Chapter 15 Finance and Fiscal Policy for Development

Chapter 15 Finance and Fiscal Policy for Development

Finance and Fiscal Policy 1. Financial System 2. Tax Revenues 3. State Owned Enerprises 15-2

1. Financial System a) Role(s) of Financial System b) Central Banks c) Microfinance 15-3

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 15-4

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 15-5

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? 15-6

Figure 15.1 The Effects of Interest-Rate Ceilings on Credit Allocation 15-7

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 15-8

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 15-9

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) 15-10

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 15-11

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 15-12

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 15-13

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 15-14

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 15-15

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!!!!! 15-16

Table 15.2 Comparative Average Levels of Tax Revenue, 1985 1997, as a Percentage of GDP 15-17

Table 15.3 Comparative Composition of Tax Revenue, 1985 1997, as a Percentage of GDP 15-18

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? 15-19

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 15-20

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 15-21

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 15-22

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 15-23

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 15-24

Concepts for Review (cont d) Privatization Rationing Rotating savings and credit associations (ROSCA) State-owned enterprises (SOEs) Transparency (financial) Unorganized money market 15-25