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Chapter 13:Financial Policy: 

Chapter 13: Financial Policy University of Maryland Department of Economics Economics 315 Jeff Werling Fall 2007

Introduction: 

Introduction Financial System as Respiratory/Circulatory system. Financial policy is much broader than “monetary policy.” Financial policy determines the structure, size, and operation of financial sector. Early Development Economics gave little thought to the role of the financial sector in development, but the importance of sector apparent from country to country and through time, especially given globalization and exchange rate complications. Many catastrophic losses of income and redistribution of income occur through problems in financial system and its markets. Financial and monetary analysis for LDCs is a field about 25 years old.

Recent History:: 

Recent History: Latin American Debt Crisis 1982-1988 Savings and Loan Crisis 1988 – 1994 ERM meltdown 1992 Mexico 1994 Asian Financial Crisis & offshoots 1997-99 Stock Price Bubble 1997 – 2001 Property Price Bubble 2004 - ??? Myriads of domestic banking crises. Developing a fully-functional and efficient financial system is one of the fundamental challenges for any LDC. McKinnon and Shaw set theoretical basis for new thinking: Money and Capital in Economic Development

Major Components of Financial System: 

Major Components of Financial System Central Banks - monetary policy and supervision Formal Credit Institutions -- banks, insurance, pension funds, investment banks Commercial Banking System – heavily regulated for stability NGO or PVO credit, cooperatives (microcredit) Informal Credit Institutions: Money-lenders (curb mkt), relatives, local banks Equity (Stock) markets – usually national Bond markets – often global

Functions of Financial System: 

Functions of Financial System Money – medium of exchange, store of value, unit of account. Monetization Ratio -- proportion of goods & services purchased with money. Financial intermediation -- borrowing (liabilities) and lending (assets) money for a profit - channel savings to investors, - savings endowments do not correspond to investment opportunities, - self finance is too restrictive, esp. for small farmers and entrepreneurs. Transfer and distribute risk and uncertainty via pooling. Policy instrument – use of money supply for stabilizing economic activity (monetary policy).

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Flow of Funds Accounts: data display of finance by sector, by assets and liabilities, usually compiled by Central Bank. Money Supply (sum of liquid assets in system) M1(narrow money) = currency + transfer deposits (checking) M2(broad money) = M1 + time deposits (savings) M3(total liquid liabilities) = M2 + special liabilities Financial assets = liquid fin. assets (currency, deposits) + nonliquid financial assets (bonds, stocks) – often not impt in LDCs Nonfinancial assets (land, gold, inventories)

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Financial ratio: net financial assets to GNP. Generally, liquid assets as percent of GDP rises with economic growth. Financial Deepening: financial assets grow faster than income. Financial policy Well-specified property rights and legal system Reserve requirements Interest Rate and Credit Ceilings Money supply, financing of deficit Transparency requirements

Inflation and Savings Mobilization: 

Inflation and Savings Mobilization Inflation – sustained increase in overall price ratio (of goods and services). Quantity Theory of Money: MV = PQ Inflation rate = 100 * (pi(t) - pi(t-1))/pi(t-1) Causes of inflation in LDCs: Govt. deficits financed by central bank through money creation. (Argentina) Massive expansion of credit to private sector. (Brazil) Imported from international shocks (oil). (Spain) Political strife or civil war. (Nicaragua)

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Periods of global inflation 1952 – 1966 very low inflation 1967 – 1972 increase to 6% (Vietnam War) 1973 – 1981 inflation accelerates because of oil shocks, low growth 4-5% 1982 – 1996 gradual slowing as Central Banks establish discipline 1997 – 2004 very low inflation with worries of deflation in Asia Types of Inflation Chronic – inflation betw 25% & 50% annually, 3 or more consecutive yrs. Acute – inflation exceeding 50% for 3 or more consecutive yrs. Hyperinflation (runaway) - rates excess of 200% one or more yrs.

Forced mobilization of savings:The Inflation Tax : 

Forced mobilization of savings: The Inflation Tax Government runs deficit and borrows money from central bank. Central bank lends to government by printing money. Inflation causes holders of money assets to lose value on assets. Govt. debt (and money) declines in value as prices rise. Given that LDCs have other, inefficient sources of tax revenue, inflation taxes were once regarded as a substitute for conventional type taxes. They are progressive, and could be more efficient than other tax types. For forced mobilization of savings to work must assume: Government propensity to invest out of income exceeds the private sector. Government invests more efficiently than private sector. Revenue elasticity of the tax structure unity or greater. Efficiency costs for inflation tax are less than those for conventional taxes. Problems: Govt. investment is rarely more efficient than private sector. Reduction of money holdings and invest. in land, gold, etc. Curtails private investment by increasing uncertainty, available savings. Expectations of inflation will decrease collection.

Interest rates and Savings decisions: 

Interest rates and Savings decisions Savings vs. Consumption Conventional theory (life-cycle hypothesis of consumption) people will save more with increased real interest rates. (Savings is for equalizing consumption over lifetime, greater return will stimulate more savings.) Empirical research for LDCs is incomplete, but small incremental increases in real interest rates do not seem to have large impacts on saving. i.e. 3-4%. But if r < 0 by substantial margin with high inflation leads to dissaving, i.e. best thing to do is spend for consumption or invest in non-financial assets, esp. foreign currency.

Interest Rates & Demand for Liquid Assets: 

Interest Rates & Demand for Liquid Assets (M2 vs. Nonliquid) i.e how wealth/savings stored. Demand for liquid savings (time deposits component of M2) is highly correlated with real interest rates. Therefore, the higher r, the more assets will be channeled through the financial system, more funds available for investment. L/P = d + d1*Y + d2*g + d3 *r where: L/P = M2 defaulted by general price level, Y = real income, e = rate of return on nonfinancial assets, r = real interest rate

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d1 > 0 as income grows, more money needed for transactions, income elasticity often greater than 1 in LDCs b/c other financial assets lacking, more of economy is drawn into monetary sector. d2 < 0 return to inventory (hoarding of consumption goods), foreign exchange, land, etc. With high inflation, relative return to such non-financial assets increases. Such assets are often non-productive in LDCs. d3 > 0 High levels induce large holdings. Where r is negative, savers pay inflation tax, therefore people less willing to hold onto liquid assets. Empirical research unanimously confirms these hypotheses. Many Asian countries have allowed interest rates to adjust with inflation and have developed capable financial systems. In Africa and Latin America, interest rate ceilings and high inflation have repressed financial sectors.

Financial Development: 

Financial Development Channeling domestic savings to investors with profitable opportunities is one course for development. Alternatives are govt. channeling of investment or reliance on foreign capital flows (either aid, investment, or loans). History shows that where domestic savings accounts for the vast majority of investment, development is enhanced. This has bearing on several issues: Foreign capital and aid flows may stifle development of a domestic financial system as nation becomes dependent on such flows. Foreign flows are the easy way out, but many commentators (McKinnon) insist that they are detrimental in the long run.

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Ongoing WTO negotiations considering international trade in services, including banking, insurance, and other financial services. Some LDC govts. believe that domestic institutions would not be able to compete with multinational banks, etc. But transfer of expertise and technology may be beneficial, as savings are channeled more efficiently. A component of many restructuring programs is removal of interest rate ceilings and other financial regulation to increase financial development. These are often the most controversial planks of such programs because they threaten powerful groups which benefit from such regulation.

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Shallow Financial Strategy M2 (liquid assets) to GDP ratio grows slowly or not at all (real size of financial system shrinks). “Repression of Financial System” Characteristics: Interest rate ceilings: Kept low to promote investment, help small producers, combat monopoly powers of lenders, etc. Inevitably backfires for reasons below. (U.S. 1800-1979) High legal reserve requirements for banks. Nonprice rationing of credit: Ceilings inevitably require government to step in and determine how credit should be rationed, to whom, to what industry, etc.

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Consequences: Fragmented capital markets - usually divided into formal/informal markets. Privileged, well-connected, large borrowers get lion's share of cheap credit in formal mkt. Lend to safest borrowers, overall costs are lower (information, risk of default, spreading of fixed costs over larger loans). Therefore, riskier investment, but those with larger potential pay offs are not funded. Projects funded below optimal rate of return, profitable projects are not. Smaller borrowers, often w/ more profitable opportunities are left w/ informal mkt. alternative, where cost of borrowing is very high, or do not get funds at all and self finance only alternative. Negative real interest rates in an inflationary economy. As seen above, negative real interest retards expansion of deposits, and, therefore, loanable funds. At same time, demand for funds increased sharply (actually profitable to borrow for immediate consumption purposes) increases all problems of financial mkt. fragmentation, above.

Deep Financial Strategy: 

Deep Financial Strategy Objectives: Mobilize a large volume of savings from the domestic economy (i.e. increase the ratio of national saving to GDP). Enhance the accessibility of savings vehicles for all types of investors (not just the rich or urban). Secure a more efficient allocation of investment throughout economy. Permitting the financial process to mobilize and allocate savings to reduce reliance on the fiscal process, foreign aid, and inflation.

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Policies: Avoid negative real interest rates – require financial liberalization allowing higher nominal rates on deposits and loans, curbing inflation or combination of both. (Remember: major cause of inflation in many LDCs is monetization of govt. budget deficit.) Promoting evolution of longer-term investment institutions, such as insurance companies, investment banks, stock and bond markets. Here government intervention (for setting the rules) is necessary. Since savings and loans and deposit banks usually specialize in relatively short-term lending and only simple time deposits. Economic development eventually requires large longer term investment mechanisms.

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Benefits: Reduces likelihood that high inflation can occur because high interest rates dampen overall demand. No inflation tax. Reduces incentives to move into non-liquid assets or into foreign capital. More money stays at home. Without rationing, capital flows to projects with best return. With greater pooling and accurate pricing, high-risk and longer-term projects more likely to be financed appropriately. Facilitates evolution of longer-term financial instruments: stocks and bonds. Facilitates eventual linkage of domestic financial markets into global markets, which will reduce cost of foreign money.

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Big discussion now is how to liberate a financially repressed economy. Unfortunately, you cannot just repeal interest rate ceilings and get desired results. Can be very tricky situation. Usually involves phased incr. in ceilings, gradual reduction of govt. deficit, phased devaluation of currency. Statics vs. Dynamics be wary here with conventional economics, structural and evolutionary factors important. Real Interest Rate: Major Price – get it right!

Monetary Policy: 

Monetary Policy Price Stability: How does the Central Bank control money supply (domestic credit) growth, and, therefore, the long-run rate of inflation. Quantity Theory (simplified): MV = PQ dM + dV = dP+ dQ, where dP = general price inflation, dQ = change in long-run Q (real GDP or production volume) depends on underlying assumptions of labor force and productivity growth, dV = velocity is usually declining in a developing economy as people increase their demand for liquid assets as a percent of income (nominal GDP), dM = dP + (dQ – dV) example: if dQ = 4, dV = 2, then dM = 8 implies 2 per cent inflation. M = DC (domestic credit) + IR (international reserves) dM = dDC + dIR

Monetary Policy Levers: 

Monetary Policy Levers Open Market Operations: buying and selling securities (bonds) for cash on spot market. Reserve Requirements: Proportion of deposits that cannot be loaned and must be kept with central bank. Credit Ceilings (general and specific): constrain the amount that banks can loan either in total or restricted by sector. Interest Rate Regulation: set ceilings, floors etc. Rediscount rate: rate central bank lends to commercial banks. Moral suasion: open-mouth operations.

Panic, Moral Hazard, and Financial Collapse: 

Panic, Moral Hazard, and Financial Collapse Banking crisis: banks face basic maturity mismatch (borrow short, lend long) that must be constantly managed. Deterioration of asset quality (nonperforming loans) can set off liquidity problems, then insolvency. Financial Panic often follow excess buildup in speculative assets (debt, stocks, real estate). Moral Hazard: where measure designed to forestall panics actually promote them (deposit insurance, for instance). Prudential regulation: inspections of banking assets. Informal Credit Markets and microfinance

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There is no consensus among economists and policy makers around the world on the best exchange rate regime. (development economists counsel avoidance of overvaluation that occurs with fixed er’s.) Fixed Adjustable Crawling Managed Wider-Band Freely Currency Board Peg Peg Float System Floating Dollarization Crucial Policy Lever is Foreign Capital Mobility: dM = dDC + dIR Three Objectives: Adjustment: Ability to control money supply & domestic interest rates. Confidence: Exchange rate stability. Liquidity: Foreign Capital Mobility (In and Out) Though each objective may be desirable in its own right, they are mutually inconsistent and you can’t have all three (especially for small open economies). Exchange Rate Policy

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The Unholy Trinity: See examples on chart. Assume: (dM = dDC + dIR)

Fixed Exchange Rate (preserve confidence):: 

Fixed Exchange Rate (preserve confidence): With capital controls (sacrifice liquidity): Central bank combats inflation (or current account deficit) by decreasing domestic credit and increasing domestic interest rates. Control over capital inflow means that no inflow of capital occurs, and therefore no pressure on ER maintenance. (DC & IR both controlled directly.) Monetary policy very effective (adjustment). With capital mobility (liquidity): If central bank increases interest rates over world rates, capital inflows increase to take advantage of higher return, IR increase counters DC decrease. Interest and inflation rates converge to world rates. Monetary policy ineffective (sacrifice adjustment).

Flexible Exchange Rate (sacrifice confidence):: 

Flexible Exchange Rate (sacrifice confidence): With capital controls (sacrifice liquidity): Changes in monetary policy on DC will be highly effective, because it is magnified by ER effect through current account. (interest rate up, domestic demand down, larger trade surplus and demand for local currency, appreciation of currency). With capital mobility (liquidity): Increased interest rates encourage capital inflows countering reduced domestic credit. If inflows large enough domestic currency may appreciate. Monetary policy weakly effective. (adjustment).