Bancos circa 1934: … the ephor of the exchange economy.

II Foro Estados Unidos-Unión Europea de la Fundación

Euroamérica

The role of financial system in economic and social

development

Miami Dade College, Wolfson CampusJose Juan Ruiz, 2014, May 15th & 16th

The banker...has become the capitalist par excellence. He stands between those who wish to form new combinations and the possessors of productive means. He is essentially a phenomenon of development, though only when no central authority directs the social process. He makes possible the carrying out of new combinations, authorizes people in name of society as it were, to form them. He is the ephor of the exchange economy.

J.A. Schumpeter, The Theory of Economic Development (1934)

Bancos circa 1934: … the ephor of the exchange economy.

He claimed he had set himself three goals in life: to be the greatest economist in the world, to be the best horseman in all of Austria and the greatest lover in all of Vienna

http://en.wikipedia.org/wiki/Austria

http://en.wikipedia.org/wiki/Vienna

The literature indicates that some tasks of the financial sector are beneficial, some attributes of financial institutions matter, and others matter less so or not at all. (…)

Without doubt, various proposed changes in regulation will be costly for the financial sector and make it more difficult for the sector to perform some activities.

But that is not necessarily a bad thing.

If a change would cost the financial sector, say, one billion a year but does not affect the total amount being produced, then it just means that there is an extra billion for the other sectors.

Wouter den Haan, 24 October 2011, http://www.voxeu.org/article/why-do-we-need-financial-sector

Bancos circa 2014: If a change would cost the financial sector, say, one billion a year (…) it just means that there is an extra billion for the other sectors

Quien se ha quemado con leche... ve una vaca y llora

https://www.imf.org/external/pubs/ft/fandd/2004/09/pdf/carstens.pdf

Back to the era of ‘the ephor of the exchange economy”

Epur si muove: Productivity Growth and Financial sector development are closely correlated

Crespi, Gustavo, Eduardo Fernández-Arias, and Ernesto Stein, eds. Forthcoming. Rethinking Productive Development: Sound Policies and Institutions for Economic Transformation. Development in the Americas Series. New York: Palgrave Macmillan and Washington, DC: Inter-American Development Bank.

LAC: Low levels financial intermediation , even controlling for GDP per capita


LAC : Real Convergence falters due to to low TFP growth

-50

-40

-30

-20

-10

0

10

20

30

40

50

1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013

GDP per capita Factor accumuation TFP


LAC growth is back to “Normal ”

Source: WEO, IMF. April 2014

…and there are high downside risks

Source: WEO, IMF. April 2014

Relative Low Growth and Middle Class Expectations

“’Reduzimos drasticamente a pobreza ea desigualdade. Conquistas são importantes, mas é completamente natural que os jovens, especialmente aqueles que tem coisas que seus pais nunca tiveram, como mais "

The Role of the Financial Sector: Why do we need to do more?

• If small credit markets resulted from low demand for investable funds due to limited investment opportunities, the financial sector would not be a bottleneck to economic development.

• However, there is evidence that small credit markets in Latin American countries are also due to distortions and bottlenecks in the supply of credit, which explains high and heterogeneous lending rates. At about 8 percent, the Region has average real lending rates which are much higher than those of most developing regions (only sub-Saharan Africa has higher average lending rates). Interest rates are especially high for small firms. High lending rates tend to be associated with credit rationing cutting off supply at low levels of credit.

• Beck et al. (2000) estimations suggest that an increase in financial development that had brought Latin America’s financial depth from its 1965-2003 average of 31 percent of GDP to the East Asian average of 70 percent of GDP would increase the Region’s annual average productivity growth by 1 percentage point, corresponding to a 60 percent reduction in the difference between average productivity growth in the two regions.

• Besides stimulating growth, well-working financial markets can reduce income inequality and promote social mobility. In countries with poorly developed financial markets, initial wealth is more important than entrepreneurial talent and potentially productive projects may not be implemented because of lack of financing. Financial markets that reallocate capital from less to more productive firms can jointly increase productivity and, by limiting the economic power of the elites, “democratize” market economies (Rajan and Zingales, 2003).


Rethinking

Productive DevelopmentSound Policies and Institutions for Economic Transformation

Rethinking Productive DevelopmentSound Policies and Institutions for Economic Transformation

Urgent need for growth policies

Most successful growth experiences around the world are associated with active productive development policies (PDPs)

Low and slow productivity in the region calls for fresh policy action to break stagnation:

– Macro stabilization and structural market reforms not enough

– Industrial policy of the past misguided

Countries are quite actively searching for PDP solutions– Not always with analytical clarity– They spend important resources, not always well– Multilaterals also dedicate sizable resources to support them

There is a great variety of PDPs …

Matching grants for business innovation projects

Reduction of number of days to start a business

Incubation services for start-ups

Training to close the skills gap for mining industry

Cluster development policies

Provision of cold storage facilities for fresh flowers

Opening offices abroad for export promotion

Tax exemptions for tourism

Strategic policies to attract medical devices sector

How to make sense of this diversity?

We need a conceptual framework to think about PDPs

We emphasize two dimensions

o Scope of the interventions (horizontal or vertical).

o Type of interventions: public goods / public inputs, or market interventions (subsidies, tax exemptions, protection).

These two dimensions define a 2x2 matrix which we find useful, because every quadrant raises different public policy considerations.

Interventions that stimulate certain activities (not sectors). What market failures do we seek to address? Not all of these policies are justified. Instruments need to be designed so as to target the type of activities that do generate them and to address market failures as precisely as possible

R&D subsidies, job training subsidies, subsidies for investment in capital equipment.

To provide public inputs that favor certain sectors. May involve collective inputs that can financed by the private sector. State may be needed to help solve coordination problems. Public-private interaction is key

Phytosanitary controlCold storage for fresh flowers

Public inputs

Market interventions

H V

Reduce number of days to start a business

How to make sense of this diversity?

Strategic bets in specific sectors. Under certain conditions –for example, coordination failures in sectors with competitive potential-- may be justified on a temporary basis

Tax exemptions for tourism

Bringing sterilization Equipment to Costa Rica

Best matches, not best practices

Prevailing practice in institutional and policy reform is to identify “best practices” and adopt them

Problem 1: policies not applied in a vacuum, but in specific contexts rich in behavioral norms and tacit “working rules”

Problem 2: countries differ with regards to existing capabilities

Rather than “best practices”, countries should focus on “best matches” between policies and capabilities, taking institutional context into account.

Policies beyond existing capabilities may be best left for the future (once capabilities are developed)

The Role of the Financial Sector: Why do we need to do more? • Market Failures and the Rationale for Interventions

• Intertemporal contracts can only exist in the presence of a proper institutional set-up and a well-working legal system that can enforce contracts promptly and at a low cost.

• Market failures associated with the presence of asymmetric information and the costs associated with collecting and managing information.

• Easier financial conditions for high social return projects whose benefits are external to the contracting parties and therefore not valued by the market.

• Financial Policies: How and where to intervene

• Public Inputs can improve productivity through better access to finance include setting transparent and enforceable ground rules for supervision and regulation of financial markets, lowering barriers to entry in financial markets, reducing asymmetries that distort the allocation of capital or lead to credit rationing, and establishing (or improving) the legal basis for credit bureaus, secured transactions, land registries, registries of moveable property, and bankruptcy laws. The ability to pledge collateral is key and problems related to the lack of pledgeable collateral are amplified by insolvency laws that do not establish clear priority rights and do not allow for quick restructuring of going concerns in the case of default.

• Market interventions are policies that attempt to counteract market failures by altering the market conditions under which financing can be obtained. Some of these policies are hybrid, blending public and private participation. Contractual arrangements in which a third party guarantees the repayment of a specific loan can be effective instruments for promoting access to credit for constrained firms and sectors. Multilateral reciprocal guarantee schemes (MGS) are cooperative arrangements in which certain partners (participating members) receive and offer guarantees, while other partners (sponsoring members) only offer guarantees.



• Public credit guarantees can directly reach credit constrained firms whose realization of high returns investments is frustrated by lack of creditworthiness.

• Cheap funding of commercial banks by second-tier development banks is a method to induce financial institutions to reduce their lending rates without explicitly affecting the risk of the loan.

• Both guarantees and funding presumably have (implicit or explicit) fiscal costs if they are conducted at below-market prices. Guarantees are better suited for tackling credit constraints, and are particularly efficient when private banks are excessively risk averse and the guarantor has superior enforcement capacity or information on collateral value. Cheap funding is ideal for targeting firms that generate positive spillovers but do not face tight credit constraints impeding borrowing, so that once the cost capital is low enough to match their private returns, investment will naturally follow at the appropriate scale.

Special policies for small firms? • Some of the market failures previously reviewed hurt SMEs with more intensity and would thus justify special care for SMEs.

• For example, the range of assets that can be effectively used as collateral is particularly important to equity scarce SMEs and it could be expanded by developing registries of movable collateral that allow lenders to track what assets have been pledged and on what terms (IDB, 2010).

• Recent changes in banking practices and regulation may also have had a negative effect on SMEs' ability to access credit (OECD, 2012), such as Basel II regulation increasing collateral requirements for SMEs.

• Banking regulations that unduly penalize SMEs ought to be reviewed, and in fact, access to credit for SMEs may be facilitated by the implementation of Basel III which, by classifying loans to SMEs as retail banking, reduces their risk weight (OECD, 2012).



• However, is there a case for special policies for SMEs beyond the generic justifications reviewed above?

• The fact that SMEs face more problems in accessing credit markets does not necessarily justify SME-specific interventions.

• Aside from social objectives, it is difficult to make a case for special policies for SMEs on productivity grounds based on this argument.

• Higher intermediation cost per unit lent is a real cost associated with operating small firms, a real cost to an economy based on small firms.

• Necessary financial intermediation costs are part of the productivity equation, and on this count SMEs are on average less productive than large firms (IDB, 2010), and therefore promotional policies that target small and medium enterprises may reduce overall productivity.

• Special policies for SMEs could be justified if credit constraints prevent productive firms from achieving critical mass to grow on their own.

• However, it is not clear how relevant this case is in practice. Alternatively, a more fruitful policy approach may be to focus on new and young firms rather than small firms in general. Fledgling firms are more likely to be trapped in a credit constraint impeding their development to reach critical mass or even their emergence in the market.


The Role of the Financial Sector: The Experiences

Relaxing collateral constraints through factoring •One way to access credit beyond available collateral is to sell accounts receivable to a factoring company. • “Cadenas Productivas” (Productive Chains), a program put in place by the Mexican state-owned development bank Nacional Financiera (Nafin), is a successful example of a policy that creates the legal and logistic framework to facilitate factoring services to SMEs by creating “chains” between large buyers, including the government, and small suppliers. By using receivables from large creditworthy buyers to obtain cash, small suppliers implicitly enlarge their collateral (they “borrow” collateral from large, creditworthy firms), and in this way can effectively reduce their credit risk. Nafin provides the financial infrastructure for the program, a public input, ensuring competition among the lenders enrolled in the program giving national reach to regional banks. Nafin also acts as a second-tier bank and refinances the participating financial institutions. Furthermore, Nafin encourages the participation of large buyers in the program and provides training for SMEs enrolled in it. Importantly, Cadenas Productivas required critical public inputs of supporting laws which allow secure and legally binding factoring transactions. •As of December 2012, Cadenas Productivas covered 550 large buyers, more than 100,000 small and medium firms, and more than 50 domestic lenders. Since the inception of the program in September 2001, Nafin has brokered more than 17 million transactions amounting to more than USD 131 billion in financing.


The Role of the Financial Sector: The ExperiencesCredit guarantees

Credit Guarantee programs “crowd in" the private sector. By providing a partial guarantee, the risk of lending by the financial institution is reduced and this allows currently credit constrained firms to obtain more credit, effectively expanding collateral. Partial credit guarantees are potentially effective and efficient instruments to counteract other market failures: By increasing the number of firms with access to credit, a credit guarantee program creates credit histories and also expands the available information for lenders to estimate and asses firms’ ability and willingness to pay. More accurate credit scores can be developed. A partial credit guarantee program can have demonstration and learning-by-doing effects as their expertise for SME lending improves. Using average rates for Latin America, for every one dollar of fiscal contribution a guarantee program generates 7.3 (the effective leverage rate) dollars of credit to their target markets. However, these guarantee schemes generate contingent liabilities, whose size depends on how the program design establishes incentives for prudent risk analysis for guaranteed loans. The lower the coverage, the greater the financial risk assumed by the financial intermediary and, therefore, the greater the incentive for safe loans..

The Chilean FOGAPE (Fondo de Garantía para el Pequeño Empresario) program, administered by Banco Estado (a state-owned commercial bank), has an innovative way to balance achieve increased market participation. Rather than setting a fixed coverage rate and guarantee fee, these parameters are flexible. First, access to guarantees is auctioned in such a way that financial institutions bidding lower coverage levels obtain larger quotas of guaranteed amounts. The maximum coverage rate allowed is 80% but the average rate on the portfolio obtained with this bidding process is currently 65%. Moreover, in order to ensure that the resulting risks are internalized, under the FOGAPE program, when the past due rate of the portfolio of a financial institution exceeds an established ceiling, the guarantee fee on its whole portfolio is increased in line with its quality deterioration. These mechanisms are factors that have contributed to the FOGAPE scheme’s success in terms of both high levels of credit additionality as well as strong and sound financial performance. Furthermore, the average firm with a guarantee had both higher profits and sales compared to similar non-participating firms (Larrain and Quiroz, 2006)


The Role of the Financial Sector: The ExperiencesCombining credit with non-financial services (NFS) •Credit programs are sometimes needed as a complement of the provision of NFS addressing market failures. For example, services that reduce information asymmetries, thereby altering the perception of risk associated with financing certain operations, would strengthen the need for credit. Clusters and value chains represent forms of industrial organization where financial services may also usefully accompany the provision of non-financial services. A proper analysis of a cluster and its firms requires a full understanding of the market, the interrelation with suppliers and clients, production and market cycles, the relevance of a firm within a chain, their associative capacity, etc. This is costly information. Public policies to ensure cluster financing imply additional credit risk evaluation whose cost may need to be defrayed. •A good example of this type of public intervention is the San Juan Province productive development Program in Argentina, which includes both financing and technical assistance components to support eleven identified value chains for a total amount of $53 million. These value chains represented 76% of the province’s exports and were responsible for 32% of the local economy. The program was coordinated by an agency created with the specific purpose (Agencia San Juan de Desarrollo de Inversiones) of facilitating the public-private linkages needed to alleviate the market failures preventing the financing of productive investments. Financing was funded through the Central Bank of Argentina operating as a second tier institution providing medium and long term financing. The funds were auctioned among private and public banks through a transparent process and beneficiaries of the program increased sales and exports by 69% and 29% more than comparable non participant firms in the province. •The experiences of partnership between agencies of innovation promotion and banks in Argentina and Colombia offer another example of synergy. Because of lack of technical expertise, banks may be unable to evaluate investment projects by firms that are interested in improving their technology. In these cases, banks delegate the task of carrying out the analysis of the technological risk involved in projects to public agencies (Rivas, et al 2010). The challenge for public policy for synergy to emerge is to make sure that these services are structured as to support the need of the financial intermediary to learn about the firm’s capacity of repayment.


The Role of the Financial Sector: The Experiences

Subsidized lending •Targeted subsidies to finance investments in energy efficiency (EE) and in the production of electricity from renewable primary sources can correct spillovers associated with pollution and CO2 emissions. EE has indirect social returns, which range from the local environment, workers’ health, lower aggregate costs associated with national energy intensity and balance of payments resilience in the case of energy-importing countries to global climate effects. •Development Banks can play a strategic role in overcoming barriers to finance EE and to capture their positive spillovers. For example, in order to address these barriers, BANCOLDEX developed a pilot program targeting the country’s fast-growing hotel and hospital/clinic industries with a US$10 million Clean Technology Fund (CTF) loan to provide investment financing and technical cooperation.

•The program provides:

• (i) an insurance policy to ensure the energy savings that the EE projects will deliver to the borrower (issued on the basis of a standardized Energy Performance contract, to be monitored and certified by a third-party technical expert), in order to address creditor and investor risks;

• and (ii) a concessional financing line to enhance local demand for credit for green technologies and increase the participation of EE service providers.

•BANCOLDEX is coordinating these instruments and supporting commercial local financial institutions (first tier) and other market participants in structuring, financing, monitoring, and evaluating projects. Over time, the program may be replicated and expanded to other sectors– including factories, businesses, schools and universities, among others.


Thank you!!

Quadrant MI / H

Interventions that stimulate certain activities (not sectors).

Examples: R&D subsidies, job training subsidies, subsidies for investment in capital equipment.

The key question in this quadrant is: “what market failures do we seek to address?” Not all of these policies are justified.

– R&D vs. investment subsidies

One should not assume “automatic” externalities.

– Some types of R&D may generate more spillovers than others.

Instruments need to be designed so as to target the type of activities that do generate them and to address market failures as precisely as possible.

BP

IM

BP

IM

H V

PI

MI

VH

Quadrant PI / V

Should the State provide public inputs that favor certain sectors?

Yes! most public inputs have differential effects on sectors– phytosanitary control important for fruits and vegetables, not for garments.

May involve collective inputs that can financed by the private sector; State may be needed to help solve coordination problems.

Typically addressed within cluster development programs

How to decide which sectors to work with?

How does the State identify their PI needs?

– Public-private interaction is key. But how to structure it?

– How should State organize itself to deliver needed PIs?– Requires cooperation across different public agencies

BP

IM

BP

IM

H V

PI

MI

VH

Quadrant MI / V

Most controversial. Lends itself to favoritism and rent-seeking.

Includes interventions with different objectives

Protect declining sectors, or sectors with no latent comparative advantage, but strong lobby capabilities (should be discouraged!)

– Example: rice protection in Costa Rica

Strategic bets in specific sectors. Under certain conditions –for example, coordination failures in sectors with competitive potential-- may be justified on a temporary basis.

– Example: tourism in Costa Rica (subsidies to several actors in the sector needed to coordinate investments)

•BP

•IM•IM

•H •V

PI

MI

VH

Bancos circa 1934: … the ephor of the exchange economy.

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