Lecture 15: Capital Formation and Financial System

Thirlwall, Chapter 14.

Todaro, Ch 15, (sections 15.1 and 15.4)
Abiad, A., Oomes, N. and Ueda, K. (2008), The quality effect: Does financial
liberalization improve the allocation of capital?, Journal of Development
Economics 87, pp270282.
Demirg-Kunt, A. and Detragiache, E. (1998), Financial Liberalization and Financial
Fragility, Annual World Bank Conference on Development Economics,
Washington.
Fry, M. J. (1997), In Favour of Financial Liberalisation, The Economic Journal, Vol.
107 (May) pp.754-70.
Huang, Y. and Wang, X. (2010), Does Financial Repression Inhibit or Facilitate
Economic Growth? A Case Study of Chinese Reform Experience, Oxford
Bulletin of Economics and Statistics, 73, pp833-855.
Stiglitz J. and Uy M., (1996) Financial markets, public policy, and the East Asian
miracle, The World Bank Research Observer, Vol. 11, No. 2, pp. 249-276.
Stiglitz, J. and Weiss, A. (1981), Credit Rationing in markets with Imperfect
Information, American Economic Review, vol. 71, pp. 393-410.

Extra reading:
Loayza, N. and Rancire, R. (2006), Financial Development, Financial Fragility, and
Growth, Journal of Money, Credit and Banking, Vol. 38, No. 4
Schmidt Hebbel, K. L.Serven and A.Solimano, (1996), "Saving and investment:
paradigms, puzzles, policies", World Bank Research Observer, vol. 11 (1).
Stiglitz J. (2001), Principles of financial regulations: A dynamic portfolio approach,
The World Bank Research Observer, Vol 16 (1), pp 1-18.
Williamson, J. and Mahar, M., (1998), A survey of financial liberalization, Essays in
International Finance, No. 211, Princeton University.

Factors that affect investment/capital formation:

Monetary policy restrictive monetary policy reduces investment, in repressed

economy credit policy affects investment;

Fiscal policy high fiscal deficit reduces availability of credit and investment
(crowding-out effect), pushes up r/i, but reduction in fiscal deficit by lowering
capital expenditure also reduces private investment (crowding-in effect). Fiscal
deficit debt affects future investment (Ricardian equivalence)

Output growth accelerator model

Exchange rate devaluation encourages export and investment in those sectors,

but investment in non-tradable sector may fall. Net gain is uncertain.

Irreversibility delays investment decision

Uncertainty affects the rate of return on investment.

Capital market narrow and fragmented in LDCs.

Two features of financial system in developing countries:

1. Existence of informal financial sector
2. Repression in formal financial sector distortions of financial prices via
administered ceiling on interest rates leading to credit rationing, govt
monopoly over banking system including barriers to entry, high reserve
requirement for private banks, compulsory lending to the government and
priority sectors.
Real Interest rate

r2

r*

r1
A

I
I1

I*

I2

Savings and investment

 If deposit rate ceiling at r1 and no ceiling on lending rate then lending rate will
be at r2, savings and investment at I1, large spread and profit for banks.
If both at r1, excess demand and credit rationing, financing less risky projects
with lower rates of return, hence overall low productivity of investment.
Produces bias in favour of current consumption, capital intensive projects.
Potential lender becomes direct investor in low-yielding projects.
Overall repression reduces economic efficiency, but might enable the
authorities to deal with problems of market failures and financial risks.

Country experience shows:

In East Asia moderate financial repression in the form of financial restraints
and directed credit to priority areas to support industrial policy or social
objectives, are all meant to remedy market failures.
In China repressive policies helped economic growth in the 1980s and the
1990s, but the impact turned negative during the past decade.
Domestic Financial liberalisation (a solution to repression)
assumes perfect competition and complete information. Therefore, increases
efficiency of investment and by screening of investment projects through market
based interest rate, reducing self-investment at low and even negative rate of
return;
improves the efficiency of resource allocation by easing credit constraint,
particularly working capital, and thereby reduce the gap between actual and
potential output.
allows to keep positive interest rate and eliminates interest ceiling and mandated
credit allocation;
encourages savings at high/positive interest rate and reduces constraint on capital
accumulation and improves allocative efficiency of investment by transferring
capital from less productive to more productive sectors;