Lecture 18: Financial Systems and Microfinance Economic Development Lecture 18: Financial Systems and Microfinance

Overview Introduction Financial systems in developing countries The role of central banks Case Study: Hyperinflation in Zimbabwe Alternatives to a central bank Development banking Informal banking Reforming financial systems The role of stock markets Microfinance Case Study: Grameen Bank

Introduction ‘Prudential regulation’ Real sector/economy v financial sector/economy Which drives which? Answer: Likely both!

Introduction Role of the financial sector: Payment services Middle-man for savers and investors Allocating credit efficiently Distributing information Managing risk Increasing asset liquidity: ‘de-chunking’

Financial systems in developing countries Monetarists v Keynesians Monetarists: Expand money supply => directly induce economic activity Keynesians: Expand money supply => increase amount of money for lending =>  interest rates =>  investment =>  economic activity

Financial systems in developing countries Problems in developing countries: Expanding/contracting money supply Affecting interest rates Why? Coordination issues Financial markets as ‘islands’ Multinational focus Managed floating exchange rates

Financial systems in developing countries Why? (cont.) Foreign reserves a high proportion of finance Currency substitution Information gaps Scarcity of funds Low sensitivity to interest rates Result? Duel monetary systems (to varying extents…)

The role of central banks Issue currency Manage foreign reserves Act as bank to the government Act as reserve bank to commercial banks Financial regulator Monetary policymaker

The role of central banks Problems in developing countries: Human capital deficit Credibility issues Lack of political independence Beholden to imprudent fiscal policy

Case study: Hyperinflation in Zimbabwe Hyperinflation = inflation > 50% per month Started in Zimbabwe in March 2007 1997 – 2007: Cumulative inflation = 3.8 bn % Living standards fell by 38% Effect on savings, financial capital

Exchange rates: comparing the $Z with the Weimar Mark

Case study: Hyperinflation in Zimbabwe Cause? Government fiscal policy Reserve bank has lost credibility, and thus ability to target inflation Attempted solutions: The denomination was changed Inflation was declared illegal (!!) Reserve bank continued to make declarations on its inflation targets...

Notes from the now defunct $Z…

Case study: Hyperinflation in Zimbabwe Result? Foreign currencies adopted illegally Barter ...then foreign currencies adopted legally! Possible solutions? ‘Dollarisation’ Currency board Free banking

Alternatives to a central bank Currency board ‘Transitional central banking institution’ Supranational central bank Outsourcing Pegging Currency enclave ‘Open-economy central banking institution’ Activist banking

Development banking Activist banking = development banking? Medium and long-term funds for industrial expansion Supranational development banks National development banks Direct involvement in enterprise …but not small loans

Informal banking Usury Income inequality Microfinance? Rotating savings and credit associations?

Reforming financial systems Financial liberalisation? Money market price ceilings Financial repression Private efficiency v social efficiency

Reforming financial systems Financial regulation: the Stiglitz list of market failures: Lack of public monitoring Institutional free-riding: overallocation and underallocation of funds Bank failure induces a run on the banks Missing insurance markets Abuse of market power Private v social returns Investment information gaps

The role of stock markets Do they promote economic growth? Benefits: Increased liquidity Risk diversification Role for government? Reducing barriers to entry

Microfinance Access to credit for investment: a way to help the poor ‘plug the savings gap’ Why not normal finance? Administration cost Lack of collateral

Case study: Grameen Bank Background: Muhammad Yunus (Banker to the Poor) Nobel Peace Prize 2006 Grameen Bank (‘Bank of the villages’) Now has assets worth $750m Almost 25,000 employees

Case study: Grameen Bank Features of Grameen Bank: Group lending Targets women (over 90%) Targets poor villages and households Small loans ($100 to $200) Weekly repayments Dual-purpose meetings

Case study: Grameen Bank Positive matching: Good-risk people want to group with other good-risk people Risky people driven out Peer monitoring: Each member bears risk of all members’ projects

Case study: Grameen Bank Drawbacks: Pressure to choose overly safe investment projects If one member has to default, all other members will want to default also Partial solution to default problem is to lend sequentially to group members