Financial markets in developing countries (rough notes, use only as - PowerPoint PPT Presentation

Econ 355W - A. Karaivanov Lecture Notes Financial markets in developing countries (rough notes, use only as guidance; more details provided in lecture) The role of the fi nancial system • matching savers and investors (otherwise each person needs to save up by themselves) • providing payment services (instead of carrying cash) • generating and distributing information — re fl ected in stock, bond prices, etc. 1

Econ 355W - A. Karaivanov Lecture Notes • allocation of credit/capital in the economy (to the uses that yield greatest returns) • pricing, pooling and trading risk (through the insurance market, part of the fi nancial system) • providing asset liquidity (some investments are long-lived; but can be made liquid through the stock market, etc.) 2

Econ 355W - A. Karaivanov Lecture Notes Credit markets • matching skills with resources • if fi nancial markets are e ffi cient (perfect information, perfect enforcement) then resources fl ow to highest returns (highest skills) • otherwise, economic outcomes depend on how much wealth people start with, not their talents • thus, fi nancial markets are important for e ffi ciency, for the economy to reach its potential 3

Econ 355W - A. Karaivanov Lecture Notes • Why are fi nancial markets particularly likely to be imperfect in developing countries? • Buying something vs. paying are often separated over time • Presence of ‘transaction costs’ — when the time to pay comes people can be: — unable to repay ( information needed in advance to prevent this; this is costly) — unwilling to repay ( enforcement needed ex-post to prevent this; this is costly) — evidence from India: in 1997, 3.2 outstanding debt cases; 40% for more than 8 years — also, limited liability — in today’s world there are legal limits on punishment for reneging on contracts (not true in the past or in black markets) 4

Econ 355W - A. Karaivanov Lecture Notes Lenders anticipate these issues, so they: • screen borrowers (if asymmetric information problem in borrower’s riskiness/type) • monitor borrowers (if asymmetric info in borrower’s e ff ort — if cannot observe it) • threaten to cut o ff from future loans (to help with enforcement problems) • require collateral (to help with enforcement problems) 5

Econ 355W - A. Karaivanov Lecture Notes FACTS • high interest rates in LDCs (Banerjee, 2004) — 52% in rural areas in India; 28-62% in urban; in the US — 6-14% 1980-2000 — cannot be explained by default alone (explains at most 23% of the interest rate level) — cannot be explained by monopoly power alone — why kill the demand so much? also, public banks and competition from informal sector present • presence of large informal sector, including moneylenders (provides 20- 30% of all loans) • personalized interest rates (co-existence of various rates, e.g. 12% vs. 60% without arbitrage) • loan amount often restricted by borrower’s wealth/assets — no more loans possible, no matter what the interest rate — “credit rationing” 6

Econ 355W - A. Karaivanov Lecture Notes • some people not given a loan of any amount and at any o ff ered interest rate (not consistent with standard supply and demand theory under perfect markets) 7

Econ 355W - A. Karaivanov Lecture Notes • Evidence for transaction costs: — the case of Debt Recovery Tribunals in India (Visaria, 2007) — sped up resolution of civil cases about unpaid loans; — reduced loan delinquency by 6-11 percentage points — interest rates fell by 1-2 percentage points • Cross-country evidence (Djankov et al. 2006) — study 129 countries over 25 years — fi nds that lenders’ legal rights (ability to enforce repayment; sell the collateral) is positively correlated with the private debt to GDP ratio 8

Econ 355W - A. Karaivanov Lecture Notes • Financial development and growth (Rajan and Zingales, 1998) — across countries the size of domestic credit market positively correlated with GDP per capita — however, causality can run the other way around — richer countries may have larger market for credit — or, both can be caused by third factors (institutions, good government policies) — however, they also fi nd a strong positive evidence on fi nancial development on growth of industries that are more credit-dependent. • King and Levine (1993) — fi nd positive correlation between higher initial levels of fi nancial development and subsequent growth (controlling for many country and policy characteristics) 9

Econ 355W - A. Karaivanov Lecture Notes THEORY Three major problems causing fi nancial market imperfections 1. Limited enforcement — borrowers can default even if able to pay 2. Moral hazard — unobserved e ff ort by borrowers a ff ect the probability of successful investment, hence repayment 3. Adverse selection — unobserved characteristics by borrowers (e.g., riskiness) a ff ect probability of repayment • the reason for the market imperfections/failure is either contract enforcement problem (1.) or asymmetric information between lenders and borrowers (2. and 3.) 10

Econ 355W - A. Karaivanov Lecture Notes Limited Enforcement Example • suppose the borrower can choose not to repay since probability of getting caught (loan enforced) is π < 1 — limited enforcement • penalty if default and caught is F ; interest rate r, e.g. 20% (i.e. for $1 borrowed must return $(1 + r ) , e.g. $1.20) • investment of I needed to set up production; borrower has initial wealth A < I • borrower borrows I − A • output is q (if investment made) • the borrower will not default if: (1) q − (1 + r )( I − A ) > q − πF 11

Econ 355W - A. Karaivanov Lecture Notes • the above inequality says that the income if not default (left hand side) should be larger than the expected income if default (escape with the money) — the right hand side • from (1), we obtain that default will not happen as long as: A > I − πF (2) 1 + r • thus, only people with high enough wealth will be lent to (the lender will not lend to someone they know will default; think of F as jail time, etc. not something that the lender gets). • note how the limited enforcement problem creates credit rationing and ine ffi ciency! — some poor people will not obtain loans, even if their business projects are pro fi table (say q > (1 + r ) I ) 12

Econ 355W - A. Karaivanov Lecture Notes • the minimum wealth necessary to borrow depends on πF — the highr the fi ne or the probability of repayment — the more people will be able to borrow. On the other hand, the higher I (i.e., the loan required) or the interest rate, the higher the wealth threshold. • Note if the right hand side in (2) is negative then any person can borrow. • refusing future loans or interlinking can alleviate the above problems 13

Econ 355W - A. Karaivanov Lecture Notes Moral Hazard Example • suppose output from a business can be either high (success), y H = 2 or low (failure), y L = 0 • the probability of success is a function of borrower’s ‘e ff ort’, e ; assume for simplicity prob ( y H ) = e and prob ( y L ) = 1 − e. • putting e ff ort is costly, cost 1 2 e 2 • investment I = 1 required to run business; opportunity cost of funds, ρ • assume y H > (1 + r ) I — i.e. the investment is worth doing ( 2 > 1 + r ) Case I: self- fi nanced entrepreneur e (2) − ρ (1) − 1 2 e 2 max e 14

Econ 355W - A. Karaivanov Lecture Notes take the derivative and set to zero to fi nd the optimal e ff ort level: e ∗ = 2 15

Econ 355W - A. Karaivanov Lecture Notes Case II: borrowing when e ff ort is observable (no incentive/moral hazard problems) • the e ffi cient e ff ort level e ∗ will be achieved if it is possible to monitor e ff ort. • assume the lender is only paid in case of success (the borrower has nothing otherwise) • The lender’s expected pro fi t is: Π L = eI (1 + r ) − ρI = e (1 + r ) − ρ • the borrower’s expected pro fi t is Π B = e ( y H − (1 + r ) I ) − 1 2 e 2 = e (1 − r ) − 1 2 e 2 • if e ff ort is monitorable, the two parties will choose e in the the optimal way to maximize joint pro fi ts: Π = Π L + Π B = 2 e − ρ − 1 2 e 2 which is exactly the same expression as that of the self- fi nanced entrepreneur. • the same, fi rst-best e ff ort level, e ∗ is obtained as a result. 16

Econ 355W - A. Karaivanov Lecture Notes Case III: moral hazard due to unobservable e ff ort • suppose now the lender cannot observe the e ff ort the borrower puts in • the borrower knows that when output is low he will pay nothing, while when output is high he must pay the interest; • it’s as if the borrower’s success is ‘taxed’ — reduces his incentive to put in e ff ort (a ‘moral hazard’ problem occurs) • The borrower chooses e ff ort alone (to maximize his own income): e ( y H ) − e (1 + r ) I − (1 − e )(0) − 1 2 e 2 = 2 e − e (1 + r ) − 1 2 e 2 max e • take the derivative and set to zero: 2 − (1 + r ) − e = 0 17

Econ 355W - A. Karaivanov Lecture Notes or, e MH = 1 + r which is less than e ∗ (see above) • the moral hazard problem leads to lower e ff ort, and ine ffi ciency (higher default rates than in the fi rst best; lower expected output). • possible role for collateral : a collateral requirement (making the borrower lose something in the low output case) will alleviate the moral hazard problem by increasing incentives to work hard 18