978-1292002972 Chapter 16 Lecture Note

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Chapter 15

Finance and Fiscal Policy for Development

 Key Concepts

Macroeconomic stabilization is stressed as a central concern of development policy since the 1980s.

This means an effort is made to moderate inflation, reduce government budget deficits, and reduce

trade deficits. Major topics of the chapter include:

·The structure of developing country financial and fiscal systems: monetary and fiscal policy challenges.

·Public administration.

·Privatization of state owned enterprises.

·The economic impact of military expenditures.

The role of financial systems in developing countries is described in section 15.1. These systems are

compared to those in developed countries. While developed countries are able to use their financial

systems to mobilize private saving and allocate efficiently saving, this is frequently not the case in

developing countries. The following describe the conditions of many developing-country financial

markets:

·In developing countries, financial systems tend to be unorganized, externally dependent, and spatially

fragmented.

·The ability of the monetary authorities to regulate the money supply is constrained by several factors:

pegging of the currency to another currency (or basket of currencies), the quantity of accumulated

foreign exchange earnings is a significant but variable source of domestic financial resources, and

currency substitution.

·A lack of transparency restricts the ability to borrow.

·A dual monetary system often exists where a small, often externally controlled money market caters

to a small segment of the economy and a large, unorganized, unregulated money market serves the rest

of the economy.

·Interest rates are often kept artificially low.

It is not uncommon to find a weak link between low interest rates (promoted to stimulate growth) and the

resulting increase in investment and output. Structural supply constraints may prevent output from increasing

and demand increases merely serve to increase price. In addition, budget deficits and expansionary monetary

policy also contribute to rising prices.

In section 15.2 the role of the central bank in developed countries is compared to its role in developing

countries. The central bank generally lacks the flexibility and independence to conduct traditional

monetary policy and regulatory functions. Four alternatives to traditional central banks, (transitional,

supranational central bank, currency enclave and open-economy central bank), are discussed. A list of

four broad patterns in changes of central banking over the past two decades is given. The text notes that

the organizational structure does not matter as much as the ability to finance and promote domestic

economic development. Commercial banks need to take a more active role in this respect. Section 15.2

concludes with a discussion of development banks.

Section 15.3 describes how informal credit markets have emerged to fill the gap left by the formal

financial systems. Development banks are specialized private and public institutions

that supply medium and long run funds for industrial growth. Existing commercial banks tend to focus on

short-run safe borrowers. Despite substantial growth in the number of development banks, they have been

criticized for concentrating on large loans and projects. To fill in this gap, informal credit markets have

emerged to address the finances of small scale enterprises, such as rotating savings and credit associations

(ROSCAs), group lending schemes, and microfinance institutions (MFIs). Details on the size of the small

scale producer sector and its unique credit needs are presented, as is an expanded discussion of NGOs and

microfinance institutions as well as three current MFI policy debates. Box 15.1 is added to describe the

financial lives of the poor, as is 15.2, describing training in relation to microfinance. At the end of 15.3, the

limits of microfinance in development are discussed.

In section 15.4, the effects of interest rate ceilings are discussed and it is suggested that the removal of

artificially low ceilings on nominal interest rates should generate more domestic savings, while higher

real interest rates should improve the allocation of loanable funds to the most productive projects. Direct

initiatives to channel credit to small entrepreneurs are also essential, and may require new types of financial

intermediaries oriented towards the traditional or informal sector. Seven market failures are enumerated

and it is suggested that the state can still play an active role, even as the financial sector is liberalized.

Finally, the role of the stock market in channeling domestic funds towards investment is mentioned.

The role of the stock market is controversial and the text discusses the debate.

Section 15.5 focuses on fiscal policy aimed at development. The mobilization of resources to finance

public expenditures is the most important purpose of taxation. Tax sources for developing countries and

the limitations developing country governments face in collecting taxes are reviewed, comparative data

on levels of tax revenue are presented.

State-owned enterprises (SOEs), described in section 15.6, contribute an average of 7–15% to GDP in the

developing world. The rationale behind SOEs includes the existence of monopoly power in markets, the

need for capital formation, and the desirability of national control over strategic sectors of the economy.

However, SOEs have frequently made losses, in part because they are expected to pursue both commercial

and social goals. Benefits of privatization of SOEs are: lower production costs, an increase in output,

an improvement in overall efficiency, a reduction in government expenditure, an increase in individual

initiative (while rewarding entrepreneurship), and broadened ownership and the sense of a stake in the

system. At the same time, questions of feasibility, appropriate financing, property rights structure, indigenous

ownership, distribution, and dualism must be adequately considered. An example of the questions posed

by the need for privatization is given in Box 15.3, focusing on Chile and Poland.

Section 15.7 describes how the quality of public administration is among the scarcest resources in a

developing country. This is an important problem that is often glossed over. The example of the Tazara

railroad through Tanzania and Zambia is mentioned to emphasize this point.

The chapter concludes with a case study on Botswana.

 Lecture Suggestions

Four distinct lecture themes emerge from this chapter:

·Monetary policy and the banking/credit system.

The role of informal credit markets and, drawbacks notwithstanding, the benefits of MFIs.

·Fiscal policy and taxation.

·State owned enterprises.

It might be useful to review the operation of monetary policy in developed countries in order to get at the

question of why it often does not work in the same way in less developed countries. This may also be

helpful if you plan to introduce additional information on inflation and cases of hyperinflation, and the

practice of monetizing the budget deficit.

You can find the outline of a lecture on the characteristics and the implications of financial repression

in a short article by Michael Dooley and Donald Mathieson, “Financial Liberalization in Developing

Countries,” Finance and Development, September 1987.

The characteristics include:

·interest rate ceilings and negative real interest rates

·pervasive credit rationing

·portfolio selection restrictions for financial institutions that prevent capital from flowing to the highest

rate of return

·central bank rediscounting of credits to key sectors, often at subsidized rates

·licensing to restrict entry into the financial services market, with associated losses due to rent seeking

behavior, high liquidity and required reserve ratio (to create a ready demand for high powered money

to finance deficits)

·disintermediation from the banking system

·lack of demand for credit rating services.

The implications include:

·reduced incentive to save

·reduced possibility of diversification

·encouraging capital flight

·reduced incentive to lend to the most profitable projects

·reduced ability to transform illiquid assets into liquid ones, hence to match financial supply and

demand and pool risks

·reduced money services, in the extreme currency substitution.

Fry’s book (endnote 7) and Diaz-Alejandro’s “Goodbye Financial Repression, Hello Financial Crash,”

(endnote 3), offer additional valuable sources of lecture notes. Lance Taylor offers a good theoretical

and empirical critique of financial repression theory and liberalization arguments in his Varieties of

Stabilization Experience. It is a good source for lectures in presenting the structuralist viewpoint, but

may be too difficult for most undergraduate students. You might consider consulting chapter 5 of Taylor’s

Structuralist Macroeconomics (section 5.2)

You may wish to discuss the sequence of financial sector liberalization in more detail. A good source is

Ronald I. McKinnon, The Order of Economic Liberalization: Financial Control in the Transition to a

Market Economy, Johns Hopkins, 1993, or Sebastian Edwards, The Sequencing of Structural Adjustment

and Stabilization, ICS Press, 1992. It would be valuable to consult original work done by McKinnon and

Shaw in the early 1970s. Issues for discussion include:

·avoiding disruption of the real sector

·avoiding damage to the information capital of the financial sector

·a consideration of the country’s level of development

·noting that very rapid liberalization may lead to financial crashes

·considering the extent to which the inflation tax is needed in the short to medium run to finance

unavoidable deficits

·getting macroeconomic stability in place first, including cutting the fiscal budget, reforming the tax

system, and achieving internal balance before external balance

·conducting current account liberalization before capital market liberalization

·liberalizing, though not entirely deregulating, the domestic capital market before opening the capital

account.

The role of stock markets in economic development is especially contentious but also of interest to students,

especially when it comes to foreign investment in stock markets of emerging economies. A survey of issues

relating to the liberalization of stock markets is G. Bekaert, C. Harvey and C. Lundblad, “Equity Market

Liberalization in Emerging Markets” Journal of Financial Research, 2003. This paper has a table showing

the initial date of liberalization of stock markets of various emerging economies (defined as the date at

which foreigners were first allowed to invest in local stock markets). This table can be presented in class

and students should find it interesting. A couple of papers showing that stock market liberalization can

have positive effects on economic growth are: R. Levine, and S. Zervos, “Stock Market Development and

Economic Growth,” World Bank Economic Review, 1996 and R. Levine and S. Zervos, “Stock Markets,

Banks, and Economic Growth,” American Economic Review, 1998; these two papers tend to be more

academically oriented. The best source of information and data on investing in emerging economies is

the Emerging Markets Data Base of Standard and Poors.

Regarding taxes, it can be useful to illustrate the political economy difficulties of implementing tax

reform with specific examples. The 1986 Bolivian tax reform can be a good topic for lecture material.

The Bolivian tax system, though nominally progressive, was in reality flat or even regressive, once tax

evasion was accounted for. Bolivia illustrates one case in which the neoclassical prescriptions for tax

reform were followed quite closely. This tax reform did help balance the budget and formed an integral

part of a stabilization reform program. At the same time, it was accomplished under (politically) very

unusual circumstances, and has left a legacy of some bitterness over its apparently regressive structure

(though again perhaps not really more regressive in practice than before) that cast doubt on its long term

sustainability.

Before discussing MFIs and ROSCAs you might consider the benefits of presenting Banerjee and

Newman’s analysis of inequality in wealth and income as presented in their 1993 Journal of Political

Economy article “Occupational Choice and the Process of Development” where the risk of default, lack of

wealth, and significant inequalities in the distribution of wealth lead to inequality in income and further

inequalities in wealth. You should refer back to the discussion of asset ownership and its impact on

inequality as found in chapter 5. Also, in discussing commercialization the Compartamos scandal should

be considered. It might be helpful to emphasize that one key limit to commercialization is that the success

of MFIs and other NGOs often involves the willingness of staff, administrators, and investors to sacrifice

salary, benefits, and return in exchange for helping others. The “scalability” of such organizations is

hinges crucially on finding a large number of employees, managers, and financial backers willing to make

such sacrifices.

 Discussion Topics

·The arguments in favor of privatizing SOEs are frequently discussed in the financial press. Students

can make a list of these and discuss them in class. If possible students should research the experience

of a specific country with reference to the political and economic climate behind privatization.

·A number of countries (e.g. Ecuador) have replaced the local currency with the U.S. dollar

(dollarization). Students can research the reasons for adopting the dollar and the aftermath of

dollarization for domestic inflation, tax revenue and evasion, and, generally, living standards.

 Sample Questions

Short Answer

1. Compare and contrast the workings of the organized and unorganized money markets in developing

countries.

2. What are some of the major characteristics of financial repression? To what degree may financial

liberalization be expected to address the issue of inadequate saving?

Answer: Discussed in the chapter, section 15.4.

3. In what ways do the actual and potential roles of central banks differ between developed and

developing countries?

4. What is a development bank? What are some of the reasons they have not had greater success?

Answer: See pages 791-792.

5. Describe the costs and benefits of privatization of state-owned enterprises. In which cases would

privatization seem most advisable?

6. Does it matter how much a developing country saves? Explain why or why not. Discuss theories

and evidence on whether developing countries can increase the net savings rate in the economy

through public policy. In particular, consider whether this can be accomplished through increased

or decreased taxation of one or more types, and increased or decreased government spending of

one or more types.

Answer: Requirements for student answers will depend on what you have introduced in lecture.

7. What are the major market failures that imply a potential role for state intervention in financial markets?

8. What are the key elements that need to be considered in developing an optimal sequence of financial

sector liberalization? Will the order differ across countries? Why or why not?

Answer: Depends on lecture coverage..

9. Explain how group lending works.

10. How can joint liability lower the interest rate for micro borrowers.

Answer: Discussed in the chapter in the section on Microfinance Institutions, section 15.3.

11.What is meant by the term dynamic incentives in the context of making loans to micro borrowers.

12. Why are women considered to be more credit worthy for micro loans?

Answer: Discussed in the chapter in the section on Microfinance Institutions, section 15.3.

13. Why do NGOs target women borrowers while making micro loans?

14. Discuss the pros and cons of the recent introduction and expansion of stock markets in the developing

countries.

Answer: Discussed in the chapter, section 15.4.

15. Compare and contrast the experience of Poland and Chile in their efforts at privatizing SOEs. Make

sure you include a discussion of the background to the privatization, methods adopted and the

outcomes of privatization in the two countries.

16. Explain how the Grameen bank has helped address the problem of poverty while minimizing the risk

of default?

Answer: Chapter 11 case study is focused on BRAC and the Grameen bank. .

 Multiple Choice

1. A development bank

(a) accepts deposits from the poor.

(b) makes loans for industry expansion.

(d) all of the above.

(e) none of the above.

2. Among the rationales for state owned enterprises is

(a) existence of monopoly.

(b) the need for capital formation.

(d) all of the above.

(e) none of the above.

3. Among the rationales for state owned enterprises is

(a) that the private sector is inefficient.

(b) that there is unemployment of capable managers.

(d) all of the above.

(e) none of the above.

4. Among the benefits of privatization of state owned enterprises is

(a) increased employment.

(b) improved efficiency.

(d) all of the above.

(e) none of the above.

5. One of the characteristics of financial repression is

(a) negative real interest rates.

(b) lack of credit rationing.

(d) all of the above.

(e) none of the above.

6. Currency substitution means

(a) use of money instead of barter.

(b) use of countertrade instead of money.

(d) all of the above.

(e) none of the above.

7. Macroeconomic stabilization involves

(a) reduction of inflation.

(b) reduction of government budget deficits.

(d) all of the above.

(e) none of the above.

8. Which of the following is an objective of macroeconomic stabilization?

(a) eliminating current account deficits.

(b) controlling inflation.

(d) all of the above.

9. When it comes to the composition of tax revenues from different sources,

(a) developing countries derive the largest portion of their revenue from income taxes and developed

countries from consumption taxes.

(b) developing countries derive the largest portion of their revenue from consumption taxes and

developed countries from income taxes.

from income taxes.

(d) both developing countries and developed countries derive the largest portion of their revenue

from consumption taxes.

10. In 1995–7, tax revenue as a percent of GDP

(a) was roughly equal between developing and developed countries.

(b) was a few percentage points higher for developed than for developing countries.

(d) was much higher (approximately double) for developed countries than for developing countries.

(e) was much higher (approximately double) for developing countries than for developed countries.