Financial development

Credit and financial development

• In poor countries, households and firms need credit/insurance – To overcome shocks – To start/expand business • The need for credit and insurance is large as wealth is low • Financial development is low (lack of institutions) – M2/GDP=0.22 in Africa (0.35 in other non-OECD) vs about 1 in OECD countries – In some countries 90% lending is outside the formal financial system – Informal moneylenders charge exorbitant rates

De Soto’s Mystery of Capital

• Why does capital work in the West? And not in other countries?

• Poor may have a lot of wealth (up to $9 trilllion?) – But cannot use it as collateral – Because it is not properly titled • Other problems with collateral: – Registered but cannot be repossessed (Djankov et al.)

Financial underdevelopment

• Lack of rule of law  formal financial markets fail – M2/GDP=0.22 in Africa (0.35 in other non-OECD) vs about 1 in OECD countries – In some countries 90% lending is outside the formal financial system – Informal moneylenders charge exorbitant rates • Same with insurance: informal markets are no substitute – to insure against village-level risks, need an impersonal insurance market

Financial development is correlated with economic development: M2/GDP

1000 100 10 1 100 1000 10000

GDP PPP per capita, 1999, log scale

100000

Financial development is correlated with economic development: Stock market/ GDP

1000 100 10 1 100 0 1000 10000 100000

GDP PPP per capita, 1999, log scale

• • • • •

Does financial development CAUSE growth?

Correlation is significant, but it may also be explained by – Financial development

follows

economic growth – Both financial development and growth are affected by the same shocks King and Levine (1993): – Financial development has positive effect on

future

growth rates Rajan and Zingales (1998): Industry-level analysis – Compare tobacco (simple, high cash flow, fast payback, no need for finances) and pharmaceuticals (long-term projects, demand for complex financial arrangements) – In Malaysia, Korea and Chile (similar income but very different financial development • Malaysia: pharmaceuticals grew 4% faster than tobacco in the 1980s • Korea: 3% • Chile: -2.5% – On average, countries with high financial development (75% of ranking) grow faster than countries with low financial development (25%) by 1% p.a.

• Especially manufacturing, microelectronics, pharmaceuticals Is financial development predetermined (e.g. by legal origins?) Rajan-Zingales 2002: The Great Reversal: – Before 1914 France was much more financially developed than US

Firm size is below optimum in non-OECD countries (Tybout, 2000)

Lack of finance constraints firm growth

• New firms cannot finance investment – Remain smaller than should be – Except firms within by large conglomerates – Hence integrated and diversified business groups – High concentration of wealth is reinforced • Caveat: – Finance may not be the only constraint – Finance may be not a

binding

constraint (e.g. predatory regulation may be more important) • FDI: a panacea?

Rural credit: Informal lenders

• Why do informal lenders outperform banks?

• Information – Local information (hence constrained to village/town) – Credit registry for informal lending?

• Exclusive dealing (also, witholding land title) • Enforcement of repayment: – Private enforcement – Dynamic incentives • Interlinkages: – Employer/landlord etc may accept collaterals that banks would not (labor, non-liquid land etc)

Microcredit

• Banks do not want to lend to the poor: – No collateral – High risk – Loans are too small to cover overheads • Microcredit: explosion all over the world after Muhammad Yunus’ Grameen Bank (1976) – But similar to earlier institutions in Western countries (e.g. German credit cooperatives, beginning of 20 th century, Banerjee, Besley, Guinnane, 1994) • Main surprise: – At least 95% repayment rate!

– Even though interest rates are very high

Leading microcredit institutions (Morduch, 1999)

Why does microcredit work?

• Dynamic incentives – Progressive lending • Group lending – Peer selection (superior information on risks within group) – Peer monitoring (superior information on actions within group) • Microcredit programs receive subsidies/subsidized loans – without subsidies, rates would be even higher

Progressive lending

• “Nowhere else to go” – Monopoly: cannot borrow from anybody else – Pay back now in order to get a larger loan in the future • But: endgame effect – At some point may grow up to tap formal financial markets and banks – Hence threat of switching to competing lenders (banks) – Finite repeated game theory: the whole system should unravel • If Debtor is one loan away from being able to borrow from banks then he will NOT have incentives to repay • Hence this loan should not be given by Creditor • Hence being two loans away Debtor has no incentives to repay etc • Irony: incentives to repay are based on the low probability of becoming rich

Microcredit and women

• Why women – Women are underserved by other lenders • In particular, are excluded from informal networks – Many microcredit programs specifically focus on women in their mandate • Implications of microcredit to women – Balance of power within family – Labor supply, fertility and education

Effect on savings

• Microcredit can also be an intermediary between savers and borrowers – Small savers are not treated well by formal banks • Widespread phenomenon: ROSCAs (rotating savings and credit associations) • Poor households are too poor to save?

– No, since have to save for the rainy day – Exactly because would have no access to insurance/credit in the absence of microcredit

Microcredit and poverty

• Even programs focused on the poor serve clients at the poverty line or slightly below • Since not financially viable, subsidies/grants are diverted from anti-poverty programs • Estimates: microcredit is still more cost-effective than other programs (as little as $0.91 to provide $1 benefit to the poor, Khandker, 1998) • But (much) more research is to be done

Implications: impact on occupational choice and the process of development

Banerjee-Newman (1993) • General equilibrium model with occupational choice and endogenous wage and credit constraints – Poor cannot finance opening new business.

– Stronger financial constraints  lower wages  rich even further better-off – Multiple equilibria: Inequality begets inequality

Risk and volatility

• Macro: terms of trade volatility – SubSaharan Africa: 16% – Other LDCs: 12% • Micro: – Weather – Price volatility – Rural India (ICRISAT): coefficient of variation of income over time: 40% • Using reasonable estimates of risk aversion, cost of volatility = 0.16 income

Responses to high risk

• Formal insurance (US style) – Fails to emerge because of lack of rule of law, and other institutions that would cope with adverse selection and moral hazard problems • Hence – Informal/local insurance AND/OR – Self-insurance

Informal/group insurance

• Based on peer pressure, reputational/clan/network concerns • Can NOT insure against common risks • Geography: – Usually constrained to village/town – Hence efficiency is low, but even lower if population density is low (e.g. Africa) • Collective insurance prevents development of private property – Invest in clans/networks to guarantee mutual help. Hence individualism is very costly – In Africa, private property rights are more common in coffee producing areas with stable rainfall where need for (group based) insurance is lower

Self-insurance

• Diversification (income smoothing) – In each activity, operation below optimal size – Avoiding risky activities (even with much higher yield on average), prefer safe crops – Tied labor contracts (long-term employment with steady but low wage) • Consumption smoothing – Borrowing constraints:

higher

demand for precautionary savings (Deaton, 1991) – What assets to hold?

• Financial system is underdeveloped – hence investments in

non financial

assets (e.g. livestock) • Savings do not get transformed into productive investments • Between rock and hard place: – Self-insurance is costly but so is exposure to risk

Insurance: summary

• Lack of insurance market results in second best strategies to cope with risk – Which hinders economic and social development • Still, risks are not fully eliminated: – Both micro and macro income and consumption remain volatile … – Which hurts investments – But also human capital accumulation suffers. • Health of children (especially girls) decreases during floodings etc • Children are taken out of schools in response to negative income shocks • Countries with non-diversified economies, lack of financial development and low population densities are hit the hardest • Within countries, poor households suffer the most

Volatility and growth

Aghion-Angeletos-Banerjee-Manova and Aghion-Bacchetta-Ranciere-Rogoff: volatility, financial development, and growth – Low financial development: Volatility has a negative impact on growth – High financial development: Volatility has no impact on growth