Chapter 15 Finance and Fiscal Policy for · PDF fileFinance and Fiscal Policy for Development . ... The Role of the Financial System in Economic Development ... •Financial policy

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 15

Finance and Fiscal Policy for Development

Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 15-2

Finance and Fiscal Policy

1. Financial System

2. Tax Revenues

3. State Owned Enerprises


1. Financial System

a) Role(s) of Financial System

b) Central Banks

c) Microfinance


a) The Role of the Financial System in Economic Development

• Six major functions of the financial system

– Providing payment services

– Matching savers and investors

– Generating/distributing information

– Allocating credit efficiently

– Pricing, pooling, and trading risks

– Increasing asset liquidity

• US: Commercial Banks, Investment Banks, Stock and Bond Markets, “Angel” Funds


How DC Financial Systems are Different from Rich Countries’ • Smaller relative to GDP – many people

have little or no contact: not even account

• Poor rely on money lenders with high interest rates

• Fewer sources of Entrepreneurial funding: =>

– Banks do more risky lending

– “Development Banks” are common

– Rely on family funding => family empires

• Less/more regulatory apparatus


15.4 Reforming Financial Systems

• Investment is negatively related to borrowing costs, i.e. interest rates, so =>

• Keep interest rates low to promote growth

• Right?


Figure 15.1 The Effects of Interest-Rate Ceilings on Credit Allocation


15.4 Reforming Financial Systems

• Below market interest rate (often negative in real terms)=>

– Reduces saving and thus Investment (International capital flows notwithstanding)

– Rations loans to less risky (richer) borrowers

• Reform: Deregulate interest rates =>

– More Credit available to more people

– Chile: Problems when banks owned other industries, which failed


15.4 Reforming Financial Systems (cont’d)

• Financial policy and the role of the state

– Stiglitz: seven financial market failures:

• The “public good” nature of monitoring financial institutions

• Externalities of monitoring, selection, and lending

• Externalities of financial disruption

• Missing and incomplete markets


15.4 Reforming Financial Systems (cont’d)

• Financial policy and the role of the state

– Stiglitz: seven financial market failures (cont’d):

• Imperfect competition

• Inefficiency of competitive markets in the financial sector

• Uninformed investors

• Of course,

– Government owned banks fail too (China)

– Government regulation fails too (USA)


15.2 The Role of Central Banks and Alternative Arrangements

• Functions of a full-fledged central bank

– Issuer of currency and manager of foreign reserves

– Banker to the government

– Banker to domestic commercial banks

– Regulator of domestic financial institutions

– Operator of monetary and credit policy


Wide range of arrangements and performance in DCs • Often, chronic inflation, typically to finance

government spending > tax revenue

• Use

– Currency board

– Currency of another country (Ecuador)

– Cannot (de-)stabilize domestic economy


15.3 Informal Finance and the Rise of Microfinance

• Financial services to people with no access or only with very unfavorable terms.

• Includes microcredit, microsavings, and microinsurance

• Primary focus: Very small loans for microenterprises

• steadily increase when loans are repaid

• Other alternatives to joint liability


15.3 Informal Finance and the Rise of Microfinance

• Microcredit often uses group lending schemes (joint liability)

• Provides “collateral of peer pressure” to jointly repay

• An alternative without joint liability: “dynamic incentives,” in which loan sizes


Potential limitations of microfinance as a development strategy

• Does not reach the poorest

• Does not address other development issues

– Human capital

– Infrastructure

– Institutional Quality (“Good” government)

– Trade Policy

– SOEs

• Not a panacea


2. Fiscal Policy for Development

• Purpose:

• Finance government expenditures, many of which are “Investments” – Infrastructure

– Health and Education

• A Mix of Current Revenues and Borrowing is appropriate

• But Borrowing is only justified for productive Investments!!!!!


Table 15.2 Comparative Average Levels of Tax Revenue, 1985–1997, as a Percentage of GDP


Table 15.3 Comparative Composition of Tax Revenue, 1985–1997, as a Percentage of GDP


DC taxes in comparison with rich countries

• Lower, as a percentage of income

• More reliance on indirect taxes versus direct (income and property) taxes

• Why:

– Difficulty collecting direct taxes in subsistence rural economy and informal sector

– What taxes did US rely on in 1800?

– 1900?


3. State-Owned Enterprise and Privatization

• State-owned enterprises (SOEs)—corporations owned and operated by the government.

– 7-15% of GDP

– Banking, telephones, heavy industry (autos), ag marketing and inputs

– US?

• Why:

– Response to monopoly (esp foreign)

– Russia (apparently) succeeded


3. Problems with SOEs

• Lose money,

– 1-3% of GDP, year after year

– Loss to taxpayers and/or education/health

• Low levels of economic efficiency

– Low labor and capital productivity

– Less employment cuz excessive capital intensity

• Why:

– Politics (think US Post Office)

– Bureaucracy and Corruption


3. Privatization of SOEs: Results

• Greater efficiency and output (often)

• SOE assets “stolen” through corrupt privatization processes (Russia)

• Public monopoly replaced by private

• Inefficient SOEs laid off many workers (Poland)

• Mixed results on e.g. Municipal water supply


15.7 Public Administration: The Scarcest Resource

• Administrative capability is a scarce public resource in the developing world

• The administrative component of economic development should not be underestimated


Concepts for Review

• Central bank

• Commercialization

• Currency board

• Currency substitution

• Development banks

• Direct taxes

• Financial liberalization

• Financial repression

• Group lending schemes

• Indirect taxes

• Informal finance

• Microfinance

• Monetary policy

• Money supply

• Organized money markets


Concepts for Review (cont’d)

• Privatization

• Rationing

• Rotating savings and credit associations (ROSCA)

• State-owned enterprises (SOEs)

• Transparency (financial)

• Unorganized money market

Documents

Chapter 15 Finance and Fiscal Policy for · PDF fileFinance and Fiscal Policy for Development . ... The Role of the Financial System in Economic Development ... •Financial policy