The World Bank has recently published this manual aiming at providing lessons on the design and functioning of Poverty Reduction Strategies (PRS) monitoring systems, based on the experience of twelve PRS countries. The focus is on the institutional arrangements of PRS systems - the rules and processes which bring the various actors and monitoring activities together in a coherent framework.
The full text and links to the individual chapters and case studies are accesible for free. The Netherlands, according to the Center for Global Development (CGD).
The CGD produces annually the Commitment to Development Index (CDI) where 21 rich countries are rated on “how much they help poor countries build prosperity, good government, and security”.
CGD's Commitment to Development Index 2006 was recently released and has the Netherlands on top, with Denmark, Sweden and Norway following closely. A lot of interesting information included in the site.
Via Owen. Like every Friday, from Raj Nallari and Breda Griffith's lecture notes.
Macroeconomic Fundamentals and Financial Development The development of a financial system will necessarily be affected by both endogenous and exogenous factors and the particular country context in terms of its socio-political development. Endogenous factors refer to indicators of health of individual financial institutions. A commonly used framework for assessing this health is the so-called CAMELS framework, i.e. capital adequacy, asset quality, management soundness, earnings and profitability, liquidity, sensitivity to market risk. Exogenous factors refer to macroeconomic developments that can in turn affect financial system depth.
Imbalances in economic growth rates may have a negative impact on the financial system of a country in at least two respects. First, low or declining aggregate growth rates often weaken the debt servicing capacity of domestic borrowers and contribute to increasing credit risk. Second, if an economy is overly dependent on one or two sectors for its economic growth and financial institutions are overly exposed in those sectors, an adverse real sector shock may have an immediate impact on the financial system. The system is even more vulnerable if these sectors are affected by exogenous forces such as climatic conditions. The pattern and trend of inflation has a direct bearing on the stability and health of the financial system. High and volatile inflation makes it more difficult to assess accurately credit and market risk with associated risks for a financial institutions portfolio and its ability to manage and plan for the future.
Financial Development and Poverty Reduction Although the relationship between financial development and growth is well-established, the same cannot be said for the direct link between financial development and income inequality, beyond the growth relationship itself. Beck, Demirguc-Kunt and Levine (2004) provide a recent comprehensive analysis of this important question.
As the authors note, theory is ambiguous when it comes to the relationship between financial development and changes in poverty and income distribution. Some models imply that financial development enhances growth and reduces inequality. According to these models, financial market imperfections, such as information problems, transactions costs, and contract enforcement costs, may be especially binding on poor entrepreneurs who lack collateral, credit histories and connections. These credit constraints will impede the flow of capital to poor individuals with high-return projects, thereby reducing the efficiency of capital allocation and worsening income inequality. Viewed from this angle, financial development reduces poverty by (i) disproportionately relaxing credit constraints on the poor and reducing income inequality, and (ii) improving the allocation of capital and accelerating growth.
Other theories, however, question whether financial development reduces poverty. Some research suggests that the poor primarily rely on informal, family connections for capital, so that improvements in the formal financial sector primarily help the rich, rather than the poor. For instance, Greenwood and Jovanovic (1990) develop a model that predicts a nonlinear relationship between financial development and income inequality during the process of economic development. At the early stages of development, only the rich can afford to access and profit from financial markets so that financial development intensifies income inequality. At higher levels of economic development, financial development helps an increasing proportion of society. Other models imply that if financial development reduces income inequality, this could slow aggregate growth and increase poverty. For instance, if the rich save more than the poor, and financial development reduces income inequality, this could reduce aggregate savings and slow growth with adverse implications for poverty. Accordingly, empirical evidence is needed to distinguish among competing theoretical predictions.
Beck et al. do this by assessing the relationship between financial development, poverty alleviation, and changes in the distribution of income using broad cross-country comparisons. They find that financial development alleviates poverty and reduces income inequality. Their findings also indicate that financial development exerts a disproportionately positive influence on the poor.
More specifically, their paper has three key findings: (i) even when controlling for real per capital GDP growth, financial development reduces income inequality beyond the growth effects themselves; (ii) financial development induces a drop in the Gini coefficient measure of income inequality; and (iii) financial development reduces the fraction of the population living on less than $1 or $2 a day and lowers the Poverty Gap.
In another recent paper, Jalilian and Kirkpatrick also find that financial development reduces income inequality, but only beyond certain income levels, in line with the Greenwood and Jovanovic predictions of an inverted U-type relationship. They find that at particularly low levels of development, financial development is likely to be positively related with income distribution but that once a threshold level of development is achieved, then financial development reduces inequality.
Next Friday: Policy Measures to Increase Access to Financial Services From Raj Nallari and Breda Griffith's lecture notes.
A large body of both theoretical and empirical literature supports a positive causal link between a well-functioning financial system and economic growth. In particular, the economic growth studies of the last decade show that financial depth causes economic growth and that it is one of the few robust determinants of the subsequent growth path of countries.
An important related question is whether macroeconomic developments themselves can impact financial sector growth. As we demonstrate below, economic growth, macroeconomic stability, inflation, and balance of payment developments can all affect financial development.
Although the link between financial sector development and growth is well-established, the direct relationship between financial development and the income of the poor remains unclear. Several competing theoretical predictions exist about the impact of financial development on changes in income distribution and poverty alleviation. Recent empirical literature has, however, found that financial development reduces income inequality by disproportionately boosting the incomes of the poor. In particular, it has been found that countries with better-developed financial intermediaries experience faster declines in measures of both poverty and income inequality.
While financial development can be very beneficial, the data show that usage of financial services is far from universal in many developing countries. Countries can, however, undertake a variety of policy measures to increase access to financial services, including through strengthening their institutional infrastructures, liberalizing markets and fostering greater competition, and encouraging innovative use of know-how and technology.
In this and upcoming postings we will analyze each of these issues in turn. We will conclude by discussing other topics that are highly relevant to the general theme of financial development and poverty: the history of financial sector reform in developing countries in recent decades, the role of microfinance in providing credit to the poor, and the increasing importance of emigrants’ remittances for many developing countries.
Financial Development and Economic Growth
The proposition that financial sector development supports economic growth is fairly well established in the literature. Almost a century ago, Schumpeter argued that financial intermediation through the banking system played a key role in economic growth by improving productivity and technical change. Specific channels through which financial development might help economic growth include: (i) raising and pooling funds (allowing more and more risky investments to be undertaken); (ii) allocating resources to their most productive use; (iii) allowing effective monitoring of the use of funds; (iv) providing instruments for risk mitigation; (v) supporting firms’ growth opportunities, especially for small and medium-sized enterprises; and (vi) lowering inequality levels.
Turning to the empirical evidence, Jalilian and Kirkpatrick (2005) and Levine (2005) review the current state of play. Recent cross-country econometric analysis provides evidence that financial development is robustly related with economic growth. (See, for example, King and Levine, 1993, Arestis and Demetriades, 1997, Levine, 1997, Rajan and Zingles, 1998, and World Bank, 2001). This seems to work mainly through higher physical capital accumulation and economic efficiency improvements under well-developed financial systems.
More recent econometric techniques, which use the pooling of cross-country and time-series data, allows a strong test of the direction of causality between financial development and growth. These studies, which include Levine, Loayza and Beck (2000) and Beck, Levine and Loayza (2000), also find that there is a positive link between financial development and growth. The causal factors include the contribution of financial development to private savings, capital accumulation and productivity, with the latter playing the most important role.
In terms of the magnitude of this impact, the World Bank (2001) has found that a doubling of private sector credit to GDP – a common measure of financial depth – is associated with a two percentage point increase in the rate of GDP growth (debate remains, however, with, for example, Aghion, Howitt, and Mayer-Foulkes (2005) raising serious questions about whether financial development affects steady-state growth, or whether it instead influences the rate of convergence to higher income countries. Either way, however, financial development is seen as positive for economic growth). But the literature also finds there is substantial cross-country heterogeneity in the relationship between financial development and economic growth. This is unsurprising and reflects structural, institutional and policy differences in the economies included in the sample (Jalilian and Kirkpatrick, 2005).
Next week: Macroeconomic Fundamentals and Financial Development The World Bank's South Asia Region has recently published a Development Policy Review on India.
From the report:
The full report, Q&A with the authors and more information on the subject available on-line: Flexible and Fixed Exchange Rates
Flexible Rates Countries with flexible exchange rates allow their currency to increase or decrease in value against other currencies, depending on its demand and supply relative to the demand and supply of other foreign currencies. For instance, if the United States government supplies many more dollars than the French government supplies Euro to the world economy – for example through more expansionary monetary policy - then there would be an increase in the relative supply of dollars and a decrease in the relative supply of Euro. Consequently, other things equal (e.g. no other changes in demand), the price (value) of the dollar relative to the Euro would fall (or depreciate) and the price of the Euro relative to the dollar would rise (appreciate).
Fixed Rates Some countries prefer to keep their currency value fixed relative to other foreign currencies, regardless of prevailing demand and supply forces. Advantages of this system include more predictability for businesses engaged in international trade. Fixed exchange rates can also perform a useful role in anchoring inflation expectations in country that is determined to break with high inflation. The disadvantage is that countries typically find it difficult to ‘exit’ from pegged exchange rate regimes, even where the exchange rate has become clearly overvalued. In such a situation, central banks often intervene to defend the currency by selling foreign reserves. When central banks’ reserves become depleted, countries are often forced to break their exchange rate pledge and devalue their currency. This can lead to higher inflation and import prices – hurting the poor – and can damage the balance sheets of the government (by raising the foreign debt burden), banks (if they have more foreign liabilities than assets) and corporations (again if they have foreign liabilities unmatched by foreign income streams). More and more developing countries have adopted floating or flexible exchange rate arrangements during the past fifteen years. Maintaining fixed exchange rates can cause a gradual erosion of competitiveness if domestic inflation is higher than that of trading partners (oftentimes the case for developing countries). Also with exports of many developing countries heavily dependent on a few commodities, flexible exchange rates can often play a useful buffer role.
Other exchange rate options
Conclusion In the last few weeks we have examined the role of monetary and exchange rate policy. These policies can have a large impact on economic performance, especially in the short term, but, badly handled, they can also impede economic growth and hurt the poor. We began by examining the nuts and bolts of monetary policy operations and instruments, and describing how developing countries still use direct instruments of monetary control, including credit ceilings and interest rate controls. These types of policies can be highly distortionary and have been largely abandoned by industrial countries in recent decades, in favor of indirect monetary instruments. These instruments, also used by developing countries, include reserve requirements, central bank lending facilities and open market operations. We then discussed different inflation measures, different types of inflation and various causes. We saw that while excessively loose monetary policy can help in the short run, it comes at a cost of high and volatile inflation. It was shown in turn that low inflation is good for long-term growth and for poverty reduction. The discussion then focused on how the costs of inflation are borne most heavily by the poor. We have concluded with a brief analysis of exchange rate policy and the various exchange rate options open to policymakers, ranging from formal dollarization to freely-floating exchange rate regimes. The choice of an exchange rate regime depends on a country’s characteristics, including its inflation performance, monetary credibility, its trading patterns, and its vulnerability to shocks
Next week: Financial Development and Poverty From PGP's Yan Wang.
Recently there are increasing signs of a US economic slow down or recession, and economists have expressed concerns on its impact to the rest of the World. Doug Casey, Chairman of Casey Research LLC, went further in his comment on "Currency Regime Change": After listing a few evidence that central banks, Italy, Russia, Sweden, Emirates, and others are diversifying away from the US dollar, he claimed that "There is a major change coming that will catch most investors by surprise: the end of the U.S. Dollar as the de-fecto world reserve currency". If this was true, it would have severe consequences on countries holding large dollar reserves and the impact will spread around the world. In addition, central bankers are bothered by the issue of where to go: an official in Banca d'Italia: "There are not many places to go once you decide to get out of the dollar". Some central banks are increasing their holdings of gold. Sweden and Russia, and now Italy are increasing their holding of British pound. The IMF said the UK pound had overtaken the yen to be come the world's third biggest reserve currency, after the dollar and the euro. Known global reserve of pounds have risen from 55bn to 111.5bn pound over two years. We are not in the business of predicting, but this has got me thinking "isn't this the right time for the IMF and all multilaterals agencies to sit down and work out a plan for a global fund for development, or a currency swap scheme --some sort of alternative investment vehicle for central bankers to choose from?" In this way, we can hopefully scale up aid by using some of the central bank's reserves. From Raj Nallari and Breda Griffith's lecture notes
Inflation and Economic Growth
While inflationary policies can provide a short-run stimulus to economic growth, the economic literature suggests that, over the medium and long term high rates of inflation are bad for economic growth. Cross-country studies show that those countries with consistent positive growth records have on average much lower rates of inflation.
Why might this be? The basic reason is that prices perform a critical signalling mechanism in any market economy, with resources allocated based on prevailing relative prices. If inflation is high these price signals become distorted – it becomes difficult to distinguish between relative and ongoing secular price changes – and resources end up not being allocated efficiently. Moreover, high inflation encourages consumption instead of saving. Higher prices induce people to purchase more products now (before they become more expensive) and discourage people from saving, because money saved for future use will have less value. Too much consumption discourages savings needed for investments in capital goods and technology, the real causes of wealth. Thus investment ends up being curtailed and productivity growth stunted. This in turn impedes overall growth. In a seminal article, Fischer (1993), while noting a positive relationship between growth and low levels of inflation, showed that economic growth is negatively associated with higher levels of inflation (and also large budget deficits and distorted foreign exchange markets). Subsequent studies have examined the relationship in depth and confirm a non-linear relationship between inflation and economic growth that is negative once a certain threshold (of the level of inflation) is reached. The threshold effect depends on the country context. The threshold level of inflation above which inflation acts as a brake on economic growth is estimated at 1 to 3 percent for industrial countries and between 7 to 11 percent for developing countries (Khan and Senhadji, 2000). Above these threshold levels, there is a robust negative relationship between economic growth and inflation, i.e. the negative relationship is not affected by the estimation method, where the threshold level is located, the exclusion of high-inflation observations, data frequency or other model specifications.
More generally, high rates of inflation are associated with poor macroeconomic performance. The typical goal of macroeconomic policy is a high and sustained growth of output alongside with low and stable inflation. As noted by Fischer (1993) inflation serves as ‘an indicator of the overall ability of the government to manage the economy.’ Inflation control is essential for macroeconomic stability and has formed a central component of the macroeconomic policy of government and the structural adjustment programs suggested by the IMF. Many African countries have succeeded in bringing down inflation with annual average inflation on the continent dropping from 17 percent in 1990 to 10 percent in 2003 (in SSA from 20 to 12 percent) (Rogoff, 2003).
Inflation and the Poor Above we have noted the negative relationship between economic growth and inflation. Given the positive impact of economic growth on poverty reduction, it is unsurprising that many studies find that the costs of inflation are borne most heavily by the poor. For example, a 2001 polling survey by Fischer and Easterly showed that inflation was more likely to be rated a top national concern by the poor than the rich. The polling survey showed that improvements in the share of per capita income for the poor were negatively correlated with the rate of inflation, as was the percentage decline in poverty and the percentage change in the real minimum wage (Fischer and Easterly, 2001).
On a more practical level, the poor and, in particular, the rural poor suffer disproportionately from inflation. They lack the wealth that would enable them to diversify into inflation-proof assets. Furthermore, it is likely that they have no access to the financial system and hold their balances in cash that quickly erode in value as a result of inflation. The poor, lacking any assets have only their labor to offer. They are therefore overly dependent on wage labor. Given that wages and prices are sticky in the short run, the poor also suffer disproportionately when inflation is increasing rapidly. High inflation tends to lower the share of the bottom quintile and the real minimum wage - and tends to increase poverty.
Next week: exchange rate policy Submissions are accepted for the forthcoming Annual Awards and Medals Competition oganized by the Global Development Network (GDN), which carries prizes in cash and travel of over US $200,000. Submissions can be for a new research proposal or for a completed research paper. The last day for submissions is September 17, 2006 .
Application criteria and guidelines available at GDN's site. The World Bank's Independent Evaluation Group (IEG) has just released a new report on the bank's work on education.
The report covers bank support to primary education in the developing world, especially since the beginning of the Education for All movement in 1990. It shows that with the help of the World Bank countries have placed high priority on increasing enrollments in primary schools, but have directed less attention to the crucial issue of whether children are learning adequately.
The report recommends that countries, the World Bank and other development partners give the same emphasis to learning outcomes as to access, so that the world's increasing investments in primary education have a far greater impact on poverty reduction and national development.
The full report is available on-line.
Related: facts about primary education. |
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