14181-Dr Ola-Brown Economics Banking and Finance in Emerging Markets-Proshare

 

Economics, Banking and Finance in Emerging Markets A collection of my essays focusing on unique challenges in emerging economies

By Dr Ola Brown, MBBS

 

Economics, Banking and Finance in Emerging Markets: A collection of my essays focusing on unique challenges in emerging economies

by Dr Ola Brown, MBBS

Copyright @ 2020 Dr Ola Brown. All Rights Reserved

Cover and Section Illustrations by Caroline Chapple Layout, Graph & Graphic Design by Iske Conradie Proofreading by Sarina Cornthwaite

 

DEDICATION I dedicate this book to my youngest sister Busola Orekunrin, who died because of what I thought was a  broken, under-funded under-funded he healthcare althcare ssystem. ystem. Now, I realise that the root cause of her death was a complex interplay of scal, structural and other economic factors that continues to contribute to underinvestment in  African healthcare healthcare systems. Continue to rest in peace, my Angel forever. I also dedicate this to my husband, David Brown. My best friend; my inspiration: I love you.

3

 

FOREWORD In recent times, literature in economics has been dominated by academics and policymakers. They typically have a somewhat peculiar way of thinking that can sometimes seem a bit abstract to casual readers, including entrepreneurs. It is what makes books by entrepreneurs all the more interesting, and not just to casual readers, but to economists as well. Ola’s book ts the bill as she explains basic concepts and ideas from the perspective of an entrepreneur trying to get things done in a developing country context. She straddles various topics, from the micro issues aecting rms such as budgeting, savings, and unions, to more “big picture” issues like taxation, monetary policy, and banking; all  written in plain E English nglish and w with ith easy tto o follow dia diagrams grams tha thatt keep thi things ngs intere interesting sting for the casual reader. Following Ola’s journey, from a mild curiosity about economics to interest enough to start a Masters in Economics & Finance and write a book, has been a joy to behold. This collection of essays is essential reading for those who just want a casual understanding of some key topics in economics, and also worth it for economists who seek a dierent perspective.

Nonso Obikili, Ph.D Development Coordination Ofcer, Economist United Nations

4

 

 ABOUT THE AUTHOR Dr Ola Brown is the founder of the Flying Doctors Healthcare Investment Group. The Flying Doctors Healthcare Group invests and operates across the healthcare and wellness value chain in hospital/ clinic construction & refurbishment, diagnostics and equipment, health facility management, pharmaceutical retail, drug manufacturing, air ambulance services & logistics, and consulting/h consulting/healthcare ealthcare technology.

Academic Background Dr Ola studied Medicine and Surgery at the Hull York Medical School after which she worked in Acute Medicine in the UK. She was then awarded the Japanese MEXT scholarship which allowed her to further her studies in Tokyo, Japan. The fellowship focused on lab-based research with induced pluripotent stem cells. She is currently completing her Master’s degree in Finance and Economic Policy at the University of London. Her post-graduate areas of study include Pre-Hospital Emergency care, Healthcare leadership and Healthcare delivery. She has a certicate in Economic Policymaking from IE Business School, Spain, and a certicate in Accounting for Decision Making from the University of Michigan in the United States.

Background in investment and nance  Along with two two other directors, Dr Dr Ola runs a leading early early stage venture venture capital capital rm – Greentree Investment company, which provides growth capital to some of Africa’s most exciting tech start-ups. Greentree Investment company has invested in start-ups in various sectors including FinTech, media, SaaS, Agri-tech, manufacturing, ecommerce, health tech and Edutech, making it one of West Africa’s leading venture capital rms with a total portfolio value of about $80m. 5

 

Publications: Books & Articles She has published four books: EMQ’s books: EMQ’s in Paediatrics, Paediatrics, Pre-Hospital Pre-Hospital Care for Africa, Africa,  Fixing  Fixing  Healthcare in Nigeria: Nigeria: a guide guide to public healthcare healthcare policy and and Banking, Banking, and  Finance & Economics in Emerging Emerging Markets: Markets: an essay collection. She has also written articles published in the British Medical Journal, the Journal of Emergency Medical Services, the Niger Delta Medical Journal, the New York Times, and the Hungton Post.

Awards, Awar ds, Speaker Engagements and Appointments She is an international speaker who has spoken at the TED global conference, the European Union, the Swiss Economic Forum, the UN, the World Bank, the World Economic Forum, the  World Health Health Organisation, Organisation, the Massachuse Massachusetts tts Institute Institute of Technology, Technology, Cambridge Cambridge University, University, and the Aspen Ideas Festival. Dr Ola and her work have also been featured by  CNN,  CNN, the BBC, Forbes and Al-Jazeera. She has received multiple awards and nominations. These include: The Mouldbreaker’s  Award, the THIS Day Award, Award, The Future Future Award as Entrepre Entrepreneur neur of the Year, New Generatio Generation n Leader for Africa, Ladybrille Personality of the Month, Silverbird Entrepreneurship Award, Nigerian Aviation Personality of the Year award, and Vanguard WOW Awards. She is also a TED fellow (see TEDx talk here here), ), a Dangote Fellow, an Aspen Fellow, and has been honoured  by the World World Economic Forum as a Young Global Leader. She is a member of the American College of Emergency Physicians, international editor of the Journal of Emergency Services and a LinkedIn Top Ten Global Healthcare Writer.

International Trade & Investment/Policy Roles Dr. Ola Brown sits on the board of the Professional Women’s Network (Lagos Chapter). She leads the Health as A Business group at the Nigerian Economics Summit Group (NESG); a think tank. She also facilitates trade between Nigeria, the United Kingdom and the United States through her seats on the committee of the British Business Group (Lagos) and the Nigerian-American Chamber of Commerce (Healthcare Section) respectively.

6

 

 TABLE OF CONTENTS Foreword .................................... ...................................................... .................................... ..................................... ..................................... ..................

4

About The Author .................. .................................... ..................................... ..................................... ..................................... ....................... ....

5

Contents ................... ..................................... .................................... ..................................... ..................................... ................................... .................

7

Introduction  .................. .................................... ..................................... ..................................... ..................................... ............................... ............ How To To Read This Book  ................. ................................... ..................................... ..................................... ................................ ..............  

8 13

Section 1: Microeconomics – Explained  .................. .................................... ..................................... ......................... ......

14

Chapter 1 (Essay 1 – Microeconomics: traditional vs. behavioural

perspectives)   .................. perspectives) .................................... ..................................... ..................................... ..................................... ...................... ...  

20

Chapter 2 (Essay 2 – Impact of trade unions on wage structure and work

conditions)   ................. conditions) ................................... .................................... ..................................... ..................................... ........................... .........

30

Section 2: Macroeconomics – Explained  ................ ................................... ..................................... ........................ ......

44

Chapter 3 (Essay 1 – Capital budgeting techniques)  ................................... ................. techniques)  ..................

50

Chapter 4 (Essay 2 – Monetary policy: the cost capital channel and the

credit channel)  channel)  ................. ................................... ..................................... ..................................... .................................... ..................... ...

56

Chapter 5 (Essay 3 – Firms’ investment decisions in emerging markets: cost of capital or quantity of nance available?)  ................ ................................... .......................... .......

64

Chapter 6 (Essay 4 – Assessing scal sustainability in emerging

 

economies vs. advanced economies)  economies)  .................. .................................... ..................................... ...................... ...  

72

Section 3: IMF & E Economic conomic Policy Policy - Is The IMF Evil?  ................... ..................................... ..................... ... Chapter 7 (Essay 1 – Mundell-Fleming and Polak Models, IMF’s approach to

stabilisation)  ................. stabilisation)  ................................... ..................................... ..................................... ..................................... ......................... ......

81 86

Chapter 8 (Essay 2 – Nature of crises in emerging markets and how the

IMF handled them, the emerging market crisis of 1997 and the global nancial crisis)  .................. ..................................... ..................................... ..................................... ..................................... ....................

96  

Section 4: Banking and Capital Markets  .................. ..................................... ..................................... ....................... .....

105

Chapter 9 (Essay 1 – Viability of Nigeria’s bank oriented economy, role of

 

nancialisation in emerging markets, corporate governance)  .................. ..................... ...

110

Chapter 10 (Essay 2 – Role of deposit insurance/lender of last resort in the stability of nancial systems, McKinnon and Pill Model)  ................. ............................... ..............

122  

Conclusion ................. ................................... ..................................... ..................................... ..................................... .................................. ...............

133

7

 

8

 

INTRODUCTION For the past seven (7) years since I moved to Nigeria, I have been taking courses in nance, economics, accounting, and banking. After living in countries like the United Kingdom and Japan, I have been fascinated by the myriad of additional considerations that entrepreneurs and policymakers in emerging markets have to think about in comparison to policymakers and entrepreneurs in advanced countries. My favourite quote from one of my recently published articles is: ‘In is: ‘In advanced countries countries,, there is only one set of forces that can act on your business- the market forces. However, here in  Nigeria, there there are tw two o sets of fo forces rces that can act on your busines businesss- the mark market et forces and the evil forces.’  Emerging markets are much more complex and nuanced, which is why business people, entrepreneurs, and policymakers often nd them more dicult to work in. I have been studying at the University of London for my Master’s degree in Finance and Economic Policy over the past year, and I’m surprised that even in a city as diverse as London, most of our reading material focuses on developed markets. We read about the US Federal Reserve, the European Central Bank, the Bank of England, and the Bank of Japan, as well as papers and textbooks mostly produced and written by Western scholars. If it’s true that business and policy management in emerging markets is more nuanced and complex, then why is so much of economics based around just a few rich countries?

Most of what we see in books and the majority of journals and we read about economics are focused on advanced markets. However, most people in the world do not live in developed countries. It is called the G7 group for a reason- there are only seven countries considered to  be extremely extremely wealthy on a global basis, out of 195.  Working one’s one’s way out o off poverty is serious bu business. siness. Stil Still, l, it becomes even more complicated  when we do do not have enough aca academic demic focus on the str strategies, ategies, po policies, licies, data and resea research rch that are needed to do this successfully.

9

 

I have read so much about the Bank of England, the Federal Reserve, the European Central Bank, and even the Bank of Japan. I also want to read just as much about the Central Bank of Nigeria (CBN) in academic literature. Thus, the purpose of this book is directed towards the dire need to focus on emerging markets. This is because there is very little information on emerging markets, despite their complexities. From now until the completion of my Master’s degree, I have decided to focus my essays on emerging markets. Either I dwell solely on emerging markets, or I try to contextualise the topics within emerging markets. I hope that this book and similar books written by Nigerians, Kenyans, Bangladeshis and Indians will begin to refocus the world on the complexity of entrepreneurship and policy-making in emerging markets. I spent a part of my childhood in London in a place called Hackney. At that time, Hackney  wasn’t a nice nice place to live as it wasn’t one of the high-end ar areas. eas. The bus 38 used to st stop op outside my house. This bus could take you from Hackney to Piccadilly Circus, one of the nicest parts of London. When I was young, I would get on that bus and ride to Piccadilly Circus. Whenever I was there, I’d begin to wonder why I couldn’t be one of those who lived in that kind of place. I found it dicult to understand why the people in my environment  weren’t as as auent a ass the peo people ple just a bus ride aw away ay from us. As I moved, I gr grew ew up taki taking ng my A-levels at a poorly performing public college and thought about it more. more. How  How could I compete with the wealthier kids that went to private school when my reality was so dierent  from theirs?  theirs?  When  When sharing my ideas- I called it the ’38 project’- I tried to get people thinking about questions like: “How do we make our lives better?” “How do we get out of Hackney into Piccadilly Circus?” This is exactly what emerging markets like Nigeria, Kenya, Congo, and Ethiopia are currently facing. We are trying to play the same game as wealthier countries, but with fewer resources.  We want the kind o off progress that will g get et us out of the meta metaphorical phorical Ha Hackney ckney into our own Piccadilly Circus. We want to have the kind of GDP that can support sustainable growth in our economies. We want to evolve. We want to have our own Google, Facebook, Uber, and Apple.  We want to have our own unique forms of iinnovation nnovation.. This book seeks to refocus the world on emerging markets, which are home not only to many of the poorest people, but also to the largest number of people.

10

 

(Source: University of Michigan)

In the global economy, only half a billion people earn above twenty thousand dollars ($20,000) a year. Two billion people earn between three and twenty thousand dollars ($3,000-$20,000) each year. However, the majority- four billion people- earn three thousand dollars ($3,000) or less per year. Most of these four billion people live in emerging markets. In spite of these statistics, instead of focusing on the needs, wants and desires of the four  billion people people that ma make ke up most of the wo world’s rld’s populati population, on, the who whole le of econo economics mics seems to  be focused on on 0.5 billion people. Therefore, the aim of this book, Economics, Banking & Finance in Emerging Markets, Markets, is to try to push the needs and desires of those four billion people forward and get us all thinking about how we can improve their lives as well. Economics is so important because it has an impact on everything. A clear understanding of economics aects the way we vote, the way we spend, the type of business we start, and the kind of things we value. It also aects the way we substitute products for others. I believe that a little bit of understanding of economics in emerging markets can make a big dierence to the world’s poorest and most vulnerable people.

11

 

This is particularly important to me because I live in Nigeria, which has more poor people than anywhere else in the world. Nigeria is home to over 80 million impoverished people.

Many people think India is a poor country. However, the truth is only 5.5% of India’s population is classied as extremely poor, compared to over 40% of Nigeria’s population. Entrepreneurs in emerging markets face a number of challenges that would not be faced if they were in developed countries. These challenges are at least, in part, policy driven. In ‘Africa Rise and Shine’, a book by one of the most successful bankers in Africa, Jim Ovia, he spoke about the condition of the road to his bank being one of the biggest challenges for him, as customers found it dicult to drive on the road without damaging their cars. So he ended up building a road! In advanced countries, it is almost impossible to hear that owners of American or German banks had to engage in road construction or their businesses, as these things have already existed. Similarly, if you take a brief look at Aliko Dangote - the richest man in Africa - you will discover that he also encountered a similar problem with infrastructure. He has built and is continuing to build roads and helping to develop ports so that he can get cement materials to and from his factories. The aim of this book, as reiterated earlier, is to refocus the world’s view of economics. It also seeks to ensure that the intricacies and idiosyncrasies of economic, nancial, and business policy in emerging markets are projected. In addition, this book attempts to encourage people to think about innovative, policy-based, business-based, and investment-based solutions that can help lift this important, but often ignored demographic of four billion poor people out of poverty and a bit closer to prosperity.

12

 

HOW TO READ THIS BOOK  This book is divided into four sections- Macroeconomics, Microeconomics, Banking & Capital markets, and the International Monetary Fund (IMF).  Although it is a collect collection ion of aca academic demic essa essays, ys, each cha chapter pter has a an n explaine explainer. r. These explainers are written from a layperson’s perspective. Some of you reading this book might choose to read the explainers and look at the pretty pictures without going onto the essays... and that’s perfectly ne.  You can pick pick up the bo book ok and say, “You know w what? hat? I’m sim simply ply going to look at the table of contents, go through the explainers and look at the pretty pictures”. By doing so, not only have you improved your knowledge of economics economics and nance, you have also improved your ability to understand the context in which you live, as well as your knowledge of how money, business and investments work in emerging markets- and that could be enough for you. However, if you feel the need to go further, please note that there are two essays in each chapter. They are my academic work and some of them dig into certain aspects of economics as well as banking and nance. I only focused on a minute area of each, so if you feel the need to dig a little deeper into our world, you are more than welcome to do that. You may want to start  with my economic video tutorials on YouTube ; - )

13

 

SECTION 1 MICROECONOMICS- EXPLAINED Microeconomics is the branch of economics that studies the economy of consumers, households and individual rms. Basically, Microeconomics looks at the day-to-day decisions of individuals and rms. To start with, I want to give an illustration centred around Hushpuppi. For those who don’t know the story, Hushpuppi (real name: Ramon Olorunwa Abbas) is a amboyant social media celebrity who was recently arrested by the FBI after investigations revealed that he was a highprole internet fraudster. Before his arrest, Hushpuppi was a spendthrift. If you take a look at his Instagram page, you  will see how how he spe spent nt his mone money y extravag extravagantly. antly. He ke kept pt charte chartering ring privat privatee jets, an and d buying super-expensive cars like Bentley, Rolls Royce and many others. His clothes and shoes were from world-renowned brands like Louis Vuitton and Gucci. Despite the endless speculations that he nanced his opulent lifestyle through fraudulent proceeds, he still audaciously posted all his luxurious spending on the internet. He continued to spend amboyantly until the day of his arrest. That is an extreme example of microeconomic decisions- decisions made by an individual that seem bizarre and strange, but still happen. That’s exactly what microeconomics is all about. It studies why we act the way we act, why we think the way we think, and why we spend the way we spend. It also examines the impact of day-to-day decisions made by households and rms. One of the most interesting things about microeconomics is the relationship between saving and spending. Microeconomics is concerned about the day-to-day spending- how we spend versus how we save money. In countries like Japan and Germany, there is a high level of savings. That helps those countries because a high level of savings means that banks have a lot of deposits to invest 14

 

15

 

in businesses. However, in a situation where a country has a low level of savings, such as in Nigeria, banks have a relatively low amount of money, which makes it dicult for them to invest in businesses. Many people in this part of the world spend more than save, and this aects us at a much higher level. Countries with a high marginal propensity to save have much more money in their banks while countries with a higher marginal propensity to consume have less money in their banks. Saving is something that requires a great deal of discipline and the government can encourage us to do certain things to establish this habit. Occasionally, the government can come up  with policies policies that w will ill allow us tto o change o our ur behaviou behaviourr and try to push us tow towards ards a spe specic cic  behaviour, however, se several veral econ economists omists say that the g government overnment is not supp supposed osed to do tthat. hat. This raises the question of whether or not the government should implement such policies.  According to to neoclassi neoclassical cal econom economists, ists, human b beings eings act naturally. The They y simply do wh what at  will benet benet them, and only obey th their eir selsh interests interests.. However, ov over er the years, years, we have discovered that if you actually study human behaviour, you will see that the government can do a few things to nudge us in the direction they want us to go. Several questions have risen about this lately. One of them is that is it right for the government to compulsively deduct money from every civil servant’s paycheck and put it in a savings account they are unable to access for ve years? I believe it’s a good thing, because it gives people money on a rainy day. But the question is- is it the place of the government to do? In my last book, Fixing Health Care in Nigeria, I suggested that if we wanted to x health care in Nigeria, the federal government should make a deal with all providers of telecommunications services and deduct ve thousand naira ( ₦ 5,000) from every citizen’s phone credit for a year. However, there was a huge uproar. Some people were of the opinion that the government should not have that much power. I said to most of them: ‘People can’t pay for their health care, so why don’t we just take it and put it in a fund so that when they have an accident or an emergency, it’s easy for them to be treated, without having to pay?’ Even with this argument, many people still said No.

16

 

This is one of the key issues I’ve addressed in the essay section. I’ve provided answers to thought-provoking thought-provo king questions such as: What is the role of the government?  Why do people do what they do?   Do people serve thei theirr selsh in interests terests al alone, one, or are they easier to inuence than we tthink?  hink?   Let’s assume that peop people le are eas easier ier to inue inuence nce than w wee think;  Should the government government actually do th thee inuence inuence?  ?   Do they have have the right? Should they have the power to inuence that kind of thing?  Another issue issue I’m going tto o discuss is the envir environment. onment. It is not in any of the eessays, ssays, but it it’s ’s crucial because environmental economics is part of microeconomics. Nigeria has suered some devastating oil spills in the Niger Delta. We generate a lot of wealth from that region as a nation, but at huge costs. Some shing communities in the Niger Delta can no longer sh because the sh have died as a result of oil spills.  When a company company produces something and an unw unwanted anted by-pr by-product oduct or har harmful mful eect o occurs ccurs as a result of that production, it is called a negative externality. Nigeria, for example, has suered greatly from these negative externalities, especially in the oil-producing region. Since emerging markets like Nigeria desperately need money from natural resources like oil,  we haven’t bothered tto o put polici policies es to pres preserve erve our eenvironment nvironment in place. As a result, we have had a lot of environmental degradation.  As I go further further in this explainer explainer,, I would like to talk ab about out corrupti corruptionon- one of Nigeria’s b biggest iggest problems. Research from the Clayton Christensen Institute explains that as people become richer and the economy develops, corruption naturally decreases. According to him, this has been observed in many countries around the world. There has been much work on market structures and how they are formed in microeconomics. I’m not going to talk about it in the essays, but I think it’s imperative to mention it when giving an overview of microeconomics.

17

 

Market structures are a crucial part of microeconomics, and the monopoly structure is a market where there is only one inuential player with a large market share. They are called price makers because they dictate prices. In this situation, no matter how expensive a product is, it is almost impossible to substitute.

In emerging markets, corruption tends to bring about some of these monopolies that impoverish people because they provide essential goods at extremely high prices, which has a negative impact on economic development. Identifying these monopolies, legislating them, and making policies around the formation of monopolies is denitely something that we should look into. It would not be fair to conclude this explainer without highlighting employmen employmentt issues. The issue of unemployment would normally be discussed in the macroeconomics explainer. In this microeconomics explainer, I will be talking about employment, although I will be focusing more on why people decide to work as opposed to just resting at home, and what makes them more likely to work. I mentioned the role of labour unions in my essay on microeconomics. I explained that one of the things that happen in emerging economies is being plagued by low wages. Unions can be a way to raise wages because an average union worker earns more than a non-union worker (references available in the essay). However, unions may be counterproductive to protability when they are too strong. If you look at the trends in union membership, you will see that union membership around the  world has decreased signicant signicantly ly in the las lastt ten (10) tto o twenty (2 (20) 0) years. This is probably due to the impact these unions have on the protability of companies. I’m going to talk more about unions in the essay section, however, I want you to understand that while there are good sides to labour unions in terms of actually raising average workers’  wages, they they can also b bee detrime detrimental. ntal.

18

 

Thank you for joining me in exploring the wonderful world of microeconomics. At the end, I’m sure you will know why you have a friend who gets her salary and spends it all right away, and  why another another one trie triess to inves investt as much a ass she can iin n land, prop property, erty, shares shares,, and stocks stocks.. You  will also know know why tha thatt other ffriend riend of your yourss likes to keep eve every ry penny she has in her savings account.  As I explained explained earlier earlier,, microecon microeconomics omics simply studies why individuals, a ass well as rms, do  what they do. Thank you so much for reading. I hope you enjoy the essay!

19

 

Chapter 1 Microeconomics Standard neo-classical theory argues that saving and spending  behaviour is the product of ra rational tional nancial planning. Discuss both traditional and behavioural views of such personal nancial decision making, highlighting the policy proposals arising from these approaches. Having high rates of saving is important for nancial development in countries like Nigeria. But currently, Nigerians save less than many of our African peers. Can government policy interventions to change consumer behaviour ever be legitimised?

Introduction This paper will start by examining both the traditional and behavioural views of personal nancial decision making. It will go on to explore how personal nancial decisions can aect the economy and whether it is therefore the place of government to design policy to attempt to change consumer behaviour. Microeconomics is concerned with the behaviour of individuals and rms. This  behaviour can can be stud studied ied from die dierent rent pers perspectives pectives a among mong which are the traditional perspectives and the behavioural perspective. Both are discussed on the next page.

20

 

 The traditional view

Figure 1

The origins of the traditional view can be found in the works of philosophers like Aristotle. Aristotle ‘based economics on needs needs,, analyzed their nature and proceeded to isolate the economic goods by which economic needs are satised’ (Koumparoulis, (Koumparouli s, 2011).  Views from from Aristotle and philos philosophers ophers like him at the time are called the preclassical theories. The pre-classical theory was then superseded by the classical theories. Classical theory was popularised by the world’s most inuential economist, Adam Smith.  Adam Smith referred to the ‘invi ‘invisible sible hand of the mar market’, ket’, explai explaining ning that because humans act rationally, there is no need for any central price planning mechanism. This is because the market moves automatically to produce more of what people  want. Smith Smith was an ardent pro proponent ponent of a laissez faire style of governa governance nce where demand and supply reigned supreme. He argued that only the free market could  bring society society into na natural tural harm harmony ony (Williams, 1976). To him, gove government rnment cen central tral planning was unnatural and unnecessary (West, 1969).

Introducing ‘Homo Economicus’… This view dominated the elds of economics, political science, sociology and philosophy for over a century (Anderson, 2000). 21

 

The term ‘homo economicus’ refers to the archetypal classical description of the  way human beings beings act and make decisions.  According to Doucouliagos Doucouliagos (1994 (1994), ), Homo Econom Economicus icus has three ma main in characteristics: 1.

He/She acts to maximise personal benet or pleasure, maximising behaviour.

2. He/She makes every decision rationally and has the cognitive ability to do so. 3. He/She acts in his/her own self-interest – individualistic behaviour. Smith argues that the main reason for anyone to engage in exchange is ‘self-love’. Homo economicus is fundamentally self-interested. The quote below from his  book ‘The Theory Theory of mora morall sentimen sentiments’ ts’ exempli exemplies es this no notion: tion: “Every man is no doubt by nature, rst and principally recommended to his own care and as he is tter to take care of himself than any other person, it is  t and right that it should be so. Ever Every y man, ther therefore, efore, is muc much h more dee deeply ply interested in whatever immediately concern himself, than in what concerns any other man.’’  (Smith, 1759) The central tenet of the subsequent neoclassical theory is similarly built around ‘rational choice theory’. This is the idea that human beings act rationally to maximise utility. However, compared to classical theory, neoclassical theory highlights the roles of marginalism and perception. Marginalism highlights the pleasure/utility experienced from the consumption of one extra unit of a particular product/service. Classical theory also focuses on the idea that price is determined by the costs required to produce a particular good or service. However, neoclassical theory recognises the role of consumer perception in determining the price or demand for goods and services. Neoclassical theory would also assume that saving and borrowing decisions are largely rational.

22

 

 The behavioural view The behavioural view challenged the notion of the completely rational homo economicus which previously was the dominant perspective on human behaviour in economics. Justin Fox refers to the emergence of the behavioural view in economics as ‘irrationality’s revenge’ in his Harvard Business Review article (Fox, 2015).

Homo economicus has evolved…  After over a century of believin believing g that huma human n beings a are re ration rational, al, many economists began to nd out that in many cases, this was not the case. However, Kahneman and Tversky (1979) were the most inuential voices in this movement, explaining how psychological phenomena such as bias, context, framing, and heuristics aect decision-making. When these insights from psychology are taken into consideration, it produces a more realistic picture of what people in the real  world actually actually do (Kahn (Kahneman, eman, 1979).

Borrowing and saving: Neoclassical vs behavioural perspective   Whilst the neoclassi neoclassical cal theory w would ould assume that savi saving ng and borr borrowing owing deci decisions sions are largely rational and based on self- interest, the behavioural theory takes a more nuanced approach.

Why do people save?  Savings move move income from the p present resent to the future whilst borr borrowing owing mov moves es income from the future to the present. People save because intemporal income (income distribution over dierent periods of life) doesn’t match consumption needs. So, during early school years, most children in developed countries don’t work but need to consume food, clothing and other expenses such as school fees. When people reach working age, income rises but declines as people move into retirement. However, retirement expenses may increase due to medical bills. 23

 

There are two classical models that explain how people save: 1.

The life-cycle model

2. Permanent income model. The life-cycle model describes how a person’s savings habits change through dierent periods of their lives. Dissaving whilst young and dependent on parents, then saving during peak earnings at working age, and then dissaving again through retirement.

Figure 2 [Source: Understanding Financial Accounts (van de Ven & Fano, 2017)].

The permanent income model, however, postulates that people will spend in anticipation of average level of long term expected income.

Figure 3 (Source: Economics Discussion.net1).

24

 

Consumers must decide how much they want to spend in the present and how much they want to save for the future; this is depicted by the intertemporal  budget line. line. This classi classical cal model hig highlights hlights the role of in interest terest ra rates tes in bot both h saving and borrowing decisions. Browning, 1996 acknowledges these models, but also explores the role of  behavioural issues th  behavioural that at aect h how ow people save and b borrow. orrow. Some people hav havee more self-control than others. Some people also possess computational ability— the ability to accurately calculate how much to save or borrow to meet their immediate and future needs (Browning, 1996). The classical models also don’t take into consideration the eect of economic cycle on saving and borrowing behaviour. People borrow more during economic  boom periods periods and save more during down reces recessions sions (Nof (Nofsinger, singer, 2010 2010). ). Furthermore, individuals may engage in precautionary saving if they feel they might experience a drop in income. So they save when the permanent income model predicts they would borrow. The neoclassical model similarly doesn’t take into consideration those extreme low-income earners that have no access to credit markets in the rst place (Jones, 2009).

 The effect of personal personal nancial decisions for government ‘The nancial stability of an economy is signicantly inuenced by the evolution of household nancial behavior.’ (Kłopocka, 2017) Kauman (1991) explains how a decline in household savings can aect the level of funds needed for investment. Furthermore, Nofsinger explains how household behaviour can actually exacerbate the entire boom/bust economic cycle. This is because during an economic boom, households are inuenced by extrapolation bias and groupthink. Extrapolation bias is the tendency to take a recent experience and believe that same pattern will continue forever. Groupthink is a situation where an entire group of people starts thinking in the same way, not questioning the weaknesses, leading to a dysfunctional outcome (Nofsinger, 2010). 25

 

So since personal nancial decisions have such a signicant eect on the wider economy, should the government try to inuence behaviour through policy?

 The role of government policy in changing consumer behaviour  As mentioned mentioned earlier earlier,, Adam Smith a argues rgues that the invis invisible ible hand o off the mark market et allocates resources in the most eective manner. This therefore negates the need for government intervention. However, Mankiw (2009) argues that the hand of the market is indeed powerful, but by no means all knowing. Limitations to the hand of the market come in the form of externalities. Externalities are positive or negative consequences of economic output that inuences a bystander, who neither pays nor receives any compensation for that eect. An example of a negative externality is pollution. Some industries produce a lot of pollution that aects people in many communities. Some governments use policy to try to reduce pollution levels and protect citizens from its harmful eects. Economists have argued that private entities are capable of bargaining amongst themselves to counter externalities; this is known as the Coase Theorem, named after the economist who rst put this idea forward.  Although it sounds sounds logica logical, l, it often fails in pr practice, actice, mak making ing a case for some form of government intervention (Mankiw, 2009). So we have established that in cases like pollution that has widespread eects on our environment, there may be a plausible role for government intervention. In a sense there are already many policy interventions that aect behaviour that are  widely accepted. accepted. For examp example, le, taxatio taxation, n, subsidies, provision o off public good goods. s. In the next section, we consider how and if at all the government should intervene in far more seemingly intrusive matters like our personal nances.

26

 

Should government get involved in how we spend vs when we save? The Boston Federal Reserve published a paper in 2007 (Benton et al., 2007). It studied low income earners and point out how they are disproportionately aected by under-saving and over-borrowing. They disagree with the classical perspective that humans act rationally when it comes to nancial decisions. They also point out how vulnerable low-income earners are when they do not save due to the possibilities of emergencies. The paper also talks about how damaging low credit scores can be for low income earners that borrow unsustainably and are unable to pay back their loans.  At the centre centre of the their ir argumen argumentt is the cconcept oncept of sself-control elf-control and how a lack of self-control, closely related to procrastination, is one of the factors responsible for over-borrowing and under-saving. Four policy suggestions are put forward to help. These include: 1.

Commitment devices; vehicles that charge high penalties for withdrawal of saved funds

2. Front loaded devices; instruments that deduct savings from wages at source 3.

Default saving clubs that participants must deliberately opt out of 

4. Promoting bank account products for the unbanked (Benton et al., 2007) However, many economists disagree fundamentally with the idea of libertarian paternalism. This is the idea that it’s possible to deliberately channel people to make decisions which are ‘better’ for them whilst leaving them with freedom of choice.

27

 

 Although some Economists call the tterm erm ‘Liberta ‘Libertarian rian pat paternalism’ ernalism’ an oxymoron, arguing that the freedom of choice and the steering of one’s choice cannot coexist, there is a great deal of support for this idea as well, simply because so many economists now agree that ‘individuals are often not the best judges of their own  welfare’ (Schlag, (Schlag, 2003). Therefore, some method of guiding people towards the correct choices for them  without coercion coercion is iinevitable nevitable (Sunstein & Thaler, 2003).

Conclusion The history of economic thought is fascinating. From the early work of Aristotle in 384 BC, the question of how and why people make choices and how to predict them has puzzled economists economists,, philosophers and psychologist psychologists. s. The pre-classical, classical and neoclassical theories view human beings as rational decision makers. However, insights from the eld of psychology reveal how a whole host of factors such as framing, anchoring, bias, and heuristics aect how we make decisions. Humans are rarely completely rational. Libertarian paternalism has been suggested as a solution to help people navigate the increasingly complex array of savings/investment and loan instruments as  well as help help people w with ith low lev levels els of self self-control -control mak makee better decisions (Carlin, 2013).

28

 

References •

 Anderson, E. (2000). Beyond Homo Economicus: New Developments Devel opments in Theories of Social Norms. Philosophy & Public Aairs, 29(2), 170–200.

•

Benton, M.; Meier, S.; Sprenger, C. (2007). Overborrowing and Undersaving: Lessons and Policy Implications from Research in Behavioral Economics, Federal Reserve Bank of Boston, Community Development Discussion papers, No. 2007-4.

•

Browning, M.; Annamaria, L. (1996). Household Saving: Micro Theories and Micro Facts. Open Dartmouth: Faculty Open Access Articles. 2429. https://digitalcommons.dartmouth.edu/facoa/2429

•

Carlin, B. I.; Gervais, S.; Manso, G. (2013). Libertarian Paternalism, Information Production, and Financial Decision Making. The Review of Financial Studies, 26(9), 2204–2228.

•

Doucouliagos, C. (1994). A Note on the Evolution of Homo Economicus. Journal of Economic Issues, 28(3), 877–883.

•

Fox, J. (2015). From economic man to behavioral economics. Harvard Business Review, May 2015 issue, 78–85.

•

Kahneman, D.; Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47 (2), 263-291.

•

Kauman, B. (1991). Microeconomics of saving. Economic Papers; Commission of the European communities. Number 89. http://aei.pitt.edu/36996/1/A3031.pdf  

•

Kłopocka, A.M. (2017). Does Consumer Condence Forecast Household Saving and Borrowing Behavior? Evidence for Poland. Social Indicators Research, 133, 693–717. https://doi.org/10.1007/ s11205-016-1376-4

•

Koumparoulis, D. M. (2011). Aristotle’s Economic Thought, Educational Research, 2(13) pp. 18311838.

•

Nofsinger, J. (2012). Household behavior and boom/bust cycles. Journal of Financial Stability. 8(3), 161-173 https://doi.org/10.1016/j.jfs.2011.05.004

•

Schlag, P. (2010). Nudge, choice architecture, and libertarian paternalism. Michigan Law Review, 108(6), 913–924. www.jstor.org/stable/40645851 913–924. www.jstor.org/stable/40645851

•

Smith, A. (1759). The theory of moral sentiments, ed. DD Raphael & AL Mace. Liberty Fund (original

•

 work published in 1759). Sunstein, C.; Thaler, R. (2003). Libertarian Paternalism Is Not an Oxymoron. The University of Chicago Law Review. 70(4), 1159-1202.

•

 van de Ven, P.; Fano, D. (eds.) (2017). Understanding Financial Accounts, OECD Publishing, Paris, https://doi.org/10.1787/9789264281288-en

•

 Waters, William R. (1976). Social economics of Adam Smith: introduction. Review of Social So cial Economy, 34(3), 239–243.

•

West, E. G. Adam Smith’s Philosophy of Riches. Philosophy, 44(168), 101–115.

•

Mankiw, G. (2009). Principles of microeconomics. Fifth edition. Southern Cengage Learning, p. 221464.

29

 

Chapter 2 How are wages determined and what role do trade unions play in improving conditions for workers particularly in emerging markets? Currently, the world is experiencing the rst truly global pandemic – an outbreak of the novel coronavirus, COVID-19. This outbreak, along with the chaos and economic strain that has come with it, has left many people asking important questions. Such questions include: Why do we pay footballers and movie stars so much more money than virologists and doctors? This paper will examine some of the factors that aect the amount people earn and why people work in the rst place. Membership of a trade union is one factor that aects how much people earn. Other factors will also be examined before taking a deep dive into the eects of trade unions and trends in trade union membership across the world. The focus of this paper will be on neoclassical labour theory and the impact of trade unions. Other factors will be touched on briey towards the end.

1. Demand and Supply The neoclassical approach to labour views a rm’s decision to hire as a decision  based on demand, demand, supply a and nd productiv productivity. ity. It sees workers and rms as completely rational. Firms seek to make the most prot whilst workers seek to maximise utility.

30

 

Figure 1

Figure 1, above, shows the balance between the neoclassical view of the goals of  workers and and rms. Neoclassical theory of labour views the labour market as a ‘place’ where buyers and sellers of labour meet to exchange hours of labour for wages, and based on demand and supply, they reach agreement/equilibrium (Fleetwood, 2014). Each factor of production earns the value of its marginal contribution to the production of goods/services at equilibrium. Neoclassical theory is widely accepted amongst economists as a starting point when trying to understand  why people are are paid di dierent erent wa wages ges across industries and profes professions sions (Man (Mankiw, kiw, 2009). Neoclassical economics views unemployment eectively as a ‘’choice’’. Unemployment is seen as voluntary leisure, chosen over employment when a  worker’s reservation reservation wage is not met (Spe (Spencer, ncer, 2006).

31

 

Figure 2 (Jean, 2014)

The graph above (Figure 2) shows the classical neoclassical representation of the labour market. However, the curve can be backward bending (as shown below) when a certain level of income is reached as people that are earning large amounts of money at some point stop working so hard. They typically spend more time doing leisure activities after a certain point. In technical languages, the substitution eect  becomes more more signica signicant nt than tthe he income eect.

Figure 3 (Prasch, 2000)

2. Impact of Trade Unions This section will explore the impact and inuence of trade unions as well as some key features/t features/trends. rends. 32

 

It’s often assumed that employers have the power to determine wages, but trade unions disrupt this balance by using collective bargaining to negotiate wages on  behalf of their memb members. ers. But the there re are a also lso less obv obvious ious ways tthat hat trade unions can inuence wages.

 Trade unions effect on wages

Figure 4

There are several indirect ways that trade unions can aect wages. Firstly, unions give workers ‘voice’ regarding tenure, training and human development, etc. (Benson, 2009). The threat of unionisation can raise wages in the non-union sector. But also, job losses in the union sector can result in excess labour supply to the non-unionised sector which depresses wages (Bryson, 2014). The main way trade unions aect wages is directly through their bargaining activities. This can give an estimated wage premium of about 15% according to some research, although there has not been consensus on this (DeFina, 1983 Bargaining activities include strikes (discussed in this section).

33

 

Unions cause wages to rise partly because unionised workers can withdraw their labour en masse, causing massive disruptions to production if their demands are not met. This is called a strike. However, over the past few decades, the number of union-backed strikes and their eectiveness as regards raising wages have changed, so it’s worth spending a little time below to understand the trends.

a) Strikes

Figure 5

Figure 5 shows the decline in number of strikes over the past few decades (Roseneld, 2014) Strikes, previously unions most powerful weapon, has declined gradually over the past few decades, despite a massive growth in the labour force. This has happened despite research that shows that unionised workers that strike obtain higher  wages than than unionise unionised d workers that don’t. S Some ome argue tthat hat the de decline cline in sstrike trike action is because workers and management understand each other better than they did a few generations ago.

34

 

However, there is also evidence that strikes simply don’t accomplish what they did in the past. In the 70s, employers began to ‘strike back’ by hiring permanent replacements and moving operations to non-unionised facilities, making union leaders think more carefully about potential repercussions before using this tool (Roseneld, 2014).

b) Efect on employment/skills However, it has been found that unions may cause few people to be employed and cause wages for non-unionised workers to fall because the unions’ demands for higher wages often cause fewer people to be employed as rms tend to employ more people when wages are lower. On the other hand, models show that the stronger the union is, the higher the mark-up over the reservation wage (the lowest salary/wage that an employee would be willing to take for any particular type of job) and the lower the resulting wage level (Tito, 2013). Therefore, unions face a trade-o between increased wages for their members and low unemploymentt (Creedy, 1989). unemploymen Oswald (1982) points out that where unions operated, there is a loss of eciency  because the the margina marginall product of labour for a union wo worker, rker, assumi assuming ng the lab labour our market is competitive, diers from that of a non-union worker. He also points out that whilst the union workers are better o, the non-union  workers are poorer poorer,, and the r rm m may or ma may y not be ne negatively gatively ae aected cted (Oswal (Oswald, d, 1982). But this wage dierential between union and non-union workers is highly dependent on skills of the worker. The more skilled the worker is, the less signicant the overall dierence in wages is between union and non-union  workers (Hirsch, 1998). This issue has led to internal disputes within unions. Many unions base their arguments around wage dierential between highly skilled and low skilled  workers, pursuing pursuing an egalitaria egalitarian n ideal. This potentia potentially lly diminishe diminishess the prem premium ium put on additional skills and may alienate highly skilled workers, causing them to leave the union completely. For example, a famous case in Italy called the ‘marcia dei 40,000’ when middle class/highly skilled workers went on strike against the unions (Tito, 2013).

35

 

c) Income inequality Most countries strive for higher levels of income equality. A paper by the National Institute for Economic and Social Research explains how income inequality  would almost certainly be higher w without ithout the bargaining power of unions. Whils Whilstt neoclassical theory emphasizes market-driven wages determined by the forces of demand and supply, unions enable workers to extract an above-market premium for their labour. The inuence of unions has decreased over time as indicated in Fig 4; this has led to increased income inequality which is detrimental to workers (Bryson, 2014).

d) Unions as monopolies Unions do exert some form of monopoly power due to their ‘strike threat system’ described above. They exert some control over the supply of labour; this generates bargaining power which is used to resist downward pressure on wages (Bryson, 2014). Their actions change both working conditions and wages; this is an evidence of monopoly power, but ‘without ‘without coercion’, accord according ing to Burkitt (1977). Also, the power that unions wield never becomes all-encompassing like producer monopolies, even when their polices are successful. Burkitt (1977) argues that “trade unions counter pre-existing market imperfections and eliminate the ‘distortions’ of unorganised labour markets.” However, Lindbolm (1958) makes an interesting counter-argument. He states that strike action is a form of coercion and that unions can have the same levels of control over the price of labour that private enterprises aren’t allowed over the cost of their products (Lindbolm, 1958).

e) Health and Safety Unions were at the forefront of pushing for better welfare and health/safety at  work. This is is particula particularly rly relevan relevantt in the mi mining ning indust industry ry where iitt was wor worker ker unions that articulated the link between brown lung disease (a form of respiratory 36

 

illness) and mining. They went on to bargain for better working conditions that have beneted unionised and non-unionised workers alike (Alejandro, 2012).

f) Political support for unions In the face of globalisation and decreased political support, the membership and impact of trade unions have decreased (see gure 6 below). Laws have been enacted to decrease the power of trade unions. A large group of air trac control  workers were sack sacked ed in the United Sta States tes under Ro Ronald nald Reaga Reagan n when the they y illegally went on strike (Goodwin, 2019).

g) The future of unions Unions must evolve to take on non-bargaining with greater levels of collaboration  with rms. rms. It is real realised ised that a union cann cannot ot oer its members a any ny jobs if tthe he rm is bankrupt (Ratnam, 2007). Ashenfelter and Johnson (1969) support this notion  by pointing pointing out the eeect ect of asym asymmetrical metrical in information formation.. They argue tthat hat there is often asymmetrical information on the part of the unions, that is, the unions may not be able to accurately determine the nancial health of the rm (Ashenfelter, 1969).

Figure 6 37

 

Figure 6, on the previous page, shows how union membership has declined over the past few decades (Tito, 2013). This section has highlighted the fact that unions are powerful institutions that can help workers to obtain higher wages through the power of collective bargaining. But it has also pointed out how unions may decrease the actual number of employment opportunities available, disadvantaging non-union workers. The role of skills was also noted; how highly skilled workers don’t need unions as much as lower skilled workers to negotiate higher wages.  Additionally, the the reason reasonss why trade union memb membership ership is declining, suc such h as globalisation, politics/law/policy and the rise of the service industry, were examined. Unions are also ageing rapidly and nding it hard to attract and recruit  younger members members (Tito, 20 2013). 13). Brief co comments mments on the possibl possiblee future of trade unions – with an expanded scope and collaborative approach – were also made. To conclude, it’s important to point out just how revolutionary trade unions have  been for mainstrea mainstream m policy. Man Many y of the be benets nets and innovation innovationss that hav havee made  workplacess easier tto  workplace o navigat navigate, e, such as e exitime, xitime, sic sick k leave a and nd childcare childcare,, were  born out of trade unio unions. ns. These ar aree commonpla commonplace ce now but were once very radica radical. l. This is a good example of how the hard work of trade unions over decades has ultimately left society better o (Goodwin, 2019).

Conclusion There are many factors that aect wages and employment that have been analysed in this paper. It has been shown that the neoclassical approach may have some merit and that has been considered in depth in this paper. Additionally, it has been revealed that demand and supply do aect how much workers are paid in wages and many human beings make trade-os between the income eect and the substitution eect when considering their work options.

The type of market a worker operates in may also aect wages. In a perfectly competitive market, the labour curve is perfectly inelastic. This means that any attempt to lower wages will result in workers leaving the rm as the market wage is determined by factors beyond the control of the employer.

38

 

However, in a monopsony, the employer has a lot of control over wages, so therefore, wages can uctuate and the workers have little power and no alternatives (Manning, 2003). Neoclassical labour theory teaches us how human beings are rational and the only reason why workers work is to earn a wage to maximise their utility. But there is alternative evidence evidence that this simply isn’t true. A job to many people isn’t just about the money. For many, its central to their identity. Studies by Kaplan (1987) and more recently by Arvey (1996) show that lottery winners don’t typically quit their jobs. Hirscheld (Hirschfeld, 2000) considers this concept of work centrality in his book. He refers to people with a high level of work centrality as “people who consider work as a central life interest, have a strong identication  with work work in the ssense ense that they belie believe ve the wor work k role to be an impo important rtant and central part of their lives.” This contrasts directly with the neoclassical approach to the labour market. Minimum wage legislation, the rise of the gig economy, technology (such as articial intelligence and robotics) are already aecting wages and will continue to in the future. It is these rapid changes that have fuelled debates around the feasibility of providing everyone with a universal basic income (Downes, 2018). Goodwin (2019) also points out how discrimination based on gender, ethnicity and sexual orientation can also aect wages. This paper focused on the role of unions, how they inuence wages, employment, and how some may view them as monopolies. Although the inuence of unions may have declined over the years, their legacy lives on in the form of benets such as childcare benets and health that have created happier, safer, more thoughtful  workplacess for us al  workplace all. l.

39

 

References •

 Alejandro, D. (2012). HOW TRADE UNIONS INCREASE WELFARE. The Economic Journal,, 9901009.

•

 Arvey, R. D. (1996). Work Centrality and Post-Award Work. The Journal of Psychology, 2-3.

•

 Ashenfelter, O. (1969). Bargaining, trade unions and indutrial strike activity. American Economic

•

Review, 45. Benson, J. (2009). Employee voice: does union membership matter? Human Resource Management Journal .

•

Berle, A. a. (1932). The Modern Corporation and Private Property. New York : Macmilan.

•

Bosco, D. (2011, Febuary 10). Why didn’t the IMF predict the nancial crisis? Foreign Policy .

•

Boughton, J. (2011). “Jacques J. Polak and the Evolution of the International Monetary System. IMF Economic Review, vol. 59, no. 2, pp. 379–399.

•

Brett, E. (1983). The World’s View of the IMF.” The Poverty Brokers: IMF and Latin America. London: Latin American Bureau.

•

Bryson, A. (2014). Union Wage Eects. IZA world of labour, 1-3.

•

Burkitt, B. (1977). Are trade unions monopolies? Industrial relations journal , 16-18.

•

Calomiris, C. (1990). Is Deposit Insurance Necessary? A Historical Perspective. The Journal of Economic History , 283-295.

•

Carstens, A. (2018). Deposit insurance and nancial stability: old and new challenges. 17th IADI  Annual General Meeting and Annual Conference on “Deposit insurance ins urance and nancial stability: recent nancial topics”. Basel : Bank for International Settlements.

•

Chens, B. (2018). The Rise and Fall (?) of the Berle-Means Corporation. Seattle University Law Review.

•

Creedy, J. (1989). “Trade Unions, Wages and Taxation. Fiscal Studies, 50-59.

•

DeFina, R. (1983). Unions, Relative Wages, and Economic Eciency. Journal of Labor Economics, 408-429.

•

Demirgüç-Kunt, A, E., Feyen, R., & Levine. (2011). The evolving importance of banks and securities markets”. World Bank, Policy Research Working Paper,, no 5805.

•

Demirguc-Kunt, A. &. (2001). Deposit Insurance Around The World . The World Bank Economic Review, 481-490.

•

Demirguc-Kunt, A. L. (1999). Bank-based and market-based nancial systems - cross-country comparisons. Policy Research Working Paper Series 2143, The World Bank.

•

Desai, P. (2011). In Financial Crisis Origin. In From Financial Crisis to Global Recovery (pp. pp. 1-20). New York: Columbia University Press.

•

Downes, A. (2018). It’s Basic Income: The global debate. Bristol: Bristol University Press.

•

Dreher, A. a. (2004). The Causes and Consequences of IMF Conditionality. Emerging Markets Finance & Trade, vol. 40, , pp. 26–54.

•

Fischer, S. (1999). On the need for a lender of the last resort. Address to the American Economic  Association. New York: American Economic Assciation.

•

Fleetwood, S. (2014). Do labour supply and demand curves exist? . Cambridge Journal of Economics, 1087-1113.

40

 

•

Gambacorta, Leonardo, J., & Yang, K. T. (2014). Financial structure and growth. BIS Quarterly Review.

•

Goodwin. (2019). Microeconomics in context, 4th Edition . New York : Routledge.

•

Hirsch, B. (1998). Unions, Wages, and Skills. The Journal of Human Resources, 201-219 .

•

Hirschfeld, R. (2000). Work centrality and work alienation. Journal of Organizational Behavior, 789–800.

•

Hogan, T. a. (2016). The Independent Review. Alternatives to the Federal Deposit Insurance Corporation, 433-54.

•

IMF. (2015). Ukraine: Letter of Intent, Memorandum of Economic and Financial. Kyiv: IMF.

•

Independent Evaluation Oce of the International Monetary Fund. (2011). IMF Performance in the Run-Up to the nancial and economic crisis. Washington DC: IMF.

•

International Monetary Fund. (1998). The Asian Crisis: Causes and Cures. Finance and Development ,  Volume 35, Number 2.

•

Ito, T. (2012). Can Asia Overcome the IMF Stigma? The American Economic Review, 198-202.

•

James, B. (2001). Silent Revolution: The IMF 1979-1989. Geneva: IMF Bookstore.

•

Jean, V. (2014). The Neoclassical Model of the Labour Market. London: Palgrave Macmillan.

• •

Joyce, J. (2000). œThe IMF and Global Financial Crises. Challenge, 88. Kaplan, H.R. (1987). Lottery winners: The myth and reality. . J Gambling Stud 3, 168-178.

•

Kapur, D. (1998). The IMF: A Cure or a Curse? Foreign Policy, no. 111, pp. 114–129.

•

King, M. (2001). Who Triggered the Asian Financial Crisis? Review of International Political Economy, 438.

•

Krugman, P. (2009). The Return of Depression Economics and the Crisis of 2008. New York : W. W. Norton & Company.

•

La Porta, R. L. (1997). Legal Determinants of external nance. Journal of nance, 1131-1139.

•

Laeven, L. (2002). Bank Risk and Deposit Insurance. The World Bank Economic Review, 109-137.

•

Levy Institute. (2013, April ). The lender of last resort: A critical analysis of the Federal reserves unprecedented intervention after 2007. pp. 1-15.

•

Lindblad, J. T. (2010). IMF: The Road from Rescue to Reform.” In The Asia-Europe Meeting: Contributing to a New Global Governance Architecture: The Eighth ASEM Summit in Brussels.  Amsterdam: Amsterdam University Press.

•

Lindbolm, C. (1958). Are Labor Unions Monopolies? Challenge, 26-31.

•

Macey, J. R. (2008). The role of banks and other lenders in corporate governance; corporate governance promise kept, promises broken . Oxford: Princeton University Press.

•

Mankiw, G. (2009). Principles of Microeconomics. Boston: South Western Learning.

•

Manning, A. (2003). Monopsony in Motion: Imperfect Competition in Labor Markets,. Oxford: Princeton University Press.

•

Mc Kinnon, R. &. (1999). Exchange rate regimes for emerging markets: moral hazard and overborrowing. Oxford Review of Economic policy , 19-38.

•

McKinnon, R. &. (1997). Credible Economic Liberalizations and Overborrowing. The American Economic Review, 189-193.

41

 

•

Mellor, M. (2010). The Future of Money: From Financial Crisis to Public Resource,. London : Pluto Press.

•

Minsky, H. (1992). The Financial Instability Hypothesis. The Levy Economics Institute Working Paper Collection, Working paper 74, 1-10.

•

Moschella, M. (2011). The Global Financial Crisis and the Reforms to IMF Lending. St Antony’s International Review , 48-60.

•

Mussa, M. a. (1999). The IMF Approach to Economic Stabilization. NBER Macroeconomics Annual, pp. 79–122.

•

Nicholas, S. (1998). The IMF as International Lender of Last Resort? A Reappraisal After the ‘Tequila Eec. London: Palgrave Macmillan.

•

Nooruddin, I. a. (2006). The Politics of Hard Choices: IMF Programs and Government Spending. International Organization, vol. 60, no. 4, pp. 1001–1033.

•

Norrbin, M. M. (2017). International Money and Finance. In S. N. Michael Melvin. Elsevier.

•

Nowak, W. (2012). Development of the Polak model . Wroclaw review of law, administration and economics, 28-35.

•

Oswald, A. (1982). Trade Unions, Wages and Unemployment: What Can Simple Models Tell Us. Oxford Economic Papers, 526-545.

• •

Papi, L. P. (2015). IMF Lending and Banking Crises. IMF Economic Review, 644-691. Polak, J. (1994). The World Bank and the IMF: A Changing Relationship. Brookings Institution Press.

•

Polak, J. J. (1957). Monetary Analysis of Income Formation and Payments Problems. Sta Papers (International Monetary Fund), pp. 1–50.

•

Prasch, R. E. (2000). Reassessing the Labor Supply Curve. Journal of Economic Issues, 679–692.

•

Prowse, S. (1990). Institutional Investment Patterns and Corporate Financial Behaviour in the United States and Japan. Journal of Financial Economics, 43-66.

•

Rajan, R. Z. (2003). The great reversals: the politics of nancial development in the twentieth century. Journal of nancial economics, 5-50.

•

Ratnam, V. (2007). Trade Unions and Wider Society. Indian Journal of Industrial Relations, 620–651.

•

Rogo, K. (2003). The IMF Strikes Back. Foreign Policy , 39-46.

•

Roseneld, J. (2014). Strikes.” What Unions No Longer Do. Boston: Harvard University Press.

•

Roubini, N. (2004). Bailouts Or Bail-Ins?: Responding to Financial Crises in Emerging Economies. Peterson Institute for International Economics.

•

Shleifer, A. a. (1986). Large Shareholders and Corporate Control. Journal of Political Economy, pp. 461–488.

•

Siebert, H. (2005). “The Capital Market and Corporate Governance.” The German Economy: Beyond the Social Market,. Oxford: Princeton University Press.

•

Sleet, C. B. (2000). Deposit Insurance and Lender-of-Last-Resort Functions. Journal of Money, Credit and Banking, 518-575.

•

Souha, S. B. (2020). Shareholder activism, earnings management and Market performance consequences: French case. International Journal of Law and Management.

•

Spencer, D. (2006). “Work for All Those Who Want It? Why the Neoclassical Labour Supply Curve Is an Inappropriate Foundation for the Theory of EEmployment and Unemployment. Cambridge Journal of Economics, 459–472. .

42

 

•

Stone, R. W. (2008). “The Scope of IMF Conditionality. International Organization, vol. 62, no. 4, , pp. 589–620.

•

Stuckler, D. a. (2009). THE INTERNATIONAL MONETARY FUND’S EFFECTS ON GLOBAL HEALTH: BEFORE AND AFTER THE 2008 FINANCIAL CRISIS. International Journal of Health Services 39, no. 4 , 771-781.

•

Theodor, B. R. (1993). Institutional Investors and Corporate Governance. De Gruyter.

•

Tito, B. (2013). Unions and Collective Bargaining- The Economics of Imperfect Labor Markets. Oxford: Princeton University Press.

•

 Vreeland, J. R. (2003). “Why Do Governments and the IMF Enter into Agreements? Statistically Selected Cases.” . International Political Science Review / Revue Internationale De Science Politique,  Vol 24, pp. 321–343.

•

 Willett, T. (2001). Understanding the IMF Debate. The Independent Review , 593-600.

•

 Woods, N. (2006). Understanding Pathways Through Financial Crises and the Impact of the IMF: An Introduction. Global Governance, 373-93.

•

 World Bank. (Accessed 2020). World Bank development indicators. Retrieved from http:// datatopics.worldbank.org/world-development-indicators/: http://datatopics.worldbank.org/worlddevelopment-indicators/

43

 

SECTION 2 MACROECONOMICS- EXPLAINED Macroeconomics, in a broad sense, is the study of what is happening in the economy. It focuses on the aggregate changes in the economy, such as unemployment, growth rate, national income, gross domestic product (GDP), and ination. In economics, we use the word ‘aggregate’. Although it confuses people, aggregate means total, i.e. an overall picture of what is going on in the economy.  Although macroeconomic macroeconomicss studies tthe he economy a ass a whole whole,, it mainly fo focuses cuses on th thee decision decisionss made by governments in two specic areas- tax & expenditure decisions (scal policy) and the decisions concerning the control of the banking sector (monetary policy). Macroeconomics also includes issues related to structural and exchange rate policy. However, in this explainer, I will pay the most attention to scal and monetary policies. The major problem with scal policy- a government’s decisions about taxation and expenditure- is poverty. It is dicult to create an eective tax system in a country like Nigeria. Sixty per cent (60%) of the population is in the informal economy, which means that they do not have a registered  business. They They also do no nott have a v valid alid bank account or accurate rrecords ecords of ttheir heir busine businesses. sses. In a complicated situation like this, how would you even know how much they earn? How do  you intend to to tax peo people ple who ke keep ep money un under der their p pillows illows or iinside nside (kolo)? These fact factors ors make taxation in Nigeria and other emerging markets complicated. Taxation is a major source of revenue for governments in advanced countries. Most of the money the government spends comes from taxes. Luckily, here in Nigeria, the government charges a form of tax on the oil sector, which is where we get our oil revenues. However, this is nowhere near the amount of money required to cater for the needs of nearly 200 million people.

44

 

45

 

 What about countries tthat hat do not have as m many any natural resources like we do do?? The answe answerr is, most of the time, their government(s) have to rely on their citizens to provide them with money. Obviously, the government needs to spend money on essential things, such as health care, education, roads, security, and so on. One of the problems in emerging markets is that a signicant percentage of the population is too poor to be taxed in most cases. It is even problematic to try to identify them. As a result, the government cannot do much because it does not have enough nancial capacity. In regards to scal policy in emerging markets, one of the primary issues to be addressed is innovatively nding out how to identify people. To begin with, the government should help people formalise their businesses and in conjunction with that, institute growth-friendly policies so that they will eventually become rich enough to be able to pay signicant taxes. In Nigeria, there are areas where people spend ninety-ve per cent (95%) of their income on food. It is hard to tax people that are starving. If you take a close look at Nigeria’s poverty rate, you will nd that over 40% of the entire population is living in extreme poverty. If over 40% of the population is extremely poor, how do you plan to tax them? Let us assume you devise a strategy; how do you get the money from them? Most of them do not have bank accounts, so do you take the money they owe in cash? Fiscal policy revolves around the government getting money from citizens and businesses. If the government nds it dicult to get money from the people, it automatically becomes dicult for such a government to spend money on the economy.

It is, however, incomplete to explain scal policy without mentioning budgeting. Have you ever wondered why international banks and nancial markets believe in advanced countries enabling them to lend at low rates? It’s not just because of their size or system of government. Rather, this belief is due to the fact that these countries are constantly committed to growth. They keep innovating. They keep building protable companies. As a result, these  banks and and nancial markets ffeel eel comfort comfortable able when lending the them m money, kno knowing wing full w well ell that they have the ability and capacity to pay back.

46

 

In emerging markets, it is much more dicult for these international banks and nancial markets to lend, and the reason for this is clear. These nancial entities do not have as much condence in emerging markets compared to advanced countries. Since they do not trust us (emerging markets), they charge us high-interest rates, making us get into debt quickly. Once  we start piling on de debt, bt, other n nancial ancial en entities tities wi will ll no longer believe in our abilit ability y to pay back back.. This makes it even more dicult for us to fund our budget as advanced countries countries do. Regarding monetary policy, it simply has to do with the way the banking system is controlled. In advanced countries, the central bank has subtle ways of controlling the way people spend.  When the economy economy is gr growing owing too fast (‘overhe (‘overheating’) ating’) and everything seems to b bee out of control, the central bank knows how to rein it in. They can actually decide that they want people to stop spending much money for the time being. They do this eciently by using a few techniques to keep banks from loaning money to businesses. As soon as they do that successfully, the economy dries up a little bit and stops overheating. In a situation where the economy is growing slowly- that is, businesses are not doing well- the central bank has a few tips and tricks to speed things up. They can give banks large amounts of money and encourage them to lend more, thereby boosting the economy. This means that central banks have a relatively good amount of control over the economy in advanced countries. When the economy is growing too fast, they can rein it in; when it is going too slowly, they can speed it up. However, in emerging markets such as Nigeria, where a large number of people do not have  bank accounts, accounts, thousan thousands ds of these tips and ttricks ricks by th thee central bank just don’t work as well. Hence, the central bank resorts to other measures when trying to control the economy.  Another critical critical point to note is the conce concept pt of Gross Domestic P Product roduct (GDP). GDP has to do with the total amount of money generated in a country, usually within a year. The equation for calculating GDP is: private consumption + gross investment + government investment + government spending + (exports- imports). In advanced countries, countries, if you divide their GDP by the total number of people, you will nd that each person has a lot of money- that is called GDP per capita.

47

 

Take a brief look at rich countries like Luxembourg- if you divide their GDP by their total population to get their GDP per capita, you will see that it’s more than a hundred thousand dollars ($100,000) each. That is massive! If you do the same thing for the U.S., you are going to get more than sixty thousand dollars ($60,000). Do the same for the U.K., and you will get more than forty thousand dollars ($40,000). On the other hand, emerging economies and developing countries tend to have relatively low GDPs. In Nigeria, if you divide the GDP by the total population to get the GDP per capita, you will see that it is just under two thousand dollars ($2000). There are some countries that once had a very low GDP per capita yet have managed to achieve massive growth, raising their extremely low GDP per capita to a much higher level. Examples of such countries are South Korea, China and Singapore. These countries and countless others have worked their way out of poverty, increasing their GDP per capita from low to much higher levels. Consequently, the question that begs for an answer is: how do we get more countries to chart the same course?  Above all, it is essent essential ial to not notee that GDP per capita is correlat correlated ed with ma many ny things. It is positively correlated with life expectancy and negatively correlated with infant mortality and inequality. GDP is a relatively good measure of output, but not welfare. Keep in mind that while GDP is not a measure of economic welfare, it is a critical component of economic  welfare. In fact, there are cities in China that no longer use GDP as a measure of economic welfare. They tend to measure the quality of life of their citizens instead. They also measure happiness, as well as personal well-being.  Angola’s GDP, GDP, for examp example, le, is very hi high gh but many A Angolans ngolans are living in a absolute bsolute pove poverty. rty. Identically, Equatorial Guinea’s GDP per capita is almost the same as some Eastern European countries, yet some of their citizens still live in poverty.

48

 

 Another question question that every gove government rnment sho should uld ask is: ho how w happy ar aree their pe people? ople? Personally, I think that if a country has lower GDP per capita, but the people are doing very  well, then that that is good good.. On a trip to San Francisco- home to the world’s biggest tech companies like Twitter, Uber and  Visa- I remember remember seei seeing ng more be beggars ggars than I had ever seen in m many any poorer countries. B Being eing rich does not mean you are a nice person. The fact that a country makes a lot of money does not mean the money will have a positive impact on everyone. This proves that GDP does not necessarily measure welfare. A high GDP per capita does not necessarily mean happiness, although as I said above, a larger GDP per capita is correlated with better outcomes. This explainer has highlighted a lot, but I am not going to end it without addressing unemployment. Recent statistics from the National Bureau of Statistics show that our unemployment rate is around 27%. This is a major problem aecting the entire Nigerian economy. When citizens of a country are unemployed or underemployed, GDP is aected. If everyone is productive, the country’s GDP will rise. However if we have low productivity rates, that does not only aect GDP, it also causes poverty. Over the course of this explainer, I have dened macroeconomics as well as its impact on the economy. I have also explained what scal and monetary policy are. I did this eectively by  breaking it it down in the best w way ay possible so that eeveryone veryone ca can n understan understand d what bot both h terms mean and how they aect the growth and development of emerging markets, including Nigeria. It would be great if you kept these ideas in mind so that when you watch Channels TV (or any other Nigerian news channel) or while election season is around the corner and you begin to hear political manifestos, it would be easy for you to understand what is being said. What you have learned here would also help you to understand what the Central Bank means when there is an ongoing MPR meeting and they are cutting- or increasing- interest rates. Take note: all of this has to do with the interplay between scal and monetary policies. Thank you for reading, and I hope you enjoy the essay!

49

 

Chapter 3  How can capital budgeting budgeting techni techniques ques be us used ed to assess investmen investmentt decisions and are there any other considerations for emerging markets.

 What are Capital budgeting techniques? Capital budgeting techniques are used to aid decision making when deploying investments on projects. Firms use them to obtain a more objective view of a potential investment which, when compared to ‘gut instinct’, is often easier to communicate to stakeholders. Gitman (2007) denes capital budgeting techniques as the “process of evaluating and selecting long term investments that are consistent with the business’s goal of maximising owner wealth.” They are dierent from current expenditures because capital budget projects usually require a larger number of resources and have longer pay back periods. Many of these investments are also dicult to reverse. These techniques have been developed to help decrease the likelihood of resources being wasted on investment projects that do not deliver nancial returns. Two examples of capital budgeting techniques include the following: 1.

Net present value

2. Internal rate of return.

50

 

Net Present Value: Net Value: Net Present Value (NPV) Value (NPV) is one of the most commonly used capital budgeting techniques. Investors/teams use it to understand the ‘time  value’ of money, money, based on the premi premise se that m money oney today is of more va valuation luation th than an the same amount in a few years’ time. Net Present Value is calculated by comparing the return on an investment in subsequent years to the return on a form of ‘guaranteed’ interest income such as government treasuries. The formula on the next page is used to calculate NPV where CF is cash ow and r is usually the interest rate on government treasuries.

Internal Rate of return: Internal Rate of Return or IRR is the interest yield on an investment at which the NPV becomes zero. It is also known as ERR or Economic Rate of Return. This can be calculated either via trial and error or by using an excel formula. This is the IRR formula:

The higher a project’s Internal Rate of the Return value, the more desirable it is to undertake that project as the most preferable investment option.  According to to Gallo (2016), tthe he best w way ay to use IRR is in conj conjunction unction wi with th NPV.

 Why are they important? Gitman (1974) highlighted three reasons for investment as: a. Cost reduction  b. Increasing Increasing revenue c. Legal requirements.

51

 

Therefore, capital budgeting techniques are important as they assist rms in nding the most ecient means of deploying capital and growing their protability/revenues. This is key for the individual rms, and also more importantly for economic growth across companies. Investments are an important component of GDP, so investments by more companies increase GDP on a macroeconomic level. Furthermore, increased investments are made with the objective of producing increased cash ows; revenue and prot which usually leads to increased taxable income for governments; increased salaries for workers; and increased consumption, further  boosting GDP. GDP.  According to Mc Kinse Kinsey y (2018), if all emerging eeconomies conomies ccould ould somehow emulate those emerging markets like South Korea, that have had strong consistent growth, they could generate an additional $11 trillion dollars for the global economy whilst reducing poverty and hunger across the world. The next section will look specically at capital budgeting techniques in emerging markets, especially in sub-Saharan Africa.

Implications for developing and emerging markets  As can be seen seen in th thee diagram o on n the nex nextt page, deve developing loping mark markets ets in sub sub-Saharan Africa typically have higher interest rates than most developed countries. This is important to note as these countries usually have very small economies  with high levels of un unemployment employment a and nd poverty. T They hey urgently n need eed econom economic ic growth to provide better standards of living for their citizens.

52

 

Figure 1

However, interest rates have a signicant eect on whether investment projects are executed by rms. Where yields from government bonds/treasuries are high, the time value of money increases. This decreases investors’ ability to justify projects as viable using NPV and IRR.

 Their limitations The most obvious limitation is that ‘bad data produces bad results’. The cash ow estimates used in calculating the NPV and IRR are estimates based on available information. They are not always accurate.  We have moved moved from tthe he era of shareholde shareholderr value to sstakeholder takeholder value whe where re factors like the environmental impact, employee morale, etc. are increasingly important. Capital budgeting doesn’t measure the value of these returns.

53

 

Conclusion There are many capital budgeting techniques that can be used to assess investment decisions. Two examples are the NPV and the IRR which both emphasize the time value of money. They are important as they provide an objective guide to investors and help prevent waste. Investment is an important component of global GDP and increased sustainable investment is important for long term global growth. This future growth should  be driven – at least in part – by emerging markets. The capital budgeting techniques provide great tools when making investment decisions, but should be viewed as exactly that – tools inside a tool box where there are other tools such as intuition, empathy, environmental concerns, concerns for quality of life for ones employees, and concerns about the communities in which we do business. This will help businesses take holistic decisions about investments which in turn take top line and bottom line growth and nancial return into consideration, and also take other factors into consideration.

54

 

References •

Gitman, L. J. (1974). Principles of managerial nance. New York: Harper and Row.

•

Gallo (2016). A Refresher on Internal Rate of Return. Harvard Business Review.

•

Hou, Z., Keane, J., Kennan, J., Massa, I. and te Velde, D.W. (2014) ‘Shockwatch bulletin: Global monetary shocks: impacts and policy responses in sub-Saharan Africa’, ODI Working Paper, March. London: Overseas Development Institute http://bit.ly/1pFOL9Q

•

McKinsey & co (2018). Outperformers: High-growth emerging economies and the companies that propel them. September 2018, Report.

55

 

Chapter 4 When it comes to monetary policy, distinguish between the cost capital channel and the credit channel and focusing on Nigeria, explain why this distinction is important.

Monetary policy works! There is empirical evidence dating back to 1964 (Freidman) as to the fact that monetary policy aects output. This is well established. However, the mechanism  by which it aects out output put is still debated am amongst ongst econ economists. omists.

Figure 1 Source: Wikipedia, Common Creatives License

The eects of monetary policy are channelled to rms and households through links known as transmission mechanisms. Figure 1 above shows a car gear system. On the left-hand side is the hand gear of the car; the part everyone sees, the part we touch and control, the part that we all recognise, the part that some is spoken about on car TV shows and polished to perfection during exhibitions. However, the right side of this system is more complex. It’s the hidden part of the gear system comprising of a set of shafts,

ywheels and uid coupling mechanisms to provide power to move the car.

 

Monetary policy transmission systems are not unlike car transmission systems. Central Bankers don’t directly compel rms and households to spend. Instead, central banks have a number of ways that they can try to inuence the banks and, hence, the economy to act in a certain way. This is sort of like the car gear example above. Central banks act through metaphorical shafts, ywheels and coupling mechanisms to exert inuence over decision making of actors like rms and households in the economy. Central banks use three main ways to inuence lending in the economy. But unlike in cars where the mechanics of how these transmission changes happen are universally accepted, with monetary policy, the role of the cost capital channel and the credit channel are still debated. Before we delve deeper into the importance of distinguishing between the two, we should rst look at the tools central banks typical use to inuence lending & economic growth.

 Tools Used by Central Banks Open Market Operations: Open market operations involve the buying and selling of securities to banks by the central bank. When banks buy securities, they have less liquidity and therefore are less likely to lend. However, when central  banks buy up up securitie securitiess from ban banks, ks, they hav havee more liqui liquidity dity and the therefore refore ar aree more likely to lend.

Figure 2

56

57

 

Quantitative easing is a more aggressive form of open market operations typically practised in more developed countries like the United States. This is when central  banks buy other other asset assetss like rea reall estate, m mortgages, ortgages, eetc. tc. from ban banks, ks, creati creating ng a lot more liquidity. The aim of this is to stimulate banks to lend because of the liquidity created. Reserve Requirement: This Requirement: This is the fraction of the balance sheet that banks have to leave in the central bank. When that fraction rises, banks have less money to lend. When the fractional falls, there is more money for banks to lend. Discount Rate: This is the interest rate at which banks can borrow from the central bank. When central banks want to encourage banks to lend, they drop the interest rate. When they want to discourage banks from borrowing from them, they increase it. Earlier in this essay, we discussed the fact that empirical evidence has shown time and time again that monetary policy works. The way central banks apply monetary policy may dier, but the three main techniques above are the most recognisable and the most commonly used. However, the exact way that these techniques aect what people do is debatable. The remaining part of this essay will focus on the dierence between the cost of capital channel and the credit channel, the evidence base that supports both channels, and how this relates to why the central bank governor in Nigeria has taken up farming.

58

 

Cost Capital Channel vs. Credit Channel

Figure 3

The cost of capital channel focuses on the interest rates, arguing that the more expensive money is, the less rms and households will borrow. Conversely, when interest rates are low, households and rms will borrow more money from the  banks as it will be easier to pay back.  Whereas the the credit channel loo looks ks at the link betw between een monet monetary ary policy a and nd the corporate nancial system as a whole, beyond just interest rates. When monetary policy tightens, so does asymmetric information. When borrowers, lenders and associated parties don’t make the same market information, i.e. they have asymmetric information, the cost of raising nance rises. This extra cost is called the external nance premium. Proponents of the credit channel argue that this is dierent from the direct eect of interest rates described in the cost of capital channel, hence, they need to be described separately. If under tight monetary conditions the external nance premium rises, this further discourages rms from raising external funds as this phenomenon aects not just the debt, but the equity market also. In addition to this, banks tend to reallocate capital from small businesses to large businesses during periods of tight monetary policy. They may also call their

59

 

loans earlier (Black, 2007). This places pressure on the prots of rms, making it harder for them to make investments using internal resources.  Whilst the cost of ca capital pital chan channel nel focuses mainly on tthe he eect of interest rates on investment, the credit channel shows how monetary policy aects the entire hierarchy of nance (retained earnings, bank debt and equity), thereby decreasing investment. In summary, the cost capital channel and the credit channel are distinct but also complementary. The introduction of this essay looked at the nature of monetary policy, the evidence behind its ecacy, and the dierent monetary policy techniques that exist. In the second section, the dierence between the credit channel and the cost of capital views was detailed. To conclude, I will examine how eective these channels have been in Nigeria and why the central bank of Nigeria has taken on a similar role to an agricultural  bank.

 Why the Governor of the Central Bank of Nigeria is visiting farmers and planting rice This nal section will look at monetary policy in an emerging market context and how the roles of both the capital cost channel and the credit channel change when nancial inclusion is low, the formal economy is small, market data is sparse, and the nancial markets are shallow. Since 2015, the Central Bank of Nigeria (CBN) has undertaken a lot of activities that many would class as unorthodox. For example, the CBN was at the forefront of the anchor borrower’s’ scheme which involved the central bank lending directly to over 200,000 farmers1. The CBN’s next big initiative is to start a poultry farm. It will provide the capital and help run the operation 2. 1 https://www.cbn.gov.ng/out/2017/d https://www.cbn.gov.ng/out/2017/dfd/anchor%20borrowers%20programme%20guideli fd/anchor%20borrowers%20programme%20guidelines%20-dec%20%202016.pdf  nes%20-dec%20%202016.pdf  2 https://guardian.ng/news/c https://guardian.ng/news/cbn-to-begin-poultry-farm-a bn-to-begin-poultry-farm-at-fuam/  t-fuam/ 

60

 

In developed countries, this is unheard of, but in Nigeria, this approach to central  banking has has gathere gathered d widespre widespread ad support. The reason reasonss why this ‘h ‘hands-on’ ands-on’ approach to central banking is supported so widely at its most fundamental is  because many many believe that ther theree is a limi limited ted eect that monet monetary ary policy a alone lone can have on the Nigerian economy. This view is supported by Beck et al. (2009) and Beck (2011) which point out how ‘undeveloped nancial markets limit the eectiveness of monetary policy’. Similarly, Olivier Blanchard, IMF Chief Economist, argues that ‘the macroeconomics of low-income and of advanced economies are incredibly dierent’. But Blanchard (2014) touches on the heart of the matter; the importance of understanding the transmission mechanism when examining the eects of monetary policy in developing markets. The capital cost channel and the credit channel are of particular relevance here.  As discussed earlier, tthe he cost cap capital ital mark market et channe channell explains how a drop in interest rates would encourage rms to lend and even induce households with mortgages to spend more, stimulating growth. The problem in Nigeria is that the unbanked, untaxed informal sector is 65% of the economy (Medina, 2017). This implies that over half the business activity in Nigeria is not ‘interest sensitive’ due to the fact that these businesses don’t have full access to nancial services. According to the World Bank, Nigeria’s nancial inclusion rates have stagnated since 2014; only 40% of adults have a formal account3. The majority of Nigerians (60%) are unbanked, making monetary policy less eective. This is coupled with the fact that according to the CBN, outstanding mortgage loans are only 0.5% of GDP in Nigeria, compared to 77% in the US, 80% in the UK, 50% in Hong Kong, and 33% in Malaysia4. So much of the eect on household seen in developed countries when interest rates drop will not be seen in countries like Nigeria.

https://blogs.worldbank.org/africacan/ve-ways-nigeria-cann/ve-ways-nigeria-can-realize-mobile-technologys-potent realize-mobile-technologys-potential-for-the-unbanked  ial-for-the-unbanked   3 https://blogs.worldbank.org/africaca 4 https://www.cbn.gov.ng/fss/tue/BSP/M https://www.cbn.gov.ng/fss/tue/BSP/Mortgage%20&%20Credit/FSS%202020% ortgage%20&%20Credit/FSS%202020%20-%20Mortgage%20Presentation.pd 20-%20Mortgage%20Presentation.pdf  f 

61

 

 When it comes comes to the credit cha channel, nnel, the eeect ect is a llittle ittle more relevant. IIn n many markets in sub-Saharan Africa, market data is sparse and there is a high level of asymmetry of information, therefore, the external nance premium is high as most capital ows towards more developed markets. Combine this with the eect of a high corporate tax rate of over 30%, which places further pressure on retained earnings/prots. These external factors blunt the eect of the credit channel, although the balance sheet eect may still be relevant. Stimulating economic growth in developing countries is complex. There are factors that constrain the transmission systems of monetary policy both in the credit and the cost capital channels. For these reasons, the central bank intervenes in the real sector directly, loaning to or even sometimes having operational oversight over projects.

Conclusion  We know that that monet monetary ary policy wo works, rks, but the there re is deba debate te about tthe he importa importance nce of various transmission mechanisms. This essay has outlined the dierences  between the cost ca capital pital cha channel nnel and th thee credit ch channel. annel. They a are re distinc distinct, t, with some overlap and commentary. The latter part of this piece was dedicated to looking at the dierences between the eectiveness of these channels in developed and underdeveloped markets.

62

 

References •

•

Black, Lamont K.; Rosen, Richard K. (2007). How the credit channel works: Dierentiating the bank lending channel and the balance sheet channel, Working Paper, No. 2007-13, Federal Reserve Bank of Chicago, Chicago. Blanchard, O. (2014). O. Remarks at the “Macroeconomic Challenges Facing Low-Income Countries” Conference. International Monetary Fund, Washington DC, January 30-31.

•

Beck, T and R Levine (2002). Industry growth and capital allocation: Does having a market- or bank based system matter? Journal of Financial Economics 64: 147–180.

•

Beck, T.. R. Levine and N. Loayza (2000). Finance and the sources of growth. Journal of Financial Economics 58: 261–300.

•

Beck, T., M. Fuchs and M. Uy (2009). “Finance in Africa – Achievements and challenges”, VoxEU, 20 July.

•

Medina, L., A. Jonelis, M. Cangul (2017). The Informal Economy in Sub-Saharan Africa Size and Determinants. International Monetary Fund. Working Paper No. 17/156.

•

Beck, T. (2009). Financing Africa: New hopes and continuous challenges. VoxEU, 16 September.

63

 

Chapter 5  Some people people argue that ‘th ‘the e cost of capital rather rather than the qu quantity antity of nance available is the most important single factor inuencing the rm’s decision to invest.’ Consider this view of rms’ investment decisions in view of the investment environment in emerging markets.

Introduction Economists are interested in the factors that make rms invest, because investment is a key component of GDP. Therefore, increasing investment levels can improve overall GDP growth.  When rms are makin making g investme investment nt decision decisions, s, there a are re many fac factors tors that are typically taken into consideration. This essay aims to ascertain whether it is the cost of capital or the quantity that is the most important factor aecting a rm’s decision to invest.  Aswath Damodaran Damodaran (20 (2016) 16) calls the cost of ca capital pital the Swiss Army k knife nife of nance because people dene it dierently. But in his words, the ‘cost of capital, in its most basic form, is a weighted average of the costs of raising funding for an investment or a business’.

Cost of capital view The ‘cost of capital’ view sees the price of nance as the only important factor in a rm’s decision to invest. This lens sees the amount of capital available as irrelevant, believing that any rm can raise money as long as it is willing to pay the price.

64

 

There is evidence to support this view. The rst serious study of inuence of capital structure of the company on its activities was conducted by Modigliani– Miller. It stated that ‘in the absence of taxes, bankruptcy costs, agency costs and asymmetric information, and in an ecient market, the value of a rm is unaected by how that rm is nanced’, whether internall internally y or externally . The Q-model of investment assumes that in the perfect capital market, the internal and external funds are perfect substitutes and therefore, the investment decision of a rm is solely a function of investment opportunities and invariant to the rm’s cash ow (Gupta, 2019). In this perfect market, a rm’s investment decisions are not inuenced by its nancial condition (Fazzari), therefore, the only factor aecting a rm’s decision to invest is the cost of capital it wishes to obtain. However, at very high interest rates, many reputable rms lose interest in lending. As Adam Smith points out, ‘If the legal rate of interest in Great Britain, for example, was xed so high as eight or ten per cent, the greater part of the money which was to be lent would be lent to prodigals and projectors, who alone  would be willing willing to gi give ve this hig high h interest interest.. Sober peo people, ple, who wil willl give for tthe he use of money no more than a part of what they are likely to make by the use of it,  would not venture venture int into o the comp competition’ etition’ (Smi (Smith,1776). th,1776). Stiglitz-Weiss Stiglitz-We iss (1981, 1983) developed a theory of credi creditt rationing. Stiglitz argue argued d that banks might not increase the interest rate they charged even in the face of an excess demand for funds, for to do so might reduce their expected rate of return  because the the probabi probability lity of defa default ult would inc increase. rease. Two reasons w were ere prese presented nted for the possible inverse relationship between the rate of interest charged and the expected return to the bank: higher interest rates reduce the proportion of low risk borrowers (the sorting eect to which Smith had called attention) and higher interest rates induce borrowers to use riskier techniques (the incentive eect). The work of both Adam Smith and Stiglitz further highlight the importance of the cost of nancing to rms.

65

 

Quantity of nance view However, the assumptions made work just like those of Modigliani-Miller (1958) – such as the absence of taxes and perfect access to information, which are atypical of the great majority of real-world investment transactions. When rms invest, they usually don’t have complete certainty or perfect access to information, and therefore, cash ows play a signicant role in a rm’s decision to invest. In most investment transactions, internal and external sources of funding are not perfect substitutes. Friction and asymmetric information make investments from internally generated revenue, such as retained earnings, better than debt of equity. This is called the pecking order of nance which will be detailed later in this essay. But prior to this, it is important to emphasise the impact of asymmetric information. The asymmetric information present in most transactions ensures that internal and external funding are rarely perfect substitutes.

 Asymmetric Information  Asymmetric informatio information n is a ter term m used to de describe scribe the situation when one party to an investment has more knowledge than the other party.  Akerlof (1970) rst highlig highlighted hted the eeect ect of inf information ormation a asymmetry symmetry in a 1970 paper entitled “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism.” In that paper, Akerlof (1970) stated that car buyers see dierent information than sellers, giving sellers an incentive to sell goods of less than average market quality.  Akerlof (1970) uses the co colloquial lloquial ter term m “lemons” to refer tto o bad cars cars.. He espouse espousess a belief that buyers cannot eectively tell lemons apart from good cars. Thus, sellers of good cars cannot get better than average market prices.  Asymmetric informatio information n increase increasess the amou amounting nting of ex external ternal n nancing ancing a company needs. It can also cause market failure. Two situations that can occur  because of asymmetric informati information on are mor moral al hazard a and nd adverse selection.

66

 

These are described below: Moral Hazard: Moral hazard is when, due to asymmetric information, a person’s behaviour changes after the transaction has been concluded.  Adverse selection: selection: Adverse  Adverse selection selection is when one of the tw two o parties has more accurate or dierent information to the other. This gives the party with superior information an advantage. This problem occurs before the transaction has been done. So far, this essay has analysed evidence as to why the cost of capital may be the most inuential factor in a rm’s decision to invest, then looked at concepts, such as asymmetric information, that may be overlooked in a solely ‘cost of capital’ perspective. The pecking order of nance theory gives further evidence that the quality, not  just the cost cost of cap capital, ital, is a ma major jor facto factorr that ae aects cts a rm’s decision to invest. The pecking order is described below.

The Pecking Order of Finance The pecking order theory states that the cost of nancing increases with asymmetric information.  According to the pecking ord order er theory, n nancing ancing comes from the following three sources: 1.

Internal funds

2. Debt 3.

New equity  Financing from internal funds is the most preferred, followed by debt, and nally, equity as a last resort. This is shown in Figure 1 on the next page.

67

 

Figure 1 (Dommes et al.,2019)

 When you look at what tthe he US non-n non-nancial ancial rm rmss do in aggr aggregate, egate, thei theirr  behaviour supports supports the pecking or order der theory. M Majority ajority of the US non non-nancial -nancial rms, in aggregate, nanced their investments through internal nancing. In fact, less than 20% of nancing in most years was external and the great majority of that was debt (Myers, 2001). So it does seem that there is indeed a pecking order and that the quantity of nance is indeed an important consideration for rms when making investment decisions.

So which is most important?  Whether a rm conside considers rs cost of capital or quantity of capital, the single most important factor in an investment decision seems to depend on a number of factors. The type of rm matters. For example, high growth, high risk technology rms tend to use equity to fund their investments. In the case of these technology rms, equity nancing through venture capital is the preferred and more suitable, compared to debt or internal funding (Gopher 2001, Cosh 2009). Some rms prefer to use internal funding as it gives tax advantages and it is also lower risk compared to external funding. But only rms that have retained earnings or prots have this option. Therefore, the nancial status of the rm plays an important role in determining which form of nance it will take on

(Shahnazarian, (Shahnazar ian, 2005).

68

 

There is also evidence in line with the pecking order theory that rms with a larger number of xed assets are more likely to take on debt compared to equity. Financing preference also varies according to industry (Sinha et al, 1993). Rajan and Zingales (1995) found that the four most common determinants that determined capital structure in G7 countries were tangibility, growth opportunity, size, and performance. Similar patterns have been seen in developing markets. The scal policy direction in the country that the rm operates is also important. In countries with high levels of government borrowing, the government can take such a large proportion of the loanable funds available that there is hardly anything left for the private sector. The total quantity of credit available to the private sector is reduced. This is known as crowding out. Figure 2 below shows how if there is an increase in demand for loanable funds driven by government, the opportunity cost for interest sensitive investments like investment by private rms and even consumption increases.

Figure 2 (Intelligent Economist, Prateek Agarwal, 2019)

Baumol (2007) makes an interesting point about the eect of government decits on the bond markets. Savers have a certain amount of money available, when government sells bonds, those bonds then compete for private sector bonds as  well as other other priva private te sector instrument instruments. s. This aect aectss private investmen investmentt because it decreases the total proportion of capital available, i.e. the quantity of nance. Furthermore, there is evidence that even when interest rates rise, the banks’

 behaviour changes. The They y become cho choosier osier abou aboutt who they lend, aectin aecting g the

 

quantity of credit they make available. This is called credit rationing. Samuelson (1952) referred to this in his testimony before the Patman committee. Finally, Guttentag (1960) points out that the nance for private investments isn’t  just about rates. There are many im important portant tterms erms in a credit agre agreement ement tha thatt a rm takes into consideration when making an investment decision. Examples of these are the maturity and the debt service to income ratio. These are also terms that nancial institutions use to ration the quantity of credit that they disburse irrespective of interest rates.

Conclusion It is evident from the empirical research presented above that rms take a number of factors into consideration when making investment decisions. Cost of capital is one of the factors and in a perfect market may be the most important factor. However, most rms exist in imperfect markets and therefore, the quantity of capital becomes just as important as the cost. This is demonstrated by the pecking order of nance and supported by statistics from listed rms in the United States, G7, and developing markets presented in this article. Fiscal policy also largely aects the quantity of nance. When the government crowds out the private sector, it aects the availability of nance by taking majority of the available loanable funds in the market. The eect of credit rationing is also important as when interest rates are high,  banks don’t make as many loans a and nd ration out credit, llending ending to o only nly a select few. Therefore, for many customers, credit is not available at any price. This means that the total quantity of credit available decreases. Investment is a key component of GDP and growth. Understanding how and why rms make investment decisions is important so that pro-growth policies can be created to support them, and in so doing, support the wider economy. The cost of nance is important, but as demonstrated above, the other factors that aect the total quantity of nance available are highly inuential when it comes to rms and the decisions they make about investments.

69

70

 

References •

 Agarwal, Prateek (2019), Intelligent Economist https://www.intelligenteconomist.com/crowdingout-eect/

•

Akerlof, G. (1970). The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. The Quarterly Journal of Economics. 84(3), 488-500.

•

Baumol William, Alan Blinder (2007) Economics: Principles and Policy, pg 695

•

Cosh, A.; D. Cumming; A. Hughes. (2009) Outside Enterpreneurial Capital. The Economic Journal,  vol. 119, no. 540, 2009, pp. 1494–1533. JSTOR, www.jstor.org/stable/40271400 JSTOR,  www.jstor.org/stable/40271400..

•

Damodaran, A. (2016). The Cost of Capital: The Swiss Army Knife of Finance http://people.stern.nyu. edu/adamodar/pdles/papers/costofcapital.pdf 

•

Espinosa, C.; C. Maquieira; J. Vieito & M. González (2012). Capital Structures in Developing Countries: The Latin American Case. Investigación Económica, 71(282),35–54.

•

Dommes, K.; M. Schmitt & E. Steurer (2019). Capital Structures in German Small and Mid Caps: Does Trade-O or Pecking Order Theory Explain Current Reality Better? Journal of Financial Risk Management, 8, 147-162.

•

Gompers, P. & J. Lerner (2001). The Venture Capital Revolution. The Journal of Economic Perspectives, 15(2), 145-168.

•

Gupta, G.; Mahakud, J. (2019). Alternative measure of nancial development and investment-cash ow sensitivity: evidence from an emerging economy. Financial Innovation 5(1), 1-28.

•

Guttentag, Jack (1960). “Credit Availability, Interest Rates, and Monetary Policy.” Southern Economic Journal, vol. 26, no. 3, 1960, pp. 219–228. JSTOR, www.jstor.org/stable/1054954 JSTOR,  www.jstor.org/stable/1054954..

•

Modigliani, F. & M. Miller (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review48(3), 261-297.

•

Myers, S. (2001). Capital Structure. The Journal of Economic Perspectives, 15(2), 81–102.

•

Rajan, R. & L. Zingales. (1995). What Do We Know about Capital Structure? Some Evidence from International Data. The Journal of Finance, 50(5), 1421–1460.

•

Samuelson, P (1952) Monetary Policy and the Management of the Public Debt, Hearings before the Patman Sub- committee on General Credit Control and Debt Management, Joint Committee on the Economic Report (Washington: Government Printing Oce, 1952), pp. 695-7.

•

Stiglitz, J. & A. Weiss (1981). Credit Rationing in Markets with Imperfect Information.

•

American Economic Review, 71(3) 393-410.

•

Stiglitz, J. & A. Weiss (1983). Incentive Eects of Terminations: Applications to the Credit

•

and Labor Markets. American Economic Review, 73(5), 912-27.

•

Stiglitz, J. & A. Weiss (1985). Credit Rationing with Collateral. Bell Communications Research Economics. Discussion paper 12.

•

Shahnazarian, H. (2005). Corporate Financial Dynamics: A Pecking-Order Approach. FinanzArchiv / Public Finance Analysis. 61(4), 516–534.

•

Sinha, S. (1993). Inter-Industry Variations in Capital Structure. Economic and Political Weekly, 28(35). M91–M94.

•

Smith, A. (1776). The wealth of nations. Book II: Of the Nature, Accumulation, and Employment of Stock, Chapter IV: Of Stock Lent at Interest.  Interest. 

71

 

Chapter 6   Macroeconomics ‘A stable debt/income ratio is central to the issue of scal sustainability.’ Firstly, is this true? Is there a dierence in what metrics to consider when assessing scal sustainability in advanced vs emerging economies?

 What is scal sustainability? sustainability? Fiscal sustainability is a measure of how capable a government is to continue its current level of spending, borrowing, taxation and other elements of economic policy in the long run, without either threatening its solvency or defaulting on some of its liabilities and promised expenditures. There is no real consensus about what an appropriate measure of debt sustainability is. The stability of debt to income ratio is usually considered alongside other metrics, such as interest rates, growth rates, debt to GDP ratios, the condition of the economy and the type of economy (whether advanced or emerging), and what currency the debt is in, as considered below using relevant examples.

72

 

1. Metrics Metrics such as debt to income ratio and debt to GDP ratio are often used as part of the assessment of scal sustainability.

a) Debt to GDP ratio The debt to GDP ratio compares a country’s sovereign debt to its total economic output for the year. There have been many attempts to establish a debt to GDP ratio threshold beyond which debt becomes unsustainable. It has been argued that when ‘public debt exceeds a certain threshold level (above 55% of the gross domestic product), it is negatively correlated with economic activity’. The famous Maastricht Criteria are the terms that European Union member states are required to meet in order to enter the third stage of the Economic and Monetary Union (EMU) and adopt the euro as their currency. Amongst other metrics, the Maastricht Criteria require that the debt to GDP ratio of qualifying countries should not be over 60% (Real, 2011). A team from Nigeria argue for a threshold of 70%. Others argue for a 90% debt to GDP ratio. But Lysandrou (2013) argues that there is no point in having a threshold as it depends on the unique economic situation and that more factors need to be taken into consideration. The chart 1 below compares the debt to GDP ratio in Nigeria to Japan, the United Kingdom and Morocco. Nigeria’s debt to GDP ratio is comparatively low. However, Chart 2 (Interest payments as a % of GDP) reveals a very dierent picture, highlighting the fact that debt repayments are becoming an increasingly large proportion of revenues. This shows the weakness of using debt to GDP ratios in isolation, because GDP doesn’t service debts. Revenue/income does. Unfortunately, many developing countries have lower revenues compared to GDP due to weaknesses in tax collection systems.

73

 

Chart 1 source: data.worldbank.org

Chart 2 source: data.worldbank.org

b) Interest payments as % of revenue Income/revenue is important when considering debt sustainability. A stable debt/income ratio gives a good indication of scal sustainability. However, rising debt/income ratios are not always a bad thing.  Whilst there there are ar arguments guments tha thatt rising p public ublic secto sectorr debt/incom debt/incomee ratios llead ead to crowding out of the private sector and higher risk of private sector default, this is only in the short run. In the long run, this eect is not seen. In an underemployed economy, there may even be some benets to increasing public sector debt which

74

 

outweigh any disadvantages. There are alternative arguments that claim that under certain circumstances, rising debt/income ratios are irrelevant (Davis, 1987). For example, given any debt path, when taxes are distortionary, governments can adjust taxes so as to attain that debt path without aecting equilibrium allocations or prices (Bassetto, 2004). Metrics often don’t tell the whole story, as argued by Reinhart (2003). Some countries have debt to GDP & debt to income ratios that would be acceptable in advanced economies, but still default. The paper calls this phenomenon ‘debt intolerance’ and therefore concludes that in addition to the traditional metrics, the countries actual track record in paying back debt should be a key consideration considera tion (Reinhart, 2003).

2. Type of Economy: Advanced or emerging  Advanced economies economies a are re often ccharacteri haracterised sed by low iinterest nterest rrates. ates. Often Often,, the interest rates, for example in parts of the Eurozone, are lower than the rate of economic growth. ‘The change in the debt is a function of the primary balance and (r - g), the dierence between GDP growth and the interest rate’ (Ubide, 2019).  

Equation 1: Ubide, 2019

Equation 1 above shows that the debt to GDP ratio (d/y) is a function of the past debt ratio, the primary balance (pb), and the relationship between the rate of growth of GDP (g) and the interest rate cost of the debt (r).  When interest interest rate ratess are low lower er than th thee rate of economic g growth, rowth, then it becomes more sustainable to use debt to fund public services. This is especially true for many Eurozone countries that already have high debt to income ratios. This is  because when when debt tto o income rratios atios are very high, th thee debt pat path h is actual actually ly more dependent on r-g, i.e. the relationship between economic growth and interest rates compare.

75

 

Peter Heller is Deputy Director of the IMF´s Fiscal Aairs Department and he denes scal space as the “room in a government’s budget that allows it to provide resources for a desired purpose without jeopardizing the sustainability of its nancial position or the stability of the economy” (Heller, 2005). The IMF describes scal space as ‘like having money in the bank’ 5. The more a government is able to increase spending without risking an adverse reaction from nancial markets or risking the country’s long-term nancial health, the more scal space it has. Alternatively, the riskier a country is perceived to be, the less scal space it has. For the most part, developing or emerging economies have less scal space  because debt debt vulnerab vulnerability ility has be been en increa increasing sing in low income coun countries tries substantially. The reasons for the increased debt vulnerabilities in low income countries as outlined by the World Bank include6: 1.

Dependence on external debt

2. Rising cost of debt service 3. Non- traditional and often higher interest debt sources 4. Countries with the fastest rise in debt were often fragile and aected by a combination of conict, weak governance, or commodity-dependence.  Advanced economies economies ha have ve a lot mo more re scal sp space ace as the they y are less fragile, hav havee stronger institutions and more favorably looked upon by international investors. Furthermore, interest rates are very low, often lower than the rate of growth,  which provides provides a more sustainable debt path, rreferring eferring tto o equation 1. In order to examine the assertion that ‘stable debt/income ratio is central to the issue of scal sustainability’, we have looked at a number of dierent factors that aect debt sustainability. We initially explored some of the metrics that inuence debt sustainability, such as debt to income ratio and debt to GDP ratio. Then, we explored the role of distortionary taxation that is purported to make increase in debt levels less relevant. https://blogs.imf.org/2018/06/27/economic-preparedness-the-need-for-scalc-preparedness-the-need-for-scal-space/  space/   5 https://blogs.imf.org/2018/06/27/economi 6 http://documents.worldbank.org/curat http://documents.worldbank.org/curated/en/378031553539256399/pdf/Debt-in-L ed/en/378031553539256399/pdf/Debt-in-Low-Income-Countries-Evolution-I ow-Income-Countries-Evolution-Implicamplications-and-Remedies.pdf 

76

 

In the second section, the importance of the level of economic development was highlighted, concluding that low income countries have less scal space compared to more advanced countries. This is due to the low interest rates in developed countries which are often lower than the rate of economic growth. In addition to this, there is the reputation and credibility of these markets that allow them to take on higher levels of debt on every metric without an adverse reaction from nancial markets. The third factor that will be considered is currency of the debt and the role of currency in debt sustainability.

3. The Role of Currency  There is a great degree of variability in the amount of foreign-currencydenominated debt that countries decide to take on, even amongst developed countries. It broadly ranges from zero % to up to 60%. Countries like Ireland, Iceland, New Zealand and Canada have foreign currency debt levels greater than 20%, whilst countries like Austria, Australia, the UK and Spain range between zero and 20%. There is a third group of countries that don’t have any foreign currency exposure at all, such as the United States, Germany, Japan and the Netherlands. Foreign currency indebtedness is positively correlated correlate d with debt to GDP ratio (Lorenzo, 1998). Japan has the largest gross debt to gross domestic product (GDP) ratio globally, reaching 230% in 2015. Meanwhile, countries with signicantly less debt have experienced debt crises. The key advantage of Japan’s domestic borrowing is that there is no currency risk for which investors would charge higher interest to cover. However, Japan was able to pursue this strategy because of its well-developed nancial markets and high level of domestic savings. Many countries in Africa have undeveloped nancial markets and low levels of saving. Therefore, they must borrow in foreign currency. Rising external debt tends to weaken the economy as foreign debt increases vulnerability to external conditions.

77

 

However, domestic borrowing also has some disadvantages, such as in some economies, it will crowd out the private sector. Nevertheless, currency considerations are important to factor in when looking at scal sustainability.

4. Demography and contingent liabilities The rst chapter of a book called ‘Japan: The Precarious Future’ by Sawako Shirahase is called ‘Demography as Destiny’. It looks at the impact of contingent liabilities to the State, such as healthcare and pensions on advanced countries like Japan where the birth rate is falling (Sawako, 2015). Japan and many other advanced nations face a situation where the number of elderly and the expenses that come with them are set to explode. Yet the working population that ordinarily should support them is shrinking. Innovations in technology such as robotics and articial intelligence may not  become advanced advanced enoug enough h in terms of the add additional itional pro productivity ductivity th they ey provide tto o an economy to bridge this gap. So economies that have a huge burden of older people and fewer younger people, meaning falling fertility rates, denitely have to consider this when they plan towards debt sustainability.

5. The condition of the economy My nal point with regard to the important factors to consider when making decisions about debt sustainability is the condition of the economy. This is probably the most important point.  When the economy economy is iin n recessio recession, n, regardles regardlesss of the de demography/con mography/contingent tingent liabilities, the currency, the debt to income ratio, the debt to GDP ratio, the currency or the type of economy, governments must nd a way to stimulate the economy.  When citizens citizens are ssuering, uering, batt battling ling diseas diseases, es, and the there re is unres unrestt due to a deep recession and monetary policy isn’t eective, then, there is usually only one  way out—taking out—taking on de debt bt and spen spending ding it on scal stimul stimulus us package packagess to allevia alleviate te suering and to ‘prime’ the economy back into growth.

78

 

 We know that the b boom oom and bus bustt is cyclical and in the long run, eve every ry economy, even in the deepest and darkest recessions, will self-correct, moving back into growth. But in the words of John Manard Keynes’ most famous quote, ‘in the long run, we are all dead’. Using monetary policy during recessions is like pushing on a string; it is frequently ineective ineective (Tenreyro, 2016).7 Fiscal stimulus must therefore be used and this often means taking on debt.

Conclusion   A stable debt/income debt/income ratio is a useful metr metric ic when co considering nsidering the issue o off scal sustainability. But the International Monetary Fund (IMF) doesn’t rely on a single metric; the IMF has expanded its denition of debt sustainability “with high probability” by combining a level assessment (debt to GDP ratio) with a ow assessment (the gross nancing needs as a share of GDP). Debt to income ratio should be considered not only alongside other metrics like debt to GDP ratio, but also other factors like currency, type of economy, interest rate, growth rate, demographics, and the wider condition of the economy when making decisions about debt sustainability.

79

 

References •

Ahmad Zubaidi Baharumshah, Siew-Voon Soon, Evan Lau, Fiscal sustainability in an emerging market economy: When does public debt turn bad? Journal of Policy Modeling, Volume 39, Issue 1, 2017, Pages 99-113, ISSN 0161-8938, https://doi.org/10.1016/j.jpolmod.2016.11.002

•

 Arai, Real. “Productive Government Expenditure and Fiscal Sustainability.” FinanzArchiv / Public Finance Analysis, vol. 67, no. 4, 2011, pp. 327–351. JSTOR, www.jstor.org/stable/41472631 JSTOR,  www.jstor.org/stable/41472631

•

Omotosho, Babatunde S.; Bawa, Sani; Doguwa, Sani I. (2016): Determining the optimal public debt threshold for Nigeria, CBN Journal of Applied Statistics, ISSN 2476-8472, The Central Bank of Nigeria, Abuja, Vol. 7, Iss. 2, pp. 1-25. Download: https://www.econstor.eu/  bitstream/10419/191686/1/890484406.pdf 

•

Photis Lysandrou, Debt intolerance and the 90 per cent debt threshold: two impossibility theorem, Journal of Economy and Society, Volume 42, 2013 - Issue 4, Pages 521-542 | Published online: 16 May 2013, Download citation https://doi.org/10.1080/03085147.2012.760346 https://doi.org/10.1080/03085147.2012.760346  

•

Davis EP, Rising Sectoral Debt to Income Ratio; cause for concern? BIS Economic Papers Number 20, June 1987. www.bis.org/publ/econ20.pdf 1987. www.bis.org/publ/econ20.pdf

•

Bassetto, Marco; Kocherlakota, Narayana, On the Irrelevance of Government Debt When Taxes  Are Distortionary, Journal of Monetary Economics51(2):299-304 · March 2004/ https://www. researchgate.net/publication/222694001_On_the_Irrelevance_of_Government_Debt_When_ Taxes_Are_Distortionary 

•

Reinhart, Carmen M., et al. “Debt Intolerance.” Brookings Papers on Economic Activity, vol. 2003, no. 1, 2003, pp. 1–62. JSTOR, www.jstor.org/stable/1209144 JSTOR, www.jstor.org/stable/1209144..

•

Ubide, Angel, Intereconomics, Volume 54, 2019, Number 5, page 279 to 285 Fiscal Policy at the Zero Lower Bound https://archive.intereconomics.eu/year/2019/5/scal-policy-at-the-zero-lower bound/#footnote-017

•

Peter Heller, Back to Basics -- Fiscal Space: Space: What What It Is and How to Get It. June 2005, 2005, Volume 42, Number 2 https://www.imf.org/external/pubs/ft/fandd/2005/06/basics.htm https://www.imf.org/external/pubs/ft/fandd/2005/06/basics.htm  

•

Pecchi, Lorenzo; and Andrea Ripa Di Meana. “PUBLIC FOREIGN CURRENCY DEBT: A CROSSCOUNTRY EVALUATION OF COMPETING THEORIES.” Giornale Degli Economisti e Annali Di Economia, 57 (Anno 111), no. 2, 1998, pp. 251–288. JSTOR, www.jstor.org/stable/23248181. JSTOR,  www.jstor.org/stable/23248181. Accessed

•

6 Jan. 2020. 2020. Shirahase, Sawako. “Demography as Destiny: Falling Birthrates and the Allure of a Blended Society.” Japan: The Precarious Future, edited by Frank Baldwin and Anne Allison, NYU Press, 2015, pp. 11–35. JSTOR, www.jstor.org/stable/j.ctt15zc875.5 JSTOR, www.jstor.org/stable/j.ctt15zc875.5

•

Tenreyro, Silvana; and Gregory Thwaites. “Pushing on a String: US Monetary Policy Is Less Powerful in Recessions.” American Economic Journal: Macroeconomics, vol. 8, no. 4, 2016, pp. 43–74. JSTOR,  www.jstor.org/stable/26156440

•

See International Monetary Fund: Sta Guidance Note for Public Debt Sustainability Analysis in Market-access Countries, 2013.

80

 

81

 

SECTION 3 IMF & Economic IS THE IMF EVIL? Policy Many people in emerging markets, including Nigeria, see the IMF as an evil spirit that needs to be kicked out of the world by re. This explainer will try to disabuse you of this idea and clarify how even though the IMF has it’s faults, overall, it’s has been a great force for good in the world. Before I go on, I will like you to have a glimpse of what the IMF is. The International Monetary Fund (IMF) is a nancial institution that was established to help countries overcome economic diculties. This means that the IMF has a lot of good intentions. It was created to be a lender to countries in crisis. But the question is, how did the IMF get this ‹evil› reputation? First of all, I would like you to know that the IMF is not like your best friend or relative. I suppose if you’re going to lend money from your mother, she will ask you to pay it back  whenever you have it it,, without st strings rings att attached. ached. She mi might ght even ttell ell you not tto o worry ab about out the repayment. Family members can lend you money with no strings attached. They love you. That’s a  beautiful thing thing about family memb members ers and clos closee friends. However, the IMF is not your mum. Therefore, only rarely lends money to countries without conditions. Due to the conditions attached, lending from the IMF remains a politically dicult option in many countries. The IMF is customarily a lender of last resort, and that explains why countries only turn to the IMF when they face substantial nancial crises and no longer have any other option. In the introduction section of this book, I spoke about the fact that so many poorer countries experience nancial diculties. Many of these countries end up having to go to the IMF to obtain nancial support. Developing countries around the world have had dierent types of

encounters with the IMF. Some have been good, others bad. 82

 

One of the conditions that the IMF gives countries (and perhaps the number one source of the ‘evil’ reputation) they are lending money to is that they should stop spending much. Let’s assume that you have a friend who spends too much. If you happen to lend her money, you’re probably going to try to warn her about the way she spends it. You might say things like ‘You don’t need a car right now,’ ‘You don’t need to waste money on that house,’ ‘You need to stop eating out.’ But, unfortunately, when you give this kind of advice to countries, it can have a very dierent result. When the IMF attempts to stop countries from spending too much, it ensures that the government cut costs on various things. This is commonly referred to as austerity.The government is sometimes required to cut costs on education, security, housing, health care, social amenities and a whole lot of things. This makes it very dicult for politicians running countries who go through IMF programmes to be re-elected, as citizens tend to despise the public spending cuts. As a politician, once you cut spending on essentials such as security, education and social programmes, it becomes extremely dicult to get re-elected. That’s one of the reasons people think the IMF is evil. The second reason people think the IMF is evil is that it can create poverty. Cuts to social spending often adversely aect the poor. As a result, people have rioted in some of the countries participating in IMF programmes. The third reason people think the IMF is evil is that it tends to ‘control’ countries that are part of its programme. People feel that it is an insult for an external institution to come to a sovereign country and start dictating how they should operate, what to spend on, and what kind of policies to implement. It feels intrusive. Their logic is in line with the assertion: that you gave me money does not mean that you’re entitled to control my life. To illustrate, let’s say now that your friend has lent you money, she starts telling you what to eat: ‘Don’t eat chicken…It is too expensive…Take your Jollof rice with eggs instead’. It’s almost as if just  because she lent you the money, you can can’t ’t eat mea meatt anymore! See how intimidating and annoying it can be on a personal level? Now imagine how it would  be at the national llevel. evel. This ha hass driven pe people ople to se seee the IMF as an evi evill force.

83

 

The fourth charge against the IMF is that people think it’s an American institution. America puts more money into the IMF than most other countries. As such, people believe it is an  Americanised  Americani sed institu institution, tion, and th that at America uses the IIMF MF to giv givee favourabl favourablee condition conditionss to its foreign relations (friends) or to deal with its enemies by imposing strict conditions on them.  So, is the IMF evil or not? On a personal note, I don’t believe that the IMF is evil. Most of the countries that turn to the IMF for nancial support are already in a devastating situation. They’re already in a situation that’s going to be extremely dicult to get out of. For example, if someone is on a ventilator in an intensive care unit with a kidney, lung, and heart failure, and a doctor comes in to help the situation. If the patient eventually dies during the treatment process, it is not the fault of the doctor. The doctor tried his/her best but that doesn’t mean the patient wasn’t going to die. The patient was in a dire situation.  Yes, the IMF IMF makes mistakes, b but ut the mist mistakes akes of tthe he IMF a are re not str strictly ictly the mi mistakes stakes of the institution. I think that they are more the mistakes of economics as a science, and as a profession. Economics is a new form of science which is still evolving. And what the IMF did in the 1970s and 1980s was just the latest in economics at the time. It’s the same thing that happens in medicine. When we didn’t have cardiac intervention procedures in medicine, we just prescribed aspirin to people with heart attacks, because we didn’t know what else to give. Then we evolved into streptokinase. Now, we are doing cardiac intervention.  When economists economists too didn’t have something sophistica sophisticated ted to pres prescribe, cribe, they were simp simply ly prescribing the things they saw in economics textbooks. As a result, the IMF made mistakes. The IMF understands that those old solutions cannot solve new problems.  We understand understand the mi mistakes stakes ma made de by the IM IMF. F. We should a also lso try to u understand nderstand tthat hat the IMF has evolved and has learned from such mistakes. I think the IMF is a better and stronger institution today than it was 20 years ago. Do I think the IMF is evil? No, I don’t.

84

 

Do I think the IMF needs reform? Yes. Every organisation needs to be reformed every time.  We live in a situatio situation n where tthings hings are volatile an and d unpredict unpredictable, able, so we need to be dynamic in our dealings. All organisations, including the IMF, need to be able to adopt constant changes quickly. Do you still think the IMF is evil? I invite you to read my essays on the IMF and make up your mind! Thank you for joining me in this section.

85

 

Chapter 7  “Both the Mundell-Fleming and Polak Models suggest that under xed exchange rates, an increase in domestic credit will lead to a fall in international reserves.” Many emerging markets have xed exchange rates, is this a bad thing?  What are the advantages advantages and disadvantages of IMF? How has the IMF  been criticised? Is there merit tto o those criticism criticisms? s? Has the IMF helped helped or hurt emerging markets?

Introduction to the Mundell-Fleming and Polak Models The Mundell-Fleming Model (IS-LM-BP Model): The Mundell–Fleming model portrays the short-run relationship between an economy’s nominal exchange rate, interest rate, and output (in contrast to the closed-economy model  which focuses focuses only on tthe he relatio relationship nship betw between een the interest rate and o output). utput). Blanchard (2017) provides a textbook treatment on both models, and here we depart from his work to show an overview of the Mundell-Fleming model. The goods-market equilibrium implies that output depends, among other factors, on the interest rate and the exchange rate:

 Where i is the interest rate equal to the policy rate set by the central bank so that.

The interest rate parity condition implies a positive relation between the domestic interest rate and the exchange rate.

86

 

Jointly, these three relations determine output, the interest rate and the exchange rate. The three equations can be reduced to two by using the interest parity condition to eliminate the exchange rate in the goods-market condition:

Once again, the last two equations determine jointly the interest rate and equilibrium output, and using

gives us the implied exchange rate.

 As seen in gure 1, an increase in the int interest erest ra rate te reduces output both directly (through investment) and indirectly (through the exchange rate). It should be noticed that an interest rate shock not only leads to a decrease in investment, but also to an exchange rate appreciation.

Figure Figur e 1. Resp Response onse to an increase in interest rate

Source: Blanchard (2017)

Source: Blanchard (2017)

87

 

 An increase increase in gover government nment spen spending ding leads tto o an incr increase ease in out output, put, provide provided d that the central bank keeps the interest rate unchanged and that the exchange rate remains unchanged too.

Figure 2. Response to an increase in government Figure spending

Source: Blanchard (2017)

However, when the central bank responds to this government spending increase  by raising the intere interest st rate, a an n exchange rate appr appreciation eciation w will ill occur.

Figure Figur e 3. Response to an increase in government spending when the central bank responds by rraising aising the interest rate

Source: Blanchard (2017)

88

 

Now, when we introduce xed exchange rates, the interest rate parity condition remains.

Let the current exchange rate equal the pegged exchange rate . If nancial markets believe that the exchange rate will remain pegged at this value, then market expectations of future exchange rate

is equal to

, and the

interest parity relation becomes:

Therefore, with a xed exchange rate, the domestic interest rate must be equal to the foreign interest rate. Then, if monetary policy cannot be used under xed exchange rates, the government needs to use scal policy and the eects are identical to the one we see in Figure 2, given that an increase in public spending is not accompanied by a rise in interest rates. In the context of xed exchange rates, the central bank buys and sells domestic currency, so that the money supply is equal to reserves plus domestic credit. Since  both domestic domestic credit and foreig foreign n currency a are re control controlled led by the ce central ntral ban bank, k, an appreciation of the domestic currency could be prevented by selling some domestic currency using foreign reserves. Furthermore, in a situation of balance of payments decit, the country would need to sell reserves to keep the xed exchange rate. Polak Model: Polak’s general approach was not new. He helped resuscitate the monetary approach to the balance of payments in the age of Keynes. The Polak Model introduced a quantitative linkage between the domestic money market and the balance of payments. This then formed the basis of many decisions made at the IMF for years to come.  When the IMF rst started to oer nan nancial cial assist assistance ance thro through ugh stand-by agreements to member countries, Polak pointed out that even though the IMF  was able to use simp simple le Keynesi Keynesian an models tto o calculate the domest domestic ic multiplie multiplierr eects, it had the ‘embarrassing inability’ to understand what monetary policy actions should be taken in situations such as devaluation or a major disequilibrium.

89

 

This was ironic, because one of the reasons that member states needed to lend in the rst place was due to challenges with external payments, yet there was no standardised way of ensuring that these countries corrected the underlying causes of their imbalances (Boughton, 2011). Polak was an IMF employee when he designed his monetary model that could calculate the impact of dierent monetary policy scenario on the balance of payments and on income. It was distinct from the previous Keynesian models as it was so simple, avoiding complex behavioural variables that would be dicult to quantify/apply. The Model consists of: 1.

Two behavioural relationships: the demand for money function and the function of the demand for imports

2. Two identities: for the money supply and for the balance of payments (Nowak, 2012). The equations used to derive the model focus on describing how the transmission mechanism leads an increase in domestic credit to result in a rise in imports. This then leads to a fall in international reserves (Boughton, 2011).

Figure 4: The Polak Model (Nowak, 2012)

Figure 4: The Polak Model (Nowak, 2012)

90

 

The values of the balance of payments and the change in nominal income are shown at the point of equilibrium between the BP line and the MM line. The increase in the rate of expansion of domestic credit (a shift of the line MM to the line MM’) causes the balance of payments to deteriorate and nominal income to rise. The Polak Model forms the foundation of the IMF’s stabilisation programme. The stabilisation programme focuses mainly on the relationship between internal and external stability. The model shows how control over net domestic credit expansion is the key to stabilising the level of foreign currency reserves. This in turn is key to keeping the balance of payments in check (Nowak, 2012).

How the Mundell-Fleming and Polak Models inuence the IMF’s approach to stabilisation  When the IMF gives support to countries, iitt does so g guided uided by cert certain ain govern governing ing principles. This is what is referred to as IMF conditionali conditionality. ty. The IMF’s approach to stabilisation has a few essential quantitative features. Important metrics like GDP, ination level & current account balance are considered, and forecasts prepared. The probability of a country being able to secure external nancing is also studied to ensure that its external payment position is viable or can become  viable. In addition to this, the IMF usually lends for a specic purpose; this is documented in the IMF’s legal charter under the articles of agreement.  Another important important a aspect spect of tthe he IMF’s a approach pproach to stabilisa stabilisation tion is its quantitat quantitative ive performance criteria. Performance criteria include ceilings and oors for certain metrics. For example, a oor can be set for net international reserves, whilst a ceiling is set for scal decit or the net domestic credit. These metrics are agreed upon by a process of discussion with the country seeking support (Mussa, 1999).

91

 

However, this was not always the case with IMF support. The rst time that an IMF support package included the type of monetary performance criteria that Mundell, Fleming and Polak advocated for was in Paraguay in 1957. Paraguay was asked not to draw o its IMF agreement unless it was able to keep bank credit from rising. Paraguay was also asked not to allow government spending to rise  beyond a certain certain ceil ceiling ing (James, 2 2001). 001). Polak’s most famous argument supporting this line of thinking is below: “The economic development could have been nanced by higher taxes or foreign loan. The factories might have been built by restriction of consumption or by the repatriation of capital. In all these situations, the desire to spend for a  particular purpose purpose w would ould not hav havee led to a p payments ayments p problem. roblem. In a real sens sense, e, the credit expansion is the cause of payments problem.” (Polak, 1957). This was an extremely persuasive argument. It convinced the IMF that domestic credit (of which public sector credit is usually the majority) must be curtailed if a country really wants to achieve its balance of payments targets.

Criticism of the IMF’s approach to stabilisation Some have argued that the IMF, like many other global institutions, has two sets of rules. One set for rich countries with a lot of inuence and one set for poorer countries with less inuence (Stone, 2008). For example, it is claimed that the IMF was under political pressure from France not to devalue the CFA, however, Kenya did not receive the same treatment. It is also claimed the United States pressurised the IMF to interpret the loan conditions for Egypt more exibly because of the pivotal role that the Egypt played for the US economy at the time (Kapur, 1998). The author of a book called ‘The Poverty Brokers; Latin America and the IMF’  believes this this too. He argues that that even tho though ugh the IM IMF F present presentss itself as a neutral, non-political organisation which makes decisions solely on scientic economic

92

 

theory, they do not believe this is always the case. The book claims that ‘there can  be no doubt’ doubt’ that the IMF’s polic policy y recommend recommendations ations ali align gn with th those ose favoure favoured d  by large internation international al capital and the mu multinationa ltinationall organisa organisations tions that benet. It also suggests motives for possible political gain as those same multinationals are important political campaign donors (Brett, 1983).  Another big big criticism of the IM IMF, F, especia especially lly prior to the mid-1980s is that tthe he conditions were shallow, and the support was too short-term, especially for poorer countries; the IMF’s main clientele. Some critics complained about how the conditions intruded on national sovereignty. Other critics focused on the work of the IMF’s work in Africa which they claimed ignored the political realities of these countries and did not take into consideration the institutional weakness apparent in many African countries. This resulted in poor outcomes. The IMF seems to have received the most criticism in the late 1980s over its conduct in Latin America when an increase in repayments coincided with a further contraction in the respective economies. It was at this point that prominent scholars like former Columbia Professor Karin Lisakers, who later  became US executive director a att the IMF IMF,, called it a ‘political or organisation ganisation’’ and implied that it was biased. MIT Professor Stanley Fischer, who later became the rst deputy managing director of the IMF, critiqued the lack of debt relief and his critique was supported by none other than Jacques Polak himself! (Kapur, 1998)  Another point point is tha thatt similar to the sit situation uation whi which ch tied tra transfers nsfers to the poor, the IMF conditionality introduces additional huge administrative costs and  bureaucracy  bureaucrac y (Dreher, 20 2004). 04). Meanwhile, the US has denied bias on IMF loans (Brett, 1983). In contrast to the criticisms above, there are studies that have found the IMF conditionality criteria exible and able to take into account the political constraints in the countries that they support. Stone (2008) argues that it was when the US pressured the IMF to relax their conditionality criteria that programmes in Russia, Argentina and Turkey failed (Stone, 2008). It’s not actually the case that the IMF always requires devaluation or movement to a more exible exchange rate. Admittedly, discussions about exchange rate are common, but devaluation as a pre-condition is not the norm.

93

 

On the issue of bias, it is worth noting that most of the decisions taken by the IMF align with the approaches suggested by common economic decision-making models such as the Mundell-Fleming and Polak Models. They practically are the same as what the average economist/economic adviser/economic consultant  would ask a country expe experiencing riencing ssevere evere bala balance nce of pa payments yments prob problems lems to do. Richard Cooper said famously at an 1892 conference that any ve randomly chosen economists if asked to design an adjustment programme would come to the same conclusion as the IMF. So these decisions were not based on bias, but on science (Mussa, 1999). Polak, in a later publication, acknowledges how much the IMF has evolved, sometimes even overlapping with the World Bank in terms of mission. This is reective of the changes in scope and style that the institution has undergone over time (Polak J. , 1994).

Ukraine Case Study  Both the Mundell-Fleming and Polak Models show how increased domestic credit, which is usually by the government/public sector, leads to a fall in international foreign reserves. The Memorandum of Economic and Financial Policies for Ukraine refers to ‘expenditure-led consolidation that targets a smaller and more ecient government. At the same time, we will make the tax system growth-friendly, transparent, and equitable to support private activity’. This sounds good, but the IMF is often criticised for introducing austerity into economic policy. Increasing taxation and government spending on salaries, some would argue, could make a recession worse (IMF, 2015). The Mundell-Fleming/Polak Models, however, support the reduction of debt as necessary to protect foreign reserves. The combination of restrictions on further credit cuts to government budgets, including social spending and increased taxation,, can adversely aect the poor (Nooruddin, 2006). taxation It should be noted that the memorandum is based under the claim that for the specic case of Ukraine, a exible exchange rate regime would be needed.

94

 

Conclusion The Mundell-Fleming and Polak Models provided a foundation for the conditionality of IMF loans. Undoubtedly, these have been helpful to some countries. Studies have actually shown evidence of some countries using the excuse of the conditionality of an IMF loan to push through reforms that would have otherwise made the leaders politically unpopular (Vreeland, 2003). However, there are some criticisms, especially concerning the eects of austerity on the poor.

References •

Blanchard, O. (2017). Macroeconomics. 7th edition. Chapter 19. Pearson.

•

Boughton, J. (2011). “Jacques J. Polak and the Evolution of the International Monetary System. IMF Economic Review, vol. 59, no. 2, pp. 379–399.

•

Brett, E. (1983). “The World’s View of the IMF.” The Poverty Brokers: IMF and Latin America. London: Latin American Bureau.

•

Dreher, A. a. (2004). The Causes and Consequences of IMF Conditionality. Emerging Markets Finance & Trade, vol. 40, pp. 26–54.

•

IMF (2015). Ukraine: Letter of Intent, Memorandum of Economic and Financial. Kyiv: IMF.

•

James, B. (2001). Silent Revolution: The IMF 1979-1989. Geneva: IMF Bookstore.

•

Kapur, D. (1998). The IMF: A Cure or a Curse? Foreign Policy, no. 111, pp. 114–129.

•

Mussa, M. a. (1999). The IMF Approach to Economic Stabilization. NBER Macroeconomics Annual, pp. 79–122.

•

Nooruddin, I. a. (2006). The Politics of Hard Choices: IMF Programs and Government Spending. International Organization, vol. 60, no. 4, pp. 1001–1033.

•

Norrbin, M. M. (2017). International Money and Finance. In S. N. Michael Melvin. Elsevier.

•

Nowak, W. (2012). Development of the Polak model. Wroclaw review of law, administration and economics, 28-35.

•

Polak, J. (1994). The World Bank and the IMF: A Changing Relationship. Brookings Institution Press.

•

Polak, J. J. (1957). Monetary Analysis of Income Formation and Payments Problems. Sta Papers (International Monetary Fund), pp. 1–50.

•

Stone, R. W. (2008). “The Scope of IMF Conditionality. International Organization, vol. 62, no. 4, pp. 589–620.

•

 Vreeland, J. R. (2003). “Why Do Governments and the IMF Enter into Agreements? Statistically Selected Cases.” International Political Science Review / Revue Internationale De Science Politique,  Vol 24, pp. 321–343.

95

 

Chapter 8 Is the IMF evil? “The IMF not only failed to anticipate both the EME and the global nancial crises, but its responses to the former were not always appropriate and proved ineective in preventing the second” is a common quote. The way that the IMF has handled and managed crises in emerging markets has been criticised extensively. Here we explore the nature of crises in some emerging markets and how the IMF has handled them.

Introduction The IMF is sometimes seen as a ‘guardian’ of sorts to the global nancial system as one of its roles is surveillance. This essay assesses the response by the IMF to both the emerging market and global nancial crises. Particular focus will  be given to to the inst institutions itutions a ability bility to an anticipate ticipate and respon respond d appropria appropriately tely and eectively to these crises. It will also consider whether controls on free movement of capital can limit the damage of a nancial crisis.  

 The EME & Global nancial nancial crises The emerging market crisis (EME) of 1997 seemingly caught the entire world unaware as it originated in the ‘Asian Tiger’ countries that previously were cited as examples of sound economic management. On the surface, it seemed like they  were getting getting everyt everything hing right. Th They ey had high rrates ates of do domestic mestic sav savings, ings, strong economic growth and prudent scal policies (International Monetary Fund,

1998). 96

 

But this supercial picture unfortunately masked some fundamental problems  with regulation, regulation, curre currency ncy risk an and d overheat overheating ing of the economy. Most accounts of the crisis report that it originated in Thailand, triggered by Japanese banks pulling their credit lines which in turn caused a devaluation in the Thai currency: the baht. This devaluation then caused liabilities for a large number of Thai rms to skyrocket. Unable to meet these obligations, rms started to fail, which in turn caused greater concern to institutional investors that had extended dollar debt to Thai companies. Eventually, this became a vicious cycle, a contagion which spread across East Asia over the next few months (King, 2001). Majority of the countries aected had high levels of capital inow in the years preceding the crisis. This was the case in the worst aected countries: Indonesia, South Korea and Thailand. In fact, in Thailand’s case, it was up to 16% of GDP. This fuelled credit creation and drove up property prices (Joyce, 2000). Close ties between companies, banks, and the expectation that the government  would bail out systemic systemically ally importa important nt banks, iincreased ncreased rrisk isk takin taking g across tthese hese dierent stakeholders stakeholders (Roubini, 2004). The global nancial crisis was in some ways very dierent from the EME crisis. But there are some similarities. Both crises were characterised by two key issues: (i) High levels of debt/unsustainable loans to private sector and households (ii) Inadequate levels of regulation or understanding by regulators of the levels of risk being taken in (i) above.  Whereas currency currency deva devaluation luation an and d exchange rate risk played a sig signicant nicant ro role le in the EME crisis, in the case of the global nancial crisis, it was the mortgage markets that played a signicant role, amongst a variety of other factors. It is also argued that there was a degree of regulatory capture. Regulatory capture is a theory that describes a situation where regulatory bodies become dominated by the interests of those which they are supposed to regulate rather than the wider public interests (Desai, 2011).

97

 

Mary Mellor in her book, ‘The future of money: from nancial crisis to public resource’, refers to the mortgage market as the trigger, not the cause of the global nancial crisis. The global nancial crisis occurred during a period where there  was massive massive expans expansion ion in the mortgage m market arket an and d American mortgage de debts bts  were being being securiti securitised sed into n nancial ancial pro products ducts which were the then n traded ac across ross the  world in dierent dierent for forms. ms. Unfortunately, the underlying mortgages became increasingly risky. Defaults  within the the rst thr three ee months of a mortga mortgage ge were p previously reviously unh unheard eard of, but they  became increasingly increasingly ccommon ommon as tthe he crisis un unfolded. folded. This w was as because more mortgages were being extended to poor families, often using high pressure sales techniques. Mellor (2010) refers to these notorious loans as ‘NINJA’ mortgages, meaning ‘no income, no job, no questions asked’. There was also a political/policy angle to the crisis. National mortgage agency executives confessed that they recognised problems with the mortgage market relatively early, however, they were under pressure from the US government to grow the number of homeowners in the country, especially the number of homeowners from low income families. Therefore, they felt they had no choice  but to continue continue to ex extend tend unsust unsustainable ainable mo mortgages rtgages (Mellor, 201 2010). 0). This section has thus far described both the EME and the global nancial crises. The next section will evaluate the response of the IMF to these crises.

 The IMF response ‘Warning member countries about risks to the global economy and the buildup of vulnerabilities in their own economies is arguably the most important  purpose of of IMF sur surveillance. veillance. This IEO evaluat evaluation ion found tha thatt the IMF fell short in delivering on this key objective.’ (Independent Evaluation Oce of the International Monetary Fund, 2011)  A report by the IMF’s own indepe independent ndent eva evaluation luation o oce ce highlight highlighted ed various challenges at the IMF such as political pressures, group think and intellectual capture. It was found that IMF sta were often intimidated by the scale of

resources available to governments, especially in developed countries. 98

 

The report also found that groupthink was an issue at the IMF. Groupthink is a phenomenon where a group of people reaches a conclusion without rigorous questioning/debate or critical thinking around the decision. It is often caused by not wanting to ‘rock the boat’ or upset the balance (Bosco, 2011). The report also touched on the eects of ‘softer’ issues like the culture at the IMF. According to the report, the culture was intolerant of contrarian views. The IMF was also overcondent about the nancial structure of advanced economies.  After the East Asia Asian n crisis, a vulnerabilit vulnerability y exercise was carr carried ied out whi which ch did not involve any advanced countries, indicating that the IMF though that an economic crisis was the preserve of emerging markets only (Independent Evaluation Oce of the International Monetary Fund, 2011).

Figure 1 lists some of the complex interacting factors that contributed to the inability of the IMF to predict the EME or the global financial crises. Nobel prize winner, Paul Krugman seems to echo this in his book. He argues that the global nancial crisis was not unheralded. In fact, he details how the previous crises in East Asia, described in the opening section of this essay, as well as the other nancial crises of the 1990s, like Japan, Argentina and Russia, provided credible warning signals to America as to how nancial crises typically unfold (Krugman, 2009). By the time of the global nancial crisis, the IMF knew all the signs, but due to structural and cultural issues, seemed not to be able to respond to them.

99

 

There seems to be widespread agreement on the failure of the IMF with regard to its anticipatory/surveillance role, however, there are more varied opinions on its response once the crises are on-going. The IMF was censured for its handling of the Asian crisis and came under increased scrutiny. But the same paper also points out how the IMF is limited  by its nancial nancial resour resources ces and in inuence. uence. Limi Limited ted nanci nancial al resource resourcess make the institution skew its lending towards larger countries. In addition to this, it cannot  be expected expected to have the same inuence a across cross the world as a central ba bank, nk, so the power of the IMF is also limited (Joyce, 2000).  When analysed analysed over a period of de decades, cades, ther theree is evide evidence nce that ccountries ountries participating in IMF-supported lending programs are signicantly less likely to experience a future banking crisis than non-borrowing countries (Papi, 2015). However, it has also been argued that the IMF was at some level responsible for causing the EME crisis in the rst place by encouraging countries to liberalise their capital accounts too quickly. It has also been accused of overstepping in terms of jurisdiction by imposing deep structural reforms that impoverish citizens and cause political/social instability (Woods, 2006). There have been further criticisms of the nature of the IMF’s response to the crisis in Asia as well as deep distrust. Some critics believe that the IMF deliberately underfunded countries like Thailand, Indonesia and South Korea, resulting in prolonged economic turmoil, increased poverty, and extended periods of capital ight. One of the most outspoken critics was Japan’s deputy minister of international nance at the time: Eisuke Sakakibara, who openly  warned Indonesia Indonesia ag against ainst lett letting ing its poo poorly rly performi performing ng domesti domesticc banks fa fail il in line with IMF’s advice. He indicated that it would not be allowed to happen in  America and and that the IMF was prescribi prescribing ng damaging medicine tto o Indonesi Indonesia a that they would not prescribe if the United States found itself in a similar situation (Lindblad, 2010). Others argue that reduction in social spending that happens in developing countries due to the conditionality of IMF loans may cause public health problems in recipient countries (Stuckler, 2009).

 Apart from the fact that many As Asian ian policy m makers akers fee feell that the IMF’s adv advice ice was either wrong or misplaced, some also felt humiliated by the leaders at the IMF, leading to a lasting ‘IMF stigma’ for the countries that received IMF assistance

during the crisis, even though empirically in the long term, there has been no 100

 

dierence in the economic outcomes of countries that received assistance and those that did not (Ito, 2012).  A piece in Foreign P Policy olicy argues that blam blaming ing the IM IMF F for the fact that eventually every country must confront its budget constraints is like blaming the Fund for gravity (Rogo, 2003). The IMF often has to pass on the bad news that nobody  wants to hear and some criti critics cs are just shooting tthe he metaph metaphorical orical mess messenger. enger. Thomas Willet (2001) gives a similarly measured opinion in his piece published in the Independent Review. He points out how the IMF has been vilied by  both the right and le left ft wing a att dierent times, for d dierent ierent re reasons asons in d dierent ierent countries, but predominantly, predominantly, overall, it has been a force for good. It is not perfect but should still exist and is in need of reform. Another major issue his piece points out is how IMF responses can be politically motivated by the large shareholders like the United States (Willett, 2001).

 The role of controls on the free movement of capital Capital ows have the ability to improve livelihoods and standards of living in so many countries around the world (Joyce, 2000). However, capital ows also have the ability to destabilise those same economies as they are left vulnerable to the  whims of foreign foreign inv investors. estors. Thes Thesee foreign investors sometimes act on the basis of hearsay rather than the fundamentals, causing panicked mass withdrawals of investments investmen ts from parti particular cular countri countries es (Roubini, 2004). One of the major criticisms of the IMF is around the advice it gives on capital controls. The most publicised work of the IMF is in crisis situations. However, the bulk of the day to day work of the IMF involves travelling to or engaging  with member member countri countries es to provi provide de advice o on n how to p prevent revent a crisis in tthe he rst place. However, much of the advice is around liberalising capital markets and ows which some senior economists believe planted the seeds of the EME crisis (Lindblad, 2010).

101

 

Rogo (2003) points out that if East Asian countries had not been so open to  borrowing in foreign currency as freely as they did, the huge debts would not ha have ve mounted and then there would have been fewer foreign creditors demanding repayments. It also reveals that, apparently, in the months leading up to the crisis, the Thai government were warned by the IMF about the currency risks that were being taken in their nancial markets, but at the time, Thailand had the ambition of becoming a global nancial centre like Singapore and large foreign currency inows were an important part of the overall strategy. Nevertheless, this was not the case in South Korea or Mexico where such  warnings were not issued by the IMF. More Moreover, over, the is issue sue around ccapital apital con controls trols is complex. In the case of the Asian crisis, countries with relatively closed economies, like China and India, were unscathed for the most part, whilst the contagion spread through the more open economies in Asia. Strikingly, New Zealand’s and Australia’s open, liberal economies where hardly aected by either crisis. This is a result of something that the EME countries lacked – strong regulation; strong exports to be able to pay down debt; and deep, strong domestic markets (Rogo, 2003).

102

 

Conclusion  In the aftermath of the global nancial crisis, a key part of the IMF’s response  was reform reform around sc scope. ope. The IM IMF F developed more lendi lending ng programm programmes es targeted at the prevention of a crisis rather than emergency management once a crisis unfolds. Examples of such include the exible credit line (FCL) and the precautionary credit line (PCL) as well as enhancement of the high access precautionary arrangement (HAPA) (Moschella, 2011). The IMF failed to fully anticipate both the EME and the global nancial crises. But after the global nancial crisis, reforms were put in place to ensure that the institution has instruments that can be used to prevent crises as well as try to x them. Like any complex, large global institution, it has its aws and there is room for further reform. But overall, it has been a force for good and has shown that it is capable of reection and improvement. On the issue of free movement of capital, the advantages appear to outweigh the disadvantages in terms of the amount of prosperity that foreign capital can bring to countries around the world. However, the IMF must temper its advice on liberalisation with warnings on the downsides; the need to strengthen regulations, deepen domestic markets, maintain an independent central bank, and focus on exports.

103

 

References •

Bosco, D. (2011, Febuary 10). Why didn’t the IMF predict the nancial crisis? Foreign Policy.

•

Desai, P. (2011). In Financial Crisis Origin. In From Financial Crisis to Global Recovery (pp. pp. 1-20). New York: Columbia University Press.

•

Independent Evaluation Oce of the International Monetary Fund (2011). IMF Performance in the Run-Up to the nancial and economic crisis. Washington DC: IMF.

•

International Monetary Fund (1998). The Asian Crisis: Causes and Cures. Finance and Development,  Volume 35, Number 2.

•

Ito, T. (2012). Can Asia Overcome the IMF Stigma? The American Economic Review, 198-202.

•

Joyce, J. (2000). œThe IMF and Global Financial Crises. Challenge, 88.

•

King, M. (2001). Who Triggered the Asian Financial Crisis? Review of International Political Economy, 438.

•

Krugman, P. (2009). The Return of Depression Economics and the Crisis of 2008. New York: W. W. Norton & Company.

•

Lindblad, J. T. (2010). “IMF: The Road from Rescue to Reform.” In The Asia-Europe Meeting: Contributing to a New Global Governance Architecture: The Eighth ASEM Summit in Brussels.  Amsterdam: Amsterdam University Press.

•

Mellor, M. (2010). The Future of Money: From Financial Crisis to Public Resource. London: Pluto Press.

•

Moschella, M. (2011). The Global Financial Crisis and the Reforms to IMF Lending. St Antony’s International Review, 48-60.

•

Papi, L. P. (2015). IMF Lending and Banking Crises. IMF Economic Review, 644-691.

•

Rogo, K. (2003). The IMF Strikes Back. Foreign Policy, 39-46.

•

Roubini, N. (2004). Bailouts Or Bail-Ins? Responding to Financial Crises in Emerging Economies. Peterson Institute for International Economics.

•

Stuckler, D. a. (2009). THE INTERNATIONAL MONETARY FUND’S EFFECTS ON GLOBAL HEALTH: BEFORE AND AFTER THE 2008 FINANCIAL CRISIS. International Journal of Health Services 39, no. 4, 771-781.

•

 Willett, T. (2001). Understanding the IMF Debate. The Independent Review, 593-600.

•

 Woods, N. (2006). Understanding Pathways Through Financial Crises and the Impact of the IMF: An Introduction. Global Governance, 373-93.

104

 

105

 

SECTION 4 Banking and capital markets   The rst essay in this section talks about bank-oriented economies versus market-oriented economies and why the dierence is important.  A bank-oriented bank-oriented econ economy omy is one iin n which mo most st people k keep eep their money in b banks, anks, while a market-oriented economy is one in which most people keep their money in the stock market. Looking at the meaning of bank-oriented economies, you’ve probably already guessed that Nigeria is a bank-oriented economy. Nigerians don’t keep a lot of money in the stock market; most of their money is kept in banks.  America, for for example, iiss a marke market-oriented t-oriented economy. You ccan an see th that at most of their mone money y is in the stock market. In fact, more than 30% of the money that belongs to American households is in the stock market. Knowing this, you can easily conclude that America is a marketoriented economy.  You may be thinking. thinking. “W “Why hy does it m matter atter if p people eople kee keep p their mon money ey in bank bankss or the sstock tock market? Why is this an issue as long as they keep their money somewhere?” It is an issue because some economists argue that countries with market-oriented economies tend to have more robust innovation levels than bank-oriented economies. If you go to the bank today to pitch them with a big idea on A.I or 3D printing or something that the bank is not familiar with , they will probably reject it. Bankers are generally old school; they gravitate towards tried and tested business models. In a market-oriented economy, however, if you ask for such an investment from households through the stock market, you are more likely to get it because households tend to be more experimental. This may partly explain why America has the largest technology companies in the world. Innovative companies like Google, Facebook, Uber, Apple, Tesla and many others are all in  America, driven driven by the stock mark market. et.

106

 

This is one of the issues aecting emerging markets, including Nigeria, even though in theory  we are more more bank-or bank-oriented. iented. In p practice, ractice, we are neith neither er bank n nor or market market-oriented. -oriented. We are mattress-oriented.  A large percentage percentage of the popula population tion does n not ot keep mo money ney in the banks. As I mentioned in my essay on microeconomics, we tend to resort to other methods of saving money; while Babajide prefers to keep his money in his trousers, Folakemi may prefer to keep hers under her pillow,. Since people don’t keep their money in nancial institutions, there is less money to lend to  businesses. This tends tto o stall pro productivity ductivity in businesses businesses,, and deprive deprivess the coun country try of the capital vital to growth and development. Getting the Nigerian Stock Exchange adequately capitalised as well as getting more people to put money in banks are crucial to business growth. This will not only have a positive impact on  businesses, but it will also boost the natio nation’s n’s GDP. Banks and capital markets play a signicant role in changing the status of a country from an emerging market to a developed market. South Africa’s stock market is over 20 times larger than Nigeria’s. However, in terms of population, there are only about 35 million South Africans, compared to close to 200 million Nigerians. South Africans have a much more developed market, so it makes sense that it may be easier for a South African entrepreneur to raise capital compared to a Nigerian entrepreneur. However, stock market capitalization in emerging markets is generally smaller compared to more developed countries. The second issue I will address in this section is how a country develops from a nancially repressed economy to a fully international and domestic liberalised economy. During the military era, the government controlled the banks, and therefore, their supply of credit in the economy; many would describe this as nancial repression. Liberalisation started when the government privatized the banking industry. Eventually, we became a fully international and domestic liberalised economy where foreign investors could come in and go as they please.  While it’s a good thing that forei foreign gn investo investors rs can to invest the their ir money, it has also gi given ven us problems, as foreign investors sometimes come with ‘hot money’. This means that when they see an opportunity, they invest in it. However, such investments are short-term and risk-averse, so at the rst sign of trouble, they all take their money out at the same time. This

produces uctuations in the economy that have led to severe crises in some emerging markets. 107

 

In my subsequent essay, I explained in detail the role the National Deposit Insurance Corporation (NDIC) plays in safeguarding bank deposits. Many assume that any money you put in any Nigerian bank is 100% insured. This assumption means that if something happens to a bank in which you have kept your money, you can just go to the NDIC and get all your money back. That’s not exactly true. It is imperative to understand that the NDIC is an organisation primarily concerned with the needs of the masses. This means that they only insure amounts they feel will cover most of the country’s bank deposits without causing too much suering to the masses. In Nigeria, the NDIC covers only ve hundred thousand naira ( ₦ 500,000). This means that if a bank goes bankrupt, only ₦ 500,000 of your money is covered. For example, if you have 10 million naira in a bank, and the bank goes bankrupt, you will only be able to get back the ₦ 500,000

covered by the government.

 When a bank bank goes ba bankrupt, nkrupt, it will lose a lot of mone money y because tthe he NDIC will only give the  bank a tiny tiny percent percentage age of wha whatt they hav havee in the b bank. ank. Theref Therefore, ore, it actu actually ally doesn’t g give ive them  what we call a moral ha hazard; zard; the te tendency ndency for b banks anks to a act ct irrespo irresponsibly nsibly just b because ecause the they y have a backup. The last thing I want to discuss in this explainer- which I believe a lot of young people will be interested in- is about new forms of banking, such as FinTechs, Digital Wallets, and mobile money. It is critical for people to know whether NDIC covers the things they’re putting their money intp. Organisations such as NDIC and other national deposit insurance companies were formed as a result of the panic caused by failed banking systems. In the past, as soon as anyone discovered that a bank was likely to go bankrupt, everyone rushed to the bank to collect their money. One thing people need to understand about banks is that if every depositor goes to them today and asks for their money, they (banks) will be in trouble because they don’t actually have it on hand. The money that you see in your account is ctional. They don’t have cash at the bank.  Your money has has probab probably ly been give given n out to som someone, eone, eith either er as a loa loan n or any ot other her thing they deem t.

108

 

 Your total deposit deposit wit with h xxx Ban Bank k is proba probably bly with Da Dangote, ngote, and he may not return it a anytime nytime soon, depending on their agreement. This is why banks have only a small percentage of the money they can give out on request. If there was a rumour that a certain bank was about to fail and everyone rushed to collect their money from that particular bank,-even if it was Nigeria’s biggest bank- it would probably fail. The reason the NDIC was formed (and the reason the CBN also ensures that banks keep some money with them) is to ensure people feel condent that their money is safe. This is good nancial practice, as well as being one of the measures that several international organisations encourage countries to take. Thanks for reading the banking and capital market explainers. I hope you enjoy the essays.

109

 

Chapter 9 Bank oriented economies vs. Market oriented economies – we look at advanced markets to see how they developed their market orientation. Nigeria has a very bank oriented economy. Is this working for us? Should emerging markets try to develop both? What is the role of nancialisation in emerging markets? How does this aect corporate governance?

Introduction This essay will compare the bank oriented nancial systems of the world to the market-oriented systems, focusing on the factors that facilitated their development along with their respective strengths and weaknesses. It will conclude with an assessment of the implications of the two systems for corporate governance.

Bank-oriented vs Market-oriented Systems Financial systems do not function in the same way everywhere in the world. There are systematic dierences between nancial systems that can be classied in dierent ways. One of such classications is the division of nancial systems into bank- or market-oriented systems.  A bank oriented oriented syste system m is one iin n which ba banks nks play the prominent role in ‘mobilising savings, allocating capital, overseeing the investment decisions of

corporate managers, and providing risk management vehicles (Demirguc-Kunt, 1999). 110

 

However, a market oriented system is one in which securities markets share a greater part of that role. In market oriented systems, securities markets are more prominent when it comes to getting household savings to rms, inuencing corporate control, and providing risk management.

There are several factors that can be used to determine whether a nancial system is bank oriented or market orientated. These are: i.

Size of bank assets relative to GDP

ii.

Stock market capitalisation relative to GDP

iii.

Household portfolio allocation

iv.

Sources of nance to industry.

Let us start by looking at bank asset compared to GDP in dierent countries:

Figure 1 (World Bank, Accessed 2020)

111

 

The data shows how countries like Japan, France and Germany have far higher levels of banking assets compared to GDP than countries like the United States. However, when we look at the stock markets in those countries, there is a dierent picture.

Figure 2 (World Bank, Accessed 2020)  When we looked looked at tthe he United S States tates by de deposit posit mone money y in banks compared tto o GDP, it was the lowest of all the countries we looked at. But in terms of equity market capitalisation of listed companies as a percentage of GDP, it is the highest! Showing that some countries have an obvious slant towards either banks or markets.  Another criteria criteria an analysts alysts look at when ttrying rying to det determine ermine wh whether ether a m market arket is more bank- or market oriented is to observe where households put their money.

112

 

Figure 3 (World Bank, Accessed 2020)

The blue line is for currency and the diagram shows how German and Japanese households keep a signicantly larger proportion of their assets in deposits/ currency in banks compared to the United States where the reverse is the case. Consequently, the question we will be tackling in the next section is, ‘Which system, if any, is better?’

Strengths and weakness of both systems (Market-oriented & Bank-oriented) The strengths and weaknesses of each nancial system will be considered under three main important functions: innovation/technology, dissemination of information, and ability to restructure. All of these are core functions of a nancial system.

113

 

This section will examine what advantages and disadvantages market-oriented/  bank-oriented  bank-orien ted systems bring to tthe he essent essential ial roles. If a company runs into nancial problems, it is easier for the company to restructure its debt with a bank than it is with the stock market/corporate bond. The bank is incentivised to help the company restructure. Therefore, under a  bank-oriented system, fewer comp  bank-oriented companies anies hav havee to shut do down wn when they are in nancial distress compared to market economies where there are usually more shareholders and renegotiation is usually more dicult/expensive. It is likely that more businesses are able to overcome temporary nancial setbacks by restructuring their debt, hopefully serving the crisis and continuing to grow. This is an advantage for bank oriented nancial systems. However, there are disadvantages too. Companies often know that banks are incentivised to restructure them, so they may take larger, even reckless risks.  Also, they may not be as disciplined with cost control. This kind of be behaviour haviour is less likely in a market oriented nancial system. One of the most important functions of any nancial market is information dissemination. Market oriented nancial systems, due to the strict reporting requirements of capital markets, disseminate information more readily. Banks, however, do not need to disclose such information. Therefore, the greater dissemination of information in market-oriented systems is an advantage. Banks have a less diverse set of people that decide on potential investments, markets provide more diversity of opinion. Therefore, some of the newer technologies/innovations that may not be funded by a bank are more likely to be funded by nancial markets. There is also the issue of stability. A study by the  bank for internati international onal settle settlements ments foun found d that whe when n recessi recessions ons have o occurred ccurred at the same time as nancial crises, the impact on GDP has been three times as severe for bank oriented nancial systems as it has for market oriented ones (Gambacorta, Leonardo, & Yang, 2014). These are key advantages for market oriented nancial markets.

114

 

Factors that facilitated development of both systems This section describes four possible (of potentially many more) factors that could have facilitated the development of both systems: 1.

Legal system

2. Special interest groups and politics 3.

Enterprise structure/Mar structure/Market ket need

4. Stage of development There has been much debate about what factors facilitated the development of these dierent nancial markets in the rst place. One theory focuses on the inuence of the type of legal system each country has and the protection that it oers to investors. A study of 49 countries found that countries with civil legal systems (which oer less protection to investors), have smaller capital markets than those with common law legal systems, which oer more investor protection (La Porta, 1997). However, this argument has its limitations. Firstly, dichotomy between countries that have civil law and common law did not exist in 1913. Common law countries  were not more nan nancially cially develo developed ped then. Thu Thus, s, legal syste systems ms may be a factor,  but not the the entire story. Rajan and Zingales (2003) argue that the inuence of special interest groups must be considered. There are incumbent rms in many countries that may  be incentivised incentivised to u use se their p political olitical in inuence uence to p prevent revent th thee developme development nt of nancial markets. These incumbent rms do not have nancing challenges. They can either nance growth from their retained earnings or through loans taken from the bank using a collateral. Open nancial markets would just allow more entrants to the market that could potentially compete with them. In the situation that access to nance is restricted, even new rms/start-ups must build alliances  with the incumbents in order tto o access  nance. nance. In tthis his way, the these se incumben incumbentt rms enjoy a form of ‘rent’. This would not be so in an open nancial market

(Rajan, 2003). 115

 

Pure structural arguments focus on the role of the legal system. Rajan and Zingales (2003) state that this view is not wrong, but that it’s incomplete. Rather, they highlight the role of special interest groups and politicians/political will. Horst Siebert (2005) suggests another possible factor that may have facilitated the development of market-oriented vs bank-oriented systems, which is the actual needs of the market. Germany has more small-medium sized businesses  which play a greater rrole ole in the economy. Ther Therefore, efore, bank nance is better ssuited uited to these SMEs as they need smaller amounts of credit. Whereas in America, there is more dominance of mid-sized/larger businesses that need larger sums which capital markets are able to provide (Siebert, 2005). The nal issue considered in this section is the stage of development of the country. A country typically becomes more market based as GDP per capita increases (Demirgüç-Kunt, A, Feyen, & Levine, 2011). Many emerging markets may still be in the ‘bank stage’ of development, and as some of these countries develop and nancial needs become more complex, they may evolve. Therefore, development stage may also explain dierences.

Implications for corporate governance This article started by comparing market oriented nancial systems to bank oriented systems in terms of features, then went on to explore the strengths and  weakness of both sys systems tems as w well ell as the possible hi historical storical re reasons asons why each type of system developed. This nal section will describe the implications that both systems have on corporate governance.

116

 

Are banks better suited to provide corporate governance and oversight? Some argue that they are, because they are less fragmented than the typical shareholders of a rm on the stock exchange. There is a view that shareholders in capital markets such as those that exist in the American market-oriented system are disaggregated. Therefore, they are unable to form eective coalitions capable of inuencing real change within the companies. This makes ‘American shareholders powerless to aect management decisions’ (Macey, 2008).  Also, due to the the fragme fragmentation, ntation, th there ere is act actually ually little incentive for any one particular shareholder to exercise control. This is known as the free rider problem. Exit is generally cheaper than intervention, especially since if the news of an intervention should spread, it could further decrease the price of the stock (Berle, 1932). Research by Shleifer (1986) shows how large shareholders like  banks can can reduce/eli reduce/eliminate minate thi thiss ‘free ride rider’ r’ problem a ass they are more ince incentivised ntivised to exercise control as their power is more concentrated (Shleifer, 1986). The American market-oriented system focuses power in the hands of management (Theodor, 1993), often disparagingly referred to as ‘Berle-Means’ corporations. This term describes the typical separation of risk-bearing and control, diuse shareholding and potential agency conicts between managers and shareholders (Chens, 2018). All these problems further highlight the  benets of of corporat corporatee governan governance ce activit activities ies coordi coordinated nated large largely ly by a singl singlee homogenous entity like a bank. The close relationships between banks and the clients that they nance in countries like Japan give an additional advantage in the form of reduced agency costs. This allows investors to monitor their investments more eciently than in the United States (Prowse, 1990). The above points demonstrate the upsides of having banks, as opposed to shareholders in markets, perform corporate governance functions.

117

 

But what about the downsides? So far, we have assumed that equity holders and banks (xed claimants) have the same interests. But this is not always the case. In fact, is has been argued that the clear conict of interests between xed claimants and equity holders is the primary reason why banks are not the ideal institutions to monitor company performance on behalf of shareholders.  A xed claimant claimant such a ass a bank iiss incentiv incentivised ised to en encourage courage com companies panies to take sub-optimal levels of risk. The aim of the bank is only to ensure that the money that it lent to the company is paid back, not necessarily to increase the value of the company’s shares. This aggregate reduction in the level of risk taking by companies results in a transfer of wealth from the shareholders to the banks. The very idea that bank-oriented systems are more likely to exercise corporate control does not seem to stand when we look at the data on takeovers. Banks seem to side with management over shareholders. For instance, Germany is a very bank oriented nancial system whilst the UK is a much more marketoriented economy, yet, the total number of takeovers during the boom period in the 1980s in Germany was less than half that of the UK. In fact, as of 2008, there had only been four recorded hostile takeovers in Germany since world war two (Macey, 2008).  Whether a nancial ssystem ystem is ba bank nk orient oriented ed or mark market et orient oriented ed seems tto o have signicant implications for corporate governance. Banks may have some advantages over capital markets in terms of corporate governance, but my opinion is that their risk averse nature no longer ts into our fast-paced world of innovation.

118

 

The internet has opened up a world of information and has also given a voice to even the smallest minority shareholders; take for example, the letter8 that Professor Scott Galloway published to Twitter last year on his blog. An excerpt of  which I have have quoted b below: elow: ‘Mr. Kordestani,  A part-time CEO who is relocatin relocating g to Africa? Enough alre already. ady.  My name is Scott Gallo Galloway way (@pro (@profgalloway). fgalloway). I a am m a Profes Professor sor of Ma Marketing rketing at NYU’s Stern School of Business, an entrepreneur, entrepreneur, and a U.S. citizen. As of 12/6 I am the direct and benecial owner of approximately 334,000 shares in Twitter. I reserve the right to establish a dialogue with like-minded shareholders regarding the nomination of class III directors and/or a resolution of “nocondence” concerning you and CEO Jack Dorsey for consideration at your annual shareholder meeting in May.’   And so, one letter on an online blog publishe published d by a minor minority ity shareho shareholder lder resulte resulted d in a media frenzy. The letter was shared multiple times on social media as the post went viral. It was partly as a result of this letter that sweeping changes were made at Twitter. On a similar note, activist shareholders also aect the rm’s performance positively according to data from France (Souha, 2020). 8 https://www.profgalloway.com/twtr-enough-already/

119

 

Conclusion This article began by describing and comparing bank oriented nancial systems  with the market or oriented iented na nancial ncial syste systems. ms. It then went on tto o evaluate their strengths and weaknesses.  After which, which, the histo historical rical fact factors ors that p potentially otentially ccontributed ontributed to the dev development elopment of each respective system were analysed. The conclusion directly linked these historical factors to the implications of each system for corporate governance.  Although the focus has b been een on th thee dierence between market a and nd bank ba based sed nancial systems, in many advanced countries, there is an overlap. Overall, the trend has been increasing inuence of the nancial sector on economic policy and the overall economy. economy. This is called nancial nancialisation isation (Mins (Minsky, ky, 1992).

120

 

References •

Berle, A. a. (1932). The Modern Corporation and Private Property. New York: Macmillan.

•

Chens, B. (2018). The Rise and Fall (?) of the Berle-Means Corporation. Seattle University Law Review.

•

Demirgüç-Kunt, A, E., Feyen, R., & Levine. (2011). The evolving importance of banks and securities markets”. World Bank, Policy Research Working Paper, no 5805.

•

Demirguc-Kunt, A. L. (1999). Bank-based and market-based nancial systems - cross-country comparisons. Policy Research Working Paper Series 2143, The World Bank.

•

Gambacorta; Leonardo, J.; & Yang, K. T. (2014). Financial structure and growth. BIS Quarterly Review.

•

La Porta, R. L. (1997). Legal Determinants of external nance. Journal of nance, 1131-1139.

•

Macey, J. R. (2008). The role of banks and other lenders in corporate governance; corporate governance promise kept, promises broken. Oxford: Princeton University Press.

•

Minsky, H. (1992). The Financial Instability Hypothesis. The Levy Economics Institute Working Paper Collection, Working paper 74, 1-10.

•

Prowse, S. (1990). Institutional Investment Patterns and Corporate Financial Behaviour in the United States and Japan. Journal of Financial Economics, 43-66.

•

Rajan, R. Z. (2003). The great reversals: the the politics of nancial development in the twentieth century. Journal of nancial economics, 5-50.

•

Shleifer, A. a. (1986). Large Shareholders and Corporate Control. Journal of Political Economy, pp. 461–488.

•

Siebert, H. (2005). “The Capital Market and Corporate Governance.” The German Economy: Beyond the Social Market, Oxford: Princeton University Press.

•

Souha, S. B. (2020). Shareholder activism, earnings management and Market performance consequences: French case. International Journal of Law and Management.

•

Theodor, B. R. (1993). Institutional Investors and Corporate Governance. De Gruyter.

•

 World Bank. (Accessed 2020). World Bank development indicators. Retrieved from http:// datatopics.worldbank.org/world-development-indicators/: http://datatopics.worldbank.org/worlddevelopment-indicators/

121

 

Chapter 10 It is not standard advice for developing countries to have a deposit insurance as well as a lender of last resort function usually performed  by the central central bank. Nigeria’s de deposit posit insurance organ organisation isation was formed in 1989. What is the role of these functions on the stability of the nancial system especially in light of the banking crisis of 2007?  As emerging markets markets liberalise, what risks does the McKinnon and Pill Model highlight? What is the role of moral hazard?

 The roleofoflast deposit lender resortinsurance/ in the stability of nancial systems Introduction The past few decades have seen a lot of market volatility. Governments have taken aggressive steps in crisis situations. For example, in Argentina in the 1980s, the government used 55% of GDP to ‘bail out’ its banking system (Sleet, 2000). Deposit insurance and the importance of the role of the lender of last resort as ‘safety nets’ for the nancial system reduce the likelihood of the breakdown of a nancial system. If breakdown does occur, these schemes limit the damage (Demirguc-Kunt, (Demirguc-Kun t, 2001). This article explores the role of deposit insurance and lender of last resort in detail using the McKinnon and Pill Model to evaluate the risk of over borrowing and moral hazard.

122

 

 The McKinnon and Pill Model The McKinnon and Pill Model explores the complex relationships between economic productivity, economic reforms, behaviour of bankers/households/ rms, and productivity. The model explores the relationship in a number of dierent scenarios. The focus of this paper will be on three of the economic scenarios that the McKinnon and Pill Model explores. These are: 1.

The nancially repressed economy

2. The economy with domestic liberalisation only  3.

The fully liberalised economy; international and domestic (McKinnon,, 1997). (McKinnon

Figure 1: The three economic scenarios in the McKinnon and Pill Model

123

 

Scenario 1: The nancially repressed economy (FRE) The initial scenario that McKinnon and Pill consider is the nancially repressed economy, where the government policy limits economic activity and, therefore, productivity. Banks in this scenario oer fewer, smaller loans as larger loans go to state owned entities and government.

Figure 2: Equilibrium iin n the financially repressed economy (McKinnon, 1997).  As shown in Figure 2 ab above, ove, despit despitee economic reforms, th thee economy rremains emains in equilibrium at level A due to the high capital costs of the type of projects that can move the metaphorical needle. This is because in a nancially repressed economy as described above, banks do not tend to fund large projects. However, because of the size of the nancing required, such projects require external nance which cannot usually be nanced by individuals. Consequently, the economy remains close to equilibrium at point A with little or no real change (McKinnon, 1997). Nevertheless, the story changes when there is liberalisation of the domestic markets as described in scenario two below.

124

 

Scenario 2: The Th e domestically liberalised economy (DLE)

Figure 3: First Best Solution in the domestically liberalised economy (McKinnon, 1997) The DLE scenario considers a case where there is real economic reform and unlike in scenario 1 considered earlier, nancial repression is absent. The local stock market (bank based) can therefore allocate capital to innovative large-scale projects which it was unable to do in scenario 1 due to nancial repression. However, it is important to note that this happens domestically, so the economy is not open to international capital ows. If it is assumed that payos for investments are known, then this model produces a very good outcome for all citizens. Some agents decide to invest in new technology and innovation, placing them at point A, whilst others remain at point B with older technology. This terms the latter group into savers, even as welfare improves for everyone. Unfortunately, this is not a typical real-world scenario. Usually, payos are not known. In a newly liberalised economy, there is a lot of uncertainty about the level of risks inherent in certain investments and what payo to expect.  When banks banks know tthat hat there is a gover government nment depo deposit sit insuran insurance ce for all depositors depositors’’ funds or that there is a bailout plan from a lender of last resort like the central

 bank, an element element of moral haza hazard rd is intro introduced. duced. Under tthese hese circum circumstances, stances, 125

 

 banks could lend exces excessively, sively, taki taking ng on unsust unsustainable ainable le levels vels of risk knowing tthat hat there is a government-backed fail-safe in place. This has further consequences for the economy because non-bank rms use bank behaviour as a signal that tells them how well the economy is doing. So when banks increase their levels of lending signicantly, it signals to rms that reforms are working, returns on investment are excellent and that they (the rms) should borrow even more money and take more risk. They believe these signals because the rms expect  banks to have superi superior or knowle knowledge dge about tthe he state o off the econ economy omy and rely on them as ‘expert investors’ to indirectly guide their own behaviour. This vicious cycle stemming from the moral hazard faced by the banking sector can snowball into a full-blown crisis. However, because the economy is eectively closed, the contagion is contained  within a single dome domestic stic econom economy. y. This scena scenario rio and the potential consequence consequencess contrast sharply with the next and nal scenario considered in this paper under the McKinnon and Pill Model (McKinnon, 1997).

Scenario 3: The Internationally liberalised economy (ILE)

Figure 4 (Mc Kinnon, 1999)

In this case, the economy is open to international investors, which opens up challenges with two variables that were not emphasised in scenario 2. a) The role of interest rates

 b) The role of of exchange rates.

126

 

The ILE scenario considers a fully liberalised economy open to both local and foreign investors. Interest rates in scenario 2 (DLE) are driven up by demand and a closed, domestic economy reaches a point where many rms cannot borrow. However, in the ILE scenario, the interest rates are not driven up to the same extent as the option/alternative of international capital exists.  Also in the DLE scen scenario, ario, money iiss borrowe borrowed d in domest domestic ic currency, w whereas hereas in the ILE scenario, borrowing also occurs in foreign currency. This comes with additional risks, the level of which depends on the type of exchange rate regimen the country has in place. Stanley Fischer, former Deputy Managing Director of the IMF, explained it like this: ‘There is a trade-o between the greater short run volatility of the real exchange rate in a exible rate regimen versus the greater probability of a clearly dened external crisis or nancial crisis when the exchange rate is pegged. The virulence of the recent crisis is likely to shift the balance towards the choice of more exible exchange rate systems, including crawling pegs with wide bands.’  (Fischer, 1999) Figure 4 shows the realistic level of lending, considering the economic situation/ level of productivity payo as αFB (FB stands for rst best outcome). In this unbiased case, rms and households will borrow from international capital markets at point XFB and consume at CFB. But when banks are aected by moral hazard, knowing that they will be bailed out and knowing that there is insurance for all deposits, they become overly optimistic. They discount the risk of collective failure and start borrowing as if the expected productivity payo level is at XOB. This leads to overconsumption and overinvestment, represented by W and V respectively on the chart (Mc Kinnon, 1999). This initial section has explored the McKinnon and Pill Model in detail with respect to the risks of each stage of economic liberalisation with specic emphasis on the role of moral hazard. This analysis, howev however, er, has so far generally only highlighted the disadvantages of deposit insurance and lender of last resort facilities and the ways these safety nets can create moral hazard, encouraging

over borrowing by nancial systems.

127

 

The next section will examine the role of these important nancial mechanisms in-depth; why they are so important and the best practices that help policy makers strike a balance between the provision of an essential safety net whilst at the same time limiting the risks posed by moral hazard and excessive risk taking.

Deposit Insurance, lender of the last resort and the stability of the nancial system This section aims to evaluate the role of deposit insurance and lender of last resort on the stability of the nancial system with focus on the role both played during the banking crisis of 2007. Currently in most countries, there are two main entities that have been established to help prevent bank runs, provide liquidity when bank runs occur, and provide assurance to the public about the safety of their deposits. They are: a. A a. A deposit insurance insurance or organisation ganisation that provi provides des partia partiall or total insurance for retail deposits. In some cases, it covers the total deposit; others cover up to a certain amount.  b. A  b.  A lender of the last resort, usually the central bank that provides loans to banks that have liquidity challenges. The central bank typically intervenes when there are minor challenges whilst the deposit insurance organisation intervenes when challenges are more serious i.e. in a full-blown crisis (Laeven, 2002). There is also the role of international lenders of the last resort such as the IMF (Nicholas, 1998).

128

 

Deposit insurance and stability of the nancial system Deposit insurance is a pillar of trust working alongside other mechanisms/ organisations such as the lender of last resort, but also, liquidity ratios, reserve ratios, and other elements of regulatory oversight. This role has not always been performed by government. By 1910, banks had developed mutual systems of interbank loans and agreements to help each other when they fall into nancial diculty. There were also various state deposit insurance schemes, many of  which failed failed (Calomir (Calomiris, is, 1990). However, the social cost of bank runs was extreme and had far reaching consequences beyond the nancial system. After the bank runs of the 1930s that preceded the great depression, the Federal Deposit Insurance Commission was formed to stabilise the banking system (Hogan, 2016). Since the 1980s, the number of countries with explicit deposit insurance schemes almost tripled, with most OECD countries and an increasing number of developing economies adopting some form of explicit depositor protection. In 1994, deposit insurance became the standard for the newly created single banking market of the European Union. Furthermore, establishing an explicit deposit insurance scheme also became part of the generally accepted best practice advice given to developing economies (Demirguc-Kunt, 2001).

During the Great Financial Crisis, government support of the banking system included the extension of retail deposit insurance scheme. Deposit insurance was increased from $100,000 to $250,000 in the United States. In other countries, such as Germany, all retail deposits were insured during the crisis. These measures formed an important part of the package that helped avoid a meltdown of the nancial system. The economic downturn during the great nancial crisis  was deep, deep, but the dep deposit osit insura insurance nce helped prevent a collapse iin n consumpti consumption on  which would would have deep deepened ened the recession. IItt is in th this is sense tthat hat deposi depositt insurance revealed its value during the crisis (Carstens, 2018). It has, however, been argued that deposit insurance creates two opposing forces. On one hand, it is agreed that it removes the incentive for depositors to run on

the bank. But on the other hand, it also allows for more recklessness by banks as depositors do not scrutinise them as closely. This is the moral hazard which 129

 

provides the evidence for arguments against deposit insurance. This notion is supported by evidence that strongly suggests that systems with higher levels of government-backed insurance have higher numbers of bank failures (Hogan, 2016).

Lender of last resort and the stability of nancial markets The lender of last resort function, as outlined in the section above, is usually undertaken by the central bank. Two problems with the response undertaken mostly by the Federal Reserve with assistance from the Treasury have been highlighted in the aftermath of the global nancial crisis. First, the rescue has the potential to create strong adverse incentives. (This problem has been a recurrent theme throughout this article.)  A few American American nanc nancial ial instit institutions utions wer weree forcibly cclosed losed or mer merged, ged, but most suered no real repercussions. Early nancial losses (for example, stock prices)  were large, large, but were recouped ov over er time fo forr the most part. Hard Hardly ly any top executives or trades was prosecuted for fraud. And most of those that lost their  jobs received received large ccompensati ompensation on anyway.  A second criticism criticism wa wass that the bailouts we were re made in secret a and nd even af after ter a freedom of information request was made, the data released was dicult to analyse. Even though both criticisms are from an American perspective, similar scenarios unfolded across the world (Levy Institute, 2013). George Soros argues that any lender of the last resort activity will result in moral hazard to some degree, but also argues that a world without a lender of the last resort, would be too unstable; this is due to the inherent instability of nancial markets in general (Soros, 2001). This idea of stability as an over-riding goal is important. During normal times, insurance schemes should not get in the way of a wholesale run on an individual institution, as this is part of healthy market discipline. But as the Great Financial

Crisis worsened, the drying-up of wholesale funding markets put the entire 130

 

system at risk, threatening overall economic stability. It therefore became important for many central banks to step in as lenders of last resort. At the same time, governments extended guarantees to wholesale funding, and in the United States, even to money market mutual funds (Carstens, 2018).

Deposit insurance post 2007  The aftermath of the nancial crisis ushered in the era of the FinTechs; many of which have started to provide bank-like intermediation, usually without the provision for deposit insurance. Notwithstanding, in some countries, FinTech rms receive banking licenses. Again, in this scenario, there is no insurance oered for deposits. How digital wallets and other e-money should be insured –or  whether it should be insured in the rst p place lace – is sstill till subject to debate. W What hat cannot be disputed is that retail customers must be well informed of the extent to  which they they are – or are not – protected (Carstens (Carstens,, 2018).

131

 

Conclusion The theme that runs through this article from the beginning to the end is that of moral hazard and the way incentives change behaviour. This is highlighted in the analysis of the McKinnon-Pill Model at the begin of this article which then moved on to evaluate the roles of deposit insurance and lender of last resort on the stability of the nancial system in light of the banking crisis of 2007. Several parallels were drawn between deposit insurance schemes and lender of last resort. Both sustain trust in the nancial system by reducing the risk of selffullling runs. But, there are important dierences. The role of the lender of last resort – at least in principle – is to address liquidity strains at viable institutions. In the midst of a crisis, it can be a complicated call to make and sometimes ultimately ends up at the central bank’s discretion. However, deposit insurance protects depositors of failing banks, and it is the rules-based nature of deposit insurance schemes that contains uncertainty. uncertainty. As such, last-resort lending and deposit insurance complement each other (Carstens, 2018).

132

 

CONCLUSION  As I said in the intro introduction, duction, the world seem seemss to be foc focusing using more on the half a billion people  who are doing doing quite w well, ell, rather than payin paying g increase increased d attenti attention on to the needs, want wantss and desires of the four billion people who make up most of the world’s population. In this book, I have tried to focus on these four billion people. Not only did I highlight their problems, I also oered possible solutions that could help these economies move from poverty, a bit closer to prosperity. In the rst chapter, I explained in detail the role of macroeconomics, government spending, taxation and monetary policy, and how they work in emerging markets compared to advanced countries. Moving further, I deliberated on microeconomics and how decisions are made on an individual and rm level. I also gave instances of how government policies can aect the level of prosperity in dierent countries.  Along with that, that, I highli highlighted ghted the role of the IMF for countries tthat hat run in into to crisis. To conclude this book, I addressed the concept of banking and capital markets, specifying the roles as well as the dierences that are seen in bank-oriented economies and market-oriented economies. I believe that in this short book, I have been able to explain in a simple way the dierent economic principles that aect our daily lives. I have also shed light on things that we as citizens should be aware of.  As citizens, citizens, I believe tthat hat this b book ook will eenable nable us to ask bett better er questio questions ns and to p propose ropose bet better ter solutions to the problems we face on a daily basis In addition, this book will provide us with a  well-informed  well-informe d perspect perspective ive on wh what at is happ happening ening in tthe he economy.  As a nal point, point, take note that economics isn’t somet something hing you memo memorise; rise; it is something yo you u conceptualise. conceptuali se. Your job, your business, your possessions, and even your life depends on it! I hope this book has helped you to understand better. Thank you for reading!

133

 

Economics, Banking and Finance in Emerging Markets: A collection of my essays focusing on unique challenges in emerging economies