# 07 Chapter 7: Savings and the Financial System

FLEX Course Material

Students will have the understanding why saving is very necessary for economic
growth.

Population
Students will also learn the positive and the negative effects of savings in terms of
capital accumulation.

Module Goals
 # 07

At the end of this module, the students are expected to have:

Explained through essay format one of the two questions given below:
Explain why financial liberalization may not necessarily result in an

acceleration of economic growth and increase economic efficiency?

What is likely to happen to the demand for informal finance when an economy
takes a downturn, or falls into recession, and unemployment increases?

Learning Goals
 Economic Development in Asia
Chapter 7 – Savings and the Financial System
 Introduction to Savings
• Savings are a key variable in determining economic
growth.

• Total savings are the sum of government, business, and

private savings.

• In developing countries, most savings are accumulated

by private households and the business sector.

• Hence, research has been concentrated on the study of

private/household savings.
 Some Savings Models
• Keynesian Model
• Income Smoothing Models: The Permanent
Income/Lifecycle Hypothesis
 Determinants of Savings

• Level of interest rates

• Role of government
• Growth in income
• Terms of trade
• Population age structure
• Level of income
• Degree of financial liberalization and stability
 Level of Savings

• Developing countries such as South Asia and Latin

America currently save up to approximately 20 –25% of
GDP.

• Savings in East Asia are the highest, and register around

35% in 2000 (Figure 7.1).

• Higgins (1998) predicts after 2010, savings in East Asia

would fall because of greying population structure.
 Banking and Financial System
• Banking systems in Asia evolved from mainly British
or Japanese colonial models.

• Financial systems are dominated by commercial

banks.

• For most of the postwar period, financial systems

were characterized by substantial financial repression.
 Financial Repression

• High reserve requirements.

• Interest rate controls.

• Compulsory credit allocations to different sectors.

• Lack of loan scrutiny.

• High profit and low efficiency as a result of lack of

competition.
 Financial Repression
• This kind of banking system evolved when
governments played a strong role in mobilization
and allocation of credit.

• Specialized banks were often used to further

allocate credit to key sectors.

• Real interest rates were often very low to help out

key sectors and as a result, levels of overall
saving/investment were discouraged.
 Financial Repression
• The miracle economies were
able to grow rapidly despite
financial repression because
the rest of the economy was
more open and export
oriented.

• Nevertheless, financial
repression still exerted a drag
on growth and efficiency.

• Financial repression was a

bigger handicap in South Asia
where it combined with other
policies like import substitution
to create inefficiency.
Financial Liberalization
• Ideally, financial liberalization
removes all of the restrictions to
the workings of markets created by
repression.

• This includes setting of interest

rates at market levels, removing
loan allocations and cutting down
the tax on the banking system from
high reserve requirements.

• The resulting financial system

functions efficiently.
 Experience in Asia (before)
• In the 1960s and 1970s,
commercial banks were
tightly controlled by
governments.

• Banks and development

finance institutions were
the main financial
intermediaries.

• Private equity and bond

markets were very thin.
 Experience in Asia (before)

• Government controlled interest rates and banks

were required to hold government securities.

• Loan allocations were made and administered

through banks and development financial
institutions (DFIs).
Experience in Asia (after)
• In the 1980s and 1990s,
some financial
liberalization took place in
East and Southeast Asia.

• Greater competition were

allowed as foreign banks
granted licenses and
banks were privatized.

• Interest rates were

deregulated to some
extent.
• Some prudential
regulations introduced
including auditing and
oversight functions.
 Experience in Asia (after)
• In South Asia the pace of reforms was slower
(Table 7.2).

• Despite liberalization, the banking culture in Asia

did not change that much in terms of how loans
were approved and the reliance on the government
for support.

• Competition increased but government role in

approving entry was still strong.
 Measures of Financial
Repression
• The ratio of money supply to GDP is a
good indication of financial repression.

• In East and Southeast Asia, this ratio

increased dramatically from 1970 to the
end of the century (Table 7.3).

• Malaysia and Thailand are noteworthy

examples.

• Slower progress in some other

economies.
Measures of Financial
Repression
• Hong Kong and Singapore
liberalized earlier. The financial
system in Korea and Taiwan
remained somewhat more closed.

• In South Asia, liberalization took

place in recent years but the
M2/GDP ratio remained low in
most cases.

• In the Philippines, banks

liberalized in 1980s and in
Indonesia the ratio increased from
a low level in the early period as
significant banking reform took
place.
Comparison with Other Regions
• Liberalization is generally
costly to the government.

• It loses revenue from having

to pay low interest rates on
debt and by taxing banks
through high reserve
requirements when there is
financial repression.

• Latin America had problems

with inflation and large
government deficits which
made it difficult to finance
liberalization.
 Risks of Liberalizing in Asia

• When there is a boom, capital inflows make it difficult

to control inflation and the pace of economic growth.

• This is because it is hard to sterilize inflows and to

maintain exchange rate at competitive levels.

• Loan supervision was also generally weak in Asia

prior to the financial crisis.
 Risks of Liberalizing in Asia

• Debt to equity ratios were also very high, creating a risky

and volatile situation (see Table 7.4).
• The amount of short term debt was also high (Table 7.5).
Risks of Liberalizing in Asia

• Institutional practices that were in

force before liberalization did not
change. i.e. - lack of competition,
• - directed lending,
• - the presence of moral
hazard,
• - poor loan approval
system
• still prevailed after
“liberalization”.

• Refer Supplementary Article 7a.

 Financial Crisis of 1997
• As the crisis unfolded,
weaknesses in the 5 crisis affected
countries was exacerbated by
currency depreciation, reduced
lending opportunities and build up
of Non-Performing Loans (NPLs).

• Large short term external debt.

• Inability or lack of will to address

weaknesses already pointed out
above.
 Financial Crisis of 1997
• Needed to introduce better process to identify worthy
borrowers;

• Further deregulate financial transactions and introduce

more competition;

• Introduce better prudential regulations;

• Continue to privatize state banks;

• Improve lender recourse;

 Financial Crisis of 1997
• Improve accounting and auditing procedures;

• There was also a need to develop markets for new

financial assets including hedging and to reduce
restrictions on entry into banking system both
domestically and for foreign banks.
Mechanisms for dealing with the
Aftermath of the Financial Crisis
• Formation of Asset Management Companies (AMCs)
in crisis affected countries.

• Closing, merging and recapitalization of bankrupt

banks and other financial institutions.

• Restructure corporate debt to help companies get

back on their feet.
 Progress in Financial
Restructuring

• NPLs have fallen since 1998.

• Banks are now stronger and in a better financial

position.

• Korea and Malaysia have made the best progress –

less so in Indonesia, Thailand and the Philippines.
 Progress in Financial
Restructuring
• Generally less progress in corporate restructuring has
been made than in banking.

• Bank credit has expanded in Korea and Malaysia but it

was still below pre-crisis levels in other countries at end of
2002.
 Informal Finance
• In many developing countries, there are significant
sectors of the population that are unable to obtain credit
from banks and other financial institutions in the private
sector.

• Informal financial institutions serve the financial needs of

these people.
 Informal Finance
• Efforts to integrate the formal and informal sectors have
moved forward slowly.

• The lack of availability of formal finance has been a

major deterrent to lending to the poor for many years.
 Informal Finance
•Inability to borrow from banks in the formal sector because:
• Access is limited for squatters and in some rural areas.

• Banks lend for investment and not for consumption.

• Transactions costs to assess loans to the poor are high.

 Informal Finance

•Inability to borrow from banks in the

formal sector because:
• Banks lack information about credit

worthiness of poor borrowers.

•Poor have no assets to serve as

collateral.

•Banks believe potential poor

borrowers are unable to repay loans at
commercial rates of interest.
 Informal Finance
• To address this shortfall in borrowing options, a
number of different institutions and schemes have
been developed.

• Group finance – Rotating saving and credit

associations (Roscas) are found in many countries
and have a long history.
 Forms of Informal Finance -
Roscas
• Roscas deal with the problems mentioned above by
organizing people who pool resources. Since they know
each other and the rate of interest is set by a bidding
scheme among the members.

• Most Roscas exclude women.

• Default is discouraged by pressure from other members

of the group.
Forms of Informal Finance -
Others
• Next is money lenders, landlords and pawnshops.

• In these forms of lending, there is one lender (better

off) and many (poorer) borrowers.

• Rates of interest are higher than the formal market.

 Forms of Informal Finance –
Others (Money Lender)

• Conventional wisdom is that the rates of interest charged

are usurious and money lenders are blood sucking
scoundrels preying on the poor.

• Recent evidence suggests that there is some competition

among lenders and rates charged by money lenders are
not unusually high given the risks and the costs of
administration of a number of small loans.
 Forms of Informal Finance –
Others (Landlords)
• Landlords often make loans to tenants to buy seeds and
fertilizer or tide them over when the harvest is bad.

• Sometimes the tenant gets so much in debt that he is

never able to save.

• This situation accentuates the problems of agriculture

where risks are high since harvest yields depend to a
considerable extent on the vagaries of the weather.
 Forms of Informal Finance –
Others (NGOs)
• Non-government organizations (NGOs) are informal
financial institutions sponsored by outside interests that
mobilize resources.

• The Grameen Bank of Bangladesh is a very famous

NGO. It has been copied in a number of other
countries.

• Some NGOs, like the Grameen Bank, may later be

incorporated into the formal sector.
 Forms of Informal Finance –
Others (NGOs)
• By working in a cooperative type environment, NGOs
enforcement and monitoring costs are minimized.

• Risk is shared within the groups that are formed within

the NGO.

• NGOs like the Grameen Bank have many characteristics

in common with Roscas.
• Refer Supplementary Article 7b.
 Informal Finance
• The experience of the Grameen Bank, NGOs and
Roscas demonstrates that access to credit is the
major problem for the poor and not the lack of ability or
incentive to repay.

• However, attempts to extend such schemes to larger

and more diverse groups have run into enforcement
and principle/agent problems.
 Informal Finance
• The difficulties in establishing a credit rating system for
finance as well as enforcement of contracts is part of
the principle-agent problem.

• This is discussed further when we deal with moral

hazard and asymmetric information in more depth in
Chapter 13.
 Informal Finance
• How large is the informal sector? It is
shrinking as financial liberalization
takes place but it is still extensive.

• Household borrowing in the rural sector

is still largely from the informal sector –
over 50% in most countries (see Table
7.6).

• The proportion of household debt owed

to the informal sector is similarly high,
although not as high in the urban
sector.
 Informal Finance & Monetary
Policy
• The main impact of monetary policy on
informal finance and on the poor in general
is through the inflation tax.

• Assets of the poor are in goods and cash,

and they depreciate rapidly with inflation.

• Therefore, to help the poor who have to

make use of money lenders and other
informal financial markets, a stable price
level should be the major aim of monetary
policy.
 Global Crisis of 2008 and 2009

• Chapter 3 examined the impact of the global financial

crisis on income and employment in Asian economies.

• The real impact of lower export demand and the outflow

of financial capital from the Asian region were explored

• Many reforms that were suggested following the 1997

Asian financial crisis had been adopted and bank
balance sheets were in better shape.
 Global Crisis of 2008 and 2009

• The size and incidence of nonperforming loans (NPLs)

had also been reduced.
• The practice of short term overseas borrowing to
refinance longer term local projects at higher rates was
also curtailed.
• Exchange rates, while still loosely tied to the US dollar
were also more flexible than before the 1997 financial
crisis.
• Recovery from the global crisis is expected in the second
half of 2009 and in 2010
 Summary
• Introduction to savings and its determinants.
• An understanding of the financial system in Asia, and
financial repression during 1960s-70s.
• Process of financial liberalization in Asia.
• Importance of informal finance.