Emerging Markets

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L E C T U R E 1 . 2 F I N A N C I A L D E V E L O P M E N T C S L E O N A R D U N I V E R S I T Y O F O X F O R D

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

Financial Repression and Financial Liberalization

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S E T T I N G T H E I S S U E S

Leonard GSOM Emerging Markets March 2009 18/03/2009

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

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 20 th century various means found to repress financial systems Leonard GSOM Emerging Markets March 2009 18/03/2009

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  Imposed ceilings on interest rates paid by banks for deposits (fear for banks’ safety in competitive environments, outdated by securities markets)—banks gain, see C fig 2.1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 Leonard GSOM Emerging Markets March 2009 18/03/2009

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

90 68 83 60 48 51 56 40 30 30 6 8 8 11 22 14 5 25 13 24 0 15 15 17 5 4 1 3 1 1 1 0 DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument of LDC Leonard GSOM Emerging Markets March 2009 policy, 1980-1992”, Journal of International Business Studies, 1994, pp. 177-188. 18/03/2009

40 30 29 28 20 5 5 5 7 10 11 3 8 8 14 18 20 0 20 14 13 8 13 5 2 1 3 1 1 1 0 DATA SOURCE: Michael Minor, “The demises of expropriation as an instrument of LDC Leonard GSOM Emerging Markets March 2009 policy, 1980-1992”, Journal of International Business Studies, 1994, pp. 177-188. 18/03/2009

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

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

Financial Repression and Financial Liberalization

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S E T T I N G T H E H I S T O R I C A L C O N T E X T

Leonard GSOM Emerging Markets March 2009 18/03/2009

Financial Development, 1970s-2000s

13  Longer run  Foreign financing in Ems moves from bonds (19 th 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 Leonard GSOM Emerging Markets March 2009 18/03/2009

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

Financial Repression and Financial Liberalization

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W H A T A R E T H E C O N T R O V E R S I E S ?

Leonard GSOM Emerging Markets March 2009 18/03/2009

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

Financial Repression and Financial Liberalization

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M E A S U R E M E N T , W H O L I B E R A L I Z E S ?

Leonard GSOM Emerging Markets March 2009 18/03/2009

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

Recent Views

24   1980s and 1990s a policy wave Policy contagion  Countries herded in abandoning pegs and opening capital accounts  Policy emulation and signalling Leonard GSOM Emerging Markets March 2009 18/03/2009

Financial Sector Reform

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C H A R A C T E R I S T I C S

Leonard GSOM Emerging Markets March 2009 18/03/2009

Objectives

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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 Leonard GSOM Emerging Markets March 2009 18/03/2009

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 “ formal, supervised financial institutions.

financial deepening

” by increasing the volume of savings going to physical investments through  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. Leonard GSOM Emerging Markets March 2009 18/03/2009

Term and Size Transformation

28    A second objective in reforming the financial system is to facilitate "

term transformation

depreciation period. "; that is, to convert relatively short-term savings and deposits into long-term financing, which is needed by capital investments with a relatively long A third objective of the financial system is “

size transformation

be financiable.

”; 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 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).

Leonard GSOM Emerging Markets March 2009 18/03/2009

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.

Leonard GSOM Emerging Markets March 2009 18/03/2009

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 2. Improve Resource Allocation (the liability side of the system) (the asset side of the system) 3. Improve Prudential Supervision of Financial Institutions 4. Strengthen Financial Competition Developing Capital Markets by Opening International Capital Flows and by Leonard GSOM Emerging Markets March 2009 18/03/2009

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.

Leonard GSOM Emerging Markets March 2009 18/03/2009

 

(i) Liberalize Deposit Rates.

savings are a major cause of financial repression.  32 Furthermore, rationing of credit by the banking system inhibit innovation, as the funds would be normally channeled to well established firms. 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). Leonard GSOM Emerging Markets March 2009 18/03/2009

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

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.

Leonard GSOM Emerging Markets March 2009 18/03/2009

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.

Leonard GSOM Emerging Markets March 2009 18/03/2009

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 Leonard GSOM Emerging Markets March 2009 18/03/2009

(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. Leonard GSOM Emerging Markets March 2009 18/03/2009

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%.

Leonard GSOM Emerging Markets March 2009 18/03/2009

(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. Leonard GSOM Emerging Markets March 2009 18/03/2009

(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.

Leonard GSOM Emerging Markets March 2009 18/03/2009

3. Improve Prudential Supervision of Financial Institutions

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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 Leonard GSOM Emerging Markets March 2009 18/03/2009

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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.

Leonard GSOM Emerging Markets March 2009 18/03/2009

 43 The main prudential regulations include:  Capital adequacy standards, based on the riskness of assets.

     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.

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

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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.

Leonard GSOM Emerging Markets March 2009 18/03/2009

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.

Leonard GSOM Emerging Markets March 2009 18/03/2009

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 of emerging economies.

3 This is a “fire 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 Leonard GSOM Emerging Markets March 2009 18/03/2009

The End

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S E E Y O U N E X T H O U R

Leonard GSOM Emerging Markets March 2009 18/03/2009