John W. Lowe
Economists have been rapidly increasing their theoretical knowledge of the evolution of financial markets. At the same time, development organizations and developing countries have been giving greater attention to analyzing and proposing structural improvements in financial markets. This article attempts to summarize what has been happening recently in this field. First, a review is made of the methods by which financial markets are being studied and analyzed. Second, some representative issues concerning their operation are considered. Finally, some pressing current problems, such as inflation and trade and investment controls, are examined in relation to policies directed toward financial markets.
For the purpose of this article, “financial market” refers to the marketplace for both short-term instruments (for example, commercial bank deposits and loans and, by extension, the banking system) and long-term instruments (such as bonds, mortgage loans, and equities).
A first question is why financial markets are studied at all. In traditional economic theory the financial sector is neutral. Real resources are assumed to flow through it toward productive sectors of the economy according to the returns available in those sectors. Keynes was among the first to call attention to the importance of the financial sector by relating equilibrium in the bond and money markets to general equilibrium in the economy as a whole. The “new” economics of the neoclassicists and quantity theorists also gives considerable attention to the financial sector. However, all these approaches tend to be very general, or highly aggregative. None is an adequate framework for detailed inquiry into the relationship between the evolution of financial markets—especially imperfect or underdeveloped ones—and economic growth. Only recently have economists been studying this relationship closely and, in particular, inquiring how policies directed toward the financial sector can be used to achieve development objectives.
Can financial markets be discussed in general terms, when each market reflects unique historical and institutional factors? Application of theory must take into account the particular features of each economy. Nonetheless, the “theory” of financial market development can yield interesting insights in general terms. It is with developments at this level that this article is concerned.
The pioneering study of comparative financial market development worldwide was Raymond W. Goldsmith’s Financial Structure and Development (New Haven: Yale University Press, 1969). Goldsmith showed that a consistently observable feature of economic development among market economies was an increase in the number and variety of financial institutions, together with a substantial rise in the proportion of both money and the total value of all financial assets relative to the gross national product (GNP) and tangible wealth. This process we define as “development” of financial markets. Among other indicators, Goldsmith developed the concept of a “financial interrelation ratio” as a measure of the extent of financial development.
At about the same time as Goldsmith’s work, a separate approach to financial market analysis had been developed by the use of flow-of-funds accounts. The foundations of flow-of-funds analysis as a system of national accounting was Morris A. Copeland’s A Study of Moneyflows in the United States (New York: National Bureau of Economic Research, 1952). In the same year, the U.S. Federal Reserve System first began to publish data on flow of funds in the United States. Much more recently, flow-of-funds accounts have been assembled for a number of developing countries. In one respect these accounts may be thought of as input-output tables for the financial sector. Flow-of-funds accounts show changes in balance-sheet items among the financial sector; they provide a map of where financial resources move in an economy. They do not identify how (nor, of course, why) resources wind up where they do, but, as an analytical tool, they have greatly advanced financial sector analysis.
Parallel with the work of Goldsmith and the development of flow-of-funds studies in providing a data framework, a number of theoretical studies have attempted to detail the cause-and-effect relationship between the observed increases in financial instruments in developing countries and the development process. Many of these are based on the increased efficiency of the savings-investment process made possible by development of the financial sector. In the barter economy, self-finance predominates. This limits the extent to which savings can be channeled to the projects of greatest economic value to the national economy. Limits to the amount of resources that can be accumulated by any one saver (or group of savers) prevent economies of scale as well as the development of more advanced (e.g., corporate) forms of organization. The development of a smoothly functioning savings and credit system, in the form of a banking system and its institutional adjuncts, to collect and channel savings to productive uses can be shown on the basis of these kinds of arguments to be an important part of the process by which a developing economy grows.
Undoubtedly the names most associated with theoretical work in this area are those of John G. Gurley and Edward S. Shaw. Gurley and Shaw’s major work is Money in a Theory of Finance (Washington: The Brookings Institution, 1960). Shaw subsequently adapted the approach of this book, which is a general model, specifically to the context of developing economies in Financial Deepening in Economic Development (New York: Oxford University Press, 1973).
Studies of financial policies
Of particular importance to developing countries is the impact of policies toward financial markets on the achievement of various development objectives. Much practical research has focused on these issues. For example, considerable study has been given to the difficult question of the extent to which development of a financial market is a direct stimulant to the level of private sector savings. This issue is of obvious importance because higher rates of savings are usually considered an essential factor in accelerating economic growth.
The evidence is not conclusive. All one can confidently state is that there is probably an indirect relationship. Taiwan during the 1950s and Korea during the late 1960s both adopted policies directed toward increasing the extent to which resources were attracted to and allocated by the financial sector. In both countries nominal interest rates on savings deposits were dramatically increased, and this succeeded in attracting a great volume of financial resources to the banking sector. However, total private sector savings (measured as a percentage of GNP at current prices) showed little immediate change. It appears that in the short run a great quantity of savings was simply transferred into financial savings from other nonfinancial forms of savings such as gold and hoardings. It is significant that in both countries, however, there were considerable increases in total private savings over the years after adoption of the new policies.
Similarly, aggregate private sector savings in Brazil in the 1960s seem to have been only indirectly responsive to policies directed toward stimulating the financial market there (see U Tun Wai and Hugh T. Patrick’s “Stock and Bond Issues and Capital Markets in Less Developed Countries,” IMF Staff Papers, July 1973). U Tun Wai has recently surveyed the relationship between the extent of financial intermediation and the growth of total national savings in some detail in a number of developing countries in Financial Intermediaries and National Savings in Developing Countries (New York: Praeger, 1972).
The result of interest rate repression is then, in effect, to encourage savers to revert to nonfinancial—and thus often nonproductive—forms of savings.
It does seem reasonable to conclude from this research that one advantage of an improved financial system is, at least, that the form of savings is improved. A considerable portion of tangible wealth in developing countries is commonly held as precious metals or other unproductive assets. If, for example, 10 per cent of total wealth were reallocated from nonproductive to productive forms as a result of increased financialization of the economy, this would—assuming a constant capital-output ratio—raise GNP by 10 per cent (assuming also, of course, that current consumption is reduced as productive investment is increased). This would be a one-shot increase in output, but a considerable one.
The effects of excessive controls, particularly over interest rates, on operations of the financial sector is another area of great current interest. Markets subject to excessive controls are often described as “repressed” because such controls typically impede development of the financial sector. As one example, governments often oblige savings-gathering institutions (particularly the commercial banking system) to acquire public securities at below-market rates. While this assures a flow of inexpensive funds to the public sector, banks pay correspondingly less to depositors when they hold low earning assets. The result of interest rate repression is then, in effect, to encourage savers to revert to nonfinancial—and thus often nonproductive—forms of savings.
It is not difficult to guess at the reason that government debt instruments are often priced at low yields. Payment of higher rates would seem arbitrarily to raise the cost of finance to the government. But increasing the yield on public sector debt so that the financial marketplace absorbs it voluntarily would result in higher yields to savers. The increased “cost” of higher interest yields on public sector securities can thus be seen to be only a form of transfer payment.
If public sector debt were priced at market rates, there would be several indirect economic “dividends.” A government would be less likely to underprice capital for its own investment projects; more efficient use of labor in the economy might result. A government might be less obliged to call upon the central bank as purchaser of its debt; this would at least diminish reliance on one form of inflationary finance. Finally, a more widespread acceptance of public sector bonds would make possible the effective use of “open market” operations as a means of controlling the money supply.
Interest rates and investment
One common issue is whether raising the interest rate structure—which might result, for example, from removing interest rate controls—would significantly discourage private sector investment. There is a strong contention by many economists that such policies may instead have the effect of reducing the cost of finance—at least to many important borrowers. This would follow if higher interest rates had the effect of integrating the rate structure of “unorganized” financial markets—typically characterized by very high rates which many borrowers are forced to pay —with the official financial market, in which rates are much lower as a result of regulated ceilings.
Low rates in the official sector result in the attraction of inadequate deposits. This requires that the authorities ration loan funds. In these circumstances large modern industry tends to have priority in access to finance over more traditional, labor-intensive industry. A merging of the controlled with the unorganized market into one freer market could provide cheaper finance to many important domestic borrowers now obliged to turn to the unorganized markets for funds. Conversely, large modern industry would have to pay more for capital. The net effect might well result in a more rational pricing of capital in the economy.
Ronald McKinnon has incisively summarized the situation prevailing in many developing economies where “repressed” financial markets prevail in Money and Capital in Economic Development (Washington: The Brookings Institution, 1973). McKinnon views money in the developing economy as a conduit that facilitates the accumulation of productive capital goods. This conclusion he derives in part from the fact that a greater quantity of average cash balances (for example, for working capital purposes) is required to finance large investments, and larger investments in many developing economies are needed to generate economies of scale. Since more money will be held economy-wide if the rate of return on savings is increased (this being one unequivocal result of the Taiwan/Korea experiences), and since a greater quantity of money holdings facilitates more productive investment in many developing economies, the productivity of physical capital under these assumptions should increase as a result of steps having the effect of increasing the demand for money. In this case a higher interest rate structure would encourage investment, not discourage it.
McKinnon argues for policies to permit the financial sector to compete freely for savers’ funds. This is the keystone to an overall strategy of liberalizing the functioning of domestic capital markets. By unraveling the tangle of restrictions typical in repressed financial markets, McKinnon argues that the financial sector can better perform its “classical” economic duty—the efficient channeling of resources. McKinnon’s work may not appeal to theoretical purists, but it must be regarded as a major bridge between neoclassical economic theory and practical development finance.
A final and very current issue is indexing. Indexing denotes correction of financial contracts to compensate for loss of purchasing power from inflation. A developed capital market, it is sometimes argued, should be able to adjust interest rates to accommodate expected rates of inflation, but in practice, particularly where inflation is high or volatile, this is very difficult. As a result it is frequently advocated that indexing can add an important degree of security to financial transactions and thereby promote development of the financial market.
Indexing has been used in various circumstances by a number of countries— among them France, Finland, and Israel. Among the developing countries, Brazil is most frequently associated with the successful use of indexed instruments. Indexing in Brazil based on a general price-level indicator followed a widespread de facto indexing system of discounting private sector inland bills of exchange (letras de câmbio) to allow for inflation. As a result of the popularity of the discounted bills of exchange, in 1964 the Brazilian Government introduced officially indexed Treasury bills, which gained wide popularity. The rationalization of financial instruments that started with this step has been viewed by many as the beginning of the renaissance of the financial sector in Brazil.
The administration of an indexed system need not be excessively difficult. The main arguments against indexing are not technical so much as practical and political. If a government is, willingly or otherwise, engaged in inflationary expansion of the money supply, indexing will accelerate the rate of inflation. This follows because one effect of inflation is to pass real resources from the holders of money to the first user of money freshly injected into the monetary system—primarily, the government. (In this sense, inflation can be considered a form of taxation.) If a government wishes to maintain a constant rate of transfer of real resources in its favor as a result of excessive expansion of the money supply and introduces indexing, then, because indexation increases the speed of the price-adjustment process, the rate of increase of inflation is likely to increase as a result of indexation. To stop this process, the government would have to restrain excess demand in the economy. If excess demand is the result of its own spending, then a government would have to restrain its own spending. But reversing this situation would arrest a major source of inflation to begin with.
Just as indexing accelerates the pace of inflation in an economy where there is excess demand, indexing accelerates the rate of reduction of inflation in an economy where there is excess supply. While this situation is not the common one, the point does emphasize that indexing itself is not a source of inflation; it merely has the theoretical effect of intensifying (positively or negatively) the rate of inflation where an imbalance in demand or supply exists.
Probably a lot of real-world weight is given to the old saw that indexing permits a government to escape from its responsibility to maintain the value of the currency. Psychological resistance against indexing can be an important consideration. George Meany, a major figure in the U.S. labor movement, when presented with the idea of indexing wage claims, is reported to have rejected the idea outright, replying, “Workers don’t want to lose their faith in the dollar.”
Effect of inflation
The ability of financial markets to function smoothly in practical terms can be severely impaired by the effect of inflation. By reducing the real return on financial instruments in markets where nominal rates are controlled (or slow to adjust), inflation can contribute significantly to the process of repressing financial markets.
It has long been generally considered that as long as inflation is slow enough not to seriously disturb general confidence, a “little” inflation can be helpful; its effects are primarily to redistribute incomes rather than to produce significant misallocations of resources. A mildly increasing price level can give a fillip to investment by increasing prospective earnings to entrepreneurs. An upward movement of wages and prices can also help to draw labor out of subsistence sectors into developing sectors of an economy.
But there is a limit to the degree to which growth can be stimulated by inflationary policies. There is a point beyond which sufficiently inflationary prospects begin to deter confidence, and investment declines. One issue that has often been raised is to what extent development can be financed by monetary expansion without inflation. The technical answer to this question is “to the limit set by the growth of demand for money consequent on the expected growth of the economy at stable prices, plus the growth of demand for money associated with the monetization of the subsistence sector, minus the portion of the growth in the money supply that must be created against private debt” (Harry G. Johnson, “Is Inflation the Inevitable Price of Rapid Development or a Retarding Factor in Economic Growth?” Malayan Economic Review, Vol. 11, April 1966, p. 25). Beyond the technical considerations, however, there are more complex—even psychological—forces involved in a complete analysis of the dynamics of the inflationary process in a growing economy.
One difficult aspect of the analysis of current inflationary pressures is the extent to which inflation is transmitted from one country to another. Our concern here is primarily with domestic financial policies, but a brief mention of these complex international problems is in order. In an “open” or trading economy, inflation tends to introduce a progressive movement toward overvaluation of the exchange rate, balance of payments problems, and resort to increasing trade protectionism. This in turn diverts resources away from export industries toward (typically higher-cost) import substitution industries, and considerable economic inefficiencies result.
Trade and investment controls
Trade distortions are not unrelated to the causes and features of repressed domestic financial sectors. McKinnon for one has argued persuasively that to correct one set of distortions—repression of the financial sector—is to go a long way toward correcting the other, trade distortions.
For example, in developing countries new industries are often protected on the basis of the “infant industry” argument. An adequate independent capital market, however, should be able to discount losses that an investment might incur in its early years. If it is desirable to retain some form of subsidy for priority projects (where the economic rate of return exceeds the financial return), subsidies in direct form are generally much more efficient than indirect ones—which in the case of investment promotion are commonly in the form of tariff subsidies.
Experience in the developed countries seems to confirm that a consistent set of liberalized policies towards operations of the financial market is much more desirable in the long run.
Indirect subsidies tend to generate distortions in resource allocation throughout the economy. A program of simplified investment subsidies can thus be seen to be a natural complement to a program of liberalized control over financial markets.
There are many similar examples. Importers of capital goods in developing countries must frequently secure a license. However, if capital were priced in a free financial market, as it would be were interest rate and exchange rate controls relaxed, the rationing of capital goods by a licensing procedure would not be necessary. The marketplace would do it as a matter of course.
If changes in the terms of trade of a major export commodity affect the profitability of certain sectors of the economy, a liberalized financial sector can also ease the process of adjustment to the new international price structure. An independent financial sector, in other words, can increase the flexibility of an economy to adjust externally as well as internally.
After all but implying that a liberalized domestic financial policy is the solution to all development problems, a concluding note of restraint. It need hardly be said that countless other factors are essential to accelerating the development process. One closely related area of policy, fiscal policy, is of particular importance in this context. The detrimental effects on financial markets of large fiscal deficits, for example, may override in importance many of the issues raised in this article. On the other hand, if the financing of fiscal deficits is carefully managed by the appropriate authorities, it should be possible for deficits to be incurred without putting undue strain on an independent financial market.
The issuance of large amounts of public debt domestically tends to drive interest rates up. Skillful debt management is necessary to avoid driving interest rates abnormally high under such circumstances without resort to compulsory investment procedures. While the weight of macro-economic theory shows that interest rates left free to adjust to changes in real or monetary sectors of the economy result in smaller swings in aggregate output than will occur if rates are controlled; nonetheless, abrupt short-term changes in interest rates can create a number of practical adjustment problems. This specific concern has deterred several countries, otherwise sympathetic to the arguments for generally liberalizing policies toward their financial markets, from freeing up their markets for public debt.
The rationale behind liberalizing the financial market remains one with an increasing number of advocates in both academic and professional circles, however, even if its implementation is not always simple. It seems to be a matter, as much macroeconomic policy is, of minimizing short-run costs for the benefit of longer-run gains. Such decisions are none the easier because they require economic planners to lessen their short-run control over some policy instruments.
Experience in the developed countries seems to confirm that a consistent set of liberalized policies toward operations of the financial market is much more desirable in the long run than are specific controls that attempt to regulate the market directly. The necessary changes may be implemented gradually or, as has notably occurred in Taiwan, Korea, and Brazil, much more dramatically. To repeat a note on which we began, in each country the institutional specifics are unique, and the techniques of financial market development must be tailored accordingly.
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