Chapter Five

Chapter Five: Public Finance and Developing Economies

5.1 Common Goals of Least Developed Countries (LDCs)

Despite the obvious diversity of countries and classification schemes, most least developed
countries share a set of common and well-defined goals. These include: the reduction of poverty,
inequality, and unemployment; the provision of minimum levels of education, health, housing,
and food to every citizen; the broadening of economic and social opportunities; and the forging
of a cohesive nation-state.
Generally least developed countries have the following features: predominantly agriculture based
economy; low capital formation; inferior technical knowhow; low per capital income; over
population and poor health and educational facilities; and high propensity to consume leading to
low capital formation.

5.2 The Structural Diversity of Developing Countries and Industry Structure of

Ethiopia

5.2.1 The Structural Diversity of Developing Countries

Developing countries are not homogeneous but are enormously diverse in their structure. They
are considered to be different from one another on eight broad categories. These are:

1) The Size of the Country (Population, Area, and Income)

The physical size of the country, the size of its population, and its level of national income per
capita are important determinants of its economic potential and major factors differentiating one
developing nation from another.

Large size usually presents advantages of diverse resource endowment, large potential markets
and a lesser dependence on foreign sources of materials and products. But it also creates
problems of administrative control, national cohesion and regional imbalances. By contrast,
small countries have problems of limited markets, shortage of skills, scarce physical resources,
weak bargaining power, and little prospects of significant economic self-reliance. Though there

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is no necessary relationship between a country’s size, its level of per capita income, and the
degree of equity in the distribution of its national income.

3) Historical Background
Most least, developed countries (LDCs) were, at one time or another, colonies of Western
European countries. The economic structures of these nations, as well as their educational and
social institutions, have typically been modeled on those of their former colonial rulers.

African and Asian nations that recently gained their independence have different political, social,
and institutional structure than Latin American Countries who gained their independence earlier
and which have similar economic, social, and cultural institutions and face similar problems.
Countries that were colonized by British have different political and legal structures than those
colonized by French.

3) Physical and Human Resources

A country’s potential for economic growth is generally influenced by its endowments of physical
resources (land, minerals, and other raw materials) and human resources (number of people and
their level of skills and knowledge). However, high mineral wealth is no guarantee of
development success (since it may result to: wars, dictatorship, political instability, social strife).
Geography and climate can also play an important role in the success or failure of development
efforts (for example, in general, coastal economies do better than land-locked economies)

With regards to human resource endowments, not only are the numbers of people and their skill
levels are important, but also are: their cultural outlooks; attitude toward work; access to
information; willingness to innovate; desire for self improvement; and administrative skills. The
nature and character of a country's human resources are important determinants of its economic
structure and these clearly differ from one region to another.

4) Ethnic and Religious Composition

The greater the ethnic and religion diversity of a country, the more likely it is that there will be
internal strife and political instability. Thus, it is not surprising that some of the most successful

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recent development experiences have occurred in culturally homogeneous societies (e.g. South
Korea, Taiwan, Singapore and Hong Kong). However; ethnic and religious diversity need not
necessarily lead to instability. It may lead to successful economic growth, such as in Malaysia.

5) Relative Importance of the Public and Private Sectors

Most least developed countries (LDCs) have mixed economic systems, featuring both public and
private ownership and use of resources. The division between the two and their relative
importance are mostly a function of historical and political circumstances. Thus, in general, Latin
American and Southeast Asian nations have larger private sectors than South Asian and African
nations.

The degree of foreign ownership in the private sector is another important variable to consider
when differentiating among LDCs. A large foreign-owned private sector usually creates
economic and political opportunities as well as problems not found in countries where foreign
investors are less prevalent. Recent trend in LDCs is to have smaller public sector and larger
private sector (privatization).

Economic Policies, such as those designed to promote more employment are also different.
Countries with large public sector have direct government investment projects, and large rural
works programs. Countries with large private sector have special tax allowance to encourage
private sector investment.

The degree of corruption differs widely across developing countries and may influence both the
size of public sector and the design of privatization programs.

The role played by civil society and NGOs in recent years is so vivid and have often been able to
make better progress in addressing problem of development such as poverty alleviation and
expanding social inclusion in many developing nations.

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6) Industrial Structure
The vast majority of LDCs are agrarian in economic, social and cultural outlook. Farming is not
merely an occupation but a way of life for most people in Asia, Africa, and Latin America.
Nevertheless, there are great differences between LDCS in the structure of agrarian systems and
patterns of land ownership.

The contrast among the industrial structures of LDCs is striking. Latin American countries
possess more advanced industrial sectors but from 1980 until now many Asian countries like
Taiwan, South Korea, Singapore, China, India, and Malaysia greatly accelerated the growth of
their manufacturing output. Africa still lags behind.

Thus, in spite of common problems, development strategies may vary from one county to the
next, depending on the nature, structure, and the degree of interdependence among its primary
(agriculture, forestry, and fishing), secondary (manufacturing), and tertiary (commerce, finance,
transport, and services) sectors.

7) External Dependence
The degree to which a country is dependent on foreign economic, social and political forces is
related to its size, resource endowment and political history. For most LDCs, this dependence is
substantial. Most small nations are highly dependent on foreign investment and trade with the
developed world. In some cases, this dependence touches almost every facet of life such as:
trade, system of education and governance, values, culture, pattern of consumption, attitude
toward life and work. A country’s ability to chart its own economic and social destiny is
significantly affected by its degree of dependence on these and other external forces.

8) Political Structure, Power and Interest Groups

Development does not depend only on economic policies, but also on political structure and
interests and allegiances of ruling elite. These factors typically determine what strategies are
possible and where the main roadblocks to effective economic and social change may lie. Most
LDCs are ruled directly or indirectly by small and powerful elite to a greater extent than the
developed nations are. Effective social and economic change requires either the support of elite

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groups or diminishing the power of these elite groups. Development will often be impossible
without changes in the social, political, legal, and economic institutions of a nation.

5.2.2 Industrial Structure of Ethiopia

Like other least developed countries discussed above, the Ethiopian Government is also
aggressively promoting industrialization in order to eradicate poverty and to enhance social
justice. However; the industrialization process in the country is based on Agricultural
Development Led Industrialization (ADLI). As the current Growth and Transformation Plan
(GTP 2010/11-2014/15) shows the emphasis of the industrial structure in the country is on:
Micro and Small Enterprises (MSEs); and Medium and Large Industries.

From the industrial sectors; particular emphasis is given to MSEs due to the fact that: the
development of MSEs is very critical for strengthening sustainable rural-urban and urban-to-
urban functional and economic linkages; the expansion of MSEs in urban area will result in large
scale job creation and thereby poverty reduction; and the expansion of MSEs is also crucial for
sustaining the rapid growth in agricultural sector. On the other hand, among the Medium and
Large Industries in the country, particular emphasis is given to the following sub-industries:
textile and garment industry; leather and leather products industry; sugar and sugar related
industries; cement industry; metal and engineering industry; chemical industry; Pharmaceutical
industry and the agro-processing industry.

5.3 Common Problems of Least Developed Countries (LDCs)

From the previous discussion about the diverse structure of LDCs we may get the idea that it is
sometime risky to generalize too much about such a diverse set of nations that are called LDCs.
Nevertheless, common economic features of developing economies allow us to view them in a
broadly similar framework. We will try to classify these common problems into seven broad
categories:

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1) Low Levels of Living

In least developed countries (LDCs), general levels of living tend to be very low for the majority
of people. This is true not only in relation to their counterparts in rich nations but often also in
relation to small elite groups within their own societies. These low levels of living are manifested
in the form of low incomes (poverty), inadequate housing, poor health, limited or no education,
high infant mortality, low life and work expectancies and in many cases a general sense of
malaise and hopelessness.

2) Low Levels of Productivity

In addition to low levels of living, LDCs are characterized by relatively low levels of labor
productivity (output per worker). Production depends not only on inputs and technology but also
on managerial skills, access to information, worker motivation, and institutional flexibility. Low
levels of labor productivity in LDCs can be explained by the absence or lack of appropriate
physical capital or experienced management.

3) High Rates of Population Growth and Dependency Burdens

Birth rate and death rate are both higher in developing countries compared to developed
countries. This also contributes to high dependency burden in the developing countries.

4) High and Rising Levels of Unemployment and Underemployment

One of the major factors contributing to the low levels of living in LDCs is the relatively
inadequate or inefficient of labor in comparison with the developed nations.
Underutilization of labor is manifested in two forms:
i) Underemployment: people who are working less than they could. It also includes those who
are normally working full time but whose productivity is so low that a reduction in hours would
have a negligible impact on total output.
ii) Unemployment: people who are able and often eager to work but for whom no suitable jobs
are available.

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5) Substantial Dependence on Agriculture Production and Primary Product Exports

Most developing countries have a very large agricultural sector and most of their exports are
usually primary agricultural products. Agriculture is not only a profession but a way of life in the
developing countries. The reliance on agriculture is a result of the subsistence nature of the rural
economy in the developing countries. The type of agriculture in the developing countries is also
very different from that in the developed countries. Agriculture in the developing countries is
primarily small scale and highly labor intensive.

Agricultural productivity in LDCs is low not only because of the large numbers of people in
relation to available land but also because agriculture in these countries are often characterized
by primitive technologies, poor organization, and limited physical and human capital inputs.
Many economies of LDCs are still oriented towards the production of primary products
(agriculture, fuel, forestry, and raw materials) as opposed to secondary (manufacturing) and
tertiary (service) activities.

6) Prevalence of Imperfect Markets and Incomplete Information

In many LDCs, legal, institutional, and cultural foundations are either absent or externally weak.
Information is limited and costly to obtain which usually leads to misallocation of goods,
finances and resources. LDCs lack, in additional to technological knowhow,
 The existence of a legal system that enforces contracts and validates property rights.
 A stable and trustworthy currency.
 An infrastructure of roads and utilities that results in low transport and communication
costs so as to facilitate interregional trade.
 A well developed system of banking and credit allocation that selects projects on the
basis of relative economic profitability and enforces rules of repayment.
 Formal credit markets that select projects and allocate loanable funds on the basis of
relative economic profitability and enforce rules of repayment
 Substantial market information for consumers and producers about prices, quantities and
qualities of products and resources as well as the credit worthiness of potential borrowers.
 Norms of behavior that facilitate successful long term business relationship.

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For all reasons mentioned above, LDCs have markets that are often imperfect. These imperfect
markets and incomplete information might be the reason for the intense government intervention
in all aspects of economic lives which is a common phenomenon in the LDCs.

7) Dominance and Dependence on International Relations

There is a highly unequal distribution of economic and political power between rich and poor
nations. These unequal strengths are manifested not only in the dominant power of rich nations
to control the pattern of international trade but also in their ability often to dictate the terms
whereby technology, foreign aid, and private capital are transferred to developing countries.

Another factor is the transfer of developed countries (DCs) values, attitudes, institutions, and
standards of behavior to LDCs. Examples include the inappropriate educational structures,
curricula, and school systems. Widespread corruption and economic plunder by privileged elite,
the migration of professional and skilled personnel to various developed nations (brain drain) is
also another important indicator of the dominance of DCs.

For all these reasons, forces outside LDCs can have decisive and dominating influences on their
economic and social well-being. Many LDCs are small and their economies are dependent with
very little prospect for self-reliance. The powerful groups within the LDCs are growing richer
often at the expense of much larger but politically and economically less powerful masses of
poor people.

5.4 Financial Policy and the Role of the State

Financial policy as one of the government policy aims to transform financial agents and markets
into instruments of inclusive growth, while ensuring that their presence and/or operations do not
render the system fragile and crisis-prone in the long run. However; designing the financial
policy should be based on four broad motives:

 Ensuring availability of finance at costs commensurate with prospective returns to key

sectors, projects and agents from a development point of view.

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 Ensuring the financial structure does not exclude important sectors of the economy or
large sections of the population when such access is required to finance viable productive
investment and emergency consumption needs.
 Minimizing the risk that the behavior of financial agents could result in losses for savers
holding financial assets or deposits.
 Pre-empting financial practices that lead to closure of financial firms and increased
fragility of the financial system, and that result in macroeconomic instability.

The rational for the intervention of a least developed countries (LDCs) governments through
their financial policies is that; their financial markets are markedly different from other markets,
market failures are likely to be more pervasive in their markets and also much of the rationale for
liberalizing financial markets in LDCs is based neither on a sound economic understanding of
how these markets work nor on the potential scope for governments intervention. Thus, the very
purpose for the government intervention through financial policies is to rectify market failure.
Accordingly, economists identified the following seven market failures to be addressed by the
LDCs:

i) The public good nature of monitoring financial institutions: Investors need information about
the solvency and management of financial institutions. Like other forms of information,
monitoring is a public good – everyone who places savings in a particular financial institution
would benefit from knowing that the institution was prospering or close to insolvency. But like
other public goods in free-market economies, there is an undersupply of monitoring information,
and consequently, risk-averse savers withhold their funds. The net result is fewer resources
allocated through these institutions.

ii) Externalities of monitoring, selection, and lending: Benefits are often incurred by lenders who
learn about the viability of potential projects from the monitoring, selection, and lending
decisions of other lenders. Investors can also benefit from information generated by other
investors on the quality of different financial institutions. Like other positive (or negative)
externalities, the market provides too little information, and resources are under allocated or over
allocated.

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iii) Externalities of financial disruption: In the absence of government insurance (whether or not
an explicit policy has been issued), the failure of one major financial institution can cause a run
on the entire banking system and lead to long-term disruptions of the overall financial system.

iv) Missing and incomplete markets: In most developing countries, markets for insurance against
a variety of financial (bank failure) or physical (e.g., crop failure) risks are missing. The basic
problem is that information is imperfect and costly to obtain, so an LDC government has an
important role in reducing these risks. It can, for example, force membership in insurance
programs or require financial institutions as well as borrowers to disclose information about their
assets, liabilities, and creditworthiness.

v) Imperfect competition: Competition in the banking sector of most developing countries is

extremely limited, meaning that potential borrowers usually face only a small number of
suppliers of loanable funds, many of which are unwilling or unable to accommodate new and
unknown customers. This is particularly true of small borrowers in the informal urban and rural
sectors.

vi) Inefficiency of competitive markets in the financial sector: Theoretically, for perfectly
competitive markets to function efficiently, financial markets must be complete (without
uninsured risks) and information must be freely available to all and not influenced by any one
participant’s action in the market. Clearly, there are special advantages to individuals or entities
with privileged information in LDC financial markets, and risk insurance is difficult, if not
impossible, to obtain. As a result, unfettered financial markets may not allocate capital to its
most profitable uses, and there can be substantial deviations between social and private returns to
alternative investment projects. In such cases, direct government intervention – for example, by
restricting certain kinds of loans and encouraging others – may partly or completely offset these
imbalances.

vii) Uninformed investors: Contrary to the doctrine of consumer sovereignty, with its assumption
of perfect knowledge, many investors in LDCs lack both the information and the appropriate
means to acquire it in order to make rational investment decisions. Here again, governments can
impose financial disclosure requirements on firms listed on local stock exchanges or require

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banks, for example, to inform customers of the differences between simple and compound
interest rates or of the nature of penalties for early withdrawals of savings.

Therefore, least developed countries governments have a proper role to play in regulating
financial institutions, creating new institutions to fill gaps in the kinds of credit provided by
private institutions (e.g., micro loans to small farmers and trades people), providing consumer
protection, ensuring bank solvency, encouraging fair competition, and ultimately improving the
allocation of financial resources and promoting macroeconomic stability. As in other areas of
economic development, the critical issue for financial policy is not about free markets versus
government intervention but rather about how both can work together along with the NGO sector
to meet the urgent needs of poor people.

5.5 Fiscal Policy and the State

Fiscal policy is also called budgetary policy. In broad terms, fiscal policy refers to that segment
of national economic policy, which is primarily concerned with the receipts, and expenditures of
these receipts. It follows that fiscal policy relate to those activities of the state that are concerned
with raising financial resources and spending them.

Resources are obtained through taxation and borrowing both within the country and from abroad.
Spending is done mainly on defense, development and administration. Financial accounts of the
income and expenditure position are shown in budgetary statement. Budget can act as an
important tool of economic policy. The state by its policy of taxation and regulated expenditure
can influence the economic activities and development.

Private outlay is insufficient to produce maximum national income. An increase in state outlay
beyond its revenue can increase national income. Economists emphasize on the effects of
government revenue and expenditure upon the economy as a whole and argue, they should be
used deliberately and consciously to secure economic stabilization. This underscores the
importance of budget in economic development.

Briefly, fiscal policy relates to the government’s decision making with respect to the following:
taxation; government spending; government borrowing and management of government debt.

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The policy relates to government decisions, which influence the degree and manner in which
funds are withdrawn from private economy. Basically fiscal policy in these different facets deal
with the flow of funds out of the private spending and saving stream into the hands of
government and the recycle funds from government into the private economy.

It is thus, obvious that fiscal policy deals quite directly with matters, which immediately
influence consumption and investment expenditure. Therefore, it influences the income, output
and employment in the economy. Fiscal policy is primarily concerned with the aggregate effects
of public expenditure and taxation on income, output and employment. In developed economies
the propensity to consume leads to stability. Excess saving by the community leads to lowering
of demand for goods and services resulting in sub optimal employment level. Fiscal policy
should balance the economy by sustaining the consumption in the economy.

In under developed and developing countries the main objectives are rapid economic
development and an equitable distribution of the income. Hence, fiscal policy is an important
instrument for attaining these objectives. Fiscal policy influences the economy by the amount of
public income that is received and by the amount and direction of public expenditure. The
important fiscal means by which resources can be raised for the public exchequer are taxation,
borrowing from public and credit creation. Accordingly, these means should be employed in
harmonious combination so as to produce the best overall effects on the economic life of the
people in terms of economic progress and social welfare.

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