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Financial development. Credit and financial development In poor countries, households and firms need credit/insurance –To overcome shocks –To start/expand.

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Presentation on theme: "Financial development. Credit and financial development In poor countries, households and firms need credit/insurance –To overcome shocks –To start/expand."— Presentation transcript:

1 Financial development

2 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

3 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.)

4 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

5 Financial development is correlated with economic development: M2/GDP

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

7 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

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

9 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?

10 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)

11 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

12 Leading microcredit institutions (Morduch, 1999)

13 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

14 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

15 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

16 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

17 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

18 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

19 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

20 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

21 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

22 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

23 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

24 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

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