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Finance-led Capitalism?
Macroeconomic Effects of Changes in the Financial Sector
Edited by
Metropolis-Verlag
Marburg 2008
Financial systems in developing
countries and economic development
Hansjrg Herr
1. Introduction
The wave of globalisation over the past decades finds its centre in the in-
ternational financial system. The deregulation of financial markets has
led to an enormous amount of new innovations and an explosion of inter-
national capital flows. The deregulation of financial systems started in
the developed world in the 1970s. However, after a time lapse most de-
veloping countries and later the countries of the former Soviet block libe-
ralised their domestic financial systems (e.g. by switching to market-
determined interest rates and allowing foreign currency deposits in the
domestic banking system) and at the same time reduced or eliminated
capital controls (e.g. allowing domestic firms to take credits abroad and
households to keep bank accounts, debt securities or shares abroad). The
question is whether these changes have increased the chance for develop-
ing countries to catch up quickly or whether development is becoming
more difficult under present conditions.
Believing in the neutrality of money, Robert Lucas (1988) argued that
the relation between financial and economic development is over-
stressed. More surprisingly, Joan Robinson (1952) pointed out that fi-
nancial development follows economic growth passively. Although she
supported a Keynesian tradition she underestimated the role of money.
As Jan Kregel (1985) puts it, Keynesian economics without money is like
Hamlet without the prince. In this essay money and the financial system
are considered of key importance for economic development in both de-
veloped and developing countries. The World Bank (2001) also strongly
supports the belief that financial systems are of paramount importance
Our second thesis now runs: in so far as credit cannot be given out of
the results of past enterprise or in general out of reservoirs of purchas-
ing power created by past development, it can only consist of credit by
means of payment created ad hoc, which can be backed neither by
money in the strict sense nor by products already existing. It can in-
deed be covered by other assets than products, that is by any kind of
property which the entrepreneur may happen to own. But this is in the
first place not necessary and in the second place does not alter the na-
ture of the process, which consists in creating a new demand for, with-
out simultaneously creating, a new supply of goods. (Schumpeter
1911, 106).
The ex-ante saver has no cash, but it is cash which the ex-ante inves-
tor requires. >@ If there is no change in the liquidity position, the pub-
lic can save ex-ante and ex-post and ex-any-thing-else until they are
blue in the face, without alleviating the problem in the least. (Keynes
1937a, 665 f.).1
1
Also cp. Keynes (1937b):
refinancing from
additional bank central bank
deposits
additional
debt-securities
and shares commercial
banking system
savings of
households,
firms, gov-
ernment credit for
investment in
working
productive capital
capital
income-
creation
process
The possession of actual money lulls our disquietude; and the pre-
mium which we require to make us part with money is the measure of
the degree of our disquietude. (Keynes 1937c, 216).
2
Other indicators issued debt-securities or stock market capitalisation in % of GDP,
would show the same relationship.
3
Other currencies do not play an important role. In March 2006 45% of all domes-
tic foreign currency deposits were kept in U.S. dollar, 26% in euro, 4% in yen, and
3% in Swiss franc (BIS 2006).
Domestic bank
credit in % of GDP
Low-income countries 55
Middle-income countries 77
High-income countries 195
China 138
Armenia 8
Bangladesh 58
Brazil 82
Cambodia 6
India 64
Korea, Rep. 107
Malaysia 125
Mexico 40
Mongolia 25
Peru 15
Russian Federation 21
4
It can also be argued that different monies have different reputations or different
brand names.
ee
(1+ iD ) = (1+ iF ) (1)
e
iD: domestic interest rate, iF : foreign interest rate, e: spot exchange rate (in-
e
crease means nominal depreciation), e : future or expected exchange rate (in-
crease means nominal depreciation)
5
Country risk premia are sometimes used to express a similar idea. A risk premium
reduces the rate of return of an asset; a currency premium increases the rate of re-
turn of an asset.
6
This is a method used by Keynes (1921).
ee
(1 iD )(1 lD ) = (1 iF )(1 lF ) (2)
e
lF: foreign marginal currency premium, lD: domestic marginal currency premium
Marginal currency
premia (1)
11
U.S. dollar
10
Rouble
Note: * The same pecuniary return in U.S. dollars and roubles is assumed.
ing system. Table 2 shows that deposit dollarisation is high and exceeds
50% or more of domestic deposits in many countries. Domestic banks
use foreign currency deposits to give foreign currency loans inside the
country and/or channel the collected foreign currency deposits abroad if
there are no good domestic debtors. Table 2 reveals only the peak of for-
eign currency holdings. There are two other ways to hold wealth in for-
eign currency which are statistically difficult to detect. Firstly, foreign
wealth can be held inside the country in foreign banknotes and is part of
dollarisation. Especially in countries with unstable banking systems
and/or the danger of confiscation of monetary wealth by the government,
cash holdings are high (De Nicol et al. 2003). Secondly, the wealth held
abroad is quantitatively more important. Dollarisation can be considered
the capital flight of small wealth owners as it is costly and needs informa-
tion to keep wealth in a foreign country. Keeping wealth outside the
country, capital flight in the original sense, is typical for the rich in de-
veloping countries. Taking into account the high degree of dollarisation
in many developing countries and adding cash holdings in foreign cur-
rencies and capital flight to foreign countries, it becomes clear that finan-
cial systems in most developing countries are highly penetrated and na-
tional currencies only partly take over domestic monetary functions.
Central banks in developed countries, as mentioned above, will ac-
commodate a circuit of domestic credit expansion, investment and
growth as long as there is no inflationary danger. The key point is that
developing countries are confronted with a systematically tighter ma-
croeconomic monetary budget constraint than developed countries.7
7
Kornai (1980) spoke about monetary budget constraints to distinguish market
economies (hard budget constraints) from planned economies (soft budget con-
straints).
Number of
Regions countries 1996 1997 1998 1999 2000 2001
South America 8 45.8 46.1 49.4 53.2 54.0 55.9
Transition Econo- 26 37.3 38.9 43.5 44.3 46.9 47.7
mies
Middle East 7 36.5 37.2 37.7 37.5 38.2 41.9
Africa 14 27.9 27.3 27.8 28.9 32.7 33.2
Asia 13 24.9 28.0 26.8 28.8 28.7 28.2
Central America and 7 20.6 20.8 22.0 22.1 22.5 24.7
Mexico
Caribbean 10 6.3 7.6 6.8 6.7 6.1 6.2
Developed Countries 14 7.4 7.5 7.5 6.7 7 6.6
Countries with low-quality monies can afford only a relatively small cre-
dit expansion in domestic currency. Let us assume 100 units of credit and
monetary wealth in domestic currency are created in such a country. Ac-
cording to the preference of wealth owners a certain percentage of the
newly created wealth will be exchanged in hard currencies. If wealth
holders want to keep 50% of their monetary wealth in hard currency in-
side and/or outside the country a very conservative assumption for
most developing countries 50 units of domestic wealth in domestic cur-
rency will be exchanged in hard currency. Everything unchanged, this
leads to a depreciation of the domestic currency which can be accepted
only to a limited extent by a developing country. Firstly, a depreciation
may trigger inflationary processes, especially as in developing countries
prices and wages are sometimes pegged to the exchange rate. Secondly,
as in developing countries foreign debt is nearly completely denominated
in foreign currency, another consequence of the poor quality of their mo-
nies, any real depreciation leads to an increase of the real debt burden of
debtors in foreign currency. Thirdly, the export and import elasticity may
be very low, a case in which very large real exchange rate movements are
needed to improve the trade balance or a depreciation even increases a
current account deficit. And finally, a real depreciation may lead to such
a reduction of real income that a (larger) part of the population falls into
poverty. It follows that countries with low-quality currencies have to stop
domestic credit expansion in domestic currency very quickly and are not
able to initiate a Keynesian-Schumpeterian credit-investment-income-
creating process which is the backbone of economic development. The
macroeconomic monetary budget constraint in many developing coun-
tries is too hard and does not allow for development.
expenditure,
Gross capi-
services, %
Current ac-
FDI net in-
flows in %
Final Con-
ance, % of
Exports of
% of GDP
goods and
count bal-
tal forma-
tion, % of
rate (CPI)
sumption
GDP per
Inflation
growth*
growth*
of GDP
of GDP
capita
GDP
GDP
GDP
Year
Without permission Chinese banks, firms and households are not allowed
to take foreign credit. As a result, foreign debt in China compared with
foreign assets is low. For FDI inflows China is one of the most open
countries in the world. Prasad and Wei (2005, 19) from the IMF are cor-
rect when they state:
Actually, for a few years China has been suffering from too high and
partly speculative capital inflows especially because of high FDI in-
flows and other financial flows connected with FDI like credits and trade
flows between foreign parent companies and subsidiaries in China.
Without the PBoCs interventions in the foreign exchange market China
would most likely be pushed into huge current account deficits.
Compared with other developing countries dollarisation in China is
relatively low. Domestic foreign currency deposit in 2006 were below
4% of total domestic deposits; domestic foreign currency credits in % of
total domestic credits were below 6% (PBoC 2008). It is important here
to recognise that capital export controls and relatively low dollarisation
prevented the early curtailing of domestic credit expansion which is the
explanation of the low ratio of domestic bank credit to GDP in so many
developing countries.
Development in China would not have been possible without the fi-
nancial system supporting and pushing investment. The backbone of the
financial system are the four big state-owned commercial banks which
today cover over 60% of deposit collection and bank credits given. Near-
ly all other banks, for example city banks or so-called policy banks, are
also state owned. Until the late 1990s there had been a credit plan with
credit ceilings. A large part of credits was policy driven. At least for two
decades after the start of reform in 1978 the PBoC, or better the State
Council, decided on the credit volume including the regional distribution
of credits. On a provincial level credit allocation was negotiated between
local government, the local branches of the banks, the local branch of the
PBoC and state-owned firms. This implied that on a macroeconomic lev-
8
Defending macroeconomic stability was not always easy for the PBoC. Especially
in the early 1990s commercial banks found ways to circumvent credit ceilings by
creating non-bank financial institutions. The banking reform in China in 1994 es-
tablished macroeconomic control of the PBoC again.
9
In 2004 the relation of domestic credit to GDP in China was 166.9%. The drastic
reduction of the ratio to around 120% in 2005 reflects that balance sheets were
cleaned up from non-performing loans (World Bank 2008).
ple compared with the highly foreign indebted USA, as original sin of
low-quality currencies. Secondly, even without the danger of currency
crises, capital inflows may erode the competitiveness of developing
countries and lead to long-run negative effects (Dutch disease).
10
The poorest developing countries are largely excluded from such cycles as they
rely on donors and cannot attract substantial private capital inflows.
Figure 3: Total net capital inflows, net FDI flows and net portfolio equity
flows in developing countries 19702005 (in million U.S. dollars)*
350.000,00
300.000,00
250.000,00
200.000,00
150.000,00
100.000,00
50.000,00
0,00
50.000,00
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003
The pitcher keeps going to the well until it is broken at last. Even small
changes in expectations can lead to portfolio shifts which are difficult to
manage for the country. There may be a political shock, as in Mexico in
1994, triggering a currency crisis; there may be the fear by foreign in-
vestment funds that asset markets and the external value of a currency
will collapse as in Thailand 1997; there may be contagion effects as in
Malaysia or South Korea in 1997; and there may be no good explanation
at all for the change in sentiments. In all currency crises foreign and do-
mestic wealth owners want to secure their wealth and prefer to keep it in
high-quality currencies. A change in expectations leads to a negative
conventional judgement which implies depreciation expectations and a
collapse of the currency premium. Economically costly twin crises which
can lead to long-term stagnation and a change in the long-run growth
path characterise the bust phase.11
In sum then, the bad news is that even if delivered with the best inten-
tions and used carefully by responsible recipient governments, there
11
Williamson (2005, 15 ff.) calculated the costs of the Asian crisis in 1997. The
cumulative loss of one years GDP from 1997 to 2000 was 82% in Indonesia, 27%
in South Korea, 39% in Malaysia und 57% in Thailand. According to IMF estima-
tions costs of bank restructuring in % of GDP were 32.5% in Indonesia, 19.5% in
Korea, 19.3% in Malaysia und 25.0% in Thailand. In all four countries in 2003 un-
employment rates were still higher than in 1997. Also, the population living under
the national or international poverty line increased after the Asian crisis. The Asian
crisis in 1997 also shows that economic development is path dependent. South Ko-
rea, for example, was able to overcome the crisis relatively quickly. In Indonesia
the crisis was much deeper and longer and pushed the country on a medium-term
growth path which is lower than before the Asian crisis.
capital imports are used to import capital goods which were not
available before and do not crowd out domestic investment. In this
case domestic capacities increase. However, without additional do-
mestic demand there will be no additional output. Imported capital
goods may lead to higher domestic productivity, which is positive,
but higher productivity does not necessarily increase domestic de-
mand and production automatically.
c) The third case is a special version of the second case. Let us assume a
situation of excess domestic demand and physical bottlenecks to in-
crease production. Under such a condition net capital inflows and a
resulting inflow of needed capital or intermediate goods increase do-
mestic production. This special case fits to the traditional World Bank
model (Chenery/Strout 1966) and to the belief of many other interna-
tional institutions and development ministries. It is based on the as-
sumption that developing countries have a lack of domestic savings
and of physical capital, and that foreign savings and a deficit in the
current account should augment domestic saving and increase the
domestic capital stock. China, which in 1978 definitely was not a
country with a good and abundant capital stock, offers no support for
this idea. It developed without current account deficits and imme-
diately followed an export-led development. Easterly (1999) tested
the saving gap model. From the 138 developing countries he tested
there was only one country (Tunisia) that supports the saving gap
model. In all other cases sometimes even very high net capital in-
flows were unable to trigger development.
d) In the fourth case net capital imports are used to finance domestic
demand. There are again two sub cases. In the first sub case firms,
public households, etc. switch from domestic finance to foreign
finance without increasing domestic demand. Here we have a clear
reduction in domestic demand as the capital import leads to an ap-
preciation and a reduction in exports and/or an increase in imports
exactly equal to the additional capital import. In the second sub case
capital imports are used to increase domestic demand. Here we have
an appreciation and thus a reduction of demand equal to the net capi-
tal import. However, this loss of demand is compensated by addition-
al domestic demand. The overall effect is zero.
The conclusion of this part is that under very special conditions insuffi-
cient physical domestic capital stock to produce more and sufficient do-
mestic demand capital inflows can increase domestic production. In
many other cases net capital inflows do not lead to an increase of domes-
tic production or even to damaging Dutch disease effects.
5. Conclusion
World financial markets are more integrated than ever before. However,
the markets are divided into different currency segments. At the top of
the currency hierarchy are currencies like the U.S. dollar, the euro, the
Japanese yen or the British pound which dominate international financial
markets. At the bottom of the hierarchy are the currencies of developing
countries. In many cases these currencies only partly take over domestic
currency functions. They are usually used for domestic transaction pur-
poses but do not serve as a store of wealth to be transferred into the fu-
ture. Compared with top currencies these currencies earn a low currency
premium and are confronted with dollarisation as well as capital flight in
hard currencies. The relatively low quality of these currencies is one of
the most important hurdles for development probably much more than
the conventionally emphasised lack of physical capital, technology, skills
of workers, etc. It prevents a domestically financed Schumpeterian-
Keynesian credit-investment-income process as a large part of domestic
monetary wealth during such a process is exchanged in foreign currency,
triggers depreciation and leads to an extremely tight macroeconomic
monetary budget constraint which suppresses development.
Strategies to increase the quality of national currencies are of para-
mount importance for economic development. There are several condi-
tions which must be fulfilled to achieve this goal. Firstly, macroeconomic
monetary stability must be realised; especially inflation rates must be low
and depreciations limited. Secondly, a very successful policy to increase
the quality of domestic currencies is to prevent current account deficits
and high foreign debt. Increasing exports together with current account
surpluses do no only stimulate domestic demand and trigger export-led
growth, they also reduce the likelihood of twin crises and thus stabilise
expectations in the stability of the domestic financial system and the do-
mestic currency. The group of developed countries should accept current
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