PhD lecture series | Ewa Karwowski, Lecturer in Economics | 17 June 2015 Finance, financialisation...

PhD lecture series | Ewa Karwowski, Lecturer in Economics | 17 June 2015

Finance, financialisation and development


Lecture OverviewWhat is development?

• Schumpeter’s Theory of Economic Development • Two-gap model• Harrod-Domar model & development policy

Development & finance

• Old development economics & finance• Financial repression hypothesis• Heterodox economics & finance

Some empirics

• Financial deepening in Africa…• …and why it does not support structural transformation


What is development?

Old development economics (Lewis, structuralists etc.):

Fundamental difference between growth & development. Structural transformation is needed not just

growth (manufacturing, technology etc.) E.g. dual sector models

This view is also shared by another eminent economist: Joseph Schumpeter

Growth is doing more of the same thing.

What countries need is development!

For Schumpeter, development is innovation: new ‘combinations’!


What is development? – Old DevEcon

Arthur Lewis, LA structuralists, Albert Hirschman etc.

Lewis (Economic development with unlimited supplies of labour, 1954):

‘The central problem in the theory of economic development is to understand the process by which a community which was previously saving and investing 4 or 5 per cent of its national income or less, converts itself into an economy where voluntary saving is running at about 12 to 15 per cent of its national income or more.’

≠ China’s gross saving rate: ca. 50% (World Bank, 2015)

Savings determine investment Lewis explicitly rejected Keynes’s ideas since labour, capital and land

are assumed to be in unlimited supply


Old DevEcon policy making: Two-gap model

National accounting identity without government:

Y = C + I + (X – M)

Another way to express it:

Y = C + S

Output (Y)Consumption (C)Investment (I)Exports (X)Imports (M)Saving (S)Bring them together:

C + S = C + I + (X – M)

(M – X) = (I – S)Foreign exchange gap

Savings gap

According to the two-gap model saving & foreign exchange are crucial impediments to growth.


Old DevEcon policy making: Harrod-Domar model

In many developing countries policy making was aimed at increasing saving rates.

Simple Harrod-Domar model: g = s/v

g: growth rate

s: saving rate

v: capital-output ratio (assumed fixed)

Interestingly: Harrod stressed the instability of growth!

Which variable should you look at if structural transformation is your aim?

Lewis (Economic development with unlimited supplies of labour, 1954):

‘This is the central problem because the central fact of economic development is rapid capital accumulation (including knowledge and skills with capital).’


Old DevEcon policy making: in practiceAfter WWII, many governments actively used finance for development purposes:

• Interest rate caps

• Subsidised loans

• Credit rationing

• Government ownership of banks

• Capital controls

Real interest rates were often negative (see Amsden on South Korea and Wade on Taiwan)


Mainstream answer: Financial repression

Shaw-McKinnon hypothesis (Shaw & Gurley, 1960, Shaw, 1973, McKinnon, 1973)

Low interest rate policies inhibit growth (and generate inefficient allocation) because people do not save.

Households do not hold bank deposits limited stock of money (M)

This inhibits investment & growth.

How? Lower investment than under a free-floating interest rate.

Inefficient allocation of resources (interest rate as price).

Reform? Private banking sector & financial liberalisation

free-floating interest rate

increased saving

high investment rates

Mechanism? Shaw: more efficient financial intermediation

McKinnon: more saving for investment


Financial repression & loanable funds theory

The financial repression argument is based on loanable funds theory.

Demand and supply of loanable funds (saving & credit) should determine interest rate (P) & credit volume (Q).

Price capping or rationing is inefficient according to mainstream theory.

It can result in ‘too much’ investment (McKinnon).

It is assumed that all saving transforms into investment ( Lewis model).

What happens if interest rate is capped?

icap shortage

Qcap


Financial repression & its critics

The financial repression hypothesis argued that interest rates were too low.

High interest rates larger savings more credit more growth

Two criticisms: Informal sector finance is absent (neo-structuralist argument):

Informal sector can intermediate more efficiently since no reserve requirement

Once again loanable funds framework Asymmetric information & risk (Stiglitz & Weiss, 1981):

Bank profit is not a linear function of interest rate Adverse selection Credit rationing by banks themselves Interest rates can be too high Still stuck with loanable funds


Where are we today?

Since 1990s, revival of the financial repression hypothesis & pushing for financial liberalisation:

King & Levine (1993), Levine (1997) financial depth predicts growth over subsequent decades

Beck et al. (2000)

finance increases total factor productivity impacting growth positively

Plus: asymmetric information & transaction costs

Banks exist because of transaction costs & for financial intermediation (Santomero, 1984)


Where are we today?

Functions of the financial system (Levine, 2005): Produce information & allocate capital Monitor investment & exert corporate governance Manage risk (especially important, Allen & Santomero, 2001) Pool saving Facilitate exchange of goods & services

Until recently, the believe that financial development will result in growth (King & Levine 1993, Levine 2005) was firmly held among mainstream economists.

Note the rhethoric: financial development

not economic development or financial growth


Financial repression & policy

The financial repression hypothesis was used to push for financial liberalisation as happened in East Asia (before the East Asian Currency and Financial Crisis).

Many economists criticised financial liberalisation (speed, sequencing, general rational) after the EA crisis (Hellman et al., 1997, Wade & Vernoso, 1998).

Liberalisation allowed for a Minsky-type shift from hedge to speculative financing (Arestis & Glickman 2002).


It needed a financial crisis in advanced economies

To reassess the impact of financial sector on growth:

• BIS paper (Cecchetti and K Kharroubi 2012): financial sector growth initially contributes to productivity growth, after a certain point (80-100% of credit to GDP) finance is bad for trend growth due to rising instability.

• IMF (2012): after a point larger effect of financial crash has a negative impact on growth: misallocation towards financial sector reduces growth in R&D-intensive industries.

• De la Torre et al. (2011): decreasing returns to finance and increasing cost of instability.

• Bezemer et al. (2014): the direction of finance is important. If growing financial sector simply feeds (unproductive) consumption/mortgage credit impact (on output & productivity) will be negative. If finance supports productive investment, impact will be positive.

• BIS paper (Cecchetti and K Kharroubi 2015): negative producticity impact as finance drains resources from other sectors


The heterodox view: How does finance relate to development?

Schumpeter: Finance (credit) is necessary for innovation

• Banks decide which new ‘combinations’ will be financed.

• Credit is available to all entrepreneurs endowed with entrepreneurial skills.

• Still influential today: entrepreneur training/skilled self-employment programmes as development policy

• Chris Blattman RCT in Ethiopia

Criticism of Schumpeter: The financial system is not a ‘democratic’ system.

Access to finance demands ownership of capital.

Only capitalists can be entrepreneurs (see Kalecki).

…of self-employment: we cannot all be micro entrepreneurs if structural transformation is the aim.


The heterodox view: What does PK theory tell us?

PK theory conflicts with much of old development economics

Main difficulty: savings-investment nexus Joan Robinson (1954): always take a country’s

institutions into account Vicky Chick (1992): The Evolution of the Banking System

and the Theory of Saving, Investment and Interest There are different stages in the development of a

financial system Loanable funds theory might be appropriate for the

very early stages Not appropriate with lender of last resort and steady

interest rate policy


Stages of banking system evolution


Stages of banking system evolution

This theoretical understanding reconciles old development economics and PK theory

Question: where does an individual developing country stand?


Financialisation in emerging economies

Since the 1970s/80s a change in the economic system in advanced economies has been observed:

• Increased importance of financial institutions (e.g. pension funds)

• Rising returns on financial investment (e.g. stock market bubbles)

• Growing size of financial sectors & profits

• Growing political influence of financial investors (e.g. rentiers) Signs of financialisation

Many different definitions of financialisation, most broadly (Epstein, 2005, p. 3):

Financialization refers to the increasing importance of financial markets, financial motives, financial institutions, and financial elites in the operation of the economy and its governing institutions, both at the national and international levels.


Financialisation in emerging economies

Financialisation & growth of financial markets might impact development negatively:

• Demir (2007, 2009): Negative impact of financial liberalisation on productive investment of non-financial firms in Argentina, Mexico, Turkey.

• Kalinowski & Cho (2009): “[T]he pressure from foreign and domestic financial investors led to costly efforts by Korean corporations to increase shareholder value and to defend themselves against possible hostile takeovers, which impeded productive investment.”

• Credit in some emerging economies (e.g. South Africa) is increasingly directed at households rather than non-financial firms.

• This potentially inflates real estate markets.

• Financialisation in emerging economies takes different forms than in advanced countries (financial libralisation, role of foreign banks, firms, households affected)

Questionable impact of finance on growth and financial stability.


Some empirics

Financial development will result in growth (King & Levine 1993, Levine 2005).

How?

Hypothesis 1: Saving will increase investment increases

rise in credit volume: Shaw 1973

rise in self-financed investment: McKinnon 1973

Hypothesis 2: Credit will be allocated better productivity increases

Hypothesis 1 doubtful: for SSA effect of financial liberalisation on financial development was negative (Hamid Rashid, UNDESA, 2013)


Analysing potential success storiesMore detailed and disaggregated country level data (Central Banks, national statistics agencies).

We have collected the data across a dozen countries which experienced fast financial deepening (Griffith-Jones & Karwowski, 2013):

Angola, Benin, Malawi, Mali, Niger, Nigeria, Sao Tome and Principe, Sierra Leone, Sudan, Swaziland, Tanzania and Uganda.

Development matters rather than growth: Hypothesis 2 of the McKinnon-Shaw story: more productive credit

Does private credit extension contribute towards development in countries that have experienced fast growth in credit volumes?


Analysing credit by sector Impact of credit varies depending on its use:

Impact on productivity (e.g. linkages, employment, knowledge/skills creation)

Manufacturing has stronger productivity impact (Kaldor, Amsden, Rodrik, Page)

Agro-processing also has productive potential…

…and high-skill services or tertiary sector activities providing infrastructure-related services (e.g. communication)

Household credit might support domestic demand, but raises issues of debt sustainability and might weaken the external balance


Productivity impact/transformative potential of credit by sector


The manufacturing share of credit has declined


Manufacturing credit as share of total credit


Tertiary sector credit


Results

Decreasing share in manufacturing credit in 10 out of the 12 SSA ‘success stories’

Most credit flows into the service sector

Especially into trade activity (very limited transformative potential)

Little evidence that private-sector credit is channelled to highly productive sectors

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PhD lecture series | Ewa Karwowski, Lecturer in Economics | 17 June 2015 Finance, financialisation...

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