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EVALUATING THE IMPACT OF FINANCIAL REPRESSION ON THE
ECONOMIC DEVELOPMENT PATTERN OF THE PHILIPPINES
Richard G. Fritz
Associate Professor of Economics
University of Central Florida
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EVALUATING THE IMPACT OF FINANCIAL REPRESSION ON THE
ECONOMIC DEVELOPMENT PATTERN OF THE PHILIPPINES
PROBLEM STATEMENT
The purpose of this research is to evaluate the relation between the
development of financial markets and their institutions and the process
of economic growth and development. Throughout the world less developed
countries are facing various stages of an international financial crisis. Major
banks in the industrialized world, as well as the IMF and World Bank have
extended credit to these countries expecting the resulting economic growth
to yield the necessary dividends for repayment. However the most
expeditious road to growth and development has never been a certain one.
Qne controversy deals with the degree and timing of maturity of the
financial institutions and financial markets. This overall process is called
"financial deepening.” Previous published research polarizes the role of
financial institutions in the process of economic development between the
supply-leading position and the demand-following hypothesis.
The empirical evidence is both compelling and contradictory. Initially,
research focused on the strong positive correlation between the degree of
financial deepening and the level of economic welfare. However this
research has failed to contribute answers to the critical questions facing
policy makers today because it does not explain the causal structure of
the development process. Recent research has focused on "financial
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repression." Financial institutions may allocate the scarce funds to less
efficient uses due to fragmented money and capital markets. The market
inefficiency can be the result of politically powerful elites who benefit from
the existing conditions of financial repression. The elite groups support the
dual society government which in turn encourages large-scale, capital
intensive industries. These politically favored entrepreneurs are then offered
subsidized credit. Thus it is argued that financial institutions can retard
potential economic development through repressive market activities. Banks
are in a position not only to serve as the custodians of the stock of money
but also to increase or decrease that stock. The consequence of this power
for society at large can be either favorable or unfavorable.
The policy implications are critically different depending on the causal
direction of the several sides of the debate. The life cycle of financial
deepening implies a supply-leading role in one stage followed by a demand-
following stage later when the country has reached a more mature stage of
the development process. The switch between cause and effect was confirmed
by Drake (1980) and Fritz (1984) using a time series sample based on the
Philippines economy. However the time series evidence is incapable of
revealing the causes for the switching of the direction of causation. The
structural components of the switching process are critical to establishing
policy guidelines for using financial deepening as an economic development
instrument.
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BACKGROUND ON FINANCIAL DEEPENING AND FINANCIAL REPRESSION
The larger proportion of researchers in the field believe in the affir-
mation effect of financial maturity on the economic development process.
Drake (1980) summarizes the focal points associated with financial institution
development: (1) augments the quantities of real saving and capital formation
from any given national income, (2) increases net capital inflow from abroad,
and raises the productivity of aggregate investment by improving its allocation.
Others have added (4) improved macroeconomic stabilization, arguing that
"greater stabilization of the economy through monetary controls is attainable
when the banking system is more widespread," (5) provide the basic imter-
mediary function between savers and investors thus supply liquidity to the
economy by creating money, and (6) financial instutitions provide entrepre—
neurial talent and guidance for the economy as a whole. The direct role of
money in economic growth has been recognized since Tobin (1955) con—
structed a neoclassical macro model combining the aggregate production
function and the monetary sector. Others have added the use value of
money more explicitly and the inter-temporal utility maximization of
saving behavior. As credible as these works are, the causation roles have
not been resolved. Pierson (1972) concede the importance of "financial
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breakthroughs" in providing efficiency and utility, They see only a
temporary stimulus.
The "demand-following” type of financial development is viewed as
somehow accommodating or reacting passively to the growth of the real
economy. As the economy moves from traditional subsistence production,
grows more complex, and generally becomes monetized, certain demands
are generated for the services of financial institutions. Such demands
are created by the growing needs of firms for external finance, as their
retained profits fall short of their investment expansion needs. This
approach emphasizes the demand for financial assets, and the responsive—
ness of existing or new financial institutions is taken for granted. Here
the contribution of the financial sector is minimal for development.
In reality, the bulk of the less developed world population is found
in rural areas engaged in subsistence farming. The average peasant
farmer's income closely matches consumption. Most farm surplus
inocme is used to buy additional consumer goods rather than saved
or transformed into productive investments. Even with a large surplus
the farmer is likely to buy more land, farm animals or agriculture
implements rather than travel to the provincial capital and depositing
funds in a financial institution. Often cultural and physical barriers
are a significant development problem. These barriers constitute
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one aspect of "financial repression.” Another related problem is the
real rate of return offered on savings. Often the average saver is
consistently offered a negative real rate of return on financial assets.
In such markets the expected inflation rate is above the interest rate
paid on deposits and securities. The real rate of interest becomes
negative, the demand for loanable funds increases while the supply
declines resulting in many borrowers and no willing lenders. The
fragmented money and capital markets of LDCs that result are in-
efficient.
Market fragmentation reinforces the rural-urban split. An
organized financial market in an LDC in the past has meant the
urban financial market. Local money lenders and shopkeepers in
many LDCs constitute 70% of financial activity. Such imperfections
stimulate average high interest rates in the unorganized rural sector.
The fragmentation also results in a consistent bias for export of
domestin savings. Financially repressed economies also tend to develop
a propensity to issue short-term instruments rather than long-term.
The planning horizon of savers becomes logically short. Asset holders
try to maximize their liquidity, avoiding being locked in at a very low
or negative real rate for a long time period. The result is investors
attempting to finance capital projects by borrowing large amounts
in the short-term money markets.
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The final restraint which retards financial reform is that politically
powerful elites generally benefit from the existing conditions of financial
repression. The elite groups support the dual society government which
encourages large-scale, capital—intensive industriies. Politically favored
entrepreneurs are offered subsidized credit to mass their empires in
land or large industries. Foreign exchange has been over valued so the
rich can import artificially low prices their capital goods and luxury
consumables.
DEFINING FINANCIAL DEEPENING AND ECONOMIC DEVELOPMENT
Financial deepening involves a combination of several avtivities
and institutions. In the past a popular method was to calculate a
ratio based on domestically held assets and foreign held assets.
Others avoid the single ratio methodology and report "selected measures
of monetization." The method applied in this research develops a
combined index, with each variable weighted according to its relative
importance. Such an index was developed for the Philippines using
the eigen value approach of factor analysis (Fritz, 1984). From the
factor loadings, indexes were developed for both financial deepening
(IFD) and economic development (IED) in the Philippines.
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FIGURE 1: STRUCTURE OF COMPUTER MODEL OF DESIRED EXPENDITURES
RESOURCES | AGRICULTURE
___
SECTOR CAPITAL = — sector 9 *
SECTOR
1
Ld
| T Goons
-j- =
SECTOR
SERVICE
SECTOR *
$4 4 DEMOGRAPHIC
LABOR SECTOR * CONSUMER
noo
ALLOCATION SECTOR
POPULATION
BASE
* Demographic Sector and Services Sector are adjusted for Finacial
Deepening and Financial Repression Effects.
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FINANCIALLY AUGMENTED DEVELOPMENT
A suggested interpretation of the development pattern, as
viewed from a system dynamic perspective, begins with the positive
loops associated with capital accumulation in the capital and
resource sectors. Following the basic model structure of N. Forrester's
"life cycle of economic development,” (1973), financial deepening may
be seen as a factor that reduces the fraction of labor time that is
nonproductive. The relation between the fraction of labor time non-
productive and the need for additional nonproductive time is deter-
mined to be negative. As the fraction of labor time nonproductive
increases, there are diminishing returns to nonproductive time. If
the fraction of labor time nonproductive only allows eating and
sleeping, then the need for additional nonproductive time is very
high. Reducing the fraction of labor time which is nonproductive
may be accomplished through a technological innovation. Lopez
(1982) argues that financial intermediation follows the sequential
process of technological innovation, which involves introduction,
diffusion, and institutionalization. Financial intermediation is
introduced into the Forrester development life cycle model in
the service sector and the demographic sector. Thereby the
innovations which constitute financial deepening may augment
the development process. The flow diagram (FIGURE 1) identifies
the relations of desired expenditures.
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FIGURE 2: FINANCIAL DEEPENING AND FINANCIAL REPRESSION CAUSAL LOOPS
SOCIAL PRESSURE
TO RETARD CHANGE
DEGREE OF
OLIGARCHY
AND GOVERNMENT
REGULATIONS
DEGREE OF
SELF-FINANCE
AND BARTER
INDEX OF
FINANCIAL
DEEPENING
DIFFUSION
oF
INNOVATION
INNOVATION
(+) \ nrropucTiON
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FINANCIAL DEEPENING VS FINANCIAL REPRESSION
Financia] deepening can be a positive source of economic develop-
ment as long as the constraint of financial repression is weak or removed.
FIGURE 2 represents the systems behavior used to introduce the dynamic
effects of financial deepening into the Forrester model. The Index of
Financial Deepening (IFD) is a level which is controlled by two rates, the
Rate of Institutional Adoption (RIA) and the Rate of Rejection (RFR).
RIA may operate to accelerate IFD or it may be turned off through the
feedback from the Propensity for Financial Repression (PFFR). The
information auxiliary, PFFR, is linked to the capital, service, and
demographic sectors and acts as a controling mechanism on the RFR,
the RIA, and the auxiliary Innovation Introduction (I).
PFFR is the key to understanding the switch in the direction of
causation. Index of Economic Development (IED) is an accumulation
process which is part of the positive loop linking the technological
innovations in finance through IFD to the service sector of the economy.
The net effect will be to reduce the level of Fraction of Labor Nonpro—
ductive (FLN), augmenting the Rate of Economic Growth (REG). FIGURES
8 & 4 show the main positive and negative feedback loops, with PFFR
playing the role of constraining the poistive loop associated with
financial deepening.
(MODEL STATEMENTS AND REFERENCES AVAILABLE UPON REQUEST)
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FIGURE 3: POSITIVE FINANCIAL DEEPENING/ECONOMIC DEVELOPMENT LOOP
+
{I ADOPTION OF -———~—~——~~»._ INDEX OF
FINANCIAL (+) FINANCIAL )
TECHOLOGY DEEPENING
FRACTION OF
INDEX OF (+) TABOR TIME
ECONOMIC NONPRODUCTIVE
DEVELOPMENT
(+) RATE OF
SN zeonoure
GROWTH
FIGURE 4: NEGATIVE FINANCIAL REPRESSION LOOP
(+)
INDEX OF FRACTION OF
FINANCIAL _-————» LABOR TIME
DEEPENING (-) NonpRopuctive
(-)
BARTER, ETC. (-) —
(+) (-) ECONOMIC
DEVELOPMENT
RATE OF PROPENSITY FOR
FINANCIAL FINANCIAL
REJECTION “-______—_ REPRESSION (+)
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LIFE CYCLE OF ECONOMIC DEVELOPMENT & FINANCIAL D
IFD=F., IED=E, FLN=N, PFFR=R
0.000T 4.750T 9.500T 14.250T 19.000T F
0.00 225.00 450.00 675.00 900.00 E
0.5000 0.6250 0.7500 0.8750 1.0000 N
+ 00500 +12875 +25250 +37625 -50000 R
1900.0 F
1950.0
N
N
2000.0 EF N- - -
BEF N .
EF N .
EF N .
E N .
E N .
E N .
E N .
E N .
«E N .
2050.0 -E- - - - N - -
E N .
-E RN .
-E NR .
-E R .
«—E R .
«iE R .
2100.0 - --E----+--+-+-+--N--F--R------
FR
