Stabilization programs supported by use of Fund resources typically contain limitations on domestic credit expansion by the banking system. In many instances, the programs also include limits on foreign borrowing by the public sector which aim, on the one hand, at the prevention or alleviation of debt service difficulties and, on the other hand, at limiting the possibilities for the substitution of foreign financing for domestic credit. Through the combination of limitations on domestic and foreign credit, stabilization programs endeavor to contain overall credit expansion to a magnitude consistent with the balance of payments, growth, and price objectives. 1
In the formulation of financial programs, attention has been focused primarily on the aggregate demand effects of the financial variables and their implications for the balance of payments. In contrast, this paper is concerned with the analysis of the implications of credit policies on output and growth and how they relate to the development of the current account and overall balance of payments. The framework chosen for the analysis is one in which availability of financing is a direct and major determinant of current and future production. In particular, the paper addresses the following issues: (1) How do limits on domestic credit and on foreign borrowing affect current output and investment and, hence, future economic growth? (2) Are there differential effects associated with restricting foreign rather than domestic credit, and investment or working capital credit versus consumption credit? (3) Can an overly restrictive credit policy reduce current and future output so that over time the current account position will deteriorate rather than improve? (4) Finally, to what extent does it matter, for current account developments and debt servicing capacity of a country, whether credit expansion leads to supply responses in the traded goods sector (i.e., export sector or import substitution sector) as opposed to other sectors of the economy?
The paper identifies three channels through which credit policies can affect production in the economy: (1) the indirect link between credit and overall aggregate demand in a Keynesian setting of unused capacities and unemployment; (2) the direct link between working capital availability and current production; and (3) the link between credit, investment, and future production. Although closely related, (2) and (3) differ in the time horizon involved. After a brief review of the first link, the paper concentrates on an analysis of the second and third links, which have not received extensive treatment in balance of payments literature, although they have been explored recently in the context of growth, development, and stabilization efforts of closed economies. 2 The principal conclusions are as follows:
Limiting the overall level of credit is not a panacea for balance of payments problems; considerations regarding the distribution and the use of credit are important because of the impact on current and future production and, hence, the developments over time in the current account of the balance of payments.
Under a fixed exchange rate system, the origin of credit (i.e, whether from domestic or foreign sources) does not matter for the achievement of demand management objectives such as output, employment, and the current account, 3 but it is important for the overall balance of payments, that is, exchange reserve developments.
Under a flexible exchange rate system, domestic and foreign credit have different exchange rate effects, and, hence, the aggregate demand, production, and current account implications of a credit expansion depend in part on the origin of credit.
The current account objectives are best served by permitting credit expansion and investment to take place in the sector with the highest productivity, independent of whether this sector produces traded or nontraded goods; unless distortions prevail, and interest rates are held too low to fulfill their allocative function, this does not require deliberate policy measures, such as sectoral credit allocation.
Tight credit policies can lead to negative effects on current and future production and, hence, endanger the current account objectives when prevailing distortions lead to a “crowding out” of productive uses of credit. Reduction of price distortions and, particularly, the adoption of appropriate exchange rate and interest rate policies must, therefore, be part of any program that contains limitations on credit.
APPENDIX; The Model
A very simple and abstract theoretical model of an open economy characterized by the presence of financial repression is developed in this section. The salient features of this model are that current and future production levels are linked directly to the volume of financial intermediation through the domestic banking system and to the availability of foreign financing.
First, it is assumed that the economy produces and trades in one composite good.15 This assumption is relaxed later, when output is disaggregated into traded and nontraded goods. For convenience and without loss of generality, units are defined so that both the price level and the exchange rate are equal to unity.
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)| false “ Galbis, Vicente, Financial Intermediation and Economic Growth in Less Developed Countries: A Theoretical Approach,” Journal of Development Studies, Vol. 13( January 1977), pp. 58– 72; reproduced in Finance in Developing Countries, ed. by ( P. C. I. Ayre London, 1977), pp. 58– 91.
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Mr. Keller, economist in the External Finance Division of the Exchange and Trade Relations Department, is a graduate of the University of Würzburg, Germany, and the University of Rochester, New York.
Compare, for example, the theoretical treatment by Friedman (1959 and 1969), Sidraquski (1967), Levhari and Patinkin (1968), Nadiri (1969), Bailey (1971), Brunner and Meltzer (1971), Mundell (1971), Dornbusch and Frenkel (1973), McKinnon (1973), Kapur (1976), and others. Of particular interest is Levhari’s and Patinkin’s (1968) criticism of Tobin (1965) for omitting in his growth model the role of real money balances as productive input. Empirical attempts by Sinai and Stokes (1972) to estimate the role of real money balances for production also sparked a heated debate. See, for example, the criticism by Ben Zion and Ruttan (1975), Khan and Kouri (1975), Prais (1975 a and 1975 b), Niccoli (1975), and others, and the rejoinder by Sinai and Stokes (1975).
Except to the extent that recourse to foreign borrowing enables a country to mobilize real foreign resources by financing a current account deficit that perhaps could not have been financed out of existing foreign exchange reserves.
The argument is, therefore, in a wider sense, akin to what Moroney (1972) terms the Austrian view of financial working capital as a fund from which advances are made to real factor inputs, including labor.
As discussed below, the balance of payments implications are quite different in the case of a permanent rather than transitory inventory build-up.
This is not to say that, as seen from an individual firm, there exists no scope for internal substitution between categories of credit.
This analysis applies also to the case of a permanent increase in inventory investment.
As pointed out above, for the purposes of this investigation we abstract from the possibility that adding to aggregate demand per se will increase output. This assumption is not as restrictive as it may appear, since, in the typical country with a current account problem, insufficient levels of domestic demand are not the problem.
With profitability appropriately assessed relative to increased interest cost of foreign borrowing to the economy rather than relative to domestic interest rates.
If, however, the increase in working capital was used to finance permanent increases in inventories of intermediate or final goods, this would not be the case, and the inventory build-up, just as with fixed capital formation, would lead to an initial excess of absorption over production and the current account would deteriorate.
Few programs contain limitations on private foreign borrowing.
It remains an empirical question whether financial programs supported by the use of Fund resources have resulted in relatively or absolutely faster real growth of private sector credit from domestic and foreign sources or, to use McKinnon’s (1973) terminology, whether a significant reduction of financial repression was achieved by limiting the crowding-out effect of financing excessive government expenditures.
This assumption does not imply that there is only one good produced, traded, and consumed in the economy, but that constant relative prices permit the aggregation of the various goods into one composite commodity.
It is assumed that all retained earnings are utilized for the financing of fixed capital formation and permanent inventory accumulation.
This does not imply necessarily that investments are profitable in the macroeconomic sense; on the contrary, it is typical of a financially repressed economy that part of the investment will not meet this criterion, since domestic interest rates are arbitrarily depressed.
No other factor payments (e.g., workers’ remittances) are assumed to exist.
Note that savings are, inter alia, a function of income, and income developments depend on the use made of credit.