Chapter 38 - The financial sector Flashcards
How is facilitating savings a role of the financial sector?
Individuals need to undertake saving, and businesses and individuals need to be able to borrow. It is through financial markets that savings can be mobilised for investment.
Individuals (and firms) wish to save for various reasons. It may be that a household needs to accumulate funds for future spending. This may partly depend upon where an individual is in the life cycle. When young, there may be a need to save in order to have a deposit on a house. Savings may also be needed to support people in retirement. The financial sector offers opportunities for people to earn a return through saving, and so have funds for later purposes. At current rates of interest, the returns may not provide a strong incentive for this.
How is facilitating borrowing a role of the financial sector?
Firms - and households - wish to borrow. Financial markets therefore provide opportunities to obtain loans. This was seen in the circular flow model, where the savings behaviour of households enables firms to borrow in order to finance their investment.
Again, the rate of interest is important, as this represents the cost of borrowing. Firms will borrow for investment as long as the rate of return on the investment exceeds the cost of borrowing. Households will borrow in order to undertake expenditures, but will also need to be aware of the cost of borrowing.
How is facilitating the exchange of goods and services a role of the financial sector?
On a practical level, financial markets need to facilitate the transactions that take place with the exchange of goods and services. The importance of this can be seen by observing behaviour in countries that have experienced hyperinflation. When inflation reaches very high levels, people begin to try to avoid using money for transactions. Firms have to keep changing their prices, and people go frequently to the bank rather than keeping cash in their pockets. The transactions costs of this behaviour are high, and underline the importance of having stable financial systems in order to facilitate transactions.
How is forward markets a role of the financial sector?
Financial markets that operate in the modern economy also enable transactions to be conducted on the basis of contracts for future delivery - these are known as forward or futures markets. These are especially important in relation to transactions in certain commodities and in foreign exchange. Such arrangements are a way in which economic agents can reduce the riskiness of transactions.
An example is a where a manufacturing enterprise needs to buy commodities as inputs to its production process. Given the volatility of some commodity prices, there is uncertainty about the prices that will hold in future periods. Futures markets can help by allowing firms to contract forward to buy the commodities they know they will need at a future period at an agreed price at that agreed future date.
Commonly used futures markets include commodities such as oil, grain or precious metals - or foreign exchange. An airline may buy fuel forward. Firms that rely on imported inputs may use the futures market for foreign currency that they know they will need for future transactions.
How is the market for equities a role of the financial sector?
The market for equities is also an important part of the modern financial system, by which firms can obtain funds through the stock market for their investment plans. The whole business of insurance and pension funds is based on the existence of stock markets. This allows investors to buy a stake in businesses that they see as offering the potential for future profits.
How is the the financial sector in emerging and developing countries a role of the financial sector?
Developing countries face particular problems in relation to the financial sector. Formal financial institutions are less well equipped to provide financial services. Stock markets may not exist, or may not function effectively. The provision of banking services to rural areas is fraught with difficulties. The banks are not readily able to assess the credit- worthiness of potential borrowers. There is a situation of asymmetric information here, as the borrowers have much better information about the riskiness of proposed projects than the banks can obtain, so are likely to be charged high interest rates. Property rights may be weak, so that borrowers cannot provide collateral that the banks would accept. This forces borrowers into the informal market, where local moneylenders have monopoly power and can charge exorbitant rates of interest.
How does saving and investment work?
For developing and emerging economies, a high priority is to enable economic growth to take place. Resources are needed to tackle poverty and provide the physical and social infrastructure required for human development. One way of viewing economic growth is as a shift in aggregate supply. This suggests that the focus must be on investment, which is necessary to enable an increase in productive capacity. If investment is to take place, then saving is also necessary in order to provide the finance for investment.
Furthermore, a country in which there are high levels of poverty, and in which many households face low income-earning opportunities, needs to devote much of its resources to consumption. The question for developing countries is, therefore, how to overcome this problem in order to kick- start a process of economic growth. A shortage of capital means low per capita income, which means low savings, which in turn means low investment, limited capital, and hence low per capita incomes. In this way a country can get trapped in a low-level equilibrium situation.
For both developed and developing countries, the potential productive capacity of the economy depends fundamentally on two things: the quantity of factors of production available within the economy, and the efficiency with which they are utilised. By increasing the quantity and/or quality of the factors of production and their productivity, the aggregate supply curve can be shifted to the right.
For the developing countries, the problem is magnified because of lack of resources. In many cases, human capital is low, and there are limited resources to devote to education, training and improving health. Capital tends to be scarce, and the flows of foreign direct investment (FDI) - especially to the poorest countries - are relatively low. Markets do not operate effectively to allocate resources efficiently. There are therefore many obstacles to be overcome in seeking to promote growth and development.
What is the Harrod-Domar model?
A model of economic growth that emphasises the importance of saving and investment.
Saving -> Investment -> Capital accumulation -> Output and income
(then goes back to saving and cycle repeats)
What is the foreign exchange gap?
A situation in which a developing country is unable to import the goods that it needs for development because of a shortage of foreign exchange
What is capital flight?
A situation in which savings generated in a developing country are invested abroad
How does the Harrod-Domar model work?
It was developed in an attempt to determine how equilibrium could be achieved in a growing economy.
The basic finding of the model was that an economy can remain in equilibrium through time only if it grows at a particular rate. This unique stable growth path depends on the savings ratio and the productivity of capital. Any deviation from this path will cause the economy to become unstable. This finding emphasised the importance of savings in the process of economic growth, and led to the conclusion that a country seeking economic growth must first increase its flow of savings.
The cycle illustrates the process that leads to growth in a Harrod-Domar world. Savings are crucial in enabling investment to be undertaken - always remembering that some investment will have to be used to replace existing capital that has worn out. Investment then enables capital to accumulate and technology to be improved. The accumulation of capital leads to an increase in output and incomes, which leads to a further flow of savings, and the cycle begins again. This figure highlights a number of problems that may prevent the Harrod-Domar process from being effective for developing countries.
Generating a flow of savings in a developing country may be problematic. When incomes are low, households may have to devote most of their resources to consumption, and so there may be a lack of savings.
Even if a flow of savings can be generated, it is then important to transform the savings into investment. This is the process by which the sacrifice of current consumption leads to an increase in productive capacity in the future. However, in many developing countries financial markets are undeveloped, so it is much more difficult for funds to be recycled into investment.
A further prerequisite for savings to be converted into investment is that there must be entrepreneurs with the ability to identify investment possibilities, the skill to carry them through and the willingness to bear the risk. Such entrepreneurs are in limited supply in many developing countries.
For investment to be productive in terms of raising output and incomes in the economy, it is crucial for firms to have access to physical capital, which will raise production capacity. Given their limited capability of producing capital goods, many developing countries have to rely on capital imported from the more developed countries. This may be beneficial in terms of upgrading home technology, but such equipment can be imported only if the country has access to the foreign currency to pay for it. One of the most pressing problems for many countries is that they face a foreign exchange gap - in other words, they find it difficult to earn sufficient foreign exchange with which to obtain imports of capital and other inputs, required in order to allow manufacturing activity to expand. In order to do this, physical capital is needed, together with key inputs to the production process. Indeed, many developing countries need to import food and medical supplies in order to develop their human capital. Human capital, in the form of skilled, healthy and well- trained workers, is as important as physical capital if investment is to be productive. A shortage of foreign exchange may therefore make it difficult for the country to accumulate capital.
Another problem in mobilising savings generated domestically is that potential investors may perceive that they can get a higher return by investing in foreign companies abroad rather than domestically. This process is known as capital flight. It may be reinforced if the country has encouraged FDI by multinational corporations (MNCs). These companies may attract funds from domestic investors. Furthermore, the capital flight may often be augmented when MNCs repatriate their profits to overseas shareholders.
In principle, it might be thought that today’s developing and emerging economies have an advantage over the countries that developed in earlier periods. In particular, they can learn from earlier mistakes, and import technology that has already been developed, rather than having to develop it anew. This suggests that a convergence process should be going on, whereby countries are able to adopt technology that has already been produced, and thereby grow more rapidly and begin to close the gap with the more developed countries.
However, by and large this has not been happening for those countries that remain under-developed, and a lack of human capital has been suggested as one of the key reasons for the failure. This underlines the importance of education in laying the foundations for economic growth as well as contributing directly to the quality of life.
How is external resources incorporated into the Harrod-Domar model?
Saving - Aid, borrowing
Investment - Foreign direct investment
Output and income - Profits, tied aid, debt
First, it might be possible to attract flows of overseas assistance from higher-income countries. Second, perhaps the amount of investment could be augmented directly by persuading MNCs to engage in FDI. Third, the developing country might be able to borrow on international capital markets to finance its domestic investment.
It is worth noting that each of these ways of attracting external resources has a downside associated with it. As far as overseas assistance is concerned, in the past such flows have been seen by some donor countries as part of trade policy, and have brought less benefit to developing countries than had been hoped. In the case of the MNCs, there is a tendency for the profits to be repatriated out of the country, rather than recycled into the economy. Finally, international borrowing has to be repaid at some future date, and many developing countries have found themselves burdened by debt that they can ill afford to repay. This became a major problem to the extent that the World Bank launched the Heavily Indebted Poor Countries (HIPC) Initiative to tackle unsustainable debt through debt forgiveness. Debt levels became more manageable during the 2000s.
What is microfinance?
Schemes that provide finance for small-scale projects in developing countries.
How does microfinance work?
For many developing countries, a particular problem has been the provision of finance for small (but important) projects in rural areas. Where a large portion of the population live in the rural areas, the difficulty of raising funds for investment has been an impediment to improving agricultural productivity - in spite of the significance of this sector in many developing countries.
There are elements of market failure in rural credit markets. In particular, there is an information failure. In the absence of branch banking, people in the rural areas do not have access to the formal financial sector. The commercial banks based in the urban areas do not have the information needed to be able to assess loan applications for rural projects. Furthermore, property rights are not secure, so it may be difficult to provide collateral against loans, when ownership of land cannot be proved.
This means that many people in the rural areas are forced to depend upon informal markets for credit, borrowing from local moneylenders or merchants at high, sometimes punitive, interest rates. The rates of interest in the informal sector tend to be much higher than are available in the formal sector, partly because of the risk premium, with it being difficult to assess the probability of default. In addition, local moneylenders may have monopoly power, as people in a village may not be able to access other sources of finance.
Attempts have been made to remedy this situation through microfinance schemes. This approach was pioneered by the Grameen Bank, which was founded in Bangladesh in 1976. The bank made small- scale loans to groups of women who otherwise would have had no access to credit, and each group was made corporately responsible for paying back the loan. The scheme has claimed great success, both in terms of the constructive use of the funds in getting small-scale projects off the ground and in terms of high pay-back rates.
How successful has the microfinance movement been? The Grameen Bank has provided finance to many people in many parts of the world. Attempts to replicate the Grameen model have also had some success, but in many cases have struggled to be sustainable in funding terms, needing support from governments or non-governmental organisations (NGOs). It has been argued that some banks operating on the Grameen model have had to rely on substantial subsidies to remain viable.
What did The Grameen Bank do?
In 1974, a severe famine afflicted Bangladesh, and a flood of starving people converged on the capital city, Dhaka. Muhammad Yunus was an economics professor at Chittagong University. He tells how he was struck by the extreme contrast between the neat and abstract economic theories that he was teaching, and the plight of those surviving in bare poverty, or suffering and dying in the famine.
He also tells how he decided to study the problem at first hand, taking his students on field trips into villages near to the campus. On one of these visits they interviewed a woman who was struggling to earn a living by making bamboo stools. For each stool that she made, she had to borrow the equivalent of 15p for the raw materials. Once she had paid back the loan, at interest rates of up to 10% per week, her profit margin was just 1p. The woman was never able to escape from her situation because she was trapped by the need to borrow, and the need to pay back at such punitive rates of interest. Her story was by no means unique, and Yunus was keen to find a way of enabling women like her to have access to credit on conditions that would allow them to escape from poverty. He began experimenting by lending out some of his own money to groups in need.
Muhammad Yunus launched the Grameen Bank experiment in 1976. The idea was to provide credit for small-scale income-generating activities. Loans would be provided without the need for collateral, with borrowers being required to form themselves into groups of five with joint responsibility for the repayments. The acceptance of this joint responsibility and the lack of collateral helped to minimise the transaction costs of making and monitoring the loans.
On any criteria, the project proved an enormous success. The repayment record has been impressive, although the Grameen Bank charges interest rates close to those in the formal commercial sector, which are much lower than those of the informal moneylenders. Since the initial launch of the bank, lending has been channelled primarily to women borrowers, who are seen to invest more carefully and to repay more reliably - and to be most in need.
After 20 years of operation, more than $2.4 billion had been loaned by Grameen Bank, including more than 2 million loans for milch cows, nearly 100,000 for rickshaws, 57,000 for sewing machines and many more for processing, agriculture, trading, shop keeping, peddling and other activities. By mid-2015, $17.3 billion had been disbursed, and by the end of 2017, Grameen had 8.93 million borrowers, 97% of whom were women. The Bank covered more than 97% of villages in Bangladesh.
As for the impact of Grameen loans in economic terms, the loans are seen to have generated new employment, to have reduced the number of days workers are inactive, and to have raised income, food consumption and living conditions of Grameen Bank members - not to mention their social impact on the lives of millions of women.
What is the evaluation of the financial sector in development?
The Harrod-Domar approach suggests that saving and investment are crucial ingredients for a strategy to promote economic growth and human development. If funds cannot be raised domestically, then an injection of funds from abroad will be necessary, in the form of FDI, overseas assistance or borrowing on international financial markets.
Whichever approach is adopted, the financial sector is vital as a way of channelling the resources to where they are needed. This needs to be accomplished in a way that addresses areas of market failure. Rural credit markets may need specific attention, but funds also need to be provided for improvements in physical and social infrastructure that will then enable markets to operate effectively. In other words, funds are needed for physical infrastructure such as road and communication links, market facilities and so on. In addition, it is important to be able to invest in human capital, by providing education and healthcare and ensuring adequate nutrition for the population.
All this is challenging for developing countries with limited resources. Where the financial sector has been able to work effectively, countries have been able to show progress on many fronts. This has been evident in the emerging economies. The economies that entered a period of rapid growth in the 1960s found ways of mobilising funds. For example, both Korea and Singapore laid the foundations for rapid growth by finding ways of encouraging saving, the funds from which were then channelled into productive investment and infrastructure. More recently, China’s success in mobilising FDI has been one of the key factors in enabling growth.
In sub-Saharan Africa, economic growth has been more elusive. Financial markets have not developed to the same extent as in East Asia, nor have stock markets flourished. Such funds as have been generated - for example, through overseas assistance or international borrowing - have not always been used effectively.
However, there are some encouraging signs for countries in sub- Saharan Africa. Some countries were able to maintain some momentum of growth through the period of global recession, and have made progress in alleviating poverty (although there is still a long way to go).
Some progress has also been made in the financial sector, from what may be a surprising source. The use of mobile phones has expanded in many African countries. This has given people in rural areas access to market information, so that they can make better judgements about what is a fair price for their produce. Mobile phone technology has also provided a way of handling transactions previously denied because of lack of access to the formal financial sector. This is in spite of the fact that relatively few people may own their own mobile phones. Entrepreneurs in some villages make a living from renting out their mobile phones or undertaking transactions.
However, to what extent is the relative performance of emerging and less developed countries due to differences in the performance of the financial sector? The emerging economies had other factors working in their favour. The East Asian economies that developed in the 1960s and 1970s all had good social infrastructure to begin with, in the form of education and healthcare sectors that provided the foundations for developing human resources. They also developed in a period that favoured world trade, and when some of the advanced economies were moving towards a service orientation, leaving gaps for newly industrialising nations to fill. In the later wave, China had vast resources and a plentiful supply of labour to be mobilised. It was also able to channel funds into investment and maintain the competitiveness of its exports.
On this basis, the evidence seems to suggest that an effective financial sector is a necessary condition for economic growth and human development to take place, as it enables funds to be channelled to where they are needed. However, it may not be a sufficient condition to guarantee that success will be achieved.
