Lecture 1 2 Financial Development (EDocFind - Com)

Emerging Markets
LECTURE 1.2 FINANCIAL DEVELOPMENT
C S LEONARD
UNIVERSITY OF OXFORD
Leonard GSOM Emerging Markets March 2009 18/03/2009

Outline
2
Repression and Liberalization

Setting the issues
Setting the historical context
Getting the controversies clear
Checking the evidence
Financial Repression (from Calomiris)
 Characteristics, Constraints imposed (6)
 Varied impact?
Financial and Capital Account Liberalization
 How/when did it happen
 Changing international order in the 1990s
 Trade conditions
 International organizations

Financial Repression and
Financial Liberalization
3
SETTING THE ISSUES

Role of Government in the Economy
4
Story as presented by Calomiris

 West: two processes democratic and market development
 Law as social contract (moral consensus)
 Merchants as powerful force in development
 By contrast with, say, self-isolating China (1400-1800)
 This is a story of governments
 Taxes and rents by government suppress financial activity
 Banking: securing money, check clearance
 Investment: securities market intermediation (no permanent
middleman) and bank intermediation, both require laws ensuring
contract enforcement, protecting against fraud

Crises
5
Continuous depreciation, like collapses, tax the

financial sector
Dev of law to support system difficult, political
pressures for rent, military pressure for the inflation
tax
20th century various means found to repress financial
systems

Financial Repression
6
 Imposed ceilings on interest rates paid by banks for deposits (fear for
banks’ safety in competitive environments, outdated by securities
markets)—banks gain, see C fig 2.1
 High reserve requirements on banks (gain to government, no interest
on reserves), inflation adds to tax on banks, C fig 2.2
 Lending to industry, and or direct credit
 Owning or micromanaging banks (Asian model of development,
control over credit alloation: Krugman [Singapore/Soviet style
allocation])
 Restricting entry into the financial system, especially by foreigners
(protectionism)
 Japan—to mid-1980s, effectively forbidden: domestic corporate bonds and commercial
paper, ie, all securities markets

Eun & Jarakiramannan
(1986)
Leonard GSOM Emerging Markets March 2009 7 18/03/2009

Number of expropriations of foreign assets in
different countries: development leading to new
globalization
8
DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument18/03/2009

Leonard GSOM Emerging Markets March 2009
of LDC
policy, 1980-1992”, Journal of International Business Studies, 1994, pp. 177-188.
Number of countries expropriating
9
foreign assets
DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument18/03/2009

Leonard GSOM Emerging Markets March 2009
of LDC
policy, 1980-1992”, Journal of International Business Studies, 1994, pp. 177-188.
Controls on capital flows
10
Restricting international capital flows (strengthens

power of government to direct flows to particular
industries)
 Capital controls widespread in all countries during Bretton
Woods period of fixed exchange rates (1948-1973)—brief
experiences of severe control (Chile, Malaysia, Brazil in
1990s)repealed

Measuring Financial Repression
11
1970s to 1980s, 1990s, remarkable lowering of

reserve ratios (fig 2.3)
Negative real interest rates (measures restrictions on
deposit interest rates) ended in burst of financial
liberalization in 1990s
Commercial bank borrowing
Relative size of stock market
Calomiris index (financial and economic
development correlated)

12
SETTING THE HISTORICAL CONTEXT

Financial Development, 1970s-2000s
13
Longer run
 Foreign financing in Ems moves from bonds (19th century) to
banks after WWII, to bonds (Brady bonds), to equity
 Countries move from protectionist policies, import –
substitution, forced upon them in the 1930s, to period of GDP
and rapid trade growth in the 1970s (even during the two oil
price spikes of 1973 and 1979, with non-oil producing countries
spending to meet demand, to the 1980s, a period of stagnation
in some countries (LA), to official relief, to privatization and
equity markets
 General state: from crisis, to stability, to crisis
 International arrangements: GATT (Tokyo Round) imposes
discipline and provides incentives for trade

More clearly..
14
Oil shocks and crises and government intervention

Division between oil exporting and oil importing
countries, with banks loaning funds of former to the latter
-- against background in 1970s of structural reform,
turning away from protectionism
 Tariffs reduced
 Crawling exchange rate pegs to maintain competitiveness
 Asia, subsidation of non-traditional exports
 Huge global liquidity world wide in times of inflation, banks search for
higher yields abroad
 Despite two major recessions in developed world, growth averaged in
1970s 4% per annum
 World trade grew by 9% per annum
 Debt/export ratios held down

Tokyo Round
15
 GATT, most comprehensive round, 1973-1979

 6 codes dealing with non tariff measures
 Tariff reductions by industrialized countries at 35%
 Developing countries given escape clause against terms of
trade shocks
1980-1983 situation changed
 Debt export ratios rose dramatically, 1979 recession
 Slows of transfers to developing world, rise in real interest
rates, Asia strengthened against this, LA ran into debt
 Syndicated bank loan rose as vehicle of capital transfer
 Banks counted on official support, sovereign lending rose

Era of debt 1980s
16
IMF assistance coupled with efforts to protect banks

Baker Plan showed continued emphasis on private
sector
Baker plan also fostered privatization as way out
By 1987, banks showing greater reluctance
Bail out of Mexico in Brady bonds, debtors and
creditors given new menu of options, conversion
bonds—writing off about 1/3 of all debt,
collateralization paid for by IMF, WB and Japanese
Import Export Bank
1990s
17
Era of restored growth, long period of US productivity

growth, GDP globally av annual at 3%, despite Soviet
Union’s collapse and Japanese recession
Uruguay Round of GATT showed success
Far reaching changes in globalization
 Communications and information
 New production technologies
 Outsourcing
 International division of labor
 1970s, lending went to governments, 1990s, went to the poor and
rich (see China), heterogenous component
 Dense network of interfirm linkages

18
WHAT ARE THE CONTROVERSIES?

Arguments against
19
Second best theory, removing one distortion does

not work, when others are present
If industries protected, funds may flow where not
efficiently used
Misallocations (where wages are inflexible
downward), say, toward capital intensive industries,
can be furthered

Arguments for Liberalization
20
Sheltering financial intermediaries from competition

does not improve them
Weakens market discipline felt by policy makers
Place additional power in hands of bureacrats
Encourage rent seeking and resource dissipation by
interest groups seeking privileged access to foreign
capital
Evidence not conclusive, which way
Benefits and disadvantages to liberalization

21
MEASUREMENT, WHO LIBERALIZES?

Methods of measuring it
22
Zero one dummy for controls, since intensity of

effort to control is fuzzy in cross country studies
Quinn (1997) some effort to index intensity for 56
countries, 1954-1994
Effort to measure international integration
 Stock market correlations? (returns vary as function of
underlying assets)
 Onshore-offshore interest differentials (limited info for
countries and years)
Conclusion: liberalization is part of a larger package,
hard to measure all of it

Who liberalizes
23
Currency pegs difficult to operate with liberalized

controls
Countries with pegs don’t liberalize
Advanced countries liberalize (causality?)
Countries where domestic savings are scarce don’t
liberalize—governments tend to channel resources
Accounts are closed when public authorities hope to use
inflation tax or to force banks to hold reserves at a certain
amount, for a certain sector
Where Central Bank is independent, this is not useful,
and so, less control

Recent Views
24
1980s and 1990s a policy wave

Policy contagion
 Countries herded in abandoning pegs and opening capital
accounts
 Policy emulation and signalling

Financial Sector Reform
25
CHARACTERISTICS

Objectives
26
A. Objectives of Financial Sector Reform

B. Measuring Financial Deepening
C. Main Areas of Reforms
1. Improve Mobilization of Resources
2. Improve Resource Allocation
3. Improve Prudential Supervision of
Financial Institutions
4. Strengthen Financial Competition

A. Objectives of Financial Sector Reform
27
 A first objective of financial sector reform is to bring the bulk of capital

accumulation in a country through the formal financial system, away
from the informal financial markets.
 In other words, the objective is to induce “financial deepening” by
increasing the volume of savings going to physical investments through
formal, supervised financial institutions.
 An increase in the proportion of savings going to investments
through the financial system should lead to an improvement in the
use and allocation of these savings.
 Potential borrowers will have to compete for these savings and those
with the most profitable opportunities and higher returns will have
an advantage in obtaining these funds.
 The deepening or increase in the size of the financial system,
therefore will improve the allocation of resources in the economy.

Term and Size Transformation
28
 A second objective in reforming the financial system is to

facilitate "term transformation"; that is, to convert relatively
short-term savings and deposits into long-term financing, which
is needed by capital investments with a relatively long
depreciation period.
 A third objective of the financial system is “size
transformation”; that is to consolidate relatively small private
savings into larger blocks of finance that can be used to fund
large profitable investments. Otherwise large projects would not
be financiable.
 A fourth objective of an adequate financial system is to achieve
“financial efficiency”; that is, to intemendiate between savings
and investments with minimum intermediation costs and
minimum risks (which requires prudential supervision).

B. Measuring Financial Deepening
29
 In most Emerging Markets, the banking system is the

mainstream of the financial system.
 Therefore, the degree of financial deepening can be measured by
the actual flow of bank loans granted by the banking system.
 Since this flow is difficult to measure, a rough indicator of the
size of the financial/banking system is the ratio of M2 (Currency
in circulation plus demand and savings deposits) to GNP.
 Changes in the M2/GNP ratio over time indicate changes in the
flow of private savings through the system. It indicates real
additions to the ongoing loanable fund capacity of the banks.
 Typical M2/GNP ratios are: Latin America, 0.35, Transition
Europe, 0.45, Emerging Asia, 0.75, USA/Canada, 0.60, Western
Europe, 1.00, Japan, 1.20
 Excessive M2/GDP ratios may also indicate over-reliance on
banks and inadequate capital market development.

C. Main Areas of Reform
30
 A precondition for the soundness of the Financial Sector is

Macroeconomic Stabilization. With high inflation and devaluations,
the financial systems will not be viable over the long term.
 The health of the Financial Sector also depends on the soundness and
creditworthiness of its borrowers. In turn, this will depend on the
sustainability of economic growth. Economic Liberalization and Public
Governance are key to achieve sustainable rates of growth.
 In fact, the financial sector "reflects" the real economy.
 Within these preconditions, the following measures are needed to
develop a sound financial sector:
1. Improve Mobilization of Resources (the liability side of the system)
2. Improve Resource Allocation (the asset side of the system)
3. Improve Prudential Supervision of Financial Institutions
4. Strengthen Financial Competition by Opening International Capital Flows and by
Developing Capital Markets

1. Mobilization of Resources
31
 A major purpose of the reform of a financial system should

be to increase its size by mobilizing increasing amounts of
private resources through the financial system.
 To increase the flow of private savings to the formal
financial system, the following measures are needed:
(i) Liberalize Deposit interest rates.
(ii) Expand Competition & Banking Coverage.
(iii) Diversify Savings Instruments.

(i) Liberalize
In many EMs, interest ceilings on
Deposit Rates.
savings are a major cause of 32
financial repression.
 Furthermore, rationing of credit by the banking system
With low deposit rates (rd vs
inhibit innovation, as the funds would be normally
Rd), savers will supply a lower
channeled to well established firms.
level of deposits to the banking
system (Q1 instead of Q2, with
"x" being intermediation costs).
Savers will tend to bypass the
banking system, increasing risks
of resource misallocation.
It generates nepotism rather than
economic criteria in allocating
the lower amounts of credit
available though at higher
lending rates (rl instead of Rl).
33
 In EMs, with greater market orientation to deposit rates,

competition among financial institutions is bound to take
interest rates on savings to the level of around 5% - 9% p.a. in
real terms.
 Liberalization of deposit rates should be accompanied by
measures to remove barriers to competition in the mobilization
of resources (particularly by enabling the entry of foreign
banks). Otherwise, monopolistic banks will pay low deposit
rates.
 Liberalization should also be accompanied by the development
of deposit insurance for small depositors, to ensure that small
depositors will not suffer if a bank gets into trouble.

34
(ii) Expand Competition & Banking Coverage.

 Eliminate restrictions to the creation of more branches to
provide easier access to depositors and induce additional private
savings throughout the country.
 Facilitate the establishment of well-capitalized banks, in order to
introduce competition and technology.
(iii) Diversify Savings Instruments.
 Banking laws in some countries list only “permitted”
instruments. This inhibits innovation. A better system is just to
prohibit certain types of undesirable instruments.
 In order to attract different types of depositors, banks should be
legally allowed to offer a diversity of types of interest bearing
instruments (passbook savings, time deposits, and certificates of
deposits) with different maturities, risks and rates.

2. Improved Resource Allocation
35
 Another major objective of financial sector reform is to

encourage the allocation of resources to the most
economically viable investment opportunities
 This will improve economic efficiency and accelerate
economic growth.
 For this purpose the following measures are normally
included in financial sector reforms:
(i) Liberalize Interest Rates on Lending.
(ii) Eliminate Preferential and Directed Credits.
(iii) Reduce Intermediation Cost.

Liberalize Interest Rates on Deposits
36
 Interest rates on lending should not be controlled by Government.

Otherwise, the formal system will be by-passed.
 As deposit rates are liberalized and becomes positive, lending rates
will also become positive in order to cover deposit cost, the cost of
reserve requirement and intermediation cost.
 If determined by free market forces, lending rates will reflect the
opportunity cost of capital the country.
 Lending rates may become excessively high if the Government
introduces excessive regulations, such as:
 forced holdings by banks of low interest government securities,
 interest transaction taxes,
 high reserve requirements (the proportion of the bank deposits that
must be placed for precautionary purposes at the Central Bank free
of interest rates), and

(ii)Effects of Inflation and High Reserve
Requirements
37
 The effect of high reserve requirements is to increase the

lending rate that the banks will need to charge on its
loanable funds, to compensate for the fact that a portion of
the deposits is not earning any interest.
 High reserve requirements will also reduce the interest rate
that the banks can pay to depositors.
 Either depositors or other borrowers as a whole end up
paying for the high reserve requirements and the financial
system becomes weaker and bypassed.

High Reserve Requirements
38
 Furthermore, high reserve requirements in the presence of high
inflation can have an devastating effect by increasing dramatically the
level of nominal and real lending rates.
 The combination of high inflation and high reserve requirements
requires banks to charge very high real interest rates on loans, to enable
them to pay positive rates to the depositors; e.g.:
 With a 55% inflation rate and a 5% real deposit rate, the nominal
deposit rate will be 60%.
 On a $100 deposit, the bank needs to earn $60 to pay depositors.
 If the reserve requirement is 30%, the bank will not earn any return
on $30 out of the $100 deposit.
 Therefore, the bank will need to recover the needed $60 just on $70
of investments.
 The lending rate on these $70 will need to be $60/$70, or 85%
 This represents a real lending rate of 30% (85%-55%) or five times
the real deposit rate of 5%.

(ii) Eliminate Preferential and Directed Credits.
39
 Many Governments in Emerging Markets have established

special facilities to provide preferential and subsidized credits for
sectors they wish to encourage, such as agriculture, small scale
industries, exports, etc.
 In some cases, banks are forced to have a share of its loans in
these preferential sectors normally at lower interest rates.
 Experience has shown that these subsidies are normally
ineffective: In fact, most investments are not sensitive to the
level of interest rates, as interest rates represent a small share
of total costs.
 If special assistance needs to be provided, it is preferably and
economically more efficient to provide it directly, such as
through investment tax credits accelerated depreciation, etc.
rather than indirectly through interest rates.

(iii) Reduce Intermediation Cost.
40
 To reduce intermediation costs, a key measure is to

eliminate excessive Government regulations on the kind of
activities permitted to banks.
 This excessive regulations may just lead to excessive
fragmentation of activities, with heavy overhead costs, as
banks will just established different companies to operate
in the various activities.
 Reducing fragmentation in the financial market will allow
banks to cover a wide set of activities and to have a wider
regional representation.
 This will also help in narrowing the disparities of lending
rates in the financial sector, and reduce operating cost.

3. Improve Prudential Supervision of
Financial Institutions
41
Banking Institutions:
 The “Core Principles for Effective Banking Supervision and Regulation” of the Basle
Committee on Banking Supervision (composed of G-10 Senior Bank Supervisors),
provides a good assessment of the components of an effective system.
 Its main five elements include:
I. Organization of the Banking Supervisory Authority:

 Clear objectives and a regulatory framework set by legislation.
 Operational independence to free it from political pressures.
 Accountability and enforcement powers to achieve its main objective:

Enforcement of bank regulations that set out the minimum standards that
banks must meet.
 For this, the authorities should:
 Strengthen bank surveillance capacity
 Improve in-site and off-site audit examination procedures

42
II. Bank Licensing

 To define institutions to be supervised, there should be clear bank
licensing arrangements
 The licensing authority should determine that the new bank has
suitable shareholders, adequate capital, feasible operating and
financial plans and management with sufficient experience and
integrity to operate the bank prudently.
 Objective and clear criteria for licensing should be issued.
III. Prudential Requirements.

 Prudential regulations and enforcement play a key role to ensure that
inherent banking risks are recognized, monitored and managed.
 The Basle Accord established prudential measures and regulations
that all banks should follows.
 Some countries with weak banking supervisory authorities may wish
to have stronger prudential regulations, as a cushion for weak
supervisory capacity.

43
 The main prudential regulations include:
 Capital adequacy standards, based on the riskness of assets.
 Loan classification (Standard, Watch, Substandard, Doubtful, Loss)
and provisioning requirements, with clear criteria to define
performing vs non-performing loans (qualitative as well as
quantitative criteria).
 Limits on Large Exposures (including country limits).
 Limits on Connected Lending (groups).
 Requirements for Liquidity and Market Risk Management.
 Internal Control Standards
IV. Accounting and Information Requirements
 Introduce generally accepted International Accounting
Standards for all banks.
 Introduce regular information reporting requirements.
 Introduce external audit of banks by qualified auditors
V. Exit Procedures for Bank Failure.
 In order to permit expeditious action, develop Prompt
Corrective Action and exit procedures in cases of bank failures.

44
4. Strengthen Financial Competition.

 A degree of competition in the financial sector is needed to bring
competition to financial services and improve service quality.
International Financial Liberalization
 Competition can be brought by opening of the financial sector to
foreign banks and liberalizing the flow of international capital.
 However, liberalization of International Capital should be preceded by
the development of strong prudential regulations and supervision, as
well as a “stable” foreign exchange rate system. Otherwise, it would lead
to Moral Hazard problems
Domestic Capital Markets Development
 A second way to bring competition in the financial sector is by
developing alternative mechanisms for firms to get financing.
 For this, the development of domestic capital markets is essential.

Domestic Capital Market
45
 The main measures to develop a domestic capital market include:

 Strengthening security trading systems, including stock exchanges, regional exchanges,
and over-the-counter markets.
 Develop modern capital market infrastructure, including a central depositary, custodians,
clearance and DVP settlement.
 Improve the legal and regulatory framework for capital markets, including protection of
ownership rights and small shareholders, prevention of abuses, prevention of fraud,
conflict of interest, inside information, broker/dealer regulations.
 Improve the functions of Prudential Supervision by the Capital Market Supervision Board
 Improve financial disclosure requirements, such as compensation of senior management.
 Improve accounting and financial reporting according to international standards.
 Encourage self-regulation.
 Encourage or establish rating systems.

Significance of Financial Market Development
46
 Focussing more closely on the 1990s
 Financial markets still very imperfect

 With trade costs, causing “sudden stops” in EM
 Mexico 1995
 Contagion to Argentina
 Russian crisis of 1998
 Asian crisis of ..
 In other words, EM s different from DE, because the debt/equity ratio can rise
rapidly. (1) collateral constraints, in the form of a margin requirement that
limits the ability of an emerging economy to use domestic finane This is a “fire
3
sale” in the sense that domestic agents rush to adjust their equity position
below the position they would optimally hold in the absence of margin
constraints. Collateral constraints, in the form of a margin requirement that
limits the ability of the Ems cannot use equity to leverage foreign debt, and (2)
asset trading costs, intended to capture the effects of informational or
institutional frictions affecting the ability of foreign traders to trade the equity
of emerging economies.

The End
47
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Emerging Markets

LECTURE 1.2 FINANCIAL DEVELOPMENT

Leonard GSOM Emerging Markets March 2009 18/03/2009

Repression and Liberalization

Leonard GSOM Emerging Markets March 2009 18/03/2009

SETTING THE ISSUES

Leonard GSOM Emerging Markets March 2009 18/03/2009

Story as presented by Calomiris

Leonard GSOM Emerging Markets March 2009 18/03/2009

Continuous depreciation, like collapses, tax the

Leonard GSOM Emerging Markets March 2009 18/03/2009

Leonard GSOM Emerging Markets March 2009 18/03/2009

Leonard GSOM Emerging Markets March 2009 7 18/03/2009

DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument18/03/2009

DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument18/03/2009

Restricting international capital flows (strengthens

Leonard GSOM Emerging Markets March 2009 18/03/2009

1970s to 1980s, 1990s, remarkable lowering of

Leonard GSOM Emerging Markets March 2009 18/03/2009

SETTING THE HISTORICAL CONTEXT

Leonard GSOM Emerging Markets March 2009 18/03/2009

Leonard GSOM Emerging Markets March 2009 18/03/2009

Oil shocks and crises and government intervention

Leonard GSOM Emerging Markets March 2009 18/03/2009

 GATT, most comprehensive round, 1973-1979

Leonard GSOM Emerging Markets March 2009 18/03/2009

IMF assistance coupled with efforts to protect banks

Era of restored growth, long period of US productivity

Leonard GSOM Emerging Markets March 2009 18/03/2009

WHAT ARE THE CONTROVERSIES?

Leonard GSOM Emerging Markets March 2009 18/03/2009

Second best theory, removing one distortion does

Leonard GSOM Emerging Markets March 2009 18/03/2009

Sheltering financial intermediaries from competition

Leonard GSOM Emerging Markets March 2009 18/03/2009

MEASUREMENT, WHO LIBERALIZES?

Leonard GSOM Emerging Markets March 2009 18/03/2009

Zero one dummy for controls, since intensity of

Leonard GSOM Emerging Markets March 2009 18/03/2009

Currency pegs difficult to operate with liberalized

Leonard GSOM Emerging Markets March 2009 18/03/2009

1980s and 1990s a policy wave

Leonard GSOM Emerging Markets March 2009 18/03/2009

Leonard GSOM Emerging Markets March 2009 18/03/2009

A. Objectives of Financial Sector Reform

Leonard GSOM Emerging Markets March 2009 18/03/2009

 A first objective of financial sector reform is to bring the bulk of capital

Leonard GSOM Emerging Markets March 2009 18/03/2009

 A second objective in reforming the financial system is to

Leonard GSOM Emerging Markets March 2009 18/03/2009

 In most Emerging Markets, the banking system is the

Leonard GSOM Emerging Markets March 2009 18/03/2009

 A precondition for the soundness of the Financial Sector is

Leonard GSOM Emerging Markets March 2009 18/03/2009

 A major purpose of the reform of a financial system should

Leonard GSOM Emerging Markets March 2009 18/03/2009

 In EMs, with greater market orientation to deposit rates,

Leonard GSOM Emerging Markets March 2009 18/03/2009

(ii) Expand Competition & Banking Coverage.

Leonard GSOM Emerging Markets March 2009 18/03/2009

 Another major objective of financial sector reform is to

Leonard GSOM Emerging Markets March 2009 18/03/2009

 Interest rates on lending should not be controlled by Government.