest-ments and provides incentives for responsible lender behavior.Raffer and Singer are looking for the same kind of proper incen-tives for international lending.

While the book has much good analysis, it suffers in too manyplaces from the inclusion of polemics. It notes how multilateralaid is split between United Nations (UN) agencies and interna-tional financial institutions (IFIs) such as the World Bank andthe IMF. The key difference between the two types of organiza-tion is that the UN agencies have one-country, one-vote systemswhereas the IFIs have voting weighted by capital shares, so thatthe rich countries have majority control. The authors dwell onthis difference at length and lobby for making the IFIs moredemocratic. Given that the two types of agencies have worked inparallel for many years, there is obviously a lot of potential forcomparing their relative effectiveness. The authors make noattempt to do this, however, and present no evidence to supporttheir assertion that the "more democratic" UN agencies are moreeffective at providing aid.

The book also ignores some important recent research thatraises serious questions about the overall impact of aid. PeterBoone's study found no evidence that aid has contributed togrowth or improvement of social indicators in developing coun-tries. At a more microeconomic level, research by DanielKaufmann and others has shown that the success of aid-financed

projects is influenced by macroeconomic policies and by otherfactors such as the extent of civil liberties. Taken together, theseresults suggest that aid has not been effective in the averagedeveloping country, and that if it is to be effective, recipient coun-tries need to provide the proper environment by formulating andimplementing suitable economic policies and ensuring adequategovernance. Raffer and Singer are quick to point out—cor-rectly—that donor countries' pursuit of self-interest renders aidless effective, but they ignore the equally important evidencethat recipient countries' policies and institutions are critical foreffective aid.

David Dollar

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WHO ELECTEDTHE BANKERS?Surveillance and Controlin the World EconomyLOUIS W. PAULY"This book provides an insightfulanalysis of the development of aninternational institutional structure toguide country cross-border financialand economic relationships. As such,it is clearly necessary reading for allthose interested in keeping abreastof the opportunities opened, and theconstraints set, by a progressively in-tegrated world financial environ-ment." —MANUEL GUITIAN,

Director, Monetary andExchange Affairs Department,International Monetary Fund

KREMLINCAPITALISMPrivatizing theRussian Economy

JOSEPH R. BLASI,MAYA KROUMOVA,AND DOUGLAS KRUSE

Foreword by Andrei Shleifer

"Kremlin Capitalism clearly lays outthe successes and failures ofprivatization in Russia, along with thedangers ahead." —Business Week

"A useful sketch of what Russian re-formers thought they were doingwhen they sold off their country'sindustry, [and] a comprehensive ac-count of what Russian managersthought they were doing when theyand their workers bought it."

—ROBERT COTTRELL,New York Review of Books

C O R N E L L U N I V E R S I T Y P R E S S



An this thought-provoking book, SamuelP. Huntington asks whether a harmoniousglobal civilization in the Western traditionis emerging in the increasingly modernizedpost-Cold War world. His answer is anemphatic no; on the contrary, he states, theworld will become multicivilizational andmore conflictive. This central theme pro-vides a basis for his advocacy of anAtlanticist US foreign policy.

Huntington challenges the assumptionthat the collapse of communism will bringabout the universal victory of liberaldemocracy while increased interactionamong peoples will lead to a world culturein the Western tradition, which has nur-tured democracy, free trade, and moderncommunication. In challenging thisassumption, he stresses that as non-Western countries modernize themselves,they seek not Westernization but culturalindependence from the West. Huntingtondismisses the idea that what he terms theDavos culture (named after the annualWorld Economic Forum held in Davos,Switzerland)—the shared beliefs of intel-lectuals, business people, and governmentofficials in "individualism, marketeconomies, and political democracy"—is amanifestation of an emerging world cul-ture, arguing that its beliefs are not sharedwidely outside the Western world. Theearly years of the next century, he asserts,will witness the peoples of the non-Westerncivilizations clashing with the West andwith each other.

Huntington emphasizes the uniquenessof Western civilization, which is foundedon the classical legacy (for example, ratio-nalism), Christianity, European languages,social pluralism, representative bodies, therule of law, property rights, and individual-ism. While not denying that some of thesefeatures can exist in other civilizations(African, Hindu, Islamic, Japanese, LatinAmerican, Eastern Orthodox, and Sinic),he believes that Western civilization isunique at present because only it has allthese features.

Regarding an issue of interest to those ofus dealing with global economic policy,

Huntington comments on the role of inter-national financial institutions, although it ison the periphery of his thesis. He is skepti-cal about the impact of these organizations.According to him, Western governmentsand international financial institutions,such as the IMF and the World Bank, areattempting to fill the ideological vacuumcreated by the collapse of communism with"the doctrines of neo-orthodox economicsand democratic politics." Through the IMFand other international economic institu-tions, "the West promotes its economicinterests" and is "attempting to integratethe economies of non-Western societies intoa global economic system it dominates." Heargues, however, that the extent to whichthese doctrines will have a lasting impacton non-Western cultures is uncertain.Quoting Georgi Arbatov, a Russian officialwho, in his New York Times article (May 7,1992) blaming Russia's price liberalizationfor the decline in living standards there,expressed a feeling that IMF officials"resemble neo-Bolsheviks," Huntingtonasserts that the IMF does not have the sup-port of the public.

Huntington's conclusions offer some-thing to reflect on for those who work inthe field of global economic policy issues.Some of his assertions and conclusions areeasy to refute; others raise questions thatare not easy to answer. The easiest ones torefute are his simplistic remarks on eco-nomic integration. He implies that the inte-gration of non-Western economies into theglobal economic system will be harmful tothem. On the contrary, such an integrationis the only option for any economy wishingto benefit from trade in products and pro-ductive factors. It is unscholarly forHuntington to underscore his unsubstanti-ated assertion that there is a lack of publicsupport for the IMF by quoting the pas-sage from Arbatov's article in which itsauthor expresses his personal feelings.More important, his account takes littlecognizance of the fact that the IMF encour-ages member countries to pursue sound,mutually compatible economic policiesaimed at bringing about durable economicprosperity. The policies that the IMF advo-cates—such as macroeconomic disciplineand competitive pricing—are not necessar-ily popular but are essential for long-runeconomic growth. Clearly, price liberaliza-tion is not the fundamental reason forRussia's economic difficulties; rather, itshould be part of the solution to them.

Some of Huntington's other conclusionsraise interesting questions. Will the faultlines between civilizations constitute an

effective barrier to globalization becausepeoples from different civilizations cannotwork effectively as trade or business part-ners? Or, as we tend to believe in interna-tional institutions, will economic incentivesovercome differences between civilizations?How might the absence of such factors asrationalism, individualism, the rule of law,and respect for property rights (catego-rized by Huntington as typical of Westerncivilization), which are essential elementsof a well-functioning market economy,affect the functioning of the market systemin a non-Western civilization? Are new eco-nomic institutions (for example, a new bud-getary or tax administration system) withproven performance in Western countriesalways readily transferable?

Huntington's book certainly containsmany controversial statements. Even theclassification of civilizations, which hebases on the work of civilization scholars,may stir controversy. The book oftenmakes sweeping generalizations. Its centraltheme is disquieting. However, the bookprovides refreshing insights into theworld's nations and their relations. It offersa fascinating discussion on interciviliza-tional fault lines. Readers who deal withglobal economic policy issues shouldseriously consider reading this book tosharpen their vision.

Ke-young Chu

Where F&D is indexedFinance & Development is indexed in awide variety of print and online publi-cations, including ABI Inform,Accounting & Tax Index, America:History & Life, Asian-Pacific EconomicLiterature, Australian Earth SciencesInformation System, BibliographieInternationale des Sciences Sotiaks,Business Index, Business PeriodicalsIndex, Excerpta Indonesia, HistoricalAbstracts, Index to InternationalStatistics, International DevelopmentAbstracts, Journal ofEconmnicliterature, Management Contents,Middle East: Abstracts and Index,Periodica Islamica, PhilanthropicStudies Index, Predicasts Overviews ofMarkets and Technologies, PublicAffairs Information Service, RuralDevelopment Abstracts, Sage PublicAdministration Abstracts, SocialSciences Citation Index, Trade &Industry Index, and World AgriculturalEconomics & Rural Sociology Abstracts.


The Clash ofCivilizations andthe Remaking ofWorld Ordersimonandschusiernewyork,1996,368s26.oo/6.99(cioth).

Samuel P. Huntington


S.L.N. Simha, a former staff member andAlternate Executive Director of the IMF,believes that not enough is known in Indiaabout the Bretton Woods twins—the IMFand the World Bank—especially amongyounger Indians. Since India is, at the sametime, the biggest beneficiary of their finan-cial assistance, especially the Bank's, andhas both deeply influenced the two institu-tions and been influenced by them, Simhahas used the occasion of the fiftieth anni-versary of the IMF and the World Bank tocorrect this deficiency. Highlighting Indianparticipation in the two organizations, hededicates his book to four Indian officialswho had major roles in the founding andearly years of both institutions: C.D. Desh-mukh, J. V. Joshi, B.K. Madan, and PS.Narayan Prasad, legendary names to old-ti-me international monetary and financialofficials and perhaps familiar to youngerones as well.

Unlike many other authors who havetended to be critical of the Fund and theBank, Simha both wants to and does writea volume full of praise for the BrettonWoods twins. His principal objective is tolet Indians know "the enormity of the inter-national monetary and financial coopera-

tion that has prevailed in the last 50 years,under the aegis of the IMF and the WorldBank, for all their defects and deficiencies."Emphasizing that his book is about 50years of existence of the Bretton Woods ins-titutions and not, like so many other com-memorative volumes, about what they havebecome 50 years after the Bretton Woodsconference, he devotes a substantial portionof the book to history. But it is evaluativehistory: throughout the volume, he inter-jects his own views on the functions andpolicies of the two institutions. And he doesdiscuss the many proposals that have beenmade for reform of the two institutions andoffers his own views and proposals.

The book is in four parts. Part One is onthe conception and birth of the IMF andWorld Bank. While it covers some of the fa-miliar ground of the events leading to theBretton Woods conference (officially knownas the United Nations Monetary and Finan-cial Conference and held in Bretton Woods,New Hampshire in 1944), Simha makes avaluable contribution. He explains at lengthIndia's role in the preparations for BrettonWoods and at the conference itself, makingit clearer how India was able to be a keyplayer there, three years before gaining itspolitical independence. Simha has therebyadded to what has heretofore been availablein official IMF histories. Part Two, on theIMF, quickly covers the IMF's overall evolu-tion and describes both its financial policiesand the changes emanating from the col-lapse of the par value system. It then eva-luates present-day surveillance conductedby the IMF and the many proposals that ha-ve been made for reform of the institution.He is well aware of the current problems fa-cing the IMF, particularly those stemming

from the tremendous flows of private inter-national capital. Part Three, on the WorldBank, is less historical. It centers more onthe Bank's lending operations up to the pre-sent time and the results of the Bank's ope-rations, as well as the various proposalsthat have been made for reforming that ins-titution. The author advocates that theBank emphasize project, rather than pro-gram, lending. Part Four is an epilogue.

All in all, Simha has done an impressivejob. Given the scope of his coverage—theexperiences of both the IMF and the WorldBank during the past 50 years, plus theirconception and birth—the volume is relati-vely short. For example, after about 100 pa-ges on the conception and birth of thetwins, he covers 50 years of IMF historyand the current proposals for reform in 160pages. He has also researched extensively,and is quite up to date on, what has beenand is being said and written about the twoinstitutions, notwithstanding the fact thathe has been working in Bangalore, 9,000miles from the scene of action. He is also askillful writer, having earlier written notonly on economics (he is the author of thehistory of the Reserve Bank of India) butalso on religion, ethics, and literature. Hewrites not only clearly but with charm andwit. Most of all, his reactions to, and viewson, the policies of the IMF and World Bankand the proposals for their reform are gene-rally cautious and sensible, although thereare several that I, and other past and cur-rent IMF and World Bank staff membersand officials, would take exception to. Ofthe many volumes marking the fiftieth an-niversary of the Bretton Woods twins, Ifound this one the most pleasurable to read.

Margaret Garritsen de Vries

World Bank increasingly move toward the"mainstreaming" of their environmentalbusiness within the concept of sustainabledevelopment, it can argued that a progres-sively greater proportion of their portfolioswill be "greened." Key questions, however,remain—how effective are these substan-tial resources in addressing global environ-mental problems, and what do we mean byeffectiveness in this context?

The key question of effectiveness is thebasic theme which Robert Keohane andMarc Levy and their team address in thisbook. The book contains case studies thatcover the Global Environment Facility(GEF), the Montreal Protocol MultilateralFund, nongovernmental organizations'

(NGOs') debt-for-nature swaps andnational donor programs, and a special sec-tion on financial transfers within Europe.

In 1993, Keohane and Levy, with PeterHaas, produced a seminal and optimisticstudy of the impact of international institu-tions on environmental policy issues(Institutions for the Earth: Sources ofEffective International EnvironmentalProtection). This volume takes that studyone step further and, five years after the1992 Rio de Janeiro Earth Summit, intro-duces an important measure of realism andcaution into the discourse. Perhaps the1993 findings were too optimistic. Becausethey were based on the practices of promi-nent institutions, the findings inevitably


\J. A. growing proportion of all develop-ment financing is directed at environmen-tal protection, and, as institutions like the

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included a disproportionate number of suc-cess stories. In this "second generation"study, the authors seek to understand theobstacles to effectiveness. They draw onthe literature of economics, internationalrelations, development assistance, andinternational environmental relations.Nevertheless, they use the same basic con-ceptual framework as the 1993 study—theso-called three Cs: concern, contracting,and capacity.

It must be a truism that the effectivetransfer of resources for environmentalprotection requires concern by at least oneparty—the provider of funds or the recipi-ent. What is clear from the studies is thathowever large the funds available, concerncannot be bought. There must be someclear complementarity in the concerns ofboth sides, although this need not be con-gruent. For example, the ingenious NGO-driven debt-for-nature swaps of the 1980soccurred at a time when the debt crisisweighed heavily on developing countries.With the huge increase in private sectorfunding in the 1990s, these swaps' appealhas waned.

The studies of the GEF Pilot Phase andthe Montreal Protocol, while concentratingon governance rather than substance, alsosuggest that once areas of commonalityhave been established—as, for example,

through the restructuring of the GEF—effectiveness increases. As David Fairmansuggests, while the jury may still be out onthe restructured GEF, the MontrealProtocol—equally innovative and signifi-cant—surely deserves more than the twocheers Elizabeth De Sombre and JoanneKauffman give it. Even they, albeit slightlygrudgingly, accept the view that "the exis-tence of the Fund facilitated an orderlyphase out (of ozone depleting substances);sent a strong message about the willing-ness of the world community to addressequity issues in environmental regulation;and perhaps opened the way for greaterparticipation of developing countries infuture environmental agreements." This isno mean achievement.

In fact, the strength of the book'smethodology is that as much can belearned from the analysis as from the con-clusions. The second C—contracting—makes this point well. Conditionality inlending is often trumpeted as the onlyeffective enforcement mechanism for globalenvironmental concerns. In fact, the studiesdemonstrate what a crude tool conditional-ity is unless there is some receptivenesswithin the host state to the conditionsbeing imposed (in other words, concern).An interesting example is provided by thePhilippines, where external conditionalities

from a variety of funding sources res-onated within the country itself. For exam-ple, reformers within the government arereported to have assisted in the draftingof the conditions affecting the loggingindustry.

The third factor, capacity, is the mostintractable. Despite the calls in Agenda 21and other international instruments forenvironmental capacity building, the stud-ies demonstrate that it is not simply anadministrative issue. Environmental insti-tutions in borrowing countries are oftennew and lack technical, organizational,human, and financial resources. But moreoften, and most important, Keohane sug-gests, they lack the political clout to makea difference. Often, the reason lies, again, inwhat he has termed "concern."

Overall, the book suggests that althoughthe lessons of environmental aid are similarto those of development assistance gener-ally, environmental aid efforts appear tofollow distinct processes and raise distinctsubsets of issues whose resolution entailsdistinct agendas. This volume provides animportant analytical framework for under-standing the dynamics of those processesand some important pointers for futuresuccesses—and failures.

David Freestone

An the preface to his book, AnandChandavarkar promises the reader a tourd'horizon of central banking in the devel-oping world. And he delivers on hispromise in a remarkably effective fashion.The tour proves to be most enlighteningthanks to the book's strengths in three dif-ferent areas. There is, first, comprehensive-ness of coverage: the analysis ranges fromthe objectives and instruments of centralbanking to its institutional and organiza-tional structure, without neglecting con-tentious or problematic topics (such as the

role of the central bank in development orthe issue of central bank losses). There is,second, the breadth of experience, wellillustrated by the author's ability to set theissues in the context of specific countrydevelopments and to examine the centralbanking theme from the standpoint of par-ticular country groupings (such as theMuslim countries or the transitioneconomies). And there is, third, the sheererudition, the mastery of the subject matterthat comes through in reading this book.The author is indeed well versed in the lit-erature on central banking (as can easily beconfirmed by a quick look at the bibliogra-phy and by the adroitness of the quotesthat introduce each chapter and here andthere spice the text); his familiarity withthe experience of a wide range of countriesreveals a long career of international civilservice devoted to advising country offi-cials on, inter alia, central banking andmonetary matters.

With this intellectual equipment,Chandavarkar is in an excellent position to

fill the long-standing gap he identifies inthe literature of central banking problemsin the developing world by providing a"descriptive, analytic, and normative"sketch of the subject in all its diversedimensions. Indeed, the combination in thisstudy of descriptive elements, analyticalinsights, and normative considerationsallows the author to place a number of rele-vant topics in a proper perspective. Amongthem, I would mention the question of cen-tral bank independence, on which much hasbeen written and where Chandavarkarskillfully separates rhetoric from reality. Orthe question of the intimate relationshipbetween central banking and prudentialregulation and supervision, often a matterof contention. Or the important issue ofexchange policy, typically left to the govern-ment and so often neglected in discussionsof central bank independence. Or theimportance of the quality, motivation, andprofessionalism of the staff of central banksat all levels, the human capital on which theart of central banking ultimately depends.


I

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Anand Chandavarkar

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In this manner, Chandavarkar succeeds incovering virtually all those aspects of cen-tral banking that demonstrate how criticalthis activity is as a fundamental link in theeconomic policymaking chain.

In his conclusion, Chandavarkar quotesDon Patinkin, who in 1965 wrote that"though the tax collector is a well-knownfigure in the Bible, the central banker isbarely mentioned." And for most of re-corded history, statements of this naturehave held true. Times have changed,

though. Chandavarkar himself acknowl-edges the change when he points out thatat "no other time in monetary annals havecentral banks been so much in the publicforum—academic, institutional, and politi-cal—as in recent years." And this is achange in the right direction for an activitylike central banking, which, as Chanda-varkar makes clear, "is a uniquelycomplex amalgam of ideas, traditions,institutions, techniques, and operationswhich does not yield a corpus of settled

unambiguous conclusions." True thoughthis statement is, I have neverthelessreached a clear conclusion. And that is thatpublication of this book should help thenewly exposed corps of central bankers bymaking such an insightful and readableexamination of their complex responsibili-ties available to all readers with an interestin the subject.

Manuel Guitidn

wKith his book The Wealth of Nations,Adam Smith turned the tide of opinionregarding the use of import tariffs andother trade restrictions. The structure ofthe debate since Smith, Professor Irwinobserves, has reflected the presumptionthat those who advocate restrictions ontrade bear the burden of demonstratinghow such policies would serve the nationalinterest.

Since Smith, a major theoretical argu-ment for protection has surfaced every fewdecades, each sparking a controversy overthe case for free trade. The analyticalobjective of the book is to sort these argu-ments into three categories: those acceptedas legitimate and important qualificationsto the case for free trade, those dismissedas curiosities with little application in prac-tice, and those rejected on grounds of logic.Irwin's intent seems to be to report the con-sensus opinion of academic economists.There is, however, some mixing of that per-spective with his own conclusions.

As Professor Irwin reads its reactions,the economics profession has been a toughaudience. Only the terms of trade (optimaltariff) and strategic trade policy argumentsare assessed as legitimate and importantqualifications. Irwin interprets both ofthese, however, as beggar-thy-neighborcases. Their import, he concludes, is not a

case for protection, it is instead to modifythe case for unilateral free trade into a casefor multilateral free trade.

Two arguments are dismissed as mis-taken economic theory: the Keynesianargument that a tariff would increasedomestic employment and the Australian,or Torrens or Dutch disease, argument thata tariff would prevent depopulation of acountry rich in natural resources but inwhich there are sharply diminishingreturns to labor in natural-resource-basedindustries. The latter, Irwin concludes, isan income distribution argument, not anargument about the effect of trade on thenational wealth. Critical scrutiny ofKeynes's macroeconomics, he explains, hasfound the Keynesian employment argu-ment to be a theoretical error. Keynes, how-ever, is not castigated as a protectionist.The author concludes that he was "for themost part, a free trader who was willing touse tariffs as an inferior, short-lived expedi-ent to remedy macroeconomic ills asopposed to doing nothing."

The infant industry case, FrankGraham's argument that a country wouldbe better off to protect an industry withincreasing returns to scale, and MihailManoilescu's argument that poor (that is,agricultural) countries should protect man-ufacturing because both capital and laborare inherently less productive in agricultureare downgraded as lacking intellectualcoherence: they are seen as being too impre-cisely specified to allow one to draw a con-clusion as to their merits. The author pointsout that a key element in each of the theo-ries is that one sector has an advantageover others that the market does not fullytake into account. In such situations, a traderestriction is never the first-best policy.

Against the Tide, by intent, covers onlyarmchair economics (not empirical work)and not what might be described as the

trade and development literature. There isno coverage of Latin American structural-ist arguments and only a mention of empir-ical studies of trade structures, with noreference to either Bela Balassa or AnneKrueger.

The book provides good entertainmentin two ways. The reader may mull over theauthor's conclusions as to where each ofthe theories he reviews belongs in the cate-gories he provides. The reader may alsoenjoy one by one the tidbits of informationthat come along with the story. For exam-ple, when J. S. Mill endorsed the infantindustry argument, in his Prindpks ofPolitical Economy (1848), the reaction ofother economists was less to counter hisargument than to bemoan the ill that wouldresult from this "sad departure from thesound principles of economic rectitude."And when it first appeared, the term "freetrade" described not the absence of traderestrictions but the alternative to govern-ment-granted monopolies over trade.

J.M. Finger

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54 Finance & Development I'June 1997

Against the Tide

An Intellectual

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Douglas A. Irwin

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READERS' COMMENTSWomen and development

I am outraged after reading the article"Rural Development, Agriculture, andFood Security" (Finance & Development,December 1996) by Wendy Ayres andAlex McCalla. I am not an expert on agri-cultural development or food securityissues, but this article gets low marks fornot bringing out some of the major realissues in development, which are women,men, and gender relations.

The article elaborates on the challengeof improving health and nutrition, empha-sizing that it is more a question of alloca-tion of resources within the householdthan of total household income. I wasexpecting a reference to how women tendto invest relatively more of their resourcesthan men (human and financial) in thewelfare of the family, if they are free to

make these kind of decisions. The WorldBank itself emphasized these issues in itsreport to the Fourth World Conference onWomen in Beijing. Not being allowed tocontrol their own resources is a commonfeature of life for rural women in develop-ing countries and, thus, a major challengeto be addressed. Also, malnutrition andpoor health is not evenly distributedamong men and women. On average, girlssuffer more than boys and women suffermore than men.

The hungry are landless, live in poornations in areas with low agriculturalpotential, and, first and foremost, arewomen. Meeting these challenges willrequire more than "renewed commitmentby scientists, farmers, national policy-makers, international donors, and theWorld Bank to increase agricultural pro-ductivity through research and technol-

ogy development," as Ayres and McCallaclaim. By all statistics, no one group isworse off than households headed bywomen. Despite some redeeming sen-tences in the article on the importance ofwomen in poverty reduction, I am puzzledand saddened by its lack of scope.

Lena HashProgram Officer, UNDP

Dhaka, Bangladesh

Wendy Ayres and Alex McCallarespond:

We wholeheartedly agree that investing inwomen is essential for achieving house-hold, national, and world food security.Investing in women's education and healthleads to better child nutrition, lower childmortality, and lower fertility. Furthermore,studies carried out in Kenya suggest that

DOLLAR AND YENResolving Economic Conflict between the United States and JapanRonald I. McKinnon and Kenichi Ohno"I find this an important and provocative volume. It is a worthwhile contribution to the literature.'— Robert Dekle, Economist, Asia Pacific Department, International Monetary Fund"This book should be carefully studied by the policy-makers of both Japan and the US in orderto avoid the recurrence of 'the syndrome of ever-higher yen1, that is distinctly suboptimal forboth of them." — Makoto Kuroda, ex-MITI Vice-Minister for International Affairs, Japan280 pp., 58 illus. $35

GOING GLOBALTransition from Plan to Market in the World Economyedited by Padma DesaiAddresses the transition of the former socialist and«otherwise centrally planned economies intothe world trading and financial system, which has become a major concern to both policymakersand social scientists.650 pp., 42 illus. $60

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if rural women were given the same accessto education as rural men, yields of foodcrops could rise by 22 percent. This hascritical implications for Africa, where agri-culture is a large part of the economy andwomen are responsible for about 75 per-cent of food crop production. Improvingaccess to land, financial resources, tools,and information is also critical to helpingwomen improve their lives. Today, in manycountries, women cannot own land andhave much more limited access to financialresources and information than men. As aconsequence, femak-headed householdswith no adult males are much more likelyto be poor and hungry than householdsheaded by men. The benefits of investing inwomen are even more pronounced whenwomen can control the allocation ofresources within the household, since, asthe article points out, women are morelikely to invest resources in the family.

The World Bank is working in manyways to improve conditions for ruralwomen. For example, in agricultural pro-jects in India, the Bank is working withlocal women's groups to improve women'saccess to scarce land resources. In Ugandaand Kenya, the Bank is supporting thedevelopment of improved techniques forgrowing vegetables near houses; simple,lightweight tools for weeding and harvest-ing; and improved village-level food process-ing techniques. In countries around theworld the Bank is supporting initiatives toincrease the access of the poor and vulnera-ble, including women, to financialresources. Women entrepreneurs areexpected to be the primary beneficiaries ofthe Consultative Group to Assist thePoorest program. In Chad, the SocialInvestment Program has given 68 percentof its loans to women. The program makesloans of less than $1,000 and has benefitedthe country's poorest women. And theBank is deeply involved in providing educa-tion and health services—for boys andgirls—in rural areas. In the future, theBank will continue to help countries realizethe large potential of women to makemajor contributions to food security, eco-nomic growth, and poverty reduction.

Determining creditworthinessThe article "Rating the Raters of CountryCreditworthiness" (Finance & Develop-ment, March 1997) by Nadeem Ul Haque,Donald Mathieson, and Nelson Mark pre-sents the point of view of a lending institu-tion. While this perspective is surely

appropriate for the IMF, a prospectivedirect investor can be expected to look atother considerations before putting upexpensive nonmobile facilities. When Iworked for a large oil company, I discov-ered that the company had four separatesets of country risk ratings, all for differentpurposes, as follows:

• The exploration and production grouplooked at the question of being able tonegotiate a favorable deal.

• The foreign affairs department lookedat whether a negotiated deal might lead toa successful outcome. Here, the UnitedStates does not come out well, as the headof Chevron International pointed out pub-licly in explaining his company's biginvestment in Kazakhstan; Chevroninvested $1.2 billion off Point Arguelo(near Santa Barbara, California) but pro-duction permits were later denied, a prob-lem that the company faced nowhere elsein the world. Some production has sincebeen allowed.

• Corporate security looked at executivesafety questions.

• The law department had its own rank-ings. I think they tried to blend the firsttwo sets of ratings but I never really fig-ured out their criteria.

My general point is that the content of acountry risk assessment cannot bedivorced from the intended use of thatassessment. In this regard, I suggest that asurvey of practices of direct foreigninvestors in a number of countries wouldmake a fascinating study.

Dr. R.L. PromboinWestlake Village, California

Attacking air pollutionAs a denizen of the most polluted city inthe world, I found "Ten Principles of theNew Environmentalism" (Finance &Development, December 1996) by AndrewSteer interesting, cogent, and stimulating.Thus far, the programs in Mexico Citydesigned to deal with overwhelming airpollution have been inconsequential andineffective. The lives of 20 million people—both very young and very old—are seri-ously affected by the rising levels of pollu-tion and it can reduce a lifespan by up to10 years. This has also affected the touristindustry.

While the situation is depressing, it isnot impossible. The solution is to switch toethanol, a fuel that already powers 4 mil-lion vehicles in Brazil. When used undi-luted, there are significant reductions in

carbon monoxide, carbon dioxide, hydro-carbon, and nitrogen oxide emissions, notto mention the positive effects with regardto the atmosphere and global warming. InBrazil, over a 20-year period, an investmentof $11.7 billion to produce fuel alcoholresulted in a savings of 220,000 barrels ofoil per day and a saving of $29 billion inimports. This net saving of $17 billion doesnot include the savings accruing to societyin the form of reduced levels of pollutionand better health.

I believe it is time to harvest Brazil'sknowledge and experience. In Mexico, aswitch to ethanol would drastically reducepollution, enhance the well-being andhealth of 20 million people, revitalize theagricultural sector, and provide an excitingnew venture for Mexican workers, engi-neers, managers, financiers, and politi-cians. Making polluters pay is good policy,and a tax upon gasoline could providesome of the financing necessary for theswitch to ethanol. It is time to transformthe pledges, promises, high hopes, andproclamations of international treaties con-cerning the environment into a down-to-earth, workable, effective program inMexico. If nothing significant is done now,the situation will deteriorate rapidly, notonly environmentally but socially as well.

Robert Quirk MacBethMexico 'City

We welcomecomments from

our readersPlease write to:Editor, Finance & Development,International Monetary Fund,Washington, DC 20431 USA

Credits: Art on cover, contents pages, andpages 3, 7, 29, 46, and 47 by MarkRobinson; photographs on contents page andpage 11 by World Bank; photograph on page17 by Denio Zara; photograph on page 38by Padraic Hughes.



1997ANNUAL MEETINGSOF THE WORLD BANK GROUP &INTERNATIONAL MONETARY FUND

PROGRAMOF SEMINARS

Saturday, September 20

to Tuesday, September 23

Topics to be addressed:

oo Finance and Capital Markets - includingfinancial system infrastructure, pensions andcapital markets, sovereign risk, capital accounts,fixed-income instruments, and stock marketperformance in Asia

0° Infrastructure Development - coveringopportunities for and constraints to privateparticipation in infrastructure, financing andguarantees, sector policies, and legal andregulatory frameworks

oo Governance and Development -addressing corporate citizenship, energy and theenvironment, and lending to low-income countries

oo Regional and Country Opportunities -exploring the latest developments for privateinvestment in Asia, Africa, Latin America, andselected countries from these and other regions

oo China's Promise of Partnership - featuringa comprehensive full-day program on China'sprospects and challenges

For further information, please contact:

1997 Annual Meetings - Program of SeminarsWorld Bank Group - IMF

Washington, D.C. 20431, USA

Telephone: {202} 473-3394 • Facsimile: (202) 623-4100E-mail: [email protected]

Asia and theWorld: Capital,Competitiveness,and Community

HONK KONG

CONVENTION

AND EXHIBITION

CENTRE


Edited by Peter K. Cornelius and Patrick Lenain

Ukraine has made impressive progress in restructuring and stabilizing its economy, yetmuch remains to be done. This volume consists of 16 papers presented at a seminarsponsored by the IMF and the World Bank in July 1996. The papers cover the medium-term macroeconomic framework; wages, poverty, and social safety net reform; privatesector development; trade policies; sectoral reforms; institution building; and governance.US$23.50. Available in English, (paper) ISBN 1-55775-619-8. xi + 291 pp. 1997.Stock #UATMEA

Economic Policies and UnemploymentDynamics in EuropeEdited by S.G.B. Henry and Dennis J. SnowerI High unemployment has plagued five European countries—France, Germany, Italy, Spain, andI the United Kingdom—for more than a decade. This book focuses on the mechanisms thatI prevent employers and employees from adjusting promptly to changing market opportunities.

US$24.00. Available in English, (paper) ISBN 1-55775-578-7. vii + 216 pp. 1997.Stock #EPUDEA

FO ORDER. PLEASE WRITE OR CALL:

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economicissues

FreuGnrtuanuiTirûeveiOpnieritS,Prospects, and Progress in InstitutionBuilding in the West Bank and Gaza StripBy the IMF's Middle Eastern Department

Since the declaration of Principles outlining the gradual future transferof responsibility to the Palestinian Authority in the West Bank and GazaStrip, the IMF has provided a wide range of technical assistance tothe Palestinian Authority. This book reviews economic and institution-building developments in the West Bank and Gaza Strip and assessesprospects for 1997.US$15.00. Available in English, (paper) ISBN 1-55775-638-4. v + 49 pp. 1997.Stock #REDPEA

Ukraine: Accelerating the Transition of Market


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