Deck 15: Finance and Fiscal Policy for Development

Question 1

Explain the distinction between organized and unorganized money markets.

Answer 1

ORGANIZED MONEY MARKET
Organized money market refers to that part of monetary system of a country which is characterized by formal banking system. Under such system, savings and loans are channeled through those financial intermediaries who are both recognized and licensed by the government.
In most developing countries, organized money market operates under variety of legal restrictions. This segment of monetary system in most developing countries generally cater to the needs of middle and upper class local and foreign businesses in modern industrial sector and thus keep small enterprises and agricultural sector as whole out of its lending preview.
UNORGANIZED MONEY MARKETS
This kind of money market arrangement generally exists in the developing countries and is characterized by the existence of informal, illegal, and usurious credit system mostly represented by moneylenders and caters to the needs of poor farmers and small firms who have to borrow from these moneylenders at exorbitant interest rates.
In most developing countries, majority of lending and borrowing takes place in unorganized money market. This happens because organized sector generally serve the needs of wealthy elites and neglects the requirements of poor who have to turn to these illegal institutions in times of financial needs.

Question 2

In the context of development priorities, what are the relative roles of central banks, commercial banks, development banks, informal and unorganized sources of credit, and microfinance such as the Grameen Bank of Bangladesh?

Answer 2

In context of development priorities, stated institutions can play very important role more specifically in case of developing countries.
Central bank through the manipulation of monetary and credit policy instruments can help the developing countries in achieving major macroeconomic objectives such as inflation control or price stability, investment promotion, and regulation of international currency movements.
Commercial banks can also play important role in terms of providing credit to industrial sector more prominently to small and medium scale enterprises. Development of SMEs is most important for the development of developing country itself. Also, commercial banks should act as repositories of commercial knowledge and business skills that are typically in short supply in developing countries.
Development banks play important role in the sense that they act as suppliers of medium and long term funds as required for creation or expansion of industrial enterprises.
Development banks generally play crucial role in terms of industrial growth in economies that have scarcity of capital. These banks also provide services such as industrial project appraisal to assess the suitability of project itself. However, development banks generally concentrate on large-scale loans and thus do not meet needs of small enterprises. This kind of behavior on part of development banks acts as hindrance in the achievement of broad based economic development especially in developing countries where majority of private sector is constituted by small enterprises.
In majority of developing countries, much economic activity comes from small scale producers and enterprises. Their demand for finance comprises small loans to buy inventories, buffer loans to tide over seasonal income fluctuations, and minor loans to purchase simple equipment or hire additional labor.
It has been witnessed that this unique demands for finance keep this segment outside the preview of commercial bank lending. Moreover, commercial banks themselves are reluctant and ill-equipped to meet needs of these borrowers. Here, informal or unorganized sources of credit play an important role in terms of fulfilling demand for finance of these small borrowers. Informal finance sources include local rotating savings and credit associations and group lending schemes. It has been witnessed that majority of low-income people utilize this route to save and borrow. Also, in this format, repayment rate and participation rate is very high. Thus, this mode by fulfilling the finance and credit need of small borrowers especially in developing countries encourage and increase the level of economic activity and contribute significantly in raising the standard of living and livelihood resources of majority of residents.
Microenterprises dominate the economic scenario in many developing countries especially in least developed countries. But these microenterprises find it difficult to obtain requisite credit often in very small denominations as they either have little or no collateral and also conventional lenders find it extremely difficult to determine borrower quality of these micro-entrepreneurs. This lack of availability of credit is regarded as a binding constraint for microenterprise development. In this regard micro financial institutions such as Grameen bank plays important role. They act as the supplier of credit, saving vehicles, and other basic financial services to poor and vulnerable micro entrepreneurs who generally have no access to credit or can only borrow at very highly unfavorable terms.
This lending to micro enterprises by MFIs help the micro enterprises in undertaking their operations in better manner and thus contribute directly towards economic upliftment of these downtrodden people.

Question 3

What is meant by financial repression, financial liberalization, currency substitution, and unorganized money markets, and how do they relate to financial policy in developing countries?

Answer 3

Financial Repression
This refers to the constraints on investment as a result of credit rationing being resorted by financial institution because interest rates and supply of savings are much below the market-determined level.
Financial Liberalization
This refers to the reduction or elimination of various types of government intervention in the working of financial markets. This enables the supply and demand of funds to determine the level of interest and thus help in combating the situation of financial repression.
Currency Substitution
This phenomenon is said to have exist when instead of local currency, foreign currency is used as medium of exchange in a country. Sometimes foreign currency is used along with the local currency as well.
Unorganized money markets
This kind of money market arrangement generally exists in the developing countries and is characterized by the existence of informal, illegal, and usurious credit system mostly represented by moneylenders and caters to the needs of poor farmers and small firms who have to borrow from these moneylenders at exorbitant interest rates.
In most developing countries, majority of lending and borrowing takes place in unorganized money market. This happens because organized sector generally serve the needs of wealthy elites and neglects the requirements of poor who have to turn to these illegal institutions in times of financial needs.
They relate to the financial policy of the developing countries in the following sense -
Financial policy of developing countries is characterized by the restrictions on lending and interest rate to be charged by the financial institutions and commercial banks. This kind of policy compels the banks to ration the credit and thus create roadblocks in undertaking investments and creates the situation of financial repression.
This prevalence of financial repression and bypassing of small borrowers by the financial institutions due to credit rationing stresses on the need to overhaul the financial policy mechanism in developing countries and the urgent need to bring in financial liberalization.
Many developing countries are constrained in terms of regulating the national supply of money and thus could not utilize this medium effectively in controlling inflation. This combined with large fiscal deficit being incurred by the government keeps the inflation rate high. Due to higher inflation rate and governments minimal ability to control this bring a massive decrease in purchasing power of the local currency. To save themselves from this falling purchasing power of local currency, general public start the use of strong foreign currency most probably U.S. dollars for exchange of goods and services and thus currency substitution prevails in the respective country.
As we know that monetary mechanism in developing countries is of dual nature with two type of money markets existing - organized money market and unorganized money market. With organized money market catering to the credit needs of only special group of middle and upper class local and foreign businesses in modern industrial sector and by passing the small businesses and agriculture sector, role of unorganized money market in developing countries is very prominent. They acts as the only source of finance for the majority of population but these sources charge exorbitant interest rates and thus create heavy interest payment and debt repayment burden on the poor. Thus, financial policy of the developing country have to be tweaked in the sense that financial reforms should be undertaken that make sure that small farmers and firms have access to the needed credit at low cost.

Question 4

List and briefly discuss the seven market failures that Stiglitz and his colleagues say justify a strong government role in developing-country financial sectors. Do you agree or disagree with this assessment? Explain.

Question 5

What are the principal sources of government revenues in developing countries? Why are many taxes so difficult to collect? Discuss.

Question 6

In what ways do you think taxation and expenditure systems in developing countries could be improved? Be specific.

Question 7

If the scarcity of administrative capabilities is a serious constraint on development policy implementation, what can developing countries do to relieve this constraint? What are the options? Discuss.

Question 8

Summarize the arguments for and against the establishment of state-owned enterprises (SOEs) in developing nations. Do you think that SOEs should be encouraged or discouraged? What are the arguments for and against privatization of the public sector in developing countries? How would you interpret evidence that a majority of privatized enterprises have increased efficiency? Explain your answers.

Question 9

When privatization picked up pace in Poland, some analysts warned that effective privatization first required more developed domestic financial institutions. Comment.

Question 10

What are the pros and cons of encouraging the development of stock markets in developing countries?

Question 11

How have microfinance institutions' strategies differed from those of other lenders in reaching lower-income borrowers?

Question 12

What are some of the benefits of expanding microcredit programs, and what are some of its potential limits?

Question 13

Consider the three recent policy debates concerning microfinance (on subsidies, nonfinancial activities, and commercialization). What kinds of evidence would you seek to resolve these, at least in a localized context?

Question 14

What lessons can be learned for low-income countries from Botswana's successes