Emerging Markets
1
LECTURE 1.2 FINANCIAL DEVELOPMENT
C S LEONARD
UNIVERSITY OF OXFORD
Leonard GSOM Emerging Markets March 2009
18/03/2009
Outline
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Repression and Liberalization
 Setting the issues
 Setting the historical context
 Getting the controversies clear
 Checking the evidence
Financial Repression (from Calomiris)
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Characteristics, Constraints imposed (6)
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Varied impact?
Financial and Capital Account Liberalization
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How/when did it happen
Changing international order in the 1990s
 Trade conditions
 International organizations
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Financial Repression and
Financial Liberalization
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SETTING THE ISSUES
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Role of Government in the Economy
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 Story as presented by Calomiris
 West: two processes democratic and market development
 Law as social contract (moral consensus)
 Merchants as powerful force in development
 By contrast with, say, self-isolating China (1400-1800)
 This is a story of governments
Taxes and rents by government suppress financial activity
 Banking: securing money, check clearance
 Investment: securities market intermediation (no permanent
middleman) and bank intermediation, both require laws ensuring
contract enforcement, protecting against fraud
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Crises
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 Continuous depreciation, like collapses, tax the
financial sector
 Dev of law to support system difficult, political
pressures for rent, military pressure for the inflation
tax
 20th century various means found to repress
financial systems
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Financial Repression
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 Imposed ceilings on interest rates paid by banks for deposits
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(fear for banks’ safety in competitive environments, outdated
by securities markets)—banks gain, see C fig 2.1
High reserve requirements on banks (gain to government, no
interest on reserves), inflation adds to tax on banks, C fig 2.2
Lending to industry, and or direct credit
Owning or micromanaging banks (Asian model of
development, control over credit alloation: Krugman
[Singapore/Soviet style allocation])
Restricting entry into the financial system, especially by
foreigners (protectionism)
 Japan—to mid-1980s, effectively forbidden: domestic corporate bonds and
commercial paper, ie, all securities markets
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Eun & Jarakiramannan
(1986)
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Number of expropriations of foreign assets in
different countries: development leading to new
8
globalization
90
83
68
60
48 51
56
40
30
22
11
6 8 8
14
24
13
5
30
15 15 17
5 4
1 3 1 1 1 0
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
0
25
DATA
SOURCE: Michael Minor, “The demises of expropriation as an instrument18/03/2009
of LDC
Leonard GSOM Emerging Markets March 2009
policy, 1980-1992”, Journal of International Business Studies, 1994, pp. 177-188.
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Number of countries expropriating
foreign assets
40
30
18
20
14
10 11
5 5 5
3
20
14 13
13
8
5
2 1 3 1 1 1
0
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
0
8 8
7
20
29 28
DATA
SOURCE: Michael Minor, “The demises of expropriation as an instrument18/03/2009
of LDC
Leonard GSOM Emerging Markets March 2009
policy, 1980-1992”, Journal of International Business Studies, 1994, pp. 177-188.
Controls on capital flows
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 Restricting international capital flows (strengthens
power of government to direct flows to particular
industries)

Capital controls widespread in all countries during Bretton
Woods period of fixed exchange rates (1948-1973)—brief
experiences of severe control (Chile, Malaysia, Brazil in
1990s)repealed
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Measuring Financial Repression
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 1970s to 1980s, 1990s, remarkable lowering of
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reserve ratios (fig 2.3)
Negative real interest rates (measures restrictions on
deposit interest rates) ended in burst of financial
liberalization in 1990s
Commercial bank borrowing
Relative size of stock market
Calomiris index (financial and economic
development correlated)
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Financial Repression and
Financial Liberalization
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SETTING THE HISTORICAL CONTEXT
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Financial Development, 1970s-2000s
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 Longer run
 Foreign financing in Ems moves from bonds (19th century) to
banks after WWII, to bonds (Brady bonds), to equity
 Countries move from protectionist policies, import –
substitution, forced upon them in the 1930s, to period of GDP
and rapid trade growth in the 1970s (even during the two oil
price spikes of 1973 and 1979, with non-oil producing
countries spending to meet demand, to the 1980s, a period of
stagnation in some countries (LA), to official relief, to
privatization and equity markets
 General state: from crisis, to stability, to crisis
 International arrangements: GATT (Tokyo Round) imposes
discipline and provides incentives for trade
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More clearly..
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 Oil shocks and crises and government intervention
 Division between oil exporting and oil importing
countries, with banks loaning funds of former to the
latter -- against background in 1970s of structural
reform, turning away from protectionism
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Tariffs reduced
Crawling exchange rate pegs to maintain competitiveness
Asia, subsidation of non-traditional exports
Huge global liquidity world wide in times of inflation, banks search
for higher yields abroad
Despite two major recessions in developed world, growth averaged in
1970s 4% per annum
World trade grew by 9% per annum
Debt/export ratios held down
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Tokyo Round
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 GATT, most comprehensive round, 1973-1979
 6 codes dealing with non tariff measures
 Tariff reductions by industrialized countries at 35%
 Developing countries given escape clause against terms of
trade shocks
 1980-1983 situation changed
 Debt export ratios rose dramatically, 1979 recession
 Slows of transfers to developing world, rise in real interest
rates, Asia strengthened against this, LA ran into debt
 Syndicated bank loan rose as vehicle of capital transfer
 Banks counted on official support, sovereign lending rose
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Era of debt 1980s
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 IMF assistance coupled with efforts to protect banks
 Baker Plan showed continued emphasis on private
sector
 Baker plan also fostered privatization as way out
 By 1987, banks showing greater reluctance
 Bail out of Mexico in Brady bonds, debtors and
creditors given new menu of options, conversion
bonds—writing off about 1/3 of all debt,
collateralization paid for by IMF, WB and Japanese
Import Export Bank
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1990s
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 Era of restored growth, long period of US productivity
growth, GDP globally av annual at 3%, despite Soviet
Union’s collapse and Japanese recession
 Uruguay Round of GATT showed success
 Far reaching changes in globalization
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Communications and information
New production technologies
Outsourcing
International division of labor
1970s, lending went to governments, 1990s, went to the poor and
rich (see China), heterogenous component
Dense network of interfirm linkages
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Financial Repression and
Financial Liberalization
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WHAT ARE THE CONTROVERSIES?
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Arguments against
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 Second best theory, removing one distortion does
not work, when others are present
 If industries protected, funds may flow where not
efficiently used
 Misallocations (where wages are inflexible
downward), say, toward capital intensive industries,
can be furthered
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Arguments for Liberalization
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 Sheltering financial intermediaries from competition
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does not improve them
Weakens market discipline felt by policy makers
Place additional power in hands of bureacrats
Encourage rent seeking and resource dissipation by
interest groups seeking privileged access to foreign
capital
Evidence not conclusive, which way
Benefits and disadvantages to liberalization
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Financial Repression and
Financial Liberalization
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MEASUREMENT, WHO LIBERALIZES?
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Methods of measuring it
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 Zero one dummy for controls, since intensity of
effort to control is fuzzy in cross country studies
 Quinn (1997) some effort to index intensity for 56
countries, 1954-1994
 Effort to measure international integration
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Stock market correlations? (returns vary as function of
underlying assets)
Onshore-offshore interest differentials (limited info for
countries and years)
 Conclusion: liberalization is part of a larger package,
hard to measure all of it
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Who liberalizes
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 Currency pegs difficult to operate with liberalized
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controls
Countries with pegs don’t liberalize
Advanced countries liberalize (causality?)
Countries where domestic savings are scarce don’t
liberalize—governments tend to channel resources
Accounts are closed when public authorities hope to use
inflation tax or to force banks to hold reserves at a
certain amount, for a certain sector
Where Central Bank is independent, this is not useful,
and so, less control
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Recent Views
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 1980s and 1990s a policy wave
 Policy contagion
 Countries herded in abandoning pegs and opening capital
accounts
 Policy emulation and signalling
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Financial Sector Reform
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CHARACTERISTICS
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Objectives
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A. Objectives of Financial Sector Reform
B. Measuring Financial Deepening
C. Main Areas of Reforms
1. Improve Mobilization of Resources
2. Improve Resource Allocation
3. Improve Prudential Supervision of
Financial Institutions
4. Strengthen Financial Competition
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A. Objectives of Financial Sector Reform
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 A first objective of financial sector reform is to bring the bulk of capital
accumulation in a country through the formal financial system, away
from the informal financial markets.
 In other words, the objective is to induce “financial deepening” by
increasing the volume of savings going to physical investments through
formal, supervised financial institutions.
 An increase in the proportion of savings going to investments
through the financial system should lead to an improvement in the
use and allocation of these savings.
 Potential borrowers will have to compete for these savings and those
with the most profitable opportunities and higher returns will have
an advantage in obtaining these funds.
 The deepening or increase in the size of the financial system,
therefore will improve the allocation of resources in the economy.
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Term and Size Transformation
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 A second objective in reforming the financial system is to
facilitate "term transformation"; that is, to convert relatively
short-term savings and deposits into long-term financing, which
is needed by capital investments with a relatively long
depreciation period.
 A third objective of the financial system is “size
transformation”; that is to consolidate relatively small private
savings into larger blocks of finance that can be used to fund
large profitable investments. Otherwise large projects would not
be financiable.
 A fourth objective of an adequate financial system is to achieve
“financial efficiency”; that is, to intemendiate between
savings and investments with minimum intermediation costs
and minimum risks (which requires prudential supervision).
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B. Measuring Financial Deepening
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 In most Emerging Markets, the banking system is the
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mainstream of the financial system.
Therefore, the degree of financial deepening can be measured by
the actual flow of bank loans granted by the banking system.
Since this flow is difficult to measure, a rough indicator of the
size of the financial/banking system is the ratio of M2 (Currency
in circulation plus demand and savings deposits) to GNP.
Changes in the M2/GNP ratio over time indicate changes in the
flow of private savings through the system. It indicates real
additions to the ongoing loanable fund capacity of the banks.
Typical M2/GNP ratios are: Latin America, 0.35, Transition
Europe, 0.45, Emerging Asia, 0.75, USA/Canada, 0.60, Western
Europe, 1.00, Japan, 1.20
Excessive M2/GDP ratios may also indicate over-reliance on
banks and inadequate capital market development.
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C. Main Areas of Reform
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 A precondition for the soundness of the Financial Sector is
Macroeconomic Stabilization. With high inflation and devaluations,
the financial systems will not be viable over the long term.
 The health of the Financial Sector also depends on the soundness and
creditworthiness of its borrowers. In turn, this will depend on the
sustainability of economic growth. Economic Liberalization and Public
Governance are key to achieve sustainable rates of growth.
 In fact, the financial sector "reflects" the real economy.
 Within these preconditions, the following measures are needed to
develop a sound financial sector:
1.
2.
3.
4.
Improve Mobilization of Resources (the liability side of the system)
Improve Resource Allocation (the asset side of the system)
Improve Prudential Supervision of Financial Institutions
Strengthen Financial Competition by Opening International Capital Flows and by
Developing Capital Markets
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1. Mobilization of Resources
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 A major purpose of the reform of a financial system should
be to increase its size by mobilizing increasing amounts of
private resources through the financial system.
 To increase the flow of private savings to the formal
financial system, the following measures are needed:
(i) Liberalize Deposit interest rates.
(ii) Expand Competition & Banking Coverage.
(iii) Diversify Savings Instruments.
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(i) Liberalize Deposit Rates.
 In many EMs, interest ceilings on
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savings are a major cause of
financial repression.
 Furthermore, rationing of credit by the banking system
 With low deposit rates (rd vs
inhibit innovation, as the funds would be normally
Rd), savers will supply a lower
channeled to well established firms.
level of deposits to the banking
system (Q1 instead of Q2, with
"x" being intermediation costs).
 Savers will tend to bypass the
banking system, increasing risks
of resource misallocation.
 It generates nepotism rather than
economic criteria in allocating
the lower amounts of credit
available though at higher
lending rates (rl instead of Rl).
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 In EMs, with greater market orientation to deposit rates,
competition among financial institutions is bound to take
interest rates on savings to the level of around 5% - 9% p.a.
in real terms.
 Liberalization of deposit rates should be accompanied by
measures to remove barriers to competition in the
mobilization of resources (particularly by enabling the
entry of foreign banks). Otherwise, monopolistic banks
will pay low deposit rates.
 Liberalization should also be accompanied by the
development of deposit insurance for small depositors, to
ensure that small depositors will not suffer if a bank gets
into trouble.
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(ii) Expand Competition & Banking Coverage.
 Eliminate restrictions to the creation of more branches to
provide easier access to depositors and induce additional private
savings throughout the country.
 Facilitate the establishment of well-capitalized banks, in order to
introduce competition and technology.
(iii) Diversify Savings Instruments.
 Banking laws in some countries list only “permitted”
instruments. This inhibits innovation. A better system is just to
prohibit certain types of undesirable instruments.
 In order to attract different types of depositors, banks should be
legally allowed to offer a diversity of types of interest bearing
instruments (passbook savings, time deposits, and certificates of
deposits) with different maturities, risks and rates.
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2. Improved Resource Allocation
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Another major objective of financial sector reform is to
encourage the allocation of resources to the most
economically viable investment opportunities
 This will improve economic efficiency and accelerate
economic growth.
 For this purpose the following measures are normally
included in financial sector reforms:

(i) Liberalize Interest Rates on Lending.
(ii) Eliminate Preferential and Directed Credits.
(iii) Reduce Intermediation Cost.
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Liberalize Interest Rates on Deposits
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 Interest rates on lending should not be controlled by Government.
Otherwise, the formal system will be by-passed.
 As deposit rates are liberalized and becomes positive, lending rates
will also become positive in order to cover deposit cost, the cost of
reserve requirement and intermediation cost.
 If determined by free market forces, lending rates will reflect the
opportunity cost of capital the country.
 Lending rates may become excessively high if the Government
introduces excessive regulations, such as:
 forced holdings by banks of low interest government securities,
 interest transaction taxes,
 high reserve requirements (the proportion of the bank deposits that
must be placed for precautionary purposes at the Central Bank free
of interest rates), and
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(ii)Effects of Inflation and High Reserve
Requirements
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 The effect of high reserve requirements is to increase the
lending rate that the banks will need to charge on its
loanable funds, to compensate for the fact that a portion of
the deposits is not earning any interest.
 High reserve requirements will also reduce the interest rate
that the banks can pay to depositors.
 Either depositors or other borrowers as a whole end up
paying for the high reserve requirements and the financial
system becomes weaker and bypassed.
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High Reserve Requirements
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 Furthermore, high reserve requirements in the presence of high
inflation can have an devastating effect by increasing dramatically the
level of nominal and real lending rates.
 The combination of high inflation and high reserve requirements
requires banks to charge very high real interest rates on loans, to enable
them to pay positive rates to the depositors; e.g.:
 With a 55% inflation rate and a 5% real deposit rate, the nominal
deposit rate will be 60%.
 On a $100 deposit, the bank needs to earn $60 to pay depositors.
 If the reserve requirement is 30%, the bank will not earn any return
on $30 out of the $100 deposit.
 Therefore, the bank will need to recover the needed $60 just on $70
of investments.
 The lending rate on these $70 will need to be $60/$70, or 85%
 This represents a real lending rate of 30% (85%-55%) or five times
the real deposit rate of 5%.
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(ii) Eliminate Preferential and Directed Credits.
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 Many Governments in Emerging Markets have established
special facilities to provide preferential and subsidized credits for
sectors they wish to encourage, such as agriculture, small scale
industries, exports, etc.
 In some cases, banks are forced to have a share of its loans in
these preferential sectors normally at lower interest rates.
 Experience has shown that these subsidies are normally
ineffective: In fact, most investments are not sensitive to the
level of interest rates, as interest rates represent a small share
of total costs.
 If special assistance needs to be provided, it is preferably and
economically more efficient to provide it directly, such as
through investment tax credits accelerated depreciation, etc.
rather than indirectly through interest rates.
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(iii) Reduce Intermediation Cost.
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 To reduce intermediation costs, a key measure is to
eliminate excessive Government regulations on the kind of
activities permitted to banks.
 This excessive regulations may just lead to excessive
fragmentation of activities, with heavy overhead costs, as
banks will just established different companies to operate
in the various activities.
 Reducing fragmentation in the financial market will allow
banks to cover a wide set of activities and to have a wider
regional representation.
 This will also help in narrowing the disparities of lending
rates in the financial sector, and reduce operating cost.
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3. Improve Prudential Supervision of
Financial Institutions
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Banking Institutions:
 The “Core Principles for Effective Banking Supervision and Regulation” of the Basle
Committee on Banking Supervision (composed of G-10 Senior Bank Supervisors),
provides a good assessment of the components of an effective system.
 Its main five elements include:
I. Organization of the Banking Supervisory Authority:
 Clear objectives and a regulatory framework set by legislation.
 Operational independence to free it from political pressures.
 Accountability and enforcement powers to achieve its main objective:
Enforcement of bank regulations that set out the minimum standards that
banks must meet.
 For this, the authorities should:
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
Strengthen bank surveillance capacity
Improve in-site and off-site audit examination procedures
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II. Bank Licensing
 To define institutions to be supervised, there should be clear bank
licensing arrangements
 The licensing authority should determine that the new bank has
suitable shareholders, adequate capital, feasible operating and
financial plans and management with sufficient experience and
integrity to operate the bank prudently.
 Objective and clear criteria for licensing should be issued.
III. Prudential Requirements.
 Prudential regulations and enforcement play a key role to ensure that
inherent banking risks are recognized, monitored and managed.
 The Basle Accord established prudential measures and regulations
that all banks should follows.
 Some countries with weak banking supervisory authorities may wish
to have stronger prudential regulations, as a cushion for weak
supervisory capacity.
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
The main prudential regulations include:
Capital adequacy standards, based on the riskness of assets.
Loan classification (Standard, Watch, Substandard, Doubtful, Loss)
and provisioning requirements, with clear criteria to define
performing vs non-performing loans (qualitative as well as
quantitative criteria).
 Limits on Large Exposures (including country limits).
 Limits on Connected Lending (groups).
 Requirements for Liquidity and Market Risk Management.
 Internal Control Standards
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IV. Accounting and Information Requirements
 Introduce generally accepted International Accounting
Standards for all banks.
 Introduce regular information reporting requirements.
 Introduce external audit of banks by qualified auditors
V. Exit Procedures for Bank Failure.
 In order to permit expeditious action, develop Prompt
Corrective Action and exit procedures in cases of bank failures.
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4. Strengthen Financial Competition.
 A degree of competition in the financial sector is needed to bring
competition to financial services and improve service quality.
International Financial Liberalization
 Competition can be brought by opening of the financial sector to
foreign banks and liberalizing the flow of international capital.
 However, liberalization of International Capital should be preceded by
the development of strong prudential regulations and supervision, as
well as a “stable” foreign exchange rate system. Otherwise, it would lead
to Moral Hazard problems
Domestic Capital Markets Development
 A second way to bring competition in the financial sector is by
developing alternative mechanisms for firms to get financing.
 For this, the development of domestic capital markets is essential.
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Domestic Capital Market
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
The main measures to develop a domestic capital market include:
 Strengthening security trading systems, including stock exchanges, regional exchanges,
and over-the-counter markets.
 Develop modern capital market infrastructure, including a central depositary, custodians,
clearance and DVP settlement.
 Improve the legal and regulatory framework for capital markets, including protection of
ownership rights and small shareholders, prevention of abuses, prevention of fraud,
conflict of interest, inside information, broker/dealer regulations.
 Improve the functions of Prudential Supervision by the Capital Market Supervision Board
 Improve financial disclosure requirements, such as compensation of senior management.
 Improve accounting and financial reporting according to international standards.
 Encourage self-regulation.
 Encourage or establish rating systems.
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Significance of Financial Market Development
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 Focussing more closely on the 1990s
 Financial markets still very imperfect
 With trade costs, causing “sudden stops” in EM
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Mexico 1995
Contagion to Argentina
Russian crisis of 1998
Asian crisis of ..
 In other words, EM s different from DE, because the debt/equity ratio can rise
rapidly. (1) collateral constraints, in the form of a margin requirement that
limits the ability of an emerging economy to use domestic finane This is a “fire
sale” in the sense that domestic agents rush to adjust their equity position
below the position they would optimally hold in the absence of margin
constraints. Collateral constraints, in the form of a margin requirement that
limits the ability of the Ems cannot use equity to leverage foreign debt, and (2)
asset trading costs, intended to capture the effects of informational or
institutional frictions affecting the ability of foreign traders to trade the equity
of emerging economies.
3
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The End
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SEE YOU NEXT HOUR
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