ECONOMICS- MONEY AND CAPITAL IN DEVELOPING COUNTRIES
This paper analyzes the existing market structure with particular reference to China in a bid to explain the aspects of fragmented domestic capital markets. The paper then goes ahead to analyze the causes of fragmentation in domestic capital markets for example lack of reliable information as well as the policy implication of financial reforms on fragmentation.
The paper then focuses on the consequences of rapid development as in the case of China in relation to market fragmentation so as to determine the link between the two. It establishes the negative and positive impacts of rapid development and proceeds to offer a recommendation of sustainable development as compared to rapid development. This is because rapid development is directly linked as a cause of market fragmentation.
The paper concludes with a recap of the key issues that are highlighted in the paper with regard to what fragmented domestic capital markets means, its causes and reform policy implications. This also follows for the consequences of rapid development and the suggested recommendation of sustainable development.
Introduction
There were a number of financial policy reforms that were initiated by most countries in the 80s with fragmentation being discouraged as it was believed to make the financial markets inefficient. Fragmentation in the capital market is characterized by differences in risk adjusted returns between segments which is blamed on poor information flow and limited access to credit.
This paper examines the market structure with an aim to better understand what fragmented domestic capital markets mean. This is with particular reference to China whose financial markets remain fragmented. It also focuses on the main causes of fragmentation of domestic capital markets. On a slightly different perspective, the paper examines rapid development as witnessed in China and tries to establish its consequences.
The paper is divided into five sections with the first section shedding more light on the meaning of fragmented domestic capital markets. The second section deals with the causes of fragmentation in financial markets while the third section focuses on policy implications on fragmentation. The fourth section examines the consequences of rapid development as a cause of domestic market fragmentation with particular reference to China and finally the fifth section concludes.
Fragmented domestic capital markets
The existence of fragmented domestic capital markets despite financial policy reforms is an issue that has continued to raise concern. It has been argued that the implementation of financially repressive reform policies is not enough to eliminate fragmentation. This is because there are other underlying structural and institutional factors that hinder liberalization that need to be addressed. These structural and institutional hindrances prevent interactions between financial market segments hence creating differences that need to be addressed.
Prior studies have established the substantial existence of fragmentation especially with the formal and informal financial sector credit lenders heavily reliant on availability of information on borrowers to select their clients. This leads to the problem of adverse selection but it is necessary for mitigation of risks. Such measures see some of the clients locked out of the formal financial sector as they do not pass the credibility tests of the formal institutions to get access to credit. However some of the clients are credit worthy but lack of reliable information to prove this makes them to lose out on formal credit.
A review of current literature on market fragmentation identifies a number of factors that determine the development of capital markets. These include the level of income, macroeconomic policies and regulatory framework. The level of income is identified as the most significant determinant based on the fact that most of the developed countries have deeper financial markets as compared to developing countries with low income levels.
The relevance of macroeconomic stability and better fiscal and monetary policies is that they serve to minimize uncertainties and risks while a well established and functional regulatory and legal framework works to assure investors and earn their confidence thereby contributing to the growth of the capital market.
On the other hand however, there exists an informal sector that has established networks to enable it gain access to information at low costs and they therefore tap into the gap left wide open by the formal institutions. The clients who lack access to formal finance are pulled in by the informal institutions where they enjoy monopoly.
In these fragmented financial markets, there are major differences in risk-adjusted returns between market segments which are due to the fact that information and money does not flow between these segments. The credit clients therefore have limited alternatives when it comes to financial instruments hence low substitutability.
Capital markets generally refer to the financial markets where individuals, governments and businesses that have saved some of their incomes can transfer the money to similar entities that are experiencing a shortage. Capital markets deal with long and short term instruments such as stock, bonds, treasury bills and equities to name but a few. There are a number of benefits that accrue from capital markets (Dennis, 2000).
To begin with, there is promotion of competitiveness and efficiency in the economy. It also provides potential investors with investment alternatives which encourages mobility of domestic savings. Capital markets create an opportunity for the masses to get involved in the corporate sector through investing in securities and last but not least enable companies and governments to raise capital at lower costs (Ewart, 2004).
In a bid to understand what is meant by fragmented domestic capital market, it is important to first acquaint ourselves with the concept of capital market integration. Capital market integration is also referred to as financial integration and as the name suggests it shows the existence of links between financial markets. The opposite of this is what encompasses domestic market fragmentation.
Most developing countries had policies that were financially repressive including control of interest rate and credit allocation as well as restrictions on market entry and capital transactions without the borders. These have particularly been implemented through government intervention and not market forces.
Opening up domestic capital markets to the international market has both positive and negative impacts to the domestic market. The positive impact includes the fact that external financing has a tendency of being long term in nature as compared to domestic financing. There is also transparency in the market as firms and governments seek financing in the international capital market thus giving domestic investors better investment opportunities.
On the other hand, there are a number of negative impacts that are associated with internationalization of domestic capital markets. To begin with, there is the risk of migration of trade activities abroad with adverse effects on domestic market trading and liquidity. Such a case is prevalent in the event of listing large domestic firms in the international market. Finally, there is the increased risk of financial trading in the international market especially during financial crises.
Integration of domestic capital markets into the international financial market is however characterized by market segmentation. The relevance of segmentation lies in the fact that with increased access to external financing as a result of integration, not all countries and firms fully benefit. For instance, net private capital flows have been seen to increase over the years in developing countries but private capital does not flow equally in these countries showing that only a small group of countries and firms reap the major benefits. The large firms and countries are in a better position to reap the most benefits as they have the capacity to tap into the international financial markets.
Fragmented domestic capital markets mean that the capital market of a given country is divided into regions and there exists some differences in their development for example the price of risk is not the same as is the case with an integrated market. China represents an example of a fragmented capital market that is characterised by differences such as varying profit rates and returns across selected regions.
China implemented economic reforms which included integration of the domestic market through state withdrawal and opening up to the international market. In this paper, focus will be on the reform period where economically the authorities paid extra attention to planning, regional self-sufficiency and autarky. China has slowly evolved its domestic capital market into a fragmented market that is characterized by control by the local authorities.
China has been practicing local protectionism which has resulted in decreased economic integration of the domestic market. Fragmentation of the domestic market in China is said to be on the increase as regional trade barriers have been reported to be on the increase. The provinces in China are each viewed as an integrated market within the confines of its borders with barriers that discourage flow of trade with the outside markets.
The political economy of China has been favourable to fragmentation of the domestic capital markets. This is due to the fact that it is founded on traditional values of regional planning. This is such that the local authorities have the mandate to govern and oversee the economic activities in a given geographical area. The local authorities with their authoritative powers seek to protect the local economy and have a number of measures at their disposal to enforce this. This includes manipulation of interest rates and price fixation. Other trade protections include imposing bans, tariffs and even offering subsidies to local production. The local authorities hid behind the import substitution strategies that seek to protect the under developed local industries from being replaced by cost effective developed industries.
Table 1 Domestic trade in China
Year
IO 19921997Inter-provincial imports50 of GDP38 of GDPInter-provincial trade80 TT66 TTAverage provincial absorption (Imports)2720Share of locally produced goods6872Share of foreign goods58From the data in table 1, it is true to say that domestic trade was huge in these years but there was a significant drop in the same between the years. The inter-provincial imports in 1992 comprised of 50 of the countrys GDP and 38 in 1997 which translates to high fragmentation of the domestic market. Additionally, inter-provincial trade comprised of 80 of the total trade in 1992 and 66 in 1997. This is proof of slow integration of the markets as the values decreased in 1997.
The theoretical understanding of protectionist policies by the local authorities can be explained using the endogenous trade policy which stipulates that determinants of trade policies not only include economic efficiency but also income distribution. Protectionist policies are therefore determined by the demand and supply relationship. The demand side of trade protection covers players such as private agents and public sector while the supply side features the government and politicians as the main players.
Domestic capital market fragmentation is said to present a number of risks to the integrity of securities markets which include undermining transparency, price and market manipulation, uncertainty as to meeting the best execution standards obligation and regulatory arbitrage.
Transparency is essential in two dimensions namely pre-trade and post-trade transparency dimensions. Pre-trade transparency requires that accurate information on size and price of prospective trade is made available while post-trade transparency requires disseminating information on price and volume of completed transactions. To the capital market, such transparency is vital as it enables price discovery and market surveillance as well as market confidence.
The obligation of best execution calls for a more sophisticated regime which recognizes distinct concerns of distinct investors across various stages. An example to show its importance is the fact that self-regulating organizations can engage in regulatory competition which could lead to compromised standards hence the need for centralized regulation. Access to accurate and transparent data is vital in the facilitation of implementing the best execution obligation.
Causes of fragmented domestic capital markets
The main causes of fragmented domestic capital markets include direct and indirect government control over interest rates and resource allocation. It is determined by existence of protectionist policies which create barriers to trade between Chinese provincial capital markets.
Because of this fragmentation, development level of local financial intermediaries has been an important factor in determining local economic performance. Causes of domestic market fragmentation can be examined through the use of two theoretical paradigms. These are policy-based and structural and institutional explanations.
Focusing on the policy based explanation financial repression theory attributes ineffectiveness of financial markets to undue government involvement. The failures of government policies as well as their repressive nature are the main causes of domestic capital market fragmentation. Imposition of controls on interest rates through ceilings has been known to increase the demand for funds and decrease supply. The excess demand then leads to rationing of funds by the financial sector players using other measures other than interest rates. This leads to an emergence of a fragmented credit market which favours some borrowers who access credit at subsidized interest rates. On the other hand, the informal market develops at unchecked rates and therefore other borrowers are forced to seek credit in the informal market which is expensive.
The remedy for this would be the removal of the restrictive policies which would in turn eradicate the need for the informal credit market as all the borrowers can get access to formal credit from the financial intermediaries (Ernest et al, 1997).
On the other hand, there are a number of structural and institutional features of capital markets of developing countries that have been linked to the explanation of fragmentation. Fragmentation has been explained on the basis of imperfect information about creditworthiness as well as cost of enforcing and monitoring lending contracts. This is said to lead to market failure as a result of adverse selection which occurs when borrowers with worthwhile investments are discouraged from borrowing loans due to increased interest rates. Moral hazard is also a cause of market failure where borrowers seek loans while they have no capacity or intention of repaying. Instead of raising interest rates when the demand for credit is higher than supply, lenders may opt to use non-price rationing to shield themselves from greater risks. Consequently, it is clear that even after removal of controls on interest rates and credit allocation, market equilibrium is still characterized by credit rationing. Liberalization of capital markets does not therefore guarantee Pareto efficiency in allocation hence government involvement is necessary (Stiglitz, 1994). The problem of imperfect information has even more devastating effects on the low income countries. The high cost of acquiring proper information on borrowers encourages fragmentation.
Another structural view seeks to portray the link between the structure of capital market and development. This relationship between finance and growth is built on the basis that development increases a borrowers net worth and in turn decreases the premium for external finance (Gertler Rose, 1994). This in turn determines the level of investment and hence economic growth.
Finally, fragmentation can be attributed to the weaknesses of the infrastructure that sustain the financial system. These weaknesses include the existence of the requirement for collateral on borrowing which locks out some of the small and medium scale borrowers who are credit worthy. There is also the legal structure which directly affects enforcement of contracts involving lending which influences the decisions of the lender and borrower to enter into an agreement and the type of security that is required (Ernest et al, 1997).
Lack of a well defined insurance system is also held accountable as a cause for fragmentation. This is because the formal financial system is exposed to risks which ought to be catered for by the insurance market but the absence of cover from the risk of defaulters makes it vulnerable.
Implications of financial policy reforms on fragmentation
After several years of financial policy reforms, fragmentation has continued to persist. This is because implementation of these policies is usually not complete and they do not fully address the core institutional and structural restraints. It is not enough to remove the repressive financial policies as it does not enhance financial deepening. The informal financial sector however targets the increased demand of clients who lack access to formal finance.
Faced with the current condition of lack of proper information and ambiguity, the informal financial sector has had a relative advantage in serving a large client base which for one reason or another has no access to formal finance. It has therefore been noted that recognition of the informal financial sector and expanding their role would result in financial deepening as more clients would access to financial services. This however is a medium term endeavour as the formal sector deals with its constraints so that it can widen its reach.
The role of the informal financial sector can be enhanced through provision of incentives that include provision of a more supportive legal and regulatory framework bridging the gap between the formal and informal financial sector. There is need to realize that until the formal sector is able to reduce the cost of acquiring information and enforcing contracts, the informal finance sector will have a relative advantage. It is important to note that formal financial deepening requires a great deal of reforms and is a long term process. The reforms should target provision of a strong regulatory and legal framework for enforcement of contracts, a sound macroeconomic environment as well as streamlining the information highway for better flow of information.
The medium term provision of incentives and linkages between the formal and informal sector would ensure that they benefit from each other hence reducing risks. For example, the formal sector like the banks will benefit from information that is held by the informal sector which is closer to the people. This results in enhanced efficiency of the financial system through expansion of mobility of savings and credit delivery.
Contract enforcement is another long term endeavour that needs to be addressed through reforming the legal system. This in most countries would mean introduction of unique commercial laws and courts. The benefits would however be immeasurable as it would facilitate lending based on other forms of collateral other than fixed assets as the informal sector does. This eventually leads to financial deepening as more people can access credit (Ernest et al, 1997).
Finally, a remedy for the difficulties involved in obtaining credible financial information so that risks can be managed is vital. This has been said to be the number one cause of financial market fragmentation as it raises the cost of the formal sector seeking information to ascertain the credibility of borrowers and the informal financial agents therefore enjoy local monopolies as they have devised their own information and social networks. Incentives to link up the formal and informal sector could therefore see the mutual benefit of the two as the formal institutions can benefit from the existing information networks of the informal institutions.
Before implementation of policy reforms of liberalizing domestic capital markets, it is important to acknowledge that there are preconditions that need to be met so that integration is not carried out at the expense of the domestic capital markets of developing countries. Some characteristics that need to be taken into consideration with regard to the nature of domestic capital markets of developing countries include their small size, weak currencies, illiquid markets and lack of risk diversification.
Consequences of rapid development
In a bid to establish the main consequences of rapid development, we need to examine a developing country that has undergone rapid capital market development and analyze its quest for development as well as the outcomes. This will help establish the link between rapid development and financial market fragmentation. The pool of developing countries that fit this criterion is limited but for the purpose of this paper the country of choice is China.
Chinas economic growth began in the 80s as the rest of the world watched in shock at the speed at which development took place. China invested so many of its resources which included domestic savings to develop its infrastructure. This also involved a lot of foreign capital inflows in establishment of its manufacturing sector (Sandra, 2000).
Figure 1 Chinas GDP and FDI in the period of rapid development
Growth measure20022003GDP89FDI-53 billionFigure 1 shows the increase in GDP which reached 8 in the year 2002 and increased to 9 in 2003 which is a very high growth rate by any standard. It also shows the level of FDI which by 2003 was at the tune of 53 billion representing 8 of the worlds total FDI.
China has embraced the concept of government intervention such that the success of a company largely rests with the government as it decides the companies that get resources from the government as well as deciding those that are listed in the stock market. The government is actively involved and directs the economic activities (Diana et al, 2004).
The Chinese government is known to intervene in domestic capital markets and as a matter of fact most of the companies that exist in China do so because they get financial support from the government. It is also known to interfere with the stock market rather than leaving it to the market forces (Diana et al, 2004). The fragmented nature of the Chinese domestic capital market is therefore a major determining factor of their rapid development.
The benefits attached to rapid economic development include the accelerator effect of economic development on capital investment where the increase in aggregate demand and output encourage investment on capital machinery investment. There is also increased confidence on the part of the business community as the increase in economic growth has a positive impact on their profits. Another benefit registered is the increase in fiscal dividend for the government. Rapid economic development boosts the revenue collection and since government finances are cyclical in nature, the government has more money at its disposal to finance more development.
On the other hand, rapid development also has its share of disadvantages to domestic capital markets. To begin with, China is said to have had massive bad bank loans which is as a result of massive borrowing so as to sustain the rapid growth of economic development. These loans have to be accounted for one way or another.
Another significantly important disadvantage of rapid development is the risk of inflation. It has been argued that if demand grows faster than the productive capacity in the long run, there is a high risk of demand-pull or cost-push inflation. Increased inflation has a destabilizing effect on the economy. This is because it exerts pressure on the interest rates to increase which hurts domestic business as it causes a loss of competitiveness internationally.
It has also led to great inequalities in levels of income with the coastal regions which attract more FDI retaining more income than the less developed regions that are at the interior. The benefits of rapid economic development are not distributed evenly which leads to an increase in income and wealth inequality in the society. The gap between the rich and the poor in the society continues to widen as well the gap between regions.
An alternative to rapid development is sustainable development which has been said to mean lasting or enduring development. It is defined as the capability to meet the present needs without jeopardizing the capacity of the generations to come to fend for their own needs. Unlike rapid development, sustainable development takes into account two major issues.
Sustainable development focuses on social progress where everyones needs are recognized and put into consideration. Sustainable development also strives to achieve and maintain high and stable economic growth and employment levels so as to ensure that everyone get an opportunity to benefit from the increased economic growth.
Conclusion
In conclusion, fragmentation of domestic markets has been analyzed and it is now clear what it means and its causes. The means to remedy this include risk management, enforcement of contracts and reduction of the cost of seeking proper and reliable information which are the barriers preventing the small and medium scale borrower from accessing formal finance. In the medium term however, the linkage of the formal and informal financial institutions is a step in the right direction as it is beneficial to all parties and it leads to financial deepening.
The consequences of rapid development have also been dealt with conclusively and the key points to note include the fact that rapid development has both positive and negative impacts. Rapid development is therefore a cause of domestic market fragmentation as it leads to a widening of the gap between countries and firms as benefits are not equally distributed. Sustainable development which is defined as lasting development is presented as an alternative to rapid development which has more costs than benefits. This ensures that all the pre-conditions are met before implementation of policy reforms such that most loopholes are addressed.