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Backgrounder #727 on Economy

September 22, 1989

Why the World Bank Should Read Its Own Report

By and

(Archived document, may contain errors)

727 September 22,1989 WHYTHEWORLD BANK SHOULD READ ITS OWN REPORT INTRODUCTION As the World Bank and International Monetary Fund (IMF) prepare to convene their annual meeting in Washington next week, the delegates should study w hat could become the hottest new publication on economic development. It is the World Development Report, issued each year by the World Bank While this year? topic, the condition of financial systems in less developed countries LDCs would seem to be tedio u s, the content and message of the report are anything but. They analyze how LDC governments have contributed to the deterioration of central and commercial banks, stock markets, and similar institutions in the developing world. While the Report avoids ide ological stands, it suggests by implication, and sometime explicitly reforms needed to restore these institutions to economic health.

World Bank officials should read their own report and use its insights to plan and pursue a strategy that will establish i n the LDCs the private banks and capital markets necessary for sustained economic growth. The report too should be of interest to the United States and other countries attempting to deal with the LDC debt problem and to promote economic growth in these co u ntries economy in providing a medium of exchange to facilitate economic transactions. Banks and other financial institutions allow surplus assets to be funneled into productive investments. Capital and stock markets allow money for large economic ventures to be raised and investment risks to be reduced by permitting individuals to divers* their assets Indispensable Medium. Money, of course, is indispensable for any 1 World Development Report 1989: Financial Systems and World Development Indicators, issued in June 1989.

Hereinafter referred to as the World Bank Report.

The new World Development Report documents how LDCs have undermined their financial systems and thus exacerbated their own economic problems. By requiring their banks to lend to certain industries, sectors, or enterprises, for instance LDC governments hav e misallocated resources and left few funds for businesses, entrepreneurs, and consumers who did not enjoy such privileges. The Report also describes how credit privileges for inefficient state-owned enterprises cause capital shortages and lead to foreign b orrowing and debt. And the Report illustrates how LDC governments, to cover huge state expenditures, ultimately resort to printing money, triggering massive inflation which undermines the currency itself To correct the situation described by the World Ban k , reform in the LDCs is now essential. This reform should require 1) Central banks to maintain stable, noninflated currencies 2) Government direction of lending to cease 3) Repeal of regulations that discourage,or prohibit private banking 4) Banks in gove rnment hands to be privatized 5) Reform of legal systems to protect the property and rights of borrowers and lenders 6) Grass-roots savings and credit to be encouraged.

For years the World Bank and IMF loaned money to LDCs and looked the other way as these countries practiced policies that the Bank now wisely criticizes. By allowing the LDC governments to avoid for so long the consequences of their actions, these policies continued and economic reform was impeded. The new World Development Report therefore is a welcome sign that the World Bank not only understands the disastrous mistakes of LDC financial policy but also has learned that lending to countries even as they continue such practices only throws good money after bad. The World Banks vast staff wou l d do well to study the new Report and use it as a compass to guide future policies and programs THE FUNCTIONS OF MONEY AND CREDIT Economic development is often thought of in terms-of the ability of factories to produce goods, farmers to grow crops, and, u ltimately, consumers to purchase the goods and services necessary for a higher standard of living.

Yet financial instruments and institutions perform the indispensable function of facilitating nearly all economic transactions.

The World Bank Report correc tly points out that The financial system makes its bi est contribution to growth by providing a medium of exchange. Money has several characteristics that make it far superior to the P 2 World Bank Report, p. 26 2 exchange of goods by barter. As it origin a lly developed, money was a commodity, usually gold or silver, that was durable and thus could be stored for long periods, unlike perishable goods. It was easily divisible, unlike bartered goods such as houses or cattle. Money was compact and easy to carry . Further, the market values of goods could be compared in terms of money Renting Out Surplus Funds. At any given time there always are some businesses or individuals who might not wish to spend their surplus assets on immediate consumption or investments. At that same moment, however there are others who might not have funds on hand to meet their consumer or investment needs. Those with surplus money are often willing to rent out their funds to others, with the original loans plus the rent or interest bein g paid back out of the borrowers future earnings or profits.

The World Bank Report observes that Savings determines the rate at which productive capacity, and hence income, can grow. On average, the more rapidly growing developing countries have had higher saving rates than slower-growing co~ntries For example, the Report found that countries with savings rates averaging 28 percent of Gross Domestic Product had high annual growth rates of over 7 percent. Countries with savings rates of around 19 percent gr ew at a slow annual rate of less than 3 percent.

Grass Roots Money Lenders. Much development occurs from the ground up with the efforts of individuals and small businessmen.The Report notes that firms and households finance much of their investment directl y out of their own s ving. Only when investment exceeds saving is it necessary to borrow J It notes further that, In the early stages of development relatives, friends, and moneylenders may be the only sources of external finance. As the financial system g rows, local banks, then national financial institutions, and finally securities markets and foreign banks become sources of funds for invest0rs.d The Report notes, for example, that in the late 1940s Nigeria had as little as 29 bank branches. Money lender s operated in the informal sector in institutions known as isusu. With the growth of indigenous national financial institutions, the financial system began to expand. By 1962, there were more than 200 commercial banks in Nigeria?

The existence of savings a nd credit allows households to enjoy the immediate benefits of various goods and services by borrowing against future earnings. For businesses, credit is crucial. Short-term credit is essential for merchants to keep inventories at levels to meet customer d emand. Longer term credit is important not only for establishing productive enterprises but also for expansion, purchases of new equipment and machinery, research and 3 3 See Ludwig von Mises, Theory of Money and &dit (Irvington-on-Hudson: Foundation for E conomic Education, 1971) for a discussion of the origins and functions of money 4 World Bank Report, p. 27 5 World Bank Report, p. 28 6 World Bank Report, p. 29 7 World Bank Report, p. 48, Box 3.4 3 development of new products, and modernization of the pr o duction process for maximum efficiency. steady, the supply of money also must grow at a slow and steady pace. Large erratic fluctuation of the money supply would cause the value of the currency that is being saved lent, .or borrowed to fluctuate similarly . The use of money for economic activities would become increasingly risky and such activities would suffer Implied by the World Bank Report is that, for economic growth to be THE COMPONENTS OF A FINANCIAL SYSTEM For economies to develop rapidly and effici e ntly, intermediate institutions between savers and investors are indispensable. States the World Bank Report Financial systems provide payment services. They mobilize savings and allocate credit. And they limit, price, pool, and trade the risks resulting f rom these activities.These diverse services are used in varying combinations by households businesses, and governments and are rendered through an array of instruments (currency, checks, credit cards, bonds and stocks) and institutions (banks, credit unio n s, insurance companies, pawnbrokers, and stockbrokers).8 Among the key financial institutions are Central Banks. Money in the form of paper currency is provided in all countries today by government monopolies called central banks. While in the past curren c y was backed by commodities like gold, today paper currency which is produced in limited quantities, in various denominations, and which is replaced when it wears out, is useful as a medium of exchange to the extent that governments increase its supply on a slow, steady basis. The value of one country's currency against that of another's might rise or fall depending on such factors as the relative supplies of each currency, the desires of individuals to invest in a given country, and general confidence in a given country's government and economy deposit SaGings and to obtiin-loans. In-the U.S b-inks that accept savings ind make loans to individuals and businesses are legally separate from investment or commercial banks.The latter specialize in purchasing an d marketing stock to help finance business ventures.

The World Bank Report points out that commercial banking was crucial to economic growth in the West. Modem banking and accounting practices were Commercial Banks. Banks provide a place for individuals an d businesses to 8 World Bank Report, p. 25 4 developed in the city-states of Northern Italy during the 15th century by individual businessmen seeking better yays to finance trade and lessen the risk of loss for exporters and importers Only later did gover nments become involved in banking regulations determined by the supply of savings and the demand of loans. Bankers who judge wisely and lend to productive individuals and businesses make a profit.

Those who do not, lose money In a system with private banki ng and no major restrictions on market entry, competition provides incentives for bankers to direct funds to the most productive enterprises and provides customers with greater access to credit Capital and stock markets. Many business activities require s ubstantial long-term investments and access to credit. Capital markets provide long-term debt and equity finance for the government and the corporate sector. Debt finance occurs when borrowing is used to finance expenditures.

An interest charge is paid for the amount borrowed. Equity financing o when stock is bought and the buyer receives a dividend for his purchase.

Stock markets allow many individuals to pool their investment resources.

Shares of stock are usually purchased from businesses and marketed by commercial banks. If the business makes a profit, stock owners receive a profit or dividend for each of their shares. Stock markets also allow individuals to reduce their financial risks. By owning shares in many different enterprises, an individual do es not lose all of his assets if one investment goes bad.

Legal institutions and accounting practices. Protection of private property rights and the certainty of legal titles to property are essenti al for any market system, and especially crucial to the financial system.The World Bank Report observes that an individuals or businesss property often provides the necessary collateral against which banks make loans, for example, by allowing borrowers to offer security in the form of mortgages over real estate The Report also observes that business laws and conventions define what is meant by a contract and what are the obligations of the parties involved. A legal system provides adjudication of business d isputes and the enforcement of contractual agreements. Standardized accounting practices allow businesses and investors, lenders and borrowers, to know the value of their assets, whether a profit or loss has been realized, and in general, how an enterpris e might be expected to perform in the future.12 Macroeconomics. A theme found throughout the World Bank Report is that correct macroeconomic policies are important to the health of a financial system. Government taxing, borrowing, and spending policies can deter When central banks keep money supplies stable, interest rates are Tirs 9 World Bank Report, pp. 41-43 lOWorld Bank Report, p. 109 llWorld Bank Report, p. 87 12World Bank Report, p. 85-86 5investments and absorb much of a countrys savings, leaving li t tle for private businesses and individuals. Trade restrictions can rob industries of access to necessary inputs and consumers of access to goods that could raise their living standards. Government regulations and restrictions on business can deter busines s creation and expansion, slowing down economic growth to cover the resulting debts, has contributed to high inflation rates. The average inflation rate in developing countries increased from 10 percent a year in 1965-73 to 26 percent in 1974-82 and 51 per c ent in 1983-87. mring 1983-87, seven countries (Argentina, Bolivia, Brazil, Nicaragua, Peru, Sierra Leone, and Uganda) had average inflation rates of more than 100 percent 13 Financing public sector industries has been costly for LDCs Massive government s p ending and borrowing by LDCs, and printing currency CAUSES OF FINANCIAL DISTRESS IN THE THIRD WORLD In light of the importance of financial institutions to economic growth most LDCs began on the wrong financial footing. In most cases the government owned s ome or all of the commercial and savings banks, in many cases prohibiting private banking altogether.This set the stage for serious abuses. The World Bank Report paints a picture of many (probably most LDC governments systematically undermining the abilit y of their citizens and businesses to engage in productive activities, and thus bringing about their own economic problems governments sought to promote economic growth by forcing investments into certain sectors of the economy. It points out that Directed Credits. The World Bank Report describes how LDC in Pakistan in 1986,70 percent of new lending by national banks, which dominate the banking system, was targeted by government In India about one-half of bank assets had to be placed in reserve requirements on governments bonds and 40 percent of the remainder had to be lent to priority sectors at controlled interest rates. InYugoslavia in 1986 58 percent of short-term loans were directed credits. In Brazil in 1987, government credit programs accounted for mo re than 70 pera# of credit outstanding to the public Sometimes, governments would use loan guarantees to specific ente rises to assure that credit was distributed according to government desires.

But whether the banks involved were government-owned or priv ate, and whether certain industries or enterprises were singled out for special favors by directed lending or loan guarantees, in the end, the government was and private sector 15p 13World Bank Report, p. 62 14World Bank Report, p. 55.

World Bank Report, p.57 6 forced to cover the costs to the financial sector of their policies. And with governments requiring banks to make specific kinds of investments, little capital was left for business that did not enjoy government favor. Especially hard hit have been small businessmen, entrepreneurs, and of course, the consumers. Further, by directing funds by law or decree to certain sectors and industries, governments removed much of the incentive for bankers to be concerned about the quality of their loans Priority for State-Owned Enterprises. In many cases, government-directed credit went to state owned enterprises (SOEs).The World Bank Report states that, The share of SOEs in nongovernmental borrowing from domestic banks in 1983-85 was 56 percent in Guyana, 43 per c ent in Mexico, 25 percent in Nepal, and 18 percent in Brazil.16 Then, in one of its most damning statements, the Report explains that Whatever conclusion is drawn concerning the impact of directed credit programs on growth and the distribution of income, it is clear that they have damaged finycial systems.

Many directed credits have become nonperfonning loans. This was in part because, Directed credit programs have often been used not to correct the inadequacies of financial markets but to channel funds to priority se ors regardless of whether these were the most productive investments.

Many of the state-owned enterprises turned into inefficient, wasteful, and corrupt money losers. Rather than shutting down such enterprises, for political reasons LDC gover nments continued to keep them afloat with new directed or borrowed money. Further, in the case of many failing private businesses, rather than let them shut down, governments continued to proyide subsidies and in many cases simply nationalized such enterp rises.

By diverting credit to inefficient enterprises, governments dried up credit for more productive endeavors. The situation became worse during the worldwide economic problems of the 1970s. Instead of adjusting to changing economic realities, most LDC governments increased their intervention and subsidies. The result: staggering costs of directed and subsidized credit.The World Bank Report finds that B in Brazil in 1987 [subsidies] were estimated at between 4 and 8 percent of GDP [Gross Domestic Produc t In Mexico subsidies relating to development finance institutions and official trust funds were estimated to average 3 percent of GDP during 1982-

87. Subsidies-of this magnitude, when financed by the central bank or charged to the government budget monet ary or fiscal restraint. compromised efforts at 16World Bank Report, p. 57. 17World Bank Report, p. 59-60 18World Bank Report, p. 59 19 World Bank Report, p. 59 7 Faced with large and growing debt burdens, inefficient economies, capital flight, and massiv e tax evasion by citizens who had little trust in their governments LDC governments found it easier to resort to budget deficits and monetary inflation than to maintain responsible monetary and fiscal policies Accumulating Debt. LDC governments have been a b le to pursue their flawed economic and financial practices for several reasons. For one thing the World Bank Report observes in self-criticism, Subsidies h ve sometimes been covered by low cost loans from international agencies For another, By the 1980s m a ny developing countries had come to rely on foreign borrowing to help finance increasing public sector defici ts For example, in 1984 the ublic sector borrowing requirement] was 15 percent of What the World Development Report delicately fails to note is t h at its sister GDP in Argentina 91 organization, the International Monetary Fund (IMF gave what amounted to loan guarantees to encourage such lending from foreign private banks to the LDC governments. As these governments used more funds to bail out state- o wned enterprises and cover huge government payrolls, the private sector and smaller entrepreneurs were starved for credit. This meant that the countrys productivity suffered and that it was less likely that LDC governments would be able to pay their debts the printing press. They simply printed up currency to cover budget deficits caused by, among other things, money losing enterprises. This undermined the currency itself and ignited massive inflation. Inflation in Argentina was around 250 percent per mont h this year. In 1985, inflation in Bolivia was ove? 50,000 percent for the year, though it was impossible to measure accurately.

In such situations people abandoned the official currency. American dollars or some other hard currency used in the black marke t became the principal medium of exchange and store of value. Citizens converted their local currency to hard currencies and smuggled their funds out of the country.

Today the value of such deposits in Western bq equals the foreign commercial debts of all of the LDCs combined raw materials, tools, and other business expenses. Because they found it impossible to save funds, such businesses could not expand or sometimes even remain in operation.

Some LDCs that depended on commodity exports undermined their financial systems in a different yet equally effective way. Unable to compete Destroying the Currency. In the end, many LDC governments resorted to High inflation harmed especially the small entrepreneurs, who must pay for UlWorld Bank Report, p.59 21Worl d Bank Report, p. 61 22LDC Debt Reduction; A Critical Appraisal, in Morgan Guaranty Trust Company, WorldFhoncitzlMudzI3 December 30,1988, p. 9 8 in an international market, the government solution often was to devalue the currency to make exports cheaper f o r overseas customers Exports showed nominal gains as a result. However, consumers and businessmen alike faced higher prices in the domestic market. This was due in part to the higher costs for imported products. In addition, domestic industries had less c o mpetition from foreign enterprises. Further, the domestic industries also had to pay higher prices for their inputs. This meant higher prices for domestically produced goods of currencies and financial systems by LDC governments has left their economies i n shambles The lesson that can be drawn from the World Bank Report is that the ruin NEEDED: FUNDAMENTAL FINANCIAL REFORM Though overdue, it is very welcome and important that the World Bank recognizes that LDC governments have wrecked their own credit syst e ms, capital markets, and currencies. It is no mystery why these countries cannot deal with their debt burdens or offer their own people opportunities to translate productive economic activity into higher living standards. The question is: what can the Wor ld Bank, IMF, and the governments of the developed countries now do? The answer, sometimes implied, sometimes directly stated, in the new World Bank Report, is that the LDCs must adopt far-reaching, free market financial reforms.

Key elements of such reforms should include 1) A Stable Currency.

The kind of runaway hyperinflation that has plagued the LDCs is caused solely by the governments themselves, specifically by central banks printing currency to meet budget demands. Such inflation renders a currency of little use as a medium of exchange and slows or even stops many productive economic activities. Such inflation can be stopped quickly if the political will exists. Bolivia brought its hyperinflation down from tens of thousands percent in 1985 to 16 per cent in 19

87. Argentina brought its inflation rate, which in June was around 250 percent per month, down to single digit levels by September le not suggested by &e World Bank Report, one way to prevent future inflation might be to insulate central banks i n part from the political process so that politicians will not be tempted or able to print money to purchase short-term political advantages at the long-term expense of the economy.The first job of the head of a country's central bank should be to protect the stability and integrity of the currency so that it can function efficiently as a medium of exchange 23World Bank Report, p; 2 9 2) No Special Privileges for State-Owned Enterprises.

Ultimately, state-owned enterprises should be returned to the private sector. During the transition period, LDC governments must end special credit privileges, loan guarantees, and direct subsidies of the state-owned enterprises, for these undermine the f inancial system. While the World Bank Report cites cases of government interference that have not led to disaster these are rare and often due more to luck than to wise government policy.

The dangers of such interference, as documented by the World Bank Re port are grave. Therefore commercial banks no longer should be forced by governments to target or direct credit to certain industries, sectors, or enterprises. Such reforms will not necessarily stop government borrowing from commercial banks. But they wil l expose the costs of such practices and cause governments to make hard decisions concerning whether funds are to be productively invested or wasted on money-losing operations 3) Market-Determined Interest and Exchange Rates.

Both interest rates and exchan ge rates should be set by market supply and demand, not by government dictates.The World Bank Report recognizes that interest rates kept artificially low by state mandates lead to low levels of savings and capital shortages. Exchange rates, the price it c o sts to purchase foreign currency, when set higher than the market rate can attract imports at the expense of more efficient local industries and ultimately drain a countrys treasury. Exchange rates set lower than market levels can cause price increases fo r businesses and consumers and lower living standards 4) Legalized Private Banking.

Competition among banks creates incentives for bankers to make productive loans and gives customers greater access to credit. Where private banking is banned by LDC governm ents, it should be legalized. Yet as the World Bank Report observes, Lack of effective competition is [often due] to restiictions on interest rat s on roduct innovation, on branching, and on the entry of new institutions. Regulations that have the effect of reducing private banking competition should be reformed 5) Privatized State-Owned Banks.

The financial institutions owned by the state should be returned to the private sector. The record of state-owned and directed financial systems has been a disaster in the LDCs. When governments can cover the losses of institutions that are poorly managed or make loans based on political rather than economic considerations, there is little incentive for such institutions to improve. And if a system does allow privat e banking, competition from the state-owned enterprises is hardly fair or economically sound 24 World Bank Report, p. 103 10 I 6) Legal Reforms.

The World Bank Report correctly observes that If financial systems are to be efficient and robust, they must be set within a suitable legal and regulatory framework A system of laws and regulations is needed to promote the use of contracts that are clear about the rights and obligations of contracting parties, to encourage discipline and the timely enforcement of contracts, and to foster responsible and pruden ehavior on both sides of the financial transaction.

This means the legal recognition of property titles so that persons can use assets as collateral for 1oans.This also allows lenders to have some assurance o f compensation in case of default.This has been a problem in many LDCs. In Egypt and Pakistan, for example, the foreclosing procedures e so slow that it often takes five years for banks to foreclose on bad loans 9 7) People's Capitalism.

Normal economic d evelopment is usually driven by smaller enterprises and entrepreneurs. Small businessmen save money or borrow small sums to reinvest in their businesses. As they become more prosperous perhaps they open new enterprises. It is in such small enterprises tha t the vast majority of jobs in most LDCs are found. Financial mismanagement in LDCs has retarded the normal development process.The World Bank Report breaks new ground for an international institution by focusing attention on the sort of informal financial arrangements that take place outside of the formal banking channels, often as a reaction to the inefficiencies of the formal institutions. It also focuses attention on the possibility of success for small local lending institutions. The Grameen Bank in Ba n gladesh, for example arose out of a need to serve the rural poor of,that country. Since 1976 this bank has grown to 300 branches serving 5,400 villages. All are locally managed and make loans averaging $100 dollars.The loan payback rate is over 97 percent . International institutions and governmenis thus should focus on the need to promote grass-roots banking and capital markets through t economic reforms and deregulation in the LDCs 2 25World Bank Report, p. 84 26World Bank Report, p. 77 11 CONCLUSION The W orld Bank is to be congratulated for this years annual Wbrld Development Report, which calls attention to the importance of financial systems to economic growth, to the damage that LDC governments have done to their economies by control of credit and the undermining of currencies, and to the kind of reforms needed if these systems in LDCs are to most effectively facilitate economic activities.

Guide for the Future. As World Bank officials gather in Washington for their annual meeting, they should study the lessons of their own Report. It is valuable, of course, not only as a chronicle of the pasts mistakes but as a guide for avoiding them in the future. On the agenda, after all, for the World Bank, the IMF, the U.S and other industrialized is the search fo r ways to deal not only with the LDC debt crisis but with the problem of the collapsing economies of Central and Eastern Europe.

In the case of LDCs in Latin America, Africa, and Asia, sound financial policies advocated by the World Bank should continue to be a top priority. In the case of Central and Eastern Europe, the World Bank should avoid mistakes of the past. Rather than push huge loans and more debt onto these countries, market-oriented financial systems first must be created.

Toward Higher Living Standards. The citizens of the less developed countries have demonstrated that they are as hardworking and entrepreneurial as people anywhere in the developed world.The problem has been that flawed economic policies have cheated these citizens of the rewa rds that should have come from that hard work.

While financial systems are often thought of in terms of large banks and impersonal institutions, such systems are most important at the grass roots.

They allow people to save their money for consumption or for investments.

They give small businessmen access to much needed credit. If the people of LDCs are to be given an opportunity to translate their hard work and efforts into higher living standards, sound financial institutions and systems are essential.The World Banks ne w World Development Report offers a guide on how to do this Edward L Hudgins, Ph.D.

Director, Center for International Economic Growth BryanT. Johnson Research Assistant e I 12

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