Chapter 7:
Finance and
Development
KEY POINTS
Financial System
Foreign Finance, Investment and Aid
Financial Instability
7.1. Financial System
7.1.2. 7.1.3. 7.1.4. 7.1.5.
7.1.1. Financial Financial Informal Formal
The Role of Markets in Market Finance and Financial
Financial Developing Failures Microfinance Systems and
System Countries Reforms
2.1.1. The Role of Financial System
Six major functions of the financial system
- Providing payment services
- Matching savers and investors
- Generating/distributing information
- Allocating credit efficiently
- Pricing, pooling, and trading risks
- Increasing asset liquidity
7.1.2. Financial Markets in Developing Countries
• Formal financial intermediaries serve much smaller fractions of the population in
developing countries
• Use of formal financial services is especially low among the poor in developing countries.
• Many households, even among the poor in developing countries, obtain financial services
from informal sources
• Informal financial services are often less attractive to clients or have more limited potential
to promote development than formal financial services.
Financial markets might not, in fact, perform these roles very well in developing
countries, especially among the poor. They deliver financial services to far fewer
households, and the services they deliver are less attractive.
7.1.3. Financial Market Failures
Asymmetric information and financial market failures
“Adverse selection arises when potential borrowers differ in their inherent default probabilities and when
borrowers know their default probabilities but lenders do not.”
• Asymmetric information can cause financial markets to fail in ways that lead to credit rationing or missing
credit and insurance markets.
• In credit markets characterized by adverse selection, in which some borrowers are better risks than
others, the better risks might drop out of the market more rapidly than the worse risks as interest rates
rise. As a result, average default rates among the borrowers who remain in the market might rise as
interest rates rise
• Adverse selection can cause a valuable credit market to disappear. Under less-extreme circumstances,
adverse selection might lead to credit rationing.
7.1.3. Financial Market Failures
Moral hazard and credit market failures
“Moral hazard arises when borrowers can improve their repayment probabilities by working harder (or
being more honest) but lenders cannot force them to work hard”
• In credit markets characterized by moral hazard, increases in interest rates can reduce borrowers’
incentives to work hard, raising their default rates.
7.1.4. Informal Finance and Microfinance
Traditional informal finance
• Informal Finance: Loans and other financial services not passed through the formal banking system—
for example, loans between family members.
• Rotating savings and credit association (ROSCA): A group formed by formal agreement among 40 to
50 individuals to pool their savings and allocate loans on a rotating basis to each member.
7.1.4. Informal Finance and Microfinance
Microfinance institutions (MFIs)
• Microfinance provides financial services to people otherwise with no access or only with very
unfavorable terms
• Includes microcredit, micro-savings, and microinsurance
• Primary focus: very small loans for microenterprises
• Microcredit often uses group lending schemes (joint liability)
• Provides “collateral of peer pressure” to jointly repay
• An alternative without joint liability: “dynamic incentives,” in which loan sizes steadily increase
when loans are repaid
• Other alternatives to joint liability
7.1.4. Informal Finance and Microfinance
MFIs: three current policy debates
• Microfinance schism--Are subsidies appropriate?
• Should credit be integrated with education, health, or other programs? (See Box 15.2)
• Should MFIs undergo commercialization, whereby an NGO providing microfinance is converted into a
for-profit bank?
Potential limitations of microfinance as a development strategy
• Microfinance is a powerful tool, but it needs to be complemented with other development and
poverty policies
7.1.5. Formal Financial Systems and Reforms
Financial Liberalisation, Real Interest Rates, Savings, and Investment
In developing countries, Financial intermediaries were subject to numerous lending restrictions
and faced mandatory interest-rate ceilings on loanable funds
This excess demand leads to a need to
ration the limited supply—a phenomenon
known as financial repression:
Constraints on investment resulting from
the rationing of credit, usually to a few
large-scale borrowers, in financial markets
where interest rates and hence the supply
of savings are below market-determined
levels
The effect of interest-rate ceilings on credit allocation
7.1.5. Formal Financial Systems and Reforms
Financial Liberalisation, Real Interest Rates, Savings, and Investment
• The suggested solution: liberalise the financial sector by allowing nominal interest rates to rise to
market-clearing levels
➔ Generate more savings and investment, evidence from countries such as Thailand, Turkey, and
Kenya
• However, evidence of the effects of financial reform in Chile during the 1970s revealed many
shortcomings of the process. This made the Chilean financial system particularly vulnerable when the
debt crisis struck in the 1980s
• Financial reform must always be accompanied by other more direct measures to make sure that
small farmers and investors have access to needed credit.
7.1.5. Formal Financial Systems and Reforms
Financial policy and the role of the state
• Stiglitz: seven financial market failures:
- The “public good” nature of monitoring financial institutions
- Externalities of monitoring, selection, and lending
- Externalities of financial disruption
- Missing and incomplete markets
- Imperfect competition
- Inefficiency of competitive markets in the financial sector
- Uninformed investors
7.1.5. Formal Financial Systems and Reforms
Debate on role of stock markets
• The enormous growth in developing countries’ stock markets has resulted in costs as well as
benefits for development., increased volatility in the economy as funds have flowed in from abroad
and even more dramatically flooded out.
• However, there are other significant problems with relying too strongly on stock markets as a
development strategy
- Stock markets lead to substantial foreign-investor influence over domestic-company operations.
- Stock markets can lead to short-term speculation that can dominate trading and distort the decision
making of managers, often inducing a short time-horizon .
- “hot money” that flows in and out of a country to speculate in markets can produce wide currency
swings and destabilise the economy.
7.2. Foreign Finance, Investment and Aid
7.2.1. 7.2.2. 7.2.3.
The International Private Foreign Foreign Aid
Flow of Financial Investment
Resources
7.2. Foreign Finance, Investment and Aid
7.2.1. The International Flow of Financial Resources
• Three main forms:
1. private foreign direct and portfolio investment consisting of:
(a) foreign “direct” investment by large multinational (or transnational) corporations, usually
with headquarters in the developed nations,
(b): foreign portfolio investment (e.g., stocks, bonds, and notes) in developing countries’ credit
and equity markets by private institutions (banks, mutual funds, corporations) and individuals
2. remittances of earnings by international migrants
3. public and private development assistance (foreign aid)
(a): individual national governments and multinational donor agencies
(b): private nongovernmental organisations (NGOs),
7.2. Foreign Finance, Investment and Aid
7.2.2. Private Foreign Investment
- Multinational corporation (MNC): A corporation with production activities in more than one
country.
- Recent growth of foreign direct investment (FDI)
Two central characteristics:
(1) Their large size: confers substantial economic (and sometimes political) power on MNCs vis-à-
vis the countries in which they operate;
(2)their worldwide operations and activities tend to be centrally controlled by parent companies
MNCs have the ability to manipulate:
(1) prices and profits, to collude with other firms to determining areas of control;
(2)generally to restrict the entry of potential competitors by dominating new technologies,
special skills, and, through product differentiation and advertising, consumer tastes.
7.2. Foreign Finance, Investment and Aid
7.2.2. Private Foreign Investment: Some Pros and Cons for Development
Traditional arguments in support of private investment:
(1) role in filling the resource gap between targeted or desired investment and locally mobilised
savings
(2) filling the gap between targeted foreign-exchange requirements and those derived from net
export earnings plus net public foreign aid
(3) filling the gap between targeted governmental tax revenues and locally raised taxes
(4) filling the management gap
7.2. Foreign Finance, Investment and Aid
7.2.2. Private Foreign Investment: Some Pros and Cons for Development
Arguments Against Private Foreign Investment: Widening Gaps
(1) MNCs may lower domestic savings and investment rates by substituting for private savings,
stifling competition. MNCs also raise a large fraction of their capital locally in the developing
country itself, and this may lead to some crowding-out of investment of local firms
(2) reduce foreign-exchange earnings or at least make the net increase smaller than it appeared,
as a result of substantial importation of intermediate products and capital goods and because of
the overseas repatriation of profits, interest, royalties, management fees, and other funds.
(3) MNCs contribution is considerably less than it might appear as a result of liberal tax
concessions, the practice of transfer pricing, excessive investment allowances, disguised public
subsidies, and tariff protection provided by the host government.
(4) The management, entrepreneurial skills, ideas, technology, and overseas contacts provided
by MNCs may have little impact on developing local sources of these scarce skills and resources
7.2. Foreign Finance, Investment and Aid
7.2.3. Foreign Aid
Conceptual: the international transfer of public funds in the form of loans or grants, either
directly from one government to another (bilateral assistance) or indirectly through the vehicle
of a multi- lateral assistance agency such as the World Bank.
any flow of capital meets two criteria:
(1) its objective should be non-commercial from the point of view of the donor;
(2) it should be characterised by concessional terms—that is, the interest rate and repayment
period for borrowed capital should be softer (less stringent) than commercial terms
Three measures problem
(1) cannot simply add up the dollar values of grants and loans; each has a different significance
to both donor and recipient countries
(2) aid can be tied either by source or by project
(3) Aid flows are usually calculated at nominal levels and tend to show a steady rise over time.
When deflated for rising prices, the actual real volume of aid from most donor countries has
declined substantially in recent decades, despite a recent uplift.
7.2. Foreign Finance, Investment and Aid
Foreign Aid:
Amounts and allocations: public aid
Official development assistance (ODA) Net disbursements of loans or grants made on
concessional terms by official agencies, historically by high-income member countries of the
Organisation for Economic Cooperation and Development (OECD), which includes:
+ bilateral grants,
+ concessional loans
+ technical assistance
+ multilateral flows
Why donors give aid?
- Political motivations
- Economic motivations: two-gap models and other criteria
• Foreign exchange constraints
• Growth and savings
• Technical assistance
• Absorptive capacity
• Economic motivations and self-interest
7.2. Foreign Finance, Investment and Aid
7.2.3. Foreign Aid: The Development Assistance Debate
The two-gap model:
(1) savings constraint
I ≤ F +sY
Where
I is domestic investment
F is the amount of capital inflows
s is the savings rate
Y is national income
(2) foreign-exchange constraint
(m1 – m2) + m2Y – E ≤ F
Where
I is domestic investment
F is the amount of capital inflows
E is the level of exports
Y is national income
m1 is the marginal import share
m2 is the marginal propensity to import
7.2. Foreign Finance, Investment and Aid
7.2.3. Foreign Aid: The Development Assistance Debate
Why recipient countries accept aid?
It supplements scarce domestic resources, it helps transform the economy structurally, and it
contributes to economic growth.
The role of nongovernmental organizations in aid (NGOs)
Nongovernmental organisations (NGOs): Nonprofit organisations that are often involved in
providing financial and technical assistance to developing countries.
- Being less constrained by political imperatives, most NGOs are able to work far
more effectively at the local level with the people they are trying to assist than
massive bilateral and multilateral aid programmes can.
- By working directly with local people’s organisations, many NGOs are better
able to avoid the suspicion and cynicism on the part of the mostly poor people
whom they serve that their help is insincere or likely to be short-lived.
The effects of aid
- assistance with conflict resolution, post-conflict recovery, and making the transition to
resumed development.
7.2. Foreign Finance, Investment and Aid
7.2.1. 7.2.2. 7.2.3.
The importance of The Cause of Responses to
Financial Stability Financial Financial
Instability Instability
7.3. Financial instability
7.3.1. The importance of Financial Stability
Financial stability is about the absence of system-wide episodes in which the financial system fails
to function (crises). It is also about resilience of financial systems to stress.
A stable financial system is capable of:
- efficiently allocating resources;
- assessing and managing financial risks,
- maintaining employment levels close to the economy’s natural rate,
- eliminating relative price movements of real or financial assets that will
affect monetary stability or employment levels.
7.3. Financial instability
7.3.2. The Cause of Financial Instability
Financial instability occurs as soon as a large number of market players are no longer
solvent, and liabilities to their own creditors can no longer be paid.
The cause of Financial Instability
- Incomplete monitoring and regulatory policies;
- Fluctuations in asset prices,
- Asymmetric information;
- Financial instability through expansionary monetary policy;
- Growing lending linked to securitization techniques.
7.3. Financial instability
7.3.3. Responses to Financial Instability
Discussion: What are the Responses to Financial Instability?
Concepts for Review
Central bank Group lending schemes
Commercialization Indirect taxes
Currency board Informal finance
Currency substitution Microfinance
Development banks Monetary policy
Direct taxes Money supply
Financial liberalization Organized money markets
Financial repression
Concepts for Review
Absorptive capacity Nongovernmental organizations (NGOs)
Commitment problem Official development assistance (ODA)
Concessional terms Portfolio investment
Foreign aid Savings gap
Foreign direct investment (FDI) Technical assistance
Foreign-exchange gap Transfer pricing
Multinational corporation (MNC) Two-gap model