The Great Divide and Beyond Financial Architecture in Transition

1
The Great Divide and Beyond -Financial
Architecture in Transition

• Erik Berglof, SITE, Stockholm School of Economics
  and CEPR
• and
• Patrick Bolton, Princeton University, NBER and
  CEPR

2
The Great Divide(s)

   
130
OECD
120
110
CE-North Baltics
100
CE-South
90
80
CIS-Peace
70
RUSSIA
UKRAINE
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
3
Financial Transition - Two Observations

• Common first reform steps, but then the Great
  Divide in finance and growth opens up
• Different policies and trajectories after
  takeoff, but converging architecture
• Dominated by increasingly foreign-owned banks
  which lend primarily to governments weak and
  unsustainable(?) local equity markets

4
Finance and Growth

• Question 1 Does finance lead or follow?
• or are both driven by some third variable(s)?
• Question 2 What determines when takeoff
  happens and what is the role of finance?
• Question 3 Is it possible to jump stages of
  financial development?
• gt financial transition as an experiment?

5
Lessons from transition experience

• Finance does not explain growth
• Finance can undermine growth
• Fiscal and monetary responsibility and
  enforcement capacity of governments jointly
  determine finance and growth
• Difficult to jump stages of financial development
  (bank-based financial system)

6
Question 1

• Does finance lead or follow? or are both driven
  by some third variable(s)?

7
The literatureLaw, finance and politics

• Law gt Finance (LaPorta et al. 1997, 1998)
• Legal origin gt investor protection gt finance
  (gt growth)
• Finance gt Law (Coffee, 2001)
• Finance gt market practices gt laws (gtgrowth)
• Politics and Finance (Rajan-Zingales, 2000a and
  b)
• Politics gt law and finance
• Endowment view (Acemoglu et al. 2000)
• Initial conditions gt institutions gt law and
  finance

8
Financial transition Phase 1 Common Genesis

• Common origin (monobank)
• First reforms similar
• Separate central and commercial banking
• Split up commercial banking wing
• Attempts to deal with the inherited portfolios
• First test came with price liberalization
• Credit crunch and banking crises
• Initial inertia from enterprises

9
Financial transitionPhase 2 Parting Company

• Some governments resisted bailouts, others did
  not
• Successful countries (CEEC Baltic countries)
  virtuous spiral of microeconomic restructuring
  and macroeconomic consolidation
• Less successful countries (former SU SEE)
• soft budget constraints, a vicious cycle of
  financial instability, and lack of restructuring
• gt the Great Divide had opened up

10
Countries on the wrong sideStuck in a vicious
circle

• Reliable deposit markets not in place
• Recurrent financial crises
• Soft institutional constraints gt arrears
• Macro instability
• Little financial development in sight

11
The Great Divide in finance
12
The Great Divide in spreads
13
The Great Divide in institutions
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Great Divide is deep, and wide

• lack of finance and growth
• lack of fiscal and monetary discipline
• but also a much broader range of institutional
  weaknesses (enforcement of rule of law)

15
Different Trajectories
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Does finance lead or follow?

• Growth and financial development
• Estonia, Poland, and Slovenia
• Czech Republic and Slovakia?
• Rapid growth and then decline in financial
  development, and economic stagnation
• Bulgaria and Russia
• Neither financial development, nor growth
• Ukraine

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...finance neither leads nor follows growth

• Little evidence of direct link between finance
  and growth
• hard budget constraints help growth
• but firms rely almost exclusively on internal
  finance
• all external finance through foreign direct
  investment
• gt Finance and growth are jointly determined
  by some underlying variable(s)

18
Explaining the Great Divide

• Why some took off but not others?
• Macro-stabilisation corporate restructuring
• What explains why some stabilised and
  restructured?
• Government commitment vs. firm pressures
• Soviet heritage (central planning industry
  structure)
• Previous experience of democracy and rule of law
• Proximity to EU (outside anchor trade links)
• Income distribution (before and after)

19
Inequality (before and after)
 
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Was Lipton and Sachs Right?

• Macro and micro aspects of transition cannot be
  separated
• Basic complementarity between fiscal (and
  monetary) responsibility and microeconomic
  enforcement
• Political economy critical income distribution
  will affect the support for fiscal (and monetary)
  responsibility and enforcement of property rights

21
Question 2

• What determines when takeoff happens and what
  is the role of finance?

22
Rule of Law and Growth

• Property rights to poor (De Soto, 2000)
• International capital to countries with rule of
  law (McKinsey Co, 2001)
• Rule of law and growth (Barro, 1997)
• Governance and income (Kauffmann et al., 1997)
• Governance and investments in financial assets
  (Demirgüc-Kunt and Maksimovic, 1998)
• gt Why if rule of law is so profitable,
• why is it so difficult to establish?

23
The literatureInstability, inequality, growth

• Inequality gt lower economic growth (Alesina and
  Rodrik, 1994)
• Expropriation conflict inequality (Perotti,
  1996)
• Greater income inequality gt weaker property
  protection political instability reduces
  investment and growth (Benabou, 1997)
• Equal distribution of wealth and human capital gt
  broad participation in commercial activities
  (Engerman and Sokoloff, 1994)

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An embryonic model

• c1 c2
• _____________________________________
• 0 1 2

Investment decision R inv. r
Vote on taxation and enforcement median voter
decides
Returns realised
Initial endowment
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Income distribution critical

• Poor with no capital care primarily about amount
  of redistribution
• Rich with excess capital not interested in
  enforcement - can either enforce law privately or
  lose stealing opportunities
• Middle class with capital for investment want
  law enforcement (provided everything is not taxed
  away)

26
Some early observations

• Multiple equilibria development trap with no
  rule of law and no investment
• Middle class may not support rule of law,
  because profits are taxed away
• Private credit market can increase the support
  for rule of law, but development trap still
  possible
• and borrowing for consumption can also crowd
  investment and rule of law
• Low legitimacy (high cost of taxation or cost
  reduction) gt high marginal cost of rule of law

27
Why poor legitimacy?

• A history of irresponsible government
• Polarized and ethnically divided populations
• High poverty rates make virtually impossible cuts
  in essential food and health support programs

28
Some more observations

• Suffrage limited to property owners gt easier to
  establish rule of law
• Government debt is small gt easier to establish
  rule of law
• Projects are large and few (natural resources) gt
  more difficult to establish rule of law
• Countries that discover resources late more
  likely to take off

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Question 3

• Is it possible to jump stages of financial
  development?

30
The LiteratureBanks vs. Markets

• Banks
• Poor infrastructure (Rajan Zingales, 1998)
• Companies small and risky no thick market
  externalities (Pagano, 1993)
• Markets
• Stock markets gt growth (Levine and Zervos, 1998)
• Empirical evidence inconclusive
• LDCs financial intermediation gt growth
  (Tadasse, 2000)
• When control for legal protection, distinction
  bank vs. market finance not significant (Levine,
  2000)

31
Countries on the right side Different policies

• Bad loan restructuring (Hungary vs. Poland)
• Hospital banks (Poland vs. Czech Republic)
• Bank privatization (Poland vs. Czech Republic)
• Entry policy (Russia vs. Czech Republic)
• Foreign entry (Hungary vs. Czech Republic)
• Firm privatization (Poland vs. Czech Republic)
• Stock markets (Hungary vs. Czech Republic)

32
Different Trajectories
33
but systemic convergence

• Strong domination for bank intermediation
• so far government rather than firms
• Investment financed through internal funds
• Most external funds from FDI
• Concentrated ownership structures
• Markets play no significant role in corporate
  finance, perhaps not sustainable

34
Why convergence?

• EU as an outside anchor (harmonisation)
• Global financial development and integration
• Natural step in financial development
• Weak institutions gt informed finance
• Double-sided informational asymmetry and moral
  hazard gt banks averse to risk (arms-length
  finance, government bonds)

35
Financial architecturein transition

• What will be the role of the foreign-controlled
  banks in the transition countries in the global
  strategies of the parent bank?
• Are local exchanges sustainable?
• What are the niches open to these systems?
• How will domestic firms secure funding?

36
Financial transition When will it end?

• Not ended yet
• The moving target global finance in transition
• Consolidation of international banking system and
  increasing cross-border activity
• Increasingly virtual nature of markets
• Accelerating integration in the Euro area
• Changing pension systems
• Increasing mobility of international savings and
  breakup of domestic financing patterns

37
Main conclusions IFinancial Development and
Growth

• Financial development does not explain why some
  transition countries grew and others did not
• Financial development without proper
  institutional framework can undermine economic
  growth
• Fiscal and monetary responsibility and
  enforcement capacity of governments determine
  financial development and economic growth
• The commitment ability of government critical,
  related to income distribution

38
Main conclusions IIExplaining Convergence

• Difficult to jump stages of financial development
  (bank-based financial system)
• Global financial development and integration may
  limit choices
• Outside anchor played a role EU Accession lead
  to convergence towards European system
• Choice of social welfare system will play an
  important role in determining future developments