At the occasion of the 2nd Call launch for the DFID-ESRC Growth Research Programm (with an envelope of 20 million Pound Sterling!) I had been asked to present three slides on the finance-growth nexus in low income countries (LICs). I had decided to structure the slides along three subthemes:
1. Finance and growth: a reassessment of the fundamentals.
2. Finance and growth: policy priorities for LICs.
3. Finance and growth: policy implementation in LICs.
Despite the video, it may be helpful to present my notes and the literature here.
Finance and Growth: A Reassessment of Fundamentals
· Empirical evidence establishing CAUSAL link since the 1990s, but multicollinearity problems abound.
· First, finance as independent predictor of growth identified by King & Levine (1993), Rajan & Zingales (1998), Beck et al (2000).
· But now, IMF and BIS research suggests a threshold at which the size of finance has a negative impact on GDP (Arcand, Berkes & Panizza (2012), Cechetti & Kharroubi (2012)), confirming Easterly & Stiglitz (2000).
So what changed the Pagano (1993) equation parameters?
· g = A (φS/Y) – δ; I = φS. How finance can raise growth, g:
· A = social marginal productivity of capital (allocation; innovation)
· φ = the proportion of saving funneled to investment (´lost´ financial intermediation cost for transforming risk, size & maturities and for handling information asymmetries (monitoring, screening of debtors)
· I = φS = capital accumulation
· δ = depreciation of accumulated capital
· Corporate savings in high-growth Asia and financial repression (Storesletten, Song & Zilibotti, 2011) in the Pagano (1993) framework.
· Re-establish LICs-specific evidence on finance-growth nexus.
· Causes and gestation process of systemic financial crises in LICs versus richer countries.
Finance and Growth: Policy Priorities for LICS
Structure and Growth
· Finance and the development stage: the New Structural Economics (Lin, 2012) posits an appropriate financial structure for any given level of development (industrial structure; average firm size; typical risks they face; lack of financial documents or history) => microcredit, informal moneylenders and small local banks?
· Related: a country´s distance to the technology frontier and the relative importance of financial intermediaries (Aghion, Howitt & Meyer, 2005) versus direct securities markets (Caprio & Honohan, 2001).
· Related: in the presence of weak institutional environments and limited funding for SME and social investment, how limited is the potential of private-sector finance and what role for public financial intermediaries (development banks, savings cooperatives ´Raiffeisen model´, credit guarantee schemes)?
Credit cycles and growth
· In the LIC context, the need for countercyclical regulation applies specifically to volatile raw material food prices. In terms of monetary analysis, the prevalence in rich countries is with financial shocks, in poor countries instead with real shocks. Both need counter cyclical response; how may they vary by country type?
· Countercyclical financial regulation and lending is of particular importance in LICs (Gallagher, Griffith-Jones & Ocampo, 2012) . What LIC-specific policies (macroprudential regulation, capital account measures, regulatory bank capital) are needed? Do they need to be complemented by countercyclical public lending ?
· Is there also for LICs an optimal sequencing of financial liberalization to stabilize cycles without compromising sustainable growth? Are there policy lessons from LICs to richer countries for insulating against foreign-born financial crises?
Finance and Growth: Policy Implementation in LICs
· The sequencing of institutional, regulatory and policy implementation in the context of LICs. What lessons from OECD and/or middle-income countries are transferable? Why? Why not?
· Financial-sector development needs to be synchronized with clusters of other policy areas. What are the closest complements (such as development of domestic bond markets, credit registries, cadastral offices, pension funding or public debt management)?
· The lack of sufficient infrastructure as well as the importance of remittances and of informal labour markets needs a central consideration in the implementation of policy reform in LICs, not least for the financial sector. What are the most promising measures to help mobilize funding for infrastructure, to make remittances work for development and how should finance cope with labour informality?
· LICs are often small and relationships of the business, policy and administrative elite very close. How can contestability be achieved in such context, financial-sector lobbying be curtailed and professional know how best be allocated to financial-sector supervision and regulation. How to achieve its independence?
Aghion, P., P. Howitt, and D. Mayer-Foulkes (2005), "The Effects of Financial Development on Convergence: Theory and Finance",The Quarterly Journal of Economics, vol. 120(1), pages 173-222, January.
Arcand, J.-L., E. Berkes, and U. Panizza, 2012, “Too much finance?” IMF Working Paper No. 12/161.
Barth, J.R., G. Caprio and R. Levine, 2006, Rethinking Bank Regulation: Till Angels Govern, Cambridge University Press, New York.
Beck, T., R. Levine, and N. Loayza, 2000. “Financial Intermediation and Growth: Causality and Causes.” Journal of Monetary Economics 46, 31-77.Cechetti, S. and E. Kharroubi (2012), "Reassessing the impact of finance on growth", BIS Working Papers No. 318.
Gallagher, K.P., Griffith-Jones, S. and Ocampo, J.A. 2012. ‘Capital Account Regulations for Stability and Development: A New Approach’ S. Pardee Center for the Study of the Long-Range Future. Issues in Brief. No. 22.
King, R., and R. Levine, 1993, “Finance and Growth: Schumpeter Might be Right.” Quarterly Journal of Economics 108, 717-737.
Pagano. M. (1993), "Financial Markets and Growth: An Overview", European Economic Review, vol. 37(2-3), pages 613-622.