Of finance and development: Neglected and unsettled questions

0305-7.50x/92 $5.00 + 0.00

World Drvrlopmenr, Vol. 20, No. 1. pp. 133-142. 1992 Printed in Great Britain.

Of Finance

Pergamon

and Development: Neglected Unsettled Questions

Press plc

and

ANANDCHANDAVARKAR

Washington,

DC

Summary.

- The article analyzes some of the neglected and still unsettled issues on the interrelationship or finance and development and in the subdiscipline ol’ finance: notaId!, the implications of the dichotomy of formal and informal finance; the modalities and aequencmg 01 financial reform; the challenge of maintaining competition in oiigopoliatic system\; the hope for market-related monetary policy instruments: the case lor autonomy 01 central banks and divestiture of their devclopmcntal role and revamping of their prudcnti;tl l’unctions. It argues for issues-oriented research agenda. a sharply focused, country-specific,

Whether other things being given. as climate, soil. etc. the wealth be not proportioned to the industry: and this to the circulation OC credit (Bishop Berkeley, Query 21, T/w Q~visr. 1735).

Fry’s competent and useful survey. in addition to presenting his own extensive research. analyzes the principal theoretical models of financial development (Tobin, McKinnon. Shaw. Kapur, Mathieson, Van Wijnbergen, Taylor. and Galbis); reviews the econometric evidence on the effects of financial conditions in the developing countries; examines the microeconomic and institutional aspects of financial development and the monetary and financial policies pursued in Hong Kong, South Korea, Singapore. and Taiwan. There is. however. a distinct Asian bias in its empirical material, which is further accentuated by a somewhat exclusive emphasis on these four high-growth “superexporter” countries, and inadequately balanced by the sketchy section on interest rate policies in the Philippines and Thailand. This slant could have been usefully redressed by representative evidence from lowor medium-growth Asian countries as well as Latin America and Africa. Fry’s book. which has a small section on indigenous financial institutions and the curb market. is well supplemented by Jagannathan’s elegant and insightful analysis of informal markets in developing countries. based on the state of the art in law, anthropology, institutional and development economics, as well on his own long field experience as an official in the Indian Administrative Service. Given the analytical approach of this study, the evidence presented is of an illustrative character. Although primarily concerned with the economic rationale of all informal markets (urban, rural, commodity, labor and credit), informal contracts. property rights and social assets, it also

CIKCULATION. This word serves as an account 01 everything. I have not yet been able to discover it? meaning. What poasihte advantage is there which the nation can reap by the transference ol checks. notes and I~dicr bonds But what production we owe to C’l1tr~~,~~4/c~~ though this term had never been explained hy those who insist on the advantages that result from :I circulation, there seems. however. to be some benefit (David flume “Of Public <‘redit.” Po/i/ic~n/ IXCOIIITCS. 1752 )

1. PROLOGUE The questions on “circulation” (read finance) which engaged two leading philosophers in the 18th century still seem unresolved despite the immense proliferation of the literature since the path-breaking contributions of McKinnon and Shaw. We seem still unclear how to assess the true significance of finance. Is it a passive follower of the real sector. or a causally significant sector in its own right‘? What are the possible interrelationships between finance and development’? Is financial liberalization an unambiguous policy recipe? The publication of two very representative books in their respective genres of informal and formal finance in developing countries by Jagannathan (1987) and Fry (IYXS) offers a11appropriate occasion for some stock taking on these and related themes. 133

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addresses issues such as rural-urban migration, corruption systems, and policy interventions in a rent-seeking society. This approach illuminates the multiple-interest linkages between financial and nonfinancial markets - a salutary reminder that informal finance is an integral part of a complex socioeconomic milieu which is the concern of both Durkheim’s Homo Sociologictrs and Smith’s Harm Economicus. This essay seeks answers to several neglected and unresolved issues in the literature. somewhat in the spirit of that admirably unique publication. 7%~ Encyclopedia of’ Ignorwm (Duncan and Weston-Smith. 1977) which, regrettably, omits economics in its quest for &*What we do not know. on matters which lie on the edge of knowledge” in the biological and physical sciences. It is hoped that such an “inverted” state-ofthe-art survey might contribute to the researcher’s agenda as well as to the policy maker’s handbook.

2. FINANCE:

STILL A FOLLOWER?

The literature leaves one overwhehning impression: finance still remains very much the poor relation of mainstream development economics. A magisterial history of the idea of economic development is bare of any references to the role of finance in development, a reflection of the state of the art rather than of any bias on the part of a studiously eclectic economist (Arndt, lYX7). The theme of the litany “By and large. it seems to be the case that where enterprise leads finance follows” (Robinson. IY52. p. X6) is faithfully echoed in the literature. Thus. none of the pioneers of development including three Nobel Laureates economics, (Bauer, Colin Clark, Hirschman. Lewis, Myrdal, Prebisch. Rosenstein-Rodan. Rostow, Singer, and Tinbergen), even lists finance as a factor in development (Meir and Seers. 19X4). Successive surveys of the economics of development. down to the latest (Stern, IYXY). seem to focus on all aspects. except the financial. Neither Stern’s inventory of “the grand issues of the subject.” nor, even more significantly, his list of omissions and the suggested research agenda, makes even a11 oblique reference to financial factors. The nearest that this survey comes to finance is a passing reference to informal credit markets in a random sample survey of 240 villages in South India! Fry reviews monetary and financial policies in economic development (lYX8. part IV) and the policies for financial development (chapter 17). but ignores the linkages between finance and development. The studied neglect of finance

is only matched by the bland eclecticism that “development involves finance as well as goods” (Gurley and Shaw, 1955, p. 515). The tantalizing conclusion of a recent study that “financial factors are important only when financial instability becomes a dominant force in the economy” (Dornbusch and Reynoso. 1YXY. p. 204) relies heavily on high-inflation Latin American experience and does not throw light on the role of finance under steady-state conditions. The more suggestive finding “that the empirical support for the growth effects of a liberalized financial system is episodic” (Dornbusch and Reynoso. IYXY, p. 206) merits systematic testing on a countrywide basis over sufficiently long periods. The state of the art is too well reflected in the candid admission of one of its leading protagonists: “Although a higher rate of financial growth is positively correlated with successful real growth, Patrick’s (1966) problem remains unresolved: What is the cause and what is the effect? Is finance a leading sector in economic development. or does it simply follow growth in real output which is generated elsewhere” (McKinnon, IYXY. p. 390). The analytic neglect of financial factors in development is also faithfully mirrored on the empirical side. Thus. financial ratios do not figure in a pioneering list of “great ratios in economics” (savings to income; labor’s share of output: the capital-output ratio: the capital-labor ratio; the transactions velocity of money), which constitute a system of equations that might serve to explain trend growth for an economy (Klein, 1962). The latest listing of ‘the Great and almost Great Magnitudes in Economics” (Simon. lYY0) adds the following: the real riskless rate of interest in various eras; the rate of return on common stocks: the price-earnings ratio for common stocks: and the income velocity of money, but still leaves out the significant ratios of monetization and financial intermediation. Even empirical studies (e.g.. Goldsmith. lY6Y). have not attempted anything akin to a comprehensive Divisia-type of index to capture the full extent of financial intermediation. Altogether. the literature points to yet one more addition. viz. the “great divide” between finance and development. to Streeten’s suggestive list of development dichotomies (1984). The two dwell in an uneasy intellectual rrptrrthrid. perhaps equal, but still very much separate. In contrast to the neglect of finance in mainstream development economics. international financial institutions take the positive stand that “efficient financial systems help to grow, partly by mobilizing additional financial resources and partly by attracting those resources to the best

OF FINANCE

AND

IYXY. p. 40). 771~ World devotes an entire chapter (3) to “illustrate the cetztrctl role of finance in development by reviewing the evolution of finnncial systems since preindustrial times” (World Bank. IYXY. p. 40. emphasis added). While it may be excessive to assign centrality to finance in the development process, the World Bank’s substantial ongoing interest in financial sector studies and financial sector loans is adequate assurance that the lapses of theory are no bar to effective practice and that finance does matter for development. But finance. too. has several unresolved issues which merit attention. uses” (World

Bank.

Da~vloprt~rr~t Rqort

3. THE

DICHOTOMY INFORMAL

OF FORMAL FINANCE

AND

There is now an extensive body of literature on informal finance and its significance is. paradoxically. now better recognized by intergovernmental institutions (World Bank, iY8Y, pp. 112-131; Asian Development Bank. IYYO. pp. 187-21 I) than by domestic authorities. Nevertheless. the discussion tends to be muddled in some respects and remiss in others. For instance, economists who consistently emphasize the fungibility of finance seem to regard informal finance as ;I virtual enclave, overlooking that the “unorganized sector is at best a loose way to describe a wide range of activities by small firms. households. and individuals. which are to varying degrees integrated with organized sector markets” (Jagannathan. lYX7. p. 3). There are in fact close borrowing and lending links. not always explicit or visible. between formal and informal finance notably through concurrent participation of different economic entities. Likewise, much of the discussion on informal finance blurs the critical distinction between its two constituents. the “autonomous” and “reactive” sectors. which raise wholly different policy issues. The core of informal finance is the spontaneous sector comprising mutual and proprietary units like ROSCAS (rotating savings and credit associations). indigenous bankers. pawnbrokers. which historically predates formal finance. The ROSCAS are a textbook example of “clubs” which. surprisingly. have been 50 completely bypassed by the economic theory of clubs (Buchanan. 1965: Sandier and Tschirhart. 1980). The other constituent of informal finance is “reactive.” since it develops primarily as ;I reaction to deficiencies in and controls over formal finance and typically assumes the form of urban curb marketx. private finance companies. and such other fringe entities. In contrast to the

DEVELOPMEN’I’

13s

autonomous sector whose size is unrelated to the degree of control over formal finance. the reactive sector expands and contracts contracyclially to repression and liberalization of formal finance and serves as a conduit for financial disintermediation, as well substantiated in the case of postwar South Korea (Cole and Park. lY83). Because of the linkages between formal and informal finance, monetary policy. as shown by South Korean and Indian experience. also affects informal finance, albeit with varying time the overall cost and Ll@. and consequently availability of credit. with the exception that informal finance is not amenable to selective credit controls (Acharya and Srinivasa. 1083, 1984). This effect well exemplifies Goodhart’s Law. so often noticed in developed countries. that controls over monetary aggregates and banking institution5 tend to breed substitutes (Goodhart, lY84, p. Y6). But even with the utmost feasible liberalization, a hard core of informal finance will always remain at one end of the financial continuum which. however, has also some inherent limitations. These limitations stem most importantly from its small average size and operating characteristics which preclude efficient financial intermediation beyond a recognizably low-scale threshold. It is therefore primarily ;I vehicle of small-scale savings and small-scale credit. which also suggests that ‘.the organized sector is more efficient as an intermediator than is the unorganized sector if wc believe that the market evolves toward the more efficient system” (Cho. IYYO. p. 4X0). What then are the elements of ;I coherent policy toward informal finance, which is currently a muddled amalgam of benign neglect and outright prejudice? Its advocates among X;Idemics and international agencies do not recognize the constraints on informal finance imposed by official policies such as the failure of the Reserve Bank of India since its inception (lY35) to rediscount bills of exchange from the informal sector and to generally develop a positive attitude in place of legalistic formalism toward informal finance. A positive policy would. among others. require a drastic reorientation of central bank attitudes, creation of special cells. as in the Bank of Thailand, to study and monitor informal finance, the strengthening of links between informal and formal finance. creative adaptation of informal financial technology based on group lending and peer review by banks, and the transformation of selected groups of ROSCAS into small-scale units in the formal sector. Oddly. the discourse has not posed the question: Why retain anti-usury laws aimed principally at informal finance when it is recognized that it has

WOKI_D

136 flourished to

precisely

circumvent

because

of its proven

DEVELOPMEN’I

ability

them’?

growth

and the

relative

to

IY73,

pp.

financial 4. FINANCIAL REFORM AND LIBERALIZATION: AGENDA AND ISSUES

formal

reform

finance.

is

the

overarching

issue

of

has been overly

but its discussion

But

for

ings.

implications.

aspect

tunity

of eliminating financial repression and restructuring of institutions with substantial nonperforming assets. Second. there is the positive element of reform in the regulatory and institutional framework. and. finally. the postlihcr~ilization agenda of how to maintain and monitor ;I viable competitive financial system und cope with the

could

otherwise

IYXX,

p. -1%).

problems and

generated

liberalization

over”

exercise

public

policy.

There scope. cial

issues. the

but

an emerging design

and

first-best

“Latin

consensus

until

not

the

stable

and prudential American

although will

internal

await

domestic

Bank.

p.

development market policy ing

The

appropriately

inflation domestic

the

savings”

generally

The

latter

1YXY:

capital

in

trade.

financial

own

problems,

intellectual

pro-

degree

of

deriv-

indicators

Villanueva

and

conceals significant

important.

financial term.

It “means

effect

credit

of usury

controls

and distort

to be

innovation

of

securities.

the securitization

;I case of “supply” for

issue.

systems

laws.

branches

of

distortions

ters,

savings

the

whose

the

excess

into

of

doubt

reflects

well

as intrabank

rate of interest

typically.

of

commercial

rural

credit

working

procedures for

bias of financial which. credit.

deposits.

the

on may

as manibank

net deposit

cen-

arc: 111cxccss of local credit,

urban

local

and what no light

urban

mostly

deposits

and the largely in

the urban

the rate

liberalization

countries.

dichotomy

into

throws

hand.

in

c’tc. 1s this

failure.

literature

in developing

compar-

interest

of credit.

or “demand”

it? The

it has

financial

instruments

such as variable

On the other

in

conseclu-

countries

new

countries

accounts

of the

instance.

of market-induced

developed

fested

and price

beneficial For

in the developing

a situation

the flow

of its expected

led to ;I splurge

rural

1YH-l. p. 3). More

“indiscriminate

some

siphon

bank

the nature

have not materialized.

have even accentuated

repres-

needs

to conjecture

liberalization.

able to the creation

a second-bat system

aces not

hard

of

First,

the

prices. including interest rates and exchange rates. which reduce the real rate of of

It is not pitfalls

(World with

diminishing

(McKinnon.

it connotes

it\

leading

unof

establishment

market-related

to reduce

system

move-

nonbank

system.

disagregated.

interact

monetary

and external

adjustments

an established

requirements.

its

rcquire-

effective

stability”

however,

the repressive

brings

by even

The

reserve

genitor:

this

Most

too

objectives?

to be

IYYO).

although

reserve

bank.

capital

in the financial

from

nuances.

in which

and

adequate

be a phased

consensus.

policy

t layekian

a central

01

of finan-

Concomitantly.

Khatkhate.

Mirakhor,

sion.

an

intervention and

and

reform

and structural and the legal

guidance

(Cho

;I starkly

instrument

is in place.

be complementary.

12X).

of

might

official

is

the

requirc-

and can optio-

to bank

of

(Fry.

to invoke

an

policy.

developmental

alternative

that

assets”

valid

essentially

Liberalization

an oppor-

interest

costs for reserve

bereft

suggests the liberalization

macroeconomic

1989,

industry.

even

tax on finanincur

on those

ments

that

an

in the end internal

liberalization

are

ceil-

portfolio

requirements

of forgone

is It really

ratt‘

and

they

Reform

appear

and

experience

should of

serve

interest

macroeconomic

framew*ork

desirability of simultaneous exchange and trade controls ments.

But

clim-

are the really critical does

relatively

because

and monetary

hypothetical

blanket

bank reserve

form

of

substance

in an increasingly

system

policy

is

nally

while

be earned

which

the

controls.

of opportunity

ments

elements in

a “discriminatory

in the

prudential

in flexible

and sequencing

liberalization

regulatory

essay

liberalization

financial

Full

climate

;I continuing

cost

criterion

the

can be ;I misleading

a “once

liberalization. not

Thus,

do not constitute

recognized

modality.

globalized

negative

arc emphatically

is now

reform

by

the

all

repression

are repressive.

cial intermediation

first.

(Shaw.

repressive

credit

policy

is.

svstem

magnitudes” not

are

policy.

selective

targets

of the financial

and consequently.

aggregative considering that is involves distinct constituents, each with different There

three

3-4).

of financial

recipe Financial

size

repression

and intent, nation

real

nonfinancial

intcrbranch

centera. The of

with

urban

market

credit bias

no

forces

as

such 21s the imputed transfers

of funds.

OF

FINANCE

AND

which, incidentally, has not inspired any attempts to apply the theory of transfer pricing to banks. But is it feasible to devise wholly marketoriented procedures to remedy financial urban bias given the known ineffectiveness of dirigiste prescriptions of targets for credit-deposit ratios of rural branches? One alternative might be to adapt a version of the US Federal Community Reinvestment Act, in terms of which the Federal Deposit Insurance Corporation requires a bank to pay due regard to the credit requirements of the local community in which it operates. The more difficult but equally neglected problem is how to maintain the competitiveness of oligopolistic financial systems in developing countries, with a few large banks, some or most of which may also be government owned and managed. There are no easy answers to this question even allowing for maximum autonomy of government-owned banks, which is not meaningful unless they are debarred from access to the government budget to meet operating losses. The contestability of the banking industry, although necessary. is not a sufficient condition for ensuring effective competition given the risk of collusive interest rate cartels even in apparently liberalized markets. Would developing countries be willing to permit free entry of foreign financial enterprise to competition? Financial competition itself is, however. an ambiguous concept. Even competitive interest rates may fall short of market-clearing levels, or may rise to risky levels, with adverse consequences for financial institutions and the economy at large (Villanueva and Mirakhor, 1990, pp. 515-519 and appendix). Moreover, bank credit as a vector of price and varied nonprice elements such as availability, collateral, lending criteria, competitive positive real rates will not suffice to clear credit markets. There will always be a Keynesian “fringe of unsatisfied borrowers,” i.e., who are unable to obtain credit despite their willingness to pay the going rate of interest. Credit rationing is pervasive as a screen and filter at different rates of interest, which means that quantity adjustments are as influential as interest rate movements in equalizing credit supply and demand. It is therefore not feasible to equalize the “playing field” for nonprice competition. But the phenomenon of credit rationing in developing countries has hardly evoked any analytic or empirical investigation in contrast to the wealth of research on the interest-elasticity of savings and investment. as so well exemplified in Fry (1988) which in reviewing the literature on credit rationing (Arndt, 1982; Stiglitz and Weiss, 1988), is unable to cite any studies of credit rationing in developing countries.

DEVELOPMENT

137

5. THE CHANGING ROLE OF CENTRAL BANKS: AUTONOMY AND FUNCTIONS Clearly, the tasks of financial reform and liberalization point to a drastic reorientation of the status, organization and powers of central banks as the principal operating agency. Are central banks properly equipped to cope with postliberalization problems? What is the extent of necessary and desirable autonomy for central banks that should, arguably, also be subject to the self-same liberalization process as other financial institutions? How would liberalization affect the relative balance of regulatory, monetary, prudential and developmental roles? The literature has been surprisingly sparse on the organizational aspects of central banking in developing countries, including the interesting experience of multinational central banks and currency areas in Francophone Africa and the Eastern Caribbean. For instance, Fry’s otherwise exhaustive Part III on microeconomic and institutional aspects of financial development has no section on central banks. The case for autonomy of central banks derives essentially from the technocratic argument for insulating monetary policy by entrusting it to organizations that “will not be tempted by the sirens of partisan politics” (Nordhaus, 1975. p. 188; Lindbeck. 1976. p. 18): The central bank can be seen as the repository of reason against the short-term claim of passion. an argument developed by Francis Sejersted in the context of Norway. For classical liberalist policy. the exchange rate and the price level were seen as crucial parameters that under no circumstances should be transformed into political control variables. Other institutions that have been accorded II similar autonomy for similar reasons include the Foreign Ministries of many countries and the BBC model of broadcasting. The removal of monetary policy, foreign policy or broadcasting from the political sphere is itself a political act (Elster. 19X8, pp. 90-91).

There is perhaps an even stronger case for autonomous central banks in the developing countries given the greater frequency and arbitrariness of political changes coupled with the politicization of finance and misplaced populism.’ But would politicians respect the autonomy of central banks, even though it might not compromise their ultimate accountability to governments? Would central banks have the capacity and will to resist fiscal importunities of governments? Even in democratic regimes the necessary minimal autonomy of central banks has been steadily eroded as in the case of the Reserve Bank of India, which now also has to contend

13x

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DEVELOPMEN’I

with

the overtly parallel Banking Department of the Ministry of Finance. An added reason for central bank autonomy in a developing country is its value as a source of independent macroeconomic advice to the government. Central banks have considerable comparative cost advantages :IS technocratic think tanks of which there are not many in the developing countries - by virtue of their expertise and direct contacts with financial markets. As Paul Volcker so aptly remarked.

The question of credit subsidies for developmental and distributive objectives raises some special problems. Such subsidies through the central bank are typically invisible, are not subject to review. and can impair credit controls and

distort

the

resources. transfer

the

through

interest

of

techniques development

such as participation banks.

prcterential

and rediscount

rates. guarantee schemes, portfolio targets and credit subsidies. This set of contradictions argues the cast for divestiture of the developmental activities of a central bank. to government. private

to

specialized

institutions.

or

to

entities. an issue which has been discussed publicly since the early lY7Os in Latin America but does not seem to have cntercd the public foi-urn in other regions. ’

sufficiently adequacy domestic

banks

vastly

discussion

capital

from

budget

of

financial

a strong

case for

the central

bank

where.

however, they are not necessarily more transparent, since even in developed countries such as the United States the budget is known to carry many implicit credit subsidies. Consequently. even after their transfer to the government budget. credit subsidies would need to be subject to periodic cost-benefit review by autonomous agencies such as the Auditor General. Judicious divestiture by central banks. however. need not preclude a catalytic and corrective as opposed to ;I participatory role in dcvrlopment. Concomitantly. the regulatory and prudential

liberalized. While this

in

subsidies

to the government

meet

tal role

allocation

is therefore

of credit

role of central

Other central banks too hwe played ;I comparable role in their respective countria. notably the Reserve B:mks of Australia and New Zcnland, the Central Banks of Indonesia. Malaysia. Sri Lanka. Thailand. and the Monetary Authority of Singapore. There is impressive &idence to refute the contrapuntal view that “not often have important ideas on economic5 entered ;I government by way of its central bank. Nor should anvone be disturbed. Thcrc is not the slightest indication that it will ever happen again” (Cialbl-aith. lY75, pp. 3&37). The relative mix of a central bank’s monetary. regulatory. prudential and rlevelopmcntal functions also merits reassessment in the context of liberalization. Can ;I central bank act concurrcntly 34 ;I controller of nioncy supply. supervisor of the financial system and as ;i developmental apencv’! There IS ;I clear conflict of interest bctwecn its primary monetarv and prudential role and its secondary and :lcq~L~red developmen-

efficient

There

need to be revamped requirements

to

of

;I high-risk competitive environment. need is recognized. much of the has been of ;I homiletic character. not focused on specific reforms such as of capital and reserves. limits on

and foreign

shareholders, risks.

will

changed

large

the optimal

surveillance

exchange customers.

mix

manuals.

jurisdiction

over

‘intermediaries.

bank

updating

of unified

and

sheet

of off-site

examination.

merits

to staff.

off-balance

and periodicity

and on-site

inspection

exposure

of

supervisory

nonbank

financial

creation

of ;I credit information, bureau and, above all. odcyuate quality. motivation and remuneration of supervisory personnel. There is also a tendency to rely uncritically, without creative adaptation. on models of capital adequacy such as the Basle Accord. which really seeks to standardize for the first time minimum capital or

standards

on the

totype

for internationally

US Federal

(Capital.

Keserve’s

Assets,

active banks. pro-

CAMEL

Management.

Earnings

and Liquidity) for on-site inspections. But even the most comprehensive prudential procedures will be ineffective unless financial institutions “recognize that the initial and primary responsibility for the prudent yet profitable conduct of their

trade

their

governments,

certainly IYYO.

not with

p, 7). hazard

moral that

rests

it

of

with

not with their widely

central held

insurance

them

their

-

not

regulators.

banks”

and

(Corripan,

supposition mistakenly

with

of the assumes

;I prudential measure whereas it is an insurance for the smell depositor. hence the relatively moderate limits of covcragc. The prudential aspect of deposit insul-ancc rcall) avowedly

is

The

squarely

OF FINANCE

AND

stems from the associated central bank supervisory and lender-of-last-resort functions and obligations and not from insurance prr SC. The moral hazards of banking could be ascribed more properly to an 3mplicit contract” that the central bank is ever ready to act as a lender of last resort to bail out any troubled institution. This issue also raises the interesting question whether “a central bank might be able to exercise its monetary policy responsibilities better if it is independent of primary supervisory and regulatory responsibilities” (Heller. 190 I. p. I I) based on the evidence that central banks mostly in developed countries without a shared supervisory authority have had lower average annual inflation rates (IYXO~X7). Yet, since “the management of the nation’s liquidity and money supply is a primary monetary policy function. it makes sense to give the central bank limited supervisory functions in the liquidity area pertaining to reserve requirements and liquidity ratios” (Heller, lYY1). But for central banks in developing countries it would be more economical and efficient to unify all supervisory functions. The scope and limitations of monetary policy instruments in fully liberalized systems too await systematic analysis. The abolition of interest rate and selective credit controls and credit ceilings puts the onus on market-based monetary instruments such as open market operations and rediscount rate mechanisms. But the efficacy of market-related monetary policy instruments assumes wide and active dealers‘ markets which are not artifacts that can be created by fiat but are the result of a process of gradual evolution of open market operations from net purchases to fully reversible net sale transactions. The direct issue of central bank securities can add materially to the breadth and competitiveness of security markets, as in Indonesia and the Philippines. In the absence of effective open market operations. the single most potent instrument of monetary policy would be the variation of commercial bank reserve requirements. Their efficacy depends on the appropriateness of the base for calculation of reserves and the fine-tuning of primary and secondary reserves as well as on the extent of compliance with such provisions since lapses in compliance are far more common than imagined, The monetary effects of open market operations and variable reserve ratios can also be supplemented by the periodic shifting of government balances between the central and commercial banks and between commercial banks, as in the Bank of Canada’s shifts of government deposits between itself and the chartered banks. or the German technique of Eirzlo~~r,~/~olitik. The

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potential of this technique has scarcely attracted any serious attention in the central banks of developing countries. Does the fact that these banks are modeled predominantly on the Bank of England and the US Federal Reserve account partly for this omission? Paradoxically, the oligopolistic nature of financial systems in developing countries may have the advantage of facilitating moral suasion as ii monetary policy instrument since the central bank has fewer entities to deal with. In the final analysis. the effective autonomy and efficiency of central banks will be dctermined not so much by statutory provisions as by and professionalism. Central their integrity banks which incur losses and are themselves in serious arrears of accounts, audit. and implementation. as in several instances in Africa and Latin America, are unlikely to command any credibility. This problem only underscores the critical, and yet the most neglected. role of human capital in financial systems. Typically. developing countried find it “much easier to staff ;I central planning commission [add central and commercial banks] with the handful of Ph.Ds [add MBAs] which most countries can supply. than to acquire the mass of persons with intermediate skills, technical and administrative competence and so on without whom any modern economy risks grinding into inefficiency” (Hobsbawm, lY6Y. pp. 61-Q). Financial labor planning might also help forestall the opposite predicament of the industrial countries. who “are throwing more and more resources. including the cream of our youth. into financial activities. remote from the production of goods and services. into activities that generate high private rewards disproportionate to their social productivity” (Tobin. 1984, p. 14).’ It is. however, only realistic to recognize that central bank failures too have the same probability as the better known government and market failures! The foregoing discussion suggests some fruitful applications of public choice and bureaucratic theory to developing countries. Bureaucratic theory has been applied extensively to central banks in the industrial countries using maximands such as prestige and self-preservation (Chant, lY72) and expense-preference (Boyes. Mounts and Sowell, 19X8). There are several variables that can enter a bureau‘s utility function such as salary, perquisites, public reputation. power. patronage. on-the-job leisure. output of the bureau, ease of management, fiscal rcsiduum. i.e.. the surplus over and above the emoluments payable to administrative staff (Niskanen. IY71: Rowlev and Elgin. 1085). But ;I central bank is a .sl;i gc”c,ri.t Webcrian (IY47)

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public interest bureau whose behavior has to be explained in terms of a maximand that can capture output variables such as efficacy of monetary, exchange rate and prudential policies. The input variables, however interesting, are subsidiary to public interest.

6. CONCLUSION This essay has attempted to pinpoint some of the major gaps in the literature on the analytic, institutional, operational. and policy aspects of finance in the developing countries. Clearly, the subject has been too long on theory and too short

on fact. It would not be amiss to remind financial economists that “Monetary theory is in ‘history’ Monetary economics, try as economists will to reduce it to a pure theory, is in fact the study of a particular social institution which has inevitably developed in different ways in different milieux” (Hicks, 1982, pp. 132-133). All this points to a rich agenda of country-specific, issuesoriented research invoking the techniques and insights of analytic and institutional economics. as well as economic history to draw up an appropriate policy menu to address the many pressing financial problems of developing countries.

NOTES I. Francis Sejerstcd‘s writings on this subject are available only in Norwegian. (See Elster‘s review 01 Sejerstcd’s work in Elster. lY75.) 3_. Some developed countries provide explicitly for the central hank’s independence. “In the Netherlands, the legislature has opted for a central hank highly independent of the government. This gives rise to the question whether this might lcad to an uncontrolled powcr this dilemma has hecn solved hy investing the Minister of Finance with the power - to he used only as a measure of last resort and, hence. suhjectcd to very strict conditions-to give the hank’s governing board directions for the coordination of the hank’s monetary policy and the budgetary policy pursued by the government (a power which has never yet been used). In Germany. the Bundcshank enjoys an even higher degree 01 independence as it is not subject to any instructions from the government. However. the Bundesbankgcsctz provides that ‘the Federal Bank shall, without prejudice to the fulfillment of its functions. support the general economic policies of the Federal Government.’ The reason for this arrangment was the fear that politicians might hc tempted to subordinate monetary policy to other policy objectives. It was the legislature itself which - with past experience (such as the prewar hyperinflation .) in mind -chose to limit the government‘s as well as its own scope for action in the monetary ficld. However bv amending legislation. it may remove this \eil restraint” (Wellink. IYXY. p. 152). 3. Colombian experience in the lY7Os is especially instructive. “The Bnnco de la Repuhlica acted as both a

central bank to control money supply and as ;I development bank. The Junta Monetaria and its advisors emphasized its role as H development hank and urged ‘selective credit controls‘ and ‘productive credit’ for working capital. The commercial loan theory of central hanking, therefore. was as alive in Colombia at this time as it had been forty years earlier in the United States when Currie first wrote of Its fallacica and dangers On February IX. IY74. the President [ofthc Republic] frankly admitted the mistakes that had led to serious inflation, that there was a need to distinguish hetwccn the different roles of a central bank and a devclopmcnt hank. Thereafter the President took much more decisive action. overruling the Junta Monetaria. to control the money supply and fiscal dcficlt. As B rcault inflation fell to a very low level in the final months of his administration)” (Sandiland\. 1YYO. pp. 25‘&25S). countries do not possess or 4. “Most dcvcloping cimnot attract sufficient expertise to stafl an effective hank supervision office, much less a securities commission” (Fry. IYXX, p. 43). The World Dcw~Iopmc~/ Rqwrf (19X9) recognized the importance of timely and accurate accounts and finnncial information and of “good compensation and career prospects” to hank supervisors (World Bank. IYXY. p, Y4). hut did not analyze financial staffing problems. Hence its candid acknowledgement that it “has treated in a perfunctory way the human and political dimensions of the subject. both in discussing the origins of the financial problem and in offering prescriptions for change” (World Bank. IYXY. p. 1.32).

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