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Financial development
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
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.)
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
M2/GDP, %, 1999, log scale
Financial development is correlated with
economic development: M2/GDP
1000
100
10
1
100
1000
10000
GDP PPP per capita, 1999, log scale
100000
Financial development is correlated with
economic development: Stock market/
GDP
Stock market cap / GDP, %, 1999, log scale
1000
100
10
1
100
1000
10000
0
GDP PPP per capita, 1999, log scale
100000
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
Firm size is below optimum
in non-OECD countries (Tybout, 2000)
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?
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)
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
Leading microcredit institutions
(Morduch, 1999)
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
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
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
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
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
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
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
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
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 coffeeproducing areas with stable rainfall where need for (groupbased) insurance is lower
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 nonfinancial 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
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
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