Financial Liberalization and Investment (Routledge Studies in Development Economics, No. 4)

FINANCIAL LIBERALIZATION AND INVESTMENT

For two decades thinking on economic policy has been dominated by the idea of economic liberalization in general and financial deregulation in particular. This field has become both extensive and controversial, yet there is no single book that treats financial deregulation in a coherent and complete manner. Financial Liberalization and Investment rectifies this by focusing specifically on the consequences of interest rate deregulation for the real sectors of the economy. What happens to savings, investment, income, and growth if governments allow interest rates to be determined by market forces? Using both analytical and simulation models, the authors analyze this question under a wide array of assumptions about the behavior of consumers, firms, banks, informal credit market, governments, and foreign aid. The study provides guidance to a number of controversial issues in the field, and suggests avenues for further research. Kanhaya L.Gupta is Professor of Economics at the University of Alberta. He has published widely on macroeconomics and monetary economics. In addition to five books he has published articles in American Economic Review, Econo-metrica, Economica, International Economic Review, Quarterly Journal of Economics, Review of Economics and Statistics, and the Review of Economic Studies. Robert Lensink is Assistant Professor of Economics at Groningen University, the Netherlands. He currently researches in development and international economics. His Ph.D. dissertation deals with capital flows between North and South, and he has recently published in Economic Modelling.

ROUTLEDGE STUDIES IN DEVELOPMENT ECONOMICS

1 Economic Development in the Middle East Rodney Wilson 2 Monetary and Financial Policies in Developing Countries Akhtar Hossain and Anis Chowdhury 3 New Directions in Development Economics (Growth, Envir onmental Concerns and Government in the 1990s) Edited by Mats Lindahl and Benno J.Ndulu 4 Financial Liberalization and Investment Kanhaya L.Gupta and Robert Lensink

FINANCIAL LIBERALIZATION AND INVESTMENT

Kanhaya L.Gupta and Robert Lensink

London and New York

First published 1996 by Routledge 11 New Fetter Lane, London EC4P 4EE Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 Routledge is an imprint of the Taylor & Francis Group This edition published in the Taylor & Francis e-Library, 2003. © 1996 Kanhaya L.Gupta and Robert Lensink All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloguing in Publication Data A catalogue record for this book has been requested ISBN 0-203-43775-6 Master e-book ISBN

ISBN 0-203-74599-X (Adobe eReader Format) ISBN 0-415-13879-5 (Print Edition)

To Carole and Ans

CONTENTS

ix xi xii

List of figures List of tables Acknowledgements 1

INTRODUCTION Appendix 1

2

THE BASE MODEL The model Financial liberalization and the supply of credit to the private sector Financial liberalization and private investment Concluding remarks Appendix 2 Appendix 3

3

4

1 8

ROLE OF FOREIGN AID AND THE GOVERNMENT The fiscal response to foreign aid The model when government expenditures and taxes are endogenized Financial liberalization when foreign aid is exogenous The role of foreign aid when aid is endogenized Conclusions Appendix 4 THE ROLE OF INFORMAL FINANCIAL MARKETS Different types of informal financial intermediaries Theories on the working of informal financial markets Role of interest rate deregulation in the presence of curb markets: A brief survey

vii

10 11 19 21 25 26 28 30 31 34 38 42 45 47 50 51 54 58

CONTENTS

The model Financial liberalization and private investment Conclusions Appendix 5 5

6

ALLOCATIVE EFFICIENCY AND FINANCIAL DEREGULATION The Galbis model Some empirical evidence The model How to measure the improvement of the allocative efficiency? The impact of deregulation of the formal deposit rate on the allocative efficiency Conclusions BANKING EFFICIENCY AND PRIVATE INVESTMENT The Viaene model The model Banking efficiency and private investment if the private sector is credit constrained Banking efficiency and investment if the private sector is not credit constrained Concluding remarks

60 63 67 67 69 70 71 75 79 79 85 86 87 87 89 93 94

7

SOME SIMULATION RESULTS The model The simulation strategy The simulation results Concluding remarks Appendix 6

96 97 107 113 142 143

8

FINANCIAL REPRESSION AND FISCAL POLICY The simulation strategy The simulation results Concluding remarks

146 147 147 164

9

SUMMING UP

166 168 171 179

Notes Bibliography Index

viii

FIGURES

7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 7.12 7.13 7.14 7.15

7.16

Base model simulations Base model simulations Base model simulations Base model simulations Base model simulations Base model simulations Alternative simulation 1: no substitution between deposits and capital Alternative simulation 1: no substitution between deposits and capital Alternative simulation 2: only investment is credit constrained Alternative simulation 2: only investment is credit constrained Alternative simulation 3: consumption not affected by real interest rates Alternative simulation 3: consumption not affected by real interest rates Alternative simulation 4: higher wealth effect in investment equation Alternative simulation 4: higher wealth effect in investment equation Alternative simulation 5: higher reserve requirements in formal banking sector and only investment credit constrained Alternative simulation 5: higher reserve requirements in formal banking sector and only investment credit constrained

ix

114 115 116 117 118 119 121 122 123 124 125 126 128 129

130

131

FIGURES

7.17 Alternative simulation 5: higher reserve requirements in formal banking sector and only investment credit constrained 132 7.18 Alternative simulation 6: aid increases with 5% 134 7.19 Alternative simulation 6: aid increases with 5% 135 7.20 Alternative simulation 6: aid increases with 5% 136 7.21 Alternative simulation 6: aid increases with 5% 137 7.22 Alternative simulation 7: aid increases with 5% and government investment positively affects private investment (γ1=0.3) 138 7.23 Alternative simulation 7: aid increases with 5% and government investment positively affects private investment (γ1=0.3) 139 7.24 Alternative simulation 7: aid increases with 5% and government investment positively affects private investment (γ1=0.3) 140 7.25 Alternative simulation 7: aid increases with 5% and government investment positively affects private investment (γ1=0.3) 141 8.1 Tax on bond interest income: private investment 149 8.2 Tax on bond interest income: government investment 150 8.3 Tax on bond interest income: government consumption 151 8.4 Tax on bond interest income: inflation 152 8.5 Tax on bond interest income: private wealth 153 8.6 Borrowing at concessional rates: private investment 154 8.7 Borrowing at concessional rates: government investment 155 8.8 Borrowing at concessional rates: government consumption 156 8.9 Borrowing at concessional rates: inflation 157 8.10 Borrowing at concessional rates: private wealth 158 8.11 Higher reserve requirements for formal banks: private investment 159 8.12 Higher reserve requirements for formal banks: government investment 160 8.13 Higher reserve requirements for formal banks: government consumption 161 8.14 Higher reserve requirements for formal banks: inflation 162 8.15 Higher reserve requirements for formal banks: private wealth 163

x

TABLES

2.1 The accounting framework of the model 3.1 Effects of aid on government expenditures and taxes 4.1 The accounting framework of the model including informal financial markets 5.1 Costs of borrowing of 68 manufacturing industries 5.2 Costs of borrowing for 28 industries in Turkey 5.3 Measures of efficiency of the allocation of investment in Indonesia 5.4 Measures of efficiency of the allocation of investment in Ecuador 7.1 Notations and definitions used in the model 7.2 The accounting framework of the model 7.3 Parameters of the asset demand equations and private consumption 7.4 Parameters of the government equations, initial values and exogenous variables 8.1 Effects of financial repression

xi

11 34 62 72 73 74 74 97 99 111 112 164

ACKNOWLEDGEMENTS

Our most sincere thanks to the referee of the publisher for constructive criticisms and suggestions and to Charlene Hill for her excellent typing. A good deal of this work was done while Kanhaya Gupta was a visiting professor in the department of economics, University of Groningen, the Netherlands, during May to July 1994. He extends his deep appreciation for the department’s invitation, facilities and its hospitality.

xii

1 INTRODUCTION The purpose of this brief introduction is to explain the motivation for our work and provide a brief outline of the chapters to follow. Inspired by the influential works of McKinnon (1973) and Shaw (1973), and by the requirements of the IMF/World Bank sponsored structural adjustment programs, the effects of financial liberalization on investment in developing countries have drawn much attention. The major thrust of this literature has been to understand the mechanisms by which interest rate deregulation and the elimination of other forms of financial repression—for example, changes in reserve requirements—affect savings and investment. Broadly speaking, we can distinguish two sets of approaches in the literature: those based on non-optimizing models and those which involve optimizing frameworks. The former includes works which essentially build on the model suggested by McKinnon (1973). This body of literature is extensively summarized in Fry (1988) and Gibson and Tsakalotos (1994). The optimizing models draw their inspiration from the pioneering works of Romer (1986) and Lucas (1988) on endogenous growth models. This part of the literature is extensively surveyed by Berthelemy and Varoudakis (1994), De la Fuente and Marin (1993), Pagano (1993) and Schiantarelli et al. (1994b), but see also the appendix to this chapter. Our work is in the tradition of the non-optimizing models. Instead of giving a survey of the existing literature, our approach is to discuss the relevant literature within the context of our model in each chapter. Consequently, in this introduction we only explain the motivation for our work and then give a brief review of the chapters to follow. In addition to the literature on the effects of financial liberalization, there is also much work on the role of informal credit markets in meeting the needs of households and firms. Other areas of important concern have been the role of foreign aid in the growth of developing countries, the implications of the credit needs of the governments to finance budget deficits, the implications of financial repression for raising government revenues, and the importance of wealth effects. However, in

1

INTRODUCTION

virtually no work on the effects of financial liberalization that we are aware of are all these different strands of thought brought together in an integrated framework. Of course, there are efforts which try to combine one or more of these issues. For example, Van Wijnbergen (1983a, 1983b), and others in the ‘neostructuralist’ school, examine the role of informal credit markets, but pay very little attention to the role of foreign aid, wealth effects, crowding out of private credit by the needs of the government to finance budget deficits and so on. Morisset (1993) examines the effects of crowding out of private credit caused by the government’s budgetary needs and a shift in the public’s portfolio caused by interest rate deregulation. But he treats government budgets as being exogenously given, ignores the role of foreign aid and informal credit markets and treats savings as being exogenously determined, thus eliminating all indirect effects of interest rate deregulation via changes in wealth. The aim of this study is to provide a systematic analysis of the whole range of questions which have been raised in the literature with respect to financial liberalization. More specifically, our study is distinguished by the following features: 1 It analyzes three aspects of financial liberalization. These three aspects are the effects of interest rate deregulation on the quantity of investment, the effects on the allocative efficiency of investment and the effects of an improvement in banking efficiency on investment. It is only the first of these effects that has received considerable attention in the literature. This is curious since the other two are mentioned almost as often as the first one. 2 Its second distinction is that it takes into account many mechanisms by which a financial liberalization may affect investment which have hitherto not been incorporated in the existing models. In particular the role of wealth effects, effects of portfolio changes and crowding out by government budgetary behavior are allowed simultaneously. We accomplish this task by using an integrated model of portfolio selection and consumption—saving, which has not been done before. Similarly we endogenize government budget deficit, thus explicitly analyzing the effects of interest rate deregulation on government expenditures, revenues and interest payment. At the same time we also incorporate informal credit markets.

2

INTRODUCTION

3 While there is a good deal of literature on foreign aid and economic growth in developing countries, as well as the conditionally of IMF/World Bank on the granting of concessional loans on the adoption of financial deregulation policies, there is, to our knowledge, no formal treatment in which the effects of financial deregulation and foreign aid on investment are modelled simultaneously. Our study tries to fill this gap by considering both sides of the structural adjustment program simultaneously. 4 While the above exercises fill many of the gaps in the existing literature and open up some new avenues, the fact still remains that our ability to derive analytical results from a model which combines all of the aspects mentioned above remains limited. One of the options is to formulate a general model and carry out simulations. This is precisely what we do. The model is based on the foundations laid out in 1, 2 and 3 above. Simulations are carried out under a variety of assumptions about the behavior of the economic agents involved in the model. These simulations help us shed light on a number of controversial issues in the literature on economic liberalization in general and financial liberalization in particular as discussed in the chapter outlines which follow. Chapter 2 constitutes the foundation for the entire work. Assuming a given government budget deficit and a demand-determined world, we specify our model and explain how it differs from the existing works. It distinguishes three sectors: a consolidated private sector, a consolidated banking sector and a government sector. Unlike the existing works, we assume that the private sector’s decisions about portfolio selection and consumption—saving are integrated, in which wealth plays an important role and where the private sector is credit constrained. This part of the model draws on the work by Owen (1981) and others on portfolio selection modeling. In this chapter we then go on to derive the conditions under which an interest rate deregulation can lead to an increase in the supply of bank credit to the private sector in the presence of crowding out effects of government’s borrowing requirements from the banks, the crowding out being induced by a reallocation of the private sector’s portfolio consequent upon interest rate changes on deposits. The chapter then goes on to derive the conditions under which McKinnon’s well-known ‘complementarity’ hypothesis

3

INTRODUCTION

holds. It is shown that the conditions are far more stringent than is recognized in the literature so far. It is also shown that the outcome is greatly affected by our assumption that the private sector’s portfolio decision and consumption—saving decision are integrated. The model in Chapter 2 assumed that government budget deficit was exogenously given and that it was entirely financed by domestic resources. In Chapter 3 we introduce two innovations compared to the rest of the literature in the field. First we endogenize the deficit. This we do by drawing on the literature on the fungibility of foreign aid. For this purpose we use an optimizing model of the government’s fiscal behavior. The second innovation is that we introduce foreign aid. While there is voluminous literature on the effects of foreign aid on the economies of developing countries, there is virtually none which tries to assess the implications of such aid for the success or failure of interest rate deregulation policies. This omission is rather curious in that in the structural adjustment programs of the IMF/World Bank a condition for the provision of concessional loans/ aid is often conditional on the adoption of reforms in the financial sector including interest rate deregulation. We try to model such an interaction using the basic model specified in Chapter 2. We show that an interest rate deregulation without foreign aid may lead to a sub-optimal situation. In the case where financial liberalization does not lead to a fall in government investment, probably the crowding out of the supply of credit to the private sector by the government will be large. Otherwise, in the case where the government tries to avoid these crowding out effects, a decline in government investment will probably be the result. We also show that foreign aid might neutralize the crowding out effects of private credit. However, it is not a guarantee for a halt in the decline in government investment. This depends on the pattern of usage of such aid, i.e. on the degree of ‘fungibility’ of such aid. In the models discussed previously we have abstracted from informal credit markets. However, recently many authors have pointed out the role of the informal financial sector in financing the credit needs of the private sector. In the literature two views with respect to the financial intermediation of the informal sector are distinguished. Traditionally, the informal lenders are associated with monopolistic moneylenders who exploit the poor charging usurious interest rates and are stereotyped as being exploitative. In this view, informal financial intermediation is very inefficient and costs are high so that a substantial part of total savings goes to informal banks

4

INTRODUCTION

as a reward for the services supplied. However, many recent studies argue that the informal financial market is a highly efficient competitive market with developed linkages with the official markets. In Chapter 4 we incorporate the informal financial market in the Chapter 2 model and assess the impact of interest rate deregulation on private investment under different assumptions about the workings of the informal financial market. We show that most of the existing works are special cases of our more general model and, once again, that the way we model the private sector’s behavior about portfolio selection and consumption—saving has important bearing on the outcomes. We also go on to derive the conditions under which informal credit markets are helpful to the effectiveness of interest rate deregulation policies. The analysis so far has dealt with the scale effects of financial deregulation, namely the effects on the quantity of investment. However, the literature also emphasizes another channel through which such deregulation may enhance growth. This has to do with the allocative efficiency effect. The idea is that higher interest rates, by inducing the selection of projects with higher rates of return, will raise the average productivity of investment and hence growth, even if the effect on savings and thus total investment was negligible. The main difficulty in dealing with this issue is how to measure improvements in allocative efficiency which are induced by financial deregulation. Using a two-sector model, Galbis (1977) tried to analyze this problem. However as we explain his model is just an assertion of his results and that it cannot be used to answer the question being considered. Besides he ignores the informal credit market which apparently plays a crucial role in this debate. In Chapter 5 we develop a two sector version of the model in Chapter 4. Then we suggest how to assess the effects of interest rate deregulation on allocative efficiency. Finally, we show the conditions under which allocative efficiency may improve as a consequence of interest rate deregulation. It is shown that such deregulation does not always guarantee an improvement in overall productivity. The outcome depends on how the two sectors react towards the formal and the informal banking sectors as lenders and as borrowers which ultimately affects the portfolio behavior of the two sectors and consequently allocative efficiency. In the previous chapters we have paid attention only to the consequences of changes in interest rates on deposits. Another important issue with respect to the effects of financial deregulation

5

INTRODUCTION

relates to the effects of changes in banking efficiency on private investment. It has been argued that a high spread between deposit and lending rates reflects high cost of financial intermediation and, therefore, lower banking efficiency. Although this issue has been raised in the literature, there is little formal analysis of it. In Chapter 6 we make an attempt to model the effects of improvement in banking efficiency on private investment. Again, this is done by using a variant of the model in Chapter 2. More specifically, we approach the concept of banking efficiency by distinguishing between effective and nominal rates of return on deposits and cost of loans. It is shown that a financial liberalization in the conventional way, i.e. an interest rate deregulation, leads to an increase in both the effective deposit and lending rates, whereas an improvement in banking efficiency leads to an increase in the effective deposit rate and a decrease in the effective lending rate. Further, it is shown that while the effects of an improvement in banking efficiency cannot be determined a priori, under several circumstances the possible negative effects of interest rate deregulation on private investment may be mitigated or even overcompensated by the positive effects of an improvement in banking efficiency. There are three major limitations of the analysis of Chapters 2–6 (particularly Chapters 2, 3 and 4). These are the partial nature of the model used. Partial in the sense that in each case we ignored some of the features. For example, in Chapter 2 we treated budget deficits as being exogenous and completely ignored informal credit markets and foreign aid. In Chapter 3, while we endogenized the deficit and incorporated foreign aid, we still excluded the informal credit markets. In Chapter 4, we rectified this shortcoming but only at the cost of the assumptions about the deficit and aid in Chapter 2. These respective simplifications were introduced so that we could derive some analytical results to highlight the significance of the attribute under consideration. But obviously a more appealing approach would be to take all of these factors into account simultaneously. The second shortcoming is the assumption about inflation. We have assumed that it was given. This is not an unusual assumption in demand-determined models. But still it is unsatisfactory. In Chapter 7 we formulate a simulation model which rectifies all of these shortcomings. But the basic structure of the model is derived from that used in Chapters 2, 3 and 4. Thus, this model is based on an integrated model of portfolio selection and the consumption—

6

INTRODUCTION

saving decision of the private sector with appropriate adding-up restrictions, with endogenous budget deficits, explicitly recognizing the role of foreign aid including the implications of the ‘fungibility’ of foreign aid as well as the role of informal credit markets without imposing any a priori restrictions on the degree of its intermediation capacity. Further, inflation is endogenized by explicitly treating the aggregate supply side. Finally, we explicitly introduce an external sector, albeit in a somewhat rudimentary form. This model is simulated to ask the same question: does interest rate deregulation affect private investment? In order to answer this question we can simulate the model in a variety of ways. But we believe that the most illuminating way for our purpose is to concentrate on one sector at a time and then do what amounts to a sensitivity analysis compared to a baseline simulation. While the possibilities are far too numerous to be outlined or examined, we concentrate on those which highlight a number of contentious issues in this area. In brief, we simulate the effects of interest rate deregulation under seven alternative assumptions about the model. These are: (1) no substitution between deposits and capital: (2) only investment or only consumption is credit constrained; (3) consumption and therefore saving is not affected by real interest rates—the standard assumption in much of the literature; (4) higher wealth effects on investment; (5) higher reserve requirements in the formal banking sector; (6) higher foreign aid; and (7) complementarity between government and private investment. As we shall see these simulations allow us to shed light on many issues. For example, we get some idea about the importance of liquidity constraint. Recently Jappelli and Pagano (1994) have shown that if financial liberalization can eliminate or relax liquidity constraints for the household, then it may lead to a reduction in savings and thus in growth. Similarly, the simulations have something to say about the sequencing of liberalization reforms, a topic that McKinnon (1991) has much to say about, namely, should budgetary reforms precede financial reforms? In Chapter 8 we add to a relatively new type of literature. So far we have concentrated on the effects of financial deregulation on the real economy. In this literature the focus is on public finance. It is beginning to be argued that financial repression can be, and is being, used by governments to extract more resources from the economy (see Sussman (1991) and Giovannini and De Melo (1993)). We deal with this issue by using the simulation model of the previous

7

INTRODUCTION

chapter. We assess the cost of financial repression in terms of its effects on inflation, private and public investment and the pattern of public consumption. The indicators of financial repression are those which are meant to raise additional revenues for the government. The measures of financial repression studied are: (1) the government levying a tax on interest income from government bonds held by the non-bank private sector; (2) the government borrowing from the banks at rates lower than those charged to the private sector; and (3) government borrowing from the banking sector by increased reserve requirements of the formal banking sector. While this approach does not provide a true cost-benefit analysis of the government’s attempts to raise revenues through financial repression, nevertheless we believe that it sheds significant light on the issues involved. Chapter 9 sums up the main findings and limitations. APPENDIX 1 There is by now a sizable literature on the optimizing models in this area. For example: Bencivenga and Smith (1991, 1992, 1993), Berthelemy and Varoudakis (1994), Bernanke and Gertler (1989, 1990), De Gregorio (1992, 1993, 1994), De la Fuente and Marin (1993), Gertler and Rose (1994), Greenwald and Stiglitz (1989), Greenwood and Jovanovic (1990), Greenwood and Smith (1993), Gylfason (1993), Jappelli and Pagano (1994), King and Levine (1993a, 1993b, 1993c), Levine (1991, 1992), Roubini and SalaiMartin (1991, 1992a, 1992b), Saint-Paul (1992a, 1992b), Sussman (1991, 1993), Sussman and Zeira (1993), Varoudakis (1992), among others. Not all of these papers use the endogenous growth models as their starting point nor do they all suggest the same mechanisms by which financial growth affects real growth, but nevertheless we can get a feel for what they do by considering the framework used in Pagano’s (1993) useful survey of this area. Using the ‘AK’ model, he shows that

where g is the real growth rate, A the social marginal productivity of capital, φ the proportion of savings not lost in the process of financial

8

INTRODUCTION

intermediation, s the private rate of saving and δ the depreciation rate. Assuming that δ is constant, financial intermediation or financial factors can affect real growth by affecting any of the other three parameters. Many of the papers cited above try to show which one of the three parameters and how it can be influenced by financial intermediation. For details the reader is asked to refer to the other survey papers or the original articles. We can only give a flavour here by referring to some of the recent works which are also used in our work above. First note that anything that can affect banking efficiency, as discussed in our Chapter 6, can affect φ. Some discussion of what those factors might be can be found in Sussman (1993). The role of financial intermediation in affecting A essentially relates to the allocational efficiency issue as discussed in our Chapter 5. In this literature, this issue has been discussed by Bencivenga and Smith (1991), Greenwood and Jovanovic (1990), Levine (1991) and Saint-Paul (1992a and 1992b), among others. There is much literature on how financial factors may affect s. But here we mention two contributions which have a bearing on our model too as we point out. These are the contributions by De Gregorio (1994) and Jappelli and Pagano (1994). Both papers use the OLG model. Jappelli and Pagano show that financial liberalization, by relaxing or eliminating liquidity constraints from the household, may depress saving, thus affecting growth unfavourably. De Gregorio, however, shows that if the borrowings by the household are also for investment in human capital, then not relaxing the liquidity constraint can harm growth. In other words, once we consider both effects, the outcome is ambiguous. Some of the papers also address the opposite question, namely, what causes financial growth. Here an interesting contribution is by Sussman (1993). Finally, some of the papers also present models in which financial and real growth take place simultaneously. Here three interesting contributions are: De la Fuente and Marin (1993), Greenwood and Jovanovic (1990) and Saint-Paul (1992a and 1992b).

9

2 THE BASE MODEL In this chapter, as pointed out in Chapter 1, we develop the base model which serves as the main framework for the subsequent chapters. The distinctive feature of the model developed here is that, unlike the rest of the works in this area, it treats the consumption— saving and portfolio allocation decisions as being jointly determined. Other authors determine these decisions as either being sequential (see, for example, Bourguignon et al., 1992) or assume that savings are exogenously determined, being independent of the rate of interest (see for example, Morisset, 1993). It is by now widely agreed upon that while the separation of the two decisions may be empirically convenient, it is not conceptually defensible (see for example, Pissarides (1978), Buiter (1980)). Pissarides, for example, has argued that the presence of transaction costs in some asset markets implies the interdependence of consumption and asset choices: If individuals are aware of these costs, they will also be aware of the importance of their portfolio, since it will, in general, be cheaper to finance consumption by running down liquid assets than by selling long-term assets before maturity. (Pissarides, 1978, p. 281) Similarly, the assumption about the exogeneity of savings or its insensitivity to changes in interest rates is grounded on appeals to empirical findings, but the evidence on this issue is far too uncertain to warrant such an extreme assumption (see for example, Gupta, 1987). Thus, a preferred alternative is to follow the route adopted by studies which treat the two decisions as being integrated. Apart from this, the model also explicitly allows for the role of liquidity constraints as faced by households and firms. Such constraints, as we know by now, may arise because of financial market imperfections. These imperfections in their turn may be caused either by government regulations of, say interest rates—a common phenomenon in developing countries—or because of asymmetric information in liberalized markets which can lead to equilibrium credit rationing (Stiglitz and Weiss, 1981).

10

THE BASE MODEL

To the extent that liquidity constraints are pervasive in developing countries, their explicit treatment in the model, as will be shown, sheds important light on the role of financial liberalization on investment. The model is in the spirit of the recent work by Morisset (1993). However, he treats savings as being an exogenous variable, the point which differs from our model. But quite apart from this and other differences, as Appendix 2 to this chapter shows, his model is overidentified, because it includes not one but two investment functions which makes it virtually impossible to draw any conclusions from his comparative static exercises and his empirical results. This chapter is organized as follows. Section 2.1 presents the model. Section 2.2 looks at the effects of an increase in the deposit rate—our measure for financial liberalization in this chapter—on the supply of credit to the private sector under different assumptions. Section 2.3 examines the comparative static effects of financial liberalization on private investment. Finally, Section 2.4 summarizes the chapter. 2.1 THE MODEL The model distinguishes a private sector (PS), a banking sector (CB: the central bank; PB: private banks), a government sector (GS) and an external sector (ES). There is no explicit treatment of the external sector (ES) and the supply side is completely ignored. We abstract from these latter factors in order to highlight the implications of the central feature of the model, which is the integrated nature of the consumption—saving and the portfolio allocation decisions. In later chapters, we allow for the external sector and the supply-side effects. Table 2.1 gives the accounting relationships of the model.

Table 2.1 The accounting framework of the model

Note: * NE=net exports.

11

THE BASE MODEL

Non-bank private sector We start the presentation of the model by considering the nonbank private sector. It is assumed to be a consolidated sector consisting of households and firms. The budget constraint of this consolidated sector is given by column 1 of Table 2.1:

The variables represent the following: four assets, namely, real domestic money (bank deposits: m), real government bonds (b), real physical capital (k) and an inflation hedge (foreign assets, represented by/and denominated in domestic currency). Cp represents real private consumption, Lp stands for real private credit, y for real non-interest income (or real Gross Domestic Product), T for taxes and y d for real disposable income, which is assumed to be exogenous.1 The consolidated budget constraint warrants some discussion. The private sector here consists of households and firms. Following Barro (1984) we can assume that investment takes place in this sector and thus justifies the budget constraint. However, the issue of consolidation is more important than that. Depending on the purpose of the exercise, one may argue that the disaggregation of the consolidated sector into its components would be more desirable as, for example, is done by Bourguignon et al. (1992) in their study of the effects of structural adjustment programs on income distribution. But they accomplish this task by imposing restrictions which would be unacceptable for our purpose. For example, they assume that households are not liquidity constrained and that not only is the consumption—saving decision independent of the portfolio selection decision, but that the latter is also sequential in terms of the liquidity of the assets. It is possible that our consolidation approach has certain shortcomings, even for our purpose. For example, it may be argued that the effects of the crowding out of the private sector credit by the government sector— an important point of the exercise here—could shed greater light on the outcome if we were able to identify whether the effect of such crowding out is confined to households or to firms. This is because the implications of the two are or, at least, can be different. The model in the simulation chapter shows that if crowding out effects are confined to firms they affect investment not only from

12

THE BASE MODEL

the demand side, but also from the supply side. Of course, one may argue that liquidity constraints may also affect the supply side from the household side by affecting the labor-leisure choice. The point is that it would be preferable to disaggregate the private sector rather than adopt the approach that we have. The main reason we haven’t done this is that one of the major aims of the study is to show the effects of government borrowing from the banking sector and its crowding out effects. If we were to disaggregate the private sector, we would have to spell out a mechanism to distribute this effect on the two components— namely, the households and the firms. This extension would make the derivation of any analytical results virtually impossible. Hence our approach. We now turn to the specification of the behavioral equations for the private sector.

im, ik, ib, and if are the exogenous nominal rates of return on deposits, physical capital, government bonds and foreign assets, respectively. Sp stands for real private savings, W for real private wealth. Finally, πe represents the exogenous expected rate of inflation. Using the taxonomy introduced by Brillembourg (1978), there are three possible reactions to portfolio disequilibrium, which, in the case under consideration, would be caused by the liberalization of interest rates leading to excess demand for bank deposits. These reactions are:

13

THE BASE MODEL

(a) a reallocation of the existing portfolio; (b) a reallocation of a given aggregate of savings by changing the menu of assets; and (c) a change in the aggregate flow of savings, which, assuming that bank deposits are a normal good, will increase their demand. In our model we incorporate reactions (a) and (c), though not (b). For this purpose, we use the integrated model of portfolio selection and consumption—saving decision proposed by Owen (1981), which itself is based on the works of Brainard and Tobin (1968), Purvis (1978), Smith (1978), Pissarides (1978), among others. A special implication of this model is that it not only allows for the ‘direct’ effects of changes in the deposit rates on the demand for money and other assets, but also for the ‘indirect’ effects which operate via wealth effects. These ‘indirect’ effects are ignored in the literature on the issue of this book, but it will be shown that once we allow for these ‘indirect’ effects, the conditions under which the ‘complementarity’ hypothesis operates turn out to be far more restrictive than is recognized in the literature so far. Equations 2, 3, 4 and 5 present the asset demand equations.2 These have been derived by using the multivariate adjustment function proposed by Brainard and Tobin (1968) in which changes in wealth (W) enter as a separate explanatory variable (see Appendix 3). This allows us to incorporate effects (a) and (c) identified above. However, it should be noted that the above equations do not include the lagged values of the various assets as specified in the BrainardTobin framework. This is because the comparative static exercises carried out in this chapter do not depend on their inclusion. Therefore, they have been excluded for convenience. However, they are included in the chapters on simulation, because the timepaths of the endogenous variables clearly depend upon their presence. Following the usual practice of this literature, it is assumed that the coefficients of disposable income and wealth are positive in each case, implying that all assets are normal goods; the coefficients of ∆Lp are also positive. The asset demands are assumed to be positively affected by the own rates of return and negatively by the alternative ones, implying that the assets are gross substitutes. Equation (6) presents the consumption function. It should be noted that this equation does not include wealth or the lagged values of the various assets. The exclusion of wealth follows from the main explicit assumption of the Owen model (1981)—namely, that the ‘end of

14

THE BASE MODEL

period wealth’ is a consequence of the consumption—saving decision and not a determinant of it. The exclusion of the lagged asset terms, although present in the Owen model, is justified for the same reasons as in the asset equations. In terms of the signs of the various coefficients in equation (6), it is assumed that 00, this would mean an increase in private investment. In other words, a given increase in im would lead to an increase in the demand for m as well as k, thus confirming the ‘complementarity’ hypothesis.

17

THE BASE MODEL

Government sector The above argument assumes that L remains constant. But there is g sufficient evidence to suggest that governments in developing countries often use bank credits to finance their budget deficits (Gupta, 1992). Assuming this to be the case, the possibility of crowding out of the credit for the private sector by government’s demand for credit from the banking sector immediately arises. In other words, even if a portfolio reallocation takes place in favor of m, both via the ‘direct’ and the ‘indirect’ effects discussed above (due to the deregulation of interest rates on deposits, leading to an increase in total supply of bank credit) there is no guarantee that a complete, or even a greater than complete, crowding out may not take place. This possibility can be incorporated into the model via the government’s budget constraint, which is given in column 4 of Table 2.1, as follows:

where Cg stands for government consumption, Ig for government investment, DEF for government deficit5 and A for foreign aid. In this chapter it is assumed that a change in the deposit rate does not affect government deficit, so that we consider government expenditures and taxes to be exogenous. Moreover, it is assumed that foreign aid is exogenous. These assumptions will be relaxed in Chapter 3. Equation (11) says that a given budget deficit is financed by borrowing from the banking sector and/or by selling bonds to the non-bank private sector and/or by foreign aid. It can be easily seen that a one dollar reduction in the demand for government bonds, given A, must mean a one dollar increase in government borrowing from the banking sector. The increase in government borrowing from the banking sector is determined by the budget constraint of this sector. This explains how a crowding out of private sector credit may occur if the government has to borrow from the banking sector. It is assumed here that the government fixes the interest rate on its bonds and the quantity of the bonds sold is then entirely determined by the nonbank private sector’s portfolio selection behavior. External sector As mentioned previously, in this chapter, there is no explicit treatment of the external sector. The current account position (net

18

THE BASE MODEL

exports: NE), is implicitly determined by the equilibrium condition on the balance of payments, or in other words the budget constraint of the foreign sector (column 5 in Table 2.1). The change in foreign assets (∆f) is determined by portfolio behavior of the non-bank private sector. As said before, foreign aid is assumed to be exogenous. By considering the budget constraints of the different sectors (equations 1, 10 and 11 and column 5 in Table 2.1) it can be shown that the goods market is automatically in equilibrium. This completes the model. The answer to the question: do changes in real interest rates affect private investment?, proceeds in two steps: first, we examine the effect of change in the real interest rate on deposits on the supply of credit to the private sector; and second, we use the results of the first step to derive the effects on private investment. 2.2 FINANCIAL LIBERALIZATION AND THE SUPPLY OF CREDIT TO THE PRIVATE SECTOR The complete model is solved to derive the following result:

It is assumed throughout that πe remains constant, so that a change in im also reflects an equal change in the expected real rate on deposits. It is easy to verify that the multiplier effect in (12) cannot be signed. However, we can get some insight into what is going on if we consider some special cases. We start by considering the case when the government does not borrow from the banking system. This case is equivalent to assuming that the demand for government bonds remains constant, implying that α21=—=α28=0. With these restrictions, equation (12) is reduced to

In terms of the signs of the coefficients in (13) and the adding-up restrictions, it can be easily verified that the denominator of (13) is positive.6 As for the numerator, a2 and a4 are positive, but in fact the sign of a44 is indeterminate, depending as it does on combinations of a negative substitution effect and a positive income effect.

19

THE BASE MODEL

In the model we have made the conventional assumption that the negative substitution effect exceeds the positive income effect, implying that ∂C/∂im0. In this case, ∂∆Lp/∂im>0, suggesting that in the absence of government borrowing from the banking sector, financial liberalization, as defined here, leads to an increase in the supply of bank credit to the private sector. On the other hand, if the positive income effect exceeds the negative substitution effect, the sign of ∂∆Lp/∂im is indeterminate. These two outcomes highlight the significance of using the integrated approach to the portfolio-allocation decision and consumption— saving decision used here. The above-mentioned point can be brought out more sharply by assuming that consumption is exogenous—that is, that the consumption—saving decision is irrelevant to the portfolio-allocation decision. In terms of the model this implies that α41=—=α48=0. With these parameter restrictions, equation (13) is reduced to

which is unambiguously positive, assuming that α3 ∂∆Lp/∂im in (13). Alternatively, let us assume that consumption—saving is not interest-rate sensitive, implying that α44=α45=α46=α47=0. In this case, equation (13) is reduced to

A comparison of (13) and (16) shows that ∂∆Lp/∂im in (13) >∂∆Lp/∂im in (16).

20

THE BASE MODEL

We can draw a number of conclusions from the above results regarding the effects of financial liberalization on the supply of bank credit to the private sector. To the extent that an increase in the supply of credit is the channel which determines whether physical capital and money are complements, our results can shed some interesting light. First, if the government finances its budget deficits by borrowing from the banking sector, it is a priori not possible to predict the effect of financial liberalization on the supply of credit to the private sector. Second, in the absence of government borrowing from the banking sector, the effect can be unambiguously determined, provided that consumption—saving is interest-rate sensitive in the conventional sense—namely that ?C/?i 0 in equation (13). However, in spite of this, it is still the case that the effect of financial liberalization on private investment remains indeterminate. We next consider the implications of the simultaneity of the portfolio-allocation decision and the consumption—saving decision, by exploiting the various restrictions which can be imposed in equation (6). Suppose that the consumption—saving decision is exogenous, meaning that wealth remains constant. This, as before, implies that α41=—-α48=0. In this case, equation (18) is reduced to

In this equation, α4/(1-α3) is the same as equation (14) which is positive since α13>0, α4α13/(1-α3)>0. In equation (19), there are two 22

THE BASE MODEL

clear effects: the ‘direct’ negative substitution effect and the total credit effect, which is positive. The net outcome will depend on the relative strength of the two. In the spirit of Section 2, we again consider two weaker versions of equation (18). Instead of assuming that consumption—saving is exogenous, we first assume that it is not liquidity constrained, so that α43=0. In this case (18) becomes

The term in curly brackets is the same as equation (15) and therefore >0 i.e., ∂C/∂im