Financial development

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 20th 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