8. Develop a global partnership for development
10.7 The process of reforming the investment climate
It is clearly the case that progress on reform of the investment climate requires more than a change in formal policies, but will stand or fall with
regard to implementation – 90% of firms in developing countries report gaps between formal policies and what happens in practice, for example (ibid.).
For the World Bank (2005b) there are four key challenges for governments in this area:
(a) Restraining rent-seeking
The effectiveness of any reform process will be largely determined by the extent to which the government is able to maintain its course and not have the reform process distorted by rent-seeking at senior levels.
(b) Establishing credibility
In order to be prepared to invest for the longer term, firms must have con- fidence in the future. In this respect, the stability, coherence and credibility of government policies are critical. Firms may suspect that long-term govern- ment policies may be abandoned due to short-term political or economic pressures – governments need to allay these fears if it wishes to spur high and sustained levels of investment.
(c) Ensuring policies fit local conditions
To be effective, any policy measures must be appropriate for local conditions.
For example, policies that have proved effective in some developed countries may not be appropriate in a developing country context, and should therefore not be simply imported as a package.
More specifically, the direction and speed of reform should also take local capacity into account: there is no point announcing a policy that cannot be feasibly implemented or enforced, particularly as this will serve to undermine government credibility.
(d) Focus on the basics
Finally, the World Bank argues that governments should focus on ‘delivering the basics’ and avoid more direct interventions in the economy.
Conclusion: going beyond the basics
The World Bank (2005b) is highly sceptical that governments should seek to go beyond the delivery of ‘the basics’, as described and analysed above. What does the Bank mean by this?
By ‘going beyond the basics’ the Bank is, to a large extent, referring to efforts to replicate the East Asian ‘developmental state’ model, where the state was actively involved in ‘picking winners’. It did this through the identi- fication of key sectors and firms, the direction of credit and tax advantages to
these sectors and firms, and the maintenance of market restrictions to enable these ‘infant industries’ to develop into strong, internationally competitive industries.
For the Bank:
The overall experience with government’s ability to ‘pick winners’ is dis- couraging . . . Even in the best of circumstances, many selective interven- tions seem to be a gamble. The more ambitious the goal and the weaker the governance, the longer the odds of success. Selective interventions should thus be approached with caution, and not viewed as a substitute for broader investment climate improvements.
While it is certainly the case that interventions of this kind should not be seen as a substitute for investment climate reforms, it is also true that the approaches are not necessarily mutually exclusive.
Many of the ‘basics’ proposed by the Bank are sensible, though others display a puzzling faith in the ‘magic of the market’ to resolve complex difficulties, when there is ample evidence that this is far from being sufficient in many instances.
For example, it is difficult to find an example of a country that has followed the ‘basics’ policy line faithfully – and importantly not gone beyond it as proposed by the Bank – that has prospered to anything like the extent that countries which have chosen a different path.
At the start of this book, and throughout it, the point has been repeatedly made that financial sector development is not an end in itself. The real goal of course, is to facilitate increased and beneficial economic activity and so promote development and poverty reduction. Ultimately, all policies in the financial sphere – as well as all other economic areas – must be judged on their performance in this regard.
Clearly, as the World Bank rightly points out, many countries have tried and failed to replicate the success of the Asian ‘Tiger economies’, often making things worse in the process than would otherwise have been the case.
However, the scale and persistence of poverty in many countries and regions in the world is such that it is very difficult to see how simply sticking to the
‘basics’ can hope to succeed in any meaningful sense.
To reiterate: where are the countries – either today or historically – that have achieved a step-change in development and poverty reduction by following the minimalist path proposed by the World Bank?
Figure 10.11 below depicts the scale of poverty reduction by developing region from 1981 to 2004.
As we see, the relatively low levels of poverty in the Middle East and North Africa have fallen steadily throughout. Europe and Central Asia ends the period with a similarly low incidence of absolute poverty to that which it began, after experiencing a quite large rise due to the transition from com- munism from the late 1980s onwards.
Two other regions showing little change are Latin America and sub- Saharan Africa: in the first instance about 10% of the population was living on less than US$1 per day throughout the period; for sub-Saharan Africa, however, between 40% and 50% of the population remained in absolute poverty for this twenty-five-year period.
In contrast, both South and East Asia saw significant falls in poverty levels, which is particularly marked in the latter. The proportion of the East Asian and Pacific population living on less than a dollar a day in 1981 was 57.7%, the highest of any of the regions. By 2004 this had fallen to 9%.
When considering lessons to be learned on the effectiveness of differing development strategies these trends are telling. The oil wealth of the Middle East makes comparisons difficult, and the transition economies experience is also unique – including accession to the European Union in many instances.
Of the four remaining regions, however, it would be reasonable to assume that sub-Saharan African and Latin America have most closely followed the World Bank line, whether willingly or as part of the conditions of structural adjustment programmes.
In contrast, the East Asian economies – and to a lesser extent those of South Asia – have taken a far more heterodox stance, which entailed ‘going beyond the basics’ consistently. Furthermore, in some countries – particularly China – many of the ‘basics’ have been largely ignored. China has virtually none of these elements in place, yet it has been growing at more than 10% a year for a decade, has recently overtaken the USA as the world’s largest recipient of FDI and is now the world’s second largest economy by some Figure 10.11 Regional poverty levels (percentage living on less than US$1 per day).
Source: World Bank WDI.
estimates based on purchasing-power parity. Most importantly, China has witnessed the greatest reduction in poverty in human history.
Clearly, not every country has the advantages of China – its sheer size makes it attractive to investors wishing to access the domestic Chinese mar- ket. However, as we have touched upon in earlier parts of this book, the evidence appears to be that a country’s ‘room for manœuvre’ is largely determined by its relative bargaining power in the world. Smaller developing countries cannot hope to match China’s status in this regard: not individually anyway.
However, the relative bargaining power of each country would clearly be greatly enhanced through closer regional ties and enhanced regional cooperation. We have considered this with regard to the development of capital markets, but the point may be more broadly applicable.
For example, the terms upon which FDI are attracted to an economy – and the benefits the country therefore derives from the investment – will be determined by the relative bargaining power of the parties. Larger regional groups taking a common stance with regard to FDI will see their bargaining power greatly increased. The same argument holds for tax competition with regard to transnational corporations of course.
Domestically, the same picture emerges. All the aspects of financial and private sector development we have seen would lead to greater societal bene- fits in a larger economic area, offering a greater range of investment opportunities and more scope for specialisation, innovation, higher product- ivity and economic growth. It is clearly an essential prerequisite for govern- ments to improve their country’s investment climate, thereby spurring growth FSD, PSD and poverty reduction – the ultimate aim of the whole exercise.
It is also very clear that this may not be enough though: governments can – and perhaps must – do more if the scourge of poverty is to be finally resolved.
However, we must also recognise that each country’s ability to do so is dependent on (a) appropriate policy design and implementation, (b) the size and diversity of the domestic economy, and (c) the relative bargaining power of the country vis-à-vis the rest of the world. Both (b) and (c) would of course be greatly enhanced by ever closer regional cooperation and greater South–South links in general.
As we conclude this journey it is clear that the approach taken to financial sector development in developing countries needs to be far more ambitious than that proposed by the World Bank. Focusing on the ‘basics’ may of course prevent policy errors in terms of intervention, but surely we can and must move further than this ‘counsel of despair’ if the step-change in devel- opment that is so sorely needed is to be achieved.
Notes
1 An introduction to the financial system in theory and in practice
1 That is, financial institutions such as pension funds and insurance companies into which individuals deposit savings on a ‘contractual’ basis.
2 On 26 June 1974 at 15:30 CET, the German authorities closed Bankhaus Herstatt, a middle-sized bank with a large FX business. Prior to the closure, however, a number of Herstatt’s counterparty banks had irrevocably paid deutschmarks into Herstatt but, as US financial markets had just opened, had not yet received their dollar payments in return. This failure triggered a ripple effect through global payment and settlement systems, particularly in New York. Ultimately, this fed into New York’s multilateral netting system, which over the following three days, saw net payments going through the system decline by 60% (BIS, 2002).
3 That is, the Bank of England is charged with ensuring that inflation is 2.5%, neither higher nor lower. The ECB, in contrast, aims for inflation to be below 2%.
For some commentators, this difference, though seemingly arcane, builds in a deflationary bias to the ECB’s operations, which may have negative effects on growth.
4 Although many countries have an official floating exchange rate, in many instances this is actually a ‘dirty float’, where the central bank (or other official institution) intervenes in the market to ‘manage’ the floating of the exchange rate.
5 This point is illustrated with his famous analogy of the beauty contest, wherein the aim is not to choose the most beautiful contestant, but rather to select that con- testant who one thinks the other ‘judges’ will select. As all are in the same position, the aim is to decide what average opinion will expect average opinion to be.
6 See Stiglitz and Weiss (1981) for the seminal paper in this respect.
2 Finance, poverty, development and growth
1 Environmental (or ecological) economists have long argued that policies geared towards generating ever-higher levels of growth – particularly at the global level – are incompatible with environmental sustainability, and ultimately with the elim- ination of poverty. See Daly (1997) The Limits to Growth: The Economics of Sustainable Development, for an account of this perspective.
2 Dollar and Kraay (2001).
3 See Chen and Ravallion (1997), Deininger and Squire (1996), Dollar and Kraay (2001) and Easterly (1999), for example.
4 See Li and Zou (1998) and Forbes (2000), for example.
5 See Barro (2000) and Lopez (2004), for example.
6 See Easterly and Rebelo (1993) and Perotti (1996), for example.
7 Easterly (2001) finds that IMF/World Bank structural adjustment programmes
tend to reduce the growth elasticity of poverty. The author suggests that this may be because the poor are unable to take advantage of the opportunities afforded by these programmes, leading to growing inequality.
8 Ravallion and Chen (2004) and Arbache et al. (2004), for example.
9 With the notable exception of neo-Marxist thought, which takes classical theory in the direction pioneered by Marx in the nineteenth century.
10 This section draws extensively on Easterly (1997), which gives an excellent – and fascinating – account of the impact of the Harrod-Domar model, particularly the concept of the ‘financing gap’, on development economics and the pattern on ODA from the 1950s to the late 1990s.
11 Schumpeter (1911).
12 Lewis (1955).
13 Goldsmith (1969).
14 See Levine et al. (2000) for evidence of causality in this respect.
15 Measured as the ratio of liquid liabilities to GDP, which describes the level of financial intermediation in the economy.
16 See DFID (2004).
17 DFID (2004: 5).
3 Financial repression, liberalisation and growth 1 See McKinnon (1973) and Shaw (1973).
2 Though it should be noted that liberalisation in this respect was not always entirely voluntary, as the conditions attached to international ‘rescue packages’
during the Asian crisis often included a requirement to remove restrictions on the entry of foreign financial institutions.
3 In terms of the money supply: M1 = cash in circulation and current accounts;
M2 = M1 + time-related deposits savings deposits and non-institutional money- market funds; M3 = M2 + large time deposits, institutional money-market funds, short-term repurchase agreements and larger liquid assets.
4 See Greenword and Jovanovic (1989), for example.
5 See Siregar (1992), for example.
6 Reported in Williamson and Mahar (1998).
7 The q ratio is simply the market value of a company as measured by its stock market valuation, divided by the replacement value of the firm’s assets.
8 See Díaz-Alejandro (1985), ‘Good-bye Financial Repression, Hello Financial Crash’, Journal of Development Economics.
9 See Stiglitz (1994) for the seminal account of the extent of market failures in financial markets and the resultant scope for welfare-enhancing government inter- vention in markets.
10 See Glick and Hutchison (2000) and Bordo et al. (2001), for example.
11 Bertolini and Drazen (1997) quoted in Eichengreen and Leblang (op. cit.) 12 The countries considered are: Argentina, Australia, Brazil, Canada, Chile, Den-
mark, Finland, Greece, Italy, Japan, Norway, Portugal, Spain, United States, Belgium, France, Germany, the Netherlands, Switzerland and Great Britain.
13 Key features of such a system are: the independence of regulators and supervisors – both from government and the private sector; adequate remuneration of staff, so as to reduce incentives for corruption; and adequate training of staff.
14 Principal–agent problems refer to the fact that often the incentives and objectives of the ‘principal’ are not mirrored in the ‘agent’ through which these objectives are pursued. In financial systems virtually all actors are both principals and agents in certain circumstances. Thus, in a democracy the government is the ‘agent’
to the voters’ ‘principal’, but the government is the principal to its regulatory body’s agent. Similarly, when dealing with the financial sector, the regulator is the
principal, while banks are agents, but at the level of the bank, the managers are agents and the shareholders are the principal. This overlapping – and often con- tradictory – network of incentives and objectives affect all financial systems, but the difficulties are more acute within developing countries with relatively imma- ture financial sectors characterised by concentrations of power and rent-seeking.
15 See Chapter 1.
16 See Stiglitz and Weiss (1981).
17 Bankers are reluctant to raise interest rates to market clearing levels, as this exacerbates problems of adverse selection and moral hazard (ibid).
4 The domestic financial system 1 See Demirgỹỗ-Kunt and Levine (1999).
2 The mitigation of asymmetric information is often cited as one of the key func- tions of banks within the financial system, or even the explanation for their con- tinued existence. In this regard, Ben Bernanke has convincingly argued that the severity and length of the Great Depression in the 1930s was, at least in part, the result of widespread bank failures that sharply increased problems of asymmetric information in the financial system (Bernanke, 1984).
3 Krugman (1998) described this process, where Asian assets were bought at very low prices, as ‘Firesale FDI’.
4 See the World Bank Firm Informality research programme (2006).
5 Indeed, much of the modern banking sector in Germany evolved from its ori- ginal community-based ‘microfinance’ institutions, which displaced the inefficient incumbent banks.
6 See Rousseau and Wachtel (2001) for an overview on the link between inflation, financial sector development and economic growth.
7 Mundell (1972).
8 See Levine et al. (2000), for example.
9 See La Porta et al. (1998), for example.
10 See Acemoglu et al. (2001) and Bloom and Sachs (1998), for example.
11 See Levine et al. (op. cit.), for example.
12 Honohan and Stiglitz (2001).
13 See Vittas (1998) for a good overview of the potential role of institutional inves- tors on financial sector development.
14 See Gerschenkron (1962).
15 It should be noted that banks too perform a similar function in the financial system. Individual depositors are able to withdraw their funds on demand – they are therefore provided with liquidity. However, knowing that only a small propor- tion of depositors are likely to do so at any one time, in the absence of a bank run, banks are able to transform these short-term liabilities by lending for longer-term investment projects.
16 See Markowitz (1952) for the seminal work on the role of portfolio diversification.
17 The first fundamental theorem of welfare economics holds that competitive mar- ket equilibriums are, by definition, Pareto efficient outcomes. See Arrow and Debreu (1954) for the formal proof of the first theorem.
18 See Greenwald and Stiglitz (1986), for example.
5 Reforming the domestic financial system 1 See Mundell (1962), for example.
2 These issues will be covered fully in subsequent chapters on the external system and financial crises. In this regard, the example given above is a description of a classic first-generation currency crisis (Krugman, 1979).
3 See Kydland and Prescott (1977, 1982, 1988) for their seminal contributions to this field, for which they were awarded the Nobel Prize in 2004.
4 See the works of James Buchanan for a US-focused perspective on public choice.
5 See Alesina and Tabellini (1987), for example.
6 This argument can be related back to the Harrod-Domar growth model discussed in Chapter 2, which relies on capital expenditure to kick-start growth.
7 See Tanzi (1987), for an early example.
8 This is particularly the case with corporation tax revenues, where profits expand more than average economic growth rates and vice versa.
9 There is some evidence to suggest that (a) compliance costs are far higher than administrative costs, and that (b) compliance costs in developing countries are far higher than is the case in developed countries (Bird and Zolt, 2003).
10 The logical conclusion in this line of thinking is the increasing popularity of the flat tax, where a uniform rate is levied across the economy.
11 See Box 5.2 on tax reforms in Ethiopia.
12 See Guttentag and Herring (1986) for an excellent account of why banks may be prone to excessive risk-taking and therefore need to be restrained.
13 A bank is solvent if the value of its assets exceeds its liabilities, after taking into account expected losses.
14 A bank is liquid if it can fund its current expenditure and meet customers’
demands to withdraw deposits.
15 These concerns were primarily focused on banks in developed countries, particu- larly in Japan. It was feared that international competition in the banking sector was leading to increasing banking fragility, as banks held less and less capital in reserve to cover future losses in attempts to compete internationally.
16 One means of protecting independence is to ensure that agencies are not dependent upon the state for funding, but obtain their financing from an independent source.
17 The old-age dependency ratio is the number of pensioners drawing benefit divided by the working population.
18 This is exactly the option recommended to the UK government by the Turner Report on pension sustainability in the UK.
19 And particularly since 1994, when the Bank published Averting the Old Age Crisis.
The World Bank approach to pension reform is perhaps set out most clearly in Holzmann and Stiglitz (2001).
20 See Zalewska (2006) for evidence in this regard with respect to pension reforms in Poland.
21 See North (1990).
6 The external financial system (I)
1 As was examined in Chapter 2, the underlying theory behind this reasoning relies heavily on the Harrod-Domar growth model, which links investment rates with growth. Where domestic savings are insufficient to fund the rate of investment estimated as being necessary to generate a target rate of growth – as is the case in most developing countries – external financial inflows are required to boost the investment rate.
2 The Organisation for Economic Cooperation and Development.
3 The G8 Summit in Heiligendamm, Germany in 2007 saw politicians come under pressure from campaigners to honour the pledges made at Gleneagles. Despite the clear need to accelerate disbursements, no binding commitments emerged, though all agreed that it was ‘vital’ to make progress.
4 For example, see Ovaska (2005) for an econometric study that finds a 1% increase in ODA (as a proportion of GDP) results in a reduction of real per capita growth of 3.65%.