Cost and access to capital as constraints to growth Elena Ianchovichina PRMED, World Bank Joint Vienna Institute July 2009

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

How do we assess whether a country is liquidity constrained?  Misleading to rely on the popular measure of the amount of credit to the private sector as a share of GDP  Low quantity of credit to the private sector is not necessarily a signal of scarcity of the factor Quantity of finance may be low because of scarce supply, in which case the country is considered liquidity- constrained (e.g. Brazil, ) But it may be low because of low demand, in which case the economy is not liquidity constrained, it is a case of low returns (e.g. Zambia, )

What measures do we use?  The price can be used to distinguish between the two cases  In the case of finance, the price to look at is the real interest rate Low quantity and high price indicate scarcity of supply relative to demand Look at international comparisons and the distance of the price from the mean  if the price signal is an outlier and is several standard deviations outside the expected range it is difficult to reject the hypothesis  It is important to look at investment by sector – investment may be adequate at the aggregate level but it may be concentrated in one sector or a few sectors Investment allocation tells us about the type of growth process occurring in the country and the likelihood that growth will be broad based and inclusive

Objective data  Look at objective data over time and cross-country: Average real lending rates as a proxy of real cost of capital – time series data Benchmark to comparators Bank’s lending rates by maturity and by borrower  The range tells us a lot about the costs faced by different types of firms  Investigate the reasons for the change in the cost of capital Is it due to changes in inflation? Is it due to changes in deposit rates? Is it due to changes in risk premiums?  Benchmark deposit rates and risk premiums What are the determinants of deposit rates and risk premiums?

Subjective data  Use firm survey data to see what are the perceptions about the cost and access to capital  Match perceptions with reality, find out: The percentage of firms complaining about the cost and access to finance as a severe constraint to firms’ growth The percentage of firms that did not apply for a loan because of the high cost of capital The percentage of firms that either obtained a loan or did not need a loan  Distinguish between loans of different maturity Access to long-term financing is typically a big problem  Even when the cost of capital is high, and the credit to the private sector is low, if the majority of firms do not need loans to expand operations then the country may not be liquidity constrained

Why is a country liquidity constrained?  Inadequate access to savings Both access to foreign borrowing and domestic savings must be limited  High spreads on foreign borrowing due to high country risk and low credit ratings  Domestic capital controls  Poverty traps  High tax burden Important to understand who is not saving: firms or households  Inefficient process of financial intermediation

Inefficient process of financial intermediation  Difficulty assessing credit risk May lead to very high risk premiums for the majority of firms, especially small firms High collateral requirements  Reasons Poor corporate governance Lack of transparency in business operations Weakness in the bankruptcy and debt recovery framework

Inefficient process of financial intermediation  Issues with access to capital Underdeveloped capital markets  The financial system may be dominated by a few banks, the stock market may be illiquid, commercial bond market may not exist, and pension funds may be small  Banks may offer a limited range of products  People may not be using the banking system due to lack of trust Financial system misallocates resources  Could result in high opportunity costs and possibly high fiscal costs  Banks may lend for consumption but not for productive projects  Banks may lend to the elite and well-connected, and for this exclusive group, private cost of capital may be low, while for the majority of individuals access to capital may be very limited

Three case studies  Mongolia  Benin  Zambia

The case of Mongolia

Was Mongolia liquidity constrained in 2005? Was private investment too low in Mongolia?  Gross domestic investment in Mongolia was high for its level of development Averaged 35% of GDP between 1996 and 2005  However, most of investment was official foreign aid and loans 59% of investment in 2004

Was Mongolia liquidity constrained in 2005? Did the composition of investment in Mongolia support inclusive growth?  The bulk of private investment went into a limited number of firms in mining and construction FDI was high and averaged 5.2% of GDP in Domestic private investment was financed mainly by own funds (72 percent in 2004), and not bank loans Domestic credit to the private sector was growing at high rates, but most of the loans were short term and financed trade, not productive investments

Were real interest rates in Mongolia high? Real interest rates came down substantially… Source: Ianchovichina and Gooptu (2007)

What was the reason for the fall in the real cost of capital? The fall in the real cost of capital was due to inflation rate increases rather than risk premium declines… Source: Ianchovichina and Gooptu (2007)

and Mongolia’s cost of capital was still high relative to other developing countries Source: Ricardo Hausman, “A framework for Growth Diagnostics”, Kennedy School of Government, Harvard University, May Mongolia

and given the availability of credit to the private sector

Why was the cost of capital still high in Mongolia? Cost of capital was high because of high bank deposit rates and risk premiums Source: Ianchovichina and Gooptu (2007)

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Why were bank deposit rates and risk premiums high? Were they high because of bad international finance?  International finance was good Mongolia’s official debt was primarily concessional, and long-term FDI inflows were strong at the time of analysis  Outlook was also good The spread on ‘B+’ Fitch rated countries was 280 to 300 basis points Collateral could be used to bring down the spread further down The outlook has changed since then due to the sudden negative TOT shock

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Why were bank deposit rates and risk premiums high? Was bad local finance the reason for the high cost of capital?  Domestic saving were rising in Mongolia due to strong growth and BOP position  Rising official reserves and commercial bank assets pushed the 2006 liquidity ratio to 600% and credit growth was highest since 1992

High cost of finance Low return to economic activity Low social returns Low appropriability government failures market failures poor geography low human capital bad infra - structure microrisks: property rights, corruption, taxes macro risks: financial, monetary, fiscal instability information externalities: “self - discovery” coordination externalities bad international finance bad local finance low domestic saving poor inter - mediation Growth diagnostics Problem: Low levels of private investment and entrepreneurship Source: Hausmann, Rodrik, Velasco (2005) poor natural resource management

Why were bank deposit rates and risk premiums high? Poor financial intermediation was responsible for the high cost of capital  Bank deposit rates were high due to intensive competition among financial institutions in Mongolia  Spreads were high due to a combinations of factors: Difficulty in assessing credit risk; High bank operating costs; Low profitability of banks’ non-lending assets;

Were the high cost of capital and limited access to capital the reasons for the large number of firms without loans in Mongolia? 72.1%27.9% With a loanWithout a loan All firms 100% 4.0%68.1% AppliedDid not apply 25.9%42.2 Did not need a loan Discouraged Why? High cost of Capital 22.0% Collateral 18.7% Low return To capital? 42.2% Lack Collateral 3%l Why? Low return To capital? 1% Loan Maturity of 1 year 27% Loan Maturity > 5 years 0.9% Source: Ianchovichina and Gooptu (2007)

Discrepancy between subjective and objective data in Mongolia  Cost of capital Whereas 56% of the firms in the ICA complained that the cost of capital is a severe obstacle to business growth Only 22% of the firms in the survey did not apply for a loan because of the high cost of capital  Access to capital Whereas 42% of firms claim that access to credit was a severe obstacle 70% either obtained a loan (28% of firms) or did not need a loan (42% of firms) Access to long-term financing is limited  Collateral requirement is excessive due to problems with assessing credit risk  Conclusion: while the cost of capital was high, it was not the primary reason for the small number of firms with loans

The case of Benin

Was Private Investment Low in Benin?  Gross domestic investment has been low by international standards, averaging 18.2% of GDP in the last 10 years  Nearly all of private foreign investment was FDI, averaging just 1.7% of GDP in the past decade In line with WAEMU, but much below SSA, HIPCs and LICs averages  Private domestic investment was a smaller share of domestic investment than the average in WEAMU, HIPC, LICs  Only a small share of firms had loans in 2004 and most of the loans to the private sector were short- to medium-term  As in other HIPCs a large share of investment in Benin was funded by foreign aid

Were there signs that credit to the private sector was tight?  Broad money rose by more than 22 percent in 2005, considerably higher than nominal GDP  No signs of crowding out There was a 20 percent expansion of credit to the private sector. As net bank credit to the government has declined, growth of credit to the private sector has remained at nearly 10 percent, with some shift towards longer term credit and lending to non-trade services, especially telecommunications.

Benin Monetary Developments (CFA Francs billions) Source: International Monetary Fund, Article IV Consultation, January 2007

Was the low level of private investment in Benin a signal of low supply or low demand for finance?  Average real cost of capital was lower compared to other developing countries  It has risen during the past 3 years  But in 2007, the cost of capital for small enterprises was close to 8 percent – much lower than the rates faced by SMEs in many developing countries Real average cost of capital Source: SIMA and Government of Benin.

Benin did not appear to be finance constrained… Source: Ricardo Hausman, “A framework for Growth Diagnostics”, Kennedy School of Government, Harvard University, May Mongolia Benin

Cost of finance was low given the availability of credit to the private sector…

Perceptions differed from reality in Benin  78 % of the firms complained that the cost of capital was a severe obstacle to business growth, but only 10 % of the firms were discouraged and did not apply for a loan because of the high cost of capital  70 percent of firms claimed that access to credit was a severe obstacle, 60 percent of the firms either obtained a loan, were approved for a loan or did not need a loan. Access to capital in Benin, 2004 (ICA) 142 (74.3% 49 (25.7) With a loanWithout a loan All firms 191 (100%) 49 (25.7%) 93 (48.7% Applied Did not apply 65 (34%) 28 (14.7%) Did not need a loan Discouraged Why? Rejected 15 (7.9%) Not rejected 34 (17.8%) Loan Maturity of 1 year or less 16 (8.4%) Loan Maturity > 5 years 7 (3.7%) Source: Ianchovichina (2008) based on Benin Investment Climate Survey Loan 1<Maturity <= 5 years 26 (13.6%) Project not feasible: 2 (1.1%) Other: 5 (2.6%) Lack of collatera l: 8 (4.2%) High cost of Capital 19 (9.9%) Collateral/ Insufficient guarantee 8 (4.2%) Process too Difficult 22 (11.5%) Other 16 (8.4%)

Real cost of capital by type of borrower in Benin Source: SIMA and Government of Benin Real cost of capital for small enterprises was rising and was much higher than the average, but still lower than in many countries and access to microfinance did not appear to be a problem

Microfinance in Benin is a dynamic sector  Microfinance has grown tremendously in the last decade  Benin has the largest number of microfinance institutions in the WAEMU region.  In 2002, there were more than 600 retail microfinance organizations belonging to about 85 programs or networks reaching about 500,000 people  A penetration rate of about 15 percent of the total active population  However, access to long term capital that can fund productive investment, not short-term trade-related activities, is very limited

The case of Zambia

Average cost of finance declined in recent years Ianchovichina and Lundstrom (2008)

But, cost and access of capital differentials were sizable  Access and cost of capital varied with firms’ size In 2003, nearly 50 percent of larger firms had a loan, while only 19 percent of small firms had a loan The cost of capital differential between large and small firms was more than 10 percentage points Similar differentials existed between the cost of capital of exporters and non-exporters, domestic and foreign companies Micro firms faced even steeper constraints  Access and cost of capital varied by area Rural areas had very limited access to capital Access to capital through informal channels at prohibitively high cost

What were the reasons for the poor access to and high cost of finance for small and micro firms?  Poor financial intermediation rather than low domestic savings or bad international finance Domestic savings as a share of GDP climbed up from 6% in 1990s to 18.1% in 2006, a share higher than the SSA average FDI and aid were higher than the average for SSA and LICs both in 1990s and 2000s  Financial intermediation was limited by small size of banking sector, and an inadequate supporting financial infrastructure Ianchovichina and Lundstrom (2008)

Despite limited use, there were signs of improvement  Only 5 to 8 percent of business owners used microfinance (FinTrust 2007)  Signs of improvement: the percentage of people identifying the cost of finance as the main reason for their poverty status halved in the period Some micro finance institutions operated by NGOs and outgrowers schemes successful in providing credit to farmers but limited coverage

Top reason for not using financial service was lack of income